Sarbanes-Oxley May Have Big Impact On D&O Litigation

Under the new act, the Securities and Exchange Commission is given broad powers to bring various administrative proceedings, including cease and desist proceedings, actions seeking injunctive relief, actions seeking fines and penalties, actions to bar executives from further service, and criminal cases.

Former SEC Chairman Harvey Pitt promised more SEC civil, criminal and administrative actions at the American Bar Association Annual Convention earlier this year. According to an Aug. 12 Federal News Service report, Mr. Pitt said: "I think we have to see more prosecutions. I think that unless people believe that significant white-collar crime in which investors are bilked out of millions and even billions is subject to the same kind of punishment as so-called blue-collar or street crime, they will continue to lack faith in our system. And all I can say is that we are very, very determined to pursue this."

Hence there may be more litigation in a wider variety of forums.

The relevance for the D&O liability insurance industry is three-fold.

First, defendants may want to strategically and quickly settle lawsuits rather than allow them to go forward, for fear of producing evidence that could damage the defendants in a parallel administrative proceeding.

Second, defense costs may increase, because more forums mean more litigation, and because more forums may mean more lawyers, such as criminal lawyers in addition to a civil defense attorney.

Third, multiple lawyers may be requested where fellow executives cannot share counsel due to conflicts.

More discourse, more evidence.

Audit committees and boards are now charged with more specific responsibilities than ever before under the Act. Consequently, power has shifted from the chief executive to the rest of the board.

A likely result will be a greater level of sensitivity and tougher questions in the boardroom. The increased scrutiny and discourse may be documented to show due diligence, which means more evidence than ever before regarding corporate decisions.

While increased discourse is intended to create better management and financial reporting, it will also provide a paper trail for plaintiffs in litigation.

More disclosures, more evidence.

The act requires more and faster financial disclosures. For example, accountants are required to submit audit reports that include an assessment of internal controls, off-balance-sheet companies and relationships, and the adequacy of the financial reporting. Accountants are also required to keep audit records and work papers for seven years.

Executives must certify that they have revealed to the auditors all fraud and all financial information. In addition, executives must disclose trades in company stock within two days thereof.

These and the other new disclosure requirements under the Act force production of more evidence around which plaintiffs may frame a new case, and which plaintiffs may use to withstand motions to dismiss for failure to plead fraud with specificity.

Fewer dismissals.

Until now, the higher pleading standard under the Private Securities Litigation and Reform Act of 1995 meant that more cases were being dismissed, albeit many with leave to file again, for failure to plead fraud with adequate specificity. With the increase in the amount of available evidence and the increase in discovery due to the fact that the same event may give rise to litigation in more than one forum, it may be easier than ever before for plaintiffs to collect enough facts to survive motions to dismiss.

Larger classes, more damages.

The act provides a longer statute of limitation for filing securities fraud suits, which means longer class periods.

Until now, shareholders could wait until the sooner of one year from discovery of the acts or three years from the act itself. Under the new Act, they can wait until the sooner of two years from discovery, or five years from the actual event.

This means potentially longer class periods, larger classes, and larger class damages.

Larger penalties, more settlement pressure.

Hefty increases in jail time and financial penalties for executives under the Act may mean that executives are not willing to have the cases go forward. They may seek to settle, and settle quickly. This may include attempts to settle collateral cases that are otherwise not yet suitable for settlement, for fear of production of adverse evidence that could be used against them in the original case.

More regulatory actions.

The SEC is required under the act to review the periodic reports of publicly traded companies at least once every three years. This kind of scrutiny may lead to more regulatory actions. In fact, former SEC Chairman Harvey Pitt expressly promised more prosecutions.

In addition, more regulatory actions may lead to additional, concurrent civil actions by private litigants.

More directors and officers as defendants.

In most securities class actions in recent years, companies and key executives were sued, rather than the entire board, in part as a result of the enhanced pleading requirements of the Private Securities Litigation Reform Act of 1995. Under the new Act, however, audit committee members and independent directors have increased and specific responsibilities, which provides a concomitant chance of increased litigation against them.

More to come.

It is important to note that the acts provisions become effective at staggered points in time over the next year, and that the SEC has been asked to promulgate rules and regulations to implement the Acts mandates. In addition, the SEC has been asked to conduct several studies, undoubtedly to measure the need for further corporate governance reform.

As such, the Act is only the beginning of an era of corporate governance reform. More duties and responsibilities will be added in the months to come, which may create a greater potential for liability. Accordingly, the continuing changes must be carefully monitored.

In addition, the exchanges are increasing the strictures on listed companies and their executives. The NASDAQ and the New York Stock Exchange have proposed listing requirements that support and supplement the corporate governance requirements of the Act.

The New York Stock Exchange's proposed rules can be found at //nyse.com/pdfs/corp_gov_pro_b.pdf

In sum, they require:

Shareholder approval of most equity- based compensation plans.

Stronger and more active audit committees.

Compensation, corporate governance and audit committees must be staffed entirely by independent directors.

A majority of every board to be independent.

Independent directors must meet regularly outside the presence of the management directors.

These requirements must also be monitored carefully as they, too, could create increased liabilities if abrogated by executives.

Carol A.N. Zacharias is underwriting counsel for CNA Global Specialty Lines in New York The opinions set forth in her article are her own. They do not reflect analysis or opinions of any third party, and the article should not be construed as legal advice.

Reproduced from National Underwriter Property & Casualty/Risk & Benefits Management Edition, December 2, 2002. Copyright 2002 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.