D & O Policies: Greater Risks Less Coverage
The Age of Scandal is reflected in policy changes to Directors' and Officers' Liability Insurance coverage.
Because of the recent corporate scandals, such as WorldCom, Adelphia, Enron, Tyco, and many others, officers and directors today face significantly more liability than in past years. As a result, the D & O Policy that purports to protect them from liability has become much more important. At the same time, the D & O Policy has become much more difficult to get, is now likely to cover fewer claims, and will now cost a lot more money than it did just a few years ago.
Directors and officers of both public and private corporations are fiduciaries under American law, and as such, may face both civil and criminal liabilities for acts they perform on behalf of the corporation. To attract top talent, companies provide directors and officers with special insurance coverage called a Directors’ and Officers’ Insurance Policy (D & O Policy). The D & O Policy generally covers the directors and officers for potential liability for defense costs, the cost of settlements and, in some instances, the cost of judgments rendered in court as a result of their activities on behalf of the corporation.
While the basic terms of a D & O policy are similar, it is important to note that there are also many differences in insurance coverage among the policies as well. For example, some D & O policies exclude claims related to securities law, fraud, and criminal law. In addition, policies differ as to the amount of legal fees and defense costs that the insurance policy will advance and/or reimburse.
D & O Policies in the Late 20th Century
Before 1985, D & O policies were similar to other professional liability insurance policies, such as those covering doctors and attorneys. Under these types of policies, officers and directors were covered for the cost of defending suits and for the cost of any settlements and court judgments (depending on the circumstances) that resulted from their acting on behalf of the corporation. Because directors’ and officers’ liability claims were few and far between, this type of insurance coverage was relatively easy to get and relatively inexpensive.
However, in 1985, a Delaware Court significantly expanded the liability of directors, making it much more difficult for companies to attract top people to be directors. As a result, many companies lobbied their individual state governments to amend the state corporation codes. These amendments allowed companies to provide in their bylaws that directors and officers would no longer be liable for ordinary negligence. In addition, companies were allowed to indemnify their directors and officers for any defense costs, settlements or court judgments that resulted from their ordinary negligence. Not all states adopted these changes allowing indemnity protection for ordinary negligence, but when Delaware adopted these amendments, most large companies followed suit and adopted in their bylaws these indemnity protections for their officers and directors.
These liability limitations reduced the exposure of directors and officers with respect to their fiduciary duties owed to the corporation and the shareholders under state corporations laws so that simple negligence would not result in liability. To the extent that the federal securities laws could impose liability for simple negligence, then liability on that front (which could be criminal) would still exist, plus to the extent that state common law still would permit civil liability for simple negligence, then liability could exist. The key really is whether the corporation is permitted to indemnify for simple negligence; if it can, then the corporation can indemnify for federal claims and/or common law claims. There have also been instances in which third parties (that is, not shareholders or other officers, directors, or employees) have brought suit for negligence. Those claims have arisen in the context of other claims for securities violations, in which non-investors said they did not invest due to representations that were false. These claims are often unsuccessful, but they can occur.
After 1985, the D & O Policy covered the directors and officers for liability for errors and omissions, and a general liability policy covered the corporation. Such coverage led to fights between the directors and officers, on the one hand, and the corporation on the other hand, over how to allocate fault between the two groups. To remedy this problem, insurance carriers began to add “entity” coverage in addition to the traditional D & O Policies. The purpose of entity coverage was to protect the corporation from charges of corporate wrongdoing, whether that wrongdoing was attributed to the corporation or to its agents.
In the 1990s, no doubt because of both state legislation allowing corporations to indemnify their directors and officers and a rising stock market that generated relatively few claims, the pricing for D & O Policies decreased even as the coverage under these policies expanded significantly. This pricing and coverage trend came to an abrupt halt when the stock market bubble burst in 2000 and when billion dollar scandals at Enron, Adelphia, and WorldCom, among others, were exposed.
D & O Insurance Coverage in the 21st Century
As one might expect in the face of the multi-billion-dollar corporate scandals of the early 2000s, the price of D & O insurance coverage skyrocketed while the scope of the coverage under such policies narrowed significantly. Therefore, it is more important than ever for current and potential directors and officers to carefully review their D & O Policies to make sure that they fully understand what is and is not covered in such policies today.
While state law attempted to limit the liability of directors and officers in the 1990s, liability under federal legislation, particularly the securities laws, has increased dramatically in the early part of the 21st century. For example, a 60 percent increase occurred in the number of federal securities action cases filed in 2001, as compared to 2000. In addition, the size of the securities litigation settlements has increased substantially as well, even before the significant expansion of federal corporate liability under the Sarbanes-Oxley Act of 2002. While a D & O Policy can cover those accused of, and even tried for, fraud under the federal securities laws, a D & O Policy never covers those who have actually been convicted of fraud. This helps to explain why virtually all SEC civil enforcement actions are settled without any admission of liability by the corporation or by the individual.
