Changes to D&O liability

Since the global financial collapse in 2008, Wall Street critics, not to mention businesses and citizens hit hard by the credit crisis, have lamented the dearth of regulatory actions taken against major investment banks. 

Certainly, there have been a few high-profile cases that have grabbed the spotlight. In July the SEC won a $13.9 million penalty against former Goldman Sachs board member Rajat Gupta for illegally sharing corporate secrets with former hedge fund manager Raj Rajaratnam. Gupta is now barred permanently from serving as an officer or director of a public company. 

There’s also a lawsuit brought by the Commodity Futures Trading Commission pending against former New Jersey governor Jon Corzine alleging negligence in oversight of an assistant treasurer who comingled client and bank funds to stave off insolvency at MF Global, which eventually filed for bankruptcy in 2011.

For the most part, however, the heads of major banks and members of their boards have escaped prosecution. Not so the smaller institutions: there has been an explosion of litigation directed at commercial banks insured by the Federal Deposit Insurance Corporation (FDIC) that have failed over the past five years. 

Over the four years ending on July 12, 2013 the FDIC had authorized litigation in connection with 120 failed banks, targeting 962 individuals for directors’ and officers’ (D&O) liability since 2009, according to an update on the agency’s website. These 962 authorized lawsuits resulted in 69 D&O lawsuits actually filed against companies, which named 530 former directors and officers. Nine of these cases were fully settled and one resulted in a favorable jury verdict.

The number of authorized lawsuits has spiked from 98 in 2010 to 264 in 2011 and 369 in 2012. This year authorized lawsuits are threatening to outpace the numbers seen in 2012, with 220 approved as of July 12. That has resulted in 25 FDIC lawsuits actually filed against directors and officers of failed banks so far in 2013, compared with 26 for all of last year.

More careful scrutiny

As a result of this environment of heightened litigation, which is underpinned by a battery of new regulations under the Dodd-Frank Act designed to curb and prevent the excesses of the financial industry, more and more companies that buy D&O liability coverage for their officers and board members have been carefully scrutinizing their policies to make sure they have the optimal coverage available, explains Tom Orrico, FINPRO financial institutions practice leader at Marsh, a division of Marsh & McLennan. ‘The definition of a claim under D&O already extends to regulatory proceedings against an insured individual,’ he points out. ‘But there’s obviously been an effort to make sure the coverage is as broad as possible.’

The aim of broadening how a D&O claim is defined is to clarify the extent to which a D&O policy covers the costs involved in responding to an investigation by the SEC or another government agency.

‘In some cases it’s an informal investigation – the [regulator] asks you to provide documents and sometimes you agree to do that without requiring it to issue subpoenas,’ says David Kroeger, a partner at Jenner & Block in Chicago and senior member of its insurance coverage litigation group. ‘There’s been a considerable amount of debate as to the extent to which the definition of a claim in a typical D&O insurance policy is going to cover that informal investigation before it rises to the level of formal charges.’

During the informal part of a probe, the SEC asks that documents be collected and produced and that witnesses be put forward, all of which can be very expensive, says Kroeger. The informal phase generally eats up a large portion of the legal budget for companies facing the prospect of SEC charges, he adds.

Formal and informal charge costs

Companies typically think all aspects of an SEC investigation should be covered by their D&O policy, but some policies make clear that those costs aren’t covered at all. Other policies are beginning to be drafted to allow full or partial coverage for those types of matters.

‘The whole goal is to avoid a formal charge,’ Kroeger says. ‘If your policy is set up so that you don’t get coverage until you get a formal charge, you may have gone a significant way down the road to defending that claim and none of it’s going to be covered if your policy isn’t set up in the right way.’ 

Because courts tend to disagree on whether the traditional language used in D&O contracts for the last 10 to 20 years will cover an SEC subpoena or informal probe, Kroeger recommends that companies try to structure the definition of a claim to better ensure coverage as soon as possible for an SEC inquiry. 

AIG was the first carrier to extend D&O coverage to informal investigations before an individual officer is charged, through Executive Edge, a product it launched in 2010. ‘Since 2010 it’s been built into our new D&O form, so you don’t have to negotiate it. It’s part of our standard offering,’ says Louis Lucullo, AIG’s global head of commercial D&O. ‘Many other carriers don’t have it built into their standard form yet. They have to add it on by endorsement, so you and your carrier have to remember to ask to add it on.’

When first introduced, Executive Edge was priced on average 10 percent above the cost of AIG’s previous D&O policy. Now that it’s included in AIG’s standard form, a large majority of the portfolio has converted to the form, says Lucullo. 

