Insurance for A-Side D&O Exposures after Enron—A Riskier Proposition?
December 2002
In today's difficult legal and economic climate,
has pure directors and officers liability coverage become a riskier proposition?
New Expert Commentator John E. Black Jr. examines the issues.
by John
E. Black Jr. and Theodore A. Boundas
Boundas, Skarzynski,
Walsh & Black, LLC
The conventional wisdom seems to be that “A-Side” directors and officers
(D&O) liability insurance coverage, compared to “B-Side” coverage, is relatively
safe for insurers to offer. However, legal and economic developments in the
wake of Enron have created uncertainty as to how corporations and courts should
view traditional notions of corporate indemnification and advancement. To the
extent these developments have put into motion changes in the legal underpinnings
of indemnification and advancement, corporations may be less willing to indemnify
directors and officers and unable to advance defense expenses. If so, directors
and officers will have no choice but to seek A-Side coverage, which may significantly
increase the exposure under this coverage for D&O insurers.
The Role of A-Side and B-Side Coverage and Corporate Indemnification
Traditional A-Side coverage is pure directors and officers liability coverage—insurance
for directors and officers for claims when the corporation is not permitted
to indemnify them or is financially unable to do so. D&O liability insurance
protects directors or officers of a corporation against liability for errors
of judgment in their official capacity.
D&O insurance was conceived initially as “sleep insurance”—providing peace
of mind to directors and officers by assuring them that an independent third
party would indemnify them for losses resulting from their corporate role when
the corporation could not do so for legal or financial reasons. This assurance
allowed the corporation to attract and retain talented individuals to serve
as directors and officers, particularly outside (i.e., nonmanagement) directors
who usually expect to receive little compensation for their service.
Before the advent of D&O insurance, directors and officers were dependent
on the corporations they served for indemnification against claims against them
in their capacity as directors and officers. State indemnification statutes,
such as Delaware CLP § 145, typically permit corporations to indemnify their
directors and officers for expenses, judgments, fines, and settlements they
reasonably incur in actions against them by reason of their being directors
or officers, but only if they act in “good faith” and in a manner they reasonably
believe to be “in or not opposed to the best interests of the corporation.”
These statutes also authorize corporations to advance the litigation expenses
their directors and officers incur in such actions.1 In practice, corporations routinely advance such expenses.
Advancing expenses, like providing broad indemnification rights, are important
for a corporation to attract qualified people to serve in management, especially
given the substantial expense of defending director and officer litigation.
Advancing litigation expenses also helps the corporation promote a common representation
and coordinated defense. Generally, an advancement can be conditioned on the
recipient’s undertaking to reimburse the corporation if the recipient ultimately
is not entitled to indemnification or on any other conditions the corporation
requires, including the retention of counsel the corporation selects. However,
advancement is not indemnification, but a loan in anticipation of indemnification.2
D&O insurance usually covers corporate advancement and indemnification payments
through B-Side coverage. This coverage reimburses the corporation to the extent
it indemnifies its directors and officers for claims made against them, as required
or permitted by the indemnification statute, charter, or by-laws. However, the
principal purpose of D&O insurance is still to provide “sleep insurance” for
the directors and officers.
After Enron, Will Corporations Be Less Willing To Indemnify Directors and
Officers?
Recent corporate debacles such as Enron and WorldCom may lead to a reduction
in the scope of corporate indemnification that is legally permissible, or which
corporate boards are willing to determine is in “the best interest of the corporation.”
Already closer attention is being paid to the role of the audit committee and
other independent directors, and the Securities and Exchange Commission (SEC)
is tightening the reins on corporate insiders.
Some commentators suggest that the SEC, which traditionally has not pursued
actions against outside directors, may now be more inclined to prosecute outside
directors.3 Concern about executives who
may have engaged in self-dealing has even reached the point that institutional
shareholders such as the California State Teachers' Retirement System are offering
bounties for recoveries against the personal assets of executives. In a class-action
securities suit filed against WorldCom, the System is offering its lawyers a
2.5 percent bounty, on top of a 12 percent base fee, for recovering “significant”
personal assets from any of WorldCom's top managers.4
Courts may also look more closely at whether outside directors acted in good
faith in discharging their duties.5In an
era of well-publicized failures of major corporations, courts may be concerned
that long-standing assumptions about the independence and attentiveness of outside
directors—who are viewed to be necessary to police management effectively—may
not be well-founded. Outside director compensation has long been considered
nominal. However, the compensation packages of outside directors have become
more substantial in recent years, potentially undermining the independence of
outside directors.
A recent survey of top 200 companies revealed that annual board compensation
averaged $138,747.6 Some estimates place
the worth of stock and option packages of Enron outside directors at over $800,000.7The
assumption that outside directors have the necessary time and energy to monitor
management may also be suspect. One observer recently noted that as many as
63 percent of the outside directors of public companies are chief executives
of other companies.8
Under Caremark,9 compliance with a director's duty of care is determined by reference to the
good faith or rationality of the process employed in making the challenged board
decision. The independence or attentiveness of the outside board members increasingly
may become an issue that courts consider when faced with an inquiry into whether
the process behind a challenged board decision was rational or made in good
faith to advance corporate interests. This may undermine the effectiveness of
the business judgment rule defense, the principal standard for courts to review
challenged business decisions. The rule provides a presumption that management
has acted with reasonable care and in good faith, so its decisions will be regarded
as a “business judgment” courts will not revisit. If the rule is eroded, directors
and officers will face a greater chance of liability in derivative lawsuits
challenging their decisions.
