What You Need To Know About E&O And D&O Insurance Protection

Monday, April 5, 2010 - 01:00
John Failla

Please tell us about your professional background and the client group you serve.

Failla: I have been involved for more than twenty years helping corporate and business policyholder clients obtain insurance recoveries. I typically represent financial institutions, professional services organizations, corporate directors and officers, industrial companies, and private equity groups and hedge funds. My practice includes coverage litigation, arbitration, claim negotiation, and claim advocacy. I also have experience handling insurance due diligence in corporate transactions and M&A deals, particularly with private equity groups, and have been involved extensively in insurance advisory work counseling clients on insurance policy language, program structure, indemnities, and similar matters.

Editor: How has the financial crisis changed the nature of E&O and D&O claims?

Failla: The economic crisis has led to a spike in claims, particularly those affecting financial institutions, as well as an increase in the amounts at issue and an increase in the scope of businesses and industries affected. The nature of claims, in a broad sense, includes breaches of various duties of care and oversight and disclosure and accounting issues. On the E&O side, we are seeing claims relating to derivatives, mortgage-backed securities, real estate transactions, auction-rate securities, bank failures, and asset management issues that are direct results of the financial crisis.

We are also seeing claims that are related to economic conditions, albeit more indirectly. For example, a number of claims have been asserted, with varying degrees of success, against financial institutions, accounting firms and other professional firms alleging liability for perpetuating, concealing, aiding, or failing to detect financial frauds, such as the Madoff Ponzi scheme. While the financial frauds did not result directly from the economic crisis, the adverse market conditions often caused these schemes to collapse or exacerbated the losses of the victims. There have been a number of claims in the high-tech area related to computer fraud, electronic trading issues, privacy and data security issues, and cyber issues. These are trends we should keep an eye on because the claim environment is changing and programs have to be tailored to manage those risks.

We are seeing similar claims in the D&O insurance market, including receiver or trustee claims against officers and directors of insolvent companies or failed banks and shareholder suits alleging the failure to disclose or manage the nature or concentration of allegedly risky investments or the potential of a downturn in business prospects.

Editor: What new trends are you seeing in the E&O and D&O cases being brought against insurers?

Failla: These cases are becoming much more contentious. In both E&O and D&O claims, insurers are raising an ever increasing number of defenses. These include threats to rescind the policy; assertions that the damages sought in underlying lawsuits or government investigations constitute ill-gotten gains, disgorgement or other amounts allegedly uninsurable as a matter of law; invocation of conduct-based exclusions or profits to which an insured is not entitled (either found in a final adjudication against the insured in the underlying action or, in less favorable language, proven by the insurer "in fact" in the coverage case); issues regarding advancement of defense expenses and allocation of loss; efforts to deny coverage for claims brought in bankruptcy proceedings by trustees or creditors; and attempts to limit coverage for regulatory investigations.

Also, excess-layer insurers have grown more litigious. In the past, excess insurers would often look to the primary insurer to do an investigation and take a position on coverage. Absent unusual circumstances, the excess carriers would often follow that determination. The trend in recent years has been much more contentious at each individual layer, with excess carriers asserting their own coverage defenses and arguing very aggressively that their layer of insurance should not be called upon to respond because the underlying coverage was not exhausted by actual insurer payments.

Editor: What exclusions are insurers adding today that were not included before? Are you advising clients on ways to renegotiate their policies?

Failla: Insurers often attempt to add exclusions to limit coverage for evolving risks. Whenever there is something that insurers perceive to be an industry-wide problem, they often attempt to address it wholly or partly through exclusions. So for instance, when regulatory, investigatory and class action claims were asserted against mutual fund complexes in 2003 to 2005, insurers typically introduced broad conduct exclusions in E&O/D&O policies that dealt with market timing, late trading, and sales practices. Similarly now, there are efforts to add exclusions for mortgage-backed securities, derivatives, and cyber and privacy risks that are category specific.

One thing clients should always focus on is early notice whenever there is an indication of a claim or a potential claim. Clients should give notice as soon as possible under their existing insurance policies so that those policies will be available to respond in the event that new or additional claims based on related acts are asserted. Therefore, you can trigger the coverage that is in existence before exclusions are added.

Also there are opportunities, particularly with market conditions as they are in the insurance markets, to negotiate policy language to improve coverage and make it more equitable. D&O and E&O coverage are both particularly capable of being improved dramatically if you take the time to focus on the language and the meaning of the policy provisions. By way of example, considerable attention should be paid to exclusions based on conduct, predicate or triggering language to exclusions, the insured vs. insured exclusion (particularly as it related to insolvency, bankruptcy, receivership, or creditor claims), the definition of loss, coverage for punitive damages, restrictions on amounts allegedly uninsurable as a matter of law, definitions of professional services and interrelated wrongful acts, and specific provisions relating to the nature of a particular client's business.

If there are exclusions that are important to particular businesses that cannot be circumscribed sufficiently, there usually are stand-alone products or additional endorsements that should be considered and then integrated into the overall program.

Editor: Have you counseled clients on restructuring their insurance portfolios in view of the shareholder suits and other types of litigation that are an outgrowth of the economic crisis?

