alansmall[1]In the following guest post, Alan Borst of Willie Borst ADR takes a look at the new and perhaps unappreciated exposures and risks posed by cyber counter-measures. Alan also explores the potential insurance issues related to these activities. 

I would like to thank Alan for his willingness to publish his post on this site. I welcome guest post contributions from responsible authors on topics of interest to readers of this blog. Anyone interested in publishing a guest post should contact me directly. Here is Alan’s guest post: 

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Practitioners of the roughly ten-year old and rapidly expanding area of cyber liability insurance coverage should be startled at the recent surge in activity both in new offerings –a leading national carrier’s inclusion of bodily injury and property damage coverage — growing penetration of the market[i], and well publicized “events”.  The events get the most public press, of course, and as such have the biggest impact on the insurance industry. 

 

Cyber victims take the offense – Up to now the scholarly reporting and insurance discussion has focused on the victims of data security and privacy events, but recently the focus has shifted to law enforcement, and to the role of private security firms in developing increasingly sophisticated countermeasures.  Just as the well-publicized pre-holiday hacking of the retail industry put a damper on an otherwise growing business in 2013, we should all take heart that our Justice Department has not been completely asleep and has scored a moral if not final victory over the Grinch-like community of hackers by “killing” at least one ransomware program, “Cryptolocker” in June of 2014.  Here[ii].   The cited New York Times article takes a cautionary look at the emergence of cyber vigilantism in the lutte internationalle against cyber-terrorism, of which cyber extortion is only the most conspicuous form.  The author, Ian Urbana, posits:

 

In response, more companies are resorting to countermeasures like planting false information on their own servers to mislead data thieves, patrolling online forums to watch for stolen information and creating “honey pot” servers that gather information about the intruders.  Last year, companies also spent roughly $1.3 billion on insurance to help cover expenses associated with data theft.  (emphasis supplied)

 

If we are now in the Wild West of cyber warfare it seems to be generally accepted that victims of data theft can and do follow and retrieve stolen data wherever it leads them.  Acting through their forensic teams, and in collaboration with law enforcement agencies, Federal law may even protect such counter-hacking activity.  The law is apparently not clear, in this regard however,[iii]  so at least in theory innocent third parties may be at risk of being hacked by a victim whether or not they have participated in the original hacking event, whether they are in possession of stolen data, or indeed whether a hacking event has occurred at all.   Cyber insureds who believe they have been attacked generally have a year to conduct an investigation into a reported data security or privacy event and cyber policies do not specifically provide coverage for intentional hacking of third party servers (nor do they exclude it).  Insureds who conduct such countermeasures may themselves be in violation of the Computer Fraud and Abuse Act or other state and federal regulations.

 

Insurance implications – Will the current group of insurance policy forms protect the insured – as sometimes expanded to include “information holders”– in this new offensive role as a “hacker-in-pursuit”, or only in the defensive role of “hackee”/ victim?   The cited article refers to a law school professor’s paradigm of protecting innocent third parties –“Aunt Sally[iv]”– from possible loss and uncertainty as the result of the reckless pursuit of hackers and their methods.  In the case of “Aunt Sally v. Your Insured” is there coverage under your cyber policy?  Is Aunt Sally an insured (if so, the Insured v. Insured exclusion may apply)?   And is there an Aunt Sally exclusion?  Probably not.  The answer to these questions is: consult your insurance broker or qualified independent risk management consultant, read your policy provisions, then go back to the broker/consultant, again.  You may decide that the risk of third party liability from the pursuit of the cyber suspects outweighs the potential reward of finding the source of any given hacking event.  Keep in mind that first party cyber coverage is triggered by an actual occurrence or the reasonable belief by the insured and insurer that a breach has occurred.  The carrier should clearly be on board with the decision to go after hackers or to knowingly transmitting malware.

 

Any coverage for affirmative hacking activity would have to fall within the definition of “Loss”, but the categories are quite broad and include crisis management with the goal of minimizing harm and restoring public confidence in the insured.  Coverage is generally afforded for both the receipt and the transmission of malicious code.  At least one policy from a major carrier provides coverage for “any other services approved by the Insurer at the Insurer’s sole discretion”[v].   If the policy would cover the insured’s expenses from an inadvertent transmission of the malware, why would it not cover deliberate transmission of malware designed to stop future attacks or mitigate their impact.   Depending on the particular attack and role of the insured in potential future attacks, I would think that various “sting” operations could be approved or maybe even encouraged by sophisticated carriers with a long term view of the exposure.  Ultimately, insurance carriers and their accumulation / clash reinsurers have an interest in the systemic risk component of almost all modern forms of cyber security.  That means catching the bad guys, if that is what it takes to restore public confidence in the insured.

 

What if the insured gets caught up on the wrong side of a lawsuit alleging deliberate hacking or other counter-measure?  As a first cut of the issue, I submit that most policy forms I have reviewed exclude coverage for intentional and criminal acts, and (more broadly) for loss “arising, based upon, or attributable” to such acts.  Wisely, the policies have carve-backs of coverage for claim expenses up to the point of an adverse adjudication, arbitral award, etc. adverse to the insured.  So if the insured company has negligently caused harm to a third party as the result of countermeasures from a reported hacking attack, the third party cyber coverage should respond.  Nevertheless, if the counter-hacking is sufficiently unrelated to a reported hacking event, and not sanctioned by the authorities or consented to by the carrier, one could easily see a situation where the alleged victim is in fact a perpetrator, with the consequent forfeiture of coverage (including the advanced expenses).  First party cyber insurance covers loss to the insured itself as the result of a data breach.  That coverage essentially protects the insured’s data residing on its own servers, or those of independent contractors.  But this protection would not extend to third parties whose data and systems might be harmed.  Cyber coverage may further expand to anticipate this exposure more directly.  In the meantime, the current policies do exclude coverage for seizure, confiscation, nationalization or destruction of a computer system by order of a government or public authority, so it is clearly advisable for insured’s not to take the law into their own hands.

 

Protecting Aunt Sally – Of the particular acts of counter-hacking it seems to me the one with the biggest threat to insurance coverage and public safety is the deliberate planting of false information in order to catch a thief or thwart attempts at hacking.  Using lawyers and outside information holders as accomplices in this subterfuge adds another layer of complexity and uncertainty to this questionably prudent practice.  If an innocent third party relies on or executes a deliberately falsified construction or manufacturing plan, resulting in property damage or bodily injury, it may not be an argument for coverage or defense to the suit itself that the insured was trying to catch a bad guy.  (Or bad gal).  Risk managers and their insurers may be faced with ethical issues in the course of investigating and reporting both routine and unusual cyber threats and creating resilient defenses.

 

As indicated by a previous post and in the Wall Street Journal here[vi], medical records have apparently become the hackers preferred booty in the data piracy sea.  If the counter-measure to catch medical record pirates is to plant false medical records on health industry servers, it is not hard to see where serious medical liability exposure might result.  Assume the original act of medical record hacking is covered by cyber coverage; will the forensic or other coverage parts extend to such counter-measures?  Could insurers who sanction such measures become exposed to the consequences?  I am not sure that insurers will necessarily be leading the attack in these murky waters, but neither will they be putting up coverage obstacles to legitimate countermeasures which are sufficiently related to a reported, covered hacking event.  Ultimately, it will be the tech community in close cooperation with insurers, government agencies (the FBI and state and local law enforcement) and the insured who should be make this call when and by what means to take the offensive. 

