Overview
The passage of the Sarbanes-Oxley Act of 2002 and the adoption of related SEC rules have reinforced the fact that fully-engaged, independent directors, in addition to a well-informed management team, are essential for ensuring a company's financial and ethical well-being. At the same time, the Act and related regulatory mandates may increase actual and threatened litigation, administrative proceedings and investigations for directors and officers. The scandals involving Enron, WorldCom and others, combined with new legislative and regulatory mandates, have contributed to a difficult D&O insurance market that includes rising premiums coupled with a narrowing in the scope of coverage provided. This article outlines certain issues regarding D&O insurance that should be given careful consideration in light of this recent trend.
How do the acts of one insured person affect another's coverage?
Severability provisions specify whether a director's or officer's behavior or knowledge of an event will be imputed to another person to deny coverage. For example, if a CFO failed to disclose information in a policy application, are the independent directors still covered by the policy? A "full severability" provision will prevent the acts or omissions of one insured person from being imputed to other insured persons. Partial severability provisions impute knowledge from one insured person to another, but limit the parties to which such knowledge is imputed.
Does the company have "entity" coverage?
Entity coverage (i.e., coverage for the company's own liabilities, often referred to as "Side A Coverage") is becoming more difficult to obtain and is being increasingly challenged. Insurance companies are taking the position that this coverage may be forfeited if an exclusion applies to a director or officer. Additionally, in a bankruptcy, entity coverage may be considered an asset of the company and thus not provide directors and officers with the intended coverage. Accordingly, companies are now purchasing separate supplemental insurance policies covering only directors and officers.
Determining the scope of coverage
Review Key Definitions
A company may wish to expand the definition of "insured person" to include not only officers and directors, but also non-officer employees such as financial personnel, who may be required to make subcertifications that will be relied upon by the CEO and CFO as part of their respective diligence efforts in making the certifications required by the Act. The definition of "claim" also should be reviewed to ensure that it includes not only civil and criminal proceedings, but also regulatory and governmental investigations, administrative proceedings and proceedings that seek non-monetary relief such as an injunction. In addition, the definition of "loss" should be reviewed because it may exclude civil or criminal fines and penalties from governmental agencies which are important as the Act provides for significant monetary penalties.
Understand Exclusions
Every D&O policy has a "fraud" exclusion that excludes coverage for losses brought about by dishonest or fraudulent acts or omissions or willful violations of any statute, rule or law. Policies may require "final adjudication" before the exclusion is applied or, less favorably to the insured, the exclusion may apply if there has been fraud "in fact" (i.e., where an employee has admitted, as part of a negotiated plea, to actions constituting fraud).
Policy Rescission
In completing an application for a D&O insurance policy, the signer of the application attests on behalf of the company that no person proposed for coverage is aware of any fact, situation or circumstance that could lead to a claim under the policy. Insurers are increasingly alleging when claims are made that the policy should be subject to recession because required information was not disclosed in response to this "warranty" question. Because the warranty question is asked with regard to all "covered" persons (e.g., directors and officers), the preparer of the application should poll all such persons regarding potential claims in order to answer this question. The warranty question will be asked again if the company moves coverage to a new insurer or if the company increases its coverage above its current level; a warranty must be made to each new insurer providing the additional coverage. Additionally, some insurance companies are attempting to receive warranties in connection with a policy renewal which companies should resist. A rescission claim also can arise when the company's financial statements, which are attached to the application, are subsequently restated.
How much coverage to purchase?
The Act extended the statute of limitations for securities class action litigation claims from three years to five years. Thus, in considering the amount of insurance to purchase, public companies should, among other factors, consider their market capitalization within the last five years rather than the three-year look-back previously recommended by many brokers. Companies should also consider the likelihood that an insurer may insist on a contribution from the company in funding a future settlement of a securities or other claim.
What happens if the company is sold?
Runoff coverage or "tail" insurance is recommended in order to obtain advancement of defense costs or the payment of liabilities directly from the insurer rather than seeking such coverage from the acquirer under its existing policy.
The tail policy should be purchased from the seller's existing D&O insurer when the transaction closes. This ensures that the tail insurance is fully paid up and not subject to ongoing payment of premiums by the acquirer. Additionally, by purchasing the policy from the existing insurer, a company avoids having to complete a new policy, which could be subsequently challenged for answers to warranty questions as is discussed above.
Conclusion
Companies should remember that D&O insurance policies should not be viewed as "form" documents. There may be provisions in these policies that can be negotiated. Companies who seek the expert advice of experienced legal counsel as well as outside insurance brokers enter the process better prepared and more fully informed of the potential issues.