D&O market in flux

Mortgage meltdown, corporate settlements threaten D&O availability and affordability

By Phil Zinkewicz

Over a very short period of time, directors and officers insurance for publicly held financial institutions has gone from being readily available at reasonable prices to being unavailable, sometimes at any price. A recent white paper by Professional Risk Solutions, a leading wholesale broker and provider of liability insurance, detailed some of the reasons the D&O market may be in turmoil.

The paper concludes that recent surveys of the litigation landscape reveal some potentially ominous trends. But even those ominous trends did not anticipate the market dislocations that were to take place as the result of the mortgage crisis.

Here are some of those trends, according to the white paper:

• Mega-settlements are increasing. Just a few years ago, only 3% of settlements came in at more than $100 million. But in 2006, that percentage more than tripled to 10%, including a record-breaking settlement against Nortel that topped the charts at $2.2 billion. In 2007, this was eclipsed by the Tyco settlement in the vicinity of $3 billion.

• The average settlement is larger. With more mega-settlements in the mix, it’s no surprise that the average settlement jumped from $23.7 million to $34 million between 2004 and 2006. Even more telling, however, is the continuing rise in the median value of settlements, from $5.3 million in 2004 to $7.3 million in 2006.

The dollar amounts of settlements with the Securities and Exchange Commission (SEC), U.S. Department of Justice and other regulatory bodies also continued to rise unrelentingly, with some reaching more than $400 million.

• The number of cases is increasing. According to the PricewaterhouseCoopers 2006 Securities Litigation Study, 214 cases were filed in 2006, which is higher than the 173 cases filed in 2005 and not much different from the average of 218 cases filed annually since 2002.

• Almost all cases were settled, not litigated. Overall, under 1% of securities-related cases actually get to litigation or trial. It appears that both corporations and plaintiffs are reluctant to risk taking the issue to trial—where a judgment could land anywhere between zero and $200 million.

• Defense costs are substantial. In its 2006 survey of insurance claims trends, Towers Perrin found that corporations reported spending an average of $800,000 per D&O case in legal fees and other defense costs.

• Companies rely on D&O coverage. On average, in the Towers Perrin survey, public companies’ median D&O limit of liability was $20 million, which is less than the value of an average shareholder claim.

Good news/bad news

The PRS white paper, which was published in 2007 and released in early 2008, goes on to say, however, that even in the wake of high-profile corporate mega-settlements, D&O insurance is widely available and its costs are actually moderating. Late last summer Rick Grimes, executive vice president of PRS and a co-author of the white paper, said insurers were “eager to write new business and protect renewals by any means necessary, sensing that recent troubles are behind them. They are generally looking to build market share, even in the face of many large litigation cases, which some attorneys believe are worth hundreds of millions of dollars and which carriers will eventually have to pay.”

Grimes told Rough Notes that while his assessment still holds true for the commercial D&O market overall, it does not apply to private institutions that have subprime mortgage exposures and back-dated stock options. That’s another story altogether, he said.

“As high-profile financial institutions fall victim to the mortgage crisis, many carriers are non-renewing D&O coverage and declining new business in the financial services industry,” said Grimes. “We at PRS have been flooded with calls from agents and brokers who can’t secure any D&O coverage for financial services clients. This is a train that isn’t going to be stopping soon,” he asserts.

Grimes said that all directors and officers need to be aware that their behavior will be scrutinized by many more eyes than in the past, including many with the interest and wherewithal to seek legal recourse when they perceive that corporate governance has been less than adequate.

The PRS white paper reviews statutes and laws that apply to directors and officers, including Sarbanes-Oxley, and addresses such issues as securities fraud. The white paper specifically looks at back-dated stock options, calling it a “hot issue.”

Says the paper: “Options backdating is a corporate governance issue as well as a public company concern. In 2005, as a result of the Department of Justice and SEC investigations into stock option practices, companies began announcing the resignations and departures of senior executives and restating their financial state-ments. Since then, more than 160 investigations have been conducted, resignations and departures have continued, and approximately 130 lawsuits have been filed alleging options backdating.”

The white paper says the main issue is when stock options were granted and in particular whether the option grants were backdated to coincide with a date when the share price was low, thus making the grant either more immediately valuable or more valuable over time to the grantee.

“Although the majority of companies that have come under scrutiny are in the technology sector,” says the white paper, “companies from almost all industries have been subjected to investigation regarding this issue. The Department of Justice has filed criminal charges against former executives of companies including Brocade Communications Systems, Converse Technology, and Monster Worldwide. Options backdating has significant implications for IPOs and executive compensation structure,” the white paper observes.

As serious as that issue is, however, the subprime mortgage issue is likely to dwarf it. By mid-January The Wall Street Journal reported that Goldman Sachs estimates that losses on delinquent U.S. residential mortgages will exceed $1 trillion.