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.

HELP WANTED: WILL ANYONE SERVE ON AUDIT COMMITTEES?
As a result of the adoption in December 1999 of sweeping new rules related to audit committee functions and performance, directors who now serve on the audit committee for a Board of Directors assume unprecedented responsibilities and potentially catastrophic personal liability exposure. As current and prospective audit committee members begin to realize the scope and potential effect of these new rules, it appears likely that those directors will to varying degrees become more anxious about their personal liability exposure and the extent to which they are financially protected for that potential exposure.

The following discussion summarizes the historical background for these significant new rules, briefly describes some of the substantive terms and potential liability ramifications of the new rules, and identifies several loss prevention and D&O insurance enhancements which may help to reduce some of the inevitable liability concerns that audit committee members will have as a result of these new rules.

1. BACKGROUND
As a result of the unprecedented number of companies restating their financial statements and in response to an increased public skepticism regarding the general quality and accuracy of financial statement disclosures, the SEC and the major stock exchanges have focused on audit committees as the primary source for restoring credibility and trust in financial disclosures. Arthur Levitt, Chairman of the SEC, has been one of the leading proponents of this effort, stating that "never has the link between corporate directors and financial reporting been more crucial." According to the Chairman, effective corporate governance is at the core of market discipline and that the key area of concern is the role of audit committees, which afford the long-term perspective necessary to offset management's desires to "make the numbers" for a particular reporting period.

To address this perception that improved board oversight of the financial reporting process of public companies is needed, the New York Stock Exchange and the National Association of Securities Dealers sponsored a Blue Ribbon Committee on improving the effectiveness of Corporate Audit Committees. The Committee's Report, which was issued in early 1999, made numerous and aggressive recommendations that were intended to empower audit committees to function as the "guardian of investor interest in corporate accountability." That Report, standing alone, was not binding or self-enacting. Rather, the securities exchanges, the SEC and the accounting industry were each required to implement the Committee's recommendations.

After substantial public debate, the SEC in December 1999 adopted final rules related to audit committee behavior and disclosures, as well as approved new rules submitted by the NYSE, the AMEX and the NASD relating to audit committee requirements. Exchange Act Release Nos. 34-42266 (SEC Rules), 34-42231 (NASD), 34-42232 (AMEX) and 34-42233 (NYSE). These new rules adopt to some extent the recommendations contained in the Blue Ribbon Committee Report, although the new rules repudiate some of the more extreme recommendations in that Report.

2. NEW RULES
The primary aspects of the new rules that will most likely impact the liability exposure of audit committee members are summarized below.

1. Annual Audit Committee Report. Beginning with the 2001 proxy season, proxy statements must include an "Audit Committee Report." That Report must include, among other things: (i) the names of each audit committee member, (ii) a statement whether the audit committee reviewed and discussed the audited financial statements and related judgments (including certain independence matters) with management and the outside auditors, and (iii) a statement whether the audit committee recommended to the full Board the inclusion of the company's financial statements in its SEC Annual Report.
2. Audit Committee Charter. Beginning with the 2001 proxy season, companies must include in their proxy statements a disclosure whether the audit committee has adopted a written charter. A copy of the charter must be appended to the proxy statement at least once every three years and the audit committee must review and reassess the adequacy of that charter on an annual basis. Among other things, the charter must specify: (i) the scope of the audit committee's responsibilities and how it carries out those responsibilities (including structure, processes and membership requirements); (ii) the audit committee's responsibility for receiving from outside auditors a formal written statement delineating all relationships between the auditor and the company, for actively engaging in a dialogue with the auditor with respect to any disclosed relationships, and for overseeing the independence of the outside auditor; and (iii) the audit committee's ultimate authority and responsibility to select, evaluate and if necessary replace the outside auditor.
3. Quarterly Review by Auditor. Independent auditors must now perform a quarterly review of interim financial statements included within a company's Form 10-Q, beginning in the quarter ending March 31, 2000. Although the major accounting firms already require similar reviews, the new rules most importantly require an auditor to discuss with the audit committee or its chair various aspects of this quarterly review on a timely basis. This review is required prior to filing of the Form 10-Q, but need not occur before the company announces its quarterly earnings. If earnings are announced prior to this review, the audit committee and the company obviously bear the risk that the subsequent review discloses inaccuracies or deficiencies in the previously disclosed earnings information.
4. Audit Committee Member Qualifications. Companies whose securities are listed on NYSE or AMEX, or quoted on Nasdaq, must certify that it has an audit committee of at least three members, all of whom must be "independent." The new rules include a more rigorous definition of "independence" for this purpose. For example, a director is not independent if he/she is employed as an executive of another entity where any of the company's executives serve on that entity's compensation committee or if the director is a partner in or a controlling shareholder or an executive officer of another business organization which transacts business with the company in an amount exceeding 5% of either organization's gross annual revenues or $200,000, whichever is more. In addition, each audit committee member must be financially literate (i.e., able to read and understand fundamental financial statements) and at least one member of the committee must have past employment experience in finance or accounting, a requisite professional certification in accounting or other comparable experience which results in the person having financial sophistication.

