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The recent spate of corporate scandals has exacted a heavy toll. These scandals have profoundly affected the way the rest of corporate America is perceived by regulators, investors, and consumers. These developments, together with the enactment of the Sarbanes-Oxley Act, expose corporate officers and directors to greater scrutiny and increased potential liability. The scandals have had their effect on the D&O insurance industry, too, prompting insurers to cut back on coverage and to raise premiums. Ironically, this insurance rollback can work in favor of companies and innocent directors and officers, by providing an incentive to exclude from coverage less scrupulous parties whose actions can jeopardize coverage for everyone else. BENEFITS OF A CRISIS? Many of the problems revealed in the recent wave of corporate scandals fall into the category of problems that insurance was not designed to solve: manipulated earnings, unauthorized compensation, and off-balance-sheet accounting are not the behaviors corporations can or should want to indemnify or protect. The best way for innocent but humanly fallible directors to limit costs and increase the protections is to focus on claim prevention — putting in place management, policies, and procedures focused on deterring wrongful conduct in the first place. Moreover, just as directors and officers need to make sure that the checks and safeguards against wrongful conduct are in place at their corporations, they need to consider, too, that appropriate limitations on indemnification and coverage for intentional wrongdoers — corporate policies and insurance policies that effectively exclude coverage for such actions and the costs of defending them — may provide the best way of ensuring that the innocent many do not pay for the sins of the few. Broad indemnification provisions in corporate agreements and insurance polices can oftentimes work against the goal of assuring innocent directors that there are funds sufficient to protect their personal assets. For example, in the past, corporate indemnification agreements and D&O policies excluded coverage only where there was a “final adjudication” of fraud. Since the majority of cases settle, however, these exclusions are rarely triggered. As a result, policy proceeds and corporate funds are spent defending wrongdoers in enormously expensive litigation. The unintended consequence of limited fraud exclusions, then, has turned out to be that there is actually less coverage for the innocent because the available funds are paid on behalf of those who have perpetrated fraud. The sins of crooked colleagues may also result in no coverage being afforded to innocent directors and officers. An insurance policy is a contract. Any contract induced by fraud may be rescinded as void from the outset. Insurers base their decisions on the terms and pricing of policies (and the decision whether to issue a policy at all) on an assessment of the risk of insuring a particular company. That risk, in turn, is assessed on the basis of the company’s application, including its financial and business disclosures in its Securities and Exchange Commission filings which are incorporated in the application by reference. Since virtually all corporate frauds involve material misstatements or omissions in SEC filings, proof of an alleged intentional securities violation can also vitiate the insurance policy. As a federal district court in the Western District of New York put it, in a case preceding the current spate of scandals, “While this result may seem unfair to the [innocent insureds] who find themselves without insurance coverage through no fault of their own, a contrary decision would . . . result[] in similar hardship to the insurance company, which would find itself supplying coverage to a risk it never meant to insure.” The 1985 opinion, INA Underwriters v. Forde & Co., continued (quoting an earlier case): “While we sympathize with [the innocent insureds'] position, and recognize that innocent [people] are likely to suffer if the entire policy is voidable because of one man’s fraudulent response, it must be recognized that plaintiff insurers are likewise innocent parties.” BEYOND SEVERABILITY So, then, what can corporations, and their directors and officers, do to ensure appropriate coverage? Severability provisions are often sold as a means of attempting to separate good from bad insureds. However, in today’s environment, provisions providing full severability are increasingly rare. More important, these provisions do not eliminate the possibility that a carrier may seek rescission or that such an action may succeed. There are two types of severability provisions: (1) those limiting the circumstances in which the wrongful acts of one insured will be imputed to others, and (2) those limiting the circumstances in which misrepresentations in the application for insurance are imputed to insureds other than the signatories. The issues (primarily, imputation) and ultimate consequences (no coverage) addressed by both types of severability provisions are similar. However, the means of best addressing these issues and consequences differ, suggesting severability as the best option in the first case but not necessarily the second. To avoid the imputation of a wrongful act excluding coverage, you need a severability of conduct provision, period. However, while a severability of the application provision may avoid imputation such that one insured’s knowledge cannot provide the