As restatements go these days, it seems a pittance.
What’s more, the change reported by Westaff, a temporary-staffing company with $110 million in second quarter revenues, looked like a positive one.
Partly because of tax law changes in the federal economic stimulus bill enacted in March, the company should have recorded a $3.1 million tax benefit in the second quarter. The company made the change at the start of September, restating a $1.7 million net income loss to a $1.4 million gain in the process.
The move was apparently too arcane to even merit a press release from the Walnut Creek, California-based company. Still it was a restatement, and any time a company issues a restatement — positive or negative — these days, there is understandable concern about possible shareholder suits. After all, many CEOs and finance chiefs at public companies have only just begun certifying corporate financial statements under the mandates of the new Sarbanes-Oxley Act.
That alone could spawn a case of the jitters. Of course, CFOs and CEOs have always been liable for false certifications under the 1934 Securities Exchange Act. For many, Sarbanes-Oxley is unlikely to break new ground in terms of executive liability. “I always felt like I was doing it personally,” says Jeff Naylor, CFO of Big Lots. “If those statements were incorrect it was my name that was on the line.”
Grist for the Till
Still, now that CFO and CEO signatures are actually mandated for all public companies under federal law, they’re tangible ammunition for plaintiffs’ lawyers. Attorneys, after all, like to supply juries with bold graphics and blowups of the evidence. “That piece of paper that starts out eight-and-a-half by 11 inches becomes three feet by five feet in a court of law,” says Doug Hagerman, an attorney with Foley & Lardner in Chicago who defends corporations. “[It's] powerful evidence of individual officer responsibility.”
New liability threats also loom over board audit committees. Sarbanes-Oxley has added some hefty new powers for their members, including hiring, firing, and oversight of independent auditors. They must also be up on the critical accounting policies and practices used by the auditor. Since their new authority and knowledge is bound to make them seem more like corporate insiders, they’re increasingly likely to be defendants in court.
With the personal assets of board members and executives apt to be more at risk, maintaining solid corporate directors’ and officers’ liability insurance coverage (D&O) is becoming crucial. In the current economic climate, however, some insureds wonder how well their coverage will hold up if the insurance policies become assets controlled by a bankruptcy court. And the coverage itself, while widely available, is becoming costlier and skimpier..”
Bigger corporations and those in high-risk areas like telecommunications or biotechnology, for instance, have more to worry about, experts in the coverage say. Fortune 500 companies have, for instance, seen their premiums soar 200 percent to 400 percent on their most recent policy renewals, says Lou Ann Layton, a Marsh insurance broker specializing in the insurance. “This is the worst D&O market in the 21 years I’ve been in the business,” she says.
Reacting to recent accounting scandals and high-profile criminal prosecution of corporate executives, insurers are demanding much more in-depth financial information from companies as well as presenting them with bigger insurance bills. Jeff Pettegrew, Westaff’s vice president of insurance and risk management, thinks the company’s D&O carrier, Gulf Insurance Company, will demand access to notes taken at audit committee meetings, along with confirmation that the meetings actually occurred. “I am fully expecting it and acting as if that is a compliance issue,” says Pettegrew.
Bumping Up Deductibles
In early summer, D&O insurers began to turn up the heat. Since then, they’ve intensified their scrutiny of insureds and stepped up their price hikes, brokers and consultants say. The current D&O crunch followed over a year of more gradual market hardening. In 2001, premiums for the line rose about 29 percent, according to a survey of 2,037 organizations released by Tillinghast-Towers Perrin in June. The increases picked up steam late in the year as a result of losses to other property-casualty insurance lines stemming from the terrorist attacks. “I personally think that 9/11 enabled D&O underwriters to jump on the bandwagon” of rate increases, says Layton.
But that was only the start. In a recent CFO.com online poll, 27 percent of 45 respondents said their companies either doubled or tripled their D&O premium payout when they last bought coverage. And corporations are being asked to retain a lot more risk. For instance, a Fortune 500 company with a $1 million deductible is typically being asked to bump that up to $5 million to $10 million, says Layton. Bigger corporations that once retained $5 million have seen their deductibles soar to $15 million to $25 million.
Coverage packages have also become trickier to assemble, according to the Marsh broker. Wary of assuming too much risk in these scandal-plagued times, an underwriter that previously insured $25 million out of the $100 million of the basic D&O coverage typically bought by a big corporation might only pick up $10 or $15 million. To sweeten the deal, the carriers offered to pick up some of the slack by providing the balance of the $25 million in less risky excess coverage. But excess insurance only provides coverage once the costs hit a certain (high) level.
