This Port in a Storm: Policyholders Should Insist on Full Coverage Promised by D&O Policies


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PUBLISHED ON: April 10, 2010

The subprime credit crisis, as well as the associated scandals, has spawned a still-burgeoning number of prosecutions,claims and lawsuits. Subsequent to the Madoff, Dreier and Stanford frauds, the Securities and Exchange Commission (SEC) and federal and state prosecutors have increased the prosecution of those accused of wrongdoing. The increase in SEC scrutiny, federal and state prosecutions, and shareholder lawsuits for the resulting financial losses, expose directors and officers to increased criminal and civil liability. Similar results are also expected in the United Kingdom and elsewhere in the European Union because of the actions of regulators, prosecutors and shareholders.

Already, approximately 200 subprime-related shareholder lawsuits have been filed. Each of these has the potential for massive policyholder losses. These cases often generate defense costs, settlements and damages totaling millions and even billions of dollars. Most corporations provide indemnity protection to their directors and officers, and also purchase directors’ and officers’ (D&O) liability insurance, primary and excess, specifically designed to cover such losses.

Today’s Environment is a ‘Perfect Storm’ for D&O Liability Insurance

The economic, liability and claims environment presents an unprecedented "perfect storm” of potential difficulty for D&O liability insurance policyholders. Four powerful forces are conspiring to cause this storm. First, the subprime and related stock market catastrophe triggered huge losses; second, the same negative investment income that hit the market in general also hit insurance companies; third, insurance companies are facing a continuing “soft” market for insurance premiums; and finally, the current economic environment impels policyholders to seek to maximize insurance recovery — which means that more policyholders are insisting that insurance companies provide the full coverage promised by their D&O policies. This perfect storm is bound to result in stricter claims review and an increase in denials of payment by insurance companies. Here are some steps to take and factors to consider with regard to filing D&O claims.

When a Loss Occurs, Think D&O Insurance

D&O liability insurance is usually not the first thought to come to mind when considering how to recoup a loss. It should be. Most D&O liability insurance policies broadly insure directors and officers, other high-ranking employees and the corporation for a loss alleged to stem from a wrongful act. Moreover, D&O polices should offer timely relief, insofar as they provide for current advancement of defense costs. Many D&O liability insurance policies insure broader categories of individuals than those narrowly defined as “directors” and “officers,” i.e., other high-ranking employees. Moreover, these policies cover directors’ and officers’ “wrongful acts,” often expansively defined as any act, error, misstatement or omissions, neglect or breach of duty committed by the directors or officers while serving in that capacity. D&O policy language typically is also broad in what it characterizes as “loss,” generally identified as the damages, settlements and defense costs that the corporation is legally obligated to pay as a result of the directors’ and officers’ wrongful acts. Finally, D&O policies also provide for current advancement of defense costs — a benefit that looms large as the legal bills mount swiftly aft er a lawsuit is filed.

Effect of Defense Counsel’s Relationship with the Insurance Company

From the outset of a claim or lawsuit, corporate counsel should work with outside defense counsel to help ensure reimbursement for the loss. Many defense counsel are well-versed in submitting defense invoices to insurance companies for reimbursement, and often have long-term relationships with insurance companies. Defense counsel should format their invoices to be easily transferred to the insurance company for payment. Defense counsel may be on a “panel counsel” list, and should probably comply with the insurance company’s billing guidelines to the extent they are reasonable. Such practical cooperation will likely ease reimbursement under D&O liability insurance policies. Of course, when a significant D&O liability loss occurs, the small print gets magnified, and insurance companies raise all manner of often specious “coverage defenses” in an effort to avoid their payment obligations. Defense counsel often face a conflict in opposing such arguments, and a policyholder often needs independent insurance “conflicts counsel” to respond adequately.

Delaware has Clarified the Stability of the Indemnity Obligation to Former Directors and Officers

Given the liability environment facing current directors and officers, they demand a secure indemnity obligation running from the corporation. Indeed, over the last two years many corporate counsel were asked about potential weakness in those indemnity rights. A corporation’s articles of incorporation, bylaws and indemnity agreements should be checked to confirm the scope of indemnity protection. A recent Delaware decision in a case that tested a corporation’s right to alter its obligations to directors and officers, Schoon v. Troy, and the Delaware legislature’s subsequent action,have thrown this issue into stark relief.

