Frequently Asked Questions About Director's and Officer's Liability Insurance
What is Director's and Officer's liability insurance?
D&O insurance covers a corporation's directors and officers for some covered claims made against them. D&O insurance also reimburses the corporation for the cost of indemnifying officers and directors for covered claims. For an extra fee, the insurance will cover the corporation itself for a more limited group of covered claims. This coverage of the corporation's liability is called entity coverage. The principal risk that D&O insurance is designed to cover is claims brought by a corporation's shareholders, including securities fraud claims. Another risk to which D&O insurance is directed is the risk of employment-related lawsuits brought by employees against officers or directors for discrimination, harassment, and the like. If your company is concerned about employment practices liability, you should consider other insurance in addition to D&O insurance.
Should a public company buy Director's and Officer's insurance?
Yes. In our view, there is no question about it. That doesn't mean that everyone agrees with us. Those who advocate not buying D&O insurance assert that a D&O policy is a 'pot of honey' that attracts the lawyers driving securities fraud claims, and that if no insurance is available claims are less likely to be brought. Although the assertion is logical, it can't be proven correct. From our point of view, this logic does not take some important factors into account. First, most corporations have the capacity to pay large judgments or settlements even if they don't have insurance. Second, securities fraud claims are often brought quickly and before the plaintiffs' lawyers know whether the defendants are insured. We are not aware of any case that has been dropped because of a lack of insurance. Third, insurance is very useful to the corporation when it is sued. Although we don't believe that the question of whether to sue turns on the existence of insurance, we do think that the amount of settlement is affected by the amount of insurance. Plaintiffs' lawyers (unless the amount of insurance purchased is unreasonably low) in many cases recognize that they will not be able to obtain a settlement greater than the available insurance. Even if the insurers will not cooperate to pay the full amount of the insurance, the existence of the insurance in these cases tends to lower the settlement cost to be paid by the corporation. Fourth, D&O insurance protects officers and directors when the corporation can't or won't protect them. Not every case brought by plaintiffs is likely to be won on a motion or even at trial. Corporations typically can't indemnify officers or directors who lose a securities fraud case; and they sometimes find themselves without the money to indemnify or fund a defense even where that is permitted. Corporations can also be more or less cooperative with respect to managers who are deemed responsible for events that prompt a lawsuit.
Isn't the company's indemnification obligation enough protection?
A corporation is required to indemnify its officers and directors for certain claims made against them because of their roles as officers or directors. If your company falls on hard times or is acquired by others, or if you no longer work for the company, the company might not be able or willing to indemnify you. This problem is particularly acute if your company filed for bankruptcy. Certain claims, such as derivative claims, may be covered by insurance even when they are not indemnifiable. The availability of insurance makes it likely that someone besides you will pay the costs of defending a complicated lawsuit while you reach agreement with your company (or former company) about indemnification.
How much D&O insurance should my company buy?
There is no one-size-fits-all answer to this question. In general, a public corporation should not buy less than $10 million. Most new high-tech companies in Massachusetts purchase about $10-15 million in coverage at the time of their initial public offering, generally at the lower end of that range. Some Internet-related companies are purchasing more insurance at the time of their IPO, in light of the possibility of rapid appreciation in their stock price and the risk of volatility. More well established companies often buy significantly more coverage. You should discuss the amount of coverage that is appropriate with your insurance broker and your lawyer.
What are coverage layers?
If the typical high-tech company wanted to buy $15 million in D&O insurance, it is highly probable that no one insurer would provide all of that coverage at a reasonable rate. Insurers want to make sure that they don't have too many eggs in one basket. They do so by declining to provide D&O policies with large policy amounts. If your company wants more insurance than the primary insurer will supply, you will need to buy "excess" layers of insurance. Excess D&O policies typically "follow form" - they have the same terms and conditions as the primary policy. The primary and excess policies together cover the same risk, and the effect of the layers is to allocate the risk among various insurers.
How many layers of coverage are appropriate?
