Enron and the D&O Aftermath:

Tips and Traps for the Unwary†

Lori E. Iwan

Charles M. Watts, Jr.

Those who cannot remember the past are condemned to repeat it.

- -George Santayana

Introduction

With the same reckless abandon used by the average investor who throws money into the stock market, insurance companies wrote D&O policies for public companies throughout the 1990’s without regard to when the bubble might burst. As a result, the insurance industry must now pay the price for risks taken in a softer market, just as it did in the aftermath of the 1929 Crash and following Black Monday in 1987.

In fact, Enron repeats the ’87 crash with a new name. Like the iceberg that doomed the Titanic, what lies beneath Enron poses a real and present danger to the D&O market. Enron’s failure merely illuminated the problem; it didn’t create the problem. Moreover, the widespread impact of the Enron ripple effect threatens to tumble the entire D&O market along with Enron. This article, therefore, enables both underwriters and claims personnel to examine directors and officers coverage with a fresh perspective.

II.

The Basics

“D&O insurance is, by nature, based on a more open-ended contract. D&O coverage typically protects against a catchall collection of ‘wrongful acts’.”[1] “The first D&O policies were written by Lloyd’s in response to the wave of lawsuits that deluged directors of public companies after the 1929 Wall Street crash.”[2] The typical policy in recent times consists of two insuring agreements:

· Direct coverage for directors and officers of the company when an entity does not or cannot indemnify them.

· Reimbursement coverage to a company for indemnifying its D&Os for wrongful acts (the Insuring Agreement C-Entity clause).

“The top three D&O insurers based on premium -- American International Group Inc., Chubb and Lloyd’s -- write about 65% of the primary business.”[3] Thus, “D&O is a niche market, accounting for $3.5 billion to $6 billion in annual gross premium written.”[4]

Typical D&O claims arise when the board of directors and/or officers of the corporation violate their duties. The duties of the board of directors are typically broader, however, than those of the officers. Non-delegable duties of the Board generally encompass overall management and instruction. Specifically, they include organizing the corporation, establishing and overseeing the accounting structure, selecting and supervising management, preparing the annual report, conducting shareholder meetings and implementing resolutions. Directors and officers must act within their authority with the requisite knowledge and ability, obtain expert advice, and act with a duty of loyalty. Liability can arise from a violation of company standards, prospectus misrepresentations, statutory violations, or criminal or tortious acts. In addition, potential claimants can comprise a number of groups: the company itself, liquidators, shareholders, creditors, third parties and government authorities.

Directors owe a fiduciary duty to both the corporation and its shareholders. The fiduciary duty is generally categorized as a duty of loyalty and a duty of due care. Under the duty of loyalty, a director owes an undivided, unselfish loyalty to the corporation.[5] The duty of loyalty can be breached in a number of respects: competing with the corporation, appropriating a corporate opportunity, using insider information, disclosing trade secrets, appropriating customers or spending corporate money for personal gain.

The duty of care requires that in managing the corporation, a director use that amount of care exercised by an ordinarily careful and prudent person in similar circumstances. The duty includes using “reasonable diligence” in gathering and considering material information. “Directors may not shut their eyes to corporate misconduct and then claim that because they did not see the misconduct, they did not have a duty to look. The sentinel asleep at his post contributes nothing to the enterprise he is charged to protect.”[6] Notwithstanding this caution, courts have developed a corresponding “business judgment rule” to protect directors. This rule codifies a presumption that the directors acted on an informed basis, in good faith and in honest belief that the action was taken in the best interest of the corporation.[7]

Enron’s problems and the ensuing litigation serve to highlight the obligations owed by directors and officers under the securities laws. The Securities Act of 1933 and the Securities Exchange Act of 1934 have been interpreted to permit claims by shareholders in initial public offering,[8] secondary market transactions,[9] proxy solicitation,[10] and tender offers.[11]

Private securities litigation alleging fraud generally is brought against corporations and their directors and officers under the Securities Exchange Act of 1934. Typically, Section 10(b) prohibits misrepresentation or fraud in connection with the buying and selling of securities, and Rule 10b-5 sanctions the use of deceptive and manipulative devices to facilitate fraud. To properly allege a Section 10(b) claim, a plaintiff must demonstrate that misrepresentation of material facts by persons acting with scienter caused them injury. The plaintiff must prove that the defendant acted with scienter by a preponderance of the evidence. The Supreme Court has defined scienter as “a mental state embracing intent to deceive, manipulate, or defraud.”[12]

The standard for finding director liability is stringent. “[O]nly a sustained or systematic failure of the board to exercise oversight – such as an utter failure to attempt to assure a reasonable information and reporting system exists – will establish the lack of good faith that is a necessary condition to liability.”[13] Furthermore, only a systematic or sustained failure of the board to exercise oversight, such as the board’s utter inability to assure a reasonable system for reporting information, will precipitate a bad faith finding so as to support liability for individual directors. Mere negligence, and most likely gross negligence, will not support director liability.[14] The standard necessary to precipitate individual director liability is one that approaches bad faith.[15]

Responding to the rise in abusive and meritless securities fraud lawsuits, Congress passed the Private Securities Litigation Reform Act (PSLRA) in 1995, making it increasingly difficult for private plaintiffs to file frivolous or unsubstantiated securities fraud claims. Congress intended that the PSLRA would apply a more stringent uniform pleading standard intended to reduce the number of private securities cases brought against corporations and/or their directors and officers. Plaintiffs must now “specify each statement alleged to have been misleading, the reason or reasons why the statement is misleading, and, if an allegation regarding the statement or omission is made on information and belief, the complaint shall state with particularity all facts on which that belief is formed.”[16] To sufficiently plead scienter under the PSLRA, the complaint must “state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind.”[17]

