Directors, Officers Can't Risk Banking Without Insurance

Directors and officers of financial institutions are particularly vulnerable to professional liability suits.

They must protect both depositors and stockholders. And, technically, they may be held liable for any losses sustained by the institution, its depositors, or its shareholders.

One might think that if the directors and officers of a financial institution exercise reasonable care and diligence in performing their duties, they would not be subject to liability suits. Unfortunately, this is not the case.

In recent years, regulatory agencies such as the Federal Deposit Insurance Corp. or the Resolution Trust Corp., and/or shareholders, have seldom failed to sue all of the directors and many of the officers of an institution that has closed - or almost closed - because of excessive bad loans, insider dishonesty, or both.

Purpose of Liability Insurance

Not all employees are covered by D&O insurance, although some carriers - by endorsement - may provide this additional protection. With the exception of the corporate reimbursement section, the corporate institution itself is not insured.

D&O insurance indemnifies past and present directors and officers of an insured corporation and its subsidiaries against claims arising from their alleged wrongful acts, including "errors, misstatements, misleading statements, acts or omissions, neglect, or breach of duty."

A clear distinction has to be drawn between claims and suits against a corporation for its alleged wrongful acts and those taken against directors and officers personally. D&O insurance does not help the corporate institution with its direct liabilities. It does protect the directors and officers personally, and the corporate institution insofar as it may indemnify or reimburse the directors and officers.

Common Allegations

As indicated by court papers, shareholders or liquidators have commonly alleged that directors and officers of financial institutions and/or companies have assented to, or failed to prevent:

* Repeated violations of the company's written lending policy.

* Numerous improvident lending transactions.

* Numerous loans to individuals and/or entities that were not creditworthy or not within the normal lending territory.

* Numerous improvident concentrations of credit.

* Loans made without adequate collateral.

* Loans made without a current credit check on the borrower.

* Loans made without properly perfecting the company's security interest in the collateral.

* Excessive and/or improvident overdrafts.

* Improvident borrowing practices by the company.

* Improvident internal control and audit practices.

According to the Wyatt Co.'s 1989 report, 24% of the financial institution D&O suits were brought by stockholders and 13.4% by governmental agencies. Protection from stockholder derivative suits is limited or eliminated under many of the D&O policies marketed today. The regulatory exclusion eliminates suits for all governmental agencies.

D&O policies, unlike blanket bonds, are not written in a standard form. Coverage is based on a blending of the most common clauses.

Each policy must be carefully reviewed to determine its precise coverage. Policies are usually issued on a blanket basis (without the need to schedule directors and/or officers by name or position) with the premium paid by the insured organization.

D&O policies are generally written on a "claims made" basis, providing protection for wrongful acts committed before or during the policy period but discovered during the policy period. D&O insurance may be a financial institution's broadest safety net, covering risks that are not covered or adequately protected by its fidelity, computer crime, and other policies.

Certain riders or endorsements can destroy the broad protection provided by D&O insurance; others can add to the coverage provided in the body of the policy.

Indemnification Provisions

The first part of the typical D&O policy covers direct or individual indemnification of the directors and officers for personal liabilities arising from wrongful acts for which the corporate institution may not, will not, or cannot indemnify.

This coverage would apply when a director is held to have been negligent or when a stockholder derivative suit is the source of the claim. It would include judgments, damages, and fees.

The second part of the D&O policy is the corporate reimbursement clause. It makes good the corporation when it indemnifies its directors and officers for their personal liabilities.

It is crucially important to have both the individual indemnification and the corporate reimbursement coverages in place. This point is driven home when one realizes that about 90% of all claims are brought under the corporate reimbursement section of the D&O policy.

If both coverages are not obtained, the loss for the wrongful acts and liability of the directors and officers may fall on the corporation, its stockholders, the directors, and officers who acted wrongfully - and, perhaps ultimately, the "innocent" directors and/or officers, who failed to secure adequate D&O insurance.

