The Increasing Risk Of Non-Indemnified Claims And Need For Side A D&O
Broad indemnification agreements are a staple protection for corporate officers of both public and private companies alike. Unfortunately, corporate indemnification isn’t a guarantee. There are a number of situations in which such protections may become unavailable or indemnification may be wrongfully denied by the company. In such situations, the only source of funds available to executives, are those provided by a the Side A insuring agreement of a D&O policy which provides coverage for non-indemnifiable claims. Without sufficient side A coverage, executives could find themselves being forced to personally fund their own defense and/or settlements when these failures occur. Unfortunately given the current economic and legal environment (discussed below), the conditions are becoming ripe for non-indemnified claims, which also means the environment is ripe for robust Side A insurance. For executives that haven’t taken a recent look at their company’s D&O tower, particularly pertaining to its side A insuring agreements and applicable limits, now would be an opportune time.
Increased Bankruptcy Filings
A company can’t protect their executives if there are no assets available, such as in the case of insolvency. Despite and “end” to the pandemic, remaining economic damage and geopolitical factors are still creating financial stress in many sectors. Many companies are still being affected by computer chip and other supply chain shortages, while many others are still trying to recoup financial losses from 2021. Additionally, rising inflation has affected nearly every sector. In addition to the numerous high profile bank failures, this is resulting in a wave of downsizing and increased bankruptcies. The S&P recently reported 2023 first quarter public company filings are the highest they’ve been since 2010 with institutionally backed private companies experiencing similar hardships. They also cited in a separate release “There were 143 US companies that filed for bankruptcy protection in the first 75 days of the year, including 16 companies with private equity or venture capital backing, according to an S&P Global Market Intelligence analysis. If the current pace continues, bankruptcies by private equity portfolio companies will be on track to total nearly 78 by the end of 2023, more than double the totals in 2021 and 2022 and the second-highest number of portfolio company bankruptcies in more than a dozen years.” Many experts are also predicting a considerably grimmer future predicting more potential bank failures and bankruptcies on the horizon.
While side A D&O is often viewed as the first line of protection during such litigation, corporate officers should carefully assess their policies’ coverage as it pertains to bankruptcy. Some policies may contain problematic terms or exclusions, and may be exposed to potential seizure by the courts if the policy proceeds are deemed to be assets of the bankruptcy estate. This can leave executives without coverage, which is why all companies should have a sufficient layer of DIC (difference in condition) coverage. Side A DIC insurance is a separate Side A policy which can effectively fill gaps in the underlying program and provide a number of enhancements (specific to bankruptcy) such as fewer exclusions, the ability to bypass an automatic stay, and automatic long tail ERPs / run off coverage.
Regulators’ Continued Pursuit of Individuals
Since the Yates Memo almost a decade ago, the DOJ has continued their focus on pursuing individual actors by means of providing cooperation credits to companies that self-report corporate wrongdoing and identify any accountable individuals. These investigations also appear to be ramping up, with the DOJ recently tightening their policy regarding cooperation credits. According to a recent article in the Wall Street Journal, the DOJ's new policy is already resulting in an increase in the number of companies deciding to self report potential wrongdoing. With the agency aggressively pursuing individual corporate officers, companies may decide not to advance or indemnify costs incurred by their directors and officers in connection with these investigations, despite being required to per their indemnification agreement. When a company wrongfully refuses to provide indemnification, the only source of protection available to fund any associated costs and litigation, is a D&O policy. In making a coverage determination however, the majority of underlying ABC D&O policies contain a presumptive indemnification clause which could subject the accused wrongdoer to a large retention before coverage is provided (and that’s IF coverage is provided). Luckily there are coverage enhancements available that can address the numerous issues involved with these cases. At a basic policy level, policyholders should carefully review the scope of coverage for both formal and informal investigations against insured persons, ensuring that the policy’s conduct exclusion agrees to provide defense costs until there is a final non appealable adjudication in the underlying action. Policies that only agree to provide defense costs until there is a determination “in fact” could eradicate coverage at a very premature stage. Underlying D&O policies should also provide some form of defense advancement or allow payments by the DIC carrier to meet any applicable retention that may be applied by the ABC D&O carrier.
Evolving Derivative Litigation
Delaware law, like many states, prohibits companies from providing indemnification for settlements associated with shareholder derivative litigation. With corporate indemnification unavailable, the only source of funding for these settlements is Side A D&O insurance. Over the past few years, a new trend has emerged: derivative cases are beginning to settle for large amounts. As highlighted by a recent report from insurer Allianz, “Claims severity has gone up. For example, shareholder derivative lawsuits typically result in small settlements or corporate therapeutics, like changes to the board. Now we see these cases settle for several hundreds of millions of dollars. We are also seeing larger settlements for cases in arbitration,”
There has also been an increase in event driven derivative litigation which allege executives breached their fiduciary duties, resulting in reputational damage, causing financial harm to the company. One such area of focus for claimants has been workplace sexual misconduct. These suits generally allege corporate insiders ignored red flags or cultivated a culture of harassment. Activision, McDonalds, L Brands, Guess, and Google are just a small sampling of companies that have been hit with such claims. Cyber security and privacy failures are also fueling derivative claims. When data breaches occur, claimants are often quick to allege executives failed to address known vulnerabilities and/or implement adequate cyber security controls. First American, LabCorp, Equifax, Target, and Yahoo have all been hit with cyber related derivative actions. In addition to sexual misconduct and cyber/privacy failures, claimants are also focusing on merger activity and other areas of ESG such as environmental issues, and diversity and inclusion failures to bring such claims. As reported by a 2021 report from Cornerstone, nearly half of securities class actions are also accompanied by a parallel derivative action, so as securities litigation increases, derivative actions would naturally be expected to increase as well.
When assessing coverage, executives should take note of any exclusions contained within the underlying ABC policy that may lack a carve-back for non-indemnifiable claims. The policy should also extend coverage for the broadest range of damages such as costs associated with books and records demands, derivative plaintiff attorneys fees, special litigation committee costs, and any costs incurred by the entity should it be named as a nominal defendant.