pos-629 · director is worth the risk. in the current environment, it is critical that directors...
TRANSCRIPT
2002D&O Insurance
White Paper
Understanding Board Member Risk
Executive Summary
It is a trying time for corporate directors and officers. Corporate scandals have put the
actions of executives under greater scrutiny. New corporate governance initiatives, while a
positive step in addressing valid concerns of the investing public, have created new liability
exposures for directors and officers, some of which may not have been intended. The personal
assets of directors and officers are at risk now more than ever. The specter of prison time
also looms large. With good reason, talented people are asking themselves whether being a
director is worth the risk.
In the current environment, it is critical that directors and officers investigate and under-
stand how their directors and officers liability insurance (D&O) protects or fails to protect
them. The findings could surprise them. As the nation’s leading provider of D&O insurance,
National Union feels strongly that the industry’s ultimate customer—individual directors
and officers—should understand why changes to the D&O insurance policy are needed.
Modifications must be made in order to refocus the policy on its original intent: protecting
the personal assets of directors and officers. These changes will serve the best interests of
directors and officers.
The modifications being made are not only in response to the recent corporate scandals and
the increased exposure that directors and officers face. They are being made because the
fundamental economics of the D&O insurance industry have been extremely negative ever
since the passage of the Private Securities Litigation Reform Act of 1995 (the “Reform Act”).
With this in mind, we thank PricewaterhouseCoopers for their assistance and input, included
herein, into some of the underlying causes behind recent securities litigation trends and the
reasons these trends have not tracked to pre-Reform Act expectations.
Despite the Reform Act’s good intentions, securities claims soared to record levels of fre-
quency and severity after its passage. The number of companies sued in securities litigation
rose nearly 300% from 1996 to 2001.1 Settlement values jumped 150% during the same time
period.2 However, given the competitive environment that was created by new entrants to
the marketplace, the premiums insurers charged to cover these increasing exposures reduced
by more than half. In 2000, the implausible economics of the situation begin to take a visible
toll. Two large D&O carriers became insolvent. Since then, several more insurance carriers
have been downgraded.
Currently, the balance sheets of many D&O insurance carriers are dangerously weakened.
In dozens of recent cases, due to the insolvency of a D&O insurer or a problem inherent in
the D&O insurance policy itself, directors and officers have been left without protection for
their personal assets. One large D&O insurance company recently went from an A- credit
rating to liquidation in 18 months, leaving many insureds with a D&O policy that was not
worth the paper it was printed on.
The inclusion of coverage for the corporation in the D&O policy has also had several
unforeseen effects, adverse to the interests of directors and officers. First, the inclusion of
“entity coverage” has diluted the amount of coverage available for directors and officers.
Policy limits intended for individuals are being eroded by the corporation’s own liabilities
when a claim occurs. Second, the existence of entity coverage has also reduced corporate
incentives to hold down litigation costs and settlements: Corporations no longer have a
vested financial interest in mitigating damages—only in settling suits within policy limits.
Since the introduction of entity coverage, settlement amounts, as well as legal expenses, have
skyrocketed. Third, in certain instances, such as the corporation’s bankruptcy, directors and
officers have found access to their policy proceeds (including funds to pay for their defense)
wholly blocked due to the inclusion of entity coverage.
Despite certain well-publicized instances of fraud, the vast majority of directors and
officers are innocent and deserve protection. If the D&O industry is unable to protect these
individuals, they will not continue to expose themselves to the threat of personal litigation.
And in order for D&O insurance and the D&O insurance market to protect innocent
directors and officers, immediate changes must be made:
• Entity coverage, which has diluted the protection available to directors and officers, needs
to be regulated. In order for the contract to provide clarity as to what it will and will not
cover, the industry needs to adopt a pre-set allocation clause, which articulates how much the
D&O policy will pay on behalf of the individuals as opposed to how much the corporation
will pay on behalf of its own exposure in securities claims.
• The quality of the insurance companies participating at every level of the D&O program
must be sound, lest insured directors and officers be blindsided by a carrier that is financially
unable to pay losses when a claim occurs. Directors and officers need to realize that their
D&O insurance is not a commodity.
• D&O underwriters must understand the true nature of the risk that they are being asked
to assume. The industry will not be able to survive if it is required to pay claims on behalf
of policyholders who provide inaccurate or misleading information as part of the under-
writing process.
• D&O insurance premiums must be aligned with the current level of securities exposure.
For this to occur, premium rates must continue to climb rapidly.
By returning the D&O policy to its original focus of protecting the personal assets of directors
and officers, these changes will also ensure that the D&O policy provides proper economic
incentives for all parties involved in defending securities claims. This will result in a reestab-
lishment of the traditional partnership among the insurer, defense counsel, directors, officers
and corporation. Individual directors and officers will be better served when this is achieved.
With recent corporate scandals, and the quick passage of the Corporate Auditing and
Accountability Act of 2002 (officially titled, “Sarbanes-Oxley Act of 2002”) in response to
these scandals, significant additional exposures have been created for directors and officers.
