In our paper, Accounting and Litigation Risk: Evidence from Directors’ & Officers’ Insurance Pricing, forthcoming in the Review of Accounting Studies, we study whether and how financial reporting concerns and traditional measures of corporate governance are priced by insurers that sell Directors’ and Officers’ (D&O) insurance to public firms. As D&O insurers typically assume the liabilities arising from shareholder litigation, the insurance premiums they charge for D&O coverage reflect their assessment of a company’s litigation risk.

Estimation of ex-ante litigation risk has always been a challenge for empirical research. Past studies employ ex-post lawsuits to derive an ex-ante measure of litigation risk. In such studies, a litigation risk prediction model is first estimated with the dependent variable being whether the firm got sued ex-post. The predicted values of the probability of getting sued are then used as ex-ante measures of litigation risk in an empirical model. Such measures ignore lawsuits filed in other jurisdictions and also cannot distinguish between frivolous and serious lawsuits. We employ a market-based measure of ex-ante litigation risk; that is, the D&O liability insurance premium, which incorporates the ex-ante expectation of both the likelihood of lawsuits and the magnitude of damages. In the U.S., public firms routinely purchase D&O insurance coverage for their directors and officers for reimbursement of defense costs and settlements arising from shareholder litigation. Most shareholder litigation is settled within policy limits, with the D&O insurers primarily footing the bill. Therefore, we expect the D&O insurers to price financial reporting risk and corporate governance risk efficiently in order to compensate for their expected payout obligations in the case of lawsuits.

…continue reading: Accounting and Litigation Risk

The aftermath of the recent acquisition of Lyondell by Basell provides a striking example of the risk that directors face if they approve a cash merger financed in substantial part through borrowing and the target then fails. The deal was characterized as an “absolute home run” by Lyondell’s financial advisor. [1] But less than thirteen months after the closing of the merger in December 2007, Lyondell filed for bankruptcy. A litigation trust established by the bankruptcy court to marshal the debtor’s assets has sued Lyondell’s former directors, seeking damages on the theory that the merger, while beneficial to Lyondell’s shareholders, unlawfully mistreated Lyondell’s creditors by causing the company to become insolvent. [2] The case is pending. To add to the directors’ problems, the excess directors’ and officers’ insurance carrier has declined coverage on several grounds, among them that, because the litigation trust stands in Lyondell’s shoes, this is an “insured v. insured” matter not covered by the D&O policy. [3]

…continue reading: Protecting Directors When Firms Fail Post-Merger

In a recent opinion, the Fifth Circuit upheld a decision that prohibited D&O insurers from refusing to pay for the defense of a number of executives charged with civil and criminal wrongdoing by the SEC and the Department of Justice. Pendergest-Holt v. Lloyd’s of London, et al., No. 10-20069, 2010 WL 909090 (5th Cir. Mar. 15, 2010). The ruling has implications for insurers and insureds alike, as it will affect the ability of insurers to stop advancement of defense costs and may result in insurers changing the language of their policies.

The case arises out of the widely-reported charges that have been leveled against several executives of Stanford Financial Group. In order to fund their defense, the executives sought coverage for defense costs under two D&O policies. Both policies had an exclusion where the claims arose “in connection with any act or acts (or alleged act or acts) of Money Laundering.” The policies provided, however, that the insurers would only pay defense costs “until such time that it [was] determined that the alleged act or alleged acts did in fact occur.”

…continue reading: Court Rejects Insurers’ Attempt to Avoid D&O Coverage

At a time of historically significant dislocation in the corporate world, directors and officers now more than ever need to focus their attention on directors’ and officers’ (“D&O”) insurance, as part of their overall strategy involving effective corporate governance and risk management. Although the best protection should continue to come from conscientious attention to directorial and management responsibilities, an effective D&O insurance program, in combination with well-drafted indemnification and exculpation provisions in corporate charters and by-laws, is a critical component of protection for directors and officers at a time of increased scrutiny by shareholders, courts and regulators. Recent judicial developments further highlight the need for careful attention to policy terms, which can be outcome-determinative in significant litigation. Below are some thoughts on D&O insurance in these troubled times.

