How to Ensure You Are Protecting Your Directors and Officers in These Troubled Times Risks, Realities, and a New Paradigm Patricia J. Villareal Head, Litigation Group Securities and Corporate Governance Practice Team Jones Day November 19, 2002
Starting Point: What Are The Risks Today?
Some Risks Haven t Changed Securities Fraud Class Actions
But, sometimes the risks may look greater than they really are
No Question: More Cases and More Money on Settlements 2001: 468 actions filed, more than double 204 in 2000 2000: $4.4 billion in class action settlements Longer to litigate = higher defense costs ($3-4 million through discovery and MSJ)
2001 Securities Class Actions: Circuits Top three circuits in number of filings - 2nd Circuit (New York) 192-9th Circuit (California) 52-3rd Circuit (Delaware/Penn.) 14 161 of 192 cases in 2nd Circuit were IPO allocation cases
And, Who Were The Defendants In These 2001 Suits? 87%: Chief Executive Officer 69%: Chairman of Board 67%: Chief Financial Officer 2003: Audit Committee Members?
Securities Class Action Suits -- 2002 Update Lower number of high-technology companies being named Now broader target areas, oil, utilities and biotech/pharmaceutical companies More NYSE companies and foreign companies named as defendants
But, Texas Not a Bad Place to Be: Cases Filed: 2000-13 2001-12 Median Settlements in 5th Circuit: 2000 - $6.0 M 2001 - $4.3 M
But, more and more cases being dismissed: Federal courts are now dismissing almost 25% of the cases being filed Why: failure to met pleading requirements imposed by the PSLRA Dallas federal courts have higher rate of dismissal than other Texas courts
And, are settlements really costing more? News you hear: Average settlement has increased to $16 million in 2001
Averages, however, can be misleading: More than 65% of all Post-Reform Act settlements total less than $10 million Median Settlement Value for all Pre-Reform Act cases: $4.0 million Median Settlement Value for all Post-Reform Act cases: $5.5 million
In fact, The median settlement value as a % of estimated damages has decreased from 7.2 % to 5.1 percent Cases with high estimated damages tend to settle for a lower percentage of the estimated damages
Higher Settlements = Underwriter Defendants or Accounting Allegations Highest median settlement: 9.6% when underwriter named as a defendant When accountant named as defendant: 7.3% Settlements significantly higher when either GAAP allegations or Section 11 claims
Cases with Accounting Allegations: More than 50% of all Post-Reform Act settlements have GAAP allegations Median settlement is 5.9% of estimated damages compared to 4.1% in cases without GAAP allegations 30% of cases involve restatements with a median settlement of 7% When accountant named as defendant: 7.3%
But, still: Median settlement in 2001: $5.5 million with GAAP allegations? Median percentage of claimed damages: 5.1%?
2001 Securities Class Actions: Milberg Weiss Milberg Weiss involved in approximately 50% of all Post-Reform Act cases settled through 2001 Median settlement in cases where Milberg involved: 4.5% of estimated damages Cases where Milberg not involved: 5.1% of estimated damages
So, bottom line -- these actions are not bringing investors significant recovery: But, lawsuits still being filed - Why? Professor Joe Grundfest, Stanford Law School: the financial incentive for plaintiff lawyers to sue is alive and well Securities fraud cases (% of settlement + attorney fees) vs. shareholder derivative cases (only attorney fees)
But, keep in mind, that almost no individual contributions to settlement: Settlements are coming from two sources - D&O insurance policies - Company defendants, often through issuance of stock But, not from contributions from individual defendants
But, today there are new risks --
But, today there are new risks: Sarbanes-Oxley Act SEC Rules NYSE Rules NASDAQ Rules Market overreaction
New risks that may threaten old assumptions about: Who do directors and officers look to for protection from liability? Will the Company s D&O insurance be there? Is D&O insurance all there is? Will it be enough?
New Risks: Sarbanes-Oxley Act Section 906: certification of financial statements fully complies with sections 13(a) and (15(d) fairly presents, in all material respects, the financial condition and results of operations $1,000,000 fine and 10 years in prison for knowing violation but
New Risks: Sarbanes-Oxley Act Section 802: Altering documents alteration, destruction or falsification of documents any matter within jurisdiction of any U.S. department or agency Fine and 20 years in prison
Are your directors and officers protected from these new risks?
A New Paradigm?
A New Paradigm D&O insurance is not where the answer starts It is the Company that is the bedrock protection for directors and officers The Company and its assets are where you need to start looking
So, when was the last time you: Read your Company s indemnification obligations? Made sure you understood what is covered and where there could be gaps? Went through how indemnification and insurance will work step-by-step if you face a claim?
