Well, here we are again with an update on the current state of the D&O market (and its related coverages - General Partners Liability, Errors & Omissions Liability, Fiduciary Liability and Employment Practices Liability) for 2005. With most of the pervasive fraud associated with Enron, Kmart, Global Crossing, WorldCom, Xerox, Tyco, Adelphia and others behind us, we have continued to see a softening of the market throughout 2005.

We commented in 2004 that the consensus among industry executives was that the typical length of time for softening of the market would not be normal and that the softening would not last throughout 2005 and more than likely not into 2006. Well, it appears that the majority of the industry executives were wrong. Most carriers were no doubt hopeful that the days of double-digit rate increases and contractions in policy terms and conditions would reappear almost as quickly as they disappeared. But, it was wishful thinking on their part as we are nowhere near those conditions, even though there continues to be staggering securities class action settlement amounts unveiled on a fairly regular basis. And, for the first time since the Private Securities Litigation Reform Act of 1995, there are now multiple cases going to trial, and the news on that front is not good either.

In fact, this year, six securities class actions have gone to trial, out of a total of nine such trials involving alleged misconduct after the law took effect a decade ago. This is out of roughly 1,733 federal securities class actions filed between 1996 and 2004, according to Cornerstone Research in Menlo Park, CA. Total settlements have skyrocketed from $145M in 1997 (in 2004 dollars) to $5.5B in 2004. This year settlement totals are expected to easily eclipse 2004’s numbers, with $7.1B in tentative settlements already reached.

Sample of Securities Class Action Settlements ($100M or >) announced in 2005:

So, how in the world is the D&O market continuing to soften throughout 2005 when claim dollars are flying out the windows of insurance companies across the globe? It’s a difficult question to answer. In fact, the answer that most buyers would probably give is “who cares?” Well, at least those of you who are not deploying fund capital into D&O insurance company investments!

In 2004, we commented on an “intoxicated” market that was driving the softening market by many accounts and that there was a strong argument that the softening market period would likely disappear in 2005. Similar to most cyclical markets, pricing is the first sign that a market is starting to turn and we are seeing no such sign of prices changing for the worse. In fact, while it is difficult to generalize percentage decreases for D&O coverage, many insured’s have seen double digit rate decreases throughout 2005. Expanded capacity continues to drive underwriters to compete, but how much longer can those conditions last for viable carriers? There is no longer a lull in the number of large D&O securities claims settlements over the past year as was the case in 2004. In fact, it’s the opposite. The complex claims that have been in the litigation pipeline for several years are being settled and sometimes tried. So, the “intoxicated” market now appears to be “insert your favorite word for overly inebriated here!”

At a recent D&O symposium sponsored by AIG, a panel of leading plaintiffs’ and defense attorneys discussed key trends and cases over the past year that are affecting directors and officers. A sample of those trends is provided below:

• The incredibly hostile D&O environment has further intensified. Cases are taking longer to settle, even larger settlements are on the horizon, and there are a huge number of cases from 2000 through 2002 still making their way through the system.
• The rise of the institutional investor continues to drive the plaintiff side. Since the introduction of the PSLRA, plaintiffs have changed from typically being small investors who are inexperienced in the prosecution of complex litigation to institutional investors who are both experienced in managing litigation and are sophisticated investors looking to maximize the recovery of their losses.
• Directors and officers are at greater personal risk than ever before. Where big frauds have been perpetrated, institutional investors often want directors and officers to be personally accountable for part of the settlement, sending a message to other directors and officers about sound corporate governance.
• In this environment, the amount and type of insurance coverage is more critical than ever. To provide adequate protection both for the company and directors’ personal assets, companies must revisit their coverage to make sure it is up to current standards based on the ever evolving marketplace.
  