The PSLRA, however, has fallen short of its intended effect. Class action securities cases have risen to an all-time high. Also, the federal appellate courts have interpreted the PSLRA standard, which was intended to provide uniformity, in significantly different ways. In point of fact, three standards have emerged. The Second and Third Circuit Courts of Appeal allow plaintiffs to adequately plead scienter by alleging facts supporting an inference that defendants had a “motive and opportunity” to commit fraud, or facts providing circumstantial evidence of recklessness or knowing misbehavior.[18] The First, Sixth, and Eleventh Circuits, on the other hand, have adopted a tougher standard. Scienter in those circuits is adequately pleaded by “alleging facts giving rise to a strong inference of recklessness, but not by alleging facts merely establishing that a defendant had the motive and opportunity to commit securities fraud.”[19] The Ninth Circuit has adopted the toughest standard of all, requiring plaintiffs to “plead, in great detail, facts that constitute strong circumstantial evidence of deliberately reckless or conscious misconduct.”[20] Under this standard, recklessness is defined as “a highly unreasonable omission, involving not merely simple, or even inexcusable negligence, but an extreme departure from the standards of ordinary care, and which presents a danger of misleading buyers or sellers that is either known to the defendant or is so obvious that the actor must have been aware of it.”[21] To properly allege a “strong inference of deliberate recklessness,” a plaintiff must state facts that come closer to demonstrating intent, as opposed to mere motive and opportunity.

III.

The State of the D&O Market

“The D&O business is very concentrated--85% [of the primary business is written] by the top 10 companies.”[22] Even before Enron failed, the market for D&O insurance was “‘a complete mess,’ pummeled by the dot-com implosion, hundreds of securities class actions, a faltering economy and years of soaring loss ratios.”[23] Although claim awards were rising, 1999 prices for D&O coverage declined for the fourth consecutive year, according to the “1999 Directors and Officers Liability Survey,”[24] offering little regard for the future. More than $100 million in losses have occurred in the D&O area over the past eighteen months alone.

Although the events of September 11 did not add to the D&O claims, “those events have adversely affected the availability, price and terms of D&O coverage,” since insurers have redirected their reserves to address the financial impact of September 11 in other unrelated lines of insurance.[25] In short, the reserve cushion that allowed insurers to offer favorable D&O coverage terms, unaffected by the loss ratios of the D&O book of business, is gone.

All in all, the pricing and availability of D&O coverage at all levels has been affected by the following events:[26]

(1) Increase in frequency of claims. The number of suits jumped dramatically from

293 in 2000 to 511 in 2001. More than 300 of those suits were related to the underwriting practice of offering shares in initial public offerings in exchange for kickbacks and other side deals (so called “share laddering”). In fact, over 1,000 share laddering cases were filed, although these have since been consolidated to 320 involving the same number of issues and against nearly 50 financial underwriters. Other typical claims involve bankruptcy and accounting restatement or irregularities.[27] The most common accounting violation identifies improper revenue recognition, alleged in 66% of the accounting cases. The second most common violation is overstatement of assets (29% of the cases). High tech continues to be the most prominent target (38% of the cases), followed by telecommunications (11%), health care providers (8%), banking and brokerage firms (6%) and pharmaceuticals (4%).[28] Potential shareholder class actions thought to be pending include claims against the directors of technology companies Lucent, Cisco Systems and Nortel, and against the dot-coms identified as Excite, Priceline, com iVillage or Drugstore.com.[29] The recent rise in shareholder class actions has been attributed to the proliferation of private individuals who held shares in the 1990’s, the dot-com technology boom and the Internet itself. The World Wide Web allows aggrieved investors and disgruntled employees access to chat rooms where they commiserate and disseminate unfavorable (or insider) information. Class action web sites that list current and proposed class actions or solicit new cases make it easy for the unhappy customer to join these efforts.

(2) Increase in severity of claims. The largest payouts in history were paid or proposed within the past two years: Cendant’s payout totaled $3.2 billion, Bank of America has proposed $490 million, and two Waste Management cases have approximated $677 million. When accounting violations are alleged, the settlement values are higher; in 2000, the average accounting violation case settled for nearly $21 million. The Insider estimates that Chubb’s D&O book is running at a loss ratio approaching 170%, while some believe the Executive Risk book to be double that figure.[30] The current estimate for Lloyd’s exposure on the 1998-2000 underwriting years is approximately £250mn, though senior underwriting sources predict that the rising trend in class action suits against institutions which advised in IPO’s, mergers and acquisitions could quadruple that number. The wider London company market exposure to D&O claims is thought to be even higher.[31]

(3) Increasing regulatory scrutiny. In fiscal year 2001, the United States Securities and Exchange Commission (“SEC”) brought 484 cases. Of that number, financial fraud cases represented 23%; offering cases involved 20%; broker-dealer cases consumed 13%; and insider trading cases were 12% of the total. These numbers represent an increase in financial fraud and issuer reporting cases over the prior year and an upward trend in filings.[32] As of February 2002, the SEC has gathered 250 financial fraud cases in its inventory, with cases arriving at nearly one per day. The Waste Management case was the first fraud injunction case commenced against a Big Five accounting firm in 20 years. The auditor climate clearly has changed, resulting in auditors who blow the whistle on clients more frequently than a year earlier.

