Mike%20Biles[1]
Michael J. Biles
Just about every publicly traded company and most private companies carry D&O insurance. It is just common sense in the current litigious environment. But while most companies recognize the need for D&O insurance, not every company maximizes its investment when purchasing the insurance. In the following guest post, Michael J. Biles, a partner in the Securities Litigation Group at King & Spalding LLP, takes a look based on his perspective as a securities litigator at ten common mistakes many companies make when buying their D&O insurance. In addition to the points Mike makes in his guest post, I would add that companies are likely to avoid these and other common mistakes if they take the time to ensure that the have enlisted the assistance of a knowledgeable and experienced broker in connection with their purchase of D&O insurance. 

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I would like to thank Mike for his willingness to publish his article on this site. I welcome guest post submissions from responsible authors on topics of interest to readers of the blog. Please contact me directly if you would like to submit a guest post. Here is Mike’s guest post.

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D&O insurance is a must-have for every public company.  The risks and costs of private lawsuits or government investigations are too great for any rational person to serve as an officer or director of a company without a solid D&O insurance policy.  After nearly twenty years of defending officers and directors in securities litigation, I have experienced firsthand the hardship caused by inadequate or inappropriate D&O insurance.  Contrary to public perception, most officers and directors of public companies are not extraordinarily wealthy – the cost of financing the defense of a securities class action, derivative lawsuit or government litigation (much less of funding a settlement) is too great to bear for most individuals without D&O insurance.

The following are the top ten mistakes that I’ve seen companies make in selecting D&O insurance.  Although some of these mistakes concern complex insurance coverage issues, I’ve prepared this article for the non-lawyer, stripped of legalese, so that officers and directors can discuss these issues with their insurance brokers to avoid these mistakes.  D&O insurance is a competitive industry.  While the core language of a standard D&O policy is generally fixed, companies can, and often do, negotiate better terms in endorsements to the policy. 

  1. Limits that Are too Low or too High

A company should purchase enough D&O insurance to reasonably protect the assets of the company and its officers and directors.  If the D&O limits are too small, then a company (or the individual officers and directors if the company is unable or unwilling to indemnify and advance defense costs) will have to use its own assets to fund and settle litigation.  Alternatively, if the D&O limits are too high, then the company not only wastes money on unnecessary premiums, but also can prolong litigation as plaintiffs’ lawyers hold out for a larger portion of the policy proceeds.  The goal is to be in the goldilocks range.

While considering the limits purchased by your peers is one data point to consider, pure benchmarking (e.g., setting the limits in the top quartile of your peer companies) is not a good strategy.  A more logical process is to understand each litigation risk the company and its leadership faces and assign a reasonable range of dollars associated with each risk.  It is not difficult to estimate a reasonable range of costs with securities class actions.  Because settlements of class actions are a matter of public record, several financial experts (e.g., Cornerstone Research) publish annual studies that provide good information concerning settlements figures over a wide range of different profiles, including market capitalization, industry, type of claim, and other circumstances.  Many brokers have similar databases.  This is a good starting point.

The difficult task is assigning a dollar range to other litigation risks, such as government investigations, enforcement actions, and criminal matters.  Often, the government is an irrational litigant.  It is not unusual for the government to pursue actions that costs millions to defend, when the government’s remedies are only thousands of dollars.  Beware the ambitious government lawyer looking to build a reputation.  And when the government is involved, officers and directors tend to hire separate counsel, which increases the costs of defense and quickly erodes the shared policy.  For this reason, I would not be an officer or director of any company – no matter how small the market capitalization – that had less than $10 million in D&O limits.  For example, even if the research data shows that a company with a market capitalization below $50 million tends to settle a securities class action for between $2 million and $5 million, I would still want at least $10 million in D&O limits to provide some protection for government litigation, which is often brought parallel to private litigation.

On a related note, when a company and its officers and directors face parallel private and government litigation, the individual officers and directors should be concerned about using too much of the D&O proceeds to settle the private litigation.  The potential adverse consequences of government action are often far more punitive to the individual, which can range from criminal sanctions to civil injunctive remedies barring a person from serving as an officer or director of a public company.  Consequently, officers and directors should try to reserve a healthy portion of the D&O policy to fund defense costs in a parallel government action.  Of course, this may create some tension between the company and its officers and directors, but as insureds under the policy the officers and directors can withhold their consent to settle.  When a company’s D&O policy provides only the bare minimum of coverage, this can create conflict between the individuals and the company that complicates (and often delays) settlement.

