Every year after Labor Day, I take a step back to survey the most important current trends and developments in the world of Directors’ and Officers’ liability and insurance. This year’s review is set out below. As the following discussion shows, this is a particularly interesting time in the world of D&O.
How Will the Number of Securities Class Action Lawsuits Filed This Year Compare with Recent Years?
D&O insurers closely follow the statistics on the number of securities class action lawsuit filings. The number of annual filings can provide some indication of the insurers’ loss costs for the calendar year. The current filing patterns can also inform the insurers’ efforts to try to determine the profit-making price for their insurance product.
The fact is that the number of securities suit filings fluctuates. During the 2017-2019 period, the annual number of securities suit filings spiked, with over 400 filings each year, largely due to an increase in the number of federal court class action merger objection lawsuit filings during the period. Beginning in 2020, the number of suit filings began to decline, and the decline accelerated in 2021 and 2022 (largely because the merger objection suits increasingly were being filed as individual actions rather than as class actions). All of which leads to the question of the number of filings that can be expected this year.
Based on the filings during the year’s first eight months, it appears that the number of year-end 2023 will be up compared to the most recent years; as of the end of August, the number of filings is on track for the highest year-end number of filings since 2020. But while the number of filings appears up this year compared to 2021 and 2022, the projected number of filings is slightly below the long-term average number of filings, and is well-below the elevated levels seen during the 2017-2019 period.
According to my tally, there were approximately 147 federal court securities class action lawsuits filed in the first eight months of 2023 (through August 31, 2023), compared to 137 federal court suits filed during the same period in 2022, representing an increase of about 7 percent. (Please note that these figures do not include state court securities class action lawsuit filings.) If the number of filings through the end of August is annualized through year end, the projected number of filings is 220, which would be the highest number of filings since 2020 and would also be close to (but slightly below) the annual average number of filings for the period 1997-2021 of 228.
Several factors are driving the relative increases in the number of filings in 2023. One factor is the impact of several continuing litigation trends, including the numbers of COVID-19 related and SPAC-related securities suits, both of which types of litigation have affected the numbers of filings during the most recent years, even though the impact of both types of filings is diminished this year compared to prior years. There were nine COVID-related securities suit filings in the year’s first eight months (compared to 14 filings in the first eight months of 2022) and nine SPAC-related securities suit filings (compared to 19 SPAC-related filings in the first eight months of 2022). Another recurring theme for the number of filings so far this year is the number of cryptocurrency-related lawsuits; there were 11 cryptocurrency and digital asset-related lawsuits during the first eight months of 2023, compared to 23 for the full year 2022.
Another factor in the number of securities related lawsuit filings so far this year has been the influx of cases related to the Banking Crisis of 2023, which I discuss further in the next section. The banking crisis is itself a reflection of a number of macroeconomic factors, including in particular, rising interest rates. In a separate section below, I discuss the various macroeconomic issues that are affecting companies’ operations and finances, and that are in some cases translating into securities litigation.
While the number of lawsuits filed is an interesting and important statistic, perhaps the more interesting statistic is the number of lawsuits filed relative to the number of U.S.-listed public companies. This ratio provides a litigation rate and measures the overall chance of any given U.S.-listed company experiencing a securities class action lawsuit.
According to Cornerstone Research’s mid-year 2023 securities litigation report (here), the projected year end 2023 litigation rate based on the filings during the year’s first six months was 3.4%, which would be up relative to the year-end 2022 rate of 3.1%, but down relative to the 2021 rate of 4.2% and down compared to the 2009-2022 annual average litigation rate of 4.9%. This is an important consideration when analyzing the implications of the number of securities suit filings this year — that is, that the litigation rate is below long-term averages.
What Next for the “Banking Crisis of 2023”?
Over the course of several weeks from March to early May this year, three large U.S. banks failed in a sequence of events that has come to be known as the Banking Crisis of 2023. Fears arose at the time that the bank failures could become a contagion event across the banking industry. With the passage of time, a general perception emerged that the worst of the crisis may have passed. But while there have been no further failures since May, there are signs that problems remain for at least some banks, and in some cases, these continuing problems have translated into securities lawsuits.
