Worst case scenario

When companies restate their earnings, concerns about relationships with investors is probably top of mind. When ClearOne Communications restated, it probably thought it had enough to deal with. But then its D&O insurance carrier, National Union Fire Insurance Company (an AIG company), rescinded the policy. It took the restatements as admissions that the financials accompanying the original application were a misrepresentation. Suddenly, coverage no longer applied going back to the original date that the insurance went into effect. After two years in court, ClearOne isn’t down for the count, but there’s a good chance that the carrier will have its way and ClearOne will be left to pick up the pieces by itself.

Rescission is a particularly ugly word if a company faces a shareholder lawsuit and you happen to be an officer or director. There’s the decided possibility that someone who did nothing wrong is suddenly going to face more zeros on a legal bill than anyone would ever want to count. Insurance carriers have seen too many high profile cases of corporations filing misleading or fraudulent financial statements at a time when their D&O policy margins are shrinking. A company must understand the changing dynamics of the insurance industry and protect itself, its offices and its directors at a time that shareholder settlements have reached all-time highs.

Rescission raises an ironic problem for the covered corporation. ‘Typically the only coverage offered to the company itself, as opposed to the executives, is for securities claims,’ says Mark Hersh, a partner at Reed Smith Sachnoff & Weaver, who is also the deputy chair of the insurance recovery group. ‘Many securities claims involve alleged false publicly filed financials. It is problematic that the insurance companies accept premiums to provide coverage for all securities claims and then turn around and say hey, we’re not providing coverage to you because you’ve filed false financials.’

To understand what is happening in D&O insurance, you have to start with the pressures on the insurance carriers. There are about 30 carriers, including ten main players, that currently offer this coverage, according to Steve Shappell, managing director for legal and claims practice at insurance broker Aon Financial Services Group. That small number is crucial, because each pays close attention to what happens to the others and ties in with recent history: Enron, Worldcom, Adelphia and Tyco. Insurance companies hate – absolutely hate – having to pay out money.

‘The claims that started coming in the door in 2002 and 2003 created a heightened focus on whether there were misinterpretations in the underwriting,’ says Todd Greeley, vice president of CNA Specialty Lines, a D&O policy carrier.

Translating that means suddenly, among this relatively small community, there was one budget busting settlement after another. ‘They were just kind of fed up with these fraudulent claims,’ Shappell says. ‘The same fraud that shareholders were claiming, insurers said, You’re doing the same [to] us.’  From about 2000 to 2005 there were an average of 193 shareholder lawsuits each year, though the number dropped significantly in 2006.

Not only have there been many suits, but the size of the settlements – and the severity of the impact on the carriers – has grown. ‘Ten years ago the average settlement was under $10 million,’ Shappell says. Last year the average was around $38 million, and that’s not including some of the largest settlements that would have heavily skewed the number even higher. Plus, last year there were 12 settlements over $100 million. In 1996, there was only one. This year the average is closer to $29 million, but add another 25 to 30 percent for legal defense costs and the amount of money is even larger. And the total could go up, depending on the vagaries of the stock market. ‘It’s been a bull market for the last couple of years,’ says David Parker, partner in regional insurance brokerage McQueary Henry Bowles Troy. ‘If you have a large drop-off in the market like we did in 2000 or 2001, where stock prices are falling considerably and their market capitalization is dropping considerably, you have a much greater potential for shareholder claims.’ The greater the loss in market cap, the greater a chance for claims.

The third factor is the increased number of participants in the market. ‘Over the last two years or so, there have been a lot of entrants to the market, creating a competitive effect on the premiums charged,’ says Vincent Caracciolo, a risk management principal at Integro Insurance Brokers. According to Shappell, the rates have been dropping by 15 percent or more each year. The profit has been getting progressively slimmer, making losses harder to bear.

So carriers have more frequently looked to rescission, or the revocation of a policy as though it had never been signed in the first place. The move does require a carrier to repay all premiums, but that would be far less than covering a settlement and legal fees. However, there are other costs. In a highly competitive insurance market, frequent rescission would drive business to other carriers. ‘In a one-off deal, they may decide that the financial benefit is not worth pursuing,’ says Damian Caracciolo, vice president of CBIZ Insurance Services.

What complicates the danger of rescission is that, for many corporations, D&O coverage is not offered in a monolithic block by one carrier. Instead, there is a ‘tower’ of insurance: a collection of blocks of coverage that together offer the full coverage. Some of the insurers taking part in the tower are more likely to consider rescission than others. The primary carriers – often such large firms as Chubb and AIG – typically have an obligation through the policy and case law to advance the defense costs. Because they are already tied in, they want as much influence on the resolution as possible, and trying to rescind the policy is rarely in their favor.

Race to the exit

Carriers providing other layers of the insurance tower are another story. Their coverage will only kick in after the primary coverage is exhausted. Getting out before getting pulled in can be just the thing they might want, particularly if the carrier is a newcomer to the D&O industry without long-term commitment. ‘If it’s somebody in the middle of the program [undertaking rescission], everybody above and below starts to question,’ Caracciolo says. Then the policy holder can be facing a race to the exit.

Even the carriers that aren’t inclined to take a case to court are more ready to use rescission as a threat. When it looks as though there is a suit that could trigger the policy, the carrier immediately reviews the policy language and issues two letters: one acknowledging the client’s notification, and the other discussing what restrictions or eliminations might apply. ‘It’s our first glimpse into the claim and how easy or difficult it will be to get settled,’ says Lauri Floresca, senior managing director at risk management firm Carpenter Moore. ‘They’re almost always citing things like … rescission. It’s their placeholder,’ she says.

