Shifting Landscapes for D&O Insurance in the Economic Crisis

17 March 2009 Publication
Author(s): Ethan D. Lenz

Legal News Alert: Insurance

Evolving Issues in the Current Economic Environment
The directors & officers (D&O) liability insurance market has already been heavily affected by the economic crisis, with substantial premium increases for financial institutions and a sharp increase in the number of class action lawsuits involving such institutions. In addition, we are seeing the competitive landscape shift due to the issues facing the American International Group, Inc. (AIG) group of insurers. The effect of the financial crisis on the D&O insurance market is likely to be further intensified as the economic crisis takes a greater toll on insureds, and we see an increase in the number of corporate bankruptcies. This phenomenon will inevitably go hand in hand with increased litigation against directors and officers and potentially lead to complex coverage issues under D&O policies. A few of the areas and provisions that are likely to be heavily tested include: (1) “Order of Payments”/“Priority of Payments” provisions; (2) the insured versus insured exclusion (IVI Exclusion); and (3) the importance of Side A coverage generally.

Typical Structure of a D&O Policy
Most D&O policies contain three separate coverage agreements. In short, these are:

  1. “Side A” — Coverage for both defense expenses and payments of settlements/judgments that arise from claims brought against directors and officers, when those costs cannot be indemnified by the company. Usually, no retention (deductible) applies to Side A coverage. Therefore, it affords protection against individual directors and officers having to use their own resources to pay the costs of any claims for which they are not indemnified by the company. In essence, Side A coverage provides the final layer of protection between an individual director's or officer's personal assets and the plaintiff(s) in a claim.
  2. “Side B” Coverage — This also is often referred to as “company reimbursement” coverage. It reimburses the company for costs of claims when the company is permitted, or required, to indemnify individual directors and officers. Because the majority of claims against directors and officers are eligible for indemnification, Side B is the primary coverage under which payments are typically made under a D&O policy.
  3. Side C”/Entity Coverage — This provides coverage for claims when the company itself is a defendant in the claim. For publicly traded companies, it typically only provides coverage for securities-related claims. For example, if a securities-related lawsuit names both the company and individual directors/officers as separate defendants, Side C coverage will come into play for any defense costs and/or judgments or settlements that are attributable to the company's separate alleged liability. On the other hand, if a D&O policy does not include Side C coverage, any amounts allocated to the company's defense or ultimate liability in that claim would not be covered by the D&O policy.

Order of Payments/Priority of Payments Provisions
Order of payments provisions are intended to govern payments when amounts are potentially due under Side A, B, and/or C of the D&O policy. These provisions typically provide that payments will be made under the Side A coverage (to the individual directors and officers) first, and before any payments are made under Sides B and/or C of the D&O policy (in which payments would be made to the company). The primary purpose of the order of payments provision is to protect individual directors and officers from an attempt by a bankruptcy trustee or other successor to deny payments to the individual directors and officers under the rationale that the D&O policy and its proceeds are an “asset of the bankruptcy estate.” See, e.g., In re Vitek, Inc., 51 F.3d 530, 535 (5th Cir. 1995). Such provisions also may protect the directors and officers where the aggregate limit of liability under the D&O policy is insufficient to discharge the covered liability of both the directors and officers of the company and the company itself.

In practice, the often vague or incomplete wording of order of payment provisions may create a situation that is ripe for dispute. For example, instead of clearly stating that the order of payments provision automatically applies and requires payment under Side A first in all claims situations, it may instead provide that it only applies in instances where the aggregate liability under the D&O policy exceeds the policy limits. In other instances, it may be worded such that it only applies upon a request from the company. Thus, in situations like these where the order of payments provision does not “automatically” apply, the resulting lack of clarity could lead to disputes in the bankruptcy context regarding whether the D&O policy is an asset of the individual directors and officers, or whether it is an asset of the bankruptcy estate. While there may be risks associated with drafting the order of payments provision to provide that payments under Side A are always first and automatic, the benefit of unambiguous policy language may well outweigh the downside risk.

