Recent cases highlight the increased risk of personal liability for directors. Is your company doing enough to protect the board?
Litigation has long been a fact of life for directors of U.S. public companies. The risk of personal financial liability has increased lately, though, particularly from shareholder derivative litigation alleging breaches of fiduciary duty. In a departure from the historical trend, a series of recent Delaware cases have declined to dismiss fiduciary duty claims and have raised the standards to which directors are held. This has unsurprisingly caught the attention of plaintiffs and translated into a significant increase in the value of derivative settlements. Since 2020, there have been at least 11 derivative settlements greater than $100 million. The 10 largest derivative settlements range from $167 million to an eye-popping $735 million, and all but two are from the last three years. Because Delaware law prohibits companies from indemnifying monetary derivative settlements (or judgments), they must be paid either by directors and officers (D&O) insurance or by directors personally.
D&O insurance is thus more important than ever in protecting the board from personal financial exposure. D&O policies are complex, bespoke contracts that often include heavily negotiated “endorsements” that alter the underlying policy form. Directors should take an active role in ensuring that management procures effective and appropriate coverage. The following five questions can help directors understand their D&O coverage and ensure it adequately protects them.
What are the coverage limits — and how much is Side A only? The first, and most obvious, consideration for D&O insurance is the total amount of coverage. There is no one-size-fits-all answer to how much coverage is appropriate, and factors to consider include the company’s market capitalization, its industry and regulatory risk profile, litigation trends and benchmarking against peers. The board should understand the analysis and judgments that informed management’s selection of coverage limits.
The board should also understand how much of the coverage is dedicated to “Side A only.” There are traditionally three types, or “sides,” of D&O insurance. In simplified terms, Side A covers only individual directors and officers, Side B reimburses the company after it indemnifies individual directors and officers, and Side C protects the company for its securities litigation risk. Because Side A-only coverage is reserved for the protection of individuals, it cannot be depleted by the company. A well-designed D&O program should have a meaningful amount of coverage that is Side A-only. The Side A-only coverage should also be “DIC,” or “difference in conditions,” meaning that it will provide first-dollar protection without a deductible when triggered.
What are the conduct exclusions for the Side A coverage? The highest limits in the world do no good if a coverage exclusion is triggered. Perhaps the most important exclusion from a director’s perspective is the conduct exclusion to Side A coverage. This is one of the very few exclusions to Side A coverage, but it can be especially consequential because it applies to self-interested, fraudulent and criminal conduct — precisely the kind of conduct likely to be alleged against directors.
The conduct exclusion can be significantly limited and even eliminated in certain circumstances. It’s now common for Side A policies to provide that the conduct exclusion is triggered only if the relevant misconduct is established by a final, non-appealable judgment in an underlying lawsuit (i.e., not one brought by an insurer seeking to avoid coverage). Side A policies also often include critical carve-backs providing that the conduct exclusion does not apply to legal fees or to independent directors. This exclusion is one of the most heavily negotiated in policies, and small differences in language can have critical consequences when coverage is needed.
What is the “prior acts” date? Another key exclusion is the prior-acts bar. This common provision precludes any coverage for claims involving, even in part, conduct that occurred before a certain date (often, but not always, the date a carrier began providing D&O coverage to the company). Because shareholder claims often allege a long period of wrongdoing — allegations of oversight failures going back five to 10 years are common — a recent prior-acts date can meaningfully limit the availability of coverage.
Is there coverage for government investigations? D&O insurance generally covers a “claim” alleging a wrongful act by an insured person. This “claims-made” framework has historically created uncertainty around coverage for government investigations. This is because investigations are often framed as information-gathering operations, with the first express allegation of wrongdoing coming if and when charges are filed.
Because of the importance — and expense — of having counsel defend an investigation, D&O policies have evolved to frequently include some sort of “pre-claim inquiry” (or similarly named) coverage. The terms of such coverage can vary widely. It’s important to consider the policy language in light of the particular types of regulatory investigations the company may face.
What is the company doing to lessen the board’s litigation risk? Even better than having great D&O insurance is not needing the coverage. Companies can do much in addition to insurance to limit directors’ personal financial exposure. The charter can exculpate monetary liability for duty of care claims. The charter and bylaws can mandate indemnification and advancement whenever it is legally permitted and designate the forum for derivative litigation. Indemnification agreements can strengthen indemnification and advancement rights and provide procedural protections to ensure they are honored even after an individual leaves the company.
Fiduciary duty litigation risk can also be mitigated through strong risk management controls. Recent Delaware cases have raised the standard for director conduct but also have provided guidance on how to defeat fiduciary duty claims. Particularly important is knowing the company’s mission-critical and core compliance risks, knowing the corporate officers responsible for those risks and ensuring there is a written, non-privileged record of the board getting information about those risks and making business judgments in response. Also critical is careful communication; undisciplined emails or texts are a too- frequent source of exposure for boards.
Careful vetting of D&O coverage should be a priority for boards given today’s litigation environment. Preparation is the best form of prevention, and asking the right questions now, before claims are filed, can ensure adequate coverage when needed.
This article originally appeared in Directors & Boards online. It is reprinted with permission of MLR Media.
This post is as of the posting date stated above. Sidley Austin LLP assumes no duty to update this post or post about any subsequent developments having a bearing on this post.