Although the usual liability policies of the corporation—commercial general liability or auto, for example—extend coverage to directors and officers serving the corporation, these policies have no coverage against liability for the financial loss described above. Moreover, the liabilities of directors and officers are outside the scope of conventional homeowners or personal umbrella policies that may be carried by directors and officers themselves. In fact, most personal umbrella policies have an exclusion of liability arising out of the insured's activities as a director or officer of any corporation or association. Even in the absence of a directors and officers exclusion however, a homeowners or umbrella policy may not cover the directors and officers exposure; the business pursuits exclusion often eliminates coverage.

The appropriate insurance treatment for this liability exposure—which is an exposure like the professional liability of doctors and lawyers—is directors and officers liability insurance.  Also, many corporations, when permitted by law, enter into formal agreements to indemnify their directors and officers for personal loss due to certain kinds of legal actions against them in their capacities. Many companies fund these indemnity agreements in part by purchasing a form of D&O liability insurance referred to as corporate reimbursement coverage. This and D&O liability insurance covering the directors and officers themselves are nearly always sold in the same policy. Because of the threat to directors' and officers' personal assets, and because of the increasing frequency and size of actual awards against directors and officers, D&O liability insurance purchased by the corporation has become for many executives a prerequisite to accepting a position as a director or an officer.

Although there is no standard form for D&O liability—each insurer files its own—there is a moderate degree of conformity in policy language. Consequently, the following pages, after tracing the history of D&O liability insurance from its origins to current market conditions, describe the typical policy provisions. Naturally, a particular policy can have significant differences from the norm, and so the provisions of any policy under consideration should always be carefully examined.

Development of D&O Liability Coverage

The demand for D&O liability insurance has been pronounced only for the past few decades, but the history of the coverage begins in the early 1930s. It was then that Lloyd's of London first offered the coverage, in response to a wave of lawsuits against directors and officers following the 1929 stock market crash. The new coverage was expensive, underwritten very selectively, and complicated by forms considered cumbersome even by the standards of that day; few policies were sold. It was not until the 1950s, after the preoccupation with World War II and recovery from it had subsided, that there arose a renewed concern over the liabilities of directors and officers. In response, Lloyd's drafted new forms for the coverage and began the contemporary era of directors and officers liability insurance.

Even after its revival, however, the coverage was underwritten cautiously and many who wanted it could not get it. The market expanded in 1964 with the entry of The St. Paul, and in 1966 with the entry of American Home Assurance. Other United States insurers followed. Still, underwriting remained highly selective and many businesses were considered undesirable merely because of the type of operations—steel, mining, and drug manufacturing, to name a few. It was a sellers' market.

Through the first half of the 1980s, the number of insurers selling D&O coverage increased, with many trying to specialize in coverage for particular business classifications or industries. However, the number of D&O suits skyrocketed, due partly to the increasingly litigious atmosphere and the promulgation of class-action lawsuits. And, this had a chilling effect on the cost and availability of D&O coverage.

Now, some see capacity slowly beginning to return to many sectors of the D&O marketplace. Premiums overall are decreasing and coverage is increasing.

D&O Policy and Issues

Directors and officers liability insurance actually consists of two distinct coverages; one for the personal liability of the directors and officers themselves, and one for the corporation's obligation, if any, to indemnify its directors and officers for certain actions against them. Both coverages can be purchased through separate insuring agreements in one policy, or either coverage can be purchased alone. For example, a corporation with no obligation to reimburse its directors and officers can purchase directors and officers liability without corporate reimbursement coverage. In the pages that follow, coverage for the directors and officers themselves is discussed first, followed by corporate reimbursement coverage.