Because of this, the need for change in the D&O insurance industry has become particularly
urgent. The need for knowledgeable, experienced brokers is critical. D&O insurers and
brokers must act quickly to enact the changes needed to ensure a stable, enduring D&O
insurance market. An in-depth analysis of the issues facing directors and officers in today’s
marketplace is attached. We hope that you will find this useful and informative in understanding
why, and how, the D&O industry needs to change.
Table of Contents
Executive Summary
Introduction ...................................................................................................................
I. Background: The PSLRA .................................................................................
II. Expectations: Post 1995 ...................................................................................
• Capacity ..................................................................................................................
• Premium Rates .......................................................................................................
• Coverage .................................................................................................................
• Entity Coverage ......................................................................................................
• Multi-Year Contracts .............................................................................................
III. Reality: Post 1995 .............................................................................................
• Frequency Rises ....................................................................................................
• Severity Increases ..................................................................................................
• Accounting Allegations ..........................................................................................
IV. What Went Wrong? .............................................................................................
• Record Rise in Restatements ................................................................................
• Accounting Rules Lag Behind ..............................................................................
• Complex Disclosure Requirements .......................................................................
• SEC Activism .........................................................................................................
• Greater Focus by Plaintiff Firms ..........................................................................
• Large Valuations ....................................................................................................
• Lack of Risk Sharing .............................................................................................
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V. Economics of the D&O Industry ................................................................
• Failed Economics ...................................................................................................
• Reinsurance Problems ...........................................................................................
• Unintended Repercussions of Entity Coverage ...................................................
VI. Corporate Auditing and Accountability Act of 2002 ..........................
• Securities Litigation Reform .................................................................................
• No Bankruptcy Discharge of Securities Law Liability .......................................
• CEO/CFO Certification ........................................................................................
• Real Time Disclosure .............................................................................................
• Increased Frequency of SEC Review ...................................................................
• Audit Committee Requirements ............................................................................
• Executive Compensation .......................................................................................
• Insider Transactions ...............................................................................................
• Disclosure of Off-Balance Sheet Transactions ......................................................
VII. Solutions for the D&O Industry ................................................................
• Regulate Entity Coverage .....................................................................................
• Price Coverage Properly ........................................................................................
• Embrace the Flight to Quality ..............................................................................
• Risk Sharing ...........................................................................................................
• Side A Excess Program .........................................................................................
• Resurrecting the Partnership ................................................................................
• Consequences of Misleading Information ............................................................
• Protecting the Innocent .........................................................................................
Conclusion ......................................................................................................................
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“What happens when the Prime Movers go on strike?
This means a picture of the world with its motor cut
off...This is the actual heart and center of the novel ...
I set out to show how desperately the world needs
Prime Movers, and how viciously it treats them.”
— Ayn Rand on Atlas Shrugged 3
In 2002, investors have been exposed to unprecedented corporate scandals. Fraud has occurred on
a massive scale. Financial statements and the auditors who validate them have been called into
question. Executives’ compensation is under scrutiny. Investors have been left suffering, during
what appears to have been a time of unbelievable corporate greed gone unchecked.
But investors are not the only victims of this dismal securities market. Innocent corporate directors
and officers are seeing their personal assets jeopardized by corporate crimes they did not commit.
Shareholder Class Action lawsuits against corporations and their boards are rising unabated, with
damages alleged to be in the hundreds of millions, if not billions, of dollars.
Insurers who underwrite directors and officers liability insurance to protect the personal assets of
directors and officers in securities litigation are affected as well. The frequency and severity of
securities claims has skyrocketed. The number of cases involving accounting allegations, an
especially costly breed of shareholder litigation, has increased dramatically. Given the content of
the newly passed Corporate Auditing and Accountability Act of 2002 (Sarbanes-Oxley Act of 2002),
and the requirement of all CEOs to attest to the validity of their company’s financial statements,
litigation will only continue to increase into the foreseeable future.
While D&O insurance policies provide coverage for events other than shareholder (securities)
litigation, securities litigation settlements make up the lion’s share of loss costs to the D&O industry
and are the major source of concern for directors and officers. Developments in securities litigation
over the past six years have strained the D&O insurance market and significantly heightened
exposure for the industry, as well as for those it insures. The corporate scandals of 2002 have put
the personal assets of directors and officers even more clearly in the spotlight, attracting the
lawyers who make a career out of suing executives.
As a result, the D&O policy is more important than ever to the directors and officers of corporate
America. Yet directors and officers must realize that the D&O insurance policy in its current state
may not be able to fulfill its fundamental purpose of protecting their personal assets. If this situation
is not remedied, talented people will ask themselves whether being a director is worth the risk.
In such an event, Ayn Rand may have shown us what our world will look like.
It is in everyone’s best interest that the D&O insurance marketplace functions as a viable source
of protection. The intent of this paper is to explore some of the causes and the consequences of
today’s securities litigation trends, and how the D&O insurance industry has come to its current
state. It is also to outline solutions that the D&O industry needs to implement immediately in order
to remain a viable source of protection for the “Prime Movers” of Corporate America.
