Emerging Issues in D&O Liability Insurance

Directors' and officers' (“D&O”) liability insurance protects corporate directors and officers from third-party claims made against them in their capacities as directors and officers for certain breaches of their duties to their corporation and its shareholders. Due to recent statutes and case law increasing directors' and officers' duties and exposure to potential liability, demand for this type of insurance has increased rapidly in recent years. This increase in demand has led to a significant rise in coverage litigation to define and interpret the language of existing policies. This article discusses a few emerging issues that can arise under D&O policies, and how they can impact policyholders.

Emerging Coverage Issues

Late Notice

Late notice is a common problem in coverage disputes, especially under D&O policies. Unlike most commercial general liability policies, which are typically issued on an “occurrence” basis, D&O policies are written on a “claims made” basis. Under a claims-made policy, coverage is triggered by a “claim” being first made against the policyholder during the policy period, irrespective of when the harm arose or the wrongful act took place. In addition to the “claim” being made during the policy period, some professional liability policies also require that the “claim” be reported to the insurance company during the policy period or an extended reporting period. Such policies are called claims-made-and-reported policies.

D&O policies typically written on a “claims-made” basis contain detailed notice procedures and requirements in the event of a claim. The policyholder must give prompt notice of the claim and cooperate with the insurance company to be covered under the policy. Courts are fairly strict in requiring the triggering event to take place during the policy period, refusing to find coverage when the claim or notice occurs outside of the policy period. See, e.g., Burns v. International Ins. Co., 929 F.2d 1422 (9th Cir. 1991); American Home Assur. Co. v. Abrams, 69 F. Supp. 2d 339 (D. Conn. 1999); Brumfield v. Shelton, 831 F. Supp. 562 (E.D. La. 1993).

Under a claims-made policy, an insurance company generally does not need to demonstrate prejudice to deny coverage when notice of a claim is provided outside of the policy period. See, e.g., Hachigian v. CNA Ins. Co., 3 Fed. Appx. 630 (9th Cir. 2001) (under malpractice insurance policy, notice provisions are strictly enforced and notice-prejudice rule does not apply); Esmailzadeh v. Johnson & Speakman, 869 F.2d 422, 424-425 (8th Cir. 1989); Brakeman v. Potomac Insurance Co., 472 Pa. 66, 76-77, 371 A.2d 193, 198 (1977). Nearly every court that has considered the issue has concluded that reporting requirements in a claims-made insurance policy should be strictly construed. National Union Fire Ins. v. Talcott, 931 F.2d 166 (1st Cir. 1991); Burns v. Int'l Ins. Co., 929 F.2d 1422 (9th Cir. 1991); United States v. A.C. Strip, 868 F.2d 181 (6th Cir. 1989); MGIC Indem. Corp. v. Cent. Bank, 838 F.2d 1382, 1385-1387 (5th Cir. 1988); Pizzini v. American Int'l Specialty Lines Ins. Co., 210 F. Supp. 2d 658 (E.D. Pa. 2002).

Courts have recently started to apply the notice-prejudice rule to “claims-made” insurance policies that do not have an explicit “reporting” requirement mandating notice of the claim within the policy period or a specified number of days later. See Hardwick Recycling & Salvage, Inc. v. Acadia Ins. Co., 869 A.2d 82 (Vt. 2004); Pension Trust Fund for Operating Eng'rs v. Federal Ins. Co., 307 F.3d 944, 957 (9th Cir. 2002). See also Kenneth W. Lucas, A Prejudicial Requirement: The Ongoing Development of Liability Policy Notice-Prejudice Issues, Coverage, Vol. 18, No. 3 (May/June 2008). This year, both the Texas and Pennsylvania Supreme Courts should decide whether the notice-prejudice rule applies to claims-made policies. The U.S. Court of Appeals for the Fifth Circuit certified a notice-prejudice question to the Texas Supreme Court. See XL Specialty Ins. Co. v. Financial Indus. Corp., No. 06-51683, 2007 WL 4461190 (5th Cir. Dec. 19, 2007). The Pennsylvania Supreme Court is hearing a dispute between insurance companies about the notice-prejudice rule in claims-made policies. ACE American Ins. Co. v. Underwriters at Lloyds and Cos., et al., Pa. Supreme Ct. Docket No. 45 EAP 2008. Given the uncertainty surrounding notice under a D&O claims-made insurance policy, however, the best course of action for policyholders is to take a proactive approach and provide notice to the carriers as soon as practicable.

Exhaustion

Issues frequently arise from an exhaustion clause in an excess D&O liability policy; specifically, whether settlement with a primary insurance carrier for less than the policy limit precludes recovery from an excess carrier. A typical exhaustion clause provides that the insurance company “shall be liable only after the insurers under each of the Underlying Policies have paid or have been held liable to pay the full amount of the Underlying Limit of Liability.”

