Director Alert:Director Alert: The Changing Face of The Changing Face of

Directors & Officers Liability Directors & Officers Liability InsuranceInsurance

Steve ShappellDirector – Legal

Aon Financial Services Group

Sources of Obligations & Defenses

Common law (created by courts) Federal statutory law (created by legislature) Regulatory rules (created by government

agencies) State law & local law Foreign law

Basic Duties(Common Law)

Duty of Care/Diligence A director shall perform his or her duties as a

director: In good faith In a manner he/she reasonably believes to be

in the best interest of the corporation, and With such care as an ordinary prudent person

in like position would use in similar circumstances

In performing his/her duties, directors may reasonably rely upon the advice of experts

In performing his/her duties, directors may reasonably rely upon the reports of committees

Basic Duties(Common Law)

Duty of Obedience A director or officer must act within the scope of his

duties and may not enter into any contract or take any action not within the authority of his/her office

Ultra Vires Acts – without authority

Duty of Loyalty The Corporation must come first A director or officer may not use his position to

make a personal profit or gain (insider trading, use of corporate opportunities)

Transactions between a director and corporation usually require:

Full disclosure Approval by a majority of the disinterested

directors

Basic Statutory Liabilities Federal Law

Securities Laws Securities & Exchange Act of 1934 Securities Act of 1933 Sarbanes-Oxley Act

Employment Laws Title VII of the Civil Rights Law of 1964 Americans With Disabilities Act Age Discrimination Act Civil Rights Act of 1866 and 1991

Sherman/Clayton anti-trust act Various pollution acts RICO ERISA FIRREA (financial institutions) False Claim Act

Frequency by Claimant[Private Company]

Shareholders - 9%=SERIES(,Sheet1!$A$1:$A$6,Sheet1!$B$1:$B$6,1)

Other8%

Competitors6%

Gov’t5%

Customers16%

Shareholders16%

Employees49%

(Tillinghast-Towers Perrin Survey

Other4% Competitors

8%

Gov’t2%

Customers14%

Shareholders47% Employees

25%

Frequency by Claimant[Public Company]

Managing the Risk

Risks to Director Prevention Indemnification Insurance

Who Pays the Bills?

Three alternatives Individual Director or Officer Corporation The D&O Insurer

Risk transfer

What is Corporate Indemnification?

Description The ability of the corporation to pay the

judgments, settlements and defense costs incurred by a director, officer, employee or agent of the corporation

Corporate Indemnification Limits

Four major limitations Not acting in good faith (decided by

board) Shareholder derivative actions (in part) Financial insolvency Superceding federal or state law

Including SEC claims under some circumstances

D&O Industry Economics 197% increase in number of companies sued in

Shareholder Class Actions from 1996 to 2001 (excluding “laddering” only allegations): 110 – 327 (Stanford Securities Class Action Clearinghouse)

The average settlement in 2002 increased from ~$17 million in 2001 to over $20 million. The standard deviation was over $58 million. Seven cases settled for over $100 million. (Securities Class Action Alert)

50% decrease in D&O insurance premium from 1994 to 2000

D&O Industry Economics

110 - number of companies sued in Shareholder Class Actions in 1996 (Stanford Securities Class Action Clearinghouse)

261 - number of companies sued in Shareholder Class Actions in 2002 (Stanford Securities Class Action Clearinghouse)

116 - number of companies restating earnings in 1997 (Huron Consulting)

330 - number of companies restating earnings in 2002: 200% increase (Huron Consulting)

Securities Class Action Trends:Large Settlements

Since mid-1999, the size of D&O settlements, particularly in securities class action lawsuits, has increased dramatically:

14 settlements or judgments in excess of $100M

1/2 of those settlements being in excess of $200M

Federal Securities Fraud Class Action Litigation Annual Totals

202163

231188

110178

236204 213

488

114

0

100

200

300

400

500

600

1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002

Federal Securities Fraud Class Action Litigation Annual Totals

202163

231188 204 213 261

489

233174

109

0

100

200

300

400

500

600

1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002

Directors’ & Officers’ Liability Insurance: Class Action Trends

Post-Reform Act claims more likely to include allegations of accounting fraud and illegal insider trading*

