Despite the passage of the Private Securities Litigation Reform Act of 1995 (“the Reform Act”) almost five years ago, directors and officers and their insurers have seen little in the way of effective “reform” in the avenue of securities fraud litigation, which remains the paradigm high severity D&O claim exposure. The D&O claim environment has changed little from pre-Reform Act days. Although claims may have a longer incubation process, due primarily to the procedural hurdles imposed by the Reform Act, this legislation has done little to decrease the average value of claim settlements. Indeed, claim settlements actually may be on the rise. Although an aberration, we have seen a D&O securities settlement in late 1999 reach the level of $2.8 billion, far outstripping the amount of available insurance for the corporation and its directors and officers.

Contemporaneous with the Reform Act was a broadening of coverage such that the oftentimes contentious coverage disputes of the 1980s and early 1990s have been greatly mitigated. This has enabled the insurers and their insureds to focus more cooperative efforts in effective “claims management,” promoting efficiency aid cost-containment and, where appropriate, speeding the settlement process.

“Claims management” refers to the process by which D&O insurers assess, monitor and resolve claims against their insureds. Because D&O claims often involve complex litigation, the management process can be difficult, requiring the involvement of experienced professionals.

It is vital that those involved in the purchase and sale of D&O insurance—including insureds, underwriters, counsel, brokers and agents—have an understanding of the playing field and the players. This article explores claims management and identifies some of the problem areas and pitfalls that may arise in the claim-management process.

The Plaintiffs' Bar

The process of claim management begins when a claim is made (usually a lawsuit) against insured directors and officers. While employment-related claims have surpassed shareholder actions as the most frequently asserted claims against directors and officers according to the most recent Tillinghast (formerly Watson Wyatt) survey, the shareholder suits remain the force that drive the need for and cost of the insurance. Indeed, the increasing prevalence of employment practices liability (EPL) insurance has become the preferred vehicle for insuring employment-related claims, as it should be in order to preserve the maximum amount of protection for directors and officers from the higher exposure claims under the D&O policy.

The high frequency and severity of shareholder claims is largely due to the sophistication and entrepreneurial prowess of the plaintiffs' bar.1 There are now approximately 30 U.S. law firms that specialize in prosecuting shareholder class actions, but since the passage of the Reform Act at the end of 1995, there has been a greater concentration of this litigation in the hands of the most competent practitioners. One very well-qualified firm in particular is involved as a lead or participating counsel in over half the cases filed. Such a law practice can be lucrative, with the average legal fee for the plaintiffs' attorneys exceeding $3 million. Plaintiffs' attorneys typically are compensated on a contingency basis or some variation thereof; on average, they retain approximately 30 percent of any judgment or settlement.

The most telling statistics supporting the proposition that D&O liability claims are largely driven by the plaintiffs' bar are (1) the location where most D&O claims are filed, and (2) the identities of the plaintiffs. The litigation is heavily concentrated in Federal courts in California and New York . This is not because they provide a better forum than other jurisdictions, but because many of the shareholder plaintiffs' attorneys' offices are located there.

With respect to the identities of the plaintiffs, one might wonder how a plaintiffs' attorney finds his or her clients. After all, in order for an attorney to file a shareholder class action, he or she must be retained to represent the interests of a shareholder or group of shareholders. So, how do these law firms find shareholders to represent? The answer is that they appear to have ongoing relationships with individuals and entities that collectively own shares in virtually every corporation traded on the various stock exchanges and in the over-the-counter market.

There is ample evidence that such a system is in place because it is not unusual for those who defend D&O claims to identify the same plaintiffs in several unrelated shareholder actions. Although since passage of the Reform Act, the prevalence of such “repeat” lead plaintiffs has become less commonplace.

To make matters worse (or better, from the plaintiffs' bar's perspective), advances in computerized database and telecommunications technology now allow the plaintiffs' bar to file lawsuits with great speed and precision. To illustrate, the typical triggering event for a shareholder class action is often the corporation's dissemination of “bad news” to the public. This is usually some announcement that results in a decline of the corporation's stock price, such as a projected reduction in earnings. Through their attorneys, shareholders will then assert that the corporation and its directors and officers failed to timely apprise the investing public of the “bad news,” thus artificially inflating the corporation's stock price.

