The stock market bubble and crash from 1998 to 2001 and the ongoing stream of corporate scandals like Enron, WorldCom and Tyco have put corporate governance under the microscope. The actions of business leaders are now at the lowest levels of trust and highest levels of scrutiny in recent memory.

Public companies and their officers and directors are well aware that in this new environment, there is an increased risk of being named as a defendant in a securities or shareholder derivative lawsuit. Most directors and officers take comfort, however, in the knowledge that they are protected against this greater risk by their company's director and officer ("D&O") insurance policy.

However, along with the surge in securities lawsuits and the increased risk of being sued has come a significant change in the D&O insurance market. This change is reflected in a recent decision of the United States District Court for the Western District of Washington in a case entitled Cutter & Buck, Inc. v. Genesis Ins. Co., Case No. C02-2569P (Feb. 11, 2004) ("Cutter & Buck").

In Cutter & Buck, the corporation and certain of its directors and officers were named in several shareholder class action lawsuits in connection with financial statements that the company restated. After the lawsuits were filed, the insurance carrier notified the company that it was rescinding the company's D&O insurance policy. The court held that the rescission was proper. Moreover, it ruled that the rescission applied to all insureds under the policy, regardless of any involvement in, or even any knowledge of, the misrepresentations.

The Cutter & Buck case reflects an insurance industry trend towards aggressively restricting D&O insurance coverage. Below, we discuss some important aspects of D&O insurance and how companies and their directors and officers can best attempt to protect themselves in the new environment for shareholder litigation and D&O insurance.

Side A and Side B Coverage

Traditional D&O insurance consists of two types of coverage, "Side A" coverage and "Side B" coverage. Side A coverage protects an insured director or officer against losses that are not indemnified by the company. Side B coverage reimburses the company for amounts it pays to indemnify an officer or director. Taken together, Side A and Side B coverage are designed to fully insure (up to the policy limits) claims against individual officers or directors. Traditional D&O insurance does not, however, provide direct coverage for securities claims against the company itself.

Securities lawsuits against individual directors or officers commonly name the company as a co-defendant. Where the individuals are insured but the company is not, disputes can arise between the carrier and the insureds as to what portion of the loss (which includes the costs of defense) is "allocable" to the individual defendants (and thus insured) and what portion is allocable to the company (and thus uninsured). These disputes are generally called "allocation disputes."

"Entity" Coverage

In the early 1990s, D&O insurance lines were among the most profitable for a number of carriers. This drew other insurance companies into the business. The increased competition drove down premiums and forced carriers to develop new products, including so-called "entity" or "Side C" coverage.

Entity coverage provides insurance for claims against the company itself. This not only protects the company, it also eliminates the problem of allocation disputes. When all three types of D&O insurance coverage are purchased—Side A, Side B, and Side C—all defendants are insured, and there is no issue of allocating losses between insured and uninsured defendants.

The Change in the D&O Insurance Industry

Following passage of the Private Securities Litigation Reform Act of 1995 ("Reform Act"), D&O insurance carriers began lowering premiums and broadening coverage. Confident that the Reform Act would reduce securities lawsuits, most carriers predicted that D&O insurance would become more profitable. In fact, just the opposite has occurred.

In 1996, 127 federal securities class actions were filed. (Following the Reform Act, some plaintiffs' lawyers filed class action securities lawsuits in state court. This led Congress to pass the Securities Litigation Uniform Standards Act of 1998, which generally requires such cases to be filed in federal court under federal law.) In 2003, reflecting the upward historical trend, 224 federal securities class actions were filed. Similarly, in 1996 the average settlement value (in constant dollars) of all securities cases was approximately $10 million, whereas in 2003 it was $19.8 million. See generally E. Buckberg et al., Recent Trends in Securities Class Action Litigation: 2003 Early Update (NERA Feb. 2004). The combination of lower premiums and expanded coverage in the mid-1990s followed by the surge in securities case filings and average losses per case after the turn of the century have weakened the D&O insurance industry.

Some Carriers Have Reacted by Seeking to Rescind D&O Insurance Coverage When a Securities Lawsuit Is Filed

In contrast to the mid-1990s, today premiums and deductibles are going up, limits and coverage are coming down, and some insurance companies are retreating from the D&O insurance market altogether. Moreover, carriers are increasingly taking aggressive positions on coverage. An example of this more aggressive approach is cases like Cutter & Buck, where carriers seek to rescind policies when their insureds are sued.

A typical case arises where a company restates its financial statements, the company's share price drops, and shareholders sue alleging that the company-and its directors and officers-knew all along that the earlier financial statements were false. In many recent cases of this type, carriers have asserted that by restating its financial statements, the company has admitted the earlier statements were false, and because the earlier financials were part of the insurance application, the application contained a material misrepresentation, and therefore the carrier is entitled to rescind the policy. (Under Washington law, an insurer must show that the misrepresentation was made with the intent to deceive. RCW 48.18.090.)

Rescission Cases Are on the Rise

Carriers have taken this position in many of the highest profile securities cases today, including WorldCom, Tyco, Enron, Adelphia, and HealthSouth. And, while there are no firm statistics as to how often carriers have sought to rescind D&O insurance policies on this basis, it is an increasingly litigated issue.

