Modern companies are increasingly becoming aware of the risks faced by directors and officers, and as a result, are purchasing D&O insurance to protect them.
Companies operate in a dynamic marketplace, where they carry out their business in varying economic conditions. As a company trades through the peaks and troughs of the business cycle, it may engage in a range of transactions that can alter its structure and future trading arrangements.
A company may identify an opportunity to undertake merger or acquisition activity, by either purchasing another business or selling its own. Alternatively, in times of underperformance or financial hardship, a company may be placed in administration or be at risk of bankruptcy.
Any of these events often lead to significant changes in a company’s corporate structure, which has flow on affects for the challenges and exposures faced by its directors and officers, and their respective insurers.
So how does a D&O policy respond to changes in the structure of a business, and when does management need to consider run-off insurance to ensure they have ongoing protection?
D&O coverage ceases after a change in control
An insurance contract is established on the information disclosed to the insurer at the time of application. As a result, when a company undertakes an activity that significantly alters its corporate structure, it will impact the coverage afforded by their existing policy.
Most D&O policies contain a ‘change in control’ clause, which automatically ceases coverage for the directors and officers of a company, following a business transaction which affects its corporate structure.
Whilst the definition of a change in control will vary between policies, it typically includes the following situations:
- When a company is merged, acquired or sold, or any event that results in a change of over 50 percent of the voting power of the board.
- When a company is declared bankrupt
- When an administrator or receiver is appointed to handle the affairs of the company
- When a company is wound up
If a change in control occurs during a period of insurance, the policy remains active, however it will provide a limited scope of coverage – only protecting executives for wrongful acts that occurred prior to the ‘change in control’.
In other words, any decisions or actions undertaken by directors after a change in control will not be covered by the existing policy.
Management remains at risk following a corporate restructure
Following a change in corporate structure, the directors and officers of a company may believe that they are no longer at risk of being held accountable for decisions made in their former role.
The reality is, that even after control of a company has transferred to a new board or trustee, the former executives remain exposed to allegations, legal claims and personal liability, long after their formal responsibilities have ended.
For example, following the sale of a company, its shareholders may allege that the directors who approved the transaction breached their fiduciary duty by acting in their own interests, and not in the interests of the company.
In the situation of a distressed company, creditors can sue directors and officers personally in an attempt to recoup losses, and liquidators will often seek recovery against the company’s own executives for financial mismanagement and insolvent trading.
Following a merger, acquisition or change in corporate structure, director’s indemnity agreements cease to exist; therefore it is critical that ongoing insurance protection is established.
Without it, the personal assets of directors and officers are exposed to losses as a result of their past actions.
Run-off insurance protects former executives from their actions
Due to the ‘claims made and notified’ nature of D&O, a policy must be active at the time an executive becomes aware of a circumstance which could lead to a claim, in order to notify the insurer and for that claim to be covered.
If insurance coverage is allowed to lapse, a notification cannot be lodged with any insurer and any subsequent claim will not be covered, even if a policy was active at the time that the alleged wrongful act occurred.
Following a change in control but before the expiry of an existing D&O policy, ‘run-off’ coverage can be negotiated with an insurer to provide ongoing protection to company executives.
Run-off insurance is designed to provide former directors and officers with cover for claims, which may arise years after an alleged wrongful act has taken place.
The policy will only indemnify management for alleged acts that have occured prior to a change in control, but it allows executives to notify the insurer of circumstances and be covered against new claims until the policy’s expiry.
Without run-off cover in place, directors and officers are left virtually uninsured against the decisions made in their past roles, and are vulnerable to claims made personally against them.
Duration of cover and cost
The legal exposures for directors and officers long remain after a corporate restructure. Stakeholders affected by the actions of executives can take time to quantify their loss and launch legal action against those responsible.
The timeframe that management remains at risk of litigation is largely determined by the statute of limitations applicable to the jurisdiction in which an action is brought.
Claims made against executives can be made up to seven years after a wrongful act in some regions, and can be extended further when the limitation period commences from the discovery date of a financial loss.
Insurers usually have the ability to provide a range of duration options to companies seeking run-off, however it is recommended coverage be sought for as long as possible, to ensure that executives are protected until the likelihood of receiving a claim no longer exists.
Run-off premiums are calculated using a range of methods, but all typically reflect the diminishing risk of executives receiving new claims over time. A run-off policy is generally purchased in a one off transaction, with insurers offering discounted rates to companies who purchase multiple years of coverage.