One of the principal advantages of forming a corporation or limited liability company is that the people who own and run the corporation generally are not personally responsible for the debts of the business. Nevertheless, most companies still purchase insurance, specifically directors and officers (D&O) liability insurance, to protect board members, executives and other key decision makers from being personally exposed when they are targeted in claims based on their conduct in running the company.

In some circumstances, however, courts may “pierce the corporate veil,” permitting plaintiffs to hold corporate officers or directors personally liable for a company’s actions. This risk of personal exposure in veil-piercing claims makes D&O liability insurance even more critical. This article discusses the basics of veil piercing and highlights important D&O insurance considerations to protect individuals from D&O liability, including when a plaintiff successfully pierces the corporate veil and seeks to hold individual defendants responsible.

I. What Is Veil Piercing and When Does It Occur?

Piercing the corporate veil is a legal term that allows courts to disregard the limited liability protection of a corporation and hold its owners, officers and directors personally liable for the company’s legal obligations. Veil piercing is an extraordinary remedy used in situations where the corporation is operating as an “alter ego” of the owners, which typically occurs when the corporate form is used to commit fraud or abuse with little to no adherence to corporate formalities.

Courts consider many factors in assessing whether veil piercing is required, depending on the governing law. But common factors relevant to veil piercing include commingling of personal and corporate assets, disregarding corporate formalities, inadequate capitalization and abusing the corporate form to shield personal misconduct. Claims against individuals involved in this kind of alleged misconduct typically include allegations that the company’s officers and directors acted unethically or fraudulently to use the company’s limited liability protections in a way that unjustly harmed creditors or other stakeholders.

II. Veil-Piercing Insurance Considerations for Individual Directors and Officers

D&O liability policies are intended to protect current and former directors and officers from personal liability, especially in the event the company is unable or unwilling to provide advancement or indemnification for legal expenses and other liabilities incurred in defending, settling and adjudicating claims challenging the individuals’ management of the business.

While veil-piercing claims seeking to hold owners, executives and other key personnel personally responsible for the company’s liabilities seems to fit within the core purpose of D&O liability coverage, there are many potential pitfalls that could lead to limited or denied claims. While each D&O insurance claim is highly dependent on the specific policy language, governing law and facts giving rise to the dispute, below are some key insurance considerations for individuals evaluating potential exposure for claims seeking to pierce the corporate veil.

Don’t Rely on Indemnification and Advancement by the Company. Veil-piercing allegations involving alleged fraud, abuse and unethical conduct may impact the company’s ability and willingness to advance defense costs or provide indemnification. This can leave insurance as the only source of potential protection. Reviewing and understanding employment agreements, indemnification agreements, bylaws and similar corporate governance documents in conjunction with all implicated liability policies is important, but individuals should pay careful attention to the strength of potential insurance policies that may be the only protection from personal exposure if the company is insolvent or refuses or fails to fulfill its advancement and indemnification obligations.

D&O Coverage Is Key. Coordinating between all insurance policies is critical to ensure that no potential source of recovery is overlooked. But the reality is that the likeliest source of coverage is the company’s D&O policies and that many claims involving veil-piercing allegations will not trigger coverage under general liability or other coverages, including homeowners’ and umbrella coverages.

Conduct Exclusions. Virtually all D&O insurance policies include conduct exclusions, which preclude coverage for fraudulent, intentional, willful or criminal conduct by an insured. Given that many D&O claims allege this kind of misconduct, most modern policies also include “final adjudication” requirements, which preserve coverage until there is a final, non-appealable adjudication that the alleged conduct actually occurred.

Veil-piercing claims often involve allegations of fraudulent or intentional conduct that can implicate conduct exclusions. Strong final adjudication triggers can preserve coverage for ongoing defense costs and potential settlement of claims for alleged fraud up to the point of final adjudication. Not all final-adjudication triggers are the same, however, and slight changes in wording can have an outsized impact on coverage in veil-piercing claims involving alleged fraudulent, knowing or criminal acts.

