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As a result of the explosion in verdicts and settlements against companies arising out of shareholder litigation, entity coverage, a key feature of directors’ and officers’ (D&O) liability insurance that carriers have marketed aggressively in recent years, is drying up. Industry observers, lawyers and other commentators have placed some of the blame for these huge payouts (Bank of America: $490 million; Computer Associates: $230 million; CompUSA: $454 million) on the ready availability of entity coverage. Many believe entity errors and omissions insurance only further embolden shareholders and their attorneys, rather than provide more protection for the company. The move by insurers to eliminate or severely reduce coverages available for the company (as opposed to their officers and directors) means that lawyers retained to defend D&O claims must once again be keenly aware of the myriad of insurance coverage issues that arise when defending claims brought against a company and its officers and directors. Defense attorneys who achieve an otherwise excellent result in a shareholder litigation might nevertheless find that their client is now at a greater financial risk and the lawyers themselves are on the wrong end of errors and omissions litigation. In the late 1990s, when D&O premiums were low and coverage was broad, amending D&O policies to insure the direct liabilities of a corporation (as distinguished from the liabilities of its officers and directors incurred in performing their duties for the company) was a popular add-on that carriers used to get new business and keep existing accounts in a highly competitive marketplace. Entity coverage was marketed by insurers as providing coverage for, among other things, securities liability claims. Carriers sold entity coverage by offering such features as self-insured retentions applicable to defense costs only, advancement of defense costs and special subsidiary coverage. The entity product was supposed to avoid the conflicts and litigation that often arose between the individual officers and directors and the company, on the one hand, and their insurance carriers, on the other hand, when litigation was brought against the company and its officers and directors. The underlying assumption by the corporation in acquiring entity coverage was that the company could retain top law firms to defend both the company and its officers and directors with little concern about eroding defense limits. The corporation could now aggressively and effectively litigate the claims on behalf of the company without having to worry about fighting with their carrier over allocation issues. Corporations and their insurance brokers flocked to purchase entity coverage. Allocation struggles return When the insurance industry realized that entity coverage accounted for big claim payouts and represented a major increase in their exposure, carriers began to eliminate entity coverage from their D&O product lines. As a result, attorneys retained to defend claims brought against a company and its officers and directors must understand (or bring in coverage counsel) to navigate the allocation traps laid by D&O carriers to avoid paying claims. Allocation battles, made less crucial with entity coverage, are now back in the forefront of insurers’ claims-handling strategies-with much more at stake given the recent history of verdicts and settlements in shareholder litigation, and the onset of a generally more shareholder-friendly regulatory environment for corporations. D&O carriers naturally regard the corporation as the true target of most litigation involving errors and omissions of business entities, with directors and officers added to the mix by plaintiffs’ lawyers solely or primarily to trigger D&O coverage. Insurers typically perceive allocation as a means of leveling the playing field, by apportioning as much of the loss (defined under D&O policies to include defense expenses, settlements and judgments) as possible to the noninsured corporation. This means that a company sued with its officers and directors should expect its D&O insurer to assert that, by the mere happenstance of the corporation being named as a defendant, the company is self-insured for a portion (perhaps a substantial one) of the liability losses and attorney fees to be paid in the case. To the corporation, this may come as a nasty surprise, particularly when it has become accustomed to having entity insurance as part of its D&O policy covering its own direct liability exposure and defense costs. As much as D&O carriers may stamp feet and wave arms demanding that companies self-insure big chunks of risk because they have no entity coverage, the declining availability of entity insurance added to D&O policies may not actually shift as much liability exposure back to the corporation as carriers might wish. Running through the bedrock of authority interpreting D&O coverage is a discernable vein of judicial skepticism about carriers’ oft-stated assertion that these policies do not cover direct liabilities of the corporations that buy them. Many courts simply refuse to adopt this notion. Those courts more friendly to the insurers’ view of allocation usually leave plenty of room for a company to characterize losses incurred jointly with its officers and directors as falling chiefly to the D&O