The world of directors and officers liability has long been characterized by rapid change. But even given these well-established dynamics, 2013 was a particularly eventful year, with several different developments that could impact the D&O arena for years to come. The list of the Top Ten D&O Stories of 2013 is set out below with an eye toward these future possibilities.
1. U.S. Supreme Court Agrees to Revisit the “Fraud on the Market” Presumption: In a development that has the potential to change the way securities class action lawsuits are litigated, the U.S. Supreme Court has granted a writ of certiorari in the long-running Halliburton case and agreed to revisit the “fraud on the market” presumption.
Since the U.S. Supreme Court’s 1988 decision in Basic, Inc. v. Levinson, securities plaintiffs seeking class certification in Section 10(b) cases have been able to dispense with the need to show that each of the individual class members relied on the alleged misrepresentation, based on the presumption that in an efficient marketplace, a company’s share price reflects all publicly available information about a company, including the alleged misrepresentation, and that the plaintiff class members relied on the market price. Without the benefit of this presumption, it would be very difficult for Section 10(b) plaintiffs to pursue their claims as a class action.
The possibility that the Court could set aside the Basic presumption means that the Halliburton case could be, in the words of leading securities plaintiffs’ attorney Max Berger of the Bernstein Litowitz firm (as quoted in Alison Frankel’s November 15, 2013 post on her On the Case blog) a “game changer.” As Jordan Eth and Mark R.S. Foster of the Morrison Foerster law firm noted in their November 15, 2013 memo about the Supreme Court’s cert grant in the case (here), Halliburton “has the potential to be the most significant securities case in a generation.”
There are, however, a range of possible outcomes in the Supreme Court’s consideration of the case. First, though it only requires four votes for the Court to take up a case, it takes five votes to determine the outcome. Based on the various Justices’ voting patterns in recent cases (particularly in the 2013 Amgen case), it isn’t clear at all that there are five votes to set aside the Basic presumption
Second, in addition to their question whether the Basic presumption should be revisited, the petitioners also sought to have the Court consider “Whether, in a case where the plaintiff invokes the presumption of reliance to seek class certification, the defendant may rebut the presumption and prevent class certification by introducing evidence that the alleged misrepresentations did not distort the market price of its stock.” Given this additional question, the Court might explain the ways in which (and when) the Basic presumption may be rebutted, if at all, at the class certification stage, rather than setting it aside.
Even of the Supreme Court sets the Basic presumption aside, private securities litigation will go on. Investors in some cases will still be able to bring class actions under Section 11 of the Securities Act of 1933, which does not require a showing of reliance but holds defendants strictly liable for material misrepresentations. Claimants who purchased their shares in public offerings will still be able to pursue their claims as class actions.
In addition, in securities cases based on alleged omission rather than alleged misrepresentations, plaintiffs do not need to rely on the Basic presumption in order to obtain class certification. As Alison Frankel pointed out in a November 27, 2013 post on her On the Case blog (here), in the Affiliated Ute case, the U.S. Supreme Court established that securities fraud plaintiffs do not have to establish reliance to sustain claims based on a defendant’s failure to disclose material information. In other words, even if the Supreme Court dumps the Basic presumption, securities plaintiffs will still be able to obtain class certification in Section 10(b) cases based on alleged omissions.
It is also worth noting that the way securities cases are being litigated was already changing in significant ways. Many of the securities suits filed in the wake of the financial crisis were filed as individual actions or group actions, not as class actions. The plaintiffs’ firms have established significant client relationships with pension funds and other large institutional investors whose claims could be aggregated to present a collective action on behalf of a group of investors, even if the lawsuit might not be able to proceed as a class action.
That said, there is no doubt that if the Basic presumption were set aside, the way securities lawsuits are litigated in this country would be significantly changed. In Section 10(b) misrepresentation cases, it would become much more difficult – perhaps impossible — for plaintiffs to obtain class certification. Without the benefit of being able to hold out the threat of ruinously large class-wide damages, plaintiffs’ lawyers would be less able to extract the kind of massive settlements that have become a feature of private securities litigation.
Among the many consequences that would result if the Basic presumption were set aside, it seems likely that the way many public companies purchase D&O insurance would change. As Joe Monteleone noted on his D&O E&O Monitor blog (here), the end result could be that “there will be less of a need to buy large towers of D&O insurance, a likely reduction in rates and perhaps an overall shrinking of the D&O marketplace with fewer players and less revenue in both the insurer and brokerage communities.” Of course, if securities litigation were to mutate into something smaller but more complex, the impact on D&O purchasing patterns and rates could take a different turn.
There are a lot of possible outcomes here, but any way you look at it the Halliburton case has enormous potential significance for the D&O insurance industry. The case is set to be argued in March 2014 and the case should be decided by the end of the current term in June 2014.
