Directors and officers are subject to many duties and statutory responsibilities. When breached, these can result in personal liability. They include the duties of care and loyalty to the corporation; responsibility to act always in the corporation’s best interest; and more than 200 federal and provincial statutes imposing liabilities in areas such as environmental law, taxation, workers compensation, and other obligations to employees.
Alleged wrongful acts associated with corporate restructuring, such as a merger or takeover, are the most common sources of D&O liability claims. This is partially due to inherently or perceived conflicting interests at times of change, such as shareholders’ interests which are affected by the directors’ actions, and the directors’ personal interests.
Directors’ and officers’ corporate responsibility is heightened in a merger or takeover. They must conduct proper due diligence of the transaction and release complete and accurate information to interested parties. Such actions will come under scrutiny from shareholders and creditors. If share prices drop because of the transaction, shareholders may take action against the directors and officers personally.
Potential D&O claims include but are not limited to:
- Disclosures in the proxy or to analysts;
- Allegations of treating one group of shareholders (or debt holders) unfairly;
Self-dealing allegations; and
Misrepresentation in the sale process.
Pre-Merger Sources of Protection May Cease to Exist
When a company goes through a merger or takeover, corporate control changes to a new board or a trustee. The former directors and officers may want to breathe a sigh of relief expecting that their personal liabilities as directors and officers have ended. However, legal action can be made against directors and officers well after the transition is over, sometimes many years after. Statutes of limitations may be years after the event in question. Worse, this may extend even further in cases where the time limitation only starts running when the claimant discovers the alleged wrongful act.
Usually directors and officers are protected by corporate indemnity and D&O liability insurance. After a merger or takeover, this protection can evaporate. The former company, its by-laws, and any indemnification arrangements no longer exist. D&O liability insurance often ceases automatically on change of corporate control. Although each policy wording varies, a change of corporate control is usually defined as a merger, sale or any event that results in a change of over 50 percent of the voting power of the board.
Sources of Protection for Former Directors and Officers
How can directors and officers protect themselves against these risks? There are four options. Two involve improving the D&O policy before knowledge of any merger or takeover:
1) Automatic Run-Off Provision; or
2) Pre-Negotiated Extended Reporting Period.
These prearranged options should be negotiated as advantageously as possible, since they may be the only protection available when the board is most vulnerable. The other two sources of protection can only be negotiated after knowledge of the merger or takeover:
3) Indemnification of Run-Off Exposure by the acquiring board (with or without coverage under a shared D&O policy); or
4) Separate Run-Off D&O Policy.
1. Automatic Run-Off of Existing Policies
Some D&O policies automatically convert to a “runoff” policy for the balance of the policy term upon a merger or takeover. The policy still applies to claims arising from wrongful acts committed before the merger or takeover date, if the claims are reported before the policy expiry date. There is no additional premium charge. There is one serious disadvantage with this coverage. If the policy term is very close to expiry when the merger or takeover occurs, the directors and officers only have until the expiry date to report potential claims. Coverage ceases after expiry. This may not be enough time for discovery and reporting of claims.
2. Pre-Negotiated Extended Reporting Period (ERP)
This option provides a more certain timespan to report claims. The cost is pre-defined to trigger the extended coverage. A standard policy may offer as little as 90 days extended reporting period, but options of one year or more may be negotiated. The cost to elect the ERP is a fixed percentage of the expiring premium. There is a major disadvantage to the ERP. The ERP may only be taken by the policyholder if the insurer has cancelled or failed to renew the policy. Although an insurer may allow the ERP in other circumstances such as merger or takeover, the ability for the insured to elect the ERP must be negotiated with the insurer.
Because both pre-negotiated options extend the existing D&O policy, they assure coverage no more restrictive than the pre-merger or takeover coverage. Once the board is aware of a potential merger or takeover, two other options may be negotiable once the circumstances of the change are known. Where available, these options may yield better protection, for a longer period.
3. Indemnification of Run-Off Exposure by Acquiring Company
The merger/sale agreement can often be negotiated to include indemnification of the acquired companies’ directors and officers by the acquiring company. Being a non-insurance option, this involves no premium cost but may bear other costs in the overall sale negotiation. There are some other potential pitfalls. The indemnification may be subject to:
The acquiring company’s bylaws, which may be different to the acquired entity’s bylaws, possibly affording uncertain protection;
Interpretation of the acquiring company’s bylaws by its board. These bylaws may be less detailed and therefore, less precise than a D&O insurance policy; and
The financial ability of the acquiring company to meet such indemnification obligations, both at the time of the transaction or in the future.
Directors and officers of the acquired company should, therefore, carefully review the indemnification language and the financial stability of the acquiring company.
This alternative can be enhanced if the acquired company’s directors and officers can be included in the acquiring company’s D&O liability insurance policy. If prior acts of the acquired company’s directors and officers are not excluded (typically they are excluded), the indemnification is backed by a D&O policy wording as long as the acquiring company continues coverage. There may be an additional premium which would be charged to the acquiring company.
Unless properly arranged, this approach could reduce the potential coverage amount available to each director and officer. Policy limits are aggregated for all directors and officers, so shared aggregate could be entirely exhausted from suits against the acquiring company’s directors and officers. This would leave no or less coverage for the former directors and officers of the acquired company. Further, the acquiring company’s coverage may be more restrictive then that of the acquired company. Careful analysis by both legal counsel and the insurance broker is critical to pinpoint these issues and resolve them, if possible.
4. Separate Run-Off D&O Policy
A separate runoff D&O liability policy may resolve most of the potential coverage limitations of the other options described above. The runoff policy:
Provides a separate unimpaired aggregate limit exclusively for the former directors and officers of the acquired company;
Is non-cancelable by either insurer or insured;
Provides a single aggregate coverage limit for the policy term, not for each annual period within the term; and
Provides a much larger window for reporting claims (one to six years or more) than the ERP option.
The run-off policy is negotiated separately from the extended coverage options described earlier, sometimes with new insurers specialized in run-off policies. Insurers may seek to restrict the coverage, so it requires extensive input and analysis from the broker to minimize or eliminate restrictive policy terms and to ensure that coverage is no less restrictive than pre-merger or takeover, if not broader.
There is a point of caution when placing a run-off policy. It is extremely important that the pre-merger or takeover limit of liability has not been impaired by a reported claim or circumstance. In the event of an impaired limit of liability, consideration must be given regarding the current impaired limit of liability versus negotiating a fresh limit of liability with the insurer.
Each corporate change presents its own unique challenges. When entering negotiations for the merger or takeover appears inevitable, directors and officers should seek a new source of protection before the event.
Personal liabilities should be protected through a well-planned risk management program including proper corporate indemnification and suitable D&O liability insurance. Current D&O policies should be checked to assure maximum coverage since it is much more difficult to negotiate coverage after the fact.
The D&O policy may not be the only policy that is impacted by a change in corporate control. Furthermore, directors and officers may not be the only individuals concerned about their future liabilities. In the event of a merger or takeover, the fiduciary liability policy and employment practices liability policy may need to be considered and reviewed with an experienced broker to determine the best way to protect past liabilities.
In corporate reorganization, these issues, along with who will pay for the coverage, can and should be reviewed with counsel and an insurance broker experienced in complex D&O liability issues. The result will be better protection for the directors and officers, at the time when they are most likely to need it.
For more information on these and other solutions from Marsh, visit www.marsh.com or contact your local Marsh representative.