Every year just after Labor Day, I take a step back and survey the most important current trends and developments in the world of Directors’ and Officers’ liability and D&O insurance. This year’s survey is set out below. Once again, there are a host of things worth watching in the world of D&O.
Will the Near-Record Pace of Securities Class Action Lawsuit Filings Continue?
The recent heightened pace of securities class action lawsuit filings remains a significant concern. 2017 was a record-setting year for securities class action lawsuit filings, and the torrid pace of securities suit filings continued in the first half of 2018, coming in at a level only very slightly below last year’s record pace. While a significant number of the first half filings are attributable to merger objection lawsuit lawsuits, the number of traditional filings alone during the year’s first half was well above historical levels. If the first half’s pace continues in the second half of 2018, the projected number of year-end filings would approach last year’s elevated total.
There were 204 federal court securities class action lawsuit filings in the first half of the year, which is slightly below the 224 lawsuits filed in the first six months of 2017. The 204 securities suit filings in the year’s first six months projects to a year-end total of 408 filings, which would be slightly below last year’s year-end filing total of 412. The projected year-end total of 408 filings is more than double the 1996-2016 annual average number of filings of 193.
A substantial number of the first half 2018 securities suit filings were merger objection lawsuits. Due to the Delaware judiciary’s hostility to the disclosure-only deals that usually characterize the settlement of merger objection suits, plaintiffs’ lawyers recently have been filings these suits in federal court rather than in Delaware state court. Of the 204 securities suit filings in the first half of 2018, 83 (or about 40.6%) were merger objection lawsuits.
While many of the first half filings were merger objection cases, there nevertheless were significant numbers of traditional lawsuit filings in the first six months of the year. There were 121 traditional cases filed in the first half, which projects to an annual total of 242 traditional lawsuit filings. The traditional filings alone project to be well above the long-term annual average number of filings of 193.
Arguably of even greater concern than the number of lawsuits being filed is the litigation rate. In 2017, the rate of litigation (that is, the ratio of the number of lawsuits to the number of U.S.-listed companies) was more than 8 percent; the rate for traditional lawsuits alone was more than 4 percent and nearly double the long term annual average rate.
Based on the pace of filings in the year’s first half, it looks as if this elevated litigation rate has increased slightly so far in 2018. According to Cornerstone Research, the projected 2018 litigation rate (based on the first half filings) is 8.5%. Even just with respect to the traditional lawsuits, the projected 2018 litigation rate is 4.6%. Both of these projected rates, if realized, would exceed the rate for any year since Congress passed the PSLRA in 1995. In other words, the chance of an individual listed company experiencing a securities class action lawsuit is as high as it has ever been and well above historical norms.
This fact has significant implications for companies and their insurers. In recent months, the D&O carriers have been bemoaning their poor loss experience and claims results, exacerbated in 2016 and 2017 by significantly increased numbers of federal court securities class action lawsuits. Given the continued elevated pace of securities class action lawsuit filings in the first half of 2018, the insurers’ recent adverse loss experience seems likely to continue in 2018.
How Will the U.S. Supreme Court’s Decision in Cyan Impact Securities Act Litigation and D&O Insurance Premiums?
On March 20, 2018, the U.S. Supreme Court issued its unanimous decision in Cyan, Inc. v. Beaver County Employees Retirement Fund, holding that state courts retain concurrent jurisdiction with federal courts for liability actions under the Securities Act of 1933. The immediate practical consequence of this decision is that if a company is hit with a ’33 Act securities lawsuit in state court, the company can’t remove the state court lawsuit to federal court even if there is a parallel or even identical lawsuit pending in federal court.
The kinds of companies most likely to be hit with ’33 Act liability lawsuits are companies that have recently completed IPOs, although companies that have recently completed secondary offerings are also susceptible to ’33 Act litigation. It is well known and commonly understood within the D&O insurance community that IPO companies generally face a greater likelihood of getting hit with a securities lawsuit than the universe of public companies as a whole. Now, as a result of the Cyan decision, IPO companies not only face chance of securities litigation, but they now also face the possibility of having to fight securities litigation in multiple jurisdictions. Indeed, IPO companies face the possibility not only of having to litigate claims in both state and federal court, but also face the possibility of having to litigate in multiple state courts at the same time.
