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Options Backdating And D&O Coverage

Date

December 1, 2006

Read Time

5 minutes

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Current trends indicate a preponderance of derivative actions, but with a significant increase in class actions as well. As of September 29, 2006, 83 issuers have been involved in civil litigation related to options backdating. Of these 83 cases:

  • 19 of 83 (23%) involve securities fraud class actions – this is a 137.5% increase (from 8 to 19) since June 30, 2006
  • 80 of 83 (96%) involve derivative litigation
  • 16 of 83 (19% ) involve both class action and derivative lawsuits
  • 6 of 83 (7%) involve ERISA or 401(k) litigation

Increases in shareholder litigation can be expected in the future. Law firm Lerach Coughlin Stoia Geller Rudman & Robins claims to be bringing 34 new cases on behalf of 350 to 400 pension funds, including funds in Europe and Asia, and they have estimated damages in the tens of billions of dollars. They intend to recover not only the difference in stock price between the level where the shares were trading when the options were actually exercised and the backdated price, but also want to take into account the compensation programs and plans that were approved for executives before shareholders knew about the backdating issues, as well as the diminution in market capitalization.

The plaintiffs’ bar is also purportedly looking at claims against lawyers, accountants, auditors, and other service providers who were allegedly assisting issuers with options backdating.

A June 7, 2006 letter from California Public Employees’ Retirement System (CalPERS) to 24 issuers urged their directors to conduct an independent investigation into backdating allegations, and publicly disclose all findings from both internal and external investigations. On September 15, 2006, CalPERS announced that it had retained Lerach Coughlin to represent it as lead plaintiff in its options backdating class action lawsuit against United Health Group, currently pending in Minnesota federal court. Lerach Coughlin was also approved as class counsel in this matter.

II. D&O Implications

Options backdating litigation will cost substantial sums to both defend and resolve. Accordingly, it is of the utmost importance that the company, and any officer and director defendants, tender the claim to the appropriate insurance company for defense and indemnity.

Most Directors and Officers (“D&O”) policies are claims made policies. This means that the triggered policy, or, the policy obligated to respond to the claim, is the one which was in existence at the time the claim was made. So, for instance, if the backdating occurred in 2005 and a company learns of a claim for options backdating in January of 2006, and assuming its D&O policy is claims made, then the insurance company which issued the policy for the 2006 time period must be immediately notified of the claim.

The damages sought in the litigation, as well as the number of plaintiffs and whether a class action is alleged, should also be reviewed to determine whether a company’s excess or umbrella D&O carrier should be notified as well. The language of any excess insurance contract should be carefully reviewed as often the notice requirements are unique or specific and turn on the specific excess policy language. A company should never assume that the excess policy language is not triggered simply because the damage request does not seem excessive, as some policies require notice if the damage has the potential to reach the excess carrier’s limits.

Not all D&O policy language is alike and, thus, it is important for the company’s Risk Manager to negotiate the broadest possible language for the company. For instance, some D&O policies cover only negligent acts of the company representatives. These insurance companies might assert then, that options backdating is an intentional act and therefore not covered under the insurance contract. In addition, there are various exclusions which may apply as well to preclude coverage.

D&O policies may also provide insurance to three different groups: (1) the directors and officers; (2) the company to reimburse it for funds it is required to pay for the directors and officers; and (3) the company itself. The key point is that typically, the liability limits in the policy apply to all three of these groups and must be enough to pay for defense fees and expenses, as well as judgment or settlement of the claim or litigation. For instance, if a company has a D&O policy with liability limits of $5 million and options backdating litigation is filed against both the company and its directors, there will be ONLY $5 million dollars available to pay for all defense fees and expenses AND any judgment or settlement. That is a relatively shallow reservoir of available funds to assist a company and its officers and directors against such potentially significant litigation.

Often a company prefers to chose its counsel to defend it against litigation. Many times D&O policies will require that the insured company and officers and directors chose counsel from a preapproved list. However, it is important to note that the “preapproved list” can often be negotiated with the carrier prior to the issuance of the policy. Even when this is not done ahead of time, and depending upon the policy language, the company can negotiate with its carrier for the counsel of its choice. But, if this is important to the company, as it typically is in these types of cases, then, the company should negotiate this matter with the carrier before a loss occurs.

Levenfeld Pearlstein LLC stands ready to assist you and your company in both your Risk Management and Insurance matters and in defending your company against option backdating and other securities claims.


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