When D&O Insurance Doesn't Cover the Directors

Two founders each own half of a growing software company and serve as its only directors. After years of tension, one sues the other, claiming he misused company funds, withheld financial information, and made major decisions without approval. The defendant tenders the lawsuit to the company’s D&O insurer, since it concerns his conduct managing the business. However, the insurer denies coverage because the plaintiff is also an insured under the policy.

The Insured Versus Insured Exclusion

Most D&O policies exclude claims brought by one insured against another. The exclusion was originally meant to prevent collusive lawsuits, such as a company suing its own officers to get insurance money for a business loss. But it applies to genuine disputes too.

The exclusion only applies if the person suing is an insured. Policies typically define insureds to include current and former directors, officers, and managers, and the company itself for some purposes. A shareholder isn’t automatically an insured just because it owns stock, so a minority shareholder with no management role who sues the CEO may fall outside the exclusion entirely.

However, most insured versus insured exclusions contain exceptions. Common ones restore coverage for:

• Former directors and officers who left the company more than a set period before suing, often several years.

• Derivative lawsuits brought on the company’s behalf by shareholders acting independently of the insureds.

• Bankruptcy trustees, receivers, and creditors’ committees.

• Defense costs only, even when indemnity is excluded.

The bankruptcy exception has been litigated in Illinois. In Yessenow v. Executive Risk Indemnity, Inc., 2011 IL App (1st) 102920, the appellate court held that the exclusion did not bar a suit by a bankruptcy trustee appointed by the court, reasoning that the trustee acts for the estate and its creditors and is not the same entity as the insured debtor. Where a policy expressly names trustees or debtors in possession as insureds, however, the result may be different.

When Insureds and Outsiders Sue Together

Suppose a former director and an outside investor sue the CEO together. The insurer may argue the director’s participation excludes the whole lawsuit. In Level 3 Communications, Inc. v. Federal Insurance Co., 168 F.3d 956 (7th Cir. 1999), however, the Seventh Circuit, applying Nebraska law, held that the exclusion barred coverage only for the insured plaintiff’s share and that the rest of the lawsuit required allocation. Exclusions that reach claims brought “on behalf of” or “with the assistance of” an insured can be read more broadly, so the exact wording controls.

When a Fired Executive Sues the Board

The exclusion comes up constantly when a removed executive sues the directors who removed him. Suppose the board of a closely held distribution company fires its CEO, who also owns 15% of the company, and he sues all five directors personally for breach of fiduciary duty. The insurer may argue that a former CEO is an insured, so the exclusion applies; whether an exception for former officers helps depends on its wording and on how long ago he left.

The insurer may also call the case an employment dispute, which many D&O policies leave to employment practices liability insurance. But a claim that directors breached their fiduciary duties isn’t automatically an employment claim just because it arises from the same board vote, and both policies may respond to different parts of one lawsuit.

Protecting the Individual Directors

For directors sued personally, the most important part of the policy is usually Side A, which covers individuals when the company can’t or won’t indemnify them and often applies with no retention. Side B reimburses the company when it does indemnify them; Side C covers the company itself.

The company may have obligations of its own. Section 8.75 of the Illinois Business Corporation Act allows a corporation to indemnify its directors and advance their legal expenses, many bylaws require it, and rights already in the articles or bylaws can’t be taken away by a later amendment for conduct that already occurred. Illinois law also limits the directors’ exposure: courts defer to good-faith business decisions, and under Section 2.10 the articles may eliminate personal liability for many breaches of fiduciary duty, though not for disloyalty, bad faith, intentional misconduct or an improper personal benefit. That is often why the complaint alleges exactly those things.

Plan Before the Partnership Fails

For closely held companies, disputes between owners are among the most likely claims, yet they are the claims D&O policies are most likely to exclude. Reviewing the exclusion and its exceptions at renewal, and asking about narrower wording, is far cheaper than discovering the gap after a lawsuit. When a dispute does arise, the policy, endorsements, governing documents, and complaint should be reviewed together, and notice given promptly under the policy’s claims-made terms.

If an insurer is denying coverage, refusing to fund a defense, or disputing its obligations under a D&O policy, we can help you evaluate your coverage and pursue available remedies. Contact us to discuss your matter.

This article provides general information and does not constitute legal advice. For guidance concerning a specific matter, see our insurance recovery services. Coverage depends on the policy wording, the facts, and applicable law. To discuss potential representation, request a consultation. Submitting an inquiry does not establish an attorney-client relationship.