More than ever, it is important now that you understand: What indemnification can and cannot cover How D&O insurance fills some gaps and creates others How indemnification and insurance fit together And, unless you do, you can t be sure that you are protecting yourself or your directors and officers
Where Does D&O Insurance Fit? Catastrophic coverage for directors and officers if Company loses coverage - if Company cannot pay Or, if Company is not permitted by law to pay - Derivative judgments - SEC/2d Circuit: no indemnification for securities fraud judgments But D&O insurance should not be viewed as the primary, basic protection for directors and officers
Troubled Waters: Bankruptcy & D&O Insurance With Enron, Kmart, and Global Crossing, insurance market is in considerable disarray Reality: Company is bedrock protection for D s&o s But when gone: D&O insurance may be all that is left
Troubled Waters: Bankruptcy & D&O Insurance Bet on it: Pre-petition indemnification gone D&O insurance: Fair game for creditors, plaintiff lawyers, and bankruptcy trustees Insurers fighting back: Enron
Today s Marketplace Dynamics 7 of the 10 largest bankruptcies in history in past 18 months 116 restatements in 1997 270 restatements in 2001
D&O Insurance Market Today Rates: Much More for Less Higher Deductibles/Retentions No More Multi-Year Policies
D&O Insurance: New Forms of Insurance Policies in 2002 AIG: $25 million policy for independent directors triggered if company s board loses its D&O coverage No Entity coverage only directors and top management Directors must follow best practices including requirement to attend 2/3 of board and committee meeting
So, What Should You Be Doing Now?
A New Paradigm Understand how indemnification and insurance fit together -- Goal: Seamless fit (or at least know where the holes are and why!)
Company Indemnification D&O Insurer reimburses Company after retention D&O Insurance Side B Side A
Understand the indemnification obligations and how they work: Who is covered (and who is not) What claims are covered (and what is not) Which entities are covered (and which are not) What procedures are in place
Understand what your D&O insurance policy covers Who is covered What claims are covered What are the key exclusions What information was provided to insurers Was it correct What knowledge is imputed
Compare D&O Coverage to Indemnification Who is covered? What are the gaps? Are you covering the real risks?
Remember: Other Sources of Protection No liability for monetary damages for breach of duty of care Good faith reliance on Company s books, records and professionals
Understand how indemnification and insurance work -- if you face a claim
Undertaking I,, being first duly sworn, do say as follows:... I undertake to repay any advancement of expenses if it shall ultimately be determined that I am not entitled to be indemnified...
Company Indemnification D&O Insurer reimburses Company after retention Company Coverage for securities claims and employment practices claims Side B D&O Insurance Company not permitted to indemnify Company unable to pay indemnity Side A
What Else Should You Be Doing Now?
Sarbanes-Oxley: Where will it fit? New and broader criminal fines and penalties But what about advancement of defense costs? Is advancement a loan? Will a public company be faced with a request for indemnification of criminal fines?
Clash: Delaware Law vs. Sarbanes-Oxley? Delaware: a consistent line of authority upholding the contractual and statutory advancement and indemnification rights of corporate officials changed with serious misconduct allegedly inspired by personal greed. Sarbanes-Oxley Act: new federal public policy
Indemnification has to rest on findings by Board of Directors that: Director or officer was acting in good faith Action in best interests of company, or at least not opposed to best interests of company And, director or officer did not believe conduct was unlawful
What else can you do now? Put in place indemnification agreements with directors and key officers Why? They can provide more procedural protections that will make a big difference to directors and officers who may face a claim Will survive current management
Charter/Bylaw Indemnity vs. Indemnification Agreements Timing of payment of expenses Typical Charter/Bylaw Indemnity: If payment not made in 90 days of claim, indemnified party can bring suit Delaware Indemnification Agreement: Advanced or reimbursed within two business days Company bears risk, not you
New Sarbanes-Oxley Forms of Indemnification Agreements Can include recitals about importance of roles directors and officers play and need for indemnification agreements Can set out Delaware law on theory of indemnification in manner that will provide support if decision made to indemnify Can justify under Delaware law theory and reasons for indemnification of criminal fines and penalties
Bottom Line: Indemnification and Insurance May be one of your most important jobs for yourself and for the Company Increased threat of liability Increased personal obligations Increased risk of company insolvencies = Fewer people willing to serve
Indemnification: Where it Started Allows corporate officials to resist unjustified lawsuits, secure in knowledge that, if vindicated, the corporation will bear the expense of litigation. Encouraging capable women and men to serve as corporate directors and officers, secure in the knowledge that the corporation will absorb the cost of defending their honesty and integrity.
Indemnification: Today and Tomorrow Bedrock protection for directors and officers: the Company Never enough insurance Insurance is there for two reasons: - to protect the Company from drain of litigation costs - to protect you when the Company can no longer Make sure you understand how it works
How to Ensure You Are Protecting Your Directors and Officers in These Troubled Times Risks, Realities, and a New Paradigm Patricia J. Villareal Head, Litigation Group Securities and Corporate Governance Practice Team Jones Day November 19, 2002