Amendments to the DGCL Permit Captive D&O Insurance

John Mark Zeberkiewicz is partner at Richards, Layton & Finger, P.A. This post is based on his Richards Layton memorandum, and is part of the Delaware law series; links to other posts in the series are available here. Related research from the Program on Corporate Governance includes Monetary Liability for Breach of the Duty of Care? by Holger Spamann (discussed on the Forum here).

The Delaware General Assembly has approved legislation amending Section 145 of the Delaware General Corporation Law (the “DGCL”) to authorize a Delaware corporation to use captive insurance, which is generally defined as insurance provided by or through a wholly-owned subsidiary funded by the corporation, to protect its current and former directors, officers and other indemnifiable persons (“covered persons”). The captive insurance may be used to protect covered persons against liability even if the corporation would not be empowered to indemnify them, subject to a limited set of minimum exclusions. The amendments, which are expected to be enacted in the near term, will afford Delaware corporations the opportunity to take advantage of captive insurance arrangements when designing their D&O insurance programs.

Background

In recent years, the market for D&O insurance has hardened significantly, with substantial increases in premiums for diminishing levels of coverage. The changes in the market for D&O insurance cannot be traced to a single source but are instead the result of a confluence of factors, including:

  • The rise of litigation finance firms;
  • The United States Supreme Court’s decision in Cyan, Inc. v. Beaver County Employees Retirement Fund, 138 S.Ct. 1061, 200 L.Ed.2d 332, which allowed plaintiffs to bring claims under Section 11 of the Securities Act of 1933 in state court venues where these claims tend to survive motions to dismiss more often and are otherwise more costly to litigate (and are sometimes concurrently litigated in federal court);
  • An increase in event-driven litigation (including cybersecurity claims, claims premised on calamitous events like the California wildfires, and oversight claims following the Delaware Supreme Court’s opinion in Marchand v. Barnhill, 212 A.3d 805 (Del. 2019));
  • An increase in social-justice related litigation; and
  • Litigation related to the COVID-19 pandemic.

To deal with adverse changes in the market for D&O insurance, some corporations have elected to purchase less insurance by, among other things, agreeing to higher retention amounts and lower claim amounts, and by foregoing all or a portion of the coverage that insures the corporation against liabilities for which it is permitted to indemnify covered persons. Due to the current structure of the DGCL, however, many corporations cannot elect to replace any or all of the “dollar one” coverage protecting covered persons in circumstances where the corporation is not permitted to indemnify them.

Current Statutory Framework and the Need for the Amendments

The power of a Delaware corporation to indemnify covered persons is established by, and subject to the restrictions of, Section 145 of the DGCL, which is divided into two key parts. Section 145(a) of the DGCL permits a corporation to indemnify covered persons in connection with actions other than those brought by or in the right of the corporation (i.e., third-party claims), while Section 145(b) permits a corporation to indemnify covered persons in connection with actions brought by or in the right of the corporation. Each subsection sets forth procedures for determining the power to indemnify, and each subsection establishes the scope of indemnification permitted thereunder. The most noteworthy difference between the indemnification available under Section 145(a) and Section 145(b) is that the former permits indemnification against “judgments, fines and amounts paid in settlement,” while the latter does not.

The distinction between Section 145(a) and Section 145(b) evidences the public policy that where the corporation has been injured by one of its covered persons, the corporation should not be held ultimately liable for that injury, as well as the determination that permitting a corporation to indemnify covered persons in connection with derivative suits promotes the settlement of meritless claims. Although it had been argued that Section 145(f) of the DGCL, which provides that “the indemnification and advancement of expenses provided by, or granted pursuant to, the other subsections of [Section 145] shall not be deemed exclusive of any other rights to which those seeking indemnification or advancement of expenses may be entitled under any bylaw, agreement, vote of stockholders or disinterested directors or otherwise,” could permit a corporation through such means to indemnify covered persons for liabilities that are not indemnifiable under Section 145, that construction of the statute has been rejected.

Despite the limitations on indemnification in Sections 145(a) and 145(b), including the limitations on the corporation’s power to indemnify against judgments and amounts paid in settlement of actions brought by or in the right of the corporation, Section 145(g) of the DGCL specifically authorizes a Delaware corporation to purchase liability insurance on behalf of its covered persons and to insure against potential liability they may incur regardless of whether the corporation has the power to indemnify them. Thus, Section 145(g) permits a corporation to insure its covered persons against expenses, judgments, fines and amounts paid in settlement, whether in a third-party action in which the covered person has not met the standard of conduct or in any action brought by or in the right of the corporation. Nevertheless, before the amendments to Section 145(g), it was not clear that a corporation had the power to use captive insurance to protect covered persons against non-indemnifiable liabilities.