Some layers are necessary; the question is whether layers are a necessary evil. We generally think that fewer layers are better than more layers, but this is something about which reasonable people disagree. Both points of view rest on different conclusions drawn from one observation: the process of persuading any insurer to part with significant sums to fund a settlement will take significant time and effort because the insurer must be persuaded that the risks are real and the settlement amounts are reasonable. Those who favor more layers focus on the frustration felt by plaintiffs' lawyers eager to make a settlement. Perhaps they will take less to settle the case because of the difficulty or impossibility of persuading one or more of the excess carriers to fund a settlement. Those who favor fewer layers focus on the same frustration from the perspective of a defendant eager to have its risk resolved with the insurers' money.
How do we get Director's and Officer's liability insurance?
The price, terms and conditions of D&O insurance policies offered by all D&O insurers are negotiable. More favorable terms and conditions are often available, often without additional cost. In order to get the best price and terms, you need the help of an insurance broker who specializes in the placement of D&O policies. An experienced broker will canvass the market to determine which insurers are prepared to offer insurance to you, and with the assistance of counsel will negotiate the best price and terms possible. Your lawyer will also have some ideas about appropriate terms, and some information about which insurers are easiest to deal with when claims are made.
A typical D&O policy covers officers and directors for claims made within a stated period because of actions officers or directors of a corporation took or failed to take in their official capacity. A number of exclusions and the stated retention limit the scope of coverage provided. The two major risks that purchasers of D&O insurance have in mind are claims that may be brought by the corporation's shareholders (for example, securities fraud) and employees (for example, employment discrimination). Your company should consider what other insurance it needs in addition to D&O coverage.
Until a few years ago, a typical D&O policy did not cover corporate liability, and instead merely reimbursed the expense incurred by the corporation to indemnify officers and directors. In order to address allocation issues, D&O insurers now offer entity coverage for securities claims. In other words, upon request the insurer will cover the liability of the corporation itself for securities law claims. Securities law claims usually are brought by or on behalf of shareholders of the corporation. A class action filed in federal court claiming that a corporation or its officers made false or misleading statements that inflated the market price of the corporation's securities is a typical securities law claim. Although most policies limit the scope of entity coverage to securities law claims, some broader coverage may be available for an additional fee.
Sometimes claims are filed in a single lawsuit against parties whose liabilities are covered by insurance, as well as those who do not have coverage. At other times, a lawsuit against a single defendant might assert claims that are covered by insurance, and others that are not covered. When this happens, the insurer may seek to pay less than all costs associated with the lawsuit on the grounds that the defendant or some claim is not covered. When insurers take this position, they say that they are allocating the costs of defense or indemnification among covered and uncovered parties or claims.
Entity coverage prevents the insurer from seeking to allocate the expenses of litigation between covered and uncovered parties. Suppose that a company buys a D&O policy without entity coverage, and suppose that a securities fraud lawsuit is filed against the company and its CEO. The claim against the CEO would likely be covered by the policy; the claim against the corporation would not be covered. The insurer might assert that half (or some greater or lesser percentage) of the cost of defending the claim is not covered by the D&O policy, because half of the defendants are not insured. If the company had purchased entity coverage, both the CEO and the corporation would likely be covered by the policy, and no allocation issue would arise.
Every insurer's basic D&O policy form is different. It would be unusual for any insurer to offer coverage pursuant to its basic form without amending it by attaching what are called endorsements. The basic form offered by most insurers does not contain the normal terms and conditions demanded by knowledgeable purchasers of D&O insurance, and many additional endorsements enhancing the scope of coverage will be added upon request as a matter of course. Nevertheless, most D&O policies have several things in common. All D&O policies: (1) contain promises to provide certain insurance to certain covered persons or entities; (2) identify the retention per claim; (3) identify the maximum dollar amount that may be paid pursuant to the policy; (4) identify the time period in which claims must be made in order to be covered; (5) detail the exclusions limiting the scope of covered claims; (6) set forth other conditions and terms that govern the way that the insurer will handle claims.
Insuring Agreements. Almost all D&O policies make at least two promises: (A) to cover officers and directors of a corporation directly for certain claims based on actions they took or failed to take in their capacity as an officer or director if the corporation does not indemnify them for these actions ("A-Side Coverage"); and (B) to reimburse the corporation for the expense incurred to indemnify officers and directors for the same claims ("B-Side Coverage"). A-Side Coverage typically does not apply unless the corporation is financially unable to pay indemnification expense. In addition, for an additional fee all D&O insurers offer entity coverage for securities law actions. Some insurers provide coverage to selling shareholders of a corporation's obligation to indemnify its underwriters for securities law claims included in an underwriting agreement for an initial public offering. Some insurers have specific coverage language applicable to Y2K claims. Other insurers offer "A-Side Only" coverage that applies only when the corporation is financially unable to pay indemnification expense.
