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Understanding Side-A Only D&O Insurance

By Dan A. Bailey

The perceived need for "Clause A" D&O insurance (i.e., insurance for non-indemnifiable loss) is based upon the premise that financial protection through an applicable state indemnification statute may be inadequate. This article discusses such arguments and explores important details of Side-A only D&O insurance you should know about.

Limitation To Indemnification

Historically, the primary areas in which indemnification has been deemed inadequate to provide sufficient protection include the following:

(1) The ability to indemnify for derivative suit judgments or settlements is severely limited or prohibited by most state indemnification statutes. The Delaware statute does not authorize indemnification of settlements or judgments in suits brought by or on behalf of the corporation (including derivative suits). This limitation is intended to avoid the circularity which would result if funds received by the corporation were simply returned to the person who paid them.

(a) D&O insurance policies typically provide coverage for derivative suit settlements or judgments, subject to various "conduct" exclusions.

(b) A few states amended their indemnification statutes in the late 1980s to limit or eliminate this indemnification restriction, at least under certain circumstances.1

(2) Indemnification against claims under the registration and anti-fraud provisions of the federal securities laws may be precluded by public policy or by preemption. The SEC's long-standing view is that such indemnification is against public policy and unenforceable.2 That position has received some judicial support.3 However, a settlement of federal securities law claims may be indemnified.4

(a) The SEC does not regard the maintenance of D&O insurance to be contrary to public policy, even where the corporation pays the premium for such insurance.5

(b) Public policy may limit indemnification under other federal statutes (e.g., RICO anti-trust laws) where Congress intended personal liability as a deterrent.6 Also, Congress expressly prohibited indemnification of individuals adjudged liable under the Foreign Corrupt Practices Act of 1977.7 Public policy may also prohibit indemnification for liability based on failure to pay payroll taxes.8 However, neither Congress nor public policy prohibits indemnification for liability under CERCLA.9

(c) D&O insurance policies typically provide coverage for certain securities and other federal law claims, subject to various "conduct" exclusions.

(3) No indemnification is permitted unless certain standards set forth in the applicable indemnification statute are satisfied and a determination thereof is made by the designated person or body. The Delaware statute requires the director or officer who seeks to be indemnified to have acted in good faith and in the reasonable belief that his actions were in, or at least not opposed to, the best interests of the corporation. A determination whether indemnification is proper in a given circumstance is to be made by the disinterested members of the board, by special counsel appointed by the board, by shareholders, or by a court.

(a) D&O insurance may provide protection for acts which do not satisfy the "good faith" and "reasonable belief" standards, so long as the insurance coverage does not otherwise violate public policy.

(b) D&O insurance may provide protection for a director or officer when the incumbent board chooses, for whatever reason, not to make the required determination and further refuses to submit the question to special counsel or the shareholders. This circumstance is apt to arise, for example, in the aftermath of a hostile takeover.

(4) The corporation may be financially unable to fund the indemnification, either because it is insolvent or because of cash flow restraints. The recent explosion in D&O defense costs and settlement severity has resulted in an environment today in which even corporations that are financially healthy may be challenged to fund some large D&O losses. When evaluating this risk, one should consider the financial strength not only of the parent company, but also each of its direct and indirect subsidiaries since the directors and officers of a subsidiary may have indemnification rights only against the subsidiary, not the parent company. Also, because the ability to indemnify is determined when the loss is incurred, one must predict the financial condition of a company for this purpose over the next five to six years, since it frequently takes that long for a newly filed lawsuit to be settled.

(a) Subject to the coverage limitations and exclusions, a D&O insurance policy ensures that adequate resources will be available to fund the defense of the corporate managers and any settlement or judgment incurred by them.

(b) Establishing a trust fund to pay the company's indemnification obligations is not an adequate substitute for D&O insurance since creditors or a receiver may be able to repudiate the establishment of the fund or otherwise attach fund assets.10

(5) Either the applicable law or the corporation's articles of incorporation or code of regulations may be modified to reduce or eliminate indemnification for directors or officers. Because protection is probably determined by the indemnification provision in effect at the time the indemnification is sought, rather than when the act giving rise to the claim occurred, such subsequent modification may reduce or eliminate protection otherwise expected by directors or officers.