Who Is Insured?

The typical D&O policy provides for payment for all loss stemming from wrongful acts for which a director or officer may be held legally liable, arising from his duties in his capacity with the insured corporation or a subsidiary. In some cases, protection is extended to cover a director or officer when acting in another organization (such as a trade association or pension trust) on behalf of the insured corporation.

This usually requires a special designation. The terms that apply to the "capacity" in which the director or officer is operating require careful analysis. Some policies do not apply to a director's or officer's external activities, even when acting on behalf of the insured corporation. Thus, coverage for external directorships, involvement in a trade association, or committee would be limited or nonexistent.

Type of Coverage Provided

The typical D&O policy operates on a "claims made" basis, which affords protection for claims noticed and/or made during the policy period of (if it is available) extended discovery period for wrongful acts committed before or during the time the policy is in place.

In the absence of any language specifically excluding coverage, loss arising from the claim over the wrongful act is covered.

Notice Provisions

Notice in writing normally must be given "as soon as practicable." Basically, this means as soon as is reasonable under the circumstances.

The policies are typically silent as to the effect of not giving timely notice of an occurrence, but not of a claim.

However, most policies specifically state that when a claim is actually made against an insured, the notice must be given in writing as soon as practicable as a condition precedent to coverage. The standard D&O policy provides that the insured organization should give notice to the carrier.

Deductions and Policy Limits

Deductible amounts may be separately specified for the individual indemnification and corporate reimbursement sections of a D&O policy, or expressed as a single - usually split - retention. Deductibles vary greatly from policy to policy.

The deductible on the individual indemnification side of the D&O policy should be modest, since the individual directors or officers will have to absorb this amount themselves.

The deductible on the corporate reimbursement side should be larger, in proportion to the liquidity of the institution involved.

Charges and Expenses

Coverage for legal costs involved in defending a claim are normally included. Usually, the carrier has no right to defend an action on behalf of an insured party.

Instead, the carrier is obligated to reimburse the insured's legal costs, incurred by a lawyer of his own choosing (subject to prior permission, which should not be unreasonably withheld). This condition favors the insured person and allows him to choose his own lawyers when his interests diverge from the interests of other defendants.

Difficulties may arise when the corporation and its officers or directors are sued jointly on the same or related incidents. D&O insurance does not protect the corporation directly, and carriers will frequently dispute the allocation of legal costs between those directors and officers for which it may be responsible and those incurred by the corporation for its own defense.

At any time during the policy period (if certain requirements are met), the carrier or the insured organization or persons may terminate the policy. Often, a carrier will terminate coverage after a substantial claim has been made or if it feels uncomfortable with the risk.

An insured person or corporation, by common law duty, is obligated to protect the subrogation rights of the carrier. The necessity of protecting the carrier's subrogation rights prohibits the insureds from releasing the parties responsible for the loss from liability without the express permission of the carrier.

From time to time during the pursuit of a recovery of a loss, it may be prudent for the insureds to settle with and release a party involved in the loss. In these instances, the carrier should be given written notice of the intention of the insured.

An explanation of the business justification for such an action should be included in this notice, and the carrier should be given a reasonable opportunity to object to the insured's intention. Cooperation and justification are necessities for preserving the claim and maximizing recoveries.

Many D&O policies do not specifically deal with the assignment of the subrogation rights. In this case, it may be presumed that the traditional rules apply.

Exclusions

As with other forms of insurance, D&O policies contain a number of important exclusions that may be embodied within the policy or added by rider. Some exclusions will apply to all sections of the policy, while others apply only to one section.

The following exclusions apply to both the individual indemnification and corporate reimbursement sections of D&O policies:

* Insured versus insured exclusion. D&O insurance is generally considered as defensive shield to protect directors and officers against actions brought by third parties. It has become popular for fidelity carriers to threaten or actually file suit against directors and officers, alleging that their negligence contributed to or caused the fraudulent loss.

