EMPLOYMENT PRACTICES INSURANCE
Employment-related claims have increased significantly in recent years. The recent adoption of broad legislation such as the Americans With Disabilities Act and the Civil Rights Act of 1991, the erosion of the "employment-at-will" doctrine, and the increased sensitivity to sexual harassment through the Clarence Thomas Senate confirmation hearings, among other things, have created unprecedented employment-related exposures to corporations and their directors, officers and employees.
Historically, insurance coverage, if any, for risks arising from employment practices existed only to a limited degree in various traditional insurance products, including the commercial general liability (CGL), the umbrella and the D&O Liability insurance policies. In 1992, several insurers introduced for the first time an employment practices liability insurance policy, which is intended to consolidate all of this coverage into one policy and provide for the first time meaningful, broad coverage for defense costs, settlements and judgments incurred by both the corporation and its directors, officers and employees relating to employment practices. This article summarizes some of the issues and considerations which arise in evaluating this new coverage.
TRADITIONAL INSURANCE PRODUCTS
The CGL policy typically responds to employment claims if personal injury, such as emotional distress, mental anguish, invasion of privacy, false imprisonment, libel or slander, is alleged. Because the CGL policy insures both the corporation and its directors, officers and employees and creates a duty to defend any claim covered in whole or in part by the policy, frequently all of the costs incurred in defending an employment practices lawsuit are covered by the CGL policy, although only limited, if any, coverage with respect to settlements or judgments is usually afforded since personal injury and defamation are frequently not the prime focus of employment litigation.
The D&O policy may respond to such a claim if and to the extent directors and officers are named defendants. However, since the D&O policy is a duty to pay not a duty to defend policy and does not cover the corporation or other employees, the policy provides coverage only for defense costs and any settlement or judgment directly allocated to covered claims against the directors and officers. Any other loss incurred in the litigation is uninsured. Because the target defendant in most employment lawsuits is the employer, not an individual director or officer, the D&O policy typically affords only limited coverage. In addition, exclusions for bodily injury, ERISA, dishonesty and perhaps, personal injury or defamation, may further reduce this coverage substantially.
Umbrella insurance policies frequently provide broader coverage for libel and slander and bodily injury claims than underlying CGL policies. However, the coverage usually has a relatively high attachment and is therefore a catastrophe coverage at best. In addition, many umbrella policies exclude employment-related risks by endorsement.
EMPLOYMENT PRACTICES POLICIES
Since traditional insurance policies provide little or no coverage for employment claims, several insurers have developed new stand-alone policies targeted specifically and exclusively to this risk. These policies vary greatly in the scope of their protection - from insuring only defense costs to providing defense and indemnification for a broad spectrum of employment claims. Typically, these policies will insure the corporation and its directors, officers and employees for covered employment claims. Since these stand-alone policies are new, employers should expect some retooling of provisions as the insurers gain experience in the market.
INSURABILITY OF EMPLOYMENT-RELATED CLAIMS
The fact that specific coverage now exists for discrimination and wrongful discharge claims brings into sharp focus the question of whether such coverage may be barred by the public policy of a given state, as insurance for intentional wrongdoing. The dispute over the insurability of employment-related claims arises most often in discrimination litigation. Fewer cases have addressed the public policy issue in the context of wrongful discharge or workplace tort claims, since most of those cases have been resolved by an interpretation of policy language.
To understand the reasoning of the courts which have discussed the public policy issue, it is necessary to understand the two fundamental theories of proof in employment discrimination litigation. Those theories are (1) disparate treatment; and (2) disparate impact.
A disparate treatment claim arises when an individual maintains that he or she was treated differently because of some trait protected by state or federal law, including age when the individual is 40 or older, race, sex (including pregnancy), religion, national origin and, more recently, disability. Disparate treatment liability requires a showing of a discriminatory intent by the employer.
Disparate impact, the second theory, involves claims that a facially neutral employment practice had a disproportionate impact on individuals with a protected trait. Examples of these "facially neutral" practices include educational or physical requirements and proficiency tests which appear on their face to be non-discriminatory but which effectively discriminate against persons with a protected trait. Disparage impact claims focus on the consequences of employment practices and not the employer's motivation. They do not require proof of a discriminatory intent. Instead, liability may result when the challenged practices are not job-related and cannot be justified by business necessity.
The issue of whether public policy permits coverage for employment discrimination claims stems from the longstanding principle that individuals should not be permitted to insure against damages resulting from intentional misconduct. The public policy debate has focused primarily on the insurability of disparate treatment claims, since such a claim requires proof of a discriminatory intent by the defendant. Courts have also discussed the issue in the context of some of the "new" workplace torts, including retaliatory discharge, which also require intentional wrongdoing. The insurability issue does not arise in disparate impact claims because no showing of intentional discrimination is required.
