Expert Commentary

Insurance for A-Side D&O Exposures after Enron—A Riskier Proposition?

In today's difficult legal and economic climate, has pure directors and officers liability coverage become a riskier proposition? New Expert Commentator John E. Black Jr. examines the issues.


Professional, D&O, and Fiduciary Liability
December 2002

The conventional wisdom seems to be that “A-Side” directors and officers (D&O) liability insurance coverage, compared to “B-Side” coverage, is relatively safe for insurers to offer. However, legal and economic developments in the wake of Enron have created uncertainty as to how corporations and courts should view traditional notions of corporate indemnification and advancement. To the extent these developments have put into motion changes in the legal underpinnings of indemnification and advancement, corporations may be less willing to indemnify directors and officers and unable to advance defense expenses. If so, directors and officers will have no choice but to seek A-Side coverage, which may significantly increase the exposure under this coverage for D&O insurers.

The Role of A-Side and B-Side Coverage and Corporate Indemnification

Traditional A-Side coverage is pure directors and officers liability coverage—insurance for directors and officers for claims when the corporation is not permitted to indemnify them or is financially unable to do so. D&O liability insurance protects directors or officers of a corporation against liability for errors of judgment in their official capacity.

D&O insurance was conceived initially as “sleep insurance”—providing peace of mind to directors and officers by assuring them that an independent third party would indemnify them for losses resulting from their corporate role when the corporation could not do so for legal or financial reasons. This assurance allowed the corporation to attract and retain talented individuals to serve as directors and officers, particularly outside (i.e., nonmanagement) directors who usually expect to receive little compensation for their service.

Before the advent of D&O insurance, directors and officers were dependent on the corporations they served for indemnification against claims against them in their capacity as directors and officers. State indemnification statutes, such as Delaware CLP § 145, typically permit corporations to indemnify their directors and officers for expenses, judgments, fines, and settlements they reasonably incur in actions against them by reason of their being directors or officers, but only if they act in “good faith” and in a manner they reasonably believe to be “in or not opposed to the best interests of the corporation.” These statutes also authorize corporations to advance the litigation expenses their directors and officers incur in such actions.1 In practice, corporations routinely advance such expenses.

Advancing expenses, like providing broad indemnification rights, are important for a corporation to attract qualified people to serve in management, especially given the substantial expense of defending director and officer litigation. Advancing litigation expenses also helps the corporation promote a common representation and coordinated defense. Generally, an advancement can be conditioned on the recipient’s undertaking to reimburse the corporation if the recipient ultimately is not entitled to indemnification or on any other conditions the corporation requires, including the retention of counsel the corporation selects. However, advancement is not indemnification, but a loan in anticipation of indemnification.2

D&O insurance usually covers corporate advancement and indemnification payments through B-Side coverage. This coverage reimburses the corporation to the extent it indemnifies its directors and officers for claims made against them, as required or permitted by the indemnification statute, charter, or by-laws. However, the principal purpose of D&O insurance is still to provide “sleep insurance” for the directors and officers.

After Enron, Will Corporations Be Less Willing To Indemnify Directors and Officers?

Recent corporate debacles such as Enron and WorldCom may lead to a reduction in the scope of corporate indemnification that is legally permissible, or which corporate boards are willing to determine is in “the best interest of the corporation.” Already closer attention is being paid to the role of the audit committee and other independent directors, and the Securities and Exchange Commission (SEC) is tightening the reins on corporate insiders.

Some commentators suggest that the SEC, which traditionally has not pursued actions against outside directors, may now be more inclined to prosecute outside directors.3 Concern about executives who may have engaged in self-dealing has even reached the point that institutional shareholders such as the California State Teachers' Retirement System are offering bounties for recoveries against the personal assets of executives. In a class-action securities suit filed against WorldCom, the System is offering its lawyers a 2.5 percent bounty, on top of a 12 percent base fee, for recovering “significant” personal assets from any of WorldCom's top managers.4

Courts may also look more closely at whether outside directors acted in good faith in discharging their duties.5In an era of well-publicized failures of major corporations, courts may be concerned that long-standing assumptions about the independence and attentiveness of outside directors—who are viewed to be necessary to police management effectively—may not be well-founded. Outside director compensation has long been considered nominal. However, the compensation packages of outside directors have become more substantial in recent years, potentially undermining the independence of outside directors.

