D&O Liabilities Managing Expo Sures

In light of a more than doubling of securities litigation cases in the U.S. last year, a legal trend that has crossed the border to infiltrate corporate Canada, no doubt companies are dealing with a challenging D&O marketplace. The coverage is there, but it is more expensive and complex, and corporations are being asked to take on a greater portion of the risk. The spill over effects of U.S. litigation are leaving Canada’s largest companies struggling to stay high and dry.

Just as September 11 cannot be blamed for the current hardening of the insurance market overall, it is also unrealistic to say that the changes shaping directors and officers liability (D&O) are the result of the collapse of Enron. Nonetheless, the failure of this once giant of American energy trading, the suspicion cast on its senior executives and board members, and the shareholder lawsuits that have followed, are certainly the most notorious example of the trends shaping D&O.

More lawsuits, courts taking an “investor friendly” view of executive responsibility, higher payouts. These are the forces at work on the D&O market and the result is a business in turmoil, according to all sources. It is not simply a question of rising rates, corporate clients are feeling these across all lines of business, but tightening terms, changing limits, new sub-limits and the reintroduction of co-insurance, are all hitting corporations at once.

Pre-Enron, D&O carriers had already begun to experience losses due to growing litigation, primarily from disgruntled shareholders in class action lawsuits. While these types of cases were on the rise, and the settlements being handed out started to climb, insurers were also in the throes of the soft market. “At the same time that prices were going down, coverages were broadening…there had to be a breaking point,” says Hano Pak, branch manager of management liabilities for AIG. At least two years ago, insurers were aware that rates needed to go up, says Francois Lavallee, partner with Gascoe Goodhue Provost. “But no one wanted to be the one going to market with these rates.” Now there is across the board momentum to bring rates back up to profitable levels, he says.

Shareholder revolt

The losses were most keenly experienced south of the border, but were certainly impacting the Canadian market, as most of this country’s largest D&O carriers are North American operators (see chart 1).

As well, Canadian companies began to find themselves targets for shareholder lawsuits, in both the Canadian and U.S. courts. Mining company Bre-X is among the largest, facing class action suits in Texas and several Canadian provinces from investors who claim the company falsely touted “the richest gold deposit ever discovered”, although it has since been discovered that no such deposit exists. Animation giant Cinar faces a class action suit in New York from stockholders who say that the company made false claims in order to receive favorable tax credits, thereby artificially inflating the corporation’s financial results.

Perhaps the most well known is the recently settled case against YBM Magnex International’s board of directors, including former Ontario premier David Peterson. When YBM failed to notify shareholders that it was under FBI investigation for alleged money laundering, and the Toronto Stock Exchange subsequently halted trading of the stock, two class action suits were launched by Canadian investors. Early this year, directors settled the case for $120 million.

Three factors seem to be pushing the litigation environment, says Udo Nixdorf, senior vice president of specialty insurance for Chubb Insurance Company of Canada. First, is the general economic slowdown, and the dot.com meltdown. “You had significant market capital declines throughout all industries, but specifically in communications and high tech.”

Second, were the practices of securities brokers, such as the infamous “laddering” cases, where initial public offering values were artificially inflated by “tie-in” deals between eager investors willing to buy shares at increasingly higher prices and brokers receiving higher than normal commissions. These cases, even though it was often unproven that directors and officers were aware of the laddering practice, came by the dozens in the U.S. and involved settlements in the multi-millions. Nixdorf expects IPO practices will continue to lead to shareholder lawsuits into the future, predicting “major claims activity” in this area.

The third, and perhaps most significant factor, is the increasing frequency of claims activity and growing severity, as evidenced in the potentially huge Enron losses. With almost 500 securities fraud class action lawsuits in the U.S. last year (see chart 2), and an average settlement of $15.5 million, insurers stand to face stiff losses.

Corporate veil falls

And the trend shows few signs of abating, including in Canada. Pak points to the increasing availability of class actions in Canada as one factor. And as the YBM case shows, although Canadian courts once were seen as restrictive for shareholders seeking redress, the status quo is changing. “Courts have traditionally respected the ‘corporate veil’, that is, management tended to be viewed as agents of the corporation,” explains Nixdorf. “In these cases [Bre-X, YBM and others], you’ll find the corporate veil didn’t hold up.” Now managers and directors are being held personally liable for what goes on in the companies they serve.

“What’s significant about Enron is not the losses it will cause to the industry, but the changes to regulation,” adds Nixdorf. A higher standard is going to be placed on key individuals, especially CEOs. “One of the comments that came out of the Senate hearings [on Enron] was that CEOs should not be able to “opt out” of any knowledge, that they will be deemed to have all knowledge at all times.”

Lavallee adds that the Canadian Business Corporations Act, in its “person remedy” has allowed a great deal of power to be given to minority shareholders who feel the actions of the directors and officers have been abusive in some way.

However, there are still some factors weighing in favor of Canadian directors and officers. One example is the “fraud on the market” case, where in the U.S. juries can infer that misinformation from companies caused shareholder actions, but in Canada such a cause and effect must be proven, explains Lavallee. “It makes us a better risk because it’s not easy to fight [defend] the fraud on the market case.”