  1. Gaps in Insurance Towers

It is common for companies to have multiple insurance companies involved in a layered D&O insurance program.  For example, a company that has D&O insurance limits of $30 million could have a primary carrier insuring losses up to $10 million, and four excess carriers responsible for losses in $5 million increments above $10 million.  When limits are in excess of $50 million, the number of carriers involved can be even higher.

Complicated insurance towers involving multiple excess insurers can make it difficult to settle litigation.  Negotiating a settlement with multiple excess insurance carriers in mediation will involve rooms of claims agents and insurance-coverage counsel.  Sometimes it seems easier to herd cats than to cobble together a resolution involving multiple insurance companies.

Insurance companies prefer multiple layers because it tends to result in lower settlements.  This is not necessarily a bad thing for companies and their officers and directors, but in addition to complicating the settlement process, there is also the problem of filling potential gaps in coverage.  Excess insurance policies often have provisions that say an excess insurer is not responsible for any loss unless and until the insurers of the underlying policies have fully exhausted their limits in the payment of loss.  The problem is that the primary carrier or an early excess carrier will often dispute some aspect of coverage and reach a resolution with the policyholder to pay something less than the full amount of their limits, which creates a gap in coverage.  An even larger problem occurs when a primary insurer or early excess insurer is unable to fund because of a bankruptcy, like what happened in the early 2000s with several insurers (e.g., Reliance National and The Home).

Some courts have held that even when the policyholder funds the gap, the underlying insurance was not exhausted and thus the excess insurer’s obligation was not triggered.  This happened in Qualcomm, Inc. v. Certain Underwriters at Lloyd’s, London, 161 Cal. App. 4th 184, 73 Cal. Rptr. 3d 770 (Ct. App. 4th Dist. 2008). Qualcomm had a $20 million primary policy with AIG and an excess policy with Lloyd’s.  Qualcomm settled a coverage controversy with AIG so that AIG paid only $16 million of its $20 million limit.  Although Qualcomm agreed to absorb the $4 million remaining on the AIG policy, Lloyd’s rejected Qualcomm’s efforts to collect additional losses under the excess policy.  The relevant provision under the excess policy provided “underwriters shall be liable only after the insurers under each of the Underlying Policies have paid or have been held liable to pay the full amount of the Underlying Limit of Liability.”  The court agreed with Lloyd’s argument because AIG did not pay its limit.  See also Comerica Inc. v. Zurich Am. Ins. Co., 498 F. Supp. 2d 1019 (E.D. Mich. 2007).  For this reason, it is essential for companies to include language in all excess insurance policies so that excess insurers recognize payments made by the policyholder or other sources to fill in the gaps.

  1. No Side A Coverage

D&O policies provide three types of coverage, called Side A, Side B and Side C.  Side C provides for coverage for the corporation and its officers and directors in certain types of lawsuits.  Side B covers the corporation when it indemnifies its officers and directors.  Side C and Side B policies have deductibles or self-retentions, meaning that the insurance company will not pay for the costs of defense or settlement until the corporation exhausts the deductible.  Side A pays the officers or directors directly for defense costs and settlements if the corporation is unable or unwilling to indemnify them.

There are limitations to Side C and Side B coverage that may leave an officer or director without coverage.  For example, the corporation may completely erode the limits of a Side C policy by settling a securities class action, and leave its officers and directors exposed to personal liability in related litigation in the event of a bankruptcy.  This happened to the officers and directors of Just For Feet – after the company exhausted Side C limits in a securities class action, the officers and directors were exposed in fiduciary-duty litigation filed in a bankruptcy action.  Side A also protects officers and directors in situations where a bankruptcy court concludes that the Side C policy is an asset of the bankruptcy estate, which could undermine an officer’s ability to obtain prompt coverage of defense costs.

Side A policies provide officers and directors with broader coverage with fewer exclusions than Side C and Side B policies, and it is more difficult to rescind Side A policies once the premium is paid.  Side A policies are excess policies—they sit on top of the Side C and Side B policies and provide coverage only when the limits of the Side C and Side B policies have been exhausted or are otherwise unavailable.  For this reason, the premiums for Side A policies are less than Side B and Side C policies.