1. Side A excess coverage:

The main types of coverage provided by many D&O insurance policies are known as A, B and C coverage. The “A” coverage directly indemnifies a director or officer with respect to claims for which the company is not able to indemnify that director or officer, either by reason of law or financial insolvency. (Some companies purchase only A coverage.) The “B” coverage reimburses the company for amounts that it pays to a director or officer through indemnification. The “C” coverage is for claims directly against the company, but, for public companies, that coverage is almost always limited to securities claims. These types of coverage work together to provide broad protection for individuals and the company. But be wary: coverage can be exhausted by claims made on the B and C coverage, i.e., coverage that, in the end, insures the company and not the directors and officers themselves. This may leave directors and officers exposed when they need coverage most — when there is a claim for which the company cannot indemnify them. To avoid this problem, to the extent they do not do so already, companies that purchase A, B, C coverage should consider purchasing additional A-only coverage in excess of the A, B, C coverage. This A-only excess coverage will protect directors and officers if nonindemnifiable claims or obligations arise after the underlying A, B, C coverage has been exhausted. There is also a more comprehensive (and thus more expensive) version of A-only excess coverage known as A-only Difference-in-Conditions (“DIC”) excess coverage. Under DIC coverage, the excess policy will “drop down” to provide coverage when another insurer fails to pay a claim (including as a result of insurer insolvency) or when a company fails to indemnify. DIC policies generally provide broader coverage terms than traditional A-only excess coverage. A DIC policy should also provide coverage if a bankrupt estate successfully argues that the underlying A, B, C policy is the property of the estate. In order to provide the greatest protection against insurer insolvency, companies that purchase DIC excess coverage should consider purchasing it from an insurer that is not on the underlying A, B, C insurance program.

…continue reading: Directors’ and Officers’ Insurance

Federal and state courts have recently issued noteworthy decisions yielding important lessons about directors and officers liability insurance policies. This column examines decisions addressing: (i) the interaction of an application severability clause in a primary policy (addressing to what extent one insured’s knowledge of application misrepresentations can be imputed to other insureds) with a “prior knowledge” exclusion in excess policies; (ii) the scope of a standard-form securities exclusion; (iii) the consequences of failing to give timely notice under a “claims made and reported” policy; and (iv) the effect of an “other insurance” clause in a D&O policy on the D&O insurer’s defense cost obligations to a mutual insured also holding a CGL policy with another insurer.

Prior Knowledge Exclusion

An application for D&O insurance typically is filled out by one or two officers of the corporation (usually the CEO and/or CFO) who make certain representations on behalf of all individuals to be insured. In addition to the traditional “warranty statements” made in the application about knowledge of facts which might give rise to a claim, most D&O applications today expressly incorporate certain documents, such as specified company SEC filings and financial statements, and provide that these documents are material to the insurer’s evaluation of the risk and expressly serve as a basis for writing the coverage. Allegations of inaccuracy in the documents incorporated into the application frequently form the basis for the very lawsuits for which D&O coverage later may be sought. If the company announces an accounting restatement, it may be argued that the company has admitted the original financial statements — and the application — were materially misleading. Without a severability provision in the application, if material representations made to the insurer during the underwriting process turn out to be false, the insurer may be able to return the premium paid and rescind, i.e., void, coverage under the policy as to all insureds. In addition, most D&O policies include severability for the conduct exclusions, such as fraud and intentional misconduct, so that the knowledge or “bad acts” of one insured cannot be imputed to innocent D&Os, who remain entitled to coverage.

In XL Speciality Ins. Co. v. Agoglia,[1] Judge Gerald E. Lynch last month assessed under New York the effect law of prior knowledge exclusions on demands for coverage under three excess D&O policies issued to Refco, Inc., once one of the largest brokerage and clearing services providers for international currency and futures markets. The decision illustrates the importance of paying attention to the wording of and relationship between application and exclusion severability provisions at both the primary and excess insurance levels.

Refco collapsed upon disclosure in October 2005 that it had been carrying an undisclosed $430 million receivable from an affiliate controlled by CEO Phillip Bennett (the “RGHI Receivable”), announcing that the receivable consisted of uncollectible debts originating in the late 1990s and that the related-party nature of the receivable had been hidden from the company’s auditors. In the litigation fallout, Bennett pleaded guilty to numerous federal criminal charges. In addition, numerous civil lawsuits were filed against the former directors and officers of Refco. Central to these lawsuits are the allegations that, prior to Refco’s August 2005 initial public offering, Bennett and others at Refco concealed Refco’s true financial position by means of the RGHI Receivable scheme.