The average $15.5 million settlement in the U.S. is not something we are likely to see in Canada, says Edouard Moreira, vice president of marketing for brokerage Willis Canada Inc. However, investors here are watching what is happening in the U.S. and becoming aware of the potential to file suit.

No safe haven

Insurers and reinsurers are becoming aware of the vulnerability of Canadian companies. Canada is no longer the “safe haven” that it was once perceived to be, says Pak. And the rate increases and term changes are being targeted at Canadian public companies with U.S. exposures. “They have the same exposures as U.S. companies, but they’ve been under rated for so long,” he adds. “For a public company trading on a U.S. exchange, it’s quite difficult – you’re being regarded as a U.S. entity,” agrees Dave Potter, vice president of special risks for KRG Insurance Brokers. “When it exposes itself to the U.S. securities market, it might as well be a U.S. company.” Nixdorf adds.

Insurers in Canada have been taking a great risk in dropping their rates for these companies during the soft market, Pak goes on to say. Because the market is smaller and does not see the same rates as U.S. insurers, one big hit could potentially wipe out a book of business for years before it can become profitable again.

Companies with a complex structure, an unstable balance-sheet, lots of merger and acquisition activity, or vulnerable to securities claims will be the hardest hit, says Moreira. “If you’re not listed on the NASDAQ and you have a solid balance-sheet, it’s not that grim.” Mi
nimum D&O increases for those companies are about 25%, although Moreira points out that this number may be “inching towards 50%…and that’s for companies with a good balance-sheet”.

As for the high-end average, there may not be one, says Potter. This is where the dramatic difference is being seen, as companies perceived as vulnerable to U.S. litigation may be facing 100% increases or more. “The margin is huge,” Nixdorf maintains, with each company being subjected to a thorough underwriting review in current renewals.

However, increases in D&O, especially for “clean companies” are not necessarily out of line with increases in other commercial lines, which have taken a hit in the post-September 11 world.

D&O may in fact be less affected than some other covers in a corporation’s risk portfolio, says Paul Martin, president of Cross Border Underwriting Services. What is changing most dramatically are the terms of coverage. Extra coverage that used to be “thrown in” is now being charged for, notes David MacDonald, vice president of ACE INA’s capital risk group. Such “throw-ins” include entity allocations, pollution, employment practices liability (EPL) and new subsidiary coverage. Entity coverage is, like many D&O covers in general, subjected to co-insurance terms where the corporation takes a portion of the settlement. It is a response to companies being too willing to settle cases rather than going to trial. “People are generally settling. It’s too much of a wild card [going to court],” says Pak “We want to keep the insured in the game” rather than seeing them settle quickly. “Because the co-insurance clause disappeared in the last five years, clients were too eager to settle,” says Moreira. Now insureds will have to participate in 10%-20% of any settlement.

But clients in Canada are resistant, say MacDonald, and are asking “isn’t that what the deductible is for?” Co-insurance, a standard policy feature in Canada and the U.S. 15 to 20 years ago, is being re-introduced in the U.S., but remains less common here. New sub-limits are also being introduced on certain portions of policies, specifically on EPL cover. EPL sub-limits are being pushed down, notes MacDonald, when they may have matched overall D&O limits in the past.

Cover at any cost

While sources agree that there is coverage available, there is also agreement that limits are going to be an issue. Insurers “don’t have $50 million like they used to. They’re ‘limit’ managing now,” says Pak.

And with a smaller Canadian market versus the U.S., there are fewer players with sufficient capacity to maintain the limits that corporations may be used to buying, says MacDonald. If carriers lower their limits, it is going to be all the more difficult to seek out new carriers to make up the difference, especially for larger companies, who have several layers of cover spread out over different carriers.

The market is not seeing the “capacity powers” that it used to, agrees Nixdorf. “Where $250-$300 million in capacity was readily available, it is becoming somewhat difficult for the most severe risks.” Nonetheless, insurers are still moving into the D&O market, says Lavallee. “Even though the risk is getting higher they are willing to get into this market, and get their piece of the pie.”

And, the demand appears to be growing, says Martin, who notes that he has seen increased requests, including from private companies, despite D&O’s traditional niche as a public corporation cover. “The [corporate] boards realize the value of this cover, especially when they see what their friends south of the border are going through,” notes MacDonald. Despite the rising rates and changing terms, he says clients will still seek out the cover and see it as a necessity.

For companies seeking to reduce the burden of premium increases, good business practices are going to be key, particularly if expected changes to financial reporting do occur as a result of Enron. “We really rely, as underwriters, on the financials,” says Pak. “We have to be more cautious.” Accounts with irregularities in reporting, or who are continually restating financials, will find this reflected in their underwriting. Capital rules will also change, and companies used to reporting under the current system will have to follow suit, which will be especially difficult for the bigger, more complex structures, says Nixdorf. And, he expects the rule changes will be fast and will spread to Canada and Europe. “No corporation will be immune to this.”

Chart 1: Canadian D&O Market Capacity(In Cdn$000,000,000)

Source: Willis Canada Inc. 2002 Market Forecast

Chart 2: U.S. Federal Securities Fraud Class Action Litigation