The ACE Report is a periodic publication distributed to policyholders and other interested parties as a service by ACE. Its purpose is to address insurance concerns worldwide, as well as present timely information on current developments in liability issues surrounding directors and officers. The Editor of The ACE Report is Dan A. Bailey, a lawyer at Arter & Hadden in Columbus, Ohio, USA and a respected voice in the complex area of directors and officers liability.

Although prepared by professionals, this publication should not be utilized as a substitute for legal counseling in specific situations. Readers should not act upon the information contained herein without professional guidance.

EMERGENCE OF INSTITUTIONAL INVESTORS AS PLAINTIFFS
One of the express goals of the Private Securities Litigation Reform Act of 1995 ("Reform Act") was to increase the frequency of institutional investors serving as lead plaintiffs in securities class action lawsuits. Although institutional investors have been appointed lead plaintiff in a few securities class actions since enactment of the Reform Act, they generally continue to avoid serving in that capacity for several reasons. For example, as a prospective class representative, institutional investors subject themselves to potentially invasive discovery by defendants with respect to their arguably confidential investment strategies, practices and decision-making techniques. In addition, as lead plaintiff, institutional investors assume various fiduciary responsibilities to the class and commit to time-consuming oversight of the prosecution and settlement of the lawsuit. In exchange, the institutional investor receives very little, if any, compensation. In other words, many institutional investors have concluded that the benefits derived from serving as lead plaintiff on behalf of the class do not outweigh the substantial commitments, costs and detriments associated with serving as lead plaintiff.

Although they have generally been unwilling to serve as lead plaintiff on behalf of the entire class, institutional investors are now filing with greater frequency individual lawsuits against companies and their directors and officers for violations of the securities laws. This strategy allows the institutional investor to aggressively pursue their claims without being burdened by many of the detriments associated with serving as lead plaintiff on behalf of an entire class of investors. Particularly in cases involving large investments by the institutional investor, this strategy can create significant leverage over the defendants and thus significant recoveries.

These individual lawsuits have been brought either shortly after the institutional investor discovers the alleged wrongful disclosure or, if a class action is filed by others, can be brought after the class action is settled and the institutional investor opts out of that settlement. There are several advantages to prosecuting an opt-out claim rather than prosecuting an individual claim at the same time the class action is being prosecuted by other shareholders. For example, the institutional investor in an opt-out claim may be able to benefit from discovery which has already occurred in the settled class action lawsuit. In addition, the institutional investor can use the pro rata class action settlement amount as a threshold for beginning settlement negotiations in the opt-out lawsuit, thus resulting in the institutional investor likely realizing a larger recovery through the opt-out lawsuit than if it had participated in the class action settlement.

Although institutional investors have always had the right to prosecute an individual securities claim separate from a class action, these separate claims are now becoming more popular, primarily for two reasons. First, the Reform Act's focus on institutional investor involvement in securities class actions has apparently resulted in at least some of the larger institutional investors becoming more interested in enforcing their rights and maximizing their recoveries through litigation. Second, as a result of some of the liability limitation provisions in the Reform Act under Section 10(b) of the Securities Exchange Act of 1934 ("1934 Act"), institutional investors can in many instances present a much stronger individual claim under Section 18 of the 1934 Act than class members can present under Section 10(b). As a result, most individual institutional investor securities claims are now being prosecuted under the somewhat archaic Section 18. The following briefly summarizes the potentially frightening exposure for companies and their directors and officers in a Section 18 claim by institutional investors.

Section 18(a) of the 1934 Act prohibits any person (including a company and its directors and officers) from making in various documents filed with the SEC any statement which is materially false or misleading at the time and in the light of the circumstances under which the statement was made. The statute expressly authorizes any person who relied upon such a false or misleading statement in purchasing or selling securities to sue the person making the false or misleading statement for resulting damages. The important elements of a cause of action under Section 18(a) are summarized below:

As a result of this increased potential for institutional investor opt-out claims following a securities class action settlement, defendants in the securities class action and their insurers should now consider the following, among other things, in connection with settling a securities class action lawsuit:

• To the extent possible, one should determine whether the proposed settlement class consists of any large institutional investors that suffered significant trading losses during the class period (i.e. identify large institutional investors who may be motivated to opt-out of a proposed class settlement).
• When negotiating a settlement in the class action, the defendants and their insurers should recognize that the settlement amount being negotiated may not resolve all future litigation relating to the alleged misrepresentations. Thus, when evaluating the reasonableness of a proposed class settlement and the benefits to be derived therefrom, the parties should recognize the potential for additional opt-out claims by institutional investors which may be expensive, time consuming and distracting to resolve.
• When negotiating the class action settlement, defendants should seek to include within the settlement documents two alternative "blow" provisions. Typically, securities class action settlement agreements include a provision which allows the defendants to terminate or "blow" the settlement if more than a designated number of shares in the proposed settlement class opt out of the settlement. For example, the parties frequently agree that the defendants can terminate the settlement if more than 5% of the shares in the proposed settlement class opt out. In light of the heightened concern about institutional investor opt-outs, the defendants could seek to include in the settlement documents a second, additional "blow" provision which would also allow the defendants to terminate the settlement if any one institutional investor owning more than a designated number of shares in the proposed settlement class opts out of the settlement. The number of shares designated for this additional "blow" provision would be substantially less than the aggregate number of shares subject to the first, more traditional "blow" provision. Because "blow" provisions merely give to the defendants (but not the plaintiffs) an option to terminate the class settlement, the defendants and their insurers cannot be hurt but only benefited from such an additional provision.
• The release agreement negotiated between the defendant insureds and the insurers in connection with the class settlement should clearly state whether the insureds are releasing claims under the insurance policy not only with respect to the defense and settlement of the class action, but also any future related opt-out claims. Insureds obviously will want to maintain their coverage for those future related opt-out claims. However, if the insurer's contribution towards the class settlement is determined based upon a negotiated discount of the policy limits (in light of losses exceeding the limit and the parties' compromise of significant coverage issues), the insurer may insist that the release by the insureds be a full policy release extending to all loss incurred on account of any future claims (including future opt-out claims).

In summary, institutional investors are beginning to take a somewhat more active role in securities litigation against companies and their D&Os. However, contrary to Congress' intent, it appears that involvement will more likely be in the context of individual claims under Section 18(a) rather than as lead plaintiffs in class actions under Section 10(b). Thus, defendants and their insurers appear destined for an unintended and undesirable double whammy: professional plaintiff lawyers continuing to control the securities class action litigation and institutional investors prosecuting separate individual lawsuits under Section 18(a), which can present new and frighteningly broad liability exposure for the defendants.

ENTITY COVERAGE AND BANKRUPTCY: A DANGEROUS COMBINATION?
The availability of D&O insurance protection for directors and officers of a company in bankruptcy is critically important. Because a bankrupt company typically cannot indemnify its directors and officers, the D&O insurance policy is usually the only protection available to the directors and officers. In fact, the risk that the company may be financially unable to fund its D&O indemnification obligation is one of the primary reasons why companies and their directors and officers purchase D&O insurance.

An issue has historically existed whether the bankruptcy law would interfere with directors and officers accessing the D&O insurance policy during a bankruptcy proceeding. Upon commencement of a bankruptcy proceeding, the bankruptcy law automatically imposes a "stay" or injunction against any conduct that would deplete or adversely affect the company's interest in any property owned by the company. This stay, in essence, freezes all assets of the company so that the bankruptcy court can oversee the management of the company's assets and reorganize the company's debts in an orderly fashion.

Generally, a company's insurance policies are considered property of the bankruptcy estate. Thus, the insurers of the company's insurance policies may not pay out proceeds under the policies to third parties without bankruptcy court approval.

However, there has been considerable debate whether D&O insurance policies should be considered assets of the bankruptcy estate and subject to the bankruptcy stay. Courts have consistently held that D&O policies are property of the bankruptcy estate because the policies are purchased by the company and, in part, insure the company to the extent the company indemnifies its directors and officers. Most (but not all) courts, though, have further held that the proceeds of D&O policies are not assets of the estate but instead belong to the directors and officers as beneficiaries of the policies. Thus, the policy proceeds are available only for the directors and officers and should not be considered property of the company. For policies that do not contain any corporate reimbursement coverage (such as policies issued by CODA), this conclusion is even more compelling and the likelihood of the policy proceeds being subjected to the bankruptcy stay is even less likely.

