All D&O Insurance Policies Are Not Created Equally
By Mark E. Miller, Greenberg
Traurig, Washington, D.C. Office
View or download the PDF version of this Alert
Addressing what has been perceived as widespread corporate abuse, Congress
recently passed The Sarbanes-Oxley Act of 2002, which represents a dramatic
change in federal securities law governing officer and director responsibilities.
Among other things, Sarbanes-Oxley sets forth new corporate responsibility
requirements, enhanced public disclosure requirements, mandatory CEO and
CFO certification of financial statements, and new crimes and penalties
that previously did not exist. The additional responsibilities created by
Sarbanes-Oxley, coupled with what appears to be a significant change in
the way many Americans view corporate directors and officers, could result
in a wave of new securities-related lawsuits, putting at risk, what in many
cases is, a lifetime of hard-earned director and officer wealth.
|"Unfortunately, many directors
and officers find out after a claim has been filed that the coverage
that was purchased is not nearly as broad as they had hoped."
One way in which a director or officer can be protected from personal
financial loss is to purchase director and officer liability insurance.
This coverage is typically purchased by corporations to cover their directors
and officers against lawsuits filed against them in their professional capacities
as directors or officers of the company. Unfortunately, many directors and
officers find out after a claim has been filed that the coverage that was
purchased is not nearly as broad as they had hoped.
Determining what coverage is provided under D&O liability insurance policies
is an not easy task. Key provisions are buried in boilerplate language.
Endorsements often take back coverage granted elsewhere in the policy or
replace one type of excluded coverage with another, leaving little clarity
as to what and how much an insurer will pay if a director or officer is
sued. To complicate matters, the subject of coverage under D&O policies
has long since been shrouded in a veil of confusion, making it difficult
to understand the differences between coverage afforded under different
policies. This alert attempts to simplify some of this confusion, and highlight
potential D&O insurance problems that could be faced by directors and officers
as a result of Sarbanes-Oxley.
D&O Coverage – Differences Outnumber Similarities
Most D&O insurance policies are similar in several important ways. All
D&O policies are designed to provide directors and officers with coverage
for lawsuits or claims alleging the commission of one or more "wrongful
acts" in the scope of a director’s or officer’s professional duties. If
a covered claim is made, D&O policies also provide for reimbursement of
defense costs incurred in defending that claim, and indemnification for
any judgment or settlement in the case.
Despite these basic similarities, D&O coverage varies considerably from
insurer to insurer and policy to policy. Some of the more important differences
- some D&O policies expressly cover securities-related claims and others
expressly exclude them;
- some D&O policies provide for reimbursement of only a portion of legal
fees and expenses incurred in defending a claim and others provide for
full reimbursement of defense costs;
- some D&O policies provide for prompt reimbursement of defense costs
within a specified period of time and others leave the timing of payment
of defense costs up to the insurance carrier;
- some D&O policies expressly exclude coverage for fraud and others
do not; and
- some D&O policies expressly disclaim coverage for criminal acts and
others are silent on the issue.
Differences in documents signed when a D&O policy is procured as well
as differences in D&O policy language greatly affect how the defense of
a claim is handled and what is actually paid by the insurance carrier if
a claim is settled or litigated to judgment.
The Minefield of D&O Insurance Applications
The first step in acquiring D&O coverage is filling out an application.
Because some courts allow a D&O insurer to rescind coverage if a material
misrepresentation has been made in the policy application, the insurance
application often becomes as important a document as the policy itself.
Some of the potential pitfalls lurking in D&O insurance applications
are illustrated in the following two cases. In the first case, an insurance
company requested that recent financial statements be attached to the application.
The policyholder, believing that the statements were accurate, attached
them to the application. Later, a lawsuit was filed, alleging, among other
things, that the financial statements were inaccurate. The insurance company
then sought to "rescind" the policy, arguing that it underwrote the policy
based on a representation that the financial statements provided were accurate.
A court agreed, and allowed the insurer to rescind its policy – depriving
the directors and officers of any coverage. In the second case, the insurance
company also argued for rescission based on alleged misrepresentations in
the policy application, but the allegedly deceptive financial statements
were not attached to the application. In that case, because the financial
statements were not attached to the application, the court held that coverage
could not be rescinded.
