Just like their counterparts at publicly owned companies, the directors and officers of privately held businesses face significant liability exposures. Yet many do not purchase directors and officers liability insurance, which can protect them from these exposures. This “private D&O paradox,” and how agents and brokers might overcome it, was the subject of a panel discussion at the Professional Liability Underwriting Society's 19th Annual International Conference, which was held last November in Chicago.

Taking part in the discussion were moderator Lisa M. McGee, vice president, Chubb & Son, and the following panelists:
–David J. Hensler, partner of Hogan & Hartson LLP, a Washington, D.C., law firm.
–Brian Inselberg, division president, Private Company & Non-Profit Management Liability, AIG–National Union.
–Paul B. Nowak, vice president, partner and executive liability department manager for Alexander, Morford & Woo, an MGA in Redmond, Wash.
–Eric Ross, specialty lines claims manager for the Beazley Group PLC.
–Robert Schueler, vice president and private D&O product manager, Travelers.
–Peter M. Trunfio, senior vice president, Aon Risk Services Inc.
Following is an edited transcript of part of the discussion.
Lisa McGee: Simply stated, the private D&O paradox is that most private companies don't see a need for directors and officers liability insurance, despite their own experience indicating its advisability. Consider some of the findings from a 2005 Chubb survey of 450 private companies. Of those who didn't have D&O insurance, 33% said they had no need, 20% said their D&O liability risk was low and 12% thought they had D&O coverage under other liability policies.
Now for the paradox: Those low purchase numbers belie these companies' actual experience. Almost a quarter of them reported a D&O claim in the past five years. Of those with 250 or more employees, almost 40% had faced a D&O lawsuit. Even 20% of small companies, those with 25 to 49 employees, experienced a D&O claim.
The figures show that companies that had D&O insurance fared better than those that didn't. The average loss reported by the surveyed companies was $380,000. For those that had D&O coverage, the average loss was $129,000. For those that did not, it was $480,000–nearly three times greater. This suggests that a company with a D&O policy can mount a strong legal defense and minimize its losses.
Clearly, private companies are vulnerable to D&O lawsuits, yet often forgo coverage. One rationalization we hear is: “We're a private company. We don't have outside shareholders. Therefore we don't have any D&O risks.” Yet the Chubb survey found that 43% of D&O lawsuits came from customers and 29% from regulatory agencies. Shareholders accounted for only 11% of D&O lawsuits.
Peter, why don't you start us off by describing the private-company D&O landscape?
Peter Trunfio: In its simplest form, a D&O policy is a “malpractice policy” applicable to errors and omissions arising from the boardroom and executive offices. Directors and officers owe a duty of care to their constituents, who include shareholders, employees and customers. A duty of care is generally described as an expectation that a director or officer will exercise reasonable care when making decisions. At its core, a D&O policy covers breaches of this duty of care.
Private companies generally are described as those that do not have publicly traded equity securities. You'll notice I specified equity securities. There are plenty of private companies that issue public debt securities. Private companies come in all sizes-from a giant like Cargill, with $66 billion in revenue, to the corner deli. They also come in all kinds of structures, including corporations, limited liability companies, partnerships, limited liability partnerships and sole proprietorships. They also have different ownership structures, including single shareholders, multiple shareholders, family ownership and employee stock ownership. We have U.S. subsidiaries of foreign parents–even private companies with public subsidiaries.
Lisa McGee: David, what types of claims are filed against the directors and officers of privately held companies?
David Hensler: One common scenario involves a private company that has a majority shareholder and one or more minority shareholders. That is a recipe for D&O claims, especially in three situations. The first is a buyout of the minority shareholders by the majority shareholder. Once he owns the whole company, the majority owner may plan to take it public–but not disclose this to the minority shareholders, even when asked point-blank. In one such case, the majority owner denied such an intention even though the company had already hired an investment banker and was fairly well along in preparing a public offering. The majority owner bought the minority owners' shares for $22 million. The company sold the shares for $82 million a few months later when it went public. Obviously the minority shareholders filed suit. The case cost $12 million to settle and another $4 million to $5 million to defend.
