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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2008 was a remarkably eventful year, from the dramatic events that rocked the financial markets to the Presidential election that resulted in a change in national leadership. Virtually all of the significant events during 2008 also had an impact on the world of D&O insurance, one way or another. In all likelihood, significant developments will continue to emerge during 2009, with further implications for the D&O marketplace.

In a year as eventful as 2008, selecting as the most significant events is a challenging task. But with an eye toward the developments of greatest significance for the D&O industry, I have prepared the following list of the top ten stories of 2008.

1. Credit Crisis Becomes Global Financial Calamity: What began in 2007 as a subprime meltdown had by early 2008 become a credit crisis, which in turn evolved during Fall 2008 into a full blown global financial disaster.

Within the space of just a few short weeks, the government took control of Fannie Mae and Freddie Mac; the FDIC took over Washington Mutual, in the largest U.S. bank failure ever; Lehman Brothers collapsed, in the largest U.S. bankruptcy ever; Bank of America agreed to acquire Merrill Lynch in a government brokered deal; the government undertook a massive bailout of AIG; Congress enacted a colossal $700 billion bailout package; and Wells Fargo agreed to acquire Wachovia. And those events came after a raft of prior financial shocks, including the collapse of Bear Stearns, the seizure of the auction rate securities market, and the disintegration of U.S. residential real estate market.

Any one of these events on its own would be significant. Taken collectively these events represent an enormous upheaval, the full ramifications and consequences of which will only emerge over the months and years to come.

And those are just the headlines. In other developments reported "below the fold," companies around the world have grappled with a general business downturn, wrestled with the threat of their own insolvency or that of their customers or suppliers, and basically tried to maintain their ground in an increasingly hostile financial environment.

All of these developments have enormous potential significance, much of it yet to unfold. These events have not only fueled litigation, but they have also presented D&O underwriters with a dramatically altered underwriting environment. The perils involve not only the challenge of underwriting financially troubled companies, but also the trial of underwriting in the context of rapidly changing (and deteriorating) conditions in the financial and credit markets.

During 2008, the world became significantly more dangerous for D&O underwriters. All signs suggest the current perilous conditions will continue into 2009, and perhaps beyond.

2. Financial Market Disruptions Hit Major Insurers: The turmoil in the financial markets also battered three insurers that are major players in the D&O marketplace. AIG’s woes required an enormous government bailout. XL and Hartford both faced differing degrees of turbulence due to write-downs in their respective investment portfolios.

Each of one of these insurers is dealing with their own unique set of circumstances. Rating agencies have noted and responded to these developments. Insurance buyers remain anxious and wary. The implications of these developments, both for each of these insurers and for the marketplace as a whole, remain to be seen. At a minimum, these events have disrupted the D&O insurance marketplace and introduced a significant element of uncertainty. The disruptive impact from these developments is likely to continue to affect the D&O industry throughout 2009.

3. Subprime and Credit Crisis Litigation Wave Rolls On: The subprime litigation wave that began in 2007 continued to surge in 2008, as there were 101 new subprime and credit-crisis related securities lawsuits filed during 2008, bringing the two-year total to 141. My running tally of the subprime and credit crisis-related securities lawsuits can be accessed here.

As time has passed, the litigation wave has continued to evolve; for example, the 2008 subprime and credit crisis-related litigation included as many as 21 auction rate securities lawsuits all of which were filed in the earlier part of 2008. Later in the year, a string of lawsuits initiated by holders of preferred or subordinated securities emerged (as discussed here).

In February 2009, the subprime and credit crisis-related litigation wave will enter its third year, but the phenomenon shows no signs of abating. The credit crisis-related securities lawsuits continued to accumulate throughout 2008. Of the 101 subprime and credit crisis-related lawsuits filed in 2008, 45 were filed in the second half of the year, including ten in December alone.

The credit crisis lawsuit filings remained high as the year ended, suggesting that significant credit crisis litigation activity will continue well into 2009 and perhaps beyond.

4. Credit Crisis Litigation Spreads Beyond the Financial Sector: As massive as the subprime and credit crisis-related litigation wave has been, it had until recently been concentrated in the financial sector. But as 2008 wore on, and largely as a result of the dramatic events in the global financial markets during September and October 2008, the litigation wave spread beyond the financial sector.

The companies that have become involved in this extended litigation wave include, for example, those that had significant exposure to Lehman Brothers or other companies that collapsed this fall. (Refer here and here for discussion of these "new wave" credit crisis lawsuits). In addition, companies that have been drawn in include companies that made wrong way bets on commodities or currencies (about which refer here).

These developments suggest that the credit crisis-related litigation wave may have entered a dangerous new phase, as I discuss at greater length here. These developments also underscore the challenges for D&O underwriters in the current environment.

My complete rundown of all 2008 securities litigation can be found here.

5. Bank Failures Surge: Led by the FDIC’s assumption of control of Washington Mutual in the largest bank failure in U.S. history, bank failures surged in 2008. According to the FDIC’s website (here), there were 25 bank failures in 2008, the highest annual total since 1994, at the end of the last era of failed banks. Perhaps even more significantly, the pace of bank closures increased as the year progressed; 21 of the 2008 bank closures took place in the second half of 2008, 12 of them in the fourth quarter.

In many ways, other financial events have overshadowed this sudden surge in bank failures. Indeed, as I noted here, the WaMu failure, the largest in U.S. history, has largely been relegated to yesterday’s news pile. But the timing and pace of the bank closures during 2008 suggests that there are likely to be further bank failures ahead, carrying with it the threat of associated "dead bank" litigation, a possibility I previously discussed here.

