The burden of power: D&O liability in a crisis

August 2020  |  COVER STORY  |  BOARDROOM INTELLIGENCE

Financier Worldwide Magazine

August 2020 Issue

Difficult decisions are the privilege of rank; accountability for their outcome equally so. At the director and officer (D&O) level of a company, this is generally a given, although the trick is to balance liability equitably. In an era of coronavirus (COVID-19), discernment is even more challenging.

Prior to the pandemic, the range of exposures facing D&Os – as well as resultant claims scenarios – had increased significantly to include, among other things, bribery, corruption and fraud, competition and antitrust matters, environmental law, health and safety, tax, international sanctions, money laundering, financial reporting and data protection. If found guilty of transgression, D&Os may face fines, even imprisonment.

And now, with COVID-19 wreaking havoc across the globe and throughout virtually all sectors and industries, the obligations of D&Os are front and centre. In the view of Cain Jackson, a partner at Wotton Kearney, COVID-19 has impacted D&Os by: (i) heightening the risks associated with the financial management of a corporation and associated decision making; (ii) bringing D&O responsibilities in terms of workplace health and safety sharply into focus, with a litany of issues, which would have been difficult to envisage prior to COVID-19 now having to be addressed by boards; (iii) increasing the exposure associated with profit guidance and forward-looking statements for D&Os of listed entities; and (iv) testing the extent to which D&O policies provide cover for claims arising out of corporate insolvency.

“The economic damage which has resulted from COVID-19 will inevitably lead to an increasing number of businesses of all sizes experiencing financial distress,” says Dan Butler, a senior associate at Freshfields Bruckhaus Deringer LLP. “In a distressed scenario, D&Os will need to consider – and take regular advice on – whether the actions they are contemplating expose them to the risk of action by or on behalf of the company’s stakeholders.”

Furthermore, in the view of James Whitaker, a partner at Mayer Brown International LLP, D&Os need to balance their business’ survival in extraordinary economic and social circumstances with their wider duties to a range of stakeholders. “As the full effects of COVID-19 emerge – particularly, but not exclusively, if insolvency becomes an issue – it is likely that decisions taken by D&Os will be scrutinised extremely closely by regulators, shareholders, creditors, employees and others,” he asserts. “It should also be remembered that, even pre-COVID-19, the trend of enhanced scrutiny of, and accountability and exposure in respect of, D&O decisions had markedly increased.”

Moreover, many of the decisions taken in the current climate may well have been arrived at in haste, driven, in some cases, by a pressing need to safeguard a company’s very existence. “Taking decisions in a higher risk environment – and often in short order – has the potential to introduce a higher risk of claims by those disgruntled by their effects and so increase the likelihood of a claim against D&Os,” says Catherine Derrig, a partner at McCann FitzGerald. “In terms of the key risks of the crisis for D&Os to manage, these include corporate financing issues, maintaining key relationships with suppliers and customers and managing their workforce.”

Clearly, COVID-19 has changed the paradigm for D&Os – with broader exposures, an unprecedented level of personal accountability and more expensive and limited coverage. “D&O insurance buyers were already facing significant price increases, narrowed terms and conditions, and even capacity constriction,” notes Kevin M. LaCroix, executive vice president at RT Proexec. “The pandemic has exacerbated all of these conditions. Now, buyers face a restricted marketplace.”

Exposures and claims

Although D&O exposures had already increased significantly in recent years, COVID-19 has amplified them, with decisions and actions now facing heightened scrutiny and potentially leading to potential claims of misrepresentation or negligent misstatement. For D&Os operating in a COVID-19 environment, maintaining vigilance is key.

“It is important that robust decision-making processes are in place and that legal and regulatory obligations are fulfilled, as they would be in the normal course,” asserts Katie Ryan, an associate at McCann FitzGerald. “The usual corporate governance rules apply during this crisis, and companies should continue to consider their corporate reporting timetables and plan accordingly.”

However, despite such safeguards, communication breakdowns within a company or a failure to address business as usual activity have the potential to result in claims. In ‘COVID-19: The Importance of D&O Insurance in a Crisis’, McCann Fitzgerald suggests that D&Os need to be particularly aware of shareholder and investor claims, breach of contract claims, regulatory enforcement and investigations, cyber and data protection risks, insolvency claims, and health and safety claims.

Of these, shareholder claims will be a key exposure for D&Os in the months ahead, according to Mr Whitaker. “Ahead is the prospect of shareholder claims – whether brought directly or on a derivative basis – as a result of precipitous stock drops caused by ‘bad news’ events linked to COVID-19,” he attests. “In the context of public companies, great care should be taken with regard to any public statement regarding, for example, a company’s preparedness for, or response to, COVID-19, as a number of securities class actions have already shown.”

Driving these actions are claims that investors were misled by statements defendants’ companies have made. “In most instances, these lawsuits have been about the companies’ response to or position to take advantage of the coronavirus outbreak,” explains Mr LaCroix. “There undoubtedly will be further disclosure-related claims as companies make statements about their ability to weather the pandemic, reopen their business, continue operations, access their supply chain and fund continuing operations.

