Maximizing Your D&O Coverage

Caroline Spangenberg , Brian Epps


June 1, 2010

Even if your company emerged relatively unscathed from the economic crisis and the related wave of securities lawsuits, your directors and officers want assurance that you have constructed a world-class D&O insurance program that will see them through even the worst-case scenario. The following practical tips will allow you to get the most out of your D&O coverage and improve their chances of weathering any storm.

Be diligent in the application process and negotiate the language. 
Providing complete and accurate disclosures in the policy application is critical because material misrepresentations in many states avoid coverage even without proof of an intent to deceive and without having to show that the misrepresentation was related to the loss. In many states, to demonstrate materiality, the insurer need not prove that it would not have issued the policy at all - merely that it would not have issued it on the same terms and conditions or for the same premium. If the insurer succeeds in rescinding the policy on the basis of misrepresentation, it is void - there is no coverage even for innocent insureds.

This draconian result is compounded by the fact that most applications require submission not only of a signed application, but also the company's financial statements and public filings, which are incorporated by reference. Some insurers incorporate all applications since the carrier first started underwriting the risk. So what should you do?

  1. Conduct and document a due diligence process. This will not prevent the misrepresentation risk but should minimize it. Furthermore, although one's bona fides may not legally protect one from a misrepresentation rescission claim, proof of such bona fides nevertheless can influence the fact-finder.

  2. Negotiate the language of the application so that only knowledge of particular insureds (CEO, CFO, risk manager) is imputed to the company.  Be very careful if you include the general counsel as one of these individuals:  at least one case has held that this waives the attorney-client privilege.

  3. Negotiate the severability of the application so that coverage is preserved for "innocent insureds."

  4. Negotiate the language of the application to "soften" the representations being made.
5. Consider "non-rescindable" Side A-only policies.

Mitigate the potential impact of conduct-based exclusions.
Most D&O policies exclude claims arising out of criminal, dishonest, or deliberately fraudulent acts or "willful" or "knowing" statutory violations. Two aspects of these exclusions should be considered and negotiated.

First, what proof of wrongdoing is required for the exclusions to apply? The base policy form typically bars coverage for wrongdoing "in fact." Often, insurers offer an endorsement that prohibits application of these exclusions unless and until there is a "final adjudication" of intentional wrongdoing. Even with the more favorable "final adjudication" requirement, insurers have attempted to obtain such a "final adjudication" in the coverage case, not the underlying litigation. Accordingly, try to negotiate a "final adjudication in the underlying claim" requirement.

Second, do the exclusions apply only to the insured who committed the act in question, or to all insureds? Most D&O policies contain a severability clause that prohibits imputing the knowledge and misconduct of one individual insured to any other individual insureds. The wording of severability clauses varies so pay careful attention.

Negotiate broad severability clauses.
For the reasons described above, one should try to negotiate a more favorable severability clause, not one limited to specific exclusions, and which correlates with misrepresentations in the application.

Pay close attention to the continuity date.
D&O policies typically contain a "prior acts exclusion" that bars coverage for claims "based upon, arising from, or in any way related to" any "wrongful act" that was the subject of a claim prior to a specified "continuity date." Many policies also include coverage for claims based upon wrongful acts occurring prior to the "continuity date" whether or not a claim was brought. Careful attention should be paid to the date specified during negotiations, and consideration should be given to whether tail coverage should be purchased for "wrongful acts" occurring, in part or in whole, prior to that date, or occurring later but "relating to" such wrongful acts.

Take steps to ensure punitive and multiple damages cover.
Most carriers exclude punitive and multiple damages from the definition of covered losses but offer a "buyback" endorsement that brings these damages within coverage. Even when coverage is provided, it is usually limited to the extent that coverage is permissible under the law of the relevant jurisdiction, and some states prohibit coverage for punitive and multiple damages as a matter of public policy. To avoid this pitfall, one can purchase a punitive damages wrap issued outside the United States, or negotiate the inclusion of a "most favorable jurisdiction" clause that guarantees application of the law of the jurisdiction that is most favorable to the insured. Be sure that such a clause also applies to the exclusion from loss of "matters deemed uninsurable under applicable law."

Pay attention to "change in control" provisions and purchase tail coverage when necessary.
Most D&O policies provide that, in the event of a change in control, the policy will remain in force for the remainder of the policy period but will provide coverage only for claims involving wrongful acts occurring prior to the change in control. Some policies terminate coverage altogether at the time of, or even a specified number of days before, the change in control. Depending upon the policy definitions, a "change in control" is either a change in voting control or the sale of all or substantially all company assets. It can also be a major acquisition.

If your company is sold, "tail" insurance should be purchased to provide coverage for claims filed after the date of closing that relate to wrongful acts occurring at or prior to closing. In addition, the coverage provided by the acquiring entity should be seamless, so that there is no gap for "wrongful acts" or "interrelated wrongful acts" that "straddle" the closing date. Insurance counsel or experts should be consulted whenever a major transaction is at hand to ensure that the run-off coverages and the new policies provide seamless coverage.