By staking out such a position, the carrier has set itself a good foundation for negotiation, a ‘not uncommon’ tactic, according to Hersh. On the one hand, it can make a strong argument to the insured that it would be far cheaper to take less than the face value of the policy than to fight out the difference out in court. ‘You have to weigh the likelihood of success versus the quantum you’re willing to take or pay, or the quantum you’re unwilling to pay,’ says Rick Bortnick, an attorney with Cozen O’Connor, which represents insurers. ‘If we think we have a 40 percent chance of winning, maybe you get a 10, 15 or 20 percent discount.’

A carrier would set a significant number that would still be less than the potential legal fees, pressuring the policy holder into compromising. And by striking a compromise, the carrier gets the benefit from a rescission clause without having to publicly associate itself with the practice, thus running the risk of appearing less desirable to an existing or potential client.

So the threat of rescission will hang in the air, and any company has to see how to limit the threat of rescission and other clauses that can work in the carrier’s favor. Learning the implications of the various cases that have hit the courts might seem like a logical approach to navigating the thicket, and it is necessary, but case history alone won’t tell enough.

‘The D&O decisions of the last five years are all over the map,’ says Andrew Reidy, a partner with Howrey. ‘There are some decisions that are very difficult to reconcile. There are some pro-industry decisions and pro-policy holder decisions. You have different rescission decisions in Enron and Worldcom and Tyco. The ClearOne ruling is more of a pro-insurance decision than some of the others, but there are ones that are pro-policy holder as well.’ What makes predicting the outcomes so difficult is an interplay of several factors: the applicable state law, exact policy language and actual scenario.

A legal shell game

Any court will interpret a contract in the context of a given state’s laws. The question is: Which state governs the agreement? According to Reidy, most insurance policies do not mention which state’s laws hold sway. ‘I can’t think of a single example of all the cases we have where they have the choice of law provision,’ he says. ‘There’s a cynical side of me that says it’s to keep their options open.’ There are three common places a company or carrier could argue for the choice of law: state of the principle place of business of the insured, the state where the dispute arose and the state where the policy was issued. When these three locations differ, a company cannot be sure which state’s laws will apply, and so must try to understand the policy language under each and how its fortunes might vary.

The exact policy language is perhaps the stickiest part of the equation, because a few words can make a tremendous difference. ‘We’ve run across situations where the insurance broker, who is typically the representative of the insured, will provide a summary of the policy,’ says Abbie Havkins, a partner at Havkins Rosenfeld Ritzert & Varriale, generally representing insurance companies. ‘Something will arise that wasn’t in the policy summary.’

Floresca mentions a couple of cases – Cutter & Buck v. Genesis Insurance Company and Federal Insurance Company v. Homestore – where severability came into question. The term is critical to director and officer protection. In theory, a severability clause lets an innocent person retain coverage even if someone else in the company had full knowledge of a problem. But both of these policies had older style phrasing that was partial and stated that if a CEO or CFO knew of a problem, the other officers and directors were treated as though they knew as well. ‘No one has that language any more, or shouldn’t if you have good representation,’ Floresca says. But a re-examination of a long-standing policy might be a wise move.

‘You want to make sure you have full severability of both application and exclusions,’ Caracciolo says. ‘If someone on the application misrepresented the financials or any part of the underwriting process, that it would only apply to that individual.’ If there was fraud or dishonesty, you don’t want innocent individuals to face harm.

Yet there are many other variations of severability. For instance, if the company cedes materiality in the application, it says that each and every statement is something the insurance company can consider material. An innocent and relatively inconsequential error could then give the carrier an excuse to bring up rescission, if for nothing else, as a negotiation tactic.

‘The area where I see some of the biggest communications challenges with clients are claims notification procedures and what their rights are and obligations are under the policy,’ Floresca says. As an example, someone might send the company a letter that technically acts as a claim, from the view of the policy, starting a process that will require notification of the carrier if coverage is to be in effect. ‘The claim comes into the department management or subsidiary manager and it doesn’t reach the CEO or risk management department for months,’ she says. A broker can negotiate a clause starting the notification clock when the official person in charge of handling claims receives it, but only if the broker remembers to ask.

When it comes to the policy language, it is best to take a belt and suspenders approach, working with both a broker and an outside attorney experienced in D&O coverage. ‘The courts consistently say, We’ll apply the language you negotiate, and the language you negotiate trumps state law,’ explains Shappell. If something is in the insurance contract, the company will have to live with it.

Then there are the actual circumstances and how state law interacts with the contract. In the ClearOne case, the application incorporated documents – notably SEC filings – that, when restated, were suddenly a misstatement in the application. The question is whether the carrier would have written the policy under the same terms if it knew about the true state of affairs. But incorporating the financial statements alone wasn’t enough. ‘The specific law out of Utah required either intentional or reckless conduct,’ Caracciolo says. However, the court hadn’t established that this was the case, which is why the appellate court remanded the case back to district court.

Best-laid plans

All in all, planning for the potential fallout is the only reasonable course to take. A company must cross the t’s and dot the i’s, certainly, but then it also needs to take the additional steps to solidify their standing. Personnel must comprehend the practical effects the contract will have, and will need training on how to handle communications from investors and others that might be considered claims.

If the carrier you’re considering is small, get your broker or a third party to check on claims histories, and see how likely it will be that the company would rescind a policy. And as Reidy suggests, companies should get friendly and develop strong relationships with their carriers. Talk to the underwriters a few hours each year, and develop a rapport with the claims people. ‘I think that if you’re dealing with them and you are working with them on a personal basis, it’s a little bit easier to get claims resolved than firing letters back and forth,’ he says. It might help make the difference between a quick phone call and a not-so-quick trip to a courthouse.