Interpreting an identical exhaustion clause, the court in Qualcomm, Inc. v. Certain Underwriters at Lloyd's, London, held that the insured corporation, which had settled securities fraud class action lawsuits for $21 million and recovered $14 million by way of a settlement with its primary insurance company, was precluded from bringing suit against the excess insurance company to recover the portion of settlement exceeding primary insurer's $20 million limit. 161 Cal.App.4th 184 (Cal. Ct. App. 2008). See also Comerica Inc. v. Zurich American Ins. Co., 498 F.Supp.2d 1019 (E.D. Mich. 2007) (holding excess policy language unambiguously required primary insurance be exhausted by actual payment of losses by underlying insurance company). According to the court, the exhaustion clause unambiguously precluded the excess insurer's liability for the insured's losses in excess of the primary policy's limit after the policyholder settled with the primary insurance company for less than the primary policy limit. Taking into account the nature of the policy as an excess insurance policy, the court noted that the objectively reasonable expectation of the policyholder would be that the primary insurance policy would have to be exhausted before excess insurance would attach.

Courts in other jurisdictions, however, have taken a different approach. In Stargatt v. Fidelity and Casualty Company of New York, 67 F.R.D. 689 (D. Del. 1975), aff'd, 578 F.2d 1375 (3d Cir. 1978), for example, the U.S. District Court for the District of Delaware held, where the sole issue was whether an excess insurance policy may be reached by a policyholder when the primary policy has been settled for less than its limit, that the excess insurers will be liable only for covered losses in excess of the primary policy limit plus the deductible on the excess insurance policy. See also Westinghouse Electric Corp. v. American Home Assurance Co., No. A-6706-01T5, A-6720-01T5, 2004 WL 1878764, at *6 (N.J. Super. Ct. July. 8, 2004) (holding excess liability policy triggered when primary policy limit reached by total costs incurred by policyholder, regardless of whether total payments to policyholder reached those limits, because excess insurance company could not possibly claim to have stake in whether policyholder actually received all of the underlying insurance limits).

Whether or not a less than policy limit settlement with a primary insurance company precludes recovery from an excess insurance company probably depends on the language of the exhaustion clause and which jurisdiction's laws apply. For this reason, policyholders should give some thought to exhaustion clauses prior to negotiating D&O coverage.

Severability

Innocent directors and officers may be at risk of losing D&O insurance coverage because of the knowledge or bad acts of other policyholders. While severability clauses may provide some comfort, policyholders should carefully review such provisions. The specific language of these provisions may determine whether there is coverage for innocent directors or officers in situations where the insurance company has valid grounds to rescind coverage for one policyholder.

Recent case law suggests that misrepresentations in the insurance application, for example, may allow the insurance carrier to void coverage as to directors and officers who had no role in the application process, had no knowledge of the alleged misrepresentations, and who honestly believed that the application was accurate and complete. Whether or not there is coverage may depend on whether the policy contains a full or partial severability clause.

When a policy has a full severability clause, the knowledge of one policyholder should not be imputed to innocent directors and officers. In In re HealthSouth Corp. Securities Litigation, 308 F.Supp.2d 1253 (N.D. Ala. 2004), for example, the court considered whether insurance companies could rescind D&O coverage based on application misstatements after former company officers entered guilty pleas and admitted that they engaged in a scheme to misrepresent the company's finances. The company's D&O policy included the following severability clause:

With respect to the declarations and statements contained in such written application(s) for coverage, no statement in the application or knowledge possessed by any Insured Person shall be imputed to any other Insured Person for the purpose of determining if coverage is available.

The court ruled that the above full severability provision “preclude[s] rescission as to all insureds regardless of their involvement in the alleged fraud.”

In some circumstances, however, courts have found that a D&O policy includes only partial severability clauses under which misrepresentations or omissions by policyholders who execute the application or other designated individuals may be imputed to other policyholders. In Cutter & Buck, Inc. v. Genesis Insurance Co., 306 F.Supp.2d 988 (W.D. Wash. 2004), aff'd, No. 04-35218, 2005 WL 1799397 (9th Cir. Aug. 1, 2005), for example, the court found that the insurance company was entitled to rescind coverage for otherwise innocent directors and officers where the CFO knowingly submitted and executed a renewal insurance application that contained material misrepresentations. The policy included the following severability clause:

In the event that the Application ' contains misrepresentations made with the actual intent to deceive, or contains misrepresentations which materially affect ' the acceptance of the risk[,] ' this Policy in its entirety shall be void and of no affect whatsoever; and provided, however, that no knowledge possessed by any Director or Officer shall be imputed to any other Director or Officer except for material information known to the person or persons who signed the Application.

The court held that the above partial severability provision was unambiguous and clearly provided that “a director's or officer's knowledge of a misrepresentation made with an intent to deceive is not imputed to other directors or officers unless the application's signer knew of the misrepresentation.”

