The material in this section was written by and reproduced with permission of Dan A. Bailey, Esq.. Mr. Bailey is a member of the Columbus, Ohio , law firm of Bailey Cavalieri LLP. Mr. Bailey specializes in D&O liability insurance, corporate, and securities law. He is a frequent lecturer and has authored and co-authored several books and articles dealing with D&O liability issues.

Initial Public Offerings (IPOs)

Initial public offerings (IPOs) of securities present unique claim exposures for the issuing company and its directors and officers, as well as for the securities underwriters who participate in the pre-offering analysis of the IPO. The following discussion explains the emerging problem of Laddering Claims, the impact of these claims on D&O insurance coverage, and steps companies can follow to reduce the likelihood of laddering claims being filed by controlling information disclosure prior to the IPO.

Laddering Claims

Beginning in January 2001, a new wave of potentially catastrophic securities class action lawsuits emerged relating to the initial public offering (IPO) boom in the late 1990s. Those lawsuits, which are frequently referred to as laddering or tie-in claims, focus on how securities underwriters allocated shares to investors in popular IPOs.

Laddering claims generally allege two types of wrongdoing:

1.Undisclosed Commissions: The complaints allege that the IPO securities underwriters received greater compensation from investors than was disclosed in the IPO Prospectus, thereby rendering the Prospectus false and misleading. This compensation took the form of additional commissions or “kickbacks” from certain investors in exchange for preferential allocation of shares in the IPO. Frequently, this alleged arrangement involved either investors agreeing to pay the securities underwriters excessive commissions on transactions in other securities, or investors agreeing to pay additional commissions after the IPO based upon the investors' profits in the IPO. It is doubtful this alleged wrongdoing will result in significant liability exposure since, among other things, such misrepresentations do not appear to be material (i.e., would not have changed a reasonable investor's investment decision). However, claims of undisclosed compensation are present in virtually all of the laddering claims, though such allegations do not technically constitute “laddering.”

2.Laddering/Tie-In Agreements: The laddering claims also allege that securities underwriters required IPO investors to agree, as a condition to receiving a favorable allocation of shares in the IPO, that the investors would purchase additional shares in the after-market immediately following the IPO. This would result in increased demand for the stock and thus an immediate increase in the market price following the IPO.

A few of the more recent laddering claims allege a third type of wrongdoing based upon a perceived conflict between the research analysts and the investment bankers within a securities underwriting firm. In order to increase the market price for a new issuance, securities underwriters allegedly would promote the securities through their research analysts, who would use their purportedly objective and independent evaluations and recommendations to manipulate the market for the new securities.

Litigation Exposure

Although all laddering claims focus on conduct of the securities underwriters, most of those claims also include as defendants the issuing company and certain directors and officers of the issuing company. The claims against the issuer and its directors and officers are primarily premised upon alleged misrepresentations in the IPO prospectus. The claims against the issuing company are premised upon the strict liability standards in Section 11 of the Securities Act of 1933, and the claims against the directors and officers are premised upon the allegation that the directors and officers either knew or should have known of the undisclosed commission arrangements and/or laddering agreements.

Defense of Laddering Claims

The existence of a material misrepresentation or omission in the Registration Statement (which includes the prospectus) is sufficient to establish a prima facie case under Section 11. However, there are two principle defenses potentially available to at least some of the defendants in a laddering claim under Section 11. First, defendants are not liable to any purchaser who knew of the misrepresentation or omission at the time he acquired the securities. Thus, institutional investors and others who participated in or otherwise knew about the alleged kickbacks and tie-in agreements should be excluded from the class. This may eliminate a large portion of the class of investors who purchased directly in the IPO. Most if not all of the investors who were allocated shares in the IPO may have known about or participated in these practices.

Secondly, directors and officers who exercise reasonable due diligence in drafting and approving the Registration Statement are not liable under Section 11. This due diligence defense is not available to the issuing company, which is strictly liable for misrepresentations or omissions in the Registration Statement whether or not the issuer knew or should have known of the false statements. It appears likely that directors and officers would be able to satisfy the due diligence defense if they relied upon the securities underwriter when disclosing the amount of commissions paid by investors to the underwriter in the Registration Statement and if the they did not participate in or otherwise know about the underwriter's laddering activity. Then, the only material liability exposure of a D&O insurer for settlements and judgments in laddering claims would be under the entity securities coverage.

The primary defense potentially available to the issuing company relates to loss causation. Plaintiffs can recover as damages under Section 11 only the decline in the value of the securities due to the alleged misstatement or omission in the Registration Statement. Such damages are measured as the price at which the securities were purchased by the plaintiff (not to exceed the price at which the securities were offered to the public) less the following:

1.the price at which the securities were sold by the plaintiff (if the securities were sold before the lawsuit was filed);

2.the price as of the date the lawsuit was filed (if the securities are still held by the plaintiff as of that date); or

3.the price at which the securities were sold by the plaintiff after the lawsuit was filed (if the resulting damages are less than as calculated at the date the lawsuit was filed).

Plaintiffs who purchased shares in the IPO and who sold those shares at an increased price as a result of the laddering arrangements suffered no loss and cannot recover under Section 11. For those plaintiffs who purchased securities in the offering and who subsequently sold the securities at a loss, defendants will argue that the full price decline in the securities should not be attributable to the laddering arrangement, but to other general market conditions and business developments which greatly reduced the perceived value of many companies' securities. In other words, for those investors that suffered a loss, a large part of that loss arguably was not attributable to the laddering arrangement, but to other market and business factors.

Factual Issues

In addition to the above-described legal defenses, there will be several very significant factual issues in the laddering claims. For defendant directors and officers, the most important factual issue will be whether those individuals knew about the undisclosed compensation and tie-in arrangements. Because executives of an issuing company routinely participate in meetings with securities underwriters regarding the pricing and allocation of shares in the IPO, there is speculation that many issuer executives knew about and perhaps benefited from these improper arrangements. The extent to which such speculation is true will be the primary factor in determining the liability exposure of directors and directors in laddering claims.