The Amendments to Section 145(g)

Authorization of Captive Insurance Arrangements

The amendments to Section 145(g) authorize a corporation to purchase and maintain insurance on behalf of covered persons by or through a “captive insurance company” licensed in Delaware or another jurisdiction or through a “fronting” or other reinsurance arrangement, which occurs where a corporation procures insurance through a third-party insurer, but all of the risk of loss is transferred to a wholly-owned captive. As with traditional D&O insurance, the captive insurance may provide coverage for liabilities incurred by covered persons whether or not the corporation would have the power to indemnify them under Section 145. The amendments to Section 145(g) thus make clear that captive insurance may be used to provide protection to covered persons for, among other things, judgments and amounts paid in settlement of claims brought by or in the right of the corporation, despite the fact that the corporation will continue to lack the power to indemnify covered persons for those amounts, subject to specified limitations described below.

Limitations and Exclusions

While revised Section 145(g) allows for the use of captive insurance for liabilities incurred by covered persons, it imposes a few narrow limitations on the use of captive insurance. Under new Section 145(g)(1), a captive insurance policy must exclude from coverage, and must provide that the insurer may not make payment in respect of any loss arising out of, based upon or attributable to a final adjudication with respect to: (i) any personal profit or financial advantage to which the covered person was not legally entitled, (ii) any deliberate criminal or deliberate fraudulent acts, or (iii) any knowing violation of law. Thus, the use of captive insurance would be unavailable, for example, in circumstances where a covered person was found, after a final judgment in the underlying proceeding, to have obtained an undue financial benefit from a self-dealing transaction or in circumstances where the covered person deliberately engaged in criminal or fraudulent transactions, such as embezzlement or securities fraud. Nevertheless, the captive insurance policy should be available to provide directors coverage for liability arising out of a breach of the duty of oversight (i.e., liability for a Caremark violation), so long as there is no ultimate finding in the underlying proceeding that the directors knowingly caused the corporation to violate the law.

From a practical standpoint, it is important to highlight that the coverage exclusions in Section 145(g)(1) apply only if the enumerated “bad acts” have been established in a final adjudication in the underlying claim. (Findings in ancillary proceedings, such as proceedings to establish entitlement to coverage, would not constitute findings in the underlying proceeding.) As a result, the proceeds of the captive insurance policy would remain available for use in the payment of settlements of any type of proceedings, whether direct or derivative and whether or not involving allegations that a covered person engaged in the type of conduct that, if established in the underlying proceeding, would preclude coverage. Notably, the statutory exclusions on the use of proceeds of the captive insurance policy only apply in circumstances where the corporation would not otherwise be entitled to provide indemnification against liability. Thus, although perhaps unlikely in many cases (given the standard of conduct determination required under Section 145(a) and 145(b)), it is possible that, despite a finding that a covered person engaged in the conduct referenced in Section 145(g)(1), the person may be entitled to coverage under the captive insurance policy where the covered person would have been entitled to indemnification.

No Prohibition Against Additional Limitations or Exclusions

The statutory exclusions on coverage, however, should be viewed as minimum requirements. So long as the statutory minimum requirements are included in the captive insurance policy, the corporation has wide discretion to impose additional limitations or exclusions on the scope of coverage.

Determinations Regarding Use of Proceeds of Captive Insurance

In addition to setting minimum restrictions on the coverage that may be provided, the amendments contain provisions prescribing the manner in which claims payment decisions must be made under the policy. Specifically, Section 145(g)(2) provides that any determination to make a payment under a captive insurance policy must be made either by an independent claims administrator or in accordance with the procedures set forth in subsections (d)(1) through (4) of Section 145 (i.e., by a majority of the directors not party to the proceeding, even if less than a quorum, a committee of such directors if such directors so direct, independent counsel, or the stockholders).

Notices

Although the corporation generally may implement and use a captive insurance policy without giving any specific notice to stockholders—and no approval of any court or other governmental body is required for its use—Section 145(g)(3) provides that, before any payment under the captive policy is made in connection with the dismissal or compromise of a suit brought by or in the right of the corporation as to which notice is required to be given to stockholders, the corporation must include in the notice that a payment is proposed to be made under the captive policy.

***

The amendments to Section 145(g) afford Delaware corporations additional flexibility to create programs of insurance that provide levels of protection that they believe are appropriate for their directors, officers and other covered persons. The amendments reflect Delaware’s commitment to maintaining a modern enabling corporate statute that is responsive to the needs of corporations and their constituents.

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