Getting personal: recent high-profile corporate scandals sprouted a new trend--attorneys targeting directors' assets.

Recruiting qualified individuals to serve as directors is a concern for public companies, and the possibility of personal exposure of directors is a consideration in the decision to serve. Many of these fears have been allayed in recent years by the increasing availability and limits of directors and officers liability insurance, as well as enhancements in such coverage seeking to offer the needed protection from shareholder and other suits.

While D&O insurance traditionally was issued to provide protection to the individual directors and officers, the introduction of entity coverage in the mid-1990s changed the dynamic between corporations and their individual directors and officers.

Before Entity Coverage

Prior to entity coverage, D&O policies provided coverage for loss incurred by the directors and officers, and provided reimbursement to the corporations only to the extent that they provided indemnification to the directors and officers to cover their loss. Any direct loss incurred by the corporation for its own liability was not covered. Typically, when settlements of shareholder suits were reached, a negotiation between the company and its D&O insurer ensued to determine the portion of the settlement that would be attributed to the directors and officers and thus covered under the D&O policy.

Following several significant court decisions limiting an insurer's ability to attribute large portions of the loss to the corporation and eliminate coverage for this loss, a trend toward entity coverage developed, eliminating the need for allocations of the loss.

The substantial increase in the average settlement of shareholder suits, however, threatened to eliminate the personal protection for directors and officers for which D&O insurance was originally created. Since the entire amount of such settlements was now potentially covered, the limits of the D&O insurance were subject to exhaustion by a single catastrophic settlement or liability. This exhaustion would leave not only the corporation but its individual directors and officers exposed for subsequent claims. While companies responded by increasing the limits of their D&O insurance, the possibility of catastrophic losses often eclipsed this increase in limits. Moreover, the risk of bankruptcy also increased the potential of personal liability, as the D&O policy was often viewed as an asset of the bankrupt company and could potentially be unavailable to provide coverage to the individual directors and officers.

To provide additional protection to individual directors and officers, companies increasingly turned to "side A only" policies. In a typical D&O policy, "side A" provides coverage for loss incurred directly by the individual directors and officers, while "side B" provides reimbursement to the company when it indemnified its directors and officers, and "side C" provides entity coverage directly to the company. Since a catastrophic loss to the company paid under either side B or side C could wipe out the entire limits of the policy and leave the individuals exposed to future claims, side A only policies were created to provide this protection.

These policies cover only direct losses to the individual directors and officers and cannot be exhausted by a catastrophic loss to the company, including an indemnifiable loss subject to reimbursement under the D&O policy. Side A only policies also provide protection when the company is unable to indemnify the directors and officers, including situations in which the company is insolvent. Moreover, if the company has filed for bankruptcy, the side A only policies cannot be classified as assets of the estate since they provide no coverage to the company, leaving the policy intact to provide necessary protection to the directors and officers.

Risk Still Abounds

Despite these increased protections for individual directors, there have been cases arising out of some of the recent corporate scandals in which plaintiffs' attorneys have targeted directors and have demanded, and obtained, personal contributions from the directors. In January 2005, 18 former directors of Enron Corp. reached a $168 million settlement with shareholders, which included an agreement by 10 of the former directors to pay $13 million from the profits of their sale of Enron stock before the company's revelation that it had exaggerated its sales and profits. Plaintiffs' attorney William Lerach was quoted as saying, "Hopefully, this will send a message to corporate boardrooms of the importance of directors performing their legal duties."

Also in January 2005, 10 former WorldCom directors agreed to personally pay $18 million as part of a total $54 million settlement with lead plaintiff New York State Comptroller Alan Hevesi. This settlement was initially rejected by the judge presiding over the WorldCom case because of the illegality of another provision of the settlement. That problem was rectified, however, and the settlement proceeded with the personal contributions by the former directors. The WorldCom case thus stands as a signal that plaintiffs may continue to target the personal assets of company directors.

In 2004, the former chairman of Global Crossing, Gary Winnick, contributed $30 million toward a settlement of a class action shareholders suit.