 

We have clearly reached the point where privacy liability and network security insurance is an indispensable part or every organization’s enterprise risk management.  The insurance is as valuable for the continual assessment and re-assessment of vulnerabilities, and access to independent forensics, as it is for regulatory and civil liability expense reduction.  What is more, applying advanced metrics to the flow of data security breaches helps to differentiate and prioritize them.  Hackers have become sophisticated about covering their tracks, using “watering hole” techniques to troll unsuspecting third parties for data over a period of time until they find something of substantial value.  Russian hackers have apparently infected websites that their targets visit often – like an on-line Chinese restaurant—with malicious software and have broken into networks of industrial control software, or I.C.S, so that when users download the latest version of the software, they also download the hacker’s malware as well.  The Chinese Army that stole data from military contractors often hid their attack software in e-mailed invitations to golfing events.  When hackers use these techniques they are exploiting the relatively weak defenses of the Aunt Sallys to penetrate the otherwise robust defenses of their intended targets.  The harm to the occasional Aunt Sally server –the Chinese restaurant or golfing event –seems an inevitable social cost of maintaining network security. So reporting minor system breaches both to law enforcement and insurers serves a useful purpose in preventing and mitigating the cost of more serious breaches.  The data thus obtained can be used by cyber defenders and governments to develop permanently improved and standardized methods.  It is all part of the world wide effort to avoid “cybergeddon” – a systemic risk of internet failure.  The World Economic Forum has studied the risk in detail as well as insurers’ role in the measurement of global cyber risks here[vii].

 

By counterattacking –setting up “honeypot” servers, bogus data banks, or a Maze[viii]—cyber-insured companies and their employees, directors and officers may at best slow down the hackers and make their work more costly, but may also face the potential risk of themselves violating the CFAA and, if so adjudicated, losing their valuable cyber coverage for economic loss, including bodily injury or property damage.

 

It has been said that “War is hell” and cyber war should be no different, I suppose.   To prevent crime and loss of internet utility, our insureds have to adopt strong countermeasures and robust security, but insurers and risk managers will need to help define where the line is to be drawn between protecting data and systems, and deliberately breaching or corrupting them in an effort to identify hackers.

 

 

Alan is an attorney at law in New York, providing professional liability claims advocacy and mediation services at Willie Borst ADR.  He has over 20 years’ experience in D&O as Vice President, Sr. Account Manager of XL Reinsurance America, a Director Complex claims AIG Domestic Claims, and most recently as a consultant with Corporate Risk Solutions, LLC. (www.crslimited.com).   

 

ENDNOTES

[i]Business Insurance, “Purchase of cyber insurance policies on the rise: Marsh”, March 31, 2014.

[ii] “Hacker Tactic: Holding Data Hostage,” NYT 6/22/2014, pg. D4).

[iii] 18 U.S.C. § 1030(f) – Fraud and related activity in connection with computers provides:

 (f) This section does not prohibit any lawfully authorized investigative, protective, or intelligence activity of a law enforcement agency of the United States, a State, or a political subdivision of a State, or of an intelligence agency of the United States.

There is no statutory immunity for civilians under the act, but one would assume that if the original hacking event was reported to the state or federal authorities, any countermeasures taken in connection with “investigative, protective, or intelligence activity” should be immune from federal prosecution under the CFAA.  While management may be protected from criminal prosecution in its anti-hacking activity, this may not protect it from civil liability or derivative exposure from an anti-hacking event.  See In re Caremark International Inc. Derivative Litigation, 698 A.2d 959 (Del. Ch. 1996).  If directors know of an illegal anti-hacking measure, fail to prevent it, and the counter measure proximately causes damage to the company, they could arguably face liability under Caremark.

[iv] As described by professor Orin S. Kerr from George Washington Law School, ”it is like a blindfolded partygoer trying to hit a piñata with a baseball bat.  He might hit Aunt Sally who happens to be nearby.”

[v] Security Failure/Privacy Event Management Insurance, Definition (h) “Loss” Chartis 101018 (11/09).

[vi] What Are the Bad Guys Up to Now?  Hacking Health Care Records, Apparently (D and O diary 2/19/2014).

[vii] World Economic Forum, Global Risks 2014 at section 2.4.

[viii] CloudFlare has developed a service called Maze which is “a virtual labyrinth of gibberish and gobbledygook”.

 

gavel2013

The number of securities class action lawsuit filings during the first half of 2014 was slightly above the number of filings in the first half of 2013. On an annualized basis this year’s filings are consistent with the full year filing figures for 2012 and 2013, though well below longer term historical averages.

 

During the first half of 2014, there were 78 new securities class action lawsuit filings, compared to 74 in the first half of 2013. The 78 filings in this year’s first half annualizes to a full year number of filings of 156. This annualized figure is slightly below the 2013  year-end total of 166, but is slightly above the 2012 year-end total of 152. However, the projected 2014 year end total of 156 would be well below the annual average number of filings of 192 during the period 1997 to 2012.

 

The relatively lower number of filings in recent years compared to longer term averages has led some commentators to suggest that securities class action lawsuit filings are down. There is no doubt that in terms of absolute numbers of lawsuit filings, the numbers of filings are down. The 156 projected number of filings for 2014 would be about 18% below the 1997 to 2012 average number of filings, and about 31% below the number of filings in 2004, when there were 228 securities class action lawsuit filings.

 

But while the number of lawsuit filings unquestionably is down, the rate of lawsuit filings relative to the number of publicly traded companies is more or less unchanged. Thus, for example, in 2004, while there were 228 securities class action lawsuit filings, there were also 6,097 publicly traded companies at year’s end, implying an overall securities suit filing rate of 3.74%. At the end of 2013 there were only 4,972 publicly traded companies. I don’t have the updated figure for 2014, but the 2013 year end number of publicly traded companies and the projected number of 2014 filings, the projected filing rate is about 3.17%.

 

According to Cornerstone Research, the 1997-2012 average annual filing rate was about 2.85%.In other words, while the absolute number of lawsuit filings is down compared to long term annual filing averages, the current rate of securities class action lawsuit filings relative to the number of publicly traded companies is actually up compared to longer term filing rates. Please keep this in mind when you see reports in the mainstream media based only on the absolute numbers of filings suggesting that securities suits are down.

 

The securities lawsuits filed in the year’s first half involved companies in a broad variety of industries. The companies named as defendants in the lawsuits represented 51 different SIC Code categories. The largest number of first half filings involved companies in the life sciences industries. There were a total of 14 lawsuits against companies in Industry Group 283 (Drugs) and Industry Group 384 (Surgical, Medical and Dental Instruments), representing about 18% of all first half filings. There were also a total of seven lawsuits against companies in Industry Group 737 (Computer Programming and Data Processing), representing about 9% of securities suit filings in the year’s first six months.

 

The securities lawsuits in the first half of 2014 were filed in a total of 28 different federal district courts, but many of the filings were concentrated in just a few courts. There were 22 securities lawsuit filings in the S.D.N.Y., representing about more than a third (35%) of all first half filings. There were also nine filings in the N.D. Cal., representing another 11.5% of first half filings. Other district courts with a larger number of filings included D.N.J, which had five, and the S.D. Tex., which had four.

 

One feature of securities class action litigation in recent years has been the number of securities suit filings involving companies domiciled outside the United States. During the first half of 2014, there were a total of nine lawsuit filings involving non-U.S. companies, representing about 11.5% of all first half filings. (Please note that I included the “Flash Boys”/High Frequency Trading securities lawsuit in this tally, as many – though not all – of the defendants in the lawsuit are based outside the U.S.). By way of comparison, in 2013, about 15% of all securities suit filings involved non-U.S. companies. Non-U.S. companies represented about 16% of all companies listed on U.S. exchanges.

 

Another significant feature of corporate and securities litigation in recent years has been the growing numbers of lawsuits arising out of mergers and acquisitions activity. Most of these lawsuits are filed in state courts. However, during the first half of 2014 there were a number of these lawsuits filed in federal courts, generally alleging that the merger-related proxy disclosures were deficient in violation of Section 14 or other provisions of the federal securities laws. In the year’s first half, there were nine merger-related lawsuit filings, representing about 11.5% of the filings during that period.