That’s sent brokers scrambling to still other insurers for bits of coverage keep their clients’ primary insurance programs intact, according to Layton. The process tends to add transactional costs into corporate insurance bills and anxiety to risk managers’ psyches. A big worry is that uninsured gaps will turn up in a company’s insurance program. Pettegrew characterizes the current state of D&O coverage as “a basket with leaky holes.”
Wag the Tail
Keeping coverage intact for extended periods is another struggle. Like most other companies, Westaff has a “claims-made” D&O policy. That means that coverage is triggered only when a claim against the insured is filed—rather than, say, when the accounting problem that spawned the claim occurred. If a claim is filed after the policy year, the company could end up with no coverage. For that reason, extending the life of the policy for at least a year is essential, the risk manager says.
But such “extended-tail” coverage comes dearly: For a one-year extension of its claims-reporting period, Westaff paid the same premium as it did for its basic coverage to its carrier. In past years, insurers commonly would provide tail coverage at a discount, commonly 75 percent of the base premium, Pettegrew says.
Costly as D&O insurance is, however, most companies are able to buy some form of it. At the same time, CFOs need to be alert to a substantial narrowing in the scope of that coverage, brokers and consultants advise. “The D&O policy gives very broadly and takes away very specifically,” observes David Mair, a vice president of the Risk and Insurance Management Society and former risk manager of the U.S. Olympic Committee. After a sweeping statement that coverage will be triggered by a “wrongful act,” D&O policies set out a laundry list of other exclusions. They generally exclude coverage for intentional acts, for instance.
Some alarming takeaways may be on the horizon. For instance, some D&O carriers have been talking about excluding claims involving an earnings restatement, says Joe Monteleone, vice president and claims counsel for Hartford Financial Products. Unheard of in the United States, restatement exclusions are fairly common in the policies of European-based multinationals with U.S. exposures, he says.
Up the Corporation
There are also rumblings that carriers might stop offering coverage for the corporate entity itself. An add-on to D&O policies, such “entity” coverage is in great demand because most lawsuits filed against directors and officers also name the corporation. More than 90 percent of U.S. insureds bought it last year, according to the Tillinghast-Towers Perrin survey.
But both insurers and insureds increasingly see entity coverage as a magnet for plaintffs’ lawyers. “It creates a large target,” says Robert Hartwig, the chief economist of the Insurance Information Institute. “Suing the entire corporation is potentially more lucrative for the plaintiffs’ bar and plaintiffs than simply going after directors and officers, where the assets are limited.”
The presence of entity coverage encourages corporations to settle cases too easily, insurers feel. As a result, predicts Monteleone, “full-blown entity coverage will be severely modified, if not eliminated.” The modifications, he says, might involve coinsurance provisions in which corporations end up assuming 20 percent to 30 percent of risk. Having more “skin in the game” might encourage insureds to put up a stiffer battle in court, he explains.
Valium for the Audit Committee
Besides keeping their coverage intact, senior managers face the added burden of calming nervous audit committee members. The challenge is to assure them despite the increased risk they face, they will be made whole if they’re sued. Many of the tools commonly used to put directors’ insurance coverage out of harms way, however, are getting pricey or tough to come by.
For example, “severability” provisions, under which each insured is separately covered, can assure innocent directors of coverage even if others commit fraud. But corporations had better buy that protection soon. “Many insurers that offer severability are beginning to rethink that,” says Hartford’s Monteleone. The carriers are shy about covering directors who bear some culpability for falsely stated numbers even though they’re not guilty of outright fraud.
Directors who get a D&O perk from one corporation for sitting on the board of another are also at risk. Previously a throw-in on standard policies, such outside-directorship liability coverage is becoming scarce, says Marsh’s Layton. In the wake of the Enron and Worldcom bankruptcies, insurers know that an outside director could well be sitting on the board of a bankrupt company with depleted D&O insurance. In that case, the outside company’s insurer might have to pick up the legal bills.
Surprisingly, such concerns have even started to ripple through private companies. Although their D&O risks are a good deal milder than those of public corporations, private-company boards can still be hit with lawsuits, says Rick Betterley, a risk management consultant in Sterling Mass. And executives at private companies can be equally anxious to comfort their directors with insurance protection. The president of a private company Betterley advises, for instance, recently asked him “to go to her board of directors and say, `No matter what happens, we’re going to pay.’”
Even though the company was a relatively low-risk account, the executive was pursuing an impossible dream, Betterley says. Absolute protection is unobtainable for the simple reason that insurance policy language is subject to varying court interpretations. Still, it’s “very important for the board to be confident,” he says. “Otherwise they can get too conservative”–and make choices that are detrimental to the company.