blowing BY JOHN C. TANNER AND DAVID E. HOWARD IT FEELS LIKE A NIGHTMARE, of the Sarbanes-Oxley sort. An unhappy

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1 THE HIDDEN INSURANCE ISSUES BEHIND SARBANES- OXLEY AND RECENT CORPORATE GOVERNANCE REFORM blowing HISTLES IT FEELS LIKE A NIGHTMARE, of the Sarbanes-Oxley sort. An unhappy employee claims that she knows about certain accounting irregularities and that she is being persecuted for her whistleblowing. You feel certain that your CFO and his team s accounting is sound, but that doesn t stop the employee from posting her allegations on a heavily trafficked internet site. Before you know it, the SEC is on the line and the company is facing a difficult and expensive investigation. Then your CFO calls: he s heard a rumor that a lawsuit is in the works, and that he s going to be named personally. I m insured, he asks. Right? Oh, and by the way I hear that you re going to be named, too. The Board wants you to summarize our insurance coverage at tomorrow s meeting. And at that point you wake up. It was a nightmare, after all. But as you watch the coffee brew in the dead hours of early morning, you start to wonder: Just how far, in fact, does your Directors and Officers (D&O) and other insurance go? & BY JOHN C. TANNER AND DAVID E. HOWARD 32 ACC Docket April 2005

2 John C. Tanner and David E. Howard, Blowing Whistles & Climbing Ladders: The Hidden Insurance Issues Behind Sarbanes-Oxley and Recent Corporate Governance Reform, ACC Docket 23, no. 4 (April 2005): Copyright 2005, the Association of Corporate Counsel. All rights reserved. CLIMBING ladders April 2005 ACC Docket 33

3 John C. Tanner is vice president and claims counsel for the Financial Services Division of insurance broker McGriff, Seibels and Williams, Inc., a wholly owned subsidiary of BB&T, where he assists brokers with insurance contract interpretation, negotiation, and manuscript drafting, as well as claim resolution matters. He can be reached at jtanner@mcgriff.com. David E. Howard is an associate of the law firm Arnall Golden Gregory LLP, and is a member of the firm s Securities & Corporate Governance Practice Team. Prior to joining AGG, Mr. Howard was a CPA with a Big 5 accounting firm, where his responsibilities included assisting in the compilation of SEC registration statements and filings in connection with public offerings of stock. He may be reached at david.howard@agg.com. This article is intended to be informational only and should not be construed as legal advice or opinion concerning any specific factual circumstance. It in no way replaces or overrides any insurance policy in place, and readers should consult knowledgeable legal counsel as to any legal questions they may have. This material may also be considered advertising under some state court rules of practice. If you have any questions or would like additional information, please contact one or both of the authors. Does your D&O insurance cover formal SEC and other governmental investigations? What about informal governmental investigations? If it turns out that there is a problem with the CFO s accounting certification, will coverage for other directors and officers be affected? Is there coverage for employee sub-certifications? Does your insurance cover the company against a whistleblower lawsuit, if one is filed? Even if the plaintiff is herself a corporate officer? Does your policy cover the company, or only your corporate officers and directors? And last, but not least are you, the in-house counsel, covered? Do you need to be? WHERE S THE FIRE? INSURANCE AND SARBANES-OXLEY More than two years have passed since Congress passed the Public Company Accounting Reform and Investor Protection Act of 2002, aka Sarbanes- Oxley (the Act). 1 This article addresses several key insurance coverage issues raised by the Act. Virtually all major companies have some form of D&O insurance, although some companies may purchase coverage only for individual directors and officers, rather than for the entity as a whole. Many companies also have some form of Employment Practices Liability coverage, which may also be relevant in Sarbanes-Oxley cases. Relatively few have a policy specifically designed for in-house counsel, called Employed Lawyers Professional Liability insurance. But Sarbanes-Oxley affects all of these coverage lines in ways that may surprise you. IT S THE SEC: DO YOU KNOW WHERE YOUR INSURANCE IS? It is no secret that companies now face an increased risk of both formal and informal SEC investigations. For example, it is not uncommon for the SEC to send informal investigation requests to all members in an industry group when it uncovers wrongdoing in one company that suggests the perceived violations might be industrywide practice. 2 (See Heightened SEC Enforcement, p. 36.) Even if fines or penalties are not covered under the D&O insurance program, this heightened risk of governmental investigation still calls for insurance coverage. Responding to information requests and defending SEC investigations and enforcement matters are expensive. Electronic discovery burdens and document review costs alone may run into the hundreds of thousands, if not millions, of dollars. And when under formal investigation, companies and individuals increasingly have less time to respond to massive subpoena requests for documents. Counsel should also keep in mind that many D&O securities cases involve governmental investigations that run simultaneously with other securities litigation. In fact, Cornerstone Research suggests that nearly 20 percent of all securities litigation settlements since 1995 have involved governmental investigations. 6 An insured company without coverage for governmental investigations is therefore faced with defending the governmental investigation at its own expense and with no credit against any larger deductible/retention amount being funded in related securities litigation. (See Insurance Lingo What Does That Term Mean? p. 37.) But despite the need for investigation coverage, 34 ACC Docket April 2005

