Note: This article is part of an ongoing series on Board Directors. To learn more about their roles and responsibilities, download this free eBook today Director's Guidebook: How to be an Effective Board Director in Early Stage Companies or purchase our books at Amazon.com.
In CYA: Liability Insurance for Directors we talked about some high-level concepts relating to Directors & Officers insurance. Here we are going to go into a bit more detail. This will get you well-grounded, but as we noted previously, there is no substitute for a good D&O broker to help you wade through your options. Without the help of a broker, it is very easy to pay more money for a lesser policy, when, with some help, you could have purchased better coverage for your needs for less money. Ask around amongst your investing colleagues, CEOs and attorneys you know to be referred to a good broker.
Key Question 1: What Time Period Does My D&O Policy Cover?
All policies cover a period of time, but some look to when the deed occurred as opposed to when the claim is made. Claims-made policies are much more objective and easier to work with, so get a claims-made policy.
Many policies will appear to be a claims-made policy, but then in a separate clause attempt to exclude acts that occurred prior to the policy period. You want continuity of coverage that goes back to the date of formation of the company, so be on the look-out for language that talks about “prior acts exclusions” or “not retroactive.”
If you know of an existing issue when the policy is purchased (any fact or circumstance that might give rise to a claim), you need to disclose that in your company insurance “warranty” at the time of binding the policy. Any existing issues will be excluded in your new policy unless you specifically purchase a special rider to cover them (that’s not going to be cheap or easy, so prepare yourself).
Key Question 2: What, How and Who is Actually Covered?
There are two parties being covered in a typical policy: the company and the directors/officers. And there are three types of claims:
Claims directly against the company, such as a shareholder derivative suit or other claim,
Claims against the director/officer where the company’s D&O indemnification clause in their charter will cover the director or officer, and
Claims against a director or officer where the company’s D&O indemnification does not cover the claim.
The way this is generally talked about is A Side Coverage, B Side Coverage and C Side Coverage. A Side Coverage relates to non-indemnified claims against directors and officers. B relates to indemnified claims against them. C refers to suits against the company itself.
Needless to say, just like you want a fire extinguisher that is rated A-B-C, you want a D&O policy that covers A, B and C claims.
As noted in CYA: Liability Insurance for Directors, one other very important concept is what is called “tail” or “run-off” coverage. If a company stops paying its D&O premiums, the policy lapses, even for claims accruing during the coverage period. This can be a major issue in the context of a change of control (i.e. an exit by acquisition). Exit transactions are often the source of lawsuits and this is the worst time to let the policy lapse. It is crucial to ensure that the policy automatically adds either “tail” or “run-off” coverage for any director who leaves and also for situations where the company is acquired. If the insurer will not give automatic coverage, insist on getting an agreed-upon price for such coverage, and make sure that price is paid and coverage is bound BEFORE the company runs out of money or closes an acquisition.
Another issue to watch out for is whether your application for insurance is severable in case you made a false claim on the application. In a non-severable policy, any misstatement is grounds for denying all coverage under the policy. You want a severable policy that will continue to cover things not related to the misstatement on the application.
Key Question 3: Who Actually Does What During a Claim Adjudication?
There are two different ways to go about a claim adjudication: having the insurer be in charge (Duty to Defend policies) and having the company be in charge (Non-Duty to Defend) policies.
In a Duty to Defend policy, the insurer is in charge of the entire defense, including choice of counsel. The company will have consultation rights, but is not in charge and must agree to any settlement.
In a Non-Duty to Defend policy, the company runs the litigation, including choice of counsel (typically subject to approval by the insurer), and the insurance company foots the bill.
As you can imagine, the insurer prefers to be in charge because they can use more specialized, experienced, captive and inexpensive counsel, and they can do whatever they deem pragmatic in settling the suit. From the company’s perspective, this is cheaper and often better, but may be more risky or unattractive in some cases because, if it is a major issue relating to the integrity of the company or its directors and officers, they might feel the urge to “spare no expense” clearing their name or “hire the best” and let them loose to seek vindication.
If a large, sophisticated company wants to have a Non-Duty to Defend policy, the insurer will gladly sell it to them, but as you can imagine, the company is going to pay more for it. One of the tricky and highly negotiated aspects of the pricing on these policies is figuring out which aspects of the claims and the defense are covered by the policy. In a duty to defend policy, the decision is easy. The insurer will cover all of the defense costs (but they might not defend some things rigorously or at all). In a non-claims made policy, there needs to be an allocation of defense and settlement costs as between covered claims and claims relating to aspects of the dispute that are arguably outside the scope of the policy.
As you can tell from this overview of just the key concepts, this is a very complex and nuanced area reflecting hundreds of years of litigation and contract law learnings. In case it was not clear enough at the beginning, we will reiterate: you should work with a great broker to help you find a good policy with adequate and appropriate coverage for a fair price. For another perspective on D&O insurance, check out this post from Dave Berkus: I won't serve on a board without D&O insurance!
For a more in-depth discussion on early stage company board issues, download our companion eBook: Director’s Guidebook: How to be an Effective Board Director in Early Stage Companies or purchase our books at Amazon.com.