From the standpoint of the issuer company and the securities underwriter, a primary factual issue will be whether an improper agreement in fact existed between the securities underwriter and the investors. Securities underwriters will likely argue that they simply allocated IPO shares to their best customers and, at most, the investors simply acknowledged their “expression of interest” in after-market purchases. It seems doubtful that documented evidence will exist showing a clear linkage between the amount of shares allocated to an investor and that investor's subsequent purchases in the after-market. In fact, one could argue that securities underwriters had a legitimate interest in trying to place IPO shares with long-term investors instead of investors who would immediately sell their shares in the after-market. Such short term investing could contribute to a volatile and downward pressure on the stock price. Obtaining an expression of interest in subsequent purchases can arguably serve as a legitimate indicator of an investor's long-term interest in and commitment to the securities. A plaintiff's ability to establish the existence of improper laddering agreements will likely be dependent upon the ability to locate disgruntled employees or other “insiders” willing to testify as to the existence of verbal agreements.

Laddering claims frequently include an after-market cause of action under Section 10(b) of the Securities Exchange Act of 1934, in addition to the IPO cause of action under Section 11. The factual basis for the Section 10(b) cause of action is the same as the Section 11 cause of action (i.e., secret agreements to artificially inflate the price of either the IPO or securities in the after-market). However, the Section 10(b) cause of action is frequently against only the securities underwriters since the issuing company and its directors and officers were not involved in the alleged after-market manipulation (there is no strict liability under Section 10(b) as is the case under Section 11). However, if evidence demonstrates that the directors and officers were aware of or participated in such agreements, they will have Section 10(b) exposure as well. Recoverable damages in the Section 10(b) claim will likely be much greater than the Section 11 claim.

In addition to the scores of class action lawsuits, there are a variety of other civil regulatory investigations, criminal investigations and congressional hearings currently underway with respect to the so-called laddering practices. These investigations and proceedings not only create additional expenses for all parties involved, but also a risk that findings or evidence from these proceedings will be useful to the plaintiffs in the securities class actions. However, at this point the SEC has stated they believe the issuers are the victims, not the culprits.

Contribution or Indemnification from Securities Underwriters

An important issue for issuer companies and their directors and officers in the laddering claims is the extent to which they can recover losses incurred in such litigation from the securities underwriters—the true culprits to the extent any wrongdoing occurred. Such a claim against the securities underwriters may be premised upon either of two different theories.

First, issuing companies and securities underwriters invariably enter into an Underwriting Agreement in connection with an IPO. Those agreements typically contain cross-indemnification provisions, pursuant to which the issuing company and the securities underwriters agree to indemnify each other for certain losses arising out of the IPO. However, the scope of the indemnity flowing from the issuer to the securities underwriter is typically much broader than the indemnity from the securities underwriter to the issuer. Frequently, the limited indemnity from the securities underwriter applies only to loss incurred by the issuing company and its D&Os that is based upon untrue statements or omissions in the Prospectus, providing such statements were made in reliance upon written information provided by the securities underwriter. Although such a provision may apply with respect to disclosure of commissions, it may not apply with respect to the non-disclosure of the alleged tie-in agreements. This is because there may be no written information provided by the securities underwriter to the issuing company relating to the existence or non-existence of such agreements.

Even if the indemnity agreement by the securities underwriter is technically triggered with respect to the laddering claims, an additional issue arises as to whether such an indemnification obligation is enforceable. According to the SEC and several courts, it is against public policy to indemnify for many types of violations of the federal securities laws. Such indemnification would defeat the deterrent effect intended by the securities laws. However, the courts have also recognized that such a public policy prohibition does not apply to settlements pursuant to which the parties disclaim any wrongdoing, or to claims for contribution by one wrongdoer against another wrongdoer. Similarly, indemnification may be available to an issuer for its strict liability under Section 11 since the issuer committed no wrongdoing.

As an alternative basis for recovery against the securities underwriters, issuing companies and their directors and officers can seek contribution pursuant to Section 11(f) of the 1933 Act. Generally, defendants are jointly and severably liable to plaintiffs under Section 11. This means that any one defendant can be liable for the entire amount of a plaintiff's loss even though several defendants caused that loss. As a result, Section 11(f) entitles a defendant to recover from other defendants to the extent that the defendant paid more than its proportionate share of the total loss. The allocation of loss among defendants for purposes of this recovery is likely based upon the concept of relative fault. Issuing companies and their directors and officers may thus have a strong claim for contribution against the securities underwriters under Section 11(f) for all or most of any settlement or judgment incurred in laddering claims, since the relative fault of the securities underwriters is far greater than that of the other defendants. A contribution claim under Section 11(f), though, applies only to the amount of any settlement or judgment, and does not apply to defense costs, whereas an indemnification claim under the Underwriting Agreement typically would apply also to defense costs.

Claims for indemnification and contribution against the securities underwriters should be appropriately preserved and pursued at an early date in the laddering claim. D&O insurers generally take the position that any coverage under the Policy is excess of any recoveries from the securities underwriters and therefore Insureds should pursue such recoveries as soon as possible. If indemnification and contribution claims are lost as a result of the Insureds' delinquency in pursuing such claims, a coverage defense may arise under the Policy since the Insureds may have impaired the insurer's rights to subrogation.

In practice, the securities underwriters are routinely either not responding to requests from the issuer for contribution and indemnification, or indicating that a decision with respect to such a request is being deferred until a later date. In response, the issuer defendants are preserving their rights against the securities underwriters through correspondence, but are not asserting cross claims in the pending litigation. This is consistent with the traditional defense strategy of avoiding public fights between co-defendants which may ultimately benefit the plaintiff. However, in the context of laddering claims, such a traditional strategy may not apply and by asserting cross claims for indemnification and contribution, the issuer defendants would be emphasizing the fact that any wrongdoing was committed solely by the securities underwriters.

