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Living in the nation’s energy capital, Houston, is never boring. During the oil and gas boom-times, the city is in perpetual motion and lawyers are running around doing deals. During the bust periods, the lawyers get busy fighting over all the busted oil deals. Recently, however, the Houston energy world has been rocked more by the financial machinations of Enron than the rise and fall of oil prices. Enron—two years ago it was THE place to work. In its recent glory days it built the world’s largest energy trading floor in a new glass and steel tower next door to its even taller tower downtown. It was the high-flying, superstar of the energy trading world with a technologically advanced new business model. Unlike the old companies, it hired MBAs more than engineers. Today, it is the nation’s favorite symbol of self-dealing greed and corporate corruption.
Enron, of course, is not alone in its predicament. WorldCom, Tyco, and many other 1990’s high flyers are now being forced to come to terms with playing fast and loose with accounting rules and corporate insider trading. In response to these scandals, Congress recently passed the Sarbanes-Oxley Act of 2002. The largely bipartisan Act sets in place greater corporate responsibility on directors and officers, including certifications of audited financial statements by CEOs and CFOs, greater internal controls, real-time updates of filings and other guidelines. The breadth of these rule changes will seriously increase director’s and officer’s obligations and liabilities. The Act restricts the role of outside auditors, requires enhanced disclosures to shareholders, and may have federal criminal consequences for some actions.
Many of these new guidelines and requirements are untested and may be onerous. But the full scope of the Act’s consequences will not be fully understood for some time to come. Seminars and courses on the new regulations are popping up every day to explain the implications, but it is the unintended consequences that are usually the worst. One guesses that these increased obligations will translate into more closely watched corporate governance and more accountability to shareholders. One thing is certain, there will be a flurry of lawsuits against directors and officers and their companies in ever greater numbers and based on a new array of violations. Moreover, these claims against Ds and Os and their companies will inevitably be turned over to liability carriers for defense and indemnity under the companies’ Directors and Officers policies.
Not surprisingly, directors and officers liability coverage, D&O coverage for short, is now both harder to find and more expensive. The Sarbanes-Oxley Act will make it harder to find and more expensive when it is available. Indeed, following the Enron, Arthur Andersen and WorldCom debacles, published reports indicated that the average payment to resolve some types of D&O claims had increased by more than 75 percent from 2000 to 2002. With even higher statutory standards of behavior, and juries much less enchanted by business executives following the incessant news reports of scandals, it is reasonable to expect even greater losses, both from settlements and verdicts.
It may come as a surprise, but many commentators now say that D&O coverage has been significantly underpriced in recent years. This may be purely hindsight, but it’s hard to dispute that the premiums paid in recent years will not support the spate of new claims, as well as the large increase in the average loss payment for claims that is taking place now. This confluence of factors, spurred on by widespread scandal, will increase losses, and will lead, and has already led to in many cases, to significant limitations in D&O coverage joined with significantly increased premiums for D&O policies. According to Tillinghast-Towers Perrin, D&O premiums surged 29 percent in 2001 and forecasts through the end of 2002 show increases at 30 percent or more. As Stephanie Jones recently noted in an article discussing WorldCom and its effect on the D&O market, premiums for large companies with capitalizations over $5 billion are likely to run 10 to 15 percent of the coverage amount or higher (IJ-Texas/South Central; July 8, 2002; Vol. 8, No. 12). The days of underpriced D&O policies is fast coming to an end.
And, of course, the huge losses will mean that fewer carriers are likely to offer D&O coverage. Some carriers, stung by the recent deluge of claims, will not renew existing coverage or write new risks. However, the demand for D&O coverage is unlikely to be significantly reduced. Public companies will not be able to avoid it, and few directors will take on the job if there is no liability coverage to protect them from personal exposure. So while the number of carriers that write D&O coverage will be likely reduced, major players in the area such as American International Group, Chubb and Lloyds of London may increase their market share.
At the same time, carriers underwriting these risks are currently reconsidering and narrowing the scope of the coverage offered. Most are reviewing the Sarbanes-Oxley Act closely and will tailor policies to avoid areas of uncertain and vague risk. Others will add broad exclusions for various types of fraud and reporting malfeasances. Some will increase deductibles or remove deductible waivers, or both. Multi-year policies will be out of fashion and punitive damages will be excluded wherever possible. This last point is important as Sarbanes-Oxley includes new and heavier penalties for many violations.
Still others will add provisions making it easier to rescind a policy for providing false information by refusing to include “severability” clauses – the provision that allows for policy revocation only for the person who actually makes the misstatements on the application for insurance, but not for other officers and directors who did not. These changes are already appearing and will become more frequent as the debate on responding to these events in the industry continues.
The bottom line is that increased claims, increased potential liabilities, and fewer carriers writing the coverage will equate with higher premiums for more narrowly drafted policies. Welcome to the brave new world of D&O coverage.
Brian S. Martin is a partner in the Insurance and Coverage Section of the Houston office of Thompson, Coe, Cousins & Irons, L.L.P. He has extensive experience in insurance coverage and defense matters, specializing in environmental, toxic tort and products cases. Martin is a frequent author and CLE speaker on insurance topics, including coverage and bad faith issues.