The Dodd-Frank Wall Street Reform and Consumer Protection Act prompted many insurers to offer compensation clawback endorsements to their directors and officers liability policies. However, new proposed legislation now seeks to keep policyholders from procuring such coverage. Steven H. Weisman and Nicholas M. Insua, partners with McCarter & English L.L.P., explore how passage of this bill could affect coverage presently available for clawback claims.

Rep. Barney Frank, D-Mass., introduced legislation during the 112th Congress (H.R. 5860) designed to prevent officers, directors and employees of financial institutions who are required to repay earned compensation or pay a civil penalty under any federal financial law or regulation from securing indemnification from a third party (e.g., from insurance companies).

In a press release from the House Committee on Financial Services, Rep. Frank said insurance policies that provide such coverage “insulate financial executives from clawbacks (as) one more effort by some in the industry to perpetuate a lack of accountability.”

Of course, coverage under directors and officers liability insurance policies for alleged nonintentional wrongful acts by insureds could be substantially affected by passage of the bill.

This article explores the effect that passage of the bill may have on insurance coverage presently available for clawback claims.

The Dodd-Frank Wall Street Reform and Consumer Protection Act is broad in scope. One aspect of the act concerns executive compensation paid to executives at companies with “any financial reporting requirements under the securities laws.” The act requires any such company (i.e. securities issuer) required to prepare an accounting restatement “due to the material noncompliance of the issuer” must adopt policies:

• to disclose such restatements; and

• to “recover from any current or former executive officer of the (issuer) who received incentive-based compensation (including stock options awarded as compensation) during the three-year period preceding the date on which the (company) is required to prepare an accounting restatement, based on the erroneous data, in excess of what would have been paid to the executive officer under the accounting restatement.”

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The act also amended the Securities Exchange Act of 1934 to empower the U.S. Securities and Exchange Commission to “direct the national securities exchanges and national securities associations to prohibit the listing of any equity security of an issuer, with certain exceptions, that does not comply with (the) compensation committee and compensation adviser requirements.”

The act also further amended the Exchange Act to empower the SEC by rule to “require each issuer to disclose in any proxy or consent solicitation material for an annual meeting of the shareholders of the issuer a clear description of any compensation required to be disclosed by the issuer under section 229.402 of title 17, Code of Federal Regulations … including information that shows the relationship between executive compensation actually paid and the financial performance of the issuer, taking into account any change in the value of the shares of stock and dividends of the issuer and any distributions.”

Following passage of Dodd-Frank, some insurance companies began offering coverage, by way of endorsements to their directors and officers liability policies, to protect individuals from Dodd-Frank's compensation clawback provision. Such insurance “promises to cover the costs and attorney fees incurred by executives during any action brought by the (FDIC), as well as reimburse any lost salary or other damages arising from non-intentional wrongful acts by executives,” according to an Oct. 28, 2011, posting on insurancenewsnet.com.

Rep. Frank, in a House Financial Services Committee press release, said such coverage is inconsistent with the purpose of Dodd-Frank “to promote financial stability of the United States by improving accountability and transparency in the financial system.”

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H.R. 5860 bars insurance companies from selling — and “officer(s), director(s), employee(s), or other institution-affiliated part(ies) of a depository institution, depository institution holding company, or nonbank financial company” from buying — insurance to protect them from civil penalties or incentive-based compensation clawbacks imposed by federal law or regulation. Based on Rep. Frank's goal to foster accountability, the bill intends to prohibit those personally liable for the repayment of incentive-based compensation or for the payment of civil penalties assessed under Dodd-Frank from “directly or indirectly, insur(ing) or hedg(ing) against, or otherwise transfer(ring) the risks associated with, personal liability for the amounts so owed.”

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Still, the bill contains two significant carve-outs. First, third parties (e.g. insurers and employers) can pay defense costs for claims investigations and litigation that seek a clawback of “previously earned compensation or civil money penalty.” Second, individuals can obtain insurance that protects them if they are held personally liable for

• penalties, judgments, or other amounts assessed against a depository institution, depository institution holding company, or nonbank financial company at the company level; or

• unintentional outcomes associated with the ordinary exercise of trade or business judgment, unless the effects of such judgment result in personal liability under a federal financial regulatory law that provides for personal liability.

It appears almost certain that, if enacted, the bill would shut down the incentive-based compensation “clawback insurance” that some insurers are selling as add-ons to D&O policies. The bill's potential effect on other coverage available under D&O policies, however, is mixed.