basis for rescinding the policy against everyone, the insurer may still attempt to rescind the policy as to each individual insured. That is, such a provision ensures that one insured’s knowledge cannot provide the basis for rescinding the policy against everyone. It does not, however, preclude the insurer from attempting to show that an individual insured in fact possessed knowledge of facts that should have been, but were not, disclosed at the time the policy was underwritten. Only a few cases have held that severability of the application provisions might work. These cases have not held that such provisions vitiate the insurers’ right to rescind. Instead, they merely require the insurer to prove its case for rescission separately against each insured. Consequently, in several recent cases, insurers have filed rescission actions against directors and officers without regard to individual fault even though the policies had purported “full severability” provisions in place. Because innocent but material misrepresentations will support a rescission action in most jurisdictions, and many policies expressly permit rescission where directors or officers have knowledge of facts that were misrepresented in the application even if they do not know that they were misrepresented in the application, the risk of a rescission action remains real. As the concept of “willful blindness” by disengaged boards gains acceptance as a possible basis for liability, the precarious protection afforded by severability provisions is likely to be further eroded. So, while severability of the application provisions may be a good thing, in the event of a corporate catastrophe, they may not be good enough. SHOPPING IN A TOUGH MARKET In order to safeguard their corporate D&O policies from wrongful acts of rogue colleagues, prudent directors and officers need to look beyond severability. They should consider the following matters in order to best ensure that their insurance is there when they need it. • Consider whom you are buying insurance for. It ought to be for the innocent directors and officers of the corporation, not for those who perpetrate fraud. In order to preserve coverage for those who deserve it, companies should not flinch at exclusions that limit or eliminate coverage for individuals who in fact participate in fraud. Companies should reconsider whether D&O insurance should be extended to cover claims against the entity which may dilute coverage available to protect the personal assets of directors and officers. Additionally, directors and officers should consider obtaining separate coverage, available only to them, that responds if and when traditional coverage is exhausted, rescinded, or otherwise unavailable. These sorts of policies are nonrescindable, and so provide far greater protection than a standard policy with severability provisions. • Consider whom you are buying insurance from. What really matters most about a policy is whether or not the carrier will be reasonable and responsive when a claim is filed. Ask about the carrier’s reputation for claims handling. Is it likely to deny coverage or seek rescission? Is it aware of the business risk of doing so? Severability provisions in a policy issued by a carrier with a reputation for seeking rescission may ultimately provide less protection than does a policy with more limited severability language issued by a carrier who rarely sues its insureds. Obviously, too, consideration of whom you are buying insurance from should include an assessment of the financial standing of the carrier — something, surprisingly, that companies often overlook. At bottom, you want to make sure that your carrier has substantial assets and adequate reserves, so that it will still be around and solvent when and if a claim is filed. • Consider what you are buying insurance for. Are you willing to pay skyrocketing premiums for lowered limits so that the company has minimal out-of-pocket costs if and when a claim is filed? Does it make more sense to keep premiums in line by insuring only for losses that the company cannot itself afford to pay? Consider increasing retentions to a level consistent with your threshold for pain. Similarly, consider co-insurance and limited severability (e.g., in instances of insolvency) as viable alternatives. • Make sure your broker and the carrier consider whom they are selling insurance to. The carrier, the broker, and all of the participants in the process (risk managers, advisers, management, and the board) must be focused on your company’s particular needs and circumstances. Look with favor upon those carriers who are willing and able to engage in a true underwriting process which considers your company’s unique risk profile, and does not merely extrapolate from industry or market trends. Today’s corporate environment has forced companies to recognize the limitations of D&O insurance. Some risks cannot be covered at a reasonable price. Others cannot be covered at any price. Businesses must adjust to the new situations. But with effective oversight to limit claims, and with an understanding of the insurance options that are available, corporations, and their directors and officers, can emerge with the coverage they need. Laurie B. Smilan is a partner in the Reston, Va., office of Latham & Watkins LLP, and is co-chair of the firm’s securities and professional liability practice group. The views expressed herein are her own and do not necessarily reflect the views of the firm.

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