Did you know that under federal law, corporate executives may be required to pay back incentive-based compensation? Further, do you know how your directors and officers liability insurance (D&O) policy may respond to such loss?
Section 304 of the Sarbanes-Oxley Act of 2002 (SOX 304) and Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (DF 954) are the two major federal claw-back laws. Simply put, SOX 304, enforced by the Securities and Exchange Commission, may force a CEO or CFO to return incentive-based compensation as a result of “misconduct” that causes a material financial restatement. Alternatively, DF 954 requires the company to recover incentive-based compensation that was not “earned” from any current or former officer under certain circumstances.
The claw-back rules were enacted in response to corporate scandals and corruption, and to provide higher standards that ultimately benefit investors and the market in general. Note that in both of these acts, the claw-back provision may be triggered even when the CEO, CFO or other officers themselves are innocent or unaware of any corporate wrongdoing.
Transferring the Risk
If executive officers challenge a requirement to return compensation or refute the underlying conduct leading to such a requirement, they may face an uphill battle. Public companies generally are required to enact “no-fault” claw-back rules for officers which can circumvent any possibility of indemnification from their company. Historically speaking, courts have prevented such indemnification, particularly when faced with liability under SOX 304.
Another source of possible protection that executive officers may seek is through a D&O insurance policy. D&O policies are written to protect executives for liability arising out of “wrongful acts” committed in the discharge of their professional duties. Seeking coverage for a claw-back claim raises potential coverage concerns, as discussed below.
A D&O policy is typically only triggered by a claim involving an allegation of a “wrongful act.” Often this requirement is not met under DF 954 or SOX 304, as the provisions do not require that there be a showing of misconduct; therefore no personal wrongdoing is alleged. Even if the insureds are sufficiently able to demonstrate to the insurer that the claim involves a “wrongful act”—by way of amending the definition of “wrongful act” to incorporate a provision that includes “any matter claimed against them as a result of their status as such director or officer…” or by demonstrating that a wrongful act was alleged, there are several other coverage hurdles to consider.
Typical D&O policies would not respond to claw-back claims, as the monies sought may be considered ill-gotten gains or some form of illegal profit/advantage. In order to seek reimbursement for defense costs, the policy conduct exclusion should be modified to require such conduct be proven through judicial determination, including “final, non-appealable, adjudication” language.
It should be noted that while many insurers are now willing to broaden the D&O contract to specifically include provisions that acknowledge coverage for fees, costs and expenses in the context of a claw-back dispute, the actual payment or disgorgement of any amount would continue to be uncovered. This approach is the most popular as it amends the definition of loss to include defending SOX 304 and DF 954 claims expressly. The most viable option in the current marketplace is for “defense costs only” coverage. If your traditional D&O policy is not amended, rest assured a viable option is available.
An excess Side-A Difference in Conditions (DIC) insurance policy is also available in the marketplace–and is offered as first dollar coverage if the underlying insurer fails, refuses to indemnify or is not liable for the loss. An executive officer may seek coverage under this Side-A DIC policy as it is much broader, and has fewer exclusions than a traditional D&O policy. These types of policies include various features of coverage including limited or no fraud exclusions and expanded definitions of loss to explicitly include defense cost and indemnity for claw-back claims, but generally not the amount representing the compensation claw-back itself. Related coverages may include a separate sublimit of liability to fight regulatory attempts to freeze the assets of an executive officer, SOX 308 fines and penalties and Dodd-Frank 210 opposition costs.
It is important to note that there are many provisions of the policy outside of the items discussed above that influence coverage availability and the extent of such coverage. The particular allegations and specific claim facts are also important in determining the scope of coverage. Finally, changes in legal decisions and policy interpretations relative to the application of such coverage may come into play.
Please contact us for specific guidance on your situation, if you have any questions or if you would like additional information on this topic.