Although this scenario is hypothetical, cases like it occur with alarming frequency. There has been a dramatic increase in litigation against corporate board members. In these lawsuits, shareholders allege that board members or corporate officers misled them while disclosing information to the public about a company's future. Since a 1988 Supreme Court ruling made it easier for shareholders to file suit under U.S. securities laws, the number of class-action lawsuits filed each year against companies by their shareholders has doubled.
These lawsuits, disruptive and costly for corporations of all sizes, can destroy smaller companies that don't have the resources to fight. Small to medium-sized firms with share prices that often experience wide swings are a perfect target for class-action suits. With the ever-present risk of litigation looming over boards of directors, companies of all sizes are doing what they can to prepare for the worst.
Though upset about the lawsuit, the chairman is relieved that he purchased directors' and officers' liability insurance six months previously. At least, he thinks, the company's insurer will cover the exorbitant costs of defending the suit and any settlement or judgment costs. To his dismay, when he reads the policy and calls the insurer, the chairman learns that the policy covers the directors, but not the company itself. In addition, several coverage exclusions apply. As a result, the insurer is only willing to pay about half of the total defense costs.
THE ALLOCATION DILEMMA
The pharmaceutical chairman has confronted an issue that all too often creates bad blood between directors' and officers' insurance policyholders and insurers. When an insured's expectations differ from the underwriter's position, a conflict may arise over "allocation," a calculation of the amount of defense costs, settlements or judgments covered under the policy. When a lawsuit names directors and officers, as well as their corporation, as defendants, a D&O policy may not provide complete coverage. If defendant directors and officers retain the same defense counsel as an uninsured defendant--in this case the company itself--or have a settlement or judgment against them jointly, the D&O policy covers only those items attributed to claims against the insured directors and officers. All other costs incurred by uninsured defendants will not be reimbursed by the D&O insurer.
Moreover, a lawsuit against insured directors and officers may include allegations that are not covered by their insurance policy. For example, if the lawsuit alleges wrongdoing against the executive in his capacities as a director and officer, and as a shareholder in the company, the D&O policy may only cover the claims against the executive acting as a director and officer, but not as a shareholder.
Interestingly, the issue of cost allocation is not new. Although the contract language has always existed as it does today, insurers and policyholders were able to reach allocation agreements rather easily in the past. Unfortunately, two developments in recent years have made allocation a contentious issue.
First, there has been a dramatic increase in the number of class-action securities suits filed against directors and officers. With plaintiffs' law firms expecting to receive about one-third of the entire settlement, the financial incentive for lawyers is high. These suits commonly name both the company and the board of directors as defendants and are settled jointly. The allocation issue is important because the amount of loss sustained in these cases is often large--too large, in fact, for most companies. In fact, approximately 90 percent of those companies that are sued--either unable or unwilling to pay mounting legal fees or to deal with the distraction of litigation--eventually decide to settle. But a settlement, in which the defendant must absorb an average expense of more than $10 million, can itself destroy a fledgling company. …