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How unsuspecting executives can lose their liability insurance coverage.

December 30, 2013 Photo
Here’s a situation to consider: A directors and officers (D&O) liability insurer has received proper notice of a claim in a timely manner; the claim stems from a wrongful act in the insured’s capacity as a director or officer of the insured entity; and the alleged wrongful act falls within the policy’s scope of coverage. But to the surprise and considerable dismay of the executive, there is no coverage. What went wrong?

Certain circumstances, such as those discussed below, may entitle the insurer to rescind, withdraw, or deny coverage to all insureds. That can cause an innocent or unsuspecting director or officer to be deprived of coverage that otherwise would have been available under the D&O policy.

False/Misleading Information or Omissions

In deciding whether to offer a D&O liability insurance contract to an applicant and the terms, conditions, and pricing it is willing to offer, an insurer will review and may reasonably rely upon the application together with supplemental materials submitted as part of the application process. For example, the insurer may require the insured entity to provide financial statements.

If an applicant provides inaccurate or misleading information or omits requested information, the integrity of the underwriting process may be compromised. The insurer quite legitimately may contend that, if the applicant had provided full disclosure, accurate information, and true representations, it would not have accepted the risk or would have issued the policy on different terms and conditions at a substantially higher premium. Under these circumstances, the insurer may be entitled to rescind the policy by returning the premium. And the rescission may be effective against all insureds—even innocent directors and officers.

The insurer’s entitlement to rescind the policy when the insured has made a material misrepresentation or omitted a material fact as part of the application and policy issuance process depends on the statutory and common law of the governing state. State law may vary on whether the burden of proof is by a preponderance of the evidence or by clear and convincing evidence and whether the insurer must establish scienter or the insured’s intent to mislead the insurer.

Numerous factors may influence whether the insurer is entitled to rescind the policy, including: (1) whether as part of the application process the insurer made inquiry of the insured on the alleged material fact; (2) if the misrepresentation is contained in supplemental materials submitted as part of the application process, whether those materials were attached to and/or incorporated into the application; (3) whether the insured warranted the truth of the false statement; (4) whether the application and any incorporated supplemental materials are incorporated into the policy; (5) whether the omission is due to the mere failure of the applicant to answer a question contained in the application; (6) whether the insurer had notice of facts or circumstances sufficient to question the validity or truthfulness of the false or misleading statement and failed to make further inquiry; or (7) whether before policy inception the insured provided additional information to the insured’s broker to correct the misrepresentation or omission.

Since D&O liability insurance is issued on a claims-made basis, the applicant is required to identify any known claims as well as knowledge of circumstances (acts, errors, or omissions) that may lead to future claims. The application usually provides that any such known claims or circumstances are excluded from coverage under the policy.

Upon policy issuance, the application then becomes part of the policy, and the policy itself typically excludes such known claims or circumstances. There is no prejudice inherent to this requirement and exclusion. This is because, if such a claim were properly reported under the D&O policy in effect when the knowledge was obtained, coverage typically would have been triggered under that policy. When the applicant fails to comply with this requirement, the exclusion applies to all insureds and not just the insured entity and any directors and officers who had knowledge of the known claim or circumstance.

When the insured entity fails to identify a known claim in the application, the applicability of this exclusion is not particularly controversial. On the other hand, one of the most litigated issues in this arena is what knowledge will permit the insurer to exclude coverage or to rescind the policy for a claim first reported under its policy on the basis that the insured entity failed to identify, or misrepresented its knowledge of, circumstances that could lead to a potential future claim. The outcome will depend on the applicable state law, application/policy language, evidence of the applicant’s knowledge, and reasonable inferences to be drawn from the applicant’s knowledge. But if the insurer elects not to rescind the policy but to merely exclude the claim, then the insurer retains the premium, and the policy continues to be in effect with respect to any other claims that may be made under the policy.

In order to protect innocent directors and officers from losing the protection of a D&O policy due to the bad acts of the insured entity or other directors and officers, an entity may contract for a severability clause in its D&O policy, or the entity can purchase a non-rescindable Side-A endorsement. But not all severability clauses are created equal. Directors and officers prefer a severability clause that allows a policy to remain in full force and effect for those directors and officers who did not engage in the acts that caused the rescission of the policy. A non-rescindable Side-A endorsement prohibits coverage under Side-A to be rescinded, and it will generally require a D&O insurer to start advancing the defense cost to the directors and officers immediately, even in situations where the insurer may have depended on the alleged misstatements of the company when issuing the policy.

