What is a Directors and Officers Liability (D&O)? (Part 1)
If you are an avid Twitter user, then there is a high chance you have come across one or two tweets from Elon Musk. The CEO of Tesla and Space X is known for sharing updates about his companies on the platform. On 7th August 2018, Musk tweeted that he could take Tesla, private, at $420 a share. This resulted into a Securities fraud charge brought against Musk by the Securities Exchange Commission (SEC). Elon Musk and the SEC eventually agreed to a settlement with Musk paying a fine of $20 million. (SEC.gov | Elon Musk Settles SEC Fraud Charges; Tesla Charged With and Resolves Securities Law Charge).
There a numerous example such as these that show how lawsuits have been brought against directors and officers of a company not only by a regulatory body but by other stakeholders. A Director or Officer of an organization has a duty to always act in the best interests of that organization and its shareholders. If they act to the contrary, then they can be subject to a lawsuit. The Term used for the action of an officer or director in this situation is known as a “Wrongful Act” and it forms the basis of coverage under a Directors and Officers Liability Policy. A wrongful Act in the legal context is an actual or alleged negligent performance of a legal duty or responsibility. It can include anything from a breach of contract, breach of duty, misstatement, neglect to breach of authority.
The Legal action that can be brought against the director or officer of an organization as a result of a wrongful act can come from a multitude of areas such as;
- Employee discrimination.
- Abuse of power or authority
- Wrongful dismissal
- Libel or Slander
- Financial irregularities
- Takeovers and Mergers
How the D&O Policy Works
The costs involved in the legal proceedings involving a director can be enormous. These costs can include legal costs, legal expenses, Judgments & settlements etc. The purpose of the D&O cover is to indemnify the Director or Office against the legal liability that results from the wrongful actions done or attempted by the directors either individually or collectively while performing their duties solely in their capacity as directors or officers of the company.
The Standard D&O policy provides coverage under two insuring clauses; Side A & Side B.
Side A Coverage (Individual Directors and Officers): This section indemnifies the individual directors and officers directly for the legal costs and settlements in circumstances where a they have or attempted to commit a wrongful act. Side A coverage usually applies in situations where the company is not in a position to indemnify its directors or officers. An example of this can be when a company becomes insolvent or where the organization is legally not allowed to indemnify the directors. The essence of the Side A coverage is to protect the personal assets of the directors and officers. The argument for Side A coverage is that without it, the individual directors or officers would have to use their individual assets to meet the financial burden of the legal costs and awards.
There is no deductible applicable under Side A Coverage.
Side B Coverage (Company Reimbursement): This section is meant to indemnify the company or organization itself for the legal costs, settlement and or judgment awards it incurs on behalf of its directors and officers. The organization can only cover the legal costs of its director or officer if it has a contractual duty to do so as part of the employment contract with the said director or officer. The essence of Side B cover is to protect the Balance Sheet of the organization. For example, the director in company X is sued for a wrongful act and legal costs are awarded against him/her. The director will then approach the company seeking reimbursement for these costs as part of the contractual arrangement he/she has with the company. The Organization will reimburse the directors legal costs and file for indemnification from the insurance company as per the D&O policy.
A deductible or Policy Retention is usually applicable under the Side B cover.
One important aspect to note Under Side A and Side B cover is that the individual director or officer is named as a defendant in the lawsuit.
There circumstances or situations however, where a lawsuit can be brought against the entity or organization itself for a wrongful act involving its directors or officers. The entity or organization itself is named as a defendant in the lawsuit. In such a circumstance, both Side A and Side B would not respond to the claims that materialize. The Appropriate cover for such is the Side C cover or what is at times referred to as the Entity Cover.
Side C cover (Securities Entity Cover): Usually purchased by Publicly traded companies, Side C indemnifies the organization itself for legal and defense costs arising from claims suffered as a result of securities related grievances. An example of this could be shareholders filing a lawsuit against the company for reasons related to securities traded on the stock exchange.
What are some of the underwriting considerations for D&O Coverage?
Some of the factors that underwriters would typically need to know or understand when rating for a D&O cover include but are not limited to;
- The Insured
- Risk Management
- Cover type and Limits
- Claims History
This information should ordinarily be picked up in the Proposal form submitted by the client. In addition, accounting information (audited book of accounts) is also particularly relevant for the underwriter’s risk analysis.
What is not covered?
There are number of losses that would be excluded under a D&O cover. The Exclusions will typically vary from underwriter to underwriter. Some of the common exclusions include the following;
- Insured Vs Insured Clause: A D&O policy will preclude coverage for claims arising from legal suits between directors and officers of the same company. The reason for this is to eliminate or avoid infighting/internal disputes and collusion.
- Anti-Trust exclusion: Anti-trust laws are put in place by governments to protect consumers and promote fair competition. D&O policy will exclude claims from activities that go against these laws.
- Prior Knowledge claims. Prior Knowledge refers to claims that the insured knew or should have known prior to purchasing the cover.
- The D&O coverage will exclude indemnification for claims related to activities that are criminal in nature or fraudulent.
- Major Shareholder exclusion: – Some D&O policies will preclude coverage for claims made by shareholders who won at least of the entity’s Stock. The reason behind this is that such claims are more often than not driven by infighting between the Shareholder(s) and the management rather than wrongful acts tied to managerial decisions by the Directors and Officers.