State corporate-indemnification laws, legislative reform, and D&O liability insurance and other risk-financing techniques can combine to provide what has been referred to as a “three-legged stool of protection,” as depicted in the following illustration as provided in Veasey, Finkelstein, Bigler, “Delaware Supports Directors With a Three-Legged Stool of Limited Liability, Indemnification, and Insurance,” 42 Business Lawyer 399-42.

Corporate Indemnification of Directors and Officers

Public policy dictates that directors and officers should not be able to immunize themselves completely from personal liability. However, they should be entitled to indemnification by the corporation if they can establish that they acted in good faith and in the best interests of the corporation. Corporation laws of all states, except for cases involving certain flagrant conduct, grant authority for the corporation to indemnify its directors and officers for liability and expenses they might incur in the discharge of their duties to the corporation. The purpose of such laws generally has been to provide an inducement to attract competent people to serve as corporate directors and officers by limiting their exposure to personal liability.

For many years most states have authorized indemnification of directors, officers, and other persons in an effort to alleviate the potential financial burdens of personal liability for alleged and actual wrongdoing. The extent to which corporations are permitted to advance costs incurred in defense of a claim or lawsuit, and to reimburse or hold harmless a director or officer against actions that result from their performance as directors or officers, is established by state law, by corporate charter or bylaw, and by contract.

Exclusive Versus Nonexclusive Indemnification

State laws sometimes prohibit the indemnification of directors and officers beyond the indemnification allowable by statute. In such cases the law is considered to be exclusive. Most state statutes, however, are nonexclusive, allowing a broad range of indemnification beyond that which the state specifically requires or allows.

The indemnification laws of some states, such as Delaware , permit indemnification of directors, officers, employees and agents of the corporation not only for legal and miscellaneous expenses, but also for judgments and settlements of civil third-party actions. For example, the Delaware statute requires that the person or persons subject to such indemnification must have acted in good faith and have reasonably believed that his or her actions were in the best interests of the corporation. When fines are involved, such as in criminal cases, the standard of conduct may further require that the director or officer had no reason to believe such conduct was illegal.

Mandatory Versus Permissive Indemnification

Statutes may provide that indemnification of directors and officers is mandatory or permissive. Mandatory indemnification, as stated in the revised Model Business Corporation Act, provides for indemnification of expenses where the directors and officers have been successful in defending allegations of wrongdoing:

Unless limited by its articles of incorporation a corporation shall indemnify a director who was wholly successful, on the merits or otherwise, in the defense of any proceeding to which he was a party because he is or was a director of the corporation against reasonable expenses incurred by him in connection with the proceeding.

[REVISED MODEL BUSINESS CORPORATION ACT § 8.52 (85)]

Permissive indemnification statutes deal primarily with the extent to which the corporation can provide indemnification when the directors and officers have been unsuccessful in defending derivative actions. The law in many states specifically precludes the corporation from indemnifying its directors and officers if they have been found to be liable to the corporation. However, indemnification of expenses and attorneys' fees is allowable if the directors and officers have successfully defended a derivative action. Most states allow indemnification beyond what is allowed by law through charter, bylaw, or separate contract. Where such extrastatutory benefits are allowed, they are often conditioned on specific standards of conduct.

Even when the law is exclusive or provides only for limited indemnification beyond statute, the courts in almost all states can order indemnification of expenses and settlements where the corporation would not otherwise have the power or discretion to indemnify.

Expansion of Corporate Indemnification Provisions

Even states with the most limited indemnification statutes now require that the corporation indemnify its directors or officers when they have been successful in defending themselves against shareholder-derivative-action claims. Some jurisdictions have expanded the extent to which the corporation is allowed to indemnify to include judgments and settlements where defense of such actions has not been successful. At least one state has adopted a position requiring that the corporation indemnify for judgments and settlements in derivative actions except in situations involving willful misconduct, improper personal profit, and other specified offenses.

