You need a better guide than somebody’s brother-in-law

By Harold P. Reichwald, co-chair of the Financial Services and Banking practice group at law firm Manatt, Phelps & Phillips, LLP

Consider the following hypothetical:

The Chair calls the bank board meeting to order and after approval of the agenda, the Chair asks for a report on the negotiations for renewal of the director’s and officer’s insurance policy, soon to expire. The Chief Financial Officer (or perhaps the chief risk officer) reports that through the efforts of the bank’s insurance broker, who happens to be a relative of the Chair, the negotiations for the renewal of the policy have been successful, at no appreciable increase in premium. Amidst positive murmurs from the members of the board, and after referring to the one-page summary of the proposed renewal coverage, the Chair moves for approval of the renewal terms, which is quickly seconded and unanimously approved. The meeting moves on to a discussion of other items of seemingly greater importance.

This summary may be pure hyperbole but it serves to point out that in the past consideration of the issues associated with D&O insurance often have been left to others–not the insured parties–others whose interests may not coincide completely with those of the board members. At the same time, board approval may have been given on a less-than-encompassing understanding of the issues.

FDIC continues to pursue claims against former directors of failed banks, and this has shone a spotlight on the nitty-gritty details of director’s and officer’s insurance policy terms and the extent of the depth and breadth of D&O coverage. This, in turn, has led to questions about what members of the bank board actually know about the extent of the coverage supposedly protecting them from liability–and the importance of an effective D&O risk strategy.

So, let’s examine the issues associated with D&O insurance that a board of directors should consider when faced with a new or renewing policy situation:

1. On whose expertise should the board rely?
2. What are the key initial considerations?
3. What are the potential obstacles to coverage?
4. What are the sometimes knotty issues in confirming coverage?

1. D&O insurance expertise
Not surprisingly, the terms and conditions of today’s D&O insurance policies can be dense and hard for the layman to navigate.

All the more reason to have a knowledgeable broker handling negotiations with the carrier for the board members. The broker has to understand not only the insurance concepts involved but also the current insurance marketplace, the recent claims experience of the carriers, and court cases affecting coverage rights. The board members would be well-advised to have knowledgeable counsel involved at this stage, as well, so that the broker and independent counsel can work together to avoid coverage surprises.

These advisers should be present in the boardroom, assist in the presentation of policy terms to the board members, and answer questions on site before the final approval of the insurance package by the board. The broker and counsel should have an opportunity to present their recommendations in writing to executive management and to the board as a whole, not merely to the company’s chief risk manager or head of insurance. This process should allow board members to get comfortable with the coverage as a whole and to provide feedback to executive management.

The D&O job doesn’t end there, however.

Just as important as the preliminaries is the ongoing interaction by board members, at least quarterly, with bank management to determine whether any events have occurred which might be considered a claim for insurance reporting purposes and to consult with independent counsel about the attendant reporting requirements.

2. Key initial considerations
Initially, there should be significant negotiation over the key elements of the coverage and the exclusions. For example, at the outset, there should be sufficiently high limits to cover the costs of defense counsel and potential liability, given today’s high cost of litigation. Strong severability provisions are extremely important–so that each individual director is treated separately and is not tarred by misstatements or misconduct of any other director.

Claims reporting requirements should be clear, coupled with the very narrowest definition of “claims” for reporting purposes but the broadest definition of “claims,” including formally initiated “investigations,” for coverage purposes.

Absent a failed-bank scenario, there is likely to be–or there should be–corporate indemnification provisions in place. This means that attention should be given to the sometimes murky interplay of corporate advancement of defense costs and the indemnification undertakings. Insurance coverage to cover gaps in indemnification protection must be considered.

3. Potential obstacles to coverage
D&O insurance contracts continuously evolve in a dynamic and changing economic environment. There is no standard form of policy and the thorny issues are numerous. Some of these require very close scrutiny and understanding of the legal implications.

The exclusions contained in the policy outline those claims for which no coverage will be available. Given the financial turmoil of the last four years, it is not surprising that claims against directors that arise out of actions taken by regulatory agencies–either banking or securities–are generally excluded. So, if a policy is in place with this type of exclusion and FDIC asserts a claim against one or more directors, no coverage will be available, either to cover defense costs or actual liability.

Additionally, D&O policies typically exclude coverage for fraudulent acts or actions giving rise to personal profit. Another example is the so-called insured v. insured exclusion which precludes an institution from submitting a claim under a D&O policy for losses caused by negligent actions by an officer. In this latter context, the question arises as to whether FDIC would be considered as the “insured” if the bank fails.

Finally, the question of whether coverage exists for “special investigations,” particularly when undertaken by a governmental authority, has received increasing attention given the costs attendant upon such activities. The importance of having that coverage cannot be underestimated.

4. Issues of confirming coverage
D&O insurance policies contain provisions requiring the insured to notify the carrier not only in the event of the assertion of claim but if circumstances arise of which the bank is aware that could lead to the assertion of a claim.

Thus, not only do the insureds have the obligation to notify the carrier promptly if and when a claim is asserted but also if some event occurs that could lead to a later claim. For example, say a bank is made the subject of a regulatory enforcement action of some kind. Those responsible for the management of the insurance coverage must be made aware of that event and immediately take steps to notify the carrier or otherwise risk the loss of the coverage or the possibility that the carrier will assert that it has a right to endorse the policy to reduce coverage after the fact.

This is another reason for involving the bank’s insurance broker and independent counsel on a regular basis so that these events can be analyzed and appropriate notice given to preclude the carrier from using such a failure to deny coverage.

Enterprise risk management
An effective D&O risk strategy hinges on more than your insurance coverage. Board members must promote an integrated framework of enterprise risk management within the bank.

To that end, the effort should be to focus on a series of components. Among them:

• The organization’s internal environment, culture, and values.

• Establishment of key objectives with which to align risk process with the organization’s mission.

• Risk assessment and response, which entails establishment of mechanisms to control identified risks.

• Internal controls reflecting the adequacy of information and monitoring of risk management.

Thus, enterprise risk management can provide a significant level of protection to directors and officers from claims of outside stakeholders because it enables these decision-makers to minimize or eliminate potential regulatory issues, court battles, and expensive litigation and reputation costs and settlement expense. Given its importance, a separate risk management committee of a board of directors is highly recommended, which would include board level attention to matters of D&O coverage for board members.

[This article was posted on March 16, 2012, on the website of ABA Banking Journal, www.ababj.com, and is copyright 2012 by the American Bankers Association.]