4 HEIGHTENED SEC ENFORCEMENT As a part of the Sarbanes-Oxley Act, Congress authorized $776 million in appropriations to the SEC for fiscal year 2003, with $98 million of that amount specifically earmarked for increased staffing. 3 The SEC requested appropriations for fiscal year 2004 in the amount of $841.5 million, the largest single-year percentage increase ever. 4 Prior to passage of Sarbanes-Oxley, the SEC annually reviewed filings for one out of every five companies. However, with increased staffing, the SEC now intends to review a third of all publicly traded companies each year. 5 In the five years immediately prior to SarbOx, the SEC filed 515 enforcement actions for financial reporting and disclosure violations. In contrast, the SEC filed more than 540 such enforcement actions in fiscal year 2003 alone. in most policies the coverage is limited. Many D&O insurance policies today expressly cover only formal investigations against the individual insureds expressly named in the investigation, or who have been subpoenaed. Few, if any, policies cover informal investigations, and most policies do not expressly cover the corporate entity for formal governmental investigations. A few carriers cover the company for formal investigations to the extent the investigations are maintained simultaneously and continuously against individual director or officer insureds, or where the company is specifically named and alleged to have committed wrongdoing. (See Sample Claim Definitions, p. 41.) In the case of informal investigations, D&O insurers frequently argue that no coverage exists. These insurers argue that informal governmental investigations or similar information and document requests are not demands for damages or other relief within the meaning of their policies, and/or that the investigations do not specifically allege wrongful acts by individual director or officer insureds so as to trigger coverage under the insuring agreements. Meanwhile, your company may incur substantial sums responding to government inquiries and defending against an informal investigation until such time, if ever, that an individual director or officer is specifically identified or wrongdoing specifically alleged. Insureds have had limited success challenging the insurers position denying coverage for such investigations. 7 Some insurers have even expressly worded their policy claim definitions to limit coverage for investigations, or have limited their exposure to an investigative costs sublimit. Traditionally, where carriers have included investigative proceedings in their claim definitions, such proceedings have been subject to the same terms and conditions as any other covered claim. The sole exception found in these D&O policies was usually a separate sublimit for investigative costs arising out of shareholder derivative demands. But now, at least one insurer has created a sublimit for investigative costs arising from formal criminal and regulatory proceedings. (See Insurance Lingo What Does That Term Mean? p. 37.) Given the current regulatory environment, insureds and risk managers should carefully review their D&O policies to determine whether the policies claim definitions will cover SEC and/or other governmental investigations against the company, as well as any criminal proceedings that may result. If the insurer refuses entity coverage for formal investigations or imposes a sublimit of liability for such coverage, companies should attempt to negotiate for their D&O insurers to recognize, at least for purposes of calculating the exhaustion of any deductible funded by the company, costs incurred in defending against and responding to investigations pursued simultaneously with otherwise covered claims. At least one mutual insurer now includes policy wording that could credit such costs against the corporation s deductible where a formal governmental investigation is pursued simultaneously with otherwise covered claims, and arises out of the same underlying allegations. In-house counsel should also keep in mind that although few insurers appear willing to extend separate investigation coverage to corporate entities, many if not most insurers are willing to cover individuals formally named in SEC proceedings. SIGNING ON THE DOTTED LINE: IS COVERAGE AT RISK? One of the first rules implemented under SarbOx was a requirement that public company CEOs and CFOs make personal certifications, pursuant to 36 ACC Docket April 2005

5 INSURANCE LINGO: WHAT DOES THAT TERM MEAN? Insured vs. Insured. Most D&O policies today exclude claims brought by one insured against another insured under a so-called insured vs. insured exclusion (the I vs. I exclusion). D&O insurers added the I vs. I exclusion to their policies to prevent collusive or friendly lawsuits where one insured would agree to have another insured assert a claim against him with both looking to the insurer to fund the loss. I vs. I exclusion wording has changed substantially over the years, but, with numerous negotiated exceptions. You should closely scrutinize I vs. I wording in your D&O policy to clarify those circumstances permitting your carrier to deny coverage. Retention. Most, if not all, traditional D&O policies today include a deductible, aka retention, amount applicable to indemnifiable claims that must be funded by the company before the D&O insurer will provide indemnification under the policy. Claims falling under corporate reimbursement coverage (Side B) or entity coverage (Side C) are subject to such a retention, typically ranging from $500,000 to greater than $10 million. Claims against individual insureds for which the company is neither financially able, nor legally permitted to provide indemnification, (Side A coverage), usually carries a zero retention. Severability. Severability typically refers to language in a D&O policy that prevents the insurer from imputing misconduct of one insured to all insureds for the purpose of denying coverage or voiding the policy outright. Make certain that your policy includes severability both as to exclusions and as to the insurer s ability to rescind coverage on the basis of misrepresentations contained in the insurance application. Side A Policy. A Side A policy typically refers to an excess policy that only provides coverage for individual insureds, and only to the extent that the company cannot legally or financially fund its indemnity obligation. Many public companies today now purchase some form of Side A-only insurance devoted to individual insureds. Some