Director Alert: The Changing Face of Directors & Officers Liability Insurance

1. Director Alert:The Changing Face of Directors & Officers Liability Insurance Steve Shappell Director – Legal Aon Financial Services Group

2. Sources of Obligations & Defenses • Common law (created by courts) • Federal statutory law (created by legislature) • Regulatory rules (created by government agencies) • State law & local law • Foreign law

3. Basic Duties(Common Law) • Duty of Care/Diligence • A director shall perform his or her duties as a director: • In good faith • In a manner he/she reasonably believes to be in the best interest of the corporation, and • With such care as an ordinary prudent person in like position would use in similar circumstances • In performing his/her duties, directors may reasonably rely upon the advice of experts • In performing his/her duties, directors may reasonably rely upon the reports of committees

4. Basic Duties(Common Law) • Duty of Obedience • A director or officer must act within the scope of his duties and may not enter into any contract or take any action not within the authority of his/her office • Ultra Vires Acts – without authority • Duty of Loyalty • The Corporation must come first • A director or officer may not use his position to make a personal profit or gain (insider trading, use of corporate opportunities) • Transactions between a director and corporation usually require: • Full disclosure • Approval by a majority of the disinterested directors

5. Basic Statutory Liabilities • Federal Law • Securities Laws • Securities & Exchange Act of 1934 • Securities Act of 1933 • Sarbanes-Oxley Act • Employment Laws • Title VII of the Civil Rights Law of 1964 • Americans With Disabilities Act • Age Discrimination Act • Civil Rights Act of 1866 and 1991 • Sherman/Clayton anti-trust act • Various pollution acts • RICO • ERISA • FIRREA (financial institutions) • False Claim Act

6. Frequency by Claimant[Private Company] Other 8% Gov’t 5% Shareholders 16% Competitors 6% Customers 16% Employees 49% (Tillinghast-Towers Perrin Survey

7. Gov’t 2% Other 4% Competitors 8% Customers 14% Shareholders 47% Employees 25% Frequency by Claimant [Public Company]

8. Managing the Risk • Risks to Director • Prevention • Indemnification • Insurance

9. Who Pays the Bills? • Three alternatives • Individual Director or Officer • Corporation • The D&O Insurer • Risk transfer

10. What is Corporate Indemnification? • Description • The ability of the corporation to pay the judgments, settlements and defense costs incurred by a director, officer, employee or agent of the corporation

11. Corporate Indemnification Limits • Four major limitations • Not acting in good faith (decided by board) • Shareholder derivative actions (in part) • Financial insolvency • Superceding federal or state law • Including SEC claims under some circumstances

12. D&O Industry Economics • 197% increase in number of companies sued in Shareholder Class Actions from 1996 to 2001 (excluding “laddering” only allegations): 110 – 327 (Stanford Securities Class Action Clearinghouse) • The average settlement in 2002 increased from ~$17 million in 2001 to over $20 million. The standard deviation was over $58 million. Seven cases settled for over $100 million. (Securities Class Action Alert) • 50% decrease in D&O insurance premium from 1994 to 2000

13. D&O Industry Economics • 110 - number of companies sued in Shareholder Class Actions in 1996 (Stanford Securities Class Action Clearinghouse) • 261 - number of companies sued in Shareholder Class Actions in 2002 (Stanford Securities Class Action Clearinghouse) • 116 - number of companies restating earnings in 1997 (Huron Consulting) • 330 - number of companies restating earnings in 2002: 200% increase (Huron Consulting)

14. Securities Class Action Trends:Large Settlements • Since mid-1999, the size of D&O settlements, particularly in securities class action lawsuits, has increased dramatically: • 14 settlements or judgments in excess of $100M • 1/2 of those settlements being in excess of $200M

15. Directors’ & Officers’ Liability Insurance: Class Action Trends • Post-Reform Act claims more likely to include allegations of accounting fraud and illegal insider trading* • Average settlement value as a percentage of alleged damages increased from 5% - 7.5% pre-reform to 14% - 22% post-reform • 2,000+ backlog of security claims in court system currently - actuarial projections are unfavorable

16. D&O Trends: PWC 2002 Securities Litigation Study • 2002 - 261 securities suits • 2001 – 483 Class Action Lawsuits Including 308 Laddering Cases and 175 Non-Laddering Federal Cases • 57% of all non-laddering cases involved accounting allegations (up from 53% in 1999 and 2000) • 2001 Accounting Breakdown: • 69% alleged revenue recognition violations • 28% alleged overstatement of assets • 26% alleged improper estimates • 9% alleged understatement of liabilities • 6% alleged improper purchase accounting Source: PricewaterhouseCoopers LLP 2001 Securities Litigation Study p 1-8 www.10b5.com

17. Restatement Trends Source: AIG 2002 D&O Insurance White Paper

18. Restatement Trends Source: AIG 2002 D&O Insurance White Paper

19. Average Securities Settlements All Cases Accounting Allegations Source: PricewaterhouseCoopers LLP 2001 Securities Litigation Study

20. Rescission Trends • Rescission: The unmaking of a contract, or an undoing of it from the beginning, and not merely a termination • During the soft market, rescission was exception rather than the rule • Hard market evidencing change in tide: • Warranties are being mandated • Applications are requiring more detailed information • Severability clauses with respects to misrepresentations in applications have been all but eliminated • Severability!

