Not for Dummies: D&O Protection

Dear Friends of Trewstar:

Back in the old days when I was a director, the general counsel for each of my boards informed us annually that the D&O policy was up for renewal.
 
Even though these GCs were at different companies, they all said exactly the same thing: “Like our peer group, our coverage amount is $X million and we recommend renewing at that level. All the insurance companies in our underwriting group continue to be rated AA or better.”
 
Every year without fail, we directors all nodded in agreement. No one asked questions. One year, when a bit of a discussion ensued, the CEO shut it down by saying the company wasn’t going to go bankrupt, so what did it matter anyway? (This was in 2006 and within two years, thanks to the financial crisis, the company was operating in bankruptcy!) 

Having endured the same scenario year after year in three boardrooms, I decided someone needed to  understand the insurance being purchased on our behalf, so I volunteered to do some work in between board meetings. I had nearly forgotten about this whole experience until last week when speaking with Kate Sampson, a board candidate, who is an expert in many aspects of modern insurance technology and previously spent considerable time negotiating and selling D&O policies.
 
Digging deep into my memory bank, I asked Kate if directors still need to worry about the possibility that the management team's legal expenses could exhaust the funds available in the Side A portion of the D&O policy, leaving nothing to defend the directors. She replied, “Yes, maybe now more than ever directors should have a Side A Directors Only policy!” 
 
This prompted me to invite Kate to expand on what directors should be asking about when it comes to protection specifically for themselves.  
 
For a refresher on the basic “whats and whys” of D&O insurance, check out this Investopedia piece.

Beth: What is a director’s most basic concern?

Kate: Since directors can be held personally liable for actions they take (or don’t take), the biggest concern is typically around the company’s ability to indemnify its directors. While many claims will be indemnified by the company, directors also face the risk of claims against them where the company cannot – or will not – indemnify them or where the company has exhausted its D&O limits (i.e. in legal expenses or indemnifiable claims) and/or is insolvent. There are also situations where the company is legally restricted from providing indemnification or is faced with a shareholder derivative demand. Therefore, it is critically important for directors to have dedicated limits designated just for themselves to ensure adequate protection for non-indemnifiable claims and expenses.

Beth: What else should directors be worried about?

Kate: Directors should understand what is excluded from coverage under the policy. For instance, policies often won’t cover directors suing directors. That can be a problem for boards with large shareholders or non-independent shareholders whose interests are not consistent with what might be best for the public or minority shareholders. Other major risks in today’s business environment revolve around company obligations related to cyber, AI and ESG issues.

Beth: What advice do you have for board members who feel awkward asking about the D&O policy?

Kate: There is never any point in spending money on an insurance policy that does not provide proper protection. Besides, this is the perfect time to be asking. For financially healthy companies, capacity is plentiful, rates are competitive, and many policyholders have seen premium reductions. The current slowdown in the IPO market, good underwriting performance, and an abundance of insurance capacity point to continued rate decreases for buyers of D&O Insurance, and the availability of Side A Directors Only coverage. While rates are competitive, it is a great time for the boards to initiate a review of the structure and details of their D&O insurance policies. As you did many years ago, it may be helpful to take it offline with the General Counsel. Keep in mind that D&O policies are a subspeciality and you might need outside counsel or insurance professionals who can offer proper guidance.
 
Beth: Would you say a director’s risks are increasing?
 
Kate:  The macroeconomic environment is unsettling. Inflationary pressures, geopolitical risk, supply chain concerns, labor supply, and adoption of new technologies at a rapid pace, all have the potential to meaningfully negatively impact company performance, triggering shareholder lawsuits. Even worse, they could drive a company into bankruptcy. 
 
Chapter 11 bankruptcy filings totaled 6,473 last year. This reflected a 36% increase year over year. Increased filings remain a distinct possibility going forward. Bankruptcy claims, which impact both private and public companies, can be among the most severe D&O claims and often trigger Side A coverage, which responds in the event the company is unable to indemnify its directors and officers. This potential increase in bankruptcy risk makes Side A coverage that has a portion set aside specifically for directors as important as ever.
 
Beth: What else has you concerned?
 
Kate: Increased regulation. Regulators globally continue to introduce or consider guidelines around emerging risk areas, such as cyber security, ESG, and AI. Companies and boards are required to comply with these new regulations when issued. Board members need to be exploring how their company is ensuring compliance with, in some cases, still-to-be-seen corporate obligations, and how their D&O policies may respond.
 
Another concern is that derivative lawsuits, where a shareholder brings a suit against the individual directors and officers on behalf of the company, continue to rise at an alarming clip. In most states, derivative claims are not indemnifiable by the company. Perhaps more alarming is the fact that many derivative cases, which were typically settled by agreeing to some corporate “therapeutics” and attorney’s fees, now often have a cash component as part of the settlement. This development is another reason Directors Only Side A is critically important today.
 
Beth: Thank you, Kate, for this timely wakeup call!

Trewstar friends, please tell us if this has helped you gain a deeper understanding of the specific D&O protections you may – or may not – have.

We want you to sleep well at night! 

Best Regards,