 

Two other aspects of securities lawsuit filings that I have previously noted are the number of filings involving IPO companies and the number of lawsuits filed in the wake of regulatory investigations. Five of the first half securities suit filings (about 6.4%) involved allegations of misrepresentations in connection with the defendant companies’ initial public offerings. Eleven of the first half filings (or about 14%) involved companies that had announced that they were the subject of regulatory investigations.

 

One interesting note about the first half filings is that there were at least three new lawsuits in which the defendant company had been using the services of a public relations firm known as the Dream Team. The three lawsuit involved Galena Biopharma (here); Cytrx Corporation (here); and InterCloud Systems (here). The allegations in the three cases are similar. For example, the CytRx and Galena cases refer to a March 15, 2014 Barron’s article discussing the two companies and stating that Seeking Alpha and other publications removed from their sites articles about CytRx and Galena that had been submitted by The Dream Team. The Barron’s article states that The Dream Team had not disclosed its paid affiliations in submitting supposedly free-lance copy. The Barron’s article (and the Seeking Alpha article to which it refers) makes for interesting reading. The lawsuit against Galena alleges that articles submitted by the Dream Team to various publications (including Seeking Alpha) had driven up the company’s share price, after which its CEO allegedly sold $3.8 million of his company shares.

 

The other important securities litigation development in the year’s first half is something that did not happen. That is, the U.S. Supreme Court did not throw out the fraud-on-the-market theory in the Halliburton case.  Had the Supreme Court tossed the presumption of reliance in class action securities suits, which is based on the theory, it seems likely that the litigation environment for Section 10(b) securities cases would have been changed dramatically. Reports like this one examining securities suit filings trends would have looked very different in the future.

 

Even though the Court did rule that defendants should have the opportunity at the class action stage to try to rebut the presumption of reliance by showing that the alleged misrepresentation did not impact the defendant company’s share price, that defense-oriented alteration to the class certification procedures seems unlikely to have a dramatic impact on the number of securities class action lawsuit filings.

 

In other words, readers can continue to look forward to period analyses, like this one, of securities class action lawsuit filing trends.

 

nystate3On June 19, 2014, in a case involving so many unusual coverage issues that it seems more like a law school exam question than an actual coverage dispute, New York (New York County) Supreme Court Judge Melvin Schweitzer, applying New York law, granted summary judgment for the former directors of the bankrupt Lyondell Chemical Company who sought coverage from their company’s excess D&O insurers for their costs of defending themselves in an adversary action in the bankruptcy proceeding. A copy of the June 19 opinion can be found here.

 

The follow-form excess insurers had denied coverage for the defense fees based on the primary policy’s Insured vs. Insured exclusion. The directors argued they were entitled to have their defense expenses paid based on a coverage carve-back in the exclusion – not a carve-back to the exclusion in the primary policy, but rather a carve-back to the exclusion in a new policy form the primary insurer had launched eighteen months after the expiration of the initial primary policy. In reliance on the Liberalization Endorsement in the primary policy, the directors argued that the language in the new policy form governed, rather than the language in the primary policy that had been issued to Lyondell. Judge Schweitzer agreed with the directors and concluded that the enhanced wording in the new policy form did not preclude coverage for the directors’ defense costs.

 

Background 

In December 2007, Basell AF S.C.A. acquired Lyondell Chemical Company and the combined companies became known as Lyondell-Basel Industries. In August 2007, prior to the merger, a shareholder filed an action in Delaware Chancery Court against the Lyondell board (the Ryan Litigation) alleging that the directors had breached their fiduciary duties because the merger consideration was “grossly insufficient.” (Judge Schweitzer’s opinion in the coverage lawsuit does not mention the outcome of the Ryan Lawsuit.)

 

The merged company went bankrupt in January 2009. Later in 2009, a creditors committee filed an adversary lawsuit in the bankruptcy proceeding (the Adversary Proceeding) against the former directors of Lyondell, alleging that the financing for the merger transaction had over-leveraged the company and forced it into bankruptcy. The creditors committee assigned the Adversary Proceeding to a litigation trust, which continued to pursue the Adversary Proceeding against the former directors.

 

The directors sought to have their costs of defending the Adversary Proceeding paid by Lyondell’s D&O insurers. For purposes of this coverage dispute, there are two relevant insurance programs, each arranged with a primary insurance policy and several layers of excess insurance. The policy period of the two towers were, respectively, 2006-2007 and 2007-2013. The primary carrier paid its full policy limit in payment of defense costs (Judge Schweitzer’s opinion does not say under which policy the primary carrier paid these costs). The directors sought to have the excess insurers pay  their continuing costs of litigation defense. The excess insurers’ policies provided follow form coverage, meaning that the terms and conditions of the primary policy determined whether or not there was coverage under the excess policies

 

The excess insurers denied coverage in reliance on the Insured vs. Insured exclusion in the primary policies and filed an action in New York state court seeking a judicial declaration that there was no coverage under their policies. The parties cross-moved for summary judgment.

 

Both the 2006-2007 primary policy and the 2007-2013 primary policy contain an exclusion (the Insured vs. Insured exclusion) precluding coverage for Loss arising from a claim “brought or maintained by or on behalf of the Company.”  The excess carriers contended that this exclusion precluded coverage for the directors’ defense expenses. 

 

Both the 2006-2007 primary policy and the 2007-2013 primary policy contained a Liberalization Endorsement, which provides that if the primary carrier issues a new policy form or a new standard endorsement then “the Company shall have the right to such new policy or such new coverage enhancement endorsement,” except that “any existing claims will be controlled by the existing policy form the claim was reported under.”

 

In April 2009, the primary carrier launched a new standard endorsement form (the Select Form). The Select Form provides a broad bankruptcy exception to the Insured vs. Insured Exclusion. The exception to the exclusion preserves coverage for Loss arising out of a claim “brought or maintained by or on behalf of a bankruptcy or insolvency trustee, examiner, receiver, similar official or creditors committee for such company, or assignee of such trustee, examiner, receiver or similar official or creditors committee.” The directors contended that by operation of the Liberalization Endorsement in the primary policies, this coverage carve back in the Insured vs. Insured exclusion in the Select Form controlled the question of coverage and preserved coverage for their defense expenses.

 

Both the 2006-2007 primary policy and the 2007-2013 primary policy include an Interrelated Wrongful Acts Provision, which stated that “all Loss arising out of the same Wrongful Acts and Interrelated Wrongful Acts of Insured Persons shall be deemed one Loss, and each Loss shall be deemed to have originated in the earliest Policy Period in which a Claim is first made against an Insured Person alleging any such Wrongful Act or Interrelated Wrongful Act.” Both of the primary policies defined the term “Interrelated Wrongful Acts to mean “all Wrongful Acts that have as a common nexus any fact, circumstance, situation, event, cause or series of causally connected facts, circumstances, situations, events, transactions or causes.”

 

The Court’s Opinion

The Court granted summary judgment for the directors based on its determination that by operation of the Liberalization Endorsement in the primary policies the enhanced bankruptcy coverage carve-back in the Select Form applied to preserve coverage for the directors’ defense expenses.

 

The insurers had tried to argue that the language in the Select Form did not apply because the Liberalization Endorsement specifies that it does not apply the language in new forms to “existing claims.” The carriers argued that because the Ryan Litigation and the Adversary Proceeding both alleged wrongdoing against the directors in connection with the Basell merger, the two claims were interrelated and therefore that they constitute one claim that was an “existing claim” at the time the Select Form was launched.

