The D & O Diary : Directors and Officers Liability and Insurance : The D & O Diary : Kevin LaCroix : Securities Laws, Corporate Fraud, D & O Litigation

In the wake of Pfizer’s record-setting September 2009 $2.3 billion settlement of charges that it had engaged in off-label marketing of Bextra and other drugs, Pfizer investors filed shareholders derivative lawsuits against the company, as nominal defendant, and 19 of the company’s directors and officer, alleging that the defendants breached their fiduciary duties by failing to detect and prevent the illegal marketing.

The parties have now entered a $75 million settlement of the derivative lawuits. The settlement has several interesting features, particularly with respect to the insurance, which is funding the entire settlement amount. The settlement is subject to court approval.

Background

On September 2, 2009, the Department of Justice announced that Pfizer had agreed to pay a total $2.3 billion dollars in settlment of the off-label marketing allegations.. In its press release describing the settlement, the DoJ said that the settlement – which represented a criminal fine of $1.195 billion and a civil False Claims Act settlement of $1 billion, as well as certain additional civil forfeitures – represented the largest health care fraud settlement in the DoJ’s history.

Following the announcement of this settlement, investors filed a number of shareholder derivative lawsuits, which ultimately were consolidated in a single action in the Southern District of New York before Judge Jed Rakoff. Background regarding the derivative litigation can be found here. The plaintiffs’ consolidated amended complaint can be found here.

The Settlement

On December 2, 2010, the plaintiffs filed a motion for preliminary approval of the derivative litigation. The motion, to which the settlement stipulation is attached, can be found here (Hat tip to the Seeking Alpha blog for the settlement documents.).

In the settlement, Pfizer and the other defendants have agreed to set up a Regulatory and Compliance Committee to report to the company’s board and to take appropriate steps to prevent future drug marketing violations. Among other things the committee will review compensation policy and practices to ensure they are consistent with the compliance objectives.

One of the things that makes this settlement unusual is the way the committee’s activities are to be funded. As part of the settlement, a pool of funds – to be financed entirely by insurance – will be used to pay for the committee’s activities for five years.

Under the settlement stipulation, four of the company’s D&O insurers "shall pay a total of $75 million into an escrow account under the control of Pfizer." After payment of fees and expenses, the remaining escrow funds "shall be subject to the exclusive control of the Regulatory Committee for funding activities of the Regulatory Committee for its initial five years." If the committee spends more than the funds available, Pfizer will make up the difference. If the committee spends less that the remaining funds, unspent amounts are to be returned to the insurers. (The four insurers involved are listed on page 9 of the settlement stipulation.)

A further provision of the settlement stipulation specifies that settlement contribution by the fourth of the four insurers is subject to arbitration. Pfizer may have to pay the insurer up to $20 million depending on the outcome of the arbitration.

An exhibit to the settlement stipulation specifies that the plaintiffs' lawyers will seek attorneys' fees of $22 million plus costs of $1.9 million. The amount of the plaintiffs’ fees awarded is to come out of and thereby reduce the $75 million. If plaintiffs are awarded the full amount of fees and costs sought, the net funds remaining of the original $75 million would be $51.1 million.

At least one news report suggests that the company’s entry into this derivative settlement, together with the earlier DoJ settlement, may have hastened or even directly led to the abrupt departure of Pfizer CEO Jeff Kindler.

Discussion

A frequent component of derivative lawsuit settlements is the company’s agreement to adopt certain governance reforms or to implement certain corporate therapeutics. So from that perspective, Pfizer’s agreement as part of this settlement to set up a compliance committee to ensure good behavior is not unusual.

One of the things that is unusual about this arrangement is that, among other things, there is a specific pot of money that is to be set aside to fund the compliance reforms to which the company has agreed as part of a derivative settlement.

And what is even more unusual, and arguably unprecedented, is that the funds to be set aside for these activities are to be provided for exclusively by the company’s D&O insurers.

I am sure the D&O insurers’ contribution toward this settlement was the subject of extensive negotiation. I can certainly imagine the carriers taking the position that the cost of the company’s compliance or governance activities represents corporate overhead expenses and as such is not covered loss under the company's D&O liability insurance. I expect these kinds of questions had to be sorted out in the course of the negotiation of this settlement. (The fact that one of the four D&O insurer’s contribution toward the settlement is subject to arbitration suggests further that these questions were not fully sorted out as part of the settlement negotiations.)

On the other hand, the idea behind the settlement may be that the individual defendants nominally agreed to pay for the remedial measures, and the insurers are simply paying on the individuals’ behalf. From that perspective, the prospect of the D&O insurers undertaking to pay those amounts on the individuals’ behalf may make the arrangement more consistent with the D&O insurance policy’s basic proposition.

But while this latter analysis may make the insurers’ contribution explainable in insurance terms, the fact that the insurers are basically paying for corporate governance reforms arguably represents something of a novel development and may represent a noteworthy precedent going forward.

Another noteworthy aspect of this settlement of this settlement is its sheer size. The $75 million dollar value of the settlement makes it one of the largest shareholders derivative settlements of which I am aware, exceeded only by a very small handful of other derivative settlements, including the UnitedHealth Group settlement ($900 million, refer here ); Oracle ($122 million, refer here), Broadcom ($118 million, refer here), AIG ($115 million, refer here), and the AIG/Greenberg settlement ($90 million, refer here).

