D&O Coverage: Tailoring Coverage for the Risks that Matter to You

D&O Coverage:Tailoring Coverage for the Risks that Matter to You

Risk & Insurance Management Society - Chesapeake ChapterOctober 21, 2010

Introduction

I. D&O Coverage: Overview

II. Current Issues & Negotiable Terms

I. D&O Coverage: Overview

Directors and Officers Face Significant LitigationExposure

– Where Does D&O Coverage Fit-In?:

D&O Coverage: Overview (cont.)

Protection For Corporate Officers and Directors isFound in Four Main Areas:

– The Business Judgment Rule

– Exculpation Provisions

– Indemnification

– D&O Insurance

The Business Judgment Rule

– The legal presumption that officers and directors havefulfilled their fiduciary duties in the absence of a showingof self-dealing or bad faith.

Exculpation Provisions

– Many states allow corporations to include in theirincorporation documents a provision stating that officersand/or directors cannot be held personally liable for theiractions in the absence of a showing of self-dealing or badfaith.

In Addition to The Legal Protection Afforded by theLaw and Corporate Documents, Companies alsoTypically Protect Executives from Legal Expensesand Liability Exposure Through:

– Indemnification

– Insurance

When Structuring Indemnification and InsurancePrograms, it is Helpful To Keep in Mind the Typesof Cases that Pose the Greatest Threat to Officersand Directors:

– Securities Fraud Class Actions

– Derivative Actions

– SEC, DOJ, and Other Regulatory Investigations

Securities Fraud Class Actions

– Generally brought by a sophisticated Plaintiffs’ bar.

– A common example is where a company learns of amistake or misrepresentation in its financial disclosure toinvestors, and indicates to those investors that it intendsto restate those financial statements – resulting in asignificant drop in the company’s stock price.

Derivative Actions

– Those actions brought by shareholders on behalf of thecorporation against the officers and directors for allegedbreaches of fiduciary duty to the corporation.

SEC, DOJ, and Other Regulatory Investigations

– The SEC has broad power to investigate potentialsecurities law violations both formally and informally.

• The SEC can also seek civil penalties against officersand directors.

– The DOJ has the power to bring criminal charges.

– Other regulatory bodies have broad investigatory powers(e.g. Food and Drug Administration)

Indemnification is the First Line of Defense forCorporate Officials:

– Statutorily Authorized

– Embodied In Corporate Documents

– Generally Very Broad

– Theoretically Unlimited Protection

Indemnification has its Limitations:

– There are Times When a Corporation May NotIndemnify an Individual (e.g., barred by law)

– Company Insolvency

Indemnification Under Maryland Law– A corporation may indemnify any director . . .

• unless the act or omission of the director was material to thematter giving rise to the proceeding and:

– was committed in bad faith, or– was the result of active and deliberate dishonesty;

• or the director actually received an improper personal benefit inmoney, property, or services;

• or in the case of a criminal proceeding, the director hadreasonable cause to believe that the act or omission wasunlawful.

See Md. Code Ann., Corps. & Ass’ns §2-418(b)(1).

Indemnification Under Maryland Law (cont.)– Indemnification may be against judgments, penalties, fines,

settlements, and reasonable expenses actually incurred by thedirector in connection with the proceeding.

• However, if the proceeding was one by or in the right of thecorporation, indemnification may not be made in respect of anyproceeding in which the director shall have been adjudged to beliable to the corporation.

Indemnification Under Maryland Law (cont.)– The termination of any proceeding by judgment, order, or

settlement does not create a presumption that the director did notmeet the requisite standard of conduct set forth in this subsection.

– The termination of any proceeding by conviction, or a plea of nolocontendere or its equivalent, or an entry of an order of probationprior to judgment, creates a rebuttable presumption that thedirector did not meet the standard of conduct.

Indemnification Under Maryland Law (cont.)

– A director may not be indemnified under subsection (b)of this section in respect of any proceeding chargingimproper personal benefit to the director, whether or notinvolving action in the director’s official capacity, inwhich the director was adjudged to be liable on the basisthat the personal benefit was improperly received.

See Md. Code Ann., Corps. & Ass’ns §2-418(c).

D&O Coverage Provides Protection for Corporate OfficialsWhen Corporate Indemnification is Not Available

– Legal prohibition

– Company insolvency

– Where the company chooses not to indemnify

D&O Coverage Also Provides a Mechanism by Which aCorporation can be Reimbursed When it Does ProvideIndemnification

D&O Policies Typically Provide Defense andIndemnification for:– Securities Class Actions

– Shareholder Derivative Suits

– Miscellaneous proceedings not covered by othertraditional insurance policies (e.g., employment practicesclaims, regulatory investigations).

The Typical Insuring Clauses:

1. Side A

2. Side B

3. Side C

Side A Coverage: “Personal” Coverage

– Reimburses individual directors and officers for lossesthat are not indemnified by the company (typically noretention or deductible).

Side A Coverage: “Personal” Coverage (cont.)

– Generally, insurance company agrees to indemnify orpay on behalf of, the director or officer, all “Loss” thatthe individual becomes legally obligated to pay for a“Wrongful Act” committed in their capacity as an officeror director.

– Loss:

• Defined in the policies, and generally includes amounts paid injudgment or settlement, as well as the costs of defense.

– Generally, “Reasonable Defense Costs” includes attorneys’fees, court costs, filing fees, expert or specialist fees –consented to in advance.

