FINANCIAL INSTITUTION DIRECTORS & OFFICERS: THE LIABILITY DEBATE CONTINUES
The frequency of claims against directors and officers of financial institutions has decreased significantly in the last year, due in large part to the improved financial health of the United States banking industry. However, the liability environment in which financial institution directors and officers ("D&Os") now serve remains quite problematic as a result of the many statutes and regulations adopted during the savings and loan crisis in an attempt to prevent a recurrence of that disaster.
The D&O liability statute which has fueled the greatest judicial debate and legislative response is Section 1821(k) of the Financial Institution Reform, Recovery and Enforcement Act ("FIRREA"), which created for the benefit of the FDIC a new federal cause of action against D&Os for gross negligence. This new cause of action can be a significant weapon against D&Os because, as a federal statute, it pre-empts any state law which may otherwise provide protection for the defendant D&O, including such defenses as the business judgment rule and reliance on the advice of others. However, in some states this new federal law ironically can be beneficial to D&Os if it pre-empts harsher state law claims. This pre-emption question has been one of the most frequently litigated issues under FIRREA since its enactment in 1989.
Under the law of some states, D&Os may be liable for misconduct constituting "simple negligence", unlike the higher "gross negligence" federal standard. In those states, the FDIC has ignored the new federal cause of action and has sued D&Os under the easier-to-prove state cause of action. The defendants have responded by arguing that the federal "gross negligence" cause of action pre-empts the state "simple negligence" claim and therefore the FDIC may not assert the broader state law claim. Although some courts initially agreed with the defendants' argument, the majority of decisions now permit the FDIC to choose either the state or federal cause of action when suing financial institution D&Os.
Fearing qualified D&Os might he unwilling to hold office in light of the "simple negligence" standard of conduct, the financial institution industry over the last eighteen months refocused their efforts concerning this issue away from the courthouse and towards the statehouse. At least seven states (Kansas, Louisiana, Nebraska, Oklahoma, South Dakota, Texas and Utah) have now enacted remedial legislation which protects financial institution D&Os from liability unless their misconduct constitutes "gross negligence". The FDIC has retaliated with lawsuits alleging that these new statutes are unconstitutional and invalid. No decisions have yet been rendered in those lawsuits.
This judicial debate and, to a lesser extent, the responsive state statutes have received much publicity in recent months, suggesting the outcome will materially affect the liability exposure of financial institution D&Os. In reality, though, it is doubtful that D&Os will face significantly different exposure with or without the adverse pre-emption rulings or the new protective legislation. The distinction between "simple negligence" and "gross negligence" is more theoretical than real. Judges and certainly juries likely will determine a D&O's liability, if any, based on a general reaction to the defendants' conduct. Regardless of the technical standard of conduct to be applied, if the facts sufficiently offend the court, liability will exist; if the facts are not offensive, no liability will exist.
Financial institution D&Os should not become excessively alarmed by the federal regulators' recent pre-emption victories or excessively comforted by the recently-enacted remedial statutes. Both developments tend to distract attention from the more important fact that directors and officers of any financial institution, regardless of what state or federal law applies, face extraordinary liability exposure under a myriad of statutes, regulations and judicial authorities. See the April 1993 ACE Report for a discussion of some of the more troublesome federal statutes and regulations creating that exposure.
ACE ACQUIRES CODA
Corporate Officers & Directors Assurance, Ltd. ("CODA"), a unique underwriter of directors and officers ("D&O") liability insurance, was acquired by ACE as of November 1, 1993. CODA will operate as a wholly-owned subsidiary of ACE, maintaining its separate identity and creative underwriting philosophies.
CODA was formed in 1986 by 53 United States corporations in response to the then limited D&O and excess/DIC insurance market and writes primary and excess D&O and ERISA fiduciary liability insurance. The D&O coverage insures only non-indemnified claims, unlike virtually all other D&O policies in the market which also insure the corporation to the extent it indemnifies its directors and officers. The CODA policy contains relatively few coverage restrictions applicable to this discrete type of claim, thus providing broad insurance protection for directors and officers when corporate indemnification protection is unavailable for any reason.