Other courts have similarly held that insurance companies can rescind coverage under a partial severability provision that is unambiguous. See Federal Insurance Co. v. Homestore, Inc., 144 Fed. Appx. 641 (9th Cir. Aug. 12, 2005) (unpublished); TIG Ins. Co. of Michigan v. Homestore, Inc., 40 Cal.Rptr.3d 528 (Cal. Dist. Ct. App. 2006). Even where D&O policies contain an unambiguous full severability provision, insurance companies have attempted to rescind coverage. See Twin City Fire Ins. Co. v. HPL Techs., Inc., No. 1-03-CV-006505, slip op. at 6 (Cal. Super. Ct. Jan. 12, 2005).

The recent case law discussed above demonstrates the critical importance of negotiating for full severability clauses. Even if the policy contains a full severability clause, innocent directors or officers may be at risk. Policyholders should make certain that the severability clause contained in their D&O policy has two primary components: 1) each policyholder is viewed as a separate policyholder; and 2) one policyholder's statement or knowledge is not imputed to another policyholder. A more direct approach, however, may be to negotiate a nonrescindable provision, which provides that the insurance company cannot, under any circumstances, rescind the policy.

Duty to Defend

General liability insurance policies commonly contain a duty-to-defend provision, which essentially states that in the event a claim is made against the named insured for an alleged wrongful act, the insurance company providing coverage at the time has the right and duty to defend the claim, even if it is groundless, false, or fraudulent. Some insurance policies, however, also contain a non'duty-to-defend provision, which states that it is the policyholder's responsibility, not the insurance company's obligation, to defend a claim when one occurs. While defense arrangements under D&O policies used to be thought of as an area with little controversy or dispute, at least one state's insurance department has waded into this area.

The Office of the General Counsel for the State of New York Insurance Department has issued an opinion that limits the ability of insurance companies that provide D&O liability insurance in New York to place the duty to defend on the policyholder rather than the insurance company. See Opinion of Office of General Counsel No. 08-10-07 (Oct. 16, 2008) (concluding that “a D&O liability policy may not include a provision that places the duty to defend upon the insured, rather than the insurer”). According to the opinion, the insurance company must provide a proper defense regardless of the cost, and a policy “may not contain any provision that limits the availability of legal defense costs. A policy that places the duty to defend on the policyholder would run afoul of 11 NYCRR ' 71.0(d)(1) (Regulation 107), which regulates legal defense costs in liability policies, because it would limit the availability of coverage for legal defense costs. By placing the duty to defend on the policyholder, the policy would condition defense cost coverage on the insurance company taking charge of the defense.

The New York Insurance Department's decision to no longer approve D&O policies lacking duty-to-defend provisions will immediately affect the rights and responsibilities of insurance companies and policyholders. Even more significant, it may be indicative of further regulatory actions to come in D&O insurance.

Exclusions

To combat the broad insuring clause in all D&O insurance policies, insurance companies limit their liability exposure by expressly excluding certain risks from coverage. Exclusions are used to exclude those risks that are deemed so potentially damaging that the insurance company is unwilling to accept the liabilities represented by them. Because exclusions, such as the following, operate to the detriment of the policyholder, they are subject to the general rule that their application is strictly construed against the insurance company.

Insured vs. Insured Exclusion: Almost all D&O policies contain an exclusion providing that the policy does not afford coverage for lawsuits between policyholders. This exclusion is frequently a source of litigation.

One recurring issue involves application of the “insured vs. insured” exclusion where some, but not all, of the plaintiffs are policyholders. Two recent federal district court decisions reached opposite results on whether the “insured vs. insured” exclusion in a D&O policy excludes all coverage for the entire lawsuit when only one of several plaintiffs is a policyholder under the policy. See Home Federal Sav. & Loan Ass'n v. Federal Ins. Co., 4:06-CV-3053, 2007 U.S. Dist. LEXIS 68558, at *11-15 (N.D. Ohio Sept. 14, 2007) (holding exclusion only applied to policyholder plaintiff's claim and allowed coverage for claims asserted by other plaintiffs because term “claim” could refer to separate proceedings had each plaintiff filed its own lawsuit); Westchester Fire Ins. Co. v. Wallerich, 527 F. Supp. 2d 896, 902-05 (D. Minn. 2007) (holding that because policy defined “claim” as “a civil proceeding ' ” exclusion should apply to entire lawsuit, not just policyholder's claim). In Sphinx International, Inc. v. National Union Fire Insurance Co. of Pittsburgh, Pennsylvania, 412 F.3d 1224 (11th Cir. 2005), a former director filed a securities class action lawsuit against the company. He then published a newspaper announcement soliciting additional plaintiffs and amended the complaint to add the group of shareholders who responded to his ad. The company's D&O policy provided in pertinent part that there was no coverage for claims brought “by or at the behest of ' any DIRECTOR or OFFICER,” which was defined to include former directors and officers. Although there were uninsured parties as plaintiffs, the court held that the “insured vs. insured” exclusion precluded coverage for the entire action. The court noted that the policyholder plaintiff had brought the suit by himself and then recruited other plaintiffs. The court also relied on the fact that the exclusion applied to claims brought “by or at the behest of” a policyholder.

