Keeping your options open: directors and officers insurance can play a central role in a company's response to investigations into backdated stock options.

Backdating stock options is drawing a great deal of attention from state and federal regulators and from the plaintiffs class-action bar. The Securities and Exchange Commission is currently investigating more than 100 companies for backdating and has brought criminal charges against several executives. In addition, approximately 25 securities class actions and more than 100 derivative suits have been filed. The problem may spread. It is estimated that more than 2,000 companies may have engaged in backdating of stock options.

A backdating controversy may cost a company millions of dollars in defense costs alone, to say nothing of the potential liability on such claims. Insurance coverage should play a central role in the company's strategy in responding to these claims. Insurers are well aware of the scope of this problem and can be expected to take an aggressive approach to claims. An equally focused approach is required by risk managers and insureds to assure they obtain the full benefits of their insurance.

D&O Coverage

Directors and officers insurance generally provides coverage for "wrongful acts" by directors and officers of the company for their actions in managing the company. D&O policies can provide several different types of coverage, including direct coverage for the personal exposure of the directors themselves--often called Side A coverage--and coverage for the company to cover its obligation to indemnify the directors and officers--Side B. In addition, many policies provide coverage for certain types of claims against the company itself, typically limited to securities claims--Side C or entity coverage.

D&O policies are typically claims made, meaning that coverage applies only if the claim is made during the policy period and notice is given to the carrier within the policy period (or a short grace period afterward). It is important that the companies and individual directors and officers provide prompt notice to the D&O insurer of any options backdating claim. While policy language varies, notice to the insurer within the policy period or immediately thereafter is usually a condition precedent to coverage. Late notice can eliminate coverage. These policies typically pay for loss consisting of both defense costs and eventual settlement payments. Unlike some other forms of liability policies, payment of defense costs is charged against the policy limits and reduces the amounts available later for settlement.

Policy terms differ from policy to policy in ways that significantly affect the scope of coverage.

Types of Claims Covered

D&O policies typically provide coverage for loss on account of any claim. The definition of claim is critical to the scope of the company's protection. Some policies define claims to be limited to demands for monetary relief. Such policies will protect the insureds in class-action securities claims and derivative suits but will not respond to governmental investigations or criminal proceedings.

Other policies are broader and provide some coverage for the defense of governmental investigations, and in some cases, criminal matters. One typical policy definition of claim includes criminal and civil proceedings if commenced by a complaint, indictment or notice of charges. Civil investigations can trigger coverage once an individual is targeted through a subpoena or other notice. If the investigation is at a preliminary stage and has not yet resulted in any of these formal notifications, however, the policy may not apply. In many cases, the vast majority of defense costs are incurred while the investigation is informal and may not be covered under such policies.

The Defense of a Claim

D&O policies usually provide for reimbursement of defense costs and do not impose a duty to defend upon the insurer. The insured must select and retain counsel, and then seek reimbursement from the insurer. Some D&O insurers require the insureds to select counsel from a pre-approved panel. The timing and frequency of required reimbursements can vary, but defense costs almost always erode the limits of coverage the policy provides.

Fines and Penalties

Policies typically exclude fines, penalties and the multiple portions of multiple damages from the definition of covered loss. Some policies expressly list taxes as excluded, while others do not, which may provide insureds with an argument for coverage, though all other policy requirements would need to be satisfied.

Rescission 

Carriers frequently assert the right to rescind the policy if there is any false statement in the application, or in any financial statements or public filings which are attached to or incorporated into the policy application. Insurers often contend that an earnings restatement is an admission of material misrepresentation, but that argument is superficial. The issue is not whether the misstatement was material from an accounting standpoint, but whether it was material to the underwriting decision. In other words, if the financials had been correctly stated, would the carrier still have issued the policy on the same terms? It may be difficult in many cases for the carrier to show it would have declined to issue the policy if the option costs had been properly expensed. The lower reported net-income figure would probably have been irrelevant to the underwriting analysis in most instances.

Moreover, many policies have severability clauses. Terms vary, but these clauses typically provide that the policy may only be rescinded as to those insureds who made the misrepresentation or who knew of the misrepresentation. This may severely limit which insureds are subject to having their coverage rescinded. Allocation rules also vary according to policy terms and state law, but a common rule is that a loss is deemed covered in its entirety despite the presence of uninsured defendants if the defense costs and liability would be the same with or without the uncovered defendants. If all defendants are equally liable for the loss, the company and its directors should still have full coverage for the loss even though the policy may be subject to rescission as to some insureds.