1
I. Background: The Private Securities Litigation Reform Act of 1995
Roughly 220 securities cases were filed in 1994, representing a 41% increase over the prior year
and a 30% increase over the average number of filings in the prior three years.4 Corporate
America had long lobbied for tort reform, arguing that the filing of securities litigation suits
was in many cases tantamount to blackmail, since the exorbitant cost of discovery, including
depositions of top management, generally far outweighed the cost of settlement.
A Wall Street Journal news article5 aptly sums up the primary problem with the state of the
tort system at the time. The article recounts the story of a Mr. Hutchens, a plaintiff who filed
more than 30 shareholder fraud cases and convinced several companies to settle these suits
for relatively low amounts. These settlement amounts represented almost pure profit for
Mr. Hutchens, because he never actually bought stock in any of the companies that paid him
off. Additionally, his overhead was low since, as the Journal notes, “His rent is covered by
the government—because his place of business is a 6-by-12 foot cell in federal prison.”
According to the article, Mr. Hutchens was serving time for attempting to bilk the IRS out
of ill-gotten tax refunds.
Mr. Hutchens, corporate America believed, was symptomatic of the shortcomings of the tort
system. So when the Private Securities Litigation Reform Act of 1995 (the “Reform Act”)
was passed by Congress, corporate America breathed a sigh a relief, believing that positive
change was imminent.
II. Expectations: Post 1995
The passage of the Reform Act was seen as a clear-cut victory for corporate America and
its D&O insurers. Overall settlement costs were expected to decline as a result of fewer
filings, and many of these filings were not expected to survive the Reform Act’s heightened
pleading standards.
Several changes occurred in the D&O insurance industry in the post- Reform Act era:
• Insurance Capacity: Up until the passage of the Reform Act, the D&O insurance industry
had a relatively stable claims history. With the passage of the Reform Act, the industry
estimated that future costs would be only more predictable. Therefore, the amount of capital
2
offered by the insurance industry to provide D&O insurance increased dramatically.
New players, lured by potential profits yet lacking any D&O underwriting and claims
experience, stampeded into the market.
• Premium Rates: As insurance capacity became overabundant, basic economic forces
drove premiums down. In the competitive D&O insurance market of 1996 through 2001,
premiums charged for D&O protection reduced by more than half.
• Coverage: Insurers significantly expanded the coverage granted under the “standard”
D&O policy. Policies soon encompassed employment practices, errors and omissions,
fiduciary liability and other exposures. All of these were in addition to the coverage for
“traditional” securities and breach of duty claims.
• Entity Coverage: Protection grew beyond its original focus of protecting the personal
assets of directors and officers to insuring the corporate entity for its own exposure.
This “entity coverage” was designed to align the interests of insurers and insureds in
defending and settling securities claims, avoiding unproductive disputes over allocation
of loss. Before the introduction of entity coverage, corporations named in securities class
actions had no coverage for their own liabilities. As a result, it was typical for insurance
carriers and the defendant companies in securities litigation cases to negotiate how much
the D&O policy would contribute to the settlement and how much of the loss would be
“allocated” to the corporation for its own exposures.
In the mid-1990s, there were a series of coverage disputes over the concept of “allocation,”
with corporations arguing that the D&O policy should pay 100% of the settlements and
defense costs regardless of any liabilities that the uninsured corporation might have.
Different jurisdictions applied different interpretations of allocation. Entity coverage was
designed to eliminate allocation disputes so that the interests of the corporation and
individuals would be properly aligned with the insurance company and litigation could
be properly and aggressively defended.
• Multi-year Contracts: Insurers allowed insureds to “lock in” coverage and coverage terms
over multiple years.
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III. Reality: Post 1995
Despite the high expectations for securities litigation reform, data on securities litigation
since 1995 makes it clear that the Reform Act has not had its expected effect.
• Frequency of Securities Litigation Has Increased: The number of securities fraud
litigation cases filed has risen nearly 300%, from 122 in 1996 to 483 in 2001.6
• Severity of Settlements Has Increased: Of even greater significance than the heightened
frequency of filings is the increased severity of settlements in securities suits, especially in
those suits containing accounting allegations. Since 1996 to 2001, the average settlement
value of a security class action increased almost150% (from $7.0M in 1996 to $17.2M in
2001).7 Even worse than this, however, in 2001 suits containing accounting allegations cost
280% more to settle than suits without such allegations. The settlement value of these
accounting suits relative to prior years is also rising rapidly.8
4
Federal Securities Class Action Litigation
• Lawsuits Containing Accounting Allegations Have Increased: The percentage of securi-
ties lawsuits containing accounting allegations has risen steadily since the passage of the
Reform Act, especially compared to pre-Reform Act levels.9
5
Average Settlement Value ‘96-’00 Average Settlement Value 2001
% of Cases Involving Accounting Allegations
All Cases Accounting Cases Non Accounting Cases
IV. What Went Wrong?
Neither Corporate America, nor its D&O underwriters, could have predicted these trends.
This is because they were fueled by numerous and diverse developments, several of which
are discussed below.
