Independent Director Liability Insurance—Worth It?

Independent directors sometimes want additional insurance coverage for themselves, coverage that is above and beyond the D&O liability insurance coverage that they share with the company’s officers.

In the last two posts of this series (found here and here) on coverage for directors and officers, we’ve been talking about when a corporation cannot indemnify its Ds and Os, and how standalone Side A insurance can step in to pay an individual’s defense costs and settlements of a claim.

Sometimes independent directors are interested in obtaining an additional safety net of insurance coverage beyond standalone Side A insurance. Designed specifically for directors, this type of insurance is referred to as independent director liability (IDL) insurance.

IDL insurance is a Side A insurance policy that responds to claims brought against independent directors. In doing so, it excludes any claims brought against officers or the company the directors and officers serve.

While it’s not a particularly popular type of policy, there are situations in which directors may want to explore its purchase.

What’s the Appeal of IDL Insurance?

One of the situations that drives independent directors to ask corporations to purchase IDL insurance is when they are concerned about fraud.

As a practical matter, when management commits fraud, one of the parties that management is trying to trick is the independent director group; directors are rarely invited to participate in the fraud.

Thus, independent directors may feel vulnerable to being subject to potentially very bad outcomes that are not in their control.

Due to the fact that it’s officers who are likely to be the primary object of litigation or enforcement actions, independent directors may be concerned that in the course of normal events, the officers will have very high legal bills.

Directors may be concerned that the regular D&O insurance limits will be drained before directors—who may also need to defend themselves—ever get to use the limits.

While it is an usual situation, there is some historical precedent to support an independent director’s concern that a tough claim could lead to the draining of the D&O insurance policy to pay for officer defense bills.

Independent directors found themselves in this situation in the face of claims against directors and officers for accounting fraud at the athletic shoe and sportswear company, Just For Feet.

This case is one of the rare circumstances in which independent directors of a publicly traded company had to pay out of pocket personally—to the tune of more than $40 million.

In the Just for Feet case, the company found itself in financial distress and ultimately filed for bankruptcy. Vigorous litigation ensued, and three executives confessed to having committed fraud.

These executives drained all the D&O policies of their proceeds before the independent directors had a chance to use those policies to settle litigation that had been brought against them, leaving the independent directors to pay out of their own pockets.

Arguably an IDL policy would have saved the day for these independent directors since an IDL policy would have provided a reserve of segregated funds just for them—funds that could not be touched by the corporation or its officers.

Why Don’t More Corporations Purchase IDL Policies?

Given these types of circumstances, why doesn’t every corporation buy IDL policies?

First, these are relatively expensive policies. IDL policies by their nature cover fewer people than standalone Side A policies, since IDL policies don’t cover officers at all, just directors. Nevertheless, the pricing for these policies reflects little (if any) discount compared to a standalone Side A policy that also covers officers.

Second, most corporations believe—correctly—that they can pay the bills of the officers directly, which means a corporation could refrain from using its D&O insurance policy for this part of the exposure.

Paying outside the policy would preserve insurance policy limits for independent directors, should they need them.

Short of being bankrupt itself, a corporation can usually indemnify its directors for most things (though not for the settlement of breach of fiduciary duty suits brought derivatively, as I have discussed elsewhere).

Finally, there’s an emotional element at play. Many independent directors are hesitant to advocate for having separate policy limits for themselves lest this be seen as lack of confidence in the management team.

What Other Coverage Exists if You Don’t Buy IDL?

Independent directors who are worried about their personal exposure have a way to address that issue without asking the corporation to pay for an IDL policy.

Independent directors, unlike officers, can buy wealth security policies. These are attractive for a number of reasons:

• Wealth security policies tend to be much more economically priced versus IDL policies.
• Independent directors can purchase them on their own, without asking the corporation to do so.
• Independent directors have the ability to put one or all of their other board positions on that policy.
• The entire limit is segregated and reserved for the independent director’s exclusive use.

Given the remoteness of the exposure that the IDL policies would cover, and the fact that wealth security policies are reasonably priced, many independent directors opt to purchase the wealth security policy instead.

IDL and Wealth Security Policies Give You Options

While the Just For Feet case is upsetting from an independent director perspective, remember that it’s just one of the very small number of circumstances where independent directors have ever paid out of pocket.

Whether or not you want to buy an IDL policy, it’s useful to know that it exists.

There are some companies whose risk management philosophy absolutely includes the purchase of an IDL policy. In the right circumstances, it’s a prudent choice.

In cases where IDL insurance doesn't make sense, wealth security policies offer a nice alternative.

You can get more advice about this from your trusted insurance broker. It might be prudent to make this part of the normal conversation you have with both your corporation’s insurance broker, as well as your personal insurance broker.