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Your D&O insurance and the changing legal landscape

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Two distinct types of public companies are facing changes in the legal landscape that elevate personal liability risk for officers and directors. Unfortunately, D&O coverage is typically not maintaining an effective pace.

The two legal environment changes that pose the greatest D&O coverage challenges involve near opposite ends of the public company spectrum. First, emerging and growth-stage companies funding the growth by filing Registration Statements with the SEC for a public offering of securities are finding that a growing number of claims are not covered in the eyes of insurers. Secondly, established companies with a pension plan or other defined benefit plan face proposed legislation that will fundamentally change the accounting treatment of the plans by moving them onto a company's financials. The resulting drain on corporate balance sheets should be expected to provide a large source of new litigation fodder. There lie substantial insurance coverage obstacles unless properly anticipated and addressed.

Registration liability

Plaintiff lawyers increasingly rely on Section 11 of the 1933 Securities Act to recover damages allegedly due to a misrepresentation in the sale of securities under a Registration Statement. This is an attractive area for the plaintiff bar because the potential for a high damages number is coupled with a relatively low standard of proof required.

One of the legal remedies increasingly pursued involves restoring the plaintiff to the condition they were in prior to the securities offering. This remedy involves restitution and disgorgement of "ill-gotten gains" through misrepresentations. Some jurisdictions view it as against public policy to insure this remedy if successfully proven.

It is no surprise that there are insurers who view this as a windfall, while others take the position that such remedies are not covered "loss" within their policy definitions. Everyone in the industry acknowledges that policyholders expect these claims to be covered; however the fact remains that a large number of insurers will deny them.

Oddly, many of the insurers that have pursued these coverage denials are willing to modify their policy language to eliminate this maneuvering. Learning the issues and undertaking a very careful review of the proposed insurance policy language has become more critical than ever. Too many companies are learning of competitive weakness in their coverage after the claim has been turned in.

Pension accounting reform

If passed as proposed, the pending legislation changing the accounting treatment of pension plans will wipe billions of dollars from corporate balance sheets and force a whole new trauma on shareholder value of seasoned corporations with defined-benefit plans.

Although many corporations in recent history have opted to offer defined-contribution plans to employees as opposed to defined-benefit plans, over 3.5 million California workers are affected by pension legislation through 3,694 defined-benefit plans, according to the Pension Benefit Guarantee Corp.

Under the new accounting methods, companies will be required to replace their estimated pension values with current, market-based numbers and move these values from the relative obscurity of financial statement footnotes directly onto the balance sheet.

The timing is particularly bad in view of the enhanced regulatory scrutiny -- the PBGC budget is poised for exponential growth -- and more importantly, the auditors must sign off on the valuations and process. Auditors are understandably very risk-averse in the post-Anderson world with the new PCAOB enforcement division hunting for examples of perceived abuse to punish.

In other words, the audit firms must be made very confident that enough money has been set aside on the balance sheet to fund the present value of the pension obligations or they will not sign off. Even companies with an over-funded pension could suffer a loss when required to shift plan expenses from footnotes to their balance sheet.

The drain on corporate balance sheets will have a predictable impact on diminished shareholder value. The plaintiff bar is ready. The renowned plaintiff lawyer Bill Lerach stated two years ago that the wave of securities litigation over pension under-funding will be "the next big thing."

This legislation would be a catalyst. All D&O policies have ERISA exclusion. Most of these exclusions are too broad and would fail to cover securities litigation relating to plan under-funding. These follow-on claims are D&O claims that can and should be effectively addressed under a D&O policy.

Even without the legislation, retirement plan-related litigation is skyrocketing. More notably, the range of individuals and entities sued in ERISA cases continues to expand beyond ERISA-defined plan trustees and administrators. Often targeted are members of the board of directors and corporate officers. A company's fiduciary liability coverage must be expansive enough to defend those targeted.

Management with an upcoming Registration Statement or with one filed within the last three years, and management with a Defined Benefit Plan are encouraged to invest the time to understand these issues and to assure that their insurance coverage is tailored to fit the exposure. Nothing "off the shelf" should be expected to fit.

Learning of competitive deficiencies in coverage after having been served with litigation is the wrong time.

Niedernhofer is a principal with Barney & Barney and is team leader of the Executive Risk Practice. Comtois is an account executive in Barney & Barney's Executive Risk Practice. For more information, call (858) 587-7144 or e-mail johnn@barneyandbarney.com.>

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