Directors and officers liability Insurance- The cover for failed leadreship

DIRECTORS AND OFFICERS LIABILITY INSURANCE THE COVER FOR FAILED LEADRESHIP
Mrs. Indrani Varma
Research Associate, National Insurance Academy, Pune

Directors and officers owe a fiduciary duty to both the company and its shareholders. It is the duty of loyalty and duty of due care.

The duty of loyalty

The duty of loyalty binds the directors and the officers towards an unselfish loyalty. It includes reasonable diligence in gathering and considering material information, compliance of laws of the land, understanding financial metrics and business model The duty of loyalty can be breached by disclosing trade secrets, using insider information, spending corporate money for personal gains.

The duty of due care

The duty of due care requires that in managing the everyday affairs of the company he or she will show the prudence and cautions that an ordinary careful person exercises in similar circumstance. Duty of due care would also ensure the duty of disclosure of material facts to the persons or organizations who have the right to such information e.g regulatory authorities, shareholders. The directors are responsible to divulge details which otherwise would not be available to the interested parties and which are material to the companys health. The duty of care is breached when the director shuts his eyes to corporate misconduct stating that it is not his duty to look. The sentinel asleep at his post he is supposed to guard contributes nothing for which he is paid for!

Bimaquest - Vol. VII Issue I, January 2007 q 69

Directors and officers liability Insurance- The cover for failed leadreship

Few recent eye openers

There have been many such cases of gross breach of trust on the part of the directors-but to name a few: The Motorola Iridium satellite phones were launched so that the subscribers could call from any global location using the services of low earth orbiting satellites. But the terrestrial cellular telephone links developed and spread faster than any anticipation. More so as the product was given a shape there were lot of flaws in design, operation and cost but the executives decided to go ahead with it and finally the company had filed for bankruptcy. (The Economic Times 07.12.2006 When Leaders steer their cos right into an abyss) In the case of Adelphia Communications US cable TV group founder Mr. John Rigas convicted of fraud and conspiracy and also indicted with charges of tax evasion. The Rigas family diverted the money to a network of family owned companies and partnerships for personal use. WorldCom, American long distance Phone Company filed for bankruptcy after it was revealed that it had improperly booked $3.8 billion in expenses. CEO of WorldCom resigned when it was found that $366 million stood as loan in his personal loans from the company. Enron manipulated energy crisis. Enron had created phantom congestion on transmission lines and entered into fake sales to boost process. Enron gets paid for moving energy to relieve congestion without actually moving energy or relieving congestion. After the Bush administration imposed interstate power caps the crisis suddenly eased and prices in the state dived down. Enron filed for bankruptcy five months later.

Shocking Revelations Under Enron

It is shocking to find how these high-flying companies such as Enron, WorldCom have misled the public about their record-breaking growth and earnings in an effort to inflate share price and maintain analysts ratings. Their directors and officers are being investigated for manipulating company financial statements to keep massive losses and debts off the companys books. In the wake of these revelations, investor confidence-and stock prices-plummeted, resulting in billions of dollars in losses.

70 q Bimaquest - Vol. VII Issue I, January 2007

Directors and officers liability Insurance- The cover for failed leadreship

Enron employees who participated in the companys pension benefit and ESOP, filed suits alleging, inter alia, breach of fiduciary duty against various corporate and individual defendants, including Mr. Kenneth Lay, Mr. Jeffrey Skilling, members of the plans administrative committees and the Enron directors who served on the boards compensation committee. Employees further claim that the directors knew about the companys financial problems but failed to disclose this information to plan participants and beneficiaries. Instead, directors are alleged to have affirmatively misled them by consistently making representations at company-wide meetings and in company newsletters that Enron was in strong financial shape and that the companys stock price was likely to increase. Plan participants were thus encouraged to hold and purchase additional Enron stock for their benefit plans at a time when the directors knew that the stock was trading at artificially inflated prices. The claim exposure for this kind of business is shown by the pie charts below

Sources of Exposure

E m p loy ees
28%

C ustom er & C lien ts 15%

44% 5%

C om p etito rs 6%

O th er T h ird Party

2% G o v ern m en t

Sh areh old ers

Bimaquest - Vol. VII Issue I, January 2007 q 71

Directors and officers liability Insurance- The cover for failed leadreship

Sources of Claims - Asia Pacific Zone

E m p loy ees C ustom er & C lien ts 15%

20%

S harehold ers
10%

C om petito rs

15% 40% R egu lato ry

Source: Chubb APZ Directors and Officers Liability Claims

Need for D&O policy

The company, the directors are managing can have contractual obligation that in case of such circumstances when liability suits are filed due to negligence or wrong decisions on the directors, the company can indemnify them. But there are instances in which the companys indemnification will not be sufficient, as in a situation When the company goes bankrupt, is dissolved or just lacks the fund to pay the claims. The company may not indemnify once the person ceases to be a director. Also company may not pay after the potential to liability is proved beyond any doubt! Moreover, a promise to indemnify may not be a promise to defend so the director has to incur heavy expenditure to defend self against such allegation which will be reimbursed only when the judgement on his innocence is pronounced So, the director needs a cover to pay up in advance some costs to arrange attorneys and manage defence in the court of law. The Director and officers are answerable on many accounts-thus arises the need for the policy.

