Insurance Coverage
JULY 2002
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
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 (those with reported annual revenues in
excess of $1.2 billion) personally to certify, in writing
and under oath, the accuracy of each of their
companies’ reports filed with the SEC, including
financial statements.1
Under the terms of the SEC’s Order, the certifications
must be submitted to the SEC by the close of
business on the first date, on or after August 14,
2002, that each company currently is required to file a
Form 10-K or 10-Q report. Unless filing a statement
under oath explaining why no certification can be
submitted, each impacted CEO and CFO will need to
sign and have notarized a statement that, “to the best
of [his or her] knowledge, based upon a review of the
. . . reports of [their company],” the reports contain
no “untrue statement of material fact” and omit no
“material fact necessary to make the statements in the
[reports], in light of the circumstances under which
they were made, not misleading . . .”
This new requirement comes on the heels of wellpublicized alleged accounting irregularities at a
number of large, high profile companies. It has been
described by SEC Chairman Harvey L Pitt as a
measure to “restore investor confidence.” This Alert
highlights the intersection between, on the one hand,
the SEC Order and, on the other hand, the protections
afforded under D&O insurance and under corporate
indemnification provisions.
THE SEC’S ORDER IN CONTEXT
While the SEC’s Order is being portrayed in some
quarters as a substantial change in the regulatory
framework, several points about the actual impact of
the Order are worth noting.
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It does not appear that the SEC’s Order is intended
to create any new causes of action that can be
asserted against CEOs and CFOs by private
investors. Under existing law, in certain
circumstances, investors already are entitled to
recover civil damages from CEOs and CFOs,
among others, based upon material misstatements
in SEC filings and financial statements.
1 A bill entitled the “Public Company Accounting Reform and Investor Protection Act of 2002” proposed by Senator
Paul Sarbanes of Maryland would impose similar certification requirements on CEOs and CFOs.
Kirkpatrick & Lockhart LLP
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The SEC’s Order does not purport to allow or
provide for any additional damages beyond those
investors already are entitled to seek under
existing law.
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As a practical matter, CEOs and CFOs already sign
and approve many SEC filings and financial
statements, albeit not under oath.
Despite the foregoing, the SEC’s Order does raise
potentially significant issues for impacted CEOs and
CFOs, as well as their employers, including issues
concerning:
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Whether the new certifications 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 new 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 the SEC’s Order will result in government
prosecution of CEOs or CFOs for perjury or
similar, related offenses;
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Whether, as the SEC’s Order and other recent
government actions generally may signal, there
will be a marked increase in the number of criminal
or civil actions asserted by the federal government
against individuals, including CEOs and CFOs,
based upon inaccurate SEC filings or financial
statements.
ISSUES RELATED TO
D&O INSURANCE COVERAGE
In forecasting the potential impact of the SEC’s Order
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 SEC’s Order) may vary significantly.
Furthermore, it remains to be seen whether insurers
2
will seek to insert new language in future D&O
policies to directly address the certifications required
by the SEC’s Order. In addition, insurance
implications of the SEC’s Order will depend in part on
how government authorities and the private
securities plaintiffs’ bar attempt to use the
certifications. Despite these variables, several issues
related to D&O coverage related to the certifications
required by the SEC’s Order are worth noting.
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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.
■
While the SEC’s Order may lead to government
prosecution of CEOs or CFOs for 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 perjury charge, at least until a criminal
act has been proven. Many D&O policies,
however, exclude coverage for fines and penalties
in the event criminal (or in some cases, civil)
liability is established. Moreover, if perjury or a
related offense is proven, D&O insurers may
argue that coverage is not available to a CEO or
CFO with respect to civil claims arising out of the
same false certifications 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
KIRKPATRICK & LOCKHART LLP INSURANCE COVERAGE ALERT
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.
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The securities plaintiffs’ bar may seek to bolster
its claims by contending that new certifications
given pursuant to the SEC’s Order 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 many D&O
policies may be available even if civil “fraud”
liability is established in an underlying
proceeding. This is particularly true where, for
example, the fraud exclusion applies only to
“deliberate” fraud.
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Even if a CEO or CFO is not entitled to corporate
indemnification, it is generally understood that a
D&O insurer may nonetheless potentially be
obligated to advance defense costs or indemnify
the individual insured.
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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. Under typical D&O
policies, coverage is provided for negligent acts.
JULY 2002
ISSUES RELATED TO
CORPORATE INDEMNIFICATION
The rights of any given CEO or CFO to be
indemnified by his or her employing corporation or to
receive advancement of defense costs for claims
asserted against the CEO or CFO 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) by-laws, 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 defend against a claim unless and
until the criminal offense is proven. Thus, if
perjury charges are filed based upon certifications
required by the SEC’s Order, depending on the
relevant facts and law, an employing corporation
may be able (or conceivably even required) to pay
for the defense of its CEO or CFO, unless and until
perjury — which typically requires proof of
“willful” falsity — is proven.
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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 its CEO or CFO 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 may be possible even
if liability is established. This would also typically
be the case for SEC enforcement actions in which
only negligence is either alleged or ultimately
proven.
Kirkpatrick & Lockhart LLP
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If perjury is proven in a criminal case, it is
possible, depending on the facts and
circumstances, that a CEO or CFO may not be
entitled to indemnification for financial loss arising
out of the conviction. Furthermore, issues may
arise as to the entitlement of the CEO or CFO for
indemnification with respect to civil claims that are
related to, or based upon, the same allegedly false
certification.
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:
CONCLUSION
Although it is too early to assess the impact of the
SEC’s Order on government enforcement actions or
claims by private investors, it seems that the Order
may eventually 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 Order may impact
available insurance coverage and indemnification.
THOMAS M. REITER
treiter@kl.com
412.355.8274
ALAN W. TAMARELLI, JR.
atamarelli@kl.com
412.355.8685
Boston
John M. Edwards
617.261.3123
jedwards@kl.com
Dallas
Robert Everett Wolin
214.939.4909
rwolin@kl.com
Harrisburg
Raymond P. Pepe
717.231.5988
rpepe@kl.com
Los Angeles
David P. Schack
310.552.5061
dschack@kl.com
Miami
Daniel A. Casey
305.539.3324
dcasey@kl.com
Newark
Anthony La Rocco
973.848.4014
alarocco@kl.com
New York
Eugene R. Licker
212.536.3916
elicker@kl.com
Pittsburgh
Peter J. Kalis
412.355.6562
pkalis@kl.com
San Francisco
Edward P. Sangster
415.249.1028
esangster@kl.com
Washington
Matthew L. Jacobs
202.778.9393
mjacobs@kl.com
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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.