2. D&O Insurance Funds Entire $139 Million News Corp. Derivative Litigation Settlement: In the past, going back ten years or so, shareholders’ derivative suits typically did not present the possibility of significant cash payouts for D&O insurers, at least in terms of settlements or judgments. The cases did often involve the possibility of significant defense expense and sometimes included the possibility of having to pay the plaintiffs’ attorneys’ fees, but by and large there was usually not a separate cash settlement component.
However, these past patterns appear to have changed, at least in some shareholders derivative lawsuits. In recent years, there have been a number of derivative suit settlements that have involved a very large cash component. Consistent with this more recent pattern, in April 2013, in what the plaintiffs’ lawyers claim to be the largest derivative lawsuit settlement ever, the parties to the consolidated News Corp. shareholder derivative litigation agreed to settle the cases for $139 million. The cash portion of the settlement was funded entirely by D&O insurance. (The details about the underlying lawsuit and about the settlement can be found here.)
The recent trend toward the inclusion of significant cash components in derivative settlements gained momentum with the options backdating scandal. Many of the options backdating cases were filed as derivative suits rather than as securities class action lawsuits. Some of the options backdating derivative suit settlements included very substantial cash components. For example, the Broadcom options backdating derivative lawsuit settlement included the D&O insurers’ agreement to pay $118 million (as discussed here).
The inclusion of a significant cash component has also been a feature of the settlements of some of the merger objection suits filed in the upsurge in M&A-related lawsuits in recent years. For example, the El Paso/Kinder Morgan merger-related derivative suit settled in September 2012 for $110 million (refer here).
This increase in the number of derivative suit settlements that include a significant cash component can only be viewed with alarm by the D&O insurance industry. Public company D&O insurers have long considered that their significant severity exposure to be limited to securities class action lawsuits. The undeniable reality is that in at least some circumstances, derivative suits increasingly represent a severity risk as well. And the settlement amounts themselves represent only part of the D&O insurers’ derivative litigation-related loss costs. The D&O insurers also incur millions and possibly tens of million of defense cost expense in these derivative suits.
An even more concerning aspect of the rise of significant cash settlements in derivative cases for D&O insurers is that these settlement amounts typically represent so-called “A Side” losses. That is, the losses are paid out under the portion or the D&O insurance policy that provide insurance for nonindemnifiable loss. A derivative suit settlement typically would not be indemnifiable, because if it were to be indemnified, the company would make the indemnity payment to itself.
The question for the carriers providing excess Side A insurance is whether or not the premiums they are getting are adequate to compensate them for the risks of the kinds of losses associated with large cash shareholders derivative settlements. By and large, the carriers providing this insurance consider that their most significant exposure is related to claims in the insolvency context. But as the News Corp. settlement and the Broadcom settlement mentioned above demonstrates, it is also possible that the Side A insurance can be implicated in a jumbo derivative settlement.
The increasing risk of this type of shareholders’ derivative lawsuit settlement represents a significant challenge for all public company D&O insurers, but particularly for those D&O insurers concentrating on providing Excess Side A insurance. Those insurers will have to ask how they are to underwrite the risks associated with these kinds of exposures, and how they are to make certain that their premiums adequately compensate them for the risk.
3. SEC Adopts New Policies Requiring Admissions of Wrongdoing in Enforcement Action Settlements: On August 19, 2013, in connection with its entry into a settlement with New York-based hedge fund adviser Phillip Falcone and his advisory firm Harbinger Capital Partners, the SEC for the first time implemented its new policy requiring defendants seeking to settle civil enforcement actions to provide admissions of wrongdoing, in contrast to the long-standing practice of allowing defendants to resolve the enforcement actions with a “neither-admit-nor-deny” settlement.
In addition, as part of its September 19, 2013 entry into a total of $920 million in regulatory settlements related to the “London Whale” trading loss debacle, and as part of the SEC’s new policy requiring admissions of wrongdoing in certain “egregious” cases, JP Morgan provided the SEC with an extensive set of factual admissions.
The SEC implemented its new policy a third time on December 19, 2013, as part of its $107.4 million settlement of fraud charges against brokerage ConvergEx for bilking its customers by inflated fees. (The company also agreed to pay a $43.3 criminal penalty as part of a related deferred prosecution agreement.) The brokerage unit and two individual traders admitted to wrongdoing in connection with the SEC settlement, and also separately admitted criminal charges as well, as discussed here.
The SEC’s new settlement policy means that, at least in the SEC enforcement actions where the agency will require admissions in order to settle, the cases will be much harder to settle. The defendants, wary of the possible impact the admissions could have in other proceedings, will be reluctant to provide admissions. One consequence of the new policy could be that the SEC will be compelled to try more cases, which could strain the agency’s resources. For those defendants providing admissions, the impact on related proceedings could be significant.