 

The Court rejected this argument, noting that the Interrelated Wrongful Act provision in the primary policy referred to “Loss,” not “Claims,” and provided only that all Loss from Interrelated Claims is “treated as ‘one Loss,’ triggering only one set of policy limits instead of two. It does not affect the separateness of the Claims.” The Court noted that the provision’s reference to “Loss” rather than to “Claims” differed from language found in Interrelated Wrongful Act provisions found in other D&O insurance policies. The language in the primary policies “treat related claims as ‘one Loss,’ not ‘one Claim,’” and therefore “although the Ryan Litigation and the Adversary Proceeding may be Interrelated Wrongful Acts, and therefore one Loss, they remain separate claims commenced on separate dates.”

 

The Court also said it didn’t matter that the Select Form had not been launched until 18 months after the end of the 2006-2007 policy period because (by contrast to language found in Liberalization Endorsement in other policies) “there is nothing in the plain language of the Liberalization Endorsement that prohibits liberalization by a form announced after the expiration of the policy period.”

 

Finally, the Court rejected the arguments of one of the excess carriers whose 2006-2007 policy did not include a liberalization provision. This excess carrier argued that because the Adversary Proceeding was Interrelated with the Ryan Litigation, the Adversary Proceeding would be deemed made in the 2006-2007 policy period in which its policy had no Liberalization Endorsement, and therefore that the enhanced wording in the Select Form did not apply to preserve coverage under its policy. The insurer argued that the two lawsuits were interrelated because they both related to the merger transaction.

 

The Court said “such a broad reading of Interrelated Wrongful Acts would encompass any Claim that is connected to the merger.” The Court found that in fact the two cases were “fundamentally inconsistent” with each other, that in the Adversary Proceeding the claimants alleged that the company had overleveraged itself to complete the transaction whereas the claimant in the Ryan litigation alleged that the company was getting inadequate consideration.

 

Discussion 

The outcome of this case depended on a couple of unusual features of the primary policy. Whereas the Interrelated Wrongful Acts provision in most policies provide for the interrelatedness of “Claims,” the Interrelated Wrongful Acts provision in these policies referred to and defined the interrelatedness of “Loss.” By the same token, again by contrast to the provisions found in many other D&O insurance policies, the Liberalization Endorsement in the primary policies had no time limitation on its applicability, and so the enhancements in a new policy form apply to the primary policy regardless of when the new form is released, even if it is released after the policy period of the policy.

 

The case does involve the rather unusual circumstances that a policy’s Liberalization Endorsement operated to define the availability of coverage. It is fairly standard for D&O insurance policies to include a Liberalization Endorsement, but at least in my experience it is relatively rare for the Liberalization Endorsement to actually affect the coverage analysis.  (Perhaps one reason it is relatively unusual for the Endorsement to be relevant is that most policies’ Endorsements, unlike the Endorsement here, specify that the liberalization applies only to new policy forms introduced during the policy period.) This case does underscore how the Liberalization Endorsement could be important for maximizing the availability of insurance for policyholders.

 

The purpose of a Liberalization Endorsement is to make sure that if the insurer launches a new form after it has issued a policy to a policyholder that the policyholder gets to the benefit of any coverage enhancements in the new form. It operates as a kind of fairness mechanism, by ensuring that the policyholder doesn’t have to do without the enhancement just because its policy was issued before the new form came out. It is fair to the insurer too, since the insurer is willing to offer the enhancement at all, it ought to provide the enhancement to present policyholders as well as future policyholders. This element of fairness to the insurer breaks down a little bit in this case, since the excess insurers that are being forced to honor the provisions of the new policy form are not the ones that issued the new policy form. Basically, by operation of the Liberalization Endorsement, the excess insurers must provide coverage for defense expenses that arguably would not have been covered under their policies, because the primary insurer – that wasn’t even a party to this coverage action – issued a new policy form after the excess insurers had agreed to provide follow form excess over the primary insurer’s former policy. The excess insurers may feel aggrieved by this, but they did agree to provide excess insurance over a primary policy that contained a Liberalization Endorsement, so there was always the risk that something like this might happen.

 

The case also highlights the importance of the wording of the bankruptcy carve-back in the Insured vs. Insured exclusion. Several specific features of the carve-back in the Select Form proved to be particularly important here. The carve-back preserved coverage for claims “brought or maintained” by the “creditors committee.” Not all carve-backs expressly refer to the “creditors committee.” Also the carve-back language in the Select form also referred to “any assignee of such trustee, examiner, receiver, or similar official or creditors committee.” Not all carve-backs expressly refer to an “assignee.” This reference was important here because the initial claimant against the Lyondell directors, the creditors committee, had assigned its claim to a litigation trust that continued to pursue the claim. Practitioners may want to note these coverage features and take them into account when reviewing policy wordings.

 

This case does present yet another instance of the elusiveness of Interrelated Wrongful Act provision interpretations. As I have noted before, the cases interpreting these provisions are all over the map. In my view, the Court’s conclusion on the interrelatedness question here is less than satisfying. Judge Schweitzer held that even though the Ryan Litigation and the Adversary Proceeding both related to alleged wrongful conduct by the directors in connection with the merger, the two claims were not related because in the Ryan Litigation the allegation was that the merger price was too low and in the Adversary Proceeding the directors had bankrupted the company by paying too much.

 

However, the definition of the term Interrelated Wrongful Acts in the primary policy refers only to “all Wrongful Acts that have as a common nexus any fact, situation, event, [or] transaction.” The definition does not add an additional requirement that the various Wrongful Acts must involve the same theory of wrongdoing or theory damages. The definition only requires that the various Wrongful Facts have a “common nexus” of “any transaction.”

 

Judge Schweitzer rejected the idea that because the two lawsuits related to the merger that they were interrelated because, he said, that would mean that any claim related to the merger would be interrelated. To which I say, well, yes, if the definition says that alleged wrongful acts that have as a common nexus any transaction are interrelated wrongful acts, then any wrongful acts related to the merger (which is, after all, a transaction) are interrelated.

 

I don’t know what the problem is with the interrelatedness question. It is not just the cases are all over the map, it is that so often courts’ analyses of interrelatedness issues are so unsatisfying.  (For a recent post in which I discuss another court’s unsatisfying interpretation of interrelatedness issues, refer here.)

 

There are also some details in the opinion that seem incomplete or that don’t add up. First, to me, it matters under which policy the primary insurer paid out its limit, as that will determine whether or not the underlying insurance has been exhausted.

 

Second, if the excess insurer paid its limit out under the 2006-2007 policy, it would likely have done so because it concluded that the Adversary Proceeding was interrelated to the Ryan Litigation. That seems like a relevant detail to me.

 

Third, Judge Schweitzer didn’t decide under which of the two programs the excess insurers’ obligations to pay defense expenses arose. That seems like an important detail to me. But instead, he prefaced his conclusion that the carve-back in the Liberalization Endorsement controlled the determination of the coverage issue by saying “Regardless of which policy (2006-2007 or 2007-2013) applies to the Adversary Proceeding, the Select Form’s terms apply.”

 

Fourth, I am confused by Judge Schweitzer’s conclusion that the Ryan Litigation and the Adversary Proceeding are not interrelated. In light of his earlier comments about the Interrelated Wrongful Acts provision in the primary policy, does his conclusion that the two lawsuits are not interrelated mean that they represent two losses rather than a single loss? That would seem to imply that each of the two insurance programs was triggered — the first by the Ryan Litigation and the second by the Adversary Proceeding.

 

As a final comment, I note that that this is yet another instance where insureds were forced to litigate with their excess insurers after the primary insurer had paid its limits in full. As I have noted elsewhere, the whole point of follow form excess insurance is so that every layer in the insurance program responds the same way to the same set of losses.

 

When the different insurers on the different layers of an insurance program respond differently to the same set of circumstances, the intent of the insurance acquisition process is frustrated. More to the point, no insured expects to have to fight their way through the various layers of the insurance program. The prospect of compulsory separate fights with separate carriers represents an undesirable burden and vexation for the policyholder – a burden that all too many insureds must face as fights with excess insurers become all too common. (For more on this theme, refer here.)