ACE and the former principals of CODA believe the acquisition will enhance the ability of both ACE and CODA to provide quality and needed insurance products throughout the world. ACE expects to adhere generally to the underwriting guidelines and premium structures developed by CODA, thus affording a stable and predictable insurance market to a wide variety of corporations. As a result of the CODA acquisition, ACE is now capable of offering up to $75 million in primary and excess D&O insurance coverage, far surpassing the capacity of any either market.
From ACE's standpoint, the acquisition allows greater underwriting flexibility to respond quickly to unique circumstances or requests. In addition, the significant financial resources of ACE are now available to support CODA in the unlikely event additional funding is necessary.
In part because ACE has managed CODA since 1986, ACE expects that existing policyholders generally will see little change as a result of the acquisition. According to Walter A. Scott, Chairman of ACE:
"It's largely business as usual from our standpoint, although the market is reacting quite favorably to the transaction as evidenced by a noticeable increase in submissions to CODA since October I. We expect the primary area of change to be in our ability to respond better to our insureds' ever-changing needs."
ALLOCATION: CAN THE PROBLEM BE ELIMINATED?
Allocation is the most difficult coverage issue to resolve in most D&O claims. The issue arises whenever defense costs or settlement amounts are attributable to both covered and uncovered claims against insured directors and officers or to both insured directors and officers and others, including the corporation. For example, many D&O lawsuits name as defendants both the corporation and certain D&Os. If one law firm represents all defendants or if a single amount is paid to settle the claims against all defendants, the D&O insurance policy will respond only to that portion of the defense costs and settlement amount allocable to the insured claims against the defendant directors and officers.
The necessity to allocate in most D&O claims is clear and not contested. However, there is great uncertainty and disagreement concerning how to allocate. The insureds and the insurers typically disagree as to the appropriate methodology and relevant factors. Courts have provided little practical guidance to assist the process.
In recent years, the environment in which the allocation issue is addressed by insureds and insurers has become increasingly hostile. Insureds generally have developed higher allocation expectations and have become more sophisticated and aggressive in their arguments. Insurers generally have become more defensive and less flexible in their positions. At best, important relationships between insureds and insurers are strained and frequently fractured. At worst, protracted and expensive coverage litigation ensues. If the allocation problem is not constructively addressed, the long-term existence of the D&O insurance industry may be jeopardized.
Within the last year, some D&O insurers introduced two different policy amendments to partially resolve allocation issues in advance. One approach, first offered by Chubb in early 1993, identifies in the policy a predetermined allocation percentage which applies to any allocation of defense costs (not settlements or other loss), regardless of the facts of each claim. A significant (e.g. 25%) additional premium is typically charged for a relatively high (e.g. 80%) pre-determined allocation percentage to the covered loss.
It is, of course, difficult for both the corporation and the insurer to evaluate in advance whether the benefits of this provision justify the cost. The insurers will be spreading over numerous policies their risk that the additional premium is inadequate, while the corporation's risk is focused solely on the one or two claims which may be made under its policy.
The second approach, first introduced by National Union in late 1993, extends D&O coverage (subject to a co-insurance clause) to claims against the corporation for "open-market" securities claims, thereby eliminating the need for allocating loss between the corporation and the defendant D&Os. A significant (e.g. 120%)) additional premium is typically charged.
Unlike the predetermined allocation approach, the entity coverage approach addresses both defense costs and settlement allocation, although it applies only to allocation between D&Os and the corporation in one type to claim, whereas the pro-determined approach applies to all types of allocation in all types of claims requiring an allocation. The terms of the entity coverage endorsement are rather complicated and lengthy in comparison to the simpler and briefer pre-determined allocation endorsement. Insureds should both carefully review and discuss with the insurer the entity coverage endorsement terms to fully understand the extent of coverage afforded to the corporation.
