Questions Directors Should Ask About Their Company’s Director And Officer Liability Insurance

Recent class action settlements involving payment by outside directors from their personal funds have heightened concerns about the adequacy of director and officer liability insurance coverage. This may appear to be a new issue, but directors have had to pay their own way on many not well-publicized occasions in the past, either because the company on whose board they served had no D&O insurance, because the policy limits were inadequate, or because the insurer denied coverage based on exclusions or sought to rescind the policy for alleged misrepresentations in the application for coverage or accompanying financial information.

Unfortunately, D&O liability insurance is a complicated topic. On top of concerns about recent settlements and adequacy of policy limits, the coverage structure and the risks insured are complex. Moreover, the D&O insurance market changes in response to litigation developments, customer demands and market conditions, with insurers revising their policies to restrict or expand the coverage terms offered or making adjustments to the way in which different insureds are treated.

D&O insurers and brokers are now rushing to offer concerned directors special policies or forms of dedicated excess coverage – using special D&O jargon, such as "Side A," "Difference in condition," "Non-indemnifiable" and "Non-rescindable" – all of which are important concepts but are difficult for directors to understand, retain and use in assessing and making prudent decisions about the adequacy of coverage. Some of these new coverage forms are offered – but to date reportedly seldom purchased – on a stand-alone basis. More often, additional coverage for directors is offered to the Company for purchase as part of its D&O insurance package.

Making arrangements to purchase and maintain adequate D&O insurance, along with other forms of insurance, is the responsibility of management. Management should possess the necessary D&O insurance expertise or have access to expert advice to establish a coordinated program of insurance, indemnification, limitations of liability and risk reduction that will provide the Board maximum protection. Even so, directors cannot rely solely on management, but must look after their own interests and need to understand basic information about their coverage.

So how do you, as an outside director, know that you are in fact adequately insured? And how do you participate meaningfully in the process of protecting yourself?

Those questions should be asked in three separate contexts – first, now, before trouble strikes and while there are opportunities to make changes in coverage. Even if your company has recently purchased or renewed its policy, it is still possible to negotiate and purchase enhancements. And if you discover that the Company is unfortunately unable or unwilling to secure adequate coverage, there may still be time to resign from the Board before problems arise and that coverage is needed.

Second, there are questions that should be raised in the merger and acquisition context, because corporate mergers and acquisitions often have coverage consequences, as well as trigger litigation. Whether your company is the survivor or whether you and your fellow directors will leave the Board, it is important to know what coverage you will have for any shareholder litigation prompted by the transaction, as well as for any claims that might arise in the future.

Third, there are questions you should ask about your coverage when problems and claims do arise or are on the horizon. It is not enough to have a good policy in place. To ensure coverage it is essential that proper notice of claims or potential claims be given to the insurer on a timely basis, and in any case before the policy expires. You need to know how the policy limits will be allocated. There are also questions about whether there are exclusions that might preclude or limit coverage for the particular losses and claims that have arisen. It is in this context that the adequacy of coverage and the "new" issue of who pays for settlements are most acute.

1. Before trouble strikes. What Directors should know about their D&O insurance protection now, before trouble strikes and while there is an opportunity to make any necessary changes to coverage:

• Name of the primary D&O insurance carrier and the Company’s insurance broker. The insurer should be strong, stable and have a good claims record. Also, it is essential today that the broker have extensive experience, if not specialists, in D&O insurance – insist on it! If the Company is purchasing its D&O policy from a nephew of the founder, you may have a serious personal financial problem in your future. Also, if there have been recent changes in insurers or brokers, why?

• Policy limits. What is the dollar amount of insurance coverage, including any excess coverage? Why were those limits chosen and why are they considered adequate? What factors were taken into account? These are some of the most important questions to ask, since policy limits will determine whether there is enough insurance funding to pay a reasonable settlement, and Directors should be persistent in obtaining clear and satisfactory answers. You should be confident that management has made a well-informed and well-considered decision and that there is enough coverage for the risk you are asked to assume.

• Risk areas covered. Do those limits apply only for D&O coverage or does the policy also cover employment liability or fiduciary (ERISA) litigation?

