The Business of Risk Part Two: The Social Value of D&O Insurance

There was a strong emphasis on corporate social responsibility in the United States between 1790 and 1860. Corporations were often required by their charters to perform duties that were deemed to be in the public interest, despite being unrelated to their business purpose. When New York City state chartered both Citibank and the Bank of America in 1812, for example, it required the former to pay $100,000 and the latter to pay $400,000 into the state’s common school fund.

Corporate charters are written documents establishing a company as a corporation and detailing its governance, structure, objective and operations. The first Bank of the United States (BUS) – Alexander Hamilton’s brainchild – had a particularly influential corporate charter which entitled shareholders to strictly limited liability. Limited liability was far from universal in corporate charters, however, with some charters specifying unlimited shareholder liability and others specifying unlimited liability for directors who exceeded corporate authority.

Limited liability gradually became the norm for corporations over the twentieth century. This encouraged the pooling of capital into large corporations that were able to achieve economies of scale which were impossible for sole proprietors. Shareholders now knew they could not lose more than the amount invested, even if the corporation failed with debts greater than its assets.

The Great Depression – triggered by the stock market crash of 1929 – was a turning point in the regulation of corporations. US Congress enacted two pieces of legislation in a bid to eliminate some of the causes of the Great Depression. The Securities Act of 1933 aimed to ensure that potential investors received relevant information concerning securities being offered for public sale, by prohibiting deceit, misrepresentation and fraud in the sale of securities. The Securities Exchange Act of 1934 aimed to regulate the sale of securities in the secondary market and enhanced protections for investors who believed they had been defrauded.

These new regulations had two key consequences. The first is that they placed significant obligations on directors and officers, who could now be held accountable in a court of law for failing to provide shareholders with timely and accurate information on their corporation’s performance. The second is that they created a more litigious environment where shareholders who felt they were misled about a corporation’s health could, and often did, sue either the directors and officer themselves, or the corporate entity.

The London insurance market introduced a new management liability product in the 1930s called directors and officer’s liability (D&O) insurance in response to the new regulatory risks imposed by The Securities Act (1933) and The Securities Exchange Act (1934). D&O insurance covers the cost of compensation claims made against a corporation’s directors and officers, or the corporate entity itself, for alleged “wrongful acts”.

Different types of D&O coverage emerged over the twentieth century following a series of landmark cases.

The first case was Dock Co. v. McCollum (1939). In this case, the New York Supreme Court ruled that the corporation could not reimburse its directors, even when they had successfully defended against shareholder derivative action. This sparked demand for ‘Side A’ coverage – this covers individual directors and officers for losses incurred when indemnification by the company is not available, such as when a company goes bankrupt.  

There was very little demand for D&O insurance prior to Dock Co. v. McCollum (1939). This ruling led several states to enact corporate indemnification statutes; up until this point, it was unclear whether corporations could legally pay the cost of an individual’s liability. In 1967, the State of Delaware passed new indemnification laws specifically authorizing corporations to purchase ‘Side B’ coverage – this covers a corporation’s obligation to indemnify its directors and officers.

These two types of D&O coverage – ‘Side A’ and ‘Side B’ – offered sufficient protections to corporations until another landmark case: Nordstrom v. Chubb (1990). In this case, Nordstrom (the plaintiff) alleged fraudulent concealment from investors of a companywide Nordstrom policy to have employees work ‘off the clock’. A settlement of $7.5 million was reached between the parties, and Chubb (the defendant) agreed that the settlement was reasonable. Chubb only agreed to pay half the settlement, however, because it contended that the uninsured corporate entity was partially responsible for the loss. This led to the introduction of ‘Side C’ coverage – this covers the corporate entity itself and not the individual directors and officers.

D&O insurance is an essential risk management mechanism for corporations in the present day. The American economic, Kenneth Arrow, describes how insurance “permits individuals to engage in risky activities which they would not otherwise undertake”. Without the protection that D&O insurance provides, corporations would not have been able to attract senior management professionals, let alone talented senior management professionals. In this sense, D&O insurance encourages entrepreneurialism and allows society to benefit from the innovation and increased production which large corporations provide.

Some industries have the potential to make a massive social contribution, despite being inherently more risky than other industries. The biotech industry is a good example of this. Biotech companies are a research science-driven endeavour that aims to develop a useful application based on a breakthrough discovery – they are almost always unprofitable. The biotech company Pfizer developed the first covid-19 vaccine, for example, which saved thousands of lives and helped society to recover from a global pandemic.

The biotech industry is inherently riskier than many other industries. This is because biotech companies are required to invest vast sums of capital into research and development before knowing whether their new products will pass clinical trials. For this reason, development stage biotech companies are frequent targets of securities class action litigation, and would therefore be unable to bring their product to market without the protection which D&O insurance provides. This is not because biotech companies have an unrealistic business model, or because their products are unsafe – in fact, most securities class action litigation brought against biotech companies result in complete dismissal. Rather, it is an inevitable consequence of operating in a high risk, high reward industry.

We are no longer living in the early nineteenth century, where limited liability was uncommon, and shareholders had little power to hold the senior management of corporations accountable for their actions. D&O insurance is an essential risk management mechanism for corporations in the twenty-first century, particularly those operating in high-risk industries like biotech.