Insurance Coverage
AUGUST 2002
The Public Company Accounting Reform And Investor Protection
Act Of 2002: How It May Affect Recoveries Under D&O Insurance
Policies And Corporate Indemnification Provisions
INTRODUCTION
On June 27, 2002, the Securities and Exchange
Commission (“SEC”) issued an order (the “SEC’s
Order”) requiring the principal executive officer (“CEO”)
and principal financial officer (“CFO”) of approximately
945 of the country’s largest public companies personally
to certify, in writing and under oath, the accuracy of each
of their companies’ reports filed with the SEC, including
financial statements. In July 2002, the authors of this alert
prepared an alert1 — available upon request — discussing
certain D&O insurance and corporate indemnification
issues raised by the SEC’s Order. On July 30, 2002,
President Bush signed into law the Public Company
Accounting Reform and Investor Protection Act of 2002
(the “Act”),2 broad-sweeping legislation that imposes
similar certification requirements on the CEOs and CFOs
of all public companies, and also a new regulatory regime
on the accounting profession and new obligations on
brokerage firms, analysts, lawyers and public company
executives. The D&O insurance and corporate
indemnification issues raised by the Act are similar to
those raised by the SEC’s Order, although the Act,
because it is broader than the Order, raises additional
issues. This alert discusses D&O coverage and corporate
indemnification implications of the Act.
SUMMARY OF PROVISIONS OF THE ACT
IMPACTING DIRECTORS AND OFFICERS:
The provisions of the Act most relevant to the provision
of D&O insurance coverage and/or corporate
indemnification to public company directors and officers
can be summarized as follows:
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2
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The Act requires the CEO and CFO of each public
company to certify that each periodic report filed with
the SEC containing financial statements of the
company “fully complies” with the disclosure
requirements of the Securities Exchange Act of 1934
and that information in the report fairly presents the
financial condition, results and operations of the
company. Violations of the certification provision will
carry criminal penalties, including 10 years’
imprisonment for “knowingly” making a false
certification and 20 years imprisonment for “willfully”
making a false certification. CEOs and CFOs also may
be required to pay significant fines in addition to being
subject to imprisonment.
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In the event of an accounting restatement resulting from
“material non-compliance” with SEC financial
requirements, CEOs and CFOs may be required to
disgorge bonuses and other incentive-based
compensation, as well as profits from the sale of
company stock.
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Except in very limited circumstances, public companies
may no longer make loans to their directors and
officers.
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During so-called “blackout periods” during which
company employees are prohibited from selling
company stock in their retirement plans, directors and
officers also will be prohibited from selling company
stock.
The authors’ earlier alert was entitled “The SEC’s Certification Requirement For CEO’s and CFO’s: How It May Affect
Recoveries Under D&O Insurance Policies And Corporate Indemnification Provisions.”
The “Act” has also been referred to as the Sarbanes-Oxley Act.
Kirkpatrick & Lockhart LLP
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Trading of company stock by directors and officers now
will need to be reported to the SEC before the end of
the second day following the date of the transaction.
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The Act lengthens the statute of limitations for civil
securities fraud claims, allowing claims to be brought
within three years of the discovery of facts relevant to
the alleged fraud or five years after the date of the
alleged fraud (from one year and three years,
respectively).
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The Act requires that CEOs and CFOs of public
companies certify that they are responsible for
establishing and maintaining internal controls to ensure
that material information relating to their companies and
their subsidiaries is fairly presented, and that they have
disclosed to auditors and the audit committees of the
companies’ boards of directors any significant
deficiencies in internal controls and any fraud
committed by any employee with significant
responsibilities for internal controls.
The Act provides that the SEC may enforce provisions
of the Act through administrative proceedings and may
bar individuals who violate federal securities fraud laws
from serving as officers or directors of public
companies.3
These provisions of the Act raise a number of potentially
significant issues for public companies and their directors
and officers, including issues concerning:
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Whether the CEO and CFO certifications will make it
easier for private plaintiffs or the government to prove,
in civil or criminal cases, the requisite degree of scienter
required to support a claim of fraud;
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Whether, as seems likely, the lengthened statute of
limitations for securities fraud claims will lead to the
plaintiffs’ bar filing a significantly increased number of
fraud claims against officers and directors of public
companies, including possibly some claims that may be
brought within the new statutory time limit created by
the Act that would have been time-barred under prior
law;
3
2
Whether the CEO and CFO certifications required by
the Act will assist private plaintiffs in proving “control
person” liability (personal liability for controlling
unlawful corporate acts) under federal securities laws;
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Whether the Act will result in a significant number of
criminal prosecutions of directors and officers for
criminal violations of the Act, including possible
perjury charges against CEOs or CFOs for false
certifications;
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Whether there will be a marked increase in the number
of civil enforcement actions asserted by the federal
government against directors and officers based upon
inaccurate SEC filings or financial statements.