Moreover, the trend is likely to continue. Over the past six years, the number of financial restatements each year has more than tripled, from 116 in 1997 to 354 for the twelve months ended June 2003. With well over half of the securities cases today involving allegations of accounting irregularities, and with outcomes such as Cutter & Buck, directors and officers have good reason to be concerned that the coverage they thought they had might not be there when they need it.

What Companies and Their Directors and Officers Can Do to Protect Themselves

Fortunately, there are several things that can be done to guard against such dangers. One of the most important is to check the policy's severability clause. Where one of several insureds is accused of wrongdoing, the wrongful conduct of the one insured may sometimes be imputed to some of the other insureds. In other words, the wrongdoing of one person can eliminate coverage for the company and some or all of its officers and directors, regardless of their innocence.

A severability clause makes it possible to "sever" the wrongful conduct between and among the insureds, thus ensuring that the wrongful conduct provides a basis to rescind the policy only with respect to the wrongdoer, not the other insureds. The extent of imputation and the protection the severability clause affords differ from policy to policy. In Cutter & Buck, for example, the D&O insurance policy contained a severability clause, but due to its wording and the facts of the case, the court ruled that it did not prevent the carrier from rescinding the policy with respect to all of the insureds. It is therefore important to work with your D&O insurance broker and legal counsel to evaluate the severability provisions in the policy forms your company is considering.

Another possibility to consider is a new D&O insurance product―individual policies, which are sometimes referred to as "non-rescindable" policies. These policies can be issued directly to the individual director or officer, and coverage is triggered if the company does not indemnify the individual for a loss, or if the company's D&O policy is nonexistent, insufficient, or has been rescinded. Some of these policies may be designed to insure the individual with respect to any, all, or some combination of the boards on which he or she sits, and most importantly, as mentioned, they are non-rescindable.

Practical Tips: Other Issues to Consider When Purchasing or Renewing Coverage Severability clauses and individual D&O insurance policies are just a couple of the items that corporations and their directors and officers should be aware of when reexamining their D&O insurance coverage with the assistance of a qualified broker and legal counsel. Other issues include: Regulatory Proceedings. Although the legal costs of responding to investigations or enforcement actions by state or federal agencies can sometimes run into the millions, many D&O insurance policies exclude or do not cover such proceedings. See, e.g.,  Cal. Union Ins. Co. v. Am. Diversified Sav. Bank, 914 F.2d 1271, 1277 (9th Cir. 1990) (agency investigation, request to comply with regulations, or assertion that wrongful act has occurred not within D&O insurance coverage where no monetary demand or direct threat of liability has been made). The existence and extent of coverage of regulatory proceedings may vary among policy forms. In this era of increased regulatory activity, you should know what, if any, coverage you have available in the event of an investigation or enforcement proceeding.   Bankruptcy. Bankruptcy courts distinguish between the D&O insurance policy itself and any proceeds from that policy. The policy itself is considered an asset of the debtor corporation's bankruptcy estate. If the D&O insurance policy provides only Side A coverage, the proceeds will generally be considered an asset of the insured directors and officers, not the debtor corporation. However, if the policy includes Side B or Side C coverage, as is typically the case, the proceeds may be deemed an asset of the bankruptcy estate on the ground that any payments to directors or officers under Side A will effectively reduce the total proceeds available to the debtor corporation under Side B or Side C. Payments under the D&O insurance policy may thus be "frozen" during the pendency of the bankruptcy proceedings, and directors and officers may find themselves unable to draw upon the policy to defend themselves or satisfy any judgment or settlement in pending securities lawsuits. The Enron case is a recent high-profile case where this issue has arisen.   Advancement. Make sure the policy provides for advancement of defense costs as they are incurred. Also, when considering the level of coverage needed, keep in mind that defense costs almost always apply against the coverage limits, thus reducing the amount available to cover any settlement or judgment.   Insured vs. Insured Exclusions. Most D&O insurance policies exclude coverage for claims brought by or on behalf of an insured. Plaintiffs' lawyers are increasingly using current or former officers or directors as confidential witnesses to meet the heightened pleading requirements of the Reform Act. Some carriers argue that the use of such witnesses can trigger a policy's insured vs. insured exclusion.   Scope of "Insured. "Make sure that the D&O insurance policy covers the people it should cover. For example, a company's general counsel may be more at risk for claims than ever before as a result of the new environment created by the Sarbanes-Oxley Act of 2002. Other persons who are not technically officers or directors are also potential subjects of claims and should be considered individually and as a group when obtaining D&O insurance coverage.   Coverage "Gaps. "Layers of insurance can create unexpected problems if one of the carriers becomes insolvent during the policy period. Your D&O insurance policy should address what happens in the event of such a "gap" in coverage.   Defense Counsel. Most D&O insurance policies allow the defendants to select their own counsel, with the approval of the carrier. Some require defendants to choose from a panel of approved lawyers. Discuss with your legal counsel the reasonableness of these limitations and whether or not you are entitled to choose defense counsel where you are headquartered rather than where the litigation is filed.

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