D&O ALTERNATIVE RISK FINANCING
In light of the recent contraction of the D&O insurance market, many companies are now questioning whether it is advisable to finance director and officer (“D&O”) liability risks through some type of non-traditional risk management vehicle. D&O risk financing alternatives create unique legal issues not applicable to financing other types of risks. Before adopting a D&O funding alternative that either replaces or supplements traditional D&O insurance coverage, a corporation must carefully analyze those unique issues and identify the advantages and, more importantly, the limitations to that funding alternative.
The consequences from such a funding alternative not responding as expected can be catastrophic to directors and officers. As a result, a corporation should be very cautious and conservative when deciding whether to adopt a D&O risk financing alternative, particularly if a reduction or elimination of traditional D&O insurance is contemplated. The vast majority of alternatives do not justify a change in the corporation’s traditional D&O insurance program.
I. Need for D&O Insurance
A corporation’s ability to financially protect its directors and officers is largely governed by the law of the state in which the corporation is incorporated. Statutes in all states permit or require corporations to indemnify their directors and officers for certain loss, and authorize corporations to purchase D&O insurance to cover non-indemnifiable loss. If directors and officers do not maintain D&O insurance but rely only upon corporate indemnification as the sole source of financial protection, three types of coverage “gaps” will generally exist, thus subjecting the personal assets of the D&Os to risk:
1. Public Policy Limitation. State indemnification statutes contain various limitations on the scope of indemnification protection that a corporation may grant to its directors and officers. For example, most state statutes prohibit indemnification of judgments, and in many instances settlements, in cases brought against a director or officer by or on behalf of the corporation, including shareholder derivative lawsuits. In addition, most indemnification statutes permit indemnification only if the individual is found to have acted in good faith and in the reasonable belief that his conduct was in or not opposed to the best interests of the corporation.
In addition to state statutory limitations, other public policy limitations may exist in respect of indemnification for violation of various federal statutes. For example, the SEC and numerous courts have ruled that it is against public policy for a corporation to indemnify D&Os for violation of the registration and perhaps anti-fraud provisions of the federal securities laws, although indemnification of settlements in claims alleging such securities law violations is probably permissible. Similar public policy limitations may restrict indemnification under other federal statutes that either expressly prohibit such indemnification or otherwise impose personal liability to deter wrongdoing.
2. Change in Circumstances. The mandatory indemnification provision set forth in the corporation’s by-laws or articles of incorporation may be changed to limit or eliminate indemnification for certain directors or fficers. This may occur, for example, when antagonism develops between controlling management and dissident or former D&Os.
This antagonism can jeopardize a D&O’s indemnification protection because state statutes typically require an affirmative determination by the board of directors, independent counsel for the corporation, shareholders or a court that the applicable standards of conduct were satisfied by the director or officer before indemnification is permitted. If this antagonism arises, the director or officer seeking indemnification will face, at best, a difficult, time-consuming and expensive battle to enforce his/her indemnification rights and may lose the indemnification protection entirely.
3. Financial Inability to Fund. The corporation may be financially unable to fund the indemnification, either because it is insolvent or because it has cash flow limitations. D&O litigation can be extremely expensive, frequently resulting in a settlement or judgment in the 10s or 100s of millions dollars. Similarly, defense costs can be in the 10s of million of dollars. Even if a corporation is financially solvent, the payment of such large amounts on behalf of the defendant D&Os could impair the corporation’s other business activities, thus forcing the corporation to abandon the defendant director and officer in lieu of jeopardizing the corporation’s continuing existence or financial health.
This risk of financial inability to fund indemnification should be evaluated not just with respect to the parent company, but also all subsidiaries. The D&Os of a subsidiary frequently are not entitled to indemnification from the parent, so D&Os of a subsidiary may lose their indemnification protection if their subsidiary is unable to fund that indemnification.
Traditional D&O liability insurance can generally fill the three gaps in protection described above. State indemnification statutes and the SEC expressly recognize the ability of corporations to purchase and maintain D&O insurance that can provide coverage for nonindemnifiable claims. Because the D&O insurance policy is a contract, it cannot be changed unilaterally and funding under the policy is not subject to the approval of current management of the corporation. Finally, the insurance policy is collectable (assuming the insurer is solvent) regardless of the financial health of the corporation.