Directors and officers insurance is generally written on a claims made basis: the insurance applies to claims made during the policy period, or the optional extension period, for a wrongful act committed subsequent to the retroactive date stated on the declarations page. Thus, after the policy expires, it does not provide insurance for acts committed during the policy period as is the case under liability policies written on an occurrence basis. However, it is customary for D&O liability policies to carry a discovery (or “extended reporting period”) clause, which enables the insured to extend coverage for a period of time—it varies among contracts, from ninety days to twelve months—in the event that the insurance company cancels the policy or refuses to renew it. This coverage applies only to claims for wrongful acts committed prior to termination and not made until some point within the reporting period. If an insured wants this coverage, it normally must notify the insurance company in writing within ten days after policy termination and pay an additional premium. Some insurers may charge up to 50 percent or more of the full annual premium for the extended reporting period, and this charge is fully earned from the start.

In the coverage application for directors and officers liability insurance a request is typically included for information about all facts known to any of the directors or officers that might result in a claim. If any facts of this type are known, the claims arising from them are excluded from coverage. This has raised questions concerning the right of the insurer to rescind the insurance contract when material information was not disclosed at the time of application, and about the coverage that might apply to “innocent” executives where the application is completed and signed by only one person.

The cases that have been decided fall on both sides of the fence. For example, the case of Shapiro v. American Home Assurance Co., 584 F. Supp. 1245 (D. Mass. 1984) indicates that a material misrepresentation in an insurance application by one corporate officer can relieve the insurer of any obligation to other “innocent” insureds. In Shapiro, the company president misrepresented corporate income for the year preceding the insurance application and was later convicted of securities fraud. Shapiro gave a false statement on the application when he said that he did not know of any ” act, error, or omission” by corporate officials that might give rise to a claim. The court found this to be a “ material” misrepresentation. Further, the application excluded coverage for any claim arising from facts known by any director or officer at the time of application. The court, reasoning that the question of coverage should be answered by contract interpretation and not by analyzing the relationship of Shapiro to the other executives under agency law, found that the latter provision unambiguously excluded such claims from coverage.

Other cases that follow the Shapiro thinking include INA Underwriters Insurance Company v. D.H. Forde & Company, 630 F. Supp. 209 (1986); National Union Fire Insurance Company v. FDIC, 837 S.W.2d 373 (1992); and First National Bank Holding v. Fidelity and Deposit Company of Maryland, 1995 WL 316892, (N.D. Fla., 1995).

On the other side of the issue, the court in National Union Fire Insurance Company v. Continental Illinois Corporation, 658 F. Supp. 775 (1987), decided that alleged false and misleading financial statements on the insurance application did not warrant a rescission of the D&O policy. Other cases that refuse to allow rescission are Continental Casualty Company v. Allen, 710 F. Supp. 1088 (1989); and, Wedtech Corporation v. Federal Insurance Company, 740 F. Supp. 214 (1990).

Due to the unsettled nature of this issue, some corporations have adopted the practice of having each insured sign a separate application or have added language stating that the application will be construed as a separate application by each insured, with no statement of knowledge by one insured being imputed to another. However, each provision of this sort should be analyzed carefully to determine whether innocent insureds are protected only from imputation to them of acts or knowledge held by officers who did not sign the application.

The insuring agreement for directors and officers protects these executives against “loss” arising from claims lodged against them during the policy period by reason of a “wrongful act.” By exclusion, the personal coverage of directors and officers does not apply where the insured corporation is required (by law or by the charter or corporate bylaws) to indemnify directors and officers. Thus, where a claim involves a situation requiring corporate indemnification of directors and officers, their protection comes from corporate indemnification and not from directors and officers liability coverage.

When a claim falls under the personal coverage promised to individual directors and officers by the insurer, the agreement, as noted above, is to pay for “loss” of the directors and officers for alleged “wrongful acts” committed in their capacities as executives of the company. “Loss” is generally defined as including costs, charges, and expenses incurred in the defense of actions, suits, or proceedings. The definition of “loss” is essential because it clarifies what types of expenditures are covered—whether damages, judgments, and settlements are covered in addition to the costs, charges, and expenses involved in defending claims.

