Bankruptcy and D&O

May 31, 2010

 

As usual, I have taken my cue from Kevin LaCroix’s DandODiary.com, here, and then attempt to provide the Canadian perspective. Kevin’s recent post, here, on bankruptcy statistics and D&O insurance is very detailed, and if you don’t let the US stats deter you, the risk and insurance comments are equally applicable to Canadian companies. Kevin refers to the American Bankruptcy Institute, here, and a record number of business bankruptcies (60,000) in 2009, “nearly 200% greater than in 2006”. He also refers to the ACE Insurance Report, here, “Financial Crisis: Bankruptcy Implications for D&O Insurance, by Keith Lavigne, Scott Meyer, Carol A.N. Zacharias”

Not surprisingly, the Canadian statistics are much different.  According to Industry Canada, here, January, which is historically a higher month for bankruptcies than December, insolvencies (bankruptcies and proposals) were down 6.7%, the largest January decline in 20 years. This includes both business and consumer insolvencies. January 2010 over January 2009 showed a business insolvency decrease of 18.5%. The 12 month periods ending January 31, 2010 and 2009, respectively, showed a 10.3% decrease in business insolvencies (6,624 total, including 5,326 bankruptcies.) These insolvency figures do not include filings under the Companies’ Creditors Arrangement Act, here, which includes 35 filings between September 18, 2009 and April 30, 2010. Another helpful website is BankruptcyCanada.com, here.

These statistics, coupled with the fact that business bankruptcies in Canada have been on a steady decline for the last ten years, half what they were ten years ago, may make Canadian company stakeholders more comfortable. However, consumer bankruptcies are up 25% year-over-year ending January 31, 2010, and consumer proposals are up 41%. And, based on CCAA, for stakeholders of Canwest,  Winalta, Tagish Lake Goldcorp, etc., comfort is a luxury they don’t have.

The value of a D&O policy should never be greater than when approaching creditor protection or bankruptcy.  On the surface, one method for a director to reduce personal liability is to resign immediately from the board, so that even if statutory obligations are levied against the director, they will stop accumulating the date they resign. Hopefully, this is when the D&O Insurer and/or the insurance broker should be stepping-in to remind the current board that they have insurance to cover their personal liability and that staying on the board and turning their mind to the challenges presented (of restructuring and corporate turn-around) is probably the only way to avoid the overall business failure and potential personal liability. 

Here is an excerpt from the ACE Report, “When a corporation files for bankruptcy, the D&O risk appreciably rises. Because indemnification from the corporation may not be available, defendant directors and officers risk their personal assets in litigation, unless quality insurance exists.” The report also quotes Dan A. Bailey, partner and chair of the D&O practice group at law firm Bailey Cavalieri, here, “Bankruptcy is the big driver of non-indemnified D&O lawsuits. It is the single biggest personal asset exposure that directors and officers need to be worried about, and that Side A D&O insurance companies, which absorb risk, must carefully evaluate from an underwriting perspective.”

I remember a situation from my underwriting days, when a building materials manufacturing company realized that a significant batch of product, manufactured and installed many years early, was failing well before the warranty period ended. Sales dropped immediately because of reputation risk; liquidity risk became a reality because of debt servicing and credit risk; insurance risk surfaced because product liability policies were based on occurrence forms and therefore administratively more difficult to handle and, based on the size of the loss, slower to respond. The creditors would not have been flexible if the senior management did not have a plan and did not stay to handle the significant challenges, the senior management wouldn’t stay if the board resigned, and the board would likely have resigned if the D&O underwriters did not meet with them and provide the comfort that the D&O policy was there to respond to personal liability should the directors and management fail in their attempt to turn the company around. The limit of liability of the D&O policy was no-where large enough to backstop the company assets (and the policy is not designed to do that), but it was large enough to provide comfort that statutory liabilities, defence costs for potential creditor and shareholder claims, and some contribution (in addition to the entity and other third parties) to settlements would be covered. This comfort provided the necessary time to organize, strategize, and gather necessary resources. One of these resources was the product liability policy, which by itself was not large enough to cover the entire loss, but, its existence provided assurance to customers, creditors and shareholders that the overall risk was manageable. The result was that over 200 employees kept their jobs and pensions, customers came back, and shareholder value was restored. And my seemingly altruistic employer did not incur a dime in loss (but we were not the product liability insurer.)

