GT Alert

All D&O Insurance Policies Are Not Created Equally

August 2002
By Mark E. Miller, Greenberg Traurig, Washington, D.C. Office

  View or download the PDF version of this Alert here.

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 include:

• 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 the misrepresentation.

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 insurance carrier.

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.

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.

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.

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 profit motive.

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.

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 case.

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.

Conclusion

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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