RISKVUE ARCHIVE | FEATURE STORIES

Corporate Scandals And Their Effect On D&O Insurance

By Laurie B. Smilan, Esq.

Not surprisingly, the recent spate of corporate scandals has had its effect on the D&O insurance landscape. As potential liabilities of corporate officers and directors increased because of legal developments occasioned by the scandals, the insurance coverage they are able to obtain has decreased for the same reason. The market shows some signs of stabilizing, but this environment has forced directors and officers to recognize the limitations of D&O insurance; i.e., that insurance cannot solve all corporate problems. There are some risks that cannot be covered at a reasonable price. There are others that cannot be covered at any price.

Some Problems Not Insurable

Many of the problems revealed in the recent wave of corporate scandals fall into the category of those that insurance was not designed to solve. Manipulated earnings, unauthorized compensation, and off-balance sheet accounting are not behaviors corporations can or should want to indemnify or protect.

The best way for innocent but humanly fallible directors to limit their exposure is of course claim prevention: putting in place management, policies, and procedures focused on deterring wrongful conduct in the first place.

Coverage And Indemnification Limitations

Corporations need to consider appropriate limitations on indemnification and coverage being provided for intentional wrongdoers to make sure the innocent many do not pay for the sins of the few. The unintended consequence of broad indemnification provisions in corporate agreements and limited fraud exclusions in insurance polices may be that there is actually less coverage for the innocent because the available funds are paid on behalf of those who have perpetrated the fraud.

The sins of crooked colleagues may also result in no coverage being afforded to innocent directors and officers. An insurance policy is a contract. Any contract induced by fraud may be rescinded as void from the outset. Insurers base their decisions on the terms and pricing of policies (and whether to issue a policy at all) on an assessment of the risk of insuring a particular company. That risk is assessed on the basis of the company’s application. If there is a misrepresentation in the application and the policy is rescinded, the innocent and guilty alike may have no coverage.

Severability And Rescission

Severability provisions are often sold as a means of attempting to separate good from bad insureds. But in today’s environment provisions providing full severability are increasingly rare. These provisions also merely ensure that one insured’s knowledge cannot provide the basis for rescinding the policy against everyone; they do not guarantee the insurer will not attempt to rescind the policy as to each individual insured.

Because innocent but material misrepresentations will support a rescission action in most jurisdictions, and many policies expressly permit rescission when directors or officers have knowledge of facts that were misrepresented in the application—even if they do not know they were misrepresented in the application—the risk of a rescission action remains real.

As the concept of “willful blindness” by disengaged or dominated boards gains acceptance as a possible basis for liability, the precarious protection afforded by severability provisions is likely to be further eroded. This risk has become apparent in several notorious cases lately where insurers filed rescission actions against directors and officers without regard to individual fault, even though the policies had purported “full severability” provisions in place.

Avoiding The Uninsured Risk

What should prudent directors and officers do to ensure that their insurance is there when they need it? Here are some points to think about:

(1) Consider whom you are buying insurance for. It ought to be for the innocent directors and officers of the corporation, not those who perpetrate fraud. Don’t flinch at exclusions that limit or eliminate coverage for individuals who in fact participate in fraud.

(2) Reconsider whether D&O insurance should cover claims against the entity that may dilute coverage available to protect your personal assets (and subject the policy to claims of the estate should the entity go bankrupt). Consider obtaining separate, non-rescindable coverage for directors that will respond if and when traditional coverage is exhausted, rescinded, or otherwise unavailable (this provides greater protection than a severability provision).

(3) Consider whom you are buying insurance from. What really matters most about a policy is whether the carrier will be reasonable and responsive when a claim is filed. Ask about the carrier’s reputation for claims handling. Is it likely to deny coverage or seek rescission? Is it cognizant of the business risk of doing so even if these remedies are available? Severability provisions in a policy issued by a carrier with a reputation for seeking rescission may ultimately provide less protection than a policy with more limited severability language issued by a carrier that rarely sues its insureds.

Obviously, too, you should assess the financial standing of the carrier—something, surprisingly, that companies often overlook. At bottom, you want to make sure your carrier has substantial assets and adequate reserves so it will still be around and solvent when and if a claim is filed.

(4) Consider what you are buying insurance for. Are you willing to pay skyrocketing premiums for lowered limits so the company has minimal out-of-pocket costs if a claim is filed? Does it make more sense to keep premiums in line by insuring only for losses the company cannot itself afford to pay? Consider increasing retentions to a level consistent with your threshold for pain. Similarly, consider co-insurance and limited severability as alternatives.

(5) Make sure your broker and the carrier consider whom they are selling insurance to. The carrier, the broker, and all of the participants in the process (risk managers, advisers, management, and the board) must be focused on your company’s particular needs and circumstances. Look with favor upon carriers that are willing and able to engage in a true underwriting process that considers your company’s unique risk profile and does not merely extrapolate from industry or market trends.

(6) Finally, and most importantly, invest time and money in effective oversight. Claim prevention is the best insurance you can buy.

ABOUT THE AUTHOR

Laurie B. Smilan, Esq. is a partner at Latham & Watkins LLP and co-chair of its securities and professional liability practice group. The views here are her own. A version of this article originally appeared in The Deal on March 1, 2004. Edited and reprinted with permission.

riskVue | The webzine for risk management professionals
June 2004