The first decade of the new millennium might be fairly characterized as the decade of high-profile corporate scandals and securities litigations. In 2001, there was Enron. In 2002, Worldcom and IPO Laddering entered the “big-case” lexicon. In 2004, Europe jumped on the bandwagon, adding Parmalat to the list of big corporate scandals. More recently, the subprime/credit crisis and the ponzi schemes orchestrated by the likes of Bernard Madoff and Allen Stanford have dominated the business press and generated numerous lawsuits and regulatory investigations. A common allegation in many of these cases is that certain directors and officers of the defendant company should be held personally liable because they either participated in the alleged fraud themselves or because they failed to act responsibly as gate keepers to protect shareholder value from corporate malfeasance.
Despite the constant reminders of high exposure securities litigation and the resultant personal exposure to directors and officers, many directors and officers still give little attention to the protections that can be provided to them through their company’s Directors and Officers Liability (“D&O”) insurance policies.
The ongoing financial crisis can be expected to give rise to even more such lawsuits — not to mention corporate bankruptcies and the D&O litigation often associated with those events. So it is more important than ever that directors and officers are actively engaged in the discussions and decisions about structuring their company’s D&O insurance programs to ensure that the D&O coverage protects both the financial needs of their companies and their personal financial interests — especially in the event the company cannot honor its indemnification obligations to them.
Discussed below are some key issues that companies and their directors and officers should keep in mind when purchasing D&O coverage.
What Type of D&O Coverage Should We Buy?
D&O coverage is intended to work, in the first instance, in tandem with corporate indemnification provisions, which are generally contained in a company’s by-laws, articles of incorporation, indemnification agreements, or officer employment agreements. All fifty states, by statute, allow corporations to provide indemnification of directors and officers by the corporations they serve. As a general proposition, the corporate entity indemnifies its directors and officers for legal expenses, judgments and settlements these individuals incur in actions and investigations pending against the individuals arising from lawful corporate capacity.
Given that D&O coverage is intended to conform to a corporation’s indemnification obligations to its directors and officers, D&O policies typically contain at least two coverage parts, commonly known as “Side A” and “Side B.” Side A coverage protects the personal assets of the insured directors and officers by providing direct insurance of individual directors and officers when the corporation does not or cannot provide indemnification to its directors and officers. The two most commonly-cited examples of Side A D&O claims are shareholder derivative actions brought against directors and officers suing on behalf of the corporate principal and bankruptcy-related D&O litigation. In the case of shareholder derivative litigation, many states prohibit the corporation from indemnifying its directors and officers for settlements or judgments in such claim because indemnification in such a situation would have a circular result: The corporation would be indemnifying its directors and officers for a settlement or judgment they owe to the corporation itself. In the case of bankruptcy-related D&O litigation, the applicability of indemnification is not the key issue: the issue in these cases is that because the corporate principal is insolvent, it has no funds with which to provide the required indemnification to its directors and officers.
But what about the other ways in which a D&O policy can respond to a claim? Side B coverage provides the company with what is effectively balance sheet protection by reimbursing the corporation when it is required or permitted to indemnify its directors and officers. Some D&O policies also contain "Side C" coverage for loss incurred by the company itself. In the case of publicly-traded companies, the “Side C” coverage typically is limited to claims against the company arising under federal or state securities statutes or under SEC rules and regulations.
Traditional public company D&O policies contain Side A, B, and C coverage with a single aggregate limit of liability, meaning that the policy limit of liability can be reduced — or depleted — through payments of loss under any coverage part. For example, if the full limit of liability is used to defend the company in a securities class action, there would be no remaining limits of liability available for directors or officers who might subsequently be named as defendants in another D&O claim.
To respond to this concern, a number of D&O insurers now offer “Side A only” or “Side A DIC” (i.e., Difference-in-Conditions) D&O policies, with a dedicated limit of liability covering directors and officers when indemnification and standard D&O insurance (i.e., the underlying Side ABC policy with one aggregate limit of liability) may be unavailable to them. As discussed above, the two primary sources of non-indemnifiable Side-A exposures that directors and officers of publicly-traded companies face arise in connection with shareholder derivative actions, and the financial inability of the company to fund its indemnification obligations.
