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Directors and Officers Liability Insurance – the Need of the Hour by Rupanjana De 4

Directors and Officers Liability Insurance – the Need of the Hour by Rupanjana De 4

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Published by: routraykhushboo on May 04, 2011
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Directors’ and Officers’ Liability Insurance – the Needof the Hour
Rupanjana De, ACS, Director, Nandi Resources Generation Technology Pvt. Ltd.,Kolkata.
Directors’ and officers’ liability insurance is relatively a new concept in India thoughit has its existence for long in the western countries. While emphasizing theimportance of such insurances the article goes in to further explain its scope, coverage,formalities, etc.
e-mail :rupanjana_de@yahoo.com
Risk management is an important component of corporategovernance practices and efficient management of the risk that key persons in a company are exposed to is therefore vitalfor every company. Insurance is the best tool for risk management. The recent years have seen a lot of developmentsin the insurance market in terms of products and services.Directors’ and Officers’ (D&O) liability insurance is one suchproduct which has now become an important part of management liability insurance. Globally, in most of thecountries in Europe and America, majority of the largecorporations maintain D&O liability insurance today. Ingeneral, the D&O liability insurance claims are more fromlarger companies, whether listed or unlisted, but for that matterit is erroneous to conclude that private or smaller companiesand their directors are immune to such an insurance product.Even in the latter type of companies litigation possibilities arenot completely ruled out and there are numerous instances of litigation between members of the family or once-upon-a-time friends who mutually agreed to start a company. Theseapart, companies, big or small, listed or not always stand opento the risk of litigations from creditors, customers, employees,banks, vendors, competitors and other public institutions.
Directors’ and Officers’ (D&O) liability insurance might be arelatively new concept in the Indian market but the westerncountries have seen its presence across the last several decades.Some insurance companies have even come up with theIndependent Director Liability Insurance (IDLI) policy whichis a welcome development. It goes a step further and protectsthe Independent directors’ personal assets as conventional D&Opolicy might not suffice for their total protection. It is slowlygaining popularity in the US. The importance of such a policyto protect the independent directors of companies was feltconsequent upon the major recent corporate scandals of Enron,WorldCom, HealthSouth etc. all of which came to light withthe dawn of the new millennium. Another new product in thismarket is the Employment Practices Liability Insurance (EPLI)which provides coverage in respect of certain claims relatingto employment made by employees.
Directors’ and Officers’ Liability Insurance, often referred toas just D&O Insurance, is one type of liability insurance whosebeneficiaries are the directors and key officers of a companyor the company itself. The payment of this liability insuranceis made in order to cover various costs of a lawsuit likedamages, defense costs, lawyers’ fees, consequent losses etc.resulting from the wrongful acts and deeds of directors andofficers of a company in their capacity as such. Such wrongfulacts might be omissions, errors, misstatements, misleadingstatements, neglect or breach of duty by such directors orofficers. Suits can be brought for various reasons by variousstakeholders like the shareholders for insider trading, orshareholder derivative suits, by the creditors for
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misrepresentation of financial health of the company, bycompetitors for unfair trade practices, by consumers for defector deficiency of product and services and by publicorganizations for various issues like pollution and other healthhazards. Lawsuits covered may range from both civil andcriminal suits to regulatory investigations and trials.The Directors of a company are bound by their fiduciary dutytowards the company and the shareholders. There is a principal-agent relation between the shareholders and the directors, and thedirectors, as agents are bound to act in the best interest of theshareholders. In this age of corporate governance, the scope of directors’ duties have been enhanced so much so that in mostcases the term ‘shareholder’ is replaced by the term ‘stakeholders’and it is believed that the directors are bound by their duty of care not only to shareholders but also to creditors, employees,suppliers, customers and so on. They can therefore be liable forbreach of contract or breach of duty, non-disclosure of interest,negligence, mismanagement of assets etc. to all stakeholders. Thissubstantially enhances their risk. In countries like the United States,corporate law makes it mandatory for companies to indemnifytheir directors and key officers against risk of personal liabilityarising by virtue of their position in the company. The idea behindis to encourage qualified and capable people to take up theseimportant positions in the companies and for the companies to beable to retain them. However, there are numerous situations inwhich the companies are not allowed to indemnify its directorsor officers in which cases the D&O insurance comes in handy.Following is a brief note on the possible ways to relievedirectors from liability:
 Ratification by shareholders
: Certain breach of duty bydirectors can be ratified by an honest disclosure of thesame in a shareholders meeting and the latter decidingto ratify the directors by passing the required resolution.
 Indemnification by company
: While the company cannotenter into contract with directors to exempt them fromany liability arising out of negligence, fraud etc. towardscompany, the company can definitely indemnify directorsagainst liability arising out of their dealings on behalf of the company with third parties.
 Business Judgement Rule
: Next comes the business judgment rule which the courts might apply when a suitis brought against the directors and none of the above isapplicable. This is the essence of section 633 of theCompanies Act, 1956.
 D&O liability insurance
: When all the above fails thencomes the D&O insurance cover for protecting directors.
It is conventionally the company that purchases the D&Oinsurance and pays the insurance premiums although the solebeneficiary may be the directors and officers in most cases.However, sometimes in order to avoid problems like that of income tax etc. the premium is split up and a portion is paidby the company while the remaining part is borne by thedirectors and officers themselves.