Equity Risk Partners continues to conduct the following for existing clients to help alleviate costs and ensure broad program terms and conditions in any market, soft or hard. While we have little control over the uncertainty of the marketplace, Equity Risk Partners does differentiate itself from the competition in many ways by educating the marketplace about individual risks specific to our clients. The following continue to be examples of how we “go the extra mile” with our clients and prospects:

1. Market account to appropriate underwriters without saturating the marketplace. Since we are in the marketplace everyday for our private equity clients and their portfolio companies, we know which carriers will be interested in a particular risk. Whether it be a General Partnership Liability placement for a Private Equity firm, a Directors & Officers Liability placement for a publicly traded portfolio company, a stand alone Employment Practices Liability placement for a large portfolio company or a Professional Liability (E&O) placement for a financial services related company, the appropriate carriers will be approached on your behalf given the current dynamic insurance market that we are living in.
2. Build and maintain an ongoing relationship with the carrier after the initial placement of coverage. It is extremely beneficial to establish and maintain a relationship with a recommended insurance carrier over the long-term. We do not believe in insurance buying decisions based solely on price. Paying a premium to the same highly rated, well-established carrier year after year will do wonders when it comes to negotiating and settling a claim as opposed to moving your insurance business to several different carriers year after year for minimal premium savings. Obviously, if the market dictates a better program at compelling premium savings with similar or broader coverage terms, we have and will continue to recommend carrier changes. But, if your existing broker is doing their job and has strong well-established relationships with the key insurance players, changing carriers on a regular basis will not occur.
3. Get senior management/deal partners involved directly in the marketing process. D&O underwriters love to rub shoulders with key executives and hear the story “straight from the horse’s mouth.” Whenever possible, whether it be a renewal or new placement, we have key individuals involved in conference calls and face-to-face meetings with carriers. This allows the underwriters to ask questions and get answers to key underwriting issues, helps alleviate concerns with respect to these questions and gives the underwriter’s direct access to senior management/deal partners who are dedicating valuable and precious time to the underwriting community. This process goes a long way in our negotiations with carriers on your behalf and ultimately benefiting you with an enhanced product.
4. Manage the timeline appropriately. Underwriters are constantly inundated with new business and renewal submissions from brokers. Requesting initial underwriting information from you should be done no more than 120 days from the renewal date. A full submission should be sent to the marketplace no more than 75 days and no less than 45 days from the renewal date. Sending a submission more than 75 days out will ensure that it gets put at the bottom of the pile in never-never land. Garnering the underwriters’ attention at the appropriate time is vital to a successful timeline.
5. Submit full and appropriate information. A full submission done right the first time is always appreciated by insurers. Sending information piece meal to underwriters will cause problems and headaches with the negotiating process and will help ensure a last minute renewal. A full GPL submission would include the following:
• Completed GPL application
• Annual and most recent financial statements for each fund
• Most recent quarterly report to LP’s for each fund
• Partnership agreement for each fund
• Offering memorandum for each fund
• Purchase/Sale agreement for each portfolio company
• Description of operations for each portfolio company
• Employee count by state for each portfolio company
• Listing of all previous and pending litigation
6. Negotiate, negotiate, and negotiate some more. Ask, and often times, you shall receive. If you don’t ask the question, you will never know the answer. Equity Risk Partners consists of a group of dedicated insurance professionals that tailor to the Private Equity Community and its portfolio companies. What you see is what you get. We don’t have a separate “marketing” team that loses/distorts information in the transmittal process. We are dedicated to providing the best insurance brokerage/due diligence service available while maintaining the highest level of professionalism and ethical standards as possible. We don’t measure ourselves based on the standards of our competition; rather we try to live up to and exceed the standards of our clients.

Current Hot-Button Issues for Directors & Officers/General Partners Liability Insurance:

1. Severability of the Application. Most directors and officers never see the D&O insurance policy application, but it can act in a manner more potent than any policy provision or exclusion. If an application is filled out incorrectly, even if the mistake was innocent, an insurance carrier may seek to rescind the policy, defeating coverage for all officers and directors. The impact of rescission is quite severe. If a policy has been rescinded, it no longer legally exists, and, as such, cannot provide coverage to any directors or officers seeking coverage under the policy. One way to address this issue is with express language outlining that fraud or inaccuracies in the application cannot be imputed to innocent directors and officers who had no knowledge of the erroneous or untrue facts contained therein.
2. Non-Rescindable Coverage. Appropriate application severability language does not, however, always offer the desired level of protection. Even with proper severability language, an insurer may withhold coverage while it investigates the knowledge of each specific director and officer. Similarly, adequate severability language may not minimize the chance of an insurance carrier filing a lawsuit against the directors and officers seeking a judicial determination that sufficient knowledge was known to justify rescission. One way to further minimize rescission risks is to place non-rescindable coverage which is obtainable for many insured’s in the current market.
3. Duty to Advance Defense Costs. Another common problem with defense coverage contained in some D&O insurance policies is that it does not specify when an insurance carrier must reimburse the directors and officers for defense costs incurred. Without such a provision, directors or officers may have to wait until the end of the underlying lawsuit for their insurance carrier to reimburse them for any of the defense costs previously incurred. This could cause the director or officer to have to pay for their own defense costs with the hope that their insurer will eventually reimburse them for all of the costs incurred. A better practice is to negotiate coverage that requires reimbursement within a specific number of days.
4. Conduct Exclusion Language. D&O policies commonly contain exclusions for criminal conduct, fraud, and illegal profit or advantage taken by the directors or officers. These exclusions can often be narrowed. The best way to narrow the scope is to require “final adjudication” language, which should obligate an insurance carrier to reimburse defense costs until a judicial decree in the underlying lawsuit establishes wrongful excluded conduct. Additionally, some insurers have been willing to narrow the fraud exclusion by inserting the word “deliberate” in front of the word fraud, which may provide broader coverage in the area of securities fraud litigation, which by its nature, alleges some level of fraud.
5. Severability of Conduct Exclusions. Another issue that arises with conduct exclusions is how the exclusions apply to innocent directors and officers. For example, if one officer is convicted of a crime, or is guilty of self-dealing, an insurance carrier could argue that coverage is defeated for all officers and directors covered under the policy, regardless of their own personal conduct. To prevent this scenario, conduct exclusions should contain appropriate severability language stating that conduct of any officer or director will not be imputed to any other officer or director. There are many different versions of severability language in the marketplace, even within one insurance carrier. It is important to review most, if not all, versions of the available language in order to determine which language makes you and your counsel feel the most protected.
6. Bankruptcy and the Insured vs. Insured Exclusion. No single D&O exclusion has generated more case law to date than the so-called Insured vs. Insured exclusion. The reasons for the exclusions are based on two common concepts: first, there should be no coverage where an insured sues itself, and second, D&O insurance should not insure the financial results of a company. Common Insured vs. Insured language, however, may do more than protect against these two perceived infringements. It may bar coverage for lawsuits brought by trustees and creditors in bankruptcy. The right to coverage for a lawsuit brought by a trustee in bankruptcy against a director or officer may depend on whether the policy states that coverage is barred for any claim “brought by or on behalf of an Insured Organization” or just for any claim “brought by an Insured Organization.” Where possible, insured’s should not agree to the “or on behalf of” language. Another option is to seek language that specifically accepts trustee claims from the exclusion, or that expressly covers such claims so long as they are brought independently and without the help of the Insured Organization.
7. Side A-Only Excess Insurance Drop-Down. Directors and officers considering the purchase Side A-only coverage should also recognize that not all side A-only coverage is alike. Two general types of Side-A excess coverage exist: standard follow-form excess Side A coverage, and excess umbrella Side-A coverage, sometimes called Difference in Condition (“DIC”) coverage. Under the former type of Side A coverage, if the primary policy contains problematic language related to severability of the application, severability of the exclusions, or adverse exclusions, the excess follow-form Side A-only policies may not drop-down and pick up coverage when the primary policies have failed. Excess umbrella Side A-only DIC coverage, in contrast, is designed to be broader than primary coverage, and should “drop-down” and function as primary insurance in situations where the primary carrier has canceled or rescinded coverage, or where the corporation has refused to indemnify the director or officer in question.
8. Warranties. Like the D&O insurance application, most directors and officers never see warranties executed by the company as part of the D&O insurance procurement process. However, these warranties, which are commonly used in D&O insurance underwriting, especially where limits have been increased, have been upheld by some courts as a way for insurance carriers to defeat coverage. For this reason, warranties should not be signed until they have been thoroughly evaluated for impact on coverage.

The important conclusion to draw from the issues listed above is that D&O insurance remains a complex coverage that requires consultation, analysis and review. D&O insurance for private equity firms and their portfolio companies requires a unique blend of deal comprehension and insurance expertise.

We look forward to the opportunity to be of service to private equity firms and their portfolio companies. Please feel free to contact Ben Gibb at (415) 874-7108 or bgibb@equityrisk.com, for further information, questions or comments. We appreciate your consideration and support.