D & O insurance carriers recognize that the risks of earnings restatements and bankruptcy have increased markedly in recent years. Directors and officers today are now much more likely to be sued, and for much more money. For example, the amount of money paid in civil settlements has gone up more than 400 percent from the 1990s to the early 2000s. As of February 2004, 50 securities lawsuits were filed in which plaintiffs in each suit were claiming more than $500 million in damages. One large insurance carrier estimates that it is facing outstanding claims of almost $1 trillion in claimed damages. Even if no liability is found, defense against these lawsuits cost millions and millions of dollars.
Now a reverse trend in D & O insurance coverage is occurring from that which occurred in the 1990s (when coverage was expanding and prices were declining). Yet because of the sometimes staggering liability that directors and officers may face, the need for appropriate D & O insurance coverage has never been higher. In fact, having the right D & O Policy can determine whether or not a corporation is able to attract qualified and capable directors and officers to the company.
What You Need to Know About Today’s D & O Market
A. More Insurance Companies Are Attempting Rescission: Insurance carriers are increasingly seeking to rescind D & O Policies to escape coverage obligations, especially for fraud. Sometimes insurance carriers will include specific rescission terms in the D & O Policy itself. At other times, these carriers may try to rescind the policy based on misrepresentations in the D & O application, which often includes attachments to the application, such as financial reports.
Organizations must look out for a subtle change in the language which is now often included on the application for a D & O Policy. For example, many of today’s D & O Policy applications now state that all documents filed with the SEC become a part of the application. If restatements or amended filings are made later, the insurance carrier is almost certainly going to argue that the D & O Policy should be rescinded. Both Xerox and HealthSouth are currently facing D & O carriers that are attempting to rescind their D & O insurance coverage by citing false financial documents that were included as part of the D & O Policy application.
B. Insurers Are Trying to Narrow Coverage: Insurance carriers have been adding both new exclusions to the D & O Policies and expanding the scope of existing exclusions. Insurance companies today are less flexible and somewhat less willing to negotiate policy provisions by issuing modifying language in endorsements. For example, “personal conduct” exclusions such as the fraud/dishonesty exclusion used to apply only upon the ultimate finding of liability. Such a finding meant that the insured could always count on the cost of his or her defense to be covered at least initially by the D & O Policy. In today’s market, insurers are increasingly attempting to apply this type of exclusion to actual or alleged acts, which would mean that coverage of defense costs would be precluded earlier in the proceedings.
As stated earlier, originally D & O Policies covered only individuals. Later, such policies expanded to cover the corporation as well (called entity coverage). This expansion to include entity coverage often backfired because enormous settlements made on behalf of the company exhausted the available policy limits and often left individuals without any funds to cover their own personal liability. In today’s environment, with the decreasing scope of coverage being given to insureds, “entity” coverage has almost completely disappeared from D & O Policies.
In the 1980s and 1990s, each insured would be considered separately or “severed” from those who provided false or inaccurate information (referred to as severability as it relates to the D & O Policy application). Therefore, the individual who signed the application, and anyone else who knew that false or inaccurate information was being provided, would be considered separately from those who did not know that false or inaccurate information was being provided. This concept of severability is now almost extinct.
C. The Amount of Insurance Coverage May Be Reduced: An insurance company that might in the past have agreed to a $50 million D & O Policy may now only be willing to issue a $25 million policy. Those companies that used to provide $25 million in coverage may only give $10 million or $15 million today, if any amount at all. Now when they need it more than ever, companies are having a much more difficult time maintaining the same level of D & O insurance coverage as they did before the scandals of the early 21st century. For companies able to achieve the same level as prior D & O coverage, to do so they often must purchase more insurance policies from a variety of insurance companies.
D. Policy Premiums are Going Up: Policy prices in recent years have increased, sometimes rather dramatically. On average, today’s D & O Policy costs between $40,000 and $80,000 per million dollars of coverage. Sometimes the increases in premiums can also be very steep. For example, Tyco International must now pay $92 million to avoid losing its D & O coverage, and Qwest had to pay additional premiums of more than $157 million. One way companies are coping with these higher prices is to accept much higher deductibles. It is not unusual today to see retentions, which are functionally similar to deductibles, in the $25 million to $75 million dollar range; whereas before, retentions might only have been in the $5 million to $10 million dollar range.
Premiums for D & O Policies in 2000 rose 11 percent, 29 percent in both 2001 and 2002, and 33 percent in 2003. These price increases leveled off in 2004 as new D & O carriers have entered the market. While some companies in some industries are still facing 75 to 100 percent increases, this is much less than the 1000 percent rate increases that they had been facing earlier this decade. In addition, some companies in low-risk industries may even be seeing some decreases in their premiums.