Moreover, carriers generally have an obligation to advance defense costs to their insured during the course of the litigation, even if they have asserted rescission. They must prove their rescission claim before they can terminate their obligations. Since the issues in the rescission case, however, overlap with the issues in the underlying claim against the insured, the insured has a good argument that pursuing the rescission claim is prejudicial to the insured's defense of the securities case and that the rescission action should be stayed until the lawsuits are over.

Personal Profit

Generally, policies exclude coverage if the insured "gained in fact any personal profit, remuneration or advantage to which such insured person was not legally entitled." Under many policies, this exclusion applies only if there is an actual adjudication that the insured obtained a personal profit. In addition, policies usually have a severability provision so that the exclusion excludes only the culpable insured.

Careful consideration also should be given to who received options and who was involved in each decision to grant options. The exclusion only excludes claims involving personal profit by the specific insured. The exclusion will not apply to option grants awarded to non-directors and non-officers. Moreover, it should not apply to the decisions made by any one director or officer to grant options to other directors or officers, since those claims do not involve personal profit.

In addition, the exclusion applies only to compensation the insured is not "legally entitled" to receive. Executives, however, were legally entitled to the full amount of their stock option compensation. The issue with backdating is not whether it was improper for the executive to receive it, but how it was reported by the company for income-statement and tax purposes.

Renewals and Notices Of Circumstance

D&O policies are typically claims made. To avoid a notice defense, the company should report the claim promptly to the insurance company, both to trigger the policy and assure that it applies to the loss, and to avoid arguments that costs were incurred without the advance approval of the insurer.

Most policies also permit notice of a circumstance even if there has not yet been a claim. If the insured is aware of a circumstance--meaning an event that could later give rise to a claim--then the insured is permitted to give notice of the circumstance during the policy period. Any later claim made based on that circumstance will be deemed made during the policy period in which notice of the circumstance was given.

Prior to the policy renewal date, insureds should give careful consideration to whether to notify their D&O carriers of a circumstance, if the company is aware of a potential problem but has not yet received a claim. A number of factors must be evaluated, including the state of any internal or governmental investigation, the questions on the renewal application and proposed terms of the renewal policy.

One insurer has requested its insureds to complete an extensive questionnaire asking detailed questions about options practices. The questionnaire contains a provision at the end excluding coverage for any claim based on known prior practices. Determining whether and how to respond to such a questionnaire is a difficult issue, as detailed answers may be discoverable in any backdating investigation or litigation, and vague or incomplete answers could lead to a rescission defense or the assertion of the exclusion in the questionnaire. Insureds should consult with counsel regarding these risks and may explore with the broker whether questionnaires can be avoided.

Insureds also should consult with counsel regarding the risks and benefits of providing a notice of circumstance prior to renewal. Providing notice could minimize the risk of a rescission claim or application of a backdating exclusion. Carriers, however, frequently dispute notices on the ground they did not provide sufficient information to constitute a proper notice. On the other hand, detailed information could operate to the company's detriment in any later investigation or suit. Notice to the carrier may also trigger other public disclosure obligations. All of these considerations must be carefully balanced in making a decision whether to give such notice.

Insurance is an important part of any company's response to a backdating controversy, and careful attention should be given to this issue in developing and implementing the company's response to any investigation or suit. The potential for backdating claims also must be carefully considered in the policy renewal process.

Key Points

* Directors and officers insurers take an aggressive approach to claims for backdating stock options.

* Notifying the insurer promptly is important because D&O policies are typically claims made. * The issue with backdating is not whether it was improper for the executive to receive it, but how it was reported by the company for income-statement and tax purposes.

Companies Under Scrutiny

The following companies are among some 120 that have come under scrutiny for how they handled stock option grants.

Apple Home Depot HCC Insurance Holdings Inc. Monster United Health

Source: The Wall Street Journal, BestWire

Understanding Stock Options

* Stock options are granted to top-level employees as a form of compensation.

* Stock options give the holder the right to buy stock at a strike price set on the day the option is issued.

* A strike price set at market price on the day it is issued is said to be "at the money."

* A strike price set below market price is called "in the money."

* "In the money" options are issued with a built-in profit and must be expensed by the company, therefore reducing the company's income.

* Backdating occurs when the option strike price isn't based on the stock's price the day the decision to grant the option is made. The grant date is backdated to an earlier date when the stock price was lower.

* The seller therefore makes a larger profit on the stock's sale.

* The central issue in the backdating controversy is how the options were reported for income-statement and tax purposes.

Contributor John D. Green is a partner in the San Francisco office of Farella Braun + Martel and can be reached at [e-mail].