Not As Easy As A-B-C

The increasing likelihood that claims will be non-indemnifiable is a key point that is missed, Mr. Bailey said. He outlined four potential A-Side claims situations:

1 Settlements and judgments in shareholder derivative suits in most states.

2 Violations of certain statutes.

3 Certain types of conduct engaged in by a director or officer.

4 Financial inability of company to indemnify.

Explaining the first situation, he said derivative suits are brought by shareholders on behalf of the company, naming directors and officers as defendants. "Effectively, the company is asserting the claim, although the shareholder is prosecuting it against the directors and officers," Mr. Bailey said. That means any settlement or judgment gets paid by the directors and officers back into the company rather than to the shareholder plaintiff.

If the company could indemnify for such payments, "the money would go in a circle," he said, explaining why states prohibit that circular result. But the statutes do allow companies to purchase insurance to protect directors and officers in these instances.

Mr. Bailey also explained that the prohibition against indemnification only applies to settlement and judgments. It does not apply to defense costs, which are covered under the corporate reimbursement (Side B) part of a D&O policy.

As for the second category of potentially non-indemnifiable claims, Mr. Bailey suggested that while violations of federal securities laws are "theoretically" not indemnifiable, in reality they are regularly covered under Side B of D&O policies. The reason is that most securities cases are settled, and therefore, the directors and officers never admit to any law violations.

The third claims situation, which hinges on the conduct of a director or officer, is a lot more worrisome to Mr. Bailey. "In the past, this was not a common area" for Side A claims, Mr. Bailey said. "But I fear its going to become one."

He explained that in the post-Enron environment of increased scrutiny of director activity, there are likely to be more findings that directors and officers "did not act in good faith." Such a finding is enough to bar corporations from indemnifying individual directors and officers under state indemnification statutes. But Side A insurance still pays, even for conduct that falls just short of good faith, as long as it is well short of deliberate fraud, he said.

Mr. Bailey also characterized the last area of potential A-Side claimsrelating to financial wherewithal to indemnifyas somewhat common. "Its not just a question of bankruptcy," he said, but rather a question of whether a distressed company has the ability to fund losses.

During a recent interview, Greg Flood, chief operating officer for National Union Fire Insurance Company, a unit of American International Group in New York, agreed that the likelihood of A-Side claims has increased.

"Historically, they haven't been as frequent or as large as they've become more recently," he said, pointing to increased numbers of derivative suits and insolvencies. Mr. Flood took particular note of a "huge derivative claim" early last month for a company named Cell Tech. According to an SEC filing, jury verdicts in derivative suits against two officers of Klamath Falls, Ore.-based Cell Tech, a maker of nutritional food products, were $105 million each.

He provided historical perspective to explain the growing interest in separate A-Side coverage from outside directors.

In the 1990s, he said, D&O insurance market participants paid a lot of attention to corporate coverage. But then came huge corporate failures like Worldcom and Enron where the only asset remaining was the D&O policy. That resulted in competition for limits between the corporation, the inside officers and outside board members, he said. Buying A-Side policies "on top of A-B towers" allayed the fears of board members that policies would run out of limits.

(See related story, page 37, detailing a broker survey of A-Side buying trends.)

While an array of A-Side policies on the market have varying features, generally they have broad terms and less exclusions than underlying A-B-C policies. "You really want to make sure the buyers [are] as wrapped in security as possible. That's what they're purchasing them for," Mr. Flood said.

Broadening coverage, however, doesnt come without risks.

Keith Thomas, senior vice president in the commercial market management solutions group of Zurich Insurance Company in New York, said, "Were watching what the plaintiffs bar is doing very closely."

"Where theres a way to tap into financial resources, [plaintiffs lawyers] are very creative in finding ways to do so. To look only historically at A-Side coverage at what the payout patterns are is a big mistake," he said.

Reproduced from National Underwriter Edition, October 14, 2004. Copyright 2004 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.