(4) Little benefit to insurers for claims that could be settled, but for refusal of the insureds.

(5) Little or no insured participation in claims payments due to low retentions and broad grants of coverage.

(6) Insufficient premium to pay for losses.

(7) Bankruptcy of D&O insurers. Reliance Group Holdings was the sixth largest writer of D&O insurance in 1999. Late in 2000, that insurer’s operation was liquidated, leaving large gaps in coverage.

(8) Departure of reinsurance support. “The smaller D&O markets and MGA’s that relied on the availability of facultative reinsurance are reporting that those reinsurance markets have pulled virtually all of their facultative capacity, resulting in either larger exposed nets or reduced limits of liability for business written by those direct writers of D&O business. D&O treaty capacity also seems to be in question.”[33] Reinsurers’ “historical willingness to roll multi-year reinsurance treaties has diminished, leaving direct D&O writers to negotiate for substantially higher reinsurance premiums or modified treaty structures, including excess-of-loss treaties with substantial nets retained by the direct writers.”[34]

In the current market, healthy companies with favorable claims experience can expect to pay nearly 35% more in premiums, but companies with greater risk exposures based on size and industry type are facing increases of 50% or more. As recently as June 2002, the Wall Street Journal reported rates increases of 300 to 400%.[35] Thus, the hardening market is forcing insureds to accept higher rates, less coverage and larger retentions.

The D&O crisis is not limited to the United States market, however. Just as the number of securities class action lawsuits filed in the United States has risen, so has the exposure to companies based elsewhere. “[S]ome underwriters had assumed that non-US companies were better protected from such actions, but they now recognize that a company listed on any US stock exchange, regardless of where the company is based, ‘has a very severe exposure to class action claims.’”[36] Not surprising to anyone familiar with the American propensity for litigation, numerous European companies have found their directors and officers subject to litigation in United States courts.[37] More significant, however, is the number of claims filed in European courts. Europe has witnessed claims by liquidators,[38] claims by shareholders,[39] claims based on prospectus liability,[40] and claims based on corporate governance issues.[41]

IV.

Lessons from Enron

“Enron was a massively complex business. From all accounts, there were few people who understood just exactly what Enron was doing. Through the use of derivatives, Enron evolved from an energy trading business to a company that boasted it could create markets in anything. To do this, Enron created complex partnerships, used intricate financing vehicles, and relied heavily on shifting risks from one entity to another.”[42]

A sampling of press releases by insurers covering the impact of Enron’s bankruptcy highlights the poor performance of the D&O line of insurance in 2000 and 2001. Various sources place Enron’s D&O coverage at $350 million. According to The St. Paul Companies, its principal net exposures, after tax, following the Enron bankruptcy, are $64 million in face value from surety bonds and $19 million in treaty reinsurance and D&O liability insurance.[43] PartnerRe estimates net loss exposure to Enron at $34 million, but it was not well situated to accurately estimate the actual losses, if any, under the various reinsurance contracts since Enron hopes to reorganize. In that event, many liabilities may be partially or even entirely paid, and many of the primary insureds will mitigate the amount of their actual losses.[44]

Enron proved that many insurers were not tracking their exposure. The years 1997-98 have been compared to the “perfect storm;” a cascade of events had to merge precisely, creating the “storm of the century.” In the case of D&O coverage, the market, insurance and reinsurance all contributed to the downfall.[45] As such, the Enron debacle affected specific coverage lines: D&O, surety coverages, accountants’ liability and fiduciary liability. It also brought into question the status of independent auditors and the possible conflicts that might exist between independent auditing and consulting services. The Enron situation also raises questions about the extent to which board members are obligated to unearth possible fraud among a company’s senior employees.

Clearly, Enron’s situation will test a variety of D&O policy exclusions and defenses. The bankruptcy has already spawned at least two separate actions in which insurers seek to void D&O coverage, having relied on information that contained “material misrepresentations” when the policies issued to Enron. If they succeed, nine other insurers are expected to follow suit, potentially voiding the $350 million of coverage Enron thought it had reserved for its directors and officers.

Equally significant, Enron’s impact extends well beyond its own insurers. In Newby v. Enron Corp., the class action lawsuit filed by the infamous Bill Lerach, two new developments may cause additional concern for the insurance industry. Not only has the list of defendants been expanded to include those who did work for Enron, but the lead plaintiffs in the lawsuit are the Regents of the University of California, an entity marked by a veneer of respectability. In addition, the April 8, 2002 amended complaint adds over three dozen defendants that include many Wall Street principals, additional partners and offices of Arthur Andersen, and two law firms. The named banks and securities firms include Merrill Lynch, Credit Suisse First Boston, Citigroup, Deutsche Bank, J.P. Morgan Chase, and Bank of America. According to the 502-page complaint, these additional defendants were named because “[t]his fraudulent scheme could not have been and was not perpetrated only by Enron and its insiders. . . . It was designed and/or perpetrated only via the active and knowing involvement of” the various law firms, banks, and the accounting firm hired by Enron. The D&O excess carriers for these other institutions are expected to heed these proceedings as well, given the potential that losses will breach the upper layers of coverage.

What’s an Insurer to do?

