Many privately held companies assume that their indemnification provisions will be sufficient to protect their directors and officers against personal liability as well as the legal costs of defending against claims or responding to investigations. This assumption may be valid in most situations, but the risk that indemnification might not be available when it is needed, however small that risk might be, is a major issue because of the potential financial consequences of personal liability. Indeed, the legal fees involved in defending against a lawsuit or responding to an investigation, even if the lawsuit is frivolous or the investigation is unwarranted, can be daunting, and few situations are more infuriating than being compelled to settle a frivolous lawsuit at personal expense just to avoid ongoing legal fees.
One situation where indemnification of directors and officers has little value is during the insolvency of the corporation—a situation where the risk of lawsuits is high, including suits naming the directors and officers personally because they are likely to have more money to satisfy a judgment than the corporation. Moreover, indemnification of directors and officers is a creature of state law. In many states, the corporation law provides that directors and officers cannot be indemnified for certain acts and related expenses. This limitation on indemnification overrides any contrary language in the corporation’s articles of incorporation or by-laws or in a separate indemnification agreement. In addition, even when indemnification is permitted by law, the form of indemnification language adopted by the corporation may grant discretion to the corporation in the application of indemnification, thereby raising the risk that indemnification will be refused when it is needed. This can occur because attitudes change, depending on circumstances. Everyone is concerned with the best interests of the directors and officers when the indemnification is first granted, but once a director or officer is accused of doing something harmful to the corporation, especially if the accuser is a governmental agency, the views of the “innocent” directors toward the alleged wrongdoer can influence the way the Board of Directors interprets or applies the corporation’s indemnification language. For example, it is common to see indemnification language that says the corporation may advance legal fees to a director or officer during a legal proceeding or investigation, subject to recoupment if the director or officer is subsequently found to have committed acts for which indemnification is not legally permitted. This use of the word “may”, as opposed to “shall”, creates a risk for each indemnified director and officer and a troubling situation for those who, when the time comes, must decide whether or not to advance legal expenses. Finally, payments by a corporation on behalf of its indemnified directors and officers, assuming the indemnification is lawful and the corporation is solvent, can be a major expense for a small private company, an expense that is probably not covered by the corporation’s general liability policy.
Thus, D&O insurance can be an important risk management tool for both the directors and officers in their personal capacity and for the corporation itself. However, D&O insurance is not a “one size fits all” product. The corporation should engage a broker who understands this market when seeking coverage and it should engage experienced counsel to review and negotiate the proposed policy. A D&O policy should always be tailored to meet the needs and circumstances of the corporation. If the insurance carrier will not negotiate, the broker should find another carrier that will.
What follows is a very basic primer, not legal advice. It is impossible to provide a good summary of D&O insurance in a space of a few blog posts. That said, it might be helpful to know some of the terminology and issues relating to coverage and exceptions.
Insurance professionals often refer to “Side A, B, and C” clauses in a typical D&O policy. Those clauses can be briefly described as follows:
Side A coverage protects individual directors and officers against liability in situations where the corporation is not legally or financially able to provide indemnification.
Side B coverage reimburses the corporation to the extent it makes payments, including legal fees, pursuant to its indemnification of its officers and directors.
Side C coverage is separate coverage for “securities claims.”
All three coverages are typically subject to a single shared limit of liability, and Side B and Side C coverages are usually in excess of a self-retention that must funded by the corporation. Many policies provide that the corporation’s articles, by-laws and board resolutions will be presumed to indemnify the directors and officers to fullest extent permitted by law. This is important for two reasons. First, the corporation’s payments on behalf of directors and officers may be reimbursable under the Side B coverage even if the corporation’s actual indemnification language does not apply to the payments. And second, if the corporation is permitted to indemnify a director or officer (and is financially able to do so) but elects not to do so, the individual director or officer should be protected by the Side B coverage, including funding of defense costs by the insurer, although the individual would be required to pay up to the amount of the corporation’s self retention.
Side A DIC coverage: In addition to the three coverages mentioned above, many companies now purchase Side A-only excess “difference-in-conditions” (DIC) coverage in addition to and on top of the primary Side A insurance. This so-called “Side A DIC coverage” provides broader coverage than that afforded by the primary Side A insuring clause.
Specifically, Side A DIC policies will typically provide coverage for non-indemnifiable claims that are excluded by the primary coverage, such as ERISA and pollution claims, which are often excluded under the primary policy. In addition, the so-called “conduct” exclusions in primary coverage (discussed below) may be narrower for purposes of Side A DIC coverage. Side A DIC clauses may also be drafted to fund an individual’s defense when the company wrongfully refuses to advance defense costs. This is a better alternative for the individual than relying on the Side B coverage because the latter is subject to the corporation’s self-retention, whereas the Side A DIC clause is not. The market for Side A DIC coverage is very competitive so the terms are open to negotiation, including individual limits for directors (so that one director does not exhaust the policy limit at the expense of the others) and elimination of most, if not all, exclusions. In fact, obtaining Side A DIC coverage can be a good solution if it becomes difficult to negotiate acceptable terms for the primary policy.
