Navigating D&O in a Brave New World

Risk Management, March, 2005 by David P. Schack

Public companies need to attract qualified directors and officers to operate successfully and to enhance value for their shareholders. Risk managers and others at public companies responsible for procuring insurance spend enormous amounts of time and substantial corporate assets in procuring directors and officers insurance to protect their board and management. Yet, in the wake of recent corporate scandals and the passage of the Sarbanes-Oxley Act of 2002, an enforcement environment now exists that requires careful coordination among management, risk managers and counsel in order to be certain that directors and officers, as well as the company, are able to be protected by the company's D&O insurance.

The SEC and states' attorney generals have become more proactive in investigating companies and entire industries where abusive practices are suspected. The SEC is also acting much more quickly to launch investigations, require production of documents and information and attempt to pressure companies and their officers and directors to settle at the outset. The SEC is now demanding complete and immediate "cooperation" with its investigations, and a company's simple denial of wrongdoing, assertion of defenses and invocation of privileges may be deemed as "uncooperative." The SEC also considers companies uncooperative if they voluntarily indemnify and defend their directors and officers in the absence of a requirement to do so under the companies' by-laws or state law. The SEC has promised and followed through on issuing stiff fines and sanctions to companies who are deemed uncooperative.

In many instances, a company's D&O policy will pay the costs of defense incurred as a result of an SEC (or attorney general) investigation and may indemnify the company (and its directors and officers) in connection with any subsequent civil actions. Yet, under the substantial pressure applied by the SEC, the company may be forced to make decisions concerning, among other things, the production of information, concessions of wrongdoing and settlement that may cause the D&O insurer to claim that the company has breached its obligations under the policy and forfeited coverage for both the company and its directors and officers. For example, most D&O policies require the insurer's consent before a settlement by the insured. Settling with the SEC without notifying the insurer or obtaining consent may incite an argument by the insurer that no monies are payable under the policy because there has been a breach by the insured. If the company produces documents that could have legitimately been withheld on the basis of privilege, the insurer may contend that the company breached the cooperation clause in the policy. If the company declines to indemnify and defend its directors and officers under pressure from the SEC, the directors and officers may face a refusal by the D&O insurer to make payments under Part A of the policy based on an argument that company was permitted to indemnify them but choose not to do so. Finally, if the company admits certain acts of wrongdoing, the D&O insurer may seek to rescind the policy on the grounds that such wrongdoing was material information that was not provided in the application.

While the D&O insurer may not successfully escape its coverage obligations on any of these grounds, it is important that the company not inadvertently create a basis for the insurer to assert such positions by taking actions in haste under the pressure of an SEC or attorney general investigation. Rather, there should be communication and coordination among the risk manager, management and counsel to take the following steps:

* Notify the D&O insurer immediately upon learning of the investigation.

* Quickly identify the insurer's claims handler, who can promptly respond on the insurer's behalf.

* Form a team including management, the risk manager and counsel to keep the insurer informed.

* Before responding to the demands of the SEC (or attorney general), consider the impact, if any, on insurance coverage.

* Seek the concurrence of the insurer to avoid arguments that cooperation or consent clauses have been breached.

* Before reaching any settlement or conceding any liability, consider whether such action will trigger a rescission claim or other defense by the insurer.

David P. Schack is an attorney with the law firm of Kirkpatrick & Lockhart Nicholson Graham LLP in Los Angeles.