Dan A. Bailey and Timothy W. Burns
This chapter begins by discussing the enormous success of directors and officers ("D&O") insurance in protecting the personal assets of directors and officers and particularly outside corporate directors. As Section 26.01 explains, despite thousands of lawsuits being filed against directors and officers, D&O insurance, in connection with the other significant corporate and legal protections afforded to directors and offices, has prevented all but a handful of these lawsuits from impacting the personal wealth of outside corporate directors. Given the complex array of liabilities facing corporate directors, the avoidance of personal liability is nothing short of astounding.
As Section 26.01 explains, corporate directors and officers face several types of liabilities. The most significant liability that directors and officers face is securities fraud litigation. Directors and officers can be sued for their role in the issuance of a company’s securities and statements concerning the operation of the company that affect the price of the company’s securities. Directors and officers also face the risk of shareholder derivative litigation relating to alleged breaches of their duties to the corporation. The most prominent of these duties are the duty of care and the duty of loyalty. Directors and officers also face what appears to be an ever increasing threat of government investigations and prosecutions. Being a subject of a government investigation can lead to substantial defense costs.
Section 26.01 continues by placing these risks in the context of the web of protections that corporation law and insurance provide directors and officers. State corporate law allows a corporation to exculpate its directors and officers from most monetary liabilities. The business judgment rule provides additional protection to directors and officers. Importantly, state corporate law allows corporations to indemnify directors and officers against most lawsuits and other legal actions and investigations and to pay the defense costs the directors and officers incur in defending against those lawsuits and investigations. Given the strength of these protections, D&O insurance often fills a subsidiary (but important role) of protecting directors and officers when all of the other protections fail. D&O insurance also offers protection for a corporation itself. For public companies, D&O insurance protects the company against securities claims. Private companies enjoy even broader protection against liability under D&O policies.
Section 26.02 discusses the special considerations posed by D&O insurance being sold on a claims-made basis. Unlike "occurrence" policies, claims-made policies cover only claims that are made during the policy period, or, in some cases, shortly thereafter. In addition, such policies have strict reporting requirements.
Section 26.03 follows with a detailed discussion of the D&O purchasing process focusing on the application for D&O insurance. D&O insurers often require corporations to present detailed information in the underwriting process. In addition, most D&O insurers review a companies’ public disclosure to the U.S. Securities and Exchange Commission during the underwriting process. If there are misstatements in the application, the material presented, or publicly filed documents, an insurer may have a basis to seek to rescind the D&O coverage. State law, however, usually allows an insurer to do so only if can show (a) a false representation; (b) that was material to the underwriting of the policy; and (3) that was relied on by the insurer. Many states also require an insurer to establish that the policyholder intended to deceive the insurer as well. As Section 26.03 explains, an innocent director or officer may be protected against rescission by including a “severability” provision in the D&O policy. There are many different types of “severability” provisions that apply a range of protection. Rescission is disfavored by many courts and a policyholder also may be protected by waiver doctrines that allow a policyholder to avoid rescission if the insurer has acted in a manner that is inconsistent with rescinding the policy.
The heart of the chapter's analyses of D&O insurance policies is contained in Sections 26.04 through 26.08.
Section 26.04 discusses issues related to retentions and limits of liability under a D&O insurance policy and how and when a D&O policy’s proceeds are paid. D&O policies are typically purchased in layers of insurance sold by multiple insurers. Layering ensures that a particular insurer bears only a limited portion of the entire D&O risk. An insurer’s risk is further reduced by the fact that most D&O policies are subject to “aggregate” rather than only “per claim” limits of liability. This means that an insurer will have to pay only a specified amount of money even if many different claims are made against the policyholder and its directors and officers. This section also discusses ”order of payments” provisions and how those provisions might serve to further protect directors and officers by ensuring that they have access to the D&O policy’s proceeds before the proceeds are used to pay the corporation’s own liability.
Section 26.05 describes the insuring agreements of D&O policies – the provisions that set forth the basic scope of the coverage provided. D&O policies typically have two or three ensuring agreements: (1) an insuring agreement that specifies the insurer will pay for the directors and officers liabilities if their corporation cannot indemnify them; (2) an insuring agreement that specifies that the insurer will pay the corporation’s liability when it is permitted or required to indemnify the directors and officers; and (3) an insuring agreement that specifies that the insurer will pay the corporation’s own liability for certain types of claims. Notably, D&O policies require the D&O insurer to pay loss on behalf of the corporation and its directors and officers, rather than requiring the insurer to indemnify the corporation after the corporation pays the loss. This provides an important protection for the policyholders. D&O policies do not in most instances require the insurer to defend the policyholders; rather D&O policies allow the policyholders to defend the case at the insurer’s expense.
