Beware of What You Wish: D&O Allocation,
Entity Coverage, and Bankruptcy

By Boris Feldman

In recent years, two sets of events converged to trigger a fundamental change in D&O liability insurance policies. The first was a series of judicial decisions that addressed the issue of allocation between company and director and officer defendants in shareholder class actions. Those decisions generally adopted the company position in the allocation wars: namely, that settlement and defense costs should be allocated largely, if not entirely, to the D&O carrier -- notwithstanding that the company itself was not insured under the policy (except with respect to reimbursement for indemnification). The second set of events was the softening of the D&O insurance market. Market conditions led to intensifying competition among underwriters on the allocation issue. Some underwriters initially chose to offer predefined allocations in the policy: x percent of the exposure would be borne by the carrier,y percent by the company. As the market continued to soften, x became 100, and y became 0.

Other carriers took a different route in response to these changes: they added "Side C" coverage to the D&O policy. For decades, D&O policies had contained two insuring clauses. Side A covered the directors and officers directly, in the event that corporate indemnification was unavailable. Side B covered the corporate entity, but only to the extent that it indemnified the directors and officers. The new Side C coverage protected the company itself for its exposure in the lawsuit.

In relatively short order, entity coverage won out over preset allocation. The vast majority of current D&O policies contain full Side C coverage for the corporation. Once the company has satisfied the deductible under the policy, its exposure is, as a practical matter, eliminated (so long as ultimate liability does not exceed the aggregate policy limits). Corporate risk managers and securities defense lawyers have tended to view this resolution as a win for their side: the company exposure is capped at a relatively low amount. Plaintiffs' lawyers, too, seem happy with entity coverage: provided that the limits are high enough, plaintiffs do not need to force the company to contribute, and can focus their fire on the carriers.

I respectfully dissent from the self-congratulatory consensus. In my opinion, the market erred in resolving the allocation struggle with entity coverage instead of with predefined allocations. I base that opinion on two factors: the divergence in interests between defendants and carriers under an entity-coverage scenario; and the impact of entity coverage in bankruptcy proceedings.

Factor One: The Absence of Skin in the Game

I believe that entity coverage has caused the interests of carriers and defendants to diverge in resolving shareholder litigation. Most companies approach shareholder class actions as a business matter. Notwithstanding their initial fury at being sued, what they want most is for the lawsuit to go away. They are resigned to paying the deductible, whether they fight the claim or settle it. Given their limited financial stake in the litigation, many companies simply instruct defense counsel to settle at the earliest opportunity. Some defendants are insensitive to the price of settlement, when it won't come out of their pockets

Carriers have become suspicious of company demands that they settle a case pronto. Because they are the ones who will be asked to pick up the tab, carriers tend to be more insistent on litigating at least through the pleading stage, and often through summary judgment. Carriers sometimes come to see themselves, rather than the defendants, as the real stakeholders.

Why is this bad for the company? Because it wants to settle the case, but has little leverage with the carrier. Some carriers may take the position that, if the company does not want to defend the lawsuit, the carrier itself will take over the defense, rather than funding what it views as an excessive settlement at a premature stage of the litigation. Some carriers may assert that, if they bear all the risk, then they should be calling the shots. A company could thus find itself no longer in control of its own destiny in the litigation.*

The settlement dynamic, in my experience, is different when the company itself has a financial stake in the outcome. Carriers are likely to be somewhat less suspicious that the company is playing with other people's money (namely, theirs). Moreover, company participation in a settlement – even at a level far lower than the carrier's – enhances the likelihood that both sides will see themselves as partners in the process.

Factor Two: Bankruptcy

The law governing D&O policies in bankruptcy has long been clear as mud. The consensus -- pre-entity coverage -- appears to have been that directors and officers did not lose the protection of the D&O policy even if the corporate entity went bankrupt. It was precisely in the context of insolvency – with corporate indemnification obligations often wiped out – that Side A coverage became most valuable to directors and officers. The D&O policy was all that stood between their wallets and the plaintiffs.

Entity coverage creates a grave new world. Although the law is unsettled on this issue, some students of D&O insurance argue that the addition of entity coverage greatly increases the likelihood that a bankruptcy court would suck all (or a substantial portion) of the D&O policy proceeds into the assets of the bankrupt estate. That is because the bankrupt entity itself now has a claim to those proceeds, in the context of a pending shareholder suit. If these observers are correct, then the danger for the directors and officers is severe: corporate indemnification would be discharged, and the D&O coverage would evaporate. The litigation would be left to continue against the directors and officers, backed by their personal full faith and credit. Imagine the reaction of directors and officers when they learn that entity coverage – which had been sold to them as a great advance in D&O protection – turns out to have been a Trojan horse for creditors.

In my opinion, predefined allocation does not pose the same risk in bankruptcy as does entity coverage. A policy with only Side A and Side B coverage does not, by virtue of preset allocation, create coverage for the corporate entity. Rather, it merely specifies the covered and uncovered risks in advance. I believe that the earlier decisions holding that directors and officers do not lose their insurance in bankruptcy would not be altered by the presence of a predefined allocation between the carrier's contribution and the company's.

Allocation Redux

If I am right on the foregoing points, then the industry took the wrong fork in the road. Instead of adding Side C coverage to D&O policies, the risks in bankruptcy would have been less if the industry had instead gone with the preset allocation solution. Moreover, if companies could be persuaded to retain even a small percentage of the risk (say, 10 percent), their interests would be more closely aligned with the carriers – and, more important, would be perceived by the carriers to be more closely aligned.

It may be that the industry has gone too far down the entity coverage road to turn back. Corporate risk managers may perceive a change from Side C to preset allocation as too, er, risky. Nevertheless, at minimum, brokers may be able to persuade clients that a change from entity coverage to 100 percent allocation entails little danger for the company, and potentially significant benefits for directors and officers in the event of bankruptcy. Ratcheting the allocation down from 100/0 will, no doubt, require greater persuasiveness. But I believe that some companies can be made to understand the relationship benefits of doing so (particularly if the premium reductions are sweet enough).

The cliché of choice with respect to class action developments since passage of the Securities Reform Act is "the law of unintended consequences." With respect to entity coverage, the right aphorism may be "beware of what you wish – it may come true." Entity coverage, with full risk-shifting to the carrier, is now the reality. It may be a reality that directors and officers come to regret.

* I do not mean to suggest that the carrier's position would be upheld, merely that it might be asserted.

The views expressed in this article are those of the writer,
and do not necessarily represent the views of his firm.