D & O insurance meets accounting fraud: so-called 'Side A' coverage can go far to protect directors and officers from the financial impact of lawsuits stemming from charges of material misrepresentation of financial statements.

The staid world of directors and officers ("D & O") liability insurance has undoubtedly been altered by the rash of accounting fraud litigation that has grown exponentially since November 2001, after the filing of a securities fraud case involving Enron Corp.

Prior to the Enron case, and during the period of a "soft market" for D & O insurance, nearly all D & O claims were customarily met with a "reservation of rights" letter from the carrier, which was normally cursorily read by the company's risk manager and/or general counsel, then promptly filed away. The claim progressed towards conclusion, and was ultimately dismissed, resolved or paid, likely without much fuss from the carrier.

The post-Enron world changed the face of D & O insurance in multiple ways. But probably the most important change was the re-institution by D & O carriers of a once-discouraged, customer-unfriendly practice of filing lawuits seeking to rescind their insured's D & O policy on account of "fraud" allegedly perpetrated by the company and its directors and officers.

The mere threat of rescission, even if not carried to conclusion, often places the company in the terrible position of not only fighting off multiple securities class actions and potential regulatory investigations--and absorbing the potentially huge costs associated with both--but fighting its insurance carriers as well. That's daunting, especially when the company is also trying to meet its financial obligations while rallying management and employees to stay the course.

Though accounting fraud litigation--especially that precipitated by a restatement of earnings--is undoubtedly painful, some of the pain and uncertainty (especially for the company's directors and officers) can be lessened if the company purchases non-rescindable "Side A" D & O coverage. This coverage is generally available to reimburse directors and officers for defense costs, judgments and settlements, even in cases of where a company admits that its financial statements are materially misleading. Indeed, Side A coverage may be a solution that many companies should consider to meet this potential threat.

"Non-rescindable" here means that even if a carrier challenges an underlying D & O policy on the grounds that it was issued based on material misrepresentations contained in the application, the Side A policy provides immediate coverage for defense costs.

Side A coverage can be purchased in many forms. It can stand side-by-side with the primary D & O policy. It also can sit above all underlying coverage, and drop down in certain situations to provide primary coverage if one of its triggers comes into play (like a denial in coverage, or the exhaustion Side A coverage should be viewed as a proactive risk management measure to guard against the risk of rescission, and protect directors' and officers' personal assets.

Defining the Problem: Big Claims, Cranky Carriers

Clearly, those risks have grown. The period since the passage of the Private Securities Litigation Reform Act of 1995 has seen the rise of the accounting "megacase," whose general attributes are well-known: a surprise announcement setting forth the nature and magnitude of the accounting problem(s); a large stock price drop, resulting in a tremendous loss in market capitalization; the institution of civil securities fraud and derivative-action lawsuits, and the simultaneous commencement of regulatory (Securities and Exchange Commission and/or Justice Department) investigations. Add in for good measure (in the extreme case) congressional subpoenas and requests for information by state regulators.

In some cases, the accounting problem is so grave that the company elects to file for Chapter 11 reorganization. That is normally troublesome and costly for carriers because once in bankruptcy, a corporation is generally unable to indemnify its directors and officers for defense costs they incur in the defense of claims. This triggers coverage under Side A of the D & O policy, meaning that the carriers must immediately start paying these defense costs, rather than wait until the company has satisfied its self-insured retention.

After "cleaning up" problems caused by "accounting irregularities" in their financial statements and dealing proactively with regulators, many companies, wanting to move on with their business, have felt compelled to make very large monetary settlements. Most practitioners in the area agree that these big settlements have not only distorted the average settlements of "accounting" cases, but also hiked the average settlement value of all securities cases.

Indeed, in the period prior to the Reform Act, the average settlement value of a securities class action was approximately $8.4 million. In 2003, that average jumped to $19.8 million, though that was down from $23.2 million in 2002. In conjunction with several years of a "soft" market for D & O coverage, which caused many carriers (even the premier ones) to dramatically reduce premiums, the profit margins and reserve cushions for many D & O carriers evaporated; as a consequence, they suffered huge portfolio losses and sometimes even worse problems. Each of these factors, standing alone, was serious; combined, they caused D & O carriers to become extremely cranky.

Carriers' Response: Rescission Suits

This crankiness resulted not only in higher premiums for D & O policies across the board, but worse yet, made the carriers seek declarations in court that the D & O policy they issued was void from the outset on the grounds that the application submitted by the insured company contained material misrepresentations which the insurer relied upon in issuing the policy.

Facing this type of suit by a D & O carrier, many directors or officers believe that the severability clause potentially contained in their policy will save them from an adverse coverage determination, especially if they played (or think they played) no role in the alleged fraud.

What is a severability clause? It's a clause that says, in general, that the knowledge of the person signing the application should not be attributed to the company's other directors and officers for the purposes of determining coverage. The problem with this argument, the carriers say, is that the severability clause arguably applies only to the responses given by the signer to the questions in the application, and not to the financials statements "attached to" the application.

Thus, regardless of the answers given to questions in the application, if the financial statements submitted along with the application prove to later be materially misstated (the likely end result of a financial restatement), the carriers will argue that their reliance on such financial statements in issuing the policy provides independent grounds to rescind the policy in its entirety as to all insureds, regardless of knowledge or intent.

This very argument was asserted in Cutter & Buck Inc. v. Genesis Ins. Co. The plaintiff, Cutter & Buck, a retail sportswear company, renewed its D & O policy with Genesis Insurance in August 2001 ("the 2001/2002 Policy"). The application for the renewal policy, which was signed by the company's then-chief financial officer, Ron Lowber, required that the company's annual report, SEC filings and CPA letter be submitted with the application. The application also required that the signer declare that the "statements herein" were true and complete.

Several months later, the company announced that its financial statements for the 2000 fiscal year were overstated due to several transactions that were not disclosed to the board or discussed with its outside auditors. Not unexpectedly, that announcement triggered multiple shareholder lawsuits. In December 2001, Genesis sent Cutter & Buck a notice of rescission. (Lowber later pled guilty to wire fraud.)

After some discovery, the court granted Genesis's motion for summary judgment as to rescission of the 2001/2002 policy based upon the material misrepresentations in Cutter & Buck's annual report, the CPA letter and its SEC filings. Importantly, the policy had a severability clause. That clause, however, stated that "[i]n the event that the application, including materials submitted therewith, contains misrepresentations made with the actual intent to deceive, or contains misrepresentations which materially affect either the acceptance of the risk or the hazard assumed by the Insurer under this policy, this policy in its entirety shall be void and of no effect whatsoever...."

Based on this clause, and Lowber's guilty plea, the court held that his knowledge should be imputed to all defendants, including innocent directors and officers.

That's the unhappy scenario that a rescission lawsuit can bring to a company and its directors and officers, even if the company has a D & O policy with full severability. That solution is non-rescindable Side A coverage, a policy that, by design, can protect the individual assets of corporate directors and officers.

Paul A. Ferrillo ([e-mail]) is an attorney in the Business and Securities Litigation Department at Gotshal & Manges LLP in New York. The opinions expressed in this article are his own.