Directors and officers (D&O) liability insurance is complex, in part because D&O litigation is complex. As a result, it is not a surprise that I am often asked how D&O insurance will respond to typical litigation scenarios involving directors and officers.
To bring some clarity to the situation, in this article, I will first discuss how D&O insurance would respond to government lawsuits. Next, I will address private litigation. In the scenarios below, I am assuming that a “classic” D&O insurance program is in place.
In other words, I’m assuming the D&O insurance program provides both:
- First-dollar coverage for individuals if a matter is not indemnifiable but it is insurable (aka Side A insurance); and
- Coverage after the company pays the self-insured retention (like a deductible) if a matter is indemnifiable. This is also known as Side B insurance to cover the reimbursement of the company’s indemnification obligations to individuals and Side C insurance for securities claims against the corporate entity.
When it comes to government enforcement actions, the general rule is that a D&O insurance program will provide defense costs for individuals under the Side B insuring agreement. However, fines and penalties are generally not insurable and thus are not covered by D&O insurance.
Modern public company D&O insurance policies provide defense costs to directors and officers even if a government inquiry is informal. Unfortunately, most modern public D&O insurance policies do not provide coverage for the informal or formal investigation of a corporate entity.
On the private litigation side, here are five common lawsuits and how D&O insurance should respond.
1. IPO Lawsuits (Registration Statement Suits)
When an IPO company’s stock falls below its IPO issue price as a result of some sort of disclosure by the company (for example, “we missed our earning guidance”), plaintiffs will often sue the company, its officers, and possibly its directors.
The suit will allege material misstatements or omissions in the company’s S-1 registration statement. Registration statements have a three-year statute of limitations. In other words, the company can be sued for misstatements or omissions in the S-1 up to three years after going public. The company is strictly liable for the contents of its registration statement.
Remember that companies file registration statements in connection with their IPOs, but that may not be the only registration statement a company files. For example, follow-on offerings involve registration statements. A registration statement is also used when a publicly traded company uses its own stock as currency to acquire another company.
These types of suits are often referred to as Section 11 suits or a ‘33 Act suits. For years, these types of securities class actions have been on the rise. Our recent Securities Class Action Flash Report reported a rate of 2.5 Section 11 filings per month. However, due to the increasing acceptance of federal forum provisions, the rate of this litigation may be on its way down.
In a Section 11 scenario, the cost of defense and settlement for directors and officers would be indemnifiable by the company. Side B of a D&O insurance program reimburses the corporation for its indemnification obligations to its directors and officers. The insurance will respond after the company first pays the self-insured retention, or SIR.
Side C of a D&O insurance policy will respond on the company’s behalf. Typically, settlements of Section 11 claims are joint settlements with individual directors and officers as well as the company. In all cases, the SIR only has to be paid once for all litigation related to the same set of underlying facts. (That is, only one retention applies for a Side B and Side C claim.)
For more about D&O insurance and IPOs, see: Guide to Going Public: D&O Insurance for IPOs and Direct Listings.
2. Classic Stock-Drop Lawsuits
There are, of course, other types of securities class actions involving a stock drop. When a public company’s stock price drops precipitously in response to company disclosure, plaintiffs often sue the company, its officers, and sometimes, its directors.
These suits allege that the officers and directors intentionally made material misstatements or omissions in public statements, particularly in the company’s 10-K annual filings and its 10-Q quarterly filings. This is often referred to as a Section 10(b) suit, a ‘34 Act suit, or a securities fraud suit.
In this scenario, D&O insurance will respond the same way it does for Section 11 suits.
You can find out more about how often stock drops become lawsuits by reviewing the data published in the D&O Diary by Stanford Law School professors, Michael Klausner and Sam Blake Curry, and Jason Hegland of Stanford Securities Litigation Analytics.
3. Simultaneous Lawsuits
In federal court, plaintiffs can bring both ’33 Act and ’34 Act allegations in the same complaint, and often do so. There is no reason for plaintiffs to forgo the opportunity to sweep in as many allegations as possible into a complaint.
In addition, companies with registration statement exposure, such as IPO companies, can face ’33 Act / Section 11 suits in multiple state courts and parallel filings in both state and federal courts (same set of allegations, different venue).
If you’ve been following this trend, you are aware of the impact that the United States Supreme Court decision in Cyan v. Beaver County Employees Retirement Fund had, which created an upward trend of Section 11 cases in both state and federal courts.