(a) A D&O insurance policy cannot be unilaterally changed to reduce or eliminate coverage.

(6) Unique regulations applicable to certain types of financial institutions also limit the ability to indemnify directors and officers.11

Benefits Of Side-A Only D&O Coverage

A typical D&O insurance policy which affords both Side-A coverage for non-indemnified loss and Side-B coverage for indemnified loss is perceived by many to adequately respond to these non-indemnifiable exposures. However, under certain circumstances such a typical D&O insurance policy may not afford the desirable protection for the directors and officers. In order to avoid that risk of inadequate D&O coverage, companies should consider purchasing a Side-A only DIC policy excess of its standard D&O insurance program. The following discussion identifies several areas where a D&O policy affording only Side-A coverage can provide greater protection to directors and officers than a typical D&O insurance policy.

No Limit Of Liability Dilution

The limits of liability under a Side-A only policy are available to fund only non-indemnifiable loss incurred by the directors and officers. In contrast, the limits of liability under a traditional Side A/B/C policy are also available to fund indemnifiable loss and corporate losses in a securities claim. In other words, directors and officers can lose their personal protection under a traditional Side A/B/C policy if the corporation incurs significant covered losses. That risk does not exist under a Side-A only policy.

Broader Coverage

Despite the typically huge difference between the resources and insurance needs of the company and the individual directors and officers, traditional D&O insurance policies afford essentially the same coverage for directors and officers under Side-A and for the company under Side-B of the policy. Only the amount of the retention and perhaps the applicability of a couple of exclusions will vary depending upon whether the loss is indemnifiable by the company. Because loss under the Side-B coverage is far more frequent and generally far more severe, the scope of coverage afforded under a traditional D&O policy is crafted by the insurers primarily with a view toward creating a reasonable underwriting response to a company's D&O indemnification exposures.

Since the vast majority of claims covered under a D&O policy are indemnified by the company, a Side-A only D&O policy allows insurers to afford much broader coverage terms than reasonably possible under a Side-B policy. For example, the following summarizes some of the features in a Side-A policy form that are generally not available from typical D&O insurance.

1. Scope of Coverage

--No presumptive indemnification (coverage applies without any deductible if the company rightly or wrongly refuses, or is financially unable, to indemnify)

--Broad definition of "Insureds" (includes not only directors and officers, but also (a) LLC managers, in-house general counsel, comptroller, risk manager and their functional equivalent in a foreign company, and (b) non-officer employees while co-defendants in a claim with directors and officers)

--Broad definition of "loss" (expressly includes exemplary, punitive, and multiple damages, which are more likely to be insurable because the policy is issued and construed in Bermuda)

2. Exclusions

--No express exclusions regarding:

*ERISA
*Section 16(b) of the Securities Exchange Act of 1934
*Pollution
*Prior litigation
*Defamation or other personal injury

--Narrow "personal profit" and "remuneration" exclusions:

*Not applicable to defense costs
*Not applicable to illegal "advantage"
*Applies only if adjudication or if illegal remuneration is repaid in settlement

--Narrow "dishonesty" exclusion:

*Not applicable to defense costs
*Applies only if adjudication of active and deliberate dishonesty committed with actual dishonest purpose and intent

--Narrow "bodily injury/property damage" exclusion:

*Not applicable to pollution claims

--Narrow "insured v. insured" exclusion:

*Applies only if the claim is (a) by or on behalf of company, and (b) at least two current senior executive officers approve or assist in prosecuting the claim
*Not applicable to claims by insured persons
*Not applicable to claims outside U.S. or Canada
*Not applicable after parent company has change of control

--Narrow "other insurance" and "prior notice" exclusions:

*Apply only to the extent loss is actually paid under other policy

3. Miscellaneous

--Consent by insurer to defense counsel not required

--Mandatory binding arbitration of any coverage dispute

--Policy non-cancelable except for non-payment of premium

--If parent company acquired, insureds entitled to three-year run-off coverage for no additional premium

--Notice of claim to insurer required after in-house general counsel or risk manager of company first learns of claim