In 2012, the American Bankers Association and Chubb Corp., registered to lobby on H.R. 5860. On July 11, 2012, the House Committee on Financial Services referred this bill to the Subcommittee on Capital Markets and Government Sponsored Enterprises and the Subcommittee on Financial Institutions and Consumer Credit. Congress, however, took no action on the bill before the end of the 112th Congress, but it may be reintroduced in the 113th Congress.

In general, D&O policies contain two coverages under two insuring agreements, referred to as “Side A” and “Side B” coverage.

Side A coverage insures any individual directors and officers (and, in some instances, certain company employees) against losses directly incurred, but who are not or cannot be indemnified by the corporation.

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In contrast, Side B coverage insures the entity itself for any reimbursements it might make to directors and officers (and, in some instances, certain company employees) for defense costs or indemnification (settlements or judgments).

Side A and B coverages could be relevant to individuals who might be affected by Dodd-Frank's compensation clawback provision, as those coverages determine whether the director or officer would have a direct right to coverage and/or whether the corporate entity would have coverage to back up its indemnification (reimbursement) obligation to the directors or officers. (Side C, or entity, coverage likely would not be affected by H.R. 5860.)

If H.R. 5860 is enacted as proposed, then any insurance coverage otherwise available for a director's, officer's or company executive's personal liability under Dodd-Frank would be eliminated.

With regard to defense costs, however, the bill preserves coverage for defense costs incurred in connection with defending against a clawback claim or civil penalty claim under Dodd-Frank or any federal financial regulatory law. With respect to indemnity costs, the bill also permits coverage for any personal liability for penalties, judgments, etc., assessed at the company level; and for damages arising from unintentional outcomes when exercising ordinary trade or business judgment. However, the bill does not permit coverage for damages arising from such unintentional outcomes if the effects of such ordinary trade or business judgments result in personal liability under a federal financial regulatory law that provides for such liability.

D&O policies usually contain exclusions for coverage of claims arising out of a willful violation of law, but some policies limit such exclusions to final judgments or adjudications establishing that such a violation occurred. Such an exclusion might exclude coverage for any loss brought about or contributed to in fact by any intentionally dishonest, fraudulent or criminal act or omission or any willful violation of any statute, rule or law, or profit or remuneration gained by any insured to which such insured is not legally entitled, as determined by a final adjudication in the underlying action.

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While H.R. 5860 would not prohibit coverage for costs to defend against the mere allegation that an individual's actions violated a federal financial regulatory law, it might eliminate indemnity coverage for judgments or settlements arising out of any violation of law, willful or not.

Likewise, although D&O policies typically exclude coverage for claims arising out of the gaining of any profit or improper or illegal remuneration, some policies limit the exclusion to final judgments or adjudications establishing that the insured was not legally entitled to such profit or advantage or that such remuneration was improper or illegal. A typical exclusion might bar coverage for loss “arising out of, based upon or attributable to the gaining of any personal profit,” but only in such instances in which “a final adjudication (after all appeals) or other alternative dispute resolution mechanism adverse to the insured(s) establishes they were not legally entitled.”

Therefore, depending on the applicable state law, indemnity costs associated with a settlement of an executive compensation clawback claim prior to a final judgment or adjudication may be covered under a D&O policy. H.R. 5860, however, likely would render that exclusion limitation inapplicable to settlements of compensation clawback claims under a federal financial regulatory law even if there never is a final adjudication or judgment on the merits of the government's or private litigant's claim.

Still, the bill would not eliminate coverage under a D&O policy for defense costs arising from such a claim. Because insurers' defense obligations typically are triggered if there exists a possibility of coverage under an insurance policy, D&O policies may have to be revised to provide for defense costs for such compensation clawback claims that, pursuant to the bill, provide no possibility of coverage.

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If enacted, H.R. 5860 could have a significant effect on the scope of insurance coverage available for claims made under Dodd-Frank and other federal financial law or regulation. It, therefore, will be worth following the House Committee on Financial Services' hearings and debates concerning this proposed legislation, as well as any amendments thereto, and seeing how the insurance marketplace responds to the final form of any enacted legislation.

Steven H. Weisman and Nicholas M. Insua are partners with McCarter & English L.L.P.'s insurance coverage and general litigation group. Mr. Weisman can be reached at 973-848-5332 or sweisman@mccarter.com. Mr. Insua can be reached at 973-639-6988 or ninsua@mccarter.com.