Do you need D&O Insurance?

By Jerry Becerra, CPCU

Businesspeople and investors often hear about the need to purchase coverage for Directors and Officers Liability, but they may not have a good understanding who is covered, what their exposures are and what coverage is provided under these policies.

Traditionally, public companies and financial institutions have suffered from a high volume of Directors and Officers lawsuits.  Smaller corporations with few or no shareholders once perceived they had little litigation exposure and saw no reason to carry liability coverage for their directors and officers.   However, the number of lawsuits being filed against privately owned companies, partnerships, closely held corporations and trusts has been increasing since the 1980’s.  Today, directors and officers of closely held corporations realize that there are many personal and corporate exposures.  They need to protect themselves against a group of litigants known as “stakeholders”.  Stakeholders are broadly defined as anyone who has an interest in a corporation and could be affected by the decisions of the directors and officers.

Who are “Stakeholders”?

• Bondholders
• Creditors
• Community Groups
• Customers
• Employees
• Lenders
• Regulatory Agencies
• Vendors

In many ways, directors and officers of closely-held corporations are just as vulnerable to D & O suits as those of large, publicly-held corporations.  Board members of small, under-capitalized firms may even find their personal assets to be at stake if the company declares bankruptcy and has insufficient assets to compensate a D & O claim.

Private Company Risk: Non-Security Holder Litigation

Private companies face significant exposure to litigation brought by parties other than security holders. In fact, plaintiffs other than security holders brought the bulk of claims filed in 1999. Any company that employs one or more individuals or deals with customers, clients, competitors, the government, or other third parties has a D&O exposure.

The directors and officers of corporations can be either the top executive officers of the corporation (inside directors) or people not otherwise affiliated with the corporation, but who have qualifications, expertise, public stature, etc., and sit on the board of directors (outside directors).  These people are answerable to their shareholders, to the organization itself and to government statues and SEC regulations.  They owe these parties the duties of diligence, loyalty and obedience.

Going Public:

Closely-held companies often seek to raise capital by filing a registration statement for an Initial Public Offering.  Companies proceeding with an IPO often have a strong need for capital and usually rely on projected growth of the corporation to justify the filing.  If this growth does not materialize, a plaintiff can present a case of all of the factors which “should” have been scrutinized more carefully before the IPO was issued.  This can impose liability on every person who was a director at the time the IPO was issued.  These complex lawsuits can generate sizeable defense costs.

Private companies planning an IPO or a private offering of debt or equity in the next 36 months should consider purchasing D&O insurance. Qualified and experienced board members usually insist on the corporation having D & O coverage in place before exposing themselves under the security laws.  Also, if the D & O coverage is already in place, it will be easier to add coverage for the IPO exposure.

Public Company Risk: Security Holder Litigation

As a public company, your greatest financial exposure is probably from security holder litigation. In order to reduce the volume and expense of claims brought by security holders against directors and officers, Congress passed the Private Securities Litigation Reform Act of 1995. However, a 1999 industry analysis discovered the following:

• The rate of D&O claims have increased.
• High-tech companies are increasingly targeted.
• NASDAQ high-tech companies are far more likely to be sued than companies listed on the New York Stock Exchange or AMEX.
• The average market capitalization of defendant companies has decreased from $2.083 billion to $529.3 million.
• Claims are increasingly complex and are taking more time to resolve.
• A vast majority of the federal securities class-action claims filed are based upon two allegations of wrongdoing: fraudulent or misleading financial statements, and/or claims of illegal insider trading.

Consequently, it is extremely important for publicly held companies to carry this insurance, particularly those that are active in mergers and acquisitions or whose stock value or industry are subject to extreme volatility.

Directors and Officers Liability coverage (D & O) protects the directors and officers of corporations from legal judgements and other expenses that result from allegations of wrongful acts committed in their individual capacity as directors and officers.  The coverage protects both the personal assets of directors and officers and the corporate assets through reimbursement of the corporation for money it must spend to indemnify directors and officers.

The trend for Directors and Officers Liability claims is upward. The average claim is reserved at $10,000,000 for damages and expenses.  Claims fall into several areas:

• Shareholder liability suits account for more than 50% of D & O claims.  These are suits alleging mismanagement, false registration statements, complaints that expected growth did not materialize, unauthorized investments, embezzlement and stock deflation.  The average award for these types of claims was $7.16 million in 1998 and rose to $9.6 million by the year 2000.  These settlements are still rising.
• Employment Related Practices Claims account for 23.8% of claims.  These include employees alleging wrongful termination, failure to honor employment contracts, discrimination and breach of contract.  Awards for these types of claims average more than $300,000.
• Other sources of claims include lenders, creditors, bondholders and vendors.  Regulatory agencies have sued directors and officers alleging conflict of interest and payment of unlawful dividends.  Directors and Officers Liability coverage has been called to defend allegations of restraint of trade, price fixing, unfair competition and misrepresentation in acquisition agreements, among other things.

Public companies have a significant exposure to shareholder claims.  Generally, corporate bylaws and government statutes require reimbursement for directors and officers, creating a need for coverage.  Private companies also often purchase this coverage especially to cover the rising cost of employment practices liability claims and other exposures, although separate coverage for employment practices liability is available.

The Impact on Management: It is difficult to attract topflight talent when your corporate officers and board of directors are vulnerable to lawsuits that may arise from the very qualities you hire them for: initiative, vision, and pursuing strategic business strategies.  Companies and individual directors and officers need to realize the importance of this coverage and how it applies to claims.  Having adequate coverage not only protects the entity and individual directors and officers, it also helps attract qualified board members.  78% of board members in private non-fortune 1000 companies believe that inadequate D & O insurance discourages potential board members from coming aboard.

The Directors and Officers Liability coverage itself is not a standard contract. Especially in this tumultuous business climate, directors and officers should devote an adequate amount of time to this process to protect themselves and their companies from losses.  Boards should work with a qualified broker who can assist them in marketing their coverage, presenting and explaining coverage differences and choosing the best available product.

Disclaimer:  The foregoing is intended only as a perspective that may be useful in the initial evaluation of various business options. This information is not offered, or intended as legal advice. It is, in no way, a replacement for consultation with experienced insurance broker and/or legal counsel.

About the author:  Jerry Becerra, CPCU Barbary Insurance Brokerage is a licensed insurance broker in the state of California since 1983.  He consults with Doherty & Associates, as well as, a wide range of clientele including non-profit organizations and publicly traded companies to assist them with all lines of property, liability, workers’ compensation and bonding coverage.  In addition to his insurance work, he has served on the board of two non-profit organizations and consulted with many businesses about their risk exposures.

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