Readers of this blog have no doubt followed both the recent ongoing controversy over whether companies should leave Delaware for supposedly friendlier jurisdictions as well as the legislation recently introduced in the state’s General Assembly to try to address some of the legal concerns behind the leaving Delaware initiative. In the following guest post, and in the context of these issues, John McCarrick, a partner at the Robinson & Cole law firm in New York, takes a look at recurring Delaware issues that in his view are of significant concern to D&O insurers. I would like to thank John for allowing me to publish his 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 John’s article.
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Over the past several weeks, followers of the Delaware Chancery Court have watched with great interest the unfolding drama over the role the Chancery Court has played in managing corporate and fiduciary behavior through Chancery Court litigation, the reactions of several high-profile public companies taking steps to reincorporate in other states in response to perceived unfairness in Chancery Court decisions and, most recently, the stated intent of the new Delaware governor and the Delaware legislature to mitigate the risk of further re-incorporations of Delaware companies in other states.
Although the hard-fought litigation battles in Chancery Court are the province of the law firms and their clients whose claim and defense interests are at stake, the economic costs of such litigation – and particularly litigation involving corporate directors and officers – meaningfully impact the bottom lines of the D&O insurers that insure the corporate defendants and their directors and officers whose financial interests are at stake in Chancery Court litigation.
This post is not intended to advocate for any particular change in Delaware law or judicial approach by the Chancery Court, but instead is intended to flag the recurring issues and frustrations D&O insurers experience insuring D&O Chancery Court litigation under the current system.
Hybrid Direct/Derivative Actions, A recurring issue for D&O insurers involves D&O litigation over whether challenges to corporate mergers should be treated as direct or derivative actions. In a number of cases, the Chancery Court has allowed hybrid direct/derivative actions to proceed by way of a single complaint, often deferring until the conclusion of fact discovery whether the case should be considered a direct or derivative action. In this situation, a single plaintiff law firm (or consortium) of plaintiff law firms purport to bring the case on behalf of the corporation (in a derivative capacity) and simultaneously on behalf of a proposed plaintiff class of shareholders.
In virtually any other context, the conflict created by the simultaneous representation of the corporation (derivatively) and its shareholders (directly) – particularly where each party is seeking to recover from the same settlement or judgment pool of monies – would not be permitted, but it apparently is a permitted practice in Delaware Chancery Court.
This representation anomaly creates multiple issues for D&O insurers. Given that derivative settlements are unindemnifiable under Delaware law, D&O insurers cannot assess whether their coverage obligations for a settlement lie under Side A coverage (available exclusively for unindemnifiable loss) or Sides B or C (available for all loss). Given the existence of separate Side A policies that respond only to non-indemnifiable loss, this uncertainty does not simply require D&O insurers to reclassify payments from one insuring agreement to another. This problem is compounded by so-called “priority of payments” provisions in public company D&O policies, which require D&O insurers to pay Side A loss before paying indemnifiable D&O loss (Side B) or entity securities coverage loss (Side C). Absent receiving any clarity from the Chancery Court as to whether an action should be deemed a direct or derivative action, D&O insurers are expected to enter settlement negotiations without knowing which insuring agreement(s) of their policies are triggered – or whether their Side A policies will be triggered at all.
Also, in these cases, when the issue of whether the available remedy is direct or derivative, it is generally within the discretion of plaintiffs’ counsel to decide whether settlement funds should be applied to the derivative portion of their claim (payable to the company) or to the direct portion of the claim (payable to the shareholder class). In practice, in the context of a motion seeking settlement approval by the court, absent an objection from a represented party, the Chancery Court does not make an independent decision as to which plaintiff(s) the settlement proceeds should be distributed, and so the decision is left up to the plaintiff’s counsel to choose one client or the other to receive the payment.
In fairness to the Chancery Court, the ability of a plaintiff to obtain both direct and derivative relief in a single complaint is the result of the Delaware Supreme Court’s 2021 decision in Brookfield Asset Management v. Rosson and is not a creation of the Chancery Court. However, the regular unwillingness of the Chancery Court to address the conflict issue when it is fixing an equitable remedy is unhelpful to D&O insurers seeking to understand if and how D&O insurance should apply to such a claim at the time of settlement.
Caremark Claims. A Caremark claim in Delaware is a claim that a corporate officer or director breached the fiduciary duty of loyalty by failing to oversee the company (e.g., by consciously disregarding the law or failing to implement an effective compliance system). But why is a Caremark claim – a common law creation of the Chancery Court – treated as a breach of the fiduciary duty of loyalty, and not a breach of the duty of care? While it is true that typical duty of loyalty cases involve self-dealing or use of corporate opportunities for personal gain, the catch-all “failing to act when there is a duty to act” element seems to cross lanes with the kinds of conduct generally considered to be within the fiduciary duty of care.