• Who is covered? Is the Company itself (and subsidiaries) insured for its own liability – "Entity Coverage" – and do the Directors share coverage limits with the Company?

• If so, do the Directors’ coverage rights take priority over those of the Company and its subsidiaries? "Order of payments" provisions give priority to individual insureds where there is reason to believe that the limits will not suffice to cover all claims for all insureds.
• Is there additional coverage (so-called "Side A Coverage") just for individual officers and directors with separate policy limits? Any coverage exclusively for outside directors? If so, what kind and how much? If not, there may be good reasons – but what are they?

• Severability and non-rescindable coverage. What happens to the Directors’ coverage if management made misstatements or failed to disclose information in applying for coverage – can the insurer rescind the policy and leave you without any coverage? What about the financial information provided to the insurer – can the insurer rescind if the Company restates its financials after the policy is issued?

• Insurers are seeking to rescind their policies in response to financial restatements with increasing frequency, leaving innocent directors without any coverage at the worst possible time.
• There are special excess policies (non-rescindable) and policy provisions (severability, nonimputation and non-rescission clauses) available from some insurers that differentiate between outside directors and "bad actor" insureds. What protection do you have?

• Selection of counsel. Does the policy provide that the Company and directors have the right to select counsel – including the Company’s outside general or securities counsel, if appropriate? Are there any restrictions on the choice of defense counsel?

• Bankruptcy. Is there coverage if the Company files for bankruptcy or is placed in receivership and the trustee or receiver sues? Some courts have held that the "insured-versus-insured" exclusions typically found in D&O policies bar coverage in that situation. Many insurers have optional policy language available to eliminate this problem. What does your policy provide?

• Regulatory investigations and enforcement. Is there coverage if regulatory agencies investigate or assert claims against the Directors?

2. Mergers and Acquisitions. What Directors should ask about their D&O insurance if the Company is planning a merger, acquisition or other important corporate transaction that may result in a change in control:

• Notice. Has the D&O insurer been notified about this transaction? D&O policies typically include provisions in the policy that require notification of transactions involving a change in control or a material acquisition in order for coverage to continue.

• Effect on coverage. What happens to the current D&O policy and your coverage under it? Under many policies, a change in control transaction converts the D&O policy to run-off coverage unless the insurer agrees to continuation of the policy in full force. (Run-off coverage provides protection, but only for claims based on pre-merger events.)

• Tail coverage. If your Company is being acquired: Is "tail" coverage being arranged to cover the merger and pre-merger events? If so, for what policy limits and how many years? Tail coverage extends the policy for a period of years beyond its current expiration to protect against claims that might be asserted farther in the future.

• Coverage going forward. Bottom line: What coverage will you have going forward – insurer, policy limits, any new exclusions, dilution problems or other changes in coverage?

3. When problems arise. What Directors should ask when they see the first signs of trouble – whether in the form of a regulatory subpoena, a shareholder demand or the threat or filing of a shareholder action, or developing financial difficulties:

• Claims. What are the actual, potential or threatened claims – by whom, against whom and for what? Are there claims asserted or wrongdoing alleged against the Directors? What is the range of possible exposure both as to the various defendants and in the aggregate? Are there differences in exposure among Directors, e.g., by tenure or committee membership?

• Coverage for claims. To what extent will the D&O policy cover the claims and the likely defendants? Is there any uninsured exposure, and, if so, how much? What exclusions may affect coverage and for which claims or defendants?

• Notice. Has the D&O insurer been notified? If not, why not? According to the policy, when must the insurer be notified? Was notice made exactly as specified in the policy (notice to the broker may be insufficient)?

• Response. Has the D&O insurer responded to the notice of claims and, if so, what was the response – e.g., a denial of coverage? A reservation of rights and, if so, on what grounds?

• Policy expiration. When does the policy expire? Is the insurer willing to renew? Is it possible and necessary to purchase a "discovery period" that will extend coverage to claims that are asserted in the future?

• Defense. Is the Company making defense arrangements and, if so, what are they?