In this new D & O insurance coverage environment, Michael H. Diamond, a lawyer who handles litigation involving directors and officers, probably offers the best advice for those seeking a D & O Policy in today’s scandal-plagued environment:
The days of just assuming that [D & O] coverage was provided and that details were unimportant are certainly past. Moreover, specific questions should be raised about the issues implicated by restatements, certifications and other changes to make sure that the policy is clear and that officers and directors know where they stand before they are served a complaint. While insurance policies do tend to be form documents, it is possible to negotiate terms, although any changes may impact the cost of premiums. Nevertheless, the clear message should be that officers and directors should no longer just assume D & O insurance will adequately protect them, particularly in this environment.
Because of this new liability environment, corporations and current and potential directors and officers should become actively involved in reviewing and negotiating their D & O policies and should seek expert advice on how to best maximize their D & O coverage programs.
Special thanks to Whitney Stein, Esq., a principal of Insurance Law Group with offices in Los Angeles and London, and two Pepperdine University MBA graduates, Jennifer Sakurai and Razvan Pasol, for their assistance in preparing this article.
 Three of the most important fiduciary duties that directors and officers have are (1) the duty of loyalty, (2) the duty of care and (3) the duty to account.
 See, e.g. Smith v. Van Gorkom, 488 A.2d 858 (Del. 1985).
 Beecher-Monas, Erica. “Enron, Epistemology, and Accountability: Regulating in a Global Economy,” Indiana Law Review, 2004, vol. 37, issue 1, p. 141-212
 Some states, such as Delaware, allow companies to limit their directors’ and officers’ liability for all but gross negligence and intentional wrongdoing while others, such as Florida and Georgia, do not.
 Romano, Roberta. “Corporate Governance in the Aftermath of the Insurance Crisis,” 39 Emory L.J. 1155, 1160-61 (1990).
 Martin, Christopher W. “Director and Officer Insurance,” 41 Houston Lawyer 38, 39 (2004).
 Stanford Law School Securities Class Action Clearinghouse study cited in Christopher W. Martin, “Director and Officer Insurance,” 41 Houston Lawyer 38, 39 (2004).
 Id. The size of securities litigation settlements increased from an average of $8 million before the passage of the Private Securities Litigation Reform Act of 1995, to $25 million after its passage.
 Pilla, David. “Corporate Trends Likely to Put Increasing Pressure on D & O Market,” Bestwire,
9 Feb. 2004.
 According to Crain Communications Inc. and Business Insurance, Gavin Souter, “Time Not Right to Lower D & O Rates,” Underwriters Say, 38 Bus. Ins., 22 Nov. 2004.
 Keogh, John, President and CEO of National Union Fire Insurance Company. Pilla, supra, n.21.
 McLeod, Douglas. “D & O Difficulties,” Bus. Ins., 5 Jan. 2004.
 Examples of exclusions and other terms generally not favorable to insureds include: secondary offering exclusions, failure to maintain insurance exclusions, short-swing profits exclusions, restatement exclusions, mandatory binding arbitration provisions and full “hammer” clauses (which ends coverage if the insureds refuse a settlement offer that has been approved by the insurance company).
 LOS ANGELES RIMS EDUCATION DAY, “D & O Coverage Issues in the Post ENRON and Worldcom World,” 6, 16 Oct. 2002.
 McLeod, supra, n. 12.
 Pilla, supra, note 8.
 Podosky, Fred, et al., “The Pain Ebbs: At Last, Some Good News for Holders,” D and O Advisor. 1 Mar. 2004.
 Diamond, Michael H. “D & O Insurance: Pitfalls in a New World,” National Law Journal. 26 Aug. 2002: A-22.
About the Author(s)
Gia Honnen Weisdorn, JD, LLM, MBA, is a practicing attorney with the Law Offices of Gia Honnen Weisdorn, engaging in client representation for transactional matters in the areas of entertainment, employment, intellectual property and the like. Clients include entertainment, internet, biotechnology and technology companies, among others. Since 2001 Prof. Weisdorn has taught business law, international business law, negotiations, and eLaw, as Lecturer in Business Law for Pepperdine University’s Graziadio School of Business and Management, and teaches both as an adjunct professor at Pepperdine Law School in the area of Securities Regulation and Entrepreneurship, and as an adjunct professor at Loyola Law School in the areas of Business Planning/start-up venture finance (a/k/a “deals”) and Securities Regulation. Prof. Weisdorn is admitted to practice in and before: the State of California; the U.S. Supreme Court; the U.S. District Court, Southern District of California; and the U.S. Tax Court.
Linnea B. McCord, JD, MBA,, Associate Professor of Business Law at the Graziadio School of Business and Management, Pepperdine University. Dr. McCord started teaching business law and ethics more than 30 years ago, first as an in-house corporate counsel and later as the General Counsel of a division that was part of a high-tech Fortune 500 multinational corporation, headquartered in New York and Paris. Her area of expertise is the critical role Rule of Law plays in the long-term success of economies and countries and why American Rule of Law is unique in the world.