6. Madoff Scandal Triggers Litigation Torrent: The revelation of the massive Ponzi scheme involving Bernard Madoff and his firm has triggered a wave of litigation as aggrieved investors scrambled to try to recoup their losses. The first Madoff-related lawsuits targeted Madoff and his firm. But given the unlikelihood of a significant recovery there, investors have quickly moved on to other targets. A running tally of the Madoff investor litigation can be accessed here.

The primary Madoff-related litigation targets are the so-called "feeder funds" that invested with Madoff on their clients behalf. Recent blog posts discussing these "feeder funds" lawsuits can be found here and here. Given the magnitude of the investor losses and the depth of investor outrage, these lawsuits are likely to continue to accrue for some time to come. Press reports (for example, here) suggest that lawyers are gearing up for a litigation onslaught.

7. Presidential Election Signals Changes: I don’t know whether you heard, but there was an election in November. The coming changes in the White House as well as the increased Democratic majority in Congress could signal significant future legislative and other developments.

The arrival of the new administration will likely mean a change in direction for judicial appointments. A more interesting question is whether the Democratic control of Congress and the White House could lead to legislative changes in the securities laws. As discussed at the PLUS International Conference in November (about which refer here), the current financial turmoil could be used as a justification for legislative reform efforts – for example, an attempt to overturn Central Bank and Stoneridge.

At a minimum, the coming changes in the leadership at the SEC, together with a different leadership interpretation of the meaning and value of regulation, could lead to a changed environment for the enforcement of the securities laws.

8. Largest-Ever Fine Underscores the Growing Significance of the FCPA: For some time now (most recently here), I have been writing about the growing importance of Foreign Corrupt Practices Act (FCPA) enforcement activity and associated civil litigation. The FCPA mounting significance was dramatically underscored recently when Siemens agreed to pay an $800 million fine.

The Siemens fine is the largest ever, dwarfing the previous record fine, paid by Baker Hughes, of $44 million (about which refer here). The outcome of the Siemens investigation is merely the latest development in a long chain of events highlighting the growing importance of the FCPA.

As I have previously noted (refer here), one of the usual accompaniments of an FCPA investigation is follow-on civil litigation. As the threat of FCPA-related exposure continues to grow, the threat of follow-on civil litigation will also increase.

The FCPA Blog has a detailed overview of 2008 FCPA enforcement activity here.

9. Defense Expense Tests Limits Adequacy: Companies ensnared in high stakes litigation may find themselves confronting an unexpected new challenge – the increasing likelihood that defense costs alone could exhaust the entire amount of available D&O insurance coverage. This threat was unfortuntately realized in connection with the Collins & Aikman bankruptcy and related criminal proceeding (about which refer here), where accumulated defense expense exhausted the company’s entire $50 million D&O insurance, before the criminal case even went to trial.

The possibility that escalating defense expense could entirely deplete available insurance presents a frightening prospect for individuals involved in a serious D&O claim, and also raises troubling questions about traditional notions of limits adequacy. In addition, the possibility of total limits exhaustion as the result of the requirements of multiple claims and multiple insureds underscores the need for insurance buyers to consider alternative insurance structures (such as, for example, separate insurance for an individual or a group of individuals) to ensure that segregated funds remain available in the event of a catastrophic claim.

10. Indemnity Developments Trigger Additional Insurance Structure Concerns: In the Schoon v. Troy case (about which refer here), the Delaware Chancery Court held that a board of directors properly could eliminate former directors' advancement rights retroactively. The possibility that former directors could lose their rights to advancement or indemnification comes as unwelcome news to many directors.

This case development, like the development about limits adequacy noted above, highlights the need to address program structure as part of the insurance acquisition process. In general, directors and officers have become more concerned about the availability of insurance protection when they need it most. As a result, interest in a wider variety of auxiliary insurance structures has increased. These structures can include new insurance solutions designed for the needs of retiring directors.

In a year as eventful as 2008, reasonable minds could differ about what events deserve to be included in any Top Ten list. I am very interested in readers’ views about the top stories, particularly those who feel that other events deserved to be included on the list.

More "Top" Lists: Making year-end lists seems to be a nearly universal phenomenon, and Top Ten lists abound. Time Magazine simplified things by creating "The Top Ten of Everything of 2008," which can be found here.

Then  there are always the lists of the "Bottom Ten," like Business Week’s list of the Ten Worst Predictions About 2008 (here). Fortune has a list (here) of the "dumbest" business decisions of 2008, but given the kind of year 2008 was, a list of just ten was not enough – the magazine’s targets 21 business decisions as "dumbest."

Perhaps the most entertaining "Top" list is VideoGum’s list of the Top Viral Videos of 2008, which can be viewed below. (Viewer discretion is advised as some persons may find some of the content offensive.)

PLUS D&O Symposium: Readers will also want to be sure to register for the annual PLUS D&O Symposium, which will be held on February 25 and 26, 2009, at the Marriott Marquis Hotel in New York. Information about the Symposium, including registration instructions, can be found here.

The Symposium will feature an all-star cast, including keynote speakers Madeline Albright and NY Insurance Department Superintendant Eric Dinallo. Wilson Sonsini partner Boris Feldman will once again be moderating the annual panel on securities litigation developments. The schedule also includes a panel on Bankruptcies and Bailouts, with panelists including VJ Dowling of Dowling & Partners Securities and David Bradford of Advisen.

The conference will also include a replay of the excellent video, "The Rise and Fall of Bill Lerach" (a movie trailer for which can be found here). Stanford Law Professor Joseph Grundfest will lead a panel discussion of the video. The video was shown at the PLUS International Conference in November 2008 and received rave reviews.

Readers with any questions about the Symposium should feel free to drop me a note or give me a call.

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