As I have detailed on this blog (most recently here), due to two Delaware court decisions — the Delaware Supreme Court’s 2015 decision in Corwin v. KKR Financial Holdings LLC (here) and the Delaware Chancery Court’s January 2016 court decision in the In re Trulia Shareholder litigation (here)—deal litigation that in the past would have been filed in Delaware is now being filed elsewhere. But while the deal litigation in Delaware generally may be declining, in recent years there has been a significant uptick in Delaware appraisal litigation. As these cases have become more common in recent years, the question of whether or not D&O insurance covers the costs companies incur in defending appraisal actions has become increasingly common as well. Indeed, in the October 11, 2017 Advisen Quarterly D&O Claims Trends Webinar (refer here), the question of D&O insurance coverage for appraisal claim-related defense expenses was a key topic of conversation. In the following post, I review the issues involved in the question of whether or not a D&O insurance covers the costs defendants incur in defending appraisal claims.
At the outset, I would like to thank my fellow panelists in the recent Advisen webinar for the thoughts they offered on these topics during the webinar. I would particularly like to thank Jeroen van Kwawegen of the Bernstein Litowitz law firm firm, who provided the panel with links to many of the sources to which I have linked below.
In an effort to protect minority shareholders who may feel they are being compelled to give up their shares without their consent, various states, including in particular, Delaware, have created a remedy for “dissenting shareholders,” allowing them to seek a judicial appraisal of the fair value of their shares. Under Delaware General Corporations Code Section 262, subject to certain conditions and qualifications, any shareholder voting against a merger on the grounds that the consideration is inadequate “shall be entitled to an appraisal by the Court of Chancery of the fair value of the stockholder’s shares of stock.”
Appraisal actions are, of course, not new. They have been around and have been filed for years. However, as detailed in a July 29, 2017 article by the Fried Frank law firm on the Harvard Law School Forum on Corporate Governance and Financial Regulation entitled “The Evolving World of Delaware Appraisal” (here), the number of Delaware appraisal action has increased significantly in recent years. According to the article, the number of transaction in which appraisals have been sought has increased from 20 in 2012 to 48 in 2016. Indeed, one recent article about appraisal litigation states that in recent years a “cottage industry of ‘appraisal arbitrage’” has developed, “in which hedge funds purchase shares in hoped of securing a higher price for those shares through appraisal.” (However, as discussed below, due to changes in the law and changes in the courts’ approach to these cases, the number of appraisal actions in has declined in 2017 YTD compared to the year before.)
The Insurance Coverage Issues
Along with the rise in the number of appraisal actions has come questions about the availability of insurance coverage for the costs companies incur in defending appraisal actions. These questions involve a number of recurring issues, including whether an appraisal proceeding involves an actual or alleged “Wrongful Act” and whether or not the appraisal action meets the definition of a “Securities Claim.”
In order for coverage to be triggered, most D&O insurance policies require that a claim has been made involving an actual or alleged wrongful act. As discussed in the August 17, 2017 article on the Harvard Law School Forum on Corporate Governance and Financial Regulation by Peter M. Gillon and Benjamin D. Tievsky of the Pillsbury law firm and entitled “Why Your D&O Policies Should Cover Delaware Appraisal Proceedings” (here), because one of the fundamental issues in the appraisal proceeding is the per-share acquisition price, “many in the D&O insurance ‘community’ have viewed appraisal proceedings incorrectly as a simple exercise in economics, not an allegation of Wrongful Acts.” (Please note that I discussed a prior version of the Pillsbury attorneys’ article in a prior post, here.)
The question of whether or not the allegations in an appraisal action meet the policy definition of the term “Wrongful Act” will depend on the actual wording used. As the Pillsbury law firm memo points out, most policy definitions of the term are quite broad and are extensive enough to reach any corporate act or omission; the authors note that “while the burden of proof in establishing liability under Section 262 is relatively low, so is the standard for meeting the typical D&O policy’s requirement of an alleged “Wrongful Act.” Indeed as recently came up in the coverage action in which CEC Entertainment is seeking insurance coverage for the defense fees in the appraisal action (refer here), some policy definitions of the term “Wrongful Act” refer to an “act,” without a requirement that the act be negligent or deficient.
Not only that, but as Jeroen van Kwawegen pointed out in the recent Advisen webinar, Delaware court increasingly are requiring in order for appraisal actions to go forward that there be some allegation that there was something wrong with the process that resulted in the agreed-upon per share transaction price. As a result of these requirements of the Delaware courts, it is increasingly likely that the appraisal action itself will involve express allegations of misconduct, which in turn should make it increasingly likely that the allegations in the proceeding meet the requirements of the relevant wording of the policy’s definition of “Wrongful Act.”
Other recent developments in Delaware appraisal litigation increase the likelihood going forward that an appraisal complaint will involve express allegations that would satisfy the “Wrongful Act” requirement. As discussed in an article by lawyers from the Fried Frank law firm on the Harvard Law School Forum on Corporate Governance and Financial Regulation earlier this year, Delaware’s courts increasingly are relying on the merger price itself to determine the fair value of the dissenting shares, while awarding an appraisal premium over the merger price only in the case of “interested transactions” (that is, “those involving a controlling shareholder, parent-subsidiary, management buy-out or other element of self-interest”). These developments suggest that if the deal is not an “interested transaction,” dissenting shareholders are less likely to bring an appraisal action, making it likelier that the appraisal action that are brought will involve actual or alleged self-interest, which in turn makes it more likely that the appraisal complaint will contain allegations sufficient to satisfy the “Wrongful Act” requirement. (These developments in the Delaware courts’ approach may be part of the explanation for the decline in the number of appraisal actions in 2017 YTD, discussed below.)