The question of what an insurer should do in the face of potentially overwhelming D&O exposure can be answered succinctly. Insurers should read the fine print on the policy and the information furnished in application and renewal forms; they should examine carefully the allegations of the case presented, and they must thoroughly review the law of the jurisdiction where any coverage action might be filed. An Enron-like claim seems to raise all the issues most actively litigated in the D&O coverage arena: (1) rescission based on a material misrepresentation or omission in the policy application or renewal; (2) application of standard exclusions; (3) allocation of indemnity and defense costs between insured directors and officers and uninsured persons, and between covered and non-covered claims; and (4) bankruptcy court authority over D&O policies and proceeds payable to the directors and officers of a debtor corporation.[46] Early involvement in the evaluation, preservation, and assertion of coverage issues is essential to minimizing exposure at the excess and surplus level. These issues are discussed more fully below.

A. Rescission Based on Misrepresentation

Several federal district courts, applying state law, have permitted rescission of D&O policies based on material misrepresentations in the policy application. This defense extends to misrepresentations and inaccuracies contained in financial statements whose submission was required by the policy application or renewal forms.[47] Misrepresentation in a policy application or renewal bars recovery when the misrepresentation is material to the risk assumed by the insurer, or when the insurer would not have offered the same terms had it known the truth. Courts have restricted the right to rescind a policy only to those situations where the information was specifically required by the insurer in the application process.[48] If the insurer did not request the specific information from the insured before issuing the policy or renewal, the courts assume the information was immaterial to underwriting the risk.[49]

Misrepresentations can emanate from a number of sources:

· Direct response to a question in the policy or renewal application.

· A false statement in the “cognizance representation” (the insured’s statement that he or she is unaware of any fact or circumstance that might precipitate a claim).[50]

· Materials that the insurer is required to attach to the application (e.g., Annual Reports, SEC filings, financial statements, etc.).

· Statements between the insurer and the insured made in conference calls or meetings (provided the insurer has carefully documented that the specific information was requested by the underwriter during these calls/meetings).

Severability clauses have crept into D&O policies in recent years during the soft market. The severability clause seeks to afford coverage to “innocent” directors and officers who did not sign the policy application and did not know of the misrepresentation. Given the scope of non-delegable duties of a board of directors, it is difficult in an accounting case to imagine that the board had no knowledge of the error, irregularity or restatement of income such that the board could credibly claim innocence. Hence, the insurer should not act too quickly when affording coverage to those directors and officers who did not sign the policy.

For example, in the Enron situation, a memorandum was circulated by an accounting employee to CEO Kenneth Lay, with copies to senior management. A sampling of those concerns raised in the memo highlights the extent to which it was widely known within Enron itself that overly aggressive accounting was being used for certain significant deals:

· “Enron has been very aggressive in its accounting - most notably the Raptor transactions and the Condor vehicle.”

· “To the layman on the street it will look like we recognized funds flow of $800 mm from merchant asset sales in 1999 by selling to a vehicle (Condor) that we capitalized with a promise of Enron stock in later years. Is that really funds flow or is it cash from equity issuance?”

· “To avoid such write-down or reserve in Q1 2001, we ‘enhanced’ the capital structure of the Raptor vehicles, committing more ENE shares.”

· “I am incredibly nervous that we will implode in a wave of accounting scandals.”

B. Exclusions

1. Regulatory Exclusion

Regulatory exclusion commonly excludes coverage for proceedings brought by regulatory agencies. Although a few courts have held that, when applied to actions brought by the banking regulatory agencies FDIC and FSLIC, the exclusion is void as against public policy,[51] the vast majority of courts have upheld the exclusion.[52]

2. Security Law Violation Exclusion

D&O policies may exclude coverage for losses arising out of the violation of security laws. Such an exclusion was the subject of litigation in Bendis v. Federal Insurance Co., which barred coverage for a claim:

. . . where all or part of such claim is, directly or indirectly, based on, attributable to, arising out of, resulting from, or in any manner related to any actual or alleged violation of the Securities Act of 1933, Securities Exchange Act of 1934, the Investment Company Act of 1940, the Public Utility Holding Act of 1935, any state Blue Sky or securities law, all as they may be amended, or any law relating to securities transactions, or any of their amendments.[53]

In Bendis, nine counts of the complaint alleged securities law violations. The remaining two counts alleged fraud and negligent misrepresentation, though these were based on the same factual allegations that framed the securities law violations. The Tenth Circuit Court of Appeals affirmed the district court finding that the policy exclusion barred coverage for all eleven counts because the tort claims were so related to the alleged securities violations as to put them “squarely within the express terms of the policy exclusion.”[54]

3. Dishonesty and Criminal Acts Exclusion

The “Dishonesty Exclusion” in a typical D&O policy provides that the company shall not be liable to make any payment for loss in connection with any claims made against any of the insured persons brought about or contributed to by the dishonesty of such insured person if a judgment or other final adjudication adverse to such insured person establishes that acts of active and deliberate dishonesty were committed or attempted by such insured person with actual dishonest purpose and intent, and were material to the cause of action so adjudicated.[55]

One of the leading cases involving application of the dishonesty exclusion established the “final adjudication” standard, by which the court held that the exclusion for dishonesty attaches only after a final judgment or other final adjudication (e.g., a plea of “guilty” in a criminal case alleging fraud or dishonesty) that implicates the directors.[56] Other courts adopted a similar view, which essentially gutted the exclusion.

A second test also has been applied by some courts. The “dishonest in fact” test is more flexible than the dishonesty exclusion, since it allows insurers to litigate application of the exclusion in a coverage action.[57] This view makes perfect sense when one considers the pleading standard required in a securities action pursuant to the PSLRA of 1995. The PSLRA sought to eliminate the frivolous shareholder lawsuit by requiring that plaintiffs allege fraud or other intentional wrongdoing in order for a securities case to survive the pleading stage. Given this pleading requirement, it only makes sense to expedite a decision regarding the coverage exclusion for fraud early in the litigation, rather than waiting for a final adjudication on the merits.