Within twenty-four hours of the corporation's issuance of the “bad news,” a complaint can be filed, although the Reform Act now requires a greater amount of “due diligence” on the plaintiffs' part in order to avoid a dismissal of the action. With the aid of computerized stock-tracking databases, plaintiffs' counsel usually can learn of the corporate announcement immediately and then can generate a complaint within a few hours. Sometimes, when the alleged wrongful conduct of the corporate directors and officers is particularly egregious, other plaintiffs' attorneys will jump into the fray by filing so-called “cookie-cutter” suits. These are often nothing more than exact copies of the original pleading.

After the lawsuits are filed, the plaintiffs' attorneys sometimes form a litigation committee and divide up the labor for proceeding with the action. The attorney who filed the original action will usually be appointed chairman of the litigation committee, and thus will do the greatest amount of work on the matter and receive the largest fee. The Reform Act does imbody a rather elaborate process for the selection of the “lead plaintiff” and “lead counsel” who presumably control the prosecution of the litigation. However, wherever possible the plaintiffs' bar seeks to engage in a coordinated effort in pursuing these cases.2 That is, the plaintiffs' bar attempts to ensure that several attorneys get a “piece of the pie.”

The Representation of the Insured

Because D&O policies are typically not of the duty-to-defend variety, insurers do not appoint counsel to represent the insured directors and officers in the event of a claim. Rather, the insureds choose their own counsel and the insurer has the right to consent to the incurring of defense costs. This process is sometimes favored by insured directors and officers because it affords them the freedom to engage the services of counsel with whom they, or the corporation they serve, have a long-standing relationship.

Usually it is preferable to have one law firm represent the interests of both the directors and officers and the corporation. Joint representation tends to cut costs by avoiding the duplication of effort that is caused by several law firms representing multiple defendants. In situations where the corporation and the directors and officers are jointly represented, the insurer may be entitled to an allocation of defense costs. However, this issue arises much less frequently today than five to six years ago, particularly in the area of securities claims. That is because most D&O policies today afford coverage for the corporate entity itself, in addition to the directors and officers, in the context of a securities claim.

When conflicts among the various defendants arise, separate representation sometimes is warranted. A conflict might occur if one or more directors and/or officers are actually implicated in wrongdoing, as opposed to the typical situation where the board and executive officers are collectively sued as a group. The “innocent” insureds may want to distance themselves from the “guilty” party or parties, or may entertain the possibility of asserting cross-claims against them.

There is also the situation where a director or officer terminates his or her relationship (either voluntarily or involuntarily) with the corporation, and the parties choose to separately defend the claims asserted against them. In this situation, the corporation may refuse to indemnify the terminated director or officer, which may affect the coverage available to that individual. The outcast director or officer thus may seek separate representation.

There may be other reasons for directors or officers to retain separate counsel to represent their interests. For example, an insured individual may simply desire the guidance and expertise of a trusted personal lawyer.3 In any event, the overriding goal is to avoid unnecessary duplication of effort among the various attorneys. One strategy that has been employed is for one law firm—usually the corporation's counsel—to spearhead the defense of the action, with the other firms playing a supporting role. If the action proceeds to trial, a time when the conflicts among the various parties come to the forefront, each attorney goes his or her own separate way and defends his or her client accordingly.

Separate from the significant role outside litigation counsel plays in representing the directors and officers in an action is the role of the corporation's general counsel. General counsel's involvement can be multi-faceted, including roles as (1) liaison between the corporation, its directors and officers and outside counsel, (2) liaison between the insureds and the D&O insurer, and (3) litigation counsel on behalf of the corporation. Although the general counsel may assist greatly in the defense of the matter, most D&O policies (which exclude from the definition of loss salaries paid to corporate officers) will not cover the costs associated with the general counsel's activities in connection with the claim.4

With respect to insurance-coverage issues, there are others who individually or jointly may represent the interests of the insureds. These include the corporate risk manager, the insurance broker and, occasionally, outside coverage counsel.

