How to Determine Whether to Insure Directors and Officers
In the world of small and mid-sized businesses, there are many misperceptions about directors and officers liability insurance.
Some small business executives believe that this type of policy, called D&O for short, is only for publicly traded companies. Not true, experts say. Although privately held businesses don't risk exposure to securities class action suits, a business doesn't have to have shareholders in order for its directors and/or officers to be personally sued. "It really depends on if you have relationships with vendors or customers, or if you intend to seek venture capital funding or other financial investors," says Lisa Jones, a vice president for private business management liability products for the Chubb Group of Insurance Companies. "These are all external exposures for which small business executives can be held accountable."
Second, some small business executives believe that their general liability or umbrella business insurance policies will cover claims involving directors and officers. Not usually, Jones says. "The general liability or umbrella policies don't respond to management liability lawsuits," she says.
Third, some small business executives believe that D&O policies are only for large companies. Not true, again, experts say. A business of any size will usually have officers and possibly directors who can be targeted by litigants over their management of company affairs. Many insurance companies now offer small business executive liability coverage starting at $1,500 per year to protect directors and officers. That's small change to protect against a potential six- or seven-figure settlement.
"It's available. These policies are out there. To not purchase this insurance is foolish," says Chris Cavallaro, managing director of ARC Excess & Surplus, of Garden City, New York, a wholesale insurance brokerage specializing in professional liability products and services.
The following guide will review what D&O insurance is, what types of coverage D&O insurance provides, and tips on purchasing D&O policies for your small business.
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D&O Insurance 101
D&O liability insurance protects corporate directors and officers in the event they are personally sued -- often in addition to the company being sued -- by investors, employees, vendors, competitors, and customers, among other parties. The insurance protects directors and officers by covering legal fees, settlements, and other costs; in addition, the coverage sometimes can extend to protect the company if it is named in a suit, as well.
In many cases, when you appoint directors or hire new officers they will demand D&O coverage as a condition of serving or employment because they don't want to put their personal assets at stake. Sometimes outside investors, such as venture capitalists or other financiers, will require D&O policies before providing funding to your business -- they often see the coverage as a way to protect their investment.
Directors and officers are sued for a variety of reasons connected with their company positions, including misuse of company funds, misrepresentation of company assets, fraud, failure to comply with workplace laws, and lack of corporate governance among other issues, Jones says. Simply hiring employees potentially exposes directors or officers to employment practices litigation (EPL), which may be covered by some D&O policies, she adds. "However, if more robust coverage is warranted, it may be best to also purchase an EPL policy that protects not only the directors and officers, but the company itself," says Jones. Claims over employment practices are now the most common lawsuits brought against a company's management. A 2008 Towers Watson (now TowersPerrin) survey found that 40 percent of all reported D&O claims from public, private, and nonprofit entities involved employment practices.
One in six company executives -- or 17 percent -- believe their business will experience a D&O related loss in the next years, according to a survey of decision-makers at 451 U.S. companies, more than 90 percent of which had annual revenues of less than $25 million. The survey, sponsored by Chubb, found that one in eight survey respondents -- or 12 percent -- had experienced a D&O lawsuit within the past five years. The costs to settle and/or litigate those cases averaged $225,682, with some losses approaching $5 million, the survey found.
"Customers of private companies are a leading plaintiff in litigation against directors and officer of private companies," Jones says, citing the survey results. Another growing area of D&O suits is over "employee piracy," she says. That's when a key employee leaves a company to start or join a competing firm and the previous employer files suit against the new firm -- and often its directors and officers -- over theft of intellectual property, customers, and other business information.
Bankruptcy is one of the leading causes of loss for a business -- and one of the leading causes of D&O lawsuits, Cavallaro says. A bankruptcy can spark litigation against directors and officers from creditors, lenders, customers, as well as investors. Even if a company doesn't go bankrupt and just needs to downsize, employee layoffs may still prompt claims personally targeting directors and officers, in addition to the business. When a company needs do layoffs, some employees might sue because they feel unfairly persecuted, he adds. They may claim they were let go because of some form of discrimination.