Insured Versus Insured Exclusion Carve Out for Bankruptcy Trustee
Virtually every D&O policy will contain an insured versus insured exclusion that bars coverage for claims “brought by” or claims “brought by or on behalf of” one insured party (e.g., the company) against another insured party (e.g., the officers and directors). In the bankruptcy context, coverage disputes have sometimes arisen when an insurer asserts that the bankruptcy trustee stands in the shoes of the debtor company and, therefore, should be treated as the alter ego of the company, subject to the insured versus insured exclusion. The typical response from insureds has been to assert that the purpose of the insured versus insured exclusion is to prevent collusion among insureds at the expense of the insurer and that there is no concern of collusion where a bankruptcy trustee stands in the shoes of the debtor. Where the argument put forth by the D&O insurer is successful, the insured versus insured exclusion applies and there is no coverage under the D&O policy for claims of the bankruptcy trustee against the directors and officers. See, e.g., Reliance Ins. Co. of Illinois v. Weis, 148 B.R. 575, 580 (E.D.Mo. 1992).

In recent years, insureds and insurers have more frequently dealt with this issue upfront, by revising the insured versus insured exclusion so that it contains a specific carve out (i.e., the exclusion does not apply) for claims brought by bankruptcy trustees. Negotiating the D&O policy in this manner may be beneficial for both the insured and the insurer, as it can create more certainty regarding the scope of coverage in the bankruptcy context, and the insurer can price the policy with the knowledge that it may be covering some claims brought by a bankruptcy trustee if the insured finds itself in an insolvency situation. However, as the market for D&O insurance hardens, and if corporate bankruptcies become more frequent, D&O insurers may look more closely for opportunities to limit the scope of this carve out or eliminate it altogether.

Importance of A-Side Coverage
As noted above, one of the primary situations where Side A coverage is triggered is where the company is insolvent — that is, in the bankruptcy context. Therefore, while Side B coverage (where the company indemnifies the directors and officers and is then entitled to reimbursement from the D&O insurer) has traditionally received the most attention, the increased financial stress facing many companies in the current economic environment will almost certainly lead to an increase in the number of Side A claims due to insolvent companies' inability to indemnify their directors and officers.

Given the heightened importance of Side A coverage in the bankruptcy/insolvency context, both insurers and insureds need to focus more carefully than ever on this coverage and the myriad of issues potentially arising under Side A. For example, if no retention applies, has the coverage been appropriately priced for the increased risk of providing first dollar coverage on Side A claims? Has the Side A coverage been written such that it is nonrescindable, regardless of any misrepresentations in the application? Are the directors and officers protected by separate Side A coverage, and does that coverage simply provide excess limits over the traditional Side A, B, and C underlying policies, or does it also provide “difference in conditions” coverage that will drop down and provide the directors and officers with additional protection in situations where there is no underlying coverage, or where the underlying insurers are refusing to pay? Although many of the questions have no “right” answer, they should be carefully evaluated by both insurers and insureds to make sure that all parties understand the consequences of a bankruptcy on the coverage that has been put in place.

An increase in corporate bankruptcies and insolvencies is likely to raise a number of new, or at least different, issues under D&O policies than we have seen in recent years. As a result, both insureds and insurers would be well served to carefully review and consider the impact of a bankruptcy on the coverage available to both the corporate insured and the individual officers and directors. Many of these issues can be dealt with prior to policy inception, through careful negotiation of the policy language, in order to create more certainty for all parties regarding the scope of coverage should the insured actually find itself in financial straits. On the contrary, the failure to anticipate and deal with such issues during the policy negotiation can also open the door to potential gaps in coverage for the insureds and expensive coverage litigation down the road.

Legal News Alert is part of our ongoing commitment to providing up-to-the-minute information about pressing concerns or industry issues affecting our clients and our colleagues. If you have any questions about this update or would like to discuss this topic further, please contact your Foley attorney or:

Ethan D. Lenz
Milwaukee, Wisconsin

Andrew A. Oberdeck
Milwaukee, Wisconsin