Bank Director`s 2001 D&O Liability Report

The peril is real. From electronic commerce, the onus on the audit committee, and fair disclosure rules to more familiar concerns like employment practices, lending liability, and credit quality, bankers face an array of threats new and old that have increased the complexity of the board`s responsibilities. What`s more, many of these factors have unfolded in the wake of the technology stock crash, which brought an end to the decade-long bull market and made investors and consumers more wary of banking practices. For directors who bear overall responsibility for setting the policies that guide their institutions through good times and bad, the liability that can arise from the decisions they makeu00e2u20ac”even where best-practices guidelines have yet to be establishedu00e2u20ac”is an essential area of concern. “Change creates exposure, even as it creates uncertainty and opportunity,” says Donald Bryan, managing director at the insurance broker Marsh USA and practice leader for its directors and officers liability group in Chicago. “D&O liability insurance is the ultimate stopgap.”

Rising numbers of suits and claims

Unquestionably, shareholders and regulators have stepped up scrutiny of every aspect of companies` operations in recent years and are ready to hold boards accountable at the first sign of a misstep. Preliminary data collected by National Economic Research Associates (NERA), a White Plains, New York-based consulting company, shows that the number of federal class-action lawsuits filed against public companies rose to 223 in 2000, up by nearly 14% over the total number filed in the prior four years. In industry-by-industry comparisons, suits involving technology companies accounted for the bulk of the increase, according to NERA, while those filed against banking companies dipped by 17% to 10. But Dan Bailey, a partner with the law firm Arter & Hadden in Columbus, Ohio, calls the banking sector decline a misleading statistic. “What`s more important,” Bailey says, “is that the cases that are proceeding are receiving a whole lot more money than before in terms of settlements.” Among all industry groups, the NERA study shows, the average settlement of a shareholder suit in 2000 (excluding the $2.8 billion settlement paid by Cendant, which was so large that it would have skewed the comparisons) was $14 million, up from an average of $12.9 million in 1999 and substantially above the $9.3 million average for the period from 1991 to 2000. “Over the last year to 18 months, there has been an explosion in the size of settlements in shareholder class-action suits,” Bailey says, adding, “We`ve seen at least 10 different securities class-action cases that have settled for well in excess of $100 million. That kind of number is absolutely unprecedented, and it has an inflationary effect on cases at lower levels as well. Negotiated settlements are coming in much higher at all levels.” Barbara J. Stafford, assistant vice president of St. Paul Fire and Marine Insurance Co. in Minneapolis, agrees: “There`s no question that claim frequency and severity are up. We know that in our own portfolio, and we know that it`s happening on a national basis as well.” Stafford cites an annual survey of D&O liability claims by Tillinghast-Towers Perrin, which put the banking industry`s “susceptibility” rate, or the chance that a bank had filed a claim over the last 10 years, at 37%. “Banks are the highest industry category in terms of susceptibility,” she says. “There are more banks reporting claims than any other industry segment.” The increasing severity of the claims that insurance carriers are experiencing can be seen in the figures for costs related to shareholder claims as revealed by the Tillinghast-Towers Perrin survey. Such costs rose to $9.62 million in 2000, from $8.67 million the previous year, while the average cost to defend against these claims was about $1.1 million, according to Stafford.