A defendant’s entry into admissions of wrongdoing could also have significant implications for the availability of D&O insurance. The specific question is whether or not the admissions would be sufficient to trigger the fraud and criminal misconduct exclusion in the D&O policy. These exclusions typically preclude coverage for loss arising from fraudulent or criminal misconduct, but only after a final adjudication determines that the preclusive conduct has taken place. If the admissions were found to be sufficient to trigger this exclusion, coverage would no longer be available for the wrongdoer, and the insurer could even have the right to try to recover amounts that had already been paid (for example, the attorneys’ fees the wrongdoer incurred in defending himself or herself in the SEC proceeding).
On the other hand, there would appear to be a substantial question whether the specific admissions to which the Harbinger defendants agreed rise to the level to satisfy the exclusion’s misconduct requirement. While the admissions represent an extensive concession that the defendants engaged in wrongdoing – and while the admissions expressly recite that the defendants acted “improperly” and “recklessly” — at no point to the defendants admit to “fraud” or to any other level of conduct that would expressly trigger the typical D&O policy’s conduct exclusion.
The defendants may be able to walk a fine line in providing admissions to the SEC that avoid many of these potential problems. J.P. Morgan’s settlement in the London Whale case may provide something of a roadmap in that regard. As Wayne State Law Professor Peter Henning noted in a post on the Dealbook blog about the J.P Morgan settlement, the admissions “will be of very limited utility to private parties suing the bank for violating the federal securities laws.” Indeed, in a September 19, 2013 post on her On the Case blog entitled “Don’t Get Too Excited About JP Morgan’s Admissions to the SEC” (here), Alison Frankel says that “JP Morgan has shown that it is possible to give the SEC an admission that will permit the agency to look tough without conceding much, if anything, in private litigation.”
Similarly, admissions of the type JP Morgan entered could present less of an insurance coverage concern. The JP Morgan admissions contain no specific admission of criminal or fraudulent misconduct. There would appear to be less of a basis for an insurer to contend in reliance on the conduct exclusion that coverage is precluded. So if the JP Morgan settlement were to become a “model” it at least would appear to present less a D&O insurance coverage concern.
The SEC’s new admissions policy is still relatively new and it is hard to know for sure how it will be implemented and what its effects will be. The question as the SEC implements the policy in the months ahead will be how specific the wrongdoing admissions must be and whether they will be of a kind that could have collateral impact on related litigation and have an effect on the continued availability of D&O insurance.
4. SEC Awards Whistleblower More Than $14 Million: The SEC’s regulations implementing the Dodd-Frank whistleblower bounty provisions went into effect in August 2011. The agency’s process for the deployment of bounty awards has proven to be quite deliberate. The agency still has made a total of only six awards overall. However, the agency’s October 1, 2013 award of over $14 million to one whistleblower – by far the largest award so far under the Dodd-Frank whistleblower bounty program – could signal that the whistleblower moment has arrived, especially given that whistleblower reports have continued to flood into the agency.
According to the agency’s annual Dodd-Frank Whistleblower Program report to Congress issued on November 15, 2013 (here), there were 3,238 whistleblower reports to the SEC during the 2013 fiscal year ending on September 20, 2013, brining the total number of whistleblower reports to the agency since the program’s August 2011 inception to 6,573.
Though the program has so far made only a few awards relative to the number of whistleblower reports, it seems likely that the number of awards will accelerate in the future. The very painstaking process the agency follows in making awards (described in the report to Congress) shows that the agency is being very deliberate in making awards. As the agency makes more awards, it seems likely that the program will attract more whistleblower reports, particularly to the extent that the agency makes more large awards on the scale of the recent $14 million award.
Another question that will be interesting to follow is whether or not there will be follow-on civil lawsuits in the wake of whistleblower reports (of the kind discussed here). The concern is that increased whistleblowing activity, encouraged by the availability of whistleblower bounties, could lead to an increase not only in SEC enforcement activity but also to an increase in follow-on civil litigation, including in particular securities class action litigation. In any event, it seems likely that there will be further whistleblower bounty awards in the months ahead.
5. Number of Banks Drops to Lowest Level Since the Great Depression: According to a December 3, 2013 Wall Street Journal article (here). the number of reporting institutions listed in the FDIC’s latest Quarterly Banking Profile (here) represents the lowest level for the number of banks since the Great Depression.
As of September 30, 2013, there were 6,891 federally insured banking institutions, down from 7,141 as of September 30, 2012. There had been 8,680 banking institutions as recently as December 31, 2006, meaning that there are 1,789 (or about 20%) fewer banks in the U.S. than there were a little less than seven years ago.
