Audit committees have many concerns to worry about, yes, but one very prosaic matter trumps all the others: that the directors themselves have enough insurance to insulate them from lawsuits.
Yes, directors all know the three basic elements of directors-and-officers insurance. So-called “Side C coverage” protects the company in the event of securities litigation; Side B coverage reimburses the company for money spent to indemnify a director or officer; and Side A coverage applies when the company can’t (or won’t) indemnify a director or officer. But that’s just the framework of coverage available to boards; applying those types of coverage to your specific company, with its specific risks and board members overseeing them, can be considerably more complicated.
Experts can list plenty of reasons why directors should pay closer attention and ask more questions the next time the issue comes up for discussion; foremost is the increased desire to hold individuals personally accountable for corporate misconduct. That has made board directors (both on and off the audit committee) the targets of regulatory enforcement and shareholder lawsuits.
“Director and officer exposure, both on the civil and criminal side, is expanding,” says Aidan McCormack, a litigation partner with DLA Piper who handles D&O insurance and reinsurance exposure. “There’s a clear and increasing tendency on the part of legislatures around the world to make directors personally liable for breaches of their duties.”
Combine that sentiment with the turbulent economy (which increases the chance of a company going insolvent or otherwise being unable to indemnify directors), and the rising cost of defending a claim, and suddenly the particulars of your D&O insurance become all the more important.
Rosenberg
“Just because you have a policy doesn’t mean it’s up-to-date or the best fit,” says Carolyn Rosenberg, a partner in the law firm Reed Smith who advises corporations, directors, and officers on insurance coverage. “What you buy, and how much, is a business judgment of the company that’s based on a variety of factors.” Those factors include the company’s past experience with litigation and claims, as well as its future activities, such as mergers or acquisitions or international expansion plans.
Boards should review D&O policies annually, since the D&O marketplace, litigation trends, the regulatory landscape, and a company’s exposures—which can all affect the amount and type of coverage needed—can fluctuate with little notice.
Godes
“Audit committees should look carefully at their coverage on a yearly basis, before their renewal, when they’ll have the most leverage to negotiate changes,” says Scott Godes, counsel in the insurance coverage practice at law firm Dickstein Shapiro. “The market changes frequently in terms of what you can get for your money in limits, coverage, and exclusions.”
What to Ask
One consideration is whether non-executive directors should have their own separate limit of liability that doesn’t cover executive directors or officers. Yes, most companies today purchase Side A coverage for directors (to protect directors individually, regardless of the company’s coverage), but if a major issue does arise, there’s a risk that the overall policy limits—which include Side B and Side C coverage—could be exhausted defending claims against company executives. That would leave directors with no coverage, fending for themselves. Separate policies for independent directors “can avoid having the directors and officers scrapping for what’s left of a limited tower of coverage,” McCormack says.
‘Just because you have a policy doesn’t mean it’s up-to-date or the best fit.’
—Carolyn Rosenberg,
Partner,
Reed Smith
Coverage limits can be particularly troublesome if a company files for bankruptcy, when there are likely to be multiple claims that can deplete the available policy limits. That is precisely what happened during the bankruptcies of auto parts supplier Collins & Aikman and shoe retailer Just for Feet, notes Kevin LaCroix, a director with OakBridge Insurance Services and author of the blog D&O Diary.
LaCroix says outside directors “should at least ask if they would be better served if there’s a separate pool of money with their name on it.” But, he adds, that conversation rarely happens because the insurance purchase is managed by company executives, and their motive is to reduce costs.
Directors should also carefully review how a policy defines a “claim.” That wording is critical, since it dictates what’s covered—an issue that’s often the subject of intense debate between insurers and directors when a problem finally explodes. For example a claim could (or could not) include lawyers’ fees related to a regulatory action, such as an informal investigation, a document request, or a grand jury subpoena.
Depending on the policy language, even if a director or officer is accused of fraud and the company won’t indemnify him, Rosenberg says, “They may still have D&O coverage, if there hasn’t been a final adjudication that they committed fraud.”
And while many policies say they won’t cover a fine or penalty, there can be exceptions, such as penalties imposed under the Sarbanes-Oxley Act or the Foreign Corrupt Practices Act, Rosenberg says. “You have to unpack the language and see what exceptions to an exclusion exist or can be negotiated,” she says.
