The ACE Report is a periodic publication distributed to policyholders and other interested parties as a service by ACE. Its purpose is to address insurance concerns worldwide, as well as present timely information on current developments in liability issues surrounding directors and officers. The Editor of the ACE Report is Dan A. Bailey, a lawyer at Bailey Cavalieri LLC. in Columbus, Ohio, USA and a respected voice in the complex area of directors and officers liability.

Although prepared by professionals, this publication should not be utilized as a substitute for legal counseling in specific situations. Readers should not act upon the information contained herein without professional guidance.

THE EVOLVING TERMS OF D&O COVERAGE
In the current post-Enron environment, both Insurers and Insureds under D&O policies are re-examining the terms and conditions of their policies to determine if the appropriate scope of coverage is afforded in light of current claims experience, market conditions and personal liability concerns. Many Insurers are revising their standard D&O policy forms or routinely endorsing older policy forms in order to restrict coverage in response to escalating loss experience. At the same time, many Insureds are requesting broader and more predictable insurance coverage as a condition to their willingness to serve.

These conflicting pressures has resulted in many D&O policies being materially changed when they are renewed in today’s market. Now more than ever it is critically important that all parties to the policy (as well as their advisers) understand the consequences and significance of these changes so there are no coverage surprises if a claim is made.

The following discussion summarizes some of the more important coverage concepts frequently being amended and various alternative approaches to each change. Ultimately, the Insurer and the Insureds should discuss, understand and agree upon the appropriate alternative in light of the unique circumstances of each situation.

A. Application Severability

One of the most important but frequently misunderstood provisions in a D&O insurance policy is the Application severability clause. Such a provision determines in large part the extent to which coverage for a director or officer may be jeopardized by false information in the Application.

Generally, courts have held that absent special policy language, a representation by one Insured in the D&O insurance Application can void the policy as to all Insureds, including Insureds who had no knowledge of the misrepresentation or the facts that were not properly disclosed. Because underwriters rely on the information in the Application when making underwriting decisions regarding the entire policy, this rule allows insurers to rescind the entire policy if that information is false. To avoid that result, most D&O insurance policies contain an Application severability provision which is intended to preserve coverage for so-called innocent Insureds even if other Insureds misrepresent material information to the Insurer in the Application.

There are several different types of Application severability provisions utilized by D&O insurers. A "full" severability provision either states that the Application is deemed to be a separate Application by each Insured or states that no knowledge of one Insured is imputed to another Insured for purposes of the Application. If the Policy includes entity coverage, this full severability provision usually states that only the knowledge of certain executive officers of the insured Company is imputed to the Company for purposes of determining coverage for the Company. A full severability provision is intended to preserve coverage for an Insured even if another Insured knew facts that should have been but were not truthfully disclosed to the Insurer during the underwriting process.

A "limited" severability provision states that the knowledge of one Insured is not imputed to another Insured for purposes of the Application, except that the knowledge of either the signer of the Application or alternatively the knowledge of certain designated Executive Officers is imputed to all Insureds. Under this limited severability provision, coverage for all Insureds could be rescinded by the Insurer if the signer of the Application or any of the designated Executive Officers knew of the false information which was not properly disclosed to the Insurer in the Application. If any Insured other than the signer or a designated Executive Officer knew such information, severability would apply, and the Insurer would be able to rescind coverage only for the Insured who knew of the misrepresented information.

Although historically most Insurers utilized a full severability provision, many Insurers today are moving toward some form of limited severability in order to allow the Insurer a meaningful remedy if the Insurer receives false information in the underwriting process. Simply rescinding coverage for the Insured who made the misrepresentation affords little, if any, relief to the Insurer since in most claims the Insurer would still be required to pay out large amounts for other Insureds under the improperly obtained Policy. However, Insureds are resisting this change since it could jeopardize coverage for "innocent" directors and officers.

Unfortunately, one cannot fully reconcile these two legitimate yet conflicting perspectives. Both the "innocent" Insureds and the Insurer are victims of the misrepresentation, yet only one of those two victims can obtain their desired relief (i.e., the Insureds want coverage and the Insurer wants to void the coverage). Stated differently, either the Insurer will be forced to pay potentially large amounts under a Policy which the Insurer would have never issued if the Application contained truthful information; or the Insureds who innocently relied on the existence of D&O insurance coverage when agreeing to serve will lose their very important insurance protection.

