The COVID-19 storm is here: are Side-A D&O insurers prepared?
COVID-19 has spread to every corner of the globe. The storm clouds are no longer on the horizon – we are in the storm. Investors are struggling to understand the implications of disrupted supply chains, containment measures, and roiled financial markets. The increased uncertainty has led to market volatility not seen since the global financial crisis. Moreover, the measures that governments are taking to fight the virus, including social distancing, has stalled economies and will likely usher in a recession.
Just as the spread of the virus is unpredictable, so are its financial ramifications. Where there are financial implications, there are often insurance implications – especially for Side-A D&O insurance that was created to protect individual directors and officers in times of uncertainty. Given the inevitable bankruptcies and cash flow issues that public and private companies will face, Side-A D&O insurers should be on high alert.
Below, we discuss the claims and issues that the Side-A D&O insurer should be prepared for and how they can navigate the storm.
SIDE-A D&O INSURANCE
Side-A D&O insurance provides coverage for “Non-Indemnifiable Loss,” which is typically defined as the defense, settlement or judgment amounts that the Company is neither permitted nor required to pay (or, simply, where the Company has no means to pay) as indemnification to its directors and officers. Side-A D&O insurance claims typically arise in the context of: (1) bankruptcy, where the Company is unable to indemnify its directors and officers for a Claim; or (2) shareholder derivative actions, where many state’s law do not allow the Company to indemnify its directors and officers for a monetary settlement of a shareholder derivative action.
Side-A D&O insurance has historically been viewed as the “insurance of last resort.” At the same time, the terms and conditions of the Side-A D&O insurance policies have been expanding over the course of the past decade. For example, some Side-A D&O policies have expanded to include coverage for regulatory investigations, fines, penalties and taxes. In addition, the definition of “Non-Indemnifiable Loss” has been expanded beyond the bankruptcy context, and now is typically triggered by the refusal or inability of the Corporation to indemnify its directors and officers for any reason. One such “reason” could be that Companies simply do not have the cash on hand to indemnify its directors and officers.
Now, with the economic fallout from a systemic event like COVID-19, Side-A D&O insurance may no longer be “the insurance of last resort.” Due to bankruptcies and companies facing serious cash flow issues, Side-A D&O programs could be tapped with more frequency.
NAVIGATING THE STORM
While we are in uncharted territories, Side-A D&O insurers can start acting now by taking these three steps:
- Examine existing claim portfolios and, where necessary, re-assess the risk exposure;
- Analyze the type and severity of claims that are being made now, in the immediate wake of COVID-19, in order to evaluate whether any of your insureds are at risk; and
- Identify the sectors and companies that are the most vulnerable moving forward, along with those that are well-positioned and resilient, and price Side-A D&O policies accordingly.
I. The Past: Dust off Existing Files, Examine and Re-Assess Risk
- Start with existing Claims. Are there matters where you wrote a Side-A D&O policy for a solvent company? What is the status of those Claims? Chances are, in a pre-COVID-19 world, there was little concern for Side-A D&O exposure. Now, check the Company’s financial disclosures and reporting. Evaluate whether this is the type of company that may be particularly at risk due to COVID-19 and the resulting economic shutdown. Is there a reason to think that the Company may no longer be able to fund a settlement or defense costs? If so, this may now present Side-A D&O exposure.
- Within the subset of existing Claims, are there matters that settled but settlements have not yet been funded? If the Company is no longer able to indemnify its directors and officers for a settlement, there could now be a Side-A D&O Loss.
- Did you write a Lead Side-A D&O policy that sits over a traditional Side ABC D&O program with a sizeable Retention under Side-B (indemnification coverage), but a $0 Side-A Retention? If the Company is solvent and is permitted to indemnify the directors and officers, but chooses not to, the higher Side-B retention may still apply to the Side ABC D&O program under the presumptive indemnification provision. However, the Side-A D&O insurer may be required to “drop down” to advance (subject to its right of subrogation) the Loss under a $0 Side-A retention.
II. The Present: Understanding the Current Claims Environment
- At least two coronavirus-related securities class action cases have already been filed against public companies: (1) Inovio Pharmaceuticals – it is alleged that the CEO announced that the company had developed a vaccine for COVID-19, and when a short seller called Inovio’s claims into question, the stock price dropped; and (2) Norwegian Cruise Lines - the company made certain disclosures about the known impact of coronavirus and the steps it was taking to avoid transmission of the infection.
- Side-A D&O insurers should examine the current COVID-19-related lawsuits in order to better understand the sectors and companies that have the greatest risk of exposure, and start analyzing financial disclosures by their own Insureds. Are they updating their disclosures in light of COVID-19? Have they made any public statements regarding COVID-19 earnings impact that put them at risk?
- While this is still early days, and despite the fact that there will continue to be significant market volatility, our expectation is that we will not see too many securities class actions or shareholder derivative actions that are directly tied to COVID-19. That is because the virus was something that companies and their boards could not have reasonably anticipated. Although stock prices have been decimated, it will be difficult for the plaintiffs to plead and prove that there was a false and misleading statement and corrective disclosure that caused the stock drop. To the extent the current situation persists and disclosure obligations arise given greater awareness of COVID-19 implications for companies and boards, it is possible that more lawsuits may be filed if those disclosures are considered inadequate.
III. The Future: Planning Ahead
- While we do not expect too many immediate securities class actions and shareholder derivative actions that are directly tied to COVID-19, we are concerned with the inevitable securities class actions and shareholder derivative actions that will be brought as a result of the financial impact caused by the global economic shutdown. Heading into earnings season, analysts expect delayed reports, withdrawn forecasts and confusing results from businesses dealing with the global economic shutdown. Rightfully or Wrongfully, we expect that shareholders will blame directors and officers for the downfall of their companies during these dire times. In the coming months, any action or inaction by directors and officers will be heavily scrutinized.
- Companies have been building up debt for the past decade. But now with the market essentially frozen, and unstable borrowing costs, financial analysts are already predicting a worldwide credit crunch that will set in motion a wave of corporate bankruptcies. When companies go bankrupt, companies are often unable to indemnify their directors and officers for any resulting claims.
- Side-A D&O exposure is not limited to just bankruptcy situations. As discussed above, “Non-Indemnifiable Loss” could be triggered by a “refusal or inability to pay” for any reason. Even a solvent company with significant assets could refuse to indemnify its directors and officers. For example, a company may have its assets tied up in illiquid assets such as real estate, or one of its customers or clients may be experiencing significant cash flow issues. In these instances, Side-A D&O insurers could be called upon to satisfy the company’s indemnity obligations to its directors and offers (subject to it right of subrogation).
- Which sectors are the most vulnerable? Airlines, tourism-related businesses and carmakers are feeling the pain. Restaurants, sporting/live events, and other services will also face significant disruption. Side-A D&O insurers should be particularly wary of sectors and companies with heightened exposure, and should price such risks accordingly. At the same time, Side-A D&O insurers should continue to look to write companies with healthy balance sheets that are particularly well-positioned for this crisis (for example, industries with less dependence on social interaction such as agriculture, and supply-side companies).
We are entering a new world with lots of unknowns. One thing is certain: there will be Claims that impact Side-A D&O insurers. Let’s all be ready.