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The Fragility of Protection

The subprime fallout prompts a need from clients and an opportunity for brokers.

Industry Canada statistics show a rise in the number of individuals and businesses that are becoming insolvent. In May 2009, Industry Canada statistics revealed a startling 30.3% increase in the number of insolvencies compared to the same time frame in 2008. Current economic situations are forcing more directors and officers to consider: What protection is available to me personally in the event of a corporate insolvency situation? This also becomes an opportunity for brokers to step up and offer some valuable advice.

Some of the most common sources of personal liability are those that arise from statutory obligations. There are currently over 100 federal and Ontario statutes that impose liability on directors and officers, either directly or indirectly. In addition, the Business Corporations Act (Ontario) holds both directors and officers liable for failing to exercise the care, diligence and skill that a reasonably prudent person would exercise in comparable circumstances or for failing to act honestly and in good faith with a view to the best interests of the corporation. Combine this with the fact that insolvency increases the number of lawsuits against directors and officers, and clients begin to ask for ways to protect against this type of liability.

One way to protect directors/officers is through corporate bylaws or agreements. These protections generally include “advancement rights” which provide funds to defend the directors and officers in litigation against them, as well as indemnify those who are found personally liable in those claims.

Problems with D&O
Another method of protection is through insurance policies. However, even with this protection, clients can find themselves exposed when a corporate insolvency occurs. For example:

1) Retroactive Amendments
The Delaware state case of Schoon v. Troy (2008 WL 821666, Del. Ch.) serves as a reminder that corporate bylaws extending indemnities to directors and officers can be amended, thereby diminishing or eliminating the purported protection. Even Canadian directors paid attention when Schoon, the director that had retired from the board, received a nasty surprise when the bylaw indemnifying him for potential claims was retroactively amended and he was denied an advancement of funds to defend a breach of fiduciary duty lawsuit launched against him. The law in Canada similarly permits bylaws to be amended. As a result, directors and officers should always obtain indemnity agreements, which cannot be amended without all parties being in agreement, for additional protection.

2) Limited Resources
Even when the bylaws and agreements appear to provide ironclad protection to directors and officers, they may be of little value in the face of an insolvency situation. If the company does not have the financial wherewithal to indemnify directors and officers, they join the growing list of unsecured creditors seeking a limited portion of a shrinking pie.

3) Creditors’ Rights
A pending bankruptcy may compel a company to freeze its assets for the benefit of creditors. Consequently, even if the bylaws or agreements permit or require the company to indemnify directors and officers, the company may not be entitled to access those funds.

4) Holes in the Policy
Finally, in an insolvency situation, insurance may not provide the protection that directors and officers may expect. This type of insurance is not standardized and coverage can vary significantly. Consequently, there are a number of factors that may lead to a loss or significantly limited coverage in an insolvency situation.

Brokers Can Step Up
These problems also mean opportunities for brokers. By becoming aware of potential problems, and possible solutions, brokers can become proactive advisors to their clients. The most common problems include:

• Upon renewal, many insurers will insert insolvency exclusions in the D&O policies of companies in financial distress. This may remove the basic coverage available to protect directors and officers, including protection for statutory remittances and back wages.
•  Many D&O policies include Side C or Entity coverage. This means that the policy limits are available to satisfy claims against the company, as well as the directors. To ensure that the available limits are not exhausted by the defence of the entity, ensure the policy contains an Order of Payments or Allocation of Limits provision. This will ensure there is sufficient protection for the directors, but will also ensure that a trustee in bankruptcy cannot claim that the D&O policy is an asset of the estate.
• Companies in financial difficulty may submit false or fraudulent financial statements to regulators, banks and insurers. Under traditional insurance principles, this type of misrepresentation would lead to a claim by the insurer to rescind the policy. To avoid this from happening, the D&O policy must contain a severability provision relating to both underwriting submissions and exclusions. Ensure the policy is non-rescindable.
•  Additionally, consider Non-rescindable A-Side coverage. This covers officers and directors in the event that the company does not indemnify them.
•  Exclusions may limit available protection. The “Insured versus Insured” exclusion generally excludes coverage where a claim is brought by the company, a subsidiary, another director or officer, or a major shareholder. It is important to ensure this exclusion doesn’t include claims by trustees, receivers or creditor committees.
•  Policies typically contain a significant exclusion for Side B or indemnified or indemnifiable claims. Ensure that the policy does not have a deemed indemnity provision in the event that there is no indemnity due to insolvency.
•  The cost of the defence of a shareholder class action or a regulatory investigation can be extremely high and beyond the means of many directors. Ensure that the D&O policy contains a provision requiring the insurer to advance defence funds as expended. Also ensure the policy contains coverage for regulatory investigations.
•  If your D&O policy has excess coverage as well as primary coverage, it’s important to ensure that both types of coverage work together. The excess policies must be written on a simple “follow the form” basis to avoid inconsistencies in coverage. In addition, there has been concern about the solvency of some insurers in the past year.This has led many companies to diversify the insurers on their excess program.

These factors could determine whether, in fact, appropriate coverage is provided to directors and officers during an insolvency situation–and could be the one factor that differentiates one broker from a trusted insurance advisor.

© Copyright 2010 Rogers Publishing Ltd. This article first appeared in the January 2010 edition of Canadian Insurance magazine.