Even the threat of such action is a useful bargaining weapon, designed to bring the insured to the negotiating table under a severe disadvantage. If the D&O carriers are notified immediately that a fidelity claim has been filed, the directors and officers should be fully protected and the insured's negotiating position is enhanced. The use of the policy to protect against these and third-party actions is referred to as "defensive use."

* Regulatory exclusion. Another rider that has now become very common, particularly in D&O policies for financial institutions, is the regulatory exclusion eliminating all coverage for claims brought against directors and officers by regulatory agencies.

Several forms exist. Any regulatory action, including an action for a cease-and-desist order, is clearly uninsured if the rider is in place.

It is a matter of public policy not to indemnify for violations of regulations or for carrying on unsound or imprudent banking practices. These endorsements can also exclude the costs of defending a regulatory action, even where the directors and officers prevail.

It will no doubt be the position of the carriers that if a financial institution is closed and the regulators elect to sue the directors and officers, they will not have the protection of the D&O insurance. It should be remembered that national bank regulations preclude indemnification for civil money penalties for regulatory actions.

National bank regulations also exclude the expense of the administrative hearing process. Further, they do not let national banks pay the premium for insurance that could cover these regulatory claim expenses.

This is an exclusion of a very important aspect of protection for the directors and officers of a troubled or closed financial institution. It invalidates coverage at the time when it is most needed.

As discussed earlier, the FDIC and RTC may sue directors and officers of any failed financial institution for negligence. Because of this exclusion, the directors and officers are uninsured against such actions. This rider is troublesome and dangerous.

* Another rider that may be added to D&O policies excludes coverage for any loss resulting from the insolvency of the insured organization.

In a typical D&O policy, coverage will often stay in place if the director or officer becomes insolvent. But, in the absence of a rider, most D&O policies are silent regarding the effects of the failure of the corporation.

It is our belief that if the corporations failed, coverage would stay in place for the directors and officers. After all, the coverage protects the directors and officers directly, while only indirectly protecting the corporation through the corporate reimbursement provision.

* A hidden exclusion in most D&O policies arises within the definition of "loss." Loss does not include fines or penalties imposed by law, or matters uninsurable under the law pursuant to which this policy is construed.

The exclusion does not restrict the company from reimbursing its directors and officers for penalties imposed against them; it simply prevents the company's recovery of these costs from the carrier.

In many jurisdictions, companies are not allowed - on public policy ground or by regulation - to indemnify their officers or directors for fines and/or penalties.

* An insider loan exclusion eliminates any coverage involving direct or indirect loans to any director or employee.

* Some D&O policies have a specific exclusion in the body of the insurance contract or attached by a rider, which is dangerous.

What happens if the directors or officers failed to have insurance? Lawsuits brought against directors and officers for not having insurance coverage are far from uncommon. By rider, some D&O policies have an exclusion that removes coverage against such claims.

The Corporation's Decision

The following questions need to be answered by the corporation in determining the value or necessity of this protection:

* How often do third parties sue individual directors and officers as opposed to the corporation or its subsidiaries?

* What third parties are legally entitled to sue the directors and officers individually?

* Of those legally permitted suits where an individual may sue a director or officer directly, which are included within the D&O insurance coverage?

Assessment of data from the records of many corporations indicates that the number of covered third-party suits is surprisingly small. It may be advisable to self-insure or to obtain catastrophic coverage - that is, umbrella-like D&O coverage with a very substantial deductible - and, if it can be purchased, legal liability insurance with a low deductible. This type of coverage pays for legal defense costs but not, ultimately liability.

D&O insurance can be very confusing, and the terms and coverages provided are rapidly changing.

To obtain the broadest coverage possible and to understand what is and is not covered by your policy, you are strongly advised to seek expert help when renewing the D&O policy or when obtaining new directors' and officers' liability coverage.

Ms. Kessinger and Mr. Ardis are attorneys with the Memphis-based law firm of Wolf Ardis.

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