Coverage of legal defense costs, charges, and expenses is usually separately described elsewhere in the policy and may include the cost of appeal, attachment, and similar bonds. An insured may be covered for legal defense in one of two ways. Most policies provide “defense expense” coverage. “Defense expense” coverage provides for reimbursement of defense costs incurred by the insured. This allows the insured to choose legal counsel (subject to the consent of the insurer, which cannot be unreasonably withheld) and to exert control over the case. The second type of legal defense coverage is “duty to defend” coverage, requiring that the insurer provide the defense.

Many courts have held that even where the defense clause is silent on the subject of appeal, the insurer must fund an appeal of a judgment against the insured when there are reasonable grounds for appeal. Some courts have found that if the insurer writes a broad clause stating its duty to defend (without excluding its duty to appeal), a duty to appeal exists regardless of whether or not the insurer reasonably believes that there are grounds for appeal. For example, the court in Palmer v. Pacific Indemnity Co., 74 Michigan App. 259 (1977) interpreted a “duty to defend” clause in a doctor's malpractice policy to include the duty to appeal, reasoning that if the duty to appeal is required only when the insurer believes that reasonable grounds for appeal exist, a harsh burden may be placed upon the insured to pursue the action independently. Furthermore, the fact that an appeal is lost is not necessarily a clear indication that the grounds for appeal were unreasonable.

In some cases, the interests of the insured and the interests of the insurer may conflict under a “duty to defend” policy. Where an insurer asserts a reservation of rights or disclaims liability for certain allegations, the insured may be able to select defense counsel and control his own defense. See, for example, Previews, Inc. v. California Union Insurance Co., 640 F.2d 1026 (9th Cir. 1981), where the court found a clear conflict of interest because the insured would be harmed by the creation of a class action suit, but the insurer, asserting that a $5,000 deductible would apply to every member of the class, would benefit. The insurer in that case would also benefit from the finding of willful conduct, but the insured could suffer greater loss from such a finding due to the imposition of punitive damages. The court found, as a result of these conflicts, that the insurer's obligation to defend extended to paying for the reasonable fees and costs of the insured's independent counsel.

The timing of insurance coverage for legal defense costs has been a much-litigated issue in recent years. Under a “defense expense” policy, several courts have held that the insurer is obligated to provide contemporaneous legal defense expense coverage if such costs are included within the definition of “loss,” unless the policy clearly states otherwise.

Generally, the issues in these cases has been whether the insurer effectively barred the insureds from receiving legal defense expenses as they were incurred by language that provided for insurer discretion to pay “costs, charges, and expense” (and these terms were undefined). The courts have reasoned that the policies are liability policies covering losses for which the insured is liable, not indemnification policies. Therefore, unless otherwise limited by policy language, whenever “loss” occurs (i.e., whenever the directors of officers are legally obligated to pay for legal expenses), the insurer must pay. Since legal expenses are due when billed, the policies require payment as incurred.

Several policies included language similar to the following that was relied on by the insurers to give them control over the timing of defense expense payments: “The insurer may at its option and upon request, advance on behalf of the directors and officers. . .expense which they have incurred in connection with claims made against them, prior to disposition of such claims. . .” Because legal expenses were included under “loss” (which the insurers were obligated to pay as incurred) and because “expenses” were left ambiguously undefined under the limiting provision, the courts construed the limiting provisions as ineffective and found that these defense costs were due when incurred: Gon v. First State Insurance Co., 871 F.2d 863 (9th Cir. 1989) [applying California law]; Okada v. MGIC Indemnity Corp., 823 F.2d 276 (9th Cir. 1986) [applying Hawaii law]; Little v. MGIC Indemnity Corp., 836 F.2d 789 (1987); FSLIC v. Burdette, 718 F. Supp. 649 (1989); and National Union Fire Insurance Company v. Brown, 787 F. Supp. 1424 (1991). However, some courts have interpreted identical language as not to impose an obligation to reimburse contemporaneously, or to allow complete insurer discretion as to whether or not to advance defense costs: Zaborac v. American Casualty Co., 663 F. Supp. 330 (C.D. Ill. 1987); National Union Fire Insurance Company v. Ambassador Group, Inc., 738 F. Supp. 57 (1990); and RTC v. Miramon, 1993 U.S. Dist. LEXIS 8361 (E.D. La., 1993).

