It goes without saying that corporate boards and management, including general counsel, must be more vigilant than ever in ensuring appropriate corporate governance and compliance with acceptable financial reporting standards. The strictest attention to compliance, however, does not ensure that the corporation will escape a shareholders' suit if its stock drops unexpectedly, no matter what the reason. Fortunately, despite gloomy prognostications of a future hardening of the insurance market, directors' and officers' liability insurance currently is, for most corporations, available and affordable. All D&O policies are not the same, however. Attention to certain policy provisions when a policy is placed may prevent unpleasant surprises when a lawsuit is filed.
Severability of the Application
Most insurers require an application to be submitted in connection with an initial placement or renewal, including recent SEC filings. Of course, one of the most likely sources of a securities claim is the fallout from a restatement of one of those filings. Insurers will argue, however, that if a financial statement which is the subject of the restatement was issued before the policy was in place (almost inevitable due to the one-year, claims-made features of the policies), they are entitled to rescind the coverage. As a result, there is no coverage for the very type of claim for which the corporation purchased the insurance.
The best way to avoid this problem is to include a broad "severability of the application" provision, either in the policy itself or by endorsement. Such a provision should provide that the wrongful statements, conduct or knowledge of one insured cannot be attributed to another. Ideally, this provision should be broad enough so that the company is not tagged with the wrongful conduct of its officers or directors, so that it loses coverage only if top management was aware of the misstatements in the application or SEC filings submitted with the application.
Even with a broad severability provision, carriers may still find ways to deny coverage for securities claims based on restatements. Many applications contain warranties or questions by which an officer of the company is required to confirm that none of the insureds has knowledge of any facts which could rise to potential claim. The application will state that any claim based on information which should have been disclosed in the application is excluded from coverage. Although the policy is not rescinded and technically available for other claims, insurers will argue that if a claim arises out of facts which were known to any insured, coverage is excluded as to all insureds. Thus, the policy and application should be reviewed to make sure that the severability provision is broad enough to also apply to these warranties.
In addition, insurers may argue that the severability provision does not preserve coverage in states where knowledge of the insured is not relevant to a rescission claim, i.e., in states (such as California) where rescission is determined essentially on a strict liability basis. Accordingly, not only should the language of the severability provision be scrutinized, but its scope should be confirmed with the broker and insurer.
Section 11 Coverage
Thanks to two recent cases, Level 3 Communications, Inc. v. Federal Insurance Company, 272 F.3d 908 (7th Cir. 2001) and Conseco, Inc. v. National Union Fire Insurance Company of Pittsburgh, PA, No. 49D130202CP00348 (Ind. Super. Situ., Marion County, Dec. 31, 2002), carriers now contend that damages under Section 11 and 12 of the 1933 Securities Act are by their nature "restitutionary" and therefore do not represent a covered "loss" under a D&O policy. An interesting position for carriers who market coverage for initial public offerings! Nevertheless, this is becoming an increasing bone of contention between insureds and insurers. This is yet another issue which should be addressed in advance with the insurer and broker, particularly when coverage is placed for a company going public.
"Side A" Coverage
While the above are some of the more serious issues facing the company as a whole, independent directors have become increasingly concerned about the scope and adequacy of coverage as it applies to them, particularly if the company does not have sufficient resources to satisfy its indemnification obligations, or if there is a threat that new management refuses to honor those obligations. Accordingly, directors are asking companies to purchase policies (commonly referred to as "Side A policies"), to provide separate coverage to the individual directors and officers only (or in some cases, only to independent directors). A number of insurers now market theses policies, and the following policy features should be reviewed at the time of placement.
Preservation of Limits for Independent Directors
While these policies provide coverage to individuals only, the number of insureds entitled to protection under the policy (and thus entitled to spend the limits in defense and indemnity costs) may dilute the limits and render the policy less attractive to an independent director. Many of these policies also cover inside directors and other officers, often defining "officer" to extend to "manager." Accordingly, unless "insured" is defined narrowly, one of the advantages of Side A coverage Â— preserving coverage for independent directors Â— can be defeated by the number of insureds with rights to that coverage.
Some Side A policies provide coverage excess to the corporate program, but do not "drop down" to provide primary coverage for the individuals if the underlying coverage is unavailable as a result of coverage defenses or the financial insolvency of the insurer. Other policies will provide primary protection in limited circumstances. Certain policies include "differences in conditions" features which not only provide excess coverage, but also provide primary coverage for claims typically not covered under a primary D&O policy, e.g., ERISA, errors and omissions, libel and slander and (limited) pollution claims. Underwriting considerations and pricing may determine the availability of these alternatives.
Because Side A policies generally are written as excess to traditional D&O policies, an insured can be at the mercy of a dispute between the primary and Side A insurers. The primary D&O insurer may deny coverage, but the Side A insurer may refuse to step in because it believes the primary insurer wrongfully denied coverage. Again, attention to policy wording at the time of placement may eliminate such disputes when a claim is filed.
In addition to features unique to Side A coverage, policy forms vary in the wording of definitions and exclusions also found in traditional D&O policies. The following are some provisions of particular concern to independent directors:
- Does the definition of "claim" extend to regulatory and criminal investigations (e.g., SEC investigations) and if so, at what point in the investigative process does coverage commence?
- Does the definition of "loss" include coverage for fines, penalties and punitive damages under a favorable choice-of-law provision?
- Does the policy contain exclusions for liabilities created by Sarbanes-Oxley (e.g., precluding coverage for payments prohibited under the Act)?
- Subtle wording difference in the "fraud" and "personal profit" exclusions can impact the burden of proof imposed on the insurer when the defense is raised.
- "Insured v. insured" exclusions vary significantly. Without appropriate wording and exceptions, they can exclude coverage for derivative actions, claims by a company in bankruptcy or lawsuits in which one of the directors has settled with a plaintiff and is providing cooperative testimony in the ongoing action.
- Side A policies may include onerous choice-of-law and alternative dispute resolution provisions. They can force the insured into an inconvenient ADR forum (e.g., London), or impose an unfavorable choice-of-law clause.
Corporate counsel and risk managers often assume that a directors' and officers' liability policy is an "off the shelf" product, that all policies are the same, and that there is not much they can do to clarify or broaden their coverage. That is not necessarily the case. Careful attention to these issues before a policy is placed may prevent the discomfort of explaining to the board, after a lawsuit has been filed, why coverage is limited or non-existent.