K&LNGAlert. Insurance Coverage Insurance Coverage for Stock Option Backdating Claims under D&O Liability Policies

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1 K&LNGAlert OCTOBER 2006 Insurance Coverage Insurance Coverage for Stock Option Backdating Claims under D&O Liability Policies INTRODUCTION In recent months, a rapidly increasing number of corporations have faced intense scrutiny from regulators, prosecutors, shareholders, and plaintiffs attorneys related to the so-called backdating of stock options for corporate executives. Given this growing controversy, it is virtually certain that a large number of corporations and individual directors and officers will be forced to incur substantial sums to defend and potentially settle lawsuits and investigations related to stock options. Directors and Officers (D&O) liability policies offer a potentially valuable source of funds to pay for defense costs and settlements in stock option-related lawsuits and investigations. The terms of D&O policies vary widely, so policyholders should carefully review their existing D&O policies to analyze the potential for coverage and to determine whether they should take steps now to preserve their rights. It should be anticipated that insurers will assert all available defenses to such claims based on the specific policy language at issue, controlling case law, and the specific facts at issue. Despite the anticipated insurer reaction, many policyholders will likely have strong arguments for coverage under many D&O policies for defense costs and potential settlement payments for the types of investigations and lawsuits that are currently pending. Therefore, when faced with any allegations of improper practices with respect to stock options, policyholders should carefully review the terms of their policies to ensure that they are taking steps to preserve and maximize coverage, including determining when and in what manner to provide notice to their insurers. BACKGROUND ON THE STOCK OPTION CONTROVERSY As a general matter, the backdating of stock options involves the alteration of the grant date of stock options issued to corporate executives from the day it was actually granted to a prior date when the stock price closed at a lower price. Corporations generally grant stock options at the money, meaning that the exercise price for the option is set at the market price of the stock on the actual grant date. For example, if the corporation granted the option on a day that the stock closed at $50 per share, and the executive exercised the option on a day when the stock closed at $60 per share, the executive could make a profit of $10 per share. If the grant dates of the options are backdated to a day when the stock closed at $40 per share, however, the executive could potentially double his or her profit. The backdating of stock options is not illegal per se. Although such issues are beyond the scope of this Alert, different accounting and tax rules may apply to at the money options and backdated options, and many of the current investigations are focused on whether companies followed the proper accounting rules, paid the appropriate taxes, and made the proper disclosures to investors. In addition, certain investigations are focused on whether stock options were inadvertently backdated or whether careless recordkeeping resulted in unintentional backdating. The controversy relating to the backdating of stock options has grown steadily over the past year, with exponential growth in the past several weeks. In Kirkpatrick & Lockhart Nicholson Graham LLP OCTOBER 2006