The possibility of multi-jurisdiction litigation not only presents the prospect of increased attorneys’ fees as the company if forced to fight a multi-front war, but it also presents the risk of logistical and procedural issues that could complicate the company’s defense. The overall prognostication is for more complicated and more costly IPO-related litigation.
It has only been a few months since the Cyan decision was handed down and so there is relatively little actual experience of companies having to deal with its effects. According to one source, in the first half of 2018, there were only six federal court IPO-related securities class action lawsuits filed; of the six, five were accompanied by at least one related state court action. Though the evidence is still relatively scarce, all signs point to the conclusion that IPO companies that become involved in securities litigation are going to have to fight a multi-front war. Indeed, even before Cyan, that was the confirmed experience in California, where (as a result of a split of judicial authority state court concurrent jurisdiction was already recognized) companies have had to deal with multi-jurisdiction litigation for some time now.
Some companies may try and adopt self-help measures. For example, some commentators have suggested that IPO companies can avoid having to litigate actions under the ’33 Act in state court by adopting by-law provisions designating federal court as the exclusive forum for litigation involving the securities of the company. While this idea is interesting, it does raise the question whether a company can by revisions to its by-laws circumvent a Congressional grant of jurisdiction. It may be that the only remedy here is for Congress itself to step in and eliminate what is by any measure an inefficient jurisdictional anomaly that is inconsistent with the efforts of Congress to try to direct securities litigation to federal court.
In any event, the Cyan decision has important implications for D&O insurers and the way they price IPO companies’ insurance. IPO companies in California were already paying relatively higher D&O insurance premiums, compared to IPO companies based on other jurisdictions, because of the increased risk of securities litigation due to the possibility of state court suits in California. Now, as a result of the Supreme Court’s decision in Cyan, it is not just California IPO companies that face this increased securities litigation risk owing to the possibility of state court lawsuits; IPO companies in every state now face this heightened risk.
This heightened risk has already translated into higher premiums for companies undertaking IPOs and it likely will affect premiums for IPO companies’ D&O insurance renewals, at least in the companies’ early years following their IPO. As actual claims experience accumulates in the coming months, and the actual costs of multi-jurisdiction litigation mounts, these D&O insurance-related impacts could be exacerbated.
What Next for Merger Objection Litigation?
As noted above, there has been a substantial increase in federal merger objection litigation. Overall, it is still very much the case that a public company merger or acquisition is likely to draw at least one merger objection lawsuit.
As this litigation has proliferated, costs associated with this type of litigation have increased at an alarming rate. A 2018 study by one leading insurer showed that between 2012 and 2016, the total costs (including defense fees as well as amounts paid to plaintiffs’ attorneys to settle the case) associated with merger objection lawsuits has increased 63% for cases that settle and 162% for cases that are dismissed. The increase in costs associated with merger objection litigation is one more alarming trend driving D&O insurers’ approach to account renewals.
While the merger objection litigation trends are indeed troublesome, there may be reason to hope that there may be more positive developments ahead. In the last few months, the courts of a number of jurisdictions have adopted the Delaware courts’ stricter standard for reviewing disclosure-only settlements. For example, in July 2018, an appellate court in Florida expressly adopted the Delaware standard.
If the courts of enough jurisdictions adopt the stricter standard, or slash the plaintiffs’ attorneys’ fees to the point that the cases are no longer remunerative, the plaintiffs’ lawyers may get the message and stop filing these kind of lawsuits, or at least file fewer than are presently being filed. While this possibility is reassuring, if it happens, it will only happen gradually. It will take some time for the courts in enough jurisdictions to make establish a sufficiently uniform standard to create a general deterrent for the plaintiffs’ lawsuits.
In the meantime, the plaintiffs’ lawyers continued to file these kinds of lawsuits in connection with a majority of merger deals. Indeed, in its most recent study of the litigation, Cornerstone Research reported that plaintiffs filed merger objection lawsuits in connection with 73 percent of mergers with a value of over $100 million announced in 2017. While this rate is below more elevated rates in recent years, it is still well above historical norms.
