THERE IS often a misconception among directors and offices ofprivately held companies that they are somewhat insulated fromD&O litigation because they are not as visible as theircounterparts in publicly-owned companies are. But based on recentsurveys and court decisions, the likelihood of a director orofficer of a privately held corporation being sued has increasedsubstantially. Widespread media coverage of employment-relatedlitigation, increased merger and acquisition activity, a stilluncertain economy and regulators' enhanced scrutiny are among thereasons for the heightened exposures directors and officersface.

The most important reason for directors and officers of privatecorporations to buy D&O liability insurance is to protect theirown assets, since they can be held personally liable for theirwrongful acts committed on behalf of the corporation. In mostinstances, a corporation is obligated to indemnify its directorsand officers for costs associated with such litigation, subject toa few important exceptions. When determining a corporation'sresponsibility to indemnify, one must review the company's bylawsand the state's indemnification statute.

A company's financial ability to indemnify should also beconsidered. A rash of bankruptcy filings over the last three years— some high-profile in nature — has led to conflicting decisionsconcerning who has jurisdiction of a bankrupt corporation's assetsand has raised questions about indemnification of directors andofficers in such cases. Unfortunately, it could be years before thecourts hammer out a final position on this issue.

One common exception to a corporation's obligation to indemnifyits directors and officers is when doing so would be against publicpolicy. A corporation cannot indemnify its executives fromderivative litigation because of its nature (shareholders seekingrecovery on behalf of the corporation itself). Usually litigationinvolving allegations of fraud cannot be indemnified because ofstates' “good faith” indemnification provisions. In all of theseinstances, directors and officers are left to fend for themselves,and without separate coverage may have to use their personal assetsto defend and settle the litigation.

Directors and officers of privately held corporations, likethose of publicly owned businesses, have a duty of care andloyalty. Directors and officers must always put the interests oftheir corporations, the shareholders and employees first. Oftenlitigation arises because a claimant alleges there has been abreach of this fiduciary duty.

This was well illustrated in June 2003, when a federal DistrictCourt in Manhattan handed down a ruling against Marshall S. Cogan,an affluent art collector and former owner of the famous New Yorkrestaurant, the “21″ Club. Mr. Cogan was found guilty of drainingTrace Holdings, his now-bankrupt international personal holdingcompany, of tens of millions of dollars while giving himself alavish lifestyle and providing loans to others, which he arrangedwithout regard to his fiduciary responsibility to the company. Thejudge not only found Mr. Cogan liable, but also held the company'sother directors and officers culpable, even though they were notinvolved in the wrongful acts. The judge felt they did little ornothing to stop Mr. Cogan, despite their own fiduciary duty to thecorporation. While one might think this is an extreme case, it isnow part of case law and has set a new standard for the fiduciaryduty owed by executives of privately held companies-no matter whattheir size.

Directors and officers of privately held companies can face avariety of allegations from competitors, customers, regulators,shareholders and employees. Claims of unfair business practices,antitrust, unfair competition, deceptive trade practices, breach offiduciary duty, conflict of interest, corporate mismanagement,misappropriation, fraud, misrepresentation, securities fraud,discrimination and capital-raising-activity misrepresentation,among other allegations, are not uncommon. A recent surveyconcluded that one of three mergers or acquisitions also results inlitigation.

Employment practices claims are by far the type most commonlyfiled against directors and officers of privately held businesses.Many damage awards are setting precedents, and settlement amountsare rapidly growing.

Directors and officers of closely held companies need to beconcerned about the effects of litigation. On its own, a closelyheld corporation may not have the resources to pay for a protracteddefense, let alone a judgment. Management liability insurancepolicies can provide invaluable protection for these corporationsand their executives. These claims-made policies have been designedspecifically for privately held corporations. Such a policyprovides both D&O and employment practices liability insurance.Fiduciary liability coverage to protect the trustee of any pensionor profit-sharing plan can be included, as well as crime,kidnap/ransom and Internet insurance in some cases. The definitionof insured usually includes directors, officers, employees and theentity.

Not all management liability insurance contracts are the same.Each insurance company offering the product has its own policy.Agents and brokers should make a comprehensive review of availableproducts to determine which offers the broadest coverage and bestvalue for a given client.

