PLUS D&O
Symposium
D&O Exposure After Sarbanes-Oxley:
Evaluating Risk in the New Regulatory Environment
Boris Feldman
Wilson Sonsini
Goodrich & Rosati LLP
William R. McLucas
Wilmer Cutler & Pickering
Lisa Klein Wager
Morgan, Lewis & Bockius LLP
Prof. John Coffee
Columbia Law School
Alan Schulman
Bernstein Litowitz
Berger & Grossman LLP
Topics
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Overview of the Sarbanes-Oxley Act
Introduction to Key Provisions Implicating Entity and
Director and Officer Exposure
Anticipated Impact on Federal Class Action Litigation
Anticipated Impact on Derivative Litigation
Possible Further Legislative/Judicial Initiatives
Implications for D&O Underwriters’ Due Diligence
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Overview of the New World Under
Sarbanes-Oxley
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Signed into law on July 30, 2002
Response to rapidly spreading Enronitis Virus
– and the Sergeant Shultz defense
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Designed to restore investor confidence by:
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improving corporate disclosures
increasing personal accountability of officers
expanding the role of the audit committee/outside directors
improving independence and reliability of outside auditors
addressing analyst conflict of interest concerns
Broad ranging set of reforms
– some immediately effective
– some mandating SEC rule-making
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Living Under Sarbanes-Oxley
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Issuers have enhanced periodic disclosure obligations
– relating to the scope and detail of the MD&A, specifically:
• off-balance sheet and contingent obligations
– purpose, structure, consequences (quantified), contingencies and potential
consequences (quantified), contingency plans if significant risks materialize
• critical accounting estimates
– identification of important assumptions underlying estimates, associated
risks.
– Practice pointer: These qualify for safe harbor protection under the PSLRA
if properly identified as forward looking and accompanied by meaningful
risk discussion.
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Issuers’ Enhanced Disclosure
Obligations (continued)
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The new MD&A requirements elevate its importance.
– It is a centerpiece of disclosure from the SEC’s perspective.
– It will be a key focus for the plaintiffs’ bar.
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Many issuers are mistakenly focused only on the certification process.
It is equally if not more important to focus on the MD&A.
If the MD&A is properly prepared and vetted,
the certifier has significantly reduced exposure
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Issuers’ Enhanced Disclosure
Obligations (continued)
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Issuers also have enhanced periodic disclosure obligations
– concerning qualifications of audit committee financial expert
– concerning existence of a code of ethics for senior financial officers
• and any waivers of code of ethics
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Issuers’ Enhanced Disclosure
Obligations (continued)
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Issuers also have enhanced disclosure obligations
– concerning current events
• expanded Form 8-K triggering events related to “material changes in
financial condition or operations” specified in new SEC rules
• accelerated Form 8-K filings - to be phased in per rules
– governing a presentation of pro forma financial information,
including generally (subject to specific exceptions), that it:
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must include most directly comparable GAAP number
must contain GAAP reconciliation (new Reg G)
special rules for oral presentations/SEC filings
should explain the basis for/utility of the presentation
must not be false or misleading
– a violation is not a basis for a 10(b) action
– but conduct that violates one may violate both
• Note the first SEC enforcement action based on pro forma use
(Trump Hotels, January 16, 2002 Release).
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Living Under Sarbanes Oxley
(continued)
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Issuers also
– are prohibited from extending/arranging personal loans to directors
and officers
• may raise issues related to advancement of defense costs
– must adopt whistleblower procedures/protections
– cannot retaliate against whistleblowers
• covers assistance provided by employees/ex-employees
• covers assistance provided to law enforcement officers
• covers assistance provided to plaintiffs’ lawyers in connection with
pending or potential litigation
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Living Under Sarbanes-Oxley
(continued)
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Principal Officers have new responsibilities.
– They have to personally certify in periodic SEC filings:
• the accuracy of the report’s content
– including financial and non-financial information
– representing that it “fairly presents” the company’s financial condition and
results of operations
• the design and effectiveness of the company’s
“disclosure controls and procedures”
• that the certifying officers have advised auditors/audit committee of:
– any significant deficiencies in design/operation of financial controls
– any fraud by employees significantly involved in controls
• that the report reflects the occurrence in the period of changes in
controls/corrective actions/factors potentially impacting controls
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Living Under Sarbanes-Oxley
(continued)
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Principal Officers have new risks.
– They may have to disgorge profit/bonuses during any period
subsequently restated due to misconduct, including:
• any incentive-based or equity-based compensation
• profits from sale of company’s securities
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Settlements and judgments against individuals in civil and
criminal actions not dischargeable in bankruptcy.
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Living Under Sarbanes-Oxley
(continued)
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The Act prohibits trading by officers/directors during
pension black out periods
– SEC has issued a clarifying release
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The Act’s requirements apply to foreign private issuers who
report under Section 15(d),register securities under the
Securities Act, or register under Section 12 (b) or 12 (g) of
the Exchange Act
– Rule releases provide minor accommodations in timing of certain
provisions (issues involving reconciliation of financial statements,
etc.)