4. Personal Profit Exclusion

The personal profit exclusion is largely self-explanatory. If the directors or officers reaped large personal gain from the alleged malfeasance, this exclusion should offer the insurer respite from the storm. As with the dishonesty exclusion, however, this exclusion is subject to the “adjudication” requirement or the “in fact” test.

5. ERISA and Plan Management Exclusion

It is fairly common for D&O policies to contain exclusions for claims arising out of the insured’s role as an ERISA trustee or similar plan manager. These exposures are covered, if at all, by fiduciary liability coverage.

6. Insured v. Insured Exclusion

The insured v. insured exclusion typically excludes coverage when the entity seeks damages from the directors or officers, or when directors and officers seek to recover from each other. The typical exclusion states:

It is understood and agreed that the insurer shall not be liable to make any payment for loss . . . which is based upon or attributable to any claim made against any director or officer by any other director or officer or by the institution . . . except for a shareholder derivative action brought by a shareholder of the institution other than an insured.[58]

The courts have determined that this exclusion unambiguously precludes coverage for claims by the insured corporation against former executives and claims between covered executives. The exclusion is sometimes difficult to apply because of ambiguity surrounding identification of the “entity.” The potential “entities” could include the bankruptcy trustee, an entity acting on behalf of the corporation, a liquidator, creditors, and assignees. Case law on this issue is inconsistent, in part because of varying policy language.[59]

Typically, many courts have declined to apply the exclusion when a bank regulator steps into a bank. The courts also have carved out shareholder derivative actions and declined to apply the exclusion when a shareholder action has been instituted, even though the particular directors or officers may hold shares in the corporation. In bankruptcy proceedings, the courts have reached differing outcomes depending on whether the company was in complete liquidation (exclusion applied)[60] or whether a business entity was formed by the creditors under a plan of reorganization to pursue the claims of the individual creditors (exclusion not applied).[61]

C. Other Coverage Issues

1. Notice

Excess policies, like primary policies, contain notice requirements. However, whether the insured and/or the primary insurer have the responsibility to notify the excess insurer of a potential loss is unsettled and varies by jurisdiction. The duty of the primary insurer to notify the excess insurer arises out of industry custom and common law; it is not a contact duty as is the case for an insured. Thus, although the primary should notify the excess carrier, it is important that an excess insurer insist that its insured provide notice of any securities litigation claim because the chance of such a claim reaching excess coverage is high. Thus, the excess policy notice provisions should require prompt notice of a claim, and the excess insurer should explain its desire for notice to its insured.

An excess insurer should also observe the conduct of the insured’s defense, where possible, and become directly involved where exposure is high. Timely notice permits an excess insurer to protect its interests during settlement negotiations where it may carry considerably more risk than the primary insurer. Except for the fact that coverage under an excess policy is not triggered until the primary or underlying insurance is exhausted, an excess insurer has the same rights to investigate claims, involve itself in settlement talks, and make independent settlement decisions. As New York’s highest court put it, “all of the salient factors point to the conclusion that excess carriers have the same vital interest in prompt notice as do primary insurers.”[62]

2. Cooperation

A common cooperation clause provides: “The Insureds shall, as a condition precedent to exercising their rights under this coverage section, give to the Company such information and cooperation as it may reasonably require. . . .” Recent case law has upheld a D&O carrier’s denial of coverage when the insured refused to submit to an interview by the insurer in order to determine if misrepresentations were made in the policy applications.[63] Thus, an insured’s failure to cooperate or failure to testify regarding knowledge available when policy application was made may form a basis for denying coverage under the policy.

3. Identifying the Insured

Policy questions may arise about who is insured once the legal relationships among corporate entities are examined in the light of day. For example, in the Enron controversy, does D&O coverage extend to the directors and officers of Condor and Raptor, the two partnerships involved in the off-balance-sheet accounting?

The structure of any deal must be carefully examined to determine if coverage extends beyond the obvious board members of the parent company. For example, where a corporation forms a joint venture with another and owns 50% or less of the venture, there is no duty to report the debts of the venture on the corporate books. To illustrate, suppose Company A and Company B both realize that it would advance their interests to construct a power plant to provide electricity to meet growing demand. However, both A and B are highly leveraged and do not wish to add debt to their respective balance sheets. A and B thus form a joint venture and contribute $50 million each. Joint Venture goes to Bank, which is impressed by the credit status of A and B, and procures a loan of $500 million. Joint Venture pays $50 million back to both A and B, using the remainder to construct the power plant. Under applicable accounting standards, neither A nor B is required to report $200 million in debt on its books. Under the circumstances, are the directors or officers of the joint venture covered by the D&O policies of A or B? To the extent the directors and officers in the joint venture are identical to those in the parent companies, an insurer may be able to restrict coverage, claiming that the individuals were acting outside of their capacity as directors or officers for the parent company.

4. Allocation of Loss and Defense Costs

“Many believe the single-most important judicial decision affecting D&O insurance since Smith v. Van Gorkon in Delaware in 1985 was the Nordstrom v. Chubb decision by the 9th Circuit Court in 1995.”[64] The dilemma in D&O settlements was always identified as the allocation of liability among the defendants, particularly in securities claims. Shortly after the Nordstrom decision, however, Chubb, AIG and many other insurers introduced “allocation endorsements.” These endorsements specified an allocation and then offered an additional or discount premium, depending on the allocation percentage. The endorsements almost immediately resulted in a 50 to 60% loss cost but, due to market conditions, did not result in commensurate premium increases. The endorsement effectively clarified allocation issues, thereby improving the working relationship during the claims-settlement process, but actual paid claims have increased substantially.