Risk managers often are responsible or partially responsible for the corporation's purchase of D&O insurance, and may be uniquely qualified to negotiate with the D&O insurer on coverage issues. Moreover, since the risk manager intimately may be involved in the purchase of the D&O insurance, he or she may have a favorable relationship with the insurer, which can foster the negotiation process.

Brokers also may play a part in the claim process. In addition to their role of assessing the corporation's D&O insurance needs and marketing the insurance, brokers may take part in monitoring a claim and facilitating communications between the insureds and the insurer. The broker's participation in the claim-management process has traditionally been a function of the corporate client's wishes, and thus can vary from case to case. It appears that as the exposure in a particular claim increases, the likelihood of the broker having significant participation in the claim-management process decreases. The reason is simply that, where the potential exposure is substantial, directors and officers usually are more comfortable having attorneys represent their interests with respect to coverage issues. This is not to say that the broker should be removed from the claim-management process or (at least as to certain aspects of the situation) is less qualified than legal counsel. Rather, the broker plays less of a substantive role in resolving insurance coverage issues on behalf of insureds.

In certain circumstances, insureds may want to retain coverage counsel, in addition to litigation counsel, to represent the insured directors and officers with respect to D&O coverage issues. Separate retention of counsel, although occurring now with more frequency, is still somewhat unusual because most practitioners in the defense bar are well acquainted with the law pertaining to D&O coverage. If defense counsel is experienced in this area, there would be no need for insured directors and officers to retain separate counsel to represent their interests vis-à-vis the D&O insurer.

The Representation of the Insurer

Because of the complexity of the D&O claims-handling process, most D&O insurers employ in-house claims attorneys. When a claim is first made against an insured director or officer and notice is provided to the insurer, the claims counsel should conduct an investigation of the matter and evaluate coverage on behalf of the insurer. This process entails a review of the relevant pleadings, an analysis of the subject policy's terms and conditions, and, where appropriate, interaction with the insureds to determine the relevant facts (as opposed to the allegations by the plaintiffs). When the coverage investigation is complete, the insurer may either accept or decline coverage. The usual course of action, however, is for the insurer to conditionally provide coverage pursuant to a reservation of the insurer's rights.

After the initial coverage evaluation is undertaken, claims counsel will monitor the underlying action, occasionally participating in the formulation of litigation strategy. As the action progresses towards resolution (i.e., settlement or judgment), claims counsel must assess the potential liability exposure of the insureds.

Depending upon the severity of a given claim, claims counsel will either handle the matter in-house or retain the services of outside coverage counsel or monitoring counsel. If the claim presents unusually complex coverage issues or requires a labor-intensive investigation, outside coverage counsel is a valuable asset for the insurer. Generally, outside counsel will have greater resources of manpower and research facilities than in-house claims counsel.

The D&O underwriter may also play a supportive role in the claim-management process. Underwriters have a significant function in developing positive relationships between the D&O insurer, the brokerage community and their major insureds. The underwriter is responsible for analyzing the risk to be insured by the policy and determining the appropriate pricing of the policy. Theoretically, coverage issues should be resolved according to the plain meaning of the insurance contract, and not based upon any pre-existing business relationship between the D&O insurer and the insured. However, there is today much greater integration of claims and underwriting functions by the better D&O insurers, and this facilitates business resolutions of difficult claim situations rather than protraction of disputes through hard and fast legal positions.

As a practical matter, the business of issuing D&O insurance is quite competitive, and the preservation of good relations with insureds is important to an insurer's survival. Underwriters who have fostered a positive and cooperative relationship with insureds during the underwriting/policy-issuing process can facilitate communications between claims counsel, the broker and the insured. Some input on the part of the underwriter is often welcomed by claims counsel, particularly if it assists claims counsel in better understanding the insured's business or communicating the insurer's coverage position to the insured.

Procedural Issues

Reservation-of-Rights Letters

Once a claim is made against an insured director or officer, the insurer will frequently send a reservation-of-rights letter to the insured. Such letters set forth all of the coverage issues relating to the claim. Because insureds sometimes misunderstand the meaning and purpose of the reservation-of-rights letter, the receipt of such a letter can be a source of frustration for insureds.

