Evaluating executive risk in the time of COVID-19

August 2021  |  FEATURE | BOARDROOM INTELLIGENCE

Financier Worldwide Magazine

August 2021 Issue

The risks facing directors and officers (D&O) continue to expand and intensify, with liability claims against them set to rise. One catalyst has, of course, been the COVID-19 pandemic. As the effects of the crisis gripped the global economy, businesses had to react swiftly to the challenges of business interruption. Senior managers grappled with whether to close offices, force redundancies or furlough workers. They had to deal with pressing issues such as supply chain disruption, falling consumer demand, travel restrictions, remote working and ensuring the health and wellbeing of staff. For some, these issues may persist for the foreseeable future. Though the crisis is beginning to subside in certain jurisdictions, its repercussions, including economic downturn, are likely to be felt for years to come.

Various other issues are also contributing to D&O liability risk. Among them are themes such as environmental, social and governance (ESG), diversity, equity and inclusion (DS&I), the #MeToo movement and sexual misconduct, insolvency exposure, cyber security flaws and data breaches, and securities litigation. Concerns around these issues are testing D&O decision-making processes and shining a spotlight on missteps. Intense scrutiny is putting D&Os in the firing line, feeding into liability claims.

Regulation and accountability

The risk landscape for D&Os has changed significantly since the start of 2020, although the common thread is a significant increase in focus on individual accountability for corporate decisions and actions, notes James Whitaker, a partner at Mayer Brown International LLP.

“That trend continues to develop and will become increasingly consequential as greater regulatory and litigation exposures – based in part on responses to the pandemic – emerge,” he says. “As the business world returns to normality, decisions and actions taken during the pandemic may well be scrutinised closely, and with the benefit of hindsight, not only by regulators, but also by commercial counterparties, shareholders, employees and other stakeholders.”

While the trend toward individual accountability was already gaining pace prior to the pandemic, the events of 2020, as well as several high-profile corporate collapses and scandals in recent years, have led to a tightening of the regulatory regime within which D&Os operate. In the UK, for example, further changes are in the pipeline.

“The recently-announced consultation on reforms to UK corporate governance exemplifies the move toward stricter frameworks,” says Mr Whitaker. “We can expect to see more focus on compliance with directors’ duties, particularly in distressed scenarios, and greater scrutiny of actual, potential or alleged conflicts of interest in business transactions. Of course, the effects of stricter regimes will be felt not only by transgressors; all D&Os will need to adhere to the rapidly developing rules.”

Proposals to reform the audit industry and corporate governance more broadly will inflate the risk profile for directors. “While the UK government’s recent proposals will inevitably be subject to further development and are unlikely to become law for some time, it is already clear that some form of enhanced scrutiny of directors – whether by a regulator or via an expansion of their duties to the company – is on the cards,” says Dan Butler, a senior associate at Freshfields Bruckhaus Deringer LLP.

Another area garnering attention is securities litigation. Although it remains relatively underused in the UK, a shift is underway. “In addition to increasing regulatory focus on compliance with civil and criminal regimes around market abuse and insider dealing, a number of high-profile private claimant cases in recent years have raised the profile of the statutory framework for claims arising from alleged misleading of the market,” points out Mr Whitaker.

“There have also been significant judicial developments around potential tortious liabilities of directors as well as, of course, claims founded upon company law duties – for example, the duty to provide shareholders with sufficient information to enable a reasonably informed decision to be made about proposals put forward. Particularly given the market volatility of the early months of the pandemic, and as stakeholder focus on corporate decision making intensifies, the steady increase in this type of action is likely to continue,” he adds.

Disruption caused by the pandemic will continue to create financial problems for companies and their employees as they battle to recover. “In turbulent economic times, instances of fraud and other ‘white-collar’ offences have historically increased, partly due to the increasingly stringent requirements of directors proactively to prevent such conduct within organisations,” suggests Mr Whitaker.

Corporate failure: the blame game

Many organisations are unlikely to recover from the economic impact of the pandemic. With a wave of insolvencies potentially on the horizon, a rise in related D&O claims may follow. “It is almost inevitable that rising insolvency levels will lead to an increase in claims against directors, either by insolvency officeholders or by creditors seeking directly to make good any losses they may have suffered,” says Mr Butler. “In the UK, regulatory investigations by bodies such as the Pensions Regulator and the Insolvency Service can also follow an insolvency.

“While the UK’s Corporate Insolvency and Governance Act 2020 has provided directors of companies affected by COVID-19 with some temporary relief from certain kinds of liability, there remains significant scope for them to face claims for breach of duty,” he adds.

The extent of the economic damage wrought by the pandemic is well documented, affecting businesses of every size. For those companies propped up solely by government support, the outlook is bleak. “Largely as a result of government assistance measures, one of the most anticipated risk factors from the pandemic, the spectre of mass insolvencies, has not yet come to pass, although it certainly seems plausible that as those assistance measures and schemes come to an end, insolvencies, and related disputes targeting the decisions and actions of those in charge, may not be far behind,” warns Mr Whitaker.

