Insurance for the liability of directors and officers (D&O) of for-profit corporations has been available for many decades. Yet, its mechanics are still apparently difficult to understand.
Insurance for the liability of directors and officers (D&O) of for-profit corporations has been available for many decades. Yet, its mechanics are still apparently difficult to understand.
Traditionally, the D&O liability policy provides two broad coverages commonly labeled as (1) directors and officers liability coverage, and (2) corporate reimbursement coverage.
The first coverage is intended to protect the corporate executives against loss for allegedly breaching their corporate duties. This is an important coverage, because officers and directors can be held personally liable for their acts, errors, omissions, or other wrongful conduct.
The legal actions against officers and directors, furthermore, can take one of two forms. The first is a derivative suit or action, and the second a nonderivative suit or action.
A derivative suit or action is one brought against the corporate executives by one or more stockholders on behalf of the corporation. A corporation in this instance is precluded by law from protecting its directors and officers in such suits. It also stands to reason that a corporation should not assist its directors and officers for committing a wrongful act that allegedly affects the corporation's financial well-being.
This is one of the more common types of suits involving D&O liability policies. In fact, most D&O cases involve class actions brought by the stockholders on behalf of the corporation alleging wrongful acts that impair the corporation's finances in some way.
Any damages obtained in these types of actions are payable not to the stockholders who file such actions, but to the corporation that has been harmed, and on whose behalf the stockholders file such suits. However, when the stockholders are otherwise successful in their action, they are commonly paid the expenses they incur, along with reasonable attorneys' fees.
A nonderivative suit is one, generally, brought against the officers and directors by someone not associated with the corporation. In other words, this type of a suit is brought by competitors, creditors, governmental entities, or others.
A corporation is permitted by law to step in and defend its directors and officers who are confronted with legal actions by third parties. However, the extent to which a corporation may decide to protect its directors and officers hinges on its bylaws, corporate resolution or other agreement. These bylaws can be lenient or strict and may, for example, protect directors and officers for any allegations of wrongful conduct short of gross negligence.
It is not important to know that there are such terms as derivative and nonderivative suit actions. What is important, instead, is how and why a D&O policy applies the way it does.
When a class action against the corporate directors and officers is brought by stockholders on behalf of the corporation, the corporation is precluded by law from protecting the directors and officers who have allegedly caused harm to the corporation. It is, therefore, the first of the two coverages of the D&O liability policy that applies, subject, of course, to the policy's exclusions and conditions.
When a corporation, subject to its bylaws, corporate resolution, or other agreement, is permitted and does take steps to protect its executives in a legal action, it can seek reimbursement of its costs to defend and settle claims under the second of the two coverages of the D&O liability policy.
It may be misleading to say that there are two coverages because some D&O liability policies have been purchased without the second coverage (i.e., corporate reimbursement). Considering that a small percentage of the suits filed against corporations fall within this category (barring allegations of employment practices liability which are excluded anyway), some corporations prefer to assume the costs of defense and settlement rather than to purchase corporate reimbursement coverage.
One must keep in mind that corporate reimbursement coverage is not automatic. Reimbursement also hinges on the policy's exclusions and conditions. For example, in the case of Wayne County Neighborhood Legal Services v. National Union Fire Insurance Co., 971 F.2d 1 (CA Mich. 1992), the insurer was not obligated to reimburse the corporation for sums expended in protecting a director because the claim did not arise from any wrongful conduct of any director or officer. This may be another reason that some corporations forgo the purchase of this second coverage.
To summarize
* Legal actions against directors and officers can be categorized into two groups: (1) class actions against the executives on behalf of the corporation, and (2) all other actions against them.
* The most common legal actions involving directors and officers are those within the first category above.
* It is the first coverage agreement of the D&O liability policy that applies when the executives are confronted with a claim or suit by the stockholders on behalf of the corporation. The reason is that the corporation is precluded by law from protecting those who allegedly have caused the corporation financial harm.
* The second coverage, corporate reimbursement, applies to all other actions, subject to the bylaws, corporate resolutions, or other agreement and if otherwise covered by the policy.
It also is important to understand that until recently, there was no coverage for the corporation itself that was sued. Currently, many of the insurers writing D&O liability policies offer what is referred to as "entity" or "corporate entity" coverage. However, this coverage is limited to actions involving alleged violations of securities laws.
A corporation, for example, may be sued directly when it employs, inadvertently or otherwise, the use of some deceptive device (e.g., a misleading brochure, offering, or solicitation) in connection with the purchase and sale of registered securities in violation of Section 10(b) of the Securities and Exchange Commission Act of 1934.
This particular section of the law, 10(b), prohibits the use of such devices by any person. The term "person" is defined elsewhere in that act to include any "company." Section 10(b), therefore, encompasses allegations of violations by the corporate entity separate and distinct from the acts of directors and officers.
Apart from entity coverage, there is no coverage under a D&O liability policy for the corporation itself. An entity found this out when it took this issue to the court in the case of National Bank of Arizona v. St. Paul Fire and Marine Insurance Company, 975 P.2d 711 (Ariz.App.Div.1 1999).
In this case, the complaint was filed against the bank alone alleging that it was negligent since its representatives knew or should have known of misappropriations of certain trust account funds and overdrafts. None of the bank's directors and officers was among the defendants named.
The court, in ruling for the insurer, held that a lawsuit against a corporation only did not state a claim against the directors and officers and, therefore, was outside coverage of the policy. This decision was despite one of the arguments that, while the suit was filed solely against the bank, in reality it constituted a claim against the directors and officers, because they were the instruments through which a bank acted.
The problem with this argument insofar as D&O liability policies are concerned is that, apart from any applicable entity coverage, coverage of a policy clearly applies for the benefit of directors and officers. The first coverage, D&O liability, applies for the protection of the executives when they cannot be protected by the entity; and the second coverage, corporate reimbursement, applies when the corporation can protect the directors and officers and does so at the corporation's expense initially. *
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