D&O Exposure After Sarbanes-Oxley: Evaluating Risk in the New Regulatory Environment PLUS D&O Symposium Lisa Klein Wager Morgan, Lewis & Bockius LLP Boris Feldman Wilson Sonsini Goodrich & Rosati LLP William R. McLucas Wilmer Cutler & Pickering Prof. John Coffee Columbia Law School Alan Schulman Bernstein Litowitz Berger & Grossman LLP

2 Topics n Overview of the Sarbanes-Oxley Act n Introduction to Key Provisions Implicating Entity and Director and Officer Exposure n Anticipated Impact on Federal Class Action Litigation n Anticipated Impact on Derivative Litigation n Possible Further Legislative/Judicial Initiatives n Implications for D&O Underwriters’ Due Diligence

3 Overview of the New World Under Sarbanes-Oxley n Signed into law on July 30, 2002 n Response to rapidly spreading Enronitis Virus – and the Sergeant Shultz defense n Designed to restore investor confidence by: –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 n Broad ranging set of reforms –some immediately effective –some mandating SEC rule-making

4 Living Under Sarbanes-Oxley n 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.

5 Issuers’ Enhanced Disclosure Obligations (continued) n 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. 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

6 Issuers’ Enhanced Disclosure Obligations (continued) n 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

7 Issuers’ Enhanced Disclosure Obligations (continued) n 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: 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).

8 Living Under Sarbanes Oxley (continued) n 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

9 Living Under Sarbanes-Oxley (continued) n 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

10 Living Under Sarbanes-Oxley (continued) n 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 n Settlements and judgments against individuals in civil and criminal actions not dischargeable in bankruptcy.

11 Living Under Sarbanes-Oxley (continued) n The Act prohibits trading by officers/directors during pension black out periods –SEC has issued a clarifying release n 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.)

12 Living Under Sarbanes-Oxley (continued) n 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: 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

13 Living Under Sarbanes-Oxley (continued) n 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

14 New Rules Governing Conduct of Attorneys (continued) n 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. n 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.

15 New Rules Governing Conduct of Attorneys (continued) n 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)

16 New Consequences Under Sarbanes-Oxley n 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. n Expanded Statute of Limitations for all private securities actions –earlier of 2 years after discovery/5 years after violation

17 New Consequences Under SOA (continued) n New/Enhanced Criminal Offenses (continued_) –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 n Additional Increased Penalties Under ERISA n 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

18 Anticipated Impact of SOA on Federal Class Action Litigation n 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 n Potentially more protacted/complicated due to anticipated increase in note-taking/record-keeping n New criminal penalties for attempting audit influence/document destruction may raise pressure to settle early/costs of doing so

19 Anticipated Impact of SOA on Federal Class Action Litigation n Less in the long term, hopefully, for Companies that succeed in improving corporate governance and disclosure practices n 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

20 Anticipated Impact of SOA on Derivative Litigation n 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

21 Anticipated Impact of SOA on Derivative Litigation n 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

22 Anticipated Impact of SOA on Derivative Litigation n One piece of good news –new director independence requirements may make plaintiffs ability to plead demand futility a thing of the past

23 Future Legislative/Judicial Initiatives n 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 off- balance 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).

24 Living Under Sarbanes Oxley (continued) n 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.

25 Implications of Sarbanes-Oxley for the D&O Insurance Underwriting Process n 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

26 SOA and the D&O Insurance Underwriting Process (continued) n 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?

27 SOA and the D&O Insurance Underwriting Process (continued) n Know your customer better. –Read their recent press releases. 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?

28 SOA and the D&O Insurance Underwriting Process (continued) n 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

29 SOA and the D&O Insurance Underwriting Process (continued) n 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?

30 SOA and the D&O Insurance Underwriting Process (continued) n 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 n Final tip: Yes, get the premium; but don’t dig yourself in deeper to do it.

31 Implications of Sarbanes-Oxley for the D&O Insurance Underwriting Process n This is not an exhaustive list, but rather is a collection of suggestions that defense lawyers have made, coming up from the trenches. n Not all the information may be needed from every company n It is intended to supplement information historically reviewed, such as claims history and audited financials. n We encourage a thorough rather than adversarial process. n Ideally, your due diligence is consistent with a self- evaluation 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.

D&O Exposure After Sarbanes-Oxley: Evaluating Risk in the New Regulatory Environment PLUS D&O Symposium © Lisa Klein Wager Morgan, Lewis & Bockius LLP New York City (o) (c)