Legislative Reform

During the 1980s a number of forces acted to limit the availability, and in many instances the affordability, of D&O insurance. There have been many theories as to the specific nature of these forces, but most authorities concur, at least in part, that a severe contraction in the global reinsurance market, an increase in merger and acquisition activities, and an increase in business failures made the problems of providing adequate insurance protection particularly acute. Out of this crisis emerged new legislation that attempted to further enhance the already liberal protection provided directors and officers. The ensuing state legislative response was quite broad and often included the following statutory provisions:

•    Many states adopted statutes that further limited liability for directors and officers in specific situations.

•    Indemnification provisions were expanded to include reimbursement of judgments and settlements in shareholder derivative actions.

•    The criteria directors and officers use in their business judgment was expanded to allow consideration of nonshareholder interests.

Most state statutes hold directors responsible for the duty of care and the exercise of informed business judgment. This means that directors are to avail themselves of all information reasonably available and, in so doing, to act with care in the discharge of their duties. On July 1, 1986, the state of Delaware adopted legislation authorizing corporations to limit, and in some cases eliminate, through the use of a shareholder-approved charter amendment, a director's personal liability for money damages based on breaches of the duty of care, including gross negligence. This charter option allowed the certificate of incorporation to be amended to contain the following.

A provision eliminating or limiting the personal liability of a director to the corporation or its stockholders for monetary damages for breach of fiduciary duty as a director, provided that such provision shall not eliminate or limit the liability of a director: (i) For any breach of the director's duty of loyalty to the corporation or its stockholders, (ii) for acts or omissions not in good faith or which involve intentional misconduct or a knowing violation of law, (iii) under 174 of this title, or (iv) for any transaction from which the director derived an improper personal benefit. No such provision shall eliminate or limit the liability of a director for any act or omission occurring prior to the date when such provision becomes effective. All references in this paragraph to a director shall also be deemed to refer to a member of the governing body of a corporation which is not authorized to issue capital stock.

Del. Code Ann. Tit. 8, § 102(b)(7) (1991)

This Delaware statute proved a popular vehicle for limiting liability. Most other states have now adopted similar optional provisions.

While liability-limiting statutes like the one adopted by Delaware and other states may provide a welcome relief from some types of liability, there are important exceptions to the extent to which liability can be limited for other types of misconduct. Although the law varies by jurisdiction, the following are not normally subject to the liability-limiting provisions of the law:

•    Liability based on the duty of loyalty

•    Wrongful acts or omissions where the director or officer has not acted in good faith, violations of law, or other intentional misconduct

•    Liability based on transactions in which the director or officer derived an improper personal profit, benefit, or advantage

It should be noted that not all states extend the benefit of charter-amendment protection to officers of the corporation. Most states follow the Delaware model and allow the immunity to apply only to directors of the corporation. Such provisions also only apply to liability a director, or in some instances an officer, has to the corporation or shareholder, and do not apply as respects liability to third parties. The Delaware law is also enabling, meaning that in order for the grant of protection to apply, the corporation must have amended its certificate of incorporation or bylaws to include the liability-limiting provision. In these instances, protection only applies to wrongful acts or omissions occurring after the time such a provision becomes effective.

Business Judgment Rule Expanded to Include Considerations of Outsider Interests

Directors and officers are charged with making business decisions in an informed fashion, mindful of the best interests of the corporation. (The “business judgment rule” immunizes management [including corporate directors and officers] from liability in corporate transactions undertaken within both the powers of the corporation and the authority of management where there is reasonable basis to indicate that the transaction was made with due care and in good faith. For further discussion of the business judgment rule, see Duty of Diligence and Care.) Questions regarding such decisions often arise out of the board's response to hostile-takeover bids and to shareholder-derivative actions, which often allege that the chosen course of action was not in the corporation's best interests.

Many state statutes now have expanded the criteria of what constitutes the corporation's best interests to also include consideration of non-shareholder interests, including those of employees, creditors, customers, and other outside entities. Some statutes even extend consideration to community, state, and nation. There is considerable variety in how and to what extent the individual jurisdictions apply such statutes. Some states allow consideration to extend to outside interests, while other states mandate such consideration. Debate continues on whether these types of statutes add any protection from liability. Some have suggested that requiring directors to consider outside constituencies may invite criticism from, or imply some obligation to, these parties, an obligation that may not have existed prior to enactment of the legislation.