Although “Side A only” and “Side A DIC” D&O policies have been available for a number of years, insureds and insurance brokers historically questioned the need for such policies, particularly given the plentiful and relatively inexpensive coverage limits that could be purchased in a traditional D&O insurance program format providing all three (i.e., Sides A, B and C) coverages. Recent events, including the stock option backdating scandal, the subprime/credit crisis and various ponzi schemes, have caused directors and officers to sit up and take notice of the significant exposure they could personally face if their corporate principal is unable to indemnify them for a lawsuit or investigation if corporate indemnification and underlying D&O insurance proceeds are unavailable to them.
How Much D&O Coverage Should We Buy?
Public company insureds are often advised by their insurance brokers to purchase limits of liability that are, at a minimum, ten percent of the company’s market capitalization. This general rule of thumb is subject to many variables, including the type of business the company engages in; the markets the company operates in; fluctuations in the company’s stock price; and inside stock ownership.
Another key consideration here is the business goal of the D&O program. If the goal of the D&O program is to provide the company with balance sheet protection, the company may want to maximize the limit of liability on a traditional D&O program that contains one aggregate limit of liability for Side A, B and C claims. However, if the goal of the D&O program is to protect the personal assets of the directors and officers and provide “sleep insurance” to these individuals, the company may want to purchase additional “Side A only” or “Side A DIC” limits of liability.
In a perfect world, the D&O insurance program’s total limit of liability would fully respond to both the costs of defense and any settlement or judgment for the most high exposure lawsuits that publicly-traded companies and their directors and officers face: the class action lawsuits brought under the Securities Act of 1933 or the Securities Exchange Act of 1934 (as well as those SEC rules and regulations promulgated in connection with these statutes). If a securities class action survives past the motion to dismiss stage, the electronic discovery costs alone could run in the millions of dollars. With respect to regulatory investigations and proceedings, discovery costs can run in the millions of dollars, even at the very early stages.
Moreover, if the directors and officers each have to engage separate counsel because of potential conflicts of interest, the costs of defense can escalate quickly and exponentially. Even after spending millions of dollars on defense costs, the company and its directors and officers may be faced with an enormous settlement demand or potential judgment. According to a Carpenter Moore (an executive liability risk management services provider) survey of securities class action settlements from 2004 through the first quarter of 2009, the average securities class action settlement was $47.3 million.
Understand the Policy
There is no one-size-fits-all D&O policy. The terms and conditions of a D&O policy, unlike some other types of insurance, are often heavily negotiated. Some of the most common definitions in D&O policies, such as “Insured” or “Claim,” contain subtle differences that may lead to drastically different coverage results. For example, if a non-director or officer of a company is named as a defendant in a lawsuit, the coverage outcome could hinge on whether the definition of an “Insured” includes “all employees” or just “current and former directors and officers.”
As another example, if a governmental or regulatory agency, such as the SEC, initiates an investigation of the company and the company’s directors and officers, the coverage outcome could hinge on whether the definition of “Claim” is triggered by “a formal investigative order” or by a “Wells” notice. The “Wells” notice is the last stage of the SEC’s investigation before the SEC’s Division of Enforcement decides to bring an enforcement proceeding. During the time period between the when the SEC issues a formal order of investigation and its “Wells” notice, insureds can spend millions of dollars in defense costs in responding to the SEC’s broad document requests.
Companies should consult with their insurance brokers and outside counsel to assess whether the proposed terms and conditions of the D&O policy meets their coverage needs. With the increased competition in the D&O marketplace, D&O insurers are often willing to modify and enhance certain terms and conditions of their policy forms.
From the Bar… is designed to present our readers with the views of counsel from outside Eisner LLP. Please visit www.eapdlaw.com for more information on Edwards Angell Palmer & Dodge LLP.