The real test of Directors and Officers Liability Insurance (D&O covers) is not the size of the cover or the premium paid, but whether it protects the directors when a corporate decision comes under scrutiny.

Board meeting:

It was well past 6.00 pm, much beyond the scheduled closing time of the Board meeting. The Directors were beginning to glance at their watches, nervous about catching their return flights to their home cities. The Chairman looked through the agenda and announced, “We have completed the key items. There are just a couple of routine matters left. Let us try to wrap quickly”. One of the remaining items was the renewal of the company's D&O Insurance policy.

The CFO drew attention to the material circulated and mentioned that the sum insured had been increased by Rs.250 million, with the premium being only marginally higher than the previous year, and that there had been no claims during the year.

The Chairman asked, “Any questions?” There was a brief silence. The Board had five independent directors, of which two were new and were attending their first board meeting. One of the new independent directors glanced at the premium comparison even as the other new ID turned to the next page of the agenda.

The first of the two spoke, “Before we approve this, may I ask a few questions and proceeded with:

• What are the covers that are available?

• How are the directors protected even after they cease to be the directors?

• Are there separate, dedicated limits for protecting directors?

• Are there situations where the company cannot indemnify the directors?

• What if the company itself brings a claim against a director, how does the policy respond?

The wordings in a policy is to be examined as a director need not necessarily win the case to receive defence-cost funding.

The Chairman looked at the CFO who fidgeted in his seat nervously as he didn't have all the answers. The CFO had not studied the policy in detail and had asked his team if the covers were in line with the earlier years. Sensing the relevance of the queries raised, the Chairman asked the CFO to circulate a detailed note to the Board and advised the Company Secretary that the item could be taken up for approval by resolution in circulation.

What are the aspects that the directors should understand about the D&O cover?

1. Legal context:

In India, directors operate within a framework that includes the Companies Act, 2013, applicable SEBI regulations, sector-specific regulatory requirements and the duties attached to their respective positions. Independent directors have particular responsibilities to exercise independent judgement and provide objective oversight. Of course, Section 149 (12) of the Companies Act, 2013 does provide statutory protection to Non-Executive Directors, including an Independent Director. Section 197 (13) clarifies that the premium paid on a D&O insurance policy is excluded from managerial remuneration.

Regulation 25 (10) of SEBI, LODR makes it mandatory for the top 1000 listed entities by market capitalisation and High Value Debt Listed Entities (HVDLE) to secure D&O insurance covers. SEBI does not lay out the sum insured or nature of risks to be covered. A director of a listed entity is responsible for all acts of its material subsidiary, particularly when it comes to significant transactions and where the “ corporate veil will be pierced. The D&O cover should extend to all such unlisted material subsidiaries.

2. What does the D&O Policy seek to protect?

Its purpose is specific in providing financial protection against covered claims and the associated costs of defending them. Insurance does not substitute for the responsibilities of the directors. Nor does it guarantee that every claim, penalty or consequence of a corporate decision will be covered.

It is important for directors to understand that a director does not have to be guilty of a wrongdoing to face an expensive legal proceeding or class action suit (permitted by the Companies Act, 2013). A decision made by the board that appeared reasonable can subsequently be challenged by shareholders, regulators, creditors etc. The risk is more so as companies make decisions on acquisitions and mergers where the shareholders can always allege that the directors did not adequately challenge the management's projections. The directors may ultimately establish that they acted in good faith, obtained professional advice, considered risks, challenged assumptions, etc. but defending their decision may still require substantial legal and expert costs. The first value of D&O cover is the ability to defend a decision successfully and protect from costs arising therefrom.

3.Who are protected under a D&O policy?

The normal D&O insurance policy operates on three components – side A, side B and side C. The distinctions between the three are not technical but determine who is insured, who receives the claim and which parties compete for the available sum insured.

Consider a company facing a shareholder claim that alleges misleading disclosures. The company needs legal representation, as do the directors severally. The interests may not be identical, and each may require separate counsel.

Side A protects the individual director or officer when sued personally for an alleged breach of fiduciary duty. It operates when a covered loss cannot be indemnified by the company. This is particularly important where the company is insolvent, legally unable to indemnify the director/officer or itself pursuing a claim against that director.

Side B reimburses the entity for covered amounts that it has incurred/paid to indemnify directors and officers.

Side C provides specific covers to the corporate entity itself, commonly for certain securities-related claims, depending on the wording.

The board should critically examine whether the policy provides adequate individual protection and whether a dedicated Side A limit is appropriate and whether the entity cover could materially erode the amount available to directors. The headline sum insured, by itself, does not provide clarity.