Advancement of defense costs

Another recent improvement in D&O contracts protects individuals from having to wait for insurance money to be released to cover defense costs if their own company refuses to indemnify them. Rather than making the director or officer cover the policy deductible from his own pocket until the dispute over whether the company should indemnify him or her has been decided, this provision allows coverage of all the director’s legal costs to advance immediately, leaving the indemnification question to be sorted out later. If in the end it turns out that the company is obliged to indemnify the director, the company will have to reimburse the insurance firm for any money that was advanced for that individual’s defense costs, says Orrico.

From an insurer’s perspective, it may appear clear that an officer who is alleged to have gotten his/her company into trouble and is being investigated or charged by the SEC will be found to have engaged not only in wrongful conduct but also in intentional wrongdoing; but that individual is still going to want his or her defense costs to be covered, says Kroeger.

New policy language

There’s an entire string of litigation concerning Allen Stanford, the former CEO of Stanford Financial, who was convicted last year in a $7 billion Ponzi scheme, along with other former officers at the company. Here, insurance carriers pushed back on being required to advance defense costs for cases where they were sure the officers would be found guilty of misconduct and so not entitled to coverage under the criminal or fraudulent acts exclusion included in the typical D&O policy.

These days, insurers are increasingly including language in D&O insurance contracts to make it clear any individual found guilty of intentional wrongdoing is required to pay back the insurance provider for defense costs advanced, says Kroeger.

The complication is that many D&O lawsuits settle before going to trial, so carriers may not be able to invoke that exclusion if – depending on the contract – there’s an exception to the exclusion that has to be determined by a court finding that fraud or criminal acts did in fact take place.

Providing analytical tools

Companies have also started to pay greater attention to whether the Side A difference in conditions (DIC) policy limits – those that are specifically earmarked for individual directors and officers – are adequate to cover potential defense costs.

Side A DIC coverage is triggered by a ‘drop-down event’ such as a situation where the underlying insurer denies or cancels coverage, becomes insolvent or is prohibited from making payment – for example, by order of a bankruptcy court if the company is in Chapter 11 – or where the company refuses to indemnify directors and officers even if it is legally allowed to indemnify and has the financial resources to do so.

In order to give companies the ability to determine the appropriate levels of their D&O coverage, insurance brokers such as Marsh have started to provide analytical modeling tools. This development is replacing the prior approach of basing limits on what industry peers are buying, observes Orrico. 

‘Part of the reason for it is the whole cost of capital analysis,’ he explains. ‘If this is what the carrier is charging, is that the appropriate charge, given your risk profile? Is it a good trade-off to buy this amount of limit for this premium? Those are the tools we’re providing companies with now.’

For the majority of Marsh’s clients, limits have stayed the same, concedes Orrico, but there are a few that have opted to buy an additional $15 million to $25 million in Side A coverage.

Order of payments provision 

Most primary D&O insurance programs combine Side A, B and C coverage in one policy, requiring directors and officers to share the policy limits with the company itself. The problem is that if the policy limits are exhausted under the Side B and Side C coverage by the company’s indemnification obligations or its own liability, it can leave nothing to cover defense costs for individual directors and officers.

An order of payments provision can dramatically reduce this risk by stipulating that any payments due for claims under Side A coverage must be made before the company is reimbursed or receives any coverage under Sides B and C. 

When there’s a claim with a half-dozen or so directors, at least a couple of officers and the company itself vying for a limited pot of funds from the D&O insurance, an order of payments provision ensures the company is last in line to receive funds, says Kroeger. 

‘It also helps you in the event you get into a bankruptcy situation, where the bankruptcy court is trying to figure out what the debtor [company’s] property is,’ he adds. ‘An order of payments provision helps to ensure the directors and officers go first and get first access to those proceeds.’ 

Independent directors’ liability coverage

One new product that hasn’t proved as popular as insurance providers had hoped is specifically geared toward independent board directors. After the credit crisis, there was some concern about whether independent directors had sufficient coverage. Firms wondered whether they should reserve coverage for independent directors to ensure they had enough to fund defense costs if they were targeted by an investigation.

‘There was concern that an officer of the corporation [whether purely an executive or someone who was also a board member] would erode his or her limits, not leaving any coverage for the independent directors,’ explains Orrico. 

It turns out that this type of policy has been most useful to companies in financial difficulty that need to attract directors. ‘A way they do that is to give them a dedicated limit,’ Orrico notes.