The result has been that D&O insurers not only have been doubling and even tripling premiums to help offset anticipated hits to their own earnings from policies they have underwritten, they are backing off providing the kind of coverage that was standard in the 1990s–sometimes, it would seem to Elson and other directors, retroactively. "Insurance policies are written from the insurance company perspective," jibes Mark Miller, a partner in the Washington, D.C., law firm Greenberg Traurig LLP, which represents several directors and officers seeking reimbursement of legal costs from their D&O insurers. "D&O policies purport to provide coverage for fraud litigation and yet they are trying to exclude all claims in which the company or its directors and officers are actually accused of committing fraud." In essence, the lawyer says, insurers end up collecting premiums and providing no coverage. "It's a great way to sell an insurance policy."

Miller is quick to add that not all insurers or D&O insurance policies fall into this category. But he cites the recent decisions by two D&O insurers–Royal Insurance Co. of America and The St. Paul Cos.–to rescind $50 million in coverage to directors and officers of bankrupt Enron Corp. as a stark example of how carriers are pulling the rug out from under boards. The insurers' reasoning was simple: Enron's board materially misrepresented the company during the underwriting process by submitting financial statements that later had to be restated. So does that mean that D&O coverage can be withdrawn from the boards of any of the 990 companies that have been forced to restate earnings since 1997? What happened, Miller wonders, to the concept of innocent until proven guilty?

Rescinding Coverage

While Royal Insurance and St. Paul rescinded their share of Enron's D&O insurance program, there was still $300 million in coverage provided by other insurers. That would probably have been sufficient–that is, until the judge in the bankruptcy court proceedings froze the insurance policy. Why? The policy covered more than just the directors and officers; it also covered the corporation itself. The judge perceived the insurance as an asset that should be preserved for the benefit of shareholders, who cumulatively lost some $25 billion with the collapse of the company.

The Enron example is not an isolated one. In October, three insurers filed to rescind $50 million in D&O insurance they had underwritten for bankrupt Adelphia Communications Corp., charging that the company's founder, John J. Rigas, and other corporate officers had provided false financial statements when applying for insurance.

It is a rather interesting conundrum. An analogy would be life insurance: If a person lies about being a smoker when applying for a $1 million policy and then dies from lung cancer, does the insurer have to pay the beneficiary? St. Paul and Royal say no. What about the Enron board members who claim that they were unaware of management's wrongdoings–though the board did approve the existence of the blind trusts at the root of Enron's legal problems? Certainly, someone with power at Enron crafted the concept of offloading debt and ultimately understating it in financials. Should insurers or shareholders be forced to pay their legal fees, too?

While Miller's indignation is profound, it is not disconnected from the potential fees over which law firms that defend directors and officers, such as his, are now salivating. The millions and even billions may not be there without the deep pockets of insurance companies.

So what's the answer? Ultimately, the judge in the Enron case released some of the funds to the poor, benighted directors and officers. But the reality that a D&O policy can be rescinded by its insurers or squirreled away to pay shareholder claims hit boardrooms across the United States like a ton of bricks. Before this, "a lot of board directors never even looked at their D&O insurance policies," says B. Kenneth West, a board director at both Motorola Inc. and the Pepper Cos. and chairman of the National Association of Corporate Directors. "Most didn't have a clue that the insurance also covered their companies in addition to them. They had no idea that if their company went tapioca, there might be nothing in the insurance limits left for them."

National Union Fire Insurance Co., part of giant insurer American International Group Inc., addressed the concern head on in September: It began offering three new "sleep-easy" policies that no longer provide the same entity coverage–that is, insurance that protected corporations, and that means ultimately shareholders, against losses from securities and shareholder suits. All three of AIG's new D&O policies are designed to "strengthen the insurance options available to individual directors and officers," says Greg Flood, executive vice president and chief operating officer at insurer National Union in New York. Chubb & Son and other major D&O insurers have followed suit with newer policies, many of which now demand skin in the game for directors and officers–co-insurance elements requiring they pay a percentage of legal fees.

Still, insurers face a real dilemma and a potential financial sinkhole of claims to be paid, given recent revelations. Premiums already reflect the industry's panic: In an era of rising premiums in all lines of insurance, D&O leads the lot–and that's saying something a year after a terrorist attack that killed thousands and destroyed billions of dollars of property.

Becoming the Fraud Detectives

Not enough, carriers claim. "We find ourselves in the difficult position of trying to determine if fraud exists and, if so, how to respond," says Tony Galban, vice president and D&O underwriting manager at Simsbury, Conn.-based insurer Chubb Specialty.

"What determines fraud from an interpretative standpoint can vary," Galban argues. "Some insurers will cover you until fraud is proven, though most fraud cases are settled before adjudication. Others believe the very fact that financials have been restated is a reflection of fraud, a contrivance designed to mislead insurers during the underwriting process. Some insurers give the benefit of the doubt, others look for a way out."

But the price tag for looking the other way is getting steep, given the record $3.5 billion settlement in 1998 stemming from shareholder suits against Cendant Corp. There are few who doubt that record will be broken sometime in the near future by one of the many pending cases against other companies that released faulty financial information to investors.

Not surprisingly, Jack Flug, a managing director at insurance broker Marsh Inc. in New York, predicts continued rate hikes through 2003. "D&O insurers have been paying out enormous sums of money in claim costs and, even though they've raised rates, they're still not at breakeven," he maintains.

Attorney Miller, who is representing several policyholders in lawsuits against D&O insurers, advises caution. "The thing about D&O policies is that they're not standard forms like CGL [comprehensive general liability] policies," he explains. "Each policy has different wording and, thus, different interpretative challenges. It sounds self-serving, but I wouldn't rely on an insurance broker to tell you what's covered and isn't. I'd call an attorney."

His other golden piece of advice: "Brokers and insurers will tell you to attach financial statements to the D&O policy application. Refuse. If you provide the statements and they turn out wrong, the insurer will say it was duped and deny coverage. If the insurer insists, then attach the statements with a written qualifier saying you played no role in compiling them and cannot verify from your own personal knowledge that they are accurate."

But that precaution seems moot. Given the recent adoption of the Sarbanes-Oxley Act, which requires mandatory CEO and CFO certification of financial statements, it is going to be difficult for any officer to deny knowledge. And in the current heightened corporate governance environment, directors–those who still choose to serve, that is–are going to find that claiming ignorance is not going to fly for them either.

"If I were a director," says National Union's Flood, "I'd be nervous."