A second situation that can lead to claims is a “freeze-out” merger, in which a majority shareholder attempts to force minority shareholders to sell their stock for less than fair market value. A third common situation is the sale of company assets to entities that are controlled by the majority shareholder.
Eric Ross: Bankruptcies are another common cause of private-company D&O claims. For a couple of reasons, a bankruptcy is an almost automatic generator of claims. One is because people come “out of the woodwork” looking for money. Also the bankruptcy court will try to find money for creditors. So you have aggrieved people who are looking for sources of recovery–and the directors and officers are fairly obvious targets. The company must have gone under for some reason, and mismanagement is often the reason alleged.
Typically, a company's bylaws require it to indemnify the directors and officers for the cost of litigation arising from the performance of their duties. Bankruptcy, of course, renders that indemnification agreement meaningless. Unless they have D&O insurance or sufficient personal resources to defend themselves from claims–which can easily cost hundreds of thousands of dollars–the directors and officers are going to be in serious trouble.
Bankruptcy claims against directors and officers run the gamut. I've seen preferential-transfer claims, particularly when a director or officer of the bankrupt company also had an interest in a vendor or other company to which payments were made just before the bankruptcy. I've seen creditors or vendors who have extended credit to private companies just before bankruptcies claim misrepresentation. Following a bankruptcy, somebody will find something to “pin” on a director or officer.
David Hensler: In regard to bankruptcy, I would add that a “hot trend” these days is the purchase of companies by private equity firms. Since they don't tap the public equity markets, private equity investors often load up on debt–sometimes massive amounts of it–to obtain additional capital and to leverage their investments. Then if there's a little “blip” in the company's operations or the economy, these companies may be right at the edge of bankruptcy.
Robert Schueler: I'd like to make a few points here. There is so much capital flowing into private equity that there are not enough good deals out there to absorb it. To put it in perspective, there were $38 billion of recapitalizations in 2005, which was a fivefold increase over the $8 billion in recapitalizations that took place in 2004. Consequently, there's a lot of good money chasing bad opportunities. The strength of the economy may be covering up some of the questionable deals. But when deals go bad, obviously D&O policies come into play. Claimants may include creditors, minority shareholders and those who sold the business to the private equity fund.
In spite of the strong economy, the current default rate on this high-interest recapitalization debt is about twice as high as it is for junk bonds, according to Standard & Poor's. This highlights the need for underwriters to view the financing of these deals with a skeptical eye. Thank goodness for one-year policies, which enable underwriters to review annually.
David Hensler: Let me turn to another situation. Probably many of you deal with family-owned businesses. At least with the first-generation owners of such a business the notion is: “We're all friends here. We're not going to sue one another, so why do we need D&O insurance?” Well, you're likely to need insurance if you have some family members/shareholders who are in the business and some who aren't. Those who are in the business have two sources of compensation: employment compensation–which sometimes can be quite substantial–and dividends. Those people who aren't in the business only have dividends. There is a constant tension between those who are in the business and those who aren't. Those who are not in the business may want to cash out, while those who are may want to continue to use the capital the non-employee shareholders provide. That can lead to litigation.
Family-owned businesses also are susceptible to claims that arise from non-business-related tensions between family members. In one fairly notorious case in which I had some involvement, the patriarch of a $3 billion empire that included both private and public companies was married but decided to take up with younger women. His son, who really had been the force behind the company's growth, sided with the mother. So the father fired his wife, son and daughters from the board of directors. As you can imagine, that led to a host of litigation.
Lisa McGee: How do carriers address these family exposures?