Bankruptcy Protection

If the insured entity files for bankruptcy protection, actions against it are automatically stayed, but actions against individual directors and officers typically are not subject to the automatic stay. While the D&O policy is generally considered to be the property of the debtor insured entity’s estate, the ownership of the proceeds of the D&O policy is a complicated issue.

Factors that come into play to determine whether the insured directors and officers can gain access to all or a portion of the policy proceeds for defense and indemnity include: (1) whether the D&O policy at issue provides coverage for the debtor entity and the directors and officers or provides coverage only for the directors and officers; (2) if the D&O policy at issue provides coverage for the debtor entity and the directors and officers, whether the policy is serving to protect the estate’s assets; (3) whether the trustee is asserting claims against the directors and officers; (4) the immediate need of the directors and officers to gain access to the policy proceeds to fund their defense; and (5) the rights of the directors and officers to seek indemnification from the debtor insured entity’s estate and the coverage afforded under the D&O policy to reimburse the insured entity for such indemnification payments.

Suffice it to say that, if the insured entity seeks bankruptcy protection, directors and officers may not be able to gain access to coverage that otherwise would be afforded to them under the D&O policy or may find that their access to coverage is limited in order to protect the value of the debtor insured entity’s estate.

Settlement with Lower Tier Insurer

All D&O excess policies have exhaustion language to trigger coverage under the excess policy. But what does “exhaustion” really mean? Does it require the underlying insurer to pay out the full policy limits? Or can an insured find other ways to trigger its excess coverage like, for example, settling with an underlying insurer or entering into a satisfaction of judgment?

Zeig v. Mass Bonding & Ins. Co. long has been considered the leading case to support the proposition that requiring an insured to collect the full amount of the policy limits from a primary or underlying excess insurer was unnecessarily stringent. The rationale is that such a reading of the word “exhaustion” would cause unnecessary delay, promote litigation, and prevent an adjustment of disputes that was convenient to both insured and insurer alike. Therefore, an insured could trigger an excess policy by achieving “functional exhaustion” of underlying policy limits by other means or “gap-filling” on the stated limits.

Recent decisions have significantly undermined Zeig’s applicability, rationale, and usefulness, noting that Zeig involved a first-party property insurance policy and not a third-party liability insurance policy, and that the freestanding federal common law that Zeig interpreted and applied no longer exists. These courts are rejecting the notion of looking beyond the clear language used by the parties in a given excess policy when making a decision on whether the limits of the underlying policy have been exhausted. If an insured entity and an underlying insurer become engaged in a coverage dispute and reach a settlement for a figure less than the full amount of the stated policy limits, directors and officers may very well be out of luck in compelling the excess insurer to pick up the rest of the bill. This may be true even if an insured fills in the gap itself by paying defense costs in an amount that equals or even exceeds that of the underlying policy limit.

Therefore, if an excess policy requires an underlying policy to “pay the full amount” or to accomplish exhaustion through “actual payment of underlying limits,” the director or officer may not be afforded coverage under excess insurance unless exhaustion to the letter of the language in a given policy is achieved.

Mitigating the Risk of Loss

No officer or director wants to learn that, due to the possible misconduct of another insured, he has no coverage under the D&O liability insurance contract. When experienced claims handlers identify these unfortunate circumstances, the starting point for analysis will be the applicable law and the structure, terms, conditions, and language of the D&O policy. But at this point, there generally is little, if anything, an innocent and unsuspecting director or officer can do to effectively alter the outcome.

The onus, generally, is on the directors and officers to mitigate these risks at the front end. Along these lines, on October 10, 2013, the FDIC issued a warning letter urging each financial institution board member and executive officer to understand fully his or her potential personal exposure based on the scope of coverage and, in particular, each policy exclusion.

Risk mitigation can come in many forms, including structuring the D&O liability program to segregate the coverage afforded to the directors and officers from the coverage afforded to the entity, negotiating more favorable terms and conditions in the D&O policy, or more closely monitoring the application process to ensure that the information being provided to the insurer is true, accurate and complete. With appropriate safeguards in place through a forward-looking approach to these issues, innocent directors and officers can mitigate or avoid loss of D&O liability insurance and the difficult question of “What went wrong?”  


About The Authors
Theodore M. Dunn, Jr.

Theodore M. Dunn, Jr., is a partner with CLM Member Firm Buckley King LPA. He has been a CLM Member since 2011 and can be reached at  dunn@buckleyking.com

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