Two banking crises since 1984 account for a significant part of the decline in the number of banks since the Great Depression. Between 1985 and 1995, as a result of the S&L crisis, 1,043 institutions failed (as discussed here). More recently, the global financial crisis has taken its toll on the U.S. banking industry – since January 1, 2007, 534 banking institutions have failed, or more than six percent of all of the banks in business at the beginning of the period. But though there have been a huge number of bank failures in recent years, the closures alone do not account for the continuing decline in the number of U.S. banks.
According to the Journal article, the reasons for the continuing decline in the number of banks include “a sluggish economy, stubbornly low interest rates and heightened regulation.” These problems are particularly acute for smaller banks, which often depend on lower margin loans. Declining interest margins hurt smaller community banks more than larger banks, because the smaller banks’ business models – what the Journal describes as “traditional lending and deposit gathering”—rely on interest income. These pressures have caused a number of smaller institutions to merge or consolidate.
At the same time, no new banks are forming to replace the banks that are disappearing. According to the FDIC’s latest Quarterly Banking Profile, there was only one new banking institution formed in the first three quarters of 2013 (the first federally approved banking start up in nearly three years), while 159 institutions were merged out of existence and 22 institutions failed during that same period.
There is every reason to believe that consolidation in the banking industry will continue. Among other things, the FDIC and the banking industry are both still dealing with the fact that – even years out from the worst of the financial crisis – a large percentage of the remaining banks are “problem institutions.” On the positive side, the number of banks on the FDIC’s "Problem List" declined from 553 to 515 during the third quarter. (The agency calls those banks that it rates as a “4” or “5” on a 1-to-5 scale of risk and supervisory concern “problem institutions.”) On the other hand, problem institutions still represent about 7.5 percent of all reporting institutions, down from about 8 percent during the second quarter.
Even though the number and percentage of problem institutions is down from the low point during the worst of the financial crisis — there were 888 problem institutions at the end of the first quarter of 2011 – the number of problem institutions remains stubbornly high. Many of the remaining problem institutions are unlikely to leave the list based on their own financial improvement. Many are likely to drop off the list only by merging or by failing.
Of course, the vast majority of banks are not problem institutions. But whether healthy or not, most remaining banks are small. Of the 6,891 banks at the end of the third quarter, 6,223 (or slightly more than 90 percent) have assets of under $1 billion. Many of these institutions are thriving and will continue to thrive. But others will face economic and regulatory pressures that may lead them to merge and combine.
These developments have consequences for the D&O insurance industry. The carriers that are active in the banking sector are already reeling from losses arising from the wave of bank failures and related litigation. These banking-related losses are continuing to accumulate at the same time that the overall universe of potential banking-related buyers continues to shrink. The carriers are struggling to spread adverse loss experience across a shrinking portfolio. The accumulating losses from prior underwriting years and the shrinking customer pool means that it is harder for these carriers to show an underwriting profit on a current calendar year basis. The heightened loss experience and shrinking customer base suggests that these carriers will be facing pressure on their calendar year results – and therefore on premiums — for some time to come.
At the same time that the carriers are dealing with these forces, they are also dealing with another dynamic that will even further complicate things for them. A shrinking customer base means less business for everyone. Carriers worried about maintaining their portfolios will have to figure out how to respond as competitors go after their business. As much pressure as there may be to maintain premium levels, competition may force carriers to adjust their premiums to avoid losing business.
It is still a tough time for banks. It is also a tough time for their D&O Insurers as well.
6. FDIC Warns Banks to Check Their D&O Policies, Denounces Civil Money Penalties Coverage: In a highly unusual step, the FDIC, the federal regulator responsible for insuring and supervising depositary institutions, weighed in on financial institutions’ purchase of D&O insurance. The FDIC’s October 10, 2013 Financial Institutions Letter, which includes an “Advisory Statement on Director and Officer Liability Insurance Policies, Exclusions and Indemnification for Civil Money Penalties” (here), advises bank directors and officers to be wary of the addition of policy exclusions to their D&O insurance policies and also reminds bank officials that the bank’s purchase of insurance indemnifying against civil money penalties is prohibited.
The FDIC is concerned that bank officials “may not be fully aware of the addition or significance of … exclusionary language.” Accordingly, the agency urges officials to apply “well-informed” consideration to the potential impact of policy exclusions. The agency urges “each board member and executive officer to fully understand” the protections available under their institution’s D&O policy, as well as the exclusions that have been added to their policy.
The letter also states that banks’ boards of directors should “also keep in mind” that FDIC regulations “prohibit an insured depositary institution or [holding company] from purchasing insurance that would be used to pay or reimburse an institution-affiliated party (IAP) for the cost of any civil money penalty (CMP) assessed against such person in an administrative proceeding or civil action commenced by any federal banking agency.”
