The Case for Side A Insurance

In the context of the recent implosion of Refco Inc. – which occurred following the laying of criminal charges against its former CEO, Phillip R. Bennett – one prominent U.S. newspaper ran an article containing the following, poignant observation: what often matters most on Wall Street these days is not so much the size of a company’s balance sheet, but the character of its management. In the same article, a prominent former research analyst and hedge fund manager is quoted as saying: “It is unfortunate that accountants can’t put trust and reputation on a balance sheet; there is just no line for it.”

The Refco debacle is one more to add to the ever-expanding list of U.S. and Canadian companies that have been afflicted by scandals – often perpetrated by members of their own management and behind the back, ostensibly, of the directors responsible for providing oversight. This is in essence the corporate governance dilemma first identified by Adam Smith in his seminal work, The Wealth of Nations. Smith observed the directors of (such) companies cannot be expected to watch over other people’s money with the same anxious vigilance with which partners of a private company would watch over their own.

While the relatively recent regulatory changes in both Canada and the U.S. are intended to preserve the integrity of public companies and deter corporate misfeasance, such measures may ultimately fall short of preventing the plague of scandals that public companies continue to face or, more importantly, fail to assist directors in their crucial oversight role.

Recent scandals such as Enron, WorldCom and Nortel – in which independent directors were sued for inadequately performing their oversight role – involved allegations of fraud (in the case of Enron and WorldCom) or fraud-like conduct (in the case of Nortel) against members of company management. By definition, a fraud is designed to escape detection; where it occurs, it is often the case that those who perpetrated it not only engaged in misrepresentation of facts, but actually took affirmative steps to prevent the discovery of the truth.

Effective corporate governance can perhaps accelerate the time it takes to discover fraud, but it never can truly prevent fraud from occurring in the first place. Despite the most comprehensive of corporate governance regimes, there is simply no conclusive manner in which to determine a person’s honesty and trustworthiness. Good corporate governance may however lead to less litigation, in the sense that governance constraints prevent managers from deviating from shareholder interests, which, in turn, theoretically trigger shareholder class action claims.

THE DILEMMA

The underlying risk management problem remains the same: namely, how can an independent director be better protected from management fraud that couldn’t be discovered through diligence? Corporate indemnities, while necessary, are ultimately only as good as the financial solvency of the company. Conventional D&O insurance appears to offer a reasonable degree of protection to the independent director. But the precise type of D&O insurance is of crucial importance in assessing the effectiveness of the overall risk management regime.

TRADITIONAL COVERAGE

A standard D&O policy contains Side A and Side B coverage, and occasionally Side C as well.

Side A coverage essentially provides that the insurer will pay covered loss to a director or officer of a company if the company is unable to provide indemnity – either because the company is insolvent, or because it is otherwise legally precluded from doing so.

Side B coverage, in contrast, does not provide direct contractual protection to the individual directors and officers of a corporation, but reimburses the corporation in respect of its indemnification obligation to the directors and officers. Side B coverage simply provides a means to risk transfer the company’s indemnification obligation where it is being honoured.

Side C coverage was originally intended as a solution for disputes between the D&O insurer and the individual insureds over what portion of a securities settlement should be allocated to the individual insured named in a securities claim. It provides direct coverage for the corporation against certain types of claims against it by security holders.

The vastly different natures of these three types of coverage, when offered under one policy, represent a virtual quagmire for insurance brokers and risk managers alike. In making the buying decision, brokers and risk managers must determine on whose behalf the coverage is ultimately procured and whose interest is supposed to be protected. Side A coverage can be rationalized on the basis that it protects the personal assets of individual directors and officers and is necessary to attract competent board members and executives. Side B coverage and to a greater extent Side C coverage are really intended to benefit the corporation. Under certain circumstances, this corporate treasury risk management protection may be at the expense of the independent directors. In a recent article advocating the mandatory disclosure of the details of all public companies’ directors’ and officers’ insurance policies, the author went so far as to suggest that one reason Side B and C coverage is sought is to avoid losses in a company’s earnings which are likely to have an impact on the compensation of executive management. In the author’s view, the purchase of entity coverage under side B or C of a D&O policy can only be explained by the fact that “companies are run by selfish managers who are willing to invest corporate assets in negative net present value projects in order to protect their own compensation packages.” While this is perhaps an extreme view, the fact remains that independent outside directors have many legitimate reasons to be concerned about the adequacy of a standard D&O insurance policy – whether it consists of Side A & B coverage only, or with Side C coverage as well – to protect their interests in the event of a fraud being perpetrated by members of company management. The conduct of management can result in the policy limits being quickly eroded without the independent directors obtaining the full benefit of their coverage. In addition, management conduct can give rise to rescission issues that may jeopardize the D&O program in its entirety.

THE NEW BOARDROOM DEBATE

Canadian boards of directors are increasingly using independent outside counsel to review their D&O coverage and make governance recommendations to improve their risk profile. As a result of this legal review process, the interests of independent directors have been identified as potentially being in conflict with the corporation’s purchasing decision of Side B & C coverage. Pure Side A coverage has therefore grown in prominence during the past few years as a means to protect the personal interests of the independent outside directors – particularly as underwriters providing conventional D&O policies have reduced their limits on particular programs or sought to rescind D&O policies on account of fraud perpetrated by management.

While there is no standard Side A form, this type of coverage generally falls into one of two basic forms. Side A excess D&O insurance insures only directors and officers of a company and is triggered after the underlying insurance – which can consist of side A & B coverage, or even Side A, B and C coverage – has been exhausted by the payment of covered loss. This particular type of Side A coverage is written on a “follow form” basis, meaning it will adopt the terms and conditions of the primary policy other than those which grant coverage under insuring clauses B and C. A Side A excess D&O form will not respond where the underlying policies have been rescinded, since it is not intended to “drop down” where the underlying insurance is not available for reasons other than the payment o
f covered loss. For this reason, Side A excess and DIC insurance is also available; this kind of coverage not only provides excess coverage under side A of the underlying D&O policy but also allows for “difference in conditions,” enabling it to provide coverage where none otherwise exists under the underlying insurance. The exact nature of the difference in conditions will vary with the type of Side A DIC policy. Generally such forms provide for broad severability in the application, meaning that fraud on the part of management may not result in the coverage being rescinded against all insureds.

CONCLUSION

The ability to save directors and their assets through effective risk transfer is ultimately subject to the same dilemma directors face when they decide to sit on the board of a public company. A director must to a certain extent have faith in the integrity of the management he or she oversees. That means allowing management to procure the type of D&O insurance that will serve all corporate purposes and not just the interests of the independent directors.

The views and opinions expressed are the authors’ own and do not reflect those of the Arch Insurance Group