The following summarizes numerous D&O lessons which can be gleaned from recent corporate debacles and some D&O insurance implications resulting from those debacles.
A. D&O LESSONS
1. Don't Ignore Basic Fiduciary Duties. Directors and officers owe to their company and its shareholders basic fiduciary duties of 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 addition, in some cases directors 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. The primary responsibility of directors is not to simply approve Board resolutions, but to effectively oversee the business and affairs of the company by probing into all aspects of the company and by exercising healthy skepticism about what is presented.
2. 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 thereto on a timely basis. For example, some of the recent claims involve the company entering into numerous transactions designed for financial reporting purposes rather than economic substance; an excessive number of related-party transactions; 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.
3. 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 can be 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 by company constituents.
4. Don't be Arrogant. Successful managers are frequently tempted to believe they have all the answers and can ignore the input of others. Such arrogance typically leads to disaster sooner or later. Instead, directors and officers should recognize that others may have helpful ideas, perspectives and suggestions and may raise 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.
5. 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 (in the event the other party to the transaction is financially unable or unwilling to honor its obligations), market risk (in the event the price or value of the underlying asset moves in an unexpected direction), valuation risk (in the event 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 a surprising disclosure to investors and others of large, unexpected losses). Directors and officers should establish policies and limitations on such leveraged transactions and should assure that a specific individual or department within the company (independent from the persons creating or administering the leveraged transactions) is 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 various possible stress conditions.
6. 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.
7. Improve Audit Committee Functions. Despite increased accountability of audit committees in recent years, a widespread perception still exists that these 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. Business, social or other relationships which may impede the independent thinking and decision-making of committee members should be considered when determining a member's qualifications for service on the audit committee.
- Audit committees should meet regularly and frequently, not just in connection with the annual audit.
- The audit committee, not the 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 particularly examine very closely 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 insist upon the highest quality accounting standards, which reflects the true economics of transactions and business operations.
- The audit committee should pre-approve any non-audit 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.
8. 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 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.
9. 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. A company's culture of integrity is established primarily through the actions of its leaders. 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.
10. Don't Aggravate Existing Problem. When a significant problem is identified either internally or externally, directors and officers should promptly address the problem through a comprehensive investigation and analysis, through decisive action and through 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. In any event, do not deny the truth, even if the truth seems harmful.
The enormous publicity given to some of the recent corporate failures has created political pressure for regulatory and legislative reforms relating to corporate responsibility. On March 7, 2002, President Bush released a 10-point plan ("Plan") to improve corporate responsibility and help protect America's shareholders. This plan, which was shaped by a task force headed by Treasury Secretary Paul O'Neill, addresses three core principles: (i) providing better information to investors; (ii) making corporate officers more accountable; and (iii) developing a stronger, more independent audit system.
With respect to better information to investors, the Plan would require the disclosure to investors of more information sooner and would require the information to be stated in "plain English."
With respect to making corporate officers more accountable, the Plan contains the following specific proposals:
- CEOs should personally vouch for the veracity, timeliness and fairness of their company's public disclosures, including their financial statements. CEOs would personally attest each quarter that the financial statements and company disclosures accurately and fairly disclose the information of which the CEO is aware that a reasonable investor should have to make an informed investment decision.
- CEOs or other officers should not be allowed to profit from erroneous financial statements. CEO bonuses and other incentive-based forms of compensation would be disgorged in cases of accounting restatements resulting from misconduct.
- CEOs or other officers who clearly abuse their power would lose their right to serve in any corporate leadership positions. This proposal, which is the only portion of the Plan which would require legislation in order to implement, would authorize the SEC to ban individuals from serving as officers or directors of publicly-held companies if they engage in serious misconduct.
- Corporate leaders should be required to tell the public promptly whenever they buy or sell stock for personal gain. This proposal would require disclosure of significant stock transactions by directors and officers within two business days of the transaction.
