The Fundamental Conflict in D&O Limits
Directors and Officers (D&O) insurance policies typically operate under a shared aggregate limit of liability. This means that Side A (Individual Protection), Side B (Corporate Reimbursement), and Side C (Entity Coverage) all draw from the same pool of money. In complex litigation where both the company and its executives are sued, the potential for the policy limits to be exhausted is high. This creates a natural conflict of interest: whose defense costs and settlements should be paid first?
Without a Priority of Payments clause (also known as an "Order of Payments" clause), an insurer might pay out the entity's legal fees under Side C first, leaving the individual directors and officers with no remaining coverage for their personal liability. In the complete D&O exam guide, we emphasize that the primary purpose of D&O insurance is to protect the personal assets of the individuals. Priority of payments clauses codify this intent by legally requiring the insurer to pay certain claims before others.
The Hierarchy of Coverage Sides
| Feature | Coverage Type | Payment Priority | Reasoning |
|---|---|---|---|
| Side A | First Priority | Protects personal assets of individuals when the company cannot or will not indemnify. | |
| Side B | Second Priority | Reimburses the company for funds already paid out to indemnify individuals. | |
| Side C | Third Priority | Covers the entity's own direct liability in securities or other covered claims. |
The Mechanics of the Priority Clause
A standard Priority of Payments clause stipulates that in the event of a loss where the insurer must pay for multiple insureds and the total loss is likely to exceed the remaining limit of liability, the insurer shall first pay for Loss under Side A. Only after Side A obligations are satisfied (or if no Side A loss exists) can the insurer apply funds to Side B or Side C.
- Side A Priority: Direct protection for individuals. This is non-negotiable in most modern policies.
- Side B/C Subordination: The company agrees that its right to reimbursement or entity coverage is secondary to the individual's right to protection.
- Written Request Requirement: Some older or more restrictive forms may require the company to formally request that the insurer delay payments to the entity to preserve limits for individuals, but most modern "Order of Payment" clauses are automatic.
Candidates preparing for the exam should practice identifying these hierarchies in practice D&O questions to ensure they understand how limits flow during a claim.
Key Drivers for Priority Clauses
Bankruptcy and the 'Automatic Stay' Conflict
The importance of priority clauses is most visible during corporate bankruptcy. When a company enters liquidation or reorganization, the D&O policy is often considered part of the "bankruptcy estate." Creditors may argue that the insurance proceeds should be used to pay the company's debts (Side C) or reimburse the company (Side B) rather than protecting the individuals (Side A).
Without clear priority language, a bankruptcy court might issue an automatic stay, freezing the policy proceeds and preventing the insurer from paying defense costs for the directors. A well-drafted Priority of Payments clause provides a contractual roadmap that helps defense counsel argue that the policy proceeds are intended primarily for the individuals, not the estate's creditors. This is vital for maintaining the duty of care and duty of loyalty, as directors need the assurance of coverage to perform their roles during a crisis.
The Risk of Limit Exhaustion
Frequently Asked Questions
The priority clause is a contract between the insurer and all insureds (both the individuals and the entity). If the entity attempts to claim limits ahead of individuals, the insurer is contractually obligated by the policy language to prioritize the individuals first. Legal intervention may occur, but the policy language serves as the primary governing document.
Yes. Since defense costs are typically included within the limit of liability (eroding the limit), the priority clause dictates that the insurer should pay the defense costs of individual directors and officers before paying the defense costs of the entity itself.
Generally, yes. Side B covers the company's indemnification of individuals. Since the goal is to protect the individuals, and Side B is the mechanism the company uses to do that, it usually sits higher in the priority hierarchy than Side C (which covers the company's own independent liability).
Yes, many policies include a 'waiver' or 'standstill' provision where the entity agrees to delay or waive its claims against the policy until all individual claims have been satisfied.