United States: Key Issues In Evaluating And Negotiating D&O Insurance Coverage

Last Updated: June 18 2014
Article by Stephen D. Allred

I. INTRODUCTION

Over the last decade directors and officers of public and private companies have increasingly become targets in civil litigation, government investigations, and enforcement actions. In today's claims and regulatory environment—with civil actions of many stripes often naming individual directors and officers as defendants and stepped up enforcement activity by the SEC and Department of Justice—directors and officers are sharply aware that their personal assets may be at risk whenever events occur in the life of their company that could make shareholders, customers, employees, or regulators unhappy, or could otherwise fetch the attention of plaintiffs' lawyers.

Because of the increasing risk to their personal assets, directors and officers are more frequently calling on outside and inhouse counsel to evaluate the adequacy of their company's D&O insurance, looking for assurances that their coverage is as broad as possible with limits sufficient to protect them. This is a challenging task for an attorney because D&O policies are densely written and complex, filled with turgid terms, exclusions, and conditions that must be weighed to evaluate possible shortfalls in coverage. In addition, a client's D&O insurance program will often consist of a primary policy and multiple excess policies (including different types of excess policies) which are frequently issued by many different insurers, often resulting in a crazy quilt of different contract forms. Also, D&O policies are intended to (or at least should) mesh with both the company's indemnification obligations to its officers and directors and the company's other liability insurance policies—further complicating efforts to take comprehensive stock of the client's coverage.

In approaching the task of assessing D&O coverage, it is important to recognize that D&O policies are not issued on standard forms and the coverage extended under D&O policies can differ in many game-changing ways. While most D&O policies follow the same basic structure and have common traits, insurance companies typically develop and use their own policy forms; there are many differences in the specific terms offered by primary and excess insurers in the market. Seemingly minor differences in policy language can make a big difference in whether directors and officers have the coverage they expect when a claim arrives.

Additionally, there is a range of difference in the willingness of insurers to negotiate policy terms. Depending on the insurer, the nature of the client's business, the risk tolerance and premium tolerance of the client—among other factors—many D&O policy terms are subject to negotiation. In any event, you don't know whether a term is negotiable until you ask, and it is difficult to ask until you know what to ask for.

The purpose of this article is to identify and discuss some of the key policy terms to review and other issues to assess in evaluating a company's D&O coverage and in negotiating D&O policies.

II. THRESHOLD PRACTICAL CONSIDERATIONS FOR D&O POLICY NEGOTIATIONS

Before discussing the details of D&O policies and key terms to evaluate in policy negotiations, there are a few front-end tips to consider in approaching the task.

The broker's role. The services of an experienced and well informed insurance broker are absolutely vital in negotiating and procuring D&O coverage. Brokers who have experience placing D&O policies should know what insurers are willing to offer and at what price, and how far one might be able to push insurers in negotiations over terms and price in light of the dynamics of the current D&O market. The lawyer's job in evaluating and assisting in the negotiation of D&O policy terms differs substantially from the broker's job. The broker typically interfaces directly with the insurers to obtain policy proposals and, if she is doing her job, proactively pushing for coverage enhancements. A lawyer should not try to take on the broker's job because it would be hazardous to the client and the lawyer.

It is best if counsel works with broker and client together to identify the client's goals and needs in obtaining D&O coverage and assess the current policy terms and the terms that can be negotiated at renewal, comparing different proposal by different insurers. A good broker will have a better understanding of the terms that are available in the market and the intent behind those terms. Counsel is usually in a better position to evaluate how policy terms have been, or will be, applied and interpreted by the courts, and where there are gaps between expectations regarding coverage and how the policy terms will actually play out when coverage disputes arise.

The timing of policy negotiations and the parties involved in the process. For policy and renewal negotiations to be successful, counsel should encourage clients to start the process early to provide plenty of time to evaluate current coverage, identify gaps or concerns in coverage, assess the client's current liability exposures (taking into account any business plans that might impact liability risks), and then give the broker enough time to negotiate with several insurers to obtain the most favorable prices, terms, and coverage enhancements available. This process can take months, not weeks or days. An insurer who knows that the expiration date on the client's current D&O policy is imminent will be much less motivated to engage in negotiations over coverage enhancements.

Counsel should also identify the executives and divisions of the company that should play a role in assessing risk exposures and identifying D&O coverage needs and goals. The risk management department frequently has primary responsibility for D&O policy negotiations and procurement, but many other officers and executives have responsibilities related to the D&O coverage and are constituents of the D&O policy. For example, the general counsel or the company's in-house legal department may need to be involved in addition to other executives who have to report to the board regarding the company's coverage. This is another reason to stress that ample time should be allocated for the D&O negotiation and placement process, so that all of the key players are provided more than a last minute opportunity to ask questions and raise concerns about the D&O coverage and the risks of liability that are of greatest concern for the company and its officers and directors.

III. COMMON FEATURES OF D&O COVERAGE

A. The Kinship between D&O Insurance and Corporate Indemnification of the Directors and Officers

D&O insurance is chiefly intended to protect directors and officers from personal liability arising from their work for the companies they serve by providing them with coverage for defense costs, settlements, and judgments for claims asserted against them. Even when a corporation broadly agrees to indemnify its officers and directors, there will be times when the company is not financially able or legally permitted to advance defense costs or fund indemnification. For example, under many states' laws, corporations are not permitted to indemnify executives for shareholder derivative actions or for liability due to the individual's breach of the duty of good faith. As another example, the SEC has long taken the position that it is against public policy for a corporation to indemnify directors and officers for violating the registration and anti-fraud provisions under the Securities Act of 1933.

