BusinessTN

Once upon a time, an invitation to sit on a corporate board of directors was routinely met with eager acceptance. The prestige and business contacts conferred by a directorship were enviable and the job requirements minimal.

No more. The scandals in corporate governance that resulted in 2002’s Sarbanes-Oxley legislation have transformed board seats into hot seats. Now spending countless hours in meetings and studying corporate documents, board members are struggling to protect themselves from today’s closer scrutiny and stiffer penalties for wrongdoing.

Directors and officers insurance, or D&O, has taken on a much more profound importance. Not surprisingly, insurance companies have ramped up both their underwriting standards and their premiums on D&O policies. To sort through the direction and challenges of liability exposure for Tennessee’s corporate directors, Business Tennessee’s editor, David A. Fox, assembled a telephone conference call with these D&O experts:

• Allen Overby, partner with Bass, Berry & Sims law firm
• David Sellars, leader of insurance broker Marsh’s FinPro practice for the region including Nashville, Memphis and New Orleans
• Steve Tisdell,president of The Compliance Partners, which advises audit committees and corporate management on Sarbanes-Oxley compliance
• David Wilds, managing partner of First Avenue Partners and director of Dollar General, iPayment, IPIX and Symbion.

Business Tennessee:David Wilds, with corporate directors under so much scrutiny and tougher penalties under Sarbanes-Oxley, why would you want to serve on four different boards of publicly traded companies?
David Wilds: I was thinking about that at 2:30 this morning, anticipating this call. In my case, our private equity partnership, First Avenue Partners, is a meaningful shareholder in Symbion, IPIX and iPayment. That’s one reason. A second reason people serve on public company boards is it’s an opportunity to interact with individuals who are bright, who are doing interesting things. And it’s a great way to network. To your point that there is considerable scrutiny, I will say this: given that scrutiny, nobody’s on boards for the money.

BTN: Have you heard of others who have declined board directorships?
DW: Absolutely. Unless someone has a particular interest in a company or some association with someone on the board of a company, people are declining board memberships because of the scrutiny.

BTN: How much more seriously are boards considering these sorts of D&O legal exposures now versus a decade ago?
DW: They’re much more serious because of the litigious climate we’re in, and it’s be come increasingly so. The Milberg Weiss’s of the world have been pretty successful at extort ing large amounts of money from corporations. So unfortunately, given the nature of some of these lawsuits and that companies tend to settle rather than go to court, it’s very important to have good insurance coverage.

BTN: Allen, I was wondering how hard is it for corporations to find qualified, willing board candidates?
Allen Overby: It’s difficult to find directors that are both qualified and have the time and inclination to serve. Companies are resorting to using search firms, going outside their circle of friends and acquaintances as well, in an effort to find directors who meet the independence standards, who add to the total mix of talents available to the board. One of the things that’s changed over the years is the amount of time directors are spending when they serve on boards. I think it’s increased dramatically over the last few years. That’s because they’ve taken on increased responsibilities and because we have an evolving set of notions of what’s required and appropriate. And that is going to play a large role in whether and how directors are protected under D&O coverage in the future. I’m speaking in terms of whether or not directors acted in good faith, of not spending enough time in discharging their duties as an absence of good faith, which is only a half-step away from bad faith.
David Sellars: The key here, from an individual D&O perspective, is: Are you doing the right things? Knowing that people are always going to allege the worst—every time you read about a case, it sounds like everybody’s a crook, and everybody was negligent—the best you can do from an insurance protection standpoint is to get up front the policy language that will at least allow you to defend yourself, hopefully with insurance proceeds, to prove your innocence. That will come down to a severability provision [which applies insurance separately to each insured under a policy], a fraud provision—at what point could that fraud exclusion take hold. And if you are an innocent board member, even if someone else was negligent in acting at that level in some kind of fraud or something, that you had up front negotiated a policy that protects the innocent, so that the entire policy isn’t rescinded as to everyone.

BTN: What are you finding to be the top areas of concerns these days as it pertains to the various features of a D&O policy?,
DS: When it comes down to it, it’s obviously your severability provision. If it’s done correctly, it’s discussed up front with your broker as to how that particular policy feature will react in the case of a claim. There’s many different variations on severability—anywhere from separate applications of coverage for each individual insured in which no knowledge is imputed from one individual to another, to situations where the knowledge of the signer of the application, probably the CFO or CEO, is imputed to all insured, including the individuals and the entity. Obviously there’s many different ways to do it.

BTN: And how has the trend in severability changed in the past few years?
DS: There’s never been a totally general consensus on severability. Some forms were actually silent on severability, which really left rescission [or repudiation of a contract under certain circumstances] up to state law. But typically in the past, you had separate applications of coverage for each individual, and no knowledge was imputed to the individuals and sometimes the entity either. Nowadays, insurers are looking more at ways to protect the individual, so they’re more likely to provide severability as to the individual, whereas no knowledge is imputed from one insured to another, but they are more likely to impute knowledge to the entity. From an individual standpoint, that’s probably a positive, because if you have a meltdown scenario, it’s more likely that the entity will not be able to recover its portion of the settlement from the policy, but the individuals would. The other obviously large concern for an insured is the fraud exclusion. Most of the standard policies five years ago were “final adjudication.” What they’ve done now is move more towards “in fact” language, or final adjudication with the addition of “the exclusion takes hold upon written admission,” “upon alternative dispute resolution.” With the current market, you can still negotiate the favorable fraud language, but it does take some effort, whereas it didn’t a few years ago. And the other issues I could get into are ones associated with what side your policy is—side A, side B, and side C. Side A is for nonindemnifiable loss—a loss that ultimately the individual directors would potentially be out of pocket for. Those are typically in scenarios where they’re financially unable to indemnify because they’re bankrupt, or derivative claims, whereas most states won’t allow indemnification of a derivative settlement. Many companies have gone towards buying an A-side-only policy, on the access basis with drop-down provisions so they can access at least some defense costs and other things. But it’s a separate limit of liability for the individuals.

