Director and Officer Insurance

By CHRISTOPHER W. MARTIN

Today–more than ever–corporate management is under attack. In the wake of the Enron debacle, corporate decisions are more carefully scrutinized, and the conduct of the company’s directors and officers is now constantly under the watchful eyes of investors, creditors, and government regulators. This heightened scrutiny compels every corporate officer and counsel to better understand director and officer (“D&O”) insurance, the one product specifically aimed at protecting important assets of directors and officers. Of course, with increasing litigation against directors, officers and their companies, a basic understanding of D&O issues is simply not enough. One must also stay abreast of emerging issues under the D&O policy.
One type of increasing litigation against directors and officers is securities litigation. According to a study by the Stanford Law School Securities Class Action Clearinghouse, plaintiffs filed 327 federal securities class action lawsuits during 2001. That figure was up 60 percent over the previous year. Additionally, the size of settlements of securities litigation has also increased. The same report found that following the federal Private Securities Litigation Reform Act of 1995, securities litigation settlements averaged nearly $25 million, up from $8 million before the reform act.1
The purposes of this article are to provide a basic understanding of D&O insurance and to introduce some key emerging issues under the D&O policy.

The Basics of D&O Insurance
The Insuring Clause:
The Heart of the Policy
In every policy, the “insuring clause” or “insuring agreement” is the heart of the policy. It sets forth the insurer’s agreement about coverage. Generally, there are at least two “insuring clauses” or “insuring agreements” in a D&O policy: (1) individual director and officer coverage and (2) corporate indemnity reimbursement coverage. A third type of insuring agreement, corporate entity coverage, is optional but often limited to securities and employment claims.
The original intent of D&O insurance was to protect the personal assets of the directors and officers of a company not the company itself. Thus, when a director or officer was sued along with the company, the D&O insurer would often take the position that, since the company was not covered under the policy, it was responsible for only a portion of the defense costs and indemnity amounts paid in the litigation. This position inevitably resulted in major “allocation” debates between D&O insurers and their insureds. Insurers would argue for an allocation that minimized the covered loss (i.e., placing most of the cost on the company). In contrast, the insureds would argue for an allocation that maximized the covered loss (i.e., placing most of the cost on the directors and/or officers).
The “allocation” debate became less important when insurers introduced “entity” coverage. This type of coverage provides coverage directly to the company. However, in most policies, it is limited to securities claims and employment claims made against the company. This type of supplemental coverage is provided to the insured at a higher premium.

“Claims-Made” Policies v. “Occurrence” Policies
Most D&O policies are “claims-made” policies, and it is important to understand the distinction between this type of policy and an “occurrence” policy.
• The occurrence-based policy is triggered if the occurrence, accident, or event takes place within the policy period, regardless of when the claim is made.
• The claims-made policy is triggered if the “claim” is made within the policy period, regardless of when the occurrence, accident, or event took place.
Under a D&O policy (which is often a claims-made policy), the claim against the director, officer and/or company must be made during the policy period and must be for an alleged “wrongful act.” While the “wrongful act” need not be committed during the policy period under most policies, many D&O policies provide a “retroactive date,” which is the earliest date a “wrongful act” can take place and be covered under the D&O policy. It is therefore important for the policyholder to understand whether the D&O policy has a retroactive date and how early that date is.
There are also variations of the “claims-made” policy form. The more restrictive form is called a “claims-made and reported” policy form. Under this form, not only does the claim have to be made during the policy period, but it also must be reported by the insured to the insurer during the policy period. The more policyholder-friendly form does not require that the insured report the claim during the policy period. Instead, it simply requires that the reporting take place “as soon as practicable” or similar language

What Is A “Claim?”
Because most D&O policies are “claims-made” policies and since the “claim” must be made within the policy period, it is critical for the policyholder to understand how the policy defines the term “claim.” Surprisingly, some D&O policies fail to define this term. This often leads to confusion and litigation battles between policyholders and their insurers. Most policies, at a minimum, define the term “claim” to include a “written demand for money” and a “civil proceeding.” It goes without saying that the broader the definition of the term “claim,” the broader the coverage that is afforded by the policy. Policyholders should seek the broadest possible definition of the term “claim.” Here are some definitions that will broaden coverage:
• Written demands for monetary, nonmonetary and injunctive relief
• Civil proceedings for monetary, nonmonetary and injunctive relief
• Criminal proceedings
• Administrative/regulatory proceedings
• Arbitration proceedings
• Civil, criminal, administrative or regulatory investigations of insured persons post “target letter” (including SEC, grand jury, EEOC and Department of Justice)
• Securities investigations of insured persons after the service of a subpoena
• Administrative and regulatory proceedings against the entity and the individual insured

As a practical matter, if the definition of “claim” is broadened (as is desirable), then corporate policyholders must be diligent to report those “claims” to their insurers once they are made. While most corporate policyholders would consider civil litigation to be a “claim,” most corporate policyholders would not consider a written demand for money, investigation, or subpoena to be a “claim,” which requires reporting to the D&O insurer.