Reservation-of-rights letters are in many respects a mechanism by which an insurer may extend the time within which it can deny coverage. Under the law, an insurer must either accept or deny coverage as soon as it possesses sufficient information concerning the claim to render a decision relative to coverage. If an insurer unreasonably delays in communicating its coverage position to the insured, or fails to raise any policy defenses of which it was on notice at the time it assumed the defense of a claim, the insurer may waive its right to deny coverage (or may be estopped from denying coverage). Practically speaking, however, a determination regarding coverage is sometimes impossible to make prior to the final resolution of the claim. A reservation-of-rights letter suspends the operation of waiver and estoppel until sufficient information is available for the insurer to adopt a coverage position.

Although a reservation-of-rights letter is vital to the protection of the insurer's interests, an overly forceful letter can alienate the insured and hinder the claim-management process. The insurer must walk a fine line between preserving its rights under the law and maintaining a cordial and cooperative relationship with its insured.

While there is no perfect method of crafting reservation-of-rights letters, one way the insurer can fulfill the twin goals of preserving its legal rights and preserving its relationship with the insured is to communicate the need for the letter before it is sent. This can be done either orally or in writing. Some insurers prepare “pre-reservation of rights” communications, which are sent in advance of or incorporated within the actual reservation letter. These pre-reservation letters serve two purposes: (1) they apprise the insured in advance of the insurer's reservations, and (2) they soften the blow of the reservations in the letter and the potential for declination of coverage.

Guidelines Regarding Defense Costs and Payments

One of the most important features of a D&O policy is that it provides coverage for defense costs incurred by the insured directors and officers. D&O policies generally do not impose upon an insurer a duty to defend its insureds, which would require the insurer to retain counsel for the insureds. Rather, the insureds retain their own counsel and the insurer has an obligation to pay the defense costs incurred in defending the insured directors and officers in connection with covered claims. This creates a number of important coverage issues that the insured should understand.

First, the insureds select their own defense counsel, rather than having the insurer provide counsel. This is preferable to most directors and officers because it allows them to choose counsel with whom they, or the company they serve, have a relationship.

The selection of counsel, however, is subject to the consent of the D&O insurer. Consent is generally granted unless the selected counsel clearly is unqualified, by virtue of inexperience or lack of staffing, to handle the litigation. Consent also may be withheld if counsel seeks an excessive hourly rate, or refuses to abide by reasonable and necessary litigation-management guidelines. Although D&O litigation often involves complex issues that demand the attention of experienced practitioners, the defense bar has become accustomed to insurers' and insureds' demands for cost-effective service. Some defense attorneys may even be willing to cut their rates in the face of an objection by the D&O insurer.

Second, because D&O policies are typically not of the duty-to-defend variety and since defense costs generally are included within the definition of loss, the defense costs incurred will deplete the policy's limit of liability. From the insurer's point of view, it is thus critical that defense costs be closely monitored. This is important from a cost-containment standpoint, and because the insurer has an obligation to police the policy proceeds to ensure that they are not unnecessarily eroded.

For this reason, insurers often require that defense counsel adhere to specific litigation-management guidelines. Defense counsel will be asked to follow criteria for staffing, for specific tasks such as motions or depositions, court appearances, for retention of experts, and for periodic reporting on litigation status.

Third, there may be an issue regarding whether the insurer has an obligation to pay, or will voluntarily pay, the insureds' legal fees as they are incurred. In the mid-1980s, the courts almost universally held that D&O policies required the insurers to pay defense costs on a contemporaneous basis. Recently, however, the trend has been that unless the policy specifically states that the insurer will pay defense costs as incurred, the insurer may await the final resolution of the claim to pay such costs. See, e.g., In re Kenai Corp., 136 Bankr. 59 (S.D.N.Y. 1992). From an insured-relations standpoint, however, assuming that coverage is not otherwise excluded, many insurers are willing to provide interim funding for the insureds' defense regardless of the policy wording.

Fourth, issues concerning allocation frequently arise in connection with an insurer's payment of defense costs. If defense counsel jointly represents the corporation and the insured directors and officers, an allocation of defense costs is needed. Case law, however, provides that if a given task is reasonably related to the defense of a covered party (i.e., a director or officer), even if it incidentally benefits a non-covered party (i.e., the corporation), the fee for that task must be borne by the insurer.