Insurance and Other Risk-Financing Techniques

Risk-control techniques, indemnification, and legislative reforms cannot completely protect an organization or its directors and officers from the risk of serious financial loss. Any claim or incident can lead to litigation, and even nuisance suits can cost tens of thousands of dollars to resolve. Defense of more serious claims can cost many times this amount. Small or thinly capitalized firms may be severely impacted by even a single claim, but even larger firms might find it difficult to absorb the cost of multiple suits or a large class-action suit.

The adoption of indemnification provisions does not always guarantee financial protection for directors or officers. D&O insurance may be available only at extremely high cost, may be limited in amount, and is often subject to numerous exclusions and exceptions from coverage. Since insurance, even if available, does not always offer comprehensive and secure protection for corporate directors and officers, many companies now are using or considering alternative ways to fund indemnification agreements outside of traditional insurance coverage.

Alternate Indemnification-Funding Methods

Many states have adopted statutes in recent years addressing alternative indemnification-funding methods. Although indemnification provisions may be quite broad, they are no guarantee of the corporation's financial ability to pay. D&O insurance, even when available and affordably priced, contains many exclusions and limitations of coverage and is often neither comprehensive nor an absolute form of protection. Alternative indemnification-funding methods may include any of the devices listed subsequently. For a thorough discussion of alternative indemnification funding methods, see “Corporate Director and Officer Indemnification: Alternative Methods for Funding” by J. Phil Carlton and M. Guy Brooks, III found in the Wake Forest Law Review, Volume 24 (1989).

Letters of Credit

An irrevocable letter of credit issued by an independent third party, such as a bank, may be used solely to pay indemnity claims whether these claims arise under an indemnification contract or the corporate charter or bylaws. A letter of credit is sometimes desired because it commits the credit and assets of an independent third party—the provider of the instrument—to cover the indemnity claims under specified conditions. Such conditions may include the refusal or inability of the corporation to pay the claims. However, a corporation in need of significant indemnification protection may not have the credit rating required for a letter of credit.

Indemnity Trust Funds

Some corporations separate the director and officer indemnification reserves from other corporation reserves through the use of indemnity trust funds. An indemnity trust involves an irrevocable disposition of assets to an independent trustee pursuant to the trust agreement and the sole purpose of the trust is to pay indemnity claims.

Under an indemnity trust, the trustee (usually a bank) holds funds deposited by the corporation in trust for the benefit of directors and officers protected by indemnification obligations. Funding of the trust may be effected in several ways, including an initial one-time contribution upon establishment of the trust, annual specified contributions, periodic funding designed to maintain a specified balance of funds in the trust, or a combination of methods. The trustee then pays indemnity claims as they arise according to procedures set forth in the trust agreement.

Some indemnity trusts provide for the trustee or other third party to administer claims, with the protected persons dealing directly with the trust's administrator. Other trusts may provide for the corporation itself to administer indemnity claims. When the corporation is the administrator, directors or officers who have been denied indemnification may be allowed to seek indemnification from the trust after some specified period of time. Also, trust agreements often require the repayment of any indemnification in the event such indemnification is later denied.

How indemnity trusts are set up is dictated by the restraints on indemnification imposed under state law and by the extent to which the corporation desires to grant and fund indemnification under the law. Consequently, they may be subject to scrutiny by federal and state tax agencies as well as the corporation's shareholders. However, such trusts can reassure company officials that if the need for indemnification arises, funds will be available to satisfy the company's indemnification obligations.

Self-insurance

Some corporations assume—or self-insure—all or a portion of their insurance risks, including the potential obligation to indemnify directors and officers. Self-insurance involves the corporation providing needed indemnification out of current operating funds or establishing a liability reserve fund to cover its indemnification obligations.

By establishing a self-insurance reserve, the corporation can avoid the payment of insurance premiums and earn interest on the reserved funds. The corporation avoids the periodic “crises” associated with the cost of director's and officer's liability insurance.

Self-insured obligations may not be considered insurance under some state laws. Rather, these states may consider self-insurance the same as indemnification, which is subject to the same statutory and public policy limitations associated with indemnification. Thus, unlike commercial insurance, self-insured reserves may be available to pay indemnification claims that the corporation would not be allowed to pay under state law.