Other Important Definitions
The Individual Insured
The individuals insured under a D&O policy are, of course, the directors and officers. The terms “insured person” or “executive” are often used to refer to the directors and officers intended to be covered under the policy. These terms, or similar ones, can be broadened to include individuals other than just the company’s directors and officers. The corporate policyholder should request a broadening of these terms by an inclusion of the following in the definition:
• Trustees and governors of the corporate entity
• Management committee members of joint ventures
• Members of the board of managers of limited liability companies affiliated with the corporate entities
• Executives of the company serving as executives on specifically covered “outside entity” companies
• The general counsel
• The company’s risk manager
• Foreign equivalent executives of foreign entities affiliated with the company
• Employees for securities claims

The Definition of “Insured”
The definition of “insured” is often broader than the definition of “insured person” or “executive.” Most often, the definition of “insured” will include not only individual insureds, but also corporate insureds. At a minimum, the corporate policyholder should request that the definition include the following:
• The corporate entity in connection with securities claims and, if desired, employment claims
• Subsidiaries of the corporate entity in connection with securities claims and, if desired, employment claims
• The debtor-in-possession of the corporate entity in the event the company files bankruptcy.

The Definition of “Loss”
In the insuring agreement, the insurer promises to pay the “Loss” arising from a claim. The term “Loss” is a defined term.
Usually the definition of “Loss” will include the following:
• Damages
• Judgments
• Settlements
• Defense costs

It often explicitly excludes the following:
• Civil or criminal fines or penalties
• Punitive or exemplary damages
• The multiplied portion of multiplied damages
• Taxes
• Any amount deemed uninsurable under the law pursuant to which the policy is construed The policyholder should seek to modify the definition of “Loss” as follows:
• Loss should include punitive, exemplary and multiple damages of an insured regarding securities claims
• Loss should include civil fines under Section 2(g)(2)(C) of the Foreign Corrupt Practices Act
• Loss should include punitive/exemplary/multiple damages of all claims if they are insurable by law

Defense Provisions of the D&O Policy
Here are some of the typical characteristics of a D&O policy with respect to the provision of a defense to the insureds:

No Duty to Defend
Unlike traditional commercial general liability policies, the typical D&O policy does not obligate the insurer to defend the insured in connection with potentially covered litigation. Instead, it is often the duty of the insured to retain competent counsel to defend the litigation. Some policies require the insured to select counsel from a “panel counsel” list provided by the insurer when the insured is involved in complex claims, such as securities claims. Sometimes the insurer is flexible in allowing the insured to retain counsel not included on the panel counsel list. However, it is best to negotiate this item before purchasing the policy. In other words, policyholders should determine if the insurance policy requires use of “panel counsel” for certain types of litigation. If so, the corporate policyholder may be able to negotiate with the insurer to add the insured’s preferred firm.
Although the insurer typically does not have a duty to defend the insured under a D&O policy, the insurer does have the “right” to associate in the defense. This means that the insurer may be allowed to retain its own counsel and assist in the defense of the litigation

Defense Costs Are Included Within the Policy Limit
Under most D&O policies, every dollar incurred in defense of the litigation is a dollar that reduces the policy limit or, said another way, the defense costs are within the policy limits. This makes the policy a “wasting asset” policy.

Reimbursement of Defense Costs
As noted above, under a typical D&O policy, the insurer does not have a duty to defend the insured. It has no obligation to hire defense counsel or to pay counsel directly. As a result, it is the responsibility of the insured to retain and pay defense counsel. Most policies, however, require the insured to first obtain the insurer’s consent before hiring defense counsel. The insurer is then obligated to reimburse the insured for those defense costs.

