Thank you for sharing!

Your article was successfully shared with the contacts you provided.
People assume that the SEC only sues bad guys. Not so. Innocent directors and officers can just as easily wind up as targets of overzealous SEC enforcement staff. It is foolish for any general counsel, director or officer of a public company to think, “It can’t happen to me.” In my last column, I noted that the SEC is bringing more marginal cases and, for that reason, losing more cases in litigation. Thus, for an individual (as opposed to a public company), litigating against the SEC is a real option. For an individual, however, defense costs are prohibitive whereas SEC lawyers get paid regardless of whether a matter is litigated. This gives the government a tremendous advantage against individuals, who must have the financial resources to defend themselves. Thus, you must have D&O insurance and, more importantly, your policy must have the correct terms. Purchasers of D&O insurance often focus only on premiums. But buying insurance is buying protection. It is essential to analyze the protection being purchased and not simply the price of that protection. Focus on the following seven issues now so that you will have the protection you need if the SEC targets you: 1. Evaluate the amount of coverage and the size of the retention. Insurance proceeds cover not simply a settlement in a private action but (and this is critical in an SEC investigation) also attorneys’ fees and defense costs. Make certain that the amount of coverage is substantial enough to cover these costs. Also, insist on minimal � or zero � retention for individuals. 2. Severability clauses in the insurance application and misconduct exclusions are essential. Severability clauses preserve insurance coverage for an innocent officer or director, notwithstanding improper conduct by others. A typical severability clause in an insurance application will provide that, if material information is omitted from the application, coverage will be denied “only with respect to the officer or director having such knowledge or information.” Likewise, a typical severability clause in the misconduct exclusion will provide that “no fact pertaining to or knowledge or information possessed by any director or officer shall be imputed to any other director or officer for purposes of applying” the misconduct exclusion. Some insurance companies have recently narrowed or eliminated severability clauses. Obtain the fullest possible protection in this area. You must not lose your coverage when you need it most because of what someone else did. 3. Examine the precise definition of “claim.” Most policies define “claim” to mean demand letters, civil complaints and administrative or regulatory proceedings commenced by a Notice of Charges. But significant attorneys’ fees and expenses are incurred in an SEC investigation � before charges are filed. Endorsements are available to cover regulatory investigations or subpoenas from the SEC or other government agencies. Insist on such a claim endorsement. 4. Check the language in the “fraudulent conduct” exclusion. Historically, this exclusion was triggered only when a court made a “final adjudication” of fraud. Thus, an insured person could avoid this exclusion by settling any time before a final judgment. Recently, some insurers have changed this language so that the exclusion takes effect upon “an adverse finding of fact against, adverse admission by, or a plea of nolo contendere or no contest by an insured person as to such conduct.” In any settlement, the SEC requires that you “neither admit nor deny” the allegations. An insurer could argue that this is functionally equivalent to nolo contendere or a no contest. While questionable, you do not want to get involved in this debate. Make sure the policy’s fraudulent conduct exclusion contains “final adjudication” language. 5. Control the timing of payments for defense costs. Some policies provide that defense costs and expenses will only be reimbursed after a matter is resolved. This means your company must advance all your fees and costs and may have to wait years to get reimbursed. And if your company goes bankrupt or refuses to advance your costs, you are out of luck. Other policies provide that defense costs will only be reimbursed on a “periodic basis.” Insist on a “pay as you go” clause. Often this language will refer to “advancing” defense costs on a current or quarterly basis. This issue has become even more important of late because Section 402(a) of Sarbanes-Oxley prohibits companies from making most kinds of loans to officers and directors. Paying defense costs could be interpreted as the company having advanced or loaned the payment, subject to reimbursement by the insurer. A “pay as you go” clause in the policy will allow a company to avoid advancing defense costs, which eliminates the risk raised by Sarbanes-Oxley. 6. Focus on venue and choice of law provisions as to insurance coverage disputes. Some policies require litigation of coverage issues in New York or London or require arbitration of such claims. Arbitration is not the best forum for an insured officer and director as most such arbitrators have ties to the insurance industry. And inconvenient venues are a real detriment to an individual in a coverage dispute. Pay attention to these issues at the outset so you don’t encounter problems later. 7. Insist on an “Order of Payments” provision. Some bankruptcy courts have concluded that a D&O policy is an asset of a bankrupt estate and should be available to pay creditors’ claims. Accordingly, they have denied requests by directors and officers for reimbursement of ongoing defense costs. Some insurance companies, relying on these cases, refuse to pay attorneys’ fees or costs until the bankruptcy court issues an order actually permitting payment. To avoid this problem, make sure your policy includes an “Order of Payments” provision. This makes policy proceeds available first to the directors and officers and only then to the corporation. At least one bankruptcy court has allowed the directors and officers to access their D&O policy to fund defense costs in response to an Order of Payments provision. In sum, you may have done nothing wrong and have the best defense in the world when it comes to responding to the SEC’s charges. But if you cannot afford to defend yourself, you could wind up in the same position as someone who actually committed fraud. Paying attention to the D&O policy issues I’ve outlined above will ensure that you will have the financial resources to vindicate yourself should you become the target of an SEC investigation. David B. Bayless, a partner in the San Francisco office of Morrison & Foerster, specializes in SEC enforcement work. He formerly headed the SEC’s San Francisco office.

This content has been archived. It is available through our partners, LexisNexis® and Bloomberg Law.

To view this content, please continue to their sites.

Not a Lexis Advance® Subscriber?
Subscribe Now

Not a Bloomberg Law Subscriber?
Subscribe Now

Why am I seeing this?

LexisNexis® and Bloomberg Law are third party online distributors of the broad collection of current and archived versions of ALM's legal news publications. LexisNexis® and Bloomberg Law customers are able to access and use ALM's content, including content from the National Law Journal, The American Lawyer, Legaltech News, The New York Law Journal, and Corporate Counsel, as well as other sources of legal information.

For questions call 1-877-256-2472 or contact us at [email protected]

Reprints & Licensing
Mentioned in a Law.com story?

License our industry-leading legal content to extend your thought leadership and build your brand.


ALM Legal Publication Newsletters

Sign Up Today and Never Miss Another Story.

As part of your digital membership, you can sign up for an unlimited number of a wide range of complimentary newsletters. Visit your My Account page to make your selections. Get the timely legal news and critical analysis you cannot afford to miss. Tailored just for you. In your inbox. Every day.

Copyright © 2021 ALM Media Properties, LLC. All Rights Reserved.