John A Rafferty discusses the Sarbanes-Oxley Act and offers some advice to corporate risk managers looking to find D&O cover for their companies in today's environment.
Back in 1995, Congress adopted the Private Securities Litigation Reform Act (PSLRA). The law was designed to curb abusive practices in securities class action lawsuits by making it more difficult for plaintiffs to bring meritless cases. PSLRA was arguably supposed to make the world a better place for corporate directors and officers and the insurance companies selling directors' and officers' (D&O) liability insurance.
Fast forward to 2002. The Enron, Adelphia, Global Crossing, Tyco and WorldCom debacles, replete with disintegrated shareholder value, corporate bankruptcies, restated financial statements and the indictment of executives, have become constant front-page news. Reacting to this rash of scandals, Congress passed another law with record speed in July 2002, the Sarbanes-Oxley Act (SOA), which potentially swings the pendulum back in the opposite direction of the PSLRA. The SOA puts issuers of securities - and their executives, audit committees, boards of directors, auditors, lawyers and investment bankers - under the microscope. Further, SOA dramatically raises the stakes, especially for corporate directors and officers, by creating and/or increasing the financial and criminal penalties for knowingly violating federal securities laws. And by focussing on the intricate details of how a corporation is run, the SOA gives new meaning to the term 'corporate governance'.
It is inevitable that the SOA will have a major impact on at least two segments of American corporate culture: corporations themselves and the insurance companies that underwrite their D&O liability coverage.
In a perfect world, the relationship between business entities and their D&O insurers is truly symbiotic. Businesses being held to strict new federal accountability standards need to protect their executives against liability; D&O insurers look to sell a product that meets their clients' increased liability needs, which also provides them with a reasonable financial return in exchange for this meaningful transfer of risk.
Corporate directors and officers now need D&O insurance protection more than ever. The irony, however, is that the D&O industry, bleeding from maturing historical shareholder class action lawsuits that would appear to have exceeded corresponding premiums by perhaps billions of dollars, has had to narrow the scope of coverage, increase self-insured retentions and often reduce the limits of coverage in its D&O policies. Similarly, D&O insurers are forced to be even more selective about whom they will even insure since seemingly any industry and any company can be a target. Underwriters are going over their current and potential policyholders' business operations and financial statements in excruciating detail, demanding written documentation and tangible demonstration of company internal control and governance procedures. They are also asking tough, probing questions of policyholder senior management that a few years ago would have been viewed by buyers and brokers as overly intrusive.
Anatomy of a law
The major thrust of the SOA is in several key areas: corporate governance, disclosure requirements, enforcement provisions, auditor independence and securities research integrity.
Corporate governance. SOA requires the Securities and Exchange Commission (SEC) to direct the stock exchanges and NASDAQ to revise their listing standards to require that an issuer's audit committee be comprised solely of independent directors, has direct oversight responsibility of auditors, and is responsible for procedures for the treatment of complaints (whether formal or anonymous) regarding accounting, auditing or internal control matters. The act calls for additional certifications by CEOs and CFOs regarding financial statement integrity and internal control adequacy that surely raise the bar - directly or indirectly - on all directors and officers of any issuer filing financial statements with the SEC. Any new or significantly modified issuer loans to executive officers or directors (including indirect arrangements to accomplish same) are prohibited.
Disclosure. Transparency was an obvious goal of Congress in passing the SOA. The act requires expanded financial disclosures regarding off-balance-sheet transactions and potential obligations triggered via relationships with unconsolidated entities. Rules around the use of pro-forma financial information as well as the accelerated timing of Section 16 filings are strengthened and will be a major challenge for executive officers and directors as they react to events and look to appropriately manage disclosure around these events in a now less-certain legal climate.
Enforcement. Under SOA, 'knowing securities fraud' is a crime punishable by fines and/or imprisonment of up to 25 years. The knowing and willful destruction of corporate audit records is subject to a fine and/or imprisonment of up to 10 years. Retaliation against informants relating to possible commission of a federal offence is a crime punishable by a fine and/or imprisonment of up to 10 years. SOA also contains a provision that requires the disgorgement by CEOs and CFOs of any bonus, incentive-based compensation and/or profits realised from the sale of company securities received during the 12-month period following the first issuance of financial documents later subject to restatement as a result of any misconduct. Furthermore, the statute of limitations is lengthened to allow securities fraud lawsuits to be filed for a period of up to five years after an alleged securities violation has occurred, provided the lawsuit is filed within two years from initial discovery of fraud.