Settlement Rights and Obligations
Under most D&O policies, an insured cannot settle a claim without first obtaining the written consent of the insurer. Indeed, an insured which settles without its insurer’s consent may be precluded from recovering under the policy.2 This clause gives the insurer tremendous power over settlement decisions. With this ultimate “veto” power, insurers can avoid making settlement payments urged by its insured. However, the policyholder can defuse this power by insisting that the policy have the following clause: The insurer’s consent shall not be unreasonably withheld.
While the insured must obtain the insurer’s consent to settle, the insurer will often reserve to itself the right to make any settlement it deems expedient subject to the insured’s written consent. Furthermore, the policy will often include an additional clause which provides that if the insured withholds consent to such a settlement, the insurer’s liability will not exceed the amount for which the insurer could have settled as proposed by the insurer. This clause is often referred to as a “hammer” clause because of the power it gives the insurer to force settlement. The corporate policyholder should seek to have the “hammer” clause removed from the policy. Alternatively, the policyholder should seek to modify the language so that it applies only when the insured “unreasonably” withholds consent to such a settlement.

Key Exclusions
The exclusions in a D&O policy vary from form to form. Some of the typical exclusions to review closely, however, include the following:

“Bad Conduct” Exclusions
Most, if not all, D&O policies contain various exclusions barring coverage for certain “bad conduct” by the directors and/or officers. Generally, they include the following:

• Intentionally dishonest acts or omissions
• Fraudulent acts or omissions
• Criminal acts or omissions
• Willful violations of any statute, rule or law
• Illegal profit
• Illegal remuneration

Of course, it is not uncommon for plaintiffs to allege that a director or officer was engaged in such “bad conduct.” Therefore, it is critical that the corporate policyholder purchase a D&O policy containing the following features with respect to these types of exclusions:
“Final adjudication” language: Before coverage can be barred based on these “bad conduct” exclusions, there must be a determination by a “final adjudication” that the director and/or officer committed such “bad conduct.”
“No imputation” language: No conduct of any individual insured will be imputed to any other insured with respect to these exclusions.

The “Insured versus Insured” Exclusion
The “insured v. insured” exclusion was originally developed by D&O insurers in response to perceived “friendly” suits brought by various financial institutions against their own directors and officers seeking to recoup operating losses resulting from the alleged business mistakes of corporate officials. D&O insurers felt that such suits were never intended to be covered by D&O insurance and constituted an attempt to transform what was essentially a third party liability party into a first party business policy. Given this background, it is not surprising that it is widely recognized that the purpose of the exclusion is to prevent collusion among insureds.3

The Insured’s Key Responsibilities: Notification and Cooperation
The key responsibilities of the insured under a D&O policy include notification to the insurer and cooperation.

Reporting the Claim
Under a D&O policy, it is critical to report the “claim” to the insurer. A failure to timely report a claim to a claims-made D&O insurer may result in a loss of coverage irrespective of any prejudice to the insurer resulting from the late notice.4 Policies differ with respect to when the claim should be reported. Some of the variations include the following:
• Claims must be reported within the policy period (this is often referred to as a “claims-made and reported” policy and is the least preferred type of reporting clause)
• Claims must be reported “as soon as practicable”
• Claims must be reported “as soon as practicable” but in all events within XX days (usually 30 to 60)
• Claims must be reported “as soon as practicable” and in all events within the policy period plus 30 days (this one along with “as soon as practicable” are the preferred clauses)

Since reporting the “claim” to the insurer is an important obligation of the insured, the insured must be careful to understand how the term “claim” is defined under the policy. The term “claim” may include more than just a lawsuit. It may also include a demand for money, an informal investigation, a notice of charges, or a subpoena by a regulatory body.

Cooperating With the Insurer
All D&O policies contain a “cooperation” clause. While most policies do not elaborate on the scope of cooperation, it is generally understood to require the insured to cooperate in the handling and defense of the litigation for which insurance has been sought.5