031aIt has been a while since I have published a mug shot gallery. The pictures have continued to arrive from far and near and now the time has arrived to post another round.

 

Readers will recall that over a year ago, I offered to send out a D&O Diary coffee mug to anyone who requested one – for free – but only if the recipient agreed to send me back a picture of the mug and a description of the circumstances in which the picture was taken. In previous posts (here, here, here, here, here, here, here, here , here, here, here, here, here, here, here, and here), I published prior rounds of readers’ pictures. I have posted the latest round of readers’ pictures below.

 

It wouldn’t be a proper D&O Diary mug shot gallery without at least one picture from overseas, and in this collection we have two. The first comes to us from Sydney, Australia. Chris Smith of the Lee and Lyons law firm sent us this picture taken from his office on Macquarie Street in Sydney. Chris reports that across the road from his office is the Royal Botanic Gardens, beyond which lies Sydney Harbour.

 

 sydneysmall[1]

 

 

 

 

 

Our next mug shot comes to us from Bermuda, and depicts Josh Schwartz of ACE Bermuda Insurance, in Hamilton, Bermuda. I wonder how many years of wearing Bermuda shorts it takes to be able to wear the shorts  as nonchalantly as Josh.

 

bermudashortssmall

 

 

 

 

 

 

 

 

 

 

The next mug shot was sent in from Atlanta, but nevertheless is in keeping with the theme of The D&O Diary mug as a global phenomenon. The picture was sent in by Dave Leonard of the Carlton Fields Jorden Burt law firm and it shows the view to the north from Dave’s midtown Atlanta office.

 

atlantasmall[1] 

 

 

 

 

 

 

The next picture was sent in by new friends Rebecca Wolinsky and Sarah Voutyras of the Boundas Skarzynski law firm in New York. I recently had the pleasure of meeting Rebecca and Sarah at an industry event near Wall Street. They sent in this colorful picture from the Jefferson Market Garden, which they described as a “beautiful park in the west village.”

 

tulipssmal[1]

 

 

 

 

 

 

 

The final picture in this collection was sent in by Andy Hamilton, who is the risk manager for Spectra Energy. Andy provided this description of his picture: “I attended the Zurich Classic this weekend in New Orleans and participated in a home rebuilding project in the St. Bernard Parish sponsored by Zurich. Here is a mug shot from the project site.”

 

NOsmall[1]

 

 

 

 

 

 

 

It is always such a pleasure to receive readers’ mug shot and to see the places they have taken their pictures. I know that other readers want to get in on the action but I am afraid I can’t fulfill any more mug orders, as my mug supplies are exhausted. Readers who would still want to contribute a picture can send in a photo of their own firm’s mugs, which I would be happy to publish.

 

In any event, many thanks to everyone who has sent in a picture. All of the mug shots are great and it has been a lot of fun sharing them with the other readers.

 

To make it easier to view past picture gallaries, I have added a new Mug Shots category to the Topics index in the right hand column.

 

skaddenFollowing the U.S. Supreme Court’s ruling earlier this week in the Halliburton case, questions have continued to swirl about the implications of the court’s decision. In the following guest post, Jennifer Spaziano of the Skadden law firm, takes a look at the impact the Halliburton decision will have on securities class action procedures, outcomes and filings. This article follows an earlier guest post Jen posted on this site (which can be found here) following oral argument in the Halliburton case but before the Supreme Court  ruled. My own take on the Halliburton decision can be found here.  

I would like to thank Jen for her willingness to publish her guest post on this site. I welcome guest post submissions from responsible authors on topics of interest to readers of this blog. If you are interested in publishing a guest post, please contact me directly. Here is Jen’s guest post:

****************************************************** 

During oral argument in Halliburton v. Erica P. John Fund, No. 13-317, much of the discussion focused on the practical realities of securities litigation, including (i) the procedures available to defendants to rebut the presumption of classwide reliance established in Basic Inc. v. Levinson, 485 U.S. 224 (1988) and (ii) the percentage of cases that make it to summary judgment and trial.  The upshot of this discussion—at least to some—was that if Basic’s presumption of classwide reliance survived, something needed to be done to ensure that its equally strong mandate regarding the presumption’s rebuttability is given effect.  

On June 23, 2014, the Supreme Court issued its ruling in Halliburton.  The ruling was consistent with the expectations of many commentators following oral argument:

First, despite recognition that the “efficient capital markets hypothesis” underlying Basic is not perfect, the Court did not overrule or modify Basic, finding no “special justification” to do so.  (Slip op. at 7; see also slip op. at 8-12.)

Second, the Court held that “defendants must be afforded an opportunity before class certification to defeat the presumption through evidence that an alleged misrepresentation did not actually affect the market price of the stock.”  (Slip op. at 23.)

The Court thus adopted a middle ground approach that left Basic’s presumption of classwide reliance intact but gave practical meaning to Basic’s plain recognition that the presumption is rebuttable.  See Basic, 485 U.S. at 248 (“Any showing that severs the link between the alleged misrepresentation and either the price received (or paid) by the plaintiff, or his decision to trade at a fair market price, will be sufficient to rebut the presumption of reliance.”).

The Court’s ruling answers several important questions:

Can a plaintiff still rely on Basic’s presumption of reliance?  

Yes.  A plaintiff can “satisfy the reliance element of the Rule 10b-5 cause of action by invoking a presumption that a public, material misrepresentation will distort the price of stock traded in an efficient market, and that anyone who purchases the stock at the market price may be considered to have done so in reliance on the misrepresentation.”  (Slip op. at 23.)

What must a plaintiff prove to invoke the presumption of reliance?  

To invoke the presumption, a plaintiff must make the following showings:  “(1) that the alleged misrepresentations were publicly known, (2) that they were material, (3) that the stock traded in an efficient market, and (4) that the plaintiff traded the stock between the time the misrepresentations were made and when the truth was revealed.”  (Slip op. at 6-7.)

Is the presumption of reliance rebuttable?  

Yes.  “[T]he presumption of reliance [is] rebuttable rather than conclusive.”  (Slip op. at 7.)  “[A] defendant [can] rebut this presumption in a number of ways, including by showing that the alleged misrepresentation did not actually affect the stock’s price—that is, that the misrepresentation had no ‘price impact.’”  (Slip op. at 1.)

Can a defendant attempt to rebut the presumption before class certification?  

Yes.  “[T]o maintain the consistency of the presumption of reliance with the class certification requirements of Federal Rule of Civil Procedure 23, defendants must be afforded an opportunity before class certification to defeat the presumption through evidence that an alleged misrepresentation did not actually affect the market price of the stock.”  (Slip op. at 23.)

If a defendant rebuts the presumption of reliance by showing that the alleged misrepresentation did not actually affect the stock’s price, can the plaintiff still rely on the presumption?  

No.  “If a defendant could show that the alleged misrepresentation did not, for whatever reason, actually affect the market price . . . a plaintiff would have to prove that he directly relied on the defendant’s misrepresentation in buying or selling the stock.”  (Slip op. at 7.)

Although the Court’s ruling provides some clarity with respect to the prerequisites for invoking the presumption of reliance and the procedural point at which a defendant can attempt to rebut the presumption, the public reaction to the Court’s ruling to date suggests that it leaves open a number of questions that will only be answered as pending and future cases play out.  These questions include:

What percentage of defendants will seek to rebut the presumption of reliance at the class certification stage? 

The Court’s ruling permits, but does not require, a defendant to attempt to defeat the presumption at the class certification stage.  Numerous considerations—including the jurisdiction in which the case is proceeding, the weakness of plaintiffs’ required showings and the strength of other defenses—might lead a defendant to refrain from raising the lack of price impact at the class certification stage. 

Will class certification decisions be made at a later point in the life cycle of a case?  