With respect to developing a stronger and more independent audit system, the Plan would limit the types of non-audit services which an external auditor may perform for an audit client; would require auditors to compare a company's financial controls with the best practices of the industry and report its findings to the audit committee; and would implement reforms regarding regulatory oversight and establishment of standards for the accounting profession.
The President indicated that his intent is to implement these reforms "without inviting endless litigation." According to the President, "[i]t is important to provide regulation and remedies where needed, without inviting a rush of new lawsuits that exploit problems instead of solving them." Although the goal may be to create greater accountability without increasing liability exposures to shareholders, it is difficult to imagine how such a goal could be accomplished. At a minimum, shareholders will be able to cite the heightened standards as evidence of expected behavior, thus enabling shareholders in litigation against D&Os to argue that significant deviation from the heightened standards constitutes sufficient recklessness under existing case law to establish personal liability.
The Plan is as notable for what is not included as for what is included. For example, some influential members of the President's task force unsuccessfully sought to include within the Plan at least two proposals which would have had far greater consequences to directors and officers. One would have lowered the standard for holding D&Os liable under the federal securities laws' antifraud provisions from "recklessness" to "negligence." Another would have required D&O insurance policies to have a minimum retention (e.g., $1 million) applicable to non-indemnifiable claims against the CEO and perhaps other senior officers. In addition, the Plan does not propose elimination or substantial erosion of the various litigation and liability protections contained within the Private Securities Litigation Reform Act of 1995.
Although these more significant reforms were not included within the Plan, substantial political support remains for many such reforms within Congress and perhaps within certain state legislatures. Thus, it is far from clear whether these and other similar types of more aggressive reforms will eventually be adopted. Notwithstanding the President's express desire, many of these other possible reforms would significantly increase the personal liability of senior officers to shareholders and would undoubtedly result in meaningful adjustments in the pricing and terms of D&O insurance policies.
B. 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.
2. Co-Insurance. In order to better align the interests of the Insureds and the Insurer in negotiating settlements and otherwise defending claims, many Insurers are now requesting co-insurance in the D&O policy, 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 co-insurance and predetermined allocation provision in the policy.
3. Application. Through much of the 1990's soft market, many D&O Insurers were willing to waive the necessity for an Application in the underwriting process, particularly at renewal. Several recent large cases have sensitized Insurers to the importance of meaningful Applications upon which underwriters can rely. As a result, it is likely that Applications will be more routinely required by Insurers in connection with underwriting both an initial and a renewal policy.
4. Severability. Although severability of the Application has and will remain a common feature of most D&O policies, 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, more Insurers will likely be utilizing a "limited" severability provision which excepts the knowledge of the person signing the Application. Under such a provision, if the Application signer knows of information which is not truthfully disclosed in the Application, coverage may be lost for all Insureds. As demonstrated by several recent large claims, when the signer of the Application participates in the subject fraud, the D&O Insurer is as much a victim as shareholders and other third parties, and therefore arguably should be entitled to full release of its obligations under the Policy.
5. For-Profit Outside Position Coverage. As a consequence of some of the highly publicized recent corporate failings, D&O Insurers will likely be more conscientious about and 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, since this coverage can result in substantial dilution or exhaustion of the Policy's limits of liability due to the wrongdoing of an unrelated company in which an Insured Person serves in an outside position.
6. 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 which state law may apply in administering claims under the Policy. That heightened sensitivity may result in some carriers adding to the Policy 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.
The foregoing D&O insurance issues are in addition to numerous other policy form amendments which 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 D&O insurance premiums appear to be attracting more attention by Insureds, changes in coverage terms and conditions can be far more significant to an Insured in the event of a claim. Therefore, Insureds should understand the reason for and consequence of these changes at the time the policy is purchased.
This articles is to convey general information on topics of interest to clients. Although prepared by a professional, it should not be used as a substitute for legal counseling in specific situations. Readers should not act upon the information contained in this article without professional guidance.