Federal Reserve Warns of D&O Policy Exclusion Concerns

Financial Services Law

In a new letter to all financial institutions supervised by the Board of Governors of the Federal Reserve System, the Federal Reserve cautioned directors and officers about the potential limitations of director and officer (D&O) liability insurance policies.

What happened

D&O policies often features exclusionary provisions that potentially limit coverage and can leave parties personally liable. For example under the Federal Deposit Insurance Corporation’s (FDIC) regulations, a covered financial institution’s D&O liability insurance policies must exclude from coverage a prohibited indemnification payment, the Federal Reserve explained in SR 19-12.

In a regulatory letter, the Federal Reserve is encouraging bank board members and executive officers to review their policies so they won’t be caught unaware of insurance gaps. Among the questions to ask: “What protections do I want from my institution’s D&O policy? What exclusions exist in my institution’s D&O policy? Are any of the exclusions new and, if so, how do they change my coverage? What is my potential personal financial exposure arising from each policy exclusion?”

D&O exclusionary provisions can relate to, among other items, actions initiated by regulators or arising out of regulatory developments as well as civil monetary penalties. In addition, directors and officers must remember that the limits available in any D&O policy are typically shared among all directors and officers, and one claim can effectively “drain the pot” from each affected individual. Accordingly, lawsuits or other claims for coverage must be reviewed individually and in the aggregate to determine whether coverage is adequate for the inherent risks of serving as a director or officer, subject to the overall limitations federal banking regulators impose generally on the scope of D&O coverage.

Although the Federal Reserve does not provide much substantive detail in its regulatory letter, which was addressed to the officer in charge of supervision at each Federal Reserve Bank, directors and officers should remember that it is incumbent on each of them to ensure that their D&O policy is actively reviewed prior to renewal, when you are still able to identify unfavorable provisions (whether new or old) and negotiate for better coverage.

Recently, however, insurers have increased the exclusions in such policies, precluding coverage on “a wide range of other types of director and officer liabilities,” according to the letter. “When such exclusions apply, directors and officers may not have insurance coverage and may be personally liable for damages arising out of civil suits relating to their decisions and actions.”

In some cases, directors and officers may not be fully aware of the addition or the significance of the exclusionary language, the Federal Reserve added. The exclusionary terms may also adversely affect the recruitment and retention of well-qualified individuals.

The choice about D&O coverage should be based on a well-informed analysis of costs and benefits, including the potential effect on directors and officers that could result from exclusions. To help directors and officers through the process, the Federal Reserve urged board members and executive officers to understand the answers to certain questions about the coverage provided by a D&O policy when considering renewals and amendments.

As many directors and officers are also aware, the high uptick in claims challenging the action of directors and officers in the context of a negotiated merger transaction can lead to unexpected cost and stress in an exit scenario. Accordingly, the scope and breadth of D&O coverage should be closely reviewed prior to adopting any change-in-control strategy, as insufficient or inadequate coverage could be negatively viewed by a potential acquirer and impact the value an acquirer is willing to offer to a target institution. In addition, since virtually every insurance policy will allow a target to extend (customarily for up to six years) the “tail” on its own D&O policy in effect prior to acquisition, negotiating a strong policy prior to a change in control will benefit directors and officers long after they cease their service.

To read the Federal Reserve’s letter, click here.

Why it matters

Directors and officers are now on notice to pay careful attention to the bank’s insurance coverage.

D&O policies are an important risk mitigation tool for financial institutions, and it is vital for members of the board of directors and senior executives to understand fully the protections and limitations provided by such policies. To that end, directors and officers should understand their institution’s policy, particularly any exclusionary provisions that might limit coverage and leave individuals on the hook for damages arising out of civil suits. D&O policies are complex and not typically written for a layperson’s understanding. Engaging an outside advisor and broker who fully understands the scope and limitations of D&O policies and can effectively advocate on an institution’s behalf is a cost well-justified. Once a policy is written, it is too late to go back to the insurer to renegotiate more favorable terms. Directors and officers must remember that they have the most leverage at the time of renewal.