SELECTED ISSUES RELATED TO
D&O INSURANCE COVERAGE
For the most part, the D&O insurance and corporate
indemnification issues raised by the Act are similar to
those raised by the SEC’s Order and, for that reason, the
discussion herein largely repeats that in the authors’ alert
regarding the SEC’s Order. In forecasting the potential
impact of the Act on the availability of D&O coverage,
some necessary context is in order. There is no single,
industry-wide D&O policy. Each insurer typically uses its
own policy form and the terms of those forms (and
correspondingly the potential insurance implications of the
Act) may vary significantly. Furthermore, it remains to be
seen whether insurers will seek to insert new language in
future D&O policies to directly address the new provisions
of the Act. In addition, insurance implications of the Act
will depend in part on how government authorities and the
private securities plaintiffs’ bar move to enforce the Act.
Despite these variables, several issues related to D&O
coverage related to the Act are worth noting.
■
Typically, D&O insurance policies contain no exclusion
for liabilities arising per se out of false or misleading
statements or certifications. Indeed, one of the reasons
D&O insurance is purchased typically is to protect a
company’s directors and officers from liability for
claims based upon such statements.
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While the Act may lead to government prosecution of
directors, CEOs, CFOs or other officers for criminal
violations of the Act or perjury or related offenses,
many D&O policies expressly define a “claim” to
include criminal proceedings. Under such policies, a
D&O insurer may be required to advance the cost of
defending against a criminal charge, at least until a
criminal act has been proven. Many D&O policies,
however, exclude coverage for fines and penalties in
The Act also creates new disclosure requirements for public companies, imposes new requirements related to the audit committees of
the board of directors of public companies and modifies the way companies will interact with their outside auditors. These provisions
are outside the scope of this alert, but were discussed in more depth in an earlier K&L Alert entitled “The Sarbanes-Oxley Act and the
New Order of Corporate Disclosure,” available upon request. Certain of the Acts provisions will be effective immediately, while others
will be effective only after the SEC promulgates related rules.
KIRKPATRICK & LOCKHART LLP INSURANCE COVERAGE ALERT
the event criminal (or in some cases, civil) liability is
established. Moreover, if criminal liability is proven,
D&O insurers may argue that coverage is not available
with respect to civil claims arising out of the same
actions that gave rise to a criminal conviction.
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In the current political climate wherein the SEC is under
pressure to uncover and punish fraud, it can be expected
that the SEC staff will commence a significant number
of enforcement investigations regarding financial
disclosures by public companies. Some of these
investigations will not result in the initiation of formal
enforcement proceedings, or claims for civil money
penalties or other sanctions, by the SEC. Nonetheless,
the costs of defending corporations and individual
officers and directors with respect to such investigations
may be substantial. Some D&O policies may cover
defense costs associated with such SEC enforcement
investigations, even in the absence of a formal SEC
enforcement proceeding. Accordingly, it is important
that corporations and individual officers and directors
focus on issues related to D&O coverage as soon as
they receive advice concerning an SEC enforcement
inquiry.
The securities plaintiffs’ bar may seek to bolster its
claims by contending that new certifications given
pursuant to the Act are fraudulent. It is certainly
possible that, in light of such contentions, D&O insurers
may seek to invoke fraud exclusions that are found in
many D&O policies. Such exclusions frequently do not
apply unless, at a minimum, deliberate fraud is proven.
In any event, defense costs typically are advanced prior
to such a determination, and policyholders often
successfully argue that the exclusions do not apply
where claims are settled in the absence of any
determination that fraudulent conduct took place.
Furthermore, because liability for “fraud” can be proven
in some jurisdictions under certain securities laws upon
a showing of mere recklessness, coverage under some
D&O policies arguably may be available even if civil
“fraud” liability is established in an underlying
proceeding, where a fraud exclusion applies only to
“deliberate” fraud.
Even if an officer or director is not entitled to corporate
indemnification, it generally is understood that a D&O
insurer nonetheless potentially may be obligated to
advance defense costs or indemnify the individual
insured.
AUGUST 2002
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Some SEC enforcement actions may seek only to
prove, or ultimately only may prove, negligence on the
part of a CEO or CFO. Typically, D&O policies
provide coverage for negligent acts.
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It is possible that, going forward, insurers may argue
that the certifications required by the Act should be
considered something D&O insurers rely on when
issuing policies. To the extent that financial reports or
SEC filings of a company are later deemed to have
been inaccurate, insurers may argue that certifications
regarding the reports or filings were warranties as to the
accuracy of the reports or filings, that the insurers were
misled during the D&O policy formation stage, and that
they should be entitled to rescind their policies on the
theory that the insured misrepresented material facts to
its insurers. However, because the required
certifications will be qualified as “to the best of [the
CEO’s or CFO’s] knowledge,” they ultimately may not
be considered warranties and rescission may be
impermissible absent proof of an intent to mislead an
insurer.