Moreover, if the rationale for framing a Caremark breach of fiduciary duty claim as a duty of loyalty breach is to avoid allowing the directors and officers to invoke the exculpation protections available with respect to duty of care claims, isn’t that concern addressed by the high pleading standard supposedly attaching to Caremark claims, which the Chancery Court has repeatedly stated “is possibly the most difficult theory in corporation law upon which a plaintiff might hope to win judgment?” In other words, doesn’t the high pleading bar necessary for a Caremark claim to survive by itself negate the chance that recovery on a Caremark claim could ever be the subject of duty of care exculpation? If so, what is the compelling rationale for treating a Caremark claim as a breach of fiduciary duty of loyalty claim? A statutory clarification of this point would reassure defendants that this treatment is not simply an arbitrary “thumb on the scale” imposed by the Chancery Court.
Corporate Indemnification for Derivative Settlements. It’s interesting that this topic does not appear to be on the to-do list for the Delaware legislature if its goal is to ensure that other states are not more attractive than Delaware for incorporated companies. As of today, there are nine states – led by Texas and Nevada (the two states that currently are the most talked-about destinations of Delaware reincorporation efforts) – that allow for indemnification of derivative settlements. Eight other states (including neighboring New Jersey and Pennsylvania) permit indemnification for both settlements and judgments in derivative case.
The stated rationale for refusing to allow indemnification of derivative settlements in Delaware is the so-called “circularity” issue: avoiding a result where the company indemnifies directors for a settlement the directors are obligated to pay to the company. On one level, that rationale makes sense. But as a practical matter, the effect of the indemnification prohibition is that every Delaware derivative case that survives a motion to dismiss poses personal financial exposure risk to directors, creating a heightened incentive for those directors to agree to any settlement – however unreasonable in amount – that allows the settlement to be funded by D&O insurance. Regular readers of The D&O Diary have watched derivative settlements balloon in size over the past twenty years, highly correlated with available Side A D&O insurance limits.
It is now a regular feature of derivative settlement negotiations that plaintiff law firms begin negotiations with a demand that the defendant directors contribute out of their own pockets beyond D&O insurance limits as an in terrorem negotiating tactic. The availability of this tactic – enabled by Delaware’s prohibition on indemnifying derivative settlements — creates a significant personal financial disincentive for derivative litigation defendants to take these cases to trial, further incentivizing the plaintiff law firms to push for higher and higher settlements.
It would be interesting to see whether there’s any data suggesting that the current Delaware prohibition on indemnifying derivative settlements has yielded better behavior by director defendants. If not, it’s unclear how the indemnification prohibition promotes better corporate outcomes. On the other hand, the indemnification prohibition leads to higher insured Delaware derivative settlements while costing Delaware companies more in Side A D&O insurance premiums.
Proposed Legislative Curbs to Plaintiff Attorneys’ Fees. Media reports and press releases suggest that in addition to legislative efforts to overall judicial scrutiny of controller transactions and books & records demands, there are efforts to curb the fees awarded to successful plaintiff law firms as a leading goal of a Delaware legislative effort. Without suggesting sympathy for the plaintiff firms, it seems as though there’s an argument that high plaintiff fee awards are downstream from the real problem: a structure that incentivizes high settlements achieved through in terrorem negotiating tactics when the process should encourage trials of Chancery Court cases – especially because the Chancery Court rules discourage the filing of summary judgment motions as a means of resolving or trimming cases before trial. The use of bench trials and the legal sophistication of the Delaware Chancellor and Vice-Chancellors arguably mitigate the risk of an inflamed jury verdict and the development of enhanced jurisprudence around corporate liability issues. So it’s a fair question whether the current system in Chancery Court promotes demonstrably better corporate governance or just higher settlements and attendant plaintiff attorneys’ fees.
Final Thoughts. One could make the argument that for newly formed companies, being incorporated in Delaware confers a kind of imprimatur of quality and consistency that new companies seek to convey to their shareholders and trading partners. For these companies, the advantages of being incorporated in Delaware are self-evident. As companies mature, however, and undertake more sophisticated transactions, including mergers, controller-influenced transactions and other activities that are not being considered by new or less mature companies, these mature companies no longer need the Delaware imprimatur to attract investors and trading partners, and instead begin to perceive the developed Chancery Court jurisprudence as imposing increasingly constrictive leashes on the companies’ ability to take advantage of complex or creative business opportunities.
The challenge for Delaware in retaining its status as an incorporation destination likely won’t impact the new or immature companies incorporated there. More mature companies, however, will have the ability to consider whether to reincorporate in other states to take advantage of non-Delaware corporate law regimes. The question for Delaware will be what it can offer those more mature companies to stay put.
[John F. McCarrick is a partner at Robinson & Cole LLP in New York, The views expressed in this post are those of the author alone and are not the views of Robinson & Cole LLP, its other lawyers or any client of the Firm.]