GREATER LIABILITY EXPOSURES
In adopting or approving these new rules, the SEC noted that "the concern most frequently expressed [by commentators with respect to the proposed rules] was that as a result of the new requirements to provide certain disclosures in a report, audit committees may be exposed to additional liability, and that consequently it may be difficult for companies to find qualified people to serve on audit committees." Ironically, the general counsel for the SEC opined to the Commission that the new rules would not increase, but rather decrease, the potential liability of audit committee members by creating new procedural requirements that would allow members to demonstrate more readily that they had satisfied their duty of care. Most legal commentators disagree with this optimistic prediction and instead believe that audit committee members face increased potential liability exposure as a result of these new rules if a perception of corporate financial misfeasance at any level within the company exists.

In an attempt to reduce concerns about increased liability exposures, the new rules contain a safeharbor for many of the audit committee disclosures required under the new rules. However, the safeharbor is quite limited in its protection, applying only to liabilities under the proxy statutes or Section 18 of the Securities Exchange Act of 1934. The safeharbor does not apply to claims under Section 10(b) of the Securities Exchange Act or to Sections 11 or 12 of the Securities Act (which are the most common bases for alleged liability in shareholder class action lawsuits against directors) or to state law breach of fiduciary duty claims.

By disclosing and committing to shareholders relatively high levels of financial oversight capabilities and responsibilities, audit committees and their members will obviously be the focus of plaintiffs whenever perceived financial irregularities or reporting deficiencies occur.

LOSS PREVENTION
As companies and their Boards address these new rules, various loss prevention opportunities will arise which may allow audit committee members to partially contain their new heightened liability exposures. Some of the suggested strategies include the following:

• The audit committee charter should be carefully drafted so that it is sufficiently detailed to clarify the roles and responsibilities of the committee without promising or implying that the committee will perform tasks that they do not have the ability, desire or resources to perform. Words such as "ensure," "guarantee," etc. should be avoided.
• The Board and the audit committee should implement procedures which allow the committee ready access to their own outside independent legal and financial experts when necessary.
• The audit committee could adopt disclaimer notices to other Board members which expressly recognize what the committee is not doing and what responsibilities the committee is not assuming. Similarly, both the committee and the full Board could adopt and publish express disclaimer notices which recognize their intent not to increase the liability risks of the audit committee members as a result of actions taken pursuant to the new rules.
• Audit committees should maintain open and regular communications with the outside auditors throughout the year. In particular, the committee should review the results of the newly required quarterly auditor review of the company's financial statements, and address any material weaknesses, reportable conditions or similar concerns identified by the auditors during their reviews. In essence, the committee should treat these quarterly reviews with the same level of diligence as the annual audit.
• The agenda for each audit committee meeting should be guided, in part, by the terms and scope of the committee's charter. The audit committee chair should refer to the charter in preparing for each meeting and the committee should periodically evaluate what it is doing in light of what the charter contemplates.
• The Board should evaluate whether current audit committee members meet the new "independence" and "financial literacy" criteria and should consider re-assigning to other committees those that do not.

D&O INSURANCE
To some extent, these new audit committee rules create an environment for audit committee members similar to the perceived director liability crisis environment that existed in the mid-1980s. Audit committee members are faced with new and potentially catastrophic personal liability exposure and, like 15 years ago, commentators are speculating that companies may find it difficult to recruit truly qualified audit committee members. Thus, the perceived adequacy of the company's D&O insurance program may play a critical role in determining whether a company will be able to maintain and recruit the type of high quality audit committee member which the regulators envision and which shareholders deserve.