--Policy may not be rescinded based upon the restatement of any financial statements of the company included within the application

--Limit of liability reinstated for discovery period if insurer non-renews

--Protective bankruptcy provisions

*Policy not subject to automatic stay under bankruptcy law
*Policy proceeds first applied toward pre-bankruptcy wrongful acts

--Difference-in-conditions drop-down feature if insurer policy is excess

Financial Inability To Indemnity

If the company becomes subject to a bankruptcy proceeding, the company will likely be unable to fund its D&O indemnification obligation. In that circumstance, Side-A coverage will be the only financial protection available to the directors and officers. If that coverage is unavailable, the personal assets of the directors and officers will be at risk. An issue will likely arise in the context of the bankruptcy proceeding as to whether the D&O policy is an asset of the bankruptcy estate. If it is, the automatic stay applicable to all assets of the bankruptcy estate will effectively freeze the policy and may preclude the directors and officers from accessing the policy's proceeds.

Courts have disagreed as to whether a typical two-part D&O insurance policy constitutes an asset of the bankruptcy estate. Some courts have concluded the policy is such an asset since the policy affords coverage for the company's D&O indemnification obligation. Although other courts have either ruled that the D&O policy is not an asset of the estate or have ruled that the proceeds of the D&O policy (as distinct from the policy itself) are not assets of the estate, it is unclear what result will occur in any particular bankruptcy proceeding. This uncertainty is exacerbated if the D&O policy also affords securities entity coverage since insurance policies that afford coverage for claims against the company are typically considered by courts as assets of the bankruptcy estate.

In other words, under a typical D&O insurance policy, it is uncertain whether directors and officers will have access to the policy proceeds in the event of the company's bankruptcy. However, that uncertainty is virtually eliminated under a Side-A only policy since the company is not an insured under that type of policy, either with respect to its D&O indemnification obligation or with respect to securities claims against the company. Stated differently, a Side-A only policy can afford more predictable and potentially more protective coverage for directors and officers in the event of the company's bankruptcy.

Derivative Settlements/Judgments

Shareholder derivative lawsuits can be filed either in tandem with a shareholder class action lawsuit or as an isolated lawsuit. A typical two-part D&O insurance policy will respond to a settlement or judgment in either type of lawsuit, provided that the class action lawsuit (or any other claim in the same policy period) does not exhaust the available limit of liability before the potentially non-indemnifiable derivative lawsuit settlement is paid. Because tandem class action and derivative lawsuits are frequently settled at the same time, prior exhaustion of the limit of liability is typically not a problem.

However, there is now a somewhat greater tendency to settle the larger class action lawsuit quickly, even if, for whatever reason, the tandem derivative lawsuit cannot be settled at the same time. For example, in one recent case, a company elected to settle a securities class action within a few months after its filing for more than $100 million (thereby exhausting the D&O policy's limit of liability) even though the tandem derivative lawsuit could not then be settled for a reasonable amount. Approximately 18 months later, the tandem derivative lawsuit was settled for approximately $15 million. Fortunately for the directors and officers, the company maintained an excess Side-A only D&O policy, which was not implicated in the indemnifiable class action settlement and therefore was available to fund the non-indemnifiable derivative settlement.

In those types of situations where the company wants to settle a large class action but cannot yet settle the tandem derivative lawsuit for a reasonable amount, the insureds are faced with a difficult dilemma under a standard two-part D&O insurance program. On the one hand, the insureds can use the proceeds from the D&O insurance program to fund the class action settlement, thereby creating potentially significant benefits to the company by eliminating the risks, distractions, and adverse publicity associated with such a potentially catastrophic claim. However, such a strategy may leave the defendant directors and officers with inadequate insurance protection for a subsequent non-indemnifiable derivative settlement. On the other hand, the insureds can preserve the D&O insurance proceeds for a subsequent derivative settlement. However, such a strategy would deprive the company of a large source of funds to pay the early class action settlement.

