Director and Officer Exposure

The current economic environment, with resulting adverse effects on the financial results of many businesses, has spurred an increase in claims and investigations. Companies that have any relationship to the credit markets, certainly to include real estate development, financial services and the mortgage industry (as well as financial institutions, investment banks, REITs, investment advisers, hedge funds, investment companies and other professionals) should carefully review their D&O coverage, well before renewal time. The continuing adverse economic conditions have resulted in increased litigation outside the financial sector. Stockholder activism is increasing, giving rise to exposure to claims. As a result, it is prudent to assess indemnification provisions and arrangements together with D&O coverage and risk management functions.

Governmental and related investigations also are and will continue to be an ongoing result of adverse conditions, related unrest in the credit markets and economic conditions. While many D&O policies cover investigations related to possible or potential violations of applicable laws and regulations, definitions contained in the policy and related riders are all important. In connection with the renewal process, careful attention should be focused on definitions. The definition of “claim” covered by the policy is significant and should be as broad as possible. D&O policies are negotiable, at the time of purchase, on renewal or during the policy period.

The Insured's Obligation

One of the initial actions that should be taken in connection with any entity that may be exposed to investigations, claims or related litigation is to ascertain the insured's obligation to provide notice to its carriers. Any failure to satisfy the requirements of notice may prevent coverage of any actual claim. Some notice requirements may be circumstantial to the extent that elements for a claim are present. If circumstances exist that appear to give rise to a possible claim, it may be appropriate to consider providing notice of the circumstances to the insurer in order to prevent any possible coverage issues involving the adequacy and timeliness of notice. Failure to provide adequate and timely notice likely will foreclose coverage.

In connection with new or renewal coverage, careful attention should be given to the application for D&O coverages. One frequent basis for denial of coverage relates to either inaccurate or inadequate disclosure of information in the formal application submitted to the insurance carrier. The application for coverage will question whether the applicant or any individual to be covered is aware of any basis or circumstance that may result in a claim under the proposed coverage. Inadequate or incomplete responses may foreclose coverage. It is important to include a severability provision to avoid imputation of any misrepresentation in the application to all insured.

A periodic review of definitions, coverage, exclusions and notice requirements, may preserve coverage, which could otherwise be denied. Review of the all important definition of what events or claims are actually covered, and likewise what is excluded, is a most important undertaking. Policy cancellation and rescission provisions on the part of the insurer should be carefully reviewed to avoid surprises. The market had been relatively soft until economic conditions became adverse, but nonetheless negotiation of these all important terms and the definitions should be undertaken.

Independent Directors and Risk Management

Based upon the current economic environment and the resulting adverse effects on the financial results of many companies, the role of independent directors and risk management activities has become even more important. As management uses its efforts to enhance corporate performance in difficult economic times, the oversight role of directors, particularly independent directors, in properly analyzing and evaluating risks in decision-making becomes even more important. Clearly, the current economic environment has resulted in significant litigation, and higher exposure to shareholder class actions alleging management misconduct and failure on the part of boards of directors to perform their fiduciary duties, including risk oversight responsibilities.

Risk Management Oversight Obligations of the Board Of Directors

As a further consequence of the current economic environment, there is a heightened awareness of board responsibility for risk management and oversight. As a result, recent legislative and regulatory proposals and initiatives address the subject. As a part of good governance practices, and as an adjunct to periodic review and evaluation of D&O coverages and exposure, analysis should include risk management and board oversight responsibility.

Several legislative initiatives have been introduced, particularly related to financial institutions and the relationship between risk-taking and management compensation. Taking the issues a step further, in the spring of 2009, the “Shareholder Bill of Rights Act of 2009″ was introduced by Sen. Charles Schumer (D-NY). It extended risk-management functions to all public companies, requiring the creation of a separate independent risk management committee of the board, charged with analysis and evaluation of risk-management practices and processes. The Corporate Governance Reform Act of 2009, introduced in the House by Rep. Keith Ellison (D-MN), requires an independent risk-management committee of the board and the creation of a chief risk officer who reports to the board committee for each public company. Likewise, various financial institution reform legislation focuses on risk management practices, among a number of other issues. None of these legislative initiatives have been enacted, but there is congressional focus.