In the context of an errors and omissions policy, the Third Circuit, in Township of Center, Butler County v. First Mercury Syndicate, Inc., 117 F.3d 115 (3rd Cir. 1997), similarly held that the “insured vs. insured” exclusion did not apply to former employees. In that case, the court noted that:

the primary focus of the [insured vs. insured] exclusion is to prevent collusive suits in which an insured company might seek to force its insurer to pay for the poor business decisions of its officers or managers. The exclusion arose from a wave of litigation in the mid-1980's when corporations attempted to use their director and officer policies to recoup operational losses. Where, however, it is clear that the underlying action is not collusive, the exclusion has not precluded coverage.

The First Mercury court concluded that the former employees were not “insureds” within the meaning of the exclusions, and determined that the claims were not collusive in nature.

In Federal Insurance Company v. Infoglide Corp., 2006 WL 2050694 (W.D. Tex. July 18, 2006), the Western District of Texas addressed an issue that was similar to that raised in Sphinx International and First Mercury, and came to a different conclusion. In that case, two former officers of the company, together with several additional parties, filed suit against the current directors and officers. The court distinguished Sphinx International, holding that the exclusion barred coverage only for that portion of the case asserting claims on behalf of the policyholders. The court relied on the fact that the non-policyholder plaintiffs were in the case from the outset and that the policy contained a provision for allocation of loss between covered and uncovered portions of the claim.

Another emerging issue that may arise concerning the “insured vs. insured” exclusion relates to claims brought by a bankruptcy trustee. In Rigby v. Underwriters at Lloyd's, London, 907 So.2d 1187 (Fla. Ct. App. 2005), the insured corporation's bankruptcy trustee sued a former director of the corporation for negligence and breach of fiduciary duty. The former director sought coverage under the corporation's D&O policy, which had been renewed while the company was in bankruptcy, at which point the trustee had requested and received an endorsement listing him as an insured under the policy. The insurance company denied coverage, relying on the “insured vs. insured” exclusion. The court, however, held that the exclusion did not preclude coverage because the lawsuit was not brought by the trustee in his capacity as an insured, but rather in his capacity as a Chapter 7 trustee.

Takeover Exclusion: Many D&O insurance policies contain a takeover exclusion in response to the rise in litigation by or against directors and officers arising out of mergers and acquisitions. A typical takeover exclusion excludes:

(1) any claims ' based upon, arising out of, directly or indirectly resulting from or in consequence of, or in any way involving, any offer to purchase, or purchase of, securities of the Company at a premium over their then-current market value, made by the Company or by the Directors or Officers, except where such offer or purchase extends to all security-holders of the Company '

Although such exclusions arose out of litigation related to hostile takeovers, insurance companies have adopted broader interpretations of them. Some exclusions cover friendly and hostile takeovers, claims arising out of the insured corporation's attempt to acquire other businesses, or assets as well as stock transactions. Because such exclusions are relatively new, insurance companies are still experimenting with their language, and this process is likely to arise in coverage litigation.

Professional Liability Exclusion: D&O insurance policies generally do not provide coverage for liability associated with the rendering of professional services. The line between professional services and acts outside the scope of this exclusion can be a fine one. Therefore, what constitutes a “professional service” is a fundamental and frequently litigated issue under D&O policies. Courts often draw a distinction between those acts that require special training or are at the heart of the profession and those acts that are administrative in nature.

To the extent possible, policyholders should seek to limit the number of exclusions at the time the policy is purchased. If and when coverage is denied or unfairly limited, a policyholder should be armed to limit the scope of the exclusions as applied to the particular case.

Bankruptcy

A corporation's filing of bankruptcy may raise a couple of potential issues concerning its directors and officers insurance coverage. Because bankruptcy trustees will be looking for insurance proceeds to satisfy creditors, courts, in dividing up the bankrupt estate, will be left to determine whether the insurance policies and proceeds are part of the estate. Some courts have held that insurance policies are part of the estate, although the proceeds may not be. See Reliance Ins. Co. v. Weis, 148 B.R. 575, 581 (E.D. Mo. 1992) (and cases cited therein). If a court determines the policy and proceeds are part of the estate, policyholders may need bankruptcy court approval to obtain the proceeds from the insurance company. Given the current state of the economy and number of companies filing for bankruptcy as a result thereof, this topic is bound to arise more frequently in litigation.

Conclusion

Policyholders should be mindful that while liability insurance usually is essential, and specialized business insurance is becoming more common, insurance coverage problems frequently develop upon filing a claim with their insurance company. Too frequently, insurance companies battle their policyholders at the worst of possible times in an effort to reduce insurance coverage for sizeable claims. Risk managers and corporate counsel should understand that an insurance policy has value only if the insurance company pays when a covered claim is submitted. By developing a fundamental understanding of their liability insurance policies and the insurance claims process, as well as adopting a willingness to fight for the policy coverage purchased, policyholders can enhance their position to secure insurance coverage.

John N. Ellison, a member of this newsletter's Board of Editors, is a partner and Matthew D. Rosso is an associate at Reed Smith LLP, in Philadelphia.