The failures of the three large banks in the spring arose from a combination of the impact of rising interest rates on the valuation of bank bond portfolios; large uninsured deposits; liquidity concerns arising as uninsured deposits fled; and industry concentration, among other things. The three banks that failed were not the only banks subject to one or more of these problems. Swift and aggressive action by the U.S. Treasury and the FDIC in the wake of the SVB failure may have averted a worse crisis. However, while the aggressive regulatory action may have helped the banking industry to dodge a contagion event, it did not necessarily remedy the underlying concerns for many banks.
In recognition of the continuing concerns facing many banks, on August 7, 2023, the ratings firm Moody’s took credit rating action on 27 banks, including downgrading the credit ratings of ten banks, putting others under review, or giving their ratings a negative outlook. The reasons for the firm’s actions included rising deposit costs (as banks are required to pay higher interest rates to attract deposits); and risks to commercial property and construction loans posed by changes to the commercial real estate market brought about by shifts to remote work during the pandemic. The report also cited the diminished value of loans such as fixed-rate mortgages in an era of rising interest rates. The presence of what the report called “whisper networks,” which could trigger sudden outflows of depositions, underlie an increased liquidity risk as well. On August 21, 2023, S&P also took actions similar to those of Moody’s, downgrading or cutting the ratings on a host of banks, for similar reasons.
The way that these types of concerns about the banking industry can translate into securities litigation, even in the absence of a bank failure, is illustrated in the lawsuit filed on August 4, 2023, in the Northern District of Ohio, against KeyCorp, the bank holding company for KeyBank, and certain of its executives. As discussed here, the plaintiff shareholder filed the lawsuit in the wake of declines in Key’s share price after bank executives announced reductions in the company’s earnings guidance, as the bank found itself required to pay higher interest rates to attract deposits. According to the complaint, the announcements triggered analyst and investor concerns about the bank’s liquidity. While the lawsuit has only just been filed and it remains to be seen whether it will prove to be meritorious, the lawsuit’s filing illustrates that, along with the continued questions concerning certain banks’ finances, there is a continuing litigation risk as well.
With the filing of the KeyCorp lawsuit, there have now been a total of the six securities class action lawsuits to be filed this year related to the 2023 banking crisis. (If you include the securities suit filed against Silvergate Bank in December 2022, you could say there have been seven securities suits arising out of the banking crisis). Whether or not there will be more banking crisis-related securities suits filed this year, the banking-related suits are a factor in the overall number of securities suits filed this year.
In the meantime, in the current environment, banks continue to face questions about their interest rate risk; their levels and amounts of uninsured deposits; sector concentration; and significant exposure to a deteriorating commercial real estate marketplace. As the year progresses, the possibilities for further interest rate increases could further exacerbate these issues. And while many economists now think the prospects of a recession in the U.S. economy this year have diminished, if the economy were to slip into a recession, the ensuing economic slowdown could put even further pressure on the performance of some banks’ loan portfolios.
In other words, while the worst of the fears following in the wake of the bank failures earlier this year may have subsided, it could be too early yet to sound the all-clear signal.
What is Next for ESG as a Source of Litigation Risk?
One of the hot button topics for several years has been “ESG” – which is an acronym representing a grab bag of Environmental, Social, and Governance concerns. For some time, many companies have felt pressured by institutional investors and other constituencies to show that they are “good” on ESG (even though there is no consensus on what it actually means to be “good” on ESG). More recently, as the issues surrounding ESG have evolved, companies have found themselves under very different kinds of pressure. The nature and extent of the litigation risk from ESG issues has also changed as well.
Until recently, the working assumption about the D&O risks arising from ESG-related issues is that companies that failed to make a sufficient ESG commitment or failed to sufficiently fulfill stated corporate ESG goals would get hit with corporate and securities lawsuits. And indeed, those kinds of lawsuits have been filed.
As discussed here, in February 2023, Client Earth, a climate change advocacy group and Shell shareholder, filed a filed an action in the English High Court alleging that the board of Shell had breached their duties under the U.K. Companies Act. The gist of the advocacy group’s complaint is that the company’s board had not taken sufficient steps to meeting the company’s emissions reductions targets. As discussed in detail here, in May 2023, the court granted the defendants’ motion to dismiss, holding that the plaintiff had failed to state a prima facie case.