Another problematic issue is that of the "innocent director or officer"
who loses coverage because a misrepresentation made by the individual signing
the application is attributed to all officers and directors, regardless
of their personal knowledge or culpability. In these cases, a number of
insurance companies have defeated coverage for all officers and directors
despite the fact that many of the officers and directors were unaware of
These difficulties in the application process will likely be raised with
more and more frequency as Sarbanes-Oxley-related coverage is sought by
directors and officers. This is the case because Sarbanes-Oxley places different
duties on different officers and directors and charges senior officers and
directors with responsibility for matters of which they may not have direct
knowledge. Fortunately, most coverage problems resulting from an insurance
policy application can be prevented if careful attention is paid to the
application process. Nonetheless, in light of the risk of losing coverage,
it is advisable to have experienced legal counsel review a D&O insurance
policy application before submission to the insurance carrier.
Defense Coverage May be Inadequate
One of the most important protections afforded by D&O insurance is reimbursement
of the company and/or the directors and officers for legal fees and expenses
incurred in defense of a covered claim. An issue often arises in securities-related
claims because most claims allege a number of causes of action, some of
which are covered, and some of which may be excluded. The general rule has
long been established that, when a legal action alleges one or more covered
claims, the insurer must defend the entire action. This general rule, however,
is often compromised.
One way in which the general rule of full defense coverage is compromised
is by the use of coinsurance provisions which require that directors and
officers, or in some cases the company (provided that it is solvent) pay
some portion of all defense and indemnity costs paid under the policy. These
provisions may not be an important consideration if directors and officers
have effective indemnity agreements with the company, and the company has
adequate financial resources to meet its indemnification obligations. They
can become a big problem, however, if the company is insolvent. In such
cases, directors and officers may find themselves personally responsible
for paying considerable sums for defense costs.
Another, perhaps more significant problem, is the ever increasing prevalence
of "defense allocation" provisions in D&O policies. These provisions permit
an insurer to pay only a portion of defense costs when a claim alleges both
covered and non-covered claims. In practice, defense allocation provisions
can result in an insurance carrier paying only a fraction of total defense
costs incurred in defending a typical securities class action case.
Another critical concern is a policy’s provisions relating to the timing
of reimbursement of defense costs. At least one court has held that an insurer
need not reimburse directors and officers for defense costs incurred in
defending a potentially covered claim until a final judicial determination
has been made that losses are covered under the policy. Under this ruling,
a director or officer might be forced to pay not only defense costs in the
underlying securities litigation, without any hope for timely reimbursement,
but also to pay for the cost of legal fees to fight a declaratory judgment
action filed by the insurance carrier seeking to disclaim coverage. Fortunately,
a number of insurers have favorably addressed the issue by introducing policies
that contain "timing of payment" provisions that require the insurance carrier
to pay for legal fees within a prescribed period of time, subject to reimbursement
if it is later determined that coverage should not have been provided.
Defense coverage is often the most important part of any D&O policy because
It often takes a considerable amount of money to fight securities-related
claims, even if they prove to be groundless, false or fraudulent. As a result
of Sarbanes-Oxley and increased focus on director and officer activities,
lawsuits and governmental actions will likely increase, and innocent directors
and officers may find themselves fighting lawsuits and administrative proceedings
for which they have no ultimate culpability. In the meantime, If the company
files for bankruptcy or otherwise becomes unable to pay for the defense
of pending claims, D&O insurance becomes the last line of defense between
plaintiffs lawyers and director and officer wealth. Because D&O defense
coverage varies widely from policy to policy, it is important for directors
and officers to examine current policies to determine if they offer adequate
protection. If current coverage is determined to be inadequate, more favorable
coverage should be secured.
"Securities Coverage" Provisions May be Questioned
In addition to the general "wrongful acts" coverage provided under the
director and officer and insured organization coverage parts of a D&O policy,
many D&O policies also contain a separate line of coverage specifically
designed to cover securities claims. A common definition of "securities
claims" provides that coverage is afforded where a claim "alleges a violation
of the Securities Act of 1933, the Securities Exchange Act of 1934, any
similar state statute or similar common law, or any rules or regulations
promulgated thereunder." Because most provisions of Sarbanes-Oxley are drafted
as "amendments" to the Securities Exchange Act of 1934, directors and officers
would argue that actions alleging violations of Sarbanes-Oxley are covered
under existing policies.
Some insurers, however, may not see it that way. Since Sarbanes-Oxley
was not contemplated when most current policies were issued, some insurers
might argue that Sarbanes-Oxley related violations should not be covered.