Robert Schueler: It is difficult, if not impossible, to delineate good risks from bad in regard to this exposure, because you're never going to get a full picture of the emotional relationships among the parties. So generally, insurers use family exclusions to carve out that risk. Also, there is the D&O policy's customary insured vs. insured exclusion. Thanks to that exclusion, the shareholder ownership that resides on the board is what we deem “tied up” by the exclusion and, therefore, poses much less risk than outside minority shareholder ownership.
Eric Ross: It's complicated, though. In a family business, it's common for somebody to be both a director and officer, but also–maybe in another capacity–to be an employee, in which case the insured vs. insured exclusion may not be enforceable. Things can get murky. You may find a shareholder bringing both a shareholder claim and an employment claim.
Robert Schueler: Family exposures are probably the most challenging underwriting risks we face. How much ownership is not represented by the board? That minority ownership is the key to shareholder exposure. The percentage of such ownership is not the yardstick to use. Rather we evaluate that outside, non-board-represented ownership–whether by book value or some other means–in absolute dollars.
It's important to scan the Internet and Westlaw to find out if there have been any prior family disputes. Certainly the agent's knowledge of the family can be valuable. Finally, we concern ourselves with third-generation management. The notion is that the company's founders struggle to create the business. The second generation watches their parents struggle and appreciate and respect what they've created. When the third generation takes over, however, things tend to get a bit “dicey.” The ownership is diluted, the parties may be less interested in the running of the business, and the liquidation of some of the ownership becomes more of a possibility.
Lisa McGee: What are the ramifications of the death of a director or officer of a family-owned business?
Robert Schueler: Sadly, such deaths have bred claims. There is a transfer of ownership. The heirs don't necessarily like what they hear when the will is read. It becomes difficult for them to resolve their differences because they often are based on emotion rather than rational business considerations. The death of the major owner may have additional implications. Was that major owner such a key contributor to the business that it may have difficulty surviving without that person?
David Hensler: D&O claims against private companies also can result from “employee pirating.” When an existing company's employees depart to form a competing business, they may take other employees with them. The way the former employer resists this new competition is by filing an employee-pirating claim. Such litigation can be intense because a lot can be at stake. The defense costs, even in a short period of time, can be quite substantial.
Eric Ross: A related exposure that resonates with any Main Street business arises when salespeople move from one company to another and want to take their customer lists with them. Or maybe a departing salesperson has a noncompete agreement. The salesperson's old company may allege that the new one is interfering with the salesperson's noncompete agreement or committing some sort of unfair trade practice. That happens all the time.
Lisa McGee: Brian, what should private companies consider when selecting a D&O carrier?
Brian Inselberg: Claims frequency may be a greater issue for privately held companies than for publicly owned businesses. You want to make sure that the carrier has a claims department staffed to handle those claims, as well as the experience to respond. The other thing to look for is financial stability.
In regard to the policies themselves, one approach is the multi-coverage product. It starts with the D&O component but may also include fidelity, employment practices, fiduciary, and kidnap and ransom insurance. You can combine limits for such coverages or have separate limits. I think for midsize private companies in particular, such “one-stop shopping” tends to work well.
Insureds can opt for duty-to-defend coverage, where the carrier takes over the defense of the claim and handles pretty much everything. That's certainly an advantage for companies that don't have inside general counsel.
“Side A” coverage, which public companies increasingly have been buying, also is an option for private businesses. It provides a coverage limit, generally nonrescindable, solely for individual directors and officers. That comes in handy in bankruptcy situations, in which litigation against the company may drain a traditional D&O policy's limits, leaving little for the directors' and officers' defense. When companies big or small try to attract outside directors or officers, I think it's important to show them that there's something to protect them in such situations.
Severability of interests is another important feature. Again, it can help a company attract outside talent by showing that if one “bad apple” violates a D&O policy's warranties, the remaining directors and officers still will have coverage.
With some private companies, you may have independent contractors, leased employees, part-time employees, etc. If they or others have the potential to create a D&O liability for a company, it should have third-party D&O coverage for that.
