Recently, we have seen a growing number of cases brought against in-house counsel sitting on boards involving insider trading, financial restatements, disputes over proxy disclosures, lawsuits regarding executive compensation, allegations of corrupt foreign business practices, and insolvencies and bankruptcies.
The Canada Business Corporations Act allows corporations to indemnify directors and officers against costs and expenses incurred while carrying out their responsibilities provided they acted honestly and in good faith with a view to the best interests of the corporation. Or, in the case of a criminal or administrative action or proceeding that is enforced by a monetary penalty, the individual had reasonable grounds for believing the individual’s conduct was lawful.
Indemnities are often broader than insurance and corporate bylaws because they tend to have fewer exculpatory clauses and apply more generally. For example, they call for the corporation to cover costs in the early stages of an investigation borne by an individual director or officer (i.e. “advancement”) rather than to wait for a claim to crystalize.
Indemnification agreements are also not subject to unilateral amendment or rescission by the company, unlike corporate bylaws, or insurance policies.
However, corporate indemnities are only as good as a company’s ability to pay, so indemnification may be unavailable if the company is financially troubled. Additionally, there is no mandatory requirement to indemnify directors or officers; some corporations simply choose not to provide them.
Indeed the same can be said of directors’ and officers’ insurance. Warren Buffett, for example, refuses to purchase D&O insurance for the directors and officers of Berkshire Hathaway because he believes directors should face consequences of their mistakes the way other shareholders do.
Nevertheless, D&O insurance is commonplace these days, and without it one would presume it would be extremely difficult to convince individuals to sit on boards given how the world has changed.
In the following sections I discuss the nature of D&O coverage and highlight some concerns for in-house counsel.
D&O insurance negotiable
D&O insurance is not an off-the-shelf product. Policy language ordinarily is negotiable, with certain coverage enhancements having direct correlation to the premium charged by the carrier.
Language matters, and it differs from one policy to the next. Insurers typically have different forms of D&O policies for differing types of companies (for example, public, private, or non-profit organizations). Forms of coverage are customizable to a specific industry (e.g. manufacturing, service sector, etc.).
In-house counsel should familiarize themselves with the various forms available and understand which clauses can and should be negotiated.
A D&O policy typically provides three types of coverage:
• “Side A” coverage for directors and officers for “non-indemnifiable” losses — that is, losses for which the company does not indemnify them, either because applicable law prohibits it or because the company refuses or is financially unable to do so;
• “Side B” coverage that reimburses the company for indemnification paid to directors and officers; and
• “Side C,” or “entity,” coverage that protects the company for securities-related claims brought against it.
In general, no one insurer is willing to underwrite the entire limit purchased by any one corporation. Most North American policies have limits of $10 million or less, with few insurers offering a policy larger than $25 million. Corporations, therefore, purchase several D&O policies to reach the aggregate amount of desired insurance. D&O insurance packages are thus said to come in “towers,” i.e. separate layers of insurance policies stacked to reach the total desired coverage.
The insurer providing the “primary policy” (at the bottom layer of the tower) is the first to respond to a covered loss and most likely to incur a payment obligation. Accordingly, the primary insurer charges a higher premium.
If one or more of the insurers suffers an insolvency, the other insurers will not step in, meaning the corporation will be financially liable for the shortfall.
Excess policies are typically sold on the same contractual terms as the primary policy (except price and limit); however, that is not always the case. Excess policies may, and frequently do, contain different or more restrictive terms than those set out in the primary policy that can impact the scope of coverage.
It should not automatically be assumed that excess policies simply follow all the terms of the underlying insurance. It is important to understand the terms of the excess policies and how those policies work together with the underlying insurance.
Cancellation or rescission
As part of the D&O insurance application process, the insurer will require the prospective insured to provide basic information about the company in a written application form. The application form will generally request current and historical financial information, details of the experience of the directors and officers, the claims history of the corporation, plans for acquisitions or securities issuances, and any prior knowledge of acts or omissions likely to give rise to a claim.
Provision of untrue information during the application process can be financially catastrophic: It will often allow the insurer to rescind the contract (i.e. void ab initio). Completion of the application form should be carefully reviewed to ensure it is both factually and legally correct and true.
Applications are usually completed by one or two people on behalf of all the individual applicants and the company. This may cause “innocent co-insureds,” who were not involved in the application process, to lose their coverage
To address this issue, in-house counsel should consider inserting a “severability” clause for directors and officers. A “severability” clause allows the policy to be rescinded only against those directors or officers involved in the breach of the insurance policy. It allows the insured to claim the applicant’s knowledge of matters relating to the application should not be imputed to other applicants.
Dilution of claims
Unlike most other insurance policies, D&O policies are “self-consuming,” meaning the policy limits include all legal expenses incurred defending a claim. Furthermore, directors share D&O coverage with other parties. This means claims involving other parties can “erode” or dilute the amount of insurance available for directors, creating the risk that D&O insurance may not be there for the very individuals it was designed to protect — the directors and officers.
Thus, if the corporation incurs loss before its directors and officers, which is usually the case, the corporation may be covered first leaving no coverage for the directors, even if there exist other potential claims at the time against the directors and officers.
To address this shortcoming, many policies provide that loss will first be paid on account of the directors (Side A), then on account of Side B reimbursement, and finally on behalf of the entity (Side C).
Directors and officers may also purchase their own Side A policy separately from the company’s D&O policy. Such a policy will ensure there is a separate, dedicated pool of insurance available for the directors. The dedicated policy may be stand-alone, or stacked on top of existing coverage (and triggered if the joint director/company policy is expended leaving the directors with liability). The “stacked” form of the policy is known as a “Side A Excess” policy.
Finally, insurers have recently offered a Side A “difference in conditions” policy. The DIC policy “drops down” to serve as the primary policy when that policy does not cover the directors’ or officers’ loss. DIC insurance may, therefore, provide protection for directors where none existed or the primary policy was rescinded or subject to exclusion.
For example, a primary D&O policy may contain an exclusion for a failure to purchase adequate insurance. If the company suffered a material loss from a flood at a plant that wasn’t adequately insured, the board could be sued for making a poor decision to underinsure. The exclusion could give the insurer a basis for excluding the claim. However, the loss would be most likely covered under the DIC policy.
Bankruptcy and insolvency
When a company is placed in bankruptcy, all the bankrupt’s “property” comes under the administration of the bankruptcy trustee.
Some courts in Canada have ruled the proceeds of a D&O policy, including the advancement of defence costs during bankruptcy, constitute part of the bankrupt estate, meaning that disbursement will be at the trustee’s discretion. The directors are then placed in a problematic circumstance where their defence costs cannot be borne by the insolvent company, and the proceeds of the policy are expended in favour of the creditors.
In response to concerns that a D&O insurance policy that covers the company as well as the directors and officers may be viewed as an asset of the company’s estate should it go into bankruptcy, the D&O policies might specify that if directors and officers and the company have simultaneous claims on the D&O policy that exceed the policy’s limit of liability, the directors and officers are entitled to payment before the company.