Thus, in order to be a viable supplement or alternative to traditional D&O insurance, any alternative D&O risk financing arrangement should address one or more of these three gaps in coverage. If an alternative successfully addresses all three gaps, the alternative may be an adequate substitute for D&O insurance. If an alternative satisfies only some but not all of the gaps, the alternative may be an advantageous supplement to D&O insurance and statutory indemnification, but is not a complete substitute for traditional insurance coverage.
At a minimum, many alternative risk financing arrangements can protect against loss that is not indemnifiable because of a change in circumstances. The following discussion analyzes the degree to which alternative risk financial arrangements can protect against loss which is not indemnifiable because of public policy limitations or financial inability to fund, as well as summarizes some fiduciary duty issues with respect to adopting a D&O risk financing alternative.
II. Avoiding Public Policy Limitations
As explained above, public policy limitations on indemnification are derived from limitations imposed by common law, state indemnification statutes and federal statutes or public policy. The public policy limitations under the state indemnification statutes and in the federal statutory context can be avoided if the risk financing arrangement is considered “insurance” since those statutes (or applicable regulations) expressly permit the company to purchase “insurance” to cover loss not indemnifiable.
Those statutes and regulations do not attempt to define what is considered “insurance” for this purpose. The largest body of authority today seeking to classify various risk financing arrangements as insurance exists in the tax arena, where corporations seek to obtain a tax deduction for premiums paid for various types of arrangements. Because those cases attempt to determine whether a particular risk financing program is “insurance,” the analysis applied in those cases arguably applies in determining what arrangements constitute “insurance” for purposes of providing D&O protection for non-indemnifiable loss.
At least in the tax context, the U.S. Supreme Court defines “insurance” as follows:
Historically and commonly insurance involves risk shifting and risk distributing.
This two-prong definition of insurance has been adopted by authorities in non-tax areas as well. Thus, it is likely that any alternative D&O risk financing arrangement will need to both shift risk to a third party and distribute risk among numerous third parties in order to cover legally non-indemnifiable loss. Otherwise, the arrangement will likely be viewed as disguised indemnification, in which case the public policy limitations applicable to indemnification (as summarized above) will apply.
The following briefly summarizes the extent to which various types of alternative arrangements have been classified as “insurance,” at least for tax purposes.
A. Captive Insurance Company
There is substantial doubt whether D&O coverage from most captive insurance companies would constitute “insurance” and therefore could provide financial protection against non-indemnifiable claims against D&Os of the parent company or other affiliates.
Tax authority generally has held that a traditional wholly-owned captive insurance company does not provide “insurance” to or on behalf of its parent corporation since no risk is either transferred or distributed. These authorities do not recognize a transfer of risk from the parent corporation to the subsidiary insurer because both corporations are members of the same “economic family.”
A captive insurer has the greatest chance of creating “insurance” if it insures not only the risks of its affiliates, but also a substantial amount of risks of other unrelated persons or entities. Courts have recognized sufficient risk distribution and risk shifting where the captive insurer’s unrelated business constituted as little as 30% of the insurer’s total premium income, although the U.S. Tax Court has indicated that a safer rule of thumb is 50% unrelated business.
In response to the D&O insurance crisis of the mid-1980s, a few states amended their indemnification statutes to specifically authorize corporations to purchase and maintain coverage from an insurer owned by the corporation. These statutes permit the captive to cover loss from non-indemnifiable state law claims, although the captive may not be permitted to cover non-indemnifiable federal claims. Even as to state claims, the applicable state statutes should be examined closely to determine if the intended coverage for non-indemnifiable claims is in fact permitted. For example, some of these statutes permit corporations to purchase “insurance” from captive or affiliated insurers. Under those statutes, risk shifting and risk distribution may be required, in which case the statutes may permit only the use of captives with substantial unaffiliated business or group insurers in which the corporation owns a fractional interest.
B. Group Insurance
To avoid many of the problems associated with a wholly-owned captive insurer, some corporations have formed a group captive in which several companies own and are insured by the same captive insurer. Because risk is transferred to the separately owned insurer and is spread among the various participants, such arrangements will likely be considered “insurance” (assuming an adequate number of companies participate in the group to create true risk distribution) and thus protection for non-indemnifiable claims should be permissible.