Settlement provisions should be considered. Sometimes when a carrier thinks it's time to settle a claim, the insured wants to continue to fight it. In such cases, the insurer will want to make sure the insured at least shares in any additional loss going forward. There are ways to arrange this, however, so that the insured doesn't feel it is being forced to settle if it really doesn't want to.
With regard to coverage for litigation arising from the issuance of private debt securities, you want to make sure your D&O policy covers you for things like bad documentation–inaccurate or inadequate verbiage in a prospectus or related materials.
Last, I'd like to mention the importance of risk management services provided with a D&O policy. For instance, if there's an announcement coming about layoffs, plant closings or even bankruptcies, a lot of policies provide for an outside crisis management company to help relay this message to the public.
Lisa McGee: I'd like to ask our agents to comment on some of these coverage features. What is important to the client?
Peter Trunfio: Each is different. The selection of counsel may be an important issue to one client, while another may not care. The same with duty-to-defend versus reimbursement coverage.
One of our roles is to be our clients' advocates if claims come in. I'm surprised to find that the biggest problems we have in claims are not with coverage issues. The policies are pretty straightforward; usually a claim clearly is covered or it's not. The biggest problems are with late reporting and choice of counsel.
In the duty-to-defend policy, the carrier has not only the duty but the right to defend a claim, which means it gets to pick defense counsel. Some carriers let clients choose counsel from a pre-screened panel counsel list. Others don't have such lists but still maintain the right to choose counsel. All too often, we find that clients don't realize their obligation to report claims under this system. They don't tell their brokers about claims, so we don't inform the carriers. We may not find out about a claim until six or 12 months into it. Meanwhile, clients have spent thousands of dollars defending themselves and possibly jeopardizing their coverage under their D&O policy. A related issue is choice of counsel. The client has chosen someone to represent them for the last six to 12 months before making anybody aware of the claim. Then we find out it's not somebody from a panel counsel list or not a carrier-approved defense firm. That can lead to disputes with carriers. I'm amazed at how often this happens.
The best thing to do is make sure clients understand their obligations. Sometimes that's as basic as going through the D&O policy's reporting provisions with them line by line, to make sure they understand what they must report. It's not as easy as it sounds. We tell clients to call us if they are unsure how to respond to an incident. We tell them, “When in doubt, let's report it.” The industry spends a lot of time tailoring coverage, but we probably don't spend as much time as we should talking to clients about what happens when claims come in.
Lisa McGee: Let's move on to underwriting.
Robert Schueler: I think the industry offers customers an outstanding value proposition, as evidenced by our high retention rates. Coverage under private D&O policies is extremely expansive. You're offering what amounts to all-risk coverage, except for that which is excluded. The option to upgrade a standard EPLI policy to include D&O for an additional 30% to 40% in premium is very reasonable.
The risk management services private D&O insurers provide are critically important, and we may be underselling them. These services save clients a lot in fees and other costs they otherwise would incur. I think we also undersell the outside directorship liability coverage for service on boards of nonprofit or civic-minded organizations.
Regarding mergers and acquisitions, we're seeing lawsuits from buyers alleging misrepresentation. That speaks to the importance of properly underwriting run-off coverage; i.e., the extended reporting periods sellers may purchase. There is material risk in that run-off.
I also encourage brokers and underwriters to review M&A purchase agreements. Is the deal all cash and an immediate buyout, or are there contingent payments or escrow funds? Disputes over contingencies tend to add to the D&O liability risk. Ask yourself as an underwriter whether the deal make sense. If the buyer overpays, the seller's insurer tends to have a greater exposure from an unsatisfied buyer a year or so down the road.
Lisa McGee: Let's move on to buying trends. Based on everything we've discussed, it would seem that the agent's job would be easy.
Paul Nowak: Before we talk about new or potential buyers, we should consider who's buying currently. We've seen buyers among emerging growth companies, start-ups, large private companies with outside boards and companies with claims histories. They are easy sells. So are companies that have complex organizational structures.