Average settlement value as a percentage of alleged damages increased from 5% - 7.5% pre-reform to 14% - 22% post-reform

2,000+ backlog of security claims in court system currently - actuarial projections are unfavorable

D&O Trends: PWC 2002 Securities Litigation Study

• 2002 - 261 securities suits

• 2001 – 483 Class Action Lawsuits Including 308 Laddering Cases and 175 Non-Laddering Federal Cases

• 57% of all non-laddering cases involved accounting allegations (up from 53% in 1999 and 2000)

• 2001 Accounting Breakdown:

69% alleged revenue recognition violations

28% alleged overstatement of assets

26% alleged improper estimates

9% alleged understatement of liabilities

6% alleged improper purchase accounting

69%

47% 49% 52% 55% 55% 57%

31%

57% 51% 48% 45% 45% 43%

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

With non-accounting allegationsWith account allegations

Source: PricewaterhouseCoopers LLP 2001 Securities Litigation Study p 1-8www.10b5.com

116 158216 233 270

330

0

100

200

300

400

1 2 3 4 5 6

Restatements By Year Filed

Source: AIG 2002 D&O Insurance White Paper

Restatement Trends

Source: AIG 2002 D&O Insurance White Paper

Restatements By Industry (1997 - 2001)

Agricultural, Mining & Construction

5%

Wholesale & Retail Trade

9%Transportation, Communication

10%

Services10%

Computer Manufacturing

11%

Finance14%

Software16%

Manufacturing25%

Restatement Trends

Average Securities Settlements

Source: PricewaterhouseCoopers LLP 2001 Securities Litigation Study

Year Settled

Number of Cases

Total Settlement Value

Total Settlement Value (1)

Average Settlement

Value

Median Settlement

Value

Average Settlement

Value for cases settled for $1

million or more and less than $50

milliom1996-2000 255 6,681,000,000$ 3,495,000,000$ 13,800,000$ 5,000,000$ 8,800,000$ 1999 82 4,341,000,000$ 1,155,000,000$ 14,300,000$ 5,200,000$ 9,300,000$ 2000 120 1,843,000,000$ NA 15,400,000$ 4,500,000$ 8,600,000$ 2001 109 1,879,000,000$ NA 17,200,000$ 5,500,000$ 10,700,000$ 2002 165 3,337,963,879 20,353,438(1) Excludes Cendant Settlement Value

Year Settled

Number of Cases

Total Settlement Value (1)

Average Settlement

Value

Median Settlement

Value

Average Settlement

Value for cases settled for $1

million or more and less than $50 milliom

1996-2000 157 2,798,000,000$ 17,900,000$ 6,500,000$ 10,000,000$ 1999 56 963,000,000$ 17,500,000$ 5,900,000$ 9,300,000$ 2000 68 1,407,000,000$ 20,700,000$ 6,400,000$ 10,100,000$ 2001 69 1,632,700,000$ 23,700,000$ 7,500,000$ 13,000,000$

(1) Excludes Cendant Settlement Value

All Cases

Accounting Allegations

Rescission Trends Rescission: The unmaking of a contract, or an undoing

of it from the beginning, and not merely a termination During the soft market, rescission was exception rather

than the rule Hard market evidencing change in tide:

Warranties are being mandated Applications are requiring more detailed information Severability clauses with respects to

misrepresentations in applications have been all but eliminated

Severability!

Sarbanes-Oxley & Potential Implications on D&O

Insurance

Sarbanes-Oxley Act & D&O Insurance

Main Provisions CEO / CFO

Certification of Financial Reports

D&O Insurance Implication Very small impact as D&O insurers

always have viewed the CEO & CFO as responsible for the financials.

Carriers will penalize those that have not certified.

Carriers may attempt to argue that the certifications are mini-warranties.

Improved Disclosure Gives insurers more details as to off-

balance sheet issues and related party transactions. Insurers may wish to exclude coverage where they see increased exposure.

Disgorgement provisions, prohibition of loans

Carriers will not have to worry so much as to executive excesses due to forgiven loans.