• A Record Rise in Restatements: From January 1, 1997 to December 31, 2001, there were
a total of 990 restatements of financial statements of publicly traded companies (excluding
restatements due to a change in accounting).10 As evidenced by the graphs on the following
page, there has been significant growth in restatements every year, prior to the accounting
scandals of 2002. Furthermore, all industry segments are at risk for restatements.
The largest securities litigation settlements in the recent past have resulted from restatements:
Consider Cendant at $2.83 billion; Miniscribe at $550 million; and Waste Management
at $220 million. The reason is simple. Restatements are an admission by a company’s
management and outside auditors that accounts were materially misstated. Hence, while the
requisite scienter, or intent, still needs to be proven for plaintiffs to recover, when companies
restate their financial statements plaintiffs have, in effect, already won half the battle.
• Accounting Rules Lag Behind: Many believe that accounting rule making has not kept up
with the market and the ingenuity of financial institutions and executives. This stands to
reason, since it takes Wall Street just weeks or months to launch a new financial instrument,
but it can take years for new accounting rules to wind their way through the public due
diligence process and clear the Financial Accounting Standards Board (FASB). In the
meantime, the appropriate accounting characterizations can be up for debate. Moreover,
unforeseen economic developments can make disclosures that seemed adequate at the time
appear inappropriate in hindsight, subjecting registrants to fraud claims.
• Complex Accounting and Disclosure Requirements: The accounting practice, often
thought of in terms of exactitude, is now, due to such debacles as Enron, Adelphia and
Global Crossing, becoming known for what it is: “more art than science.” It is impossible to
write specific accounting rules to cover the array of transactions and financial instruments
extant in the marketplace today, yet this does not seem to have deterred the FASB and the
SEC, both of whom continue to publish pages upon pages of often difficult to understand
guidelines for various financial vehicles. Whether guidelines are understood or not, when
registrants are found not to have followed accounting rules, restatements and the inevitable
lawsuits ensue.
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Restatements by Year Filed
Agricultural, Mining and Construction
5%
Manufacturing25%
Software16%
Finance14%
ComputerManufacturing
11%
Services10%
Transportation,Communication
10%
Wholesale and Retail Trade
9%
Restatements by Industry (1997-2001)
• SEC Activism: The SEC’s rule-setting and enforcement activity under former Chairman
Arthur Levitt is well documented. Two of the three Staff Accounting Bulletins (“SABs”)11
issued in the closing months of 2000, while declaring no changes to current rules, signifi-
cantly transformed the application of generally accepted accounting principles, or GAAP,
by virtually every registrant. The most insidious of the SABs, from the perspective of a
registrant, was SAB 99 relative to materiality. The SEC made it clear that the application
of materiality was no longer strictly subject to mathematical rules of thought, leaving regis-
trants in a state of perpetual uncertainty over whether their treatment of an issue deemed
immaterial will be challenged by the SEC. The concepts outlined under SAB 99 are not
lost on the plaintiffs bar.
• Greater Focus by Plaintiffs on Cases That Survive Dismissal: Based on both anecdotal
and empirical evidence, the Reform Act seems to have succeeded in keeping many
frivolous cases out of court. While dismissals comprised only 12% of case dispositions prior
to the Reform Act, dismissals comprise fully 26% of case dispositions post-Reform Act.12
However, the cases that do pass through the motion to dismiss of the heightened pleading
standards are viewed as having a stronger basis, leading to greater settlements. Accordingly,
plaintiffs’ strategy appears to have shifted, out of necessity, from one of filing and settling
many cases to pursuing cases that survive for all they are worth. The emergence of institu-
tional shareholders as lead plaintiffs has only strengthened this strategy.
• Large Valuations Amplify Losses: Higher stock valuations mean a harder fall when things
go wrong.With market valuations at stratospheric levels in the late 1990s, earnings expec-
tations missed by only a penny a share often caused a stock price to plummet. In such an
environment, allegations that a securities fraud caused a false run-up in value, and that the
subsequent disclosure of the purported fraud caused a precipitous drop in value, will be
accompanied by extremely large damage calculations—often in the hundreds of millions of
dollars, and frequently in the billions.
• Risk Sharing Is Lacking: With settlement costs borne 100% by the insurer, corporations
that faced protracted and costly litigation began immediately settling suits, perhaps even
for unreasonable amounts, and even if they had a good chance of prevailing. While it is not
possible to illustrate empirically, this inclination to settle may have contributed to the rapid
rise in settlement costs and the “mega-settlements” that are increasingly common today.
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V. Economics of the D&O Industry
Starting around 1996, and confident that the Reform Act would reduce exposure to meritless
securities claims (which had cost the D&O industry untold millions), the D&O insurance
marketplace became very competitive. Up until this point, the industry had relatively stable
and predictable earnings. Since the Reform Act had the intended purpose of limiting securities
lawsuits, the insurance industry predicted that the D&O product would only become more
profitable. As a result, barriers to entry were lowered, coverage terms were broadened and
premium rates fell dramatically.
• Failed Economics: Among the most pronounced problems the D&O insurance industry
faces in the wake of the Reform Act is inadequately priced D&O policies dating back
to 1996.
