Chapter Thirty-Two

• Jurisdiction: New York

Chapter Thirty-two

Directors and Officers Liability Insurance Coverage

James M. Ringer, Esq. Martin L. Seidel, Esq.

I. Introduction

When the first directors and officers (D&O) insurance policies were sold in 1962, the primary risks were perceived to be claims that might arise from alleged breaches of a corporate officer’s traditional duties, such as breaches of fiduciary duties, usurpation of corporate opportunities and the like. Since then, however, there has been a trend toward expanded personal liability on the part of directors and officers in areas and for things that previously were unimaginable. The rate of D&O claims appears to have leveled off in recent years, with a steady but high prevalence. Directors and officers, and thus their insurers, are exposed to a significant risk of liability, arising not only from their traditional duties but also from a burgeoning body of statutorily created liability sources in areas as diverse as securities regulation, data privacy and environmental protection.

The magnitude of the risk involved in such lawsuits is often prohibitive, with potential damage awards totaling hundreds of millions or even billions of dollars. However, actual liability is not the only, nor perhaps even the primary, risk. Counsel fees incurred in defending these suits, which are typically complex and protracted, can easily run to six, seven and in some cases, even eight figures. The specter of bright, diligent, capable, creative and efficient attorneys prosecuting and defending a claim is enough to cause directors and officers, not to mention their insurers, many a sleepless night.

Adequate directors and officers liability insurance protection has become increasingly difficult to obtain and is significantly more expensive once it has been obtained. Coverage for high-risk activities may even become impossible to get as underwriters add more and more exclusions to the policies.

II. State Statutes Authorizing D&O Liability Insurance

A. Indemnification

Since most state statutes that authorize corporations to purchase and maintain insurance for their directors and officers simply are extensions of statutory indemnification provisions, the practitioner must understand the concept of indemnification, as well as its legal limits. In the context of directors and officers liability, indemnification generally refers to corporate reimbursement to a corporation’s directors and officers for amounts they become liable for in connection with their duties to and for the corporation. Such indemnification generally falls into two categories of reimbursement: mandatory indemnification and permissive indemnification.

1. Mandatory Indemnification

Under a mandatory indemnification statute, corporate directors and officers are indemnified for all liability incurred upon the successful determination of the merits of the case against them.⁴⁵¹²

2. Permissive Indemnification

In order to qualify for indemnification under a permissive state indemnification statute, the successful director or officer must meet the requisite standards of conduct as provided in the statute. New York’s statute authorizing permissive indemnification provides the following:

A corporation may indemnify any [director or officer of the corporation] made, or threatened to be made, a party to an action . . . if such director or officer acted, in good faith, for a purpose which he reasonably believed to be in, or, . . . not opposed to, the best interests of the corporation and, in criminal actions or proceedings, in addition, had no reasonable cause to believe that his conduct was unlawful. ⁴⁵¹³

B. The Need for D&O Liability Insurance

Due to exclusions and gaps in the indemnification statutes, state indemnification provisions do not provide directors and officers with complete protection from liability. These limitations on indemnification statutes have helped create the need for directors and officers liability insurance. The following are among the reasons why indemnification statutes are considered inadequate as compared to insurance:

1. The corporation, due to insolvency or some other reason, may be unable to fund the indemnification adequately.

2. The directors or officers may not be able to meet the standards for indemnification set forth in the state indemnification statute.

3. The corporation may decide not to indemnify—for example, after a hostile takeover.

4. Limits in some state indemnification statutes may prevent reimbursement for derivative suit settlements and judgments. ⁴⁵¹⁴

To offset some of the limitations on indemnification statutes, most states expressly authorize a corporation to purchase insurance that will indemnify its directors and officers regardless of whether, under the particular circumstances, the corporation would have been permitted under the state’s business corporation law to provide indemnification directly.⁴⁵¹⁵

The New York statute authorizing corporations to maintain liability insurance for directors and officers allows the corporation to purchase and maintain such insurance, which will enable it:

(1) [t]o indemnify the corporation for any obligation which it incurs as a result of the indemnification of directors and officers . . .

(2) [t]o indemnify directors and officers in instances in which they may be indemnified by the corporation . . .

(3) [t]o indemnify directors and officers in instances in which they may not otherwise be indemnified by the corporation . . . provided the contract of insurance . . . provides, in a manner acceptable to the superintendent of insurance, for a retention amount and for co-insurance. ⁴⁵¹⁶

It is interesting to note that the New York statute requires notification by the corporation to its shareholders of the purchase or maintenance of insurance and of any indemnification or payment of insurance.⁴⁵¹⁷ This notification provision, which is not required by most other states, serves as a check on management by holding management accountable to its shareholders as to the reasons behind the need for this insurance.

III. The Insuring Agreements

A. D&O Liability Form

Most D&O insurance policies include three separate sections, also known as “sides,” that share the policy’s limit of liability. These sections afford coverage for (a) non-indemnifiable loss, (b) indemnifiable loss, and (c) entity loss. Today’s D&O policy forms often include provisions addressing the potential tensions between coverage for the individual directors and officers, and coverage for the insured entities. These provisions ultimately subordinate entity coverage to the benefit of the insured directors and officers, with coverage for non-indemnifiable personal liability loss as the primary insured risk.

B. “Side A” Non-Indemnifiable Coverage

The Side A insuring agreement provides coverage to the directors and officers for claims where the company is legally prohibited from providing indemnification—primarily derivative litigation judgments and settlements—and where the company is financially unable to indemnify. Typically, no retention or deductible applies to Side A coverage. Governing state law ultimately determines what is indemnifiable and the specific process the company must follow when making such determinations with respect to its directors’ and officers’ rights, including considering any broader grants of indemnification under the company’s bylaws or charter compared to what is required under state law.

C. “Side B” Indemnifiable Coverage

The Side B insuring agreement reimburses the company for its indemnification payments to the directors and officers. The policy’s applicable retention or deductible will apply. Side B coverage responds to the majority of claims against the directors and officers, insuring the company’s indemnification obligations.

D. “Side C” Coverage

The “Side C” insuring agreement, also known as “entity coverage,” provides coverage when the company is sued or investigated, often along with its directors and officers. The policy’s applicable retention or deductible will apply. Private companies often have broader entity coverage than public company coverage, which is often limited to defined “Securities Claims.” Side B and Side C protect the company; Side A protects the individual directors and officers when the company is statutorily or financially unable to do so.

E. Stand Alone “Side A” Insurance Coverage

A company will often buy excess policies to provide additional limits of liability beyond its primary policy, including Sides A, B and C coverage. A stand-alone Side A policy is intentionally limited to cover only the directors and officers; these Side A limits of liability are never shared with the company. A subset of stand-alone Side A policies is referred to as “Difference in Condition” or a DIC coverage, often providing broader coverage than the Side A insuring agreement found in the primary policy. Many boards will now insist on the company purchasing some form of stand-alone Side A coverage as it is considered the insurance market’s best protection against the directors’ and officers’ personal liability.

Stand-alone Side A coverage is also for protecting directors and officers in the bankruptcy context. During a bankruptcy proceeding, a company will not be able to fulfill its indemnification obligations to the directors and officers, who may have to defend a host of claims against them, while the company enjoys a stay of claims under the bankruptcy laws. In this situation, the directors and officers can access the no-retention/deductible Side A coverage under both the primary policy and any excess, or DIC, Side A policies.

Most D&O insurance policies today also include a “priority of payments” provision, expressly prioritizing Side A coverage over Side B and C coverage, then prioritizing Side B coverage over Side C coverage, with the intent of protecting the individual directors and officers over the entity, with all coverage subordinated under the...