The courts have articulated two rules to determine how defense and indemnity costs should be allocated between insured directors and the corporation or other uninsured persons. The two rules are known as the “larger settlement” rule and the “relative exposure” rule. Pursuant to the “larger settlement” rule, allocation is permitted to the extent that any settlement was enlarged by the wrongful actions of uninsured persons. Where the corporation’s liability is determined to be vicarious of the actions of insured directors and officers, the entire settlement has been allocated to the directors and officers. The “relative exposure” rule, on the other hand, provides that the amount in issue is allocated according to the degree to which the parties contributed to the injuries in the underlying litigation.

Similarly, an insurer may allocate defense costs between covered and non-covered claims asserted against an insured in the litigation. Courts are divided, however, about whether the insurer has a duty to advance defense costs to directors and officers. The popular press reports that the court denied requests from Enron’s lawyers to have insurers cover the legal costs of representing Enron and its executives in hearings before Congress and in other judicial proceedings pursuant to the terms of a fiduciary liability policy.[65] Other media reports contain potentially inconsistent accounts, suggesting that a federal judge has allowed executives and directors to tap insurance policies in order to cover legal fees arising from the company’s failure.[66]

In determining whether defense costs should be allocated among covered and non-covered claims, most courts have adopted the “reasonably related” test. If the cost is reasonably related to the defense of a covered claim, it may be apportioned wholly to the covered claim. Although courts are divided on the burden of proof that attends the allocation issues, a majority of courts place the burden on the insured.

VI.

Tips for the Future

1. Do not underestimate the potential exposure to directors and officers. Lately, people have been inundated with news of financial scandal. The Enron/Andersen debacle provides fodder for politicians who seek to curry favor with their constituents. Each new scandal is front page news. Many people are upset that their portfolios and retirement accounts have fallen dramatically over the past two years. The substantial patience of the investing public is increasingly tested by the mounting reports of conflicts of interest and accounting manipulations by corporate officers and directors. Each week a new villain seems to emerge in the form of a person to whom one can assign responsibility for the declining value of these retirement accounts. Disappointment with investments is palpably giving way to anger, and anger feeds a call to action. Many in the public believe that some entity should compensate them for the loss of paper wealth. This sentiment will fuel more litigation. Likewise, the SEC’s new fury will generate the liability findings necessary to prove these cases with greater ease. Accompanied by closer scrutiny and the potential for new regulation of accountants, public disclosure of questionable practices will likely increase in the immediate future.

2. Monitor insureds in high-risk industries and the web sites tracking their financial success or failure, as well as the sites that identify potential class actions; keep an early alert for any potential loss.

3. Enhance the underwriting process to ensure that the following factors are being critically analyzed:

· Executive employment contracts that provide incentives to executives for good performance, or that protect or pay substantial income if the executive is terminated (these contracts may cloud the executive’s business ethics).

· Notice of any SEC or IRS investigation or inquiry, or the issuance of any earnings restatement, irregularity or error, including specific notice whenever the company’s earnings fail to meet published targets.

· The background and expertise of the audit committee: whether it is a financially astute, proactive body, or a perfunctory gathering of members lacking financial training and credentials.

· Whether comprehensive requests for information are part of the application and renewal process.

· Whether cognizance representations are required to be signed by all directors and officers, or at least those holding executive incentive contracts, and whether the renewal process requires the submission of new signed statements. (It should).

· The relationship between the auditor and the company. The amount of fees paid, other projects undertaken by the auditor, the internal accounting functions performed by the auditing company and the length of the relationship are relevant factors to consider when determining whether the auditor has maintained its objectivity relative to the corporation’s books and records.

4. Critically examine any claim for the application of exclusions, allocation of costs and indemnity issues, and compliance with policy terms.

VII.

Conclusion

In the hardened insurance market, there is increasing opportunity to bring D&O premiums in greater alignment with potential risks. The one certainty following the Enron failure is that no one can or will do as good a job of protecting the interests of the insurer as the insurer itself. Thus, heightened vigilance is required of insureds in an effort to identify and respond to the early warning signs of financial trouble.

ENDNOTES

† Submitted by the author on behalf of the FDCC Business Law Section.

[1] Judith A. Blades, The Need for D&O Coverage, Best’s Rev., July 1, 2001, available at 2001 WL 12285550.

[2] Wall Street Losses Hit Lloyd’s, The Ins. Insider, Sept. 2001.

[3] Lynna Goch, Cover Charge, Best’s Rev., May 1, 2002, available at 2002 WL 10441437.

[4] Id.

[5] Smith v. Van Gorkom, 488 A.2d 858 (Del. 1985).

[6] Francis v. United Jersey Bank, 432 A.2d 814, 822 (N.J. 1981).

[7] Aronson v. Lewis, 473 A.2d 805, 812 (Del. 1984).

[8] Securities Act of 1933 §§ 11, 12(2).

[9] Securities Exchange Act of 1934 § 10 (b).

[10] Id. at § 14(a).

[11] Id. at § 14(e).

[12] Ernst & Ernst v. Hochfelder, 425 U.S. 185, 193 n.12 (1976).

[13] In re Caremark Int’l Inc. Derivative Litig., 698 A.2d 959, 971 (Del. Ch. 1996).

