Here’s how a major insurance company (Travelers) describes D&O insurance: “Directors & Officers (D&O) Liability insurance helps cover defense costs and damages (awards and settlements) arising out of wrongful act allegations and lawsuits brought against an organization’s board of directors and/or officers. These types of claims have become increasingly common and directors and officers themselves could be held personally liable. To attract and retain qualified executives and board members it’s crucial to have Travelers Directors & Officers Liability insurance.”
The problem with D&O insurance is that, while it sounds wonderful in theory, it contains loopholes big enough to drive a tractor-trailer through. Which is not to say that it isn’t essential. It’s just that, if you ever need to make a claim under the coverage, you’ve already probably allowed things to go too far. Think prevention.
A couple of recent federal cases dealing with the “insured v. insured” exclusion illustrate my point.
In a Ninth Circuit case, FDIC v. BancInsure, Security National Security Pacific Bank became insolvent, and the FDIC took over as receiver. The FDIC filed suit against Security Pacific’s former directors and officers, seeking to enforce coverage for losses from alleged negligence and breach of fiduciary duty. But the D & O Policy excluded coverage for suits brought “by, or on behalf of, or at the behest of” Security Pacific, or by “any successor, trustee, assignee or receiver.” The FDIC argued that it was not a “receiver” within the meaning of the exclusion, because, by statute, it had a “unique role” representing “multiple interests,” including the interests of shareholders. So, the FDIC argued, its lawsuit could essentially be considered a shareholders’ derivative action, and the insured-versus-insured exclusion contained an exception for such actions.
The Court said nice try, not buying. “The shareholder-derivative-suit exception does not render the insured-versus-insured exclusion ambiguous with respect to the FDIC as receiver merely because the FDIC also succeeded to the right of Security Pacific’s shareholders to bring a derivative action – which right (1) is secondary to the FDIC’s right to bring the same claims directly as Security Pacific’s receiver and (2) may be exercised only if the FDIC does not exercise its primary right to bring the claims directly.”
The interesting aspect of this case is that the policy separately excluded coverage for losses arriving arising from “any action or proceeding brought by or on behalf of any federal or state regulatory or supervisory agency or deposit insurance organization.” But the policy specifically deleted that exclusion by endorsement, which pretty clearly shows that suits brought by government regulators (like the FDIC) were supposed to be covered. No problem, said the Court, we can reason our way around that one: “The regulatory endorsement deleted the regulatory exclusion but did not vary, waive, or extend any of the other terms of the D & O Policy, and thus did not alter the scope of the insured-versus-insured exclusion. As a result, the FDIC’s claims remain barred by the insured-versus-insured exclusion.” (Huh?)
Jerry’s Enterprises v. U.S. Specialty Insurance Co., out of the Eighth Circuit, involved a dispute over the valuation of shares in a grocery store chain (JEI). The founder’s daughter, Cheryl Sullivan, inherited 28.06% of the company, and her daughters Kelly and Monica received 2.4% and 1.2%, respectively. Sullivan (a former director of JEI) and her daughters later filed suit against JEI, alleging multiple acts of misconduct by JEI directors designed to lower the value of their shares. JEI settled, and sued its D&O carrier for defense costs and the amounts paid under the settlement agreement. The Court found that the “insured- versus-insured” exclusion barred coverage for any lawsuit brought by a former director, and that Sullivan fell into that category.
The problem for the carrier (and the Court) was that the policy also contained an allocation clause, which basically required the allocation of insurance coverage between covered and noncovered claims. JEI argued that neither of the daughters had been directors or officers of the company, so at least their part of the lawsuit should have been covered. Nah, said the Court: “Cheryl Sullivan was the driving force of the litigation. She…owned the vast majority of shares at issue in the underlying lawsuit, and she was the former director who repeatedly raised concerns about the valuation of shares to JEI’s Board of Directors.” (Did the policy contain a “driving force” exclusion?) In other words, stop bothering us with pesky facts. We made our decision, and that’s that.
The JEI Court’s discussion of “judge world” is particularly entertaining. See, those of us who have done coverage work for any length of time know that there are parallel universes. One contains “judge world,” and the other contains the “real world.” Here’s the JEI Court’s discussion of the insurance-buying process in “judge world”: “JEI’s argument exhibits a fundamental misunderstanding of the insurance policy and our role in analyzing the policy’s language… JEI and US Specialty entered into an agreement in which they defined the terms of that agreement. It is our responsibility to give effect to that contracted language.” (Emphasis added.)
That makes it sound as though the insurance company and the policyholder sat down together over a cup of joe and negotiated what the contract would say, and exactly how it would be applied. That, of course, is nonsense. Insurance policies consist largely of preprinted forms, or, at the least, language drafted by the insurance industry. There may be some limited ability for a policyholder to negotiate minor variations in policy language, but by and large, it’s a take-it-or leave-it proposition.
But enough of my ranting about how courts buy into what the claims department says about policies, as opposed to what the sales department says. The bottom line is that D&O insurance is important, because it does provide protection against certain types of lawsuits (although, not all of the types of lawsuits that you would reasonably expect). Just keep in mind that your internal controls and procedures are far more important than your insurance. If you don’t analyze your risks carefully, and take aggressive steps to minimize them, you are putting yourself at the mercy of the claims departments of insurance companies. And, for all of their advertising about avoiding mayhem and being a good neighbor, insurance companies are in the business of making the largest returns possible for their shareholders. Poor loss control also puts you at the mercy of judges, many of whom (forgive me) don’t really understand how insurance works, and don’t really want to understand, because they’re way too busy.