Negotiating the terms of a directors and officers insurance policy can be a tricky thing.
In essence, each D&O policy is more akin to a negotiated commercial contract than an “off the shelf” insurance product. The negotiation process is made even more difficult by the ever-changing landscape of directors and officers liability, as new laws, new exposures and new interpretations arrive, seemingly every day.
Failure to painstakingly explore and evaluate this new environment and compare today’s new risks to current policy language is rampant with danger, as failure to do so can lead to unfulfilled expectations and even personal liability to the individual directors and officers.
The essence of any contract is certainty of purpose and effect. Since the protection of a board member’s personal assets is one of the primary obligations of a D&O policy, the importance of certainty is even greater. Some might say that the greatest challenge of the D&O insurance industry is to continue to provide that certainty in an ever-changing environment. An examination of the history of securities litigation validates this statement.
Today, D&O underwriters and policyholders alike face new challenges. Chief among these are growing liability exposures including:
- Heightened risk of non-indemnifiable conduct, such as acts not taken in good faith, shareholder derivative claims, certain securities and sexual harassment allegations and cases of corporate financial insolvency;
- Increased claims activity alleging employment practices violations such as sexual harassment;
- Likelihood of governmental investigations; and
- Year 2000 (Y2K) exposure.
To fully understand the challenges facing D&O underwriters and policyholders today, we must look back to the spring of 1995. As with today, providing contractual certainty was a critical issue.
In 1995, D&O insurance underwriters faced a challenge. Since the mid-1980s, when securities litigation against directors and officers skyrocketed, one of the chief purposes for D&O policies had been to provide coverage for claims brought by shareholders of publicly-traded corporations. After ten years of experiencing high-severity securities claims, D&O underwriters encountered a major problem in that the corporate entity, as well as individual directors and officers, were generally named as co-defendants in securities claims.
Unfortunately, the D&O policies of the time provided coverage for directors and officers, but failed to insure the corporate entity. As a result, standard D&O policies had to allocate joint defense costs or indemnity payments between the covered and uncovered parties. The question for underwriters was “how to allocate.”
At first, most insurers opted for policy silence on the allocation issue. After all, D&O policies had not expressly dealt with the “allocation problem” since these types of policies were first designed in the late 1960s, so why do so now? This approach left it to the insurer’s claims department to figure out what the allocation should be at the time of the claim.
The problem with this approach is that it left both parties to address allocation at the time of the claim, arguably when the insured is most vulnerable.
Recognizing the certainty was most beneficial to both insurer and insured, and with the Private Securities Litigation Reform Act on the horizon, American International Group’s National Union, in May of 1995, became the first carrier offer a policy that expressly addressed this exposure, providing a pre-set allocation between the directors and officers and the corporate entity, thus creating certainty of coverage. Entity coverage, as it came to be known, became the new standard for D&O insurance purchasers.
A year later, following the enactment of the Private Securities Litigation Reform Act, changes in the environment required a reexamination of D&O policies. The Reform Act had impacted securities litigation by increasing the severity of certain types of securities claims and shifting much of securities litigation to state courts.
Again, some underwriters chose policy silence, essentially failing to update the policy language to the new liability environment. However, National Union in 1996, and later other underwriters, introduced specific coverage enhancements expanding the definitions of “Securities Claim” and “Insured” as well as providing enhanced coverage for state court securities cases.
The bottom line: First in 1995 and then again in 1996, certainty and breadth of coverage had won over silence.
In 1998, we are revisiting the same issue, this time in response to the emergence of Y2K exposures for companies and their management.
Directors and officers face both disclosure and management responsibilities for Y2K. Claims arising from these responsibilities can take many forms, including:
- Shareholder class actions alleging improper or even deliberate fraud, in connection with disclosure of Y2k events;
- Shareholder derivative actions alleging mismanagement;
- Governmental investigations including service of personal subpoenas by the Securities and Exchange Commission;
- Breach-of-contract suits by customers, suppliers or others;
- Whistle-blower suits by employees; and
- Claims brought by bankruptcy trustees or corporate creditors should Y2K force a company into bankruptcy.
How should D&O underwriters respond to these potential liabilities?
Essentially, there are three possible approaches.
One, insurers, frightened by potentially massive losses, will try to exclude coverage. While not common in today’s soft market, at least one insurer has decided to exclude Y2K claims from some of its D&O policies (see NU, May 11, 1998, page 10).
Other insurers, as was the case in 1995 and 1996, may prefer for the D&O policy to remain silent on this issue. These insurers may state that Y2K claims will be covered “to the same extent as any other claim.”