If the necessary comfort is not volunteered by the Insurer, the policy wording can still do the job (it just needs broker support and, when appropriate, legal advice.) Here are ten comments I have extracted from my much larger list of D&O policy review points (if you would the whole list, please feel free to call me directly):

  1. Coverage for the entity be limited and fully transparent
  2. Extensions of coverage should be fully understood, as they expose the policy to loss other than personal liability of directors and officers which creates limit sharing and limit exhaustion
  3. Limit-of-Liability management should consider PML (probable maximum loss from stakeholders: employees for wages, severance; shareholders; creditors; government for unremitted taxes, pollution liability; etc.), as well as entity coverage and other extensions
  4. Priority-of-Payments provisions may be necessary but should not provide too much comfort, because there is no precedent in Canada, and the Canadian courts apply a ‘first-past-the-post’ doctrine which could negate the provision. And, it doesn’t come without risk because some wordings might create liability for a specific officer and expose that individual to further loss (after limits have been exhausted)
  5. Insured vs Insured exclusion should at minimum contain specific ‘carved-back’ language (eg. Trustees in bankruptcy) and there is no common wording in Canada
  6. Affirmative coverage for regulatory proceedings should be confirmed, and the extent of this coverage should be highlighted in the ‘entity coverage’ transparency
  7. Financing of D&O premium should be avoided because it usually requires assignment of cancellation rights, which means the policy is cancelled by the finance company prior to a claim being made
  8. Automatic run-off should be maintained, and policy made fully-earned and non-cancellable at any change in control (not just for bankruptcy, but any time, because some Insurers will suggest that removal of automatic run-off is in your best interest – always be careful of Insurers bearing gifts)
  9. Repeat to yourself, “there are D&O losses in Canada”, “there are D&O losses in Canada”, five more times
  10. No matter what they say, plaintiff lawyers do exist in Canada, they have sufficient motivation to pursue claims, and lawyers on both sides of the claim are well paid

Please note this is not an exhaustive list of things to consider with your directors’ and officers’ liability coverage and the possibility of creditor protection or bankruptcy. Bankruptcies are commonly a slow and painful ordeal, with years worth of financial and business indicators. Many D&O underwriters are business grads, MBA’s, CFA’s, CA’s, and their job is to identify future bankruptcies and reduce their employer’s risk. D&O policies are annual and very rarely written with multi-year policies (no, an intent-to-renew letter is not a multi-year policy), and clauses in some policies state that any offer to renew the policy, with any change in terms, conditions or premium, will not constitute a refusal to renew, so extended reporting provisions (ERP) cannot be triggered.

Negotiation of these renewals should be a very demanding process, but my experience is that Insured’s management has already heard such bad news from clients, bankers and suppliers, that they don’t have the energy (or proper advice) to aggressively negotiate an acceptable policy wording. There are dozen’s of different ‘bankruptcy’ exclusions, and rarely does the most onerous one have to be accepted by the Insured.

Please feel free to call me to expand on any of these issues, or provide you with other documents, like the Pitfalls of Indemnification, or Lightening of Continuity.

CAUTION: The information contained in the Mitchell Sandham website or blog does not constitute a legal opinion or insurance advice and must not be construed as such. It is important to always consult a truly ‘independent’ registered insurance broker and a lawyer who is a member of the Bar or Law Society of the relevant jurisdiction with regard to this material before making any insurance or legal decision. All material is copyrighted by Mitchell Sandham Inc. and may not be reproduced in any form for commercial purposes without the express written consent of Mitchell Sandham Inc. Anyone seeking to link this site from any external website must seek the consent of Mitchell Sandham Inc. by sending an e-mail to gshields@mitchellsandham.com.