By the time the industry began raising premiums in early 2001, rates were approximately
half of those charged back in 1996. Meanwhile, the industry’s total exposure (in terms of
loss costs and including the impact of entity coverage) had increased an estimated 1000%,
from $427 million in 1996 to $5.6 billion in 2001.13 Due to the long-tail nature of D&O
claims, which often do not settle until three-to-four years after a claim is filed, the pricing
of D&O risks was woefully inadequate in light of the actual increase in exposure that had
occurred. The ramifications of this are just beginning to emerge.
In 2000, two large D&O insurers became insolvent, leaving countless directors and officers
without access to coverage and with their personal assets at stake in claims. Several other
carriers have since had their credit ratings downgraded or placed on credit watch with
negative implications.
• Reinsurance Problems: The reinsurance industry also recently awoke to the serious
problems of the D&O marketplace. Reinsurers had been subsidizing the underwriting of
many recent entrants to the D&O marketplace, sometimes providing up to 90% of their
underwriting capacity, without exerting any control over the allocation of this capacity and
the underwriting practices of these new, inexperienced players. Furthermore, reinsurers
suddenly realized that they had a serious aggregation problem. They were exposed to the
same loss multiple times for the different insurers they reinsured. With severity increasing
drastically, reinsurers paid out exorbitant losses on an excess of loss basis.
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In 2002, reinsurance capacity has rapidly withdrawn from the marketplace and reinsurance
rates have soared, creating even greater instability among D&O insurers. Which D&O
carriers depend on reinsurance to pay claims, and what is the state of their reinsurer
relationship? Answers to these questions have become critical for many D&O insureds
and their brokers.
• The Unintended Repercussions of Entity Coverage: Despite its good intentions, entity
coverage has actually been harmful to directors and officers, as well as to D&O insurers.
The reasons are several.
First, at the time entity coverage was created, D&O insurers typically negotiated a 50% to
70% allocation of coverage between the insurance policy and the uninsured exposure of the
corporation, depending upon the circumstances of the case. Therefore, by granting entity
coverage across the spectrum of its customer base, the D&O industry almost doubled the
amount of cover it granted under its policies. Yet during the time that entity coverage
became widely adopted, premium rates dropped in excess of 50%. In hindsight, it is clear
that insurers were not pricing for this cover.
Second, while entity coverage was meant to align the interests of insurers and insureds, by
insuring both corporations and directors and officers in securities claims, it unintentionally
removed the corporate insured’s financial interest in how claims were resolved. Pre-entity
coverage, the corporation had a significant uninsured liability. As a result, it had a vested
financial interest in negotiating the lowest possible settlement. With that uninsured liability
now covered, companies’ concern shifted to simply settling a suit within the D&O policy
limits. Settlement amounts skyrocketed. This, along with a lack of restraint in controlling
defense expenses (which are paid for by the D&O policy as well), has had a tremendous
negative impact on the economics of the D&O industry and has strained the insurer-
insured relationship.
Third, because of entity coverage, bankruptcy courts have interfered with the payment of
defense expenses and settlements in shareholder cases. D&O policies have routinely been
treated as assets of a company’s bankrupt estate; often Bankruptcy Court orders are
required to permit payment of defense expenses and grant relief from the automatic stay.
Recently, bankruptcy trustees have become aggressive in targeting any and all assets for
potential recovery. By allowing a D&O policy to insure the corporation, directors and
officers face the reality that the bankruptcy trustee will target their policy, so it will be used
for the benefit of the creditors as opposed to the protection of directors and officers.
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The lesson is that in a bankruptcy situation—when proper D&O coverage is a paramount
concern of directors and officers—the existence of entity coverage can impede the policy’s
ability to respond to protect the personal assets of directors and officers. In non-bankruptcy
situations, the D&O policy, and the amount of coverage available for individuals, is eroded
because the policy pays for the liabilities of the corporation. Protecting the personal assets
of directors and officers should be the fundamental purpose for which directors and officers
liability insurance is purchased. Any impediment to achieving that purpose should not be
allowed to continue.
VI. The Corporate Auditing and Accountability Act of 2002
On July 25, 2002, the United States Congress passed The Corporate Auditing and Account-
ability Act of 2002 (Sarbanes-Oxley Act) by an overwhelming majority of 423 - 3 in the
Congress and 99-0 in the Senate. On July 30, 2002, President Bush signed the Bill into law.
The Corporate Auditing and Accountability Act of 2002 (Sarbanes-Oxley Act) will have
a direct and immediate impact on directors and officers, as well as on D&O insurance.
The Act’s mandates may create additional civil liabilities as well. The Act’s mandates include16:
• Securities Litigation Reform: The Act extends the current statute of limitations for
securities litigation to the earlier of five years after the alleged violation or two years after
its discovery. The previous statute of limitations was within three years of the alleged
violation or within one year of its discovery.
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“Provisions in the Bill that expand the ability of people to sue may have a positive effect on making people
pay attention to their business, but we all know based upon our legal system that this is going to be abused.”
— Senator Phil Gramm14
“ ‘The law gives a straight path of liability’ to the pocketbooks of individual executives.”
