D&O Lessons From Recent Claims

October 2004

By Dan Bailey, Esq.

Mr. Bailey is a member of the Columbus, Ohio, law firm of Bailey Cavalieri LLP. Mr. Bailey specializes in D&O liability insurance, corporate, and securities law. He is a frequent lecturer and has authored and coauthored several books dealing with D&O liability issues.
Recent large and highly publicized claims against directors and officers provide valuable lessons for those wishing to avoid being subjected to similar claims and the adverse publicity, embarrassment, and potentially catastrophic financial consequences resulting from them. Here are some of the lessons learned from these claims.

Ironically, the underlying causes of large and highly publicized claims are not new or exotic. Almost without exception, the claims were the result of directors and officers straying from simple and basic concepts of fiduciary duties, prudent management processes and common sense. It may be tempting to rationalize that in today's highly competitive and sophisticated environment, equally sophisticated new rules of corporate governance should apply. However, just the opposite is true: as a company's affairs become more complex, basic fiduciary duties of directors and officers, and corporate governance principles, do not change. Rather, they simply become more important.

The following discussion summarizes some of the lessons which can be gleaned from these recent claims and the resulting D&O insurance implications.

Lessons Learned

Don't Ignore Basic Fiduciary Duties

Directors and officers owe to their company and its shareholders the basic fiduciary duties of due diligence, care, and loyalty. Several recent claims primarily involve alleged breaches of the duty of loyalty, which generally precludes directors and officers from engaging in personal conduct that would injure or take advantage of the company. In some instances, officers routinely participated in transactions with the company and otherwise created blatant conflicts of interest with seemingly little regard for their fiduciary duty of loyalty. D&Os should make a renewed commitment to avoid even the appearance of conflicts of interest whenever possible, and should fully disclose and recuse themselves from any truly unavoidable conflicts.

In some cases directors also failed to appreciate and respond to the risks and dangers faced by the company (many of which resulted from officer decisions). In fulfillment of their duty of care, directors should thoroughly understand the basic operations and economics of the company and periodically assess the company's strategy and key performance indicators. Management should encourage and directors should raise challenging questions, and directors should insist upon satisfactory answers.

Investigate Warning Signs

In most instances, alarming company disclosures are preceded by warning signs visible to senior management and directors. D&Os should be vigilant in identifying those warning signs and should adequately respond to them on a timely basis. For example, some of the recent claims involve the company entering into numerous and highly complex transactions in which the structure, purpose, terms, and effect of the transactions were not understood by some senior managers and the directors. Such activity should be thoroughly investigated and the transactions should be approved by knowledgeable, informed, and truly independent persons based on the advice of qualified outside advisors where appropriate.

Don't Manage to Securities Analysts

Most public companies have in recent years become increasingly focused on meeting analysts' expectations. Maintaining or increasing the company's stock price can become an obsession. As a result, an environment is created in which personnel at all levels of the company are pressured to do whatever it takes to meet quarterly budgets and goals. Such a mindset unduly emphasizes short-term performance and may encourage deceptive disclosures. Instead, companies should strive to build long-term credibility with investors and analysts, and should seek to avoid unreasonable expectations.

Don't Be Arrogant

Successful managers frequently believe they have all the answers and can ignore the input of others. Such arrogance can lead to disaster. Instead, directors and officers should recognize that others may have helpful ideas, perspectives, and suggestions and legitimate concerns. An atmosphere of candid and open exchange of views should be fostered. Senior executives should encourage and carefully consider concerns and criticisms expressed by subordinates and should meaningfully respond to inquiries. Directors and officers should not surround themselves with “yes” employees and advisors who are either unwilling or incapable of challenging faulty reasoning or decision making.

Maintain Reasonable Leverage

Many companies are utilizing ever more complex methods to obtain leverage, including use of various types of complicated derivative instruments and off-balance-sheet financing arrangements. These arrangements present a variety of potentially enormous risk, including credit risk (the other party to the transaction may be or become financially unable or unwilling to honor its obligations), market risk (the price or value of an asset or product moves in an unexpected direction), valuation risk (the instrument is not properly valued at inception or during the term of the contract), operations risk (caused by inadequate internal controls, deficient procedures, human error, system failure, or fraud), and inadequate disclosures (typically resulting in large, unexpected losses).

Directors and officers should establish policies and limitations on such leveraged transactions. A specific individual or department within the company (independent from the persons creating or administering the leveraged transactions) should be responsible for measuring and reporting risk exposures and compliance with those policies and limitations. “Worst case” scenarios should be anticipated, and decisions to accept leveraged risks should be made with a view towards possible stress conditions.

Avoid Vague, Confusing, or Exaggerated Disclosures

Directors and officers should insist upon full and meaningful disclosures which are truthful and forthright. Clever “spin” or other vague or confusing communications with investors, analysts, and other constituents should not be tolerated. Instead, communications should be plain, easy to understand, and convey the whole truth. Even unsophisticated investors should be able to readily understand the disclosed information. Bad news should not be understated and good news should not be overstated.

Improve Audit Committee Functions

A widespread perception still exists that audit committees remain ineffective in many situations. A myriad of suggested reforms are now surfacing, some of which will be left to individual committees to implement and some of which will probably be required by future regulation or legislation. Some of the more compelling suggestions include the following:

·   Audit committees should be composed of only financially literate members who can fully understand and critique the company's financial statements and disclosures.

