New regulations, emboldened shareholders and changing attitudes have created a perfect storm for businesses across the world, heightening the importance of appropriate Directors and Officers (D&O) coverage.
Scandals involving company directors have emerged with worrying regularity over the past 12 months, most notably in the US where, in October 2017, The New York Times published a story detailing decades of allegations of sexual harassment against film producer Harvey Weinstein.
The Weinstein Company was only saved from bankruptcy by a major investment.
In January 2018, casino owner Steve Wynn was accused of sexual misconduct spanning decades and it was reported that he had paid a multimillion-dollar settlement to a former employee.
Having almost doubled in value during 2017, Wynn Resorts’ stock fell almost 10 per cent in the first six months of this year.
Then in July it emerged that John Schnatter, founder and CEO of Papa John’s pizza chain, had used a racial slur during a media training session.
The fallout pushed the company’s stock to its lowest level for more than two-and-a-half years.
On this side of the Atlantic, the UK Department for International Development suspended its funding for Oxfam earlier this year after it was accused of covering up claims that staff used sex workers while delivering aid to Haiti in 2011.
Some 100 staff lost their jobs as a result of the charity’s subsequent drop in revenue.
In Germany, Audi CEO Rupert Stadler was arrested in June over allegations that he attempted to interfere with evidence relating to Volkswagen’s cheating of emissions tests in the US, which is estimated to have cost the company more than €25 billion.
None of these incidents should come as a complete surprise – it has long been recognised that inappropriate and/or unethical conduct takes place in the workplace.
What makes them significant is that they are indicative of a trend for unacceptable behaviour to be called out and result in action being taken against the perpetrators.
While companies across all sectors face increased regulatory scrutiny, the potential implications are greater for businesses operating in highly regulated industries such as financial services.
In a review of the issues impacting D&O policies, Clyde & Co Partner James Cooper notes that financial regulators continue to focus on a firm’s culture and governance, combatting corporate fraud and market abuse (recently strengthened in the EU by the Market Abuse Regulation) and clamping down on bribery and corruption.
Any investigation into a firm also presents a risk to individuals working for that firm, particularly in light of the Senior Managers and Certification Regime, triggering claims to D&O policies as well.
Cooper observes that, in theory, a comprehensive D&O policy should already cover senior managers and that, similarly, if the policy provides for investigation costs, then this should already address the potential actions against these managers.
However, companies should check that their policies expressly refer to Senior Managers Regime functions being covered.
The General Data Protection Regulation (GDPR), which came into force in May 2018, also has implications for directors and officers who – in the event of data loss – could be held liable for failing in their supervisory duty to protect the data of the organisation and its customers, or for a lack of proper controls to prevent cyber attacks and fraud.
K&L Gates Partners Jeffrey Meagher and Sarah Turpin caution that D&O policies may not have been written with cyber liabilities in mind and that directors and officers may be at risk of breach of duty claims, particularly if the company goes into insolvency as a consequence of the cyber incident.
They note that it is not common for claims alleging or arising from the failure to ensure proper management of cyber risks to be excluded from D&O policies, but say this needs checking, particularly as claims exposures increase.
In addition, some policies impose jurisdictional exclusions, which can prove problematic in the cyber context given the increased risk of liability arising from violations outside the country in which the company operates.
Policies may also seek to exclude any misconduct that is deliberate or intentional, so the wording of such exclusions requires careful examination – most conduct is intentional and such exclusions should only apply where there has been an intentional breach of the law.
In any event, the policy should make clear, by means of a severability provision, that the misconduct of one director or officer will not impact the cover available to other directors and officers covered by the same policy.
The good news for proactive companies is that cyber-related lawsuits against management have not yet resulted in massive pay- outs, primarily because the courts perceive companies as vulnerable.
The general feeling among the judiciary seems to be that, as long as a board is able to demonstrate that it took reasonable steps to protect against a breach, the courts are not going to hold it accountable.
Clyde & Co Partner Mark Sutton and the firm’s Legal Director, Karen Boto, observe that D&O insurance will be a potential source of cover for some sexual misconduct-related claims, particularly if an employment practices liability (EPL) extension is present.
While policy-wording-dependent, an EPL extension will typically cover claims made by employees based on the alleged misconduct of their co-workers.
Most extensions cover claims for sexual harassment, wrongful termination and discrimination and some may provide coverage for additional employment-related claims, such as defamation or negligent retention and supervision (where entity cover is available).
In order to trigger cover under a D&O/EPL policy, the wrongful act must have occurred while the insured person was acting in the course and scope of his or her employment.
This may present obstacles if the alleged misconduct occurred outside of working hours.
Another significant limitation is the common D&O/EPL exclusion for claims alleging bodily injury. While claims for verbal sexual harassment may be covered under a D&O/EPL policy, claims for physical sexual assault typically are not.
If a claimant alleges both verbal and physical harassment or assault, a policy may provide partial coverage.
