By WILLIAM A. BOECK, senior vice president, insurance and claims counsel, for Lockton Financial Services
The year 2008 will be remembered as the year when the U.S. government made its most extraordinary interventions in the financial system since the Great Depression. The amount of money being spent is breathtaking. The bailouts of Bear Stearns, AIG, Fannie Mae and Freddie Mac alone exceed the cost to resolve the entire savings and loan crisis of the late 1980s and early 1990s. These bailouts are in turn dwarfed by the $700 billion Emergency Economic Stabilization Act of 2008. While the EESA has been welcomed by many financial institutions, some of the strings attached to the assistance it provides may have potentially significant costs for affected companies and their directors, officers and insurers.
The EESA probably won't create a flood of new D&O claims. The act does not create any new duties or liabilities for directors and officers of companies participating in the Troubled Asset Relief Program. Participation in TARP may have adverse consequences for shareholders though, and that could result in some directors' and officers' liability claims. Those claims are likely to concern decisions made regarding asset sales and the effect of giving equity stakes in the companies to the government.
When the EESA was passed, some commentators worried that the government would overpay for troubled assets in a rush to free the gears of the financial system. While that should be less of a concern now, given the Treasury's decision not to purchase troubled assets, if the government changes course again and complies with its statutory mandate to minimize taxpayer losses, it will drive hard bargains with financial institutions. If shareholders believe the price received for the troubled assets is too low, they may file lawsuits alleging that the company's directors and officers breached their fiduciary duties to obtain the best possible price.
The taxpayer protection provisions of TARP and the government's recent decision to invest directly in financial institutions may also generate shareholder lawsuits. In the event the value of a company's shares is diluted because of the government's receipt of stock or its exercise of warrants, shareholders may allege that the company's directors and officers acted wrongfully by selling shares to the government.
Similar arguments could be made by shareholders of companies that received separate bailouts. Affected shareholders may allege that directors and officers acted improperly by agreeing to the bailout and that the dilution created by giving the government large equity stakes was too high a price to pay for government assistance. Such a lawsuit has already been filed against AIG and its directors and officers in connection with the AIG bailout. If the government eventually does purchase troubled assets, shareholder plaintiffs may well argue that the company should have kept the assets and used the optional insurance provision of the EESA to guarantee their value to avoid any share dilution.
It will be interesting to see whether the government will file lawsuits against directors and officers based on its status as a shareholder. While Section 113 of the Act precludes the government from receiving or exercising voting rights, acquisition of such rights may be possible under the terms of other bailouts. Regardless of whether the government receives voting rights, neither the Act nor the terms of the other bailouts appear to prevent the government from filing a shareholder lawsuit.
There is precedent for this. During the savings and loan crisis of the late 1980s and early 1990s, federal regulators and the Resolution Trust Corporation did not hesitate to sue directors and officers over actions that allegedly damaged the financial institution. Some of those suits were brought as shareholder derivative actions.
There certainly will be strong defenses to lawsuits provoked by a company's participation in TARP or agreement to the terms of other bailouts. At minimum, the claims will be a distraction in difficult times and could be expensive to defend and settle. This last point makes it important to assure that a company's directors' and officers' policies will respond fully.
Lawsuits concerning the price received for troubled assets are likely to come in the form of shareholder derivative actions. These are lawsuits filed by shareholders on behalf of a corporation against a director or officer. Insureds should take care to assure that their policies include coverage for shareholder derivative demand investigations. Such coverage typically is not subject to any retention or deductible, but is limited to $250,000. As most derivative investigations cost far more than $250,000, insureds should consider asking insurers to increase that coverage. Unfortunately, it can be difficult to persuade insurers to do so.
Public company insureds should also review their policies to assure that "securities claim" is defined to include shareholder derivative lawsuits. While most policy forms have adequate definitions, some do not include derivative lawsuits. As a result, defense costs incurred by a public company (which typically is only covered for "securities claims") will not be payable.
It is particularly important for insureds faced with possible derivative lawsuits to have the broadest possible coverage for loss that the company cannot indemnify. Financial distress could prevent a company from indemnifying its directors and officers. As recent headlines make all too clear, companies holding troubled assets may be in extreme financial distress.
A company may also be legally prohibited from providing indemnification. The vast majority of states do not allow companies to indemnify directors and officers for settlements and judgments in derivative suits. While coverage for nonindemnifiable loss, frequently referred to as "Side-A" coverage, is included in virtually all D&O policies, traditional policies may not be able to respond if the company is in bankruptcy. Perhaps more importantly, policies that only provide Side-A coverage generally contain much broader terms. Companies that participate in TARP or other government bailouts should carefully consider obtaining separate Side-A policies.
Given the possibility of lawsuits by the government in its status as a shareholder, companies should pay attention to policy terms and conditions to assure that the policy will respond appropriately.
During the savings and loan crisis, many actions by federal regulators were not covered because D&O policies contained regulatory exclusions. Those exclusions, which are not common now, generally preclude coverage for lawsuits brought by federal and state regulatory agencies regardless of the capacity in which the agency files the lawsuit. In the event an insured's policy contains regulatory exclusion, the company should ask the insurer to remove it or limit its scope.
The size of any equity stake received by the government could also implicate policy exclusions for claims by major shareholders. A claim by the government also could, depending on its circumstances, implicate the policy's exclusion for lawsuits brought by or with the assistance of insureds against other insureds. Insureds should seek appropriate exceptions to these exclusions as needed.
By any measure, the bailouts of the past year are historic. The size of the financial commitments, the extent of the government's direct involvement in financial institutions, and the consequences to the U.S. and world economies if the TARP and other bailouts don't work, are massive.
Although the EESA and other bailouts place new burdens on directors and officers of participating financial institutions, they should not create vast numbers of new claims. It is important, however, to assure that current D&O insurance programs are fully ready to respond if and when a claim comes in. D&O insurance may be the only "bailout" executives get.
January 1, 2009
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