2 May 2005, the controversy was fueled by an academic report published by a business professor at the University of Iowa, Erik Lie. Professor Lie s report identified so-called pre- and post-grant price patterns with respect to a substantial sample of options that suggested that stock prices tended to decrease immediately before the date on which many corporations granted options. Based on this statistical pattern, the report concluded that unless corporate insiders can predict short-term movements in the stock market, at least some of the grants had been backdated. 1 In turn, Professor Lie s research attracted media and regulatory attention to the problem. 2 For example, on March 18, 2006, The Wall Street Journal published an article questioning the timing of stock option grants at UnitedHealth and five other companies. 3 Within a few weeks, it was reported that the SEC and federal prosecutors were investigating dozens of companies. 4 By May 6, 2006, The Wall Street Journal reported that at least 10 companies have been caught up in the stock-option-dating matter. 5 By July 17, 2006, the New York Times reported that at least 60 companies had publicly disclosed that they are the targets of government investigations, had been sued by investors, or had commenced internal investigations concerning stock options. 6 In mid-july 2006, Professor Lie (along with certain collaborators) published another report suggesting that more than 2,000 companies appear to have used backdated stock options to sweeten their top executives pay packages. 7 In September 2006, the SEC testified before Congress that it was investigating more than 100 companies. 8 SEC Enforcement Director Linda Thompson testified that as the use of options compensation has increased, however, so apparently has its abuse. This practice benefits employees at the expense of shareholders. 9 By mid-october 2006, it was reported that at least 135 companies were under investigation, and the list of corporate executives that had been fired or had resigned continued to grow. 10 There also has been a spike in regulatory and prosecutorial activity within the past few weeks. For example, on July 13, 2006, the U.S. Attorney in San Francisco created a task force dedicated to investigating companies suspected to have engaged in improper backdating practices. 11 In addition, on July 20, 2006, the SEC filed its first enforcement action against three former officers of Brocade Communication Systems, 12 alleging that Brocade concealed millions of dollars in expenses from investors, and significantly overstated the Company s income, by falsifying records relating to employee stock option grants. 13 On the same day, a criminal complaint was filed against two former officers of Brocade in the Northern District of California. 14 The allegations in the pending derivative and securities class action civil lawsuits vary, ranging from allegations of collusive behavior, simple negligent oversight, breach of fiduciary duties, violations of 1 Erik Lie, Backdating of Executive Stock Option (ESO) Grants, reprinted at 2 Amanda Cantrell, More Than 100 Firms Probably Backdated Options, July 12, 2006, reprinted at 3 The Perfect Payday, The Wall Street Journal, March 18, An Investor Guide to the Stock Option Timing Scandal, Institutional Shareholder Services, Rev., July 2006, at 1. 5 Charles Forelle and James Bandler, Backdating Probe Widens as 2 Quit Silicon Valley Firm Power Integrations Officials Leave Amid Options Scandal; 10 Companies Involved So Far, The Wall Street Journal, May 6, S. Saul, Study Finds Backdating of Options Widespread, N.Y. Times, July 17, Frank Ahrens, Scandal Grows Over Backdating of Options, Wash. Post, Oct. 12, S. Saul, Study Finds Backdating of Options Widespread, N.Y. Times, July 17, Complaint filed July 20, 2006, SEC v. Reyes, et al., No. C (N.D. Cal.). 13 at Criminal Complaint dated July 20, 2006, United States v. Reyes and Jensen, No (N.D. Cal.). 2 Kirkpatrick & Lockhart Nicholson Graham LLP OCTOBER 2006

3 shareholder approved stock option plans, accounting violations, tax violations, and violations of securities laws relating to false or misleading statements. 15 The pending complaints seek various types of relief, including compensatory damages, disgorgement of all backdated options or the proceeds on any such options that have been exercised, and other appropriate relief. POTENTIAL COVERAGE UNDER D&O POLICIES The availability of coverage may turn on a number of policy provisions or insurer defenses, including the issues discussed herein. Claim D&O policies generally afford coverage for claims, a term whose definition varies widely among D&O policies. Many D&O policies define claim broadly to include not only lawsuits, but also a wide array of regulatory or criminal investigations. For example, certain D&O policies define claim to include SEC investigations commenced by the service of a subpoena on an insured person or criminal proceedings commenced by the return of an indictment, information, or similar document. While there appears to be no dispute that lawsuits involving backdated stock options satisfy the claim requirement, many policyholders may be entitled to coverage for defense costs incurred in responding to a wide variety of regulatory and criminal investigations related to stock options, including investigations by the SEC. Definition of Loss Insurers may attempt to contest claims related to the backdating of stock options on the grounds that the repayment of profits earned by corporate executives who exercised backdated stock options constitutes a type of restitution that does not fall within the definition of loss. Policyholders will have several arguments to counter this potential defense, based on the facts of the claim and the policy at issue. Initially, this defense should have no application to a wide array of potential claims that do not seek any sort of restitution. For example, this defense should not apply to claims seeking damages under the securities laws for improper disclosures or other claims seeking damages for negligent supervision or other breaches of fiduciary duties. Even with respect to claims that expressly seek restitution or disgorgement, however, policyholders will have arguments in support of coverage. Many D&O policies define loss to include a wide array of damages or settlements, but typically do not define such terms. Moreover, while certain policies exclude fines or penalties from the definition of loss, D&O policies do not typically exclude restitution or disgorgement from the definition. Many courts have rejected this insurer defense, reasoning that it is an attempt by the insurers to rewrite their policies by adding restrictions on the definition of loss that do not appear in the policy itself. 16 Policy Exclusions Insurers may attempt to rely on a variety of exclusions to contest claims related to the backdating of stock options. For example, certain D&O policies include exclusions barring coverage for claims related to remuneration paid to directors and officers without proper approval. In addition, some D&O policies include so-called conduct exclusions, which potentially bar coverage for certain claims relating to criminal or fraudulent activity or for claims alleging that the insured received a profit to which he or she was not legally entitled. The terms of these exclusions vary widely. While certain exclusions arguably bar coverage when the excluded conduct is merely alleged, many versions of the exclusions apply only when the insurer meets its burden of proving that the excluded conduct in fact occurred or when the excluded conduct is established via a final adjudication or nonappealable judgment. 17 Under the in fact test or final adjudication test, policyholders are often entitled to coverage for defense costs and for settlement payments with respect to claims that settle without an admission of guilt. In addition, such exclusions arguably will have no potential application to claims alleging negligent oversight or careless recordkeeping that resulted in unintentional backdating. 15 See, e.g., Shareholder Derivative Complaint dated May 31, 2006, Ziering v. Levy, et al., No. C (N.D. Cal.). 16 See, e.g., International Insurance Co. v. Johns, 874 F.2d 1447 (11th Cir. 1989). 17 See Alstrin v. St. Paul Mercury Insurance Co., 179 F. Supp. 2d 376 (D. Del. 2002). 3 Kirkpatrick & Lockhart Nicholson Graham LLP OCTOBER 2005