Courts addressing the public policy considerations of allowing insurance for employment-related claims have generally evaluated the same factors whether coverage will stimulate unlawful conduct, whether the purpose of the law is deterrence or compensation, the importance of freedom of contract, and the need to enforce contracts as written. The courts have reached different conclusions by weighing these competing considerations differently. Some courts have ruled that public policy prohibits insurance for certain types of employment claims, while other courts have upheld the insurability of such claims.
The court decisions which have found certain employment claims to be uninsurable appear to be based in part on confusion over the term "intentional" as used in employment law and the connotation of severe misconduct attaching to a finding of discrimination. In fact, liability for disparate treatment employment discrimination frequently results not from purposeful misconduct, but from a misunderstanding of the law. The conduct leading to liability may in reality amount to negligence, or at worst, recklessness. Many smaller businesses do not have access to legal counseling on employment matters and consequently blunder into liability. Public policy should not prohibit the insurability of such non-egregious conduct.
Two recent developments suggest that the dynamics of the public policy analysis may change and that courts in the future will more consistently find that employment-related claims are insurable. Each is summarized below.
An important issue in evaluating whether public policy precludes coverage for discrimination claims is whether the anti-discrimination laws are intended to deter discriminatory conduct or to compensate those injured by the discriminatory conduct. If the purpose is to deter wrongdoing, public policy may prohibit the insurability of such claims since insurance may defeat the intended deterrent effect. However, if the purpose is to compensate the victim, insurance would promote, not defeat, that purpose and therefore such claims would be insurable.
The Civil Rights Act of 1991 appears to emphasize the compensatory purpose and therefore claims under that Act may be more likely to be insurable under a public policy analysis. As a result of that Act, individuals claiming disparate treatment discrimination under Title VII and the ADA are entirely for the first time to seek compensatory damages. The legislative history of that Act stated that its first purpose was "to provide monetary remedies for victims of intentional employment discrimination to compensate them for resulting injuries and to provide more effective deterrents."
The second recent development potentially affecting the public policy analysis is the availability of employment practices liability insurance policies, many of which expressly cover certain alleged employment discrimination. The existence of these specific policies may also increase the likelihood that coverage under such policies will not be precluded by public policy considerations. Most courts recognize the strong public policy favoring freedom of contract and the enforcement of contracts as written. These decisions have generally been rendered in the context of general liability policies, where there have been significant questions about whether alleged discriminatory acts were covered occurrences. Courts have not to date had an adequate opportunity to consider the public policy issues in the context of the new employment practices liability policies, which unquestionably evidence an intent by the contracting parties to insure the employment-related claims.
In light of these and other developments, it appears likely that coverage for employment-related claims under the new employment practices policies does not violate public policy considerations and should be permitted by the courts.
DERIVATIVE SETTLEMENTS: SUBSTANCE OR SHAM?
Theoretically, director and officer liability exposure in shareholder derivative suits is of great concern to directors and officers because most state indemnification statutes do not authorize indemnification of settlements or judgments in such suits. Because any such settlement or judgment is paid directly to the corporation, not to the shareholders who litigate the claim on behalf of the corporation, such indemnification limitation is intended to avoid the circular result which would occur if the defendant paid money to the corporation and was then indemnified by the corporation for that same amount.
In reality, director and officer liability exposure in derivative litigation has generally not been alarming in recent years, subject to several notable exceptions. Two developments have primarily contributed to this reality. First, courts in recent years have generally deferred to the judgment of independent directors of the corporation as to whether litigation of the derivative lawsuit by shareholders is in the best interests of the corporation and have dismissed the litigation if not in the corporation's best interests. Second, in those cases which are not dismissed, the parties frequently agree to a non-monetary settlement pursuant to which the corporation adopts certain corporate "therapeutics" such as implementing new guidelines or procedures to prevent reoccurrence of the alleged wrongdoing. In such a settlement, the only monetary payment is the plaintiffs' counsel fee and expense award.
Some recent court decisions have rejected, or at least criticized, proposed "therapeutic" derivative suit settlements, thereby placing in doubt the routine use of that mechanism to settle such cases.
In In re: Oracle Securities Litigation, 1993 U.S. Dist. LEXIS 11387 (N.D. Cal. Aug. 9, 1993), the court was asked to approve a derivative settlement pursuant to which the corporation made changes in its insider trading and revenue recognition policies, and the plaintiff's counsel was to receive $750,000 for fees and expenses. The court found, based on the presentation of the evidence, that the derivative plaintiffs "appear extremely unlikely to prevail on their claims against the individual defendants, and the proposed settlement and dismissal of the derivative action would seem appropriate."
