Startups need D&O coverage
Newly formed organizations are not exempt. In fact, they’re more likely to need D&O coverage. Startups, by their very nature, are inclined to make seat-of-the-pants decisions and will tolerate more risk, meaning the company’s principals may not have taken the time to assess all the pros and cons of a management decision. Also, after those heady first days, companies may discover that one member of the new management team is a liability waiting to happen, creating issues for the whole organization.
What is Directors & Officers Insurance?
Directors & Officers insurance provides financial protection for the directors and officers of your company in the event they are sued in conjunction with the performance of their duties as they relate to the company. Think of Directors & Officers insurance as a “Management Errors and Omissions” policy.
Directors & Officers insurance can usually include Employment Practices Liability and sometimes Fiduciary Liability. The former involves harassment and discrimination suits, and is where the majority of your exposure will be.
Directors & Officers insurance is often confused with Errors & Omissions Liability. The two are not synonymous; Errors & Omissions is concerned with performance failures and negligence with respect to your products and services, not the performance and duties of management. Generally it is a good idea to carry both policies.
When do I need Directors & Officers Insurance?
When you assemble a board of directors, they will frequently make the requirement. Even if a company is not public, it still needs D&O insurance, especially if it is involved in raising capital or anticipates merger or acquisition activity. Both of these events can expose a company and its directors and officers to litigation. For example, if a company deteriorates financially after successfully raising money, recent investors in the company may sue management for not disclosing the company’s problems. In addition, stockholders of a target company in an acquisition may sue its directors and officers for selling the company too cheaply or for breaches of their fiduciary duties.
Investors, especially Venture Capitalists, usually require that you show evidence of Directors & Officers insurance as part of the conditions of funding your company.
Also having employees opens management up to employment practices lawsuits.
Why do I need Directors & Officers Insurance?
First, claims from stockholders, employees, and clients will be made against the company, AND against the directors of the company. Since a director can be held personally responsible for acts of the company, most directors and officers will demand to be protected rather than put their personal assets at stake.
Second, investors and members of your board of directors will not be willing to risk their personal assets to serve as a corporate director or officer, no matter how heartfelt their belief in your company.
Last, employment practices suits constitute the single largest area of claim activity under D&O policies. Over 50% of D&O (directors and officers) claims are employment practices related.
Directors & Officers can be held personally liable for the decisions they make. Yes, as leaders of a private company, directors and officers can be held personally liable for the decisions they make. Is your company’s board of directors comfortable with their level of personal risk?
Being private does not mean that the decisions of your board are immune from public scrutiny. Shareholders, employees, customers, suppliers, competitors and even the government may bring an action against your private company and its board. A corporate shield and broad by-laws offer board members and employees some protection. Unfortunately, in many cases, it is not adequate.
Typical lawsuits against directors and officers include allegations of:
- Mismanagement of operations or company assets
- Self-dealing and conflicts of interest
- Misrepresentation during the sale of company assets
- Misrepresentation in a private placement prospectus
- Acts beyond authority granted in by-laws
- Violation of certain state and federal laws
- Breach of fiduciary duties
Each of these types of litigation can last several years, becoming a financial burden and a continuous drain to a private company’s profit margin. Indemnification from the company is a protection for its directors, officers and employees, but, sometimes it’s not enough. If a company cannot indemnify its directors, officers or employees, either because of the allegations of a lawsuit or as a result of the company’s insolvency, then this financial burden can become the personal responsibility of the company’s directors, officers or employees.
A D&O liability policy can protect the company itself as well as the individuals who run it. While larger organizations can probably manage a single liability issue, a smaller, newer organization may well be decimated by the same type of issue.
How Are D&O Policies Typically Structured?
Standard D&O policies typically cover three types of losses, which are commonly referred to as Sides A, B, and C:
- Side A covers a director’s or officer’s direct losses (meaning those not indemnified by the company). This type of coverage is important because a company may not be able to indemnify its directors or officers if it becomes insolvent or where it is prohibited legally from doing so (see What Is Separate “Side A Only” Coverage and Do Directors Need It?).
- Side B covers losses relating to claims made against the directors and officers but for which the company has indemnified them. In other words, the company gets reimbursed when it indemnifies its directors or officers or advances legal costs on their behalf.
- Side C covers losses incurred based on claims against the company itself. This is often referred to as “entity” coverage. It is generally limited to losses related to securities claims. Some D&O policies also include a Side D insuring clause, which provides coverage for costs arising from responding to a stockholder derivative demand.
A D&O policy has a stated limit of liability, which is the total amount of loss that the insurer will cover during the policy period, regardless of how many claims are made. The limit is shared among all insureds. That means, for example, that one insured’s defense fees will deplete the amount of coverage available to other insureds. Because many insureds usually share in a single pool of insurance coverage, this can be a significant issue. However, there are certain ways to address this issue in policy selection (see What Is Separate “Side A Only” Coverage and Do Directors Need It?). Companies typically purchase a primary D&O policy and one or more excess policies. The primary policy usually sets the key terms and conditions for the excess policies that follow it. Once the primary policy’s limit of liability is exhausted, the first excess policy is triggered and provides coverage. This continues up through the rest of the excess policies until all coverage is exhausted. D&O policies also have retentions (deductibles) that must be paid before coverage kicks in. Retentions are usually applied only to Sides B and C clauses.