— Wall Street Journal 15
• No Bankruptcy Discharge of Securities Law Liability: The Act amends the federal
bankruptcy laws to immediately prevent the discharge of debts under any claim relating to
a violation of state or federal securities laws, or any securities fraud or manipulation.
• CEO/CFO Certification: The Act requires the CEO and CFO of any publicly traded
corporation to make personal certifications in each quarterly or annual report filed to the
SEC certifying:
• The officer has reviewed the report.
• The report does not contain any untrue statements.
• The report is not misleading.
• The officer is responsible for maintaining internal controls.
• The officer has reviewed the internal controls and has commented on their effectiveness in the report.
• The officer has disclosed to the company’s auditor any deficiencies in the internal control systems.
• Whether there were any significant changes in any internal controls.
• Real Time Disclosure: The Act requires companies to disclose on a “rapid and current basis”
information concerning material changes to their operations and/or financial condition.
• Increased Frequency of SEC Review: The Act requires the SEC to review the disclosures
of all publicly traded companies at least once every three years.
• Audit Committee Requirements: The Act requires the SEC to direct companies to have
Audit Committees that are made up entirely of “independent” directors. Companies will be
required to publish in their financial reports that at least one of these directors is a
“financial expert.”
• Executive Compensation: The Act requires that any CEO or CFO of a company preparing
to make an accounting restatement forfeit any bonus or other incentive-based compensation
(including profits from any sale of company stock) received during the 12 month period
following the publication of the financials being restated. The Act further prohibits any
loans to be made to directors and/or executive officers, as well as freezes any “extraordinary
payments” to be made to an insider during the course of any investigation for possible
securities law violations.
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• Insider Transactions: The Act requires directors, executive officers and/or any entity
owning more than 10% of the company’s outstanding stock to disclose any transaction
(as required under a Form 4) within two business days following the transaction. The Act
also makes it illegal for any insider to purchase or sell any security of his/her company
during a blackout period, as defined by the Act.
• Disclosure of Off-Balance Sheet Transactions: The Act requires the SEC to issue rules
requiring disclosure of all material off balance sheet transactions, as well as requiring the
disclosure of all relationships with unconsolidated entities that may have a material impact
on the financial condition of the registrant. Further, the Act directs the SEC to issue rules
prohibiting the presentation of “pro forma” information.
VII. Solutions for the D&O Industry
National Union Fire Insurance Company of Pittsburgh, Pa.® (National Union), an AIG member
company, believes the following steps are required to return stability to the D&O insurance
market and to return the focus of D&O insurance to protecting the personal assets of directors
and officers:
• Regulate Entity Coverage: The D&O policy should exist for the exclusive benefit of
individual directors and officers. Entity coverage has so diluted the coverage afforded to
the individuals that it can no longer serve this function. The solution is to regulate the use
of entity coverage in the D&O insurance contract, and to reinstate allocation for securities
claims against both the corporation and its directors and officers.
The purpose entity coverage was originally intended to serve, i.e., eliminating disputes
between insurers and insureds in a claim situation, can be served instead by broadly
adopting a pre-set allocation clause. As a result, corporations will have a vested interest
in resolving cases in a financially responsible manner. More important, directors and
officers will have certainty that the policy exists for their exclusive benefit.
Regulating entity coverage is also essential to ensure that individuals are protected in the
event of the corporation’s bankruptcy. This can only be done by making the directors and
officers the only insureds under the contract.
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Some corporations will resist removing entity coverage from the D&O insurance contract.
However, it is important that the directors and officers of these companies be made aware
of the consequences they may face as a result of this decision.
• Price Coverage Properly: In line with traditional economic models, D&O insurance rates
have been steadily increasing over the past year as D&O capacity has constricted with
D&O insurers becoming insolvent or retreating from the market. Reinsurers have also
impacted prices significantly by either withdrawing from the marketplace or imposing
greater restrictions on those insurance companies still allowed to use their capital.
As mentioned earlier, there has been an exponential increase in severity and frequency of
claims covered by the D&O policy since 1996. As a result, the insurance industry is paying
billions of dollars in claims and is underfunded as a result of inadequate pricing levels.
To align with today’s escalated exposure, D&O insurance rates must continue to increase
drastically.
• Embrace the Flight to Quality: All D&O insurance capacity is not created equal. Nor is
the quality of underwriting and claims servicing. In order to ensure that the D&O insurance
market continues to operate effectively for directors and officers, companies and brokers
should scrutinize the quality of the underwriters they choose to participate at every level
of their D&O program. The significant liabilities emerging from asbestos and medical
malpractice claims, coupled with the overall poor performance of the property and casualty
insurance industry, have weakened the financial resources of some insurers and could
impair their ability to pay directors and officers claims in the future.
Insureds should be wary of carriers who offer aggressive terms, or large commissions, in
order to make up for weaknesses in their balance sheet. The market should also be wary of
those who during economic booms relied on inflated investment returns to mask financial
vulnerabilities. On average, D&O claims take three-to-four years to resolve. Because of
this, insureds should not only be concerned with the present stability of their insurance
carrier, but must also consider whether the insurance carrier will be around when it comes
time to pay a claim.