Failla: Yes. We emphasize the need to anticipate the types of liabilities that may emerge to make sure that our clients' insurance programs can meet them. Both the types of claims and the severity of claims must be addressed, not only in terms of the amount of limits of coverage that are available, but also how that coverage responds to the liability. These policies all start from standard-form policies, but very rarely does a standard-form D&O or E&O policy sufficiently address the risks of individual clients. There are specific business risks that each industry group and each client will face. And frankly, there are lessons learned from litigating and negotiating coverage claims that should be considered when reviewing policy language.

One must also make sure that the risk management programs as a whole are in unison such that the different types of insurance coverage interrelate well and do not create gaps or conflicts or, equally important, do not overlap. The insurance programs also must be aligned with any indemnities in contracts or transactions, as well as the clients' overall risk management structures, and contractual provisions for customers, clients and service providers. The program must be considered holistically and not in isolation.

Editor: What new insurance products should business consider in the light of problems posed by the crisis and the attitude of insurers who are trying to reduce or deny claims?

Failla: In addition to refining the existing products, particular attention should be paid to computer and electronic crime coverage. Sometimes that is covered in a business-crime policy or in a fidelity bond, or in endorsements to either type of policies, including E&O or D&O policies or management liability programs. The language of that coverage can make a huge difference to the scope of coverage provided, and increasingly we are seeing claims arise from those types of exposures.

Policyholders should also consider broad-based cyber risks, privacy and data protection coverage, either as a stand-alone policy or by endorsement. Claims arising from these exposures are enormously expensive and the underlying liabilities are very difficult to predict. Financial institution electronic transaction and trade error coverage is increasingly significant as trading activity moves towards electronic platforms.

From a D&O standpoint, particularly for individual protection, difference in conditions or "DIC" coverage is significant to protect individual directors and officers against insolvency or rescission risks. The language of those programs varies significantly. In light of insurer solvency risks, as well as bankruptcy, liquidation and rehabilitation risks, that sort of coverage can be especially important given current economic conditions.

Editor: What role does overall risk management play, including use of insurance, in assuring a business is covered for major contingencies?

Failla: It is absolutely crucial. Risk management is a discipline - more than simply going out and buying insurance. Insurance is a critical part of it, but the core principle of risk management is the very way businesses are run - whether risks and liability concerns are sufficiently identified; whether there are practices both at the corporate level and in the field to address those risks; whether there are practices to ensure that concerns are brought to management's attention quickly; whether contracts with employees, independent contractors, service providers, customers and clients are properly drafted; whether the limitations of liabilities and indemnity provisions are integrated and considered as a whole; whether insurance fits into the whole program. The critical point is not the elimination of risk, because that's impossible, but whether the risk can be managed in an acceptable way. Everything from business practices trying to mitigate or avoid liability, to corporate contracts, to indemnities, to insurance and self-insurance provisions, to policy design and structure, to litigation risk management - all of these are essential parts of comprehensive risk management.

Editor: How can a corporate policyholder protect itself against an insolvent insurer?

Failla: There is no surefire way to do that. In 2008, we saw a number of insurers affected by the financial crisis. Even insurers that we all thought were the gold standard from a solvency standpoint could have problems that were largely unforeseen by policyholders. There is an element of financial diligence that a risk manager or broker can take to try to mitigate that risk. For individual directors and officers, a form of DIC coverage can fill in a gap, both as a source of coverage for the individuals that is independent of the main corporate program and when there is a layer of the program that will not respond because of insolvency.

From a corporate standpoint, there are programs in the excess market, which are not widespread at the moment but they are becoming increasingly available, in which a high-level excess policy can fill in a gap in coverage that results from another insurer's insolvency. Attention has to be given to making sure there are enough layers of excess coverage so there is a balance between cost and protection. There have to be enough layers of coverage so that if an individual insurer does become insolvent, it does not jeopardize a large percentage of the program. The same principle holds true if you are using a quota-share type structure. You need to ensure that a company's insurance is not overly concentrated with a single insurer or insurance family.

Editor: As a result of the global economic situation, it seems that companies are merging so that they can combine resources or are taking advantage of asset acquisition opportunities. How are the individual insurance assets impacted by these corporate decisions? What insurance matters should corporate leadership consider before the merger or acquisition?

Failla: Mergers and acquisitions present both opportunities and challenges with respect to insurance issues. First, careful due diligence should be performed to determine whether historical insurance assets are available to provide coverage for potential long-term liability exposures. Counsel must ensure that transaction documents explicitly ensure that rights, claims, and proceeds available under historical insurance policies transfer to the successor businesses.

Second, nearly all claims-made policies (which almost always include D&O and E&O policies) contain change of control provisions that must be reviewed before these transactions close. These provisions generally provide that upon a change of control the policies convert to a "run-off" status whereby they will cover claims alleging wrongful acts performed before the close of the transaction, but will not cover claims based on wrongful acts after the transaction. To ensure seamless coverage, companies often consider purchasing extended reporting "tail" coverage to cover claims alleging pre-transaction wrongful acts which are reported up to six years after closing.

Finally, if a transaction presents unique and difficult issues that cannot be addressed adequately through representations and warranties and indemnities, companies should consider purchasing transaction-based insurance. Such policies, which are underwritten for each case, can provide coverage for specific tax liabilities, litigation risks, breaches of representations and warranties, and other deal-specific transaction risks.

Please email the interviewee at jfailla@proskauer.com with questions about this interview.