When determining how much protection to buy, there are twooptions to consider. Traditionally the only option was oneaggregate limit for all coverages in the policy. Thus acatastrophic EPLI claim would substantially diminish the remainingprotection for a D&O, fiduciary or other claim. In the last fewyears, some underwriters have begun to offer separate limits ofliability for each coverage. While such products are more expensivethan single-aggregate policies, they provide greater protection todirectors, officers and the company itself.

D&O policies designed for public companies provide entitycoverage only if the entity is a co-defendant with a director orofficer in a securities claim. Management liability policies, onthe other hand, cover entities as co-defendants in any type ofclaim (subject to the policy's terms and conditions). This avoidsthe “allocation” issue that arises with most monoline D&Opolicies. Entity coverage is particularly important in EPLI claims,which almost always name the company as well as directors,officers, managers and supervisors.

Management liability insurance often provides prior-actscoverage. The policy also contains a section referring tostatements and representations made in the application.

A submission requires a completed application, the company'slatest financial statements, an employee handbook and, forcompanies less than three years old, a business plan. A completedapplication becomes part of the policy and is materially relied onby the underwriter. The application includes a number of warrantystatements that, if breached by the insured, could affect theclaims settlement. Application forms and warranty questions differwidely from one company to another. They should be carefullyconsidered when evaluating proposals from multipleunderwriters.

To broaden coverage, many underwriters offer a “severability”extension. Simply stated, severability protects those who do notsign the application should warranty issues arise. This can becomeimportant in the event of a claim arising from an incident of whichthe insurer believes the app's signer had prior knowledge. (Suchclaims are excluded by one of the warranty statements.)

Management liability policies may be written to provide“duty-to-defend” or “non-duty-to-defend” coverage. Under theformer, the insurer will select defense counsel in the event of aclaim. Under the latter, the insured is responsible for selectingcounsel. The insurer retains the right to approve the insured'schoice, but consent cannot be unreasonably withheld. One drawbackto the “non-duty-to-defend” option is that the insured bears thecost of defense from the outset of a claim until it is reimbursedby the insurer. Some policies advance defense payments to limit thedrain on the insured's working capital.

Most management liability contracts have “pay on behalf of” asopposed to “reimbursement” wording. With the latter, an insuredtemporarily could incur substantial out-of-pocket costs.

Worldwide coverage is desirable, since many large, privatelyheld companies have foreign operations. Depending on the state ofthe insurance market, other enhancements available may includethird-party discrimination coverage, defense costs in addition tothe liability limit and a modified settlement (“hammer”)clause.

When evaluating management liability markets, consider thecarriers' expertise, seasoning and commitment to the product; thequality of their underwriting; their dependence on reinsurers; andtheir willingness to compromise if there is a difficult situation.Consider an insurer's claims-settlement reputation and practices.Two issues in particular should be investigated: the insurer'sdemonstrated interest in equitable solutions and its willingness tocontinue coverage after claims. Some carriers offer aggressiveterms and pricing but will sever the relationship once a claim issubmitted. Being “nonrenewed” by an underwriter creates a number ofproblems.

Privately held companies thinking of going public within threeto four years should choose their management liability insurercarefully. By discussing this issue in advance with underwriters,agents and brokers can improve the odds that their clients will nothave to change insurers when they alter their ownership status.Freed of the necessity to find another carrier, producers and theirclients can focus on switching to D&O and EPLI coverage frommanagement liability insurance. By staying with the same carrier,an insured also may not have to sign another warranty statement,which could create new exposures.

While many insurers have slowed their pace of D&O writingsfor publicly held companies, there has been an influx of capacityfor management liability insurance, which has lowered pricing tomid-1990 levels. Many insurance companies have separated EPLI andmanagement liability underwriters, creating internal competitionfor business, which can work in an insured's favor.

Offering comprehensive management liability insurance to theprivately held businesses among your clientele gives you theopportunity to be proactive and to address two of the fastestgrowing perils directors and officers face (D&O and EPLI). Itshould be standard operating procedure for all agents and brokersactive in commercial lines.

Wayne Bernstein is a managing director and founding member ofExecutive Perils Inc., a Los Angeles based national wholesaleinsurance broker, specializing in EPLI, D&O, professionalliability, crime, fiduciary liability, intellectual property andtechnology liability coverages for corporate andfinancial-institution accounts. He can be reached at (310) 444-9333or at [email protected].