Retention. A retention is like a deductible that applies to each claim. Most high-tech companies purchasing D&O insurance in connection with an initial public offering purchase policies having a $250,000 retention for each securities claim. This means that the corporation will be required to pay the first $250,000 of expense related to each securities claim. It is important to ensure that there is no retention with respect to A-Side Coverage. Although it is reasonable for the corporation to agree to pay the first $250,000 of expense associated with a claim (to the extent it is financially able to do so), a significant retention would be a severe burden for individuals entitled to A-Side Coverage because of the corporation's financial incapacity.
Maximum Dollar Amount. All D&O policies plainly state the maximum amount for which the insurer is at risk under the policy, including costs of defense. Other types of policies can include a duty to defend in addition to a duty to indemnify up to a stated amount per claim; D&O insurance policies do not impose any duty on the insurer to defend the claim. The effect of this is that the costs of defending the claim diminish the amount available to pay a settlement or judgment. In other words, if your company has $5 million in D&O insurance, and it costs $5 million to defend and settle the first claim to which the policy applies, there will be nothing left to defend or settle a second claim. If it costs $2 million to defend the claim, only $3 million would be available for settlement or judgment.
Claims Made Insurance. D&O insurance is "claims made" insurance. With limited exceptions, it covers only claims actually made in the period stated in the policy. This means that if the policy period is January 1, 1999 through and including December 31, 1999, a claim filed in court on January 1, 2000, based on an action taken in June 1999, is not covered. Depending on the policy, even if the same claim was filed on December 31, 1999, it might not be covered if you don't find out about until January 1, 2000. This is different from other kinds of insurance written on an "occurrence" basis. For example, whether comprehensive general liability insurance applies generally depends on when the action claimed to cause liability occurred, and not the date upon which the claim for liability was filed.
Exclusions . The insuring agreements contained in a typical D&O insuring agreement are very broad, but are sharply restricted by exclusions narrowing the scope of coverage. The typical D&O policy contains at least a dozen exclusions in its basic form, and additional exclusions added by endorsement. One example included in every D&O policy is the "actual fraud" exclusion. This may come as some surprise, given that one major risk that insureds seek to cover by D&O insurance is securities fraud claims. If the policy does not cover securities fraud claims, why bother to buy the insurance? The answer to this question requires recognition of the generally limited scope to which any indemnification of fraud claims is permissible. It is generally against the law to indemnify people for deliberate fraudulent or criminal acts; otherwise (if perpetrators knew that they would be insured if they were caught) there might be more fraud and crime. It is not against the law, however, to advance to those accused of fraud the costs of defending themselves, or to settle claims where fraud is alleged but not proven. Consistent with these principles, the typical D&O policy excludes coverage for fraud claims after there has been a final determination of liability for actual fraud. The words that each policy uses to describe this exclusion make a difference. Some policies exclude fraud claims only after an "actual adjudication" adverse to the insured. The courts interpreting this provision have for the most part held that the fair reading of an "actual adjudication" requires the adjudication to be made in a case brought by a third party against the insured, and cannot be made in a case brought by the insurer to avoid payment on its policy. In response, some insurers have changed their wording to exclude fraud "in fact," to better position themselves to argue that they can bring their own action to determine whether an insured committed fraud. Your broker and lawyer can advise you about how to try to narrow exclusions and obtain the most favorable policy language.
Other Terms and Conditions. The typical D&O policy has numerous other provisions, and should include an express obligation of the insurer to advance defense costs after exhaustion of the retention. Other typical provisions are worthy of deletion where possible, such as arbitration clauses or other procedural hurdles preventing an insured from prompt recourse to the courts in the event that the insurer's claims handling practices leave something to be desired.
This is a complicated question that you should discuss with your lawyer and attempt to plan for in connection with negotiating your policy.
- Software errors and omission
- Professional liability
- Comprehensive general liability
- Employment practices liability insurance
- Coverage for venture capital firm employees sitting on public company Boards of Directors
- Cyberspace liability