A business trap: the “carve back” for employee shareholder claims Featured

2:44pm EDT April 1, 2011
A business trap: the “carve back” for employee shareholder claims

You are an emerging privately held company originally funded by venture capital. You have compensated your valued employees with stock options. For various reasons, certain employees decide to leave your company to work for competitors or are let go. Now, these former employees holding stock options in your company decide to make a claim against you and the rest of management alleging the value of their stock interests have been diluted by your subsequent capital funding.

Whether they have a valid claim or not, are you covered for the millions of dollars it may cost you to defend the litigation? The answer depends on whether you hold the right type of directors’ and officers’ (D&O) coverage.

Smart Business spoke to Jonathan Sokol, a partner with Greenberg Glusker Fields Claman & Machtinger LLP, about how business can ensure they have the D&O coverage that’s right for them.

Shareholder suits typically represent the majority of claims brought against directors and officers of a corporation. D&O insurance, unlike other lines of insurance, is not sold on a common policy form used by the insurance industry as a whole. Each insurance company has developed its own set of forms. Because D&O insurance involves a highly specialized line of insurance, the standard of care applicable to brokers representing clients in the procurement of such policies dictates that they be informed of the different insurers and their policy terms to place coverage at the best available terms for clients.

Unfortunately, however, not all brokers, upon whom most companies rely exclusively in the procurement of their D&O insurance, possess the expertise necessary to advise their clients properly regarding various options available in the marketplace.

Companies, particularly emerging privately held companies that hope to eventually go public and provide compensation to their valued employees and executives in the form of stock options, have a particular need for D&O insurance. This affords coverage for claims brought by employees or former employees owning stock or stock options in the company.

Not all policy forms used by the various D&O insurers provide coverage for securities claims brought by employees in their capacities as shareholders. Some policies contain a form of “insured v. insured” exclusion that bars coverage for securities claims brought by employees or former employees, unless the insured company purchases a special “carve-back” endorsement to the exclusion to provide coverage for such claims.

The insured v. insured exclusion

All D&O policies have an “insured v. insured” exclusion to prevent one insured from collusively suing another to trigger coverage (e.g., management suing itself to trigger coverage). A common form of this exclusion provides as follows:

The insurer will not be liable to make any payment of Loss in connection with a Claim brought by or on behalf of, or in the name or right of, the Insured Organization, whether directly or derivatively, or any Insured Person, unless such Claim is brought and maintained independently of, and without the solicitation, assistance or active participation of, the Insured Organization or an Insured Person.

The problem arises through the definition of an “Insured Person” that typically includes employees — a seemingly harmless act of expanding coverage under the policy for claims brought against employees. However, by expanding the definition of Insured Persons to include employees, the “insured v. insured” exclusion now becomes applicable to claims brought by those same employees against the corporation, creating a potentially huge gap in coverage for securities claims brought by employees or, worse, by disgruntled former employees holding stock options.

The “carve back” to the “insured v. insured” exclusion provides coverage for claims brought by employees or former employees in their capacity as shareholders without the active participation of the company’s management. Some insurers offer this coverage as part of their basic coverage form without the payment of an additional premium. Others require the purchase of a special “carve back” endorsement to obtain this coverage.

If a company’s broker places coverage with one of these latter insurers without obtaining the “carve back” endorsement, the company could be facing substantial uninsured exposure for securities litigation brought by employees, or more typically disgruntled former employees or directors of the company. Without adequate D&O coverage, the company could have to spend millions of dollars defending such litigation — even if the case has little merit.

Such a crippling scenario begs the question, “So what should a company do to protect itself against major gaps in D&O coverage?”

  • Use a retail broker who has expertise in procuring D&O coverage. The broker should be up to date as to the various policy forms available in the marketplace so that he or she can place coverage at the best available terms.

  • Make sure your retail broker works with wholesale brokers who have access to the marketplace and are also experts in the various coverages available therein.

  • Provide your brokers with as much information as you can about the nature of your business.  Include the nature of your employee and executive compensation so that they are well aware of your particular insurance needs.

  • Involve an experienced insurance coverage attorney in the process of reviewing your existing coverage to identify gaps. Your attorney can also work with your broker when it comes time to renew coverage to negotiate necessary changes to policy language to protect you and the company.

Understanding your coverage and working with the right brokers and attorneys can provide you with the security that you have got your bases covered.

Jonathan Sokol is a partner with Greenberg Glusker Fields Claman & Machtinger LLP. He has more than 20 years of experience representing policyholders in complex insurance coverage litigation. He can be reached at (310) 201-7423 or JSokol@greenbergglusker.com