D&O Run Off Explained & Why (6 Year) Pre-Quoted Cover is Vital (Including Claim Examples).

As sure as night follows day, organisations will be bought and sold, so the circumstances in which the decision to purchase ‘run off’ cover might present themselves will always exist. And whilst Directors & Officers (“D&O”) policies have evolved in recent years, the arguments in favour of run off have remained constant.

Put simply, run off cover buys a period of time after a specific event when control and/or ownership passes from one party to another. Run off cover protects former insured persons against claims arising from acts committed/allegedly committed before the event date but which are reported after. Without this cover, individuals may face significant personal liability for historical decisions. All transactions will be unique, but the reasons to buy run off cover will be consistent:

• on acquisition, the incumbent management group may depart or lose control of the organisation. However, prior to that point they were responsible for the actions taken and directions given. Liability for this does not evaporate and can exist for many years afterwards (generally, under The Limitation Act 1980, most civil claims (including breach of duty) have a 6 year limitation period from the date the cause of action accrued – this is why a 6 year automatic policy option is crucial to have);
• even if the directors remain the same, the mechanics of D&O insurance will automatically prevent cover attaching for anything that happened after the event date, in line with the change in the ownership interest;
• the acquiring party is unlikely to be willing or able to provide a backward-looking indemnity, particularly given that they had no control, influence or interest prior to that point. Indeed, one of the most significant risks under a D&O policy on acquisition is from the purchaser itself. Key themes in run off claims are misrepresentation during the sale, breach of fiduciary duty, fraudulent transfers and regulatory investigations, so the argument that an acquirer of a business might buy a policy for the seller to use if they sue them is often not a terrifically persuasive one;
• the premium for run off cover is fixed and fully earned at inception, so it cannot be cancelled or amended once placed. The indemnity limit is ringfenced and dedicated to the liability of the management group who were in place up until the time of the transaction;
• there can be no certainty on the protection of insured persons post-acquisition/event. For example, there may be no assets to back up a promise to indemnify, or complications associated with doing so.

When an acquisition event occurs during the D&O policy period, if nothing is done, run off will activate automatically until renewal under all policies, with cover for wrongful acts that occurred/allegedly occurred prior to the event date. However, complications can arise:

• not all policies pre-quote run off so there is zero certainty when the policyholder needs it;
• some policies only offer run off on referral to underwriters, who are free to choose their own terms or even refuse to quote;
• not all insurers will offer any more than 1 year at a time, which does not match limitation;
• some policies do not give any run off or reporting period options at all on an insolvency event;
• It is worth noting here that there is no established market for stand-alone run off, so if no D&O cover is in force at the time of the change, it is almost impossible to buy it on any commercially viable basis. Even if cover does exist, if the incumbent insurer refuses to quote or has limited options, there is almost always nowhere else to go.

Run off can be confused with “Extended Reporting Periods” or “Discovery Periods” and that is because they are essentially the same thing. What differs is the trigger, which here is a ‘refusal to renew’ (which should be at the option of either party). Insolvency events are variations of the refusal to renew and policy provisions should also exist that pre-quote options for longer periods, so there is certainty of cost and availability at the start of the policy period should the worst happen.

Another common question is on the overlap with Warranty & Indemnity (“W&I”) cover, and the possible substitution of D&O run off for that product. However, they are distinctly different, with W&I providing protection for the shareholders (warrantors), as opposed to the managers, and the respective capacities as such (‘insured capacity’ is a key determinant for cover under any D&O policy). Although a warrantor may also be a director or officer of the company, warranties are typically given in the context of a shareholder rather than a director or officer. Therefore, a D&O policy would not respond to a contractual warranty claim, or an indemnity, arising under a merger and acquisition (“M&A”) contract.

In a nutshell, run off provides protection against the risks management faced when they were in control of the company and which may not manifest themselves immediately. Add to this that many fiascos involve M&A activity, meaning careful inspection is required when selecting D&O insurance to ensure there are no unpleasant surprises in the event of a run off scenario and cover is potentially available in circumstances such as the following:

1. The policyholder was sold. The new owners alleged that one of the former directors breached his fiduciary duties by conflicting his duties as a director with his position as a shareholder. Loss costs were in excess of £250,000.
2. Buyers alleged they were induced to invest through fraudulent misrepresentations given by the defendant director who warranted the material truth and accuracy of a financial due diligence report on which the claimants relied. Defence costs and settlement were over £400,000.
3. Existing management wanted to buy out the company. Non-executive directors were retained to ensure shareholders got the best deal. They accepted a different offer from a third-party, terms of which were better than that offered by the management. The purchaser sued the directors alleging they had misused the buyout proposal to extract a higher price than was fair or necessary. Policy costs were over £250,000.
4. The Joint Administrator issued proceedings against a defendant director alleging that he breached his duty of care as a director with regard to several transactions in the year leading up to the policyholder entering administration. The costs of the claim were over £120,000.
5. A high court claim involved 5 insured persons following the sale of the policyholder. The purchase price in the completion statement was disputed alleging various accounting irregularities against the policyholder’s former CEO, finance director, and the 3 other directors. 3 law firms were required because of conflicts. Defence costs reached the policy limit.
6. Prior to the sale of the policyholder, it was alleged that a director had re-aged debts so they appeared to be younger than they actually were and did not appear in the schedule of old debt that was submitted to the purchaser, therefore inflating the price. Although he was a shareholder, the allegation was made against him in his capacity as a director and employee. It was also alleged that he created false invoices so he could transfer £65,000 of cash from the bank account. Loss costs were over £225,000.
7. An acquiring company launched proceedings against the principal directors of the target company, alleging negligent and/or fraudulent misrepresentation of the financial standing of the company. The amount claimed was the entire purchase price. Following lengthy and expensive case preparation, the action was settled with damages and defence costs of over £750,000.
8. A company entered administration. Creditors commenced proceedings alleging that the defendants knowingly and recklessly made false representations both orally and in writing regarding the financial status of the company on which the claimant relied to advance funds. Defence costs were over £100,000.