Captive Insurance Company Arrangements

Some corporations establish an insurance company which is formed usually as a wholly-owned subsidiary to provide directors' and officers' liability insurance for the parent company and perhaps a subsidiary or other affiliated company. Many of these captive insurance companies are domiciled in foreign or state jurisdictions that permit organization of such limited purpose entities as well as provide certain tax advantages. Captives typically are capitalized by the parent entity, are managed professionally, and provide insurance through policies similar to traditional insurance policies but without some of the limitations and exclusions that are present in commercial insurance policies.

Captive insurance companies have both advantages and disadvantages. As compared to regular insurance companies, captives generally (1) can be more efficient and productive, (2) may provide insurance at a lower cost, (3) may provide greater access to affordable reinsurance, (4) may be more profitable, and (5) may provide tax benefits. However, captives also may be subject to statutory and public policy limitations on indemnification and are often expensive to organize, capitalize, and operate in accordance with applicable corporate and insurance laws.

Risk Retention Groups (Group Captives)

Some corporations, usually members of trade and industry groups, band together to form an insurance company to provide directors' and officers' liability insurance to the members of the group. Group captives are typically formed to provide insurance that is otherwise unavailable to the individual members at an affordable price. The theory behind the creation of group captives is that since they are not controlled by one entity and the risk is spread among the members, the group captive should be able to avoid the tax and indemnification problems of single-parent captive insurers.

Like single-parent captives, group captives offer the potential advantages of (1) reduced insurance costs, (2) ability to retain investment income, (3) greater access to affordable reinsurance, (4) favorable tax consequences and (5) the ability to tailor coverage to the specific needs of the group members. However, membership in group captives tends to be expensive and involves a long-term commitment of capital. In addition, group captives must satisfy stringent insurance, underwriting, and other regulatory requirements relating to capitalization.

Fronting Arrangements

Another indemnification funding alternative is the establishment of a fronting arrangement by a corporation—and perhaps its captive insurer—with a traditional commercial insurer. Under such an arrangement, the commercial insurer becomes a “fronting company” and issues a regular directors' and officers' liability insurance policy to the corporation. The corporation then reimburses the fronting insurer for all or part of the losses the insurer pays in excess of the premiums. The commercial insurer receives a fee or a minimum nonrefundable premium for fronting the corporation and typically reimburses the corporation if premiums exceed losses. In some fronting arrangements, the corporation's captive reinsures all or part of the risk.

Insurance

State statutes may prevent the corporation from indemnifying its directors and officers in some instances. However, nearly all states permit the purchase of insurance to protect these individuals in situations where the corporation is not allowed to indemnify. An example would be in derivative actions, where the indemnification of judgments and settlements might be precluded by law in some states. The emphasis of insurance normally has focused on protecting the directors and officers from personal liability. As a practical matter, D&O insurance probably is equally desirable as a means of financing the corporation's indemnity obligations. In some instances D&O insurance may also provide protection for loss associated with direct suits filed against the corporation.

D&O liability insurance can cover much of the risk that cannot be otherwise reduced or eliminated. Numerous insurers provide insurance specifically designed to protect against claims or suits alleging wrongful acts by the company and/or its directors and officers. Very high coverage limits are usually available, making it possible to buy excess D&O insurance above primary coverage or a relatively large self-insured retention.

It should be noted, however, that D&O policies may not and often do not provide coverage for the corporate entity, wrongful employment practices, or offenses under environmental legislation or securities laws. Coverage for these exposures is sometimes available by endorsement or under a separate policy form.

“Side A” Insurance Policies

(Information on Side A policies was provided by Dan A. Bailey, Esq. Mr. Bailey is a member of the Columbus, Ohio , law firm of Bailey Cavalieri LLP. He specializes in D&O liability insurance, corporate and securities law.)

Some company directors and officers may be concerned that standard D&O policies do not afford enough protection for their individual liability. Often this is because of the potential erosion of policy limits in payment of losses to the company under entity coverage provisions or class action lawsuits. As a result, some companies consider the purchase of a “Side-A only” D&O policy that applies excess of the company's standard D&O insurance program.

