Frequently Asked Questions about Director's and Officer's Liability Insurance

Frequently Asked Questions about Director's and Officer's Liability Insurance


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.

What claims against Directors and Officers are covered by a typical D&O policy?

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.

What claims against a corporation are covered by a typical D&O policy?

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.

What is an "allocation issue"?

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.

What relationship does entity coverage have to the issue of allocation?

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.

How do I determine the scope of my D&O policy?

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.

What happens to my D&O coverage if my company goes bankrupt?

This is a complicated question that you should discuss with your lawyer and attempt to plan for in connection with negotiating your policy.

What insurance should I consider in addition to D&O insurance?

William H. Paine