D&O Insurance Implications

As discussed previously, absent evidence indicating that defendant directors and officers actually knew of the alleged wrongdoing by the securities underwriters, the exposure to Insureds under D&O policies issued to the issuing companies should be limited to the following:

1.Defense costs. These costs should not be extraordinary under any one policy since most of the issuer defendants are engaging a law firm which represents numerous other issuer defendants as defense counsel, thus allowing common defense costs to be spread among numerous policies; and

2.A modest settlement on behalf of the issuing company defendant (assuming entity coverage exists), if the motion to dismiss is unsuccessful. Based upon the somewhat limited information now available, it appears likely that the average settlement amount per issuer company should be very modest. Thus, only the primary layer of insurance will likely be exposed in most instances.

Although a modest loss per policy is not catastrophic in itself, the aggregate effect on the entire D&O insurance market may well be catastrophic. For example, if the average paid loss per policy for a laddering claim is $2-3 million, and if there are ultimately a total of 200 laddering claims (probably a conservative projection), total losses paid by D&O insurers for laddering claims would be $400 million to $600 million. Such a result would have huge consequences to the entire market, including insurers that do not have direct exposure for laddering claims. This is because reinsurers who would bear a large portion of this total loss would need to distribute their losses among the entire market. In addition, such losses could cause the collapse of some smaller primary D&O insurers that heavily participated in IPO D&O programs.

D&O Underwriting

From a D&O insurance underwriting perspective, the potential for laddering claims presents an unusual and challenging dilemma. D&O underwriters may carefully consider the appropriate response to that likely exposure. Some of the renewal options which are being utilized by underwriters include: (1) extending rather than reinstating the limit of liability; (2) requiring that the Insureds give notice of the potential laddering claim under the expiring policies as a condition to renewal; (3) applying a separate, higher retention and/or a sublimit to any new laddering claim filed after policy renewal; and (4) making at least the entity coverage for any new laddering claim excess of any indemnification and contribution from the securities underwriter, and withholding payment under the policy until the indemnification/contribution claim against the securities underwriters is fully resolved at the insured's sole expense.

D&O Claims

From a D&O insurance claims perspective, one of the biggest challenges will be for claims adjusters to resist the efforts of plaintiffs and perhaps the securities underwriter defendants to negotiate a “global” settlement. The liability exposure of any one issuing company and its directors and officers is highly fact-specific and likely will vary greatly between IPOs, particularly with respect to recoverable Section 11 damages. Any global settlement will almost by necessity ignore many of those factual issues, thus resulting in larger settlements on behalf of the issuing company and its directors and officers. To avoid this problem, each laddering claim should be separately evaluated and its settlement separately negotiated in order to avoid excessive settlement payments.

ERISA Tagalong Claims

ERISA tagalong claims are a relatively new type of class-action lawsuit being filed against directors and officers when the market price of stock in their company drops significantly following the disclosure of surprising adverse information about the company. Historically, such a stock drop would often result in class actions filed on behalf of purchasers of the company's securities for some defined time period prior to the surprising disclosure. Those class actions would allege that the company and its directors and officers named as defendants failed to disclose the adverse information sooner, thereby resulting in the artificial inflation of the market price for the company's securities during the alleged class period. The actions would allege that those who purchased securities at artificially inflated prices suffered damages and are entitled to recover the difference between what they actually paid for the securities and what the market price would have been if full and accurate information had been timely disclosed.

Although ostensibly brought for the benefit of the injured shareholders, securities class actions frequently are instigated and prosecuted primarily by and for the benefit of the plaintiff lawyers. As a result of the Private Securities Litigation Reform Act of 1995, more and more of these securities class-action lawsuits are being handled (and effectively controlled) by a small group of sophisticated and highly experienced plaintiff law firms, which are routinely retained as lead counsel by institutional investors serving as lead counsel. Plaintiff firms without institutional clients are shut out of the lucrative lead counsel role. This dynamic has caused some of those plaintiff law firms to explore alternative means to recover large settlements in some type of class-action lawsuit following a significant drop in a company's stock price, and thus recover large fee awards.

A favorite new type of class-action lawsuit now being filed by plaintiff law firms shut out of major securities litigation is brought under ERISA. These class actions are brought on behalf of participants and beneficiaries of a company's retirement plans to the extent those plans own securities of the company. The complaints in these class actions contain the same factual allegations as set forth in the securities class-action lawsuits (i.e., the defendants misrepresented or failed to disclose certain material information about the company or its financial performance or condition). However, instead of alleging those misrepresentations or omissions constitute a violation of the securities laws, the new lawsuits allege the defendants breached their fiduciary duties under ERISA. As a result of the breaches, the plan participants and beneficiaries allegedly were allowed or induced to invest or maintain their plan assets in company stock at artificially high prices, or otherwise suffered loss because their plan assets were invested in overpriced or ill-advised securities.

