The impact restated financials can have on coverage.

Directorsand officers ("D&O") liability insurance offers a corporate officer and director protection from personal liability to another individual for the conduct or decisions made in his or her corporate capacity. Typically, D&O policies are claims-made policies, meaning that the coverage they provide are triggered only when a claim is made during the policy's period. The purpose of this type of insurance is to provide defense and indemnity to directors and officers in lawsuits filed by third parties.

Companies in Los Angeles County that have purchased D&O coverage have run into difficulties maintaining that coverage when restating their financial statements. Such companies have found themselves faced with litigation battles on two fronts. On the one side are the companies' shareholders, filing securities class actions and derivative liability lawsuits. On the other side are the companies' carriers, attempting and sometimes succeeding in rescinding their D&O policies based upon the restated financial statements.

One of the central issues in these battles is the role that public policy plays in the insurance industry. The public has a strong interest in protecting insurance consumers who are at a significant disadvantage in relation to both the policies' language and ensuring the carrier's performance in the event of loss. California courts have precluded carriers from exercising even clearly delineating rights to avoid coverage if valid public policy concerns warrant.

For example, one court prohibited a D&O carrier from canceling its policy even though a mutual cancellation allowed it to do so without cause. The court found the carrier's decision to rescind its policy arbitrary, because the carrier based its decision on mere allegations of fraud and because the cancellation included those directors and officers unconnected to the fraud allegations.

Unfortunately for policyholders, California courts have not yet extended this allowance to companies being sued for restating their financial results. Companies restate their financial information for numerous valid reasons, yet some insurers have alleged that such restatements are based upon misrepresentations made by one of the company's directors or officers. Insurers then contend that the conduct of that one should be imputed to all of the directors and officers, meaning the conduct of one will negate the coverage for all. Giving merit to such an interpretation would have serious public policy consequences.

It could create a powerful incentive for companies to discourage their directors and officers from providing valuable information to securities fraud plaintiffs to avoid losing their insurance coverage. It could further discourage a company's board of directors from investigating and exposing any financial fraud involving the company's senior executives.

Directors or officers who investigated any possible accounting fraud, or who cooperated with the Department of Justice and the Securities and Exchange Commission to bring senior officers guilty of violating securities laws to justice, might not do so for fear of losing the insurance coverage and protection afforded by the D&O policies.

The negative impact of allowing insurers to escape their obligations under their D&O policies is not just limited to the insurance industry. Corporate law broadly authorizes corporations to indemnify their directors and officers against litigation expenses, judgments, fines and amounts paid for settlements in lawsuits. Cal. Corp. Code [section] 317. Such legislation encourages capable individuals to serve as directors and officers of companies, and the availability of insurance to protect these individuals is a significant factor to be considered before assuming such responsibilities. The protection offered by D&O policies "has now become expected, even required, before business people will accept high managerial positions or serve on boards of directors, particularly as outside directors."

If the materialization of the very problem that is the focus of D&O protection (securities claims based on misstatements made in financial reports requiring their restatement) results in the complete annihilation of that protection, then honest and capable corporate directors and officers may seriously reconsider whether they are willing to assume such awesome responsibility with such little protection afforded.

David M. Halbreich and Jennifer L. Shoda are attorneys in the law firm of Morgan, Lewis & Bockius. Mr. Halbreich is a partner and Ms. Shoda is an associate in the Litigation Practice Group, and both concentrate their practices on insurance recovery and complex litigation. They can be reached at [e-mail] and [e-mail].