DIRECTORS & OFFICERS DEVELOPMENTS

A recent study released by Stanford Law School showed an interesting trend developing in the area of securities litigation, one that does not bode well for the cost of D&O insurance. The school's Securities Class Action Clearinghouse reports annually on the number securities fraud class action lawsuits filed in Federal court. The total number of filings for 2001 was 488, up from 213 in 2000, and Moody's predicts that D&O claims will rise ``dramatically."

Historically, there was a decline in litigation after passage of the Private Securities Litigation Reform Act of 1995 (PSLRA), from 231 class actions in 1994 to 109 in 1996. It was thought that this legislation would reduce the liability exposure of corporate officers and directors and, concomitantly, the cost of D&O insurance. By 1998, however, litigation was back to pre-PSLRA levels. Clearly, this is not going to help lower premiums that have already spiked as a result of the hard market and criminal actions against officials of Enron, WorldCom, Adelphia, etc.

In addition to increasing premiums for new and existing business, insurers are also trying to reduce their costs by fighting claims. Not only are they denying specific claims, many companies are attempting to rescind their policies entirely, alleging fraudulent misrepresentations in the application for coverage. In both the Enron and the Adelphia bankruptcies, D&O insurers have asked the bankruptcy judge for permission to notify the insureds that they intend to rescind their policies.

Normally, in a bankruptcy proceeding there is a stay imposed on filing new lawsuits against the company until arrangements are made to pay existing creditors. In both of these instances, Enron and Adelphia are arguing that they have an interest in the policy that must be adjudicated by the bankruptcy court. It is unclear at this point in these cases what that interest may be, but this is not a novel argument.

The traditional D&O policy provides personal coverage for the individual officials and pays its proceeds to them or on their behalf. Coverage is usually structured in two parts: payment to the individuals themselves when they are not indemnified by the corporation, and payment to the corporation as reimbursement when it does indemnify them.

During the soft insurance market of the 1990s, insurers started offering various ``bells and whistles" to differentiate themselves from other competing insurers. Among these was the so-called ``entity" coverage that covered the corporation directly for its separate liability. This entity coverage was often, but not always, restricted to securities claims, and it was touted as a way to avoid allocation disputes where claims are brought against both the company and individual officers or directors.

The general rule in a bankruptcy proceeding seems to be that the D&O policy is the property of the company (and, thus, the bankruptcy estate) but the proceeds belong to the officers and directors. This is particularly the case when there is only personal coverage involved and there is no corporate reimbursement coverage (not a common situation).

Although there seems to be some case law to the contrary, it is also generally accepted that a policy with both personal and corporate reimbursement coverage would be treated the same way. There might be an exception where the bankrupt company has an actual claim under the policy (e.g., where it has already paid its indemnification obligation to the individuals involved), but this argument has also been rejected by some courts.

Where the policy provides entity coverage, however, there might be a different result because proceeds could arguably be payable directly to the company for its own liability. Since this is a relatively new phenomenon, there have not been many decisions dealing with it, but some bankruptcy courts have said that entity coverage for securities claims only would be irrelevant because securities claims against the company are automatically stayed upon filing for bankruptcy. Broad-based entity coverage that is not restricted to securities claims, however, could have a different result.

Not only does the addition of entity coverage diminish the amount of coverage for the directors and officers by possibly impairing the policy's aggregate limit, it also appears that it may pose problems in a bankruptcy proceeding. At the very least, arguments over the status of D&O coverage in a bankruptcy proceeding could delay the payment of proceeds to the individual officers and directors at a crucial time when they may need the funds to pay for their own defense. This provides yet another reason not to load up D&O coverage with a lot of extraneous coverage extras.

-- Christopher B. Ashton, CEBS

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