D&O insurance is often viewed as filling in the gaps where advancement of defense costs or indemnification by the company is unavailable. Accordingly, D&O insurance should be structured to insure individual directors and officers when the company cannot or will not indemnify them due to insolvency, legal restrictions, or for other reasons. To achieve this and to guard against gaps occurring in the D&O coverage, the D&O policy should be evaluated in connection with the mandatory and permissive rights of advancement of defense expenses and indemnification that the company extends to company executives through its charter and other governing documents or indemnity agreements.

Be aware of "presumptive indemnification" provisions. There are a number of places in a D&O policy where a company's indemnity obligations to its officers and directors intersect with the policy terms. For example, many D&O policies include a "presumptive indemnification" clause that could determine whether an individual director or officer must personally pay the self-insured retention before she can access coverage under the policy.

Most companies buy D&O policies with a large self-insured retention, ranging from thousands to millions of dollars depending on the size of the company and other factors. The retention must be paid by the company before the policy will indemnify the company for losses, but the retention typically does not apply to coverage extended directly to individual directors and officers for losses that are not indemnified by the company—such that the insured individual is not required to pay the retention as a condition of obtaining coverage for losses the company does not indemnify.

However, if the policy contains a "presumptive indemnification" clause, the policy will generally provide that if the insured company is legally permitted to indemnify a director or officer but fails to do so for reasons other than insolvency, then the individual insured will have to pay the full retention from her own pocket before the insurer is obligated to step in and provide coverage. This term builds a presumption into the policy that the company will indemnify its officers and directors to the fullest extent permitted under governing law. This term is designed to guard against the risk to the insurer that the insured company will elect not to indemnify officers and directors to force the insurer to indemnify them. Unless the individual insured has the financial resources to pay the large retention, a presumptive indemnification term could effectively bar an individual insured from gaining access to D&O insurance.

Even if an insurer refuses to remove a presumptive indemnification provision from the policy, there are ways to eliminate the risk that an individual executive will have to personally pay a huge retention. (See the discussion below regarding the "drop down" coverage provided by "Side Aonly excess DIC policies.") But one way to address this risk is to try to ensure that the terms of the company's D&O policies align with the indemnification provisions in the company's charter documents and indemnity contracts.

B. The Many Sides of D&O Coverage.

Almost every D&O policy provides liability coverage to individual officers and directors for losses resulting from claims made against them arising from wrongful acts in connection with their role and responsibilities as executives for the company. D&O policies also usually provide coverage to the insured company for certain types of losses and claims, although the extent and nature of the insured entity's coverage can vary substantially.

The ABC's of Coverage. D&O policies typically include several different insuring agreements, often referred to as Side-A, Side-B, and Side-C coverage. While this naming convention is a bit obtuse, it is useful to understand the ABC's of D&O coverage grants because these terms are routinely used in D&O policies and by brokers discussing the core terms of coverage.

Side-A coverage (or Insuring Clause 1) – The Side A coverage grant insures individual directors and officers against losses that the company is not legally or financially able to indemnify, often referred to as insurance for directors' and officers' "non-indemnifiable losses." This coverage protects the personal assets of directors and officers in the event the company does not pay defense costs or fund indemnification.

Side-B coverage (or Insuring Clause 2) – This coverage provides the company with balance sheet protection by agreeing to reimburse the company if it advances legal fees to officers or directors or indemnifies them against losses.

Side C coverage or "entity coverage" (Insuring Clause 3) – This coverage provides insurance directly to the insured company for certain types of claims. In policies issued to public companies, Coverage C is almost always limited insurance for "Securities Claims" — claims based on state or federal securities laws. In D&O policies issued to private companies, the entity coverage (sometimes referred to as "management liability coverage") often applies broadly to a wide range of claims against the company arising from wrongful acts by the insured company or its officers or directors.

Other Insuring Agreements – Many D&O policies extend other types of entity coverage to the company. For instance, it is fairly common to see policies include an insuring agreement (Side D) that provides a company with separate coverage for costs incurred in connection with internal investigations incurred in response to a shareholder derivative claim. Such coverage is typically subject to a "sub-limit" that is often insufficient to cover the likely costs of such investigations. Thus, a company with a D&O policy that carries a $10 million limit of liability may provide a sub-limit of $250,000 for corporate investigations in response to a demand from an unhappy shareholder.

When a policy contains an insuring agreement that is subject to a reduced sub-limit of insurance for entity coverage extended to the insured company, counsel should evaluate whether the additional insuring agreement is a backhanded effort to impose a lower limit of liability on certain types of claims, expenses, or losses that might otherwise be covered under the policy without being subject to a reduced limit of liability. Additionally, counsel should keep in mind that any additional coverage extended to the insured company can exhaust the limits that would otherwise be available for directors and officers. Also note that an insuring agreement subject to a sub-limit typically does not increase the total limits of liability under the policy, meaning that (using the example discussed above regarding the derivative claim) if $250,000 is incurred for an internal investigation, the $10 million in limits will be eroded by those covered expenses.

To read this article in full, please click here.

Originally published in Notes Bearing Interest by North Carolina Bar Association.

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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