United States: Options Backdating—D&O Insurance Issues

In recent months the U.S. Securities and Exchange Commission (SEC) and the U.S. Department of Justice (DOJ) commenced investigations into the practice of backdating options awarded to directors and officers. Investigators are exploring whether certain companies backdated options to a time when the share price was lower in order to maximize the recipient’s financial benefit while preserving favorable executive compensation tax treatment.

The practice itself may not be illegal, but the conduct surrounding the options is subject to scrutiny. Investigators are seeking answers to certain key questions: Did the company forge documents to accomplish the backdating? Did the company communicate the practice to shareholders? Did the company properly report the option grants in earnings reports? Did the company properly account for the backdated options in its tax returns?

The investigations have led to criminal and civil charges for securities fraud against several executives, and the list of companies and individuals facing investigations and potential charges is likely to grow. Shareholders also have filed suit against several companies concerning the practice, and additional suits are expected. The affected companies and individuals can and should turn to their director and officer (D&O) liability insurance to fund defense costs, settlements and potential judgments.

D&O policies cover "claims" for alleged "wrongful acts" against the individual directors and officers. However, many policies afford no coverage for direct claims against the company or only limited coverage for "securities claims" often defined as "alleging a violation of any federal, state, local or foreign regulation, rule or statute regulating securities," brought by the recipient of an offer to purchase or sell securities or a disgruntled security holder of the organization. As with most of the key coverage issues, policy language can vary, and the specific language of the company’s policy is crucial.

The nature of the proceeding also can be relevant to a coverage determination, as the typical policy definition of "claim" includes criminal and civil proceedings if commenced by a complaint, indictment or notice of charges. Civil investigations can trigger coverage once an individual is targeted clearly through a subpoena or other notice. If the investigation is at a preliminary stage and has not yet resulted in any of these formal notifications, however, the D&O insurer likely will not reimburse legal fees.

D&O policies cover "loss," usually defined broadly to include most damages, settlements, judgments and defense costs. Certain liabilities the company or individuals incur due to options backdating claims may not meet this definition. Such liabilities can include civil or criminal fines or penalties, taxes, punitive damages in jurisdictions where they are uninsurable, and restitution.

As a threshold matter, it is imperative that companies and individual directors and officers provide prompt notice to the D&O insurer of any options backdating claim. While policy language can vary, notice to the insurer within the policy period or immediately thereafter (30 to 90 days) is a condition precedent to coverage. Untimely notice can mean no coverage.

Even if no proceeding meeting the policy’s definition of "claim" exists against an insured (for example, if the policy only covers claims against the directors and officers, but the options backdating complaint names only the company), the company should give the insurer notice of circumstances that reasonably could give rise to a covered claim. Such notice can preserve coverage under the present policy should a covered claim based upon related allegations arise against the company’s directors or officers in the future. This is particularly important in light of speculation that D&O insurers will exclude options backdating claims from the coverage afforded by future policies.

D&O policies usually provide for reimbursement of defense costs and do not impose a duty to defend upon the insurer. The insured must therefore select and retain counsel, and then seek reimbursement from the insurer. The timing and frequency of required reimbursements can vary, but defense costs almost always erode the limits of coverage the policy provides.

Some major D&O insurers require the insureds to select counsel from a pre-approved panel, most commonly for securities claims.

Certain D&O policy exclusions may bar coverage for options backdating claims in certain limited circumstances. In particular, most policies exclude claims arising out of the gain of any profit or advantage to which the insured was not legally entitled; payments to insureds without previous approval of the stockholders; and deliberate criminal or fraudulent acts.

A key coverage issue is the evidentiary threshold an insurer must meet before denying the insured’s claim on the basis of these exclusions. The specific policy language is crucial, as some policies bar coverage only if the wrongful conduct and intent is established by "final adjudication," while other policies may support a denial if the wrongful conduct and intent are established "in fact." If the former standard applies, the insurer cannot rely upon the exclusions to deny coverage at the outset of the case, or at any time thereafter if the options backdating claim against the insured is settled short of final adjudication.

For purposes of these exclusions, the alleged knowledge of bad actors generally is not imputed to "innocent" directors and officers. This concept, known as "severability," also protects the company when certain individuals are alleged to have committed criminal or fraudulent acts, as only very senior management’s knowledge is imputed to the organization.

Most D&O policies state that the insurer relied upon the statements and representations contained in the application (including written materials submitted with the application), and all such statements and representations shall be deemed material to the risk the insurer assumes. To the extent the insured company provided information concerning its granting of options in the application, or it included such information in reports or filings provided to the insurer during the application process, under certain limited circumstances the insurer might claim that misstatements concerning option backdating were knowingly false and provide a basis for the insurer to rescind the policy.

Rescission is a drastic remedy generally disfavored by the courts, however, and a highly publicized rescission claim could have negative commercial consequences. Moreover, most policies contain "severability" language confirming that false statements by alleged bad actors are not imputed to "innocent" insureds, whose coverage cannot be rescinded. Consequently, it is unlikely that insurers will press this defense in all but the most egregious incidents of alleged misrepresentation.

Press reports suggest that D&O insurers will exclude option backdating claims from future policy forms. Because the potential remains for new claims arising out of conduct in prior years, companies should consult counsel and an experienced insurance broker during their D&O policy renewals to obtain the broadest coverage possible.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.