Neither of these two approaches fully eliminates the allocation problem, although both are constructive steps towards that end. The ultimate solution may be a pre-determined allocation provision which applies to all allocable loss on account of all claims. Besides being relatively simple and easily understood, such a provision would eliminate allocation disputes without unnecessarily transferring corporate risk to the insurer, thus presumably allowing for a premium less than would apply to full entity coverage.
For this or any other comparable solution to become feasible, the views of both insureds and insurers will need to further mature. Neither of the currently available approaches has received general market acceptance because the insiders and the insurers have widely different opinions as to the appropriate cost and resulting value of the provision. Through further experience and analysis, these differing opinions may tend to converge towards a middle position. Unless and until that occurs, allocation will remain the most difficult, contentious and potentially destructive D&O claims issue.
BEWARE OF SECURITIES ANALYSTS AND REPORTERS
In recent months, complaints against directors and officers ("D&Os") alleging federal securities law violations have placed greater emphasis upon alleged communications by the defendant D&Os with securities analysts and reporters. This pleading strategy by the professional plaintiff bar is intended to minimize their risk that the complaint will be dismissed by the court prior to discovery and a jury trial. Unlike claims based upon written disclosures in corporate documents, claims based upon oral disclosures to securities analysts and reporters typically create important fact issues concerning what actually was disclosed by whom. These important fact questions frequently persuade a court not to dismiss the claim before the fact issues are resolved by a jury.
Although allegations of improper oral disclosures can never be completely avoided, it is imperative that D&Os exercise extreme caution in discussions with securities analysts and reporters. As explained in the July 1993 ACE Report, meetings with or other oral disclosures to securities analysts and reporters should be carefully prepared, rehearsed and documented. Unfortunately, D&Os are at the mercy of analysts and reporters as to what is ultimately reported. At times, D&Os have been subjected to baseless litigation simply because a reporter misunderstood or erroneously reported comments of the D&O.
In December 1993, the Second Circuit Federal Court of Appeals issued an important decision which gives D&Os a new safe harbor when dealing with analysts and reporters. Because the Second Circuit includes New York and surrounding states where a large percentage of securities lawsuits are filed, the decision will directly benefit many corporations and their managers. In addition, the Second Circuit is frequently followed by other federal circuit courts with respect to the interpretation and application of federal securities laws, and therefore this decision may ultimately result in the adoption in other parts of the country of a broader protection for D&Os in this context.
The case involved claims under the federal securities laws against Time Warner and four of its officers for allegedly misleading the investing public by statements and omissions made in the course of Time Warner's efforts to reduce its debt. The complaint cited various newspaper stories and securities analysts' reports containing anonymous quotes or paraphrases of statements from alleged Time Warner insiders, and alleged that some as yet unknown agents of Time Warner made misleading statements in discussions with the reporter or analyst. The appellate court affirmed the lower court's dismissal of the claims based upon these anonymous statements, ruling that a plaintiff must identify in the complaint the speaker of the allegedly fraudulent statement.
An allegation that the unattributed statement was made by a yet unknown agent of the corporation is insufficient. By dismissing the claim, the court did not allow the plaintiff to use the lawsuit as the basis for seeking further discovery to identify the speaker of the allegedly fraudulent statements.
The court recognized that its decision could result in unfortunate effects, but concluded that such a risk was outweighed by the risk that the defendants would be unnecessarily burdened either by the expense of discovery or by a settlement "extracted under threat of such discovery":
"A scheming corporation could inflate its stock price through fraudulent statements whispered to reporters or analysts. If the reporters or analysts refuse to reveal their sources and if no one inside the corporation leaked to the stockholders or to regulators the identity of the speakers, the corporation would have perpetuated a fraud that could not be remedied by a private civil action under the federal securities laws. For several reasons, however, we have some confidence that this is not a sufficiently likely scenario to justify a rule that would permit a suit alleging unattributed statements to survive a motion to dismiss."
Although discussions with or other oral disclosures to analysts and reporters continue to be risky, this case provides significant additional protection to directors and officers if their disclosures are not specifically attributed to them. The loss prevention lesson from this case is that when dealing with analysts and reporters, D&Os should request anonymity whenever possible.