As the Pillsbury law firm memo also points out, the appraisal claimants may couple their appraisal claim with a breach of fiduciary duty claim, in line with the mandate under Section 262, which charges the Chancery Court to consider “all relevant factors” in reviewing the sales process and in determining the true pre-merger value of the company.
Another question that recurs in disputes involving questions of coverage for the costs companies incur in defending appraisal actions. Typically, appraisal actions will name as defendants just the corporate entity itself. A public company D&O insurance policy provides coverage for the corporate entity (under the policy’s Side C coverage) only for a “Securities Claim” as that term is defined in the policy. The question of whether or not an appraisal action meeting the policy’s definition of the term “Securities Claim” thus is critical in the determination of whether or not the policy provides coverage for the costs a company incurs in defending an appraisal action.
Those of us who are active in this area know that there is policy definitions of the term “Securities Claim” vary widely, and the question of whether or not an appraisal action meets the definition of the term is going to depend on the specific wording of the relevant policy definition.
There are at least three different important ways that the definition of the term “Securities Claim” vary: (1) according to the whether and how the substantive law is referenced; (2) according to the identity of the claimant involved; and (3) according to the specific securities involved.
Items 2 and 3, though they can be the source of a significant disagreement, are less likely to be troublesome in an appraisal dispute. The issue referenced in Item 2 is the requirement that the claimant be a securityholder of the company. Since only a stockholder of the company can bring an appraisal action, this issue likely will not be a source of dispute in determining whether or not an appraisal action meets the definition of the term Securities Claim. Similarly, Item 3, referencing the securities involved, is unlikely to be an issue here, either; this item becomes relevant if the definition requires that the dispute involve the securities “of the Organization” or “of the Company” in order to constitute a Securities Claim. Again, because an appraisal action is only in play if the shareholder owns shares of the company involved, this item is unlikely to be relevant to the question of whether or not an appraisal action is a “Securities Claim.”
However the question of whether or to what extent the definition references substantive law could well be relevant. Here it is important to keep in mind two basic but fundamentally different ways that public company policies define the term “Securities Claim.” Under one of these two approaches, the definition restricts the definition of the term to claims involving allegations of the securities laws; under the alternative approach, the policies define the term by reference to who is bringing the claim — that is, generally limiting the term to claims brought by shareholder or securityholders of the company. This latter approach does not require a claim to specifically allege a violation of the securities laws in order for a claim to be a Securities Claim.
Even with respect to the policies whose definitions of the term Securities Claim expressly require an actual or alleged violation of the securities laws, it could be argued that the description of the securities laws in the typical definition is sufficiently broad that it could encompass an appraisal action. In that regard, the Pillsbury law firm memo references a recent Delaware Superior Court decision in which the court applied a broad view of the term “Securities Claim,” to extent to “allegations related to issues inherent in laws regulating securities transactions.” The decision to which the law firm memo is referring is the March 2017 ruling by Judge William Carpenter in a claim arising out of Verizon’s spinout of its electronic directories business, which I discuss at length here. To be sure, the Verizon dispute did not involve an appraisal action, but the ruling did involve a broad interpretation of the use of the term “rule” in the relevant policy’s definition of “Securities Claim.”
The Pillsbury law firm memo makes one more point in favor of coverage, based on the bump-up exclusion found in many insurance policies. These exclusions typically preclude coverage for an agreement or obligation to increase the consideration to be paid in a merger or acquisition transaction; the exclusion bars coverage for the amount of the increase (the so-called “bump up”), but often these exclusions also carve-out defense expenses from the exclusions’ preclusive effect. The law firm memo’s authors argue that the carve-out “indicates that insurers intend to cover defense costs for exactly those kinds of claims – claims that appear in appraisal actions.” So the bump up-exclusion and the exclusion’s carve back for defense expenses “appear to provide strong support for coverage of defendants’ appraisal action defense costs under standard D&O policies.”
As I suggested above, there is an important note about appraisal action filings trends. While it is true that during the period 2012 to 2016 the number of appraisal actions increased, the evidence now suggests that more recently the number of appraisal actions may actually be going down.
Last summer the Delaware legislature amended Section 262 in order to eliminate de minimus appraisal actions and to try to reduce interest rate appraisal arbitrate. A September 8, 2017 post on the Harvard Law School Forum on Corporate Governance and Financial Regulation (here) suggests that the number of appraisal actions in the first half of 2017 actually declined by one-third compared to the same period in 2016. The developments in the Delaware courts’ approach to appraisal cases – in which the courts are prepared to accept the actual deal price as representing “fair value” if the deal does not involve an interested transaction – may also explain the decline in the number of appraisal actions so far this year. If these declining filing trends continue, the urgency of these questions about coverage for appraisal actions could decline as well.