Canada: Are You Covered?

D&O Insurance and Corporate Indemnities May Not Be the Safety Nets that Directors and Officers Expect

A sea change in laws, corporate governance standards and attitudes of institutional investors has dramatically increased the personal risk for directors and officers. Although suitable compliance programs will reduce the risk, bad things happen to good people—and good people need considerable resources to defend themselves.

So we are advising clients to scrutinize their D&O insurance and corporate indemnity coverages. These coverages have been tested in recent years, and major weaknesses exposed. In today’s environment, directors and officers should not assume that they are adequately covered; nor should they, without careful assessment, rely on general assurances that they have adequate protection.

This advisory outlines the main issues that directors and officers should consider, in consultation with their advisers, to ensure that the safety nets are there if they need them.

You should ensure that the insurance policy is reviewed carefully before your company accepts it. This sounds obvious, but the usual practice is to rely on "bound" insurance coverage well before the actual policy is available. And even after the policy is provided, it is typically not reviewed in detail by management or counsel. But when claims arise, insurers rely on the actual wording of the policy. You can and should insist that your company begin the process of obtaining insurance or renewing your current coverage so that there is sufficient time to review and negotiate the policy terms before they are accepted.

Conflicts may arise when an insurance broker is asked to develop a single policy that attempts to respond to the differing interests of different insureds (such as the company, management and independent directors). A policy that on its face appears to protect the interest of different insureds may fail to do so, in some circumstances.

Like any supplier, D&O insurers differ in their approach to underwriting coverage and assessing claims. While you must be aware of your insurer’s solvency and financial strength, you should also understand what your insurer’s approach will be when claims are made.

You should be satisfied that the maximum coverage under the policy (and related policies) is sufficient. Often, you can obtain comfort by comparing the limits of your policy with those of appropriate reference organizations. Benchmarking information, however, must be used with caution because it can be a year out of date (it may be drawn from prior years’ reported purchases). Furthermore, benchmarking information may fail to take into account significant changes in exposure (such as Ontario’s new law on liability for corporate disclosure). You should also consider the sufficiency of any sublimits in the policy for particular types of claims (for example, environmental claims, employee liabilities and defence costs).

Special situations (such as regulatory investigations, proxy battles, privatizations, hostile bids and restatements of financial statements) may change the picture of risk. While you generally cannot buy insurance "while the house is on fire," you should reconsider your insurance objectives and coverage when special situations arise because different or additional coverage may be available.

Have you considered the "deductible" or "retention" under the policy—that is, the amount your company may have to fund before the insurer is required to pay? In what circumstances will that deductible be required? Will an individual director be subject to the deductible if he or she claims directly on the policy (for instance, when the company is insolvent)?

You can make choices about your D&O coverage. Each choice will create a different picture of risk and will have its own cost implications. And different people in your company may have different views about the choices. You should ensure that the policy strikes the right balance for you and for your company in what is and is not covered—and you should understand the benefits and costs of achieving that balance.

Key defined terms in the policy are "claims", "loss", "wrongful act" and "insured". The broader the definitions of these terms, the more coverage you have. But increased coverage also means that the policy limits can be reached in more ways. For example, policy limits can be exhausted in funding defence costs for executives who have been accused of wrongdoing, well before liability claims against the directors have been established and paid—at which time there may be no or only limited insurance coverage left.

Defence costs can be enormous. Ensure that your policy will pay defence costs as they are incurred, so that you do not have to fund your own defence costs and wait for reimbursement until the matter is resolved. Ensure that an insurer’s mere allegation that a director has engaged in misconduct—and thus be outside the coverage—does not postpone payment. Insist on final adjudication by a court or an arbitrator before the insurer has this defence.

Policies typically deal with allocation issues. They can, for example, set out rules governing the percentage to be paid by the insurer if a claim includes an insured and an uninsured component, or involves one party covered by insurance and one not covered (the company itself is often not an insured party). Percentages can be determined by litigation, arbitration or pre-set allocation rules. Each approach has advantages and disadvantages.

Policies might not cover the professional liability of the general counsel (and other lawyers) or the CFO (and other accountants) for incidental professional services liability. This kind of coverage can often be obtained in the negotiations, at no or little additional cost.

"Side C coverage" (entity coverage) is insurance for the company for its own liability for wrongful acts. There is likely to be increased interest in this coverage because Ontario’s new law on liability for corporate disclosure increases the likelihood of shareholder class action lawsuits against the company for disclosure violations. But the inclusion of Side C coverage puts pressure on the coverage available for directors and officers (called "Side A" or "Side B" coverage) when they need it the most—because the aggregate policy limits can be reached by claims under the Side C coverage. Furthermore, Side C coverage may impair the protection available to directors and officers if the company goes bankrupt. You should consider whether separate coverage for the directors would be desirable (for instance, through severable Side A difference-in-conditions coverage).

Insurers can cancel the policy if there is a "misrepresentation" in the insurance application. Misrepresentations can be innocently, negligently or fraudulently made and can occur, for example, in company financial statements that later must be restated. Directors and officers who are not directly involved in preparing the insurance applications can obtain severability rights, so that cancellation of the policy as a result of a misrepresentation does not terminate their coverage. It is also important to understand the extent to which any misrepresentation may be held against a non-involved director or officer (since this determines the level of independent due diligence that you must conduct).

Many policies are cancellable at any time during their term on notice by the insurer. Cancellation could occur at a time when it might be difficult or expensive to replace the insurance. The insurer’s right to cancel can often be removed through negotiation.

D&O insurance policies are usually valid for one year on a "claims-made" basis. This means that all claims must be made during the currency of the policy. Often, however, claims do not come to light until after the expiry of a particular policy. Thus, it is important to ensure that coverage continues under a new policy, and that you can make claims after expiry of the previous policy. Some carriers permit claims to be made for up to 60 days after the expiry of the policy for no additional premium.

In addition, "run-off insurance", which covers claims for an extended period (such as six years) after the expiry of your policy, can also be negotiated when your policy is put in place.

It may be prudent to give notice of potential claims (even if formal claims have not yet been made) before coverage expires under an existing policy.

If there is a risk that your company will not maintain its D&O insurance, it may be important for you to obtain adequate assurance that D&O insurance will be put in place by others or for you to obtain your own insurance. This is a particular risk if your company becomes insolvent or is acquired by a third party.

Companies typically provide indemnities to their directors and officers through by-laws and contractual indemnities. Of course, these are only as good as the solvency of the company. In addition, indemnities have traditionally been drafted in somewhat basic terms that fail to deal with issues that can be contentious. These issues include advancing defence costs as they are incurred, reimbursing out-of-pocket or the time costs of litigation or investigations, and obligating your company to maintain D&O coverage. As with insurance, you should be familiar with the coverage that your corporate indemnities provide.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.