Directors and officers still reeling from the fate of their counterparts at Enron and WorldCom—who saw millions in personal assets seized after corporate scandals engulfed their companies—are increasingly paying close attention to whether they have sufficient D&O insurance to protect them from similar financial doom.
The spate of “very large corporate scandals, and the realization by individual officers and directors who are directly or indirectly implicated as to the potential financial consequences of these claims,” has heightened interest in D&O insurance, says Donald Kiel, a partner with Kirkpatrick & Lockhart Nicholson Graham in Newark, N.J.
Of particular concern are directors and officers who “are really innocent” with respect to the underlying fraud, but who nevertheless face considerable personal financial exposure in the current regulatory climate, notes Kiel. That’s because liability has dramatically changed as a result of The Sarbanes-Oxley Act of 2002, which not only altered corporate cultures, but altered the potential for liability among directors. “The job of the director is no longer a free ride,” says Kiel. “The responsibility of a director is taken very seriously by the SEC.”
According to Thomas Bentz Jr., a lawyer with Holland & Knight in Washington, D.C., Enron and WorldCom were “a wake-up call” for directors and officers who weren’t used to having their personal assets targeted. And as a result, many directors now “will insist on certain types of [insurance] coverage before they will agree to serve.”
Gordon Davenport III, a partner in the Madison, Wis., office of the law firm Foley & Lardner, told Compliance Week that increasingly directors are asking for “some sort of outside review of the D&O program—by a broker or some sort of insurance consultant or outside counsel.” Directors might ask the company to hire an attorney to do a review of the policy, he adds, noting that it’s critical for lawyers to get involved in the process early. “It’s very important that you have a lawyer who has knowledge of this specific field [and] not just rely on the brokers,” says Davenport. “Some brokers are better than others. Frequently they don’t do a good job making sure you have the broadest possible coverage terms. It’s critical to have it looked at by someone else, someone not working on a commission.”
D&O insurance policies come in several different forms:
Side A coverage directly reimburses directors and officers for their personal liability arising from the performance of their duties;
Side B coverage reimburses the corporation if it was required to indemnify its directors and officers for their personal liability;
Side C coverage reimburses the company for its own liability, rather than for the liability of its directors and officers (for most public companies, this coverage is limited to securities claims).
There is “no magic formula” for determining how much coverage is enough, says Kiel at Kirkpatrick & Lockhart Nicholson Graham. “It really becomes a question of how [much of] a stomach the board members have for taking on risks,” he says. “A lot of stomachs are getting weaker and weaker as they read the stories coming out in the press. It really becomes an evaluation of how much risk you’re prepared to take, how much security you’re going to have when your head hits the pillow.”
In today’s marketplace, “the policyholder has a bit more negotiating power,” says Kiel, who notes that experienced lawyers can sometimes negotiate much more favorable terms than insurers might otherwise be inclined to offer.
“These policies are highly negotiable and need to be negotiated,” agrees Bentz at Holland & Knight.
One of the key issues that must be considered is rescission—the ability of the insurer to rescind coverage on the grounds that the company failed to make full disclosure in applying for the policy. This frequently happens when a corporation restates its financials.
Directors and officers can be protected from rescission if the policy has a severability clause, which provides that a misstatement in the application is not imputed to the innocent director.
“If you have a severability provision in your policy, you may protect the coverage of directors who are innocent—who had no knowledge of the bad information in the financial statements,” says Davenport at Foley & Lardner. “Those who knew about the misinformation are going to lose their coverage, but those who didn’t are not going to lose their coverage.”
Kiel notes that, unless you ask for severability language, most insurance companies don’t include it. “You’ve got to be willing to ask the hard questions of the underwriters if you want to craft your coverage as broad as you can get it.”
All Over The Map
The wording and nature of coverage exclusions are also essential considerations. “There are tons of coverage issues,” says Bentz, noting that one sensitive area is the “insured vs. insured” exclusion, which bars coverage if a director sues another director or the company sues a director. This exclusion is a problem in the bankruptcy context because the bankruptcy trustee often sues directors on behalf of the corporation. “You need to negotiate a carve-back [to ensure] that the insured vs. insured exclusion will not exclude [claims filed by] the bankruptcy trustee,” he says.
A corporate bankruptcy filing can also make it difficult for directors and officers “to tap into the proceeds of the [D&O] policy,” says Davenport, noting that the problem can be avoided by including in the policy a provision waiving the automatic stay.
Although intentional wrongdoing by individuals is almost always excluded, directors and officers can protect themselves by making clear that a court finding is necessary to trigger the exclusion, Kiel says.
Ensuring that there is coverage for SEC investigations is also important, says Davenport. “D&O policies vary all over the map on whether or not they cover that,” he says. “Sometimes they will cover formal SEC enforcement proceedings, but won’t cover investigations. Sometimes they won’t cover anything at all that falls short of a lawsuit. It’s a difficult point to negotiate, but one that needs to be looked at—you need to negotiate it hard.”
Davenport says that a “hot trend” is for companies to purchase additional Side A coverage. “Most D&O policies cover not only the officers and directors but also the corporate entity itself. … Having entity coverage included in the policy can have some problems—claims against the company may be bigger in amount than the amount of insurance available. You can have all the coverage eaten up. A layer of Side A-only coverage applies only to the officers and directors, sometimes only to the directors.”
Because D&O policies tend to have very high limits and the claims made under them are often big-dollar ones, “virtually always the D&O insurer comes up with a laundry list of reasons the claim is not covered,” says Kiel. “If you bring in knowledgeable counsel who knows what that laundry list often consists of, you’re better able to identify the issues and to negotiate improved language.”