As long as these elevated litigation rates persist and as insurers incur the costs associated with this type of litigation, the D&O insurers will take steps to avoid these merger-related costs. Most carriers on most public company D&O placements continue to include a separate merger-related litigation retention. The inclusion of these kinds of retentions are likely to continue so long as the merger objection litigation continues to be filed at the current elevated rates. In the meantime, we can all hope that the courts continue to evince hostility to the disclosure-only settlement of these cases, in time creating enough case law to create a filing deterrent.
Will the #MeToo Movement Lead to Further Management Liability Litigation?
As revelations of sexual misconduct have continued to unfold as part of the #MeToo movement, the accountability process has come to include not only efforts to hold wrongdoers liable, but also efforts to hold boards and corporate management who permitted the behavior or turned a blind eye responsible. There have now been a number of management liability lawsuits filed in the wake of revelations of sexual misconduct, and continuing revelations suggest there may be more to come.
The first of these recent sexual misconduct D&O lawsuits was filed late last year against 21st Century Fox. The shareholder derivative lawsuit alleged that the company and its officials tolerated a long-standing culture of sexual harassment, and that the company continued to turn a blind eye to misconduct by high-profile media personalities, ultimately to the detriment of the company as it was forced to pay huge settlements to victims of the harassment. The derivative lawsuit settled for a payment of $90 million – one of the largest derivative lawsuit settlements ever — funded by the company’s D&O insurer.
Other D&O lawsuits involving allegations of sexual misconduct have followed. Wynn Resorts has been hit with a shareholder derivative lawsuit and a securities class action lawsuit following revelations of alleged misconduct involving the company’s founder and CEO, Stephen Wynn. In July, National Beverage Corp. was hit with a D&O lawsuit following news reports of allegations that the company’s Chairman and CEO had sexually harassed company employees. In August, a CBS shareholder filed a securities class action lawsuit against the company and certain of its executives following revelations of alleged sexual harassment involving the company’s CEO, Leslie Moonves. Later in August, a shareholder of Papa John’s filed a securities class action lawsuit against the company and its former CEO and Chairman, John Schnatter, following allegations that Schnatter and other company executives had engaged in a pattern of sexual harassment and other sexual misconduct at the company.
D&O lawsuits relating to allegations of sexual misconduct are not limited just to publicly traded companies. Weinstein Company, the firm from which the first of these revelations emerged, is a private company – although it should be noted that the lawsuits that have been filed against the company and its executives was brought by the alleged victims, rather than by investors, as is the case with respect to the litigation described above. Non-profit organizations have experienced these kinds of lawsuits as well. The Metropolitan Opera is involved in litigation with its former music director, James Levine, following published reports of Levine’s alleged sexual misconduct involving musicians, job applicants, and music students.
This story does not show any signs of winding down. Earlier this year, the Washington Post published a detailed report of sexual misconduct involving prominent figures in the classical music world. In late July, the Wall Street Journal ran a front-page article about several instances of sexual misconduct involving partners at prominent law firms. Not all of these revelations have yet led to lawsuits, but the continuing revelations suggest that the threat of further litigation arising in the wake of reports of sexual misconduct continues.
As two commentators put it in a recent guest post on this site, “With the increased focus on sexual harassment in the news, the apparent increased willingness of employees to report such behavior, and a climate where state and local governments are stepping up to support the movement, employers (including directors and officers) and insurers should recognize that an increase in sexual harassment claims and lawsuits may be inevitable.”
Will There Be Further D&O Litigation Involving Companies Hit With Data Breaches?
It is not anything new that companies getting hit with data breaches may also have to deal with related D&O litigation. During the time frame 2014 to 2016, there were a number of shareholder derivative lawsuits filed against companies that had experienced data breaches, including, among others, Wyndham Worldwide, Target, and Home Depot. These lawsuits were largely unsuccessful, although the Home Depot case did settle for the defendants’ payment of the plaintiff’s attorneys’ fees while the dismissal was on appeal.