Federal Rule of Civil Procedure 23(c)(1)(A) states: “[a]t an early practicable time after a person sues or is sued as a class representative, the court must determine by order whether to certify the action as a class action.”  Justice Ginsburg noted in her concurring opinion in Halliburton that “[a]dvancing price impact consideration from the merits stage to the certification stage may broaden the scope of discovery available at certification.”  It remains to be seen how courts will balance their obligation to consider class certification at “an early practicable time” with the need to conduct appropriate discovery in assessing the applicability of the presumption at class certification.

Will the percentage of class certification motions that are granted decrease?  

According to Halliburton’s counsel, “[t]he most recent studies by NERA and Stanford show that 75 percent of class certification motions are granted in securities cases; and that number is much, much higher with respect to New York Stock Exchange companies that essentially have no way to dispute market efficiency.”  (03/05/2014 Hearing Tr. (“Tr.”) at 50:17-22.)  Allowing defendants to challenge the presumption of reliance at class certification should result in a decrease in the percentage of classes that are certified.  The magnitude of that decrease, however, remains unknown.

Will the percentage of cases that settle following class certification increase?  

As Halliburton’s counsel noted at oral argument “only 7 percent” of securities fraud class actions make it to the summary judgment stage, “because once the case gets past class certification . . .  there is an in terrorem effect that requires defendants to settle even meritless claims.”  (Tr. at 51:5-9.)  The rate is even lower with respect to trial:  “less than one third of one percent actually go to a verdict.”  (Tr. at 23:8-9.)  These numbers are already very low and it is hard to imagine them getting any lower.    

Will there be a decrease in the number of securities fraud class actions that are filed?    

The Court’s ruling places an additional hurdle before a plaintiff seeking to pursue a securities fraud class action.  In addition to satisfying the requirements of the Private Securities Litigation Reform Act and establishing the prerequisites for invoking the presumption of classwide reliance, a plaintiff also may face a price impact challenge from the defendant before a class is certified.  This additional hurdle likely will be considered by plaintiffs and their counsel in deciding whether to file an action.   

To sum up:

  • ·        The Court’s ruling leaves intact Basic’s presumption of classwide reliance but gives effect to Basic’s directives regarding ways in which the presumption can be rebutted.
  • ·        Now, a defendant will have the opportunity to test Basic’s presumption prior to class certification with evidence of a lack of price impact.
  • ·        What this means as a practical matter remains to be seen.

Halliburton does not appear to represent the sea change some had anticipated.  That said, it may lead to fewer certified classes and, ultimately, fewer filed cases.  Time will tell.  At a minimum, the Court’s ruling addresses the practical realities of securities litigation that were a focus of oral argument by providing defendants a meaningful opportunity—one they previously did not have in many jurisdictions—to rebut the presumption of classwide reliance.  

—By Jen Spaziano, Skadden, Arps, Slate, Meagher & Flom LLP

Jen Spaziano is a partner at Skadden, Arps, Slate Meagher & Flom LLP’s Washington, DC office.

The opinions expressed are those of the author and do not necessarily reflect the views of the firm, its clients, or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.

supctsealOn June 25, 2014, in an unexpected development at the end of its current term, the U.S. Supreme Court held in Fifth Third Bank v. Dudenhoeffer that ESOP fiduciaries are not entitled to a “presumption of prudence” in connection with their decision to invest in or maintain investments in employer stock.  In a unanimous opinion written by Justice Stephen Breyer, the Court held that ESOP fiduciaries are subject to the same duty of prudence that applies to ERISA fiduciaries in general, other than the duty to diversify plan assets.  A copy of the court’s opinion can be found here.

 

In recent years, several of the Circuit courts had recognized the existence of a presumption of prudence for ESOP plan fiduciaries. Many ESOP plan fiduciaries had successfully relied on the presumption as the basis for a motion to dismiss claims filed against them under ERISA. The Supreme Court’s opinion could make it more difficult for ESOP fiduciaries to obtain dismissal in ERISA stock drop cases. However, the Court did recognize the importance of motions to dismiss in helping to weed out meritless suits. The Court laid out several guidelines for the lower courts to use in considering motions to dismiss in ERISA stock drop suits. The net effect of the Court’s opinion is that the environment for ERISA stock drop litigation has been substantially changed.

 

Background

Congress has recognized that Employee Stock Ownership Plans (ESOPs) and Eligible Individual Account Plans (EIAPs), which invest in employer stock, further an important public policy goal by encouraging employee ownership. The lower courts in turn had held that fiduciaries of these types of plans should not be subject to liability for investing in employer stock, as that was the reason the plans were created, consistent with the Congressional objective of fostering employee ownership.

 

In a 1995 decision, Moensch v. Robertson (here), the Third Circuit concluded that fiduciaries of plans that required or encouraged investment in employer stock were entitled to a presumption that they acted prudently under ERISA by investing in the employer stock. This presumption could only be overcome by a showing that the plan fiduciaries abused their discretion by continuing to invest in the employer stock. Several circuit courts adopted the Moench presumption of prudence; however, the courts disagreed about whether the presumption could be raised at the motion to dismiss stage and how the presumption could be rebutted.

 

This case involves Cincinnati-based Fifth Third Bank and arises out of the global financial crisis. The plaintiffs in the case are employees of the bank and participants in the company’s profit sharing plan. Participants in the plan had the option of investing the funds in their plan accounts in several different investments, including the stock of Fifth Third Bank. The bank matched a portion of an employee’s investment in their plan account with stock of the bank, although after a period the employee was free to transfer the stock match investment to other authorized investments.

 

In their complaint, the plaintiffs allege that the bank, its CEO and the plan fiduciaries breached their fiduciary duties under ERISA by maintaining significant plan investments in company stock and maintaining company stock as an investment option at a time they knew that it was imprudent to do so. The company’s share price declined as the global financial crisis unfolded.

 

The district court granted the defendants’ motion to dismiss the complaint, holding that as ESOP plan fiduciaries the defendants were entitled to a presumption that their decision to remain invested in employer stock was reasonable. The district court also found that the plaintiffs had failed to allege facts sufficient to overcome the presumption. The plaintiffs appealed.

 

In a September 7, 2012 opinion (here), the Sixth Circuit held that the district court had erred in concluding that the presumption of reasonableness applied at the motion to dismiss stage. The Sixth Circuit considered the presumption to be evidentiary, subject to factual rebuttal, and therefore not appropriate to consider and apply at the motion to dismiss stage. The Sixth Circuit also found that the plaintiffs’ allegations were sufficient to state a claim. The defendants filed a petition for a writ of certiorari, which the Supreme Court granted.

 

In support of the bank’s cert petition, The U.S. Department of Labor filed an amicus brief in which the agency urged the Court to grant cert in the case on the grounds that a split exists between the circuits. However, rather than arguing for or against the position adopted by the Sixth Circuit, the DoL argued that there should be no presumption of prudence at all, saying that “ERISA’s text and purposes do not call for the application of a presumption at any stage of the proceedings.” The DoL argued further that the judge-created presumption of prudence is based “largely on policy considerations that extend beyond ERISA’s text and are unconvincing in their own right.”

 

The Court’s Opinion 

In a unanimous opinion written by Justice Breyer, the court held that ESOP fiduciaries are not entitled to a presumption of prudence. The Court said:

 

In our view, the law does not create a special presumption favoring ESOP fiduciaries. Rather the same standard of prudence applies to all ERISA fiduciaries, including ESOP fiduciaries, except that an ESOP fiduciary is under no duty to diversify the ESOP’s holdings.

 

The Court expressly rejected the defendants’ argument that that the Congressional policy expressed in ERISA in favor of employee ownership meant that ESOP plan fiduciaries were entitled to a more “relaxed” duty of prudence.

