Much has been written about the Wall Street Reform and Consumer Protection Act (commonly known as the Dodd-Frank Act) which was created as a tool for preventing another financial crisis. This new legislation seemingly represents the most sweeping overhaul of America’s financial system in decades. This article explores the ways in which the Dodd-Frank Act may create and intensify exposures confronting corporate directors and officers and discusses the potential net effects on the directors and officers liability coverage (D&O) purchased for these individuals.

The House Financial Services Committee summarized certain key components of the Dodd-Frank Act as follows:

• Consumer Watchdog: The legislation creates a Consumer Financial Protection Board (CFPB), ostensibly independent, but housed within the Federal Reserve. The stated mission of the CFPB will be to "ensure American consumers get the clear, accurate information they need to shop for mortgages, credit cards, and other financial products, and protect them from hidden fees, abusive terms, and deceptive trade practices." The CFPB will have the authority to examine banks and other financial institutions, and to enforce regulations to protect the interests of consumers.

• Concluding the "Too Big to Fail" Era: The Federal Reserve will be able to increase standards around leverage, liquidity, and other aspects of risk management. Companies deemed to pose a systemic risk to the U.S. economy in the event of their failure would be subject to regulation by the Federal Reserve, and in extreme cases, such companies may be required to divest some of their holdings. Corporations of a certain size and complexity will be required to periodically submit plans for rapid and orderly shutdowns in the event of their demise. Failure to submit such plans with sufficient detail may result in the imposition of higher capital requirements as well as restrictions on growth by the federal government. Note, however, that the criteria for what constitutes "too big to fail" is not defined in the legislation. Finally, the “Volcker Rule” will require regulators to impose severe limitations on proprietary trading by banks, their affiliates and holding companies.

• Orderly Liquidation: The Federal Deposit Insurance Corporation (FDIC) will be able to wind down the operations of struggling financial companies deemed to be "systemically significant." Shareholders and unsecured creditors will bear the brunt of any losses and directors can be removed for their malfeasance. As such, greater losses for stakeholders will likely fuel even greater demands against directors and officers, which in turn could place upward pressure on settlement figures.

• Market Transparency: The derivatives market will be subject to new requirements with respect to data collection and publication, both to provide disclosure to investors and to facilitate regulatory oversight.

• Credit Ratings Agencies: The Securities and Exchange Commission (SEC) will create an Office of Credit Ratings that will be charged with conducting and reporting on annual examinations of nationally recognized statistical ratings organizations. Among other things, the ratings agencies will be required to disclose information regarding their methodologies and use of third parties as well as consider credible outside information regarding a company they are rating. At least one half of the boards of ratings agencies must be comprised of independent directors. Significantly, the legislation allows for private rights of action against the credit rating agencies, subject to a knowing or reckless standard, in their investigation of the company and use of outside, independent information when conducting their analysis and assigning a rating.

• New Standards for Executive Compensation: Shareholders will now have a right to cast a non-binding vote on executive pay and "golden parachutes." The SEC will also have the authority to grant shareholders proxy access to nominate directors. Compensation committees will only be composed of independent directors who will be empowered to hire independent consultants to assist them with their duties. Moreover, the SEC will mandate that companies chart their executive compensation relative to stock performance. One may envision how this amalgamation of data in a public filing could serve as fodder for the plaintiffs' bar.

• More Robust Enforcement by the SEC: The Dodd-Frank legislation also provides for additional funding to the SEC, which will likely go to the enforcement divisions to allow them to conduct additional and more comprehensive investigations. Whistleblowers will be eligible for additional rewards—up to 30 percent of funds recovered—for reporting alleged securities violations to the SEC. The Commission will now host an Investor Advisory Committee and an Office of Investor Advocate within its organizational structure.

It is noteworthy that the Dodd-Frank Act does not create a private right of action for plaintiffs to allege "aiding and abetting" of securities fraud by professional services firms and other advisors. Nor does this legislation affirmatively grant "extraterritorial jurisdiction" to federal courts presiding over cases alleging misconduct relative to the securities laws in the U.S., but where the transaction occurs overseas and involves only foreign investors. By omitting these provisions from the final law, Congress refrained from adopting certain proposals that could have further constrained capital markets in the aftermath of the financial crisis.

Coverage Considerations

The combination of increased regulatory scrutiny and empowerment of consumers and investors creates powerful incentives for board members and senior management to fulfill their fiduciary duties. While the enabling regulations mandated by the Dodd-Frank Act may take several years to implement, companies should prepare for enforcement of this law by reviewing their own practices, particularly in the areas of data collection, governance, and compensation. Corporate leaders must be proactive in anticipating the new requirements and preparing their organizations for the advent of the new regulatory landscape.

From a D&O insurance perspective, consider the following:

• Do the affirmative coverage grants adequately address the emerging exposures? 

• Will the costs of defending the company from enforcement actions or responding to inquiries from the new CFPB be covered? Do such actions fall within the definition of “claim” under the D&O policy? Are limits of liability sufficient to address the exposure of a more vigilant SEC?

• What about federal actions to remove suspect directors from a corporate board? As the new regulations will likely provide the target director with an opportunity to respond to the charges, will the cost of hiring independent defense counsel be covered, or will the insurer attempt to argue that the federal government is standing in the shoes of the company, and that the matter is thus subject to an "insured vs. insured" exclusion? 

• How will "change in control" provisions within the typical D&O policy respond to governmental intervention with regard to a distressed company? Once an entity meets the criteria established by the U.S. government for testing whether an institution is "too big to fail," will certain transactions, such as a forced divestiture of certain holdings, trigger the provision? 

There are no established responses to these questions as our collective understanding of how D&O insurance products will respond to these exposures continues to evolve, but for companies seeking to protect their directors and officers from the onslaught of new potential liabilities, it all starts with asking the right questions.

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