The FDIC’s warnings about the need for bank officials to be well-informed about their D&O insurance and to be wary about the addition of policy exclusions are simply good advice. However, the FDIC was not just offering disinterested guidance. The FDIC didn’t say it, but it has a very specific concern in mind. The FDIC is worried about the inclusion in banks’ D&O insurance policies of a so-called “regulatory exclusion” precluding coverage for claims brought by regulatory agencies such as the FDIC. When a policy has one of these exclusions, the FDIC is unlikely to be able to recover under the policy for any claims the agency files against a bank’s directors and officers.
The FDIC is in the midst of filing and pursing a host of lawsuits against the former directors and officers of many of the banks that failed between 2007 and the present. In these lawsuits and in other suits that the agency might want to pursue, the FDIC may be stymied in trying to secure a recovery if the failed bank’s D&O insurance policy has a regulatory exclusion. The FDIC issued its advisory statement because it wants to try to enlist banking officials’ assistance in trying to ward off the inclusion of these kinds of exclusions on D&O insurance policies.
The problem for both bank officials and for the FDIC is that if a bank is sufficiently troubled, no amount of attentiveness will be sufficient to avoid the addition of exclusionary provisions. Banks that are in troubled condition are likely to find that they have few D&O insurance options and that the only coverage they can obtain is an insurance program that includes a regulatory exclusion or other coverage limiting provisions.
Nevertheless, while in some circumstances (especially with regard to troubled banks) there may be little that bank officials can do about the addition of coverage-narrowing policy exclusions, there is certainly nothing wrong with urging bank officials to be attentive to the changes in their coverage on renewal. The FDIC’s suggestion that bank officials stay informed about changes in their D&O insurance is, as noted above, good advice.
The agency’s separate statements about insurance for civil money penalties are interesting and represents something of a public clarification of a long-standing issue. By way of background, under FIRREA and related regulations, civil money penalties may be assessed for the violation of any law or regulation, as well as for a violation of any condition imposed in writing by the appropriate Federal banking agency in connection with any written agreement between a depository institution and the agency.
The agency’s issuance of the Advisory Statement and the clarification of the agency’s position with respect to insurance for civil money penalties means that the industry’s practices with respect to this type of coverage will change. Several leading carriers have indicated that they will no longer offer civil money penalties coverage and that they will remove it upon request.
7. Delaware Courts OKs By-Law Forum Selection Clauses: One of the more troublesome litigation developments in recent years has been the proliferation of multi-jurisdiction litigation, in which competing sets of plaintiffs’ lawyers filed lawsuits concerning the same circumstances and issues in different jurisdictions’ courts. This phenomenon has been a particular problem in litigation involving merger and acquisition activity. As one possible way to try to avert these kinds of multi-front disputes, some commentators suggested the companies should adopt by-law provisions requiring shareholder disputes to be litigated in a specified forum (usually Delaware).
This proposed remedy received a substantial boost on June 25, 2013, when Chancellor Leo E. Strine, Jr. of the Delaware Court of Chancery held that forum selection bylaws adopted by Chevron and Federal Express are statutorily and contractually valid. The companies’ by-laws designated Delaware as the sole forum for derivative lawsuits, lawsuits under the Delaware General Corporation Law and other lawsuits involving the “internal affairs” of the companies. A copy of the Chancellor’s opinion can be found here.
Chancellor Strine’s ruling undoubtedly will encourage other companies to adopt forum selection provisions in their by-laws similar to Chevron’s and Fed Ex’s. That possibility was significantly boosted when the plaintiffs in the Chevron and Fed Ex cases withdrew their appeal, leaving Strine’s ruling unchallenged. There are, however, a number of unanswered questions remaining about the forum selection provisions. For example, it remains to be seen whether the courts of other jurisdictions will defer to the choice of forum specified in the by law provisions.
In a November 5, 2013 proceeding, Vice Chancellor Laster considered many of these remaining questions in a Delaware action filed by Edgen Group, to try to enjoin a separate merger objection lawsuit that had previously been filed in Louisiana. Edgen’s charter contained a forum selection clause designating Delaware as the forum for shareholder disputes. As reflected in a transcript of the Delaware proceeding (here), Vice Chancellor Laster declined to issue a temporary restraining order enjoining the Louisiana proceeding.
Vice Chancellor Laster observed that the case “exemplifies the interforum dynamics that have allowed plaintiffs’ counsel to extract settlements in M&A litigation and that have generated truly absurdly high rates of litigation challenging transactions.” Vice Chancellor Laster also observed that the case demonstrates why companies “have seen fit to respond” with the adoption of forum selection clauses “in an effort to reduce the ability of plaintiff’s counsel to extract rents from what is really a market externality.”