  1. Exclusions that are Broadly Written or Easily Triggered

Insureds also need to watch out for exclusions that are broadly written or easily triggered.  For example, it is common for D&O policies to exclude coverage for liability arising from illegal pollution, intellectual-property violations, and ERISA violations.  But often these exclusions are broadly written to include “any claim based upon, arising out of, attributable to, or directly or indirectly resulting from” such violations.  This kind of language gives the insurer too much latitude to deny coverage in securities cases that have some connection to claims involving pollution, intellectual-property, or ERISA claims.  For example, a company may face a securities class action after invalidation of a key patent or after an oil spill, under the theory that the company’s prior SEC filings misstated or omitted information relevant to these issues.  If the exclusions are broadly written, then an insurer may deny coverage because the allegations in the securities case are “related to” an excluded claim.  It is therefore important to negotiate the policy to obtain the narrowest exclusionary language possible.

Mere allegations in a complaint are ordinarily insufficient to trigger an exclusion.  Typically, exclusions are only triggered after there is a “final adjudication” of the fact underlying the exclusion.  This protects the policyholder because it means that the insurer must continue to cover losses until there is a non-appealable judgment that establishes the exclusion.  But sometimes, exclusions are triggered when there is “an admission in writing” by an insured or when there is an exclusion “in fact.”  This type of language should be avoided because it permits the insurer to invoke an exclusion before there is a final adjudication.  See Westport Ins. Corp. v. Hanft & Knight, P.C., 523 F. Supp. 2d 444 (M.D. Pa. 2007) (holding that allegations in the complaint were sufficient for the court to find that a personal benefit exclusion had “in fact” occurred).

  1. Inadequate Derivative Investigation Coverage

Under Delaware law, directors must exercise “good faith” in dealing with potential or actual violations of the law or corporate policy.  Stone v. Ritter, 911 A.2d 362 (Del. 2006).  When directors are placed on notice of misconduct within the company, they must—at a minimum—take reasonable steps to investigate and remedy the problem.  An independent and thorough investigation is the first step to protecting the board from claims by shareholders in derivative litigation or, more importantly, by the government in enforcement proceedings, that directors failed to properly exercise their oversight or gatekeeper duties.  Most D&O policies provide coverage for boards to conduct internal investigations following a demand made by a shareholder.  Unfortunately, the coverage provided for derivative investigations in most D&O policies ($250,000 to $500,000) is insufficient to cover the full costs of conducting and documenting a reasonably thorough investigation.

The costs associated with document retention and review alone can cost hundreds of thousands of dollars.  And if there is a need to interview numerous fact witnesses, the cost of an internal investigation can easily exceed $500,000 – typically much more if the investigation involves international travel.

For these reasons, public companies should obtain investigation coverage for at least $500,000, and much more for larger companies.

  1. Coverage For Restitution And Disgorgement Claims

Most D&O policies contain language defining covered “loss” to exclude amounts that are uninsurable as a matter of law.  Insurers often claim that this exclusion precludes coverage for the payment of restitution or the disgorgement of “ill-gotten gains.”  It is also common for carriers to argue that an officer or director does not suffer an economic loss when he or she is forced to return monies obtained unlawfully.  This has been accepted as a valid coverage defense by several courts.  See e.g., Level 3 Commc’ns Inc. v. Fed. Ins. Co., 272 F.3d 908 (7th Cir. 2001).

The problem is that insurers can assert this “restitution/disgorgement defense” based on common claims in securities cases – from insider-trading accusations to claims under sections 11 and 12(a) of Securities Act of 1933.

Accordingly, policyholders should negotiate language in the endorsements to the D&O policy that prevents the insurer from denying coverage under the “ill-gotten gains” exclusion for claims under sections 11 or 12(a) of the Securities Act of 1933, claims for civil penalties under the Foreign Corrupt Practices Act, antitrust claims, bankruptcy trustee fraudulent-transfer claims, and even standard fraud claims under the Securities Exchange Act of 1934 that involve insider-trading claims.  At the very least, policyholders should insist that this exclusion is only triggered after there is a “final adjudication” that the officer and director actually received an “ill-gotten gain” or illegal payment.  This provides at least some protection for policyholders when these claims are asserted.

  1. Excluding Government Investigations from the Definition of “Claim”

D&O policies only provide coverage for defined claims – if the matter does not fall within the policy’s definition of “Claim,” then there is no coverage.  There is a wide variation of coverage available for government investigations.  A good definition of “Claim” is broadly written to cover the panoply of matters the government may bring against a company.  This definition of “Claim” also includes any formal or informal investigation by the government, including any written request for the production of documents or interviews of company employees.  The SEC enforcement division often conducts informal investigations that request the production of documents and interviews, which can cost a company hundreds of thousands of dollars to handle.