Side A excess policies also contain a DIC or difference-inconditions feature that may, in some circumstances, cause the policy to respond at a primary layer where the Side A policy provides broader coverage than that of the traditional D&O program. Sublimit of Liability. All D&O policies contain a limit of liability provision that provides the total dollar amount that the insurer will pay on a given claim. Some policies also provide a sublimit of liability that specifies a lower sub-limit of liability for certain categories of claims or costs. For example, a D&O primary policy that contains a $35 million total limit of liability may also impose a $500,000 insurance cap for investigative costs associated with shareholder derivative demands. Traditional D&O Policy. A traditional D&O policy is a primary policy that provides the first line of defense against D&O claims and includes three types of insuring clauses. Coverage under Side A (referred to as Insuring Clause 1 in some policies) provides coverage to individual insureds where the company is legally or financially unable to indemnify them. Coverage under Side B (or Insuring Clause 2 in some policies) provides corporate reimbursement coverage to the extent the company indemnifies the individual directors and officers, usually in excess of a large deductible. Finally, many traditional D&O policies today also include Side C coverage that provides entity coverage for securities claims, again in excess of a large deductible. Most companies today purchase a large tower of traditional D&O coverage that provides all three coverage types. Sections 302 and 906 of the Act, in each quarterly and annual report filed with the SEC. As a result, the personal risk of the CEOs and CFOs making the certifications has increased. CEOs and CFOs must now essentially vouch for the accuracy of the company s public filings, including the description of the company s financial condition. But a lesser-known danger is that these sections increase the risk that D&O insurers will deny coverage or void D&O policies outright if a company restates previously certified financial statements. CEOs and CFOs signing these certifications must therefore recognize that if a D&O insurer can argue that the financial statements submitted to the insurer during the underwriting process were false, it may seek to rescind coverage of all insureds on account of the false certifications. As a practical matter, this risk existed before the Act s certification requirements. But the fact that some carriers now expressly rely on and incorporate Sarbanes- April 2005 ACC Docket 37

6 NEGOTIATING RESCISSION PROTECTION The rescission risk goes to the heart of D&O claim exposure, because D&O underwriters evaluate the same underlying corporate financial information and public filings in making their underwriting determination as would-be shareholder plaintiffs do in making their investment decisions. For example, shareholder plaintiffs may sue your directors and officers for financial and other misrepresentations allegedly made in SEC and other filings. Unless you previously negotiated severability or non-rescission wording into your D&O insurance program, your insurers may point to the same alleged misrepresentations at issue in the underlying claim as the basis for rescinding D&O coverage as to all insureds, including all individuals. The following is an example of full severability wording historically considered most favorable to insureds: The written application(s) for coverage shall be construed as a separate application for coverage by each of the Insured Persons. With respect to the declarations and statements contained in such written application(s) for coverage, no statement in the application or knowledge possessed by any Insured Person shall be imputed to any other Insured Person for the purpose of determining if coverage is available. Courts have generally interpreted such wording as limiting an insurer s right to rescind coverage solely to those individuals who made knowing misrepresentations in the application or who otherwise had knowledge of underlying fraud. While fewer insurers today are willing to provide such full severability protection in the traditional D&O policy, companies considered to be good risks are still able to negotiate some degree of full severability protection in their traditional program. Consider purchasing a Side A excess policy devoted to individual insureds, particularly where your traditional D&O policy (i) contains no severability provision, (ii) includes severability wording imputing the knowledge of the application signer to all insureds, or (iii) the insurer refuses to expressly waive its right to rescind coverage for non-indemnifiable claims asserted against individuals. Many such policies include substantially broader coverage terms than that offered in a traditional primary D&O policy, including a provision expressly stating that coverage is non-rescindable. Oxley certifications into their policy definition of Application increases the rescission risk. Fortunately, there are various market solutions available today to address the policy rescission risk and protect individual coverage in the absence of fraud. Many carriers now offer specialized nonrescindable Side A insurance products providing coverage solely for non-indemnifiable claims asserted against individual insureds. Moreover, nearly every traditional D&O policy today now includes some form of severability provision intended to protect against a carrier rescinding the policy as to innocent insureds. (See Insurance Lingo What Does That Term Mean? p. 37.) Not all severability provisions, however, provide the same level of protection against the rescission risk. Make certain that your company has coverage that provides maximum protection for non-certifying directors and officers and requires that a false certification be fraudulent before a carrier can rescind the policy even as to the individuals required to provide certification. (See Negotiating Rescission Protection, on this page.) CEOs and CFOs are not the only corporate employees at increased risk in the new world of SarbOx. Because of the increased burden on CEOs and CFOs to vouch for company financial statements, many companies have implemented an employee subcertification system to support the ultimate Section 302 and 906 certifications. 