4. What is protected under a D&O policy?

The D&O policy definition of wrongful act typically encompasses specified errors, omissions, misstatements, breaches of duty, neglect and other alleged managerial wrongdoing. While individual wording may differ from insurer to insurer, the crux is that an allegation may trigger a claim even when liability has not been established. On such an allegation, the entity and the directors may need the help of lawyers, forensic experts and specialist advisors before the merits of the allegation are determined. Critical questions that emerge are:

i. What expenses qualify as defence costs? Whether defence costs eat into the overall limits that are fungible or whether they operate outside the limit?

ii. Does the insurer provide an advance for defraying expenses before the determination of the final outcome? Is consent of the insurer necessary prior to appointment of experts/counsel or incurring significant expenditure?

iii. What happens to the advances should the decision come through as a wrongful act? Is repayment required if an exclusion is ultimately established?

iv. How are covered and uncovered allegations allocated?

The real value of a D&O insurance is not determined by the sum insured or the premium paid but by the terms of the protection available when a claim situation emerges.

The wordings in a policy is to be examined as a director need not necessarily win the case to receive defence-cost funding. Equally, funding the defence does not guarantee that the ultimate liability will be insured.

5. Does the policy operate on an occurrence basis or claims made basis?

Occurrence based covers responds to a covered occurrence during the policy period, even if the claim is made later, subject to the wording. In such a policy, the claim period is open-ended and provides for a long tail for filing the claim and payment. In other words, the policy covers for an incident that occurred in the policy period even though the discovery and action can be in any succeeding period.

Claims made policies generally require the claim to be first made during the policy period and reported as required by the wording. The wrongful act must satisfy the policy's applicable prior acts/retroactive provisions and the claim must satisfy the claims made and reporting requirements.

A restrictive retroactive date may exclude incidents that occurred prior to that date.

In both cases, the policy may provide for extended reporting periods where the duration and the costs are to be ensured. Where there is a change in insurers, it should be ensured that there is continuity of retroactive dates.

6. What is not covered by D&O policies?

Fraud and deliberate dishonesty are commonly excluded from the scope of cover. This is a legitimate limitation as insurance is not intended to protect deliberate, conscious wrongdoing. The timing and operation of the exclusion, however, matters. Generally, breaches of fiduciary responsibility, trust and duty, misstatements & misrepresentations, misleading statements, neglect and failure to exercise due care would all be deemed wrongful acts.

D&O covers do not generally cover internal infighting such as internal corporate disputes, boardroom squabbles, as the cover seeks to protect leadership from external third-party claims. There can be some carve- backs such as employment practices claims (wrongful termination suit brought by an officer)

Claims arising from bodily injury, property damage, product liability, professional indemnity, cyber-related claims, environmental liability, etc. are generally excluded as the boundaries between various insurance policies have to be clear. For instance, if there is a major data breach and claims arise, the cyber insurance risk can operate but the D&O cover may become relevant if the directors are alleged for negligence in failing to oversee cyber risk adequately.

Suppose a director is accused of fraud, spends two years defending the proceedings and is ultimately exonerated. If the policy excludes every claim merely alleging fraud, the director's defence may be left unfunded from the outset. A provision that operates only after a specified final adjudication or admission may offer materially a different protection. It is therefore necessary to have clarity as to when the exclusion takes effect, what happens to previously advanced defence costs and how the policy will differentiate between exonerated directors and directors adjudged for misconduct.

Likewise, the admissibility of regulatory fines and penalties depend on the nature of the payment, applicable law and policy wording. Even where a particular penalty cannot lawfully be insured, defence costs and other permitted expenses may remain covered.

7. What are run-offs and what is to be ensured?

A director's exposure continues long after he ceases to be a director as an allegation could turn up calling for scrutiny of events occurred during his tenure. Change of control provisions may alter the policy's operations or its existence (as in a merger or the company getting acquired). In such cases, it is to be ensured that the D&O cover preserves the protection for past acts and of former directors. It is equally relevant for a retiring director to know how long the protection will continue for him and on what terms.

8. What should be the sum insured?

Limit adequacy should be assessed against plausible severe scenarios rather than determined solely by last year's limit or the premium that the entity can afford. The amount determined would depend on the entity's size, nature of business, geographical reach (in terms of liability globally or only the Indian market), market capitalisation, regulatory exposure, litigation profile, corporate activity by way of acquisitions/sale of businesses, financial condition etc.

The Board should examine if the policy limit is per claim or aggregate, the various sub-limits, the extension time periods, if side A protection is separately protected etc.

Conclusion:

The Board should regard D&O policy buying and its renewals as a risk governance exercise. Even as the CFO needs to have a deep understanding of the policy, the Board should understand the material aspects, gaps and whether the protection is adequate, under the circumstances. The aspects that the Board should insist on specific information to be contained in the board note include:

• Material changes from the existing policy

• Significant exclusions and sub-limits

• Geographical reach, particularly whether the cover is global or any specific countries are excluded and inclusion of all subsidiaries

• Any reduction in prior acts protection

• Limitations on regulatory investigation covers including overseas regulators

• The adequacy of protection for former directors

• The consequences of a common limit being exhausted

The real value of D&O insurance is not determined by the sum insured or the premium paid but by the terms of the protection available when a claim situation emerges. The objective of the Board should be, “If the worst happens tomorrow, do we know exactly as to how this policy will protect the directors and the entity?”