‘Instant Options’ Claims Are Covered: Insurance For Backdated Options

Executive Insurance Advisor

PUBLISHED ON: June 5, 2006

A recent statistical analysis of the“instant options” grants found that as many as one-third of companies have used backdated options as part of their compensation packages by allowing employees to buy stock at a lower, retroactive price and thereby maximize returns. (See Stephanie Saul, “Study Finds Backdated Of Options Widespread.” The New York Times, July 17, 2006.) The SEC and other government agencies have launched numerous civil and criminal investigations of the practice, specifically focusing on allegations that certain companies manipulated the dates at which the options would be granted so as to maximize returns.

In addition, the practice has already spawned a variety of civil lawsuits,including derivative and shareholder class actions. These lawsuits generally allege breaches of fiduciary duty by companies’ directors and officers(D&Os) and violations of the securities laws by the companies and their D&Os for alleged failure to disclose properly the backdated options or alleged misleading or false statements made in SEC filings and press releases allegedly to the detriment of shareholders. Many, many hours of defense counsel time are being spent which should be paid under D&O insurance policies.

Policyholders who are potentially subject to these backdated options claims and investigations should ensure that they take the necessary steps to protect their rights to insurance coverage.

Insurance Industry Reaction to Backdated Options Claims

The insurance industry says that it views backdated options claims as a potentially significant source of claims. Chubb’s chief underwriter has stated that “[i]f we have any cause for concern, we may exclude the risk,” indicating that the insurance industry may be looking for avenues to deny or limit their exposure to backdated options claims. (See Liam Pleven, “Options Timing Raises Concerns Among Insurers.” The Wall Street Journal, June 20, 2006.) A leading lawyer for the insurance industry was more pointed: “I don't want to say every claim is going to be denied … But there is enough here that there are going to be some significant coverage issues in many of these cases for at least some of the defendants.” (See Dan Bailey, Bailey Cavalieri, quoted in, Miles Weiss & Jesse Westbrook, Nasdaq Unit Says Options Scandal May Drive Up Rates (Update 2). Bloomberg June 8, 2006.) The “prevent defense” has already started to form.

D&O Policies Cover Backdated Options Claims

Directors and officers’ liability insurance policies (D&O Policies) provide coverage for backdated options claims. Generally, D&O Policies provide coverage for all “Loss” (which includes defense costs and amounts paid in settlement or judgments) incurred as a result of claims against alleging “Wrongful Acts” by D&Os, typically defined as any “breach of duty, neglect, error, misstatement, misleading statement, omission or act.” Thus, allegations that a D&O committed wrongful acts in connection with backdated options constitute a covered claim and D&O Policies should respond with payments for the defense costs and ultimately, if necessary,amounts paid in settlement or as a result of a judgment. Many D&O Policies also contain coverage for the company against securities claims brought in connection with the backdated options issue and this may include coverage for the costs of responding to a government investigation. Policyholders should also review their fiduciary liability policies for possible coverage for certain types of backdated options claims that may be brought alleging detrimental effects on employee benefit plans.

Avoid Common Traps

D&O Policies are “claims made” policies providing coverage for claims made during the policy period. Policyholders should give immediate notice to their insurance companies of any backdated options claims. Just as important, however, policyholders also should give notice of any circumstances or facts regarding backdated options practices that may give rise to a claim in the future, a requirement inmost D&O Policies. If such notice is given, and a backdated options claim is later made that arises out of those circumstances, D&O Policies typically provide that the claim will be deemed to have been made during the policy period in which notice is given. A failure to give notice of circumstances during one D&O Policy period may lead to denial of a claim in the future that occurs during a renewed or replacement policy period. As a result, in order to maximize the possibility of insurance coverage, if a company or its D&Os are the subject of an SEC informal letter of inquiry or investigation relating to backdated options issues, then the company should give notice under its D&O Policies. Not only may there be possible coverage for the costs relating to the inquiry or investigation, but such notice will help protect against potential notice defenses to coverage in the event of a claim. Similarly, if a company decides to conduct an internal investigation of issues relating to backdated options and the investigation indicates the possibility of potential claims, the company should consider notice of that investigation under its D&O Policies.

Resist Attempts by Insurance Companies to Limit Coverage for Options Backdated Claims

Insurance companies will likely raise a variety of exclusions to limit or deny coverage for backdated options claims, including exclusions for fraudulent acts or the “gaining of unlawful profit” or that any damages or settlements arising out of the claims are supposedly “uninsurable as a matter of public policy.” None of these purported exclusions should apply to prevent coverage for defense costs or settlements and may apply only potentially to limit coverage for damages in very limited circumstances. Policyholders should resist attempts by their insurance companies to limit or deny coverage under their insurance policies for backdated options claims. The instant options backdating scandal presents a typical example of behavior which may well have been permissible at one time, becoming proscribed at the later time. The insurance which likely applies was sold before this “new awareness,” and should apply to cover instant options claims.