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.

1. The Company is financially insolvent, bankrupt or otherwise financially unable to fund the indemnification; or
2. The defendant D&Os are obligated to pay a settlement or judgment amount in a shareholder derivative lawsuit. In most states (including Delaware), Companies are prohibited from indemnifying for settlements and judgments in shareholder derivative lawsuits. This indemnification prohibition is intended to defeat the meaningless and circular result which would occur if the D&Os paid money to the Company in settlement of the derivative claim and then the Company paid the money back to the defendant D&Os as indemnification of the settlement amount.

A typical D&O Insurance Policy which affords both Side-A coverage for non-indemnified loss and Side-B coverage for indemnified loss is perceived by many to adequately respond to these two non-indemnifiable exposures. However, under certain circumstances such a typical D&O Insurance Policy may not afford the desired protection for the D&Os. In order to avoid that risk of inadequate D&O coverage, Companies should consider purchasing a Side-A only DIC Policy excess of its standard D&O insurance program. The following discussion identifies several areas where a D&O policy affording only Side-A coverage can provide greater protection to D&Os than a typical D&O insurance policy.

A. Broader Coverage
Despite the typically huge difference between the resources and insurance needs of the Company and the individual D&Os, traditional D&O Insurance Policies afford essentially the same coverage for D&Os under Side-A and for the Company under Side-B of the Policy. Only the amount of the Retention and perhaps the applicability of a couple of exclusions will vary depending upon whether the loss is indemnifiable by the Company. Because loss under the Side-B coverage is far more frequent and generally far more severe, the scope of coverage afforded under a traditional D&O Policy is crafted by the Insurers primarily with a view towards creating a reasonable underwriting response to a Company's D&O indemnification exposures.

Since the vast majority of Claims covered under a D&O Policy are indemnified by the Company, a Side-A only D&O Policy allows Insurers to afford much broader coverage terms than reasonably possible under a Side-B policy. For example, the following summarizes some of the many features in the newly-revised CODA Side-A Policy form that provide broader coverage protection than the typical D&O insurance policy form:

1. Scope of Coverage

• No presumptive indemnification (coverage applies without any deductible if the Company rightly or wrongly refuses, or is financially unable, to indemnify);
• Broad definition of "Claim" (includes not only civil or criminal judicial, administrative, regulatory or arbitration proceedings and investigations, but also oral or written demands and circumstances that may give rise to a Claim);
• Broad definition of "Company" (includes foundations, charitable trusts and political action committees controlled by a Company, and any Company as a debtor-in-possession);
• Broad definition of "Insureds" (includes not only directors and officers, but also (i) LLC managers, in-house general counsel, comptroller, risk manager and their functional equivalent in a foreign Company, and (ii) non-officer employees while co-defendants in a Claim with D&Os);
• Broad Outside Position coverage (blanket non-profit Outside Position coverage for any person serving in an Outside Position at request of Company; no exclusion for Claims by Outside Entity or its D&Os);
• Broad definition of "Loss" (expressly includes exemplary, punitive and multiple damages, which are more likely to be insurable because the Policy is issued and construed in Bermuda) (see July 1999 ACE Report).

2. Exclusions

• No express exclusions regarding: ERISA;
• • Section 16(b) of the Securities Exchange Act of 1934;
  • pollution;
  • prior litigation; or
  • defamation or other personal injury;
• Narrow "personal profit" and "remuneration" exclusions:
• • not applicable to Defense Costs;
  • not applicable to illegal "advantage";
  • applies only if adjudication or if illegal remuneration is repaid in settlement;
• Narrow "dishonesty" exclusion:
• • not applicable to Defense Costs;
  • applies only if adjudication of active and deliberate dishonesty committed with actual dishonest purpose and intent;
• Narrow "bodily injury/property damage" exclusion:
• • not applicable to derivative or class action claims by securities holders;
  • not applicable to pollution claims;
• Narrow "insured v. insured" exclusion:
• • applies only if the Claim is (i) by or on behalf of Company, and (ii) at least two current senior executive officers approve or assist in prosecuting the Claim;
  • not applicable to Claims by Insured Persons;
  • not applicable to Claims outside US or Canada;
  • not applicable after Parent Company has change of control;
• Narrow "other insurance" and "prior notice" exclusions:
• • apply only to the extent Loss is actually paid under other policy.

3. Miscellaneous

• Consent by CODA to defense counsel not required;
• Mandatory binding arbitration of any coverage dispute;
• Protective Policy renewal provisions:
• • for 3-year rolling policies, non-renewal notice by CODA must be given at least 2 years in advance;
  • renewal premiums determined pursuant to established rating plan;
  • renewal Policies include all coverage enhancements in any new standard CODA policy form;
• Policy non-cancelable except for non-payment of premium;
• If Parent Company acquired, Insureds entitled to 3-year run-off coverage for no additional premium;
• Notice of Claim to CODA required after in-house general counsel or risk manager of Company first learns of Claim;
• Policy may not be rescinded based upon the restatement of any financial statements of the Company included within the Application;
• Limit of Liability reinstated for Discovery Period if CODA non-renews;
• Protective bankruptcy provisions:
• • Policy not subject to automatic stay under bankruptcy law;
  • Policy proceeds first applied toward pre-bankruptcy Wrongful Acts;
• Difference-in-Conditions drop-down feature if CODA Policy is excess.

