Early in 1996, Roanoke entrepreneurs Randall H. Frazier and John M. Holland got a chance - rare in those parts - to join the board of a fast-growing high-tech company called Optical Cable. At the time, the firm was so obscure that not a single investment bank would help take it public. The company's founder, Robert Kopstein, was engineering a do-it-yourself IPO, working the phones and selling chunks of stock to friends, customers and whomever else would listen.

Kopstein succeeded and Frazier and Holland joined the board of the fiber-optic cable manufacturer. Together they began a journey that pretty much encapsulates, in microcosm, the delirium that was the 1990s. Within a month of the IPO, Optical Cable's stock shot from the $10 initial price to $130, giving its early backers paper fortunes and turning Kopstein into a state celebrity. Next came the inevitable steady decline, as day traders bailed and more sober investors realized that, while healthy, Optical Cable was worth only a fraction of its mania-driven high. Then came the crash, when it was revealed last fall that Kopstein had used his massive holdings of Optical Cable stock as collateral for a series of ill-fated tech stock trades. He ended up owing millions to several big brokerage houses, which unloaded the stock to cover their losses - driving down the price.

Now it's lawyer time, as Optical Cable, its officers and directors face a series of suits from shareholders who allege they were defrauded. Frazier and Holland can't comment because of the litigation, but it's a safe bet that they're wondering if it was all worth the trouble.

They're not alone. Running a Virginia public company used to be, if not exactly cushy, at least relatively low-risk. Shareholder lawsuits seldom touched the personal assets of top executives and directors, thanks to the multilayered defenses that had evolved in recent years. If corporate officials followed the basic rules of good behavior, the Virginia Corporate Code exempted them from liability. Company bylaws, meanwhile, generally indemnified officials and covered their legal costs. And directors and officers' insurance -- "D&O" coverage in industry parlance - stood ready to defray any liability that somehow evaded indemnification.

But those days of innocence are over. Thanks to a whole slew of unhappy events, ranging from dot-com busts to the implosion of energy giant Enron — the walls separating angry shareholders from officers' and directors' personal assets have developed some gaping holes: Indemnification, it turns out, doesn't help if a company is bankrupt. And D&O insurance premiums are skyrocketing, while the quality of coverage deteriorates. Add it all up, and the people running Virginia's public companies are suddenly very vulnerable.

Like so many of today's other problems, the seeds of this one were sown in the late 1990s. At that time, the booming stock market seduced the issuers of D&O insurance into "cash flow underwriting," says Diane Barber, a D&O specialist in the Richmond branch of insurance broker Marsh USA. That is, they sold policies at a loss and hoped to make up the difference by investing the premiums in the market. To drum up more business, they spiced their D&O policies with extras like entity insurance, which covers the whole company in the event of a lawsuit.

This little extra put the insurers on the hook for their customers' inflated market capitalizations. When the tech bubble burst, shareholder anger was quickly converted into a tidal wave of big-money class action lawsuits. Many of these suits went directly after the officers and directors of the failed companies, with painful results.
In 2001, for example, Vienna-based MicroStrategy settled suits alleging misstatement of revenues for a total of $113 million, only $13 million of which was covered by insurance. The company paid the rest, with officers and directors surrendering shares of Microstrategy stock worth $10 million to help cover the bill. Since then, nine other suits have been filed against Virginia companies, according to Stanford University's Law School. Nationwide, Stanford calculates that 465 suits were filed in 2001, more than double the previous year's total. The cases are being settled for an average of $15 million each.

This alone would have been enough to cause an orgy of higher premiums and skimpier coverage in the D&O market. But then came September 11, with its tens of billions of dollars in property damage. Since the same companies that write D&O insurance also write property and casualty insurance, the attack cut the industry's pool of capital, leaving less available for new policies of any kind.

And then, of course, came Enron, the mother of all corporate insurance debacles. "A case this size cuts across all areas of activity," says Bill Brown, a New York-based insurance consultant. "You may have not just the D&O policy, but employment practices, ERISA, partnership liability. Add to that the accountants being sued, the lawyers, the investment bankers, all of whom have various kinds of D&O insurance. In a lot of cases the same insurers are writing this stuff. It's an absolute monstrous aggregation of liability."

As a result, "Rate increases [for D&O coverage] are all over the board, anywhere from 30 percent to 2,000 percent," says Marsh's Barber. Where they land for a given company depends on three things: The company's financial strength, its industry (tech, telecom, and health care especially dicey right now) and the loss history of the insurance carrier. "If the carrier has paid out a lot of losses, they've got to make it up in the form of rate increases," says Barber. Though specifics are unavailable, stories abound of local companies whose premiums jumped from the $125,000 annual range to $500,000 or more in the past year. "We're having a lot of come-to-Jesus meetings with our clients to warn them of what they can anticipate [when their D&O policies come up for renewal]," she says.

