Traditional D&O insurance may not be enough to protect outside directors targeted in liability lawsuits.
Let’s say you are an outside director of a large company and you keep a close watch on corporate reporting, accounting standards, financial exposures, employment practices and all other areas where your company could potentially run into trouble. But, unbeknown to you, senior management – including some of your fellow board members – have been cooking the books for years. The fraud eventually explodes in public, and the company and its directors are sued for large sums.
The case goes to court, where it drags on for years, and the company invokes its directors’ and officers’ (D&O) liability insurance to pay legal and settlement costs. But the cases against company insiders go to trial first, and they use up most of the insurance. By the time the lawsuits against outside directors come to trial, the D&O insurance is exhausted, or the company is bankrupt – and outside directors face the prospect of paying much of the legal and settlement costs from their own pockets.
This cautionary tale is not so far-fetched. As the recent settlement involving outside directors of Enron shows, D&O insurance is not always available to outside directors who think they are covered. There could be many reasons for this: inadequate coverage in the first place; policies the insurer can revoke for all insured parties whether or not they were individually involved in a fraud; or corporate coverage rolled into individual director coverage so that it might be depleted on insiders’ cases before outside directors’ cases come up.
Whatever the reason, D&O coverage is not always enough to fully fund increasingly large settlements. ‘We have seen situations where towers of insurance are depleted,’ says Heather Fox, senior vice president and chief underwriting officer of National Union Fire Insurance Company of Pittsburgh, an American International Group (AIG) company and the leading D&O carrier in the US.
Getting personal
At the same time, directors’ need for insurance is rising fast. The number of securities fraud cases is growing, and the severity of the cases is increasing. In 2002 there were 50 major unsettled securities cases with $1.17 tn in total market capitalization loss, according to data from Cornerstone/SLS and AIG. By 2003 the number of pending cases had grown to 79, with total market-cap loss of $1.32 tn. By 2004 there were 119 cases with $1.46 tn in market-cap losses, and by January 2005 the number of cases had risen to 120, with total losses of $1.47 tn.
Moreover, there is a growing tendency for plaintiffs to go after the personal assets of directors, even where D&O insurance is available. In January WorldCom’s outside directors agreed to pay a total of $18 mn of their own money, and Enron’s outside directors agreed to pay $13 mn to end litigation against them. While the WorldCom settlement was subsequently thrown out on a technicality, these cases highlight the vulnerability of directors’ personal funds.
Enron and WorldCom are not the only companies where lawsuits against directors have been settled with personal funds. Anicom, Global Crossing, HealthSouth, Lucent and Xerox were all involved in securities class action cases that led to settlements involving personal funds. Federal regulators are currently trying to freeze or recover bonus payments to senior executives of Fannie Mae and Freddie Mac. And at Nortel twelve executives returned $8.6 mn of 2003 bonuses in a settlement agreement, and the company is suing three others for the return of $10 mn.
One reason for the growing trend to target directors individually is that plaintiffs have become better organized, and the plaintiffs’ bar more aggressive. This is due in part to an SEC rule change enacted in 1995, which stipulates that a class action will be led by the investor with the largest economic loss. This has caused a scramble among plaintiffs’ lawyers to control class action lawsuits and reap all the rewards. As litigiousness increases, cases drag on longer. ‘The cost of this type of litigation has risen 400 percent in the last seven years,’ notes Greg Flood, executive vice president and chief operating officer of National Union.
Courts and regulators, meanwhile, have become increasingly inclined to make examples of directors caught up in corporate fraud cases. The State of Wisconsin Investment Board offers higher contingent plaintiff fees to firms that win cases against individual defendants. The SEC has devoted increased resources to enforcement of financial disclosure and accountability rules. Stephen Cutler, the SEC’s enforcement director, has been quoted as saying: ‘There’s nothing more important than trying to hold accountable individuals. We think it’s important to punish both individual and corporate wrongdoers. Effective deterrence requires personal accountability.’
Against this backdrop, ‘we see increased demand from individual directors who want their own insurance limits that cannot be depleted by others,’ says Fox.
Beyond D&O
The traditional safeguard for both directors and firms targeted by such lawsuits has been D&O liability insurance. Savvy independent directors insist the company’s policy includes Side A coverage, under which an insurer pays directors those costs that are not reimbursed by the corporation.
But having Side A coverage, while important, is not enough. It should be stand-alone, rather than rolled together with the other aspects of the D&O policy, such as insurance covering the company’s reimbursements to directors and officers (Side B) or company expenses incurred defending itself (Side C). Stand-alone Side A coverage helps to prevent a situation in which the company’s D&O policy is depleted by the defense of the company itself before outside directors’ cases come to trial.
Even having stand-alone Side A coverage is not enough, however. From the point of view of directors, D&O cover should also include specific safeguards against a blanket rescission of the insurance for all directors if even one director is accused of fraud. Non-rescindable coverage, or coverage that allows the severing of one director from the policy while leaving all others insured, enhances protection for innocent parties.
Sometimes even a non-rescindable, stand-alone Side A D&O policy is not enough, though. Most insurance carriers now offer separate coverage to independent directors, a type of insurance pioneered two years ago by National Union in response to demand from directors. Independent director coverage, which is marketed to individual directors but bought by corporations, is intended to sit on top of traditional D&O coverage, providing an extra layer of protection for outside directors.
Protecting the board
What does independent director coverage do that traditional Side A coverage doesn’t? First, unlike regular D&O insurance, independent director coverage cannot be rescinded by an insurer – the policy is used to pay for the legal and settlement costs of the named individual director only, not other members of the board. Moreover, independent director insurance can be used when traditional D&O cover is unavailable due to threatened or actual rescission of the policy, or inability of the D&O carrier to pay Side A claims for any other reason.
Significantly, independent director coverage remains in force even if the director’s company has become bankrupt, or when it is otherwise unable or unwilling to indemnify the director for legal and settlement costs. Under traditional D&O insurance, by contrast, insurance policies can be considered part of the company’s assets and frozen by a bankruptcy court.
Normally, independent director insurance comes into play only after underlying D&O Side A coverage has been exhausted. However, under the terms of an independent director policy, if there is a ‘difference in conditions’ event – such as rescission of the underlying D&O policy or inability of the D&O carrier to pay the claims – the insured director still has coverage.
Independent director policies are also more comprehensive than traditional Side A policies. For example, Employee Retirement Income Security Act (Erisa) related claims are covered under National Union’s independent director policy, but excluded from most D&O contracts. The independent director policy also covers claims arising from errors and omissions; acts of libel, slander or defamation; failure to maintain insurance; and acts resulting in environmental pollution (excluding cleanup costs).
Independent director coverage is no substitute for D&O insurance but, says AIG, it’s still essential. ‘The world has become considerably more dangerous in D&O litigation,’ says Flood. ‘There are times when traditional D&O insurance could be exhausted before all individual liabilities are paid.’