Certain policies now have adopted language that clearly postpones payment of legal expenses until after the legal proceedings have been concluded, such as “It shall be the duty of the directors and officers and not the duty of the underwriters to defend claims. . .provided that no costs, charges, or expenses shall be incurred without Underwriter's consent. . .In the event of such consent being given. . .underwriters shall reimburse cost, charges, and expense only upon the final disposition of any claim made against the directors and officers.”

Another issue with regard to just what “loss” includes is the exclusion of “fines or penalties imposed by law” or “other matters deemed uninsurable” under the applicable law. In practice, the exclusion of fines or penalties might apply to treble damages awarded in an anti-trust action, and the exclusion of uninsurable matters might apply to punitive damages in a jurisdiction that has forbidden insurance coverage for punitive damages. Note that the uninsurable matters exclusion would not eliminate coverage for punitive damages in a state allowing insurance to cover punitive damages.

The majority of cases have found that insurance policies providing coverage for “damages” include coverage for punitive damages arising from gross negligence unless specifically excluded. For example, the court in Hensley v. Erie Insurance Co., 283 S.E.2d 277 (W. Va. 1981) found that coverage for punitive damages was available for all but intentional acts where the policy language stated that the insurer would “[pay] on behalf of the insured all sums which the insured shall become legally obligated to pay a damages,” reasoning that the “all sums” provision as quite broad and the policy specifically excluded coverage for damage “caused intentionally” but did not specifically exclude damage caused by gross negligent. But the courts are divided as to whether enforcement of coverage for punitive damages is against public policy. Court decisions in this regard depend upon which state's law will apply in construing the policy.

Policies differ in the mechanics of defining directors and officers covered by the policy. Some policies cover “any duly elected director or duly elected or appointed officer of the company;” in other policies it is necessary to schedule the positions of officers covered by the policy or to schedule only the positions of officers not covered.

Because the insurance is written on a claims made basis the past acts of retired officers can only be covered under the corporation's in-force policy. For this reason, it is desirable that the policy state that coverage applies to past directors and officers of the corporation. Wording to this effect on a typical policy lists insureds as “any persons who were, now are, or shall be a director or officer of the corporation.”

This language also brings up the importance of coverage for directors and officers occupying newly created positions. Some policies automatically cover all new directors and officers by virtue of their broad definitions of directors and officers, while other policies may require written notice to the insurance company within a certain number of days after each policy anniversary date.

It is also customary that the policy cover, to some extent, directors and officers of the corporation's subsidiaries. The provisions governing directors and officers of subsidiaries—usually contained in a definition of that term—should be checked carefully as there is variation among policies in this respect.

Most policies cover an insured executive acting within the scope of his duties as a director or officer. This raises questions about those activities that are not clearly within the duties performed for the corporation, such as professional association, charitable, or public speaking activities. For example, coverage may be in dispute where an officer, at the corporation's urging, makes a speech to a professional organization and during the course of the speech he makes allegedly slanderous remarks. And, what about the coverage for outside directorships taken on by the executive at the request of his corporation?

Because D&O insurance covers the personal liability of directors and officers, it normally grants insured status to the estates, heirs, legal representatives, or assigns of deceased directors and officers, as well as the legal representatives or assigns of directors and officers in the event of their in competency, insolvency, or bankruptcy. Provisions to this effect are normally stated in the policy's definition of directors and officers or in a separate provision.

The broad scope of coverage created by the insuring agreement and the definitions of such terms as “loss,” “wrongful act,” and so forth, is limited considerably by numerous policy exclusions. The following paragraphs describe some of the more common exclusions that may be found in D&O liability policies. Note that exclusions can be written throughout the policy and not just in the exclusions section.

