Canada: Swiss Cheese D&O Insurance

Originally published in Lexpert Magazine

Directors' and officers' insurance contracts are often riddled with clauses that, while seemingly reasonable and well-intentioned, can lead to bizarre court decisions

PREVIOUS COLUMNS have discussed how directors' and officers' insurance programs are "just contracts." Al-though the exercise may seem surreal, in circumstances in which the actual insurance policies are typically not available for months after they have been purchased, courts apply normal contract interpretation principles to insurance programs, seeking to discern the "intentions of the parties." You must, therefore, insist upon receiving your policy documents and you should read them carefully.

An example of what can happen otherwise is illustrated by "insured vs. insured" clauses, which find their way into virtually every D&O policy form in the first instance. These provisions state that there is no insurance coverage in a lawsuit brought by a person or company potentially insured under the policy against anyone else also named in the policy. The purpose of these clauses is obvious and, at one level, not unworthy: they exist to prevent collusion between insureds who could manufacture disagreements for the purpose of accessing insurance proceeds.

Unfortunately, the clauses have been construed to mean precisely, and fully, what they say, and that can produce strange results. In a recent US case, a former director who resigned to pursue a takeover bid sued his former director colleagues who had taken steps to thwart the bid. Because all parties had been directors at one point, and therefore "insureds" under the policy, there was no coverage.

The effects of the insured vs. insured exclusion are often exacerbated by another common clause, the "major

shareholder exclusion," under which insurance is not available in lawsuits by shareholders holding a specified percentage of the company (typically 10, 20 or 25 per cent).

Most policies contain a number of exceptions to these exclusions and, if they do not, exceptions are usually readily available for the asking, and at no cost. So, for instance, many policies extend coverage to lawsuits by insureds such as trustees in bankruptcy, whistleblowers and suits by the company (derivative suits) despite the plaintiff being an "insured."

But where an exception is not available, there can be serious holes in coverage. Many officers may be protected under the policy, so suits by them are not covered. Suits between feuding directors will not be covered. Suits by shareholders may well not be covered where, for instance, the shareholder is also a director.

This can be particularly problematic in the context of a private company, since these lawsuits are realistically the only things that directors fear. The insured vs. insured problem also puts tension on the breadth of coverage sought in the program: the broader the coverage, the greater the number of individuals covered under the program, but the greater the relevance of the exclusion.

It is important to address the issue. Some insurers will agree to remove the exclusion, or at least to limit it. For instance, it is often possible to have the exclusion limited to claims by the company, leaving coverage available for suits by officers and directors. Sometimes the matter can be addressed through additional insurance coverage, particularly a "difference in conditions" (DIC) policy: DIC policies usually do not contain insured vs. insured or major shareholder exclusions. It may also be possible to limit these exclusions so that defence costs are covered, although substantive liability would not be. The risk to a conscientious director or officer is less losing and paying damages at the end of a lawsuit than it is the costs of defending the suit to the point of exoneration.

If these techniques fail, a remedy may have to be sought outside of insurance programs. In some cases, directors will obtain waivers from parties who might otherwise claim against them. For instance, a majority shareholder/director of a private company could agree with incoming directors that he or she will not sue them, thus eradicating the relevance of insured vs. insured and major shareholder exclusions. Waivers can be given as directors join, but are more frequently the case in the context of runoff insurance, when directors are leaving the company.

In the absence of these solutions, the company can establish a protective trust fund under which a sum of cash is put in escrow for the benefit of the directors. Given that the amount escrowed will not be available to the company, these arrangements are typically established to ensure that funds adequate for defence are available, and they rarely extend to substantive liability coverage.

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.

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