Although such group arrangements can provide several advantages to their participants, they are not without risk or problems. Membership in these associations generally will not be available to high risk or financially unstable corporations. Additionally, the group captive must satisfy the stringent insurance and underwriting regulatory requirements relating to capitalization and other matters, as well as applicable federal and state securities laws if it is a stock captive. To be a viable alternative to the traditional D&O insurance market, these group insurers must be well organized and operate with the purpose of long-term survival. Their capitalization, underwriting criteria, and claims handling should be reasonable and tailored to the statutory requirements. Its members must be loyal to the captive and not abandon the facility during favorable cycles in the traditional insurance market.
C. Fronting/Finite Risk Arrangements
A fronting insurance arrangement is an agreement between a corporation and a traditional insurance company pursuant to which the insurance company issues a standard or perhaps enhanced D&O insurance policy in exchange for the corporation agreeing to fund all (or at least a substantial portion of all) loss under that insurance policy. The insurance company receives a fee for its services in providing a “fronting” policy, but assumes no or very little risk of loss.
A true fronting policy may not be capable of covering non-indemnifiable D&O claims because arguably no risk is transferred. Tax authority consistently has concluded various types of fronting arrangements do not constitute “insurance,” although it is at least arguable that some arrangements may under certain circumstances actually transfer risk.
Finite risk programs are similar to fronting arrangements. Although the exact terms and structure of such a program vary, generally an unrelated insurer affords a defined amount of coverage over an extended period of time in exchange for which the insureds agree to pay a very large initial premium and/or agree to pay a certain percentage of loss incurred under the program. A finite risk program pursuant to which the insureds fund only 20%, for example, of the covered loss would likely create sufficient risk transfer to constitute insurance, whereas a finite risk program pursuant to which the insureds fund 90%, for example, would likely not constitute insurance. Between those two extremes, there is no clearly defined point at which the program converts from a risk shifting insurance arrangement to a non-insurance arrangement. Although a program which funds 50 to 70% of loss may arguably be considered insurance, such a conclusion is largely speculative given the current lack of significant judicial precedent.
D. Trust Fund
Another method for securing financial protection to D&Os is the irrevocable trust. The corporation establishing the trust typically enters into a trust agreement with a bank or other third party as trustee and transfers a sum of money to the trustee to be held in trust pursuant to the provisions of the agreement. The trust agreement may provide that the corporation will keep the value of the trust assets at a given level at all times, or it may provide for a single contribution or annual contributions. The trust agreement typically reads substantially similar to a D&O insurance policy, with the covered directors and officers being the designated beneficiaries.
It is doubtful a trust arrangement is “insurance” because no risk transfer or distribution typically occurs. Accordingly, it is doubtful such an arrangement can provide coverage for non-indemnifiable claims.
A few states have amended their indemnification statutes to expressly permit the use of trust funds for protecting directors and officers. For example, Louisiana, Maryland, Nevada, New Mexico, Ohio, Pennsylvania and Texas now authorize the use of trust funds to provide protection against non-indemnifiable state claims, although it is doubtful even in those states that trust funds can provide protection against non-indemnifiable federal claims.
E. Miscellaneous Other Alternatives
Depending upon the financial condition of the corporation and the applicable state indemnification law, several other alternative D&O risk financing alternatives may be available. For example, a corporation may enter into indemnification contracts with its directors and officers and secure coverage afforded by those contracts with a letter of credit (“LOC”), surety bond or other similar arrangement. Like many of the alternatives summarized above, these arrangements can protect directors and officers against unilateral amendments by the corporation to the indemnification protection and against other unforeseen changes in circumstances. Similarly, if structured properly, the arrangements can insulate D&Os from the financial insolvency of the corporation. However, such an arrangement clearly does not constitute “insurance” and thus could not cover nonindemnifiable claims.
Another possible alternative is “self-insurance.” Recent legislation in Arizona, Louisiana, Maryland, Nevada, Ohio, New Mexico and Texas, for example, expressly authorize corporations to maintain “self-insurance” for the benefit of its directors and officers and to provide coverage through such self-insurance for non- indemnifiable state claims. These statutes do not define what is “self-insurance.”