Laster went on to say that the Louisiana action is “quite obviously violative” of the forum selection provision in Edgen’s charter, which Laster found to be “valid as a matter of Delaware corporate law.” He also said that the filing of the Louisiana action “facially breached the exclusive forum clause” because the claim asserted in the Louisiana action “falls squarely within the clause.”
However, despite the showing of “irreparable harm,” Vice Chancellor Laster declined to grant Edgen’s request for injunction relief, among other things because of concern for “interforum comity.” He said, in consideration of Chancellor Strine’s opinion in the Chevron case, that the question of the enforceability of the forum selection clause should be made in the “non-contractually selected forum.”
The adoption of a forum selection clause offers one way to try to eliminate the curse of multi-jurisdiction litigation. However, as the Edgen case shows, one of the shortcomings of the clauses is that they are not self-enforcing. Even with a forum selection clause, there is nothing to prevent a shareholder plaintiff, like the one involved in the Edgen case, from filing an action in another jurisdiction. The company still has to face the action in the other jurisdiction and hope that the other jurisdiction’s court will respect the requirements of the forum selection clause.
There are many issues yet to be worked out as companies seek to rely on forum selection clauses. The one thing that is clear is that the adoption of a forum selection clause alone will not be sufficient to eliminate the possibility that a company might still face shareholder litigation in other jurisdictions. Perhaps as time goes by a body of case law will develop in other jurisdictions’ courts establishing their willingness to enforce these clauses and to defer to the selected forum, but until that time the threat of multi-jurisdiction litigation will continue.
8. IPO-Related Suits and Regulatory Follow on Suits Boost 2013 Securities Lawsuit Filings: As detailed in my recent year-end analysis of 2013 securities class action lawsuit filings, new securities suit filings were up slightly for the year compared to 2012, although otherwise below historical averages. Among the more interesting developments was the rise of at least two categories of securities suits filings that helped drive filings during the year.
As I noted in a recent post (here), IPO activity in the U.S. during 2013 was at its highest levels since 2007. While the listing activity bodes well for the economy and the financial markets, the increased number of IPOs also led to an uptick in IPO-related securities litigation. There were a total of at least six new securities lawsuits filed between August 1 and year-end involving companies that had completed IPOs in 2012 or 2013. These IPO-related filings were a particular factor in the increase of securities suits filings in the year’s second half, compared to the two preceding six-month periods.
As I also noted in a recent post (here), another factor behind securities lawsuit filings in 2013 was the increase of regulatory activity triggering follow-on securities litigation. As many as 13, or almost eight percent, of the 2013 securities suit filings followed prior regulatory or enforcement activity against the defendant companies. While there have been these types of follow-on lawsuits in the past, what is different about these more recent cases is the broad array of investigative and regulatory actions that have preceded and triggered the lawsuits; the regulatory and investigative actions have involved, among other things: anticompetion investigations; alleged illegal arms trading activities; alleged trade in illegally harvested forest products; alleged Medicare fraud; and alleged corruption activities.
In addition, these lawsuits increasingly reflect the increasingly active efforts of regulators outside the U.S., both on the part of U.S. regulators as well as non-U.S. regulators. As regulators around the world step up their investigative and enforcement activities, the likelihood of these kinds of follow-on lawsuits will increase.
The follow-on lawsuits represented a significant part of 2013 securities litigation activity and may also represent a continuing securities suit filing trend in which increased numbers of securities class action lawsuit filings will arise in the wake of governmental investigative or regulatory activity. The impact of this trend will depend in part on the outcome of the Halliburton case, as discussed above; if class certification in Section 10(b) misrepresentation cases is no longer possible, many of the potential class action lawsuits will not be filed (at least as class actions). But if the Supreme Court does not set aside the Basic presumption and if securities class actions remain viable, securities suits following in the wake of regulatory activity could represent an important component of future filings.
9. As Dodd-Frank Provisions Stage In, Public Companies Acquire Additional Disclosure Requirements: Three and a half years ago, in the wake of the global financial crisis, Congress enacted the Dodd-Frank Act, a vast piece of legislation that included extensive reform measures. Many of the Act’s provisions were not self-executing, but instead required implementing regulations. As a result, many of the Act’s requirements are only just now staging into effect. For example, the so-called Volker Rule prohibiting depositary institutions from certain types of proprietary trading just went into effect in the final weeks of December.
The regulations implementing several other Dodd-Frank reforms also were proposed or went into effect during 2013. Many of these have significant implications for public company disclosures. Among the more significant of these new provisions is the proposed pay ratio disclosure requirement. The Dodd-Frank Act’s pay ratio disclosure provisions reflected a Congressional perception that CEO compensation has gotten out of line and a hope that increased disclosure might encourage greater pay equity.