72 q Bimaquest - Vol. VII Issue I, January 2007

Directors and officers liability Insurance- The cover for failed leadreship

Basic cover
The Directors and Officers liability policy stands out to bail out the directors or officers in the times of difficulty when they are sued for damages for taking wrong decisions. But the risks associated with such policies are aplenty. Unfair trading, Illegal price fixing Infringement of copyright or patent law Abuse of authority Mismanagement Controversial financial transactions. Misstatements Breach of confidentiality Libel and slander cases. Who can bring liability suits against directors & Officers. The action is more often brought about by the Employees on questions of wrongful termination, harassment, defamation, and age/gender discrimination, lost wages or tax bills that have been wrongfully deducted from the salary. The Stockholders are also authorized to bring upon the liability suit if their interest is not served, such as On the questions of inadequate and inaccurate disclosure Wrong financial reporting Poor financial performance Negligent supervision of delegated responsibility Bid or threat by another company for takeover Wrong decision regarding merger or acquisition Errors of judgment in allowing a company to carry on trading when the business should have ceased The competitors can sue the director on the ground that the action of the director can bring a distortion in the market. The Environmental Public Activist can also sue the director if the enterprise has not taken care of the ecological disbalance it can cause to the environment The Government agencies, Police and Public prosecutors, Customers and Vendors all can bring upon an action against the directors for flouting rules and norms.

Bimaquest - Vol. VII Issue I, January 2007 q 73

Directors and officers liability Insurance- The cover for failed leadreship

The Directors and Officers Liability Policy thus covers The damages awarded against the directors The defence costs. Insurers also cover criminal allegations but only if the director is found innocent. Features of D & O Covers The cover can be on Annual Basis which means a new proposal is required every year prior to renewal to ensure that insurers underwrite the risk based on the up to date facts and this in turn acts as a check on potential claims. The cover can be on a blanket basis that is for all those who are, were or will be directors and officers of the parent, supervisory and subsidiary board. All Shadow and Constructive directors are included in the blanket cover. The directors can be allowed Outside Board Cover-i.e. cover can be extended to allow service on other boards on a named basis only. But claims made by one director against the other are excluded unless specifically covered that too restricting the actions concerned with wrongful termination between past and present directors. Corporate Reimbursement This type of policy agreement taken by the corporate indemnifies the company when it pays to the directors and officers for claims against them. The cover for the corporate includes all current, main, subsidiary and associated companies and their respective boards and all previously owned, associated and subsidiary companies. Entity Security coverage This provides protection to the company for its own liabilities even if the directors are not sued. Employment Practices Liability This coverage protects the directors against employment related claims by the employees. EPL claims have also witnessed a sharp rise in frequency and severity over the past years

74 q Bimaquest - Vol. VII Issue I, January 2007

Directors and officers liability Insurance- The cover for failed leadreship

Cover for spouse The cover for spouse is extended if the claim against the spouse seeks damages from the marital property. But spouse will enjoy the same coverage as the insured person. The insurer will not be liable for any breach of duty by the spouse of the insured. The policy does not impose the insurer a duty to defend the erring director but provide coverage for defence costs but has the right to associate with the defense policy Salient factors for prudent underwriting The following factors must necessarily be verified while assessing the risk Business plans, background and experiences of the directors and officers concerned. Whether any merger or acquisition is on the card which can alter the risk percepted totally. Internal controls and the management policies. Country of origin and practice because the area of jurisdiction matters a lot so far as awards are concerned. Limits of indemnity and excesses asked for. Claim history, declinature or cancellations of cover. Whether the company has a contractual duty to reimburse the director in case of such lawsuits. To avoid situation where relevant information is not passed between the directors /officers the insurer has to ensure that each director protects his/her own rights and interests since each directors circumstances and right to indemnity are considered separately and not prejudiced by the knowledge or claim of any person. Different bases of underwriting are Occurrence basis-policy covers all claims arising out of the policy period even if its brought about at a much later period. Claims made basis- where claims are reported and made during the policy year. To avoid having to pay up for claims made for incidents well in the past, claims made policies have a retroactive date, which can be adjusted.

Bimaquest - Vol. VII Issue I, January 2007 q 75

Directors and officers liability Insurance- The cover for failed leadreship

The coverage under the D&O policy is usually done on Claims-Made basis. It pays for claims reported and made during the policy period the occurrence of which is not prior to Retroactive Date* as selected by the insured under the policy. So the underwriter is allowed to charge todays premium for todays risks. Exclusions Dishonesty Exclusion -This clause bars coverage for claims where the insureds dishonesty or willful violation of the law or statutes is proved beyond doubt. This calls for the Severability Clause. Severability clause that states that the acts or knowledge of one insured will not be imputed to any other insured for the purpose of applying the exclusion. Insured Vs Insured Infighting Exclusion- This refers to the claims made by one insured on the other being directly or indirectly affiliated with the insured. This exclusion prevents a company from suing or orchestrating a suit against its directors and officers in order to collect insurance claims under the D & O policy Prior Acts Exclusion-This clause excludes all claims arising out of wrongful acts committed prior to specified date-the date might coincide with the expiry date of the previous policy or the date of mergers/acquisitions Prior and Pending Litigation Exclusion Clause excludes claims pending prior to the inception of the policy and subsequent claims based on the same facts or circumstances. Exclusion for Punitive Damages puts forth that insurer is not responsible for any punitive damages imposed on the insured by the law of the land. The penalties are imposed, as a deterrent so should not be insured.

To sum up, the D & O policy should be administered with great prudence so that enough coverage lets the board sleep comfortably and should not be so much that the plaintiffs attorney sleeps comfortably. *wThe retroactive date can be the inception of the first policy issued by the insurer wThe first period of similar coverage secured by the insured. wThis ensures that insurers pick up exposures for wrongful acts on a going forward basis from a designated date.

76 q Bimaquest - Vol. VII Issue I, January 2007

Directors and officers liability Insurance- The cover for failed leadreship

References 1. Campbell C.T., Liability of Corporate Directors, LLP, London, 1993. 2. Chandnani L.R., Directors & Officers liability Insurance, Chartered Secretary, Dec., 1998, p-1237-1243.

qqq

Bimaquest - Vol. VII Issue I, January 2007 q 77