Traditionally D&O policies had three insuring clauses viz., Side-A or Insuring Clause 1 provided insurance coverage to individualdirectors and key officers of a company when because of thelegal provisions or financial constraints of the company, theindemnity against any losses are not or cannot be provided bythe company, examples are in case of the company being bankrupt(financially incapable) or for derivative suits brought againstsuch insiders by shareholders on behalf of the company (legallyincapable); Side-B or Insuring Clause 2 provided insurancecoverage not to individuals but to companies when the latterindemnified its directors and key officers and thereby incurredcost or losses and in this way it protected the company’s balancesheet; and Side-C or Insuring Clause 3 which provided coverageto the companies for losses incurred by it, e.g. when any claimsare made against the company itself.
For many decades, there existed only side-A and side-B policieswith hardly a thin line of differentiation with the result thatmuch depended upon interpretation of clauses when actual claimswere to be made. To resolve this ambiguity the ‘presumptiveindemnification’ clauses were introduced much later in the mid1980s and then permanently built into the policies thereafter. Itstarted with a Philadelphia based NYSE listed company thathad taken a Side-B policy of $5 million and that was themaximum they could take at that point of time. A class actionsuit followed shortly after naming all directors as defendantsand the cost was much higher than the policy retention. Thepolicy was ambiguous on when the Side B would apply andwhen side A would be applicable. It followed that the lawyerscreatively deduced that if the company simply refused toindemnify its directors, the Side-A would be applied and thecompany would be saved of the high cost. Since the wordingwas vague on this issue, the courts upheld the interpretation andthis was how simply because of inappropriate and exclusivelanguage of the policies, the company could shift a Side-B claimto a Side-A claim and managed to get a $5000 million in placeof a mere $5 million as originally taken in the policy. Takingthis case as a precedent, the ‘presumptive indemnification’clauses were introduced and all future policies were endorsedwith the same. This clause stated that Side A would apply only
 Directors’ and Officers’ Liability Insurance – the Need of the Hour 
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when an insured company is legally or financially incapable of indemnifying its directors and officers and that the companyhas no right to simply refuse to indemnify and thereby changea Side-B claim into a Side-A one.It was not until mid 1990s that Side-C insuring clauses cameinto being. Historically the concept of D&O insurance hasprimarily been individual protection and so whenever thecompany was named as a co-defendant in suits along with thedirectors and officers, there invariably was a great difficultyin making a fair allocation of defense and other costs betweenthe companies and individuals and those by far led to furtherdisputes. This dilemma was finally resolved in the case of 
. Chubb
in 1995. Post this decision, the insurerswere made to add a new Side-C insuring clause thus puttingan end to the entire confusion.Though introduction of Side-C policy, solved one problem, itgave rise to some new problems. One such problem related to thefact that consequent upon the increase in exposure, the insurancecompanies could not do much about increase in premium pricing.Almost for the same premiums the insurers were now insuringboth individuals and companies. Consequently the risk to theunderwriters increased many folds. Another problem related tothe limit of liability purchased by companies. After addition of companies in the insured list, the insurance policy limit were notconsequentially increased implying that the directors’ and officers’individual protection got substantially reduced as they now sharedit with their employer companies as co-insured. This is one of the reasons that have led to a renewed interest in Side-A onlypolicies, the others being factors like increased cases of companies’financial bad health, increased number of litigation and higherdefense and other related costs. The companies tend to prefer notto indemnify its directors and officers and get an insurancecoverage instead.
It would be erroneous to deduce that D&O insurance makesdirectors or officers negligent to their duties and that itencourages them to undertake unauthorized activitiesintentionally. While unintentional wrongs are covered by mostD&O liability insurance, intentional, unlawful andunauthorized acts by directors and officers of companieshowsoever high positions they hold are not covered by D&Oinsurance policies. In order to be so covered, the wrongful actshould come under the definition of “wrongful acts” in theconcerned policy, and ideally it includes those acts, omissions,commissions or mis-statements made by such directors orofficers in good faith in their capacity as such director orofficer of the company. This does not imply that D&Oinsurance would cover fraud, illegal and unlawful activities.
For the purpose of claims things that are typically covered bythe definition of loss are damages, settlement cost and defensecost. Punitive and exemplary damages may be included onlyif specifically mentioned in the policy taken. Losses fromwrongs that are legally uninsurable are not covered. Also notcovered are penalties, fines and taxes. There are certainexclusion clauses that might be there in the D&O insurancepolicy taken. These are:(a)Exclusion of coverage of dishonesty or intentional wrongby a director or officer(b)Exclusion of coverage of an insured person againstanother insured person (e.g. a company cannot claimagainst a director in a case when both are insured)(c)Exclusion of coverage of liability arising fromprofessional services (e.g. doctors)(d)Exclusion of claims arising out of acts committed on adate prior to a specified date (ideally the date of takingthe policy).(e)Exclusion of claims already pending at the date the policyis taken(f)Exclusion of claims resulting from insider trading(g)Exclusion of claims relating to bodily injury, mentaldistress, sickness, death etc.
The basic principle that governs the D&O insurance regime isthe economic concept of risk aversion and its effects. Risk aversionimplies the unwillingness of a person to accept a propositionwhich has an uncertain result and instead opt for anotherproposition that guarantees a certain result even if it be lowerthan the highest expected result in the first case. This concept of economics would apply to a highly knowledgeable individualwho might be unwilling to take up the position of a directorsimply because he is afraid of ending up with personal liability.D&O insurance provides a shield in these cases. Such insurancecan make a director or an officer risk-neutral if not risk-loving,both of which will benefit the company ultimately. By being risk neutral they can take important decisions for the company basedupon all necessary information available at hand at the time of taking decision and in this manner they can give their 100% tothe company. In addition to the above, purchase of a D&Oinsurance policy by a company will also give it the signalingstrength by which it can claim to be a good employer in the jobmarket. It can have an edge over its competitors. A liability arisingfrom their position in the company might not only cause financial
 Directors’ and Officers’ Liability Insurance – the Need of the Hour 

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