Understanding Emerging Issues Under the D&O Policy
D&O insurance is frequently viewed as professional liability insurance for directors and officers. Corporations traditionally seek D&O coverage in order to encourage individuals to serve as corporate officials, the thought being that such insurance protects the personal assets of corporate officers and directors from claims made against them arising out of their service on behalf of the corporation.
Today, however, corporate risk managers are likely to view the D&O insurance policy as much more than just another professional liability policy. This is because most D&O insurance policies now also offer coverage to the corporation (commonly referred to as “entity coverage”) for employment-related claims and “Securities Claims,” a defined term in D&O policies generally equated with claims brought under the Securities Act of 1933, the Securities Exchange Act of 1934 and parallel state securities statutes.
With the expansion of the insurance coverage available under the D&O policy to include entity coverage for these types of claims, D&O insurance plays an even larger role in the risk management programs of publicly-traded corporations, frequently serving as the first line of defense against such claims.
The expanded entity coverage for employment and securities claims afforded by modern D&O policies also highlights the fact that most D&O policies now serve two different masters, the corporation on the one hand and its directors and officers on the other. In many situations, such as a Securities Claim asserted against both the corporation and its directors and officers, the interests of both masters are aligned against the claimant(s). More problematic, however, is what happens when the interests of the corporation and its directors and officers diverge.
Diverging interests can result when claims against a corporation and its directors and officers leave insufficient insurance limits available to satisfy the claims against both the corporation and its directors and officers. Diverging interests also result under litigation brought by a corporation against its directors and/or officers, although rare. D&O policies generally do not respond to such suits because of an exclusion barring from coverage disputes brought by the corporation against its directors and officers (i.e., the “insured v. insured” exclusion).
Since the real purpose of D&O insurance is to protect the personal assets of the company’s directors and officers, it may make sense to avoid jeopardizing that protection by simply not purchasing “entity” coverage. If the policy provides no direct coverage for the company’s wrongful acts, then it will be difficult for the bankruptcy estate of the company (should it file for bankruptcy protection) to argue successfully that the policy proceeds are assets of the estate. If the policy proceeds are not assets of the bankruptcy estate, then the directors and officers should have no difficulty demanding that the D&O insurer advance defense costs or settle claims on their behalf.
Most securities and employment-related claims, however, involve the corporate entity. With this in mind, companies will want the coveted insurance to protect not only the personal assets of the directors and officers, but also the company assets. In short, this may not be a likely solution to the problem in most cases.
One way to diffuse the effect of the company’s bankruptcy is to insist that the policy provide that the insurer’s obligations are not relieved should the company file bankruptcy. This type of clause leaves no doubt that the insurance company is required to continue providing coverage to the directors and officers even where the company is unable to indemnify the directors and officers despite its commitment to do so.

Endnotes
1. The Stanford study is cited in Business Insurance, March 25, 2002. 2. See, e.g., Charter Roofing Co., Inc. v. TriState Ins. Co., 841 S.W.2d 903, 907 (Tex. App. – Houston [14th Dist.] 1992, writ denied). Cf. Insurance Co. of N. Am. v. McCarthy Brothers, Inc., 123 F.Supp. 2d 373, 379 (S.D. Tex. 2000) (imposing a prejudice requirement before an insurer will be relieved of its obligations under a liability policy based on the insured’s violation of a no voluntary assumption of liability clause). 3. See, e.g., Ostrager and Newman, Handbook on Insurance Coverage Disputes, § 20.02(g) (10th ed. 2000); Kalis, Reiter and Segerdahl, Policyholder’s Guide to the Law of Insurance Coverage Disputes, § 11.05[d] (2001); Russ and Segalla, Couch on Insurance 3d, § 131:33 (1997). 4. See, e.g., Hirsch v. Texas Lawyers Ins. Exch., 808 S.W.2d 561, 565 (Tex. App. – El Paso 1991, writ denied). 5. See, e.g., Filley v. Ohio Cas. Ins. Co., 805 S.W.2d 844, 847 (Tex. App. – Corpus Christi 1991, writ denied). Arguably, the “cooperation” clause does not require an insured to provide the insurer with ammunition that will bolster a coverage defense. See, e.g., LaFarge Corp. v. Hartford Cas. Ins. Co., 61 F.3d 389, 39798 (5th Cir. 1995).

Christopher W. Martin is a founding partner of Martin, Disiere, Jefferson & Wisdom, L.L.P. He specializes in the evaluation and handling of insurance matters and disputes involving questions of coverage, industry practices, claims handling, underwriting, legal exposure, and other legal issues. He is board certified in Consumer Law by the Texas Board of Legal Specialization. Martin is the author of The Lawyer’s Guide to Texas Insurance Code, Article 21.21(Lexis Legal Publishing) and Texas Practice Guide: Insurance Litigation (West Publishing). He also is the editor of The Journal of Texas Insurance Law, published quarterly by the State Bar of Texas.

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