The insurance imperative

As companies battle to adapt to the pandemic and its economic fallout, alongside myriad other issues, D&O liability insurance will be vital, offering protection to senior decision makers and their companies.

“The Side A insuring agreement of a D&O policy is the insuring clause that provides direct coverage to D&Os when the company cannot provide indemnification,” explains Evan Bundschuh, executive liability insurance manager at GB&A Insurance. “This is often the greatest concern of the D&Os, as it is effectively, directly protecting their personal assets. Given the increasing risk of insolvency and growing number of derivative actions, we have noticed a greater emphasis being placed on the Side A layer.”

According to Brian Scarbrough, a partner and co-chair of the insurance recovery and counselling practice at Jenner & Block LLP, D&O liability insurance can also be an important source of balance sheet protection for both public and private companies. If the company indemnifies individuals directly it can incur substantial costs, both for defence and settlements or judgments, known as Side B coverage. And a company can incur substantial costs in responding to claims directly against the company, known as Side C coverage.

“D&O liability insurance can help protect the company’s balance sheet in these circumstances,” he says. “This is especially important for private companies – while in the US, Side C coverage is limited to securities claims for public companies, private company D&O liability insurance can provide more general coverage for the company itself not tied to securities claims.” These types of ‘full’ D&O policies provide balance sheet protection in the form of coverage for claims against the entity, and coverage for indemnifiable claims brought against the D&Os.

Hardening market

But for buyers of D&O insurance policies, the market has become more adverse. One trend is the rising cost of premiums. In the US, direct premiums for D&O insurance grew significantly in 2020 amid a near-historic level of demand, as companies continued to face elevated levels of litigation, according to S&P Global Market Intelligence. Direct premiums written for D&O commercial business lines increased 40.9 percent year-over-year industrywide in 2020, with written premiums increasing by 41.4 percent among the top 20 underwriters. According to Marsh, in the third quarter of 2020, D&O pricing for public companies rose more than 50 percent, with more than 90 percent of parties renewing with rate increases.

In addition to higher pricing, companies also face narrowing coverage, with underwriters no longer willing to provide some enhancements. “D&O markets have now been tightening for some time as insurers look to reduce their exposure to D&O liabilities by offering reduced levels of cover, and in many instances including renewal conditions such as the exclusion of any claims relating to a company’s insolvency,” says Mr Butler. “Businesses have therefore often needed to accept paying a higher cost for an equivalent level of insurance, or directors have been forced to accept an increased level of personal risk.”

As Mr Butler points out, the tightening of D&O markets over the past 18 months has led directors to focus increasingly on their own individual exposures. “When market capacity is scarce and premiums are rising it is understandable that directors’ first concern will often be their Side A protection; and that increased Side B retentions are seen as an acceptable price to pay for the maintenance of a favourable coverage limit,” he says.

The pandemic has certainly had a clear influence on these trends in the D&O insurance market. “COVID-19 has exacerbated what was already a hardening D&O liability insurance market,” confirms Mr Scarbrough. “Premiums have gone up, limits have tightened or gone down, retentions or deductibles have increased, and policy enhancements can be harder to obtain.

“While I am not aware of a trend of insurers adding COVID-19 or pandemic exclusions to D&O liability policies, companies and their insurance brokers should be vigilant about that issue and pay particular attention to any changes to bodily injury or property damage exclusions,” he continues. “The market eventually should soften as more insurers and capital become available to meet demand.”

In some cases, insurers are specifically addressing COVID-19 risks when underwriting. “We are now seeing carriers regularly require COVID-19 questionnaires as part of the application process, getting off certain classes of business, applying above-average premium increases, restricting policy terms, increasing policy retentions, limiting their overall appetite, and underwriting financials more aggressively,” notes Mr Bundschuh. “From a policy term perspective, we are seeing more insolvency and downsizing exclusions being applied, additional Side A limits attached to full D&O policies being reduced or removed, and in the private company context the scope of entity coverage being further reduced.”

Assessing coverage

In reaction to recent trends, some companies are changing the way they approach D&O insurance. “Companies in hard-to-place markets, such as the crypto or cannabis space, and those that are encountering large premium increases are either deciding to drop from full D&O coverage to Side A only, or they are reducing the limits on their entity or balance sheet protection, while increasing their Side A coverage,” says Mr Bundschuh.

“Another trend we have seen is more companies incorporating or increasing the Side A difference in condition (DIC) coverage within their D&O towers. Side A DIC policies provide myriad benefits and really act as a sort of D&O swiss army knife,” he adds.

For peace of mind, D&Os are encouraged to proactively seek the maximum protection possible, to carefully check coverage terms and exclusions and to engage expert advice.

© Financier Worldwide

BY

Richard Summerfield