A classic chicken-and-the-egg argument is currently raging over the subject of liability insurance for corporate directors and officers. A decade ago, it was a judgment call whether or not a company should provide such protection for its top brass; today, it is virtually a necessity.

Wyatt Co., the Chicago-based actuarial consulting firm, surveys the field every two years, and found last year that of the 1,269 companies in its sample, a whopping 90 percent buy liability coverage for directors and officers. The totals vary by industry: 96 percent of the banks and similar financial institutions buy the insurance, but only 61 percent of the companies in construction and real estate. Liability limits rose an average of 45 percent between 1982 and 1984.

The policies have become a standard fixture in the boardroom because directors and officers are being sued so much more often. But surety lawyer Gilbert J. Schroeder suggests that the very reaction to the litigation explosion has itself been a cause of litigation. "The more common D&O directors and officers coverage becomes, and the higher the limits of liability, the more likely are claims against directors and officers," he says.

There's seldom one neat reason why a particular type of lawsuit grows in popularity; one breakthrough victory by a plaintiff encourages future suits that make the claim seem more reasonable and therefore easier to win. But perhaps the single event most responsible for the surge of suits against those who run major corporations was the passage of the Employee Retirement Income Security Act in 1974. Not only did that statute dealing with pension protection expand the fiduciary obligations of company directors and officers, but it also set lawyers to thinking about what other kinds of responsibilities the top brass might have. Can top management be sued for the activities of a dishonest employe, for instance, on the theory that a better-run company would have detected the dishonesty?

In fact, it took a major change in legal concepts before the insurance industry could protect directors and officers from such liability suits. Because the suits claim that the defendants did something wrong, there could be a serious question about whether it is the proper use of corporate funds to defend someone who allegedly has breached his or her duties to the corporation. State legislatures solved that problem by passing statutes that specifically allow corporations to indemnify their managers. But still, the typical D&O policy carries a long list of exclusions: If the director or officer is guilty of -- or even accused of -- personally profiting from shady dealing or of illegally using insider knowledge for stock trading, for instance, the policy will not apply. Nor does it cover allegations of libel or slander or what lawyers call "bodily harm."

But even with those exceptions, the insurance policies make directors and officers an attractive target when bad managerial decisions affect corporate profits or even when an employe feels he or she has been wronged. "Catastrophic losses necessitate deeper or more numerous pockets to satisfy them," Schroeder notes. "Directors and officers, and their liability carriers, are another pocket."

Directors of a Tennessee bank that failed, for instance, paid as much as $125,000 to settle cases claiming that they should have stopped the slide into bankruptcy: The bank had canceled its D&O insurance in a money-saving move, and settling was cheaper than taking the cases to trial.

Most insurance policies give the insurance company the right to take over the defense of litigation. But D&O policies, covering sophisticated executives, instead let the defendants hire lawyers and then reimburse the defense costs. The most recent Wyatt survey turned up one case in which the defendants had $4 million in legal expenses. The average cost of defending against a claim was $461,000.

With legal costs so high, insuring corporate directors and officers can be risky for insurance underwriters, even if policyholders are never found liable for any wrongdoing. And with investment yields down, insurance companies are having a lot of second thoughts about some of the coverage they went after just a couple of years ago. Then, anyone willing to pay a premium was a welcome policyholder because so much money could be made investing those premiums. Now, just as insurance companies are refusing coverage for midwives, newspapers, city governments and other targets of increasing litigation, they are pulling out of the D&O field they had just rushed into.

Firms that are staying in the business are raising their rates, sometimes by as much as 50 percent. And others are getting a lot tougher about policy terms, particularly about the outer limits of coverage. Some corporate brass are having to settle for smaller policies this year than they bought last year.

That development doesn't worry everyone. "I don't think the legal responsibility is something to worry about, providing the board is performing its fiduciary responsibility," says Richard R. West, former dean of Dartmouth College's Amos Tuck School of Business. But William Chisholm, a New York consultant who finds board members for smaller firms, flatly refuses to recommend any candidates to a company that will not provide D&O coverage. He says he feels it's too risky.

But if D&O insurance continues to be hard to get, it will at least provide a lab test of Schroeder's theory that plaintiffs will be less inclined to sue if there's no big insurance pot to aim at.

In another case, a court ruled that:

*Courts continue to be able to rule on the fairness of Internal Revenue Service regulations. The Treasury had argued that changes in the Tax Code took away from courts the power to look over the IRS's shoulder in such matters. But the U.S. Court of Appeals in Denver refused to buy the argument. The judges there tossed out an IRS regulation that it would pay a bank no more than $5 an hour for searching for subpoenaed records, ordering the Treasury to reimburse at twice that rate. (U.S. v. Community Bank, July 17)