RESTATED FINANCIAL STATEMENTS: DANGEROUS LIABILITY AND INSURANCE CONSEQUENCES
The number of companies which are restating their financial statements appears to be at a record level. When a company announces a restatement, securities class action lawsuits are likely to be filed against the company and its directors and officers based upon alleged misrepresentations to investors. A less obvious, but equally troubling, consequence to restating financial statements is the potential loss of D&O insurance coverage based upon alleged misrepresentations in the application for insurance. Accordingly, directors and officers should have a general familiarity with the relevant issues and the dynamics creating this tenuous environment and should consider methods to minimize the risk of both liability and insurance issues that arise if a company restates its financial statements.
There are several reasons for the increased frequency of restatements. Probably the most important reason is the current attitude of the SEC, which is now applying a very rigid and strict interpretation of when a restatement is necessary. Largely because of this increased regulatory scrutiny, independent auditors are more conservative in deciding when a restatement is necessary and more insistent upon forcing a company to restate its financial statements if there is a reasonable argument the prior financial statements were erroneous.
In addition, the record level of merger and acquisition activity has resulted in a higher frequency of situations where an acquiring company or new auditors either take a fresh look at historical financial disclosures or adopt different accounting policies and practices for the consolidated company than existed before the merger or acquisition. Similarly, restated financial statements sometimes accompany a change of senior management at a company. New management may be motivated for compensation or other reasons to push back into prior fiscal periods adverse financial developments, thus creating the appearance of improved current and future performance. Also, as companies become involved in more unusual or complex transactions, the accounting issues involving those transactions can become equally complex and uncertain, thus increasing the potential for a subsequent determination that the initial financial reporting was done improperly.
Companies most vulnerable to this risk include high tech and other companies whose stock is hypersensitive to earnings; health care and other companies subject to substantial regulatory restrictions and oversight; companies with a significant international presence in countries with traditionally lax accounting discipline; and companies active in the merger and acquisition arena.
In light of the current propensity of the SEC and independent auditors to require a restatement even in "close" cases, particularly companies in these high-risk areas should be extra cautious and conservative regarding accounting practices, policies and procedures, not only within the central finance office but throughout the company. For example, unique accounting issues which are especially difficult or subjective in light of a company's business or industry (such as revenue recognition issues in many high tech companies) should be addressed through a uniform policy statement which is widely distributed to and understood by the relevant departments (both financial and otherwise) within the company.
A. Liability Exposures
By issuing restated financial statements, a company admits that its previously disclosed financial information, upon which investors relied, were materially in error. Persons who purchased the company's stock in the open market or in an offering while the erroneous financial statements were "alive" in the market typically have an attractive claim against the company and its responsible directors and officers for violations of the federal securities laws. Plaintiffs in this type of case usually allege, among other things, the defendants were at least reckless in allowing the issuance of materially false financial information, thereby deceiving investors into believing the company's financial condition and performance were better than they actually were.
In many instances, these claims are relatively easy for plaintiffs to prove. For example, SEC rules recognize that financial statements filed with the SEC that are not presented in accordance with generally accepted accounting principles ("GAAP") shall be deemed to be misleading or inaccurate. 17 C.F.R. § 210.4-01(a). Almost by definition, financial statements which must be restated are not in accordance with GAAP and therefore are per se materially misleading or inaccurate.
Unfortunately, this almost strict liability exposure can arise not only when the company clearly misstated its financial condition or performance, but also when there was considerable doubt as to how best to report certain financial information. In many restatement situations, it is unclear whether the revised financial information simply reflects a change in an estimate or reserve which was included within previously reported financial statements or whether the revised financial information reflects a previous error. If the revision only changes an estimate, the prior financial statements need not be restated, but rather the revision is reflected in the current financial statements. However, if the revision constitutes a correction of a prior error, the prior financial statements must be restated. In many cases, distinguishing between a change in an estimate and correcting an error is a rather subjective and difficult analysis. Conservative independent auditors may consider the change a correction of an error whereas management may believe the change simply reflects a revised estimate or reserve. In other words, restatements can occur and the enormous liability exposure resulting therefrom can arise even when the prior financial statements were prepared in good faith and with reasonable diligence and even when the company does not believe the prior financial statements were in error.
B. Insurance Issues
The restatement of financial statements will also likely create difficult D&O insurance issues. Although directors and officers typically appreciate the liability exposure associated with a restatement, the D&O insurance implications arising from a restatement are frequently not anticipated and therefore often surprise defendant D&Os when they seek coverage for the resulting securities class action lawsuit.