There was a time when a significant cash payment was not a part of shareholders’ derivative lawsuit settlements. However, as this growing list of jumbo settlements underscores, derivative suit settlements involving a large cash component are becoming increasingly common – which , among other things, has important implications for D&O insurers and their policyholders.

Along those lines, one thing the Pfizer settlement has in common with these other jumbo derivative settlements is that each of these settlements involves solvent entities. The relevance to me from the fact that Pfizer is solvent derives from the added fact that this settlement almost certainly represented a payment of the Side A of the company’s insurance program – indeed, the identity of the insurers involved strongly suggests that this settlement represents a Side A insurance loss.

If as I assume to be the case this settlement represents a Side A insurance loss, this settlement represents yet another case in which insurers have been called upon to fund a substantial Side A loss outside of the insolvency context. (Please see my discussion of the Broadcom settlement, here, for a more detailed review of the significant of the Side A loss payment outside of the insolvency context.)

These kinds of settlements provide concrete evidence of the value to policyholders of significant amounts of Side A insurance even outside of the insolvency context.

These settlements also underscore the fact that even Excess Side A insurers are exposed to potential losses – even outside of the insolvency context – and that this exposure seems to be increasing over time. Only the insurers themselves can answer the question of whether or not they are actually pricing their products for the risk of Side A losses outside the insolvency context.　

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In prior posts (refer here), I have discussed the increasing reluctance of U.S. courts to exercise subject matter jurisdiction over securities claims against foreign-domiciled companies brought by foreign claimants who bought their shares on foreign exchanges (so-called “f-cubed” claimants).

In the most recent example of this, Judge Thomas Griesa of the United States District Court for the Southern District of New York, in a June 3, 2008 opinion (here), granted the defendants’ motion to dismiss the claims of “f-cubed” claimants against AstraZeneca and certain of its directors and offices.

The complaint essentially alleges that Exanta, a pharmaceutical being develop by the AstraZeneca (a U.K.-based company) “was not as safe or effective as defendants’ public statements made it out to be.” The plaintiffs’ claimed that these statements inflated the company’s share price. Refer here for background regarding the lawsuit.

The outcome of the subject matter jurisdiction question was probably tipped in the court’s opening observation that “over 90% of the members of the putative class are foreigners who purchased their shares on foreign exchanges.”

The court reviewed the propriety of its exercise of jurisdiction over claims brought on behalf of these foreign shareholders, by considering whether or not there were sufficient allegations of U.S.-based conduct causing sufficient U.S.-based effects. The court found that while there were sufficient allegations of U.S.-based conduct, plaintiffs “do not allege facts in support of the second prong of the test – that the United States conduct ‘directly caused’ plaintiffs’ losses.”

The court said that in order to establish this requisite causal link, the plaintiffs must have “sufficiently alleged that the foreign purchasers relied on United States based conduct when deciding to acquire the stock”. In order to establish this kind of reliance, the plaintiffs urged the court in effect to adopt a global “fraud-on-the-market” theory, arguing that “it is illogical to suggest that the fraud-on-the-market theory applies within the United States but not outside of it.”

The court noted that other courts had rejected the global fraud-on-the-market theory, out of concerns that it would “extend the jurisdictional reach of the United States securities laws too far.” The court further noted that the Second Circuit had not yet provided guidance on whether the fraud-on-the-market theory should apply to foreign countries, and “in the absence of clear authority in favor of a global fraud-on-the-market theory, the court declines to adopt such a theory.” The court dismissed the claims of the foreign claimants based on lack of subject matter jurisdiction.

The court further concluded that the plaintiffs had not sufficiently alleged that two foreign-domiciled individual defendants had the requisite “minimum contacts” with the U.S. for the court to exercise personal jurisdiction over them.

Finally, the court concluded that the plaintiffs had not sufficiently pled scienter, and dismissed the remaining claims on that basis. The court held that neither the allegations of insider trading nor the allegations relating to a secondary offering were sufficient to establish scienter.

The court further rejected the plaintiffs allegations that the defendants had consciously disregarded the truth, based on the court’s own review of the various disclosure documents on which the plaintiffs sought to rely. The court concluded that the plaintiffs “have not alleged anything to negate the idea that that defendants were attempting to develop a drug they thought beneficial and were do describing it to the public.” The court found that the plaintiffs had “not alleged an inference of scienter as compelling as the opposing inference.”

The fact that the case will not be going forward even as to the domestic shareholders reduces the impact of the court’s ruling to exclude the f-cubed claimants from the class. The dispersion of the class, with such an overwhelming percentage of f-cubed claimants in the purported class members may well have inclined the outcome on the jurisdictional issue in any event.

Plaintiffs’ attorneys in the most recently filed cases seem to be anticipating that courts are inclined to exclude these claimants from the putative class and increasingly are taking that into account in their initial pleadings. For example, as discussed here, when plaintiffs’ lawyers recently launched a U.S. securities lawsuit against Société Générale, they included in the purported class only U.S residents and investors who bought ADRs on U.S. exchanges. Their purported class by its own construction excludes foreign residents who bought shares on foreign exchanges.

The increasing exclusion of f-cubed litigants from U.S. securities class actions (whether voluntary or as a result of court action) is one of the reasons that interest in U.S.-style securities relief is increasing in other countries, as I discussed in a recent post (here).

In any event, the court’s dismissal of the AstraZeneca case also continues another trend, which is that while life sciences companies are frequently sued (compared to companies in most other categories), the cases filed against them are often dismissed, as I also discussed in a prior post (here)

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