One of the most important director and officer litigation risks is the possibility of a shareholder derivative lawsuit. In the following guest post Sam Vardy and Carey Lynn take an overview of derivative suits and discuss some of the important D&O coverage issues the cases present. Sam is a lawyer and Divisional Director, and Carey is a lawyer and Managing Director, in the Financial Lines division of Howden. A version of this article was published previously on the Howden website. I would like to thank Sam and Carey for allowing me to publish their article as a guest post on this site. I welcome guest post submissions from responsible authors on topics of interest to this site’s readers. Please contact me directly if you would like to submit a guest post. Here is Sam and Carey’s article.
In an era of shareholder activism, Derivative Claims are on the increase. Whereas such suits may previously have been considered the preserve of the US and likely to settle on the basis of a change of conduct, more recent years have seen a well-publicised action in the English Courts (more on that, below) and hundred million dollar plus settlements over the Atlantic[i]. In this article, we consider the protection a D&O policy can provide to directors and a company facing a derivative suit, much of which is often contained outside of the main insuring clauses.
What is a Derivative Claim?
A derivative claim is a mechanism by which shareholders can bring an action against company directors for alleged actual or potential breach of duty[ii]. Whilst most publicity focuses on public company claims, it is a weapon equally available to shareholders in private companies.
In a securities suit[iii], the claim is made directly by shareholders against directors, usually follows a drop in share price, and will also usually be made against the company. In a derivative action, by contrast, the claim is brought on behalf of the company against directors, as it is the company that has suffered the harm. Shareholders bring the litigation (which is “derivative” of the company’s claim) where they consider the company should commence proceedings but has not.
An Upwards Trend
With, in some respects, a limited barrier to entry for commencing derivative suits, they have become a popular mechanism for shareholders. In particular, activists seeking change or institutional investors pursuing corporate social responsibility agendas have increasingly turned to derivative actions. The fact that only a small shareholding is required makes derivative suits attractive for those seeking to hold large corporations and their directors to account.
In that context, the subject matter of derivative actions is unsurprising. As ever, the US has been a hotbed of new theories of litigation. There have been several actions against directors seeking to improve diversity on boards, although none have succeeded to date[iv]. Environmental based suits have started to emerge, and equally inevitably, we are starting to see these themes in UK cases. Importantly, good old dissatisfaction with the management of the company and return on investment still provide a steady stream of cases.
Focus on the environment – damned if you do…
Climate change and environmental litigation has multiple forms – some more expected than others. Client Earth and others pursuing a climate change agenda is perhaps the more intuitive, and “greenwashing” type claims against companies that have set targets for improvement and (allegedly) failed to meet those aspirations[v] are also common.
On the other side of the fence, many US states have adopted anti-ESG legislation[vi] that promotes financial returns over environmental concerns. Directors seeking to balance competing interests and agendas of their different shareholders may soon find themselves facing claims if alleged to have sacrificed financial gain for environmental policies.
The most notable English case is Client Earth’s attempt to pursue directors of Shell for alleged breaches of duty relating to climate change policy. Client Earth established a minority interest in Shell in order to attempt to bring the claim. The High Court halted progress of the claim at an early stage, but Client Earth has appealed, with the outcome eagerly anticipated.
In the Depths of the D&O Cover
From initial shareholder dissatisfaction to final judgment or settlement, the derivative claims process consists of a number of (potentially expensive) phases. So how can a D&O policy assist?
The most obvious source of cost is directors defending claims, and paying any judgments against or settlements agreed by defendant directors. The very essence of the D&O policy is to provide a defence to claims, and so coverage for these will be found in the main insuring clauses – don’t forget insurer consent!
There are, however, many more ways in which costs can be spent on derivative claims, and coverage for these is more likely found in the weeds of the extensions. The names of the extensions can vary, but typical labels and what they cover is as follows:
1. Derivative Demand Costs – before commencing a Derivative Claim, shareholders may petition the company to start a claim against directors directly. The Company will need to review that demand and likely take legal advice on the merit of acceding to shareholders’ requests. A Special Litigation Committee (“SLC”) of independent individuals may be formed to assess the demand. Legal costs are unavoidable.
2. Director investigation costs – on the other side of the demand, the company or SLC may interview directors to help with their assessment of the demand’s merits. Directors will require legal advice and representation at these interviews.
3. Nominal Defendant Costs – although the claim is on behalf of the Company, the Company itself may be named as a nominal defendant, requiring some defence cost spend.
4. Costs of Shareholder – the Court may order that the Company pay the legal costs of the shareholder in bringing the claim[vii]. These are not “Defence Costs” and so require coverage from an extension.
5. Books and records costs – whilst there is (as yet) no equivalent procedure in the UK, shareholders in Delaware companies are using rights to obtain copies of company records as a way of identifying or reinforcing claims. An extension available in the market for some time now covers the costs of complying with such requests, and we wait to see whether equivalent procedures will be established and utilised in other jurisdictions.
Plainly, the lesson here is to review your policy and ensure you have what you need.
Are Limits Adequate?
Having all the policy bells and whistles in place is of limited use if the amount of cover is severely restricted financially. So, what are the considerations here?
Director defence, judgment and settlement costs will be covered via the main insuring clause, and so not subject to any sub-limits. That said, a derivative claim will almost certainly be Side A or non-indemnifiable loss in D&O terms for any damages, as the directors cannot have the benefit of a company indemnity for a claim, effectively, by the company. If insurance limits run out in the event of a large damages award, directors will be personally liable. That emphasises the need to ensure limits meet needs, including any specific cover for Side A/non-indemnifiable loss only.
The additional extensions in play may be subject to a sub-limit. How can you ensure they meet your needs? Work with your legal department to consider the potential costs for each phase, and with your broker to ensure you are pushing the sub-limits in the appropriate areas.
[i] See US$700m plus settlement, Tesla-settlement.pdf (dandodiary.com), US$167m settlement (Paramount Gets $167 Million Settlement In CBS Shareholder Lawsuit – Deadline) and US$124m settlement (Summary Notice to Stockholders of Cardinal Health, Inc. of Proposed Settlement of Stockholder Derivative Action, Settlement Hearing, and Right to Appear – Jul 22, 2022)
[ii] Under the Companies Act 2006 – section 260-269 in the UK.
[iii] Under Financial Services and Markets Act 2000 – section 90 in the UK.
[v] See, for example, Enviva Inc. – Complaint (00522532-2).DOCX (climatecasechart.com) – a Securities Class action alleging environmental based statements were misleading.
[vi] See, for example, Republican Candidate Ron DeSantis’s statement on proposed Florida legislation Governor Ron DeSantis Announces Initiatives to Protect Floridians from ESG Financial Fraud (flgov.com)
[vii] See 19.19 of the Civil Procedure Rules applying to the English Court.