This decision had catastrophic consequences for D&O insurance carriers and, subsequently, the cost of D&O insurance for IPO companies increased dramatically.
While still being tested in courts, Delaware companies with federal choice of forum provisions in their certificates of incorporation may only face ’33 Act suits in federal court-—not in two courts simultaneously. It is a good idea to have these provisions included in the IPO company’s certificate of incorporation.
These related lawsuits can be expensive to defend since they are in separate courts. However, since they concern the same set of facts, only one SIR will need to be paid. As with Section 11 and Section 10(b) suits, Side B reimburses the corporation for advanced legal fees and settlements for individuals, and Side C pays for the legal fees and settlements of the corporation.
4. Derivative Lawsuits
Based on experience, approximately two-thirds of stock-drop suits are accompanied by a derivative suit, which is a type of breach of fiduciary duty suit against directors or officers. In a derivative suit, shareholders are bringing suit against the directors and officers on behalf of the company.
In these suits, shareholders assert that the directors and officers have harmed the corporation by breaching their fiduciary duties, and that the shareholders must step in because the poorly behaving directors and officers will, of course, not take corrective action on their own.
Derivative suits are a matter of state corporate law, not federal securities law. As such, the controlling law is the corporations code of the company’s state of incorporation.
There are also derivative suits that are entirely unrelated to stock drops. Indeed, unlike Section 10(b) or Section 11 cases, derivative suits do not require a stock drop at all. For more information on this, see: Five Types of Derivative Suits With Massive Settlements.
Recently, we have seen an unusually large number of large dollar derivative suit settlements. Over the past five years, notable derivative suits have paid out more than $1.4 billion in cash settlements.
Here is how the D&O insurance policy would respond to a derivative suit brought against a Delaware-incorporated company:
- A company can indemnify its individual directors and officers for their defense costs (but not settlement costs). Side B of the D&O insurance policy will respond to reimburse the company for indemnifying the directors and officers after the company pays the SIR.
- On the other hand, the cost of settlements for individual directors and officers is not indemnifiable by the company. This is where Side A of a D&O insurance policy will respond on a first-dollar basis. There is no self-insured retention.
- Although a derivative suit is a breach of fiduciary duty suit brought by shareholders on behalf of the company against directors and officers, there can be a company defense element to the claim. Such costs are handled by Side C of the D&O policy. Note, however, that there is usually a separate sublimit for things like corporate investigations as well as “books and records” requests, a common precursor to derivative suit litigation.
To illustrate how a common derivative suit scenario might play out, imagine a Delaware-incorporated company has a $50 million D&O policy with all three insuring agreements (Sides A, B, and C), and assume the policy has a $15 million SIR.
Now assume that the directors and officers spent $5M to defend themselves in the derivative suit, and ultimately settled the suit for $20M. The D&O policy only pays for defense costs after the SIR has been met. The $5M in defense costs is less than the $15M SIR, so in this case the D&O insurance policy would not pay anything.
However, the settlement of the claim is not indemnifiable by the company, so there is no SIR. In our hypothetical, the D&O insurance policy would pay the full $20M settlement.
Because derivative suits settlements are usually not indemnifiable, there is a lot of pressure to ensure that the Side A portion of the D&O insurance program is robust. Indeed, it is common for companies to purchase extra, dedicated Side A insurance in addition to D&O insurance that has all three insuring agreements.
Delaware companies with state choice of forum provisions will only face these suits in Delaware state court. It is a good idea for companies to include these state choice of forum provisions in their certificates of incorporation. Companies incorporated in other states will want to consider state choice of forum provision for their state.
The other major type of D&O litigation in the United States that is not indemnifiable by a company is when creditors of a bankrupt company bring suits against directors and officers. Of course, not all bankruptcies lead to creditor suits against the directors and officers. However, when it happens, it is Side A insurance that responds on a first-dollar, no SIR basis.
Will D&O Insurance Respond to Your Future Litigation?
The scenarios listed above are hypothetical illustrations and are a useful starting point when thinking about how much D&O insurance you may want to purchase as well as how you want to structure your insurance program.
However, whether your D&O insurance policy will cover your specific claim is determined by your specific facts as well as the negotiated terms and conditions of your insurance contracts.
If you are working with a D&O insurance expert, the language of your D&O insurance program will be highly negotiated. Whether you have coverage or not can turn on the placement of a comma, so this contract negotiation piece is critical and is why seasoned directors and officers often use specialist brokers to place their programs.
Keeping Directors and Officers Up to Date: Usable Insurance Data and Advice
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