4 In addition, many D&O policies include severability provisions that preclude the insurer from imputing the knowledge or actions of so-called bad actors to other innocent directors and officers as a bar to coverage with respect to some or all exclusions. Such provisions may preserve coverage for innocent directors and the company itself, even if no coverage is available for so-called bad actors. Rescission There remains a chance that an insurer may respond to a stock option-related claim by claiming that the policyholder made a material misrepresentation in the policy application and that it, therefore, has the right to rescind the policy. The legal standards applicable to this defense vary according to state law and the specific terms of the policy. As a general matter, the insurer s burden on this draconian defense is very high, and several courts have held that an insurer must continue to reimburse defense costs until a court issues a final ruling on the rescission defense. In addition, many policies contain provisions that restrict the circumstances in which a misrepresentation defense may be asserted and that protect innocent insureds, even if an insurer meets its burden of proof with respect to so-called bad actors. Coordination of Defense Efforts In most cases, D&O policies do not require the insurer to defend claims filed against a policyholder, but rather require the insurer to reimburse defense costs incurred by the policyholder. Nevertheless, D&O policies often contain terms relating to the policyholder s defense of the claim, such as terms requiring the policyholder to obtain the insurer s approval of any defense counsel, to inform the insurer of significant developments in the case, and to make reasonable efforts to obtain the consent of the insurer to any settlement opportunity. In defending any stock option claims, therefore, policyholders should ensure that their defense attorneys coordinate with their coverage counsel to ensure that steps are being taken to maximize the potential for coverage. In addition, it should be noted that the aggregate limit in D&O policies generally applies to all insureds under the policy. As such, insurers often take the position that once they have paid their limits to any insured or insureds, they are no longer liable to insureds that are still defending claims. Therefore, when analyzing if and whether to settle stock option claims, policyholders should carefully monitor the impairment of any applicable policies due to the payment of defense costs or settlements related to claims against co-policyholders. CONCLUSION As noted above, D&O policies offer a potentially valuable resource for policyholders facing stock option investigations and lawsuits, and policyholders should take steps now to preserve their rights to coverage. Thomas M. Reiter treiter@klng.com Gregory S. Wright gwright@klng.com Thomas M. Reiter and Gregory S. Wright are partners in the Pittsburgh and Washington, D.C. offices of the law firm of Kirkpatrick & Lockhart Nicholson Graham LLP ( K&LNG ), where they regularly advise policyholders with respect to a wide variety of insurance coverage claims, including claims under D&O liability policies. 4 Kirkpatrick & Lockhart Nicholson Graham LLP OCTOBER 2005

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