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ARE YOU REALLY PROTECTED BY YOUR D&O INSURANCE?
D&O insurance is like your bankruptcy lawyer or dental surgeon: better to not need it at all but, when you do need it, it better be damn good.
Unfortunately, not all policies of insurance against director and officer negligence are of high quality, and tight corporate budgets are leading too many managers to shop for coverage of any type purely on price and regardless of quality of protection. We are seeing even some of the better-known insurers now offer policies with glaring holes in coverage, and it has become very difficult for business leaders like you to determine whether a company’s policy of D&O insurance is sufficient for you to put your family’s financial future at risk by accepting an otherwise attractive position as a director, officer, chief restructuring officer or other company fiduciary.
Too often, the only question asked of a company about its D&O insurance before joining the Board or accepting an officer position is, “How much is the coverage?” However, whether the policy is $5 million or $25 million is in many ways less important than the exact scope of actual coverage provided, and determining that takes a little more work. You should take the time to walk through the following 10-point checklist as to each opportunity to serve so that you have the coverage you need if things do not go as hoped:
1. Read The Application.
Any policy is only as good as the application for that policy. Insurance companies reluctantly pay out dollars, and before they do they will look hard at whether there have been misrepresentations, even inadvertent ones, in the application for coverage. The application should be a quick read. Without reading the application, you will not know whether there were statements made that, with the benefit of present hindsight, were not entirely accurate. If that is the case, now is the time to get that corrected. Also, if no one can find the application, that is a red flag in and of itself, so do not accept any excuse and have someone get the application from the broker if necessary.
2. Pending Claims Reduce Effective Coverage.
Obviously, all coverage is limited, and any pending or threatened claims reduce the effective coverage available for your protection. We recommend that you ask to see, in addition to the policy application, copies of any pending claims and any other notices provided to the insurer (or received by the company) as to actual or threatened claims for coverage.
3. Is There “Side A” Coverage?
Solid D&O insurance policies contain what is commonly referred to as “Side A” coverage. Essentially, Side A coverage provides for a special sub-amount of coverage that is available only to individual insureds, so that company reimbursement claims cannot eat up all of the coverage that would otherwise be available to the individuals. This is important for two reasons. First, even if the company incurs heavy defense costs for other claims, Side A coverage provides a separate basket for the defense costs or liabilities incurred directly by you or other individual insureds. Second, even if the primary insured (that is, the company) were to go into bankruptcy (precisely the situation in which coverage is most critical), most bankruptcy judges will permit continuing and immediate access to the Side A pocket of insurance even if the primary policy were to be considered “property of the bankruptcy estate” and thus not available on a real-time basis for reimbursement until the sum total of all possible claims against the policy were determined (often many months or years out).
4. Is There “Severability” As To Coverage Representations?
Another important concept in all good D&O policies is “severability” as to the representations made by the company in applying for coverage. All policies exclude coverage for events that were not properly disclosed if known at the time of the policy application. Weaker policies give rise to the danger that the person signing the application does so sloppily or otherwise without disclosing relevant known facts, and then that knowledge is imputed to you, even though you did not know of the status of affairs at the time of application and in all likelihood did not participate directly in the application process. Better policies provide that any misrepresentation serves to disqualify from coverage only the person making the misrepresentation, and the misrepresentation is “severed” from the “innocent” insureds. Depending on a policy without this type of “severance” puts too much faith in those that completed the application and possibly no longer serving the company.
5. Even Potential Changes In Control May Terminate Coverage.
Companies that you serve may have recently undergone, or may be considering, a recapitalization or other material event. Even high-quality D&O insurance policies often provide that coverage will not extend to events that occur after a “change in control,” often with that term very broadly defined. For example, policies often provide that the mere issuance of warrants that, if exercised in the future, would then result in a change of control (such as the right to designate a majority of a board’s directors), cause coverage to terminate immediately on the date of issuance. This is an often-overlooked policy feature, and may require the company to work with its insurance broker proactively to obtain a rider ensuring that recent or contemplated capital events do not inadvertently serve to terminate critical coverage.
6. Priority Of Coverage Is Important.
Most good policies provide that, if there is insufficient coverage to cover all claims, the claims of individual insureds (such as you) would be given priority over claims of the company itself for reimbursement.
7. Examine Exclusions Of Coverage For Affiliates Of Major Owners.
As you know, directors often serve as designees of significant investors. However, even good D&O policies sometimes exclude coverage for the acts of “affiliates” of significant owners (sometimes disqualifying coverage for individuals affiliated with even a 10% shareholder, for example). Almost always, the insurer is willing to extend coverage to such affiliates if the affiliation is specifically disclosed. However, getting a rider in place is critical to provide explicit coverage under those circumstances.
8. Getting A Good Exception To The “Insured vs. Insured Exclusion” To Coverage Is Critically Important.
All D&O policies exclude coverage for claims of one insured versus another, such as lawsuits between officers, or for the defense of a claim by the company against one of its directors for alleged breach of loyalty. This exclusion is commonly referred to as the “insured vs. insured exclusion,” and it is standard in virtually all policies and generally not negotiable. However, the better policies contain an exception to this exclusion to make clear that lawsuits by a company’s creditor representative, such as a bankruptcy trustee, receiver or creditors’ committee, do not fall within that exclusion. This “bankruptcy exception” to the “insured vs. insured exclusion” is a critical element of your coverage, for the simple reason that if the company is not in bankruptcy it generally can make good on its promise to indemnify you for defense costs, even without insurance coverage; however, if the company is in bankruptcy, it probably cannot honor its indemnification obligations, and so insurance coverage with this exception in place is critical.
9. Do Not Accept A Policy That Excludes Coverage When It Is Most Necessary.
As noted above, D&O insurance coverage is most often critically needed when the company finds itself in a chapter 11 case or other insolvency proceeding and thus unable to honor in the ordinary course its standard indemnity obligations for defense costs. As unbelievable as it may seem, even high-quality insurers are now starting to add fine print endorsements or riders that cancel coverage in these situations. For example, one of the leading providers of D&O policies across many industries, National Union Fire Insurance Company, has added the following endorsement into perhaps hundreds of outstanding policies:
In consideration of the premium charged, it is hereby understood and agreed that the Insurer shall not be liable to make any payment for Loss in connection with any Claim made against any Insured in any bankruptcy proceeding by or against an Organization, when such Claim is brought by the examiner, trustee, receiver, creditors’ committee, trust, liquidator or rehabilitator (or any assignee thereof) of such Organization.
Even more surprisingly, many companies have actually purchased policies with this endorsement, not appreciating that this endorsement effectively guts the policy protections when likely needed the most.
There have been several lawsuits by insureds against the insurance companies who add these endorsements, alleging that the endorsements are void as a matter of public policy or violate basic bankruptcy law. Unfortunately, the results of those lawsuits have been mixed: some courts have struck down that language as violative of bankruptcy law, others have upheld it and found that the insurance was essentially void once the company was in an insolvency proceeding. (We are now challenging the validity of this provision in a chapter 11 case, so we hope to add to the case law striking down these provisions.) The take-away seems clear: there is little practical value in any policy with this provision.
10. Have A Lawyer Look At The Policy For You.
D&O policies, like most insurance documents, can be dense, especially if you do not review them on a regular basis. In your position, you should be able to have this review done for you for no or minimal charge by at least one good lawyer friend. Or, you need to make another one.