8 It is not known how D&O insurers and courts will ultimately value these subcertifications, but their presence could add some protection to company CEOs and CFOs who rely on them. To the extent that these subcertifying employees might be named in lawsuits, they will need financial protection. Corporate indemnification for such employees is often at the board s discretion (as compared to mandatory indemnification typically provided directors and officers), and standard D&O policies insure only duly elected and appointed directors and officers. If the company purchases entity coverage for securities claims, the coverage might extend to these employees, protecting them against claims in that category. In any case, risk managers should confirm how their D&O program addresses this exposure and should consider whether to extend corporate indemnification and D&O insurance protection to these employees. 38 ACC Docket April 2005

7 HEAR THAT WHISTLE BLOWING: ARE YOU COVERED? Time magazine named Sherron Watkins, the Enron whistleblower, one of its Persons of the Year. 9 Her high-profile role in the exposure of Enron heightened the public s awareness of the whistleblower who informs a federal authority or a corporate supervisor about corporate fraud or SEC violation. Not surprisingly, whistleblower complaints have been on the rise. (See Whistleblower Complaints Rise, on this page.) Investigating whistleblower complaints can be expensive. This is all the more true in that whistleblower complaints are often sent simultaneously to a regulatory authority such as the SEC or Department of Labor, and to the company s audit committee which typically prompts a response, valid or out of fear, to investigate each and every allegation. But insurers usually cover only the costs of investigations prompted by formal governmental or regulatory proceedings or an actual lawsuit: If the whistleblower claim has not ripened into a formal proceeding or lawsuit, the investigation costs are usually not covered. 15 The company is thus left with heightened exposure to outside counsel investigation WHISTLEBLOWER COMPLAINTS RISE Sarbanes-Oxley directs public company audit committees to establish confidential procedures for handling whistleblower complaints regarding accounting or auditing matters. 10 The NYSE and NASDAQ also require compliance with these directives. 11 As a result, public companies have implemented anonymous complaint systems that have led to increased whistleblower complaints and an increased claim risk to the company. According to John Stark of the SEC s enforcement division, the SEC had received almost 250,000 whistleblower complaints through July 2004 about possible securities law violations. This is striking when compared to the 2001 complaint total of 77, Whistleblowing investigations are serious business SarbOx protects whistleblowers from retaliation or discrimination; obstructing a whistle-blower investigation can land you in prison for up to 10 years. 13 If a company officer does retaliate and the company loses the resulting whistleblower case, the retaliating officer could be held personally liable in a subsequent criminal proceeding. 14 costs that will go directly to the bottom line as an uninsured cost of doing business in a post-sarbanes- Oxley environment. Moreover, even if the whistleblower claim ripens into a lawsuit claiming retaliation or discrimination, D&O insurance may not provide entity coverage. Historically, D&O policies did not cover the corporate entity. Although many policies today now include entity coverage for securities claims, this coverage often will not extend to whistleblower claims for the following reasons: Some companies do not purchase this coverage. Policy definitions of securities claims may not include whistleblower claims. For example, in some D&O policies, only claims brought by security holders of the company qualify as securities claims. Even if the D&O policy defines securities claims broadly, a whistleblower claim might not arise out of the purchase or sale of securities in any case. In contrast, whistleblower claims against individual director or officer insureds alleging retaliation are more likely to be covered under a D&O policy. Some D&O policies include coverage for certain specified employment practices claims asserted against individual directors or officers. But even here, whistleblower claims can present coverage problems. Many policies contain an insured vs. insured exclusion that can block whistleblower claims if the whistleblower is one of the officers or directors individually covered by the D&O policy, as could well be the case. (See Insurance Lingo What Does That Term Mean? p. 37.) Claims and lawsuits by high-ranking whistleblowers may also create coverage problems for any related shareholder securities litigation. The problem is that in some D&O policies, the insured vs. insured exclusion excludes coverage for shareholder claims unless such claims are instigated and continued totally without the assistance of, or active participation of, any insured. Some carriers may argue that if a whistleblower lawsuit assists shareholder plaintiffs even if the whistleblower is not a plaintiff in the shareholder lawsuit there is assistance within the meaning of the policy that can exclude coverage. And it is very likely that a whistleblower lawsuit will assist the plaintiffs in any related securities litigation, because whistleblower lawsuits are not subject to the Private Securities Litigation Reform Act s heightened pleading standards or its 40 ACC Docket April 2005

