A Director's and Officer's ("D&O") insurance policy does not provide full protection to directors and officers. Every D&O insurance policy contains numerous coverage exclusions, some obvious and some hidden. Moreover, insurance companies are expert at construing their policies to deny coverage in new and arcane ways. Companies must work carefully with their insurance brokers and consultants to craft the best possible insurance policies. However, directors and officers must realize that even with the best policies, an insurance company may deny coverage and that a court may uphold the denial on the basis of the restrictive policy language.
D&O policies are "claims-made" policies. Thus, the insured officer or director or the company itself is covered for "claims" first asserted, and noticed to the insurance company, during the policy period. Under D&O policies, late notice of a claim will frequently foreclose coverage. However, the insured may not know how to recognize a "claim."
Standard definitions of "claim" in D&O insurance policies may be extraordinarily broad, encompassing not only the commencement of legal proceedings, but rather any "written demand for monetary or non-monetary relief." While the insured usually recognizes that it need give notice of a complaint against it, it may not realize that it must also give notice of far more informal communications. See, e.g., FDIC v. St. Paul Fire & Marine Ins. Co., 993 F.2d 155, 158 (8th Cir. 1993) (stating that an insured is required to provide proper and timely notice under a D&O policy of all "acts and occurrences that could become future claims").
Most people, from homeowners to general counsel, do not like telling insurers about speculative claims that are not likely to ripen, for the simple reason that it may increase premiums. Under D&O policies, if the insured does not give notice of the initial informal claim that later ripens after the policy period, the insured may have forfeited coverage. Also, a D&O policy usually does not provide coverage for a claim that 'relates back' to a claim first made prior to the policy's inception date. For example, assume you receive a letter from a shareholder alleging some absurd theory and requesting, on that basis, that you restructure the company. You ignore it. A year later, a class action is filed seeking the restructuring of the company. If the class action allegations relate back to the letter you previously disregarded as "absurd," you may have no coverage.
Do Damages Include "Ill-Gotten Gains"?
D&O policies provide coverage for "damages." Some courts have recently interpreted this term narrowly to apply solely to compensatory legal damages as distinct from equitable relief, and to find no coverage for judgments ordering disgorgement of wrongfully obtained funds. For example, in Level 3 Communications, Inc. v. Fed'l Ins. Co., 272 F.3d 908 (7th Cir. 2001), the court denied coverage for restitution of artificially inflated stock prices to shareholders by the corporation.
In Liss v. Federal Ins. Co., No. MRS-L-1845-01 (N.J. Super. Ct. App. Div., June 29, 2004), the New Jersey Superior Court held that while no express coverage exclusion applied to the restitution of wrongfully acquired funds, coverage was nonetheless barred for such "damages." The court looked to the policy's definition of loss, stating that since loss "does not include ... matters uninsurable under the law ...," the public policy of New Jersey warranted declination of coverage for restitution of such gains as an "implied exclusion." Id. at *4.
A severability clause in a D&O policy may preserve coverage for innocent directors and officers despite the fraudulent acts of others. A recent Fifth Circuit case, TIG Specialty Ins. Co. v. PinkMon key.com, Inc., 375 F.3d 365, 369 (5th Cir. 2004), confirms the importance of having an effective severability provision.
In that case, while the insurance policy explicitly covered securities claims against the company and insureds, it contained a personal profit exclusion precluding coverage for ill-gotten gains. Greene, the largest shareholder, chairman and CEO of the tiny start-up company, was found guilty of statutory stock fraud based upon misrepresentations to procure investment in the company. Despite no evidence that Greene received any money directly, the court remarkably applied the personal profits exclusion, reasoning that the sizeable capital investment in the company provided Greene the opportunity to become the owner of a successful business, and this constituted a personal advantage. Over a vigorous dissent, the court then denied coverage for the other five officers and directors implicated in the action and to the company itself, reasoning that since all of the claims arose out of the original fraud by Green, the exclusion precluded coverage for all of the insureds.
Payment And Reimbursement Of Defense Costs
D&O policies do not provide coverage for many claims. Often, their true worth is to pay defense costs. However, here too there is a problem, because most D&O policies only provide that the insurer must advance costs, subject to a right of reimbursement if the claim ultimately is not covered. Little case law exists on the impact of this provision, however insurers use their right to reimbursement as a club in settlement negotiations to force insureds to accept inferior settlements.
