Why Outside Directors Shouldn't Leave Home Without Their D&O Coverage

Following the Sarbanes-Oxley reforms, both regulators and corporate management tend increasingly to rely on outside directors as a safeguard against claims of corporate malfeasance. At the same time that outside directors are being asked to do and deliver more, they are subject to more claims by investors and creditors, among others, for alleged breaches of duties and other purported wrongdoing. In the face of these heightened litigation risks, outside directors and their counsel should not only familiarize themselves with the scope of director and officer ("D & O") insurance coverage available to board members but make sure they understand the interplay between D & O coverage and litigation dynamics.

To begin with, outside directors ought to be comfortable with their applicable D & O coverage before accepting a board position. While D & O insurance premiums are jumping, the scope of coverage is being increasingly curtailed by, among other things, exclusions and limitations in policies. To maximize available coverage, an outside director should consider whether D & O coverage might exist not only from policies purchased by the company on whose board the outside director sits, but also from policies purchased by the director's own employer.

It usually is prudent to have an experienced coverage attorney or insurance broker carefully review relevant policy documentation, including, among other things, any application materials submitted to insurers during the underwriting process. A key issue is the scope of policy exclusions, particularly exclusions relating to fraudulent or criminal conduct, known litigations, or punitive damages. Other points to consider when examining coverage details include: monetary limits; conditions of termination or renewal; the creditworthiness and reputation of the insurer(s); any representations made during underwriting; and deductibles, retentions or co-insurance obligations.

No matter how improbable litigation may appear, an outside director should have a game plan in place in the event claims are brought against board members. An attorney for the outside director should be involved in tendering the notice of claim to the insurer, since technical requirements for the presentment of notice often feature in coverage disputes. The attorney also should elicit the insurer's coverage position regarding that director, including all defenses, many of which often are directed principally at inside executives.

There may also be substantive differences between the litigation positions of the various officers and directors who are named as defendants. Those differences may relate to the respective lengths of their tenures as directors; the particular responsibilities of directors based on committee assignments; what meetings different directors attended; or a particular director's background and knowledge.

For an outside director - whose principal business interests likely are focused elsewhere - the burdens associated with being named as a defendant include protracted and tedious discovery, and the stigma of being named as a defendant. It thus often will be in the outside director's best interest to settle the case as quickly as possible. The more defendants there are, however, the harder it can be for any single person to obtain a quick settlement, because plaintiffs' cost of prosecuting the case will not decrease significantly if that one defendant is dropped. The result in many cases, where plaintiffs have sued many or all current or former directors and officers, is often a "critical mass" of defendants from whose gravity it can be difficult for even the most tangentially involved outside director to escape.

Despite the practical hurdles to a quick settlement, there are strategies to maximize initial settlement efforts on behalf of an outside director. In situations implicating payment by the insurer, standard D & O terms provide for the insurer's pre-approval of any settlement, and it would in any event be prudent practice to obtain that approval. Unless the insurer denies coverage outright, the policyholder has a sound basis to treat its communications with the insurer about settlement with plaintiffs as confidential and subject to attorney-client privilege.1

To facilitate a settlement, the outside director and coverage counsel may have to engage in a balancing act to negotiate with, on the one hand, the plaintiffs in the case, and, on the other, the insurer. Perhaps the best argument that the outside director has to encourage settlement is that the defense costs being incurred to defend the director are reducing the policy limits. The plaintiffs thus have an incentive to settle before the policy limits are further depleted by defense costs. The insurer, however, may perceive itself as having competing concerns, since a common view is that it is less costly overall to have a global settlement for all directors and officers rather than a series of individual settlements. The outside director and counsel should consider pressing for settlement individually if global talks reach an impasse, emphasizing to the D&O insurer that it owes insureds individually a duty of good faith and fair dealing.