Negotiate to remove mandatory ADR clauses.
Although alternative dispute resolution (ADR) is admirable, most insureds normally want the freedom to pursue coverage litigation in the forum of their choice. One can always later agree to arbitrate. So it is generally best to avoid mandatory arbitration, especially before a panel of insurance industry experts.

In addition, some D&O carriers insert provisions within ADR clauses that choose a particular state's law (often New York law) and/or that purport to render inapplicable the maxim of contract construction that insurance contracts should be construed against the insurer as the drafter, one of a policyholder's most powerful weapons in a coverage dispute. If the arbitration clause is deleted, this harmful negation of the presumption will also be removed.

Indemnify directors to the fullest extent possible.
Make sure that your company agrees to indemnify its officers and directors to the fullest extent permissible under the law of the state of incorporation. D&O policies contain a provision that presumes the company will have indemnified the individual defendants to the maximum extent permitted by law and that the company's bylaws have been amended to require such indemnification. Thus, if the insured company is permitted to indemnify the individual but fails to do so (other than for reasons of financial insolvency), many D&O policies will not pay the individuals under Side A, or will only pay after exhaustion of the (usually very substantial) self-insured retention or deductible applicable to Side B coverage. Narrowing indemnification decreases the scope of the company's Side B coverage for indemnified losses, and needlessly erodes coverage available to the directors and officers under Side A for non-indemnified losses.

This issue is particularly problematic for companies incorporated in Delaware in light of a recent decision holding that a board could amend the bylaws to eliminate former officers' or directors' advancement entitlement even after a loss has occurred.

Purchase stand-alone, Side A-only coverage in addition to the standard ABC policy.
Most companies today purchase a D&O program that includes the standard ABC policy and a tower of Side A-only coverage. Side A-only policies provide direct coverage to directors and officers when the company is unable to provide indemnification because of dissolution, financial difficulty, or legal prohibition. There are several reasons why standard "ABC" policies may fail to provide directors and officers with adequate protection.

First, some bankruptcy courts consider standard D&O policies to be assets of the bankrupt company because of the Sides B and C protection afforded to the company. Second, since a standard D&O policy combines coverage for both indemnified and non-indemnified losses, the policy limits may be exhausted or depleted by indemnified losses, leaving directors and officers uninsured or with little Side A coverage.

Two types of Side A excess coverage exist: standard follow-form excess Side A coverage, and excess umbrella Side A coverage, sometimes called Difference in Condition (DIC) coverage. Under the former type of Side A coverage, if the primary policy contains problematic language, the excess follow-form Side A-only policy may not drop down and pick up coverage when the primary policy has failed.  Excess umbrella Side A-only DIC coverage, in contrast, is designed to be broader than primary coverage, and should "drop down" and function as primary insurance when the primary carrier has canceled or rescinded coverage, or when the corporation has refused to indemnify the director or officer in question.

Be mindful of the restitution/disgorgement problem.
Several courts have held that policies insuring against "loss" or "damages" do not provide coverage for restitution or disgorgement because an insured suffers no loss or damage by restoring a gain to which it was not entitled in the first place. Unfortunately, there is no easy solution to this problem, other than being cognizant of how the relief is characterized when discussed with the carrier.

Conduct post-claim diligence.
Prompt notice to the carrier of a claim is always essential. Although some (but not all) states or policies require a showing of prejudice for an insurer to succeed on a late notice defense involving an "occurrence" policy, late notice beyond the policy period or extended reporting period is almost universally fatal in a "claims-made" or "claims made and reported" policy, including almost all D&O policies. Remember that a "claim" may be broadly defined under the policy and typically includes not only the formal service of a complaint, but also any "written demand for damages or non-monetary relief," and/or the commencement of criminal, administrative or regulatory proceedings.

The best practice is to coordinate closely with the risk management and law departments whenever a "litigation-hold" notice is issued on the one hand, and notice of a claim or circumstances is sent to any carrier on the other. The carrier will respond to the notice letter by requesting more information, denying coverage or accepting coverage, often under a reservation of rights. You should hire coverage counsel to advise you of your rights and obligations in each scenario, including the right in some states to independent counsel, retained by you at the carrier's expense, when the insurer accepts a defense under a reservation of rights. In addition, do not settle the underlying action without first obtaining the carrier's consent unless the carrier has materially breached the contract by categorically denying coverage. In most states, settlement without consent voids coverage unless the insurer has materially breached.

Consider the international risks.
Companies conducting business outside of the United States should consider an international insurance program to provide consistent cover for all risks worldwide, particularly in light of the exportation of American-style litigation and the resulting increase in international D&O lawsuits.
Caroline Spangenberg is a partner at Kilpatrick Townsend & Stockton.
Brian Epps is a partner in Kilpatrick Stockton's insurance recovery team.