Definition of Wrongful Act. D&O insuring agreements require claims against insureds that allege “wrongful acts.” The term “wrongful act” varies among policies but generally means any alleged error, misstatement, misleading statement, act or omission, or neglect or breach of duty by an insured in their official capacity discharging their duties on behalf of the insured company. Therefore, the definition requires not only that the claimant allege misconduct by the individual, but also that the misconduct was done in their “insured” capacity as an officer or director of the company.

This second element tied to insured “capacity” can be critical in veil-piercing because veil piercing claims may allege conduct by individual directors and officers, like comingling of assets or using the corporate form to shield personal liabilities, that was done in personal capacities and not in discharging duties in covered capacities on behalf of the company.

Capacity Exclusions. Issues with insured “capacities” may also arise if a D&O policy has a standalone “capacity” exclusion. Capacity exclusions are intended to bar coverage for claims for wrongful acts by an individual insured in any capacity other than the capacity insured under the policy at issue (e.g., acts on behalf of another uninsured company, acts in a personal capacity). These exclusions are potentially problematic because in many cases they extend far broader than the capacity-requirements in the definition of wrongful acts and threaten to eliminate coverage for entire claims based on a single allegation or connection to an individual’s dual capacity.

Some capacity exclusions are broad, barring coverage for entire claims that allege, arise out of or are based upon or attributable to any act in any capacity other than the insured capacity as an officer or director of the insured company. If a corporate veil is pierced based on an individual acting in an uninsured capacity, even if the claim also alleges other acts on behalf of the insured company, an insurer may rely on the capacity exclusion to bar coverage.

Insured Versus Insured Exclusion. The Insured versus Insured exclusion is one of the most frequently litigated provisions in private company D&O disputes. The exclusion bars coverage for claims brought by or on behalf of one insured against another insured. If a corporate veil is pierced based on findings that an individual director or officer was unjustly enriched, acted unethically or otherwise harmed the company, the company may pursue claims against the individual that could implicate the Insured versus Insured exclusion.

Severability Provisions. Severability or non-imputation provisions protect innocent individuals who are covered under a D&O policy from losing coverage based on the wrongdoing of another individual insured. These provisions are commonly implicated in veil-piercing claims that challenge the acts of specific individuals. If one individual defendant is found to have acted fraudulently or abused the corporate form, a robust severability provision should prevent that individual’s wrongdoing to eliminate coverage for other, innocent insureds.

Side A-Only Coverage. Veil-piercing claims based on the extreme conduct, criminal activity or fraudulent acts of directors or officers can lead to large exposures. Such claims have the potential to exceed all available insurance and can quickly erode, if not fully exhaust, all available limits.

If a company only has traditional “Side ABC” policies—that is, policies that protect both individuals and the company—those policy limits are available to all insureds. This can pose problems for individuals if, for example, the company faces significant litigation that erodes or exhausts the D&O policy limits but claims against the individuals arising from the same dispute are not made until months or even years later (such as if the company litigation uncovers previously unknown misconduct by the directors giving rise to individual liability). In that situation, the individuals may be left with little to no insurance protection.

Purchasing a dedicated set of “Side A” limits—insurance limits available exclusively for claims against individual directors and officers that are not indemnified by the company—can mitigate the risk of leaving individuals uninsured. Side A-only coverage can be procured as separate limits in a Side ABC policy or through a standalone, separate policy. Standalone Side A-only D&O policies often have other benefits, like enhanced protection through difference-in-conduction (DIC) coverage, that can result in broader coverage and fewer exclusions.

Takeaways

D&O liability insurance can protect individual directors and officers in the event of a veil-piercing claim. However, there are numerous provisions, including many not addressed in the illustrative list above, that can lead to limited or excluded coverage. Policyholders should review the terms of their policies and work with experienced broker, coverage counsel and other risk professionals to understand the availability and scope of potential coverage for individuals who may be targeted in claims alleging acts that may result in a court piercing the corporate veil.