For this reason, if a thorough review of coverage indicates that Sarbanes-Oxley-related
securities claims might not be covered under specific securities claims
provisions, it may be prudent to secure an addendum clarifying the definition
of "securities claims," or, in the alternative, to move coverage to another
Exclusions Vary from Policy to Policy
Because wrongful act coverage in D&O policies offers such broad coverage,
D&O insurance carriers often rely on broad-reaching exclusions to limit
the scope of coverage granted. Several exclusions of particular importance
after the passage of Sarbanes-Oxley are addressed below.
1. The Violation of Securities Laws Exclusion
Although contrary to the purpose of D&O coverage, some policies contain
exclusions for claims alleging violations of "securities laws." If present,
these exclusions should be reviewed in detail to make a determination of
potential coverage for newly created Sarbanes-Oxley liability. The better
approach, however, is for directors and officers to seek coverage that does
not contain any securities-related exclusions.
2. The Regulatory Exclusion
Similarly, some D&O policies contain an exclusion which states that the
insurer shall not be liable for any action or proceeding brought against
the directors or officers based upon or attributable to any action or proceeding
brought by or on behalf of any federal or state regulatory agency. Although
this exclusion has been held to be void and against public policy in many
jurisdictions, it may present problems in those jurisdictions where its
meaning has not yet been favorably addressed. Policies containing these
types of exclusions could negatively impact coverage for both SEC civil
actions and criminal actions brought under Sarbanes-Oxley. This exclusion
should not have any impact on private lawsuits alleging violations of Sarbanes-Oxley.
3. The Personal Profit or Advantage Exclusion
Many D&O policies contain an exclusion which excludes from coverage all
claims arising out of personal profit, gain or advantage to which the directors
and officers are not legally entitled. This exclusion is often raised in
insurance company reservation of rights letters because a personal profit
motive is routinely alleged in private lawsuits against corporate directors
and officers. Passage of Sarbanes-Oxley is likely to lead to an increase
in such a practice because a number of Sarbanes-Oxley provisions, including
its important CEO/CFO certifications and disgorgement of compensation and
profits provisions, were enacted to counter what is perceived as a personal
This exclusion is most problematic with respect to legal defense coverage.
Because it is likely that many Sarbanes-Oxley related lawsuits will allege
some illegal activity for personal gain along with other less problematic
types of claims (such as negligent misrepresentation and breach of duty),
it is important for directors and officers to carefully assess this exclusion
in conjunction with the defense coverage offered under the policy.
4. The Criminal or Deliberate Fraudulent Acts Exclusion
Although the wording of this exclusion varies from policy to policy,
it is not uncommon for D&O policies to include an exclusion for claims arising
out of any criminal or deliberate fraudulent act. Even before Sarbanes-Oxley,
these exclusions have proved problematic because most securities-related
claims allege some form of fraud, and most D&O policies are purchased specifically
to protect directors and officers against securities-related claims, in
general, and securities fraud class action lawsuits, in particular.
Courts, insurance carriers, and insurance regulatory agencies have dealt
with this dichotomy in a number of different ways. The best approach requires
that insurance companies insert a mandatory endorsement which deletes the
exclusion altogether. In other instances, insurance carriers have revised
the exclusion so that it provides for defense coverage until such time as
it has been determined in the underlying securities case that the director
or officer committed a deliberate or fraudulent act excluded under the policy.
Courts in many jurisdictions have further limited the impact of the exclusion
by holding that an insurance company may not re-litigate fraud in an insurance
coverage case if fraud was not adjudicated in the underlying securities
Coverage for criminal liability raises a number of different issues.
Many states hold that it is against public policy to allow an insurance
policy to cover criminally imposed fines. Yet, not all of these jurisdictions
hold that it is similarly against public policy to allow an individual to
be insured for defense against such claims, because, one is presumed innocent
until proven guilty. Thus, if the policy at issue does not contain a criminal
acts exclusion, defense coverage for criminal acts may be provided.
In summary, given these marked jurisdiction-to-jurisdiction and policy-to-policy
differences, coverage for deliberate fraud and criminal acts should be independently
examined for each D&O insurance policy.
Although it is too early to predict how insurance companies will treat
additional Sarbanes-Oxley related claims under current D&O policy forms,
it is certain that actual coverage provided will depend on D&O policy language.
To help protect personal wealth, directors and officers should, with the
help of legal counsel, take an active role in understanding the coverage
provided under current D&O policies, which may be inadequate, and pay particular
attention to changes in coverage when policies are renewed. D&O policy review
should also be coordinated with a review of indemnity obligations running
from the company to the directors and officers, with particular attention
paid to the preservation of insurance rights in bankruptcy. This is the
only way that directors and officers can be assured that they are protected
against the widest range of claims.
© 2002 Greenberg Traurig
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