Backdating backlash: will corporate insurers be wiped out by a tidal wave of D&O 'stock options' claims?

Directors and officers liability insurers continue to assess the impact of corporate stock option "backdating" practices, originally feared as holding the potential for Enron-sized market losses. And rightly so, with experts estimating the practices may have been used at some 2,000 companies, and with federal investigations pending into the nature of stock options granted to senior executives at more than 60 companies.

While the backdating phenomenon is causing substantial tipples throughout the corporate insurance sector as claims for reimbursement of defense costs mount, the ultimate toll in terms of a surge of covered damage claims is yet to be determined.

How did this all happen? Numerous publicly traded companies granted backdated stock options. Compensation packages were issued or amended to fix the price at which an employee had the option to purchase company shares based on an artificial purchase date, usually by reference to an earlier share date when the share price was lower. The employee was therefore virtually guaranteed the ability to buy low and sell high.

While this practice is not inherently wrong, some companies failed to disclose their actions to investors, who, as a result, did not have a correct picture of corporate expenses and executive incomes.

Moreover, some companies went so far as to skirt insider trading rules and other ethical constricts by timing stock prices at dates either before or after significant corporate events, either increasing or decreasing the share price--practices known as "spring loading" and "bullet dodging"

Shareholder litigation has since ensued. The Securities Class Action Clearinghouse, a database maintained by Stanford Law School, lists 21 securities fraud class actions involving allegations of stock options backdating.

Traditional shareholder litigation seeks damages from the company, its directors and officers, financial auditors and investment underwriting banks on the theory that these corporate insiders failed to adequately disclose the company's true financial condition. Damages are generally measured by the drop in the share price, usually following the corrected disclosure.

Options cases, however, more often appear to involve shareholder "derivative" lawsuits, where the investor sues to force a change in corporate practices. In most situations, the disclosures of backdating practices have not been significant enough to influence stock prices. Nonetheless, the practices are sufficiently egregious to cause activist shareholders to want to force the corporation to take action to stop the practice.

Enter the insurance companies. D&O insurers have been called upon to pay defense costs in these actions under policies which generally have a broader duty to indemnify settlement amounts or judgments. Defense costs can easily top several million dollars, and reimbursement claims have begun exhausting the limits of primary policies.

Nonetheless, D&O insurers have asserted the right to disclaim coverage for awards or settlements (and even defense costs) by raising various coverage defenses. For instance, some corporate insurance policies commonly exclude coverage for conduct of fraud, insider trading or personal profiteering. And, some have based their coverage positions on that language.

Fraudulent conduct exclusions generally bar coverage for an insured's intentionally wrongful, fraudulent and even illegal acts. Exclusions for insider trading and personal profiteering preclude indemnity of those damages and defense costs paid as a result of an insured's gaining of a profit or advantage to which that insured was not legally entitled.

Insurers have additionally questioned coverage for costs associated with government and regulatory inquiries. And, we will see arguments surface surrounding whether a company's practices of backdating really involved the kind of conduct generally covered by corporate insurance.

With the flood of investigations trader way, corporate insurers and their D&O claims specialists should look to the facts of each case, including evaluating whether the insured's practices were publicly disclosed, whether company insiders conducted themselves in a particularly egregious manner to benefit themselves or whether corporate officials reasonably relied on advice from outside financial and tax advisers.

D&O insurers, particularly primary insurers, also would be wise to keep a close eye on defense costs to ensure that counsel meet the written litigation objectives and guidelines. With other issues surrounding backdating lawsuits likely to unfold, it's key for corporate insurers to continue closely watching and assessing the size--and nature--of this unpredictable wave.

Kevin M. Mattessich, right, a Best's Review contributor, is a shareholder in the law firm of Cozen O'Connor in New York City, where contributor Patrick M. Kennell is an associate. They can be reached at [e-mail] and [e-mail].