However, the court did not end its analysis there. It recognized that it had not received an unbiased portrayal of the merits of the derivative claim because both plaintiffs' counsel and defendants had an incentive to justify the settlement. In the absence of a disinterested presentation on behalf of the corporation (i.e., the true plaintiff), the court found it impossible to determine the reasonableness of the settlement and, therefore, refused to approve the settlement.
Interestingly, four members of Oracle's seven-member board who were not named defendants in the derivative lawsuit had been appointed to a special independent committee to evaluate and ultimately approve the settlement on behalf of the corporation. Yet the court concluded that the committee did not act with requisite independence. The court stated:
We must be mindful that directors are passing judgment on fellow directors in the same corporation and fellow directors, in this instance, who designated them to serve both as directors and committee members. The question naturally arises whether a "there but for the grace of God go I" empathy might not play a role.
Because "independent" directors are often beholden to the defendant directors who appointed them, the court emphasized the retention of independent counsel by the independent directors as providing one of the few safeguards to insure the legitimacy of their settlement analysis. In this case, though, the independent directors retained only the corporation's in-house general counsel, not independent outside counsel. The court concluded that the corporation's general counsel would be reluctant to recommend a position advice to the individual defendants, for whom he worked on a day-to-day basis and who controlled his future with the corporation.
The special committee's lack of independent counsel contributed to the court's conclusion that the derivative settlement "reeks of collusion between derivative plaintiffs' counsel and the individual defendants, at the expense of the corporation". The court refused to approve the proposed settlement.
Similarly, in Fischer & Porter company v. Tolson, 1993 U.S. Dist LEXIS 11481 (E.D. Pa. Aug. 18, 1993), the court found a proposed derivative settlement to be unfair, inadequate and unreasonable to the corporation. In that case, the proposed settlement included corporate "therapeutics" and a settlement fund of $850,000. Because the D&O insurance policy had a $500,000 deductible, the insurer paid $350,000 and the corporation paid $500,000 of the cash fund. The proposed settlement payment to the plaintiff shareholder and plaintiffs counsel was $420,000. As a result, the company contributed $350,000 towards a settlement and received back as beneficiary of the settlement (after payment of plaintiffs fees and expenses) $280,000, representing a $70,000 loss to the company.
The court concluded that the company would derive little, if any, benefit from the proposed settlement since it would cost the company $70,000 and the proposed "therapeutic relief" was "only marginally valuable".
In a third recent case, a federal appellate court upheld the approval of a proposed derivative settlement, but expressed grave concerns about the valuation of the corporate "therapeutics" included within the settlement. In Bell Atlantic Corporation v. Bolger, 1993 U.S. App. LEXIS 20934 (3rd Cir. Aug. 18, 1993), the corporation agreed to establish and follow new procedures to monitor sales and marketing programs, and the plaintiffs counsel would be paid $450,000 in fees and expenses. In upholding the reasonableness of the settlement, the court found that the expected payout at trial to the corporation was small and therefore even if the corporate governance changes had a small valuation, the settlement was reasonable. The court, through, recognized the potential dangers from a "therapeutic" type derivative settlement:
We affirm the substantive fairness of the settlement. We say this with some caution because of the difficulty in valuing the non-pecuniary relief accorded the corporation. Although non-monetary relief is adequate consideration for settling a derivative or class action, the risks of concealment and collusion are not insignificant. Derivative actions may settle for cosmetic changes and no tangible relief to the corporation in exchange for large attorney's fees.
These cases suggest that defendant directors and officers and their corporations should proceed with caution if they attempt to settle a derivative lawsuit through use of corporate "therapeutics". Truly independent directors, with advice from independent counsel, should thoroughly evaluate the reasonableness of the proposed settlement to the company. Corporate governance changes may be appropriate consideration in some cases, but it appears questionable whether courts will assign significant value to many of those changes. If cash is contributed by the company to the settlement, extra caution must be taken to demonstrate a net benefit to the company from the settlement. As a result, derivative suits which are not otherwise dismissed may become more expensive to settle in the future since more of the consideration may need to be cash.
It appears doubtful, though, that these cases will impact the use of so-called "paper settlements" in class action lawsuits (see April 1993 ACE Report). Unlike a "therapeutic" derivative suit settlement, settling shareholders in a class action "paper" settlement, settling shareholders in a class action "paper" settlement receive real economic benefit in the form of stock, warrants, rights or other securities.