A recent survey of top 200 companies revealed that annual board compensation averaged $138,747.6 Some estimates place the worth of stock and option packages of Enron outside directors at over $800,000.7The assumption that outside directors have the necessary time and energy to monitor management may also be suspect. One observer recently noted that as many as 63 percent of the outside directors of public companies are chief executives of other companies.8

Under Caremark,9 compliance with a director's duty of care is determined by reference to the good faith or rationality of the process employed in making the challenged board decision. The independence or attentiveness of the outside board members increasingly may become an issue that courts consider when faced with an inquiry into whether the process behind a challenged board decision was rational or made in good faith to advance corporate interests. This may undermine the effectiveness of the business judgment rule defense, the principal standard for courts to review challenged business decisions. The rule provides a presumption that management has acted with reasonable care and in good faith, so its decisions will be regarded as a “business judgment” courts will not revisit. If the rule is eroded, directors and officers will face a greater chance of liability in derivative lawsuits challenging their decisions.

The increased responsibilities and penalties that the Sarbanes-Oxley Act places on senior management and the audit committee may make corporations less willing to indemnify executives and audit committee members accused of violating the Act. Among the most widely publicized provisions in the Act are §§ 302 and 906, which require CEOs and CFOs to certify quarterly and annual reports filed with the SEC. Criminal penalties may be imposed on any CEO or CFO who knowingly or willfully falsely certifies the corporation’s financial statements.

The Act also enhances the responsibilities of the corporate audit committee, making it directly responsible for the oversight, appointment, and compensation of outside auditors and requiring it to possess financial expertise. Given these significant responsibilities, any failure of these persons to exercise due care in discharging their duties may raise questions as to whether the best interests of the corporation and its shareholders are served by granting indemnification.

Does the Sarbanes-Oxley Act Bar Corporations from Advancing Defense Costs?

Another corporate governance change contained in the Sarbanes-Oxley Act is Section 402(a), which prohibits issuers from making “personal loans” to directors and officers. Although there is little legislative history concerning this provision, it probably was intended to address the $400 million loan made by WorldCom to its CEO, Bernard Ebbers. However, an unintended consequence of this provision is that an issuer may not be allowed to advance defense fees to its directors and officers, thereby compelling them to seek coverage under the A-Side of the D&O Policy.

Section 402 (a) adds a new § 13(k) to the Securities Exchange Act of 1934, which makes it “unlawful” for an issuer, directly or indirectly, “to extend or maintain credit, to arrange for the extension of credit, or to renew an extension of credit, in the form of a personal loan to or for any director or executive officer (or equivalent thereof) of that issuer.” The Act does not define “personal loan.” The only exemption in the Act is for certain loans made in the ordinary course of the issuer’s consumer credit business that are of a type and on terms generally available to the public, such as home improvement loans and consumer credit. Thus, while state law may expressly authorize a corporation to advance litigation costs on behalf of its directors and officers, a registered issuer may be barred by § 13(k) from taking advantage of the state advancement provision.

Whether a litigation advance should be considered a “personal loan” for the purpose of § 13(k) is not clear. Arguably, advancements serve a legitimate corporate purpose—protecting managers from litigation that may have a chilling effect on their decision-making. Indeed, in a 1999 release concerning the Investment Company Act of 1940, the SEC recognized that the unavailability of indemnification and advancement of legal fees “could inhibit the willingness of independent directors to take appropriate but controversial actions and discourage qualified individuals from serving as independent directors”.10 Recently, several prominent corporate law firms circulated a white paper suggesting that advancements, as well other standard corporate extensions of credit such as travel advances, not be treated as personal loans.11

Whether the SEC would apply § 13(k) to bar advancements also is unclear. In the past, the SEC has recognized the appropriateness of indemnification and advancement provisions. In a 1980 release, the staff addressed whether an investment company was permitted under § 17(h) of the 1940 Act to provide indemnity to its directors and officers, stating that an indemnification provision would not violate § 17(h) if indemnification is provided under circumstances providing reasonable assurance that the director or officer was not liable by reason of prohibited conduct (such as willful misfeasance, bad faith, or gross negligence).12