A bad definition of “Claim,” which unfortunately is very common, does not include informal government investigations, but instead requires the issuance of a subpoena in a formal investigation.  This places the company in the awkward position of actually wanting the government to initiate a formal investigation to trigger coverage.  And an ugly definition of “Claim” affords no coverage at all for the company in government investigations, but instead only covers individual officers and directors who receive subpoenas.  These definitions of “Claim” leave a company exposed to the enormous costs of defending itself in government investigations.

  1. Failing to Minimize the Impact of a False Application

Every D&O carrier requires the company and its officers and directors to fill out an application.  Courts have generally held that, absent an “application severability provision,” a material misrepresentation by one insured in an application voids the policy as to all of the insureds.  For example, if the application requires the company to attach prior financials and there is a subsequent financial restatement, the carrier may try and rescind the entire policy – a result that would represent a draconian outcome for insureds that had no knowledge or involvement in the accounting errors at issue.  To avoid this result, it is important for your D&O policy to contain a strong application severability provision that preserves coverage for innocent officers and directors, even if another officer misrepresents material information in the application.

“Full” application severability provisions are better than “limited” provisions.  “Full” provisions provide that the application is deemed to be a separate application for each insured and that the knowledge of one insured cannot be imputed to other insureds for the purposes of the application.  If there is a Side C policy (company coverage), a “full” application severability provision typically states that only the knowledge of the CEO or CFO is imputed to the company for the purposes of the application.  By contrast, “limited” severability provisions state that the knowledge of one insured is not imputed to other insureds, except that the knowledge of the signer of the application (or certain officers) is imputed to all insureds.  In other words, if the insurer can show that the person who signed the application knew it was false, then there is no insurance at all.

  1. Failing to Immediately Place the Insurers On Notice

One of the most common reasons for denial is the failure to place all your D&O carriers – including excess carriers – on notice of a claim within the policy period.  D&O policies are generally “claims made” policies, which means that there is no coverage unless the insurer receives written notice of the claim within the policy period.  Even if you doubt that the matter qualifies as a “Claim” under the policy you should always provide written notice of the matter to your carriers.

Suppose that you receive a demand from a shareholder but decide not to provide notice to your carrier because you do not think the letter asserts a claim against your officers and directors.  What happens if a shareholder or the government brings an action a year or two later and asserts claims based on similar facts alleged in the original demand?

In this situation, you may have no coverage under your current D&O policy because of the “interrelated wrongful acts” exclusion, which bars coverage for claims that are related to claims that were, or should have been, made under a previous D&O policy period.  For this reason, it is important for companies to provide notice of any potential claims and, if possible, include a detailed explanation of the circumstances surrounding the claim so that your company is covered if related claims are made years later.

  1. Failing to Cover In-House Counsel

D&O policies typically cover officers and directors while acting in their official capacities for the company.  This means that only actions taken as an “officer” or “director” will be covered.  The problem for in-house lawyers is that actions taken as a “lawyer” may not be covered, even for those in-house lawyers who are lucky enough to be “officers” of the company.  Also, most D&O policies have a “professional services” exclusion, which may be invoked by the carrier to exclude coverage for actions taken by in-house counsel.

The solution here is to make sure that the definition of “Insured” expressly includes the general counsel and other in-house counsel.  It also helps if the organizational charts and SEC filings identify the general counsel as an officer.  Finally, companies should amend the definition of “Wrongful Acts” to remove references to actions taken “solely” in an officer or director capacity – rather, the definition should include all actions done in an official capacity, even when they are interrelated with actions taken in other capacities.

Finally, companies should consider purchasing employed-lawyers insurance, which can be included in an endorsement to the D&O policy.

Conclusion

The glossy handouts that you receive from D&O insurance companies during the sales process provide the impression that they will protect your company and board members in any type of litigation or government action.  That is simply not the case.  D&O insurance is not an “off the shelf” product.  The specific language and the endorsements are negotiable and matter a great deal as to whether your company and your officers and directors receive adequate protection.  Companies can avoid the mistakes discussed in this article by negotiating better terms when purchasing (or renewing) D&O insurance.

 

Michael J. Biles is a partner in the Securities Litigation Group at King & Spalding LLP.  The opinions expressed in this article are his alone.