In 2017, there were several more data breach-related D&O lawsuits filed. By contrast to the earlier lawsuits, which were filed as shareholder derivative lawsuits, these later lawsuits were filed as securities class action lawsuits. Among other companies hit with these kinds of lawsuits in 2017 were Yahoo and Equifax. Both the Yahoo and Equifax lawsuits involved massive data breaches, among the largest ever.
In March 2018, the Yahoo securities suit settled for $80 million. The settlement is noteworthy in and of itself given its size, but also because the settlement represents the first significant recovery in a data breach-related D&O lawsuit. The Yahoo case may have been somewhat unique, in that the announcement of the data breach caused demonstrable economic harm to Yahoo shareholders after Verizon insisted on renegotiating the price of its pending takeover of Yahoo based on the news. Just the same, the settlement represents a milestone because it constitutes the first evidence that plaintiffs’ lawyers might be able to make money on data breach-related D&O lawsuits.
Yahoo’s successor-in-interest Altaba was involved in another legal milestone of sorts in April 2018 when it became the first-ever company to settle a data breach-related SEC enforcement action. Altaba paid $35 million to settle the enforcement action, relating to Yahoo’s delay in disclosing its massive data breach. The settlement and the agency’s earlier release of updated cybersecurity disclosure guidelines underscore the fact that data breach and cybersecurity disclosures remain a high priority for the SEC.
The settlement of the Yahoo securities lawsuit and related SEC enforcement action, along with the SEC’s emphasis on cybersecurity disclosure issues, suggests that data-breach and cybersecurity issues generally will continue to be an area of heightened risk for securities litigation. The $80 million Yahoo securities suit settlement will likely hearten and encourage the plaintiffs’ lawyers as well. It seems likely that there will be further data breach and cybersecurity litigation ahead.
Will Privacy Issues Become Another Area of Emerging D&O Exposure?
The data breach and cybersecurity issues discussed in the preceding section relate to concerns surrounding the way data is secured. A related but different issue involves privacy concerns – that is, the way company’s use the data they have gathered. The recent debacle at Facebook involving revelations that the company had transferred user data to Cambridge Analytica highlights the ways the privacy concerns can give rise to D&O litigation is. The revelations about the transfer of user data to Cambridge Analytica led to a storm of outrage. In March 2018, the revelations also led to a securities class action lawsuit, in which the claimants allege that Facebook’s investors were misled about the company’s privacy policies and use of user data.
The important thing to note about the Facebook litigation relating to the Cambridge Analytica debacle is that the user data release to Cambridge Analytica did not involve a data breach The fundamental concern behind the furor is not that user data was exposed in a breach; rather the concern is that Facebook allowed third party developers to access private user information. The outrage of politicians and others, as well as the reaction of investors that caused the company’s stock price decline, involve concerns that the company was insufficiently protective of its users’ private personal data.
The Cambridge Analytica revelations came to light shortly before the EU’s updated General Data Protection Regulation went into effect in May 2018. These sweeping new regulations impose strict privacy protection requirements throughout the EU, and subject violators to stringent penalties. The regulations have a broad scope, applying to companies outside the EU that collect data on citizens within the EU.
Compounding the privacy-related concerns arising from the GDPR, in late June 2018, California enacted its own privacy legislation. The California bill imposes on businesses significant privacy obligations, creates a number of privacy rights, and provides for enforcement both through private right of action and regulatory enforcement. The Act’s passage arguably represents a significant step toward making privacy issues a prominent part of the liability landscape in the months and years ahead.
These new regulatory enactments ensure that privacy-related issues are going to be a significant business concern. A further development also involving Facebook suggests that these new regulatory measures could also involve potential liability and litigation concerns as well.
In a quarterly earnings release at the end of July, Facebook disappointed analysts by reporting slower than expected earnings growth for the period. Among other things in explaining the disappointing results, company officials cited the unexpectedly high costs and complications associated with the company’s compliance with the GDPR regulations, which had gone into effect during the period. The announcement was followed by what is the largest single-day drop in shareholder value in the history of the markets, as Facebook lost nearly $120 billion in market capitalization on the news. Securities class action lawsuits followed shortly behind.