But while ESG-related lawsuits of type originally anticipated have been filed, the real ESG litigation action has been elsewhere. As pressure from activists on other points on the political spectrum has developed, an ESG backlash has emerged, resulting in political and legislative action in some conservative states, and in litigation in other instances as well.
An example of the ESG backlash legislation is the bill Florida governor and Presidential candidate Ron DeSantis signed into law on May 2, 2023, which bars Florida state officials from investing public money to promote environmental, social and governance goals, and prohibiting ESG bond sales. According to an August 17, 2023 memo from the Reed Smith law firm (here), at least 18 states have enacted some form of anti-ESG legislation, with a common theme involving a ban on the use of ESG criteria when managing public retirement systems or public funds. According to the memo, anti-ESG legislation has been introduced in Congress as well.
In addition to this kind of legislative initiative, attorneys general from conservative states have proactively sought to affect corporate conduct in other areas. For example, following the U.S. Supreme Court’s decision at the end of June declaring the use of affirmative action in college admissions to be unconstitutional, the conservative attorneys general (and others) have, in reliance on the court’s decision, targeted corporate diversity, equity, and inclusion (DEI) efforts. Among other things, a group of red states’ attorneys general in July 2023 sent a letter to the CEOs of the Fortune 500 companies “threatening legal consequences” over race-based employment preferences and diversity policies.
The ESG backlash has also resulted in litigation. For example, as discussed here, in June 2023, a plaintiff shareholder filed an ERISA class action lawsuit against the trustees of the American Airlines employee benefit plan, alleging that the plan’s trustees breached their fiduciary duties “by investing millions of dollars of American Airlines employees’ retirement savings with investment managers and investment funds that pursue leftist political agendas through environmental, social and governance (‘ESG’) strategies, proxy voting, and shareholder activism—activities which fail to satisfy these fiduciaries’ statutory duties to maximize financial benefits in the sole interest of the Plan participants.”
Similarly, and as discussed here, in August 2023, an investor acting on behalf of an advocacy group filed a securities lawsuit in the Middle District of Florida against the retailer Target, alleging that the company and certain of its directors and officers “betrayed … investors by making false and misleading statements concerning Target’s Environmental, Social and Governance (ESG) and Diversity, Equity, and Inclusion (DEI) mandates that led to its disastrous children-and-family themed LGBT-Pride campaign.”
While activists and others have proven eager to file these kinds of ESG backlash lawsuits, the plaintiffs’ track record in these kinds of cases so far is poor. For example, in August 2023, the court dismissed the lawsuit that an activist investor filed last year against the board of Starbucks alleging that the directors had breached their fiduciary duties in allowing the company to adopt and implement a diversity, equity, and inclusion program, which, the plaintiff alleged, violated the federal civil rights laws. The federal judge presiding over the case clearly had little patience for the plaintiffs’ arguments, saying (according to Reuters), “If the plaintiff doesn’t want to be invested in ‘woke’ corporate America, perhaps it should seek other investment opportunities rather than wasting this court’s time.”
Similarly, and as discussed in detail here, in July 2023, the Delaware Chancery Court denied the books and records request of an activist shareholder who sought to hold the Disney board liable for the company’s public opposition to Florida’s Don’t Say Gay legislation. The Vice Chancellor rejected the request because the claimant had insufficiently alleged that the board had engaged in wrongdoing, noting, in particular, courts’ general unwillingness to substitute their judgments for those corporate boards.
The bottom line is ESG as a liability risk has developed into a very different issue that it was originally perceived to be. ESG has also come to reflect the political polarization that characterizes many social issues today in American life. Companies themselves increasingly just want to stay out of the cross-fire, as a result of which increasing numbers of companies are resorting to “greenhushing” – that is, taking a much lower profile on ESG-related concerns. The likelihood is that pressures from both sides of the political divide will continue.