BTN: Steve, these are all pretty complicated issues. How well are audit committees able to get their minds wrapped around this, and are they taking these new responsibilities seriously?
Steve Tisdell: The universal cry of audit committees is that they don’t have enough time because of all the forms they need to put into their meetings these days, whether it be accounting policy, resolution or 404 internal controls, or putting together a whistle-blower program. Many of these audit committees are struggling with these technicalities. The landscape is changing a lot, and it’s hard to keep up with it.

BTN: Allen, how do you think audit committees of these publicly traded companies are responding to this environment?
AO: Actually, they’re responding well. People who are serving on audit committees are taking their responsibility very seriously, and generally they’ve done a very good job of marshalling the resources available to them to try to do their jobs well. It is a difficult job.

BTN: Is there any certain area where most companies might be a little weak when it comes to controlling their D&O risks?
AO: I would say that people should avoid the thought that there is a form of governance that is appropriate and constitutes a best practice for every company. There’s some general guidelines that probably do apply to everyone, but hopefully people are taking time to address their particular situations, trying to design a set of governance policies that promote sound governance at that particular company. A checklist is not a substitute for an active, involved director

BTN: David Wilds, what do you see going on in efforts to improve the infor mation flow to directors like yourself?
DW: What I see in the four companies that I’m involved in is that starting with the CEOs, they each follow the practice of board members getting as much information as the board feels like it needs to perform its individual or collective job. So, access to appropriate members of management. You know, a board member’s job is not to manage, so it’s a fine line with respect to what the board then does with the information, but internal auditors today have, in my view, more interaction with the audit committees. There is more time on a quarterly basis, at least with the independent auditors in sessions without management. It’s a heck of a burden on the members of the audit committee, but they have to spend an inordinate amount of time not just receiving reports but delving into information that is given to them.

BTN: How confident do you think corporate directors are that their own personal legal liability exposures are being covered adequately by their D&O insurance?
DW: We discuss the exposure in the four companies I’m on. The real question is not do we have enough insurance, but are we doing the right things.

BTN: You mean, to avoid problems?
DW: Absolutely. And do we have in place people with high integrity, and do we have checks and balances? One of the questions I’ve asked repeatedly in the last few years is what is the job of the so-called independent auditor? And because I’ve become a bit skeptical of what we were paying for in years past, it is more the responsibility of the board and the audit committee specifically to make sure that the company is complying as compared with the independent auditor. That’s my view. It’s a heavy burden.

BTN: Are there formal whistle blower procedures that are put in to facilitate the flow of information so that people aware of improprieties can voice them without recrimination?
DW: Yes. Absolutely. One practice is to hire an independent organization so that the employees can feel comfortable providing information that they think is appropriate in the whistle-blower context, and that’s what we’ve done in all of our companies. We want people to come forward, but Steve, I defer to you on the subject.
ST: I think there’s a big fear that management filters data before it gets to the audit committee. They’re concerned that the data is independent, and they’re very cautious about protecting the independence of the whistle blower. Sarbanes-Oxley put in a number of retaliation and criminal penalties regarding the firing of a whistle blower or retaliating against a whistle blower. We’ve even had many private companies start to sign up on this program, and we actually had a nonprofit yesterday. The tone of Sarbanes-Oxley, I think, is good in that it encourages ethical behavior. While the 404 issues are very complex, the whistle blower provisions are fairly easy to administrate.

BTN: It’s two years since Sarbanes-Oxley was enacted. Allen, what’s your advice to companies to further minimize their D&O exposure?
AO: I think the best advice probably starts with the notion that a wise board is one that mobilizes all the resources available to it. The brokers play an important role; management plays an important role; and counsel can also be helpful.

BTN: David Sellars, what do you expect on underwriting standards for D&O going forward?
DS: I think that they’ll continue to be what they have become in the last couple of years. Five years ago, it was a matter of taking a look at the financial statements, and if everyone was doing well, they didn’t necessarily have a meeting, they would move forward. Now, not only do they want to know that the financials look good, but an underwriter is concerned that those financials are true and accurate. Most insurance companies want to meet face-to-face with the insureds, because it’s not about the numbers. It is more about getting a feel they get from the insureds. They want to know if it’s a culture where bad news does flow through the organizations, not just because it’s required with whistle blower provisions and that type of thing, but because that’s the culture of the organization. They want to know how accounting issues are handled. Many of underwriters will ask the questions about what were some of the tough accounting issues the audit committee discussed this year and how were they handled. Some of the big items—revenue recognition, overstatement of assets, understatement of liabilities. One of the big things now is how are you identifying swap or barter arrangements. Is the auditor approving revenue recognition? Have there been any disagreements with the auditor over certain accounting principles? Not that they’ve checked off the list and they’re meeting the requirements, but that there are actually processes in place where any type of fraud would be uncovered early and handled appropriately. There has to be a culture where people within the divisions are obviously flowing information up. So, I would just say, the underwriting will continue, the market is stabilizing right now, and the underwriters are more willing to do some things they weren’t a year ago.

BTN: Very interesting. Thanks.