The Schoon court held that a former director’s right to advancement of expenses under indemnification provisions in the corporation’s bylaws did not “vest” until an indemnifiable claim was asserted against him (either when the corporation’s payment obligation triggered or the date of the filing of pleadings against such former director). Therefore, prior to such time, the corporation could amend its bylaws to eliminate the right to advancement of expenses with respect to such former director. See Schoon v. Troy, 948 A.2d1157 (Del. Ch. 2008). Subsequently, an amendment to Delaware General Corporation Law § 145(f), effective August 1, 2009, addressed the decision in Schoon. The amendment provides:

A right to indemnification or to advancement of expenses arising under a provision of the certificate of incorporation or a bylaw shall not be eliminated or impaired by an amendment to such provision aft er the occurrence of the act or omission that is the subject of the civil, criminal, administrative or investigative action, suit or proceeding for which indemnification or advancement of expenses is sought, unless the provision in effect at the time of such act or omission explicitly authorizes such elimination or impairment after such action or omission has occurred.

Thus, subsequent to the statutory amendment, Delaware directors and officers are more secure in their right to indemnification.

Since D&O liability insurance policies largely are designed to dovetail with indemnity exposure, these aforementioned changes have a concomitant impact on D&O liability insurance rights as well.

Can the Justice Department Force Waiver of Attorney-Client Privilege? — The Impact of the Filip, McNulty and Thompson Memoranda

Federal investigations of a corporation or its directors and officers are jarring events. Corporations are reported in the past to have stopped paying defense costs after they were pressured to comply with federal prosecutors’ demands that the payment of defense costs to indicted directors and officers would be viewed as a sign of noncooperation under the so-called Justice Department’s Thompson Memorandum. The Justice Department more recently issued revised guidelines by Deputy Attorney General Filip that changed the earlier McNulty Memorandum. Among other things, the new guidelines mean that federal prosecutors cannot demand that corporations waive privilege over “attorney-client communications or non-factual attorney work product” nor condition cooperation credit on such a waiver. Further, in determining cooperation, federal prosecutors may not consider whether a corporation has: 1) advanced attorneys’ fees to employees; 2) entered into a joint defense agreement; or 3) terminated the employees involved in wrongdoing. The Filip memo is available online, “Principles of Federal Prosecution of Business Organizations,” memorandum from Mark R. Filip, Deputy Attorney General, to Heads of Department Components and United States Attorneys (Aug.28, 2008) at 9-28.760 (available at http://www.usdoj.gov/opa/documents/corp-charging-guidelines.pdf).

Consistent with the Filip Memorandum, corporate counsel can continue to advance defense costs to directors and officers while under federal investigation, and not jeopardize the Justice Department’s determination of cooperation.

Investigation Costs are Covered

Many corporations face formal and informal investigations by the SEC as well as federal and state prosecutors. The costs associated with these investigations can be significant. Courts have found that investigation costs are covered under D&O liability insurance policies. Specifically, these cases broadly construed what triggers an insurance company’s obligation to pay the policyholder for such costs. When faced with an investigation, corporations should also look to their D&O policies for coverage.

D&O Liability Insurance Can be Important in Bankruptcy

The current increase in corporate bankruptcies means that D&O liability insurance takes on added importance to the corporations and individuals it is designed to protect. If the corporation’s indemnity obligations are lessened or eliminated in bankruptcy, the directors and officers will care dearly how their D&O policies function. Accordingly, among other things, look for the following in typical D&O liability insurance policies:

1) the wording of the so-called “insured versus insured” exclusion; 2) the “change in control” provisions; and 3) an “order of payments” that forces direct coverage for the directors and officers. For example, the insurance company will likely argue that a trustee’s claims against the corporation’s directors and officers fall under the “insured versus insured” exclusion. Courts have found that the trustee’s claims do not fall under the exclusion. Examining D&O liability insurance policies prior to a bankruptcy can promote superior protection in the event of a bankruptcy. Even with enhanced terms, policyholders still need to be prepared to assert their rights to D&O liability insurance.

Do Not Take No for an Answer When Presenting a D&O Liability

Insurance Claim Insurance companies know that denying claims means some policyholders simply walk away. An enlightened approach to handling a D&O liability insurance claim means insisting upon full value and refuting any overly broad coverage defenses asserted by the insurance company. If an in-house analysis tells you that you have coverage, do not take no for an answer.