We highly recommend that directors and officers, particularly volunteers, demand that their organizations purchase directors’ and officers’ liability insurance to protect them in the event they are sued in their capacity as officers and directors. We have previously noted that as a practical matter, the likelihood that a monetary judgment will be rendered against a volunteer director or officer is fairly remote, particularly if the volunteer is in the slightest bit attentive. This is particularly true given many state liability shield statutes and the federal Volunteer Protection Act (which will not limit direct actions by the nonprofit or the state’s attorney general). However, there is still the cost of defending a lawsuit. This is where D & O insurance is worthwhile, particularly when combined with employment practices coverage.
When reviewing a D & O policy, we have always believed...
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that the insured directors and officers must read the coverage, definition, and exclusions portion of the policy carefully, recognizing that the interaction of these three discrete sections of the policy determines the overall scope of coverage. As it turns out, at least based on a recent case decided by the California Court of Appeals, even more careful review is warranted. See Medill v. Westport Insurance Corporation, 142 Cal. App. 819 (2006).
In this case, the plaintiffs were former directors and officers of a nonprofit corporation who were sued for negligence and breach of fiduciary duties. The suits arose following a default on the nonprofit’s (and related parties’) default under several municipal bonds. The insurer refused to defend the insureds, arguing that the policy excluded losses arising from violations of federal or state securities laws. The definitions portion of the policy defined a loss so as to specifically exclude losses arising from breach of contract.
The insurance company prevailed, with the court denying coverage. The directors and officers argued that the lawsuit against them was based in part on an alleged breach of fiduciary duty. However, the court ruled that this was a legal theory wholly dependent on an underlying breach of contract (failure to make payment under the bonds). Without the underlying breach of contract, there would be no claim for breach of contract. Therefore, if the insurance contract excluded breaches of contract from coverage through its definitions provision, the insurance company had no obligation just because one of the theories for recovery was breach of fiduciary duty, a derivative claim. In other words, the court analyzed the conduct underlying the lawsuit against the directors and officers rather than the legal theories attached to the conduct.
This may appear to be a harsh result. However, the lesson is clear. Anytime an organization is engaged in specialized activity, it should discuss that activity with its insurance company to make sure it has the necessary specialized coverage. Typically, insurance contracts exclude losses arising from securities litigation, requiring special policies or endorsements.
What we found particularly interesting about this decision was how the court allocated the burdens of proof with respect to the policy’s component parts. As noted earlier, we have always viewed the component parts of the policy as defining the actual scope of coverage. In other words, it is not sufficient to just read the actual coverage or loss clause of the policy. It is also necessary to read the exclusions and definitions. Our view still is correct, but the burdens of proof may cause the prospective insured to focus on a little closer on each set of provisions. The appeals court indicated that the insured must first consider the scope of coverage before examining the exclusions. Here the court notes that the burden is first on the insured (the directors and officers) to establish coverage under the coverage clause of the contract. If the insured establishes basic coverage is available under the coverage clause (taking into the definitions), then the insurance company can raise the exclusions. At this point, the burden shifts to the insurance company to demonstrate that an exclusion is applicable. The court noted that the insurance company’s burden is a heavy one because the exclusions are to be narrowly construed.
As a consequence of these rules of construction, the insured wants the broadest coverage (definition of loss) that is can negotiate. More importantly, if the insured anticipates the possibility of certain types of losses, it should ask whether those reaons for loss are covered and get the answer in writing.
All of this focuses on California law. While we cannot for sure, we would be surprised if the law differed in other jurisdictions. However, as is always the case, the law in the applicable jurisdiction must be reviewed before reaching any conclusions.
We thank Attorney Michael Peregrine of McDermott Will & Emory LLP for bringing this case to our attention.
Internal Revenue Service - Circular 230 Disclosure: As provided for in
Treasury regulations, any advice (but none is intended) relating to
federal taxes that is contained in this communication is not intended
or written to be used, and cannot be used, for the purpose of (1)
avoiding penalties under the Internal Revenue Code or (2) promoting,
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addressed herein.
THE FOREGOING IS NOT AND SHOULD NOT BE TAKEN AS LEGAL ADVICE. IF LEGAL ADVICE IS REQUIRED, THE NON-PROFIT OR OTHER PARTY IN QUESTION SHOULD SEEK THE ADVICE OF QUALIFIED LEGAL COUNSEL. If you liked this post, please visit http://www.charitygovernance.com for a description of our training and consulting services. You will also want to acquire a copy of Jack Siegel's book, A Desktop Guide for Nonprofit Directors, Officers, and Advisors: Avoiding Trouble While Doing Good."
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