There are at least two new insurance-related issues raised
by the Act:
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A common exclusion found in many D&O insurance
policies excludes coverage for claims based upon or
arising from an insured person having gained personal
profit, remuneration or advantage to which the person
was not legally entitled. Insurers may argue that such
an exclusion is implicated where, under the Act, a CEO
or CFO is required to disgorge bonuses or other
remuneration because of a restatement of a
corporation’s financial statements. However, even if
this common exclusion will apply under certain
circumstances — which is not by any means a certainty
because it is not clear under such circumstances that the
individual in question was not legally entitled to the
bonuses or remuneration in question when received —
- under most D&O policies, defense costs should be
advanced until actual disgorgement is ordered.
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The longer statute of limitations created by the Act may
have relevance to D&O coverage. It is possible that
this lengthened limit will prompt lawsuits based upon
acts or omissions that were undertaken a number of
years ago. Some D&O policies expressly state that no
coverage will be provided under any circumstances for
actions undertaken prior to a specific “retroactive date.”
Conceivably, the acts in question could precede the
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retroactive date. Similarly, some policies may state that
there is no coverage if, as of some specific prior date,
the insured had knowledge of circumstances that may
give rise to claim. Again, such provisions could give
rise to coverage disputes.
defend against a claim unless and until the criminal
offense is proven. Thus, if criminal charges are filed
based upon alleged violations of the Act, depending on
the relevant facts and law, an employing corporation
may be able (or conceivably even required) to pay for
the defense of a director or officer, unless and until a
criminal act is proven.
SELECTED ISSUES RELATED TO
CORPORATE INDEMNIFICATION
The rights of any given director or officer to be
indemnified by his or her employing corporation or to
receive advancement of defense costs for claims asserted
against the individual will depend, among other things, on
some or all of the following: (a) the nature of the claim
asserted against the individual; (b) the actual facts
regarding the individual’s conduct; (c) bylaws, articles of
incorporation, indemnification agreements and other
documents (collectively, “Indemnification Provisions”)
defining the rights of the individual to indemnification and
the duty of the corporation to indemnify; and
(d) applicable law, both statutory and common, governing
the extent to which indemnification will be allowed.
Depending on the foregoing, in any given case several
points are worth noting:
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In many jurisdictions, a corporation may not indemnify
an individual for proven criminal acts. Typically,
however, defense costs potentially may be advanced to
The Insurance Coverage practice group at Kirkpatrick &
Lockhart Nicholson Graham LLP offers an international
policyholder-oriented practice on behalf of Fortune 500 and
numerous other policyholder clients. Its lawyers have
authored Policyholder’s Guide to the Law of Insurance
Coverage and edited the Journal of Insurance Coverage.
For further information, please consult our website at
www.klng.com.
FOR ADDITIONAL INFORMATION concerning this topic
or Kirkpatrick & Lockhart LLP’s insurance coverage practice,
please consult the Kirkpatrick & Lockhart LLP office
contacts listed below:
Boston
Dallas
Harrisburg
Los Angeles
Miami
Newark
New York
Pittsburgh
San Francisco
Washington
John M. Edwards
Robert Everett Wolin
Raymond P. Pepe
David P. Schack
Daniel A. Casey
Anthony La Rocco
Eugene R. Licker
Peter J. Kalis
Edward P. Sangster
Matthew L. Jacobs
617.261.3123
214.939.4909
717.231.5988
310.552.5061
305.539.3324
973.848.4014
212.536.3916
412.355.6562
415.249.1028
202.778.9393
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With respect to civil fraud claims brought by investors,
the result likely would be similar in most jurisdictions.
A corporation typically may provide a defense for an
officer or director unless and until deliberate
malfeasance is proven. If only negligence or
recklessness is proven with respect to the falsity of
particular SEC filings or financial statements,
indemnification might be possible under some state
laws even if liability is established.
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If a criminal act is proven, it is possible, depending on
the facts and circumstances, that a director or officer
may not be entitled to indemnification for financial loss
arising out of the conviction. Furthermore, issues may
arise as to the entitlement of the director or officer to
indemnification with respect to civil claims that are
related to, or based upon, the same alleged conduct.
CONCLUSION
Although it is too early to assess the impact of the Act on
government criminal or civil enforcement actions or claims
by private investors, it seems that the Act eventually may
be at the center of certain D&O insurance coverage and
corporate indemnification disputes concerning potential
financial fraud. Insureds may wish to review the specific
language of their D&O policies and Indemnification
Provisions to understand better how the Act may impact
available insurance coverage and indemnification.
THOMAS M. REITER
treiter@kl.com
412.355.8274
jedwards@kl.com
rwolin@kl.com
rpepe@kl.com
dschack@kl.com
dcasey@kl.com
alarocco@kl.com
elicker@kl.com
pkalis@kl.com
esangster@kl.com
mjacobs@kl.com
ALAN W. TAMARELLI, JR.
atamarelli@kl.com
412.355.8685
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This publication/newsletter is for informational purposes and does not contain or convey legal advice. The information herein
should not be used or relied upon in regard to any particular facts or circumstances without first consulting a lawyer.
© 2002 KIRKPATRICK & LOCKHART LLP.
ALL RIGHTS RESERVED.