McCormack
Next question to ask: Who is actually covered under the policy. “It sounds simple, but with expanding exposure, it can be a problem,” McCormack says. “It’s likely all current directors and officers are covered, but is the general counsel covered? Is the compliance officer covered? What about past directors and officers? Those often are ones who slip through the cracks.”
ORDER AND OPINION
Below is an excerpt from the decision in Comerica v. Zurich American Insurance:
Plaintiff Comerica, a financial services corporation (i.e., bank), entered into a settlement of five securities fraud class action lawsuits (which had been consolidated into two actions) for $21 million. Comerica’s primary insurance carrier, Federal Insurance Company—which disputed coverage on at least some of the claims on various grounds and whose policy carried a $20-million limit of liability—ultimately agreed to pay $14 million toward the settlement, leaving Comerica to pay the other $7 million, which it did. Defendant Zurich American Insurance Company wrote a following form excess insurance policy that was triggered “after all such ‘Underlying Insurance’ has been reduced or exhausted by payments for losses.” Comerica sought $1 million plus costs of defense ($2.6 million) from defendant Zurich under the excess policy in connection with the class action settlements. Zurich refused to pay on the grounds that the primary coverage had not been exhausted, and it did not believe that damages paid pursuant to section 11 of the Securities Act of 1933 were covered by the primary policy or the excess policy. Comerica brought suit against Zurich for payment under the excess policy, and the matter is presently before the Court on cross motions for summary judgment. Zurich seek dismissal of the case in its motion on the ground that coverage has not been triggered by exhaustion of the liability limits on the Federal policy. Comerica disputes that argument, and it moves for partial summary judgment in its original and amended motions seeking a determination that section 11 damages are covered. The Court heard the parties’ arguments in open court on January 8, 2007, and now finds that the plain language of the excess policy issued by Zurich requires exhaustion of the primary insurance’s liability limits by actual payment of losses by the primary insurer before the excess policy is triggered. Since Federal’s $20 million liability limit was not exhausted by payment of $14 million on the claim by Federal, Zurich has no obligation to Comerica under the excess policy. Therefore, the defendant’s motion for summary judgment will be granted and the plaintiff’s motions for partial summary judgment will be denied.
Source
Opinion in Comerica v. Zurich American Insurance (July 27, 2007).
McCormack’s examples not just theoretical any more, either. As recently as earlier this month, when the Securities and Exchange Commission settled its fraud charges with Goldman Sachs, one stipulation was that Goldman’s chief compliance officer and chief legal officer will certify that the Wall Street powerhouse is in compliance with the SEC settlement. Provisions like that are what expose lower-level executives to D&O types of risk.
Since most companies purchase layers of insurance from more than one carrier, Godes says directors should also check the language in any excess policies they have. Depending on that language, some excess insurers may argue that the limits under the primary D&O policy must be met for coverage from an excess insurer to kick in.
While courts have disagreed on that issue, Godes cites the 2007 case of Comerica v. Zurich American Insurance, where Zurich, Comerica’s first excess D&O carrier, won dismissal of the company’s claim on the ground that coverage hadn’t been triggered under the policy’s plain language, because a $20 million liability limit on the primary policy hadn’t been exhausted.
Comerica had sought $2.6 million from Zurich under its excess policy in connection with the settlement of five securities fraud class action lawsuits, but lost, even though Comerica’s primary insurer paid $14 million toward the $21 million settlement, and Comerica paid the rest.
What’s New
Other recent developments may make it worthwhile for boards to revisit their policy terms and coverage. Rosenberg says boards should look at their existing policy recession clauses, since recent endorsements can prevent insurers from rescinding or voiding coverage for the entire policy.
Additional options for Side A coverage are also available these days, because more insurers have entered that market. LaCroix notes that one carrier (Chartis, the property-casualty insurance arm of AIG) introduced a new D&O insurance form in May that will cover pre-inquiry legal fees, such as attorney fees stemming from an SEC informal document request, which can be costly.
Rosenberg says insurers have recently been willing to add a credit rating trigger endorsement, so that if the insurer’s credit rating falls because of financial difficulties (similar to what happened to AIG), the policyholder can cancel mid-term and get a pro-rated portion of the premium back.
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