The claims asserted in these so-called tagalong class actions are summarized as follows:

·Claims against officers and directors for deceiving plan participants and beneficiaries by disclosing false and misleading information and failing to disclose material information about the company and its financial condition and performance, either in statements to the general public, to shareholders or to employees

·Claims against plan fiduciaries (many of whom are also officers) for failing to disclose the adverse information to plan participants and beneficiaries, failing to disclose such information to other plan fiduciaries who had responsibility for investing plan assets, and failing to correct misleading statements made by other officers and plan fiduciaries

·Claims against plan fiduciaries for retaining or investing in company stock in plan accounts, permitting participants to invest in company stock by continuing to include the stock as an authorized investment option in self-directed plans, failing to adequately diversify plan assets, and failing to investigate the suitability of plan investments

These ERISA tagalong class-action lawsuits are sufficiently new that a meaningful body of case law is not yet developed addressing the propriety of the underlying legal theories. On their surface, however, these lawsuits, which typically name as defendants senior officers and the board of directors of the company as well as other designated plan fiduciaries, raise several concerns for the defendants. First, the definition of eligible class members in the ERISA class action is broader than the definition of class members in the securities class action. Whereas the securities class is limited to purchasers of securities during the designated class period, the ERISA class action is on behalf of all plan participants or beneficiaries who held or invested in the company's securities through their retirement plan during the class period. In other words, persons who simply held company securities in their retirement account, and who made no direct investment decision regarding those securities, may be a member of the ERISA class, but would be excluded from the securities class. Although participants and beneficiaries who purchased company securities during the class period could be a class member in both the ERISA and securities class actions (thus rendering the ERISA class action somewhat duplicative), the ERISA class action will include a potentially large number of additional plaintiffs in its class.

Second, securities claims under Section 10(b) of the Securities Exchange Act of 1934 require plaintiffs to prove the defendants acted with scienter (i.e., with intent to deceive or reckless behavior), whereas claims for breach of fiduciary duty under ERISA may require a lower threshold similar to negligence. Pleading standards for an ERISA action may also be more relaxed. Plaintiffs may therefore be able to more easily establish liability in the ERISA class action (or survive a motion to dismiss) than in the securities class action.

Potential Defenses

Defendants in the ERISA class action do have several intriguing and potentially persuasive defenses unique to the ERISA class action claims, but which have not yet been fully explored by courts in the context of an ERISA tagalong class-action lawsuit.

·Who is an ERISA fiduciary? The ERISA tagalong class actions seek to expand the definition of an ERISA fiduciary to include corporate directors and officers not otherwise responsible for the management of plan assets. Traditionally, courts have recognized a person as a fiduciary under ERISA only to the extent the person exercises discretionary authority or control in connection with managing or administering an ERISA plan, providing investment advice for the plan, or investing plan assets. In addition, such a fiduciary is generally treated as a fiduciary only to the extent of the plan function over which the person exercises authority or control. Thus, under pre-existing authority, it is doubtful that a director or officer who does not have express discretionary authority or control with respect to plan investments and does not in fact exercise such authority or control, would be treated as an ERISA fiduciary and subject to ERISA fiduciary duties.

However, most ERISA tagalong class actions seek to impose such duties upon directors and officers who do not have or exercise such authority or control. In some recent decisions, the courts ruled that directors are not ERISA fiduciaries simply because they appoint fiduciaries. As a result, the directors did not have a duty to monitor the appointed fiduciaries. However, a recent decision in the Enron tag-along cases found directors to be fiduciaries and to have such a duty to monitor the appointed fiduciaries.

·Does ERISA apply to matters regulated by the securities laws? For more than seventy years, the federal securities laws have regulated matters relating to the purchase and sale of securities, with the goal of assuring that all affected parties have the benefit of accurate and complete information in order to make an informed investment decision. ERISA, on the other hand, traditionally has been viewed as establishing only four general standards of conduct for fiduciaries (i.e., the duty of loyalty to act for the exclusive benefit of the plan and its participants; the duty of prudence to act reasonably with respect to plan matters; the duty to diversify plan assets; and the duty to follow the terms of plan documents consistent with the other three duties). If the ERISA tagalong class actions are successful in imposing upon fiduciaries the duty to disclose complete and accurate information about the company's securities or to preclude participants from investing in company securities under certain circumstances, new and unprecedented duties for ERISA fiduciaries would be created. Although defendants have argued such a result is inconsistent with the long-standing securities regulation scheme, courts to date have rejected defendants' arguments.

·Are directors and officers acting in a corporate or ERISA fiduciary capacity? Traditionally, courts have recognized that a company and its directors and officers can take actions in the ordinary course of business which may adversely affect ERISA plans without creating liability exposure (e.g., terminate or amend plans). When directors and officers who have no fiduciary responsibility for investment of plan assets make disclosures of allegedly false or misleading information to employees, shareholders or the public, such conduct arguably is not taken in their capacity as an ERISA fiduciary, but is in their “settlor” capacity in conducting the affairs of the company. Again, if the ERISA tagalong class actions are successful in creating ERISA liability for such disclosures on behalf of the company, existing ERISA liability exposure would be significantly expanded. Courts to date appear to be endorsing that broader capacity concept.

·What are directors and officers expected to do if they discovery adverse material nonpublic information? If upon learning of nonpublic adverse information directors and officers quickly disclose the information and sell the company stock held in the plans, the company's stock price would undoubtedly drop significantly given the large number of company shares usually held in plan accounts. Such a dramatic collapse in the stock price would likely constitute an overreaction to the adverse information and thus unnecessarily penalize plan participants and other shareholders. In addition, if the directors and officers “quietly” begin divesting company stock held in plan accounts without publicly disclosing the adverse information, they would be trading while in possession of material nonpublic information and thus would likely violate the insider trading laws. Stated differently, the underlying premise of the ERISA tagalong class actions, if supported by courts, would place directors and officers in an impossible dilemma that could result in excessive and unnecessary losses to plan participants and beneficiaries. Notwithstanding these defense arguments, courts to date have required such disclosure of nonpublic information by ERISA fiduciaries and have ignored the practical and securities laws implications from such disclosure.

While the courts decide the legal viability of the ERISA tagalong claims, the financial exposure to directors and officers remains very real. As with securities class actions, companies and their directors and officers often prefer to settle rather than risk a potentially debilitating judgment. Directors and officers subjected to the uncertainty of whether ERISA tagalong claims are viable face real financial risk, and thus they should take appropriate steps to assure they are adequately protected financially in the event they do incur significant liability in these claims.