The SEC

From a regulatory perspective, the Securities and Exchange Commission (SEC) has implemented disclosure requirements, including risk oversight practices, as a part of a public company's compensation practices. The disclosure requirements became effective Feb. 28, 2010. The amendments require disclosure and analysis of compensation policies in light of risk management practices. The focus of the SEC on disclosure of board activities involving risk management and oversight has prompted a heightened awareness of board responsibilities, resulting in public companies implementing risk management committees and risk management officers, specifically charged with this function.

In connection with a periodic assessment of corporate governance and related compliance evaluation, Sarbanes-Oxley (SOX) imposed significant governance requirements on the board of directors, including an independent audit committee and disclosure controls and procedures, related to required certifications. Furthering these requirements, stock exchange rules require an independent audit committee to develop guidelines and policies in connection with the process by which risk assessment and management is undertaken. Hence, even if there is no dedicated board committee or subcommittee for risk management functions and oversight, the audit committee in connection with its functions, and likely under its charter provisions, is charged with risk management oversight. These functions squarely fit within the suggested periodic review of the adequacy of liability protection measures, such as indemnification and D&O coverages.

Insurance Considerations

Under current market conditions, class action suits often arise out of alleged failure of adequate disclosure. As the value of a company's stock falls, with allegations of inaccurate or incomplete disclosure, securities class action litigation will likely follow. It should be noted that a bankruptcy filing raises a host of coverage issues that should be addressed well in advance of any proceeding, including whether there is any coverage and if so, who is entitled to the benefits. Together with a review of policy provisions, definitions and exclusions, the type of coverage provided also should be reviewed. Consideration should be given to whether “Side A” coverage should be included, to protect individual directors and officers when the entity may not or cannot, indemnify its directors and officers.

Given this environment, many independent directors seek stand alone type insurance coverage, dedicated to independent or outside directors. This has given rise to Independent Director Liability (“IDL”) insurance coverage, where the coverage provided is not reduced or eroded by claims and losses from officers and inside directors or the company. IDL coverage can either be provided by stand alone insurance contracts in favor of independent directors or can be a form of excess coverage for a standard “Side A” policy. “Side A” coverage was developed as a method to indemnify directors and officers when the corporation is either financially unable to indemnify or is prohibited from doing so. The IDL coverage would be an adjunct to this coverage solely for independent directors. One of the advantages of this type of coverage is that it does not cover inside directors, officers, other employees or the company, and as a result may have fewer exclusions and exceptions. For example, IDL coverage generally cannot be rescinded and provides for full severability. As with other D&O type insurance coverages, terms and conditions of IDL coverage vary and a careful analysis of terms, conditions and limitations as well as exclusions from these policies is most significant, together with how the policy fits within the framework of the overall D&O insurance program.

Many companies elect to maintain D&O insurance in layers, with a primary carrier and one or more excess carriers. Many excess policies are so called “follow form” policies, meaning these policies are to conform to the terms and conditions of the primary policy. However, some excess policies contain express conditions that specifically alter the terms of the excess coverage. It is important to carefully review excess coverage to make certain these pieces fit together as a unified D&O insurance program. Often, excess coverage is triggered only when the primary insurer pays the full limits of its coverage. Where the primary issuer pays less than full coverage limits, the excess carrier may deny that excess coverage has been triggered.

Actions to Take Now

Management and the board should conduct a thorough review of coverages and potential issues related to coverage which may save significant difficulties going forward, particularly in the current environment. This review process should not only include the D&O insurance program, but also should include the company's indemnification provisions, whether in the basic corporate documents, separate indemnification agreements, or employment agreements. Given regulatory and legislative initiatives, it is also most important to review board risk management policies and functions. All too often, what should be a unified program, contains flaws, inconsistencies and adverse provisions, which together can create unintended consequences.

The current environment and the perception that excessive risk taking was a significant cause of current conditions, have caused extensive legislative and regulatory consideration of the management and control of risk. Given pending legislative initiatives, regulatory requirements and reform activities, management and boards should pay careful attention to these initiatives and the adequacy of their risk management systems.

William L. Floyd is a corporate partner in the Atlanta office of McKenna Long & Aldridge LLP. His practice focuses on securities and corporate finance, mergers and acquisitions and corporate matters, including corporate governance and responsibility. He may be reached at [email protected] or 404-527-4000.