In August 2018, just days after the more recent Facebook lawsuit filings, investors filed a lawsuit against Nielsen Holdings plc after the media performance ratings company disclosed in its quarterly earnings release that GDPR-related changes affected the company’s growth rate, pressured the company’s partners and clients, and disrupted the company’s advertising “ecosystem.”
These two recent GDPR-related lawsuits highlight the ways in which the new regulations and related emerging concerns about privacy issues can give rise to potential liability issues. Facebook and Nielsen are far from the only companies that are going to struggle complying with the new regulatory privacy requirements. Other potential exposures arise from the possibility of follow-on civil lawsuit arising in the wake of privacy-related regulatory actions.
We are in the early days yet as this issue unfolds, but privacy-related concerns could prove to be a significant area of potential D&O liability exposure. The key here is to understand that this is a potential liability exposure that is separate and distinct from liabilities arising from data breaches and cybersecurity generally. This area of exposure involves the way companies use the data they are collecting from their customers and others. Many companies collect these kinds of data, and the ways the companies use this data are going to be a source of increasing scrutiny – and of potential liability exposure, as well.
Will Communications on Social Media Become a Source of D&O Liability?
The possibility of a securities class action lawsuit based on alleged misrepresentations made on social media has been there as long as there have been social media. The potential relation between statements made on social media and the requirements of the federal securities laws was highlighted in 2013 when Netflix CEO Reed Hastings used his Facebook account to announce that Netflix subscribers had surpassed 1 billion users. That sparked an SEC investigation looking into whether, among other things, Hastings’ Facebook post violated Reg. FD. The SEC ultimately concluded that companies can use social media to announce key information in compliance with Reg. FD as long as investors have been told to look there.
The recognition that companies could use social media for company announcements raised the possibility that investor would later claim that a company statement on Twitter or Facebook would be the basis of a securities class action. That possibility became a reality in August, when a tweet storm by Tesla’s Chairman and CEO Elon Musk led first to a stock market rally and bust, and then to a group of securities class action lawsuits.
On Tuesday August 7, Musk set the securities markets and the business pages alight with an extraordinary series of Tweets on his Twitter feed, in which Musk stated, among other things, that he is “considering taking Tesla private” at a price that represented a substantial premium over the current share price; that “funding secured”; “shareholders could either sell to [SIC] sell at 420 or hold shares & go private”; and “Investor support confirmed.”
The company’s share price leapt upwards, to an inter-day high 13% above the prior day’s closing price. The trading volume in Telsa’s share rose to 30 million shares (compared to an average daily trading volume of 8 million), representing over $11 billion of purchases in the open market. Almost immediately questions arose about the source of the funding Musk referred to, as well as the extent to which the company’s board had considered and approved the transaction. The company’s share price declined and within days investors had filed a series of securities class action lawsuits. Media sources also reported that the SEC was investigating Musk’s tweets and the supposed take-private deal.
Tesla is far from the only company that uses social media to communicate with the investment community. Most of these communications are entirely benign. However, using social media does involve certain risks. The relative informality of the media compared to traditional corporate communications methods creates the possibility of statements that are insufficiently filtered or reviewed. Musk’s take-private tweets certainly seem to illustrate these risks. Tesla may be the first company to get hit with a securities class action lawsuit based on allegedly misrepresentations made using social media, but it is unlikely to be the last.
Does Climate Change-Related Disclosure Represent an Area of Potential Liability?
Climate Change is an issue that has hovered on the periphery of the discussion of D&O liability issues for many years. By and large, however, concerns about the issue have not translated into claims. The one notable exception is the securities class action lawsuit investors filed against ExxonMobil and certain of its directors and officers in November 2016. Investors alleged that the company had a far different internal view of the potential impacts on the company’s future ability to realize the full value of its hydrocarbon assets than the one the company communicated publicly, and as a result the company delayed writing down the value of certain of its assets, resulting in a misrepresentation of the company’s financial condition.
