Management Liability, Directors and Officers (D&O) Insurance Overview

Corporate directors and officers have two sources of protection for claims made against them in their business capacity: indemnification by their companies or D&O insurance (sometimes referred to as Management Liability Insurance).  Since directors sit outside the corporate veil they can be held personally liable for their actions.

Although the corporate entity can - and almost always does - indemnify its directors and officers, this form of protection by itself is usually considered inadequate for several reasons:

• The company may go bankrupt, or may have insufficient resources to pay the costs of defending and / or settling a lawsuit.
• Some claims may not be indemnifiable , for example, violations of Federal securities laws.
• Changes in the leadership of the company may make current directors unwilling to indemnify prior directors and officers.

Managment Liability Insurance was developed to complement indemnification, in order to mitigate risk for business leaders. You can think of D&O insurance as Errors and Omissions coverage for your company’s management team.  It can essentially act as the funding vehicle for the corporate indemnification; it can also respond to non-indemnifiable claims; it can also provide coverage to the corporate entity itself.

A Little History

Originally, D&O insurance was designed to protect only the individual directors and officers of a company.  Over time, D&O insurance has expanded and evolved into what is now known as A-B-C coverage. “Side A” coverage provides for indemnification of individual directors and officers where the underlying claim against them is nonindemnifiable—i.e., where the company legally is not permitted to indemnify them. “Side B” coverage reimburses the company for proper indemnification payments made to its directors and officers. “Side C,” or entity coverage, covers the company itself, for claims against it, such as securities law claims. 

While, on its face, this expanded coverage would appear to be a good deal for everyone, the fact is that it has turned out to be a double-edged-sword, particularly in the event of a major meltdown claim.  Think of it this way, if you baked a pie, and invited only a few friends over to share it, you'd probably have enough pie for everyone to enjoy.  The more people you invite, however, the less pie there is to go around.  True, some of your friends might not like pie and therefore may not take a piece, but one or two friends might really, REALLY like pie and may try to take more than their fair share.  Eventually, one way or another, conflicts will arise . . . unless you bake more pies.

With all of the directors - both insiders and independent - officers, and the corporate entity sharing the same D&O "pie", these same conflicts can - and do - arise.  The following are but a few of the typical scenarios that can create conflict:

POORLY - OR FRAUDULENTLY - PREPARED APPLICATION: The application is almost always prepared by one or more of the corporate officers, and the independent directors rarely participate.  What if a problem exists within the company about which the officer preparing the application is aware, but which he/she fails to properly disclose, whether deliberately or otherwise?  In a worst-case scenario, maybe this officer is actively participating in on ongoing fraud, about which the board members are unaware?  The failure to disclose knowledge of circumstances that could reasonably be expected to give rise to a claim is considered a material omission or misrepresentation, and could be the basis for the denial of coverage - or worse, an action to rescind coverage altogether.

TOO MANY GUESTS; NOT ENOUGH PIE: In the event of a major claim, you have the corporate officers, independent directors, and the entity itself all competing for the limited resources of the insurance policy(ies).  What if the entity was forced to file bankruptcy?  Now you could be faced with a new, unexpected guest . . . the bankruptcy estate, and possibly even a receiver or trustee to deal with.  One of the responses to this issue is the advent of "Dedicated A-Side" coverage, which provides excess coverage to the independent directors in the event that the primary policy(ies) are depleted or otherwise impaired.

A REAL PIG OF A GUEST: Back to the pie analogy...  What if one or two individuals' need for coverage is disproportionate to everyone else.  Maybe you have one or two "bad actors" who - allegedly - are at the center of whatever problem is causing the claims.  In order for them to mount their defense, it may deplete the insurance resources, leaving everyone else to fight over what's left.

Since the collapse of the dot-com bubble at the end of the 1990s, the corporate accounting scandals in the early years of this century (Enron, WorldCom, Tyco, Adelphia, Qwest, just to name a few), and the more recent meltdown in the financial services/mortgage lending arena, the size of D&O settlements, especially in shareholder class action suits, has grown enormously. Since that time, there have been dozens of settlements exceeding $100 million, with over half of those exceeding $200 million.

Of course, regardless of the outcome of a particular case, the complexity - and thus the cost - of defense can be staggering.  Again, this is often compounded by the various constituencies within a company.  The independent directors' defense strategy may be in conflict with the inside directors/officers, whose strategy may be in conflict with certain individuals, as well as the entity itself.

Increased Regulatory Scrutiny

In 2002, as a response to the Enron, Tyco, WorldCom and other accounting-based scandals, Congress passed the Sarbanes-Oxley Act. Although the official name of the law is the “Public Company Accounting Reform and Investor Protection Act of 2002,” some of its provisions are also helpful to, and thus widely used in, private and non-profit companies.

Sarbanes-Oxley established clear requirements for company directors and officers to ensure that financial systems were well designed and managed, and that financial reports were true, complete and accurate. 

More recently, the changes in Washington have seen a newly invigorated SEC, along with aggressive action on the part of the Federal Reserve, Treasury Dept., FINRA, CFTC, etc.

It is vital that businesses understand their increased exposure and adequately insure their directors and officers. Whether yours is a public company, a non-profit organization, or is a privately-held company, ELA can help you find the best possible D&O coverage. Browse the pages in this section of our site and then contact us. Let us work with you to obtain this critical protection for your directors and officers.

Contact

Robert O. Link, Jr. 212 504 6172 robert.link@cwt.com