The current economic environment, with resulting adverse effects on the financial results of many businesses, has spurred an increase in claims and investigations. Companies that have any relationship to the credit markets, certainly to include real estate development, financial services and the mortgage industry (as well as financial institutions, investment banks, REITs, investment advisers, hedge funds, investment companies and other professionals) should carefully review their D&O coverage, well before renewal time. The continuing adverse economic conditions have resulted in increased litigation outside the financial sector. Stockholder activism is increasing, giving rise to exposure to claims. As a result, it is prudent to assess indemnification provisions and arrangements together with D&O coverage and risk management functions.

Governmental and related investigations also are and will continue to be an ongoing result of adverse conditions, related unrest in the credit markets and economic conditions. While many D&O policies cover investigations related to possible or potential violations of applicable laws and regulations, definitions contained in the policy and related riders are all important. In connection with the renewal process, careful attention should be focused on definitions. The definition of “claim” covered by the policy is significant and should be as broad as possible. D&O policies are negotiable, at the time of purchase, on renewal or during the policy period.

The Insured's Obligation

One of the initial actions that should be taken in connection with any entity that may be exposed to investigations, claims or related litigation is to ascertain the insured's obligation to provide notice to its carriers. Any failure to satisfy the requirements of notice may prevent coverage of any actual claim. Some notice requirements may be circumstantial to the extent that elements for a claim are present. If circumstances exist that appear to give rise to a possible claim, it may be appropriate to consider providing notice of the circumstances to the insurer in order to prevent any possible coverage issues involving the adequacy and timeliness of notice. Failure to provide adequate and timely notice likely will foreclose coverage.

In connection with new or renewal coverage, careful attention should be given to the application for D&O coverages. One frequent basis for denial of coverage relates to either inaccurate or inadequate disclosure of information in the formal application submitted to the insurance carrier. The application for coverage will question whether the applicant or any individual to be covered is aware of any basis or circumstance that may result in a claim under the proposed coverage. Inadequate or incomplete responses may foreclose coverage. It is important to include a severability provision to avoid imputation of any misrepresentation in the application to all insured.

A periodic review of definitions, coverage, exclusions and notice requirements, may preserve coverage, which could otherwise be denied. Review of the all important definition of what events or claims are actually covered, and likewise what is excluded, is a most important undertaking. Policy cancellation and rescission provisions on the part of the insurer should be carefully reviewed to avoid surprises. The market had been relatively soft until economic conditions became adverse, but nonetheless negotiation of these all important terms and the definitions should be undertaken.

Independent Directors and Risk Management

Based upon the current economic environment and the resulting adverse effects on the financial results of many companies, the role of independent directors and risk management activities has become even more important. As management uses its efforts to enhance corporate performance in difficult economic times, the oversight role of directors, particularly independent directors, in properly analyzing and evaluating risks in decision-making becomes even more important. Clearly, the current economic environment has resulted in significant litigation, and higher exposure to shareholder class actions alleging management misconduct and failure on the part of boards of directors to perform their fiduciary duties, including risk oversight responsibilities.

Risk Management Oversight Obligations of the Board Of Directors

As a further consequence of the current economic environment, there is a heightened awareness of board responsibility for risk management and oversight. As a result, recent legislative and regulatory proposals and initiatives address the subject. As a part of good governance practices, and as an adjunct to periodic review and evaluation of D&O coverages and exposure, analysis should include risk management and board oversight responsibility.

Several legislative initiatives have been introduced, particularly related to financial institutions and the relationship between risk-taking and management compensation. Taking the issues a step further, in the spring of 2009, the “Shareholder Bill of Rights Act of 2009″ was introduced by Sen. Charles Schumer (D-NY). It extended risk-management functions to all public companies, requiring the creation of a separate independent risk management committee of the board, charged with analysis and evaluation of risk-management practices and processes. The Corporate Governance Reform Act of 2009, introduced in the House by Rep. Keith Ellison (D-MN), requires an independent risk-management committee of the board and the creation of a chief risk officer who reports to the board committee for each public company. Likewise, various financial institution reform legislation focuses on risk management practices, among a number of other issues. None of these legislative initiatives have been enacted, but there is congressional focus.