Directors' and officers' (“D&O”) liability insurance protects corporate directors and officers from third-party claims made against them in their capacities as directors and officers for certain breaches of their duties to their corporation and its shareholders. Due to recent statutes and case law increasing directors' and officers' duties and exposure to potential liability, demand for this type of insurance has increased rapidly in recent years. This increase in demand has led to a significant rise in coverage litigation to define and interpret the language of existing policies. This article discusses a few emerging issues that can arise under D&O policies, and how they can impact policyholders.

Emerging Coverage Issues

Late Notice

Late notice is a common problem in coverage disputes, especially under D&O policies. Unlike most commercial general liability policies, which are typically issued on an “occurrence” basis, D&O policies are written on a “claims made” basis. Under a claims-made policy, coverage is triggered by a “claim” being first made against the policyholder during the policy period, irrespective of when the harm arose or the wrongful act took place. In addition to the “claim” being made during the policy period, some professional liability policies also require that the “claim” be reported to the insurance company during the policy period or an extended reporting period. Such policies are called claims-made-and-reported policies.

D&O policies typically written on a “claims-made” basis contain detailed notice procedures and requirements in the event of a claim. The policyholder must give prompt notice of the claim and cooperate with the insurance company to be covered under the policy. Courts are fairly strict in requiring the triggering event to take place during the policy period, refusing to find coverage when the claim or notice occurs outside of the policy period. See, e.g., Burns v. International Ins. Co. , 929 F.2d 1422 (9th Cir. 1991); American Home Assur. Co. v. Abrams , 69 F. Supp. 2d 339 (D. Conn. 1999); Brumfield v. Shelton , 831 F. Supp. 562 (E.D. La. 1993).

Under a claims-made policy, an insurance company generally does not need to demonstrate prejudice to deny coverage when notice of a claim is provided outside of the policy period. See, e.g., Hachigian v. CNA Ins. Co. , 3 Fed. Appx. 630 (9th Cir. 2001) (under malpractice insurance policy, notice provisions are strictly enforced and notice-prejudice rule does not apply); Esmailzadeh v. Johnson & Speakman , 869 F.2d 422, 424-425 (8th Cir. 1989); Brakeman v. Potomac Insurance Co. , 472 Pa. 66, 76-77, 371 A.2d 193, 198 (1977). Nearly every court that has considered the issue has concluded that reporting requirements in a claims-made insurance policy should be strictly construed. National Union Fire Ins. v. Talcott , 931 F.2d 166 (1st Cir. 1991); Burns v. Int'l Ins. Co. , 929 F.2d 1422 (9th Cir. 1991); United States v. A.C. Strip , 868 F.2d 181 (6th Cir. 1989); MGIC Indem. Corp. v. Cent. Bank , 838 F.2d 1382, 1385-1387 (5th Cir. 1988); Pizzini v. American Int'l Specialty Lines Ins. Co. , 210 F. Supp. 2d 658 (E.D. Pa. 2002).

Courts have recently started to apply the notice-prejudice rule to “claims-made” insurance policies that do not have an explicit “reporting” requirement mandating notice of the claim within the policy period or a specified number of days later. See Hardwick Recycling & Salvage, Inc. v. Acadia Ins. Co. , 869 A.2d 82 (Vt. 2004); Pension Trust Fund for Operating Eng'rs v. Federal Ins. Co ., 307 F.3d 944, 957 (9th Cir. 2002). See also Kenneth W. Lucas, A Prejudicial Requirement: The Ongoing Development of Liability Policy Notice-Prejudice Issues, Coverage, Vol. 18, No. 3 (May/June 2008). This year, both the Texas and Pennsylvania Supreme Courts should decide whether the notice-prejudice rule applies to claims-made policies. The U.S. Court of Appeals for the Fifth Circuit certified a notice-prejudice question to the Texas Supreme Court. See XL Specialty Ins. Co. v. Financial Indus. Corp., No. 06-51683, 2007 WL 4461190 (5th Cir. Dec. 19, 2007). The Pennsylvania Supreme Court is hearing a dispute between insurance companies about the notice-prejudice rule in claims-made policies. ACE American Ins. Co. v. Underwriters at Lloyds and Cos., et al., Pa. Supreme Ct. Docket No. 45 EAP 2008. Given the uncertainty surrounding notice under a D&O claims-made insurance policy, however, the best course of action for policyholders is to take a proactive approach and provide notice to the carriers as soon as practicable.

Exhaustion

Issues frequently arise from an exhaustion clause in an excess D&O liability policy; specifically, whether settlement with a primary insurance carrier for less than the policy limit precludes recovery from an excess carrier. A typical exhaustion clause provides that the insurance company “shall be liable only after the insurers under each of the Underlying Policies have paid or have been held liable to pay the full amount of the Underlying Limit of Liability.”