In Assoc. Electric & Gas Ins. Srvcs, Ltd. v. Rigas, 2004 WL 540451 (Mar. 17, 2004), the court held that a D&O insurer must advance defense costs until it has proven the merit of its coverage defenses. This decision, while favorable for policyholders, does not foreclose the possibility that an insurer may be able to avoid advancing defense costs altogether where it can make a strong threshold showing that coverage is barred under the policy, or later obtain reimbursement. See Brown v. Am. Int'l Group, Inc., 339 F. Supp. 2d 336 (D. Mass. 2004).
Allocation Of Defense Costs
In Hebela v. Healthcare Insurance Company, 370 N.J. Super. 260 (App. Div. June 28, 2004), the New Jersey Appellate Division set forth a very clear standard to use when apportioning defense costs between covered and uncovered claims.
The court focused its attention to the overlapping attorneys fees between an uncovered claim and a covered counterclaim, setting forth the standard that the insurer had to pay all of the "mixed fees," i.e., costs attributable to both covered and uncovered claims. The court reasoned that the insurer had agreed fully to defend against any covered claim, and should not benefit from the fact that its defense incidentally aided the insured on uncovered claims.
For insureds, disputes with insurers over how to allocate have been a nightmare. This is frequently an issue in D&O cases, where, for example, some claims may be within the insured v. insured exclusions and others not, or where a complaint may allege a mix of D&O, employment and fiduciary claims. Hebela provides an extremely favorable allocation standard. The insurer preliminarily has the burden of paying all defense costs, and then has the burden of demonstrating which costs were incurred solely with respect to uncovered claims.
The "Insured v. Insured" Exclusion
"Insured v. insured" exclusions preclude coverage for claims brought by one insured against another. This exclusion is intended to avoid collusion among insureds, and is usually subject to an exception for derivative actions brought by corporate shareholders against individual directors and officers or actions brought by a receiver or bankruptcy trustee, since these entities are deemed to act for the benefit of the corporation's creditors and not for the benefit of the corporation. See, e.g., In re County Seat Stores, Inc., 280 B.R. 319 (Bankr. S.D.N.Y. 2002). While some courts have excepted wrongful termination lawsuits from the exclusion,1 i.e., suits brought by former officers or directors, the Seventh Circuit in Level 3 Communications, supra, has stated that the exclusion bars coverage for such a claim. Some D&O insurance policies now explicitly except wrongful termination suits from the insured v. insured exclusion in their policies.
Broad Form Exclusions
Expansive exclusions in D&O policies may wipe out a broad array of coverage. In Porter v. American Int'l, Case No. A-5213-02T2 (N.J. App. Div. Nov. 1, 2004), the policy excluded claims "alleging, arising out of, based upon, or attributable to any actual or alleged contractual liability of the Company or any other Insured under any express contract or agreement." In this case, the policyholder acquired all but one unit of the seller's business, and had control of a lockbox for payments to the seller related to the remaining business. The seller sued in conversion, unfair practices and misrepresentation when the payments were not made. The court found no coverage because the claims "arose out of" the Asset Purchase Agreement.
Similarly, in National Union Fire Ins. Co. v. U.S. Liquids, Inc., 88 Fed. Appx. 725 (5th Cir. Feb. 17, 2004), the policy excluded claims "alleging, arising out of, based upon, attributable to, or in any way involving, directly or indirectly . . . any environmental claim." The court held that this exclusion barred coverage for a shareholders derivative suit arising out of failure to disclose illegal waste disposal practices.
The presence of such expansive exclusions in D&O policies, extinguishing critical coverage for corporate directors and officers, may have broker malpractice implications.
Recent developments in D&O case law highlight the need for insureds to work with their brokers to ensure they are getting what they pay for - comprehensive D&O coverage. Failing to negotiate appropriate language in a D&O policy or failing to understand the terms in that policy before a claim is lodged can leave policyholders bare.
1 See, e.g., Conklin Co. v. Nat'l Union Fire Ins. Co., 1987 WL 108957 (D. Minn. Jan. 28, 1987).
Robert D. Chesler is the Chairman of the Insurance Law Practice Group of Lowenstein Sandler PC, based in Roseland, New Jersey. He can be reached at (973) 597-2328. Cindy R. Tzvi is an Associate in the firm's Litigation Department. She can be reached at (973) 597-6164.