Without a Net*
June 14, 2005
Last year was marked by the settlement of major shareholder class actions against directors and officers which had made misrepresentations as to the financial health of the corporation. In 2004, three of the eight most important settlements were concluded in parallel to some of the recent financial scandals. Because of the multiplication of such recourses and the increase of the value of judgments rendered against directors and officers, the D&O insurance carriers do not hesitate to rescind the insurance policies they issued, a situation which is quite detrimental for the directors and officers.
Very recently, Chubb, the second largest D&O carrier in North America, filed a motion before an Ontario Court to rescind the insurance coverage of $40,000,000 US it had issued to Nortel and its directors and officers. In this motion, Chubb alleges that it agreed to subscribe to this risk based on misstated financial statements and that its decision to renew the policy would have been different had it been informed of the true financial state of Nortel.1
In the matter of WorldCom, the directors, including the independent directors, were left without any insurance coverage after the rescission of all the excess policies subscribed to WorldCom and its directors and officers. WorldCom had subscribed to many insurance layers and the directors thought they could count on a coverage totaling $150,000,000 US. After the institution of recourses by some investors, the primary carrier whose policy limit was $25,000,000 US assumed the defense costs until it discovered that the financial statements of the company had been misstated. The insurer attempted to rescind the policy but the Court refused since it was of the view that the insurer could not reconsider the decision it had taken to assume the defense costs. The primary carrier therefore had to continue to pay the defense costs until exhaustion of its $25,000,000 US2 limit but the excess carriers which had refrained from taking a position as to the insurance coverage available were able to annul the insurance policies they had issued to WorldCom and its directors and officers. They were thus left without any insurance coverage once the primary limit was exhausted.
In the absence of any insurance coverage, the independent directors negotiated a settlement with some of the investors in an attempt to limit their personal liability. This settlement provided that each would personally pay an amount of $2,000,000 US but the Court refused since it viewed such an agreement would limit the directors’ liability and increase the potential liability of the investment banks also named as defendants in these lawsuits. The independent directors are thus still involved in this major lawsuit. They are exposed to a significant condemnation while they have no coverage for defense costs or for indemnification for the amounts they may be condemned to pay.
The possibility of a rescission further to misrepresentation is particularly preoccupying for independent directors who often do not have the same knowledge of the internal affairs of the company.
The legitimate worries of the independent directors with respect to rescission has allowed for the emergence of insurance policies designed to meet their needs. These policies offer coverage for all loss that the directors may be condemned to pay and for which they were not indemnified by the company. Such coverage is known as "Side A coverage." Such policies can be purchased alone or in excess to the D&O program subscribed to by the company. The advantages of such policies are multiple. First, the insurance limits of the Side A Coverage are there exclusively to pay the loss which the directors are obligated to pay and are never used to reimburse the loss of the company. Moreover, the protection offered by the Side A Coverage is often more generous. The definitions are generally less restrictive and the exclusions less numerous. In addition, in the case of an insolvency, the directors will not be involved in a debate with the trustee in bankruptcy who could otherwise attempt to appropriate the insurance limit for the sole benefit of the company since in Side A-only policies, the company is simply not an insured under such a policy.In order to better answer the specific requirements and preoccupations of the independent directors, insurers have put non-rescindable Side A Coverage on the market. In order to avoid situations such as the one that occurred to the independent directors of WorldCom, policies containing a specific clause by which the insurer renounces its right to rescind in case of misrepresentation by some of the directors appeared on the market. Such a protection is evidently quite advantageous but it is important that you carefully read such a clause in parallel with the other clauses of the policy. The policy can contain some exclusions such as an exclusion for misrepresentations or for failure to maintain insurance that could have the effect of annulling the protection that you thought you benefited from with respect to rescission. If you are acting as an independent director and if you wish to maximize your protection and the protection of your personal assets, you should consider subscribing to a non-rescindable Side A Coverage.
*For more information on this subject, please refer to "Financial Restatements and your D&O Insurance Policy", Insurance News (March 2003 at page 3), /article_detail.aspx?id=1313
1As this text went to publication, we learned that Chubb had decided not to file the motion.
2It is important to note that under Québec law, the defence costs are assumed by the insurer over and above the policy limit.
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