Insureds frequently argue that because the defense of the insured individuals is indistinguishable from the defense of the corporation, all of the defense fees incurred should be covered. On the other hand, insurers may maintain that the respective defenses are indeed separable and a reasonable allocation can be derived. Along these lines, the insurers may also assert that to accept the insureds' argument as valid would provide the corporation with a free defense for which the insurer is not obligated.

Of course, allocation disputes have been virtually eliminated in the area of securities claims with the advent of “entity coverage” for these claims. Unlike other types of claims under the D&O policy, the corporation now may garner coverage for its own liability and cost of defense in connection with securities claims.

Whatever the parties may argue and however heated these disputes may become, the parties should never lose sight of the fact that it is the plaintiffs who are the true adversaries. Too often in this litigious insurance climate insureds and insurers allow their differences to distract them from the underlying litigation, which is, after all, the main focus of the defense. It cannot be stressed strongly enough that the insured-insurer relationship must be united against the plaintiffs. Any disputes that may exist should be subordinated to the primary objective of a zealous defense of the insureds.

Trials and Settlements

Since D&O claims hardly ever proceed to trial, it is not useful to dwell on the topic.5 Because the subject of settlement arises in almost every D&O claim, a variety of procedural problems can develop during the settlement process.

While the following discussion of allocation remains more than academic outside the securities area, even there the resolution of allocation disputes has been facilitated by arbitration provisions in policies and greater judicial guidance.

Serious disputes can arise between insured and insurer over determination of the relative liability between covered and uncovered parties. Because the corporation is not usually an insured as respects direct actions, any liability directly attaching to the corporation would not be funded by the D&O insurer.

When negotiating the relative liability between parties, it is common for the corporation to assert that it can only act through its directors and officers and that it is the directors and officers who should bear the lion's share of the liability. If this view prevails, the insurer would be required to fund the bulk of the settlement. In response, the D&O insurer will assert that the corporation faces liability exposure independent of that confronting the directors and officers and, thus, the corporation should fund its fair share of a settlement.

Whatever the validity of either argument, allocation is more a process of negotiation than an application of proscribed procedure. Without a final adjudication of liability, there is no way for either party to maintain with precision that the other is truly liable. In the end, allocation often boils down to a painstaking negotiation process.

To provide a word about the players involved, first, defense counsel (who jointly represents the corporation and the insureds) should bear in mind the potential for a conflict of interest when arguing allocation on behalf of the corporation. As noted above, the argument is that the individual insureds are liable and the D&O insurer therefore should pay the settlement. Asserting this argument places defense counsel in the untenable position of arguing the liability of its own clients and, worse, exalting the interests of one client (the corporation) over other clients (the individual insureds).

Although defense counsel would argue that zealous pursuit of D&O coverage serves both of his or her clients' interests, they should bear in mind that unnecessary depletion of the policy, resulting from the corporation's refusal to contribute its fair share toward the settlement, can be harmful to the directors and officers. For instance, if other unrelated claims should be asserted against the insureds during the policy period, the insureds may be underinsured or totally uninsured because the policy proceeds were used to settle a single claim.

There is also the issue of how visible the insurer should be during settlement negotiations with the plaintiffs. One school of thought is that the insurer should maintain a low profile during the settlement process. Under this theory, there is no need for the insurer to become embroiled in the underlying litigation because its presence represents a “deep pocket” that potentially can drive up the settlement value of the case. Additionally, if there is an ongoing coverage dispute between the insurer and the insureds, there is no useful purpose in bringing that fact to the forefront through the insurer's interaction with plaintiffs' counsel during settlement negotiations.

On the other side of the equation are those who believe that the insurer should be involved in the settlement process every step of the way. Under the Federal Rules of Civil Procedure and most state procedural laws, the plaintiffs are entitled to the directors' and officers' insurance information through discovery and/or mandatory disclosure. Therefore, the plaintiffs will be aware of the D&O insurance available to the individual defendants whether or not the insurer participates in the settlement negotiations. If there is significant participation by the insurer, the defendants and the insurer can give the appearance of a united front committed to vigorously defending the suit. As the theory goes, this joint effort may provide the defendants with a more secure bargaining position, which in turn may lower the settlement value of the case. Even more importantly, a higher profile affords the insurer the opportunity of closely monitoring the terms of settlement, thus placing the insurer in a better position to protect its interests.