Even though original and renewal D&O insurance Applications today rarely include a warranty statement (which requires disclosure of facts or circumstances which could give rise to a future claim), both original and renewal Applications typically require submission to the insurer of the company's current financial statements. Those financial statements usually are considered a part of the Application and incorporated into the policy when issued. If those financial statements are later restated, the insurer may argue that the Application contained material misrepresentations which may allow the insurer to either exclude claims relating to the restatement or to rescind the policy as void ab initio. Like the plaintiff shareholders in the underlying claim, the insurer can persuasively argue that it relied to its detriment upon the erroneous financial statements. In essence, the insurer would argue that the company the insurer thought it was insuring was far different (from a financial standpoint) than the company it in fact insured.
In many states, including New York and California, an insurer is permitted to rescind an insurance policy if it relied upon misstatements of material fact by the insureds in the Application regardless whether the insureds either knew the information was in error or intended to mislead the insurer. Under that standard for rescission, virtually any restatement of financial information included within the Application could give rise to a rescission of the D&O policy, thus leaving the directors and officers uninsured for potentially enormous liability exposure relating to the restatement.
Under this circumstance, a typical Application severability provision in the D&O policy may afford no protection against the insurer's rescission of the entire D&O policy or against the denial of coverage for the entire restatement claims. Unlike an Application defense based upon a false warranty statement in the Application, an insurer may not need to prove either knowledge of the false financial information or intent to deceive the insurer in order to rescind or deny coverage based upon the false financial statements. Thus, a severability provision which simply states that knowledge of one director or officer shall not be imputed to any other director and officer would have no relevance to this type of rescission analysis.
To avoid this harsh result, insureds may argue that the insurer is required to prove intent or knowledge (notwithstanding applicable state insurance rescission law to the contrary) if the Application states that the person signing the Application declares to the best of his or her knowledge, after reasonable inquiry, that the statements contained in the Application are true. Under this language (which appears in some but not all D&O Applications), insureds may argue that the insurer must prove the falsity of this representation in addition to the falsity of the attached financial statements in order to rescind the policy or exclude coverage with respect to the restatement claim. In other words, coverage could be rescinded or excluded only for directors or officers who knew or should have known of the falsity of the financial statements. However, this declaration in the Application (if it exists at all) may be viewed by the insurer and by a court or arbitration panel as applying only to the answers and statements of the insureds in the Application form itself, and that misrepresentations in separate documents which must be submitted with the Application are not limited by the "best of knowledge" and "reasonable inquiry" provisions in the Application.
A second type of severability provision states that the Application shall be deemed to be a separate Application by each insured director and officer. This type of provision likely would provide no protection since the false financial statement would be deemed attached to each separate Application of each director or officer. Thus, the false financial statements would taint each director's or officer's Application.
Both the insurer and the insureds have legitimate interests and concerns to protect when considering the coverage ramifications to a restatement of financial statements. "Innocent" directors and officers do not want to lose insurance coverage, however the insurer does not want to insure a company far different than the company the insurer thought it was underwriting. In order to avoid surprising coverage positions in connection with claims arising out of a restatement, it may be beneficial for the insurer and the insureds to examine severability and Application language and to discuss at the time the policy is being underwritten the coverage implications and the applicability of severability concepts to a restatement of the financial statements submitted in connection with the Application.
UPDATE TO SECURITIES LITIGATION REFORM
It has now been more than two years since enactment of the Private Securities Litigation Reform Act of 1995 ("Reform Act"), which was summarized in the January, 1996 ACE Report. Based upon experiences over the past two years, it is now possible to begin to reach some preliminary conclusions regarding the ultimate effect of that landmark legislation. Unfortunately, as predicted in the prior ACE Report, the new legislation is not providing the intended relief and, ironically, it appears to have contributed to an increase in both the frequency and severity of federal securities law class action claims against companies and their directors and officers. Although Congress is expected to adopt, in 1998, legislation which is intended to close some of the "loopholes" in the prior legislation, that new enactment also appears unlikely to materially change the trend for increased D&O exposure in securities claims.
A. Frequency of Claims
During the first twelve to eighteen months following the December, 1995 enactment of the Reform Act, there was a noticeable reduction in the number of new securities claims filed. In hindsight, that initial decrease in claim frequency apparently was attributable to two factors. First, the plaintiffs' bar was evaluating the Reform Act in order to determine how best to continue their very profitable practice of leveraging securities class action lawsuits into large settlements. Second, by effectively eliminating the race to the courthouse, the Reform Act allows plaintiff lawyers to wait for up to one year after a significant stock drop before filing the shareholder class action lawsuit.