Under New York law, the implied covenant of good faith and fair dealing imposes on the insurer a duty to "consider, in good faith, the insured's interests as well as its own when making decisions as to settlement."2 Where an insurer's bad faith results in the loss of an actual opportunity to settle within policy limits, the insurer can be held liable for a subsequent settlement in excess of those dollar limits.3 In Brown v. United States Fidelity & Guaranty Co., the Second Circuit found that the insurer's conduct, in impeding settlement, "may well be viewed as 'the intentional disregard of the financial interests' of the assured, or the 'willingness to gamble with the insured's money,' which constitutes bad faith and subjects the company to liability beyond the policy limits".4

The First Department held in Smoral v. Hanover Ins. Co. that the insured's duty of good faith is implicated where it prefers the interests of one of its insureds to those of another.5 In Smoral, the insurer paid its entire policy amount to settle on behalf of one insured at the expense of another. The second insured ultimately settled and sued to recover from the insurer. The trial court dismissed and the First Department reversed, holding that the insurer owed the second insured a duty of good faith to provide "adequate protection." The Smoral court specifically noted that "[i]t is absolutely no answer for the company to say that it paid the full amount of its policy if in so doing it fully protected one of its insureds and left the other completely exposed."6

Smoral is among the few reported cases in New York addressing the question of settlement on behalf of less than all insureds. Subsequent cases in other jurisdictions, however, treat Smoral's ruling as limited to its peculiar facts. The Fifth Circuit, for example, has held that an insured who was not at the time a named defendant had no claim against an insurer who exhausted policy limits settling on behalf of other insureds.7 A federal court in Missouri distinguished Smoral as "involv[ing] a matter in which the insurer acted in bad faith," holding that an insurer "should not be obligated to defend an additional insured after paying its limits in a reasonable settlement for the named insured."8 Similarly, a Pennsylvania court distinguished Smoral on the ground that the insurer in that case was "specifically found [to have] acted in bad faith," and noted that Smoral "did not establish a complete prohibition on partial settlements by insurers."9 When Smoral is read in context, New York law still permits insurers to settle on behalf of fewer than all insureds, "even if such settlement exhausts the policy proceeds."10 Indeed, a strong argument could be made that a failure to approve a reasonable partial settlement would give rise to a claim against the insurer for bad faith.

In many situations, the dynamics are such that settling an outside director out early to avoid mounting defense costs will benefit all the parties. Thus, particularly if plaintiffs can be persuaded to make a reasonable settlement demand within policy limits with respect to the outside director, the insurer has a duty to consider it and - if the offer is genuinely reasonable - accept it.1 In re Texas Eastern Transmission Corp. PCB Communication Ins. Coverage Lit., 1990 Dist. LEXIS 7912 at *14, n. 7 (E.D.Pa. June 27, 1990); Remington Arms Co. v. Liberty Mutual Ins. Co., 142 F.R.D. 408, 418 (D Del 1992)
2 Harris v. Standard Accident & Insurance Co., 191 F.Supp. 538, 540 (S.D.N.Y.), rev'd on other grounds, 297 F.2d 627 (2d Cir. 1961); see also Gordon v. Nationwide Mutual Ins. Co., 30 N.Y.2d 427 (N.Y. 1972).
3 See, e.g., Employers Mut. Cas. Co. v. Key Pharmaceuticals, Inc., 871 F. Supp. 657, 672 (S.D.N.Y. 1994)
4 314 F.2d 675, 678 (2d Cir. 1963) (internal citations omitted)
5 337 A.D.2d 23, 25 (1st Dep't 1971)
6 Id.
7 Travelers Indemnity Co. v. Citgo Petroleum Corp., 166 F.3d 761, 764 (5th Cir. 1999)
8 Millers Mut. Ins. Ass'n v. Shell Oil Co., 959 S.W.2d 864 (Mo. Ct. App. E.D. 1997)
9 Anglo-American Ins. Co. v. Molin, 670 A.2d 194 (Pa. Commw. Ct. 1995)
10 STV Group, Inc. v. American Continental Properties, Inc., 234 A.D.2d 50, 51 (1st Dep't 1996)

Published March 1, 2004.