Message to Board: Find Out What’s in Your D&O Policy Before It’s Too Late

Not knowing the difference between a “severability clause” and a “final adjudication exclusion” could have major consequences for audit committee members and their fellow directors.

Board members who are ignorant of their directors and officers liability insurance could end up exposed both legally and financially. What’s more, audit committee members should review those policies–and know the details–before problems occur, not after.

Thanks to the onslaught of lawsuits related to corporate fraud and financial restatements, companies face higher premiums and need more coverage. In addition, employees engaged in questionable activities can siphon off the directors’ insurance fund to pay legal costs.

“D&O policies are getting harder to come by,” said Melanie Damian, a principal in Damian & Valori law firm in Miami who works with audit committees. “It’s getting more expensive, and what [policies] are covering is getting smaller and smaller. It’s because of these corporate wrongdoings.”

Those wrongdoings have led to numerous shareholder class-action lawsuits, any one of which could exhaust a company’s D&O insurance coverage. They include derivative suits filed by shareholders on behalf of the company against the board, Securities and Exchange Commission investigations, and the so-called “tag along” 401(k) Employee Retirement Income Security Act lawsuits.

A study by Milwaukee-based law firm Foley & Lardner shows that 2003 D&O insurance premiums for companies with annual revenue of $1 billion and over was $2.2 million in 2003. For companies with revenues less than $1 billion, average D&O costs were $850,000.

A company facing fraud charges along with a possible restatement of earnings can find itself short of coverage. Preparing for such a doomsday scenario is one factor that drives the amount of coverage a company seeks. Another is whether or not the company will (or can) indemnify a director in such a situation. Many of these decisions begin with the size of the company.

“The market capitalization is the starting point,” said Gordon Davenport III, a partner with Foley & Lardner. “The biggest dollar exposure is market capitalization.”

From Jan. 1, 1996, to Sept. 27, 2004, there had been 2,087 federal class-action lawsuits filed against public companies, according to Greg J. Flood, chief operating officer of National Union Fire Insurance Co. of Pittsburgh, a subsidiary of AIG. Flood, who spoke at a recent Directorship Search Group corporate governance forum in New York City, added that of those cases, only six have gone to trial. As of Sept. 27, more than 1,000 had not been resolved. Those include litigation related to the mutual fund market timing scandals and investment banking research analyst conflicts of interest.

Just what should board members do when it comes to their D&O policy?

“I caution board members to get a little more involved,” said John Keogh, president and CEO of National Union. “You would think the head of the audit committee would want to meet with the insurance carrier.”

Keogh, who spoke at the recent Practicing Law Institute corporate governance conference in New York, finds it hard to believe that directors are ignorant when it comes to their liability coverage, especially since they’re on the firing line when it comes to shareholder litigation.

“We never meet them,” Keogh said of board members. “We meet with someone from middle management in the company who deals with risk and insurance.”

One audit committee chairman said his committee is briefed on the company’s D&O policy by outside counsel once a year.

“When we have that legal briefing, we are asking, ‘what is our specific coverage?’ and ‘how does it relate to the audit committee charter as well as the corporate charter [bylaws]?'” said C. Warren Neel, audit committee chairman for Saks Inc.

Two issues that concern Neel, who is also executive director of the University of Tennessee’s Corporate Governance Center, are possible changes in the business judgment rule for board members and the effects the Sarbanes-Oxley Act might have on liability. Scott Reed, a partner with KPMG’s Audit Committee Institute, said an informed audit committee member is a prepared one.

“Some of the best advice I have heard about D&O coverage is to make sure you know the type, amount, and exclusions included in your coverage and have someone on the outside who specializes in D&O help determine what’s in and what’s out,” Reed said. “A number of audit committees have been seeking such advice from counsel with extensive experience in this area.”

Damian and Davenport, who both specialize in D&O policies, believe the whole board should be involved in choosing the insurance carrier and types of coverage.

“The board is making that call,” Davenport said. “Each of those directors will have a keen interest in the coverage and won’t defer to just the audit committee.”

Damian doesn’t totally rule out committee responsibility on the matter. “The entire board should know what their D&O policy is,” she said. “Is it appropriate for that responsibility to be given to the audit committee? Probably. But most boards today also have corporate governance committees that might be used.”

Under many policies, claims based on fraud or dishonesty can be excluded from coverage. Perhaps the most prevalent type of exclusion calls for a lack of coverage if there is a “final adjudication,” or court decision, that the alleged fraud did take place.

More than 90 percent of such lawsuits are settled out of court. However, since the language exists in the policy, many courts interpret it to mean that defendants in such lawsuits can put in claims for coverage up until there is a final adjudication.

The bottom line on the effectiveness of coverage is whether or not defense costs will be paid. “Sometimes plaintiffs will allege torts [a wrongful act that is not a crime or breach of contract], which could put you outside the coverage,” Damian said. “Ultimately, you want defense costs to be covered by insurance.”

There are other clauses in D&O policies that board and audit committee members need to scrutinize as well, including severability, in which innocent directors and officers are better protected from losing coverage if an insurer receives inaccurate information about a company’s financial condition that could lead to a restatement or is indicative of fraud.

“Severability is a real protection,” Davenport said. Directors and officers have to make sure the severability clause specifies the policy cannot be rescinded for innocent directors. “Some policies are going to cover [defense costs for] SEC investigations,” Davenport said. “Sometimes directors can be squeezed out of coverage during a bankruptcy.”

Gary Clark is managing editor of Audit Committee Insights. Article reprinted with permission from KPMG’s Insurance Insider

Topics Lawsuits Fraud