D&O Coverage - What You Should Know In This Compliance-Oriented and Litigation-Intensive Environment

Thursday, June 1, 2006 - 01:00

Editor: Tell us about developments influencing the market for D&O insurance.

Campbell: People are thinking very carefully about taking board positions, especially with public companies, and looking very closely at the adequacy of the D&O insurance being offered. Corporate Board Member did a survey of 900 board members in 2005 and learned that 48 percent had turned down a board position because of the risk of being sued. Of these, 49 percent said that D&O coverage (or a particular policy that was being provided by the company they were considering) was an important factor in that decision.

One encouraging statistic is that the market for D&O insurance is softening. Tillinghast reported a nine-percent decrease in average D&O premiums for public companies in 2005, and a 10% decrease in 2004. This follows in the wake of 50% to 150% increases in D&O premiums between 2001 and 2003. The further away we get in time from the major corporate scandals that hit in the early 2000s, the more softening we see in the market for D&O coverage.

Kincade: The run-up in cost of D&O insurance that Don mentioned was in large part attributable to the substantial loss in market value that public companies suffered during the 2000 bear market that lasted until 2003. When stock prices decline substantially, as they did during that period, insurers increase rates in anticipation of more litigation. The sustained market gains over the last few years have reduced some of the concern about litigation exposure. Another factor in the softening of the market has been the increased emphasis on good corporate governance and implementation of stronger compliance programs in the wake of Sarbanes-Oxley. The focus of litigation also seems to be shifting toward smaller companies. Their in-house counsel will want to be sure that their directors and officers have adequate D&O coverage.

Editor: Do insurers look at a company's governance and compliance practices, before issuing a D&O policy?

Campbell: The major carriers conduct a detailed and extensive analysis of corporate governance and other issues before they underwrite D&O insurance for a company. A company's corporate governance rating will impact the availability, coverage, limits and price of D&O insurance. Standard & Poor is probably the most prominent rating service for public companies. S&P will look at a laundry list of good corporate governance practices and then drill down to assign their risk rating. This process is applicable primarily to public companies but private companies (including private equity funds) are also purchasing D&O insurance. Carriers have a wide variety of procedures for reviewing the corporate governance standards followed by these organizations.

Editor: What are the components of a D&O policy?

Campbell: There are three main components. Side A protects the directors and officers from personal loss if the corporation is unable to indemnify them. Side B coverage reimburses the corporation for amounts that it is required to pay directors and officers for indemnifiable claims. Side B usually carries a pretty significant "retention" - which, like a deductible, is an amount the company must pay before the insurance is triggered. The third type of coverage, Side C, covers the entity itself usually for securities claims. It also involves a substantial retention.

Kincade: For directors and officers, Side A coverage is key. There are circumstances where it is of critical importance. One is where the company is insolvent and unable to pay. A second is if the conduct of the director is outside the scope of the indemnity provision in the company's articles or bylaws. A third possibility would be if the company is barred by law or regulation from providing indemnity - for example, in a derivative suit.

Editor: CEO's and other senior officers are encouraged to broaden their experience by serving on other public company boards. Should exposures resulting from such service be covered by their employer's policy?

Campbell: The major carriers generally do not provide coverage in that situation because they become an underwriter of liability growing out of service on the boards of unrelated corporations. Such coverage dramatically expands the exposure of the underwriter. Directors who serve on multiple boards should make sure that each company maintains adequate D&O insurance. The exception to this rule would be service on the boards of subsidiaries or affiliated companies who are defined as insureds under the policy.

Kincade: From a corporate governance standpoint, counsel like former Attorney General Dick Thornburgh, who was the court-appointed examiner in the WorldCom bankruptcy, have mentioned to me that there may well be less internal pressure on corporate executives to sit on multiple outside boards. Given the increased responsibilities of directors, be they management or outside directors, they now are expected to put in more time as board members. Service on multiple boards may increasingly be perceived to be inconsistent with this expectation. Under the new regulatory framework, counsel may well recommend that a company not bring in someone as a director who is sitting on multiple boards and may recommend against having its officers and directors sit on more than one other board. Serving on multiple boards is becoming too burdensome and may create additional exposure because it gives rise to an assumption that a director on multiple boards cannot put in the time required to discharge his or her responsibilities as a director. Mr. Thornburgh was clear in his view that the days of the professional director sitting on multiple boards were coming to an end.

Editor: What is the hottest issue involving D&O insurance?

Campbell: Once it was both rescindability and severability. However, the severability issue has been largely resolved. Most policies now contain a severability clause. Now, for most boards rescindability is the principal issue. Rescindability arises when the insurer contends that there was a misrepresentation in the application for insurance. It takes the position that it would not have written the policy if it had known about the misrepresentation and that therefore the policy was void from the beginning. Companies need to be careful to narrow or eliminate the rescindability of D&O insurance. The language can be narrowed by specifically listing the documents that are being relied upon by the insurance carrier.

Editor: How do directors protect themselves from rescindability when so many companies restate earnings?

Campbell: The best way for directors to protect themselves now is for the company to purchase non rescindable Side A coverage for the outside or independent directors. This coverage makes it clear up front that the policy is not rescindable because of a misrepresentation in the application. The market does not offer it for officers or inside directors who are more likely to be involved in the situation that triggered the restatement.

Editor: What are the potential risks of not obtaining D&O coverage?

Campbell: One can argue that it would be reckless for a board of a public company not to obtain D&O insurance. And, it would be unlikely that anyone would serve on the board of such a company. Because the potential harm to the company is so great, it would be extremely rare to find a public company that does not have D&O insurance. Conversely, some executives - especially for private companies - think their company is a less enticing target if it does not carry D&O insurance, and while perhaps true in very limited cases, that is quite a risk to carry. Most companies struggle more to decide how much D&O coverage is appropriate, not whether to purchase it in the first place.

Editor: What is the role of outside counsel experienced in the area of D&O insurance?

Kincade: Boards should be selective when identifying which counsel they use to review D&O insurance policies and work with the broker. Experience is an important factor to consider. You should work with someone who is knowledgeable about the various provisions of a D&O policy. Counsel should first advise the board about the points that should be negotiated. And, counsel should then work with the broker to arrive at the best result from the board's standpoint. Finally, more and more individuals are hiring their own personal counsel to review D&O policies at a corporation as a precondition to serving on a board because of the fear of personal liability. This also occurs when there is a renewal of a policy.

Editors Note: Mr. Kincade is co-chair of the firm's Securities Litigation & Enforcement Practice Group. Mr. Campbell is a member of the Practice Group and focuses his practice on corporate governance litigation and counsel and cases involving claims of breach of fiduciary duty, including those involving directors and officers.