Clients sometimes ask why they should purchase Side “A” Directors and Officers (D&O) liability coverage to protect against lawsuits when they already provide broad indemnification for damages and defense through their corporate bylaws (or an equivalent).
The simplest answer is that D&O liability insurance is a good way to attract and retain qualified board members. Their personal assets are at risk every day in making decisions to further the organization’s growth and success. Outside directors, in particular, tend to feel more secure when there is an insurance policy in place to back up the organization’s promise to indemnify. The Side “A” portion of the coverage provides protection for directors, officers or members of a board of managers (and other individuals in equivalent positions) in situations when they are not indemnified by the organization.
But if the organization always intends to indemnify its directors and officers, which is why the indemnification provisions exist in the bylaws, when would Side “A” insurance coverage ever come into play?
Indemnification of an organization’s directors and officers is generally permissible in every state for most causes of action; however, it is generally only mandatory in a limited number of circumstances. In most cases, the company has the option to indemnify or not to indemnify. Possibly even more important is whether the organization is permitted to (or will) advance money to the directors and officers to properly defend themselves against allegations, regardless of their merit. The cost to defend these claims is often more than the actual damages.
Prudence would suggest that an organization provide for broad indemnification provisions in its bylaws or equivalent, so as to attract and retain qualified board members. However, consider the following:
- Organizations generally may not indemnify their directors and officers when faced with a securityholder derivative demand. This occurs when company securityholders or shareholders sue the directors and officers on the organization’s behalf. It is intended that the proceeds of the lawsuit be paid by the directors and officers directly to the organization, making the organization whole for the directors’ and officers’ liability. The securityholders are indirect beneficiaries. In this instance, most state statutes will not allow the organization to turn around and indemnify its directors and officers for the money they were responsible to pay back into the company. This would be circular, and ultimately the company would not be made whole.
- Regardless of what the corporate bylaws state, the insurance policy can be written to provide defense costs to an insured director or officer if the organization refuses to cover these costs. The insurance carrier will seek reimbursement from the organization, if warranted.
- Organizations cannot indemnify their directors and officers if there are no corporate assets (i.e., the organization is in bankruptcy proceedings).
- Present board members cannot assume current bylaws will remain in place after their tenure. It is not unheard of for broad indemnification provisions to be removed from the current bylaws (those in place at the time of the claim) with respect to certain former directors who might have fallen out of favor.
This is exactly what happened in Schoon v. Troy (948 A. 2d 1157 Del.Ch. 2008). In this case, the court decided there is nothing barring a company from revising its bylaws in future years, potentially placing former directors and officers at risk. Although the bylaws that were in place during their tenure on the board will not necessarily be in effect at the time of a future lawsuit, the insurance policy that is in place generally will be the policy that provides coverage during a lawsuit.
Excess/DIC Side ‘A’ Coverage
In addition to buying Side “A” coverage, organizations should consider purchasing Excess/DIC Side “A” coverage through a separate insurance policy to provide extra protection for the directors and officers only. This will provide additional limits in excess of the underlying D&O liability Side “A” coverage and will provide additional benefits if the organization is financially or legally unable to, or otherwise fails or refuses to indemnify them. However, the insurance carrier will have the right to subrogate against the organization if it has wrongfully failed or refused to indemnify.
Additionally, bankruptcy courts can seize the D&O liability policy as an asset of the bankruptcy estate. This leaves the directors, officers or members without coverage at a time when they are very susceptible to claims. The Excess/DIC Side “A” policy provides separate limits that apply only to the directors and officers, not the organization. Therefore, it cannot be seized by the bankruptcy court as an asset of the estate and will remain available for the directors and officers.
Another benefit is that these policies are written with very few exclusions and provide coverage on a primary basis, where coverage is broader than the underlying primary D&O liability policy. For instance, the policy does not typically have an Insured v. Insured exclusion (or this exclusion might be limited to an Entity v. Insured exclusion). If there is concern about one director being sued by fellow board members with regard to the company’s management, certain Excess/DIC Side “A” policies can be purchased to provide protection for that director in the event the organization does not indemnify him. These lawsuits usually are excluded in a primary D&O liability policy.
There are several other key advantages to the purchase of an Excess/DIC Side “A” policy:
- DIC coverage for situations where the underlying D&O liability carrier wrongfully refuses to indemnify the directors, officers or members;
- drop-down coverage for situations where the underlying D&O liability carrier can rescind the underlying policy; and
- drop-down coverage in the event the underlying carrier becomes insolvent.
According to the most recent Towers Watson Directors and Officers Liability Survey, Side “A” D&O liability coverage is the most widely purchased component of a D&O liability policy. Out of 401 survey respondents (public, private and nonprofit), 86 percent purchased Side “A” coverage, either on its own or in addition to either Side “B” (coverage for the organization’s indemnification of its directors, officers or members) or Side “B” and Side “C” (coverage for suits brought directly against the organization). Additionally, 57 percent purchased Excess Side “A” or Side “A” DIC policies. The vast majority of organizations cited the breadth of the coverage under the Excess/DIC Side “A” policies as their main reason for making that purchase. These percentages increase each year.
A Prudent Purchase
There are several reasons why an organization’s promise to indemnify might fail its directors and officers (whose personal assets are at risk every day) in their time of need. Purchasing D&O liability insurance, particularly the Side “A” coverage component, provides extra assurance to directors and officers that the organization’s promise to indemnify will be fulfilled.