D&O Puts RMs On Hot Seat

I just finished reading a thriller fashioned around what thebook jacket describes as the “most exciting and dangerous game ofall making money.” Published in 1995, “The Takeover” featuresprotagonist Andrew Falcon, who becomes the linchpin in the largestcorporate takeover in history. Besides pushing him to the top ofhis game, the deal will earn him a cool $5 million fee.

But the voices keep nagging at the back of his head. There'ssomething not quite right about the deal little details that hechooses to subordinate to the dreams of what hell do with $5million and the future power and influence the deal will bringhim.

Sound familiar? The novel is oddly similar to what we've beenhearing in the last few years about Enron, Adelphia, Tyco, and thelike.

These real-life scandals might not be riddled with all theintrigue and dead bodies that populate “The Takeover,” but the corethemes are the same money and power are worth anything.

What does all of this have to do with risk management andinsurance? A lot, if you risk managers have been put on the hotseat by CEOs and board members pressing for guarantees that thecompany-purchased D&O policy will protect them. Or a D&Ounderwriter who has to review ever increasing amounts ofinformation when underwriting new accounts and re-underwriting eventhose that have been on the books for years.

The scandals also are haunting insurers that, in the depth ofthe soft market, expanded D&O coverage well past its initialpurpose protecting the personal assets of directors and officersfor claims alleging errors or poor judgment when their decisionsdidn't produce the intended results.

The broad-based addition of entity coverage to many D&Oforms has resulted in questions about whether the policy mightbecome the property of a corporation's bankruptcy estate,potentially leaving the directors and officers with substantiallyless coverage than originally contemplated.

At times like this, Im sure many directors and officers arepressuring their risk managers for information on the status oftheir policies. So it's a good time to review the types ofexclusions that might be particularly important in light of recentdevelopments.

D&O policies typically were crafted with two insuringagreements. Side A provides coverage for directors and officerswhen corporate indemnification of them is not available. Side Bfunds claims that are subject to corporate indemnification.

Under corporate indemnification provisions, the corporationindemnifies directors and officers for financial liability fromtheir business decisions.

Most states have enacted laws that allow companies to indemnifytheir directors and officers at least partially because, withoutcorporate indemnification, many individuals would not serve oncorporate boards. When there's only Side A and Side B on a D&Opolicy, however, there is no coverage for claims against thecorporation itself.

A problem often arose when some parts of a claim were covered bythe D&O policy and other portions were not. When that happened,the insurer and insured had to allocate coverage between theclaim's covered and non-covered parts.

There typically are two types of covered/non-covered situationsin D&O actions:

Claims that involve covered and uncovered parties

o Claims that involve covered and uncovered allegations

Some carriers responded to the allocation issue by including“best efforts” language, which meant that the insurer and insuredwould use their best efforts to arrive at a reasonable allocationbetween covered and non-covered events. Others offered a presetallocation percentage so the allocation issue was decided before itbecame a problem.

Other carriers responded by crafting a third type of coverageSide C or entity coverage. Entity coverage, which long had beenincluded in policies for not-for-profit organizations, providedcoverage to the corporate body for certain types of claims.

Its this entity coverage that has given rise to questions aboutwhether the D&O policy may be included among corporate assets,as other insurance policies are, in a bankruptcy. If the D&Opolicy is determined to be part of the bankruptcy estate, thedirectors and officers theoretically could be left bare.

Along with this is the move by some insurers to rescind policieson the basis of material misrepresentation in D&O insuranceapplications.

One of the peculiarities of D&O insurance, as well as othertypes of professional liability coverage, is that the applicationbecomes a part of the policy. There also typically are warrantystatements, which indicate that the directors and officers do notknow of issues or practices that could result in claims andlawsuits against the board.

The unraveling of complex accounting and financial pyramids, andeven financial restatements, has given a number of insurers theammunition to try to have the applicable policies rescinded. Thiswould result in all coverage being nullified, even for directorsand officers who may not have been aware of or involved in theproblematic behavior.

Although this may seem harsh to those directors unwittingly leftout in the cold, the case is made that these directors should haveknown what was going on with the companies they manage.

And theres always the point that the D&O “application” isnot just the formal, written application that is attached to thepolicy. It includes the financial statements and history, and alldiscussions and meetings that were held to negotiate coverage.

Directors and officers, at the least, should understand what isbeing represented in this application process, even if they're notintimately involved since, after all, its their personal assetsthat are at stake.

The other issue that unfortunately is taking center stage in themidst of all these corporate scandals is that of fraud. All D&Opolicies contain exclusions for illegal financial gain or advantageand deliberate criminal or fraudulent acts.

Policies may differ as to what standard must be used tosuccessfully trigger fraud exclusions. Must an insured be judged ina court of law to have committed fraud? Do all appeals have to beexhausted? What constitutes “deliberate” acts of fraud?

But, at the least, the unveiling of so much corporate fraud hasgiven insurers the impetus to try to invoke such exclusions whenthe question of fraud arises. This is rightfully so, because noinsurance policy was ever designed to protect insureds from bearingthe financial responsibility for their own fraudulent acts.

If the general public is disturbed by the proliferation ofcorporate scandals, think of what insurers and their stakeholdersare experiencing, knowing that they may be asked to help pay forsuch white collar crime.

Unlike the ending of “The Takeover,” in which protagonist Falconfinally stands up with the good guys and the corporate crooks aretaken down, the jury's still out on many of these real-lifesituations. And it will be years until the true effect on existingD&O policies as well as how they will be crafted into thefuture is determined.

Diana Reitz is editor of the National Underwriter Companypublication, “The Tools & Techniques of Risk Management &Insurance” as well as the “Risk Funding” and “Self-Insurance”Bulletins, both available at www.nationalunderwriter.com/nucatalog.

Reproduced from National Underwriter Edition, May 21, 2004.Copyright 2004 by The National Underwriter Company in the serialpublication. All rights reserved.Copyright in this article as anindependent work may be held by the author.