Besides costing insurance carriers a fortune, Enron's near-instantaneous implosion shattered the illusions of both corporate indemnification and D&O protection. "When you go into bankruptcy, [a director or officer faced with legal fees] is treated as a general creditor," says Allen Goolsby, an attorney with Richmond-based Hunton & Williams. "You have to get in line, and if there are secured creditors ahead of you as is so often the case, the line may end with an empty cup."

When Enron recently petitioned a New York court to tap its copious D&O coverage to pay the legal fees of its top people, the request was denied. Though the judge's reasoning wasn't clear to Goolsby, the impact on Enron's officers and directors might be catastrophic. "I hate to think about the legal fees they're running up," he says. "[Dir-ectors] didn't used to go to bed at night worrying about whether this board seat might put at risk everything they own," says Goolsby. "That certainty is no longer there today."

For prospective managers and/or directors, some hard questions are in order. First, how financially solid is the company? The promise to indemnify board members and executives against legal costs may not survive Chapter 11, so it's imperative that a company be either profitable or headed that way, that it has sufficient cash to weather a bad stretch and that the debt coming due over the next few years is manageable. And, of course, that it's not engaged in the kinds of financial shenanigans that have caused so many recent implosions.

Making certain that a company's governance procedures are adequate is also critical. Among other things, this means maintaining a board that's independent, and stocked with competent outsiders who understand the business and the laws and regulations governing it. Board meetings should be sufficiently frequent, and should address the important issues. Directors or officers who have conflicts of interest should recuse themselves when appropriate, and discussions with analysts and investment bankers should be honest and above board. And - yet another Enron lesson — the relationship between company and outside auditor should be free of conflicts. If the latter is providing consulting services to the former as well as auditing its books, that's now seen as a potential problem.

Once satisfied that the company itself is solid and well-run, directors and managers should approach the issue of D&O insurance with the understanding that it isn't boilerplate like, say, a homeowners' policy. It's a complex legal contract that's generally customized for each company, and can contain all kinds of land mines. So have an expert — say a corporate attorney or insurance analyst — read the contract, with an eye to the following:

Who is the carrier? A financially weak insurer is likely to raise premiums and/or scale back coverage in ways that might eventually cause trouble. When push comes to shove, it may be unable to pay. So monitor the underwriter's AM Best rating. Right now, says Mike Sullivan, vice president with Richmond-based insurance broker Hilb Rogal & Hamilton, the main D&O carriers like AIG and Chubb are rock-solid, and most of the other players are strong as well. But Reliance National, a once-solid D&O underwriter, recently failed, so "make sure that you continue to monitor the carrier. Ratings get adjusted all the time," he says.

Is the coverage broad enough? "A lot of companies buy policies that are so exclusionary that you're really not buying anything," says Barber. "They tell the board of directors 'yeah, we've got D&O,' and they say 'great' and go on from there. And when something hits the fan they don't have any coverage." For example, some polices have a change-in-control clause, which causes the policy to enter a "runoff" phase if an outsider buys more than 50 percent of the company. Anything that occurs after that point is not covered. "Some clients have sold a good portion of their company to somebody else and never even notified us," Barber says, possibly leaving themselves without coverage.

Another red flag involves continuity of coverage. Changing insurance carriers is a big temptation now that premiums are rising erratically. But under most D&O policies, claims have to be made during the policy period, so changing carriers can cause a loss of coverage for things that happened in the past. Should a company restate earnings or be hit with an SEC investigation of past accounting practices, the resulting liabilities might not be covered. So find out when the current D&O policy began and when it ends, and make sure coverage is continuous.

Managers also might demand a severability provision. This insures that "the coverage and the exclusions apply on an individual basis," says HRH's Sullivan. Otherwise, when the CFO secretly creates a series of illegal offshore trusts, the whole management team can lose coverage.

Private companies, meanwhile, are not liable for stock price declines, but face litigation risk involving employment practices and such, says Barber. And "sometimes [this liability] is huge." As a result, such companies often buy hybrid policies that fold employment practices coverage into a D&O policy. Here again, it's a good idea to have an expert sort out the details.

But even the best D&O policies don't cover gross negligence, so be aware that the legal risks have risen considerably, and take fiduciary responsibilities seriously. Show up for meetings, investigate the terms of major deals and generally leave a paper trail that's as clear as it is competent.

Return to Virginia Business - May 2002