Like other D&O exposures, directors and officers will have two potential sources of financial protection in the event they incur liability in an ERISA tagalong class action: insurance and indemnification. However, there are unique issues with respect to both types of protection as they apply to this type of new litigation. Some of those unique issues are summarized in the following paragraphs.

Insurance Issues

D&O insurance policies typically exclude coverage for ERISA tagalong class actions by virtue of an ERISA exclusion in the policy. Thus, any insurance coverage available to a defendant director or officer in tagalong litigation will likely exist only under the company's ERISA fiduciary liability program. Historically, that program has not been the subject of thorough analysis or negotiation by companies because it has been relatively cheap and infrequently triggered. With the rise of ERISA tagalong suits, companies and insurers will now need to reexamine their fiduciary liability exposure. When reviewing the adequacy of a fiduciary insurance program in light of this new ERISA exposure, the following issues should be considered:

·Coordinate with D&O Insurance. The scope of coverage afforded under the fiduciary policy should be coordinated as closely as possible with the scope of the ERISA exclusion in the D&O policy, to limit any gap, or overlap, in coverage between the two policies. To minimize the risk of an inadvertent gap in coverage, a few Side A-Only D&O insurance policies do not contain an ERISA exclusion.

·Evaluate Adequacy of Limits. Because a much larger potential liability exposure now exists for the fiduciary insurance program to cover, the size of the fiduciary insurance program should be reevaluated. In many instances, more limits of liability may be needed, depending upon the amount of company stock held in retirement plans maintained by the company.

·Evaluate Tie-In Limits. Because the ERISA tagalong class actions arise out of and allege essentially the same wrongdoing as alleged in securities class actions that are covered under D&O insurance policies, some D&O insurers are now requiring a tie-in of limits between the fiduciary and D&O insurance policies issued by the same insurer to the same company. Companies should consider the advantages and disadvantages of placing their D&O insurance and fiduciary insurance policies with different insurers, thus eliminating the need for a tie-in of limits. If a tie-in of limits endorsement is attached to the D&O and fiduciary policies issued by the same insurer, two issues should be addressed. First, does the tie-in apply only to a single claim covered under both policies, or to all claims covered under one or both policies? Second, will the excess policies in the D&O and fiduciary programs drop down in the event the underlying policies are exhausted by reason of the tie-in of limits endorsement even though the underlying policy has not paid out its stated limit of liability? Even if a tie-in of limits endorsement is not required by the insurer, a potentially difficult allocation of loss between the two types of policies will likely be required if defense costs or any settlement amount are covered in part under both policies.

·Anticipate Significantly Higher Premiums. Fiduciary insurance historically has been priced comparatively low, largely reflective of the insurers' positive claim experience. However, in light of this new and potentially catastrophic exposure under the fiduciary policy, insurers are increasing the premiums for fiduciary insurance. This greater exposure to insurers is highlighted by the fact that unlike many other types of ERISA class actions, the policy exclusion which eliminates coverage for benefits due under a plan will likely not apply to settlements or judgments in an ERISA tagalong class action.

·Duty to Defend. Unlike D&O insurance policies, most fiduciary insurance policies state that the insurer has the right and duty to defend any covered claim. Thus, the insurer will have the right to select defense counsel for the defendant directors and officers in the ERISA tagalong class action, even though the directors and officers select their defense counsel in the tandem securities class action. Insureds may not want insurers to select counsel for ERISA tagalong lawsuits. When they do select counsel, insurers will have to be mindful of selecting a firm with class-action defense capabilities.

·Retention. Some fiduciary insurance policies apply one retention to all Insureds (including directors and officers) whether or not the Loss is indemnifiable. In light of the potentially large exposure in fiduciary cases today and the indemnification limitations that apply (see discussion below), the fiduciary policy should not apply a retention to non-indemnified loss (similar to the retention provisions in D&O policies).

Indemnification

In light of the increased liability exposure of ERISA fiduciaries as a result of these ERISA tagalong class-action lawsuits, companies and their ERISA fiduciaries should thoroughly understand and evaluate the adequacy of not only the ERISA fiduciary insurance coverage, but also the available indemnification from the company for the ERISA fiduciaries. The indemnification issues are important to evaluate not only in order to assure the fiduciaries have maximum financial protection if the insurance is unavailable or inadequate, but also because more companies are now exploring the possibility of purchasing only coverage for non-indemnifiable fiduciary losses (similar to a Side-A Only D&O policy, which is discussed previously) as a means to manage the escalating cost of this insurance.

As a general rule, a sponsoring company may indemnify its ERISA fiduciaries in most instances. However, under federal and state law, the availability of that indemnification is less predictable than the indemnification of directors and officers for non-ERISA matters. As a result, it appears unlikely fiduciary coverage for only non-indemnifiable loss will be as widely available as D&O Side-A only coverage. The following summarizes many of the indemnification issues unique to ERISA fiduciaries.

ERISA Indemnification Provisions

A plan sponsor is generally permitted under Department of Labor regulations to indemnify a plan fiduciary, but indemnification provisions that encourage undesirable fiduciary behavior may be questioned by the courts.

A fiduciary cannot by agreement be relieved of his responsibility or liability under ERISA (ERISA § 410(a)). However, a plan, employer or fiduciary may purchase insurance protection for fiduciary breaches. If the plan purchases the coverage, the insurer must have the right to seek recourse from the fiduciaries for amounts paid by the insurer on account of fiduciary breaches (ERISA § 410(b)).

Consistent with ERISA § 410, a plan may not agree to indemnify a fiduciary for fiduciary breaches, although an employer may do so. Thus, an employer is generally permitted under ERISA to indemnify a plan fiduciary. However, the scope of permissible indemnification under ERISA may be limited under certain circumstances.