As if all of that were not enough, various sustainability and climate change reporting and disclosure requirements are being put into place or readied. On July 31, 2023, the EU Commission adopted its first set of mandatory ESG reporting standards, which, as discussed here, could have a significant impact both within and outside the EU. For its part, the SEC has not yet released the final version of the Climate Change disclosure guidelines the agency first proposed in October 2022, but the final rules are anticipated in October, and, separately, California is considering legislation that would create yet another set of disclosure requirements. The SEC and the California rules, when and if finally adopted, undoubtedly will face legal challenges. However, the adoption of disclosure requirements is likely to further complicate the already fraught topic of ESG. The implementation of the disclosure requirements could also fuel even further ESG-related litigation.
Will Continuing Macroeconomic Concerns Mean Further Litigation?
The impact of rising interest rates clearly is one of the important factors affecting the banking sector, but interest rates are only one of several macroeconomic factors weighing on businesses, affecting their financial performance, and in some cases, giving rise to securities litigation. Other important macro factors businesses are facing include economic inflation; labor supply shortages; supply chain constraints; and the War in Ukraine. Companies encountering operating challenges from these factors have in some instances also been hit with securities lawsuits.
One example of a case in which a company experiencing inflationary pressure in its supply chain drew a securities suit is the lawsuit filed in early March 2023 against the coffee chain Dutch Bros (as discussed here). The complaint alleges that in early 2022, the company made reassuring statements about its ability to continue to prosper in an inflationary environment. However, in announcing a net loss for the first quarter 2022, the CEO said that “margin pressure” had caused the poor financial performance, citing “faster inflation and cost of goods, especially in dairy.” In the same earnings call, the CEO said further that “we did not perceive the speed and the magnitude of cost escalation within the quarter.” The company’s share price declined on the news and a plaintiff shareholder filed the securities suit.
On March 2, 2023, in another example of the impact of economic inflation resulting in a securities lawsuit, the organic foods company United National Foods was hit with a securities suit following the company’s disappointing earnings announcement in which the company disclosed a decline in profitability, despite increasing sales, due to inflationary pressures. Among other things, the plaintiff shareholder alleged in that lawsuit that the company had failed to disclose the constraint on the company’s ability to “respond adequately to cost pressure, such as inflationary pressure.”
Continuing supply chain related issues also have resulted in securities suit filings. For example, as discussed here, in April 2023, the fuel cell company Plug Power was hit with a securities suit after its share price declined following the company’s announcement of disappointing financial results driven in part by supply chain issues. The complaint alleges, among other things, that the defendants misrepresented or failed to disclose that the Company “was unable to effectively manage its supply chain and product manufacturing, resulting in reduced revenues and margins, increased inventory levels, and several large deals being delayed.”
Similarly, as discussed here, in July 2023, the drug and healthcare company Baxter International was sued due to the decline in the company’s share price after the company’s announcement that continuing supply chain woes were setting back its operations and financial results more significantly than the company had anticipated. In its earnings release that triggered the share price decline, the company said that ““ongoing macroeconomic challenges and supply chain headwinds continue to weigh on business performance.” The plaintiff shareholder that filed the lawsuit alleged that the defendants had concealed “conceal the true extent of the supply chain problems affecting Baxter’s financial earnings and operations.”
Another macroeconomic factor weighing on businesses and in some cases leading to securities litigation is labor supply disruption. In January 2023, the vision services and products supplier National Vision was hit with a securities suit after a share price decline following the company’s revelation of its difficulties of hiring and retaining sufficient staff in the wake of business re-openings following pandemic-related business closures. In order to attract and retain sufficient optometrists, the company implemented wage increases, a move that would later impact the company’s reported financial results. The company subsequently reported disappointing financial results, due in part to the increased wage costs. (Obviously, economic inflation was also a macroeconomic factor that contributed to the circumstances that led to the securities suit.)
Other macro factors have also affected some companies and have led to securities litigation. For example, in July 2023, the date storage technology company Seagate Technology Holdings plc was hit with a securities suit that illustrates how growing trade tensions and related trade regulation enforcement can translate into corporate and securities litigation. The securities suit was filed after the company paid a $300 million U.S. Department of Commerce for alleged violations of U.S. trade restrictions relating to the Chinese technology company Huawei.