ExxonMobil moved to dismiss the investors’ climate change disclosure-related claims. However, in an August 14, 2018 opinion, Northern District of Texas Judge Ed Kinkeade largely denied the defendants’ motion to dismiss, ruling that the claimants had sufficiently pled that the defendants had made material misrepresentations about the company’s calculation of future climate change-related costs and in the company’s failure to adjust or delay in adjusting of specific assets valuations. Judge Kinkeade also found the plaintiffs had adequately alleged scienter despite the absence of insider trading allegations.
One claim does not make a trend, but the ExxonMobil lawsuit’s survival of the motion to dismiss nevertheless is a significant development. The fact that the allegations based on climate change-related disclosure proved sufficient to survive a motion to dismiss suggests that the potential D&O exposure related to climate change disclosures could be substantial. At a minimum, this lawsuit’s survival of the dismissal motion could be enough to encourage plaintiffs’ lawyers to file additional climate change related lawsuits.
Investor claims are one source of potential climate change related litigation; another potential source is the possibility of claims brought by advocacy groups as a way to try to draw attention to climate change policies. An initiative by one advocacy group this summer provides an example of these kinds of claims.
On August 2, 2018, the non-profit legal group Client Earth filed complaints with the U.K. Financial Conduct Authority (FCA) against three different U.K. insurers. The legal group contends that the insurers’ annual reports failed to meet the requirements of the Disclosure Guidance and Transparency Rules due to the absence in the reports of any climate change-related disclosures.
As these new complaints demonstrate, the possibility of this type of litigation is not mere conjecture. As discussed here, in 2017, investors filed a lawsuit in Australian court against Commonwealth Bank, alleging that the company’s 2016 annual report did not adequately report on the company’s climate change business risk or its management of climate change risks. The obvious purpose of the lawsuit was to try to force changes to the company’s climate change disclosure practices. (The lawsuit had an impact; the company’s 2017 annual report contains several pages of climate change-related disclosures.)
Companies will continue to face pressure from shareholders and advocacy groups about their climate change-related disclosures. Along with pressures to alter or improve disclosures may come claims that prior disclosures were inadequate or misleading. The 2016 ExxonMobil securities class action lawsuit is an illustration of the form that this type of lawsuit might take. In addition, the possibility of future claims in this area includes the risk of a regulatory enforcement action as well. The bottom line is that climate change and climate change-related disclosures likely will remain an area of concern for corporate boards.
Will the Number of SEC Enforcement Actions Continue to Decline?
The early evidence suggests that SEC enforcement activity has sharply declined under the agency’s Trump administration leadership. According to a report a May 2018 report from Cornerstone Research and the NYU Pollack Center for Law & Business, the number of SEC enforcement actions against public companies and their subsidiaries declined in the first half of FY 2018 (which ended March 31, 2018) compared to the comparable year prior period, continuing a sharp downward trend that began in the second half of FY 2017 and falling to the lowest level in years.
According to the report, the SEC filed 15 new enforcement actions against public companies and their subsidiaries in the first half of FY 2018, representing a 67 percent decline from the 45 enforcement actions the SEC filed in the first half of FY 2017. The number of enforcement actions filed in the first half of 2018 is significantly below the average of 29 enforcement actions filed per half year during the period FY 2010 through FY 2017, and below the median of 26 actions per half year filed during that same time period.
The current trend toward significantly reduced numbers of enforcement actions against public companies and their subsidiaries began in the second half of 2017. In the last half of the 2017 fiscal year, the SEC filed only 17 enforcement actions against public companies and their subsidiaries, compared to 45 actions filed in the first half of FY 2017.
Not only were the number of enforcement action filings down in the first half of FY 2018, but monetary settlements “decreased substantially” from prior fiscal years. The highest monetary settlement during the period of $14 million was “by far the lowest maximum monetary settlement in any half year in the database.” The average monetary settlement of $4.3 million is also the lowest half-year average in the database.
The Cornerstone Report itself does not include any speculation on the cause of the decline and whether or not the decline represents changing enforcement priorities under the current administration or whether the agency under the current administration has instituted a new, lower enforcement-focused approach to public company regulation.
