Managing Rescissions and Exclusions

The rise in claims has spurred an increase in the number of cases in which carriers refuse to cover claims. "D&O liability insurance companies employ many nefarious and improper arguments to attempt to avoid obligations to provide insurance," warns William G. Passannante, a senior shareholder in the New York City office of Anderson Kill & Olick PC and co-chair of the firm's insurance practice group. "Recently, we have seen the repeated and strained assertion of the so-called 'rescission' argument in an attempt to avoid a policy in its entirety and various coverage exclusions."

CFOs need to be aware of how carriers respond to securities class-action lawsuits arising from earnings restatements that are triggered by alleged accounting irregularities. "These types of claims are often the trickiest," says Paul A. Ferrillo, counsel at law firm Weil, Gotshal & Manges LLP in New York City. "Carriers often raise arguments that they, too, were deceived based upon alleged material misstatements made in the company's application for D&O coverage, and thus claim they are entitled to rescind the policy."

In the recent Tyco, Adelphia, Enron, Xerox and WorldCom cases, for example, the D&O insurance companies attempted to wholly avoid the policies that they sold. Passannante notes that the courts have generally decided in favor of the policyholders, but warns that any case may involve a fight with the carrier.

The solution to this problem may be one of the newer products in the D&O insurance marketplace: Side A excess DIC (difference in conditions) D&O insurance. "This type of policy is generally noncancelable and nonrescindable," Ferrillo explains. "Even if allegations of alleged financial fraud abound, this policy will likely be there to protect the innocent insured directors or officers. It is dedicated coverage for directors and officers and does not generally hinge upon the financial status of the insured company."

The most important aspect of Side A excess DIC coverage is probably its "difference in conditions" feature. "Unlike most other types of excess coverage, the DIC policy drops down from its excess position in certain situations to provide coverage where an underlying carrier refuses to pay," Ferrillo says. "Thus, and most importantly, in a situation where a primary carrier attempts to rescind its policy in a financial restatement case, the DIC policy can drop down and serve as the primary policy and start immediately funding defense costs."

Even as CFOs consider the risk of rescissions, they have to watch out for the pages of exclusions contained in a typical D&O policy. For example, according to Passannante, policies increasingly exclude the provision of professional services. Some D&O policies contain exclusions for lawsuits brought under the Securities Act or the Employee Retirement Income Security Act. Most D&O policies contain exclusions for property damage, claims by regulatory agencies, claims seeking environmental damage, and fines and penalties. They also exclude coverage for liabilities arising from fraud or self-dealing by directors and officers if wrongful conduct is conclusively established.

Working With Underwriters

CFOs can take steps to minimize risk and work with insurance carriers to lower premium costs. They should be aware, though, that the D&O insurance underwriting process continues to be highly subjective, according to Simon Hodge, Atlanta-based executive vice president for the executive liability practice at Palmer & Cay Inc., an insurance brokerage and benefits consulting firm in Savannah, Ga.

"Underwriters evaluate clients and prospective clients based upon a myriad of considerations," Hodge says. They perform the customary financial and securities exposure analysis in addition to examining corporate governance standards, the perceived quality and experience of the company's management team and board of directors, the regulatory and industry environment in which the company operates, the transparency of its business model and financial reporting, and its compliance record. "Underwriters also take into account their own claims experience with other clients in the company's industry," he adds.

Before CFOs prepare their presentation for underwriters, they need to lay a foundation for their D&O insurance program. First, they need to establish the reason the company needs D&O insurance and its coverage priorities for personal and corporate liability, Hodge advises. They should also have a firm understanding of the company's goals for quality of coverage, program structure and pricing.

Conferring with a broker is helpful during this process. "You need to work with an experienced broker who can help you shape your risk management philosophy and implement a thoughtful marketing strategy," Hodge suggests. "The broker's role needs to be consultative, not just transactional." The CFO should be prepared to go far beyond typical financial disclosures in discussions with the broker.

For the presentation itself, Hodge has the following tips. "Your presentation to underwriters should be fair and balanced and address potential 'red flag' issues and areas of concern head on," he recommends. "Take the time to explain your business and industry issues and focus on your company's absolute and relative performance."

Hodge encourages corporate executives to meet with their D&O underwriters on a regular basis. "Underwriters appreciate frank and candid discussion with their clients," he points out. "Face-to-face meetings still play a significant part in the underwriter's overall assessment of your risk."

Chubb's Galban tells CFOs that providing underwriters with direct access to senior management is, by far, the most important thing they can do to influence underwriting judgment. "A compelling story told in a compelling fashion can have substantial effect," he explains. "Conversely, there are obviously risks if the story or the presentation are not effective."

Fielding Questions From the Board CFOs must be prepared to answer probing questions from the board of directors about Directors and Officers (D&O) coverage. In addition, "in light of the frequency with which CFOs themselves are named as defendants, it is in their own personal interest to ask questions as the D&O policy is being purchased or renewed," says Thomas S. Richey, partner at the law firm of Powell Goldstein LLP in Atlanta. Richey notes the six most crucial questions that a CFO can expect directors to ask about their D&O coverage: Who are the D&O insurer and the company's insurance broker? Is the insurer financially sound, and does the broker have the necessary expertise to represent directors effectively? What are the policy limits, why were they chosen, and why are they considered adequate? Are the policy limits for directors separate from limits for officers, or do the limits apply to directors and officers together? If the limits are not separate, why not? Does the coverage for individual insureds take priority over coverage for the company? Does the policy cover all types of litigation and claims likely to be asserted against directors if problems arise? For example, what about a class-action lawsuit based on the Employee Retirement Income Security Act by the company's pension plan participants? Can the insurer deny coverage if the company's financial statements are inaccurate? Is the policy nonrescindable -- at least for innocent directors? What protections do directors have if officers act fraudulently or if some information is not disclosed in the application for insurance? What happens to D&O coverage if the company files for bankruptcy? Are directors covered if a bankruptcy trustee or creditors' committee sues the board? Can the policy be tied up in bankruptcy proceedings? How will directors' defense costs be paid if the company is in bankruptcy? "The CFO can obtain answers to these and other questions from knowledgeable company counsel and the company's insurance broker," Richey says. "But you should be asking these questions before coverage is bound. Then you should have not only accurate answers, but good answers to give the board."

Renewing a D&O Policy CFOs are increasingly called on to play an active role in overseeing the placement of D&O coverage. "One of the most frustrating parts of this process is that renewal bids are often presented within hours or days of the expiration of existing coverage, leaving no time for understanding coverage, negotiating changes or communicating with directors and officers," notes Mark E. Miller, shareholder, insurance coverage and litigation, in the Washington, D.C., office of law firm Greenberg Traurig LLP. Miller designed the timeline shown below to help companies pursue the D&O policy renewal process with sufficient time for appropriate legal review and negotiation. No later than 120 days before the policy is scheduled to be renewed, the company should interview and select insurance brokers and conduct a legal review of current coverage to identify problems that need to be solved on renewal. Sixty days before renewal, the broker should submit the account to competing D&O insurance carriers, and soon afterwards, the broker should provide actual policy forms that competing insurers are using so that legal counsel can conduct a side-by-side analysis of the products. Finally, the company should receive competing quotes 30 days before policy renewal so that all parties have ample time to negotiate appropriate endorsements and to communicate available options.