[14] Jonathan L. Freedman & Bart R. Schwartz, Audit Committees of the Boards of Directors: How Much Responsibility Do They Have? How Much Responsibility Should They Have? ACCA Docket 20, no. 5 (2002): 4863.

[15] Id.

[16] 15 U.S.C. § 78u-4(b)(1) (1997).

[17] Id. at § 78u-4(b)(2).

[18] In re Silicon Graphics Inc. Sec. Litig., 183 F.3d 970, 974 (9th Cir. 1999).

[19] In re Comshare, Inc. Sec. Litig., 183 F.3d 542, 549 (6th Cir. 1999).

[20] Silicon Graphics, 183 F.3d at 974.

[21] DSAM Global Value Fund v. Altris Software, Inc., 288 F.3d 385, 389 (9th Cir. 2002).

[22] Lynna Goch, Falling Markets, Rising Risks, Best’s Rev., May 2001, available at 2001 WL 12285366.

[23] Barbara Bowers, Risk Takes Center Stage: Enron Hurts Already-Faltering D&O Market, Best’s Rev., June 2002 (quoting Donald J. Bailey, managing director of risk services for Aon Financial Services Group), available at 2002 WL 10441319.

[24] 1999 Directors and Officers Liability Survey, published by Tillinghast-Towers Perrin, a management and human resources consulting firm in Chicago.

[25] Willis Study Finds D&O Market in Disarray, Ins. J., March 14, 2002, available at http://insurancejournal.com/html/ijweb/breakingnews/international/in0302/in0314022.htm.

[26] See id.

[27] The term “irregularities,” when used in the accounting context, means fraud or egregious error.

[28] Tower C. Snow, D&O Symposium, The Evolving World of Securities Litigation, Professional Liability Underwriting Society, Feb. 6, 2002.

[29] Wall Street Losses Hit Lloyd’s, supra note 2.

[30] Id.

[31] Id.

[32] Thomas C. Newkirk, US SEC, D&O Symposium, The Evolving World of Securities Litigation, Professional Liability Underwriting Society, Feb. 6, 2002.

[33] D&O Market Trends, Duane Morris Financial Products Insights (Winter 2001), available at http://www.duanemorris.com/publications/finprod.pdf.

[34] Id.

[35] Wall St. J., June 7, 2002, at C20.

[36] Carolyn Aldred, Non-US Companies Facing Steep Hikes on D&O Policies Covering US Exposures, Bus. Ins., Feb. 11, 2002, available at 2002 WL 9517115.

[37] Phillips; Alcatel: Baan Company; Deutsche Bank; DaimlerChrysler; Intershop; Deutsche Telekom, to name a few.

[38] ARAG (German supervisory board obligated to pursue chief executive who failed to halt illegal activity resulting in DM 80 million losses); Nasa Electronique (D&Os of failed French Company held joint and severally liable for FF400 million shortfall due to mismanagement based on violations of bankruptcy, account and company standards); Banque Pallas Stern (FF9 billion bank failure, largest ever in France); Spar-und Leihkasse Thun (liquidator sued board, management and auditors for CHG 50 million based on alleged mismanagement); Omni Holding (former board members paid CHF 5 million to settle liquidator’s claim of liability in connection with CHF 1 billion failure of the holding company).

[39] Union Bank of Switzerland (BK Vision v. Senn) (CHF 240 million lawsuit against the entire board for failing to intervene in bank share transactions that allegedly manipulated the outcome of a shareholder’s vote); SairGroup (Board resigns and special auditor appointed after CHF 2.9 billion in losses in 2000); World Online (Dutch shareholder association sued the company and its bankers on behalf of 10,000 small investors after collapse of this Internet provider; investors lost EUR 1.6 billion within two weeks prior to IPO when it was learned that CEO had sold her shares for a fraction of the offering price); Biber Holding (Swiss shareholder action group sued former Chairman of bankrupt paper company for mismanagement and misinformation).

[40] Phillips (in wake of ADR stock drop suit in the U.S., a Dutch shareholder association’s suit against the company -- but not the D&O’s -- was filed in the Netherlands and reportedly settled for Euro 4.5 million); Holzmann (major Dutch shareholder suing the company and its bankers for DM 400 million arising out of substantial investment in this German company that had to be rescued by the German government).

[41] Cadbury (UK); Vienot (France); Dragghi (Italy); Olivencia (Spain); KonTraG (Germany).

[42] Editor, Enron’s Impact on the Insurance Industry (May 23, 2002), available at http://www.riskindustry.com.

[43] The St. Paul Reports Aggregate Limits Exposed to Enron Bankruptcy at Less than $85 million After-tax, Net of Reinsurance, St. Paul Re, December 4, 2001, available at http://www.stpaulre.com/home.nsf/vContentW/E8E85EC8670A2F3E85256B5D00767715!OpenDocument&Highlight=0,december,4,2001.

[44] PartnerRe Estimates Net Loss Exposure to Enron at $34 Million, Ins. J., December 14, 2001, available at http://insurancejournal.com/html/ijweb/breakingnews/international/in1201/in1214012.htm.

[45] Ralph Jones, President and CEO, Chubb & Son, D&O Symposium, Professional Liability Underwriting Society, Feb. 6, 2002.

[46] Barry Ostrager & Thomas Newman, Handbook on Insurance Coverage Disputes § 20.01, at 1067 (11th ed. 1999).

[47] Nat’l Union Fire Ins. Co. v. Sahlen, 999 F.2d 1532, 1536 (11th Cir. 1993) (applying Florida law). Similar rules have been applied in Louisiana, Washington and California.