8 SAMPLE CLAIM DEFINITIONS Below are two different versions of policy claim language currently offered in the marketplace. There may be little practical difference between the two versions when it comes to coverage for investigations, particularly as to coverage for individual insureds. The first option provides entity coverage for formal administrative or regulatory proceedings only to the extent individual insureds are simultaneously named defendants. The second option provides coverage to the entity for formal proceedings where such proceedings satisfy the Company Wrongful Act definition, and without any requirement that the claim be simultaneously asserted against individuals. Example 1: Claim means: (1) a written demand for monetary, non-monetary or injunctive relief; (2) a civil, criminal, administrative, regulatory, or arbitration proceeding for monetary, non-monetary, or injunctive relief which is commenced by (i) service of a complaint or similar pleading; (ii) return of an indictment, information or similar document (in the case of a criminal proceeding); or (iii) receipt or filing of a notice of charges; or (3) a civil, criminal, administrative or regulatory investigation of an Insured Person: (i) once such Insured Person is identified in writing by such investigating authority as a person against whom a proceeding described in Definition (b)(2) may be commenced; or (ii) in the case of an investigation by the SEC or a similar state or foreign government authority, after the service of a subpoena upon such Insured Person. The term Claim shall include any Securities Claim and any Employment Practices Claim. Securities Claim means a Claim, other than an administrative or regulatory proceeding against, or investigation of an Organization, made against any Insured: (1) alleging a violation of any federal, state, local or foreign regulation, rule or statute regulating securities (including but not limited to the purchase or sale or offer or solicitation of an offer to purchase or sell securities) which is: (a) brought by any person or entity alleging, arising out of, based upon or attributable to the purchase or sale or offer or solicitation of an offer to purchase or sell any securities of an Organization; or (b) brought by a security holder of an Organization with respect to such security holder s interest in securities of such Organization. Notwithstanding the foregoing, the term Securities Claim shall include an administrative or regulatory proceeding against an Organization, but only if and only during the time that such proceeding is also commenced and continuously maintained against an Insured Person. Example 2: Claim means: (1) a written demand for monetary or non-monetary relief; (2) any civil proceeding in a court of law or equity, or arbitration; (3) any criminal proceeding which is commenced by the return of an indictment; and (4) a formal civil, criminal, administrative regulatory proceeding or formal investigation of an Insured Person or the Company (but with respect to the Company only for a Company Wrongful Act) which is commenced by the filing or issuance of a notice of charges, formal investigative order or similar document identifying in writing such Insured Person or the Company as a person or entity against whom a proceeding as described in (c)(2) or (3) above may be commenced, including any proceeding before the Equal Employment Opportunity Commission or any similar federal, state or local governmental body having jurisdiction over any Employment Practices Wrongful Act. Company Wrongful Act means any actual or alleged act, error, omission, misstatement, misleading statement or breach of duty by the Company in connection with a Securities Claim. Securities Claim means a Claim made against an Insured for: (1) any actual or alleged violation of the Securities Act of 1933 as amended, the Securities Exchange Act of 1934 as amended, any similar federal or state statute or any rules or regulations promulgated thereunder; (2) any actual or alleged act, error, omission, misstatement, misleading statement or breach of duty arising from or in connection with the purchase or sale of, or offer to purchase or sell any securities issued by the Company, whether such purchase, sale or offer involves a transaction with the Company or occurs in the open market. April 2005 ACC Docket 41

9 mandatory discovery stay pending a ruling on the motion to dismiss. Moreover, many whistleblowers are disgruntled former employees who may be all too willing to help out plaintiffs in parallel lawsuits. There is therefore a very real threat that shareholder plaintiffs will benefit from backdoor discovery in a companion whistleblower lawsuit that provides a roadmap of possible company wrongdoing. Through careful negotiation with its insurer, a company can limit the possibility that the insured vs. insured exclusion will gut its D&O coverage. Many insurers will except from the exclusion wrongful termination suits brought by former employees. However, as the whistleblower protection extends to discrimination in any term or condition of employment, and not just to circumstances of employee dismissal, further exceptions to the exclusions may be needed. Many carriers will also except from the exclusion shareholder claims brought by employees. Carriers may, however, be unwilling to carve out whistleblower claims of, or assistance provided by, corporate officers. (See Protect Your D&O Coverage From A Whistleblower Insured, p. 45.) SARBANES-OXLEY S PROTECTIONS FOR WHISTLEBLOWERS ONLY INCREASE A COMPANY S ALREADY SUBSTANTIAL RISK OF SUCH CLAIMS. Employment Practices Liability Insurance Fortunately, D&O coverage is not the only kind of coverage available for whistleblower claims. Many companies maintain some form of Employment Practices Liability (EPL) insurance for claims by workers who assert that their legal rights have been violated by sexual harassment, discrimination, wrongful termination, negligent evaluation, or similar actions. Sarbanes-Oxley s protections for whistleblowers only increase a company s already substantial risk of such claims. EPL policies generally include coverage for the entity and define employment practices violations to include harassment, discharge, retaliation, and discrimination. Such definitions should be interpreted to include whistleblower claims contemplated by the Act. EPL insurers may, however, be willing to further define covered employment practices violations to expressly include whistleblower claims brought pursuant to Section 806 of the Act. In any case, company officers should review their policies with corporate risk managers, brokers, and/or outside counsel to negotiate maximum protection for an increasing whistleblower claim risk. EXPOSED TO THE ELEMENTS: IS IT TIME FOR IN-HOUSE COUNSEL TO SEEK COVERAGE? Many in-house attorneys mistakenly believe that they have minimal liability exposure because they have only one client their corporate employer. Historically, it has been true that corporate employers have brought relatively few professional negligence claims against their in-house attorneys. But there is a growing call for attorneys to serve as watchdogs for the benefit of the investing public. Sarbanes-Oxley is only one part of this movement toward greater attorney responsibility in the prevention of corporate fraud. Inevitably, this movement is raising the question of insurance coverage for in-house counsel. Exposed: Direct Malpractice The Enron bankruptcy examiner s detailed analysis of in-house counsel culpability, and conclusion that fact questions existed as to the potential liability of several Enron in-house attorneys, demonstrate a heightened risk of liability exposure for direct malpractice claims. 