The increased responsibilities and penalties that the Sarbanes-Oxley Act
places on senior management and the audit committee may make corporations less
willing to indemnify executives and audit committee members accused of violating
the Act. Among the most widely publicized provisions in the Act are §§ 302 and
906, which require CEOs and CFOs to certify quarterly and annual reports filed
with the SEC. Criminal penalties may be imposed on any CEO or CFO who knowingly
or willfully falsely certifies the corporation’s financial statements.
The Act also enhances the responsibilities of the corporate audit committee,
making it directly responsible for the oversight, appointment, and compensation
of outside auditors and requiring it to possess financial expertise. Given these
significant responsibilities, any failure of these persons to exercise due care
in discharging their duties may raise questions as to whether the best interests
of the corporation and its shareholders are served by granting indemnification.
Does the Sarbanes-Oxley Act Bar Corporations from Advancing Defense Costs?
Another corporate governance change contained in the Sarbanes-Oxley Act is
Section 402(a), which prohibits issuers from making “personal loans” to directors
and officers. Although there is little legislative history concerning this provision,
it probably was intended to address the $400 million loan made by WorldCom to
its CEO, Bernard Ebbers. However, an unintended consequence of this provision
is that an issuer may not be allowed to advance defense fees to its directors
and officers, thereby compelling them to seek coverage under the A-Side of the
D&O Policy.
Section 402 (a) adds a new § 13(k) to the Securities Exchange Act of 1934,
which makes it “unlawful” for an issuer, directly or indirectly, “to extend
or maintain credit, to arrange for the extension of credit, or to renew an extension
of credit, in the form of a personal loan to or for any director or executive
officer (or equivalent thereof) of that issuer.” The Act does not define “personal
loan.” The only exemption in the Act is for certain loans made in the ordinary
course of the issuer’s consumer credit business that are of a type and on terms
generally available to the public, such as home improvement loans and consumer
credit. Thus, while state law may expressly authorize a corporation to advance
litigation costs on behalf of its directors and officers, a registered issuer
may be barred by § 13(k) from taking advantage of the state advancement provision.
Whether a litigation advance should be considered a “personal loan” for the
purpose of § 13(k) is not clear. Arguably, advancements serve a legitimate corporate
purpose—protecting managers from litigation that may have a chilling effect
on their decision-making. Indeed, in a 1999 release concerning the Investment
Company Act of 1940, the SEC recognized that the unavailability of indemnification
and advancement of legal fees “could inhibit the willingness of independent
directors to take appropriate but controversial actions and discourage qualified
individuals from serving as independent directors”.10 Recently, several prominent corporate law firms circulated a white paper suggesting
that advancements, as well other standard corporate extensions of credit such
as travel advances, not be treated as personal loans.11
Whether the SEC would apply § 13(k) to bar advancements also is unclear.
In the past, the SEC has recognized the appropriateness of indemnification and
advancement provisions. In a 1980 release, the staff addressed whether an investment
company was permitted under § 17(h) of the 1940 Act to provide indemnity to
its directors and officers, stating that an indemnification provision would
not violate § 17(h) if indemnification is provided under circumstances providing
reasonable assurance that the director or officer was not liable by reason of
prohibited conduct (such as willful misfeasance, bad faith, or gross negligence).12
The staff further stated it would not recommend an enforcement action if
the company advanced expenses under an appropriate indemnification bylaw where
the indemnitee provided security, the company was insured, or an independent
review determined that the indemnitee would ultimately be entitled to indemnification.
Significantly, the SEC staff also indicated it would not view an advancement
as a personal loan, noting that a litigation advancement would not violate §
17(a)(3) of the 1940 Act, which makes it unlawful for an “affiliated person”
of an investment company “to borrow money or other property from the corporation.”13
However, the staff’s position in these releases appears to be based principally
on practical concerns. As the SEC noted in the 1999 release, the purpose was
to “enhance the effectiveness of independent directors by encouraging funds
to nominate directors who will effectively protect the interests of shareholders;
relieving independent directors of concerns regarding their ability to act in
shareholders' best interests without undue fear of personal liability; [and]
helping funds attract the most qualified persons to serve on their boards....”
Thus, the releases may more represent the staff’s prosecutorial intentions than
its legal analysis.
Given the current legal and economic climate, it is open to question how
broadly the staff might interpret the Act’s express ban on “personal loans.”
Without guidance from the SEC, public corporations may be reluctant to advance
litigation expenses, at least in situations where the corporation does not have
a mandatory commitment to do so. Absent a proper by-law or contract mandating
advancement, any advancement of expenses would be determined by the board members,
who are required to treat any decision to advance their personal expenses as
a self-dealing transaction that must be fair to the corporation.
In such cases, the board will be under great pressure to weigh the factors
involved, including the magnitude of the expenses, the ability of the indemnitee
to repay any funds advanced, and the probability that indemnification will ultimately
be available. In connection with this, the board members should also consider
the enhanced criminal penalties under the Sarbanes-Oxley Act and that a violation
of § 13(k) could result in fines to the corporation.
Theodore A. Boundas is Chairman of Peterson & Ross. He is a graduate
of Villanova University and Harvard Law School and has practiced in the areas
of directors and officers, professional, and financial institutions liability
and insurance for over 25 years. Mr. Boundas has handled many of the most significant
cases in the fields of professional and directors and officers liability insurance
and also has written and spoken widely on those subjects throughout the world.
He is a frequent author and speaker on professional liability and D&O issues.
He also served as chair of the American Bar Association Subcommittee on Directors
and Officers Insurance Coverage Litigation (Insurance Coverage Litigation Committee)
and is currently a Senior Legal Advisor for
Professional Liability
Insurance, published by IRMI.
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