Why Should Private Companies Purchase D&O?

Private company D&O coverage is a meaningful risk management tool for privately held companies and, accordingly, insurance companies and brokers need to better explain to private companies why they should invest in it.

So what kinds of claims are private companies and their owners subject to that should lead them to purchase Private Company D&O?

Duty to Defend.

First, and most importantly, private D&O is usually written on a duty to defend basis. It is well understood that that the duty to defend is broader than the duty to indemnify. Where at least one allegation of a lawsuit is potentially covered, many states require the insurance company to defend the entire lawsuit.

This is less significant for employment-related claims where the allegations are often related and covered by the policy, but is significant for non-employment claims.

For example, consider a fairly typical claim scenario where fraud or negligent misrepresentation is alleged in conjunction with a claim otherwise excluded by the policy. In this situation, it is likely that the duty to defend would be triggered for the entire claim, and the associated defense expenses may approach six figures.

The duty to defend is a valuable coverage that can easily exceed the cost of the policy and significantly protect the financial position of a privately held company.

Beyond the value of duty to defend for the corporate entity itself, it can also be valuable to the individual directors and officers or employees. Consider this claim where an insured person was named in a lawsuit alleging breach of contract against the company. The insured person was alleged to have misrepresented the true nature of the contractual relationship and was also alleged not to be entitled to the protection of the corporate structure or corporations indemnity.

Since the contract itself was with the entity and not the person, it was hoped that the individual would simply be dismissed from the lawsuit. Unfortunately the matter quickly shifted to bankruptcy court, which has been slow to remove the person from the suit.

As the company moved into bankruptcy, its ability to indemnify the director was impaired, and without insurance the director would have had to pay defense expenses from his own pocket for a claim rightly directed against the corporation. Defense expenses exceed $250,000.

Aside from the purely economic benefit of the duty to defend, private companies must also consider the tremendous amount of time and energy that these claims can take, impacting their owners ability to manage the day-to-day operations of the business. This can cost the company substantially in terms of lost opportunities, dissatisfied customers and a host of other potential problems.

While insurance companies handle these claims every day, a private company might not even be involved in one every year. Therefore, a primary benefit to the insured is having an experienced insurance company and outside counsel to help handle these claims, significantly reducing the impact of the lawsuit on the company.

Employment Practices Liability

The next important point is that private company D&O coverage almost always contains the same comprehensive employment practices liability coverage as a stand-alone EPL policy. The EPL exposure to companies is well documented and needs no further elaboration other than to note that its relative importance as a risk management tool has grown to such an extent over the past 10 years that, for most companies, it is a core insurance coverage purchase.

While some insurers have limited employment practices coverage in their private D&O policy, in most cases it is similar to the employment practices enhancements that they provide in their stand-alone form. Producers should make sure that the coverage they offer to their private company clients contains all of the coverages appropriate to the unique exposures faced by that client.

Fiduciary Liability

Third, private D&O coverage protects the directors, officers and often employees of the insured for their acts in their capacities as such. Directors and officers of private companies have fiduciary duties that they owe to the corporation–the same as those they would owe to a public company. If they breach those duties, they can be held personally liable.

This liability can be separate and distinct from the company.

Many owners of private companies do not realize this fact, thinking that they are protected by the "LLC" or "Inc." suffix of their company name.

This is where the private D&O policy may be the only coverage that will respond. Consider the following claim, highlighting the potential exposure to breach of duty claims.

Partners of certain limited partnerships sued the controlling interest in the partnerships in eight separate lawsuits alleging breach of fiduciary duty, fraud, misrepresentation and a host of other allegations. The partnerships had been established as investment vehicles and the investments were substantially devalued when the Internet bubble burst.

The investors alleged that they were particularly disillusioned regarding how their money was ultimately used versus what they were told it would be used for. Defense expenses total approximately $3 million, and alleged damages, not all of which are necessarily covered, are estimated to be in excess of $20 million.

Entity Coverage

A very important point to impress upon owners of private companies is that private D&O coverage includes coverage for the entity itself. According to the Tillinghast-Towers Perrin Directors and Officers Liability Survey for 2001, the corporate entity has historically been named in 80-90 percent of all suits brought against directors and officers. The entity coverage provided in private D&O policies could save a company from financial ruin.

The value of this coverage is its breadth. Typically, like the coverage offered to the directors and officers, the company is covered for any act, error or omission–period. Although subject to the policy exclusions, it is easy to imagine dozens of scenarios in which a company could spend hundreds of thousands of dollars in connection with a claim brought against it.

Producers should ask their clients whether the corporation or the directors and officers individually could afford to defend themselves in a suit that could have been covered by a very affordable insurance policy.

Securities Liability

While private D&O policies will typically contain some form of securities exclusion, a company can still probably negotiate coverage for transactions that are not required to be registered under securities laws. Within the industry, this coverage is referred to as a "private placement carve-back" (to the securities exclusion).

Technically, a private placement is but one type of securities offering not required to be registered under securities laws. So the coverage is actually broader than the name suggests.

The bottom line is that private companies need to be made aware of the comprehensive and affordably priced policies and package policies available to them in todays market. They need to be educated on the tremendous value of private D&O in terms of the many exposures they face and how these claims might be covered by the policy.

Finally, and maybe most importantly, officers and directors need to understand both that they have personal liability in many cases that can only be covered by private company D&O and that coverage for the entity can save their company from financial ruin in the event of a catastrophic claim. Only through education will the value of this coverage be realized.

Jeffrey Klenk is senior vice president, executive liability for Travelers Bond.

Reproduced from National Underwriter Edition, May 19, 2003. Copyright 2003 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.