Printer Friendly

Emerging RM concerns for directors and officers.

In the current economic environment, where volatility is a given, corporations engage in complex business relationships involving multiple parties, each a potential source of exposure in an increasingly litigious society. Corporate officers and directors are exposed to personal liability not only from shareholders and government regulators, but also from present and former employees, competitors, customers and clients.

The results of a recent Wyatt Co. survey estimates that the frequency of claims against directors and officers increases 5 percent to 15 percent per year. The report indicates that companies involved in a merger, acquisition or divestiture or businesses that have experienced an after-tax loss in the past five years, showed significantly higher frequency and susceptibility to D&O claims than other companies. The survey's most startling finding is that legal defense costs of D&O claims are rising 8 percent to 10 percent annually, with the average defense cost for claims made in 1989 projected to be almost $1.3 million. The common practice of including directors and officers in the corporation's lawsuits makes the figures especially telling for executives responsible for corporate governance.

A risk manager who understands this environment plays an important role in his or her company. In fact, effective risk control measures are as important for officers and directors as a good insurance policy and state statutory immunity The risk manager's awareness of exposures associated with certain business relationships is the first step toward adopting policies and procedures to limit the company's potential risk of personal exposure.

New Shareholder Activism

These days corporations are being scrutinized by shareholders and federal and state regulatory agencies. According to proxy solicitors The Georgeson Co., evidence of new shareholder activism, particularly institutional shareholders holding a large portion of stock in U.S. corporations, can be found in the 112 governance proposals broached at annual meetings in the first quarter of 1990 alone. Dissident leaders intent on takeover or forcing a major restructuring of the company have been soliciting the support of these large shareholders in proxy contests challenging corporate governance.

Shareholders account for about half of all claims and allegations against directors and officers. These claims often follow adverse announcements which affect share value and are associated with merger and acquisition activity by either the acquiring or the acquired company. Allegations involve such issues as prematurely cutting off an auction, the fairness of a merger price, the value of an acquisition, shutdown costs or whether a leveraged buyout inordinately benefitted inside directors. Two recent cases reported in the May issue of Securities Class Action Report entailed substantial settlements and attorneys' fees. One suit charged that the directors of SmithKIine, a pharmaceutical and clinical laboratory company, failed to seek additional potential acquirers at a higher price than that obtained through a merger with Beecham Group PLC. It also alleged that the directors breached their fiduciary duty by placing defensive devices such as a "poison pill" and "golden parachutes" in the way of an acquisition.

Conversely, the directors of Interco Inc., a manufacturer and retailer of clothing and home furnishings, were sued because they refused overtures for a negotiated merger by City Capital Associates and recommended that Interco shareholders reject a City Capital tender offer. The suit alleged that the board, in approving a restructuring and recapitalization program in lieu of a merger, which included the sale of the Ethan Allen furniture division, the company's crown jewel, devalued the company's stock.

"The frequency of claims against

directors and officers increases

5 percent to 15 percent per year"

While defensive maneuvers to a takeover bid permit a board to explore alternatives to enhance shareholder value, corporate officers should know the exposures associated with employing them. Because takeovers generally increase share value, shareholders often object to measures designed to discourage them. In the case of Armstrong World Industries Inc., the company's directors were sued for breach of fiduciary duty during an effort to stave off an aggressive takeover attempt. The complaint charges that defensive measures adopted by the company were an unreasonable response to an unsolicited tender offer. As expensive media campaigns have become an integral part of proxy contests and some anti-takeover efforts, officers and directors also become liable to allegations of spending corporate funds to entrench themselves.

While merger and acquisition activity should continue at a somewhat reduced level, proxy contests, which are fertile ground for mismanagement charges, are expected to multiply Virtually all proxy fights spawn associated lawsuits, challenging either the proxy process itself or state anti-takeover statutes. Sometimes they occur later because of the charged atmosphere of allegations created by these struggles. During a hostile takeover bid or proxy contest for corporate governance, management may believe that it is making sound judgments to preserve the company, but its actions may be challenged as entrenchment or self-interest. Any decline in stock price can precipitate legal action, and defending against entrenchment allegations or missed opportunities can be costly. When a company faces merger and acquisition activity or a proxy contest, its officers should objectively consider all possible options and document their procedures. Directors must maintain a supervisory role independent of management, seeking the advice and documenting the actions of independent professionals.

The newest exposure, growing out of the intense merger and acquisition activity of the 1980s, relates to the dramatic rise in highly leveraged companies. For instance, in cases where mergers have created more debt than the new entity can service, shareholders have charged management with blunders in marketing and strategic planning. Companies unable to service their debt, either due to a large acquisition or taking the company private, can seek Chapter 11 protection. The drop in share price associated with bankruptcy and the possible loss of equity often translate into shareholder and bondholder suits for violation of securities laws or derivative actions for mismanagement of the company.

The shareholder suit charging officers of Campeau Corp.'s Federated Department Stores and Allied Stores with concealing the disastrous effects of the debt assumed by Mr. Campeau and the bondholder suits against Donald Trump are real incidents of what is occurring throughout the corporate sector. While bankruptcy stays actions against the entity, suits against individuals can go forward. Directors and officers, as a result, could find themselves unprotected because an insolvent company can no longer indemnify them.

