One Year After Sarbanes-Oxley, a Fresh Look at D&O Underwriting

The anniversary of the Sarbanes-Oxley Act of 2002 (SOX) has opened the door of dialogue to the benefits of sustainable, effective corporate governance. The Securities and Exchange Commission’s (SEC) shift in focus from regulating disclosure to corporate governance brings new exposures to directors and officers. Over the past 12 months, substantive and constructive reforms have been made in corporate governance, operational control and business practices.

Executives, corporations and their board members are asking the question: What is good corporate governance and business practices? That query is difficult to answer as corporate governance is a soft science. The courts have addressed similar soft issues in a manner that does not provide simple answers to complex issues. Supreme Court Justice Potter Stewart concurred in Jacobellis v. Ohio, 1964 to the question of “What is obscenity? His response to the question was: “I know it when I see it.” Adding to the complexity is the fact that corporate governance standards are open to an array of appropriate practices beyond the baseline, with the baseline for any corporation being the SOX and the corporate governance standards maintained by the self-regulatory organization of the corporation’s respective stock exchange.

Still, the SEC has weighed in on the issue of good corporate governance and business practices. On March 24, 2003 SEC chairman William Donaldson stated the following:

“…Companies, their management, their directors and the gatekeepers who serve them must look beyond just conforming to the letter of the new laws and regulations. They must redefine corporate governance with practices that go beyond mere adherence to new rules and demonstrate ethics, integrity, honesty, and transparency. The recent shifting of primary corporate governance responsibilities to the Board of Directors demands that directors be the true stewards of corporate governance, and their actions must demonstrate their dedication to this stewardship without interference from the CEO.”

Responsibility, transparency, accountability
The tenets of the board and management for good corporate governance are responsibility, transparency, and accountability to shareholders. The upside of stock prices for good corporate governance is minimal. The downside to a breakdown in corporate governance can be extreme—a financial meltdown and a vaporized share price. This asymmetrical market response can be mitigated in D&O underwriting. One objective of a D&O underwriter is to accurately assess risk so that good insureds do not subsidize higher risk insureds. This is an area where a corporation’s insurance broker may help reduce the inherent asymmetric information flow between the insured and the insurer in assessing risk. Information provided to the D&O underwriter that provides a clear and open view of the internal controls and good corporate governance should result in more favorable pricing and terms.

D&O underwriters review the corporation’s evaluating, documenting and monitoring process for its internal controls. The review is a quasi-investment decision-making process. D&O underwriters are looking for clearer explanations and deeper insight into the economics that drive the business and operational controls. The Management, Discussion and Analysis (MD&A) section of the corporation’s SEC Filings should provide a clear picture of operations and earnings. The MD&A section should be more qualitative disclosure, consistent with Section 204 of the Sarbanes-Oxley Act, rather than quantitative. More information regarding trends and year over year changes in liquidity measures, the balance sheet, critical accounting policies and the cash flow of the corporation is warranted.

The checklist approach that focuses on substance rather than form gets closer to the right answer. In addition, a principle-based approach should be embraced. A robust model of testing effective and adequate internal controls needs to be demonstrated by the insured. This means an evaluation of disclosure controls, review of any changes in internal controls, and remediation and corrective action of deficiencies with respect to any weaknesses of the corporation’s accounting practices needs to be disclosed. D&O underwriters evaluate risk in part by posing questions to insureds and evaluating the corporation’s principles.

Questions to be considered include:
• Are systems adequate to protect corporate assets?
•Are systems adequate to process transactions?
•Are internal controls adequate to avoid the misuse of corporate assets?
•What are the risks facing the company?
•Does the company have a director education program?
•How is the company implementing procedures and processes to comply with SOX and their respective SROs corporate governance requirements?
•Were there any aspects of the outside auditor’s plan to which management objected?
•Were significant adjustments required to management prepared financial statements?

Describe the management’s relationship with its outside auditor.

Operational control and risk mitigation need to be coupled with good corporate governance. Enterprise resilience is the ability and capability to withstand systemic discontinuation and adaptability to new risk environments. Resilient organizations establish transparency, accountability and responsibility through business practices and internal control to address risk across the extended enterprise. The objective is to institutionalize the integrity of financial controls, good corporate governance and ethical business practices. The goal is to be an agent of change to build and strengthen a principle based corporate culture.

Corporate culture has a role
Beyond the corporate governance and business practices, an evaluation of the corporate culture is important. The evaluation of the corporate culture provides insight to the character of the organization. A company that has a risk averse culture that mitigates liability through openness, introspective evaluation of weaknesses, and efficacious internal controls tends to be a better D&O risk. A company that builds a culture of trust and integrity is preferred. An essay by Sir Isaiah Berlin titled, “The Hedgehog and the Fox,” hits to the core of a corporate culture. “The fox knows many things, but the hedgehog knows one big thing.” Companies that have a single central vision and one system of control are principle-based. They exhibit a more coherent picture of performance. Preferred risks foster a corporate environment where the management team and board are focused on execution, accountability, responsibility and transparency. These companies tend to outperform the overall market over the long term with less hype and more substance. Their stocks tend to be less volatile relative to the overall market. And principle based corporations are less likely to be sued by their shareholders.

The role of independent board members is one of stewardship fostering a healthy relationship with management to ensure that management and the board are aligned in the company’s strategic plan and operating in the long-term interests of shareholders.

Corporations need to implement effective corporate governance practices and institutionalize operational and financial controls that foster a principle based corporate culture. D&O underwriters need to accurately assess risk and appropriately price and provide insurance solutions that work for its insureds. In doing that, D&O underwriters act indirectly in the private sector’s role of keeping good corporate governance and ethical business practices on the “front-burner.”

On April 7, 2003 SEC Commissioner, Cynthia A. Glassman put it succinctly: “In the current environment, companies have a strong incentive to adopt rigorous governance procedures because those that fail to do so will be unable to attract top quality directors and will pay a risk premium in terms of both director compensation and possibly officer and director liability insurance.”

Christopher Duca is president of Navigators Pro, a division of Navigators Management Company Inc., and member of the board of directors of Navigators Insurance Company. Navigators Pro offers financial insurance products including directors and officers, fiduciary, employment practices liability and crime insurance for privately held and publicly traded corporations. He can be reached at cduca@navg.com.