21. Sarbanes-Oxley & Potential Implications on D&O Insurance

22. Main Provisions CEO / CFO Certification of Financial Reports D&O Insurance Implication Very small impact as D&O insurers always have viewed the CEO & CFO as responsible for the financials. Carriers will penalize those that have not certified. Carriers may attempt to argue that the certifications are mini-warranties. Sarbanes-Oxley Act & D&O Insurance • Disgorgement provisions, prohibition of loans • Carriers will not have to worry so much as to executive excesses due to forgiven loans. • Severability • Conduct exclusions • Improved Disclosure • Gives insurers more details as to off-balance sheet issues and related party transactions. Insurers may wish to exclude coverage where they see increased exposure.

23. Expansion of time permitted to bring a suit for securities violations (2/5 years) Insurers will now be forced to examine stock price volatility over a longer period of time, thus increasing their exposure to past actions of D’s & O’s. May cause non-renewals / less capacity, contracts with no past acts cover, and increased premiums. • Main Provisions • Audit Committees & increased responsibilities and requirements • D&O Insurance Implication • May cause a higher awareness as to D&O insurance limits by the audit committee of the board. Reinforces the need for severability of the D&O contract. • May create friction between inside and outside board members • Act applies to foreign private issuers (no appearance of carve-outs) • Will cause controversy with foreign private issuers as respects disclosure requirements. Liabilities of D’s & O’s likely increased along with D&O insurance rates. • Section 302 Rule applies to foreign issuers. Sarbanes-Oxley Act & D&O Insurance

24. Current Trends:Energy Suits & Settlements

25. Security Class Actions Suits filed in 2002 by Industry

26. Average Settlements 2002:Energy Sector vs. All Industries

27. Energy Sector Settlements:1998 - 2002 Triton Energy - $49.5M Plaintiff’s allegations • During the Class Period, Triton had two main assets: (1) a non-operated share of two oil fields in Colombia; and (2) a one-half interest in eight undeveloped offshore natural gas fields in Southeast Asia. Triton also had on-going projects in several other foreign countries. On March 30, 1998, Triton announced that it had hired investment bankers to assist it in maximizing shareholder value as the market "had not yet fully recognized the value of [Triton's] assets." Analysts immediately disseminated reports, based on detailed guidance from Defendants, that Triton was seeking to sell the whole company. On news of Triton's March 30, 1998, announcement, its stock price rose dramatically, increasing from approximately $30 per share to a class period high of $42 per share during a six week timeframe. During the months that followed, Triton and its executives engaged in a systematic campaign throughout the Class Period to deceive the investing public into believing that Triton would be acquired for a premium price.

28. Energy Sector Settlements:1998 - 2002 EEX Corp. - $25M • The company overestimated the value of an investment in its majority interest in an energy exploration project and overstated the value of oil and natural gas reserves in East Texas and the Gulf of Mexico. Northeast Utilities - $25M • Northeast Utilities failed to disclose safety problems at its Millstone nuclear power plant in Waterford, CT which resulted in its shut down about a year ago. Arakis Energy - $24M • Disclosure violations in connection with a proposed financing agreement for a pipeline in the Sudan between the company and Arab Group International.

29. Energy Sector Settlements:1998 - 2002 Marketspan Corp. - $7.9M • The defendants breached fiduciary duties by paying former Long Island Lighting officers "secret" payments of $67 million in retirement benefits and other compensation. Coeur D'Alene Mines Corp.- $7M • Falsely represented that it was improving its financial results by reducing its losses in 1994 and reaching profitability during 1995, that its Golden Cross gold mine in New Zealand would achieve gold production in 1996 of about 77,000 ounces and that the company was on track to achieve strong cash flow, net income and earnings peer share growth in 1996 and 1997. Unicorp America - $3.25M • Company failed to obtain the highest price on a proposed sale of real estate assets. The potential bidder, Coscan Inc., is not a bona fide third-party purchaser because it is affiliated with Hees International Bancorp, Inc., which owns 22% of Unicorp Canada.

30. Energy Sector Settlements:1998 - 2002 Bayard Drilling Technologies - $3.1M • Failed to disclose in IPO documents financial difficulties of company's largest customer which eventually led to substantial decrease in drilling contracts. Offshore Energy Development. - $3M • According to the complaint the positive statements made by the defendants during the Class Period, including defendants' statements that OEDC would generate significant production, earnings and cash flow gains in 1997 and 1998 and that OEDC's results could be "predicted with high degrees of confidence," were false and misleading when made as they misrepresented and/or omitted to state facts necessary to make the statements made not misleading Hallwood Energy - $1M • The defendants breached their fiduciary duty in regards to a merger price that was inadequate.