On March 18, 2006, the Wall Street Journal published an article indicating that a number of public companies supposedly 'backdated' grants of stock options to senior executives to allow those executives to profit. That article set off a firestorm of activity surrounding the practice of options backdating. Around the country, numerous corporations launched internal investigations into the practice of options backdating with special committees of directors convened to review each company's historical stock option practices and related accounting treatment. Several companies issued financial restatements to revise the compensation expense attributable to options granted. Federal and state regulators, including the Securities and Exchange Commission (SEC), the U.S. Attorney and the Internal Revenue Service, have launched regulatory and criminal probes. The SEC probe questions whether companies made false and misleading statements in their filings and wrongfully failed to disclose the practice.
Not surprisingly, this publicity has sparked a spate of derivative and class action lawsuits. Numerous shareholder derivative lawsuits have been filed against directors and officers based on alleged improper stock option backdating. According to the plaintiffs in these lawsuits, the defendants manipulated stock option grant dates so that the options would be valued as of a date when the corporation's stock price was low, with the expectation that the beneficiaries of the stock options would be able to obtain greater gains when it came time to exercise the options. The complaints allege that the directors and officers breached their fiduciary duties to their companies by allowing this to occur. In addition to the shareholder derivative complaints, other shareholders have filed class action cases alleging violations of the antifraud provisions of the federal securities laws. These shareholders assert that they were misled by alleged false and/or misleading public statements, including press releases and SEC filings that did not accurately describe the stock option programs.
Directors & Officers Liability (D&O) and Fiduciary Liability insurance policies cover many of these lawsuits and investigations. D&O policies provide coverage for 'wrongful acts' allegedly committed by a company's directors and officers and cover a company's indemnification of its directors and officers. Most D&O policies also cover securities claims brought against the company itself. Depending on the particular allegations, options backdating claims may also be covered under Fiduciary Liability policies, which protect against 'wrongful acts' in connection with employee benefit plans. Companies that have been sued or have received demands or threats, or which are the targets of investigations must immediately review and analyze their insurance policies to determine whether they need to submit claims on their own behalf, on behalf of their individual directors and officers, or on behalf of covered pension or employee benefit plans and trustees. In most cases, immediate notice must be provided to the insurers. D&O policies and Fiduciary Liability policies are 'claims made' policies and notice must be provided during the policy period in which the claim is first made. Some policies, for instance, may require notice within as little as 60 days from the date that the claim was first made.
Most policies obligate the carrier to advance defense expenses on an ongoing basis, and may even cover costs for internal investigations. Some D&O policies will cover expenses incurred to respond to government investigations and even costs to defend criminal actions. These expenses will mount quickly, and the carriers will argue that they are not responsible for costs for which they did not provide consent. While carriers are not likely to prevail absent a showing of prejudice, the entire issue is easily avoided.
Further, even if a lawsuit or investigation has not yet been instituted, companies might still want to provide notice to their carriers. D&O policies typically allow the insured to submit a 'notice of circumstances' if they are aware of any situation that might give rise to a claim. If such a notice is provided, any later filed claim will be deemed to have been made during the policy period in which the 'notice of circumstances' was given. Since renewal policies may contain exclusions for backdating claims, or may have higher self-insured retentions and lower limits, it may be prudent to provide notice even before an actual claim is received. Moreover, if notice of circumstances is not provided, carriers may argue in response to a later notice that coverage is barred under the later policies and should be pursued under earlier policies.
The content of any notice to the carriers and all communications with them should be carefully vetted by counsel experienced in dealing with D&O claims. Companies should not simply rely on their insurance broker to handle these matters, as information conveyed early in the process may have serious implications later on regarding how the claim is handled by the carriers and whether coverage will be provided. Also, communications between insureds and their broker may not be subject to any privilege.
The terms, conditions, and exclusions of D&O policies and Fiduciary Liability policies differ from insurer to insurer. These policies can often be improved greatly with input from insurance attorneys or claims specialists during the negotiation and renewal process. It is important to review each policy in detail to determine whether it covers these claims.
Although defense costs and many indemnity claims arising from the options backdating issue are likely to be covered by D&O and Fiduciary Liability insurance, we anticipate that carriers will attempt to raise a number of defenses, including the following:
Rescission is a draconian remedy that is justifiably difficult for insurers to obtain. Insurers often must prove that a material misrepresentation was made to the insurer with the intent to deceive. Some insurers already have stated that recission is not appropriate in options backdating claims. For example, Evan Rosenberg, senior vice president at Chubb Specialty Insurance, has been quoted as saying that attempts to rescind policies due to alleged timing problems with stock options would be 'an overreaction to the issue.' 'Stock-option probes spark D&O concerns,' Business Insurance, May 22, 2006 at 26.
Reasonableness of Defense Costs
These are just some of the issues that carriers have raised in similar types of claims in the past. The bottom line is that claims need to be reported, and the insurance issues should be treated with as much care as the defense of the underlying claims. The availability of insurance, even if it is just available to cover defense expenses, may prevent an unpleasant situation from becoming a financial disaster.
John Edward Failla is a Partner in the Litigation Practice Group in Morgan Lewis' New York office. David M.Halbreich is a Partner in the Los Angeles office, where he practices in the Litigation Practice Group.