Whether the insurer maintains a high or low profile, it should always review the settlement agreement to ensure that appropriate releases are obtained from the plaintiffs in favor of the insurer (separate agreements usually are entered into between the insurer and the insureds). The absence of the insurer's participation in drafting the settlement agreement opens the door to mischief, because defense counsel then may draft the settlement agreement to allocate the bulk of liability for the settlement to the insured directors and officers.

In this way, corporations successfully have used the structure of settlement agreements to their advantage when negotiating allocation with the D&O carrier. See, e.g., Nodaway Valley Bank v. Continental Casualty Co., 715 F. Supp. 1458 (W.D. Mo. 1989), affirmed, 916 F.2d 1362 (8th Cir. 1990) (settlement agreement allocated all liability toward breach of fiduciary duty claims against officers and directors). However, the Ninth Circuit Court of Appeals adopted a jaundiced view of a settlement agreement that was structured in this way. The Court stated that the insureds in that case “crafted a win-win solution for themselves, with the insurance company footing the bill.” Slottow, et al. v. American Casualty Co. of Reading, Pa., 1 F.3d 912 (9th Cir. 1993).

Closing of Claims

The agreement upon a settlement figure is only the first step in a long, arduous process of administering and closing the settlement. It is not unheard of for more than a year to elapse between verbal agreement on a settlement figure and the closing of the claim. In the interim, many problems can arise, such as disputes over:

·   the structure of the settlement

·   the terms of the settlement agreement

·   the selection of an administrator of the settlement

·   the payment of interest accrued from the settlement fund

·   the structure and timing of the execution of releases among the parties

·   the payment by the D&O insurer of defense counsel's fees that are incurred during the settlement process.

These are only some of the issues that can hinder the settlement process and claim closure. The parties should address and attempt to resolve as many of these issues as possible before disputes arise. If the settlement in its general form is agreeable to all parties, the details should not present major stumbling blocks to the final resolution of the matter. The parties should always have their respective interest ardently represented, but they should also avoid making minor points “deal breakers.” The parties should always weigh the down-side risk of conceding a particular issue and, if legal interests are not impaired, should not stand on principle at the risk of destroying the settlement.

Although the tendency for insurers is to close the file as quickly as possible, insurers should patiently await the final outcome of the settlement payout. Problems and disputes never seem to end until the last check is tendered. Insurers therefore need to resist the temptation of closing a claim file until there is no longer the prospect of further issues that would require extending or reopening the matter.

Conclusion

The insured's understanding of the claims-management process is critical to development of a collaborative relationship between the insured and insurer. Although one can never be completely versed in all the contingencies that might arise until he or she has experienced a D&O claim firsthand, the broker and insurer need to educate the insured about the risks and issues involved in a D&O claim. This can be accomplished through pre-claim or even pre-policy inception meetings with the insured wherein these topics are addressed. Brokers and underwriters should never assume that the insured understands all of the issues discussed in this monograph.

Direct pre-claim contact between the insured and claims professionals can also foster the relationship between the insured and insurer when a claim ultimately is made. Such interaction eliminates the surprise and uncomfortable feelings associated with new players entering the game. In summary, the primary goal is for the insured and insurer united in interest to work as a team to successfully defend the claim.

End Notes

1 The term “plaintiffs' bar” refers to those practitioners who are regularly involved in the prosecution of civil fraud class-action suits for violations of federal securities laws. There are other sources of claims under a D&O policy apart from class-action securities matters where a formally or loosely organized segment of the bar does not traditionally operate. However, because securities claims are of paramount importance to most professionals having an interest in D&O insurance, we focus our comments solely on this group of lawyers.

2 We acknowledge that there may be nothing legally or ethically wrong with the operation of plaintiffs' lawyers' practice in this area. Some commentators assert that the plaintiffs' bar is serving the function of a private attorney general or substitute for the SEC. This may be particularly true where the regulators or Justice Department are not inclined to or are otherwise limited in being able to pursue such claims.