B. Financial Inability to Indemnify

If the Company becomes subject to a bankruptcy proceeding, the Company will likely be unable to fund its D&O indemnification obligation. In that circumstance, Side-A coverage will be the only financial protection available to the D&Os. If that coverage is unavailable, the personal assets of the D&Os will be at risk. An issue will likely arise in the context of the bankruptcy proceeding as to whether the D&O Policy is an asset of the bankruptcy estate. If it is, the automatic stay applicable to all assets of the bankruptcy estate will effectively freeze the policy and may preclude the D&Os from accessing the policy's proceeds.

Courts have disagreed as to whether a typical two-part D&O Insurance Policy constitutes an asset of the bankruptcy estate. Some courts have concluded the Policy is such an asset since the Policy affords coverage for the Company's D&O indemnification obligation. Although other courts have either ruled that the D&O Policy is not an asset of the estate or have ruled that the proceeds of the D&O Policy (as distinct from the Policy itself) are not assets of the estate, it is unclear what result will occur in any particular bankruptcy proceeding. This uncertainty is exacerbated if the D&O Policy also affords securities entity coverage since insurance policies that afford coverage for claims against the Company are typically considered by courts as assets of the bankruptcy estate.

In other words, under a typical D&O Insurance Policy, it is uncertain whether D&Os will have access to the Policy proceeds in the event of the Company's bankruptcy. However, that uncertainty is virtually eliminated under a Side-A only Policy since the Company is not an insured under that type of Policy, either with respect to its D&O indemnification obligation or with respect to securities claims against the Company. Stated differently, a Side-A only Policy can afford more predictable and potentially more protective coverage for D&Os in the event of the Company's bankruptcy.

C. Derivative Settlements/Judgements

Shareholder derivative lawsuits can be filed either in tandem with a shareholder class action lawsuit or as an isolated lawsuit. A typical two-part D&O Insurance Policy will respond to a settlement or judgment in either type of lawsuit, provided that the class action lawsuit (or any other Claim in the same Policy Period) does not exhaust the available limit of liability before the potentially non-indemnifiable derivative lawsuit settlement is paid. Because tandem class action and derivative lawsuits are frequently settled at the same time, prior exhaustion of the limit of liability is typically not a problem.

However, there is now a somewhat greater tendency to settle the larger class action lawsuit quickly, even if, for whatever reason, the tandem derivative lawsuit cannot be settled at the same time. For example, in one recent case, a company elected to settle a securities class action within a few months after its filing for more than $100 million (thereby exhausting the D&O Policy's limit of liability) even though the tandem derivative lawsuit could not then be settled for a reasonable amount. Approximately 18 months later, the tandem derivative lawsuit was settled for approximately $15 million. Fortunately for the D&Os, the company maintained an excess Side-A only D&O policy, which was not implicated in the indemnifiable class action settlement and therefore was available to fund the non-indemnifiable derivative settlement.

In those types of situations where the Company wants to settle a large class action but cannot yet settle the tandem derivative lawsuit for a reasonable amount, the Insureds are faced with a difficult dilemma under a standard two-part D&O insurance program. On the one hand, the Insureds can use the proceeds from the D&O insurance program to fund the class action settlement, thereby creating potentially significant benefits to the Company by eliminating the risks, distractions and adverse publicity associated with such a potentially catastrophic claim. However, such a strategy may leave the defendant D&Os with inadequate insurance protection for a subsequent non-indemnifiable derivative settlement. On the other hand, the Insureds can preserve the D&O insurance proceeds for a subsequent derivative settlement. However, such a strategy would deprive the Company of a large source of funds to pay the early class action settlement.

Many standard D&O insurance policies with securities entity coverage now contain a Priority of Payment provision which, depending on its language, usually mandates that all proceeds under the Policy be maintained for the non-indemnifiable derivative settlement, regardless of the size of the D&O insurance program, the amount of the class settlement or the likely amount of the subsequent derivative settlement. Thus, if the Company desires or is compelled to settle the class action early, it must fund the entire settlement amount out of its own assets and seek reimbursement under the D&O Insurance Policy for the covered Loss at some unknown subsequent date when the derivative lawsuit is settled. As demonstrated by the case described above, this result can require the Company to advance tens of millions of dollars, if not hundreds of millions of dollars, to resolve the class action, even though much or all of such a settlement is otherwise covered under the untapped D&O insurance program.

From the perspective of the defendant D&Os, this dilemma is especially frightening. If the current Company management is not sympathetic to the defendant D&Os, the Company may choose to access the D&O insurance program to fund the indemnifiable class action, thereby leaving the defendant D&Os with little or no insurance to settle the subsequent non-indemnifiable derivative lawsuit. Although the defendant D&Os would likely object to that use of the Policy, at best a difficult controversy will exist which will create uncertainty as to the extent of the defendant D&Os' financial protection under the Policy.