16 Bankruptcy trustees and other parties standing in the shoes of a corporate debtor client have been much more willing to assert claims against in-house attorneys, especially where the facts demonstrate complicity with other corporate insiders. Exposed: Indirect Malpractice In-house attorneys, like their outside brethren, also face potential liability to third parties under a number of other indirect malpractice theories, including negligent misrepresentation (particularly in the context of issuing opinion letters), and aiding and abetting fraud or breaches of fiduciary duty by corporate constituents. Recently, several in-house general counsels were criminally indicted for their roles in allegedly facilitating client fraud ACC Docket April 2005

10 Exposed: Securities Law Violations and Disclosure Obligations The securities law arena is obviously a significant source of liability for in-house counsel. Private plaintiffs have often turned to Rule 10b-5. Although private plaintiffs have not been able to hold professionals liable under the Rule as aiders and abettors of corporate securities fraud since the Supreme Court s ruling in Central Bank, 18 professionals are still subject to significant 10b-5 liability. There is a growing body of authority allowing 10b-5(b) claims against outside professionals as primary violators for their participation with clients in making material misrepresentations or omissions in violation of the securities laws. 19 Moreover, recent court opinions have expanded secondary actor liability exposure to third parties. PROFESSIONALISM SEC STYLE The SEC regulates the professionalism and ethics of attorneys and other professionals who practice before it in much the same way that states regulate attorneys through state bar rules of ethics or codes of conduct. The SEC recently described such 102(e) actions as an integral part of its enforcement program, which suggests that an increase in the frequency of such proceedings is likely. 22 In one early 102(e) action, In re Carter and Johnson, the SEC specifically cautioned attorneys on the need to take affirmative steps to avoid any inference that they willingly participated in their client s wrongdoing, including, counseling against improper disclosure, notifying the board of directors or individual officers or key management members, or ultimately, resigning. 23 In a later 1992 SEC release (not premised on 102(e)) the SEC noted that in-house attorneys, particularly chief legal officers, also have a duty to act where they know that the company has failed to take appropriate corrective action. It expanded the list of appropriate steps attorneys should take to include potential disclosure to the regulatory authorities. While the release noted that state bar rules could have a bearing on the course of conduct attorneys could properly pursue, it clearly stated the SEC s view that disclosure to the Commission could be warranted in some circumstances. 24 These opinions apply subsections (a) and (c) of Rule 10b-5 where secondary actor professionals arguably engaged with their clients in deceptive and fraudulent acts, notwithstanding the lack of any clear misrepresentation or omission directly attributable to the secondary actor. 20 Shareholder plaintiffs asserted such claims against two of Enron s outside law firms and a number of Enron s in-house attorneys. Finally, there is a growing push in Congress to overrule Central Bank and restore the ability of private party plaintiffs to assert aiding and abetting claims against attorneys and other professionals who recklessly assist public corporations in deceiving the investing public. 21 Exposed: SEC Enforcement Actions and Related Disciplinary Proceedings In contrast to private parties, the SEC has the authority to hold professionals liable under Rule 10b-5(b) as aiders and abettors of client securities fraud. But the more significant issue for inhouse counsel under an SEC regime may be the question of disclosure obligations and an expanding liability exposure for allegedly failing to prevent client wrongdoing. Even before Sarbanes-Oxley, the SEC had opined that attorneys had a role in ferreting out corporate fraud. This position was reflected in Rule 102(e), in particular, of the Commission s Rules of Practice. (See Professionalism SEC Style, on this page.) Sarbanes-Oxley expanded these disclosure obligations by imposing a formal disclosure rule, Part 205, mandating up the ladder reporting by attorneys who appear and practice before the Commission, and permitting attorneys, without the consent of their client, to reveal confidential information to the SEC under certain circumstances. 25 In a sense, the Act makes all attorneys mandatory whistleblowers. The current SEC rules merely permit, but do not require, disclosure of confidential information to outside regulatory authorities; however, the SEC continues to review alternative proposals that would mandate some form of noisy withdrawal or outside disclosure. An attorney obligation to report client wrongdoing to the government would increase the liability exposure of attorneys to nonclient shareholder plaintiffs or other victims of corporate fraud by enabling the plaintiffs to argue that the authorities would have stopped the fraud- 44 ACC Docket April 2005