While the examples above show how companies can experience securities litigation resulting from challenges arising out of macroeconomic factors, these factors affect many companies — but not all companies wind up getting sued. Whether or not these kinds of circumstances lead to D&O claims arguably depends not only on how the company deals with the adverse business conditions but what the company says about how the adverse conditions are affecting the company and its business. Another factor that could contribute to the litigation risk is the extent of a company’s willingness to soft-pedal or downplay the magnitude of the impact on the company from these macro factors.
Continued economic uncertainty, the impact of rising interest rates, and economic inflation, among other factors, seem likely to continue as the year progresses. It is in any event already clear that the constellation of macroeconomic factors will have an important role in the number of securities class action lawsuit to be filed this year.
What is Next for the Risk of Cybersecurity-Related Litigation?
The possibility of a corporate or securities lawsuit arising out of a cybersecurity incident is nothing new – the threat of cybersecurity-related litigation has been a recurring theme for several years now. The litigation threat is continuing; for example, in March 2023, a plaintiff shareholder filed a securities class action lawsuit against pay TV services provide Dish Networks after the company experienced a cybersecurity incident involving its internal communications network, as discussed here.
The plaintiffs’ lawyers have continued to file these cybersecurity-related lawsuits even though the track record for these kinds of claims is particularly good. For example, in March 2023, the court presiding over the securities class action lawsuit pending against cloud-based software company Okta dismissed the cybersecurity incident-related claims from the suit (though the court denied the dismissal motion with respect to other unrelated claims).
The possible future direction and content of cybersecurity incident-related suits may be significantly affected by the new cybersecurity-related disclosure guidelines that the SEC approved in July 2023. As discussed here, the new guidelines are quite detailed; the key features of the guidelines are the requirements that companies (i) disclose material cybersecurity incidents they experience, and also (ii) disclose on an annual basis material information regarding their cybersecurity risk management and governance. The new rules are effective on September 15, 2023, and require disclosures for annual reports on Form 10-K (or the foreign company equivalent) ending on or after December 15, 2023. The rules regarding incident reporting take effect on December 18, 2023.
The new incident disclosure provision requires reporting companies to disclose any cybersecurity incident they determine to be material, within four days of determining the materiality, and to describe the material aspects of the nature and scope of the incident as well as the likely material impact of the incident on the company’s operations and financial condition. The reporting company must determine the materiality of the incident without unreasonable delay following discovery, and if the incident is determined to be material, file a report on Form 8-K within four business days of the determination. The disclosure may be delayed if the U.S. Attorney General determines that immediate disclosure would pose a substantial risk to national security or public safety. The Commission amended Form 6-K to required foreign reporting companies to furnish information on material cybersecurity incidents that they are required to disclose in a foreign jurisdiction to a securities exchange or to security holders.
Under the new rules, reporting companies will be required to disclose in their annual filing their processes for assessing, identifying, and managing material risks from cybersecurity threats, including whether any threats have materially affected or are reasonably likely to materially affect the company. The final rules also require the company to describe the board of directors’ oversight of the risk from cybersecurity threats and the role and expertise of company management in assessing and managing cybersecurity risks. The Rules also provide that foreign issuers will be required to make comparable disclosures on their annual reports.
These new rules could create circumstances that could increase the litigation risk for companies experiencing a cybersecurity incident. For example, after a company suffers a cybersecurity incident, plaintiffs’ lawyers, armed with the knowledge of what kind of incident the company suffered, will go back and scrutinize the company’s disclosure and say that the company did not properly disclose to investors the risk of the specific incident that later took place, or that the company described procedures that were represented as sufficient to prevent the kind of incident that occurred.
Similarly, mandated disclosures concerning board cybersecurity governance practices, particularly with respect to board oversight processes concerning cybersecurity could also contribute to securities litigation. Again, the plaintiffs’ lawyers armed with the benefit of hindsight after an incident has occurred will go back and scrutinize the prior board governance disclosures to try to argue that actual practices differed or omitted disclosures of oversight inadequacies that permitted the incident that occurred.