State Indemnification Provisions

A sponsor company's indemnification of plan fiduciaries is also subject to the indemnification statute in the state in which the company is incorporated. State indemnification statutes typically permit a corporation to indemnify its directors, officers, employees and agents for loss incurred on account of claims against such persons in such capacity. Indemnification statutes also permit a corporation to indemnify any person who serves at the request of the corporation as a director, trustee, officer, employee or agent of another entity or other “enterprise.”

A number of indemnification statutes expressly define “enterprise” to include ERISA plans. As a result, in many states, a sponsoring company may indemnify plan fiduciaries only if and to the extent the plan fiduciary is serving at the request of the sponsor company. Absent such request, no indemnification would be available. In addition, even if the plan fiduciary is serving at the request of the sponsor corporation, indemnification by the sponsor corporation will only be permissive under the statute and not mandatory, unless the corporation's bylaws or certificate of incorporation require indemnification of persons serving in an outside position at the request of the corporation. Many bylaw indemnification provisions do not require such outside position indemnification.

In addition to the possible indemnification limitations summarized previously, several of the limitations applicable to indemnification of directors and officers are also applicable to indemnification of ERISA fiduciaries under state law. For example, no indemnification will be available if the ERISA fiduciary fails to satisfy the requisite standard of conduct (e.g., the ERISA fiduciary must act in good faith and in the reasonable belief that his conduct was in or not opposed to the best interests of the corporation. In some instances, the ERISA fiduciary is required to take actions that arguably are not in the best interests of the sponsor corporation, such as collecting amounts owed by the sponsor corporation to the plan. In those instances, a question may arise whether this statutory standard of conduct was satisfied by the plan fiduciary.). In addition, indemnification will not be available if the corporation is financially unable to fund the indemnification.

Indemnification Planning

Based on the foregoing, corporations should examine the following primary issues when evaluating the quality of indemnification protection for its ERISA fiduciaries:

·Review the applicable state indemnification statute to determine if an ERISA fiduciary must be serving at the request of the company in order to be indemnified. If so, be sure any person intended to be protected is clearly serving at the written request of the corporation as plan fiduciaries. Review the applicable state indemnification statute and internal indemnification provision of the corporation to confirm that the corporation is obligated to indemnify all of the persons intended to be protected without any material restrictions on that indemnification.

·Consider whether the terms of the indemnification provisions may create public policy concerns similar to those expressed by the cases summarized above. For example, such public policy concerns are more likely to arise with respect to employee stock ownership plan (ESOP) fiduciaries.

·The internal indemnification provision should mandate indemnification “to the fullest extent permitted by law” in order to increase the possibility that indemnification will be available in suits by or on behalf of the sponsoring corporation.

Securities Loss Prevention: Selective Disclosures and Internet Disclosures

The single greatest exposure for directors and officers of public companies is under the federal securities laws. Any effective D&O loss prevention program must focus to a large extent on minimizing that exposure. The following discussion addresses D&O loss prevention opportunities in two areas that are rapidly changing and therefore require updated and new loss prevention practices.

Selective Disclosure

Selective disclosure is the practice of disclosing information to one or more third parties prior to full dissemination of that information to the marketplace through press releases or other public disclosures. Typically, selective disclosure situations arise when D&Os discuss corporate information with analysts and institutional investors before that information is released generally to the investing public. It has become commonplace for companies to conduct periodic closed conference calls with securities analysts to discuss company performance, prospects and other important information. These practices tend to nourish a symbiotic relationship between the company and the analysts that follow the company, thereby allowing the analysts to better serve their clients through access to information and an enhanced understanding of the company.

The practice of selective disclosure is generally justified on the theory that only immaterial or insignificant information is being provided to analysts and other insiders. However, because the notion of materiality is rather vague, any disclosure with analysts that is not clearly within the realm of information publicly available runs the risk of violating securities laws.

Selective disclosure of material nonpublic information can create liability for the participating directors and officers under several theories, including illegal insider trading and illegal manipulative conduct in connection with the purchase or sale of securities. Currently, there is little authority directly addressing liability exposures for selective disclosures. Some of the critical facts which will affect the potential liability of directors and officers are:

1.to whom the information is selectively disclosed (i.e., whether it is reasonable to assume that the recipient of such information will use it for personal or client gain);

2.the nature of the information disclosed (i.e., the materiality of the information and the degree to which it is considered “hard” factual information versus “soft” qualitative comments); and

3.when the information is disclosed (i.e., the proximity and time between the selective disclosure and the full public disclosure by the company).

Regulation FD

On August 10, 2000, the SEC adopted Regulation FD (for “fair disclosure”), with an October 23, 2000, effective date. This ground-breaking Regulation is intended to eliminate selective disclosure by requiring that whenever a company or certain persons acting on its behalf (including its senior management) discloses material non-public information to securities market professionals or those holders of the company's securities who could be reasonably expected to trade on that information, the company must:

•Simultaneously provide such information to the general public if the disclosure was intentional; or

•Promptly provide such information to the general public if the disclosure was unintentional.

Regulation FD applies to disclosures by a company's senior management, its investor relations professionals and others who regularly communicate with market professionals and security holders on behalf of the company. In addition, the regulation only applies to disclosures to securities professionals (such as broker-dealers, investment advisors, certain institutional investment managers, investment companies, hedge funds and their affiliated persons) and shareholders of the company to the extent it is reasonably foreseeable that such persons will trade on the information.

The regulation does not apply to communications with the media generally, other insiders or communications with customers or suppliers in the ordinary course of business. In addition, the Regulation expressly excludes communications with the following groups of persons:

•temporary insiders who owe the company a duty of trust or confidence, such as attorneys, accountants or investment bankers;

•any person who expressly agrees to maintain the information in confidence; and

•any entity whose primary business is the issuance of credit ratings, provided the information is disclosed solely for the purpose of developing a credit rating and the company's ratings are publicly available.