Auditors/accounting. The SOA establishes a new Public Company Accounting Oversight Board in an attempt to dramatically improve professionalism and accountability standards in the accounting arena. Auditor independence is enhanced via the prohibition of providing many non-auditing services to audit clients, the alignment of external auditor accountability directly into the audit committee (as opposed to CFO or CEO) and the periodic rotation of lead partner on all client engagements.
Research integrity. The SOA directs the SEC to adopt rules to generally foster greater public confidence in the securities markets by improving the objectivity of investment research via, among other things, the disclosure of potential conflicts of interest.
High anxiety for all
The SOA comes at an extremely critical time for corporate directors and officers and their D&O insurance carriers. If we set aside 2001's IPO tie-in/laddering phenomena, where more than 300 lawsuits alone were filed against IPO issuers regarding inflated brokerage commissions and/or the alleged artificial inflation of share prices via pre-agreed purchase arrangements in the secondary market, the number of federal securities class-action filings is at an all-time high as evidenced by 259 actions in 2002. There's no sign that frequency will fall near-term. Furthermore, there has been a meaningful shift in target by the plaintiff bar towards larger market capitalisation companies. In 2002, there were 61 Fortune 500 companies who were the target of securities class action suits, compared with an average of well under 30 per year in 1999-2001. The ramifications of this are significant since the stakes are generally higher for everyone when large capitalisation companies are involved, since investor losses can be tremendous and D&O insurance programs are often built in the hundreds of millions of dollars. These programs bring many direct insurers into the same losses, creating aggregation problems for reinsurers who may back numerous direct insurers. The average shareholder class action settlement likewise hit a high in 2002 at $19m, up nearly 200% from 1997. Furthermore, the number of companies reporting financial restatements in 2002 reached 330, which again approaches a 200% increase since 1997. All in all, D&O carriers and their reinsurers have reason to be very concerned.
It remains to be seen what impact the SOA will have on the number of financial restatements and securities class-action lawsuits and, just as important, on severity levels as measured by the size of claim settlements. While the issues of corporate accountability and more transparent public filings are just and noble causes, the short-term practical outcome of the new law could be less about improved corporate governance and more about the plaintiff bar's increased ability to file lawsuits and collect fees. And with the new law's extension of the statute of limitations from three to five years, coupled with increased funding for the SEC to hire more investigative auditors and lawyers, it seems highly likely that the number of such cases has nowhere to go but up - at least in the short run. Understandably, D&O underwriters have moved quickly to increase premiums, raise self-insured retentions and restrict coverages. However, with frequency and severity trends heading in an upward direction, the inherent delay in the securities claim maturation process and the shifting legal landscape brought on in part by the SOA, neither buyer nor seller of the D&O product feels overly confident about what tomorrow may bring.
For corporate risk managers looking for D&O coverage in the current environment, it will be more important than ever to truly differentiate the risk characteristics of their employer. This requires an honest assessment of the firm's risk profile and a strategic approach to painting your firm and its management team in the best light possible by anticipating areas of heightened concern for D&O underwriters.
Risk profile assessment. It is important to understand that D&O underwriting is a mosaic of evaluation considerations consisting of literally dozens of risk factors: from industry issues to ownership structure, stock price volatility to underwriter perceptions of corporate governance strength, plus an assessment of accounting aggressiveness and even management arrogance. Informed buyers appreciate that certain industries and/or individual risk characteristics have been significantly worse than others for D&O underwriters. For example, problems within the energy-trading/utilities, telecommunications and financial services industries are well known and can be specifically used to show how and why similar problems may not be part of a given risk. Therefore, a utility should demonstrate convincingly that there have been no round-trip transactions (if true, of course). Efforts should be made to discuss in detail any special purpose entities or off-balance sheet contingencies. It is wise to anticipate underwriters' need to verify there was no California marketplace-type manipulation on their part. It is clearly better to openly acknowledge these tough issues directly, rather than to naively or arrogantly assume they will not be a factor in your D&O programme's underwriting evaluation. Understandably, scepticism permeates D&O underwriting facilities at this time. This cannot not be ignored.