14
Consider the hard lessons learned from the recent case of a well-known insurance company,17
a prominent and aggressive underwriter of D&O policies during the 1990s. A known
“brand,” and so assumed by many to be stable, this company wrote a significant number
of primary and excess D&O policies during the years that the industry’s loss costs grew
exponentially. In 2001, the company went from A- rated to liquidation, in 18 months.
Many claims involving this company’s insureds are only now being settled, and insureds
and brokers are for the first time realizing the real costs of doing business with this carrier.
Due to its liquidation, this insurance company is unable to meet its financial obligations
under its D&O insurance contracts. This leaves “holes” of millions of dollars in uninsured
amounts in D&O insurance programs underwritten in the late 1990s. Turmoil surrounds
the resolution of claims of any insurance program involving this insurance company, and
the personal assets of directors and officers are exposed.
• Reinstate Risk Sharing: On policies where entity coverage continues to exist, adding
coinsurance or other risk sharing provisions may counteract some of the ill effects of entity
coverage by aligning the financial incentives of the insured and insurer in managing securities
claims. These elements of risk sharing will need to be properly aligned with the relative size
and financial capabilities of the insured, as well as with its appetite for risk.
• Establish Side A Excess Program: Side A coverage is pure directors and officers
coverage. It provides coverage for directors and officers only for claims in which the
corporation is not permitted to provide an indemnity. A Side A excess program, sitting on
top of a “traditional” program of D&O insurance, can provide real value. However, the
underlying program needs to be fundamentally sound.
A properly functioning Side A excess program can only sit on top of a program that has
substantial limits and appropriate risk sharing between the insured and insurer. With this
structure, the underlying policy with a pre-set allocation can protect and align the interests
of the co-defending company and individual directors and officers. The “A side tower,” as
this is called, permits limits to be reserved exclusively for the directors and officers in the
event that the pre-set allocation policy(‘s) limits are used settling shareholder securities
class actions, and shareholder derivative actions are still pending against the individuals.
15
• Resurrecting the Partnership Among the Insurer, Insured, Law Firm and Broker:
The need for this partnership is critical to the litigation strategy that requires a united
front in opposing the plaintiff’s bar to achieve the most cost effective result. The corporation
has the documentation and knowledge needed to mount the defense and is in the best
position to control defense expenses. An experienced insurer has significant expertise to
contribute in dealing with plaintiff firms and will have a broad knowledge of recent settle-
ments and strategies. The right law firm has the expertise needed to mount an aggressive
defense. This is the very reason behind National Union’s Panel Counsel, i.e., to ensure that
our insureds are provided with the best defense possible and to ensure a united front in
opposing plaintiffs.
Very few securities cases actually ever go to trial. Companies and executives do not want
their business strategies held up by this type of litigation; they do not want their liquidity
to be threatened, and perhaps most important of all, they do not want to face the threat of
having their reputations tarnished by a possible guilty verdict. Against that threat, responsible
insurance companies provide a valuable service in negotiating cost effective resolutions
due to their vast amount of experience in handling these types of settlement negotiations.
However, if there is a breakdown in the partnership, the people that ultimately lose are the
individual directors and officers.
• Consider the Consequences of Misleading Information: Most critical to an underwriter’s
ability to understand risk is the quality of information provided by the insured or broker.
The underwriter relies upon a wide range of information, financial statements, applications
and representations made in meetings or conversations, etc., to evaluate a risk.
The financial soundness of a corporation is one of the most critical assumptions made in an
underwriter’s decision to put his/her company’s capital at risk for the directors and officers
for that particular corporation. Regardless of the innocence or guilt of individual directors
or officers as to the accuracy of the financial statements, if the corporation’s financial
statements are inaccurate, then the risk as presented to the underwriter is misrepresented.
As in any contract that relies upon information that was incorrect, the party relying upon that
information has an obligation to its own shareholders to seek appropriate remedies, which
could include rescission of the contract. The contract of D&O insurance is no different.
16
• Protecting the Innocent: Underwriters recognize that even though certain individuals
may put the overall D&O coverage at risk, there will still be innocent individuals who
need, and deserve, coverage. More often than not, these will be independent directors
who were unaware of the actions that subsequently jeopardized their D&O coverage and
their personal assets. Typical D&O policies try to address this consequence through the
application of severability. However, severability will not protect these individuals if the
policy has been rescinded or otherwise excludes the specific claim.
To resolve this issue, National Union has created a new product which provides coverage
for independent director liability. This policy covers independent directors only and
is non-rescindable.
Side A excess coverage, previously discussed, serves a similar function, protecting all
innocent directors and officers. However, a traditional Side A coverage does not offer complete
protection in the event a restatement exclusion applies or the primary or Side A polices
have been rescinded. In order to protect innocent insiders as well as independent directors,
we have developed a non-rescindable Side A policy for all directors and officers, which
“drops down” in the event of a rescission or application of a restatement exclusion, as well
as fulfilling the traditional Side A role.
Both of these policies become effective if the underlying traditional D&O policy is rescinded
or excludes the claim outright.These policies are offered only for insureds who have their
primary policy underwritten by National Union.