For unintentional selective disclosures, the Regulation states that the “prompt” subsequent disclosure to the general public must occur within 24 hours after the unintentional disclosure or before commencement of the next day's trading on the New York Stock Exchange (whether or not the stock is actually traded on the NYSE), whichever is later. For example, if a senior official discovers an unintentional selective disclosure of material non-public information after the close of markets on Friday, the company will have until the beginning of trading on the NYSE on Monday to widely disseminate that information to the general public.

If public dissemination of information is required, the Regulation permits public disclosure by issuance of a news release, by filing the information with the SEC, or by other methods that are reasonably designed to provide broad public access without excluding members of the public. A Web site only posting is unlikely to be sufficient, at least for now.

Importantly, Regulation FD does not provide a private right of action to shareholders or others if it is violated. However, the SEC can bring an administrative, civil or enforcement action alleging violation of the Regulation. In addition, violations of the Regulation presumably can be used by plaintiffs in class actions as evidence of the defendants' allegedly manipulative conduct in connection with the disclosure of material information about the company.

As a result of this new Regulation, companies must significantly change their practices regarding communications with analysts, including analyst conference calls. Now, material information disclosed in those analysts communications must be simultaneously disclosed to the public. The SEC offers the following as a model for companies to follow:

•First, issue a press release, distributed through regular channels, containing the information. If a company is not widely followed, management should also file a Form 8-K to ensure public dissemination.

•Second, provide adequate public notice, by a press release and/or Web site posting, of a scheduled conference call to discuss the announced results, giving investors both the time and date of the conference call, and instructions on how to access the call.

•Third, hold the conference call in an open manner, permitting investors to listen either by telephonic means or through Internet web casting. The SEC suggests that issuers should consider providing a means of making the information available for “a reasonable period of time” after the meeting. In many cases, a transcript or audio replay of the conference is included on the company's Web site for this purpose.

In addition, senior management who participate in the conference call should be well informed regarding the nature and extent of information already disclosed to the public and should not disclose additional material information in the analysts' conference call. Instead, those calls should now be limited to explaining and putting into context the publicly disclosed information, rather than disclosing new material information.

Internet Disclosures

Like virtually all other aspects of business, the Internet is creating difficult issues in the context of securities law compliance. As information about companies becomes more readily available over the Internet, and as companies use the Internet for communications with investors, traditional notions regarding securities law compliance must evolve to better fit this new paradigm. That process will likely take years as regulators and courts struggle with appropriate application of the securities laws to cyberspace. Unfortunately, while that evolution occurs, companies and their directors and officers must operate in a world of uncertainty, thereby subjecting themselves to potentially catastrophic liability exposure if their behavior is later found in violation of these ill-defined and evolving rules.

The SEC has been active in policing securities violations through use of the Internet. The Office of Internet Enforcement reportedly has more than 800 enforcement personnel nationwide and more than 120 persons in a “cyberforce” who actively scan the Internet to identify securities violations. As a result of this policing effort and complaints from the public, the SEC has brought numerous Internet-related enforcement actions in recent months. These proceedings allege a variety of securities law violations, including insider trading based on sharing material non-public information among chat room friends, disseminating on the Internet false reports or information (either positive or negative) about a company, and purchasing or selling securities through the Internet without proper registration and disclosure.

Although these enforcement efforts by the SEC are significant, as a practical matter the SEC can monitor only a small portion of the endless communications occurring daily on the Internet. Thus, the public users of the Internet (including professional plaintiff lawyers and disgruntled investors) are the most likely source of allegations against a company and its directors and officers for Internet-related securities violations. Despite the enormity of the Internet, if a securities violation occurs, it is reasonably likely that someone will detect the violation and cause the filing of either an administrative proceeding or a private lawsuit.

To some extent, securities loss prevention concepts regarding the Internet are not new. Companies and their directors and officers should treat any communication through the Internet, whether via a Web page, an on-line forum, e-mails or otherwise, the same as they would treat “paper” communications. The same caution and loss prevention concepts which are well recognized and frequently followed by companies continue to apply in the Internet context.

However, two areas which present new and troubling securities exposures and thus demand specialized loss prevention practices are use of the company's Web site and on-line forums such as chat rooms and message boards. Both are discussed below.

Websites

Home websites present both opportunities and challenges for companies in creating positive relationships with, and communicating timely information to, shareholders. The following procedures should minimize the risk of securities law violations through use of a company website.

Current Information

Unlike press releases, which are generally considered to be current for only a short time period after the release date, a Web site continuously makes information available to investors and others as long as the information is on the Web site. Thus, stale information that has been on the Web site for some time may seem fresh when it is outdated and misleading.

To reduce the risks associated with the continuous publication of stale information on a Web site, a company should do the following:

1.Include on the website a prominent disclaimer to the effect that various information speaks as to a specific date of issuance and may become outdated.

2.All issued press releases (either good or bad) should be included and maintained identically.

3.Older or outdated information which remains on the website should be placed in a separate section clearly identified as an “archive” which contains an appropriate disclaimer that the information is dated and will not be updated. Not all information should be archived, though. For example, a company should permit shareholder access to replays or transcripts of analyst conference calls for only a short period of time after the conference call (e.g., 7–10 days).

4.A designated compliance officer should periodically review the entire website to ensure that all information remains current and accurate. Fifth, each section of the Web site should contain an indication of when that section was last updated.

5.Each section of the Web site should contain an indication of when that section was last updated.

Manage Content

Website content is often prepared by different company departments, each trying to communicate to a different target audience. All information and statements on the website should be ultimately subject to an internal review and approval by a qualified compliance officer to assure that all disclosures included on the site are accurate, complete and appropriate, much like the pre-approval for any company press release. With respect to information intended primarily for investors, a separate section of the website should be developed, so labeled and carefully monitored for accuracy, completeness and timeliness.

