Entity securities coverage: Protecting public companies from shareholder litigation

Company shareholders are more informed than ever about their rights as investors, and the responsibilities of management appointed to manage a company’s affairs.

As key stakeholder of a business, shareholders will often take drastic measures to protect the value of their investments, resulting in significant legal exposure for not only the executives of a company, but also the company itself.

The risk of shareholder litigation

Shareholders invest their finances into a company with the expectation that they will receive a financial return. With large investments often at stake, shareholders can be sensitive to the management and performance of companies in which they have ownership. If the market value of a company’s share price is affected by a business decision or wrongful act, investors can commence legal proceedings against those responsible. With legal advice and litigation funding becoming increasingly available, shareholders have the resources required to attempt to recover their losses. The resulting securities claims are often lodged in the form of a shareholder class action, implicating the company and its executives as responsible for reducing the company’s value.

Protecting a company from securities claims

While the primary intention of D&O is to protect the executives of a business, the Side-B insuring clause (company reimbursement) does provide a company with some balance sheet protection. Despite this indirect cover for the business, the company is not typically insured for its own liability in securities related matters. Entity securities coverage, also referred to as the Side-C insuring clause, protects the company if it is implicated in a lawsuit arising from the purchase or sale of its shares. Side-C cover can be elected as an extension of regular D&O coverage, allowing the policy to also respond to claims by shareholders made directly against the company entity. Because the addition of entity cover increases the risk undertaken by the insurer, the policyholder is typically required to pay an extra premium for this benefit. Without entity securities coverage, a company is effectively self-insured for its own liability.

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Side-C coverage aligns the legal interests of all parties

When a shareholder legal action names both the company and its directors as defendants, there can be conflicting interests between the two parties. In situations where entity cover is not in place, an insurer is required negotiate with the company to determine the allocation of legal defence and settlement costs. That is, how much the insurer will pay on behalf of directors in relation to the company’s own (uninsured) expenses for its share of liability. The inclusion of Side-C cover in a D&O program can remove any potential allocation disputes, and can more closely align the interests of directors, company and insurer when defending a securities claim.

Entity claims can erode the cover available to executives

Despite the benefits of including entity cover within D&O, there are disadvantages. D&O insurance often shares an aggregate limit of liability across all sections of a policy; therefore the inclusion of entity cover can have significant affect on the protection afforded to executives. When Side-C cover is in place, an insurer is responsible for paying the legal costs of defending actions made against the company entity. As an insurer incurs costs on behalf of company the limit of liability is eroded, effectively reducing the limit available for protecting directors and officers. The erosion or exhaustion of the policy limit can leave management without adequate coverage, thereby personally exposing the very executives the policy was intended to protect.

Keeping directors and officers protected

In response to the conflicting interests of Side-C coverage, companies can implement a range of strategies to ensure its executives remain protected:

• Purchase stand-alone Side-A coverage to provide directors and officers with a policy solely dedicated to their personal protection.
• Negotiate a Side-A excess layer over an existing D&O policy, increasing the limit of liability available to directors & officers.
• Establish a Side-A DIC policy to cover executives if the limit of liability is exhausted by Side-B and Side-C claims.