Corporate America, and the American economy, needs the best and brightest to serve as
directors and officers. However, without adequate financial protection, many individuals
will not expose themselves to the potential abuses of shareholder litigation. The solutions
outlined above will allow individuals to continue to serve as decision-makers, knowing that
if they behave properly and lawfully, their personal assets will be protected by insurance.
17
A Final Note
In order to do what it was originally created to do—protect and defend the personal assets
of directors and officers—the D&O liability insurance policy needs to provide appropriate
incentives for all concerned: the insurer, defense counsel, directors, officers and corporation.
All must work together toward a common end in defending a claim.
National Union believes that fundamental change is needed to ensure that the personal assets
of Corporate America’s directors and officers are truly protected. In order to do this, the
industry needs to remain viable. Entity coverage must be removed from the contract and
replaced with a pre-set allocation, with significant risk sharing between insurers and the
corporations served by insured directors and officers. The quality and financial strength of
D&O carriers must be foremost in the mind of insurance purchasers, and the product must
be adequately priced. These changes will enable the D&O industry to sustain itself and to
provide sound protection for directors and officers as they confront unprecedented scrutiny
in today’s marketplace.
William Cotter is Chief Underwriting Officer of National Union Fire Insurance Company
of Pittsburgh, Pa., a member of American International Group, Inc. (AIG), and the nation’s
leading provider of directors and officers liability insurance.
Christopher Barbee is a partner in the Dispute Analysis & Investigations practice of
PricewaterhouseCoopers LLP (“PwC”) in Philadelphia, specializing in forensic accounting
matters and internal corporate investigations, including securities litigation.
Insurance underwritten by member companies of American International Group, Inc. The description herein is a summary
only. It does not include all terms, conditions and exclusions of the policies described. Please refer to the actual policies for
complete details of coverage and exclusions. Coverage may not be available in all jurisdictions.
18
EndNotes:
1 PricewaterhouseCoopers Data - The 2001 litigation activity includes the 308 “laddering” cases filed in 2001.However, it is important to note that a substantial number of these cases involve other allegations outside of, and in addi-tion to the allocation allegations. IPO tie-in or so-called “Laddering” cases are those in which the principal allegations relateto allocation of shares to purchasers of stock in IPO’s and post-IPO activity. These cases arose in large numbers during2001 and may have temporarily diverted the plaintiffs bar from filing traditional securities litigation claims. Filings of such“traditional” claims has picked up substantially in 2002.
2 National Economic Research Associates, Securities Litigation Study, Figure 12; PricewaterhouseCoopers, 2001Securities Litigation Study, 7.
3 Ayn Rand, Atlas Shrugged (New York, Random House, 1957).
4 PricewaterhouseCoopers, 1997 Securities Litigation Study, 1.
5 Wall Street Journal 26 October 1998.
6 PricewaterhouseCoopers Data. - The 2001 litigation activity includes the 308 “laddering” cases filed in 2001.However, it is important to note that a substantial number of these cases involve other allegations outside of, and in additionto the allocation allegations. IPO tie-in, or so-called “Laddering” cases are those in which the principal allegations relate toallocation of shares to purchasers of stock in IPO’s and post-IPO activity. These cases arose in large numbers during 2001and may have temporarily diverted the plaintiffs bar from filing traditional securities litigation claims. Filings of such “traditional” claims has picked up substantially in 2002.
7 National Economic Research Associates, Securities Litigation Study; PricewaterhouseCoopers, 2001 SecuritiesLitigation Study, 7.
8 PricewaterhouseCoopers, 2001 Securities Litigation Study, 6-7.
9 According to a 1999 PricewaterhouseCoopers Securities Litigation Study, the number of suits containing accountingallegations in 1995 was roughly 25% of total suits filed, 2.
10 Huron Consulting Group, A Study of Restatement Matters, 4.
11 SAB’s issued during Levitt’s term included SAB 99 relative to the concept and application of “materiality,” SAB100 regarding restructuring reserves, and SAB 101, which deals with a variety of aspects of revenue recognition.
12 National Economic Research Associates, Securities Litigation Study, figure 11.
13 Avg Settlement amount in 1996 = $7.0M x 50% (allocation) x 109 companies sued = $427M. Avg settlement amountin 2002 = $17.2M x 100% (entity coverage) x 327 companies sued (estimate to exclude laddering only cases) = $5.6B.
14 Brian Gruley, “New Kind of Badfly Turns Public Firms Into Sitting Ducks,” Wall Street Journal 26 October 1998, 1.
15 Richard B. Schmitt and Henry Sender, “CEO’s Personal Wealth May be at Stake in Investor’s Lawsuits,” Wall Street Journal 9 August 2002.
16 Sullivan & Cromwell, Memorandum entitled “Congress Passes Broad Reform Bill in Substantially the Form Passedby the Senate Last Week: President’s Signature Expected Shortly, 26 July 2002.
17 Christopher Oster, “When the Boss Caused the Loss, Who Pays?” Wall Street Journal 13 June 2002, Page C1.
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