These problems can be greatly mitigated, if not eliminated, by the purchase of Side-A only DIC coverage excess of the Company's standard D&O insurance program. Such excess coverage assures the existence of insurance protection for non-indemnifiable claims against D&Os even if the rest of the D&O insurance program has been exhausted by indemnifiable or entity losses. In addition, such coverage may allow for deletion of the Priority of Payment provision in the underlying D&O policies, thereby enabling the Company to access the underlying D&O insurance proceeds for an early settlement of the class action even if the tandem derivative lawsuit is not settled at the same time. Obviously, the larger the limits for this Side-A only coverage, the greater the likelihood that this type of insurance program structure will accomplish the goals of both the Company and the insured D&Os.

NEW INSIDER TRADING RULES
In August 2000 when the Securities and Exchange Commission adopted the highly publicized Regulation FD which mandates simultaneous "fair disclosure" to all investors (see October 2000 ACE Report), the SEC also adopted new Rules regarding insider trading by directors, officers and others. Although over-shadowed by Regulation FD, these new Rules are quite important in defining the scope of improper insider trading and how D&Os should handle routine trades. Companies wanting to actively maintain effective securities loss prevention programs should amend their insider trading policies to reflect these new Rules and should inform their directors and officers of the protective opportunities created by the new Rules.

The primary focus of new Rule 10b5-1 (which became effective October 23, 2000) is to formalize the SEC's long-standing position that a person may be liable for illegal insider trading if that person trades while in knowing possession of material non-public information, whether or not the person used the information for trading purposes. Several recent federal courts of appeal decisions rejected that SEC position, holding that the person must not only possess but also use the material non-public information in making the trading decision. Those recent decisions apparently convinced the SEC that it should issue for the first time formal Rules defining illegal insider trading.

The new Rule creates a presumption that a purchase or sale of a security by an insider is on the basis of material non-public information (and therefore illegal) if the person making the purchase or sale was aware of the non-public information at the time of the transaction. This presumption can be rebutted (and personal liability avoided) only if the inside trader proves that before becoming aware of the non-public information, he or she had (i) entered into a binding contract to make the trade, (ii) instructed another person to make the trade for his or her account, or (iii) adopted a written plan for trading pursuant to which such trade was made. Under the Rule, such a contract, instruction or plan must have either (a) specified the amount to be purchased or sold, the price (which may be either a particular dollar price or the market price on a particular date or a limit price) and the date on which the securities were to be traded, or (b) included a written formula or computer program for determining the amount, price and date, or (c) precluded the trading person from exercising any influence over how, when or whether to effect purchases or sales.

This "safe harbor" applies only to claims seeking a disgorgement of the insider's illegal trading profit and does not directly apply to shareholder class action lawsuits against directors and officers arising out of a sudden drop in the company's stock price. Plaintiffs in securities class actions typically allege that the defendant directors and officers traded in the company's stock during the class period and then use the existence of that trading to show the defendants had a motive to artificially inflate the stock price. Class action plaintiffs do not seek to disgorge the defendants' insider trading profits. Therefore, the safe harbor in new Rule 10b5-1 does not directly apply to the defense of those securities class actions.

However, a trading program consistent with new Rule 10b5-1 may be helpful in defending a securities class action lawsuit against directors and officers who traded during the class period. By adopting the new Rule, the SEC is acknowledging that trading by insiders consistent with the "safe harbor" is proper and therefore should not constitute evidence of securities violations. Plaintiffs will likely argue, though, that even under a trading program pursuant to new Rule 10b5-1, directors and officers may still know that shares owned by them will be sold and therefore those directors and officers arguably still could be motivated to inflate the company's stock price in order to benefit from that prearranged sale. Stated differently, although compliance with the new Rule's trading program safe harbor will not hurt the defense of a securities class action, it is unclear whether in many cases it will materially help the defense. Unquestionably, though, a safe harbor trading program will help prevent liability in claims by the SEC for illegal insider trading.

It is likely that securities brokers and other financial advisers will be aggressively contacting directors and senior officers with information about the new Rule in order to convince those directors and officers to enter into a safe harbor trading program with the broker or financial adviser, such as setting up blind trusts, discretionary accounts, hedging strategies, etc. Companies should consider a proactive approach to this topic, providing their directors and officers with objective information and advice regarding the value and necessary terms of such a prearranged trading program.

Corporate general counsel should find this new Rule particularly helpful. Most public companies currently have pre-established trading windows in which directors and officers are normally permitted to trade in the company's securities. However, the company's general counsel usually has the obligation under a trading window program to monitor the flow of material non-public information and, when appropriate, to shut the window and prohibit trading by directors and officers. This is a rather subjective responsibility that at times can be politically and personally challenging to the general counsel, particularly when a senior officer or director strongly desires to trade during a period when the general counsel has subjectively "shut the window." A trading program consistent with the new Rule eliminates this subjectivity and takes the general counsel off the "hot seat."