11 PROTECT YOUR D&O COVERAGE FROM WHISTLEBLOWERS D&O policies typically exclude coverage for claims against director and officer insureds brought by other individual insureds. Sarbanes-Oxley s whistleblower provisions make such claims far more likely. A disgruntled former officer turned whistleblower could aid shareholder plaintiffs in a way that jeopardizes D&O coverage for the shareholder claim. Regardless of whether your D&O policy provides coverage for the whistleblower claim itself, make certain that you will not lose your D&O coverage for shareholder claims when whistleblower insureds team up with shareholder plaintiffs against your directors and officers and the company. Over the years, insureds have successfully negotiated a number of exceptions to the insured vs. insured exclusion. The following examples include exceptions frequently negotiated into today s D&O policies, with suggested new wording in italics: Example 1: EXCLUSIONS The Insurer shall not be liable to make any payment for Loss in connection with any Claim made against any Insured: Brought by or on behalf of any Insured, or which is brought by any security holder of the Insured Organization, whether directly or derivatively, unless such Claim is instigated and continued totally independent of, and totally without the solicitation, assistance, active participation or intervention, of any Insured. Provided, however, this EXCLUSION shall not apply: (a) To any Claim brought by an Insured Person, where such Claim is in the form of a cross-claim or a thirdparty claim for contribution or indemnity, which is part of and results directly from a Claim that is not otherwise excluded by the terms of this policy; (b) To an Employment Practices Claim brought by an Insured Person; (c) To any instigation of or involvement in any Claim by, or solicitation, assistance, active participation or intervention of, any Insured whistleblower under Section 806 of the Sarbanes-Oxley Act of 2002 or under any similar federal or state statute, rule or regulation; (d) In any bankruptcy proceeding by or against an Insured Organization, any Claim brought by the examiner, trustee, receiver, liquidator or rehabilitator (or any assignee thereof) of such Insured Organization, if any; (e) To any Claim brought by and maintained by an employee of the Insured Organization solely to enforce his or her rights as a holder of securities issued by the Insured Organization; or (f) To any Claim brought by any past Executive of an Insured Organization who has not served as a duly elected or appointed director, officer, trustee, governor, management committee member, member of the management board or General Counsel (or equivalent position) of or consultant to an Insured Organization for at least four (4) years prior to such Claim being first made against any person. Example 2: EXCLUSIONS The Insurer shall not be liable to make any payment for Ultimate Net Loss or Investigative Expense arising from any Claim(s) made against any Director or Officer: Brought or maintained by or on behalf of the Insured Organization or any Director or Officer in any capacity, unless such Claim is: (1) a derivative action brought or maintained on behalf of the Insured Organization by one or more persons who are not Directors and Officers and who bring and maintain the Claim totally independent of and without the suggestion, solicitation, direction, assistance, participation or intervention of the Insured Organization or any Directors or Officers (This exclusion does not apply to the suggestion, solicitation, direction, assistance, participation, or intervention by any Insured whistleblower under Section 806 of the Sarbanes- Oxley Act of 2002, or under any similar federal or state whistleblower statute, rule, or regulation); (2) brought or maintained by a Director or Officer for contribution or indemnity, if the Claim directly results from another Claim covered under this Policy; (3) made solely and entirely in a jurisdiction other than the United States of America, its territories and possessions and is subject to the substantive and procedural laws of such foreign jurisdiction; or (4) brought and maintained by or on behalf of a bankruptcy or insolvency trustee, receiver, liquidator or conservator of an Insured Organization or any assignee of such trustee, receiver, liquidator or conservator. (This exception does not apply to Claims brought or maintained by or on behalf of a debtor-in-possession.) April 2005 ACC Docket 45

12 ulent scheme in time to limit damage to the plaintiffs. Even under the current reporting scheme (limited to reporting up the corporate ladder internally), plaintiffs may argue that nonculpable directors or officers would have prevented the alleged fraud if only their in-house attorneys had made them aware of it. Although the SEC rules specifically state that they do not create any new private cause of action, there is always the risk that courts will interpret such rules as relevant to the attorney s applicable standard of care. And while new SEC and other corporate governance reforms may create an obligation to disclose, in-house attorneys must also abide by state bar rules of professional conduct that may vary on the issue of disclosure. IN-HOUSE ATTORNEYS SHOULD CAREFULLY CONSIDER WHETHER THE CURRENT LIABILITY LANDSCAPE WARRANTS NEGOTIATING FURTHER INSURANCE PROTECTION UNDER THE D&O INSURANCE PROGRAM, OR THE PURCHASE OF A SEPARATE, STAND-ALONE EMPLOYED LAWYERS PROFESSIONAL LIABILITY POLICY. Taking Cover: Indemnification Some in-house attorneys may find that corporate indemnification offers some protection from the risks described above. But in a recent survey of in-house attorneys conducted by ACC, only about 30 percent of the respondents indicated their companies had some form of indemnification program. 