However, as D&O policies also typically contain an ‘insured v insured’ exclusion, this may operate to preclude cover for claims made by employees – if they are an insured person – against an insured person (the accused executive) and/or the company.
Companies need to check their policy wording to help them determine which party has the ability to settle a claim and how.
Typically, D&O policies allow the insured to settle a matter with the prior written consent of the insurer, such consent not to be unreasonably withheld.
Provided the insured can identify a credible reason for a proposed settlement, an insurer is not likely to be able to justify withholding its consent.
Likewise an insurer may have difficulty in persuading an insured to settle early if they feel strongly that they want to defend their position.
A proactive approach
If internal investigations are to remain an uninsured expense, this should encourage companies to ensure that they conduct adequate background checks on their employees and that their procedures and controls are adhered to in practice, in order to prevent the need for launching internal investigations in the first instance.
It may also promote transparency by requiring appropriate disclosures to be made to shareholders or investors regarding knowledge of any egregious behaviour.
An article on management liability and the ‘#MeToo’ movement by law firm Kennedys states that, under the Equality Act 2010, claims for sex discrimination, harassment or victimisation may result in both the perpetrator and the employer being jointly and severally liable to the victim for compensation.
Typically, an employer will be ‘vicariously liable’ for acts committed by its employees in the course of employment, unless the conduct can be said to amount to the employee entering a ‘frolic of his own’.
Employers can avoid such liability if they are able to show that they took all reasonable steps to prevent the conduct, although the firm acknowledges that in practice this is often a difficult defence to run.
All these developments will inevitably have an impact on the cost of D&O insurance, observes Kurt Rothmann, Head of Management Liability at JLT Specialty in London.
“Underwriters are definitely looking to reassess exposures and this has had an impact on the capacity they provide and the prices they charge, although private UK and European companies can still obtain competitive coverage terms, most noticeably on excess layers,” he says.
Different sectors, different exposures
Awareness of potential exposure varies across different industries.
So, while the move by regulatory regimes towards greater personal accountability has generated considerable interest in scenario planning and gap analysis among financial institutions, other sectors have been slower to wake up to the new threats they face.
“Sectors such as construction have a reactive awareness of the risks,” says Rothmann. “We have seen this in the UK following the collapse of Carillion where firms suddenly realised they were in choppy waters and started looking at where they might be at risk.”
Global firms need to keep abreast of litigation trends in all the markets in which they operate Colin Daly, Head of Management Liability Practice, Financial Lines for JLT Specialty USA, observes that companies in that country run a high risk of being sued and need to understand that defending an action will be very expensive.
“Carriers are differentiating between companies in the same industry,” he explains. “Some they view as more challenged risks might be seeing rates go up by 10 per cent.”
The cost of defending claims is also a major issue in the Nordic region. A recent case in Sweden involving HQ Bank, which had its banking licences revoked in 2010 but faced a string of legal issues that ended with the company directors eventually being found not guilty, still cost €25 million to defend.
Increasing pressures on D&O cover
The major driver in the claims explosion has been shareholder class actions around financial non-disclosure and misleading statements.
A report by Cornerstone Research into US securities class action filings notes that plaintiffs filed more federal securities fraud class actions in 2017 than in any previous year since the enactment of the Private Securities Litigation Reform Act of 1995.
The main contributory factor in this increase was filings related to merger and acquisition transactions, which doubled in number from 2016.
The upshot is that many organisations will find underwriters asking tougher questions in the next renewal season.
“The combination of the fairly benign litigious environment in the UK and favourable market conditions over the last few years means that companies may not have paid attention to the quality of the cover,” warns Rothmann.
“Now, more than ever, companies are under pressure from board members to ensure that their D&O cover provides adequate coverage with an appropriate limit of liability,” he adds.
“This is particularly prevalent in large corporations where non- executive director board members may be accustomed to having access to sophisticated D&O programmes while sitting on other boards.”
Some sectors – such as construction – may find those losses mean all firms face greater scrutiny. Melissa Hickey, Management Liability Account Executive in JLT’s London-based Financial Lines Group, says this should act as a wake-up call to other sectors that have not yet experienced such claims activity.
“Companies may not have examined their financial lines insurance programmes and undertaken detailed gap analysis,” she continues.
“For example, professional services firms typically focus on mandatory insurances, such as professional indemnity (PI), and with the key decision-makers typically not being risk managers or insurance professionals, they may be under the impression that D&O claims would be paid out under their PI policy.”
"The internationalisation of commerce – and with it risk – has put the need for specialist support and advice at the heart of conversations with clients about D&O cover," says Sophie Robson, Legal and Technical Advocate in JLT’s Financial Lines Group in London.
"There is a move towards bespoke policies for large and more sophisticated clients, as well as a focus on individual accountability by regulators," she concludes.
For more information please contact Kurt Rothmann, Head of Management Liability on: +44 (0)20 7528 4961 or email email@example.com.