For D&O policies that also afford entity coverage (usually applicable only to securities claims), this distinction between the policy and its proceeds becomes less compelling because the proceeds of such a policy protect both claims against directors and officers and also claims against the company. Since a single aggregate limit of liability applies to both the D&O and entity coverage under those policies, depletion of that limit of liability by payment of covered loss incurred by the directors and officers adversely affects coverage otherwise available to the company and thus arguably affects adversely the bankruptcy estate. Therefore, D&O policies affording entity coverage are arguably more likely to be subject to the automatic bankruptcy stay and all proceeds under such a policy may be frozen upon commencement of the bankruptcy proceeding.

In September 1999, a New York bankruptcy court provided the first judicial guidance on this issue, although the decision does not contain clearly defined standards for dealing with this difficult issue in future cases. In In re First Central Financial Corp., 238 B.R. 9 (Bankr. E.D.N.Y. 1999), the court recognized that the proceeds of a D&O insurance policy that contains entity coverage may be, but are not necessarily, considered property of the bankruptcy estate under certain circumstances. For example, according to the court such a determination would be appropriate when many or large entity coverage claims against the company threaten to exhaust the insurance proceeds and thereby jeopardize bankruptcy estate assets over and above the policy limits.

However, under the facts of that case, the court ruled that the proceeds of the D&O policy were not assets of the bankruptcy estate and therefore not subject to the automatic bankruptcy stay. In that case, no securities claims were filed against the company during the first 18 months of the bankruptcy proceeding. Therefore, the bankruptcy estate was not in need of the entity insurance protection under the policy. According to the court, "[if] entity coverage is hypothetical and fails to provide some palpable benefit to the estate, it cannot be used by a trustee to lever himself into a position of first entitlement to policy proceeds."

Although directors and officers can take some limited comfort that one court under one set of circumstances concluded the proceeds of a D&O policy with entity coverage were not an asset of the bankruptcy estate and subject to the automatic stay, there remains an increased risk of a contrary conclusion when entity coverage is added to the D&O policy. There are at least three possible methods to address that increased risk:

1. Policy Waiver. Because the bankruptcy stay is for the benefit of the company, the D&O policy could contain a provision which states that the company agrees to waive the automatic stay with respect to the policy and its proceeds in the event a bankruptcy petition is subsequently filed. The enforceability of such a pre-bankruptcy waiver of the automatic stay has been considered by various bankruptcy courts in other contexts. The emerging case law upholds and enforces this type of waiver of the automatic stay, although a few courts have refused to enforce such a waiver. Even if the provision is found unenforceable, there should be no detriment in including such a provision in the D&O policy and there is a potentially significant benefit.

The following paragraph sets forth a sample of such a policy provision:

1. If a liquidation or reorganization proceeding is commenced by or against an Insured Organization pursuant to the United States Bankruptcy Code, as amended, or any similar state or local law, the Insureds hereby (i) waive and release any automatic stay or injunction which may apply in such proceeding to this Policy or its proceeds under such Bankruptcy Code or law, and (ii) agree not to oppose or object to any efforts by the Insurer or any Insured to obtain relief from any such stay or injunction.

2. Pre-Determined Allocation. The primary reason for including entity coverage within D&O policies is to eliminate difficult allocation issues when both the company and insured individuals are defendants in a securities claim. That allocation issue can instead be eliminated through use of a predetermined allocation provision in the D&O policy. By predetermining the allocation rather than affording entity coverage, the D&O policy does not directly cover claims against the company and therefore the heightened bankruptcy concerns arising out of entity coverage should not exist.
3. D&O-Only Coverage. A company's D&O insurance program could contain a significant layer of Clause A or D&O-only coverage, like that afforded by CODA. Since the company is not an insured under that policy even with respect to corporate reimbursement coverage, there would be virtually no material risk that the policy or its proceeds would be considered an asset of the bankruptcy estate and therefore subject to the bankruptcy stay. If this layer of coverage constitutes the top portion of the insurance program, the policies could afford "difference-in-conditions" coverage, thereby dropping down to primary coverage in the event the underlying policies are unavailable for any reason, including the proceeds being subject to the bankruptcy stay.

In summary, insureds who are concerned about the negative bankruptcy implications from adding entity coverage to the D&O insurance policy can and should consider one or more alternative policy features which may minimize those concerns.