When faced with a complex, high-stakes securities claim, corporate and individual insureds may be pleasantly surprised - indeed relieved - when their Directors and Officers Liability ("D&O") insurer agrees to meet its defense and indemnity obligations rather than deny coverage or rescind the policy. Individual insureds and their counsel, however, must take care that the benefits offered by the insurer do not come at too high a price.
The insurer often will expect the corporate and individual insureds to execute an Interim Funding Agreement ("IFA") in exchange for advancing defense costs. An IFA may specify that all insureds agree to reimburse the insurer for such defense costs in the event that the insurer ultimately obtains a determination that it had no obligation to advance them. Eager to secure funding for defense costs, the insureds may not object to the terms by which the insurer confirms its right to reimbursement. Most D&O policies do not explicitly require the insured to execute an IFA. Thus, it may be improper for the insurer to demand that the insured execute a new contract to obtain the benefits that the D&O policy already provides.
When an insurer agrees to fund settlement under a reservation of rights, or final funding agreement ("FFA"), the insureds may be so eager to conclude the litigation that they unwittingly allow the insurer to reserve more rights than the policy provides. If an insurer demands that an FFA be executed in connection with the funding of a settlement (a condition sanctioned by California law even if not specified by the policy), or if the policy requires an IFA, the agreement should be limited to what is required by the policy or applicable law. It should also be executed only by the insured(s) actually receiving the benefits of the policy.
Generally, an individual director or officer should agree to execute an IFA or FFA only when the corporation is unable or unwilling to fulfill its contractual or statutory indemnification obligations to its directors and officers. The corporation should enter into such an agreement only after confirming that the proposed agreement does not grant the insurer broader rights than those in the policy.
If the corporation can indemnify its directors and officers, the insurer's rights and obligations under the D&O policy are governed by that portion of the policy (typically called "Coverage B") that provides coverage for the corporation's contractual and statutory obligations to indemnify its directors and officers. Under Coverage B, the corporation is the insured, rather than the individual director or officer. The corporation receives the benefits of the insurance, namely coverage for its indemnification obligations. Thus, the corporation, not the individual insured, is responsible for reimbursement of defense and settlement costs if the insurer ultimately establishes that there is no coverage for the claim.
Individual directors or officers may feel pressure to sign a funding agreement. For example, the company does not want its balance sheet harmed by the indemnification obligations, nor does it want cash flow problems created when it must pay defense bills up-front, then wait for reimbursement. It also wants to ensure that a settlement is promptly funded. An individual may be told that an IFA is the equivalent of the undertaking which the company requires in connection with advancement of defense costs under his or her indemnification agreement with the company, i.e., "if you have to sign an undertaking, why not go ahead and sign an IFA instead?"
Once the individual allows the company and the insurer to circumvent the protections he or she receives from the D&O policy and the corporate indemnification agreement, however, the individual's chance of an unreimbursed exposure increases. For example, the insurer may rely on an unfavorable finding in the underlying action to seek reimbursement. Or it may seek to rescind the policy as to all insureds based on the conduct or knowledge of one "guilty" insured that is imputed to all. Often the indemnification agreement with the company may provide protection to the individual for what are now uninsured exposures. But in the meantime, the once solvent corporation may have become insolvent, rendering the indemnification rights valueless. Or a change in control may mean that new management will not honor the new arrangement without extensive effort, or even litigation.
Even if a funding agreement is warranted, it should not give the insurer any rights not found in the policy. The policy may not clearly address the insurer's right to reimbursement of defense costs, allowing the insured to argue that the right in fact does not exist. An IFA can close this loophole. Or an IFA may impose joint liability for defense costs incurred on behalf of all insureds, even the corporation, while the policy specifies that the insureds are sever-ally liable. An FFA may provide that all insureds are jointly liable for reimbursement of an uncovered settlement, even if one or more insureds otherwise could have argued that only a small portion of the settlement, if any, is based upon their liability.
Usually these concerns never materialize into actual exposures. Often the insurer decides not to pursue its rights, or it settles with the corporation. But when the insurer does pursue its reimbursement rights, an individual insured - particularly one with significant assets - can face serious liability that would have been avoided by careful review of an IFA or FFA, or by refusing to execute one.
Mary E. McCutcheon heads Farella Braun + Martel’s Insurance Coverage Group and represents corporations, public entities and individuals in coverage issues arising out of a variety of lawsuits, including securities fraud and insurer rescission actions, intellectual property, civil rights, employment, aviation and other forms of products liability, environmental and construction litigation.
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.