It will be interesting to see how companies fare grappling with the four-day reporting requirement. To be sure, the four days run only from the date that the company determines that the cyber incident is material. The concern is that the company may be quite sure that an incident is material but not yet be in a position to be able to report all of the specific items the rules require companies to disclose (that is, to describe the material aspects of the incident’s nature, scope, and timing, as well as its material impact or reasonably likely material impact on the reporting company). One can easily imagine a securities suit being filed based on the allegation that the initial, rushed 4-day disclosure was misleading because the incident turns out to have been far different than was initially thought – that is, that it turned out to be much greater in scope, or involving a much longer time-period than initially thought. My fear is the disclosures that the rules require companies to make in a big rush may force companies to have to “go public” before they fully understand the situation, and that plaintiffs’ lawyer will later claim these rushed disclosures were misleading and that the companies deliberately tried to “soft pedal” the description of the incident. Plaintiffs’ lawyers may try to raise arguments about allegedly delayed materiality determinations as well.
Later this fall there could well be a rash of news articles in which it is reported that companies are struggling to get themselves in a position to comply with these new rules, and that companies are finding it very costly and time-consuming to try to put themselves in a position to comply. I also suspect it won’t be too long after the rules go into effect that claims arise after a company suffers a cyber incident alleging that the cybersecurity disclosures were misleading because they failed to warn of the risk of the incident that occurred; or alleging that the companies four-day cybersecurity incident report was misleading because various aspects of the incident turn out on full investigation to be different than was initially disclosed.
Will the SEC’s In-House Courts Withstand Constitutional Challenge?
On June 30, 2023, the U.S. Supreme Court agreed to take up a case to consider the legality of the SEC’s use of in-house administrative tribunals, which the agency uses to enforce the federal securities laws, as discussed here. The agency sought Supreme Court consideration of a federal appellate court ruling that held the administrative courts to be unconstitutional. The case could significantly impact the way in which the agency enforces the federal securities laws.
The case involves hedge-fund operator George Jarkesy. In 2013, the SEC commenced an administrative proceeding against Jarkesy and his advisory firm, Patriot28, based on allegations that Jarkesy and his firm allegedly mismanaged two hedge funds controlling $24 million. In 2014, an ALJ found Jarkesy liable for fraud, ordering him to pay a $300,000 fine and barring him from participating in the securities industry.
Jarkesy filed a separate action in federal court seeking to challenge the SEC’s authority to bring the enforcement action against him before the administrative tribunal. In May 2022, a divided three-judge panel of the Fifth Circuit ruled in Jarkesy’s favor, holding that the administrative courts, as currently constituted and structured, violate the Seventh Amendment’s right to a jury trial. The appellate court also held that the agency’s authority to choose between pursuing enforcement actions in district court or in an administrative tribunal overstepped the limits on Congressional delegation of power. Finally, the appellate court held that Congress violated the separation of powers pertaining to the removal of executive officials. In October 2022, the Fifth Circuit denied the SEC’s petition for en banc rehearing of the case.
In March 2023, the U.S. Justice Department, on the SEC’s behalf, filed a petition to the Supreme Court for a writ of certiorari. In its petition, the agency asked the Court to take up the case to reverse the Fifth Circuit’s decision. The agency argued that the Supreme Court has a history of upholding Congressional laws that establish public rights and in which Congress has provided for the laws’ enforcement through administrative proceedings. The agency argued that the Court has long held these types of proceedings to be consistent with the Seventh Amendment. The agency also argued that the agency’s authority to enforce the federal securities laws either in the district courts or through administrative tribunals does not create violate the constitution, as the choice is purely an executive function and not a legislative power delegated by Congress.
The Supreme Court’s decision to take up the case sets up the court’s consideration of a host of interesting legal issues. From my perspective, the Seventh Amendment question – that is, whether the agency’s use of the administrative tribunals violates the constitutional right to a jury trial – is particularly interesting. The other issues, about delegated authority and separation of powers, are more intricate and technical, but could equally resulting in the Court restricting the agency’s ability to seek financial penalties through its in-house courts.
It remains to be seen how this case will unfold; the case will be argued sometime in the Fall, and it will be decided some time before the end of the Court’s next term, in June 2024. While the case has not even been fully briefed, much less argued, the betting line has to be, at least for now, that the Court will affirm the Fifth Circuit and strike down the agency’s use of the in-house tribunals. The current Supreme Court has shown a willingness to confront the administrative state.