policy. This creates opportunities even without entity coverage for the well-prepared and well-represented corporation to get coverage for its own liabilities by exploiting courts’ ambivalence about carriers’ positions on allocation. In short, while pulling entity coverage off the table would certainly mean a loss of premium income for D&O carriers, it need not signal the end of coverage for the liabilities of the corporation. A way to limit coverage Traditionally, D&O insurance covered a corporation for losses it incurred indemnifying officers and directors for their personal liabilities incurred in the performance of their duties. This meant the corporation could claim under a D&O policy only when two events converged: Its directors and officers incurred losses for their own wrongful acts in running the company, and the corporation actually paid these losses-in the form of defense expenses, settlements or judgments-pursuant to its duty to indemnify agents (by statute, articles and bylaws). As a result, the liability of directors and officers was covered, to the extent the corporation indemnified them for this liability. Under very limited circumstances, a director or officer who was not being indemnified by the corporation could assert claims directly under the D&O policy. But under the traditional D&O policy, the liabilities of the corporation for its own misconduct-as distinguished from the directors’ and officers’ wrongful acts, liability for which the corporation indemnified them-were never covered. The kind of economic loss traditionally covered under D&O policies rarely requires plaintiffs to sue the company’s officers and directors alone, without necessarily naming the company. To create maximum risk for the company, however, plaintiffs’ counsel nearly always name the corporation as well. Typically, the company hires the same law firm to represent it and its directors and officers. Since the vast majority of lawsuits are settled rather than tried, whether and to what extent liability is assigned to the company as opposed to its officers and directors is always an issue in the absence of entity coverage-because no judgment is ever entered to answer this question. Get inside insurers’ heads Understanding the way D&O insurers think is vital to extracting entity coverage out of traditional D&O insurance. Insurers have long taken the position (with some support of the courts) that the carrier is entitled to allocate loss between covered and noncovered claims and covered and noncovered parties. When a D&O policy does not include entity coverage, carriers assert that D&O insurance should not respond to defense expenses, settlements or judgments incurred jointly by covered officers and directors and their noncovered corporate principal. Carriers argue that they underwrote the D&O policy based on coverage for the officers and directors only. Therefore, say the insurers, unless the corporation pays a premium for the policy and goes through additional underwriting, the company cannot reasonably expect its own losses (contrasted from those of its officers and directors) to be covered. If the corporation was offered entity coverage and decided not to buy it, this argument may have some credibility. In the current climate, however, when entity policies are less available, carriers really are arguing something quite different: Because carriers no longer wish to insure strictly corporate liabilities and defense expenses, D&O policies should respond to suits brought against both directors and officers and the corporation they serve only to the extent the liability of the corporation (which, carriers contend, is the real target of most litigation anyway) is increased by that of the individual directors and officers. D&O insurers have changed their tune since the late 1990s, when the bull market made it the underwriter’s job to get as much premium in the door as possible-even if this meant underpricing the risk-in order to earn substantial investment returns. Whereas carriers were willing to write broad coverage then, without thinking too hard about the underwriting intent of the D&O policy, now they are back to interpreting their coverages narrowly (along with pushing up premiums and cutting back the scope of coverage). D&O insurers now claim they always intended to cover only the amount by which the presence of individual defendants in a liability suit brought jointly against a company and its officers and directors increases the corporation’s exposure. This argument contains a fundamental fallacy that can be exploited to the corporation’s benefit. A corporation can act only through its officers and directors. It cannot act independently of the people who work for it. Therefore, if a company is sued for some alleged wrongdoing, the acts on which liability is based can only have been committed by a person or persons whose acts are imputed to the company by virtue of their status as corporate officers, directors, employees or agents. Directors and officers are covered under D&O policies only for losses they incur in their capacity as corporate representatives. Acts by a company’s officers and directors outside their actual or apparent authority are never imputed to the corporation, and therefore are never covered by a D&O policy. However, acts of officers and directors within the scope of their duties for the company will trigger D&O