26 Even where a company offers indemnification, it can prove to be an inadequate form of protection. In-house attorneys without mandatory indemnification from their corporate employers are subject to the discretion of the board of directors, and have no assurance that indemnity will be forthcoming until such time as the board renders its indemnity decision, which often occurs only after reviewing the individual claim allegations. Favorable indemnification language in bylaws and indemnification policies that exist today may be restricted or eliminated altogether in the future. Even where in-house attorneys have mandatory indemnification through state statutes or written indemnification agreements, the attorney s individual financial resources will be at risk if the company files for bankruptcy or otherwise becomes insolvent. Taking Cover: Insurance Solutions In-house attorneys should carefully consider whether the current liability landscape warrants negotiating further insurance protection under the D&O insurance program, or the purchase of a separate, stand-alone Employed Lawyers Professional Liability policy. Inclusion in the D&O Policy A typical D&O policy with no entity coverage for securities claims affords at best limited coverage for in-house attorneys. Many such policies cover only directors and officers. Moreover, under such policies, insurers may argue that coverage exists only for wrongful acts committed by insureds in their capacity as director or officer. A general counsel who also serves in an officer capacity may later face a coverage battle of whether his alleged wrongdoing was committed in a covered capacity. For example, insurers may contend that bar proceedings or claims arising out of up the ladder reporting obligations do not arise from director or officer duties. If the D&O policy includes entity coverage for securities claims, then the policy may also extend coverage to all employees for such claims, including in-house attorneys. But again, this will provide only limited protection, as some of the claim risks discussed above do not fall neatly into this category. In the past, some D&O insurers agreed to add inhouse attorneys as covered insureds by endorsement, either by amending the policy definition of Directors and Officers to include in-house attorneys or by specifically listing the in-house attorneys by name. For companies without separate ELP liability insurance, this approach provides the greatest protection to in-house attorneys under the D&O policy, so long as there is no exclusion for claims arising out of the rendering of professional services. 46 ACC Docket April 2005

13 But there are a number of reasons why the corporate D&O program may not be a practicable solution: The addition of in-house attorneys as insureds in the D&O policy dilutes coverage of the primary intended beneficiaries under the policy the company s directors and officers. The D&O policy, which was specifically crafted to address D&O liability concerns, may not adequately respond to the more recent claim risks faced by in-house attorneys. For example, liability exposure for direct malpractice claims brought by the company or directors and officers is likely excluded under most D&O policies by the insured vs. insured exclusion. Similarly, by adding in-house attorneys as D&O insureds, whistleblower claims arising out of attorney reporting obligations may implicate the insured vs. insured exclusion, potentially jeopardizing coverage that might otherwise exist for the underlying wrongful acts. With the introduction of new insurance products specifically tailored to meet the claim risks faced by in-house attorneys, fewer insurers are willing to permit modification to their D&O program, preferring instead to funnel such coverage requests to their employed lawyers professional liability insurance underwriters. Purchasing Employed Lawyers Professional Liability Insurance Coverage Many insurers today offer a separate liability insurance policy specifically designed for in-house attorneys called employed lawyers professional liability insurance (ELP). Such policies include a separate limit of liability from that in the D&O program, cover in-house attorneys for nonindemnifiable claims, and cover the company to the extent it indemnifies any such in-house attorneys. A principal advantage of purchasing separate ELP coverage (rather than endorsing a D&O policy) is that the ELP policies were specifically designed to address the unique issues faced by in-house attorneys. For example, several ELP policy forms expressly include as covered claims any bar proceedings and claims or charges arising out of the up the ladder reporting obligations issued pursuant to Section 307 of the Act. Some D&O insurers may not consider such proceedings to be covered claims under standard D&O policy claim definitions or may take issue with whether the underlying conduct occurred in the insured s capacity as a director or officer. Many ELP policy forms cover defense costs for direct malpractice claims brought against inhouse attorneys, while such claims are likely excluded (including coverage for defense costs) in most D&O policy forms by the insured vs. insured exclusion. ELP policies may cover claims arising out of moonlighting, pro bono, or other legal services provided by the in-house attorneys unrelated to their corporate employer, as well as personal tort claims such as false arrest or imprisonment, malicious prosecution, defamation, and/or violation of the right to privacy. As with other lines of insurance, not all policy forms are created equal. Whether insureds address in-house attorney liability exposure under the company s D&O program or choose to mitigate the risk by purchasing a separate ELP policy, coverage enhancements to the existing policy forms may be necessary. For example, as previously noted, in-house attorneys today face greater liability exposure in the bankruptcy context. Insureds may accordingly wish to negotiate an exception to any insured vs. insured exclusion such that claims brought by bankruptcy trustees or other parties standing in the shoes of the debtor client find coverage both in terms of defense costs and other loss. Such exceptions are commonly added to D&O policies. Moreover, other important coverage issues in a D&O policy, such as negotiating protection against policy rescission, deserve equal attention in negotiating ELP coverage. Finally, it should be noted that certain coverage issues, such as the lack of coverage for fines or penalties that may be assessed arising out of SarbOx, might remain without adequate solution under either program. ACT NOW OR PAY LATER Your day began with a Sarbanes-Oxley nightmare and a question of insurance coverage. Fortunately, it was just a bad dream and you have an opportunity to evaluate how SarbOx impacts your corporate insurance program before the nightmare becomes reality. The heightened regulatory climate brought about by the Act has dramatically increased public company 48 ACC Docket April 2005