“There will also be mismanagement claims or claims alleging breach of the duty of oversight, as companies seek to resume operations in a changed business environment,” he continues. “The key is that companies continue to alert investors to risks and uncertainties. The temptation for many companies as they reopen may be to project optimism and confidence. However, they should be cautious to temper enthusiasm with clear signals about operational and financial challenges.”

D&O insurance

Given the colossal impact the COVD-19 pandemic is having on companies’ financial position, it is advisable that D&Os are aware of the breadth of the insurance cover they have in place, as well as its limitations.

“D&O insurance is particularly important in a time of crisis when there is an intensity to challenging decision making,” affirms Ms Derrig. “Taking the time now to assess the cover available should give D&Os comfort, security and confidence in their next steps. It will also arm them with the information they need to be able to assess the coverage available for any potential exposures.”

D&Os, of course, need to take all necessary steps to satisfy themselves as to the extent of their insurance coverage, including the policy’s duration, the limits of indemnity, as well as any exclusions. “It has rarely been as important as it is in the current environment for D&Os to have a clear understanding both of the extent to which their organisation can, and will, indemnify them in respect of personal liabilities – including the costs of defending claims – and of the extent of the D&O insurance cover in place,” believes Mr Whitaker. “Being adequately insured, and ensuring that the insurance policy’s requirements are followed in the event of a claim, is absolutely critical.”

D&Os are also well-advised to have recourse to the expertise of high-risk insurance specialists. “D&Os should speak to their risk manager or broker if they are concerned about cover for particular kinds of claims,” advises Mr Butler. “For example, if a company is considering an issue of debt securities or planning a major transaction, this may require an extension to cover which would need to be negotiated with insurers. In the current climate, any such mid-year adjustments to policy terms are likely to be expensive, so D&Os will want to analyse the position carefully before proceeding.”

For many D&Os, particularly those that have previously been somewhat lax as to the extent of their individual downside protection, the stark reality is that COVID-19 has been a wakeup call – a scenario demanding constant review.

“Given the disruption in the marketplace, insurance buyers are going to have to reset their expectations about the insurance placement process and about available terms and conditions and available pricing,” suggest Mr LaCroix. “From a process standpoint, companies need to understand that their upcoming renewal process is going to be very different than what they may have experienced in the past.

“It is going to be more time-consuming, labour-intensive and unpredictable,” he continues. “Similarly, insurance buyers that have set expectations about what the insurance may cost and on what terms and conditions are going to have to reset their expectations as well. The likelihood for most companies is that the cost of their D&O insurance is about to become much higher than in the past, even compared to the increased prices companies may have paid at their 2019 renewals.”

Residual impact

As the COVID-19 pandemic presumably fades in intensity and passes from the scene over the coming months, the residual impact on D&O liability is likely to continue for much longer – another ‘new normal’ to add to a rapidly growing list. Indeed, in the view of many practitioners, the D&O insurance market will be volatile for the foreseeable future.

“It will be a hard market for D&O insurance at least into 2021, and possibly longer,” says Mr LaCroix. “That means that D&O insurance is going to be more expensive than it has been in the past, and terms and conditions are going to be constrained. Unfortunately, all of this is happening at a time when many companies may need their D&O insurance now more than ever.

“Of course, this is the reason the carriers are pulling back – they are all well aware that in the months ahead there could be significant demands on many companies’ D&O insurance programmes,” he continues. “The long-term impacts on the industry will depend on how gradual the upcoming reopening process is and how long it takes for the economy to come back. If the economy shows signs of a return to normalcy, then the current distressed period could be of shorter duration. But if the economic constriction continues, the constrains on the D&O insurance marketplace could continue for some time to come.”

Also expecting to see an increase in D&O liability over the coming months is Mr Whitaker. “As the pandemic hopefully reduces in intensity, decisions and actions taken in the ‘fog of war’ will be scrutinised with hindsight,” he opines. “New, or heightened, exposures are likely to emerge, in areas such as, for example, how D&Os responded to the pandemic, how they dealt with employment, supply chain, cashflow and creditors, as well as business continuity issues. And in consumer-facing industries in particular, whether there was any suggestion of anti-competitive behaviour, profiteering, price-gouging or the like. The effects of these trends are likely to be felt for some time into the future.”

Others, however, think it remains difficult to call whether there will be a rise in COVID-19 related claims. “Looking ahead, it remains unclear whether there will be a significant number of claims against D&Os,” says Ms Derrig. “However, a substantial increase in such claims may have the result of rising D&O insurance premiums. It may also prompt insurers to look for more detailed information when providing D&O liability cover, in particular to ensure adequate risk controls are in place. This is also true for policy renewals, and parties should pay close attention to renewal terms.”

As the COVID-19 narrative unfolds over the coming months – presumably heading in the direction of a significant diminishment of the pandemic – its full impact on D&Os will become clearer. However, with global economies reeling and financial markets in turmoil, the likelihood is that D&O claims and legal action will escalate, forcing those in the firing line to confront the reality of ultimate exposure.

© Financier Worldwide

BY

Fraser Tennant