Meaningful Dialogue. D&O underwriters today are basically forced to act as part securities analyst, part forensic accountant and part investigative reporter. As a prospective client, make your CEO and/or CFO available for in-depth conversation surrounding revenue recognition policies, rating agency relationships and credit facility covenants. Provide hard, specific examples of the audit committee's independence from the CFO/CEO. Prepare the corporation's general counsel to discuss the company's insider-trading policy and exactly how verification responsibility follows. Detail your 10(b)5-1 trading plans, if they exist - and again demonstrate how deviations would be detected and why they would not be tolerated.
D&O underwriters may ask for access to the audit committee's alternative methods of accounting that were discussed with management, as well as documentation of any written communication between the accounting firm and the company that is material and/or relates to disagreements or discrepancies in accounting policies and practices used. The CFO (or better yet, the head of the audit committee) should be prepared to answer questions about audit committee meetings and charter and any non-audit services being performed by the auditor.
Insurers are also casting a sharp eye on executive compensation packages. A recent study, jointly conducted by the Washington DC-based Institute for Policy Studies and Boston-based United for a Fair Economy, shows that top executives at 23 companies under investigation for their accounting practices collectively pocketed $1.4bn in compensation from 1999-2001 - while the collective value of their firms' shares plunged $530bn, about 73% of their total value. The fallout from this sort of discrepancy will certainly intensify. The proactive client will be prepared to discuss and defend executive compensation figures with their D&O underwriters.
On the flip-side, however, it is entirely appropriate to require D&O carriers to have seasoned underwriting personnel involved in these insurer-client meetings for meaningful dialogue, drawing differentiation conclusions and acknowledgement of favourable policy terms and conditions, if warranted.
The days ahead
We collectively find ourselves in a down economy with disappointing corporate earnings, sagging stock prices, a proliferation of financial restatements and increasing shareholder litigation activity. Not surprisingly, the immediate ramifications of the SOA - with its enhanced disclosure and accountability standards and improved corporate governance motive - are difficult for all involved in the D&O insurance world. We continue in the surge of financial restatements brought on in part by the enhanced CEO/CFO certification process and the aftermath of Andersen's downfall and the resulting transition of its 1,300 former clients to other auditors. New auditors have every incentive to prospectively disavow any questionable historical accounting assumption or decision and point at Andersen, heightening the potential for restatements and subsequent litigation. An emboldened SEC with new leadership and enhanced funding also will surely lead to more near-term investigatory and enforcement actions. Attracting and/or retaining qualified outside board members is likely to be more difficult.
At present, there are perhaps more questions than answers surrounding the SOA, corporate governance and the fate of D&O insurers. That said, over time the emergence of stronger boards of directors, increased CEO/CFO accountability and a more independent and conservative accounting industry bode well for the future. Faced with the triple threat of fines, jail time and the disgorgement of incentive compensation following a financial restatement due to fraud, at some point we are likely to see fewer restatements and perhaps more missed earnings scenarios. These straightforward securities class action lawsuits - provided there are no financial restatements and other surprise disclosures - are likely to mitigate the rising trend in settlement values. It is always amazing as well to witness the effect of an improving economy and strong corporate results (that will be arguably more believable) on shareholder satisfaction and subsequent litigation activity. The SOA in the long run should help to improve the integrity of our country's financial markets, enhance corporate accountability and lessen the vulnerabilities to D&O lawsuits. Unless and until this manifests itself - as evidenced by fewer restatements and slowing/decreasing securities class action frequency and severity trends - buyers of D&O insurance will need to act in a thorough and forthcoming manner to increase their chances of securing the most stable, cost effective and client-favourable coverage available.
By John A Rafferty
John A Rafferty is Vice President, D&O, at Hartford Financial Products in New York City. Hartford Financial Products is a unit of The Hartford Financial Services Group, Hartford, Conn.