Interpreting an identical exhaustion clause, the court in Qualcomm, Inc. v. Certain Underwriters at Lloyd's, London, held that the insured corporation, which had settled securities fraud class action lawsuits for $21 million and recovered $14 million by way of a settlement with its primary insurance company, was precluded from bringing suit against the excess insurance company to recover the portion of settlement exceeding primary insurer's $20 million limit. 161 Cal.App.4th 184 (Cal. Ct. App. 2008). See also Comerica Inc. v. Zurich American Ins. Co. , 498 F.Supp.2d 1019 (E.D. Mich. 2007) (holding excess policy language unambiguously required primary insurance be exhausted by actual payment of losses by underlying insurance company). According to the court, the exhaustion clause unambiguously precluded the excess insurer's liability for the insured's losses in excess of the primary policy's limit after the policyholder settled with the primary insurance company for less than the primary policy limit. Taking into account the nature of the policy as an excess insurance policy, the court noted that the objectively reasonable expectation of the policyholder would be that the primary insurance policy would have to be exhausted before excess insurance would attach.

Courts in other jurisdictions, however, have taken a different approach. In Stargatt v. Fidelity and Casualty Company of New York , 67 F.R.D. 689 (D. Del. 1975), aff'd , 578 F.2d 1375 (3d Cir. 1978), for example, the U.S. District Court for the District of Delaware held, where the sole issue was whether an excess insurance policy may be reached by a policyholder when the primary policy has been settled for less than its limit, that the excess insurers will be liable only for covered losses in excess of the primary policy limit plus the deductible on the excess insurance policy. See also Westinghouse Electric Corp. v. American Home Assurance Co., No. A-6706-01T5, A-6720-01T5, 2004 WL 1878764, at *6 (N.J. Super. Ct. July. 8, 2004) (holding excess liability policy triggered when primary policy limit reached by total costs incurred by policyholder, regardless of whether total payments to policyholder reached those limits, because excess insurance company could not possibly claim to have stake in whether policyholder actually received all of the underlying insurance limits).

Whether or not a less than policy limit settlement with a primary insurance company precludes recovery from an excess insurance company probably depends on the language of the exhaustion clause and which jurisdiction's laws apply. For this reason, policyholders should give some thought to exhaustion clauses prior to negotiating D&O coverage.

Severability

Innocent directors and officers may be at risk of losing D&O insurance coverage because of the knowledge or bad acts of other policyholders. While severability clauses may provide some comfort, policyholders should carefully review such provisions. The specific language of these provisions may determine whether there is coverage for innocent directors or officers in situations where the insurance company has valid grounds to rescind coverage for one policyholder.

Recent case law suggests that misrepresentations in the insurance application, for example, may allow the insurance carrier to void coverage as to directors and officers who had no role in the application process, had no knowledge of the alleged misrepresentations, and who honestly believed that the application was accurate and complete. Whether or not there is coverage may depend on whether the policy contains a full or partial severability clause.

When a policy has a full severability clause, the knowledge of one policyholder should not be imputed to innocent directors and officers. In In re HealthSouth Corp. Securities Litigation, 308 F.Supp.2d 1253 (N.D. Ala. 2004), for example, the court considered whether insurance companies could rescind D&O coverage based on application misstatements after former company officers entered guilty pleas and admitted that they engaged in a scheme to misrepresent the company's finances. The company's D&O policy included the following severability clause:

With respect to the declarations and statements contained in such written application(s) for coverage, no statement in the application or knowledge possessed by any Insured Person shall be imputed to any other Insured Person for the purpose of determining if coverage is available.

The court ruled that the above full severability provision “preclude[s] rescission as to all insureds regardless of their involvement in the alleged fraud.”

In some circumstances, however, courts have found that a D&O policy includes only partial severability clauses under which misrepresentations or omissions by policyholders who execute the application or other designated individuals may be imputed to other policyholders. In Cutter & Buck, Inc. v. Genesis Insurance Co. , 306 F.Supp.2d 988 (W.D. Wash. 2004), aff'd, No. 04-35218, 2005 WL 1799397 (9th Cir. Aug. 1, 2005), for example, the court found that the insurance company was entitled to rescind coverage for otherwise innocent directors and officers where the CFO knowingly submitted and executed a renewal insurance application that contained material misrepresentations. The policy included the following severability clause:

In the event that the Application ' contains misrepresentations made with the actual intent to deceive, or contains misrepresentations which materially affect ' the acceptance of the risk[,] ' this Policy in its entirety shall be void and of no affect whatsoever; and provided, however, that no knowledge possessed by any Director or Officer shall be imputed to any other Director or Officer except for material information known to the person or persons who signed the Application.

The court held that the above partial severability provision was unambiguous and clearly provided that “a director's or officer's knowledge of a misrepresentation made with an intent to deceive is not imputed to other directors or officers unless the application's signer knew of the misrepresentation.”

