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Bankruptcies Raise Questions On D&O

Four years ago, I wrote my first “FC&S On Lines” column. It was about directors and officers liability insurance, and the possibility that some of the coverage extensions that had become standard just might not be in the best interest of the primary insureds–the directors and officers.

Ironic, isnt it, that D&O coverage–and how some of these extensions have surfaced as potential issues in the recent corporate governance scandals–has again become a common topic of conversation at seminars, in boardrooms, and in National Underwriter. Just to refresh everyones memory, D&O insurance originated to protect directors and officers from personal liability that arises from board service. Many states have enacted legislation that permits corporations to indemnify their directors and officers for financial damages arising from this personal liability. As a result, D&O insurance has two primary coverage grants:

Side A Coverage, which covers the directors and officers in situations that are not subject to corporate indemnification; and

Side B Coverage, designed to respond to director and officer losses that are subject to corporate indemnification.

D&O insurance was not developed to cover claims against the corporation itself, even though the named insured often is the corporation. However, in the last decade the coverage has been extended to provide a third insuring agreement, which provides coverage for specific types of claims filed against the organization itself, instead of the directors or officers.

This coverage grant goes by a variety of titles–entity coverage, organization coverage, or corporate coverage. Its different from corporate indemnification (side B) coverage because it responds to certain types of claims filed against the entity, claims that are not filed against individual directors or officers and that do not involve corporate indemnification of those directors and officers.

Some policies offer entity coverage for securities claims, employment practices liability claims, or, in the case of not-for-profits, claims arising from broader exposures. In the 1990s, entity coverage became a hot marketing tool for carriers that wanted to increase their market share, especially in the arena of publicly traded companies.

It was touted as a solution to the allocation issue that arose when a claim named both directors/officers and the corporation in a securities-related case. Since the policy did not cover the corporation, there had to be an allocation of limits between covered (director/officer defendants) and noncovered (corporation as defendant) claims. In addressing this allocation issue–as well as other potential coverage snafus–one carrier would introduce a coverage extension, others quickly followed suit, and soon the extension because a necessity.

One of the fears I expressed in my first column was that the available coverage for the original insuredsthe directors and officerswas being diluted by one extension after another. The extensions were too good to pass up for many corporations, which in some cases may have broadened their coverage substantially without buying additional limits for the individual directors and officers.

The recent publicity surrounding Enron, WorldCom, and other corporate scandals has put renewed emphasis on this issue and highlighted another twist. What happens when an organization declares bankruptcy? Does the D&O policy that contains entity coverage remain dedicated to the directors and officers, or does it become the property of the bankruptcy estate? If it becomes the property of the bankruptcy estate, could the coverage for directors and officers become nonexistent?

The answer is critical in terms of how much–or even whether–the directors and officers can count on the policy to pay their defense, settlement and judgment costs.

A cursory review of case law involving policies without entity coverage shows that there was some inconsistency in the courts over whether even side B, corporate indemnification, made the policy or its proceeds the property of the bankruptcy estate. But there still was a viable argument that the policy and its proceeds should be dedicated to the directors and officers. Even under side B, they are the policys ultimate beneficiaries.

However, with the addition of entity coverage, that argument may be weakened because entity coverage provides direct protection to the corporation. Entity coverage makes the corporation a policy beneficiary and, as such, more widely opens the door to the policy becoming the property of the bankruptcy estate. Will the presence of entity coverage serve to preempt coverage for individual directors and officers in bankruptcy cases?

Its obviously too early to tell what will happen in the D&O arena as a result of situations such as the widely publicized Enron and WorldCom bankruptcies. One potential resolution that may be available pre-bankruptcy is the provision of separate towers of coverage dedicated solely to the directors and officers–coverage that is designed to kick in if the limits on the primary D&O policy are either exhausted or committed to the bankruptcy estate.

There are other possible coverage structures and endorsements that may help in such a situation–many have been discussed in the pages of this magazine previously by experts in the field. The key, though, is that these avenues be explored before a companys financial condition begins to deteriorate.

No one wants to “plan” for a bankruptcy, but the reality exists. And directors and officers should be able to count on the D&O policy to be there, even when the unforeseen occurs.

Diana Reitz, CPCU, AAI, is associate editor of the FC&S Bulletins and editor of the RF&S Bulletins, published by the National Underwriter Company in Erlanger, Ky. The editors welcome comment and questions, and may be reached by fax at 859-692-2293 or via e-mail at [email protected]

Reproduced from National Underwriter Property & Casualty/Risk & Benefits Management Edition, November 18, 2002. Copyright 2002 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.

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