Severability Conduct exclusions

Sarbanes-Oxley Act & D&O Insurance

Expansion of time permitted to bring a suit for securities violations (2/5 years)

Insurers will now be forced to examine stock price volatility over a longer period of time, thus increasing their exposure to past actions of D’s & O’s. May cause non-renewals / less capacity, contracts with no past acts cover, and increased premiums.

Act applies to foreign private issuers (no appearance of carve-outs)

Will cause controversy with foreign private issuers as respects disclosure requirements. Liabilities of D’s & O’s likely increased along with D&O insurance rates.

Section 302 Rule applies to foreign issuers.

Main Provisions Audit Committees &

increased responsibilities and requirements

D&O Insurance Implication May cause a higher awareness as

to D&O insurance limits by the audit committee of the board. Reinforces the need for severability of the D&O contract.

May create friction between inside and outside board members

Current Trends:Energy Suits & Settlements

Security Class Actions Suits filed in 2002 by Industry

Healthcare3%

Diversified Services3%

Media2%

Food & Beverage2%

Retail4% Other

5% Biotech6%

Pharmaceuticals6%

Telecom11%

Financial Services29% Technology

16%

Energy13%

Average Settlements 2002:Energy Sector vs. All Industries

$0$5,000,000

$10,000,000$15,000,000$20,000,000$25,000,000$30,000,000

1998 1999 2000 2001 2002

Energy All Industries

Energy Sector Settlements:1998 - 2002

Triton Energy - $49.5M Plaintiff’s allegations During the Class Period, Triton had two main assets: (1) a

non-operated share of two oil fields in Colombia; and (2) a one-half interest in eight undeveloped offshore natural gas fields in Southeast Asia. Triton also had on-going projects in several other foreign countries. On March 30, 1998, Triton announced that it had hired investment bankers to assist it in maximizing shareholder value as the market "had not yet fully recognized the value of [Triton's] assets." Analysts immediately disseminated reports, based on detailed guidance from Defendants, that Triton was seeking to sell the whole company. On news of Triton's March 30, 1998, announcement, its stock price rose dramatically, increasing from approximately $30 per share to a class period high of $42 per share during a six week timeframe. During the months that followed, Triton and its executives engaged in a systematic campaign throughout the Class Period to deceive the investing public into believing that Triton would be acquired for a premium price.

Energy Sector Settlements:1998 - 2002

EEX Corp. - $25M The company overestimated the value of an

investment in its majority interest in an energy exploration project and overstated the value of oil and natural gas reserves in East Texas and the Gulf of Mexico.

Northeast Utilities - $25M Northeast Utilities failed to disclose safety

problems at its Millstone nuclear power plant in Waterford, CT which resulted in its shut down about a year ago.

Arakis Energy - $24M Disclosure violations in connection with a

proposed financing agreement for a pipeline in the Sudan between the company and Arab Group International.

Energy Sector Settlements:1998 - 2002

Marketspan Corp. - $7.9M The defendants breached fiduciary duties by paying

former Long Island Lighting officers "secret" payments of $67 million in retirement benefits and other compensation.

Coeur D'Alene Mines Corp.- $7M Falsely represented that it was improving its financial

results by reducing its losses in 1994 and reaching profitability during 1995, that its Golden Cross gold mine in New Zealand would achieve gold production in 1996 of about 77,000 ounces and that the company was on track to achieve strong cash flow, net income and earnings peer share growth in 1996 and 1997.

Unicorp America - $3.25M Company failed to obtain the highest price on a

proposed sale of real estate assets. The potential bidder, Coscan Inc., is not a bona fide third-party purchaser because it is affiliated with Hees International Bancorp, Inc., which owns 22% of Unicorp Canada.

Energy Sector Settlements:1998 - 2002

Bayard Drilling Technologies - $3.1M Failed to disclose in IPO documents financial

difficulties of company's largest customer which eventually led to substantial decrease in drilling contracts.

Offshore Energy Development. - $3M According to the complaint the positive statements

made by the defendants during the Class Period, including defendants' statements that OEDC would generate significant production, earnings and cash flow gains in 1997 and 1998 and that OEDC's results could be "predicted with high degrees of confidence," were false and misleading when made as they misrepresented and/or omitted to state facts necessary to make the statements made not misleading

Hallwood Energy - $1M The defendants breached their fiduciary duty in

regards to a merger price that was inadequate.