Other courts have similarly held that insurance companies can rescind coverage under a partial severability provision that is unambiguous. See Federal Insurance Co. v. Homestore, Inc. , 144 Fed. Appx. 641 (9th Cir. Aug. 12, 2005) (unpublished); TIG Ins. Co. of Michigan v. Homestore, Inc. , 40 Cal.Rptr.3d 528 (Cal. Dist. Ct. App. 2006). Even where D&O policies contain an unambiguous full severability provision, insurance companies have attempted to rescind coverage. See Twin City Fire Ins. Co. v. HPL Techs., Inc., No. 1-03-CV-006505, slip op. at 6 (Cal. Super. Ct. Jan. 12, 2005).

The recent case law discussed above demonstrates the critical importance of negotiating for full severability clauses. Even if the policy contains a full severability clause, innocent directors or officers may be at risk. Policyholders should make certain that the severability clause contained in their D&O policy has two primary components: 1) each policyholder is viewed as a separate policyholder; and 2) one policyholder's statement or knowledge is not imputed to another policyholder. A more direct approach, however, may be to negotiate a nonrescindable provision, which provides that the insurance company cannot, under any circumstances, rescind the policy.

Duty to Defend

General liability insurance policies commonly contain a duty-to-defend provision, which essentially states that in the event a claim is made against the named insured for an alleged wrongful act, the insurance company providing coverage at the time has the right and duty to defend the claim, even if it is groundless, false, or fraudulent. Some insurance policies, however, also contain a non'duty-to-defend provision, which states that it is the policyholder's responsibility, not the insurance company's obligation, to defend a claim when one occurs. While defense arrangements under D&O policies used to be thought of as an area with little controversy or dispute, at least one state's insurance department has waded into this area.

The Office of the General Counsel for the State of New York Insurance Department has issued an opinion that limits the ability of insurance companies that provide D&O liability insurance in New York to place the duty to defend on the policyholder rather than the insurance company. See Opinion of Office of General Counsel No. 08-10-07 (Oct. 16, 2008) (concluding that “a D&O liability policy may not include a provision that places the duty to defend upon the insured, rather than the insurer”). According to the opinion, the insurance company must provide a proper defense regardless of the cost, and a policy “may not contain any provision that limits the availability of legal defense costs. A policy that places the duty to defend on the policyholder would run afoul of 11 NYCRR ' 71.0(d)(1) (Regulation 107), which regulates legal defense costs in liability policies, because it would limit the availability of coverage for legal defense costs. By placing the duty to defend on the policyholder, the policy would condition defense cost coverage on the insurance company taking charge of the defense.

The New York Insurance Department's decision to no longer approve D&O policies lacking duty-to-defend provisions will immediately affect the rights and responsibilities of insurance companies and policyholders. Even more significant, it may be indicative of further regulatory actions to come in D&O insurance.

Exclusions

To combat the broad insuring clause in all D&O insurance policies, insurance companies limit their liability exposure by expressly excluding certain risks from coverage. Exclusions are used to exclude those risks that are deemed so potentially damaging that the insurance company is unwilling to accept the liabilities represented by them. Because exclusions, such as the following, operate to the detriment of the policyholder, they are subject to the general rule that their application is strictly construed against the insurance company.

Insured vs. Insured Exclusion: Almost all D&O policies contain an exclusion providing that the policy does not afford coverage for lawsuits between policyholders. This exclusion is frequently a source of litigation.

One recurring issue involves application of the “insured vs. insured” exclusion where some, but not all, of the plaintiffs are policyholders. Two recent federal district court decisions reached opposite results on whether the “insured vs. insured” exclusion in a D&O policy excludes all coverage for the entire lawsuit when only one of several plaintiffs is a policyholder under the policy. See Home Federal Sav. & Loan Ass'n v. Federal Ins. Co., 4:06-CV-3053, 2007 U.S. Dist. LEXIS 68558, at *11-15 (N.D. Ohio Sept. 14, 2007) (holding exclusion only applied to policyholder plaintiff's claim and allowed coverage for claims asserted by other plaintiffs because term “claim” could refer to separate proceedings had each plaintiff filed its own lawsuit); Westchester Fire Ins. Co. v. Wallerich , 527 F. Supp. 2d 896, 902-05 (D. Minn. 2007) (holding that because policy defined “claim” as “a civil proceeding ' ” exclusion should apply to entire lawsuit, not just policyholder's claim). In Sphinx International, Inc. v. National Union Fire Insurance Co. of Pittsburgh, Pennsylvania , 412 F.3d 1224 (11th Cir. 2005), a former director filed a securities class action lawsuit against the company. He then published a newspaper announcement soliciting additional plaintiffs and amended the complaint to add the group of shareholders who responded to his ad. The company's D&O policy provided in pertinent part that there was no coverage for claims brought “by or at the behest of ' any DIRECTOR or OFFICER,” which was defined to include former directors and officers. Although there were uninsured parties as plaintiffs, the court held that the “insured vs. insured” exclusion precluded coverage for the entire action. The court noted that the policyholder plaintiff had brought the suit by himself and then recruited other plaintiffs. The court also relied on the fact that the exclusion applied to claims brought “by or at the behest of” a policyholder.