Presumably, separate funding is not required, although it would be desirable if the corporation’s financial ability to pay is potentially in doubt. Because this statutory authorization is contained in the state indemnification statute, it is doubtful that such a self-insurance plan would circumvent the restriction against
indemnification for violations of the federal securities laws and other federal statutes since no risk transfer or risk distribution occurs.
III. Insulation of Funds from Creditors
If a goal of the risk financing arrangement is to assure a source of funding, it is essential that the arrangement be structured to insulate funds from potential claimants who may seek to apply the funds for purposes other than protecting the directors and officers. For example, creditors or a bankruptcy trustee
may seek to recoup for their benefit the corporate assets used to fund the alternative arrangement under fraudulent conveyance or bankruptcy preference statutes.
Carefully considered and structured risk financing arrangements that are irrevocable, funded at a reasonable level by a solvent corporation and treated by the corporation as an arms-length transaction should generally
withstand these types of attack. An additional concern particularly applicable to a subsidiary captive insurance company is the risk that if the parent corporation becomes subject to a bankruptcy proceeding,
the bankruptcy court may order an equitable consolidation of the parent and captive subsidiary, thereby sweeping the captive subsidiary’s assets into the bankruptcy proceeding of the parent corporation. In
effect, this remedy allows third party creditors to assert claims against a common fund. The primary situations where this consolidation occurs involve the subsidiary being a “mere instrumentality” of the parent or the subsidiary and parent being hopelessly interrelated and thus separating the two entities is very expensive or difficult. Financial and operational independence of the captive from its parent should help reduce this risk. In addition, if the risk financing arrangement transacts business with unaffiliated persons,
the prudence of those third party transactions must be continually monitored in order to assure the ongoing economic solvency of the funding arrangement.
IV. Fiduciary Duties in Implementing Risk Financing Alternatives
Directors and officers who consider the adoption of a D&O liability risk financing alternative should consider the appropriateness of such arrangement from the standpoint of the corporation and its shareholders. For
example, if the formation of a funding arrangement causes the corporation to be undercapitalized or otherwise adversely affects the corporation’s business operations, a potential claim for breach of fiduciary duty may arise against the approving directors and/or officers. Because the beneficiaries of the arrangement are the persons approving the arrangement, courts may require the directors and officers to establish the intrinsic fairness of the arrangement to the corporation and its shareholders, particularly if the cost of the arrangement significantly exceeds the cost of available D&O insurance. Accordingly, the corporation should fully document the justifications for the funding arrangement and the reasonableness of the amount funded in light of the financial condition of the corporation. Where appropriate, shareholder approval of the arrangement, after full disclosure of all material information, could be obtained to further insulate the approving directors and officers from claims of self-dealing, waste of corporate assets, and the like. In addition to adequately justifying the reasonableness of the arrangement, management should also confirm that the funding does not directly or indirectly violate any loan covenants or other agreements of the corporation which limit or require prior approval of payments to or on behalf of the directors and officers. Regulated companies may also need regulatory approval for the funding.
V. Conclusions
Several risk financing alternatives can provide meaningful and valuable protection which is either not afforded by the traditional D&O insurance market (e.g. coverage for or arising out of pollution incidents), or if traditional D&O coverage is unavailable, greater than that afforded by statutory indemnification.
However, it is highly questionable whether any D&O liability risk financing alternative that does not transfer and distribute risk is a complete substitute for traditional D&O insurance coverage.
When evaluating various alternatives, companies should identify the goals sought to be accomplished by the risk financing arrangement and then determine the extent to which those goals are satisfied by various alternative arrangements. If an arrangement provides some degree of protection beyond that afforded by a company’s D&O insurance policy, it is worth considering as a supplement to, but not as a substitute for, traditional D&O insurance.
Unlike most other areas of corporate risk management, alternative risk financing arrangements in the D&O context create complex issues involving, among other matters, corporate indemnity law, insurance law,
bankruptcy law, D&O liability law and tax law. Expert analysis of these various issues is an essential ingredient to any D&O liability risk financing plan if the maximum protection and benefits from that arrangement are to be attained. Unfortunately, much of the analysis and planning in this area must be in somewhat unchartered waters. Because of the enormous adverse consequences to the covered directors and officers if the risk financing plan does not successfully accomplish its intended goals, a conservative approach to this topic is recommended.