Putting Suits in Context

These settlements could be considered aberrations for several reasons, including the egregious nature of the alleged fraud, the massive publicity surrounding the cases and the active trading of the stocks which resulted in extraordinarily high potential damages.

However, attempting to impose personal liability on directors is becoming a trend. First, these settlements have established a precedent and could lead to expectations in future cases that similar contributions will be sought and made. Plaintiffs' attorneys will be reluctant to allow directors and officers to escape with ever-increasing gains from stock sales and compensation packages while individual and institutional investors suffer tremendous market losses. Second, these cases were highly publicized because they were the first of the so-called massive corporate scandals that in part led to passage of the Sarbanes-Oxley Act. The public in general is more aware of these situations, and all subsequent cases of alleged corporate fraud will be more in the public eye than ever before, making the cries for personal liability of corporate directors and officers ever louder.

Third, the amounts of compensation, including stock options, that directors and officers are receiving have increased dramatically, thus increasing personal wealth that could serve as a target of plaintiffs' attorneys. Fourth, significant damages are always a potential in class action securities cases, and such potential damages have only been increased by the volume of investments pouring into mutual funds and the resulting market capitalization of most public companies. The magnitude of the potential exposures could increase the willingness of directors and officers to contribute.

The Risk of Rescission 

In addition to the potential of personal contributions to settlements, directors and officers have increasingly bad to face the risk of rescission of their D&O coverage. With the revelation of these massive alleged corporate frauds, insurers are increasingly seeking to obtain rescission of the policies they issued in reliance on financial statements and other representations of management. Since many companies have revealed fraudulent accounting practices, for example, insurers have argued that the financial condition of the companies, relied on by the insurers in issuing their policies, was knowingly misstated. While in some instances insurers have sought rescission only as to the directors and officers involved in the wrongdoing, others have sought rescission as to all directors and officers. Whether such wholesale rescission is warranted is in large part dependent on the language of the policy and the application submitted by the company.

The risk of rescission has led some insurers to begin marketing non-rescindable D&O coverage available to outside, independent directors. Individuals considering service on boards of public companies must be aware of the insurance available to them and make a careful review of the insurance obtained for their protection.

These considerations will certainly be paramount in the minds of qualified individuals who are asked to serve on the boards of public companies. Whether these recent developments have an effect on the ability of corporate America to recruit the most qualified individuals to serve remains to be seen, but they have certainly created potential obstacles that will have to be factored into the decision-making process.

Key Points

* Individuals considering service on boards of public companies must be aware of the insurance available to them and make a careful review of the insurance obtained for their protection.

* News reports about Enron, WorldCom and Global Crossing have placed the subject of corporate fraud in the public eye, making the cries for personal liability of corporate directors and officers ever louder.

* Because of massive alleged corporate frauds, insurers are increasingly seeking to obtain rescission of the policies they issued in reliance on financial statements and other representations of management.

Precedent Setters

Plaintiffs' attorneys in high-profile corporate scandals such as Enron, Global Crossing and WorldCom have demanded, and obtained, personal contributions from board members.

Kenneth Lay 

Former Enron CEO 

Eighteen former directors of Enron Corp. reached a $168 million settlement with shareholders, which included an agreement by 10 of the former directors to pay $13 million from the sale of Enron stock before the company's revelation that it had exaggerated its sales and profits.

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Bernard Ebbers 

Former WorldCom CEO

In January 2005,10 former WorldCom directors agreed to pay $18 million as part of a $54 million settlement with lead plaintiff N.Y. State Comptroller Alan Hevesi. The case stands as a signal that plaintiffs may target personal assets of company directors.

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Gary Winnick

Former Global Crossing Chairman

In 2004, the former chairman of Global Crossing, Gary Winnick, contributed $30 million toward a settlement of a class action shareholders suit.

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Contributor Andrew L. Margulis, a partner in RMKB's New York office, devotes his practice to D&O and professional liability litigation and insurance coverage. He can be reached at [e-mail].