In the context of an errors and omissions policy, the Third Circuit, in Township of Center, Butler County v. First Mercury Syndicate, Inc. , 117 F.3d 115 (3rd Cir. 1997), similarly held that the “insured vs. insured” exclusion did not apply to former employees. In that case, the court noted that:

the primary focus of the [insured vs. insured] exclusion is to prevent collusive suits in which an insured company might seek to force its insurer to pay for the poor business decisions of its officers or managers. The exclusion arose from a wave of litigation in the mid-1980's when corporations attempted to use their director and officer policies to recoup operational losses. Where, however, it is clear that the underlying action is not collusive, the exclusion has not precluded coverage.

The First Mercury court concluded that the former employees were not “insureds” within the meaning of the exclusions, and determined that the claims were not collusive in nature.

In Federal Insurance Company v. Infoglide Corp., 2006 WL 2050694 (W.D. Tex. July 18, 2006), the Western District of Texas addressed an issue that was similar to that raised in Sphinx International and First Mercury, and came to a different conclusion. In that case, two former officers of the company, together with several additional parties, filed suit against the current directors and officers. The court distinguished Sphinx International, holding that the exclusion barred coverage only for that portion of the case asserting claims on behalf of the policyholders. The court relied on the fact that the non-policyholder plaintiffs were in the case from the outset and that the policy contained a provision for allocation of loss between covered and uncovered portions of the claim.

Another emerging issue that may arise concerning the “insured vs. insured” exclusion relates to claims brought by a bankruptcy trustee. In Rigby v. Underwriters at Lloyd's, London , 907 So.2d 1187 (Fla. Ct. App. 2005), the insured corporation's bankruptcy trustee sued a former director of the corporation for negligence and breach of fiduciary duty. The former director sought coverage under the corporation's D&O policy, which had been renewed while the company was in bankruptcy, at which point the trustee had requested and received an endorsement listing him as an insured under the policy. The insurance company denied coverage, relying on the “insured vs. insured” exclusion. The court, however, held that the exclusion did not preclude coverage because the lawsuit was not brought by the trustee in his capacity as an insured, but rather in his capacity as a Chapter 7 trustee.

Takeover Exclusion: Many D&O insurance policies contain a takeover exclusion in response to the rise in litigation by or against directors and officers arising out of mergers and acquisitions. A typical takeover exclusion excludes:

(1) any claims ' based upon, arising out of, directly or indirectly resulting from or in consequence of, or in any way involving, any offer to purchase, or purchase of, securities of the Company at a premium over their then-current market value, made by the Company or by the Directors or Officers, except where such offer or purchase extends to all security-holders of the Company '

Although such exclusions arose out of litigation related to hostile takeovers, insurance companies have adopted broader interpretations of them. Some exclusions cover friendly and hostile takeovers, claims arising out of the insured corporation's attempt to acquire other businesses, or assets as well as stock transactions. Because such exclusions are relatively new, insurance companies are still experimenting with their language, and this process is likely to arise in coverage litigation.

Professional Liability Exclusion: D&O insurance policies generally do not provide coverage for liability associated with the rendering of professional services. The line between professional services and acts outside the scope of this exclusion can be a fine one. Therefore, what constitutes a “professional service” is a fundamental and frequently litigated issue under D&O policies. Courts often draw a distinction between those acts that require special training or are at the heart of the profession and those acts that are administrative in nature.

To the extent possible, policyholders should seek to limit the number of exclusions at the time the policy is purchased. If and when coverage is denied or unfairly limited, a policyholder should be armed to limit the scope of the exclusions as applied to the particular case.

Bankruptcy

A corporation's filing of bankruptcy may raise a couple of potential issues concerning its directors and officers insurance coverage. Because bankruptcy trustees will be looking for insurance proceeds to satisfy creditors, courts, in dividing up the bankrupt estate, will be left to determine whether the insurance policies and proceeds are part of the estate. Some courts have held that insurance policies are part of the estate, although the proceeds may not be. See Reliance Ins. Co. v. Weis , 148 B.R. 575, 581 (E.D. Mo. 1992) (and cases cited therein). If a court determines the policy and proceeds are part of the estate, policyholders may need bankruptcy court approval to obtain the proceeds from the insurance company. Given the current state of the economy and number of companies filing for bankruptcy as a result thereof, this topic is bound to arise more frequently in litigation.

Conclusion

Policyholders should be mindful that while liability insurance usually is essential, and specialized business insurance is becoming more common, insurance coverage problems frequently develop upon filing a claim with their insurance company. Too frequently, insurance companies battle their policyholders at the worst of possible times in an effort to reduce insurance coverage for sizeable claims. Risk managers and corporate counsel should understand that an insurance policy has value only if the insurance company pays when a covered claim is submitted. By developing a fundamental understanding of their liability insurance policies and the insurance claims process, as well as adopting a willingness to fight for the policy coverage purchased, policyholders can enhance their position to secure insurance coverage.

John N. Ellison, a member of this newsletter's Board of Editors, is a partner and Matthew D. Rosso is an associate at Reed Smith LLP, in Philadelphia.