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Shareholders of publicly traded companies are showing more interest in executive compensation, and with the Securities and Exchange Commission's proposed rule changes on compensation disclosure, they're about to learn a lot more.

Specifically, companies will have to disclose the pay of the chief executive officer, the chief financial officer and three other highest-paid executive officers. In addition, all perks such as stock options, retirement benefits, severance packages, and the use of corporate jets and apartments will have to be spelled out in greater detail.

As it stands, shareholders are increasingly vocal in the wake of highly publicized corporate malfeasance. Add to this specific information spelled out in line-item fashion on lucrative retirement packages, generous stock options and perquisites reminiscent of "Lifestyles of the Rich and Famous," and the resulting fury is not difficult to imagine.

Perhaps most irksome to shareholders will be equity awards to executives. If a company is performing well, the reaction to executive stock packages could be mild. In light of poor performance, however, investors are likely to see red.

In addition to the perception that an executive is being rewarded for running a company into the ground, the liberal distribution of stock options and restricted stock can dilute the value of all the shares. And that may seem like rubbing salt in a wound to those who are not seeing a return on their investment. The same can be said for noncash benefits, which will have to be disclosed in detail for everything more than $10,000--down from the current $50,000 cutoff. Shareholders of struggling companies could see this not only as another reward for failure but also as a financial drag on the company's stock.

In this era of the activist shareholder, the increase in lawsuits brought against directors and officers can come not only from hordes of incensed individual investors with torches in hand, storming the corporate castle but equity investment houses and venture capitalists.

Institutional investors operate on a different level than mutual funds. The clients whose money they manage are wealthy, and they expect results. Consequently, these houses have become quite aggressive in dealing with lackluster company performance. Oftentimes, they purchase a controlling interest in a company and work to oust failing executives through a proxy fight.

They have also been known to sue the members of compensation committees for failure to execute their fiduciary duties. Individual investors also have questioned compensation committee decisions.

A recent example of this was the unsuccessful shareholder lawsuit against Disney's board of directors over former president Michael Ovitz's $140 million severance package. Plaintiffs' attorneys in this case recently appeared before the Delaware Supreme Court to appeal the lower court's decision. The high court is expected to render a decision in the case sometime this spring.

The question for commercial insurers in all of this remains: How will this affect the directors' and officers' liability insurance market?

EFFECT SEEN AS MINIMAL

Although we can expect an increase in the frequency of derivative lawsuits, predicting their severity and costliness is more difficult. One point of view holds that the added detail on equity awards will spur more allegations of insider trading and the artificial inflation of restricted stocks at the time they are vesting.

In the absence of suspiciously timed liquidation, however, any allegations of insider trading will not hold water, at least for securities-fraud actions.

The industry has been keeping a close watch on the relationship between low D&O premiums and high payouts, a scenario that was created after a number of insurers entered this market in light of high-profile corporate scandals and litigation.

Once the new SEC rules are approved and implemented, which is very likely, the question will become: What effect will this have on D&O insurance? The short answer is probably not much. Of course, the disclosure of new information will be a factor in the underwriting process, but it should not fundamentally change or shift that process.

If a company's executive compensation is out of line with its performance, making it vulnerable to lawsuits involving allegations of breaches of fiduciary duties, an insurance company will price that company's D&O policy accordingly. Or, if the risk is unacceptable, the insurer will decline to provide coverage. However, a marked pricing change in the D&O market is not expected industrywide over the short term.

Because current D&O policies already respond to lawsuits that are derivative in nature, new products are not needed in response to the rules change. However, the renewal process is expected to be more robust, and a policyholder's compensation committee will be more thoroughly scrutinized. A company's compensation system should be comparable to that of its competitors and in line with the industry as a whole in order to reduce risk.

Those who believe that the current D&O market will eventually force smaller carriers to exit may believe that the new disclosure rules will hasten this departure. If and when this exodus occurs depends more on the outcome of pending litigation that takes years to work its way through the courts. The size of these payouts, if they are large, will force smaller players into receivership before any cases involving the rules change have a similar effect.

This dynamic was set in motion some time ago and will take years to run its course. However, once the market hardens, new D&O carriers may be created to take the place of those who depart due to a great deal of investment capital that is currently in flux.

The increase in derivative lawsuits will likely constitute a sea change. In the final analysis, the new disclosure rules are one of many factors governing the D&O market. For instance, consider the way the Sarbanes-Oxley law played out last year. Although 2005 saw a record number of financial restatements, the number of securities-fraud lawsuits filed actually decreased.

The falling stock values that spurred many of these suits could be equally attributable to a general market correction as to any executive high jinks. Good corporate governance and effective internal controls remain the best risk control strategy for a publicly traded company. Those who practice this strategy will be less vulnerable; those who don't will face the consequences; and the D&O market will continue to be governed by the immutable law of supply and demand.

JIM NESTHEIDE is vice president of public company liability for the Financial and Professional Services business unit at St. Paul Travelers.

KATHRYN WALKER is second vice president of public company liability for the Professional Errors & Omissions Claim unit at St. Paul Travelers.

April 1, 2006

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