New directors and officers battle looms over stock option backdating.

Policyholder law firms are preparing for a major battle with insurers over the backdating of stock options. Anderson Kill & Olick P.C. is warning clients that insurance companies reflexively will look for ways to deny coverage, generally referring to a few tried-and-true defenses such as rescission attempts or denials of coverage based on exclusions for intentional or dishonest acts.

Stephen Weisbrod of Gilbert, Heintz & Randolph LLP, an attorney who represents policyholders with respect to insurance coverage for corporate directors and officers, said some insurers may try to escape their obligations by asserting that insurance applications contained misstatements or incorporated misstatements that were made in SEC filings. "Those methods of escaping coverage don't usually work if the policyholder fights back," Weisbrod said.

The reactions from at least two major D&O writers have been subdued. In earnings conferences, they told the investment community not to panic.

St. Paul Travelers Cos. said its potential losses would be limited because of its high-layer excess position; management of limits; and the claims-made nature of the policies in question. The fact that defense costs must be within the policy limit would play a major role in reducing the severity of claims, the company said during an earnings call with investors.

So far, St. Patti Travelers has received 19 claims related to the stock-options backdating scandal. Some of these claims are in suits and others are notices of circumstances, Chief Operating Officer Brian MacLean said. "We're primary in only one of the 19 claims, and for that account we have a $10 million net limit. For the other 18 where we are excess, our average attachment point is just shy of $40 million," he said.

MacLean said the ultimate value of a typical derivative action is something less than $10 million--well below St. Patti Travelers' average attachment point. "We see the problem as it emerges as being primarily for the primary insurers and those lower-layer excess players," he said.

Chubb Corp., also a leading D&O writer, wouldn't immediately be exposed to defense costs because of its consistent underwriting strategy over the past few years "to shift our program participation from primary to excess layers for publicly traded companies," said John Degnan, chief administration officer at Chubb.

Degnan said he believes the early hype about the impact of backdated stock options on D&O insurers may well be overblown and is reminiscent of the early speculation about mutual fund claims. Also, several factors differentiate claims over backdating of options from those of the corporate scandals in 2001 and 2002, he said.

First, the limits on recent D&O policies are far lower than those in force during the corporate scandals, Degnan said. "In almost every claim we've received, we wrote only one layer in an insured's D&O program, unlike the high aggregate losses that arose in the corporate abuse cases from our participation then in multiple layers," Degnan said.

Degnan said most of the options-backdating notices are derivative actions, and those directors and officers most susceptible, particularly those that benefited from backdating, "are likely to trigger coverage defenses and those directors and officers who were less involved are not likely to be found culpable."

Weisbrod said policyholders implicated in the scandal must file notices with insurers promptly. "If they give that notice, then coverage is locked in for the current year even if the claim isn't made until some later year. It's an option that policyholders have to prevent insurance companies from avoiding covering options-backdating claims by inserting exclusions into future policies that would bar coverage for such claims."

Devin Beresheim, a managing director with the Marsh FinPro practice, admitted the growing scandal has raised concerns among underwriters but said it hasn't yet affected pricing or coverage.

Estimates of Unscheduled *,
At-the-Money ** Grants Backdated

About 235 of all at-the-money options before the
Sarbanes-Oxley Act were backdated or manipulated;
10% after SOX.

                                                    Number   Estimated
                                                        Of    Fraction
                                                    Grants   Backdated

Panel A: Pre-SOX Grants ***

All grants                                          13,828       23.0%
Grants by low-tech firms                            10,410       20.1%
Grants by high-tech firms                            3,418       32.0%
Grants by small firms                                4,113       23.1%
Grants by medium-size firms                          6,407       27.0%
Grants by large firms                                3,308       15.4%
Grants by firms with low stock return volatility     4,493       13.6%
Grants by firms with medium stock return
  volatility                                         4,743       26.2%
Grants by firms with high stock return volatility    4,434       29.0%

Panel B: Post-SOX Grants

All grants                                           6,494       10.0%
Grants filed within two business days                5,002        7.0%
Grants filed more than two business days after
  grant date                                         1,492       19.9%

* A grant is scheduled if it is dated within one day of the one-year
anniversary of a prior grant, or followed by a grant that is dated
within one day of the one-year anniversary.

** If the exercise price of the grant equals the price on the grant
date.

*** On or before Aug. 29, 2002.

Source: Erik Lie, Professor at University of Iowa; Randall A. Heron,
Professor at Indiana University.