Opening Doors to More Coverage

Any upcoming placement for a Canadian organization’s directors’ and officers’ [D&O] liability program is sure to be dynamic and exciting due to the many options currently available in the market. Fierce competition amongst insurers for a larger share of Canadian corporate premium dollars has fuelled a softening of the Canadian D&O liability marketplace, resulting in lower premiums and broader available terms and conditions. Since there is no standard industry D&O policy form, focus on the variations in language and intent of the coverage are of critical importance when evaluating quotes from multiple insurers. Some of the most important features to consider in the negotiation of the policy wording are as follows:

Severability of Application/Warranties

Most directors and many officers never see the application for the D&O policy, and yet an intentional or unintentional mistake made by the individuals completing the application could cause an insurer to attempt to rescind coverage for all of the insureds. Therefore, the policy should expressly stipulate that any errors or omissions contained within the application do not affect the coverage for innocent directors and officers. It is important to look closely at the clause(s) contained within the basic policy, as well as any language included in the endorsements to the policy that could have an impact on the basic clause.

Definition of a Loss

Insurance proceeds are available only in respect of ‘loss’ suffered by an insured, and so the definition of loss contained within the policy is of critical importance in D&O liability programs. It is possible to include punitive damages within the definition of a ‘loss,’ although coverage for fines and penalties is not typically available. Many policies will include the costs of investigation and defence once a formal action has been commenced. However, there may or may not be coverage provided for investigative costs incurred for an informal investigation.

Conduct Exclusions

Typical exclusions for criminal conduct — fraudulent acts, illegal profit or advantage gained by the directors and officers — can be amended in several ways. Optimal wording would require that alleged wrongful conduct be proven before the insurer is entitled to deny coverage. By requiring “final adjudication” before exclusions are applied, the policy will stipulate that defence costs be advanced by the insurer until a judicial decision is made regarding the conduct of the insured.

Some policy forms in the market do not include the requirement to have the conduct proven or admitted before the exclusions are applicable. These policies may result in an insurer denying a claim and refusing to advance defence costs on the basis of an alleged — rather than a proven — act.

Conduct exclusions should stipulate that the behavior of one insured will not be imputed to any of the other insureds. Moreover, for the exclusions to be applicable against any one insured person, the conduct must be proven against each individual. This language will ensure that the policy is fully severable for exclusions.

Non- Rescindable Side A

Examples of insurers attempting to rescind a policy (essentially declaring it to be void from the outset) have made headlines in the last few years and are very unsettling. Ensuring the severability language is consistent with the language discussed in this article does make an insurer’s rescission action unlikely to be successful. In an effort to sidestep the issue altogether, with respect of Side A claims, it is possible to negotiate coverage on a Side A basis that is non-rescindable by the insurer.

In the softening market, some insurers are willing to provide non-rescindable coverage for Side A, Side B and Side C. But any endorsement purporting to provide this coverage must be reviewed closely before acceptance: the endorsements currently being offered have the potential to introduce additional exclusions to the policy, depending on the specific language employed.

Insured versus Insured Exclusion

It is not possible in a traditional policy form to remove completely this exclusion for claims brought by one insured against another. Nevertheless, it is possible to negotiate a number of exceptions to the exclusion that bring back the coverage in many scenarios. Most policy forms provide the following basic exceptions: derivative suits brought without the assistance of any insured person; cross-claims (claims made by an insured person against the company for the company’s refusal to indemnify him for a claim brought by a third party); and employment-related claims by an executive against the directors.

In addition, insureds engaging in protective activities (as prescribed in “whistleblower” protective legislation such as the Sarbanes-Oxley Act) can be exempted from triggering this exclusion.

Another key issue is the right of coverage for lawsuits brought by trustees and creditors in bankruptcy. The language of the exclusion should exempt trustees and creditors for claims brought independently and without the help of the insured organization. It is also possible to negotiate an exception for claims brought by directors or officers who have not held the position within the past four years.

Major Shareholder Exclusion

Actions brought by shareholders who own more than a certain percentage of voting shares are typically excluded under a D&O policy. In recent years, however, some underwriters have been willing to increase the percentage thresholds, or to provide coverage in situations in which the shareholder in question does not have current board representation. It is important to understand clearly which shareholders fall above the threshold, since there might be an opportunity to negotiate further exceptions to the exclusion on a case-by-case basis.

HAMMER CLAUSE

According to some policies, typically those written on a ‘duty-to-defend’ basis, should the insured refuse a settlement offer the insurer recommends, then the insurer’s liability will be limited to that recommended amount. A modification can be negotiated in which the insured’s liability is limited to some percentage (e.g. 50%) of a settlement amount that falls above the recommended settlement offer. Alternatively, the clause can be deleted entirely.

PRIORITY OF PAYMENTS CLAUSE

With many D&O policies, limits are shared between: Side A (non-indemnifiable by the company); Side B (amounts the company pays to directors and officers as indemnification for claims); and Side C (claims arising from the entity’s own liability) coverage.