Side C coverage (securities claims) may or may not be appropriate for a private company. The decision to obtain this coverage will be based on a balancing of the cost for this coverage versus the level of risk of directors being held personally liable. The level of risk depends on the corporation’s future financing plans and the nature of its current and prospective investors. Of course, directors of SEC reporting companies face a much higher risk than those of a private company because Section 11 of the federal Securities Act of 1933 imposes liability, in a registered public offering, on directors and any officers who signed the registration statement for any material misstatements or omissions in the registration statement, unless those directors or officers believed, after reasonable investigation, that the statements in the registration statement were true. This same standard does not apply in private placements. However, plaintiffs can and will add directors and officers in a lawsuit to recover losses from a private placement by the company, alleging that the directors and officers knowingly participated in a scheme to defraud investors. Courts have generally not been sympathetic to such claims, but there are still legal fees involved in defending, and an insolvent corporation may not be able to cover those fees. In this regard, it is possible to obtain, in lieu of Side C coverage, a version of Side A&B coverage with language allocating loss between the corporation on the one hand, and the directors and officers on the other. This will not afford coverage for securities claims made solely against the company, but it will treat as a covered loss defense costs and other losses jointly incurred by the company and the directors and officers who are named as defendants.
D&O policies typically have exclusions for fraud, dishonesty, and illegal profit or advantage—so-called “conduct” exclusions. While most directors and officers are confident that they would not act in a manner that fell within one of these exclusions, the issue is often raised by the way the plaintiffs characterize their claims. For example, securities law violations are brought as fraud claims and the individual directors are alleged to have knowingly aided and abetted the fraud. Similarly, an action by a shareholder to recover, on behalf of the corporation, payments made to directors under back-dated stock options will attempt to characterize the Board’s approval of the options as self-dealing. In these situations the insurer, after receiving notice of a claim, will typically reserve its rights to deny coverage under the policy, even if it pays the defendants’ legal fees. The wording of the policy can be critical in these situations where the allegations against the directors and officers, if taken literally, would put their conduct into one of the policy exclusions. Relevant here is the “trigger” language in the policy that allows the insurer to invoke the exclusion. Some policies require a court judgment or “final adjudication”, i.e., the insurer cannot deny coverage in the absence of a final adjudication by a court of fraud or illegal profit in the underlying lawsuit. This is favorable to the insurer in two ways. First, most cases settle so there is never a “final adjudication”, and second, this type of clause should afford the insured coverage for defense costs, assuming other exclusions do not eliminate coverage.
Other D&O policies have wording that only requires the conduct in question to have occurred “in fact.” That is, the insurer may invoke the exclusion if there is evidence sufficient to show that the alleged misconduct did in fact occur. (Note that insurers are not likely to act arbitrarily when applying an “in fact” trigger because, as with any insurance policy, an insurer that unreasonably denies coverage can be sued for “bad faith”, which in many states can result in punitive damages and/or attorney’s fees.) Some newer policy forms have a variation of the “in fact” trigger for the exclusion: coverage can be denied if the wrongdoing is evidenced by an insured’s own written statements, documents, or admissions. This raises the question of whether an admission by one director can be attributed to other indemnified persons.
Obviously, a trigger of “final adjudication” is the best alternative for the directors and officers and the corporation. This alternative is also consistent with most indemnification clauses adopted by corporations, which require or permit payment of a director’s or officer’s legal expenses until a final adjudication is reached. By negotiating a “final adjudication” trigger in the D&O policy, the corporation can avoid the risk that it will be advancing legal expenses to its directors or officers after the insurer has denied coverage on the basis of an “in fact” trigger.
Insured vs. Insured Exclusion
The “insurer vs. insured” exception was originally designed to prevent collusion between the directors of the insured corporation and the corporation itself (which, as a practical matter, is run by the same directors). For example, a corporation might choose a supplier of parts on the basis of the recommendation of one of its directors. Suppose the vendor later files for bankruptcy and the corporation cannot get delivery of the parts, thereby falling behind on orders, which in turn leads to a cancellation of major contracts and loss of future business. Suppose further that the corporation learns, after the fact, that the director who recommended the supplier knew about but did not disclose the supplier’s financial difficulties because the owners of the supplier were close friends of his. What would prevent the corporation from suing the director on a “friendly” basis for breach of his duty of care as a director, and then reaching a settlement with the director in the expectation that the D&O insurer would cover the settlement? It is the “insured vs. insured” exception that prevents it. Fair enough. But the exception is now often applied in a much broader manner than was originally intended, and it raises several difficult questions.
A typical D&O policy provides coverage for past, present, and future directors and officers. It is not hard to conceive a situation in which a former director or officer brings legal action against both the corporation and the directors. Suppose, for example, that a CEO, who is also a shareholder, is terminated by the Board of Directors for his opposition to an important transaction that, in the CEO’s view, could not be approved by the Board without a breach of the directors’ fiduciary duty. The CEO then brings a lawsuit for wrongful termination against the corporation and a derivative claim against the directors who voted in favor of the transaction. The “insurer vs. insured” exclusion would apply under most D&O policies, although such a situation was probably not contemplated at the time the exclusion was first developed. In today’s world, the possible claims by former directors and former officers, including claims based on whistleblower laws, suggest that the exception should be limited to claims by the corporation itself against other insureds. This type of limitation can usually be negotiated. Moreover, the “insured vs. insured” exception can often be further narrowed through negotiations with the insurer so that it does not apply to shareholder derivative claims and certain claims brought on behalf of a corporation while it is in bankruptcy.
There are other issues to consider when reviewing a D&O policy but they are beyond the scope of this posting. Suffice it to say that D&O coverage is not a simple matter and, if sought, should be negotiated on behalf of the corporation by an attorney with the requisite experience. Of course, threshold question for a privately owned corporation is whether to obtain D&O coverage at all. This is simply a matter of risk management. Does the cost outweigh the risk protection? How significant is the risk in terms of the probability of relevant events occurring and the financial consequences if one of the events does occur? Different companies will arrive at different answers to these questions, but it certainly makes sense to assess the cost and the level of protection available, and then to make an informed decision.