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Living Under Sarbanes-Oxley
(continued)
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Expanded Audit Committee Responsibilities:
– Section 301 directs the SEC by March 2003 to direct the stock
exchanges to require the audit committees of listed companies to:
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have direct responsibility for engagement of auditors
consist of independent directors
adopt procedures for handling complaints re accounting matters
have authority to hire advisors
– Section 204 will require audit committees to receive reports from
auditors on critical accounting policies, alternative accounting
treatments and other matters
– Principal officers required to report to the audit committee on
adequacy of controls/fraud by control personnel
– Stock exchanges have also increased requirements
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Living Under Sarbanes-Oxley
(continued)
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New Rules Governing Conduct of Attorneys
– require “up the ladder” reporting of a material violation
• to CEO or CLO or “Qualified Legal Compliance Committee” (QLCC)
• materiality is determined by an objective standard
– require reporting to audit committee, independent directors, or full
board if CEO/CLO does not respond “appropriately”
– cover issuer’s counsel who have notice that they are preparing or
assisting in preparing materials that will be filed with the
Commission
• includes foreign attorneys under specified circumstances
– preempt conflicting , less rigorous, state rules
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New Rules Governing Conduct of
Attorneys (continued)
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The new rules permit disclosure of issuer’s confidential
information to:
– prevent material violation likely to cause substantial financial or
property damage to issuer or investors,
– prevent an illegal act by issuer, or
– to rectify a material violation or illegal act that used attorney’s
services.
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The attorney conduct rules also:
– affirmatively disclaim creation of a private right of action,
– vest exclusive enforcement authority with the Commission, and
– will be effective 180 days after publication in Federal Register.
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New Rules Governing Conduct of
Attorneys (continued)
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Proposed rules requiring “noisy withdrawal”
– drew extensive comments
– comment period has been extended for 60 days
– January 2003 release proposes alternative:
• attorney’s quiet withdrawal
• public disclosure of withdrawal by issuer
– in a current filing (e.g. Form 8K)
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New Consequences Under
Sarbanes-Oxley
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Statutory Whistleblower Protection
– new criminal penalty for retaliation against informing law
enforcement officers
– new private cause of action for discrimination against employees
who are informants/provide assistance to law enforcement
personnel or in connection with private actions involving alleged
securities law violations or fraud.
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Expanded Statute of Limitations for all private securities
actions
– earlier of 2 years after discovery/5 years after violation
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New Consequences Under SOA
(continued)
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New/Enhanced Criminal Offenses (continued_)
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Destruction of documents to impede law enforcement inquiry
Retaliation against law enforcement informants
Criminal “securities fraud” Increased mail/wire fraud penalty
Fraudulently Misleading an Auditor
Additional Increased Penalties Under ERISA
New Commission Enforcement Powers
– Power to Freeze Payments
– Power to Bar Officers/Directors
– New Private Right of Action for Retaliation by Whistleblowers
• available to those who inform law enforcement officers
• also available to those who inform private attorneys pursuing or
contemplating litigation
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Anticipated Impact of SOA on Federal
Class Action Litigation
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More in the short term, exacerbated by brevity of legislative
history and absence of a comprehensive conference
committee report
– interpretation of terms
– availability of private right of action where not explicit
– certification of disclosure controls may facilitate particularized
scienter pleading
– certification of content coupled with expanded MD&A may facilitate
omission pleading
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Potentially more protacted/complicated due to anticipated
increase in note-taking/record-keeping
New criminal penalties for attempting audit
influence/document destruction may raise pressure to
settle early/costs of doing so
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Anticipated Impact of SOA on Federal
Class Action Litigation
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Less in the long term, hopefully, for Companies that
succeed in improving corporate governance and disclosure
practices
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Another cost concern:
– implications of attorney conduct rules for “issuer’s” counsel may
lead to more requests for individual separate counsel or for
separate counsel for D&O’s and issuer
– SEC emphasis on full cooperation may lead to requests for
separate counsel for D&O’s and issuer
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Anticipated Impact of SOA on
Derivative Litigation
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More in the short term
– concerning the viability of derivative claims for breach of fiduciary
duties
• may give teeth to Caremark duties
• particularly attractive to institutional shareholders seeking corporate
governance changes
– potentially including a new variation of parallel derivative litigation
• following restatements/extraordinary adjustments
– alleging that CEO/CFO breached duty by coercing auditors to limit time
period/magnitude/characterization of a restatement in order to avoid
disgorgement of bonuses/incentive/equity based compensation
– potentially over claims forgiveness of existing loans
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Anticipated Impact of SOA on
Derivative Litigation
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More in the short term
– The Act may be a full employment act for smaller plaintiff firms that
have been squeezed by PSLRA lead plaintiff rules and SLUSA
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Anticipated Impact of SOA on
Derivative Litigation
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One piece of good news
– new director independence requirements may make plaintiffs ability
to plead demand futility a thing of the past
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Future Legislative/Judicial Initiatives
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Potential Legislative/Judicial Initiatives
– Plaintiff’s wish list includes:
• legislative or judicial establishment of private aiding and abetting
liability, which could lead to:
– expanded liability for accounting firms, law firms, investment banking firms,
and financial institutions, and
– new causes of action against those who allegedly assist in fraud by
financing, structuring/funding of special purpose entities and other offbalance sheet arrangements that underlay omission and misrepresentation
claims;
• repeal of mandatory discovery stay or amendment to make
discretionary, and
• reinstitution of joint and several liability.
