Market Took Off After Directors, Officers Found Personally Liable

Two court rulings in 1968 brought risk to the attention of executives; 1976 ruling opened the spigots of securities class actions
By Dave Lenckus

Insurers first offered directors and officers liability insurance 70 years ago, but the coverage did not draw insurance buyers on a large scale until the late 1960s, when courts began handing investors victories in securities litigation.

The first D&O policy, written by Lloyd's of London underwriters, appeared in the United States in the mid- to late 1930s after the enactment of the first federal securities laws, according to market experts.

"For the first time, you, as a director or officer, faced exposure" over investors' losses, said policyholder attorney William Passannante, a partner with Anderson Kill & Olick P.C. of New York.

Federated Department Stores Inc., now known as Macy's Inc., is widely considered the first buyer of the coverage.

Market experts disagree over whether the earliest Lloyd's policies consisted of what came to be the coverage's traditional A and B sides. Side A covers executives directly when corporate indemnification is precluded; Side B reimburses the corporate entity after it has indemnified its executives.

But Carol A.N. Zacharias, senior vp and underwriting counsel for ACE USA in New York, maintains that the Lloyd's policy contained both sides. There was little demand for the coverage, however, because organisations were not yet allowed to indemnify their executives, and most executives did not perceive that they faced a great risk, she said.

That perception changed in 1968, when the 2nd U.S. Circuit Court of Appeals ruled in Escott vs. BarChris Construction Corp. that the defendant company's directors and officers were personally liable to investors who relied on misleading financial figures developed by an outside accounting firm. The court ruled that the executives failed to exercise due diligence by not substantiating the figures.

"This jolted Ds and Os," said insurer attorney Dan A. Bailey, a partner with Bailey Cavalieri L.L.C. of Columbus, Ohio. "It led to a lot of companies buying this product."

Another ruling by the 2nd Circuit that year also startled executives, Mr. Passannante noted. In SEC vs. Texas Gulf Sulphur Co., the court ruled that executives could be held liable for investors' losses even when the defendants did not personally profit from their actions.

While those cases got directors' and officers' attention, they did not drive up claim frequency significantly.

But the U.S. Supreme Court's 1976 ruling in Ernst & Ernst vs. Hochfelder did. In that case, the court ruled that plaintiffs did not have to prove they were intentionally deceived but only that corporate officials were reckless.

"That starts the spigot" of securities class action claims and fuels the growth of powerful plaintiff law firms, Mr. Bailey said.

Meanwhile, a 1972 Pennsylvania federal court case, Bird vs. Penn Central Co., sent a warning to buyers that insurers would not tolerate misrepresentations in coverage applications.

The court confirmed that Lloyd's underwriters could rescind their policy covering the directors of Penn Central, which at that time was the biggest company in U.S. history to file for bankruptcy. Underwriters sought the rescission after investigations into the company's demise unveiled that some top corporate officials were involved in an illegal scheme to profit from the company's employee pension plan investments.

At the time, D&O policies did not have severability provisions, so innocent as well as culpable executives could have lost their coverage. Lloyd's underwriters later settled the dispute for a small fraction of policy limits, according to insurer attorney Stu Ross, who represented Lloyd's. Mr. Ross is now a partner with Ross, Dixon & Bell L.L.P. in Washington.

Insurer attorney Richard J. Bortnick, a partner with Cozen O'Connor P.C. in Philadelphia, says that the case highlighted the value of D&O insurance.

It also demonstrated an important concept in coverage litigation, Mr. Ross said: "Insurers have some rights, too."

Over the next decade, corporate America's merger and acquisition binge compounded claim problems for buyers and insurers. Mergers that did not fare well led to state court lawsuits in which investors claimed that top management breached their fiduciary duties. In three decisions in 1985, the Delaware Supreme Court agreed.

"That was a huge wakeup call" for executives who had relied on the business judgment rule to protect them from such claims, Mr. Bailey said. The rule guards executives from liability for poor business results if the executives had used sound reasoning in making their business decisions.

The resulting crush of losses exacerbated the already tightening insurance market. Many buyers could not find coverage after many D&O insurers exited the market, and buyers that did find coverage could not find enough. Plus, the cost of coverage shot up from five or six figures to seven figures, recalled broker Lou Ann Layton, a managing director and the national D&O practice leader for Marsh Inc. of New York.

Those market conditions drove buyers to set up their own Bermuda-based excess liability facilities, including what are now known as ACE Ltd. and XL Capital Ltd.

When the market began softening in the late 1980s, policy terms and conditions began broadening to extend defense costs to executives facing criminal charges.

That is an indication that policy enhancements have gone to insiders more than independent directors, noted Evan Rosenberg, a senior vp with Chubb Corp. unit Chubb Specialty Insurance of Warren, N.J.

At the same time, the Supreme Court knocked down a litigation barrier for class action plaintiffs. In its 1988 ruling in Basic Inc. vs. Levinson, the court ruled that every member of a class action does not have to prove they relied on misleading financial material, as long as the material was absorbed into the investor community and affected the defendant company's share price.

"The securities class action arena really starts taking off," Mr. Bailey said.

But buyers hoped to see a reduction of frivolous claims with the enactment of the Private Securities Litigation Reform Act of 1995. Claim frequency did drop below 1995 claim levels for two years but then went up sharply until 2005, largely because of an unstable stock market and a rash of corporate fraud in the early part of this decade.

That wave of corporate scandal led to the Sarbanes-Oxley Act, the 2002 federal statute designed to improve corporate governance and hold corporate officials accountable for the accuracy of financial statements.

While securities class action claim frequency has fallen for a few years, loss severity is rising. And many market experts contend that the frequency figure is misleading, because it doesn't take into account a number of derivative action lawsuits.

The mid-1990s also marked the zenith of coverage allocation disputes between insurers and policyholders.

Insurers did not want to cover the portion of losses attributable to the actions of the uninsured organisations. That meant policyholders could expect only partial coverage of their losses, even though they contended that a corporation's and individuals' actions were inseparable and that settlements were not any larger because of a corporate entity's actions.

The issue "was an evolving train wreck," as alleged damages, and therefore the amount of coverage at stake, grew larger, said Steve Shappell, managing director of the legal and claims practice for Aon Corp. unit Aon Financial Services Group in Denver.

Three federal appellate courts returned pro-policyholder decisions in the dispute in 1995, prompting underwriters to modify D&O policy forms. Eventually, the market responded to policyholders' demands for full entity, or Side C coverage, rather than the alternative option of a preset allocation.

But that decision eventually hurt corporate executives sued over their organisations' bankruptcies. Because their policies now included entity coverage, the policies were corporate assets that bankruptcy courts froze along with all other corporate assets.

The spate of corporate corruption and financial problems and the resulting multibillion dollar class action settlements this decade has popularised stand-alone Side A coverage for securities claims, which Bermuda-based C.O.D.A.-later acquired by ACE-introduced in the 1980s. The separate tower of difference-in-conditions coverage comforts directors not only because of the additional limits it provides but also because it cannot be frozen or rescinded.

Market experts foresee other potentially significant developments for D&O insurers and policyholders over the next five to 10 years.

Aon's Mr. Shappell and Chubb's Mr. Rosenberg pointed to the brewing coverage allocation debate involving corporate investigations by the Securities and Exchange Commission. D&O policies do not cover costs related to those investigations, though they often are intertwined with covered claims.

Mr. Bailey questioned whether companies might have to defend against claims that their operations contributed to climate change, while also dealing with the Supreme Court's ruling that greenhouse gases are pollutants; D&O policies typically contain pollution exclusions.