Here’s another verse of those bad old “restatement blues.”

You’re a CFO of a prominent public company that’s materially misstated its earnings and now must issue a restatement. Besides the prospects of a plummeting stock price, possible accounting fraud by your underlings, and suits by angry shareholders, you now face another woe.

Your insurer goes to court to pull your directors’ and officers’ liability insurance policy out from under you, depriving you and your company of the very coverage that could buffer you from the cost of those suits.

“Certainly, whenever a company has a restatement, they are vulnerable to arguments of rescission by D&O carriers,” says Wayne E. Borgeest, a lawyer with Kaufman, Borgeest and Ryan in New York City, who primarily works with D&O carriers on their policies.

Speaking at a seminar on the liability of corporate board audit committees held earlier this week by Marsh, the biggest insurance- brokering firm, Borgeest said he has two clients, whose names he wouldn’t reveal, who sued to rescind their clients’ policies.

“The [insured] companies admitted their financial statements were wrong, and the insurers rely on those financial statements” to underwrite coverage, he said.

Borgeest tells CFO.com that while an insurer could unilaterally rescind a policy and give back the premium, insureds usually don’t accept that. Instead, a carrier often sends a letter notifying the insured of the take-back and then heads straight for court.

New Securities and Exchange Commission rules adopted late last year put audit committee members at an increased risk of losing their D&O coverage, Borgeest adds. Members of audit committees, which under the SEC rules, must consist of at least three outside directors, are “now a couple of steps to being insiders” in terms of the companies’ financial information, he says.

The audit committee now has to provide a report in the corporation’s proxy statement confirming that the audit committee recommended to the full board whether or not the audited financial statements should be included in the 10K, he notes. “That would put them in peril….[They] start to look like people with whom we might have a rescission argument.”

Placing higher standards on audit committees to verify financials opens them up to shareholder suits if things go badly or results are misstated, says Jack S. Flug, a managing director with Marsh in New York City. In addition, insurers could very well go to court to rescind policies, argues Flug.

“I’m not suggesting a rash of rescissions going forward,” the broker says. Instead, Flug feels that changes like the new audit committee rules and the SEC’s Regulation FD (“Fair Disclosure”) create opportunities for D&O insurers to look more closely at rescinding coverage.

The problem, however, is: Who in their right mind would consent to be an audit committee member if D&O coverage could be removed, making the member vulnerable to the costs of shareholder suits?

With the threat of rescission hanging over members’ heads, says Flug, “companies might find it hard to recruit truly qualified audit committee members.”

Still, “it’s a drastic measure for an insurer to go through a rescission order,” says Michael Mitrovik, president and chief executive officer of Axcelera Specialty Risk in New York City.

It might, in fact, be tough for an insurer to make a case for rescinding a company’s D&O coverage after a restatement if the insurer itself hasn’t been vigilant about its client’s financials.

Obviously, says Mitrovik, if a company went without insurance for 10 years and then bought coverage two months before making a claim, the insurer would have a good case. The carrier might argue, for instance, that the company knew a lot more about its financial problems than it was letting on.

But if an insurer had been at risk for several years and not asked for information, it would be hard for the carrier to win a rescission.

One solution to the threat of a company’s audit committee losing its coverage might be to buy an Audit Committee Liability Insurance Policy, suggests Borgeest. Created by Marsh and underwritten by North American Capacity Insurance Co., a subsidiary of Swiss Re, the policy states that it may not be rescinded unless there’s a final determination that the company or policyholders committed fraud. The policy, which has a coverage limit of $50 million for the entire audit committee, covers only the committee members, not the company itself.

Besides the threat of outright policy withdrawal, companies are also facing a general tightening of the D&O insurance market, making affordable and adequate coverage tougher to come by. Insurers are claiming that the explosion of policyholder suits has rendered their past D&O pricing obsolete.

“I don’t think there’s any profit in this book anymore. It’s underpriced. Reinsurance is drying up,” says Mitrovik, a former AIG executive.
For the story on his company’s efforts to provide insurance to cover pending lawsuit liabilities, click here

“I don’t think the market can persist with the kind of losses we’ve been seeing,” he adds.

Mitrovik says he’s hoping for a “Greenspan solution” for D&O pricing problems akin to the “soft landing” Fed Chairman Alan Greenspan envisions for the U.S. economy. The situation most likely won’t resemble that of the mid-1980s, when there were wholesale cancellations of policies and renewals of coverage at much higher prices, he contends.

Mitrovik also feels that the inevitable price hikes will come more gradually, giving risk managers time to explain to CFOs why their companies’ D&O insurance costs will rise.

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