– Note that the recent district court decision in Enron chips away at
Central Bank of Denver (Supreme Court decision that abolished
private rights of action for aiding and abetting).
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Living Under Sarbanes Oxley
(continued)
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Potential Legislative/Judicial Initiatives
– Defendant’s wish list includes:
• expansion of SLUSA to cover all piggy-back, tag-a-long litigation
alleging violations of SOA responsibilities, internal codes and
procedures or insider trading, and
• amendment of Delaware Corporate Law to provide for mandatory rule
11 findings/presumptive fee shifting in Delaware common law cases
brought by shareholders.
– You heard it here first.
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Implications of Sarbanes-Oxley for the
D&O Insurance Underwriting Process
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Know your customer.
– Read their SEC filings.
• If you don’t understand how they make their money, stay away.
• How close is the MD&A to what will be required?
– Are they making fulsome critical accounting disclosures, identifying forward
looking assumptions, and disclosing meaningful related risks sufficiently to
invoke the safe harbor?
• Do they have good risk discussion - not boilerplate to anyone in the
industry
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SOA and the D&O Insurance
Underwriting Process (continued)
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Know your customer.
– Talk to them.
• Discuss intended changes and assess their understanding of the
issues and the degree of care they have given them.
– The proper focus is not on whether they have definitive answers, as
much as on an assessment of whether they are thinking and
preparing to act.
• Ask about off balance sheet transactions or financing arrangements.
– Are new disclosures anticipated of previously nonpublic information
– Can they articulate and quantify the impact and risks of such
arrangements
– Have they thought about contingency arrangements
• What market response is anticipated and have they considered need
for a current disclosure?
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SOA and the D&O Insurance
Underwriting Process (continued)
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Know your customer better.
– Read their recent press releases.
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Are they objective in tone?
Will their use of pro-forma financials pass muster?
Are they using safe harbor properly and consistently?
Are they the responsibility of the same people responsible for SEC
disclosure documents?
– Will there be a disclosure committee and if so who will be on it?
• How do they envision the disclosure process working?
– Are they undertaking any audits of controls or procedures?
• Are there divisions of recently acquired businesses for which this
should be done?
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SOA and the D&O Insurance
Underwriting Process (continued)
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Know your customer better.
– Who is the general counsel and what is his/her background, style,
and relationship with management?
– Who is corporate counsel/ what is their role/ what weight is given to
their opinions?
– Are they involved early in the preparation of periodic filings to have
meaningful input?
– Will there be a QLCC?
• What are their whistleblower procedures?
• Is there a code of ethics for financial officers?
– Who are the independents?
• Are they staying?
• What is their roles/backgrounds/styles/relationship with management?
• What are the company’s plans for complying with NASDAQ/NYSE
rules
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SOA and the D&O Insurance
Underwriting Process (continued)
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Know your customer better.
– Who are the auditors?
• Have there been auditor changes/disputes?
• Are their auditor independence issues- explore?
– How does their MD&A and risk discussion compare to their major
competitors?
– How is executive compensation structured/ vis a vis competitors?
– Does management have 10b-5-1’s, what has been their stock sale
history?
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SOA and the D&O Insurance
Underwriting Process (continued)
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Bottom line- Are you comfortable that these are trustworthy
committed people and are they as committed to doing it
right as they are to being financially successful in their
business
Final tip: Yes, get the premium; but don’t dig yourself in
deeper to do it.
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Implications of Sarbanes-Oxley for the
D&O Insurance Underwriting Process
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This is not an exhaustive list, but rather is a collection of
suggestions that defense lawyers have made, coming up
from the trenches.
Not all the information may be needed from every company
It is intended to supplement information historically
reviewed, such as claims history and audited financials.
We encourage a thorough rather than adversarial process.
Ideally, your due diligence is consistent with a selfevaluation your insured is undertaking and will undertake
periodically - a process that improves the chances that
they will never actually have to file a D&O claim.
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PLUS D&O
Symposium
D&O Exposure After Sarbanes-Oxley:
Evaluating Risk in the New Regulatory Environment
© Lisa Klein Wager
Morgan, Lewis & Bockius LLP
New York City
(o) 212-309-6113
(c) 917-881-8426