At a minimum, the case will require the court to consider how the SEC will enforce the federal securities laws. The case could have a significant impact on the way that agency pursues enforcement actions against individuals and firms that are accused of violating the federal securities laws. The Court’s opinion could also have a great deal to say about the SEC’s use of its statutory authority and about the agency’s authority’s reach.
Will Breach of the Duty of Oversight Claims Continue to Proliferate?
For many years until quite recently, claims alleging that boards of directors breached their duty of oversight (or what are sometimes called Caremark claims) were considered to be among the most difficult for a plaintiff to bring successfully. However, starting with the Delaware Supreme Court’s 2019 decision in Marchand v. Barnhill, Delaware’s courts have proven to be more receptive to these kinds of claims. It is certainly the case that plaintiffs are filing more claims alleging breach of the duty of oversight; for example, as discussed here, in March 2023, a plaintiff shareholder launched a derivative suit in Delaware Chancery court against certain directors and officers of Meta, alleging that certain directors and officers of Meta, alleging that the executives failed to take sufficient action with respect to allegations that the company’s social media sites were being used for human trafficking.
There have also been recent significant judicial developments with respect to breach of the duty of oversight claims. For example, as discussed here, on January 25, 2023, Delaware Vice Chancellor Travis Laster, in a shareholder claim against the former global head of HR at McDonald’s, held that liability for breach of the duty of oversight, which Delaware courts had previously extended only to corporate directors, can also extend to corporate officers, as well. The practical significance and potential consequences of this decision is reflected in the Meta derivative suit mentioned above; the complaint in the Meta lawsuit names as defendants certain corporate officers, as well as corporate directors, as defendants in the breach of the duty of oversight action.
That is not to say that breach of the duty of oversight claims are no longer difficult for plaintiffs to sustain. Indeed, in the same McDonald’s case mentioned above, Vice Chancellor Laster granted the motion dismissal motion of the company’s directors. Laster held that, notwithstanding significant evidence of board awareness of significant problems with alleged sexual harassment at the company, the plaintiff had failed to present allegations sufficient to show that the board had failed to respond to the allegations.
These considerations matter not only because of the likelihood that plaintiffs’ lawyers will continue to try to pursue breach of the duty of oversight, but also because of disclosure rules changes that the SEC is adopting.
As discussed above, the SEC recently adopted new rules requiring disclosures with respect to cybersecurity incidents and about cybersecurity governance. Among the disclosures the new rules require are disclosures pertaining to board oversight of corporate cybersecurity. Companies must now make periodic disclosures regarding the board’s processes for overseeing cybersecurity. In the aftermath of a cybersecurity incident, prospective claimants may review the prior disclosures to see if the company’s board fulfilled the oversight role described in the disclosures. In short, the new disclosure rules may not only provide ammunition for future misrepresentation claims of the type I described above, but could also support breach of the duty of oversight claims as well.
In addition to the cybersecurity disclosure guidelines, the SEC also has proposed climate change-related disclosure guidelines pending as well. These rules have not yet been finalized and it remains to be seen what the final rules will require. But the climate change rules as proposed also provided for disclosures relating to governance practices, and specifically call for companies to disclose their processes and mechanisms companies use to oversee climate change-related issues. Should the final climate change disclosure rules reflect these kinds of oversight process disclosures, the required disclosures could later help support subsequent breach of the duty of oversight claims.
Will Mega Shareholder Derivative Settlements Continue to Become More Common?
There was a time not long ago when it was an unusual development for the settlement of a shareholder derivative lawsuit to involve a significant cash component. Instead, the cases usually settled for an agreement to adopt corporate therapeutics and the payment of plaintiffs’ attorneys’ fees. In more recent years, it has become more common for derivative suit settlements to include a significant cash component. When it became clear several years ago that these large dollar derivative suit settlements were becoming a thing, I began to track the settlements. My updated chart of the largest derivative suit settlements can be found here. (I strongly caution readers referring to the chart to read the notes and to read the text following the chart, for important context.) It is worth noting that nine of the top ten largest settlements over the last 20 years have taken place just in the last four years alone.
