Serving as a director or officer of a company carries certain inherent risks—including the prospect of lawsuits challenging managerial actions. For that reason, companies often arrange to carry D&O insurance to attract and protect individuals who serve in such roles. Unfortunately, the first time that many officers and directors drill down into the details of coverage available to them as part of a policy is after a claim for damages is asserted against them.
Counsel for directors and officers should not allow clients to end up in that position. Rather, counsel should emphasize to clients that the time for understanding a policy’s protections is at the outset of a company’s purchase or renewal of insurance. Waiting until a claim is made is obviously not the time to attempt to redraft policy language or obtain additional protection. Counsel for individuals thinking of serving in director or officer roles can provide essential value by asking critical questions, obtaining certain answers, and securing appropriate policy provisions.
Set forth below are five essential aspects of D&O insurance that counsel should emphasize to clients in the current business environment. A recent Sixth Circuit opinion discussed below, Indian Harbor Ins. Co. v. Zucker, highlights the significance of these points. Counsel should emphasize these points to individuals serving or contemplating serving in the role of officer or director.
1. D&O Actions Commonly Arise in Distressed Situations
When a company encounters a period of distress—whether by market conditions, fraud, an overleveraged balance sheet, or other factor—it is common for the actions of the company’s directors and officers to be examined for possible causes of action. A typical scenario today is a quick sale of the company’s assets in a distressed situation. In the usual case where sale proceeds are not sufficient to satisfy all constituents, a fiduciary (such as a creditors committee or liquidating trustee) may bring litigation against the directors and officers with the goal of increasing the pool of funds available to creditors. In such a situation, the directors and officers will want to know that the company’s D&O policy will cover defense costs and satisfy any settlement or final judgement. Any indemnification rights the director or officer may have against the company are typically worthless in a distressed situation. Directors and officers most need the protection of a solid policy in the event of corporate distress, and in such circumstances, it is critical to ensure adequate policy language that will provide protection is in place. In the absence of adequate coverage, personal assets will constitute the most likely source of resources to satisfy an adverse judgement.
2. D&O Policies Are Not Uniform
It is difficult for a business person or lawyer who does not regularly work with D&O policies to appreciate potential grounds for an insurer’s denial of coverage embedded in a policy. Directors and officers with questions often will ask an insurance broker to provide an answer to a hypothetical situation. Yet, if a director or officer seeks coverage under an issued policy, the broker’s assurances will mean little to a court focused on the actual written words in the policy and how those words should be interpreted in a particular factual setting. Counsel should ensure that clients relying on a policy for risk mitigation understand the operative terms and how similar terms have been interpreted in prior disputes. Counsel should seek to obtain alternative formulations when necessary to provide greater coverage. Clients should be encouraged to actively seek out competing policies if doing so will help obtain more favorable terms.
3. D&O Policies Are Claims Made
Directors and officers must understand that D&O policies are “claims made,” meaning that coverage exists only for claims made during the time period the policy is in effect. If a company begins to encounter challenging circumstances, it is essential that the policy not lapse. If the company needs to enter into some restructuring or liquidation proceeding, the company should acquire a “tail”—an extended time period for the reporting of claims for events occurring during the period in which the policy was in effect. Claims made while no policy or extended reporting period are in effect are not covered. In the Indian Harbor case, the policy at issue had a one-year term and was extended twice by the company; thus, the policy covered the time of the alleged violations of fiduciary duties by the officers. That good news, however, was offset by rather bad news as discussed below.
4. Understand Clauses That Can Eliminate Coverage
A critical aspect of any D&O policy is understanding the clauses that can eliminate coverage. Such clauses include, but are not limited to, the list of exclusions. One key exclusion is known as the “insured versus insured”—a provision at the heart of the decision in Indian Harbor. The policy in that case included language excluding from coverage “any claim made against an Insured Person . . . by, on behalf of, or in the name or right of, the Company or any Insured Person” except for certain derivative suits and employment claims. The litigation in Indian Harbor was brought by a liquidating trustee against former officers asserting breaches of fiduciary duties and seeking $18.8 million in damages. The insurer denied coverage on the basis of the insured-versus-insured exclusion—a position upheld by a panel of the Sixth Circuit. The particular facts of that case limited any potential recovery for creditors to funds available under the policy; the confirmed reorganization plan provided that no personal assets would be available to satisfy any adverse judgment. That fact-specific aspect of the case does not detract from the larger lesson: insured-versus-insured clauses can leave directors and officers exposed unless carefully drafted to provide an exception to that exclusion.
5. Negotiate Appropriate Exceptions to Exclusions
Directors and officers who want to ensure that an insured-versus-insured exclusion will not deny coverage must have previously negotiated an appropriate exception to that exclusion. Such an exception would allow coverage for claims brought by a liquidating trustee, bankruptcy trustee, or similar fiduciary. However, the exception itself must be carefully drafted because there is no “standard” language that will easily provide comfort of coverage. A director or officer may end up as a defendant in a suit brought by any number of differently named entities depending on the ultimate fate of the company, such as a debtor in possession, a chapter 7 trustee, a chapter 11 trustee, a liquidating trustee, a creditors committee, an assignee for the benefit of creditors, a receiver, and others. The exception to the insured-versus-insured exclusion should be well drafted with input from those experienced with the current market for such exceptions and with judicial interpretation of such clauses.
Directors and officers should know a great deal more than the above five points concerning D&O insurance. Indeed, each defined term in a policy deserves careful scrutiny from experienced eyes. Also requiring careful analysis are provisions governing allocation, retention, policy limits, and the priority of payments for so-called Side A (protecting individual directors and officers) with Side B (reimbursement to the company for indemnification claims) and Side C (coverage for the company for certain direct damages). Counsel should help clients drill down into the details of D&O policies as early as possible—and well in advance of any sign of distress—to ensure the protection clients think exists will actually be there when most needed.