[48] Home Ins. Co. v. Spectrum Info. Tech., Inc., 930 F. Supp. 825 (E.D.N.Y. 1996).

[49] See Collins v. Pioneer Title Ins. Co., 629 F.2d 429, 433 (6th Cir. 1980).

[50] In order to assert a false cognizance representation, a renewal or continuity of coverage must be submitted; the insurer must ask for a new statement prior to issuing the renewed or continuous coverage. A policy that relies on the original statement, or incorporates it by reference, or merely indicates the renewal is a supplementation of the original application to which the cognizance representation was attached, is not sufficient to rescind coverage. Nation Union Fire Ins. Co. v. Cont’l Cas. Corp., 643 F. Supp. 1434 (N.D. Ill. 1986).

[51] Fed. Sav. & Loan Ins. Corp. v. Oldenburg, 671 F. Supp. 720, 723-24 (Utah 1987).

[52] See cases cited in Ostrager & Newman, supra note 46, § 20.02[d], at 1081.

[53] Bendis v. Fed. Ins. Co., 958 F.2d 960, 961 (10th Cir. 1991).

[54] Id. at 963.

[55] PepsiCo, Inc. v. Cont’l Cas. Co., 640 F. Supp. 656, 660 (S.D.N.Y. 1986).

[56] Id.

[57] See Nat’l Union Fire Ins. Co. v. Cont’l Ill. Corp., 666 F. Supp. 1180 (N.D. Ill. 1987).

[58] Fed. Deposit Ins. Corp. v. Zaborac, 773 F. Supp. 137, 142 (C.D. Ill. 1991), aff’d sub nom. Fed. Deposit Ins. Corp. v. Am. Cas. Co., 998 F.2d 404 (7th Cir. 1993).

[59] Level 3 Communications, Inc. v. Fed. Ins. Co., 168 F.3d 956, 958 (7th Cir. 1999).

[60] Reliance Ins. Co. v. Weis, 148 B.R. 575 (E.D. Mo. 1992), aff’d in part, 5 F.3d 532 (8th Cir. 1993) (since there is no difference between the debtor and the bankruptcy estate, the exclusion applies).

[61] Nat’l Union Fire Ins. Co. v. Jewel Recovery LP (In re Zale), No. 392-3001-SAF-11, Adversary Proceeding No. 393-3309 (Bankr. N.D. Tex. Apr. 11, 1995).

[62] Am. Home Assur. Co. v. Int’l Ins. Co., 684 N.E.2d 14, 18 (N.Y. 1997).

[63] Bogatin v. Fed. Ins. Co., No. 99-4441, 2000 WL 804433 (E.D. Pa. June 21, 2000).

[64] Peter R. Taffae, Navigating Rough Seas, Best’s Rev., Jan. 1, 2002, available at 2002 WL 10441037.

[65] Christopher Oster, Questioning the Books: Judge Says That Insurers Should Decide if Enron Lawyers Get Insurance Money, Wall St. J., Feb. 28, 2002, at A4.

[66] Barbara Bowers, Risk Takes Center Stage: Enron Hurts Already-Faltering D&O Market, Best’s Rev., June 1, 2002, available at 2002 WL 10441319.

(Authors’ bios)

Lori Iwan is a principal and founding partner in Iwan Cray Huber Horstman & VanAusdal, LLC, a Chicago-based law firm with a national civil trial practice. She has extensive trial experience in the state and federal courts. Ms. Iwan is licensed to practice before the United States Supreme Court, several U.S. District Courts and the Illinois Supreme Court. She has been admitted in over 26 state courts pro hac vice. Her practice is concentrated in the supervision, preparation and trial of commercial contract and product liability cases for a number of corporations and insurance companies on a national basis. Ms. Iwan has successfully defended a wide variety of products including children's products, medical devices, electrical control equipment, and industrial equipment in cases involving catastrophic injury, fire loss and business interruption claims. She is a frequent lecturer for the Chicago Bar Association, the National Practice Institute, the Defense Research Institute, the Federation of Defense & Corporate Counsel, Mealey’s, private industry and insurers. She is the author of numerous articles on trial tactics, law office economics, products liability, healthcare, preventive law and technology issues. She authors "Lori's Links," a monthly Internet column regarding legal research sites on the World Wide Web at www.thefederation.org. Ms. Iwan is a member of the American Bar Association (Litigation and Corporate Counsel Sections), the Illinois State Bar Association (Tort Law Section), the Defense Research Institute (former Law Institute member, as well as Technology, Products Liability, and Trial Tactics Sections), the Illinois Association of Defense Trial Counsel, The Lawyers Club of Chicago, and the Federation of Defense & Corporate Counsel (Board of Directors, Litigation Management College Dean, Product Liability Past Section Chair, and Technology Section Vice-Chair).

Charlie Watts was admitted to the Bar of the State of Illinois and to the U.S. District Court for the Northern District of Illinois in 2001. He graduated from Loyola University Chicago School of Law and was Executive Editor of the Loyola Consumer Law Review, and Regional Finalist in the Sutherland Rich Intellectual Property Law Moot Court Competition. He also served on the Executive Board of the Public Interest Law Society. While in law school, Charlie received the Pro Bono Recognition Award and Leadership and Service Award. Charlie graduated magna cum laude from Eastern Michigan University Honors College with a Bachelor of Science degree in 1995. He concentrates his practice in intellectual property, commercial contract and products liability litigation.