Cases Highlight Dangers In D&O Insurance Gaps

T

hree recent federal court decisions have sent a sharp reminder that corporate directors and officers must all hang together figuratively—or insurers might force them to all hang together legally.

In all three cases, one person’s false statement invalidated director and officer insurance protecting everyone else on the board. The decisions underscore the need for independent directors to scrutinize their D&O insurance coverage, and even hire outside counsel to help them parse their policies if necessary.

MacDonald

“It’s something that should be discussed, given that things are still ill-defined as to how liabilities are going to shake out,” says Robert MacDonald, currently a board member of Minneapolis-based Windsor Financial Group and a director at several insurance companies in his career.

Hiring outside counsel to review D&O insurance coverage is “extremely prudent,” he says. “I would highly recommend… people to explore the option of doing that. The cost relative to the additional layer of protection is so small.”

Peter Gleason, chief operating officer and director of research for the National Association of Corporate Directors, says his organization “always tells directors to have somebody come in and look at the policy, to get an independent assessment.”

That independent evaluation need not be done by a lawyer, says Gleason, whose group helps members get an assessment from a third party who is not a broker. “The review of the terms and scope of policy itself can come from the general counsel,” he says. “If directors are not satisfied, then they can go outside” for legal advice.

Three times a loss

Two of the cases were recently affirmed on appeal in the 9th Circuit Court. The first, Cutter & Buck Inc. v. Genesis Insurance Co., alleged that Cutter’s chief financial officer manipulated sales data to boost revenue. Cutter’s application for D&O insurance contained a revenue-recognition clause requiring the applicant to verify the truth of all statements, and a federal judge in Washington state ruled that the false revenue statements could have influenced Genesis’ decision to provide coverage. As a result, Genesis could cancel coverage for all directors and officers at Cutter, thanks to a severability clause stipulating that a false statement known to the person who signed the application “can be imputed to innocent directors and officers.”

In the second case, Federal Insurance Co. v. Homestore Inc., Homestore renewed its policy with a statement that everything submitted in connection with the application was deemed material to Federal’s decision to issue the policy. Homestore’s CFO, who signed the application, was later charged with and pled guilty to overstating revenue and filing false quarterly reports with the SEC. The company’s 10-Q filings had been submitted as part of the insurance application. A federal judge in California ruled that the plain language of the policy allowed Federal to rescind coverage based on the CFO’s misrepresentations.

The third case, ClearOne Communications Inc. v. Lumbermens Mutual Casualty Co., had Lumbermens trying to rescind an insurance policy based on representations in ClearOne’s financial statements, which had been part of ClearOne’s policy application. The SEC had filed a civil action claiming ClearOne had falsely inflated its revenues, and a federal judge in Utah last year ruled that Lumbermens was within its rights to cancel D&O coverage for all directors and officers, saying, “a company’s financial statements are indicative of its financial health, and therefore generally evaluated by an insurer before issuing a policy.”

Language Is Negotiable

Bonenfant

Mark A. Bonenfant, a partner at law firm Buchalter Nemer in Los Angeles, warns that too often companies “negotiate and renew the D&O policy and just report that to the board.” And while a company generally will try to protect its directors and officers so it can retain good leaders, “the company also has an interest in narrowing costs,” he says. “Independent directors have their own interests here: their assets and liability.”

Directors should also know that D&O policy language can be bargained, Bonefant says. “It’s not boilerplate. When pressed, the insurance company may back down.” He encourages outside directors to have their own lawyers review and negotiate policy language.

Bonenfant suggests that language be included stating that “the application can be construed as a separate application for coverage by each of the insured persons, and that no knowledge possessed by any one insured person will be imputed to another.”

Another pitfall, he says, is the scope of documents incorporated by reference into the policy and the breadth of representations that the application requires. “You want to get that narrowly tailored,” he says.

A third step for directors, according to Bonenfant, is to examine the company’s charter, bylaws and indemnification agreements. “That should always be done on a periodic basis to see how they work with the D&O coverage,” he says. “To the extent the D&O policy is taking something away or limiting something, you can beef up the protection in the charter, bylaws or indemnification agreements.”

The related cases can be found in the box above, right.