02.17.2004
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Updates
The stock market bubble and crash from 1998 to 2001 and the ongoing stream of corporate scandals like Enron, WorldCom and Tyco have put corporate governance under the microscope. The actions of business leaders are now at the lowest levels of trust and highest levels of scrutiny in recent memory.
Public companies and their officers and directors are well aware that in this new environment, there is an increased risk of being named as a defendant in a securities or shareholder derivative lawsuit. Most directors and officers take comfort, however, in the knowledge that they are protected against this greater risk by their company's director and officer ("D&O") insurance policy.
However, along with the surge in securities lawsuits and the increased risk of being sued has come a significant change in the D&O insurance market. This change is reflected in a recent decision of the United States District Court for the Western District of Washington in a case entitled Cutter & Buck, Inc. v. Genesis Ins. Co., Case No. C02-2569P (Feb. 11, 2004) ("Cutter & Buck").
In Cutter & Buck, the corporation and certain of its directors and officers were named in several shareholder class action lawsuits in connection with financial statements that the company restated. After the lawsuits were filed, the insurance carrier notified the company that it was rescinding the company's D&O insurance policy. The court held that the rescission was proper. Moreover, it ruled that the rescission applied to all insureds under the policy, regardless of any involvement in, or even any knowledge of, the misrepresentations.
The Cutter & Buck case reflects an insurance industry trend towards aggressively restricting D&O insurance coverage. Below, we discuss some important aspects of D&O insurance and how companies and their directors and officers can best attempt to protect themselves in the new environment for shareholder litigation and D&O insurance.
Side A and Side B Coverage
Traditional D&O insurance consists of two types of coverage, "Side A" coverage and "Side B" coverage. Side A coverage protects an insured director or officer against losses that are not indemnified by the company. Side B coverage reimburses the company for amounts it pays to indemnify an officer or director. Taken together, Side A and Side B coverage are designed to fully insure (up to the policy limits) claims against individual officers or directors. Traditional D&O insurance does not, however, provide direct coverage for securities claims against the company itself.
Securities lawsuits against individual directors or officers commonly name the company as a co-defendant. Where the individuals are insured but the company is not, disputes can arise between the carrier and the insureds as to what portion of the loss (which includes the costs of defense) is "allocable" to the individual defendants (and thus insured) and what portion is allocable to the company (and thus uninsured). These disputes are generally called "allocation disputes."
"Entity" Coverage
In the early 1990s, D&O insurance lines were among the most profitable for a number of carriers. This drew other insurance companies into the business. The increased competition drove down premiums and forced carriers to develop new products, including so-called "entity" or "Side C" coverage.
Entity coverage provides insurance for claims against the company itself. This not only protects the company, it also eliminates the problem of allocation disputes. When all three types of D&O insurance coverage are purchased—Side A, Side B, and Side C—all defendants are insured, and there is no issue of allocating losses between insured and uninsured defendants.
The Change in the D&O Insurance Industry
Following passage of the Private Securities Litigation Reform Act of 1995 ("Reform Act"), D&O insurance carriers began lowering premiums and broadening coverage. Confident that the Reform Act would reduce securities lawsuits, most carriers predicted that D&O insurance would become more profitable. In fact, just the opposite has occurred.
In 1996, 127 federal securities class actions were filed. (Following the Reform Act, some plaintiffs' lawyers filed class action securities lawsuits in state court. This led Congress to pass the Securities Litigation Uniform Standards Act of 1998, which generally requires such cases to be filed in federal court under federal law.) In 2003, reflecting the upward historical trend, 224 federal securities class actions were filed. Similarly, in 1996 the average settlement value (in constant dollars) of all securities cases was approximately $10 million, whereas in 2003 it was $19.8 million. See generally E. Buckberg et al., Recent Trends in Securities Class Action Litigation: 2003 Early Update (NERA Feb. 2004). The combination of lower premiums and expanded coverage in the mid-1990s followed by the surge in securities case filings and average losses per case after the turn of the century have weakened the D&O insurance industry.
Some Carriers Have Reacted by Seeking to Rescind D&O Insurance Coverage When a Securities Lawsuit Is Filed
In contrast to the mid-1990s, today premiums and deductibles are going up, limits and coverage are coming down, and some insurance companies are retreating from the D&O insurance market altogether. Moreover, carriers are increasingly taking aggressive positions on coverage. An example of this more aggressive approach is cases like Cutter & Buck, where carriers seek to rescind policies when their insureds are sued.
A typical case arises where a company restates its financial statements, the company's share price drops, and shareholders sue alleging that the company-and its directors and officers-knew all along that the earlier financial statements were false. In many recent cases of this type, carriers have asserted that by restating its financial statements, the company has admitted the earlier statements were false, and because the earlier financials were part of the insurance application, the application contained a material misrepresentation, and therefore the carrier is entitled to rescind the policy. (Under Washington law, an insurer must show that the misrepresentation was made with the intent to deceive. RCW 48.18.090.)
Rescission Cases Are on the Rise
Carriers have taken this position in many of the highest profile securities cases today, including WorldCom, Tyco, Enron, Adelphia, and HealthSouth. And, while there are no firm statistics as to how often carriers have sought to rescind D&O insurance policies on this basis, it is an increasingly litigated issue.
Moreover, the trend is likely to continue. Over the past six years, the number of financial restatements each year has more than tripled, from 116 in 1997 to 354 for the twelve months ended June 2003. With well over half of the securities cases today involving allegations of accounting irregularities, and with outcomes such as Cutter & Buck, directors and officers have good reason to be concerned that the coverage they thought they had might not be there when they need it.
What Companies and Their Directors and Officers Can Do to Protect Themselves
Fortunately, there are several things that can be done to guard against such dangers. One of the most important is to check the policy's severability clause. Where one of several insureds is accused of wrongdoing, the wrongful conduct of the one insured may sometimes be imputed to some of the other insureds. In other words, the wrongdoing of one person can eliminate coverage for the company and some or all of its officers and directors, regardless of their innocence.
A severability clause makes it possible to "sever" the wrongful conduct between and among the insureds, thus ensuring that the wrongful conduct provides a basis to rescind the policy only with respect to the wrongdoer, not the other insureds. The extent of imputation and the protection the severability clause affords differ from policy to policy. In Cutter & Buck, for example, the D&O insurance policy contained a severability clause, but due to its wording and the facts of the case, the court ruled that it did not prevent the carrier from rescinding the policy with respect to all of the insureds. It is therefore important to work with your D&O insurance broker and legal counsel to evaluate the severability provisions in the policy forms your company is considering.
Another possibility to consider is a new D&O insurance product―individual policies, which are sometimes referred to as "non-rescindable" policies. These policies can be issued directly to the individual director or officer, and coverage is triggered if the company does not indemnify the individual for a loss, or if the company's D&O policy is nonexistent, insufficient, or has been rescinded. Some of these policies may be designed to insure the individual with respect to any, all, or some combination of the boards on which he or she sits, and most importantly, as mentioned, they are non-rescindable.
Practical Tips: Other Issues to Consider When Purchasing or Renewing Coverage Severability clauses and individual D&O insurance policies are just a couple of the items that corporations and their directors and officers should be aware of when reexamining their D&O insurance coverage with the assistance of a qualified broker and legal counsel. Other issues include:
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