Directors and officers coverage is more important than ever
By Jordan Fox, for SBT
Corporate directors and officers today are facing liability risks that have never been higher. The infamous escapades of the CPA consulting firm of Arthur Andersen, and some of the corporations involved in the recent accounting scandals, specifically Enron, WorldCom and Xerox, have been part of that problem.
And frustrated investors more and more are charging corporations and their officers and directors with securities fraud whenever a company’s stock price drops dramatically.
Directors and officers are now coping with increasing responsibilities and lower investor tolerance for performance and governance failures. That means increased scrutiny of financial statements and of the key people who sign off on them.
A news item of the other week vividly illustrates that point: WorldCom Inc. has offered an additional $250 million in common stock to a proposed $500 million accounting fraud penalty. The company hoped this would help win court approval for the record settlement.
On approval, the company would issue the shares after it reorganized and its new stock was trading. According to the SEC, the new shares would allow victims of the fraud perpetrated by that company to share in the potential upside of owning WorldCom common stock when it comes out of bankruptcy.
Even though Wisconsin-based corporations didn’t participate in that illegal behavior, they are facing stringent, new standards, according to Karen Rechlicz, vice chairman of the Mequon based insurance brokerage firm of Fitzgerald, Clayton, James & Kasten.
She says that last year’s Sarbanes-Oxley legislation, along with heightened awareness of the importance of directors and officers (D&O) liability insurance, came about because of the missteps of those scandal-touched companies. The new law made it clear that the kind of corporate behavior that has occurred is not to be tolerated.
"Sarbanes-Oxley is a federal statute that mandates that high executives in publicly held corporations guarantee the financial information of their companies that they present to the public," she explains. "Given the current business environment, shareholders and individuals are more inclined to sue directors and officers," she says.
According to Rechlicz, a 42-year-veteran of the insurance industry, the new law dictates that corporate governance must be effectively in place and that company executives reassess their personal liability to the companies they serve.
"A corporation’s board of directors composition must include an audit committee and a compensation committee," she states. Audit committee members specifically are becoming responsible for appointing the auditors, reviewing non-audit services, and overseeing procedures to encourage whistle blowers.
"There’s got to be an internal audit and all of the pertinent financial information must feed into senior corporate officers and the person who heads the organization, who then must sign off on the accuracy of those figures."
If it turns out that those figures are inaccurate, then the CEO and other top people are in violation of the act and become personally liable to shareholders. That might even mean jail, she says.
"Do we need tighter auditing standards?" asks Thiensville CPA Stephen Derfel. "The answer is a definite and resounding yes," he says. "Enron paid the Arthur Andersen firm $100 million in fees for both auditing and management consulting. Andersen people should be ashamed of themselves because they put a black mark on the accounting profession."
"The magnitude of D&O insurance claims has increased over the last few years," Rechlicz states. "These figures don’t even include the WorldCom and Enron messes: Last year the average positive closed claim was about $5.5 million; this year it’s up 75% from that figure. In 2001, claims from shareholders were running around $17 million in awards. And the year before that, the all time high was about $10 million."
She also reports that defense costs, including related court costs and attorney fees, last year came to about $400,000. This year they’ve climbed to $500,000.
"This scenario is pretty scary for public corporations," she says.
Rechlicz also sites some other significant statistics: In 1994, the total amount of damages awarded came to $38 million, which included $5 million in punitive and $33 million in non-punitive damages. "And in December of last year the total was $139 million, which was comprised of $23 million in punitive and $116 million in non-punitive damages. So you can see that in nine years these things have quadrupled," she says.
"Another significant statistic shows that there were 3,617 arbitration cases filed in 1990, and in 2002 those cases more than doubled to 7,704.
"The public’s eyes have been opened and, therefore, the importance of corporate governance has been very much emphasized. That means that more companies are buying D&O insurance. But with the losses of 9/11 and depressed stock returns, among other things, D&O insurance is becoming extremely expensive. And the capacity will drop. Insurance carriers have been losing staggering amounts of money in the D&O marketplace. Some of them will get out of D&O insurance and others will stay in it but at a very high price," she says.
"When it first came out many ago, you could buy a policy for about $500 and it covered almost everything. And now you’re looking at six or seven figures and a $500,000 deductible and $1 million in exclusions. Remember, no D&O insurance is the same; they’re all custom tailored to the risks. You can’t buy one off the rack. And they’re pretty much negotiated between the broker and the insurance carrier. But it behooves companies to get into D&O insurance and get into it quickly," Rechlicz says.
Without an established history with a good carrier, a company may have difficulty finding insurance right now, regardless of their litigation history. She suggests that companies do not change their carriers. "Some people shop carriers every year. You really shouldn’t do that because you’ll burn them out and pretty soon they won’t quote you on D&O insurance."
Although private companies and nonprofit organizations don’t have to comply with the new law, they still have a valid need to purchase D&O coverage, she says. "They have customers, clients and competitors and government agencies that can sue them.
"I talk to a lot of individuals who sit it on boards of private organizations. They’re good people and serve without compensation. They want to help, but if they’re sued, they’re screwed."
Rechlicz suggests that companies without D&O coverage contact their insurance brokers and investigate the possibilities before the Enron and WorldCom scandals cause the rates to go even higher.
Those already with coverage are encouraged to closely review the details of their policies to see if their coverage is up-to-date.
Because D&O insurance forms are continually evolving, directors and officers should regularly consult with an insurance broker and counsel experienced with it to determine whether there are new standard terms or possibilities for enhanced coverages which should be included in their policies.
Among the insurance carriers offering D&O coverage are Chubb, National Union, Great American, Continental, St. Paul and Hartford. "Find an insurance carrier with a high rating and strong financial position," advises Rechlicz. Without that stature, a carrier’s D&O policy could be worth less than the paper it’s written on. There’s no point in placing a policy with an insurance carrier that’s having financial problems, she says.
July 11, 2003 Small Business Times, Milwailee