coverage, and by definition cannot be ultra vires. Corporate agents cannot incur personal liability for wrongful acts committed within the course of their duties that is greater in scope than the liability of the corporation-although the company certainly can incur liabilities for which the directors and officers have no personal exposure. In short, unless a company is sued for some act separate and apart from the theory of liability on which it and its officers and directors are alleged to be jointly and severally liable, the presence of directors and officers in such a suit never increases the company’s liability. The D&O insurer that says it intends to cover only the marginal increase in a corporation’s liability exposure occasioned by a plaintiff’s election to name individual defendants is kidding itself and its customers. Such a D&O policy would afford very little, if any, actual coverage. Real world concerns In the real business world, when directors and officers and their company are sued together based on a common set of facts, the directors’ and officers’ status as defendants in the suit should only rarely increase the settlement or verdict value of the case, or the defense expenses incurred by counsel representing the company and the officers and directors simultaneously. If a company has a D&O policy but no entity coverage, then any suit naming it and its directors and officers should provoke relatively little real increase in exposure-a fact that should be drawn to the D&O carrier’s attention when allocation is raised as a partial defense to coverage. Viewed against this backdrop, why was entity coverage so popular? The answer is that it rendered allocation issues moot, making claim adjustment and assignment of risk between corporations and individuals easier, while creating the impression that the insurer was providing a lot more coverage for the premium charged. Entity coverage had, and continues to have, a great perceived value. Before entity coverage became available, the courts adopted three different views on allocation in the context of D&O claims. (Though they fell into disuse in the late 1990s, one can expect them to return to the front burner now). One court held that the insurer may decline coverage only for those defense expenses that would not have been incurred but for the presence of noncovered claims (and, by implication, any noncovered entity as well). Scottsdale Ins. Co. v. Homestead Land Development Corp., 145 F.R.D. 523 (N.D. Calif. 1992). Other courts required an allocation based on the relative exposure of each defendant, determined by the carrier’s prediction as to how the facts relevant to liability of the individuals and the company are likely to pan out. Pepsico Inc. v. Continental Ins. Co., 640 F. Supp. 656 (S.D.N.Y. 1986); Atlantic Permanent Savings & Loan Assoc. v. American Casualty Co., 670 F. Supp. 168 (E.D. Va. 1986); Nodaway Valley Bank v. Continental Casualty Co., 916 F.2d 1362 (8th Cir. 1990). Still other courts adopted a rule, dubbed the “larger-settlement rule,” holding that the carrier is not obligated to cover any portion of the claim attributable to the actions of either an uninsured party (like the corporation) or a party not named as a defendant in the case. Harbor Ins. Co. v. Continental Bank Corp., 992 F.2d 357 (7th Cir. 1990); Safeway Stores v. National Union, 64 F.3d 1282 (9th Cir. 1995). The larger-settlement rule seemed least vulnerable to abuse by insurers because it focused on whether any of the liability asserted could as a matter of law be alleged against an uninsured entity (necessitating little argument over facts). Because all three rules are in use, it is important that a corporation’s lawyers find out, at the onset, the rule applicable in their particular jurisdiction. The harm to the company should a significant portion of a verdict or settlement be allocated to the corporation, and therefore be considered self-insured, is obvious. A corporation’s counsel are expected to know this and plan accordingly, on pain of professional liability. This exposure is not limited solely to those circumstances resulting in uncovered claims or portions of claims. Defending the action in a manner that allows a D&O insurer to raise an objectively viable defense to coverage has been raised as grounds for a malpractice claim, where the actual harm constituted the company’s increased costs necessary to litigate coverage claims. In the D&O coverage context in particular, where liability claims can often be catastrophic, it is critical that allocation issues be spotted, and insurer strategies for limiting coverage countered, at corporate counsel’s initial point of attack. Entity coverage was great while it lasted, because it gave insureds a warm feeling of extra protection. Now that it is on the way out, companies can expect to face allocation defenses again, as they did before entity policies became popular. The impact on insureds of allocation defenses can be minimized through early planning, especially if defense counsel marshals a careful coverage analysis as soon as he or she is appointed. Entity coverage looks great in hindsight, but its absence need not be felt as keenly as D&O carriers hope. David E. Wood is a principal at Los Angeles’ Wood & Bender, where he specializes in the representation of insurance policyholders.

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