We're also seeing a lot of buyers from cross-selling. These are companies that have bought employment practices liability insurance the last five to 10 years. They're asking to have D&O added to the EPLI renewal quote in package policies. The additional premiums can be so low that they go along with the broker's recommendation and buy it.
Interestingly enough, we're starting to see private companies buy D&O insurance because their peers are purchasing it. They may be in a field in which CFOs get together in associations and discuss issues they're facing. The topic of D&O may come up, and the next thing you know, we have CFOs asking us for D&O policies.
Peter Trunfio: Some clients who have not bought the coverage make a change to the board of directors. Maybe it's a family-owned business that gets its first outside director. This new person refuses to sit on the board unless the company gets a D&O policy.
Paul Nowak: Typical nonbuyers, on the other hand, include those we previously discussed who are unaware of the common exposures or deny they are applicable to them. It's our job to educate them.
Some private companies also are unaware of the quality of the product. Many insureds to whom we've presented D&O proposals in years past compared the price to their estimates of their exposures and concluded the cost was too high for the potential benefit. Some, however, are beginning to see how broad underwriters are making these policies and reconsidering.
Some prospects don't understand the value of the products. D&O policies for privately owned companies either automatically provide entity coverage or offer an option to add it. That's significant, especially when you pair entity coverage with the duty-to-defend provision. We previously discussed claims alleging interference with noncompete contracts. That's not an exposure most D&O policies intend to cover, but if it's one of a dozen or so charges in a complaint, at least one of which is clearly covered, the insurer will defend all of them under a duty-to-defend policy. I think that's critical.
Some nonbuyers are unaware how flexible the buying process can be. Smaller insureds want it to be very quick and painless. They want one-page applications. They want to give us their assets, liabilities and profit margins and then get the quote. We have products that respond to those insureds. We also have privately held companies that don't want anyone other than their banker looking at their financials. We have well-trained underwriters who can assure them the level of confidentiality they require. We can offer face-to-face underwriting where that's desired.
Most insureds are used to buying a policy for a specific risk they know they have. They buy property insurance because they can easily envision losing their property to fire or other peril. When it comes to D&O, however, it's more difficult for them to grasp where claims may come from. Our job is to talk about sources of claims we wouldn't have imagined five years ago and communicate the power of this product to cover them.
Why are some nonbuyers changing their minds? I believe it's because the industry has put together a successful product. Coverage is much broader than we would have dreamt of 10 or 15 years ago. Package policies also are drawing attention. Most companies buying D&O also are interested in employment practices liability, fiduciary or what have you. Competition is leading not only to better products but also to better pricing, which obviously leads to more sales.
Many private companies say to us, “I know I have an employment practices liability exposure; I just don't know if I have a D&O exposure.” They want the facts. So we may wind up getting them a customized, tailored product with $5 million of employment practices coverage and $1 million of D&O. Such things are now possible through the creativity of the underwriters.
Brokers are spending more time going after privately held companies and seeking new creative ways to sell the product. As more companies buy it, we see more loss data, which allows underwriters to price the product better.
Lisa McGee: How might we get the smaller buyers to see their D&O exposures?
Paul Nowak: You have to provide examples. Most underwriting firms have fliers and marketing materials containing them. When we raise the possibility of bankruptcy, and a prospect replies that we don't understand how strong the company is, you have to agree with them–then show them examples of quality companies that lost an important customer and ran into financial difficulty.
Peter Trunfio: Prospects don't think they're ever going to get sued. They don't think about an attractive transaction in terms of the risks it also creates. They don't understand why selling $10 million worth of company stock to an ESOP could create some exposure for them.
Paul Nowak: The thing we do is ask, “Have you spoken to counsel about this?” I'm sure counsel would say, “Yes, there is an exposure”–especially when you get involved with something like an ESOP. After speaking with counsel, they may well conclude a D&O policy is a good idea.

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Overcoming the private-company D&O paradox

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