State of the D&O insurance market: rising rates ... scaled-back coverage ... risk-sharing mandates. What you need to know to navigate in the turbulent marketplace for director and officer protection.

• Author: Podolsky, Fred T.
• Position: D&O Insurance - Directors and officers liability - Related articles: The Cost to Be Protected, Other Coverage Restrictions

DIRECTORS AND OFFICERS feel increasing pressures as their job responsibilities appear to be expanded by regulatory and legislative action. At the same time, directors and officers continue to be concerned about their protection from personal liability and look for reassurance to both the company balance sheet and the extent of D&O liability insurance coverage. This article analyzes the liability issues for directors and officers, as well as the current state (mid-2003) of the D&O insurance market.

Corporate governance is now the law of the land. For directors and officers of publicly traded companies, the passage of the Sarbanes-Oxley Act of 2002 (S-O) set forth numerous duties and obligations and created clear civil and criminal penalties for non-compliance. Since its passage, the Securities and Exchange Commission has promulgated new rules designed to implement certain provisions of the Act. In addition, the New York Stock Exchange, the American Stock Exchange, and Nasdaq have all passed their own rules regarding director and officer conduct.

Although many of the obligations contained in S-O, such as the obligation of the CEO and CFO to certify the financials of the company, already existed to some degree, S-O makes very clear the scope of the required certifications and the penalties (both civil and criminal) for non-compliance or false compliance.

Some of the provisions of S-O also could have a direct impact on D&O coverage. For example, Section 301(4) requires the audit committee to create and maintain an internal complaint procedure for the receipt, retention, and treatment of complaints received by the company regarding accounting, internal accounting controls, or auditing matters. This includes but is not limited to complaints regarding financials that may be made by employees. Because of the broad definition of claim in the typical D&O policy, any "writing" about these internal complaints may well constitute claims under a typical D&O policy. D&O policies require timely notice of claims, so this can be a very real issue unless addressed in advance either through a company's risk management department or through modification of D&O contracts.

Focus on reporting ... and restating

Congress continues to focus on financial reporting by public companies. In October 2002, the General Accounting Office issued a report to the Senate Committee on Banking, Housing and Urban Affairs that addressed financial restatements. The GAO noted that the number of restatements has steadily increased between 1997 and 2002 (see accompanying exhibit), even though the average number of companies listed on United States exchanges has decreased by 20% over that same period.

While the causes of a restatement may vary, the stock market response is uniformly negative, so the stock price often drops, and securities holders bring suit. In 2002, we saw this market "knee jerk" reaction regardless of the reason for the restatement and regardless of the financial impact of the restatement. A similar reaction occurred with D&O underwriters during 2002. Thus far in 2003, it appears that D&O underwriters are taking more time to understand the cause and the effect of the restatement before reacting, and we see this as a favorable market move.

Along with new rules and regulations, the SEC, the Department of Justice, and state attorneys general are all focusing on corporate activity, at both public and private companies. There is an increase in both formal and informal investigations, and an increase in administrative proceedings against companies and their directors or officers. For example, according to a PricewaterhouseCoopers study on securities litigation, the SEC initiated more than 300 investigations during 2001 (compared with 166 during 1997), an 81% increase. Federal Deposit Insurance Corp. (FDIC) regulatory investigations of financial institutions are also heating up.

This increased regulatory scrutiny has directors and officers clearly on alert, and adverse publicity has put them on the defensive. At the same time, both public and private companies seek to attract and retain competent executives and must find independent outside directors (most of whom need to be financially literate). While the corporate balance sheet is the first line of protection for directors and officers, the significance of D&O insurance cannot be overlooked.

Directors and officers previously questioned whether D&O insurance was in place. Now, they want to read the fine print of the policy and understand the coverage that it provides. D&O insurers previously asked questions about the qualifications of the board; now they want backup documentation. For both insurers and insureds alike, the cost of D&O insurance and...