Risk Management

Backdating Flap Could Make Insurers Wary

Concerns about shareholder suits involving the stock option scandal could move D&O carriers to try to rescind policies.
Jaclyn MarieJuly 25, 2006

With some eighty companies reportedly being investigated by the Securities and Exchange Commission over the possible illegal backdating of stock options, a set of related worries is cropping up among senior managements: the emergence of backdating-related shareholder lawsuits and the possible dwindling of directors and officers liability insurance.

Concerned about the shareholder suits and the insurance claims that crop up whenever a widespread corporate scandal erupts, D&O insurers generally seek out ways to deny coverage, contends attorney Mark Keenan of the firm Anderson, Kill & Olick in New York, which represents corporate insurance policyholders.

While it’s tough to forecast how high the level of shareholder claims against companies and officers will rise in the coming months as more and more companies are named, Keenan predicts that, “given the creativity of plaintiffs’ trial attorneys, they’ll be quite a number of actions based on the backdating of stock options.” And with those actions will come quite a number of coverage exclusions by insurance companies, he says.

To be sure, backdating—the practice of adjusting stock option grant dates to an earlier time than they were actually granted in order to provide a windfall to the new option holder—isn’t illegal, per se. “Failure to accurately disclose how the options were awarded and accounted for is where concern lies,” explains Jennifer Sharkey, senior vice president in the Executive Risk Practice of William Gallagher Associates Insurance Brokers in Boston.

When it comes to disclosure, there are some hefty legal concerns. From the corporate point of view, says Steve Shappell, managing director of the legal and claims practice for the financial services group of Aon, the big insurance brokerage: “If you give me a stock option at $20, but at the time you give it to me, it’s really worth $40, that $20 difference needs to be treated as an expense and an income to the individuals that it’s being granted to.”

If that extra $20 doesn’t jibe with the expense the company had told its shareholders it was going to dole out, the new option holder potentially owes that money back to the company, according to Shappell, who noted that in such a case the company officials who approved the backdating could be liable to the shareholders.

More potentially onerous is the risk that the company’s stock traded artificially high as a result of the misrepresentations executives might have made on the company’s SEC’s filings. Then, when the announcement of the missteps is made, and the share price drops off a cliff, shareholders could well sue for fraud, he says. Such lawsuits, which are often class actions, can yield very high settlements.

Further, there’s the exposure to significant legal fees, which can represent a big cost for insurers and employers alike. That’s so because backdating and other high-profile governance litigation “tends to be handled by the country’s best lawyers, who charge the highest fees and rates,” says Wayne Borgeest, a lawyer with Kaufman, Borgeest and Ryan who represents insurers.

Faced with such potential liabilities, directors and officers worried about shareholder suits involving the backdating of stock options may well want to revisit their D&O insurance policies and their internal procedures to manage the risk, according to insurance experts.

Certainly insurers will be peering into the coverage companies currently have. “One of the first things insurance companies are going to do is … look back at all the information that companies provided to them to get the insurance,” Shappell says.

The consequences of such research could be financially devastating, resulting in the total rescission of a company’s D&O coverage. If an insurer discovers that a director or officer lied during the underwriting process, claiming falsely to have not had “any knowledge of any fact, situation or circumstance that might give rise to a claim,” says Borgeest, “the insurer has the right to rescind the policy in its entirety.”

More commonly, insurers trot out individual policy exclusions. Unlike a rescission, in which a carrier wipes out all of an insured’s coverage, an exclusion means that the company or the director or officer doesn’t get paid for that particular claim, Borgeest notes.

Insurers may try to deny coverage on backdating-related D&O claims, for example, by claiming the expiration of a statute of limitations. That’s because many of the cases pre-date the passage of Sarbanes Oxley in 2002, when the reporting window for the approval and granting of stock options was tightened, Shappell notes.

Many policies, for example, have a prior acts exclusion that requires a claimant to bring a claim within a certain number of years since learning about the alleged wrongful act, or within a specified time after the date of the alleged wrongful act, the broker explains. Insurance companies also will commonly deny coverage if a company performs “a deliberate, fraudulent, criminal act,” he adds.

But insurers can only invoke such exclusions after a court has rendered a “final adjudication” and found that someone is at fault, according to Keenan. As a result, corporate policyholders would do well to settle shareholder lawsuits before the case goes to court.

One of the main advantages of the “final adjudication” policy wording “is to enable directors, officers, and corporations to resolve litigation without admitting … or denying [an infraction],” says Keenan. “And that settlement cannot be used by the insurance company as the basis of an exclusion.”

To be sure, the backdating scandal is having a considerable impact on coverage negotiations involving D&O policies currently in effect. But it’s also bound to stiffen insurers’ backs when they underwrite new and renewed corporate coverage in the upcoming months.

For that reason, risk management executives need to have a plan to present to insurers the best case for their companies. “They need to do an excellent job of demonstrating that they are not a company that has been or will be caught up in the backdating of options,” says Shappell.

In doing that, they need to show underwriters what their companies are doing to police stock option grants and how seriously their boards’ executive compensation committees take this issue, according to the Shappell.

Companies currently being investigated with regard to the backdating of options are almost sure to see higher prices and less coverage in their upcoming renewals, of course. “Underwriters are asking questions and doing their due diligence on companies current and historical option-granting practices during D&O renewal meetings,” notes Sharkey.