The critical failure in this approach is that it does not indicate whether such coverage is sufficient. This raises a question: Is providing coverage for Y2K claims to the same extent as non-Y2K claims giving the insured enough coverage?
The third approach, to expressly address Y2K exposures, answers the question posed above. Close examination of standard D&O policies will almost always find that they do not provide all the Y2K coverage an insured may require.
The Securities & Exchange Commission, in a July 29, 1998 Commission Interpretation of their Jan. 12, 1998 Staff Legal Bulletin on the Y2K issue, recognized the potential deficiencies in existing insurance policies, stating that “we stress in this release the uncertainties related to remediation, third parties, litigation, insurance coverage and other contingencies in the Year 2000 context.”
In the same document, the SEC favorably addressed Y2K-specific insurance policies, stating that “in considering whether potential Year 2000 consequences are material, companies may offset quantifiable dollar amounts of those consequences that would be covered by Year 2000-specific insurance policies, provided that the policies have a sufficiently broad coverage to cover all risks.”
Current “entity coverage” policies provide substantial coverage for securities claims of every nature-class, derivative or direct. Coverage is provided for the corporate entity as well as all directors, officers and employees. Yet, as broad as that coverage is, there is room for improvement. For example, the term “Claim” does not cover SEC investigations, a type of claim that is expected to increase in frequency in the wake of the previously referenced July 29, 1998 statement by the SEC on companies’ Y2K disclosure:
“We [the SEC] intend to intensify our efforts to elicit meaningful disclosure from companies about their Year 2000 issues. Only through that disclosure can investors make informed investment decisions. We believe that companies have sufficient incentive to provide meaningful disclosure to investors and meet their Year 2000 disclosure obligations. These incentives include business reasons, investor relation concerns, and possible referrals to our Division of Enforcement.”
Given the length to which the SEC has gone to spell out disclosure obligations, companies that fail to make a good-faith effort to meet these obligations might be found to have acted with deliberately fraudulent intent, triggering the fraud exclusion in a standard D&O policy.
Outside the securities laws, three problems emerge with a standard D&O policy.
The first is a familiar one-allocation. Since the entity is not an insured for non-securities claims, contract claims naming both the corporation and directors and officers require loss allocation between the covered directors and officers and the uncovered corporation.
Unlike 1995-and this is a critical point-there is little hard data available on how these types of claims have been allocated by the industry in the past. One significant reason is that the vast majority of breach-of-contract claims never name a director or officer and thus are never submitted to a D&O carrier.
The data that does exist strongly indicates that a D&O policy would contribute very little to these claims in the event a director or officer was named. At this time, the Y2K claims of a contractual nature that have been brought have not named a director or officer.
Regardless of the differences in data collection, the fundamental questions for D&O underwriters and insureds are remarkably similar to those posed in 1995. Should policyholders leave this allocation issue to the time of the claim, perhaps hoping for a more favorable result? Should they choose to fight two fronts, the claimant and the insurance company? Should they choose to spend the substantial legal fees necessary to negotiate a higher level of coverage or, rather, should they obtain the coverage they need, clearly and expressly?
Additionally, is it in the best interest of the insurance industry to avoid today’s problems until tomorrow when the claim is reported or to solve the issue up front?
We at AIG believe that the answer today is no different than the one in 1995-a negotiated fixed pre-set allocation approach.
The second non-securities-related deficiency in standard D&O policies is clear. Standard D&O policies do not provide coverage for government investigations, even those against individual directors and officers. Given the enormous potential impact of Y2K on regulated industries, it can be expected that government regulators will investigate those companies, and the individuals within them, with questionable Y2K compliance.
Finally, if Y2K has the economic impact many experts believe it will, bankruptcy filings will increase. For those companies filing under Chapter 7 of the U.S. Bankruptcy Code, claims brought by bankruptcy trustees frequently can be expected.
Standard D&O policies contain a so-called “insured vs. insured” exclusion. In many states, this exclusion has been interpreted as applying to claims brought by a bankruptcy trustee, thus robbing directors and officers of coverage when they need it the most, when their company is financially unable to protect them.
Whether the Y2K-related policy issues are the result of allegedly fraudulent securities disclosures, contractual claim allocation, government investigations or bankruptcy, standard D&O policies do not sufficiently address these risks.
For D&O underwriters and their insureds, the answer is clear: certainty over silence, expanded coverage over boilerplate.
In the end, 1998 is not different than 1995. We believe that public and private companies alike need to thoroughly review their D&O programs to contemplate not only Y2K exposures, but the changing role of regulators and the evolution of corporate governance around the world.