D&O: A Flawed Product?

First, Vince DiBlasi, a lawyer for New York-based Sullivan & Cromwell who defends financial services firms, raised the question of whether D&O insurance has "a fundamental design flaw."

D&O coverage, he said, "is not even close to the damages that can be proven by the plaintiffs" even in normal large cases, not just multimillion-dollar cases."

Mr. DiBlasi opined that D&O is "the opposite of catastrophic coverage. In fact, it frequently becomes a hurdle to climb over for management, which needs to settle the case for more than those limits."

He did not, however, have any suggestions for redesigning the product. Indeed he seemed to suggest that it was out of the realm of possibility for insurers to cover the potential demands of plaintiffs' attorneys who bring large securities cases.

"Part of it is a capacity issue," he said.

"You can't look at a product for a company that has a market capitalization in the tens of billions" of dollars and think that a $50 million D&O policy is going to do that company any good.

"Where is the capacity to insure that risk? Or are we really saying that D&O is designed intentionally not to be available for the meltdown?that a meltdown risk should fall on management."

But this is not something that members of boards of directors who are businesspeople rather than lawyers readily grasp, according to Mr. DiBlasi.

"There's a fundamental disconnect between the seller and the consumer as to what they are getting.

"And I see shock in the boardroom when I tell them how damages will be computed" and how they dwarf insurance proceeds, he said.

At a different session titled, "Key D&O Policy Provisions?How They Really Work," an insurance buyer wasn't in shock, but he did express confusion about the several provisions of D&O policies.

For the buyer, Raul Carrillo, senior vice president and general counsel for El Paso Electric Company in Texas, one provision in particular?severability?seems to be based on flawed notions in an era of corporate governance reform where certifications by executives are now required by Sarbanes-Oxley.

Mr. Carrillo raised questions about D&O severability provisions after Carol Zacharias, counsel for ACE USA in New York, explained how severability is supposed to work. Basically, she explained that severability is a provision of a D&O policy that softens the blow of traditional insurance law, which voids the policy for all insureds if there's a material misrepresentation by the person that signs the policy application.

Severability provides that the knowledge by any one insured person won't be imputed on any other insured, she said. "Evil knowledge by one does not equal evil knowledge by all," she said, noting that full severability protects the innocent.

Mr. Carrillo asked: "So, what does that really mean? If you've got Sarbanes-Oxley requirements [and] the CEO and CFO have to certify [and if] insurers are requesting that we attach financial statements to our application, then is there really anybody in the company who doesn't know what goes into the application?

"Is there really anybody who doesn't have knowledge?" he asked, conjecturing that insurers will ultimately say everyone had knowledge and deny coverage.

While he sees that type of scenario playing out in the future, Mr. Carrillo said, "I still want to have a severability provision" in my policy. "I want to be able to go back and argue that there are people in my company who did not have knowledge of the application process or certified financial statements."

Ms. Zacharias explained that under full severability, no one's knowledge can be imputed to anyone else. With partial severability provisions, she said, the CEO and CFO's knowledge is imputed to everybody, but no one else's knowledge will be imputed to anyone else.

Asked whether D&O purchasers are buying policies with partial severability or if they are insisting on full severability, Ernest Martin, a partner with Haynes and Boone in Dallas, who helps insured interpret coverage provisions responded: "Most policyholders do not fully understand what D&O policies provide."

He said, "When you get into issues of severability, rescission, partial severability?it just goes over their heads."

"Does the severability clause really get you anything?" asked Mr. Carrillo?

"In my company, the general counsel, treasurer, chief financial officer and the internal auditors all know about statements that go into an application." From a practical perspective, nearly everyone in the company is contributing information that goes into financial statements attached to the application, he said.

Ms. Zacharias said if an officer has an inclination to answer yes to the question, "Do you know of any facts or circumstances that would give rise to a claim?" they should tell their risk managers about the situation, who can consult with attorneys to decide whether such situations need to be reported to the insurance carrier.

"That doesn't mean you're not getting coverage. In fact, you've protected yourself," she said, noting that while carriers could opt to not write the account, they might also opt to write the account excluding the matter, or simply to write the account without excluding the matter once they get comfortable with it.