Public Exposure

The central issue regarding D&O risks is public disclosure of information. Most claims are shareholder class actions alleging violation of securities laws either for dissemination of false and misleading information or for omissions of information which constitute material misrepresentation. Lawsuits are based on the idea that misleading the public in press releases, quarterly and annual reports creates an artificially inflated stock value. When true information comes to light, stock value drops and shareholders seek damages to recover their loss.

Corporate executives walk a fine line. Optimistic statements about expected benefits from an acquisition or from a new product encourages investment in the corporation. Conversely, statements not based on fact can also cause harm. One difficult area is announcing new product expectations. A recent class action suit, Blackman v. Polaroid Corp., stemmed from allegations that the price of Polaroid's securities were kept artificially inflated because of the corporation's failure to disclose negative facts about the Polavision videocamera.

Plaintiffs claimed that Polaroid failed to issue statements to correct a glowing quarterly financial report, even though it had become aware of significant problems with the Pola - "Almost any negative event followed by a drop in stock price can be linked to a lawsuit " vision and halted its production. In January 1990 a panel of the U.S. First Circuit Court agreed with the plaintiffs, holding that when a corporation makes a disclosure, it has a duty to ensure that it is neither false nor misleading. The panel added that "a duty to disclose can arise if a company possesses material facts that must be released in order to render prior statements not misleading."

The Polaroid case is similar to the 1984 class action suit charging the directors and officers of Coleco Industries with alleged fraud in outwardly promising record sales of its new Adam computer, despite obvious engineering and production flaws which would prevent mass delivery by the promised date. In July 1986 D&O insurers and Coleco paid settlements of almost $16 million, plus $4 million in legal fees. Polaroid has since won a retrial. The ultimate decision will further define the disclosure obligations of corporate directors and officers. If additional courts create duties to correct or update prior truthful statements, the potential exposure of corporate officials for public statements will be significantly expanded.

Sometimes public disclosure issues about a company's financial health are of more general concern. Changing market conditions or other causes of declining sales are a potential D&O risk. In addition, volatile market conditions in the highly competitive high-tech industries make them particularly vulnerable. For example, last year officers and directors were named in a class action suit against Microsoft Corp., a well-known supplier of operating system software. The complaint alleged that defendants issued false public statements and omitted facts. The plaintiffs specifically cited one product's inventory as being insufficient to meet customer demand, another product produced in excess of demand and delays in the development and shipment of a new product, all of which led to a loss in earnings.

Market conditions in other manufacturing and retail industries can cause similar pressures on corporate officials. For example, Windsor Industries Inc. was recently involved in litigation alleging that the company failed to disclose rapidly declining sales of its kerosene heaters, which resulted in substantial inventory writeoffs and losses over several years. The suit centers around an initial public offering prospectus published at the start of those difficulties which had portrayed the company as profitable.

Corporate officers should also know that fast-paced growth is often accompanied by difficulties which increase their risk of personal exposure. Recently, shareholders filed suit in a federal court after Network Equipment Technologies Inc. announced disappointing fourth quarter sales and earnings as a result of an invalid order. The announcement was followed by a precipitous decline in the price of Network shares.

Almost any unusual corporate transaction or negative event followed by a drop in stock price can be linked to a lawsuit. Although plaintiffs may find it difficult to prove causation between the officers' actions and the decline in stock value, such allegations are expensive to defend. Under the securities laws there is no obligation to make public statements about the company's future. However, once officers choose to do so, they become liable to personal exposure. Because shareholder allegations sometimes fail to correct or update prior disclosures, directors and officers should be conscientious when selecting the content of public statements and in considering obligations to disclose developments which affect prior statements.

Regulatory Scrutiny

As corporations are subjected to increased shareholder challenges, the government has taken a more active regulatory role. From the standpoint of directors and officers, most current litigation comes from federal and state agencies regulating financial institutions, particularly the Federal Deposit Insurance Corp., as it aggressively seeks to shake out questionable institutions. According to FDIC spokesman Alan J. Whitney in a letter to The New York Times, the agency alone has more than 500 lawsuits prepared against directors, officers and other professionals who may have contributed to losses in bank and thrift failures and their insurers. Mr. Whitney notes that since the beginning of 1990, the agency has tried or settled cases that will recover approximately $200 million from professionals and their insurers, and pending cases involve a substantially greater amount.

Similarly, The Resolution Trust Corp. has investigators aggressively pursuing claims and litigation to help recover losses incurred by the industry. While many of the regulatory bodies have targeted individuals involved in the most severe acts of self-dealing, they frequently include charges against other directors and officers of the institution for improper supervision.

Heightened regulatory scrutiny has forced financial institutions to increase their loan loss reserves for non-performing assets. Because this step adversely affects earnings and stock price, it frequently leads to securities actions by shareholders and regulatory suits. While most D&O policies cover shareholder suits, the underwriter's intent for including a regulatory exclusion would not cover suits brought by regulators. However, the courts have generally been divided on the enforceability of this exclusion.