It may well be that the lower enforcement figures are simply reflect disruption in enforcement activity due to the change in administration and in the top personnel managing the agency’s enforcement docket. However, it does seem significant that the current significantly reduced level of enforcement activity really began during the second half of FY 2017 and continued through the second half of FY 2018. The timing and persistence of the decline does seem to suggest that more is going on than just a disruption from the change in administration; the decline really does seem to suggest that under the new administration, the agency is taking a significantly different approach to enforcement, at least with respect to public companies and their subsidiaries.
It will be very interesting to see whether or not the reduced filing trends that emerged during the last two fiscal half-year periods continue. If the SEC were to take a significantly less active enforcement approach as an intended result of a changed enforcement philosophy, that would represent a significant change in the liability environment for public companies.
Will the SEC Permit Companies to Require Mandatory Arbitration of Shareholder Claims?
A number of commentators have proposed that companies filing with the SEC to complete IPOs ought to be able to include in their bylaws a mandatory arbitration provision requiring shareholder claimants to submit claims – including even claims under the federal securities laws – to arbitration. This idea, which has been percolating for years, received a significant boost in a statement last summer from outgoing SEC Commissioner Michael Piwowar, in which he suggested that the SEC would favorably view submissions by IPO companies that included bylaw provisions requiring mandatory arbitration of securities claims.
Since Piwowar’s statement last year, SEC representatives have made a variety of different comments about the possibility of allowing mandatory arbitration of shareholder claims. In an April 24, 2018 letter to Democratic Congresswoman Carolyn B. Maloney (here), SEC Chair Jay Clayton weighed in with a more detailed expression of his views on the idea of mandatory arbitration of shareholder claims. His overall point of the detailed letter is that “I have not formed a definitive view on whether or not mandatory arbitration for shareholder disputes is appropriate in the context of an IPO for a U.S. company.” He also said that in light of other issues on which he and the agency are focused, the issue is “not a priority for me,” noting that any decision on the issue by the agency would “divert a disproportionate share of the Commission’s resources” from matters Clayton considers higher priority.
Clayton’s detailed letter highlights his view that the issues other than the introduction of mandatory arbitration clauses more urgently require the agency’s attention and resources. Nevertheless, while emphasizing that the issue is not a priority for him, his letter does not close the door on the idea. To the contrary, he noted in his letter that the “views of the market participants on this issue … are deeply held, and in many cases, divergent.” And while it is not a priority for Clayton himself, he acknowledges that it remains the subject of “heightened interest” and he says that he has “encouraged those with strong views to support their position with robust, legal and data driven analysis.”
Clayton’s letter does suggest that if this issue is going to come up at the agency, it is going to come up in the context of a specific company’s registration statement submission, and not through a formal rulemaking process – and therefore not involving all of the formal processes that formal rulemaking requires. Clayton does suggest that any submission would be reviewed at the Commission level rather than at the delegated-authority division level.
Under these circumstances, a prospective IPO company candidate might well choose to include within its pre-effective registration statement submission incorporating a corporate charter with a mandatory arbitration provision, if for no other reason than to try to force a decision on the issue. Indeed a company could try this at any time.
For that reason, it seems unlikely that this issue is just going to go away, even though it is not a priority for Clayton. To the contrary, it seems likelier that this issue is going to bubble up and require Commission action, sooner rather than later.
What is Next for Cryptocurrencies and Initial Coin Offerings (ICOs)?
Anyone who reads the business pages these days has to be aware that there has been a surge of interest and activity involving cryptocurrencies, and in particular involving initial coin offerings (“ICOs”). According to the CoinDesk website, the total cumulative value of funds raised through ICOs now exceeds $20 billion. This level of activity has in turn attracted regulatory scrutiny and even enforcement activity. In addition, there has been a series of ICO and cryptocurrency-related securities class action lawsuits filed in late 2017 and so far in 2018.
Regulators arguably were slow off the mark in taking the initiative on cryptocurrencies. In July 2017, the SEC issued its first Investor Alert directly concerning ICOs, noting that in some circumstances an ICO may involve the offer or sale of securities and therefore be subject to the U.S. securities laws, and in other circumstances offerings made in reliance on exemptions from the securities laws may not in every instance be compliant with the requirements for the exemption. The Alert including an express warning against fraudulent activity.
