Insurance Will Protect Companies, Officers And Directors From Options Backdating Claims

Friday, September 1, 2006 - 01:00
Morgan, Lewis & Bockius LLP
John Edward Failla
David M. Halbreich

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
  • . Since a corporation's public filings are generally incorporated into the insurance policy application, in the past the carriers attempted to rescind coverage, in whole or in part, based on alleged misrepresentations or concealments in the application. In some cases, this had the effect of voiding the policies ab initio. In cases where a corporation restated its financials, the carriers often contended that this constitutes an admission that the application contained false or misleading information. Many policies contain 'severability' provisions that limit the ability of the carrier to rescind only as to those individual insureds who actually had knowledge of the information allegedly misrepresented or concealed in the application and as to the company only if high-level executives had such knowledge.

    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.

  • Conduct Exclusions
  • . Carriers have been known to raise various exclusions in response to any claim. D&O policies typically contain exclusions that preclude coverage for claims involving allegations of fraud and improper profits or other gains obtained by directors or officers. These exclusions may only apply, however, if there is an actual adjudication against the individuals or an admission of wrongdoing. Companies must consider how their responses to these claims and investigations might impact whether a policy exclusion will apply. These exclusions also should contain severability clauses to protect 'innocent' directors and officers.

  • Allocation.
  • Carriers also have argued that there must be an allocation of defense expenses between covered and uncovered claims, and covered and uncovered parties. There may be causes of action or claims in a complaint that are not covered, and carriers argue that some of the expenses must be allocated to these uncovered claims so that they need only pay some percentage of the defense costs. In addition, it may be the case that only the individual directors and officers are covered as opposed to the corporate entity and the carrier will seek an allocation based on this. These issues are very complex and different jurisdictions have different standards regarding allocation. The policy might also contain language regarding the allocation methodology, but such language often raises more questions than it answers.

  • Reasonableness of Defense Costs
  • . Carriers also raise issues regarding the reasonableness of defense costs incurred by the policyholder. Although these claims raise complex issues, carriers seek to further limit what they have to pay by raising issues regarding selection of defense counsel, hourly rates and other issues regarding the extent of the defense activities, based on policy provisions providing that defense expenses must be 'reasonable and necessary.'

  • Notice
  • . While giving notice of circumstances and notice of claim promptly is critically important, notice communications should also be precise and carefully drafted. Particularly where multiple types of insurance or policies issued by different carriers may cover the loss, carriers have argued seemingly inconsistent positions on the notice issue in an effort to avoid paying claims. We are aware of several matters in which carriers receiving notice of circumstances asserted that those notices were insufficient to trigger coverage, while other carriers that issued coverage for later time periods or different types of claims attempted to rely on that same notice of circumstances as proof that they should have received notice sooner, or that the claims actually arose before those carriers provided coverage. These risks can be ameliorated with attention to detail, careful drafting, and notice under all policies at the outset that could cover the claims.

  • Cooperation.
  • Insureds should maintain ongoing communications with the carriers regarding the progress of the claims. Carriers that believe they are not being kept adequately informed will attempt to argue that the insureds are in violation of their duty to cooperate. In addition, settlement discussions in the underlying matters must be communicated to the insurers, and the insurers should be given an opportunity to consent before any settlement is entered into. If insurers are not given an opportunity to participate in settlement discussions, they will argue that any ensuing settlement is not covered and in violation of the consent provision in the policy.

    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.

    Please email the authors at or with questions about this article.