July 22, 2010

Congratulations! You have been asked to join the board of directors of the hypothetical Lancaster Corp. As a good corporate citizen, you take very seriously the obligations that you will owe to the company and its shareholders if you accept the appointment. As an independent director, you will be asked to keep the management of Lancaster "honest" by ensuring that it does not put its concerns ahead of shareholders' interests. Although you believe you are up to the challenge, this can be a tough job that comes with a significant risk of liability.

No matter how well you perform your responsibilities as an independent director, there is always a risk that your actions will result in a regulatory investigation or litigation. Even if a claim against you is meritless, responding to an investigation or defending a lawsuit can be very expensive. Moreover, a settlement or judgment easily can outstrip the financial resources of even the wealthiest individual director. Although directors are often indemnified for defense costs and liabilities, you should be reasonably concerned because there are a number of situations in which the company may be unable to or refuse to indemnify.

In comes D&O insurance, which can provide a measure of protection for liabilities resulting from errors, omissions and breaches of duty, as well as other wrongful acts in connection with service as a director or officer. But not all D&O coverage is the same. Variations in policy terms and program structures can make all the difference in whether an insurer will pay the costs of defending a claim and any resulting liability or settlement. Before you accept a directorship, assess the adequacy of the company's D&O insurance using the same qualities of prudent decision-making that made you an attractive director candidate. While the following 10 questions are by no means exhaustive, they do provide a basic starting point for identifying the merits and pitfalls of a management liability insurance program.

1: Are the insurers and general program limits acceptable?

Insurers can be evaluated on a number of factors, such as financial health and reputation for acknowledging or fighting coverage for similar claims. If you are considering a directorship, it is worth knowing if the company's D&O insurers have a reputation for delaying payment of defense costs and litigating with insureds over coverage. It is also important to determine if your company's D&O program limits are appropriate for its risk profile. For example, Lancaster Corp. has had considerable turmoil in its executive ranks, is engaged in a bitter proxy battle with YorkCorp, and is mired in a protracted takeover battle with Valois Inc.—all sources of considerable liability risk. As such, Lancaster faces a significantly higher D&O risk profile than other, more stable, companies

2: Are individual outside directors adequately protected?

Lancaster has a reputation for constantly shifting board alliances. As a result, today's trusted counselor may be tomorrow's management scapegoat. Given the ongoing proxy fight with York, the current board could find itself out of office and facing meritless claims of breaches of duty. In anticipation of this possibility, it may be prudent to insist that the insurance program include Side A/DIC coverage, a type of D&O insurance that (1) provides excess coverage for individual directors and officers to the extent that they are not indemnified by the company and (2) fills gaps in coverage if other insurers deny coverage or fail to honor their obligations. Side A/DIC coverage is not, however, a cure-all. As with any insurance coverage in this area, there are variations in the terms under which it is offered. Circumstances that trigger the coverage under one policy may not do so under another policy.

3: Is the risk of rescission adequately limited?

Your insurance is of value only if it actually exists. In very broad terms, an insurer can rescind the coverage (treat it as if it had never been issued) if a misstatement was made in obtaining the insurance. Because applications for D&O insurance typically incorporate public financial filings and past applications, a misstatement in one of those incorporated documents may provide the basis for rescission. In general, an insurer must sue to rescind. But that is little comfort if you are a defendant in a significant claim in which the insurer has denied coverage and is suing for rescission because of an error in a financial statement pre-dating your service as a director. There are, however, a number of ways to limit an insurer's ability to rescind, ranging from a bar on rescission, to limiting the availability of rescission to "culpable" parties, to limiting the materials that are deemed incorporated into the application. These and other options provide widely different levels of protection and should be reviewed closely.

4: What is the scope of the conduct exclusions and is there any risk that the exclusions will apply even if you did nothing wrong?

In general terms, the "conduct" exclusions apply to loss resulting from criminal or fraudulent acts or to improperly obtained compensation. Most businesspeople would agree that such loss should not be covered. But if you were dragged into a lawsuit because a fellow director was allegedly involved in a fraudulent scheme (of which you were innocent and unaware), wouldn't you expect your defense to be covered by insurance? If that same director ultimately acknowledged that he or she engaged in fraud, should you be forced to repay your defense costs? If you lose at trial, should you be expected to bear the costs of an appeal? Although your answers to these questions are likely self-evident, the answers you would find in standard form D&O insurance policies may vary widely.

5: What is the risk that individual insureds will be forced to pay a retention?