Policies providing Side-A coverage have been available for years but only recently have been receiving considerable attention. Such policies not only can provide coverage limits in excess of the company's standard D&O policy, but can also serve as a Difference-in-Conditions (DIC) policy to fill coverage gaps that may result from the depletion of D&O policy limits or when the corporation is unable or unwilling to indemnify the Directors & Officers for expenses incurred in defending lawsuits.

The two most frequent circumstances under which a corporation does not indemnify its D&Os (and thus Side-A coverage applies) are:

1.  The Company is financially insolvent, bankrupt, or otherwise financially unable to fund the indemnification; or

2.  The defendant D&Os are obligated to pay a settlement or judgment amount in a shareholder derivative lawsuit. In most states, companies are prohibited from indemnifying the D&Os for settlements and judgments in shareholder derivative lawsuits. This prohibition is intended to prevent the meaningless and circular result which would occur if the D&Os paid money to the company in settlement of the derivative claim and then received indemnification of the settlement amount from the company.

Most traditional D&O insurance policies afford both Side-A coverage for nonindemnified loss and Side-B coverage for indemnified loss and are perceived by many to adequately respond to these two nonindemnifiable exposures. However, under certain circumstances traditional policies may not afford the full amount of desired protection for the D&Os.

There are several areas where a Side-A only D&O policy can provide greater protection to D&Os than a typical D&O insurance policy. These areas are discussed in some detail in the following section.

Coverage

Despite the typically huge difference between the resources and insurance needs of the company versus that of the individual Directors & Officers, traditional D&O insurance affords essentially the same coverage for D&Os (under Side-A) and for the company (under Side-B). Only the amount of any retention and perhaps the applicability of a couple of exclusions will vary, depending upon whether the loss is indemnifiable by the Company. Because loss under the Side-B coverage is far more frequent and generally far more severe, the scope of coverage afforded under a traditional D&O policy is designed to create a reasonable underwriting response to a company's D&O indemnification exposures.

Since the vast majority of claims covered under a D&O policy are indemnified by the company, a Side-A only D&O policy allows insurers to afford much broader coverage terms than reasonably possible under a Side-B policy. The following examples are some of the many possible features in a Side-A policy form that can provide broader coverage protection than the typical D&O insurance policy form:

Scope of Coverage

•    No presumptive indemnification. Coverage applies without any deductible if the company rightly or wrongly refuses, or is financially unable, to indemnify the Directors & Officers;

•    Broad definition of “Claim” that includes not only civil or criminal judicial, administrative, regulatory, or arbitration proceedings and investigations, but also oral or written demands and circumstances that may give rise to a claim; and

•    Broad “outside position” coverage. The policy provides blanket nonprofit outside position coverage for any person—not just D&Os—serving in an outside position at the request of the company. There is no exclusion for claims made by an outside entity or that entity's D&Os.

Exclusions

•    No express exclusions regarding ERISA, Section 16(b) of the Securities Exchange Act of 1934, pollution, prior litigation, or defamation or other personal injury;

•    Narrow illegal “personal profit” and “remuneration” exclusions that are not applicable as respects defense costs and which apply only if the wrongdoing has been determined by adjudication or if the illegal remuneration is repaid in settlement;

•    A narrow “dishonesty” exclusion that applies only if adjudication determines active and deliberate dishonesty was committed with actual dishonest purpose and intent. The exclusion does not apply as respects defense costs;

•    A narrow “bodily injury/property damage” exclusion that is not applicable to derivative or class action claims by securities holders, nor to pollution claims;

•    A narrow “insured v. insured” exclusion that applies only if the claim is (i) by or on behalf of company, and (ii) at least two current senior executive officers approve or assist in prosecuting the claim. This exclusion is not applicable to claims made by persons insured under the policy, to claims outside U.S. or Canada , or after the parent company has a change of control; and

•    Narrow “other insurance” and “prior notice” exclusions that apply only to the extent loss is actually paid under other policy;

Miscellaneous

•    No requirement that the insurer consent to defense counsel;

•    Provides for mandatory binding arbitration of any coverage dispute;

•    Protective policy renewal provisions. For example, as respects three-year policies, the insurer must give nonrenewal notice at least two years in advance. Renewal premiums are determined pursuant to an established rating plan, and renewal policies include all coverage enhancements included in any new standard policy form issued by the insurer. In addition, the policy is noncancelable except for nonpayment of premium;