·   Audit committee members should be truly independent from management and the auditors and should meet regularly and frequently, not just in connection with the annual audit.

·   The audit committee, not the company's CFO, should have full responsibility for the selection, hiring, and termination of outside auditors. A periodic turnover of auditors every five to seven years is advisable.

·   The audit committee should adopt and oversee the enforcement of revenue recognition policies within the company and should closely examine the financial reporting and accounting policies for significant transactions that can materially effect the company's earnings performance for a quarter or year.

·   The audit committee should preapprove any nonaudit services to be performed by the outside auditor. Preferably, the only meaningful business relationship with the outside auditor is the audit.

·   In recognition of the increasingly complex and comprehensive responsibilities for the committee, members should be appropriately compensated, which in many instances will require a significant increase in pay.

Encourage Diversification of Employees' Investments

Consistent with sound investment concepts, management should encourage employees to diversify their investments and not include within their investment portfolio an unreasonably large percentage of company stock. Although in many cases employees should be encouraged to maintain an ownership interest in the company, thereby aligning their interests with outside investors, an excessive concentration of an employee's investment portfolio in company stock can not only create unnecessary investment risk, but may motivate employees to act inappropriately in order to artificially maintain or increase the company's stock price.

Work with People of High Integrity

Directors and senior management should demonstrate and insist upon a strong commitment to the highest level of legal, moral, and ethical conduct. Companies should not tolerate at any level activity which is perceived to be deceptive, manipulative, self-serving, or otherwise improper. It only takes one person's illegal conduct to cause enormous harm to the company and to expose numerous other directors and officers to potentially dangerous litigation.

Don't Aggravate Existing Problems

When a significant problem is identified either internally or externally, directors and officers should promptly address the problem through comprehensive investigation and analysis, decisive action, and forthright communications. If at all possible, timely and meaningful explanations should be made to investors, employees, other constituents, and the public regarding the source and consequences of the problem and the plans to address the problem.

Facts and evidence relating to the problem should be preserved for later reference, particularly if investigations or litigation are expected or pending. In addition, directors and officers should avoid the appearance of receiving special treatment either before or after the matter is disclosed. Do not deny the truth, even if the truth seems harmful.

D&O Insurance Implications

The D&O insurance market is undergoing a significant transformation, largely as a result of the significant increase in large losses arising from problematic claims. The following summarizes some of the ways in which D&O underwriters are and will likely be responding to these recent claims and issues which insureds should consider in light of recent claim experiences.

Entity Coverage

D&O insurance policies which include coverage for certain claims against the company are more likely to be considered assets of the bankruptcy estate if the company subsequently files bankruptcy. As an asset of the estate, the policy and its proceeds are automatically frozen when the bankruptcy petition is filed. The company's directors and officers thus cannot access the policy's proceeds to pay defense costs unless and until the bankruptcy court approves such payments, potentially impeding the ability of the defendant directors and officers to properly defend claims against them. This risk is greatly reduced if the policy does not contain entity coverage. Predetermined allocation can accomplish many of the same benefits as entity coverage without creating this increased bankruptcy risk.

Coinsurance

In order to better align the interests of the insureds and the insurer in negotiating settlements and otherwise defending claims, some D&O insurers are now including a coinsurance provision in their policy forms or by endorsement, at least with respect to corporate reimbursement coverage. If the policy also contains a predetermined allocation provision, insureds should fully understand the interrelationship and the cumulative effective of both a coinsurance and predetermined allocation provision in the policy.

The Application

Insurers are now sensitized to the importance of meaningful coverage applications upon which underwriters can rely. As a result, it is likely that new and renewal applications will be more routinely required by insurers.

Severability

It is likely that a limited version of severability will become more common. Unlike a “full” severability provision which does not impute the knowledge of any insured person to any other insured person, a “limited” severability provision excepts the knowledge of the person signing the application. Under a limited provision, if the signer of the application knows of information which is not truthfully disclosed in the application, coverage may be lost for all insureds.

For-Profit Outside Position Coverage

D&O insurers will likely be less willing to afford for-profit outside position coverage. In some respects, this more conservative approach to outside position exposures is consistent with the interests of all insureds. This is because there can be a substantial dilution or exhaustion of the policy's limits of liability as the result to the wrongdoing of an unrelated company in which an insured person serves in an outside position.

Choice of Law Provision

Several recent large claims have demonstrated the significant disparity in relevant insurance law which exists among various states. As a result, many D&O insurers are now more sensitive to various state laws that may apply when administering claims under the Policy. That heightened sensitivity may result in some carriers adding a “choice of law” provision which seeks to apply the law of a favorable jurisdiction in connection with the interpretation and enforcement of the policy.

In addition to the insurance issues above, numerous other policy form amendments are likely to appear as a consequence of the general tightening of the D&O insurance market. Unlike other hard market terms and conditions, though, the coverage terms discussed above directly result from the recent large claim experience of D&O insurers. Although dramatic increases in the cost of D&O insurance appear to be attracting more attention by insureds, changes in coverage terms and conditions can be far more significant in the event of a claim.