D&O Policies

Directors and officers of publicly traded corporations have numerous duties imposed upon them by both statute and common law. A failure to meet these duties can lead to liability being imposed on the director or officer in addition to the corporation. Given the relative ease with which class actions are certified in Canada as opposed to the U. S., along with the relatively recent adoption of secondary market civil liability legislation in several Canadian provinces, it is reasonable to expect the number of securities-related class actions in Canada will continue to increase over the coming years. This suggests the legal spotlight will continue to shine brightly on corporate governance issues and that D&O insurance policies will be increasingly implicated.

Shareholder claims against directors and officers often seek rescission of share purchase agreements in addition to damages. As a result, one of the most common coverage issues arising out of shareholder-plaintiff claims that include rescission is the extent to which those claims allege a covered “loss.” Under a D&O policy, the insurer is obligated to indemnify the directors and officers for loss, which typically is defined as follows:

“Loss” shall mean compensatory damages, punitive, aggravated or exemplary damages, the multiple portion of any multiplied damage award, settlements and costs of defense, provided, however, loss shall not include criminal or civil fines or penalties imposed by law, taxes, or any matter which may be deemed uninsurable under the law pursuant to which this policy shall be construed…”

The obligation of an insurer under a D&O policy is to reimburse for loss, which includes any award of damages, or an agreed settlement, as well as costs of defence. If, at the pleading stage, a shareholder’s claim is not limited solely to rescission, and the claim for monetary relief may fall within the definition of loss, then the D&O insurer is likely obliged to defend the claim.

Handling and allocation of costs

In the initial stages of handling a claim against directors and officers, the insurer should proceed to issue a reservation of rights letter that addresses claims that fall within and outside coverage. This will often raise the question of the allocation of defence costs between covered and uncovered claims.

The typical D&O policy contains a predetermined allocation formula that requires the insurer to reimburse the insured for roughly 70-80 per cent of its defence costs. Typical policy wording may include allocation terms such as:

“In the event of loss that includes allegations or relief that is not covered by this policy, the insured and the insurer agree to allocate the amount of the loss payable by the insurer based upon the following: 80 per cent of defence costs in relation to the claim shall be reimbursed as loss unless a court of competent jurisdiction determines that a different percentage shall be reimbursed by the insurer, or both unless parties agree upon a different percentage. In the event that the company is unable to indemnify the Insured by reason of insolvency, no defence costs shall be allocated to the company.”

Less frequently, D&O policies contain “relative risk and benefit” allocation clauses, an example of which is:

“If a claim made against any insured includes both covered and uncovered matters, or is made against any Insured and others, the insured and the insurer recognize that there must be an allocation between Insured and uninsured loss. The insureds and the insurer shall use their best efforts to agree upon a fair and proper allocation between insured and uninsured loss.”

Under this type of allocation clause, the allocation of defence costs between the uncovered claim for rescission and the covered claim for damages can be premised on a 50/50 split between the insured and the insurer at the pleadings stage, while reserving the right to reallocate in the future. Further, the insurer should advise the insured if, at a later stage, the plaintiff elects to proceed only with a claim for rescission instead of damage, the claim will not constitute loss and, as of the date of the election, the insured could be responsible to pay 100 per cent of the defence costs on a going forward basis.

The reason behind this is that for coverage purposes, the mere repayment of a share purchase price does not constitute loss under the policy, since the insured entity has not suffered a pecuniary deprivation akin to damages. The rescission remedy entails the return of the shares to the company, and the return of the purchase price to the shareholder(s). The parties are simply put back in the same position as before the share transaction, and as such, there is no loss as defined in the D&O policy.

Judicial Consideration Of Loss

A further consideration will be whether any monetary relief sought by the shareholder-plaintiff itself amounts to loss. In the field of D&O liability insurance there is a body of cases that make clear that if the D&O is being sued for monies he or she is not legally entitled to, then that money cannot be claimed as reimbursement under a D&O policy. Otherwise, an insured could use insurance to pay itself for monies it was never entitled to. This principle was enunciated in Level 3 Communications v. Federal Insurance Co, 272 F. 3d 908 (7th Cir. 2001). In the underlying securities fraud action, shareholders alleged the insured sold shares to the insured based on fraudulent representations of the insured. The insured then successfully sued the D&O insurer alleging it was liable for reimbursement of the amount the insured paid to settle an underlying securities fraud action. The insurer appealed, and the Court of Appeal granted the insurer’s appeal, concluding the insured’s restitution of its ill-gotten gains did not constitute a loss for which the insurer could be held liable. The Court stated:

“. . . restitutionary relief that is relief intended to divest the insured of the net benefit of an unlawful act or “the restoration of an ill-gotten gain” is uninsurable because such protection would “insure a thief against the cost to him of disgorging the proceeds of a theft.”

That same reasoning has been applied in factual circumstances where the essence of the claim is for disgorgement of funds improperly acquired. In the case of Vigilant Insurance Company v. Credit Suisse First Boston Corporation, 2004 WL 2066353 (N. Y. A. D. 1 Dept.) Credit Suisse allegedly allocated shares of “hot” IPOs to those customers who were willing to funnel a portion of their profits back to it. These profits were returned to Credit Suisse in the form of excessive commissions on unrelated trades. The Court was required to determine whether the obligation to pay “restitution” of $70 million as part of a settlement with the United States Securities and Exchange Commission and NASDR “requir[ing] disgorgement of certain funds allegedly improperly obtained through violations of various securities regulations” was covered “Loss”. The Court concluded that “[t]he risk of being directed to return improperly acquired funds is not insurable. Restitution of ill-gotten funds does not constitute “damages” or a “loss” as those terms are used in insurance policies”.

The same reasoning has been applied in Canada by the Quebec Courts. In Concordia University v. London Guarantee Insurance Company [2002] J. Q. No. 5011 a university purchased a fiduciary liability policy. The plaintiff claimed that the insured appropriated funds from the employer and employee pension plan and the insured sought its past and prospective defence costs required to respond to the claim. The Court concluded that to permit the insured to seek reimbursement for amounts incurred by reason of its voluntary contractual
obligations (i. e., to pay monies into a pension plan), when those same funds had been removed and were being claimed as damages, did not amount to loss. The Court pointed out that treating such damages as loss would permit the insured to use the policy to replenish monies it was otherwise contractually committed to pay.

These cases make it clear a claim for relief against directors and officers seeking to recover monies to which D&Os are not legally entitled, does not amount to loss under D&O policies and generally will not attract coverage. Similarly, claims against directors and officers which seek only rescission, as opposed to monetary relief, do not amount of loss and will not be covered under most D&O policies.

When confronted with a D&O claim, insurers should always be cognizant of the possibilities that some or all of the claims may not be covered. This underscores the need to closely examine whether damages are being sought, and if so, the nature of the claim for damages, in assessing coverage. Where rescission is available remedy to a class of shareholders, or where the claim may entail “unjust enrichment,” it is important to analyze the relevant coverage issues at an early stage, issue a reservation of rights letter, and discuss your position with the insured.

Michael Libby, of Dolden Wallace Folick, LLP in Vancouver, B. C., practices exclusively in the field of insurance law with an emphasis on professional errors & omissions, liquor and host liability, construction, employment practices liability, and directors’ and officers’ liability.