The SEC

From a regulatory perspective, the Securities and Exchange Commission (SEC) has implemented disclosure requirements, including risk oversight practices, as a part of a public company's compensation practices. The disclosure requirements became effective Feb. 28, 2010. The amendments require disclosure and analysis of compensation policies in light of risk management practices. The focus of the SEC on disclosure of board activities involving risk management and oversight has prompted a heightened awareness of board responsibilities, resulting in public companies implementing risk management committees and risk management officers, specifically charged with this function.

In connection with a periodic assessment of corporate governance and related compliance evaluation, Sarbanes-Oxley (SOX) imposed significant governance requirements on the board of directors, including an independent audit committee and disclosure controls and procedures, related to required certifications. Furthering these requirements, stock exchange rules require an independent audit committee to develop guidelines and policies in connection with the process by which risk assessment and management is undertaken. Hence, even if there is no dedicated board committee or subcommittee for risk management functions and oversight, the audit committee in connection with its functions, and likely under its charter provisions, is charged with risk management oversight. These functions squarely fit within the suggested periodic review of the adequacy of liability protection measures, such as indemnification and D&O coverages.

Insurance Considerations

Under current market conditions, class action suits often arise out of alleged failure of adequate disclosure. As the value of a company's stock falls, with allegations of inaccurate or incomplete disclosure, securities class action litigation will likely follow. It should be noted that a bankruptcy filing raises a host of coverage issues that should be addressed well in advance of any proceeding, including whether there is any coverage and if so, who is entitled to the benefits. Together with a review of policy provisions, definitions and exclusions, the type of coverage provided also should be reviewed. Consideration should be given to whether “Side A” coverage should be included, to protect individual directors and officers when the entity may not or cannot, indemnify its directors and officers.

Given this environment, many independent directors seek stand alone type insurance coverage, dedicated to independent or outside directors. This has given rise to Independent Director Liability (“IDL”) insurance coverage, where the coverage provided is not reduced or eroded by claims and losses from officers and inside directors or the company. IDL coverage can either be provided by stand alone insurance contracts in favor of independent directors or can be a form of excess coverage for a standard “Side A” policy. “Side A” coverage was developed as a method to indemnify directors and officers when the corporation is either financially unable to indemnify or is prohibited from doing so. The IDL coverage would be an adjunct to this coverage solely for independent directors. One of the advantages of this type of coverage is that it does not cover inside directors, officers, other employees or the company, and as a result may have fewer exclusions and exceptions. For example, IDL coverage generally cannot be rescinded and provides for full severability. As with other D&O type insurance coverages, terms and conditions of IDL coverage vary and a careful analysis of terms, conditions and limitations as well as exclusions from these policies is most significant, together with how the policy fits within the framework of the overall D&O insurance program.

Many companies elect to maintain D&O insurance in layers, with a primary carrier and one or more excess carriers. Many excess policies are so called “follow form” policies, meaning these policies are to conform to the terms and conditions of the primary policy. However, some excess policies contain express conditions that specifically alter the terms of the excess coverage. It is important to carefully review excess coverage to make certain these pieces fit together as a unified D&O insurance program. Often, excess coverage is triggered only when the primary insurer pays the full limits of its coverage. Where the primary issuer pays less than full coverage limits, the excess carrier may deny that excess coverage has been triggered.

Actions to Take Now

Management and the board should conduct a thorough review of coverages and potential issues related to coverage which may save significant difficulties going forward, particularly in the current environment. This review process should not only include the D&O insurance program, but also should include the company's indemnification provisions, whether in the basic corporate documents, separate indemnification agreements, or employment agreements. Given regulatory and legislative initiatives, it is also most important to review board risk management policies and functions. All too often, what should be a unified program, contains flaws, inconsistencies and adverse provisions, which together can create unintended consequences.

The current environment and the perception that excessive risk taking was a significant cause of current conditions, have caused extensive legislative and regulatory consideration of the management and control of risk. Given pending legislative initiatives, regulatory requirements and reform activities, management and boards should pay careful attention to these initiatives and the adequacy of their risk management systems.

William L. Floyd is a corporate partner in the Atlanta office of McKenna Long & Aldridge LLP. His practice focuses on securities and corporate finance, mergers and acquisitions and corporate matters, including corporate governance and responsibility. He may be reached at [email protected] or 404-527-4000.