 

The Court also rejected the defendants’ argument that the existence of a presumption of prudence was necessary to discourage meritless, burdensome lawsuits. The Court said that “we do not believe that the presumption at issue here is an appropriate way to weed out meritless lawsuits,” adding that “the proposed presumption makes it impossible for a plaintiff to state a duty-of-prudence claim, no matter how meritorious, unless the employer is in very bad economic circumstances.” The presumption “does not readily divide the plausible sheep from the meritless goats.” The task of weeding out the meritless suits “can better be accomplished through careful context-sensitive scrutiny of a complaint’s allegations.”

 

The Court did recognize motions to dismiss as “one important mechanism for weeding out meritless claims.”  The Court identified several factors for the lower courts to keep in mind when considering motions to dismiss in ERISA liability suits. First, “where a stock is publicly traded, allegations that a fiduciary should have recognized from publicly available information alone that the market was over- or undervaluing a stock are implausible as a general rule.” Second, where the claim is based on a failure to act on nonpublic information, the courts must recognize that fiduciaries cannot be required to break the law, such as by insider trading. Similarly, where the claim is based on a decision not to trade, the court evaluating a motion to dismiss should consider whether not trading would give rise to disclosure issues or would the stock price and thereby harm the fund.

 

Discussion

In recent years, the presumption of prudence has been an important first line of defense in ERISA stock drop litigation.  The Supreme Court’s conclusion that ESOP fiduciaries are not entitled to the presumption will make it more difficult for ESOP fiduciaries to obtain dismissal of an ERISA stock-drop lawsuit filed against them.

 

Just the same, the Court did also emphasize the importance of motions to dismiss in helping to weed out meritless lawsuits. The motion to dismiss mechanism, the Court said, “requires careful consideration of whether the complaint states a claim that the defendants acted imprudently.” The guidelines the Court laid down for lower courts to consider while reviewing motions to dismiss in ERISA liability lawsuits address many of the kinds of allegations that plaintiffs often allege in ERISA stock drop suits. In particular the Court’s suggestion that plan fiduciaries can rely on the share price and that the duties of plan fiduciaries do not require them to trade on inside information could help defendants seeking to have an ERISA stock drop suit dismissed.

 

In other words, the Supreme Court’s decision introduces a host of factors that will affect how the trial courts address and rule upon the motions to dismiss in ERISA stock drop suits involving ESOP fiduciaries. These new factors mean that the way that motions to dismiss are framed will change. What that ultimately will mean in terms of outcomes definitely remains to be seen. The lower courts will have to sort out these issues.

 

There is no doubt that the Court’s holding that the ESOP plan fiduciaries are not entitled to a special presumption of prudence represents a setback for fiduciaries named as defendants in ERISA stock drop suits. The consequences from this ruling may not only be that fewer of these cases are dismissed, it may also mean that more of them are filed. Indeed, some have suggested that the ruling may even act as a deterrent for employers from offering company stock. A June 25, 2014 Forbes article about the ruling (here) quotes two commentators as saying that companies may just stop offering their own stock to employees until lower courts decide more cases.

 

The one thing I know for sure is that this decision represents a significant change in the environment for ERISA stock drop litigation involving ESOP fiduciaries.  

 

gavel1The onslaught of litigation filed after the advent three years ago of the Dodd-Frank “say on pay” requirements may finally be winding down. According to a June 23, 2014 memorandum from the Pillsbury law firm entitled “Is Proxy Disclosure Shareholder Litigation on Executive Compensation Finally Over?” (here), the litigation came in three distinctive waves. The first two waves have died down and the third wave is waning, and we may be nearing the point where we can close the book on what has largely proven to be a less than successful plaintiffs’ litigation approach.

 

The first of the three waves of shareholder litigation involved lawsuits filed against companies that experienced a negative say on pay vote. (Readers will recall that the Dodd-Frank Act included provisions requiring listed companies to hold a nonbinding shareholder vote on executive compensation, an arrangement commonly referred to as “say on pay.”) This phase in the litigation progression has long been over. The last of these lawsuits were filed in September 2012. Overall there were a total of 24 of these cases filed that were not consolidated, involving 21 companies. Motions to dismiss were granted in 50% of the cases. Five of the cases settled. A very small number of these cases remain pending.

 

The second wave of these executive compensation related lawsuits involved an effort by plaintiffs to enjoin annual meetings by contending that the disclosure in proxy statements regarding executive compensation was inadequate. Although these lawsuits involve many of the same features as M&A litigation — including the pressure on defendants to settle to avoid complicating a pending event — as it turned has out, many companies involved in these cases, unlike  companies in M&A related litigation, chose to fight rather than to settle. And “when those companies fight, they win.”

 

According to the memo, there were 31 of these second wave lawsuits filed in total. Nearly 40 percent of these cases have resulted in a denial of the motion to enjoin the annual meeting and over 25 percent have been voluntarily dismissed. Plaintiffs have prevailed on motions to preliminarily enjoin the annual meeting, in whole or in part, in only two cases: In April 2012, in a case involving Brocade; and in October 2012, in a case involving Abaxis. Only two of these second wave cases have been filed recently, with one in December 2013 and another in January 2014. The motion for preliminary injunction was denied in both of these more recent cases.  

 

In the third phase of this executive compensation-related shareholder litigation, the lawsuits alleged that the executive compensation award was not made in compliance with the relevant plan. The kinds of allegations raised in these cases fall in three categories: (1) that the amount of shares awarded under a stock incentive plan exceed the maximum annual limit imposed by the plan; (2) that the award was made under a stock incentive plan that had lapsed due the board’s failure to seek shareholder re-approval; (3) that the Board had made a stock award that was not tax deductible under the relevant provisions of the federal tax laws.

 

According to the memo there have been a total of 34 of these third wave cases filed that have not been consolidated, involving 29 companies. Motions to dismiss have been granted in 20 percent of these cases and denied in 9 percent of the cases. Dismissal motions remain pending in another 20 percent of the cases. 24 percent of the cases have settled, but as the memo details, in the cases that have settled, the plaintiffs have had a difficult time obtaining a fee award in the amount sought. In several key cases, the amount of the award has only been a small fraction of the fees sought. The fee award decisions “may give plaintiffs’ counsel pause in considering whether or not to file third wave cases in the future.”

 

In any event, the kinds of issues that have led to these third wave lawsuits are preventable. The memo concludes with a short summary of the steps that companies can take to ensure that questions are not raised later about whether or not a stock award is in compliance with the operative stock compensation plan. These steps include taking care to ensure that no award exceeds limits in the plan; ensuring that the plan is re-approved every five years; and ensuring that the proxy materials do not guarantee that every stock award will be exempt from tax deduction limits under the Internal Revenue Code.

 

The memo includes a detailed appendix incorporating extensive numerical details and analysis of each of the three successive waves.

 

Special thanks to Sarah Good of the Pillsbury law firm for sending me a copy of the memo.

dolAccording to a June 23, 2014 Wall Street Journal article entitled “U.S. Increases Scrutiny of Employee-Stock Ownership Plans” (here), the federal government is “stepping up scrutiny of how U.S. companies are valued for employee-stock ownership plans.” This increased scrutiny includes increased litigation activity, often alleging that ESOP share valuations are flawed. The targets of this litigation include not only the appraisers who valued the shares but also the plan trustees that have fiduciary duties to “put the interests of workers first.”

 

As of fiscal 2011, the latest year for which information is available, about 6,800 U.S. companies had employee stock ownership plans, involving more than 13.4 million workers. The plans have amassed total assets of $940 billion. For many of the workers participating in these plans, the ESOP is the principal or sole retirement benefit.