Many standard D&O insurance policies with securities entity coverage now contain a priority of payment provision which, depending on its language, usually mandates that all proceeds under the policy be maintained for the non-indemnifiable derivative settlement, regardless of the size of the D&O insurance program, the amount of the class settlement, or the likely amount of the subsequent derivative settlement. Thus, if the company desires or is compelled to settle the class action early, it must fund the entire settlement amount out of its own assets and seek reimbursement under the D&O insurance policy for the covered loss at some unknown subsequent date when the derivative lawsuit is settled. As demonstrated by the case described above, this result can require the company to advance tens of millions of dollars, if not hundreds of millions of dollars, to resolve the class action, even though much or all of such a settlement is otherwise covered under the untapped D&O insurance program.

From the perspective of the defendant directors and officers, this dilemma is especially frightening. If the current company management is not sympathetic to the defendant directors and officers, the company may choose to access the D&O insurance program to fund the indemnifiable class action, thereby leaving the defendant directors and officers with little or no insurance to settle the subsequent non-indemnifiable derivative lawsuit. Although the defendant directors and officers would likely object to that use of the policy, at best a difficult controversy will exist which will create uncertainty as to the extent of the defendant directors and officers' financial protection under the policy.

These problems can be greatly mitigated, if not eliminated, by the purchase of Side-A only DIC coverage excess of the company's standard D&O insurance program. Such excess coverage assures the existence of insurance protection for non-indemnifiable claims against directors and officers even if the rest of the D&O insurance program has been exhausted by indemnifiable or entity losses. In addition, such coverage may allow for deletion of the priority of payment provision in the underlying D&O policies, thereby enabling the company to access the underlying D&O insurance proceeds for an early settlement of the class action even if the tandem derivative lawsuit is not settled at the same time. Obviously, the larger the limits for this Side-A only coverage, the greater the likelihood that this type of insurance program structure will accomplish the goals of both the company and the insured directors and officers.

Notes

1 See, e.g., Indiana Code § 23-1-37; New York Bus. Corp. Law § 722.
2 See 17 C.F.R. §§ 229.510 and 229.512(i).
3 See, e.g., Globus v. Law Research Service, Inc., 418 F.2d 1276 (2nd Cir. 1969), cert. denied, 397 U.S. 913 (1970); Baker, Watts & Co. v. Miles & Stockbridge, 876 F.2d 1101 (4th Cir. 1989); First Golden Bancorporation v. Weiszman, 942 F.2d 726 (10th Cir. 1991); Eichenhotlz v. Brennan, 1995 U.S. App. LEXIS 6134 (3d Cir. 1995); Odette v. Shearson, Hammill & Co., 394 F. Supp. 946 (S.D.N.Y. 1975); Ades v. Deloitte & Touche, 1993 U.S. Dist. LEXIS 12901 (S.D.N.Y., Sept. 17, 1993).
4 Raychem Corp. v. Federal Insurance Co., 853 F. Supp. 1170 (N.D. Cal. 1994).
5 See 17 C.F.R. § 230.461(c).
6 See Sequa Corporation v. Gelmin, 851 F. Supp. 106 (S.D.N.Y., 1993) (indemnification for RICO liability prohibited as against public policy).
7 15 U.S.C. § 78ff(c)(4) and § 78dd-2(b)(4).
8 Plato v. State Bank of Alcester, No. 19580 (S.D., Nov. 6, 1996).
9 See, 42 U.S.C. § 9607(e); Witco Corp. v. Beekhus, 38 F.3d 682 (3d Cir. 1994); U.S. v. Lowe, 29 F.3d 1005 (5th Cir. 1994).
10 Gibson v. RTC, 1995 U.S. App. LEXIS 10469 (11th Cir. 1995).
11 See, e.g., 12 C.F.R. §7.5217; 12 C.F.R. §545.121.

ABOUT THE AUTHOR

Dan A. Bailey is a member of the Columbus, Ohio, law firm of Bailey Cavalieri LLC and chairman of its D&O practice group. He is a frequent lecturer and has authored and co-authored several books dealing with D&O liability issues.

The material in this outline is not intended to provide legal advice as to any of the subjects mentioned but is presented for general information only. Readers should consult knowledgeable legal counsel as to any legal questions they may have.

This article originally appeared in The Risk Management Letter.

riskVue | The webzine for risk management professionals
August 2007