The liability landscape

Several banking practices have emerged over the last few years that have direct and indirect implications for D&O liability. The most obvious and significant change in banks` operational landscape stems from the rise of the Internet, which entails a range of new concerns like data security, service interruptions, and even copyright infringement. Few bankers would disagree with the proposition that offering customers online banking services is an essential step to remaining competitive. Yet Internet operations present a number of potential liability exposures, says John Feniello, assistant vice president and product manager for financial institution Internet products at American International Group`s National Union Fire Insurance Co. of Pittsburgh. These include what Feniello calls “content” exposure, meaning charges that material posted on a bank`s website is libelous or infringes on trademarks, copyrights, or privacy. Another crucial exposure, Feniello says, has to do with network security and first- and third-party claims arising from unauthorized intrusions or virus infections. While directors should be aware of the bank`s exposure to liability in these situations, Feniello says, claims in both of these areas would more properly fall under coverage for errors and omissions rather than D&O liability, Feniello says. “D&O coverage could come into play if directors were sued because they didn`t procure or secure the proper Internet coverage,” he says, adding that some of these suits have already come to light. In addition, the technology sector collapse has threatened to carry the larger economy into recession, bringing worries over credit quality and lending liability to the surface for the first time since the early 1990s. “This could be a tough time for bank directors,” says Ron Glancz, a partner with the Washington, D.C. law firm Venable, Baetjer, Howard & Civiletti. Whenever there is deterioration in loan quality, regulators come down hard on banks, he says. Directors must be particularly sensitive to the impact of problem loans on their overall loan portfolios and their banks` exposure to interest rate and liquidity risks. “We`re seeing some real deterioration in loan quality, and whenever that happens, regulators come down hard on banks,” he says. “It puts a burden on directors to make sure they are on top of the situation and asking management tough questions. It`s up to directors to make sure they have proper systems and controls in place. They can`t prevent a downturn, but they have to make sure that the bank is doing everything it can to prepare for it.” Says Stephen M. Klein, a partner and co-chairman of the banking group at Graham & Dunn, a Seattle law firm: “We`re sensing already that they are starting to scrutinize things much more carefully during examinations.” And, he predicts, “We`re going to start seeing administrative actions, after 10 years that have been very quiet.” One particular area of credit quality concern cited by John K. Villa, a partner at the Washington, D.C. law firm Williams & Connolly, is loans to start-up companies, many of which have been badly damaged in the technology shakeout over the last year. “Banks have been pretty good on lending criteria, and nobody could have anticipated the problems they`ve had with start-up companies,” Villa says. Most technology start-ups were funded initially by venture capital, but many of these concerns had progressed to a second stage of financing, often using bank loans before they ran into trouble. “The question is really when we`re going to start seeing recognition of losses on these loans,” he says. In addition to internal factors, several knotty corporate governance issues confront directors of publicly traded banks. The Securities and Exchange Commission now requires companies to adopt a written charter for the audit committee and mandates that at least three independent directors on the committee have specific financial expertise. They also must include a report by the audit committee in the company`s annual report. Moreover, securities officials intend to take a tough stance on new rules that require interim financial statements to be reviewed on a quarterly basis by independent auditors. Bailey notes that the new audit committee rules were partly intended to decrease directors` potential liability by spelling out procedural requirements that would allow them to demonstrate that they had done their fiduciary duty to shareholders. But, as he wrote in a recent paper on the subject, “Most legal commentators disagree with this optimistic prediction and instead believe that audit committee members face increased potential liability exposure as a result of these new rules if a perception of corporate financial misfeasance exists at any level within the company.” Insurance experts point out that because the audit committee members essentially are required to endorse the independent auditors` report, they will become the focus of shareholder dissatisfaction if problems are later discovered with the financial results. “My personal view is that this has heightened directors` liability,” Marsh`s Bryan says. “The audit committee rule has codified standards for due diligence, and investors relying on the byproducts of that behavior, i.e., the financials, are going to hold people to higher standards. It increases people`s comfort in relying on the financial statements, but ultimately, if the financials are incorrect, it is going to increase the board`s liability for having breached those standards.” Adds Bailey of Arter & Hadden: “The effect of these rules is to increase the visibility of those independent directors serving on the audit committee. If there`s a perception of financial irregularities in a company, those directors are going to effectively serve as lightning rods for any litigation.” As of mid-April, no liability claims had arisen yet under the audit committee rules, according to insurance industry experts. Nevertheless, there is speculation that the new requirements could make it difficult for companies to find qualified directors to serve on the audit committees. To help assuage potential members` concerns, Bailey suggests several steps that boards and their insurers may want to consider to make sure their D&O coverage is adequate. Among them: deleting fraud and personal profit exclusions for audit committee members; waiving deductibles for D&O coverage; expressly barring rescission of the coverage because the company restated its financial results; and buying a separate, additional limit of liability for committee members. Another issue legal experts are watching closely is Regulation FD, which requires that any time companies provide material nonpublic information to Wall Street analysts or other securities market professionals, they must make sure that it is provided simultaneously to the general public. Lawyers and insurance experts say it is important to note that Reg FD does not allow for shareholders to file suit directly against boards or officers in cases of alleged violation. But it does allow the SEC to bring civil or criminal enforcement actions. The early indications are that the regulation has caused many companies to sharply reduce the amount of information they disclose; along with the technology sector`s difficulties, that has led to a string of earnings reports that missed analysts estimates. “The impact from a D&O liability standpoint is more indirect,” Bailey says. “Whenever you have missed earnings estimates and, therefore, a significant drop in the stock, there`s a much better chance there`s going to be a suit filed.” George Biancardi, senior vice president at Gulf Insurance Group, says he expects to see an upsurge in lawsuits and, eventually, liability claims related to Reg FD. “Banks and companies in general are more reluctant to guide analysts, and when they say nothing, there`s bound to be a surprise when they do speak up,” he says. “Any time there`s an earnings surprise, there`s litigation.” In general, advisers say, both of the new rules will require added vigilance from directors. “There is a greater degree of potential exposure, because the duties of directors have been expanded as a result of these recent SEC initiatives,” says John Houston, a partner with Robins, Kaplan, Miller & Cirese, a Minneapolis-based law firm. “There are more rules to follow.”