• Generally excludes fines, penalties, treble/multiple damages,and matters uninsurable as a matter of law.

– Wrongful Act:

• Generally defined to include any negligent act, erroror omission, or breach of duty committed by theofficer or director in the discharge of their duties in thecapacity as director or officer.

– Duty of Care

– Duty of Loyalty

– Duty to Disclose

D&O Dedicated Limit Policies– Generally a separate policy providing Side A type coverage

– Provide additional/excess coverage limits

– Fill potential gaps in coverage

• Dedicated to officers and directors – Coverage for company’sliability will not deplete coverage.

• Where the underlying D&O policy is held to be a bankruptcyasset.

• Where the underlying D&O insurer becomes insolvent.

• Where the underlying D&O insurer attempts to rescindcoverage.

D&O Dedicated Limit Policies (cont.)

– Side A Excess Policies

• Can be structured as simply excess coverage to theSide A coverage of the underlying D&O policy.

– Side A Difference-In-Conditions Policies

• Can serve as an excess policy or drop down to theprimary position if the underlying traditional D&Opolicy cannot, or fails to respond.

– Provides broader coverage terms.

– Independent Directors Liability Policies

• Only provides coverage to independent or outsidedirectors.

Side B Coverage: “Corporate Reimbursement”

Coverage”

– Reimburses the company for its indemnification of lossesincurred by directors and officers (typically largeretention or deductible).

– Does not provide coverage to the company for its ownliability.

Side C Coverage: “Entity” Coverage

– Covers loss incurred by the company for claims againstthe company (retention).

• For public companies, generally only responds to SEC relatedclaims against the company.

• Coverage for claims against the entity can erode coverage forindividuals.

Employment Practices Liability Add-On

– Sometimes added to D&O Policy by Endorsement

• Generally covers officers, directors, employees and/or thecompany against employment-related claims brought byemployees (coverage for claims by third-parties can be added).

– Wrongful discharge

– Failure to promote

– Sexual harassment

– Violations of state and federal employment anddiscrimination law

Typical Policy Features of D&O Coverage

– Claims-Made Coverage

• Only covers claims that are first made during thepolicy period (i.e. date of wrongdoing is irrelevant).

– Claims-Made and Reported Coverage

• Some policies also require that the claim be reportedto the carrier during the same policy period.

Typical Policy Features (cont.)

– Generally no “duty to defend”

• However, they do provide coverage for defense costs and giveinsurer the right to associate with the defense and approvedefense strategies, expenditures and settlements.

• Although they do not control the defense, the insurer generallyonly required to reimburse “reasonable defense costs.”

Typical Policy Features (cont.)

– “Pay-on-Behalf of” Coverage

• Insurer is obligated to pay all covered loss “on behalfof the insured” (i.e. the insured does not have to paythe loss and then seek reimbursement from theinsurer—this is broader than simple indemnification).

Typical Policy Features (cont.)– Outside Position Coverage

• Coverage often provided for claims arising fromdirectors’ and officers’ roles as directors and officersof outside entities, if service is at request of or withconsent of the insured company (e.g. non-profitorganizations).

The D&O Policy Market

– No standard form means that policies vary greatly frominsurer to insurer.

– Important terms are usually negotiable.

II. Current Issues & Negotiable Terms

1. Definition of “Claim”

2. Conduct Exclusions

3. Presumptive Indemnification

4. Policy Rescission and Severability Clauses

5. Definition of “Insured Person”

6. Insured v. Insured Exclusion

Current Issues and Negotiable Terms (cont.)

1. Definition of “Claim”

– Civil proceedings

– Written demands?

– Criminal proceedings?

– Administrative proceedings?

– Administrative investigations?

2. Conduct Exclusions– Coverage typically excluded for certain self-serving, egregious acts

• Personal profit and advantage

• Fraud

• Willful violation of the law

– How must such conduct be proven in order to preclude coverage• “In fact” determination

• Adjudication – in underlying proceeding or in coverage action

– Standard of proof will affect ability to settle claims

3. Presumptive Indemnification

– Policy requires Company to indemnify to fullest extentpermitted by law. Failure or refusal to do so could resultin large deductible being applied to personal coverage.

4. Policy Rescission and Severability Clauses

– With relatively recent wave of large-scale corporatescandals, D&O insurers have attempted to rescindpolicies based on misrepresentations in the policyapplication.

• Issue: If misrepresentations are made in theapplication, whose coverage may be rescinded?

Policy Rescission and Severability Clauses (cont.)

– Severability clauses govern whether the knowledge ofone insured person may be imputed to another insuredperson

• e.g. can the knowledge of senior executives beimputed to innocent directors and officers so as torescind their individual coverage?

Policy Rescission and Severability Clauses (cont.)

– Policyholders should seek full severability provisionsthat disallow the imputation of any one insured person’sknowledge to another insured person.

5. Definition of “Insured Person”

– Does the insured want coverage for more than just D’sand O’s?

• Management positions (e.g. general counsel)

• All employees?

6. Insured v. Insured Exclusion

– Policyholders must look for and attempt toeliminate provisions that exclude coverage forclaims brought by shareholders with theassistance of a whistleblower who is an “InsuredPerson.”

Conclusions

Questions?

D&O Coverage: Tailoring Coverage for the Risks that Matter to You

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