Although a "limited" severability provision seeks a partial compromise between these two competing concerns, both concerns remain. The "innocent" Insureds can still lose their coverage based on the conduct of others; and Insurers may still be required to pay large amounts under policies obtained by false representations.

Even if the D&O policy provides full severability, "innocent" directors and officers still have a risk that the Insurer may rescind their coverage under certain circumstances. A severability provision merely precludes imputing knowledge of one Insured to another Insured. In most states an Insurer need not prove the Insureds knew of the misrepresentation or intended to deceive the Insurer in order to rescind coverage. Because knowledge or intent is irrelevant to a rescission analysis in those states, the existence of a severability provision may likewise be irrelevant. In other words, the Insurer may be able in certain circumstances to rescind the entire policy even if the policy contains a full severability provision. This risk depends in part on the type of alleged misrepresentation in the Application.

Most frequently, an Insurer may seek to rescind coverage under a D&O insurance policy in one of two situations. First, a long-form Application usually inquires whether any prospective Insured knows of any facts or circumstances which may give rise to a claim in the future. If an Insured knows of such facts or circumstances but fails to disclose that information in the Application, the Insurer may have grounds to rescind coverage. Because such a misrepresentation relates to the knowledge of an Insured, a severability provision should protect "innocent" Insureds from rescission even in states which do not require knowledge or an intent to deceive, if the rescission is based upon another Insured knowing about but not disclosing in the Application such a potential claim (i.e., knowledge of the potential claim will not be imputed to the "innocent" Insureds).

Second, rescission may be based upon the falsity of objective facts which are disclosed in Application answers. The submission to the Insurers of false financial statements (as evidenced by their subsequent restatement) is one of the more frequent circumstances which can give rise to this type of rescission. If under applicable state law the Insurer is not required to prove the Insureds intended to deceive the Insurer in order to rescind coverage, a severability provision may afford little if any protection to the "innocent" Insureds in this type of rescission. Because knowledge or intent is irrelevant, a severability provision which simply states that the knowledge of one Insured shall not be imputed to another Insured may be similarly irrelevant. Thus, depending upon what state law applies, even a full severability provision may afford no protection to Insureds against rescission if the Application contains false financial statements or other objectively false information.

One reasonable solution to the severability dilemma which is gaining some popularity today recognizes that the preferred type of severability provision varies depending on the type of coverage being afforded. Because Side-A coverage (either under Insuring Clause A of a standard D&O policy or in a "Side-A Only" type of D&O policy) protects the personal assets of directors and officers against non-indemnifiable losses, the Insureds have the greatest need for full severability protection under that coverage, and Insurers are most willing to grant that protection for Side-A coverage. In fact, some Insurers (including CODA) in certain situations have gone so far as to expressly waive in the policy their right to rescind Side-A coverage.

In contrast, the more frequently invoked coverage for the Company (i.e., coverage under either the corporate reimbursement Insuring Clause B or the entity securities Insuring Clause C) merely protects the corporation. If the Executive Officer who acted on behalf of the corporation in obtaining the D&O policy knew of the Application misrepresentation, the Insurer should be entitled to rescind coverage for the corporation (i.e., limited severability should apply to Insuring Clauses B and C). This approach does not harm, and to some extent helps, the insured directors and officers since more of the policy’s limit of liability is preserved for Side-A losses which the directors and officers might otherwise have to pay personally.

B. Fraud Exclusion

Although raised by Insurers in most reservation of rights letters, this exclusion rarely serves as a basis to deny coverage because the exclusion typically applies only if a final adjudication establishes fraudulent or dishonest conduct by the Insureds. Courts have consistently ruled that this final adjudication must occur in the D&O claim itself, not in subsequent coverage litigation. Because virtually all D&O claims settle, the exclusion rarely applies.

However, in the aftermath of numerous recent cases which appear to have been caused by fraudulent conduct, many Insurers are now moving away from the "final adjudication" requirement in an attempt to avoid paying defense costs and settlement amounts for truly dishonest Insureds. Some newer D&O policy forms, for example, invoke this exclusion if there is any type of finding in any judicial or other proceeding, or if an admission or written document by the Insured, establishes the fraud actually occurred. In that event, the Insurer can deny coverage for the dishonest Insured even if the D&O claim is settled. Because these policies invariably have an exclusion severability provision which precludes the exclusion applying to the innocent Insureds, this broader version of the fraud exclusion should not be troubling to the innocent Insureds, and in fact benefits them by preserving more of the policy limits for their protection.