WHAT ARE THE KEY CONSIDERATIONS WHEN DECIDING THE SIZE OF THE RETENTION?
Companies should consider their balance sheet when determining retention size. Higher retentions will result in lower premiums. As a general rule, a company should not retain a payment obligation larger than it can afford to pay in one quarter without materially hurting earnings or cash flow. For companies with good cash flow and sound balance sheets, higher retentions make a lot of sense. However, what appears reasonable in good times may be a big problem when troubles arise. Securities class action lawsuits often hit at the worst time; when large losses have occurred and cash flows have dried up.
For several years, many companies purchased policies with $250,000 retentions. Retentions began to increase in the early to mid-2000s, with the average peaking at $426,000 in 2006. Since that time, retentions appear to be trending downward again. The most recent Towers Perrin D&O Liability Survey reported that the average retention in 2008 was down to $191,000. This average includes companies of all sizes and the study showed that the average retention for companies with an asset size of $10 billion was $3,621,000. Results for 2009 were not available at the time of publication of this Article.
HOW CAN D&O COVERAGE BE STRUCTURED TO PROVIDE PROTECTION IN THE EVENT OF BANKRUPTCY?
The recent global recession has led to a sharp increase in US bankruptcy filings. Statistics from the American Bankruptcy Institute show that there were almost twice as many business bankruptcy filings in 2009 compared to 2006. When a company becomes insolvent, indemnification is often no longer available and D&O policies become the remaining line of defense for directors and officers to avoid covering losses from their personal assets (see Practice Note, Fiduciary Duties of Directors of Financially Troubled Corporations (http://us.practicallaw.com/9-
384-4955)). A company should ensure that its D&O policies are structured to maximize coverage in the event of insolvency. When a bankruptcy is filed, a judge typically issues a stay that is intended to protect company assets that may be used to pay creditors.
D&O policies that provide entity (Side C) coverage for losses in securities actions have been determined to be company assets in some instances. To preserve this particular asset, a few bankruptcy courts have denied requests by directors and officers for reimbursement of ongoing defense costs. Relying on these cases, insurers now commonly refuse to pay attorneys’ fees or costs until the bankruptcy court issues an order permitting payment. The following provisions can help prevent this from happening: Order of payments. D&O policies that provide entity coverage should include an order of payments provision that requires Side A claims to be paid before claims under Side B or Side C. This language provides strong support for the argument that the D&O policy is first and foremost a policy for the individuals and not a company asset that should remain available to satisfy creditor claims in bankruptcy. Bankruptcy. D&O policies should also include a bankruptcy provision that clearly establishes that bankruptcy or insolvency of any insured will not relieve the insurer of its obligations. This prevents an insurer from rescinding its policy if insolvency occurs.
Insured versus insured exclusion. The insured versus insured exclusion in a D&O policy should make sure claims brought against any directors or officers on behalf of an organization in bankruptcy are covered (see Insured versus Insured). In other words, it should be clear that any claim brought on behalf of an examiner, trustee, receiver, liquidator or rehabilitator (or any assignee) of the organization is covered. In addition to these provisions, also consider whether the company should purchase a Side A only policy. Side A only policies can provide valuable protection to directors and officers because these policies are never seen as company assets in the event of financial insolvency.
WHAT IS SEPARATE “SIDE A ONLY” COVERAGE AND DO DIRECTORS NEED IT?
Side A policies have grown in popularity in recent years. A 2008 study (http://www.towersperrin.com/tp/getwebcachedoc?webc=U SA/2009/200908/DO_Survey_Report_20088_Final.pdf) showed that 43% of public companies and 73% of companies with assets over $10 billion have purchased Side A policies. The study also found that 15% of companies with assets over $10 billion carry only Side A coverage and do not carry any Side B or Side C coverage. In comparison, only 5% of companies in the early 2000s purchased separate Side A policies.
Why have separate Side A policies grown in popularity? This is because they provide an extra layer of protection to directors and officers in situations where the company is unable to indemnify them. Some Side A policies also provide more favorable coverage terms than a traditional D&O policy. These policies are referred to as Side A Difference in Condition (DIC) policies. Companies should ensure that their insurance program includes this additional protection for the directors and officers, either in the primary policy or by using separate Side A DIC coverage for the following reasons: Reduced chance of coverage depletion. Unlike most D&O policies, the limit of liability for a Side A DIC policy is shared only among the individual officers and directors. The company is not an insured and therefore cannot use the Side A policy to reimburse it for its indemnification obligations or its own losses. Coverage during a company’s insolvency. Side A DIC policies are not considered company assets during bankruptcy proceedings and can provide coverage to directors and officers when primary policies are frozen or insurers withhold payment. Broader terms of coverage. Side A DIC policies often have broader terms of coverage than standard D&O policies. Unlike most standard D&O policies, Side A DIC policies may provide coverage for losses that are not indemnified by a company even though indemnification is legally and financially permissible. These policies may also have more favorably worded claim, conduct and insured versus insured exclusions. In addition, Employee Retirement Income Security Act (ERISA) and pollution exclusions, regularly included in standard D&O policies, may be narrowed or removed from Side A DIC policies.