Greg Shields, Partner, Mitchell Sandham Insurance Brokers, 416 862-5626, gshields@mitchellsandham.com


Mortgage Fraud

May 7, 2010

News on this topic goes in waves. A few years ago Identity Theft and Mortgage Fraud got public attention when scams we detailed of perpetrators identifying a typically older single person who owns a home with a very small existing mortgage. The criminal will fake the homeowner’s identity and pay off that mortgage, and then remortgage the property to almost its full value. The homeowner does not find out about the fraud until the payments go into arrears and the lenders come calling, or until they attempt to pay-down their small mortgage and find it was already paid-off and a new credit search shows a very large amount owing to a different lender.

Now, the Oklahoman or Skip Transfer. A group, or several different groups, conspire to purchase lower priced homes in a given neighbourhood and then flip them to “straw buyers” for inflated prices. The straw buyers are paid a few thousand dollars for the use of their identity, their financial position is forged, and they get mortgages from mortgage lenders at prices typically $40,000 or more in excess of the property’s market value.

One of the big Canadian banks, in their Alberta operations, has recently announced a mortgage fraud involving $120 million in property. Many news organizations have been reporting on this, here, here, here. This scam could involve many interrelated organizations in many countries, and include many institutions, and, by fraud or negligence, many Canadian lawyers, mortgage brokers, and bank employees. Some reports suggest that irregularities were identified as early at 2006.  

My experience is that fraud is not contingent on new space-age technology or extraordinarily complicated strategies. One recent claim example was a loss of almost a half million dollars to a relatively small private company that, like many organizations, had a holding company and an operating company, where only the operating company was audited. A mid level employee in the finance department very simply included herself as an employee of both the holding company and the operating company. When senior finance requested a run of T4 slips she provided only photocopies, removing sequential numbering, and pulling one of the two T4 splits. This complex plan, diabolical in its brilliance, lasted ten years. When a new senior finance employee requested original sequential T4 slips, the criminal mastermind admitted guilt and offered to pay back the money.

Rarely in cases of Fraud (and for that fact, employee injury, general liability, product liability, etc.), is the Loss Control activity a new or original device. The Loss was likely dependent on lax oversight or application of long existing policies and procedures. Safety bars removed, eye protection not enforced, emails with sensitive information sent to former employee addresses, vendor lists not audited, not witnessing signatures, overlooking questionable behavior, not performing regular or periodic background checks, etc. etc. Any one of these can easily contribute to losses in the six and seven figures, but individually, they are just plain boring. Even in the case of a nine figure mortgage fraud, the sophistication of the scam is not based on 21st century listening devices, or some form of computer hacking, cross-site scripting, malware implanted virus, it is likely based on taking advantage of lax oversight of mundane operating activities, which individually are completely lackluster transactions, within multiple parties.

If you want a good history of mortgage fraud in Canada, I refer you to a May 6 article by By Jen Gerson, in the Calgary Herald, here. The article makes important distinction between Alberta real estate law, and says that “…because in a boom economy, it’s often easier to hide fraud because actual boom time values can quickly match fake inflated values. Banks, in this case, can recoup their losses. But when property values stabilize or fall, fraud becomes more apparent.” The article also provides an estimate by the Quebec Association of Real Estate Agents and Brokers that “fraud could cost $1.5 billion per year across the country.”

Greg Shields, Partner, Mitchell Sandham Insurance Brokers, 416 862-5626

CAUTION: The information contained in the Mitchell Sandham website or blog does not constitute a legal opinion or insurance advice and must not be construed as such. It is important to always consult a truly ‘independent’ registered insurance broker and a lawyer who is a member of the Bar or Law Society of the relevant jurisdiction with regard to this material before making any insurance or legal decision. All material is copyrighted by Mitchell Sandham Inc. and may not be reproduced in any form for commercial purposes without the express written consent of Mitchell Sandham Inc. Anyone seeking to link this site from any external website must seek the consent of Mitchell Sandham Inc. by sending an e-mail to gshields@mitchellsandham.com.


Bribery, Whistleblowing and D&O Insurance

May 6, 2010

Bribery continues to be a fairly quiet issue in Canada, but it is really heating up in the US and Internationally. In the US, enforcement of the Foreign Corrupt Practices Act (FCPA) has been used to bring or resolve 36 cases in the first quarter of 2010, up from 6 and 4 in the first quarters of 2009 and 2008, respectively, according to international law firm Willkie Farr & Gallagher LLP. The report and significant review of FCPA cases can be found at The D&O Diary, here.