• Separate counsel. Are there actual or potential conflicts of interest among the insureds? Do you (or do the Outside Directors as a group) need separate counsel and will the Company or the D&O insurer pay for it?

• Settlement. What are the settlement prospects and the likely settlement range?

• Available limits. Are there any other prior or pending claims under the current policy? Have any of the policy limits already been used and, if so, how much? How adequate are the remaining limits? How are they being used and allocated?

• Retention. What is the amount of the deductible or "retention," and how is it being handled?

4. After leaving the Board. If you are no longer on the Board, if there is any question of the Company’s survival or its ability or willingness to indemnify you, and/or if your interests conflict with those of the other Directors, Officers or the Company, then you should take steps to make sure that you are in a position to protect and assert your rights as an insured under the D&O policy:

• The policy. D&O policies cover both present and former directors and officers. Obtain a full copy of the D&O policy, a copy of any notice to the carrier and the carrier’s response.

• Claims. Obtain a copy of the complaint in any lawsuit in which you have been sued and a copy of any notice of charges by any regulatory agency.

• Indemnification. Obtain copies of the Company’s articles of incorporation, bylaws and any agreements, including merger agreements, under which you have rights to indemnification. Indemnification provisions typically cover former directors, as do state corporation codes.

• Decisions and action. Ask knowledgeable personal counsel to advise you on coverage, indemnification and representation:

• Do you need to give separate notice to the insurer?
• Do you need to make an indemnification demand on the Company?
• Do you need separate litigation counsel?
• What other action, if any, do you need to take to protect yourself?

5. Other sources of D&O insurance coverage. Many outside directors are also officers of other companies or entities which themselves have D&O policies. Your own company may have a duty to indemnify you, and its D&O policy may have provisions that could afford you coverage, for your service as an outside director on other boards. This is especially true if you are serving on another board at the request or for the benefit of your own company. However, this coverage is not automatic for service on the boards of other for-profit companies and, in any event, must be in place before claims materialize. You should ask the following questions:

• Does your own company’s policy have coverage that will protect you against claims related to service on another board? This is sometimes called "outside director" coverage – not to be confused with the new forms of additional coverage, discussed above, that a company can purchase for its outside directors.

• Are you serving on this Board as a representative or designee of your own company? Is that a necessary condition for "outside director" coverage under its policy?

• Does that request need to be explicit and/or in writing?
• Do your company’s indemnification obligations extend to protect you as a director of the other company?

• If you are not representing your company on the board of the other company, would "outside director" coverage be a wise use of your own company’s D&O coverage limits? It is possible that catastrophic claims arising at the other company could deplete your own company’s policy limits.

• What do you need to do in order to put "outside director" coverage into force:

• Notify your own company’s D&O insurer?
• Obtain an endorsement listing the other companies on whose board you are serving?

Our practice involves assessing D&O insurance coverage, assisting clients in negotiating policy provisions, handling claims under D&O policies and defending directors, officers and companies in shareholder class actions and other litigation covered by D&O insurance. In some of our clients, we find good D&O insurance programs already in place – not surprisingly where there are well-informed in-house counsel, experienced risk managers and insurance brokers with expertise in D&O insurance and a clear idea of whom they represent. Unfortunately, we have also encountered deficient policies, inadequate limits, overbroad exclusions, untriggered coverage provisions, untimely notice, inexperienced brokers and improper denials of coverage by intransigent fringe insurers.

D&O insurance is one area of company affairs in which Directors have a vital personal interest. For all the hard work they do and the considerable risks they assume, Directors are entitled to adequate protection and have a right to know what provisions have been made to secure it. Informed directors are better able to protect their interests and assert their rights. Directors, here no less than in other matters, need to supervise management and may occasionally need to step in to make sure that management is performing its responsibilities.

Finally, as in other areas of Board activity, the more questions that Directors raise about their D&O insurance coverage, the better the attention and effort that senior management tends to devote to ensuring that they not only have accurate answers, but also good answers to give you.

For more information please contact Tom Richley at trichey@pogolaw.com or on +404.572.6600

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.