At an open meeting on September 18, 2013, and by a vote of 3-2, the SEC approved the new proposed pay ratio rules for public comment. The SEC’s proposed pay ratio disclosure rule can be found here. The agency’s September 18, 2013 press release about the proposed new rules can be found here. The proposed rules are now subject to public comment. At this point it seems that the final rules will be adopted sometime in 2014, in which case the earliest that companies with calendar year-end fiscal years would have to report the pay ratio would be in their 10-K or proxy statement filings in 2016.
In coming up with rules to specify how companies should calculate and disclose the compensation ratio, the SEC had to decide who does and doesn’t count as an employee, and how median employee compensation is to be calculated.
With respect to the question of who is an employee, the SEC’s proposed rule takes an all-inclusive approach. Because Congress required the pay ratio to express the ratio of CEO compensation to the compensation of “all employees,” the proposed SEC rule includes all individuals employed by a company and any of its subsidiaries – including any “full-time, part-time, seasonal or temporary workers” as of the last day of the company’s prior fiscal year. Non-U.S. workers are included in the definition.
With respect to the method of calculating median employee compensation, the SEC opted not to mandate a specific methodology but to allow companies the discretion to use the most appropriate method of calculation base on the size and structure of its business and the way it compensates employees. Whatever methodology a company uses, it must include in its pay ratio disclosure a brief narrative description of the methodology employed.
While the pay ratio disclosure requirement may have derived from a belief that greater transparency might help to rein in CEO compensation and encourage pay equity, in the end, the pay ratio disclosure may prove to be of at best limited value. As the Troutman Sanders law firm noted in its September 19, 2013 memo about the SEC’s new proposed rule (here), “the SEC’s decision to provide a flexible approach to the calculation means that there will not be any meaningful way to compare the pay ratios of peer companies.”
In addition, the ways that different companies staff their operations will also make company to company comparisons difficult. As discussed in a September 20, 2013 Wall Street Journal article entitled “It’s Hard to Slice and Dice CEO Paychecks” (here), companies’ pay ratios “will vary based on differences in how companies deploy their workforces and how they’ll crunch the numbers.” Among other things, the ratios at companies with predominantly U.S. employees will be lower than the ratios for companies with more lower-paid workers overseas.
While the pay ratio disclosures may be of limited value, they could encourage opportunistic plaintiffs’ lawyers. Any time something is required to be disclosed there is an opportunity for plaintiffs’ lawyers to allege that the disclosure was incomplete or out of compliance with requirements. Indeed, just as the Dodd-Frank Act’s requirement for a non-binding shareholder vote on executive compensation led to a rash of “say on pay” shareholder litigation, it seems probable that the new pay ratio disclosure requirements will also stimulate a wave of pay ratio litigation.
Another set of Dodd-Frank Act disclosures provision that seems likely to have an impact in the months ahead are the Conflict Mineral Disclosure rules. The Act included a provision directing the SEC to promulgate rules requiring companies to disclose their use of “conflict minerals” originating in the Democratic Republic of Congo (DRC) or an adjoining country. It has taken some time for the regulatory process to unfold, but the conflict mineral disclosure requirements are now in effect.
On August 22, 2012, the SEC adopted the conflict mineral disclosure rules. The SEC’s August 22, 2012 press release can be found here and the rule itself can be found here. The specific minerals at issue are tantalum, tin, tungsten and gold. The countries covered by the disclosure rules are, in addition to the DRC, Angola, Burundi, Central African Republic, the Republic of Congo, Rwanda, South Sudan, Tanzania, Uganda and Zambia. Several business groups mounted a legal challenge to the rules, but in a July 2013 order, Judge Robert Wilkins of the District Court for the District of Columbia struck down the challenge. An appeal of the ruling remains pending. Companies are required to comply with the new disclosure rules for the calendar year beginning January 1, 2013; if the rules survive the pending appeal, the first disclosures are due May 31, 2014 and subsequent disclosures are due annually each year after that.
As discussed in a recent post (here), the conflict minerals determinations and disclosures present a significant challenge for many companies. First and foremost, companies face a serious potential PR risk. Companies found to be out of position on conflict minerals could face a publicity firestorm from humanitarian groups and activist investors. Although it remains to be seen, adverse publicity could prove to be a problem not just for companies that must declare their use of conflict minerals but even for those that are unable to declare themselves conflict mineral free.
There is also a significant litigation risk associated with the conflict minerals disclosure requirements as well. Companies compelled to reveal their use of conflict minerals could be the target of shareholder suits. A particularly difficult problem would involve companies that had declared themselves to be conflict free that are later shown have been using conflict minerals after all. The negative publicity and likely share price decline could be followed by a securities class action lawsuit. Activist shareholders could also launch derivative suits against companies based on allegations such as the failure to implement adequate procedures to ensure that the company’s products were conflict mineral free.
