Two misconceptions about D & O coverage: what you don’t fully understand may really hurt you—unless you protect yourself

Publicly traded companies routinely buy Directors and Officers Liability Insurance (D & O), and even larger privately held companies are now doing so too. For good reason. In this country, we seem to have an inalienable right to be sued. And the leaders of corporations are increasingly prime targets of all manner of claims. No longer is D & O coverage needed to protect only against claims of serious breach of fiduciary duty in large mergers, egregious error in accounting procedures, or misleading disclosure of a major scale.

Nowadays, nearly every acquisition produces litigation against the target company, and sometimes the acquirer too. This is true even in relatively small value transactions. Even a modest stock price drop will generate threats of security fraud suits, or the actual filing of them. Additionally troubling is the emergence in recent years of large numbers of “unconventional” D & O claims that don’t involve securities issues, mergers, or the accuracy of financial statements at all. This new wave of litigation complains of mismanagement or gross negligence in environmental or other regulatory compliance, or even of employment practices and policies deemed offensive.

It is no wonder that outside directors, in particular, are sensitive to these exposures. So are senior executives, and they should be. Costs associated with D & O risk, including the settlement of essentially frivolous claims (which often include compensation to the plaintiffs’ lawyers) are an important and—for many companies—growing component of Total Cost of Risk (TCR). And when the big claim comes, and appears to have arguable merit, settlements are often large, in the tens of millions or even much more.

Despite its importance to the board and management’s interest in it, the practical application and fundamental terms of D & O insurance coverage are often misunderstood. These misunderstandings come to light when the large claim arrives. Tension in the c-suite, and sometimes embarrassment too, is the unfortunate and unnecessary result.

Other posts here will discuss additional pitfalls in D & O, but two common knowledge gaps are these.

1. How the Policy Limits Apply, and the Adequacy of the Amount of Insurance

A total limit of, say, $40 million for a company with $2 – 4 billion in revenue and a comparable or lower market capitalization, may seem on its face to be formidable. But is it? No director or officer enjoys $40 million in coverage available to himself or herself to protect their personal assets. (Many think they do, or that has been inferred to them.) That $40 million is shared limit, for all legal expense and settlement funding combined. And it is likely shared with quite a crowd. If there are 10 directors and 20 executive and so-called “Section 16 officers” in the company, you have 30 individuals sharing that limit. If one or more named insured is a “bad actor” with real exposure, and perhaps even fear of criminal liability on the horizon, the legal fees alone of such a person or group will substantially erode the limit and what is available for everyone else’s legal defense. And we haven’t even reached the question of how much will be needed to settle the claims.

A related misnomer is the belief that the adequacy of the D & O limit is rectified by the auxiliary purchase of a “Separate Side A” policy or policies. This kind of extra coverage is important, but it is not a substitute for adequate limits in the regular D & O program. This is because Separate Side A coverage does not apply to normal director and officer liability exposure. It only applies to non-indemifiable liability (or in the event insolvency prevents indemnification that otherwise would be available). The great majority of legal liability of D’s and O’s is indemnifiable under law and probably also under the corporation’s regulations, bylaws, or indemnification agreements—and therefore not payable under most Separate Side A policies.

The solution: get good independent advice and assessment as to your D & O limit. And remember that when you rely on benchmarking data, your decision is only as good as the limits reflected in it. If other companies are underinsured, and you rely on their decisions, you are climbing into the same boat.

2. Large Expenses Incurred to Prepare Your Defense and Document What Happened Will Not Be Covered Unless You Have Negotiated Special Terms

In our coverage claim settlement facilitation work, we have found a commonly recurring issue in which the company and its D & O insurer are immediately at odds. The company wants its substantial legal investigation and factual preparation expenses reimbursed, and the insurer says “no way”. This is not a small dollar issue.

The first instinctual response of most companies to a serious SEC or DOJ threat is to engage highly skilled legal defense counsel. A deep investigation is often launched immediately. Accounting professionals, even crisis management consultants, may also be engaged. Individual directors may be authorized by management to engage their own independent counsel, who in turn conduct their own investigations and prepare for the worst. We have seen claim evaluation and investigation costs exceeding $10 million as the threat continues to progress.

Companies are angry when their insurer informs them that none of these expenses (or a trifling sum provided for “early evaluation”, often as little as $500,000) are covered because such expenses are only covered after a formal “Claim”, as defined in the policies, has matured and been made against both the company and at least one individual named insured. And, unless you have taken the care to negotiate coverage with an earlier trigger of your right to reimbursement, you are in for a dogfight, without a strong position to argue.

This is especially important because in the usual SEC or governmental inquiry, the process begins informally with an inquiry or threat of possible legal pursuit. The government will normally do its work over many months, interviewing employees and gathering its evidence. It will begin at the bottom (and outside of the organization) and work its way up, saving senior-most executives and outside directors for last. It will not formally name an individual, such as the CEO or CFO, until the very end of its process. And by that time, your legal and accounting expenses may already be through the roof. But your policy may well state that a “Claim” has been made and is covered only when both the company and an individual named insured has been formally charged in a civil or criminal proceeding.

The solution: Understand your coverage and engage and direct legal and other defense resources accordingly and prudently, aware that this is probably going to be your money, and not the insurer’s you are spending. Better yet, get independent help and negotiate terms by endorsement—before any threat is made or known—with better coverage for these early defense and investigation costs.

Joseph W. Bauer is the Principal of Bauer Advising LLC. Bauer Advising offers independent help to companies in understanding an optimizing their insurance, and facilitates the settlement of large coverage issues. It also assists companies by matching insurance technology resources to risk management and claim management needs. For information on its Coverage and Gap Analysis offerings, read more here.

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