Is bribery a brand new phenomenon, or the creation of a 20th century diabolical genius?  No, I would suggest it is as old as time, and practiced regularly throughout the world. However, motivation for whistleblowing could make the FCPA a front-running piece of legislation. The draft bill of the Restoring Financial Stability Act of 2010, (a very detailed review can be found on lexology.com, here), in a small section called Improving Investor Protection at the SEC, includes a proposal to offer “internal whistleblowers a financial reward of up to 30% of any funds recovered.”  Which in the SEC v. Siemens case, here, that could mean $480 million to a ‘good Samaritan’.  

 The US DOJ is good enough to provide a laypersons guide to the legislation, here, and the relationship with Canada is the broad language of “Who” (is the subject of enforcement) including, “any individual, firm, officer, director, employee, or agent of a firm and any stockholder acting on behalf of a firm” and whether the “violator is an “issuer,” a “domestic concern,” or a foreign national or business.” A fairly easy test for many Canadian companies and individuals to pass. I won’t provide more details, at the fear of it suggesting that Canadian entities can avoid this legislation.

In the UK, the Bribery Act 2010, here, received Royal Assent on April 8, 2010, but I see not provision for whistleblower rewards.

The Canadian version of the legislation is called the Corruption of Foreign Public Officials Act (CFPOA), here, but I could not find any provision for rewarding whistleblowers, and even the Foreign Affairs and International Trade Canada, here, site suggests there has been only  one prosecution (2002) under the Act in its ten year history. However, there is one case of a Calgary energy company that acknowledged (Jan 2009) that it was being investigated by the RCMP for alleged improper payments to public officials in South Asia, here.   McMillan LLP, suggests, here, that this legislation should not be dismissed, in part, because “a corporation will meet the mens rea requirement where a senior officer or director “intentionally or recklessly, with knowledge of the facts constituting the offence, or with willful blindness to them “permits the offence to occur.” Though this legislation is not likely to keep most D’s and O’s up at night, there is a very real concern of the close US ties in our business activities, an in the significant loss that can occur from follow-on D&O claims. Therefore, I agree with McMillan that compliance with the legislation is important, and it should be a risk management priority because of the reputation damage and D&O defence costs that can result from an alleged violation. In the Calgary energy company case, the announcement of the alleged corruption corresponded with a relatively short term dip in the company stock price and a five year low in that stock. Luckily there were no follow-on claims.

The insurance implications: fines and penalties, from a CFPOA action, are usually excluded from D&O policies, but depending on the wording, there may be some coverage for defence costs. The real exposure comes from follow-on class action securities claims or derivative actions, which could mean significant payout from the D&O policy. The biggest concern is limits management, limits exhaustion and sharing of limits, because entity coverage for securities claims is the most likely case for the ‘entity’ exhausting limits that would otherwise be available to individual directors and officers. A big cheque from the insurance company may be good, if you maintain a $100 million limit, and the total loss is $25 million, but if your limit is $10 million, and the total loss is $25 million, your directors and officers might be very disappointed with ‘broad’ coverage. The Calgary company lost over half its value in a few short months, and if a claim had been brought and settled, even at a very low “plaintiff-style” damage factor, most Canadian public company D&O policies would have been fully exhausted.

If you would like to discuss any of these issues, please call me directly.

Greg Shields, Partner, Mitchell Sandham Insurance Brokers, 416 862-5626, gshields@mitchellsandham.com

CAUTION: The information contained in the Mitchell Sandham website or blog does not constitute a legal opinion or insurance advice and must not be construed as such. It is important to always consult a truly ‘independent’ registered insurance broker and a lawyer who is a member of the Bar or Law Society of the relevant jurisdiction with regard to this material before making any insurance or legal decision. All material is copyrighted by Mitchell Sandham Inc. and may not be reproduced in any form for commercial purposes without the express written consent of Mitchell Sandham Inc. Anyone seeking to link this site from any external website must seek the consent of Mitchell Sandham Inc. by sending an e-mail to gshields@mitchellsandham.com.


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