The trend toward shareholder derivative settlements has continued in 2023, as there have been several settlements announced this year that made my largest settlements chart. Two of these settlements seem worthy of mention here.
First, as discussed in detail here, in April 2023, Paramount Global announced the $167.5 million settlement of the derivative lawsuit brought by CBS shareholders in Delaware Chancery Court in connection with CBS’s $30 billion 2019 acquisition of Viacom. (The combined company was known as ViacomCBS, which changed its named to Paramount Global in February 2022.) The CBS/Viacom merger settlement was large enough to make the top ten of the list of largest derivative settlements. The settlement of the CBS shareholders’ action is noteworthy in and of itself, but it takes on even greater significance when considered along with the fact that there was a separate direct action for damages relating to the same merger transaction filed on behalf of Viacom shareholders that settled for $122.5 million (as reflected here). (Because the Viacom shareholder action is a direct and not a derivative action, it does not make the list of largest derivative settlements). The $290 million collective value of the two settlements is impressive milestone of a certain kind.
Second, in what is as far as I know the largest shareholder derivative lawsuit settlement ever as measured by nominal dollar value, the defendant board members in the Tesla Board compensation derivative suit have agreed to settle the case for a combination of payments and transfers with a total stated value of $735 million. The lawsuit alleged that the board had paid themselves “outrageous” compensation in the form of directors pay, stock awards, stock options, and other benefits and bonuses. The complaint alleges that the board “granted themselves millions in excessive compensation and are poised to continue this unrelenting avarice into the indefinite future.” The complaint sought to have the board members disgorge “egregious” stock option awards, reforms to board compensation practices, and a declaration that the defendants had breached their fiduciary duties to Tesla and its stockholders.
The Tesla settlement is interesting not only because of its sheer size, but also because the defendant directors agreed as individuals to return massive amounts of cash, stock, and options they were awarded as compensation for board service. Not only that, the compensation was awarded during a time when Tesla’s stock value rose massively. If the directors did well during that time, well, so did the Tesla shareholders, even if the directors’ compensation was out of proportion to amounts that directors were or are paid at other corporations.
I know that there will be observers and commentators who will quibble about how the Tesla settlement properly should be valued and about whether the settlement actually has the same value to Tesla’s treasury as the nominal cash value of the settlement. These objections notwithstanding, the fact is that the settlement is massive, and it represents a whole new standard for measuring shareholder derivative settlements. To make sure the point is not lost, it should be emphasized that even though the Tesla settlement does not involve the payment of any D&O insurance dollars, a settlement of that size could have an impact on future settlements – which could in turn cause the expenditure of D&O dollars. The two recent settlements, and in particular, the Tesla settlement, underscore how much things have changed since the days when derivative suit settlements rarely involved the payment of significant cash amounts.
What is Next for the D&O Insurance Market?
From late 2018 through the end of 2021, the D&O insurance marketplace was in a so-called “hard” market, meaning that most buyers saw their D&O insurance premiums increase significantly. Some D&O insurance risks were “hard to place,” meaning that the insurance was available for those companies, if at all, only at a very high cost and subject to very large self-insured retentions. The hard market pricing environment attracted new capital and new participants. The presence of the new market participants started to have a significant effect in 2022, as competition returned to the marketplace. Many buyers saw the overall pricing for their D&O insurance decline, at least relative to the higher pricing that prevailed during the hard market.
The more competitive conditions have continued in 2023. Many buyers are continuing to see reductions in the cost of their D&O insurance, particularly with respect to excess layers of insurance. Of course, there are certain buyers who are continuing to see more elevated pricing (such as financially troubled companies or companies with a poor claims history), but many other buyers are seeing price decreases, in some cases significant price decreases. The more competitive price environment is in effect throughout the D&O insurance marketplace, including with respect to private company D&O insurance.
Insurance is a cyclical business and it is always difficult to project in advance when the insurance market will move into the next phase of the cycle. There are some commentators in the D&O insurance arena expressing concern that the more recent price decreases have fallen below risk-based pricing levels; these same commentators are suggesting that there could be a pricing correction ahead for D&O insurance. What the future may bring remains to be seen. For now, at least, competitive conditions remain in effect and it remains a more favorable pricing environment for policyholders than in the recent past.