Finally, employees and former employees also represent a source of potential D&O risk. Wrongful termination suits are particularly common, and recent jury decisions in some states have resulted in substantial awards. Typically, allegations in wrongful termination suits include breaching an expressed or implied employment contract against the corporation, as well as tort allegations against directors and officers.

Even an employee manual can constitute a contract, and termination must comply with procedures outlined in that manual. The discharged employee may argue that the employer made overtures regarding continued employment. In similar "failure to promote" or "constructive termination" suits, an employee may charge that he or she was misled into accepting employment or deceived at the time of employment by a promise of promotion.

Employment Exposures

The courts in some states have granted more exceptions to the employment at will doctrine than in others. For instance, in the case of Greely v. Miami Maintenance Contractors Inc., the Ohio Supreme Court created a public policy exception regarding discharge or discipline of an employee for reasons prohibited by statute. Some employment attorneys see the decision as an expansion of tort remedies to the issue of employment-a situation that can expose employers to unpredictable jury awards.

In other examples of employment-related exposures, suits have been filed against directors and officers of a corporation which allege executive wrongdoing. They are similar to the suit brought a few years ago by two discharged employees of Ashland Oil. The employees won a $69 million verdict against the company and its directors and officers; the case was subsequently settled for $25 million.

In employment-related areas, full knowledge and awareness of pertinent issues, as well as keen attention to proper procedures, can also help control the risk of personal exposure. First, the board must be objective, independent of management and responsive to shareholders' concerns. It should encourage shareholder representation on a committee in an advisory role. To be actively involved as overseers, the board must attend meetings and insist on receiving minutes and regular reports far enough in advance of meetings to comprehend them fully. If unusual or negative events occur, board members should immediately request additional information from management. It is also important that board members document their decisions and the facts on which they are based.

Regular independent assessment is also essential to maintaining an objective stance. The board should rely on independent legal and financial advice and ensure that outside directors are well represented on the corporate audit committee. Regular self-evaluation is a valuable complement to the independent review. The size and composition of the board are significant factors in the board's ability to accomplish all these tasks effectively. A relatively small board composed of approximately 80 percent outside directors should be able to perform its role. Finally, as individuals, board members must avoid even the hint of a conflict of interest.

Yet even the most conscientious risk management program cannot fully erase the personal exposures of directors and officers in today's business climate, and the untested state statutes contain undefined terms, as well as significant loopholes which the plaintiff's bar can exploit. Therefore, the purchase of D&O insurance has become increasingly important to companies, and directors and officers have shown keen interest in the quality and quantity of their firm's insurance coverage.

The risk manager is responsible for keeping up to date on D&O insurance. There are several key coverage issues to consider, such as contract quality and clarity. The coverage should be broad and customized to the company and the industry. The contract should clearly define wrongful acts or damages and specify the intended impact of exclusions. Given today's high legal fees, it should clearly address the availability of defense cost coverage.

An equally important consideration is the carrier's financial stability. Risk managers should understand how each insurer uses its capacity relative to their accounts. A company that puts down its full available capacity may expose its client to a restricted capacity when reinsurance markets retreat, as they did in 1985. Because an insurer's pricing philosophy can have a significant impact, it is also important to match a pricing philosophy with the company's management goals. A carrier's ability to price on a fixed basis over time allows a company to avoid the surprises and problems which the insurance industry has faced in the past.

For D&O coverage to be effective, the underwriter should strive to understand the company's goals and challenges and respond by tailoring coverage to meet its needs. From the chief executive's perspective, the company should provide the underwriter with all the required information needed to properly assess the risk. No company wants to be surprised by an irresponsible insurer, or for that matter, unexpected or unnecessary risks. Communication between insurer and insured is the best prevention against uncertainties and the best guarantee for mutual satisfaction. Richard E. Cartland is president of Aetna/Executive Risk, Aetna's underwriting manager for D&O insurance in Simsbury, CT.
COPYRIGHT 1991 Risk Management Society Publishing, Inc.
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1991 Gale, Cengage Learning. All rights reserved.

Article Details
Printer friendly Cite/link Email Feedback
Title Annotation:risk management
Author:Cartland, Richard E.
Publication:Risk Management
Date:Feb 1, 1991
Words:2874
Previous Article:Author: I did not mean to bash Bermuda.
Next Article:Making the M&A transition with D&O run-off coverage.
Topics:


Related Articles
HEIDI G. MILLER NAMED CHIEF FINANCIAL OFFICER OF TRAVELERS GROUP
RIMS' 42nd president, William J. Kelly: a look back.
Intracorp Study Shows Employers Benefiting from Injury Prevention Investments.
Intracorp Study Shows Employers Addressing Injury-Prevention Through Ergonomics, Prior to Proposed OSHA Mandate.
Executives unhappy with risk management. (Risk Reporter).
Risk management in the nonprofit sector.
ERM: walking the walk on holistic risk.
Q&A: meet the President.
Dubai Customs concludes a number of Risk Management Workshops.

Terms of use | Copyright © 2016 Farlex, Inc. | Feedback | For webmasters