Along with the Dodd-Frank’s whistleblower bounty provisions, which as outlined above are beginning to have a significant impact, the pay ratio disclosure requirements and the Conflict Mineral Requirements could also have an impact on companies in the months ahead. Among the implications of these new requirements is the possibility of a heightened litigation risk. In coming months, we will be hearing more about companies’ struggles to ready themselves for these disclosure requirements. In addition, questions surrounding companies’ preparations to meet the disclosure requirements increasingly will become a part of the D&O insurance underwriting process.
10, SEC Proposes Crowdfunding Rules: While federal agencies have been busy staging in the requirements of the Dodd-Frank Act, many of the same agencies have also been struggling to propose regulations implementing the requirements the JOBS Act, which Congress enacted in April 2012. Among many other things, the JOBS Act contained so-called “crowdfunding” provisions providing exemptions under the securities laws allowing start-up ventures to raise equity financing from non-accredited investors using Internet fundraising platforms. The Act left many of the details to the SEC and directed the agency to release implementing regulations within 270 days.
On October 23, 2013, the SEC finally approved and released for public comment the proposed rules implementing the crowdfunding provisions. The rules will not become effective, subject to any revisions, until the end of a 90-day comment period, meaning that the rules will not go into effect until some time early in 2014. The SEC’s October 23, 2013 press release regarding the new rules can be found here. The proposed rules themselves can be found here.
Consistent with the Act’s provisions, the proposed rules specify that a company may raise no more than $1 million in any one 12 month period through crowdfunding. The rules also specify that investors may invest up to the greater of $12,000 or five percent of their annual income or net worth if both their annual income and net worth are less than $100,000, or ten percent of their annual income or net worth if their annual income or net worth are greater than $100,000. Securities purchased in a crowdfunding offering cannot be resold for one year.
The proposed rules specify the information companies must provide in the crowdfunding offering documents, including the identities of the company’s directors and officers as well as the identity of anyone owning more than 20 percent of the company; a description of the company’s business and intended use of the offering proceeds; and the target price of the offered securities and the intended size of the offering; The offering document must also identify related-party transactions and the financial condition of the company. The offering documents also must include the company’s financial statements.
The proposed rules also specify the issuing company’s ongoing reporting requirements after the completion of the offering. The proposed rules would require companies to file an annual report no later than 120 days after the end of their financial year, with the reports to be filed with the SEC and posted on the company’s website. Because the crowdfunding securities are freely tradable after one year, the reporting requirement would be continuous in order to provide potential future investors with information about the company.
Although it will be a few months before companies can commence crowdfunding financings, it will be interesting to see when we finally get there how much interest there ultimately will be in raising funds through these kinds of offerings. The limitations put on the amount of funds that can be raised as well as the information requirements for the offerings, along with the annual reporting requirements, may present burdens that some start up ventures may be unwilling to undertake (especially because they will almost inevitably require the association of outside professionals, including accountants and attorneys).
In addition, it is important to note that some of the JOBS Act’s provisions and related crowdfunding regulations include significant liability provisions. Section 302(c) of the Act expressly imposes liability on issuers and their directors and officers for material misrepresentations and omissions made to investors in connection with a crowdfunding offering. The crowdfunding provisions themselves may blur the clarity of the distinction between private and public companies. The crowdfunding provisions expressly contemplate that a private company would be able to engage in crowdfunding financing activities. Yet, at the same time, that same private company will be required to make disclosure filings with the SEC and could also potentially incur liability under Section 302(c) of the JOBS Act.
Many private company D&O insurance policies contain a securities offering exclusion. The wordings of these exclusions vary widely, and some wordings could be sufficiently broad to preclude coverage for crowdfunding activities. In addition, some private company D&O insurers have already introduced exclusions expressly precluding coverage for claims arising from crowdfunding.
As was the case with the Sarbanes-Oxley Act and the Dodd-Frank Act, the D&O insurance industry may face a long period where it must assess the impact of changes introduced by the JOBS Act. It will be interesting to see both how extensively the crowdfunding liability provisions are invoked and whether a market develops for insurance products providing crowdfunding companies and their directors and officers insurance protection for crowdfunding liability. It seems likely that the carriers will develop liability insurance products targeted at crowdfunding companies, but it will be interesting to see if crowdfunding companies are interested in using their limited funds to purchase the insurance.
As I noted at the outset, there is always a lot going on in the world of D&O liability and insurance, and 2013 was no exception in that regard, But what is interesting is how so many of 2013’s key developments foreshadow coming events in 2014 and beyond. The U.S. Supreme Court’s November 2013 decision to grant the petition for a writ of certiorari in the Halliburton case looms particularly large as we head into 2014. In the same way, the impact of many other key 2013 developments will only be fully realized in 2014 and beyond.
For that reason, we will have to wait to see the implications of many of the key events in 2013. The one thing that seems certain is that 2014 will be an eventful year.