D&O insurance policies typically contain different retentions (or deductibles) depending on the particular coverage grant. If Lancaster is being reimbursed for the defense of one of its directors, there likely will be a retention, ranging from tens of thousands to millions of dollars. On the other hand, if the insurer is paying directly for your defense because you are not being indemnified, there may be no retention at all. What if Lancaster and the insurer, however, disagree about whether Lancaster should be providing a indemnification? Will the insurer begin advancing your defense bills from day one, or are you responsible for paying the retention that the insurer believes should have been paid by Lancaster? If there is Side A/DIC insurance that fills in any gap caused by Lancaster's refusal to indemnify you, will an underlying insurer recognize that payments by the Side A/DIC insurer satisfy the retention? Different policies will provide different answers to these questions.

6: Under what circumstances does the "insured vs. insured" exclusion apply?

Lancaster Corp. is beset by in-fighting on the board and is engaged in a proxy fight with YorkCorp (a large shareholder with representatives on the board). Standard D&O policies contain some version of an "insured vs. insured" exclusion, which generally bars coverage for claims brought by one insured (an individual director or officer or subsidiary) against any other insured. But what about claims brought by former directors or officers? What about claims brought by YorkCorp given that it has representatives on the board? Does the exclusion apply if an embittered former officer brings a "whistle-blower" claim (purportedly for the benefit of the company) alleging that the board engaged in illegal conduct? Once again, the answer will vary among the policies that are generally available in the marketplace.

7: What protections are available to insured persons in the case of bankruptcy?

Who actually owns a D&O insurance policy? Lancaster is the policyholder and it paid the premiums, but you are an insured under the policy. If Lancaster declares bankruptcy, will the insurance program be treated as part of the bankruptcy estate? If so, what if there is a lawsuit against individual directors? Will the insurance company stand by the individual insureds to make the policies available for their benefit? If a receiver, appointed for Lancaster, sues former members of the board claiming that they were derelict in their duties, is that claim subject to the "insured vs. insured" exclusion? There may be significant differences in how these questions are answered depending on the particular policy form.

8: Are "claim" and "loss" defined broadly enough?

As a director, you have been served with an investigatory subpoena by a governmental regulatory agency. It will cost you considerable expense to respond. This must be a "claim," right? Not under many D&O policies. What if you have been assessed with a penalty for a purely inadvertent violation of short-swing stock trading rules? Once again, this is not necessarily a covered loss. What if, as part of the settlement of a complex class action (in which the insurer refused to fund the settlement), you allowed a judgment to be entered against you that will not be executed if the settlement amount is paid by insurance proceeds? Is this a covered loss? Not under some common D&O policy forms.

9: Are there favorable terms for the advancement of defense costs?

If you are sued, you have to pay your attorneys to defend you against all of the claims, not just the ones you think might be legitimate. If you don't pay your defense bills in a timely manner, you would expect to hear about it from your attorneys. The same logic must apply to D&O insurers, right? Not necessarily. According to some D&O policies, the insurer will advance all defense costs for claims against individuals that contain a mixture of covered and uncovered matters. More commonly, however, policies will require a D&O insurer to pay only for the defense of covered claims, and it is the insurer that typically is entitled to determine which defense costs apply to covered claims. Of these two alternatives, which one would you prefer? Similarly, some policy forms require payment within a certain time period after the receipt of defense bills. It is far more common, however, for a D&O policy to be silent regarding the speed with which an insurer must pay an individual's defense costs. Again, of these two alternatives, which one would you prefer?

10: Is the program structured as consistently and seamlessly as possible?

Realizing that Lancaster is facing risks on multiple fronts, management has made the decision to add several new layers of excess D&O coverage. The devil is in the details, however. When is an excess policy's coverage required to kick in? Is it after the underlying insurer has paid its limits or after the underlying insurers and/or the insured have paid losses equaling the amount of the underlying limits? What happens if the underlying insurer refuses to pay its limits and, in order to avoid litigation, there is a settlement for less than limits? Depending on the terms of the excess policies, there may or not be coverage in this situation. Coordination across policy years is also important. Lancaster has beefed up its coverage because it is concerned about the risk of claims. But many "features" could leave you asking, "Where's the beef?" For example, what if the new coverage contains language that lumps together current wrongful acts with "related" prior wrongful acts or current claims with "related" prior claims covered under prior policy years? What if the new policies contain "prior acts" exclusions? With careful planning, these types of pitfalls may be avoidable.

Carefully Evaluate before You Agree to Serve

Even if you understand and appreciate the risks and responsibilities inherent in serving on a corporate board, it is not wise to accept a position without asking hard questions about D&O coverage. Using the same business acumen and good judgment that made you an attractive board candidate in the first place, take the time to work with legal counsel to evaluate the company's D&O program to make sure it will adequately protect you from personal liability in connection with your tenure as a director.

This article contains material of general interest and should not be construed as legal advice or a legal opinion on any specific facts or circumstances. Under applicable rules of professional conduct, this content may be regarded as attorney advertising.