D&O Insurance and Executive Pay

As executive compensation issues draw increased scrutiny and place executives and their companies under greater risk, they are becoming more important factors in determining corporate strategies for D&O insurance coverage. One of the most challenging duties may be trying to identify and assess these new exposures, which may be further triggered by new legal or regulatory obligations, changes in accounting rules, market pressures, shareholder concerns and demands imposed by both lenders and investors.

Already, new compensation laws have led to increased D&O insurance premiums for companies in Germany. Meanwhile, in the United States, recipients of Trouble Asset Relief Program (TARP) bailout funds are exposed to limitations on executive compensation and the possible return of previously awarded compensation. In addition, bailout-imposed restrictions on executive pay may force companies to rewrite pre-existing compensation agreements or create difficult choices concerning employee retention. Certainly, this is why financial businesses that are experiencing successful results now are scrambling to repay bailout funds. In some segments, the compensation pressures created by government ownership and oversight may be a reality for some time to come.

Looking beyond legislative or regulatory uncertainty, many publicly traded companies have a very real concern that following compensation "best practices" (such as creating a special compensation committee of the board composed of outside directors) may no longer be adequate to ward off shareholder claims. Shareholder pressures-and in some cases, highly charged shareholder activism-are increasing the demand for changes in compensation practices.

As a result, several high-profile companies have gone through considerable public hand-wringing about how they will handle executive pay going forward. These kinds of scenarios are likely to continue to increase, especially if the economy does not improve significantly-and quickly.

Even those companies that are neither subject to TARP nor publicly traded might face provisions imposed by lenders, venture capital providers or strategic investors that result in constricted compensation structures. In closely held corporations, particularly in a difficult economic environment, compensation-related disputes may arise between majority and minority shareholders, or between active shareholders and those who are more passively engaged.

For small businesses and S corporations, there is also considerable fear that any number of potential governmental, tax or regulatory obligations will pose a direct threat to the income of owners and proprietors.

Given the levels of attention public and government officials pay to executive compensation, we should also expect compensation and the way it is determined to become grist for significant increases in future litigation and other enforcement actions. Potential scenarios could include fines, penalties, shareholder or creditor lawsuits, lawsuits brought on behalf of employee-pension or stock-ownership plans, whistleblower claims, lawsuits brought by employees whose compensation packages have changed, and lawsuits brought by former employees whose stock has lost value.

In light of the current regulatory and economic environment, businesses should expand their thinking about D&O insurance. The uncertainty surrounding executive compensation provides an opportunity to look at D&O insurance as a corporate asset that should be actively managed and structured to respond to potential risks.

But D&O policy forms certainly were not written with the current changing climate in mind. This means that: (1) it may not be immediately clear-cut whether a claim involving executive compensation issues is covered, (2) a claim's viability may well hinge on varying or conflicting legal interpretations and applications of policy terms, and (3) if there can be a dispute about whether a particular claim or category of claims is covered, chances are there will be a dispute.

Instead of waiting for compensation-related claims to develop and then turning to your existing policies in the hope that they are covered, corporate policyholders should take a far more active role in understanding how their current insurance policies are likely to perform in the present environment, and what options should be considered upon renewal. Even now, it is foreseeable that questions being raised about current practices could result in litigation and D&O policy vulnerabilities.