D+O Insurance: The Critical Protection Behind Dramatic News Headlines

What, Exactly, Is D+O Insurance?

D+O insurance is a relatively new insurance product, having only emerged in the 1940s, following The Great Depression in the USA. The early products were offered by Underwriters at Lloyd’s, London, with US insurers not offering products until the 1960’s (St. Paul Insurance Company is given credit for being the first US insurer to offer the product).

The basis of the insurance is that individual Ds and Os will be afforded defense (employees are added as insured persons in most private company and non-profit D+O policies), with the entity also being covered in most such policies (although not necessarily automatically so the presence of entity coverage must be confirmed and identified).

What is often missed or confused is that corporate bylaws are intended to be “coordinated” with the purchase of D+O insurance, in the way that the basic insuring agreements are presented, in most basic, private company D+O insurance policies, as follows:

Insuring Agreement A: Coverage for Insured Persons only, for situations which are not indemnified by the organization (“indemnification” generally refers to that provision so named in the bylaws, which allows the corporate treasury to make indemnified persons “whole”, following personal expense incurred to defend oneself, or to pay settlements/judgments for legally permissible activities). The two best examples of situations which are NOT indemnifiable would be a lack of treasury funds to fulfill the bylaws promise of indemnification, and, statutorily impermissible indemnification for shareholder derivative suits (which varies, depending upon the actual state of incorporation of the insured entity);

Insuring Agreement B: Reimbursement to the corporate treasury, following indemnification, as provided by bylaws indemnification provisions. [Without this important D+O insurance provision, the corporate treasury would be left with a deficit, following the fulfillment of the Indemnification provision of corporate bylaws.], and,

Insuring Agreement C: Coverage for the entity, including subsidiaries as specifically defined, should the entity incur defense expenses in lawsuit allegations.

So, as can be seen, it is important to understand both the state of incorporation of the organization in question, as well as that state’s position regarding shareholder derivative litigation expense reimbursement.

Perhaps, an easy way to summarize the intent of D+O insurance is to refer to it as “managerial malpractice” insurance: insurance coverage for defense and settlements of situations alleged against management and the organization itself, and arising out of non-illegal activities involving errors in business judgment. D+O insurance policies often carry specific exclusionary language for bodily injury liability; property damage liability; and, personal injury liability, as these “perils” are the subject of more basic liability insurance coverage.

So, If There are No Shareholders, Then There Really Isn’t a Need for D+O Insurance, Right?

No. There can still be allegations brought by regulators; business dependencies; customers, or even employees. D+O insurance is often protection for situations which might seem to be focused on other injuries (such as bodily injury/property damage/personal injury liability), but depending upon plaintiff attorney allegations, D+O insurance can be activated if allegations relate to management decisions or governance responsibility.

Here are Some Examples From the News Headlines

  1. A major “big box retailer” suffers a data security breach, which is found to involve an outsourced provider of IT services, and payment terminals used by the retailers’ customers when making plastic card purchases at the store’s locations. Following detailed forensics and investigations, the retailer is sued by affected customers. If those allegations include facts pertaining to a lack of due diligence in selecting the third party outsourcing organization, including any past, less severe situations which should have alerted management to potential problems, or if management did not have proper security or checks and balances in place to provide alerts of potential problems with the outsourced IT firm, then allegations related to governance or improper management of this situation could trigger the retailer’s D+O insurance. Remember, hindsight is always “20/20”, and ANY allegations made by potential plaintiffs have to be responded to and defended by the retailer;
  2. A small privately-owned tour company business, has a specific vehicle which is involved in a serious accident while conducting a tour of a major metropolitan city. There are several fatalities, and various degrees of injuries to customers occupying the tour vehicle. After an post-accident inspection of the vehicle involved, it is determined that more than a year previous to the accident, management was alerted to a mechanical problem with the vehicle, and either elected to forgo immediate repair, or decide to postpone repair until a more convenient time. If there are allegations that management’s delay in repairing an active vehicle constitute placing safety behind the cost of the repair, OR, if the allegations involve management’s wiliness to operate unsafe equipment in conducting its business, onto which customers were invited and for which customers paid participating money, then the tour operator’s D+O insurance could be activated (let’s hope they had this important coverage);
  3. A national business whose stock is publicly traded, specializes in floor covering materials, and is shown to be in violation of federal regulations involving the use of chemicals in the processing of its products by a foreign manufacturer. The unallowable material is a carcinogen, and the amounts actually included in the manufacturing process significantly exceed US government allowance. Basically, the foreign manufacturer not only allowed the excessive ingredient, but also admitted to falsely labeling the manufactured product, so that it appeared to comply with US government regulations. As a result of the revelation, the stock valuation significantly drops, causing shareholders a financial loss. If the shareholder class action suit (not to mention US government regulatory allegations), allege management manipulation or improper management oversight on either the manufacturing process or supervision of the foreign manufacturer, then this could easily trigger allegations of “managerial malpractice” on the part of the flooring business management.

One must be careful not confuse the roles of Commercial General Liability (CGL) insurance and D+O insurance: they are designed to be mutually exclusive, in that CGL should address allegations of bodily injury/property damage and personal injury liability, while D+O insurance should address allegations of mismanagement, failure to properly govern the organization, or negligent actions in the role of entity management.

Any director, officer or employee should be concerned about how defense for management-related allegations will be financed (if there isn’t enough money in the treasury to do so, then affected persons will need to finance defense on an individual basis, in the absence of D+O insurance). D+O insurance is not expensive: annual premiums begin about $1,000 for decent coverage, written for non-profit or private company risks. Most prominent D+O underwriters are willing to provide indications of pricing upon review of only two pieces of information: the organization’s annual revenue figure, and the organization’s web site URL. In order to bind the indicated coverage for first time buyers, a completed and signed application will be required.

It may be true that in small business start-up situations, D+O insurance would not the single most important insurance coverage; however, if there are shareholders; if there are outsiders on the Board; if there are outside investments; or, if there are plans to sell the company, then D+O insurance takes on new importance.

Ben Franklin was known for saying, “Don’t be penny-wise and pound-foolish”. Truer words were never spoken with regard to D+O insurance protection for the business decision-makers and the entity!