Dodd-Frank & Corporate Investigations: Should D&O Insurance Cover The Cost?

Although in-house risk professionals and corporate lawyers may not relish the opportunity to review their company’s directors and officers liability insurance policy, provisions of the Dodd-Frank Act should prompt them to seriously consider the scope of their coverage.

In addition to the passage of the act, formerly known as the Dodd-Frank Wall Street Reform and Consumer Protection Act, an increasingly active regulatory environment is another factor pointing to the urgency of such a review for all public companies—especially smaller ones.

Particularly important is whether—and how—their policies will cover internal corporate investigations prompted by whistleblowers alleging corporate wrongdoing in an effort to recover bounties on potential penalties collected by the Securities and Exchange Commission. Bounties are available under Dodd-Frank for SEC penalties exceeding $1 million.

Should these sorts of complex internal investigations be covered under the company’s pre-existing directors and officers liability insurance coverage?

Why is this question even important?

Simply put, corporate investigations set in motion by a whistleblower or regulatory authorities, including the SEC, the U.S. Department of Justice or states’ attorneys general, can lead to a whole host of problems for a company and its directors and officers, including:

(1) Potential fines and penalties

(2) Potential criminal repercussions for individuals accused of wrongdoing

(3) Follow-on civil litigation commenced by the plaintiffs’ bar seeking to take advantage of potentially damaging facts that came to light as a result of the investigation.

It also goes without saying that internal corporate investigations are expensive to conduct, including not only the associated legal expenses, but also IT expenses, which are occasioned by the need to review e-mails and other soft-copy documents that might be relevant to the investigation.

A competently handled investigation where no wrongdoing is found may cause regulators to walk away satisfied that the company “did the right thing,” and many times will add no fodder to the follow-on civil litigation. On the other hand, a poorly handled investigation can lead to disastrous consequences for all involved—especially the company who has to ultimately “foot the bill.”

Corp. Investigations Coverage: Then and Now

Prior to 2011, D&O coverage for certain categories of internal corporate investigations was relatively standard in most primary D&O policies.

• Individual directors and officers were generally covered (depending, of course, upon the primary carrier and policy form in question) for informal inquiries and requests for information, as well as for civil, criminal, administrative or regulatory investigations commenced by either the issuance of a target letter or Wells Notice, or after the service of a subpoena.

• The company, however, was almost never covered, except when it was named (along with an individual directors and officer) in a “formal” SEC investigation—and then only when the D&O policy at issue specifically allowed for such coverage.

•  No coverage, at all, existed for the company for responding to “informal” inquiries and requests for information from the SEC.

The New Threat: WHISTLEBLOWERS & More Investigations

On May 25, 2011, the SEC adopted final rules implementing the whistleblower provisions of Dodd-Frank. In a nutshell, the Dodd-Frank whistleblower provisions provide that an eligible individual, such as an employee of the company, who “voluntarily” provides the SEC with “original information” about a potential violation of the federal securities laws that ultimately leads to a “successful” enforcement action may be entitled to receive a cash award.

Cash awards range from 10-30 percent of the total monetary sanctions in excess of $1 million recovered by the SEC in a civil or judicial action.

(For a thorough review of the whistleblower provisions of Dodd-Frank, see June 3, 2011 Weil Alert: “SEC Disclosure and Corporate Governance: Dodd Frank Update: SEC Adopts Whistleblower Rules.”)

Importantly, despite the fact that the potential whistleblower might just have easily reported the potential wrongdoing through the company’s own internal reporting and compliance program, the whistleblower provisions of Dodd-Frank do not require him or her to first do so. 

Instead, the whistleblower may go directly to the SEC in order to be “first in line” to receive the potential bounty.

The new rules enacted by the SEC do give the whistleblower an “incentive” to first report internally by allowing him or her up to 120 days to report such information to the commission after he or she first reports internally, while still retaining his or her place in line to receive the bounty). The rules allow for the attribution to the whistleblower who first reports internally all subsequently reported information reported by the company following its own internal investigation.

These reporting provisions, along with the monetary incentives of Dodd-Frank, present the company at issue with a number of potential challenges:

• More internal investigations as a result of the clear financial incentives of employees and others to “blow the whistle.”

There are reports already that the SEC has received an increased number of tips (often with supporting documentation) since the passage of Dodd-Frank. In addition, on May 25, 2011, SEC Chair Mary Shapiro noted publicly that while the SEC has a history of receiving a high volume of tips, “the quality of tips has improved since Dodd-Frank became law. And we expect this trend to continue.”

• The potential need to move quickly to perform an internal investigation should the whistleblower report to the company first, knowing that he or she has 120 days to report to the SEC.

Indeed, it may be in a company’s interest to self-report to the SEC before the SEC contacts it first.

• Being ready to perform the investigation upon first contact with the SEC should the whistleblower choose to bypass internally reporting procedures.

Investigations D&O Coverage Today

Prior to 2011, companies generally had no insurance mechanism to cover a costly internal investigation triggered by a regulatory inquiry. Today that is not the case. One large insurer has created a stand-alone product that potentially covers a company for a wide variety of potential corporate investigations, whether triggered by internal reporting through a company’s internal compliance program (with subsequent self-reporting of a potential securities law violation), or triggered by a direct formal or informal written or telephonic communication with the SEC requesting information, documents or interviews. There are rumors that other companies will soon follow suit and provide similar, if not alternative products or solutions, to cover the costs of internal corporate investigations triggered by regulatory inquiries.

A standalone corporate investigations D&O policy has a clear advantage for many companies seeking to insure for corporate investigations, and a compelling advantage from the standpoint of a director or officer of a public company. Since it is “standalone,” monies spent under an “investigations” policy will not reduce the limits of the company’s pre-existing directors and officers insurance coverage.  Simply put, separate dedicated limits for a corporate investigation is the best solution.

Still, a standalone product may be costly. If such a product is not affordable, but a carrier agrees to attach or “blend” corporate investigations coverage directly into the primary directors and officers policy, the directors and officers should insist either that the company only purchase such coverage with a significant “sublimit” (meaning that only a portion of the primary policy can be used for a corporate investigation), or that it purchase much higher D&O limits from a “tower of insurance” perspective, knowing that “on any given Sunday” a complex investigation could eat up millions of dollars of the tower.

For many companies, it may be a good idea to consult with an insurance broker or advisor that has a high degree of experience in insuring public companies, as they can often help inform decisions about the corporate investigations D&O insurance strategies laid out above.

Paul Ferrillo is Of Counsel and a senior litigator in the Securities Litigation/Corporate Governance Group of Weil Gotshal & Manges, LLP.  He may be reached at paul.ferrillo@weil.com. Before joining Weil in 2002, Ferrillo served as vice president and associate general counsel of National Union Fire Insurance Company (now Chartis).

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