The staff further stated it would not recommend an enforcement action if the company advanced expenses under an appropriate indemnification bylaw where the indemnitee provided security, the company was insured, or an independent review determined that the indemnitee would ultimately be entitled to indemnification. Significantly, the SEC staff also indicated it would not view an advancement as a personal loan, noting that a litigation advancement would not violate § 17(a)(3) of the 1940 Act, which makes it unlawful for an “affiliated person” of an investment company “to borrow money or other property from the corporation.”13

However, the staff’s position in these releases appears to be based principally on practical concerns. As the SEC noted in the 1999 release, the purpose was to “enhance the effectiveness of independent directors by encouraging funds to nominate directors who will effectively protect the interests of shareholders; relieving independent directors of concerns regarding their ability to act in shareholders' best interests without undue fear of personal liability; [and] helping funds attract the most qualified persons to serve on their boards....” Thus, the releases may more represent the staff’s prosecutorial intentions than its legal analysis.

Given the current legal and economic climate, it is open to question how broadly the staff might interpret the Act’s express ban on “personal loans.” Without guidance from the SEC, public corporations may be reluctant to advance litigation expenses, at least in situations where the corporation does not have a mandatory commitment to do so. Absent a proper by-law or contract mandating advancement, any advancement of expenses would be determined by the board members, who are required to treat any decision to advance their personal expenses as a self-dealing transaction that must be fair to the corporation.

In such cases, the board will be under great pressure to weigh the factors involved, including the magnitude of the expenses, the ability of the indemnitee to repay any funds advanced, and the probability that indemnification will ultimately be available. In connection with this, the board members should also consider the enhanced criminal penalties under the Sarbanes-Oxley Act and that a violation of § 13(k) could result in fines to the corporation.


1See, e.g., Del. CLP 145(e).

2See Advance Mining Systems, Inc. v Fricke, 623 A2d 82 (Del Ch 1992).

3“SEC Investigates Lucent,” Wall Street Journal, 1 November 2002.

4Lynnley Browning, “Shareholders Rise Up (In Wild West Fashion),” New York Times, 16 December 2001.

5Leo E. Strine, Jr., “Derivative Impact? Some Early Reflections on the Corporate Law Implications of the Enron Debacle,” The Business Lawyer 57, no. 4 (August 2002).

6Pearl Meyers & Partners, 2000 Director Compensation: Meeting the Equity Challenge, Top 200 Corporations and Dot.com 100.

7Reed Abelson, “Enron Board Comes under a Storm of Criticism,” New York Times, 16 December 2001.

8Ronald J. Gilson and Reinier Kraakman, Reinventing the Outside Director: An Agenda for Institutional Investors, 43 Stanford L Rev 863 (1991).

9In Re Caremark International Inc. Derivative Litigation, 698 A2d 959 (Del Ch 1996).

10Investment Company Act of 1940 Release No. 24083, 1999 SEC LEXIS 2196 (14 October 1999).

11Sarbanes-Oxley Act—Interpretive Issues Under §402-Prohibition of Certain Insider Loans, (16 October 2002); see also, Leading Issues Under Sarbanes-Oxley—Part I, John C. Coffee Jr., New York Law Journal, 19 September 2002.

12Investment Company Act of 1940 Release No. 11330, 1980 SEC LEXIS 778 (4 September 1980).

1315 U.S.C. 80a-17(a)(3).


Theodore A. Boundas is Chairman of Peterson & Ross. He is a graduate of Villanova University and Harvard Law School and has practiced in the areas of directors and officers, professional, and financial institutions liability and insurance for over 25 years. Mr. Boundas has handled many of the most significant cases in the fields of professional and directors and officers liability insurance and also has written and spoken widely on those subjects throughout the world. He is a frequent author and speaker on professional liability and D&O issues. He also served as chair of the American Bar Association Subcommittee on Directors and Officers Insurance Coverage Litigation (Insurance Coverage Litigation Committee) and is currently a Senior Legal Advisor for Professional Liability Insurance, published by IRMI.


Opinions expressed in Expert Commentary articles are those of the author and are not necessarily held by the author's employer or IRMI. Expert Commentary articles and other IRMI Online content do not purport to provide legal, accounting, or other professional advice or opinion. If such advice is needed, consult with your attorney, accountant, or other qualified adviser.

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