Beginning in early to mid-1997, though, a noticeable increase in securities class action filings began to occur, as the plaintiffs' bar became more adept at circumventing the Reform Act limitations and as the numerous cases which were being investigated by the plaintiffs' bar began to approach the one-year statute of limitations. In fact, the frequency of new shareholder class action filings in 1997 did not just return to pre-Reform Act levels, but rather significantly exceeded pre-Reform Act frequency. For example, the Securities and Exchange Commission ("SEC") recently released a report which concluded that 197 investor class action lawsuits were filed in Federal court under the Reform Act in 1997, compared with 158 investor class actions before the Reform Act in 1995 and 153 in 1993.
B. State Court Proceedings
As an initial response to the Reform Act, the plaintiffs' bar filed during 1996 a significantly larger number of shareholder class actions in state court, rather than Federal court. Because the Reform Act applies only to alleged violations of the Federal securities laws, a state court action alleging violations of state and common laws was intended to side-step some of the more troubling provisions in the Reform Act for plaintiffs. For example, plaintiffs can seek immediate discovery in the state court proceeding (even though discovery is stayed under the Reform Act while a defendant's initial motion to dismiss in pending), thus allowing plaintiffs to obtain sufficient information regarding the alleged disclosure violations to survive a motion to dismiss. Similarly, these state court proceedings arguably allowed the prosecution of aiding and abetting claims against secondary wrongdoers and potentially afforded a more sympathetic forum for the plaintiffs.
This trend was largely reversed during 1997, as plaintiffs became more comfortable with litigating under the Reform Act and became more disenchanted with state court litigation. Partly as a result of several initial state court rulings, plaintiffs realized that significant new procedural, jurisdictional and liability hurdles existed in the state court litigation.
The recently released SEC study confirms that conclusion by noting that of the 197 investor class action suits filed in Federal court in 1997, only twenty of those suits (i.e. 10%) included parallel state court actions. Other recently published studies likewise show a small percentage of cases filed in state court and a significant decrease in state court filings from 1996 to 1997.
Notwithstanding the reduction in state court securities class action filings when compared with 1996, Congress appears poised to enact new legislation in 1998 which would virtually eliminate securities class action lawsuits being filed in state court. The proposed legislation, which is reportedly supported by a majority of the Senate, the Chairman of the SEC, and a substantial number of House representatives, would provide that allegedly defrauded investors can bring a class action securities claim only in Federal court under the Federal securities laws, and not in State court. The proposed legislation also is likely to "clean up" certain provisions of the Reform Act, although those amendments are unlikely to afford any meaningful new protections to defendant directors and officers.
Perhaps most notable, the Senators sponsoring the new legislation have agreed to clarify in the bill's history that the Reform Act was not intended to require plaintiffs to prove intentional fraud, but rather was intended to preserve the "recklessness" standard which previously existed. This clarification was requested by the SEC and the plaintiffs' bar in light of several recent court decisions which have required plaintiffs to plead facts which give rise to a strong inference of intentional misrepresentations by the defendants, rather than mere recklessness. In other words, this clarification does not help, and in some respects may hurt, the ability to defend securities class action lawsuits.
C. Severity
The Reform Act has not resulted in smaller settlements. Ironically, just the opposite has occurred. Accordingly to a recent study in the Securities Class Action Alert publication, the average settlement value in securities class action lawsuits increased 18% from 1996 to 1997. Plaintiffs' lawyers contend that this increase in settlement values is justified because of the significantly greater investigation which now must be conducted by plaintiffs, as well as the increased expenses associated with litigating the many new issues which are arising under the Reform Act. In reality, the settlement value increases are more attributable to the simple fact that the plaintiffs' lawyers have used the Reform Act as an excuse to increase their settlement demands and the defendants ultimately have very little leverage to reject those increased demands since defendants are typically unwilling to try these cases.
D. Insurance
From an insurance standpoint, these developments are quite sobering. Settlements in securities class action lawsuits have historically represented by far the largest percentage of covered loss paid by D&O insurers. As that large loss exposure further increases in both frequency and severity, D&O insurers are likely to experience significantly less favorable results in the foreseeable future. That prediction is aggravated by the now common granting of securities entity coverage under the D&O policy, thus further increasing the insurers' liability for loss on account of securities claims. It is also unclear the extent to which this securities entity coverage will cause even larger settlements since the insured defendants have no economic incentive to negotiate a smaller rather than larger settlement and since the D&O insurer may have a limited ability to control or influence the settlement negotiation process.
Finally, a substantial backlog of securities cases appears to have developed over the last two years because of the increased filings and because these cases are now taking longer to settle. Once that pipeline is filled, more cases will begin to be settled and more loss payments will be made by insurers.
All of these developments (particularly when combined with Year 2000 exposures) suggest that the current soft market conditions may be coming to an end in the foreseeable future.