Refco’s D&O liability insurance program for the relevant period consisted of a U.S. Specialty Insurance Company primary policy, with Allied World Assurance Company (“AWAC”), Arch Insurance Company (“Arch”) and XL Specialty Insurance Company (“XL”) providing third, fourth and fifth excess layer coverage, respectively. The AWAC and Arch polices expressly followed form to the primary policy, except to the extent they contained limitations or restrictions beyond those in the primary policy. The XL policy did not follow form to the primary policy. These excess insurers sought a declaration on summary judgment that coverage was precluded by prior knowledge exclusions in their policies.

…continue reading: Recent Developments in D&O Insurance

(Editor’s Note: This post is based on a client memorandum by Jonathan C. Dickey and Aric H. Wu of Gibson, Dunn & Crutcher LLP.)

I. Introduction

What began in late 2006 as a disruption in the market for subprime mortgage-backed securities, collateralized mortgage obligations (“CMOs”), and collateralized debt obligations (“CDOs”) has metastasized into a global financial crisis that has plunged much of the world into recession and brought down some of the world’s largest financial institutions. These adverse developments have generated a wave of private securities litigation, as well as regulatory inquiries by federal and state authorities.

In September 2008, the government takeover of mortgage giants Fannie Mae and Freddie Mac was followed by the collapse of Lehman Brothers, the acquisition of Merrill Lynch by Bank of America and an $85 billion (and now $170 billion) government investment in American International Group. With the stock market in freefall, the Treasury Department proposed a $700 billion “Troubled Asset Relief Program” (“TARP”) to buy toxic assets from the nation’s banks in order to shore up their balance sheets and restore confidence to the financial system. The proposal was initially rejected by the House of Representatives, but passed in early October in a modified form that initially released $350 billion, with Congress retaining the discretion to release or withhold the remainder. As of February 6, 2009, nearly 400 financial institutions had received assistance under this program.[1]

Concluding that prior government responses to the financial crisis were “late and inadequate,” the Obama administration in February 2009 announced a comprehensive “Financial Stability Plan.”[2] The plan provides for the establishment of a Financial Stability Trust, a Public-Private Investment Fund designed to “cleanse” financial institutions’ balance sheets of legacy assets, and initiatives to support loan securitization and community lending while preventing foreclosures.[3] The Financial Stability Plan also promises to impose accountability and transparency on financial institutions that receive government aid by subjecting them to a “stress test” before they may participate in the Financial Stability Trust and requiring them to limit executive compensation and dividends, mitigate foreclosures and expand public reporting.[4] The initial reaction of the markets to the Financial Stability Plan was underwhelming. On the day the plan was announced, the Dow Jones Industrial Average dropped 4.6%.[5]

On February 17, 2009, President Obama signed the American Recovery and Reinvestment Act (the “Stimulus Act”), which provides $787 billion in government spending and tax cuts and also codifies (and in some cases expands) the Treasury Department’s restrictions on executive compensation.[6] Under the Stimulus Act, recipients of TARP funds must eliminate incentives that encourage executives to “take unnecessary and excessive risks” or manipulate reported earnings; recover any bonus or other compensation awarded based on financial statements later found to have been materially inaccurate; eliminate “golden parachute” payments to top executives; limit most bonuses to top executives to one-third of an executive’s total annual compensation; and permit nonbinding shareholder votes on executive compensation.[7] Originally, all recipients of TARP funds were to be subject to the Stimulus Act’s executive compensation restrictions. Following the signing of the Stimulus Act, the Treasury Department announced that the requirements would not apply to recipients of TARP funds through the Term Asset-Backed Securities Loan Facility (“TALF”), which is designed to increase lending to consumers and small businesses on more favorable terms by encouraging investment in highly-rated asset-backed securities. The decision to exempt TALF participants from the Stimulus Act’s executive compensation restrictions appears to have been made out of concern that the requirements could chill participation in TALF.[8] Following the signing of the Stimulus Act, the Obama administration announced it also would spend $75 billion to encourage home mortgage lenders to modify loans for borrowers in foreclosure or at risk of foreclosure, and up to $200 billion to allow homeowners to refinance through Fannie Mae or Freddie Mac.[9]

In the meantime, activist shareholders are on the warpath. In December 2008, after the Securities and Exchange Commission (“SEC”) concurred in the exclusion of shareholder proposals seeking greater disclosure of risks related to mortgage investments at Washington Mutual, a coalition of over 60 investors called on then President-Elect Obama to limit the ability of companies to exclude shareholder proposals related to corporate risk evaluation.[10] The corporate governance challenges for the companies being targeted by these activist shareholders no doubt will be intense for the foreseeable future.

…continue reading: Subprime-Related Securities Litigation: Early Trends