Coverage when underlying insurer is unable or fails to pay. Side A DIC policies can be structured to cover losses when an underlying insurer cannot pay due to financial insolvency or refuses to pay. Without this coverage, directors and officers may be required to bridge any gap in coverage themselves for non-indemnifiable losses. Coverage of derivative settlements. A recent trend of large derivative settlements has underscored the need for directors to ensure they have adequate Side A coverage. In one of these settlements, Side A DIC policies paid out $40 million of a $118 million settlement.
Insurers also have begun offering individualized Side A policies that are also worth considering. These include Independent Director Liability policies, which provide coverage for a board’s outside directors (and not the company’s officers), and Officer Liability policies, which provide coverage just for a company’s current and former officers. These types of policies can prevent the possibility that an early settlement or defense fees of some insureds may deplete the coverage available to others. Other variations of Side A coverage include policies covering specific officers or directors and policies covering individual directors for potential liability they may have from sitting on multiple boards.
SHOULD DIRECTORS AND OFFICERS INSIST ON SEVERABILITY CLAUSES?
Directors should always insist on severability clauses. Without severability provisions in both the insurance application and misconduct exclusions, each insured is at the mercy of the other officers and directors. A misrepresentation or act of misconduct by any one of them could cause all of them to lose their insurance. Severability clauses address this problem by preserving insurance coverage for innocent directors and officers, despite any improper conduct by other insureds.
A typical severability clause provides that, if material information is omitted from the application, coverage will be denied for the director or officer with knowledge of the omission. A similar severability clause in a policy’s misconduct exclusions will protect innocent directors when another insured has engaged in fraudulent conduct. This kind of provision typically provides that knowledge possessed by any director or officer will not be imputed to other directors or officers for purposes of the policy’s misconduct exclusions. Some insurance companies have tried to either narrow their severability clauses or eliminate them entirely. For example, some insurers make severability inapplicable when the person signing the insurance application knew of misstatements in the application. Another version imputes the knowledge of a company’s chief executive officer (CEO) and chief financial officer (CFO) to all insureds, but severs innocent officers and directors from misconduct or misrepresentations known only to others. These modified severability provisions pose significant risks. Fortunately, many insurers continue to offer broad severability clauses in both their applications and misconduct exclusions, although sometimes at a higher premium. Still, a broad severability provision may be money well spent. In addition, ensure that these clauses will apply to all of the policies in the company’s D&O tower; otherwise coverage under an excess policy may be denied. Most excess policies adopt all of the primary policy’s key terms and conditions and are not a concern. Excess policies that contain their own knowledge exclusions, however, should either include their own severability clauses or explicitly reference the company’s primary policy clauses.
WHAT CAN A COMPANY DO TO AVOID HAVING ITS POLICY RESCINDED?
Rescission is the scariest risk faced by purchasers of D&O policies. Most states, including California and New York, allow an insurer to cancel a policy based on a material misrepresentation or omission in the application for insurance. An insurer may be able to rescind its policy even if the misrepresentation or omission was innocent. This risk can be compounded depending on the number and scope of representations made in insurance applications.
Many applications also incorporate by reference all of a company’s SEC filings for the past year or two. So what happens if the company is one of the hundreds of companies each year that must restate its financials? The insurer has the ability, at least in theory, to respond by rescinding its policy. At the very least, the insurer may reserve its right to rescind and may use the threat of rescission during heated settlement or allocation negotiations. A company can take several actions to reduce its risk of rescission. A company should exercise extreme care in preparing its application. Sometimes a company can avoid submitting an application by simply renewing its policy with its existing insurer.
Other insurers will issue a renewal policy based on an abbreviated renewal application. A company should be careful in responding to requests made by some insurers for answers to supplemental questionnaires (customized questionnaires appended to the standard form of application). When policyholders seek to increase their limits of liability at the time of renewal, insurers will often require the company to sign a warranty letter containing a knowledge exclusion clause before extending additional coverage. Companies should use caution when signing these letters. Warranty exclusions have been used to deny coverage of defense costs when claims allege individual insured persons had knowledge of accounting improprieties when the warranty letter was signed.
Concerning policy provisions, ensure that the company’s D&O policies include a non-rescission provision that prevents an insurer from rescinding Side A coverage under any circumstances. This type of provision has become relatively common in standard D&O policies. Also, the company should ensure that only material misstatements or omissions trigger adverse action on the part of the insurer. Finally, as previously