It is important for the policy language to stipulate clearly that Side A claims will take priority over Side B or C claims in the event limits are insufficient to meet all claims. In addition, various insurers may designate either an individual (e.g. a CEO) or the “insureds” as decision makers for release of payment of loss either to the company or directly to an insured. In either situation, a dispute could arise. For example, the individual designated may decide to punish a hostile board member by withholding payments to save the available limits for further losses.

Or, in situations in which the “insureds” have decision-making authority, it seems unlikely all of the “insureds” will be able to agree on a single course of action.

Advancement of Defense Costs

The policy form does not always clearly outline at which point in a claim the insurer is required to reimburse the directors and officers for defence costs incurred. Some basic policy forms require that the parties to the contract use their best efforts to determine what portion of the defence costs are to be paid by the insurer in the event of a claim that involves covered and uncovered parties, matters or capacities. [This is a common form of claim.] . When parties are required to negotiate the allocation on the basis of “relative legal exposure,” it is very likely there will be a dispute as to how the apportionment will occur. Any dispute will delay the advancement of defence costs. It is possible to negotiate an endorsement that pre-determines the allocation of the defence costs, thus removing any dispute and ensuring that the defence costs will be paid on a current basis.

It is also important to consider whether the policy will pay defence costs only after formal proceedings have been commenced, or if there is a sub-limit available for expenses incurred through an informal investigation.

Allocation in a Securities Claim

In any securities claim, it is typical for the company to be named as a defendant alongside the directors and officers. It then becomes necessary for the parties to agree on what portion of the defence and loss amounts relate to the company’s liability, and what portion relates to the liability of the individuals. One method of dealing with this issue is to purchase Side C coverage, which provides coverage for the liability of the company itself. This coverage, also called entity coverage, must be considered carefully. Inclusion of coverage for the entity means the policy limits may be eroded much more quickly than they would be otherwise. Also, issues can arise in a bankruptcy situation in which the trustee is determining ownership of the policy; some of these issues can be addressed through a priority of payments endorsement.

One option to the inclusion of Side C coverage is to negotiate an endorsement for pre-determined allocation in any securities claim. In this scenario, the parties agree at inception of the policy to the percentage of both defence costs and loss amounts that will be allocated to the insured persons in the event a claim contains both covered and uncovered persons, matters or capacities.

Presumptive Indemnification

Typically, it is a condition of any D&O policy that the organization will provide indemnification of the directors and officers to the fullest extent provided by the bylaws and resolutions of the board and permitted by common and statutory law. Most policy forms go further to require that, in the event a company wrongfully refuses to indemnify an insured person, the insurer will be entitled to treat the claim as a Side B claim and to apply the Side B deductible. For any director or officer, having to pay personally a significant deductible before receiving indemnification from an insurer is simply not palatable. Some insurers are willing to amend the language to remove the deductible requirement in the event the company has wrongfully refused to indemnify the insured person(s). Alternatively, if the insurer is unwilling to make this amendment, the purchase of an excess Side A DIC [Difference in Conditions] policy may be considered.

DISCOVERY CLAUSE/EXTENDED REPORTING PERIOD

The discovery clause is often written to allow an insurer to trigger the discovery period by refusing to renew the coverage. An insurer is also entitled to collect an additional premium that may be agreed upon at inception or negotiated once the clause is actually triggered. The clause can be amended to permit the company to trigger the discovery period upon its decision not to renew the coverage with that insurer, typically termed “bilateral discovery.”

It is preferable to have the additional premium agreed upon at inception. Frequently when an insurer refuses to renew a policy, it is because the insured is facing a serious issue; this may cause the insurer to attempt to extract a much higher additional premium than would have been required at inception. The issue the insured faces may also make it difficult to procure new insurance, making the coverage provided under the discovery period very important.

SIDE A EXCESS COVERAGE

Directors and officers of a company may require the company to purchase a dedicated Side A-only policy as part of their program. This policy might take the form of a traditional policy wording confined to Side A-only coverage, thus ensuring the full limit is dedicated to non-indemnifiable claims against the directors and officers. Alternatively, it is possible to purchase a Side A Excess DIC policy that includes several enhancements and will, in certain scenarios, drop down and fill in coverage gaps in the program. The broad coverage afforded by the excess DIC policies can be specifically tailored to meet an individual insured’s needs; this flexibility is reflected in their price.

AVOIDING OPTION OVERLOAD

We have entered into a very exciting time for the D&O liability marketplace. The market has welcomed new entrants and capacity, and the options available on a coverage basis continue to broaden significantly. Companies and their directors and officers have displayed more savvy about the benefits and limitations provided by D&O liability programs; they are reviewing the policies with a critical eye. It is critically important for risk managers and their clients to examine each option available in the market and take up only those policies that are consistent with the specific purchasing priorities of each insured.