Ensuring directors are covered

The rise in frequency and severity of D&O claims, as well as the appearance of new factors expected to generate liability for directors, has contributed to the rise in premium cost for D&O coverage. Carriers raised premium prices by 3% to 5% in 2000, with larger increases expected in coming months, St. Paul Fire and Marine`s Stafford says. “Price increases are going to range anywhere from 15% to 25% and in some cases, more, depending on the quality of the risk, claims history, and diversification,” she says, referring to, for example, a bank that acquires an insurance agency, thereby expanding its business operations and, thus, its risk profile. Data compiled by Marsh show that average annualized premiums paid by banks of all asset classes as of April 2001 were $571,230, a jump of nearly 9.5% from a year earlier. Marsh officials say they expect the price hikes to become even more pronounced as the year goes on. Beyond price increases, directors can expect to be asked to find higher retentions and restrictions on the kind of multiyear policy contracts that were common as recently as a year ago. A three-year policy commitment, for example, may be available only if a bank is willing to accept provisions for annual review and the possibility of amending the policy over the course of the term. “Multiyear deals are becoming much rarer,” says Larry Goanos, executive vice president in National Union`s financial institutions group. “Most carriers are reluctant to commit to a three-year contract when they realize they may be able to get a bigger increase in the second or third year.” This impression is confirmed by the Marsh benchmarking study from April 2001, which shows the average policy term for banks of all asset classes at 2.08 years, compared with an average of 2.33 years in April 2000. The study shows that the average policy term has fallen below three years for even the largest banks. The changing price environment and the rise of new liability exposures for boards and officers should be a reminder of the need for regular reevaluation of D&O coverage, experts say. “It`s a good time for directors to have management do two things,” says Graham & Dunn`s Klein. “They should have a presentation to the board giving them an update on directors` fiduciary duties, and they should do an audit on their insurance coverage and the practices that could give rise to claims.” Then, he added, they should have the lawyers take a look. “Many banks don`t have the lawyers review these policies, and they should,” he says. “For the last decade we`ve had the best of times, but I would suggest that in this environment, there will be creative lawyers who will come up with new theories of liability,” Klein continues. “Whether it will be Reg FD or the audit committee or the Internet, there will be some creative theories developed in order to find a way to make claims.” It is up to directors to make sure they are ready.