Section 26.06 discusses the key definitions in D&O policies. Like most insurance policies, D&O policies are filled with defined terms. One of the most important of these definitions is the definition of “claim.” In many ways, this definition defines the scope of the D&O policy. If it is defined broadly, the term “claim” may require an insurer to defend even informal investigations. If defined narrowly, an insurer may have the obligation to defend only lawsuits and formal government proceedings. “Loss” also is an important definition. The scope of that definition will determine the types of damages, defense costs, and settlements paid by the insurer. Some insurers seek to avoid coverage of claims under Section 11 of the Securities Act of 1933 by narrowly defining the term loss. Other insurers embrace coverage for this type of securities claim in their definition.
Section 26.07 focuses on D&O policy exclusions that limit the broad grants of coverage provided under the insuring agreements. Many of these exclusions are designed to require the policyholder to find coverage for a particular type of claim under another type of policy. For instance, the bodily injury and property damage exclusion is included in the D&O policy because most corporations purchase general liability insurance policies to cover these types of claims. Other exclusions in D&O policies are designed to allow the insurer to avoid covering a director or officer if the director or officer has been convicted of a crime or a fact-finder has found that the director or officer committed fraud or received an illegal benefit. Particularly because of this type of exclusion, it is important that the exclusion section of a D&O policy contain a severability provision, which specifies that the insurer cannot exclude coverage for one insured based on the conduct of another insured.
Finally, Section 26.08 discusses the key conditions in D&O policies such as notice of claim and the requirement to obtain the insurer's consent to settle a claim. A policyholder risks losing coverage if the policyholder does not comply with these conditions. For example, if the policyholder does not timely report a claim, an insurer may rely on the notice of claim condition to deny coverage. If the policyholder does not seek the insurer’s consent to settle a claim, the insurer may argue that it is not required to fund the settlement.
Because a company is unlikely to purchase all of its D&O insurance needs from one insurer, D&O policies are sold in layers of coverage. Section 26.09 addresses issues germane to excess D&O insurance policies, such as when liability attaches to those policies and the follow-form nature of those policies. There has been significant litigation over when an excess policy attaches. Early case law favored the excess attaching even in situations in which the underlying insurer had not paid its full underlying limit of liability, so long as the total liability was within the excess insurer’s layer of insurance. Some more recent cases have held that the underlying insurer must be forced to pay its entire limit of coverage before the excess insurer has any duty to pay whatsoever. These recent decisions presented a danger for policyholder that agreed to settle with its underlying insurer for less than the full underlying policy limit. Numerous endorsements now attempt to avoid the results in the recent case law.
Section 26.10 concludes the chapter with a detailed discussion of an increasingly popular specialized D&O insurance policy that provides protection only to the directors and officers of a company for losses not indemnified by the company. Many of these “Side-A” policies have unique and broad coverage features that make them attractive to boards of directors of companies. These policies are specifically designed to protect directors and officers in the following situations: (1) when their own companies refuse to indemnify them; (2) when their company becomes insolvent and the bankruptcy court prevents the company and its insurers from protecting the directors and officers; (3) when an insurer seeks to rescind or deny coverage; and (3) when an insurer becomes insolvent.
Cross References: For practice guidance with respect to D&O insurance coverage issues, see New Appleman Insurance Law Practice Guide Chapter 37. For practice checklists with respect to D&O insurance coverage issues, see New Appleman Premium Online Checklists Chapter 37.
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Dan A. Bailey is a nationally recognized expert regarding directors' and officers' responsibilities, liabilities, indemnification and insurance. As Chair of Bailey Cavalieri LLC’s "D&O" practice group, he represents directors and officers, corporations and insurance companies relating to corporate governance matters, and has been involved in most of the largest D&O lawsuits in the country for more than 25 years. In addition to publishing dozens of articles on the subject, he is co-author with William E. Knepper of Liability of Corporate Officers and Directors (8th Edition), which is cited as the standard treatise on the topic.
Timothy W. Burns is a partner at Perkins Coie LLP and chairs its insurance recovery practice group. He is the former Co-chair of the Insurance Coverage Litigation Committee of the American Bar Association. Tim has developed a nationally prominent D&O insurance practice. He advises clients on all aspects of D&O insurance, including counseling them with respect to the D&O insurance aspects of securities and derivative litigation and government investigations, initial public offerings, spin-offs, mergers and acquisitions, and bankruptcies. Tim's practice also includes representing corporate policyholders in their disputes and litigation with their insurance carriers. He has represented major policyholders in insurance coverage litigation since 1992.