Got Protection?
California CPA magazine: March/April 2008
By David W. Tate, CPA, Esq.
As directors and officers are hit with lawsuits from shareholders, employees, clients, competitors and the government, insurance is one way to protect against the wolves—whether at home or abroad.
Consider this: You’ve been a director and an audit committee member of a company for about a year when you learn that the CEO, CFO and directors are being sued by shareholders for alleged financial fraud that has been ongoing for three years.
Further, the recently fired whistle-blower employee has filed a separate lawsuit against the CEO and the audit committee (which oversees the whistle-blower reporting process) for wrongful termination and retaliation. And the SEC has begun its own investigation.
All of the plaintiffs are seeking compensatory and punitive damages, and the fired employee is also seeking attorneys’ fees.
To make matters worse, you’ve been told that the lawsuit is not covered by the directors and officers (D&O) insurance policy (coverage may be denied for the fraud claim because the company withheld information in the application for insurance, or for all the alleged intentional wrongful acts). The fees that are being paid to the defense attorneys are reducing policy limits that could be used to settle the case, and it has been mentioned that you have to pay some of the costs to defend and help settle the case.
As a director or officer, knowledge of D&O and related insurance issues is key to knowing what questions to ask and understanding whether the company’s D&O insurance coverage and application process sufficiently protect you from liability.
Tony Galban, vice president with New Jersey-based Chubb & Son, says while most directors and officers have been increasingly focusing on enterprise risk management, more attention must be given to their own liability exposures.
Directors and officers “need to focus on their indemnification protections (individually crafted or otherwise) from the company,” he says. “They need to be fully schooled on any D&O liability insurance, understanding that it is common for this insurance to be purchased in a manner that may ultimately benefit the company and the insiders more than outside directors.”
Standard D&O insurance covers:
• Liabilities owed by the individual directors and officers, including attorneys’ fees (sometimes referred to as Side A liability coverage); and
• Amounts paid by the company as indemnification when the company is able to indemnify the directors and officers for liability arising from alleged wrongful acts (sometimes referred to as Side B indemnity coverage). Some policies also provide coverage (sometimes referred to as Side C entity coverage) for certain claims made directly against the company. There is tremendous variation in insurance policy coverage, so each should be structured to address the specific needs of the company for which it is written.
Losses Covered
Losses typically covered under D&O insurance include amounts that the directors or officers are legally obligated to pay for claims against them for wrongful acts, including settlements, judgments, costs of litigation and investigation, attorneys’ fees and other related items.
The definition of the losses covered under the company reimbursement provision typically includes amounts that the company is permitted to pay to indemnify the directors and officers.
From the insurance policy’s viewpoint, a company’s indemnity payments are a loss: they are payments that the company has to make to directors or officers to pay for liability that they incur as a result of their wrongful acts. Policies are self-liquidating, meaning that the amounts paid, such as for attorneys’ fees, reduce the amount remaining for future coverage.
Generally, coverage won’t include fraud, willful or intentional wrongdoing, and criminal or highly culpable misconduct. Whether or not an act is willful or highly culpable may be the subject of disagreement, but an option may be available that makes coverage contingent upon some final judgment of wrongdoing. Losses relating to punitive damages also generally are not covered. And depending on circumstances, fines, penalties and treble damage amounts may or may not be covered.
For a list of typical exclusions for which directors and officers should be aware of, visit www.calcpa.org/Content/24928.aspx. Keep in mind, it may be possible to purchase an endorsement to the policy, or a separate policy, to cover these excluded areas. For example, it would be possible to add an endorsement/separate policy to cover employment practices liability or bodily injury and property damage.
Additional Concerns
According to Winnie Van, senior vice president and director at Redwood City-based ABD Insurance and Financial Services–A Wells Fargo Company, in addition to aligning coverage with their needs and situations, directors and officers must strategically structure their policies.
“Insureds should look to the financial rating and claim-paying experience of carriers,” she says. “The present value of a typical D&O primary policy doesn’t go as far these days. Studies show a rise in average and median class-action settlements. Policy limits are being further eroded by escalating defense costs (due to higher legal billing rates and case complexity) and claims that are beyond the historical types of securities claims, such as derivative lawsuits, opt-out claims and regulatory and criminal proceedings.”
International issues are also coming to the forefront of the D&O insurance world as the business world gets smaller.
“Based on my experience working with companies that are purchasing D&O insurance and studies conducted by our firm, the scope of the potential unlimited personal liability of directors and officers of companies in non-U.S. jurisdictions continues to evolve as rapidly as it is in the United States,” says Priya Cherian Huskins, partner and senior vice president at San Francisco-based broker Woodruff-Sawyer & Co.
“A good D&O insurance program will take into account local jurisdictional requirements, especially in foreign jurisdictions where a U.S. company has major operations,” she says. “For example, the failure to consider whether a locally admitted policy is required could result in a variety of consequences, including a tax penalty on an individual insured or possibly the complete unavailability of insurance proceeds. Also critical to fully protecting directors and officers is the optimization of corporate governance protocols, such as insider trading and corporate governance policies, that reduce D&O risk.”
2008 and Beyond
The new year has also brought new concerns to keep in mind.
“In 2008, buyers (both the directors and officers and companies) should be sure to consider the D&O coverage clarifications that have evolved over the course of 2007,” says Michael Mahoney, senior vice president at San Francisco-based broker Willis Executive Risks. “This includes the clarification that damages arising under Section 11 and 12 of the Securities Code (for initial public offerings and secondary offerings, respectively) will not be labeled as disgorgement by the carrier if they are not categorized as such in a court award or settlement agreement. This can be a valuable clarification, as some case law suggests that disgorgement is not a coverable loss under a D&O policy.”
Generally, people involved with D&O insurance will want to evaluate their situation (the industry, products, services and risk exposures of the company and its directors and officers to lawsuit and liability—including the dollar amount of coverage that should be purchased) and need for insurance coverage. It would also be wise for an insured director or officer (as well as the company) to ask about each area of possible exclusion or limitation (visit www.calcpa.org/Content/24928.aspx for a list) to see if the policy covers the company, directors and officers for those items. If the policy does not, some manner of coverage could or should be arranged either by an additional endorsement to the policy or by purchasing a separate policy to cover those areas in which it is determined that insurance can and should be purchased.
Lawsuits are filed against directors and officers for different and sometimes surprising reasons. But they all tend to involve large dollar liability risk and are expensive to defend. While D&O insurance is an important type of insurance that every public, private and nonprofit entity must consider, policies are not standardized and are generally written to address the specific—and sometimes conflicting—needs of the insured entity and D&Os, so it’s important that directors and officers fully understand the policy they are working under to ensure proper coverage.
Dave Tate, CPA, Esq. is an attorney is San Francisco. You can reach him at tateatty@yahoo.com or http://davidtate.us.