In addition, on September 25, 2017, when the SEC announced the creation of an internal Cyber unit to focus on cyber-related misconduct, among the specific areas the agency identified that the task force will explore was “violations involving distributed ledger technology and initial coin offerings.” Since that time, the task force has been involved in the initiation of a number of enforcement actions involving cryptocurrencies and ICOs.
The claim activity has not been limited to the regulatory arena. Since July 1, 2017, there have been as many as 18 cryptocurrency, ICO, or blockchain-related federal court securities class action lawsuits filed. Many of these lawsuits are brought by investors who purchased the cryptocurrencies, alleging that the coins or tokens offered are “securities” within the meaning of the federal securities laws and that the issuers or sponsors failed to register the securities with the SEC as federal law requires.
Although the assumption is that the companies involved in cryptocurrency activities are start-up ventures, more seasoned companies have adopted a cryptocurrency strategy as well. Indeed, Overstock.com, a publicly traded company, was hit with a securities class action lawsuit earlier this year after the company’s announced plans for a cryptocurrency offering were derailed after the company announced that its planned offering had drawn SEC scrutiny.
Given these regulatory issues and legal disputes, regulators, investors, and others – including D&O underwriters – are understandably wary of cryptocurrencies and ICOs. On the other hand, as regulators and others have stepped forward, the legal environment for digital currencies has begun to get a little clearer, which in turn could help both regulators and D&O underwriters to get more comfortable with the digital currencies. For example, in a June speech, the SEC Director of Corporate Finance delivered some helpful guidance on when digital assets will be considered securities under federal law. Many of the pending lawsuits will help to provide some clarification on a number of other issues as well.
While needed clarity is coming to the digital currency arena, D&O underwriters remain cautious. For many if not most of the D&O insurers, ICOs and cryptocurrency companies remain a restricted class of business. Others will write companies with a digital currency risk only on very restricted terms and conditions and at substantial premiums. Nevertheless, given the magnitude of the business activity involved, ICOs and cryptocurrency companies represent a significant opportunity. At least some carriers will try to use the emerging legal standards as the basis for risk segmentation within the digital currency arena, and will try to take advantage of what is potentially a very significant business opportunity.
For now, though, the D&O insurance community has yet to establish a widely adopted paradigm for the right way to approach digital currency companies. ICO companies and other cryptocurrency companies remain hard to place accounts. The interest among these companies for D&O insurance remains strong, and so the D&O insurance community will struggle to try to provide appropriate solutions for these kinds of companies.
How Will the D&O Insurers Respond to the Challenging Circumstances?
As the descriptions above show, D&O insurers face a number of significant challenges. Record numbers of securities claims, changing technologies, emerging claims trends, and an evolving legal environment present the insurers with a host of problems and concerns. These issues arise in the context of an insurance marketplace that for years has been characterized by pricing decreases. Years of pricing cuts combined with difficult claims trends has translated into deteriorating underwriting results for many insurers.
Under these circumstances, the insurers – particularly those that are most active in the primary layers – have started to try to push for pricing increases. The question is whether or not the marketplace will support the increases. The problem for carriers is that insurance capacity remains abundant and competition remains vigorous. The push for increases has been more successful in certain industry sectors – for example, life sciences, and high tech — but still largely within the primary layers. In other industries, at the excess levels, and in the private company sector, competition continues to act as a check on rate increases.
It is important to note that during the course of the year, the marketplace has been changing rapidly. Some carriers have reconsidered their underwriting and risk selection guidelines, which has led to a change in appetite for certain classes of business. Other carriers, responding to deterioration in their claims portfolio, have shifted their approach on certain terms and conditions.
The result of the changing pricing environment and evolving underwriting conditions is that it is a very volatile time in the world of D&O insurance. Now more than ever it is important for insurance buyers to enlist the assistance of a skilled and experienced D&O insurance advisor that is immersed in the day to day changes in the insurance marketplace.