•    If the parent company is acquired, a three-year run-off coverage period is provided for no additional premium;

•    Notice of claim to the insurer is required only after the in-house general counsel or risk manager of the company first learns of the claim;

•    The policy may not be rescinded based upon the restatement of any of the company's financial statements included within the Application;

•    If the insurer nonrenews, the policy's limit of liability is reinstated for the Discovery Period;

•    Protective bankruptcy provisions are included. The policy is not subject to automatic stay under bankruptcy law, and policy proceeds are to be first applied toward prebankruptcy wrongful acts; and

•    A Difference-in-Conditions dropdown feature applies if the policy is written as excess.

Because the Side-A policy limits of liability are not depleted or exhausted by payment of claims involving company liability or indemnified loss, the coverage is preserved for when the D&Os really need it (i.e., when the company can't or won't indemnify).

Financial Inability to Indemnify

If the Company becomes subject to a bankruptcy proceeding, it may be unable to fund its D&O indemnification obligation. In that circumstance, Side-A coverage will likely be the only financial protection available to the D&Os.

Should Side-A coverage be unavailable, the personal assets of the D&Os could be at risk. An issue will likely arise in the context of the bankruptcy proceeding as to whether the typical D&O policy is an asset of the bankruptcy estate. If it is an asset, the automatic stay applicable to all assets of the bankruptcy estate will effectively freeze the policy and may preclude the D&Os from accessing the policy's proceeds.

Courts have disagreed as to whether a typical two-part D&O policy constitutes an asset of the bankruptcy estate. Some courts have concluded the policy is such an asset since the it affords coverage for the company's D&O indemnification obligation. Although other courts have either ruled that the D&O policy is not an asset of the estate or have ruled that the proceeds of the policy (as distinct from the policy itself) are not assets of the estate, it is unclear what result will occur in any particular bankruptcy proceeding. This uncertainty is exacerbated if the D&O policy also affords securities entity coverage, since insurance policies that afford coverage for claims against the company are typically considered by courts as assets of the bankruptcy estate.

In other words, under a typical D&O insurance policy, it is uncertain whether the D&Os will have access to the policy proceeds in the event of the company's bankruptcy. However, that uncertainty is virtually eliminated under a Side-A only policy since the company is not an insured under that type of policy, either with respect to its D&O indemnification obligation or with respect to securities claims against the company. Therefore, a Side-A only policy can afford more predictable and potentially more protective coverage for D&Os in the event of the Company's bankruptcy.

Derivative Settlements/Judgments

Shareholder derivative lawsuits can be filed either in tandem with a shareholder class action lawsuit or as an isolated lawsuit. A typical two-part D&O insurance policy will respond to a settlement or judgment in either type of lawsuit, provided that the class action lawsuit (or any other claim in the same policy period) does not exhaust the available limit of liability before the potentially nonindemnifiable derivative lawsuit settlement is paid. Because tandem class action and derivative lawsuits are frequently settled at the same time, prior exhaustion of the limit of liability is usually not a problem.

However, there is today a somewhat greater tendency to settle the larger class action lawsuit quickly, even if the tandem derivative lawsuit cannot be settled at the same time. For example, in one recent case, a company elected to settle a securities class action within a few months after its filing for more than $100 million (thereby exhausting the D&O policy's limit of liability) even though the tandem derivative lawsuit could not then be settled for a reasonable amount. Approximately eighteen months later, the tandem derivative lawsuit was settled for approximately $15 million. Fortunately for the D&Os, the company maintained an excess Side-A only D&O policy, which was not implicated in the indemnifiable class action settlement and therefore was available to fund the nonindemnifiable derivative settlement.

In situations where the company wants to settle a large class action lawsuit but cannot yet settle the tandem derivative lawsuit for a reasonable amount, insureds are faced with a difficult dilemma under a standard two-part D&O insurance program. On the one hand, the insureds can use the proceeds from the D&O policy to fund the class action settlement, thereby benefiting the company by eliminating the risks, distractions, and adverse publicity associated with such a potentially catastrophic claim. However, such a strategy may leave the defendant D&Os with inadequate insurance protection for a subsequent nonindemnifiable derivative settlement.