The new rules do not directly implicate specific D&O insurance provisions which should now be amended. However, in order to minimize heightened concerns by audit committee members regarding the adequacy of their financial protection, companies and their D&O insurers may want to consider affording various types of extraordinary insurance protection for the audit committee members and perhaps all other independent directors on the Board. For example:

• Exclusions. The fraud and personal profit exclusions could be deleted with respect to claims against independent directors. Outside, independent directors typically have far less motivation and to some extent less opportunity to commit fraud or to obtain illegal personal advantage than the officers of the company and therefore deletion of these exclusions in most instances should not subject the insurer to unreasonable risk of loss (particularly if the exclusions are otherwise conditioned upon a final adjudication). Similarly, claims against independent directors could potentially be excepted from other appropriate exclusions, such as the insured v. insured exclusion.
• Retention. The D&O policy's presumptive indemnification provision (which applies the larger corporate reimbursement deductible to loss which the company is permitted and financially able to indemnify, but which the company fails to indemnify) could be deleted at least with respect to independent directors. Thus, if the company can but fails to indemnify the independent director for any reason, the independent director could access the D&O insurance protection without paying any deductible and the D&O insurer would have the responsibility through its subrogation rights to seek payment from the company of the indemnifiable loss.
• Limit of Liability. A separate, additional limit of liability in excess of the policy's standard limit of liability could be available only for independent directors, thus assuring the independent directors that some defined amount of insurance protection will be available for them regardless of the amount of covered loss incurred by insured officers or the company. This independent director-only coverage could be afforded either by endorsement to the standard D&O insurance program, or could be purchased through a separate and very broad excess DIC insurance policy covering only the independent directors.

Although many of the new rules do not become effective for up to another year, it is prudent for a company, its Board and its risk management department to begin now to understand, implement and react to these new rules and their potential liability consequences. Regulators and shareholders are and will continue to scrutinize audit committee performance more closely than ever. An audit committee and a Board of Directors can no longer simply point their fingers at a subordinate officer or outside auditor when financial reporting issues arise. Therefore, the company and the D&O insurance industry should be prepared to assure these more vulnerable audit committee members that quality and comprehensive financial protection truly exists to support their increased responsibilities and exposures.

PATENT INFRINGEMENT: NEW D&O OPPORTUNITY AND CONCERN?
As a result of recent developments regarding what is patentable, a number of companies and individuals are now obtaining patents on business processes or methods which traditionally have been considered not a proper subject matter of a patent. This development began in 1998 when the Court of Appeals for the Federal Circuit, which has exclusive appellate jurisdiction over patent cases, rejected 90 years of precedent and held that business methods or systems can be the subject of a patent as long as the system or method is sufficiently novel, is not obvious and can be adequately described. State Street Bank & Trust Co. v. Signature Financial Corp., 149 F.3d 1368 (Fed. Cir. 1998). As a result of that decision, a growing number of companies have been filing patent applications to protect various types of business methods and the U.S. Patent and Trademark Office has been allowing a growing number of such applications. For example, the following business methods have been recently patented:

• Automated healthcare payment and COBRA compliance methods;
• Internet frequent buyer programs;
• A "One-Click" electronic shopping method;
• A method for training janitors; and
• A method for generating customized web pages

Because a patent grants to its holder a monopoly over the claimed invention for 20 years, the patent holder can preclude others from using these patented business methods or processes. Although patent infringement litigation is not uncommon, the breadth of these new business-method patents suggests that businesses that obtain these patents may seek to prevent a large number of competitors from using the patented business method. Stated differently, a new generation of patent infringement litigation may be beginning which will target not just technology reliant companies, but virtually any type of company that utilizes some type of business method or process. Because the motivation for such litigation will likely be an attempt to obtain a competitive advantage or other strategic leverage over the defendant competitor, such litigation may name as defendants not only the competing company, but also its directors or officers in order to maximize the psychological impact and potential leverage from the litigation.

Historically, courts have ruled that directors and officers are not jointly liable with the corporation for patent infringement by the corporation. However, in recent years, courts have recognized a valid tort claim against directors and officers for authorizing or participating in patent infringement activity. According to these more recent cases, directors and officers are liable for the corporate infringement if the individuals are "conscious, moving forces" behind the corporation's patent infringement, even if the D&Os acted in reliance on the advice of competent patent counsel that the activity did not constitute infringement.

These developments suggest that companies should evaluate their critical business methods and systems to determine if they are patentable under this new criteria and if they violate someone else's new patent. Because recently passed patent reform legislation precludes liability for infringement by someone who used the patented method at least one year before the filing date of the patent, the risks and opportunities presented by patenting business methods primarily will relate to relatively new business methods or to relatively new competitors. In any event, patent law may become a far more critical area of legal concern, exposure and strategic opportunity for far more companies in the future than the technology reliant companies that have historically focused on this somewhat esoteric area of the law.