C. Coinsurance

In order to better incentivize the Insureds to aggressively defend D&O claims, more Insurers are requiring a significant co-insurance in D&O policies. Insureds should consider several points when evaluating a co-insurance option. First, the co-insurance should not apply to the Side-A coverage (i.e. coverage for non-indemnifiable loss). Otherwise, directors and officers would be required to personally fund a significant portion of any non-indemnified loss which is otherwise covered under the policy.

Second, co-insurance applies only to loss otherwise covered under the policy. Therefore, in many claims an allocation analysis must occur first, and then the coinsurance percentage is applied to the amount allocated to covered loss. In other words, the Insurer is entitled to double discount the amount of loss paid under the policy in many claims (i.e. loss is first discounted by an allocation analysis, then by the co-insurance analysis).

Third, the co-insurance should apply only to loss excess of the retention. Otherwise, the co-insurance would effectively require the Insureds to incur loss well in excess of the stated retention amount before coverage is triggered.

D. Allocation

Most D&O policies today expressly recognize the need for allocating loss between covered claims against insured persons and all other loss. Many policies also describe the methodology to be used in determining that allocation.

In the past, the most common methodology stated in the D&O policy required the parties to allocate based upon the "relative legal exposure" of the parties to covered and non-covered matters. The only relevant considerations under this methodology are the legal and factual merits of the covered and non-covered claims being made. Other considerations which may have impacted the size of the settlement are irrelevant.

Many newer D&O policy forms are changing this methodology, allowing the parties to allocate based upon the "relative legal and financial exposures of and relative benefits to the parties." This alternative methodology is generally viewed as more favorable to the Insurer and requires the parties to examine not only the factual and legal strengths and weaknesses of the relevant claims, but also the financial impact and collectibility of the defendants and the benefits derived by each defendant from the settlement or defense. In other words, the Insurer and the Insureds are entitled to consider many more factors when determining what is an appropriate allocation.

E. Presumptive Indemnification

Most D&O policies contain a presumptive indemnification provision, which in essence states that the Insured Company is presumed to indemnify its directors and officers if such indemnification is permitted or required by law (unless the Company fails or refuses to indemnify by reason of Financial Impairment). Pursuant to this provision, if an Insured Company is legally and financially able to indemnify its directors and officers but fails or refuses for any reason, the coverage available to those insured directors and officers is subject to the rather large Insuring Clause B deductible. Under that circumstance, the coverage for such a director or officer effectively becomes illusory in many instances since many individual directors and officers will be unable to personally fund such a large deductible (which can range from several hundred thousand to several million dollars).

From the Insurer’s perspective, this presumptive indemnification provision is important since it protects the Insurer against the Company simply ignoring its indemnification obligation, thereby circumventing the large deductible under the Policy. Although many Side-A only D&O policies now delete this provision, relatively few Insurers are willing to delete the provision in a standard D&O policy with corporate reimbursement coverage.

As a means of compromising these legitimate concerns of both the Insureds and the Insurer when the Insurer is unwilling to delete the provision in its entirety, the presumptive indemnification provision could be amended in one or more of the following respects in order to dissuade the Insured Company from wrongfully withholding indemnification.

These types of provisions arguably reduce the likelihood that the Insured Company will wrongfully withhold indemnification, and thus reduce the risk that the potentially dangerous presumptive indemnification provision is invoked by the Insurer.

F. Definition of Claim

In the aftermath of the Sarbanes Oxley Act of 2002, there are increased concerns by D&O Insurers and Insureds regarding the potential for criminal proceedings against directors and officers. Although any fine, penalty or other sanction awarded in such a proceeding would not be covered in any event, criminal defense costs may or may not be advanced under the D&O policy depending on whether the definition of Claim includes criminal proceedings. Most policies include such proceedings as a "Claim," but several policy forms (including some newly amended forms) delete criminal proceedings from the definition of Claim. Under those more restrictive forms, defense costs incurred in successfully defending a criminal charge would not be covered.

G. Failure to Maintain Insurance Exclusion