On the other hand, the insureds can preserve the D&O insurance proceeds for a subsequent derivative settlement. However, such a strategy would deprive the company of a large source of funds to pay the early class action settlement.

Priority of Payments Provision

Many standard D&O insurance policies with securities entity coverage contain a “Priority of Payment” provision which mandates that all proceeds under the policy be maintained for the nonindemnifiable derivative settlement, the amount of the class settlement, or the likely amount of the subsequent derivative settlement. Thus, if the insured company desires or is compelled to settle the class action early, it must fund the entire settlement amount out of its own assets and seek reimbursement under the D&O insurance policy for the covered portion of the loss at some later date when the derivative lawsuit is settled. This may require the company to advance tens of millions of dollars, if not hundreds of millions of dollars, to resolve the class action, even though much or all of such a settlement is otherwise covered under the untapped D&O insurance program.

From the perspective of the defendant D&Os, this dilemma is especially frightening. If company management is not sympathetic to the defendant D&Os, it may choose to use the D&O insurance policy to fund the indemnifiable class action, thereby leaving the defendant D&Os with little or no insurance to settle the subsequent nonindemnifiable derivative lawsuit. Although the defendant D&Os would likely object to use of the policy for that purpose, the extent of the D&Os' financial protection under the policy will be uncertain.

The problems discussed here can be greatly mitigated, if not eliminated, by the purchase of Side-A only coverage that applies excess of the company's standard D&O insurance program. Such excess coverage assures the existence of insurance protection for nonindemnifiable claims against D&Os even if the rest of the D&O insurance program has been exhausted by indemnifiable or entity losses. As a side benefit, such coverage may allow for deletion of the “Priority of Payment” provision in the underlying D&O policies, thereby enabling the company to access the underlying D&O insurance proceeds for an early settlement of the class action even if the tandem derivative lawsuit is not settled at the same time. Obviously, the larger the limits for this Side-A only coverage, the greater the likelihood that this type of insurance program structure will accomplish the goals of both the company and the insured Directors & Officers.

Risk Retention

Most organizations retain some portion of risk as a cost of doing business unless there is some specific reason or requirement to do otherwise. In the past, little consideration may have been given to retaining losses that might arise out of the D&O exposure because the risk was often considered to be so small that it was of little consequence. Today, however, the D&O liability exposure is better recognized and understood. Now with the option to insure against loss arising out of wrongful acts by the corporation's directors, officers, and employees, a more thorough analysis of how much of the D&O risk should be retained is warranted.

One reason for retaining risk is that there is a charge for insurance. Insurance companies must charge an amount of premium in excess of what it expects to pay in losses to cover general overhead, producer commissions, and state and federal taxes. Because of this, insurance will usually cost much more than retention. Risk retention for D&O claims also focuses attention on and promotes the prevention and control of loss.

An arguable disadvantage of risk retention is that costs may vary significantly from year to year. However, past insurance market conditions have demonstrated that even insured programs are subject to unplanned, substantial fluctuations in cost.

Amount of Risk Retention

A general rule of thumb is that all predictable losses should be retained. However, D&O losses usually are infrequent and thus may not be predictable. In order to establish what amount of retention is acceptable, it usually is necessary to examine annual revenues, which are a measure of an entity's loss-absorbing capacity. When a sudden expense occurs, it may be possible to shift expenditures, defer projects, or somehow readjust finances to accommodate the need. The degree of flexibility within an organization's budget to make such accommodations is one measure of a tolerable loss level.

Perhaps the most common method of selecting a retention amount is to have premium quotations provided at different retention levels. A decision usually can be made on an intuitive weighing of dollars saved versus expected losses assumed. But such an approach also can be misleading. The premium reduction gained by increasing the retention may at the time appear small in relation to the possible assumed loss. However, because the insured may have no way to calculate the actual frequency of claims, this may result in the insured rejecting a premium reduction that would be beneficial in the long run.

Whatever risk-retention level is chosen, it should be selected by the board of directors after consultation with the corporation's chief financial officer to determine how unbudgeted losses will impact the organization's present and future financial condition.