Hyperlinks

Do not provide links to any other materials, particularly analyst reports. By linking to other sources of information, a company's website may be deemed to be adopting or endorsing the content of that information and thus the company and its directors and officers may become liable for misrepresentations in those other materials. If some reference to analyst reports is strongly desired, the company website could provide a list of the names of all analysts known to follow the company, without providing a hyperlink to the analyst's website or reports. If links to the analysts are deemed necessary, the link should be provided in an objective fashion without drawing distinctions between favorable and unfavorable reports. The link should also be accompanied by a disclaimer stating the company does not endorse or adopt third-party statements or forecasts and assumes no responsibility for ensuring that they remain up-to-date and accurate.

The disclaimer should be located such that it will be seen before the analysts' reports are viewed. Any identification of analysts should reference all analysts that publish reports on the company and should be listed in alphabetical or chronological order in order to avoid the appearance that the company favors any of the analysts over others. Any identification of analysts should also include a prominent link to the company's own risk disclosures, so that the statutory safe harbor applicable to forward-looking statements arguably applies if and to the extent the company is deemed to have adopted the analyst's report or estimates.

To reduce concerns arising from links to analyst reports, some companies link to “consensus estimates,” which are websites maintained by outside service providers who compile the estimates of several analysts. Arguably, this practice reduces liability exposure because (1) the estimates revealed are selected by an independent source, (2) no individual estimate is revealed, only a consensus, and (3) shareholders, who demand this type of information, could obtain it easily anyway. However, hyperlinks of this nature still present many of the problems potentially applicable to direct links to analyst reports and therefore should either be avoided or used with the same precautions discussed previously.

Gun-Jumping

Companies are prohibited from offering to sell securities before a registration statement has been filed with the SEC. Also, a company may not prime the market for an impending securities offering by releasing information that alerts the public to the possibility of a securities offering or otherwise arouse investor interest in a prospective offering (“gun-jumping”). As a result, information contained in a company's website and any links to analysts' reports and other information must be carefully controlled while a company is preparing and conducting a securities offering.

It is customary for the SEC to review a company's website in connection with its review of the registration statement. Although the company may continue its customary disclosure of company news and developments during that time period if the information is unrelated to the offering, statements regarding the financial performance of the company or the value of the company should be avoided during this period. Furthermore, to the extent that a company's website contains an interactive feature permitting, for instance, customers to pose questions directly to a senior member of the company, the company should disable this feature until the registration statement becomes effective.

Link to Disclaimer

Companies should accompany most disclosures with an appropriate disclaimer. Disclosures of forward-looking statements should be accompanied by meaningful cautionary statements in order to qualify for the safe harbor under the Private Securities Litigation Reform Act. It is unclear whether a link to a disclaimer page is sufficient for this purpose. Preferably, the disclaimer should appear on the main page of the company's website as well as on any sections of the website that are intended primarily for investors, thus assuring that the investor will see the disclaimer.

Protect Oral Transcripts

If a company elects to include a transcript of oral statements (such as analyst conference calls) on its website, links to appropriate risk disclosures should be included so that the written transcript arguably is accompanied by appropriate cautionary language for purposes of the statutory safe harbor for forward-looking statements.

Differentiate from Other Sites

A company should design its website to create a common appearance that differentiates it from any other Internet site about the company that is maintained by others. A notice can appear when a user leaves the website (by hyperlink or otherwise) thanking the user for visiting site and disclaiming responsibility for information in any other site.

Security

A company should implement security protections for its website to ensure that information displayed on the website cannot be altered and additional information cannot be included without the company's knowledge and approval.

On-line Forums

Chat rooms, bulletin boards, and other on-line forums create increasing potential problems for companies from a securities law standpoint. These sites publish anonymous communications about companies and their securities with no control over the accuracy of the information disclosed. Because the statements are anonymous, they are frequently quite critical and frank. The following are several suggestions for minimizing the risk of securities violations relating to these forums.

Sponsorship and Hyperlinks

Companies should not sponsor or host their own on-line interactive forum or include a link to chat rooms or bulletin boards in its website. Such links, may suggest that the company endorses or is entangled with those forums and their content.

Responding to Rumors

Because companies are generally not required to respond to rumors in the market, they should generally refrain from responding to cyber gossip in any way. That position should be consistently maintained regardless of the rumor, since selective responses may effectively confirm or deny certain rumors. An exception to this policy might be made if, for example, a third party widely disseminates on the Internet false information that appears to be issued by or attributable to the company. Because these types of communications appear to be coming from the company, an immediate disclaimer by the company of the false information is appropriate. In those rare cases where the company feels compelled to respond to Internet rumors (either for business reasons or because it has arguably become entangled with the statement made), it should do so only after widely disseminating a press release and, if necessary, the filing of a Form 8-K with the SEC.

Employee Participation

Any statement made by someone from a company in an on-line forum could be viewed as a disclosure by the company. Therefore, employees should be prohibited from participating in forums that discuss or reference the company or, at a minimum, prohibited from using company computers and identifying their affiliation with the company when participating. A message sent from a company's e-mail address or from a person identified as an employee may appear to be a communication on behalf of the company. If an absolute prohibition is unacceptable or impractical to enforce, employees should be given clear guidelines that proscribe discussions of internal corporate matters, company business, client information or other confidential business information in such forums.

Even if not attributable to the company, participation in on-line forums by employees or other insiders creates the risk that material non-public information will either intentionally or unintentionally be disclosed in violation of the insider trading laws. Because companies and their directors and officers can be liable for the illegal insider trading of subordinates, companies should re-double their efforts to periodically inform all employees and insiders of the insider trading prohibitions and to implement appropriate compliance procedures.

Monitor

Companies should monitor Internet chat rooms, message boards and other sites mentioning the company. Certain service companies sell this service to public companies. Only by knowing the nature and severity of the rumors can a company create an appropriate counter-strategy.