Before examining these exclusions, it is useful to emphasize the effect of the exception to the exclusions that is often located at the end of the exclusion provisions in D&O liability policies. Language typical of such exceptions states: “The wrongful act of any director or officer shall not be imputed to any other director or officer for the purpose of determining the applicability of the exclusions enumerated in this clause….” If, for example, the directors of a corporation become jointly liable for the dishonesty of one director, the policy exclusion of dishonest acts would exclude coverage only for the dishonest director and would not affect coverage for the innocent directors. As is the case with other types of liability insurance, D&O liability insurance applies separately to each insured under the policy. However, an innocent insured may not be covered if the insurer is relieved of liability due to misrepresentations in the application for insurance, as noted earlier under the discussion of applications.

Libel and slander: The liability for these acts is normally insured under the corporation's personal/advertising injury liability and umbrella liability policies.

Personal profit: No D&O liability policy covers claims against directors and officers resulting from their gaining personal profit or advantage to which they are not legally entitled, as, for example, through their use of inside information.

Excess remuneration: If a director or officer becomes liable to return to the corporation salaries or bonuses received illegally without the stockholders' prior approval, the insurance will not respond.

Short-swing profits: If a director or officer profits by the purchase or sale of securities of the corporation within the meaning of Section 16(b) of the Securities Exchange Act of 1934 or similar provisions of any state statutory law, the policy will not protect the executive against resulting claims. The section of the law referred to above addresses profits an executive might make through the purchase and sale (or sale and purchase) of corporate securities within a period of less than six months.

Dishonesty: If a claim alleging dishonesty is brought against an executive, the typical D&O liability policy will protect the insured unless it is established—by “judgment or other final adjudication”—that the executive engaged in deliberate dishonesty with “actual dishonest purpose and intent.” Loss to the principal through executives' dishonesty is customarily insured through fidelity bonding.

Failure to procure or maintain insurance: The insurance does not cover liability resulting from the failure to effect or maintain adequate insurance for the corporation. If, for example, the directors fail to authorize the purchase of products liability insurance and the corporation subsequently becomes liable for an uninsured, unfunded products liability loss, the insurance will not cover resulting claims against the directors. Some insurers will delete this exclusion after examining the corporation's insurance program. Deletion may or may not entail an additional premium.

Indemnity under previous policy: Most policies exclude any coverage for claims covered under a previous policy (as through the discovery period described earlier). Some policies provide for excess coverage over such previous insurance.

Indemnity by corporation: If a claim against an executive is paid in accordance with the corporation's agreement to indemnify directors and officers, the executives would be enriched, rather than compensated, by a duplicate payment from the insurance company. Therefore, claims for which directors and officers receive corporate indemnity are excluded. (If the corporation carries corporate reimbursement coverage, it will itself probably be compensated in large part by the insurance company.)

ERISA: The Employee Retirement Income Security Act (or Pension Reform Act) of 1974 so broadened the potential liabilities of fiduciaries of employee benefit plans that some insurers have chosen to eliminate coverage from their D&O liability policies for liability based on ERISA. Instead, the exposure is covered through separate employee benefit liability insurance.

Bodily injury or property damage: Some policies emphasize the intended effect of D&O liability insurance not to overlap other forms of insurance covering liability for bodily injury and property damage.

Pollution: Some policies exclude bodily injury and property damage resulting from pollution or contamination. Pollution claims represent an huge potential exposure for directors and officers. The director or officer can be held liable on a personal basis (if he or she had actual control over the handling of pollutants), or due to a “prevention test” basis through which the director or officer is held liable because he or she had the power to prevent the pollution and did not do so.

Nuclear hazards: Generally, all insurers attach the broad form nuclear energy liability exclusion endorsement to their D&O liability policies.

Suits by the insured corporation. Because D&O insurance is a form of “liability” insurance, most claims triggering coverage are third party lawsuits or shareholder derivative claims. However, in unusual suits brought in 1985 and 1986 by corporations against their own executives, the insurers were required to cover the liability of these executives. Since insurers viewed these lawsuits as an attempt to use D&O insurance to recover operating losses, many forms now include an exclusion to clarify that no coverage is available for claims brought by the insured corporation itself.