 

According to the Journal article, the government contends that “some owners are selling stakes in their companies to employee-stock-ownership plans at inflated prices.” The U.S. Department of Labor is the plaintiff in 15 current ESOP-related lawsuits, virtually all of which involve alleged “shoddy estimates” of company shares. The agency has filed a total of 28 ESOP-related lawsuits since October 2009, double the number of lawsuits filed during the previous six years. Since the start of fiscal 2010, the Department of Labor has recovered over $241 million through lawsuits and through investigations that were resolved without a lawsuit being filed, nearly all of which involve valuations.

 

According to the lawsuits described in the article, the target in many of these lawsuits is the appraiser that provided the valuation although the article notes that “the agency also is getting tougher on trustees who work on behalf of employee-stock ownership plans – and have a fiduciary duty to put the interests of workers first or face financial liability if things go wrong.”

 

Problems often emerge when company management are involved in the appraisal process. According to the article, 95% of companies with ESOPs are closely held, forcing appraisers to rely heavily on company management for information.

 

The Journal article primarily is focused on lawsuits brought by the U.S. Department of Labor, but as several of the examples cited in the article make clear, company employees often file their own separate lawsuits when earlier share price valuations prove to have been inflated. While these employee lawsuits often also target the appraisers, the targets of the employee lawsuits often involve the plan trustees.

 

The Journal article makes it clear that in many cases there may be good reason for the government’s scrutiny of ESOPs. Valuation issues clearly are a recurring problem. Many insurance industry professionals know that for purposes of management liability insurance ESOPs are sometimes viewed as a riskier class of business than are other private companies.

 

However, the article does make it clear that there are certain factors than can help avert faulty appraisals, such as through the requirement that the ESOP obtain a share price evaluation when a stock plan is started and a requirement that workers are told once a year how much their shares are worth. The presence of factors showing that the appraiser performing the appraisal was independent and that the appraisal was not influenced by management (such as through management provided revenue estimates) also may help avoid problem valuations. The presence of these and other factors supporting the share valuation the company uses could help reassure insurance underwriters about companies with ESOPs.  

sup ct 5On June 23, 2014, the U.S. Supreme Court released its long-awaited decision in Halliburton Co. v. Erica P. John Fund, in which the Court had taken up the question whether or not to set aside the presumption of reliance based on the fraud on the market theory that the Court first recognized in its 1988 decision in Basic, Inc. v. Levinson.  The case was closely watched because its outcome had the potential to transform securities class action litigation in the United States.

 

In the end, the Court, in an opinion written by Chief Justice John Roberts and joined by five other justices, declined to overturn Basic, but held that a securities class action defendant should have the opportunity at the class certification stage to try to rebut the presumption by showing that the alleged misrepresentation did not impact the defendant company’s share price. The Supreme Court’s opinion can be found here. Justice Thomas, joined by Justices Scalia and Alito, wrote an opinion concurring in the judgment in which he contended that the Court should have overturned Basic.

 

While the Court’s decision will not alter the securities litigation landscape as much as might have been the case if it had overturned Basic, the Court’s holding that defendants may at the class certification stage seek to rebut the presumption of reliance based on the absence of price impact could have a significant effect on securities litigation. In many cases, plaintiffs may be unable to obtain class certification where in the past they might have been able to have a class certified. In any event, the class certification phase likely will become more costly as the parties dispute the issues surrounding the impact of the alleged misrepresentation on the share price.

 

Background

Since the U.S. Supreme Court’s 1988 decision in Basic, Inc. v. Levinson, securities plaintiffs seeking class certification have been able to dispense with the need to show that each of the individual class members relied on the alleged misrepresentation, based on the presumption that in an efficient marketplace, a company’s share price reflects all publicly available information about a company, including the alleged misrepresentation, and that the plaintiff class members relied on the market price.

 

In the U.S. Supreme Court’s 2013 decision in Amgen (about which refer here), at least four justices (Alito, Scalia, Thomas and Kennedy) appeared to question the continuing validity of the presumption. In his concurring opinion, Justice Alito asserted that the presumption “may rest on a faulty economic premise,” and specifically stated that “reconsideration” of the Basic presumption “may be appropriate.”

 

Recognizing the opportunity to have the Court reconsider the fraud on the market theory, the defendants in the long-running Halliburton securities class action litigation sought to have the Court consider whether the Court should “overturn or significantly modify” the Basic presumption of “class wide reliance derived from the fraud on the market theory.”

 

The Halliburton case has been pending since 2002. In their complaint, the plaintiffs allege that the company and certain of its directors and officers understated the company’s exposure to asbestos liability and overestimated the benefits of the company’s merger with Dresser Industries. The plaintiffs also allege that the defendants overstated the company’s ability to realize the full revenue benefit of certain cost-plus contracts.

 

For several years, the parties in the case have been engaged in full-scale combat on the issue of whether or not a class should be certified in the case. Indeed, the class certification issue in the case has already been before the U.S. Supreme Court; in 2011, the Court unanimously rejected  the company’s argument (and the Fifth Circuit’s holding) that in order for a plaintiff to obtain class certification, the plaintiff must first establish loss causation.

 

Following the Supreme Court’s earlier ruling, the case was remanded back to the lower courts. In June 2013 the Fifth Circuit affirmed the certification of a shareholder class in the case.  In its opinion, the Fifth Circuit expressly affirmed the district court’s holding that Halliburton could not present evidence at the class certification stage that the alleged misrepresentation did not impact the company’s share price and therefore that there was no basis for the presumption of reliance. Halliburton filed a petition for writ of certiorari, which the U.S. Supreme Court granted.  

 

The Court’s June 23, 2014 Opinion 

In an opinion for the Court written by Chief Justice Roberts, the Court vacated the Fifth Circuit’s judgment and remanded the case for further proceedings.

 

At the outset, the Court declined to overturn Basic, noting that “before overturning a long-settled precedent … we require a special justification,” and concluding that “Halliburton had failed to make that showing.” In reaching this conclusion, the Court rejected Halliburton’s argument based on statutory analysis that plaintiffs should always have to prove individual reliance. The Court also rejected Halliburton’s argument that Basic should be overturned based on changes in economic theory surrounding the “efficient market” hypothesis on which the fraud on the market theory is based.

 

The Court also declined to overturn Basic in reliance on principles of stare decisis, holding that these principles have “special force in respect to statutory interpretation.” While noting Halliburton’s argument that the Basic presumption produces a number of “serious and harmful consequences,” such as allowing plaintiffs to “extort large settlements from defendants for meritless claims,” the Court said that “these concerns are more appropriately addressed to Congress, which has in fact responded to some extent to many of the issues Halliburton raised,” for example, through the PSLRA.

 

The Court also rejected Halliburton’s argument that in order to obtain class certification the plaintiffs should have to prove that the alleged misrepresentation actually affected the defendant company’s share price. The Court said requiring the plaintiffs to make this showing “would radically alter the required showing for the reliance element” in a 10b-5 case. The Court said that “for the same reasons we declined to completely jettison the Basic presumption, we decline to effectively jettison half of it by revising the prerequisites for invoking it.”

 

But while the Court declined to require plaintiffs to directly prove price impact in order to invoke the Basic presumption, the Court did agree that defendants “should at least be allowed to defeat the presumption at the class certification stage through evidence that the misrepresentation did not in fact affect the stock price.”

 

The Court noted that the defendants already may introduce price impact evidence at the merits stage and that in many cases plaintiffs already introduce price impact evidence (such as event studies) at the class certification stage to show that the market price of the defendant’s stock responds to information about the company, to establish that the market for the company’s shares is efficient. The court reasoned that if plaintiffs were allowed to present price impact evidence to satisfy the efficient market requirement (which requirement the Court described as “an indirect proxy for price impact”), it makes no sense to preclude the introduction of evidence for the direct purpose of showing that the alleged misrepresentation did not impact the price:

 

Price impact is thus an essential precondition for any Rule 10b-5 class action. While Basic allows plaintiffs to establish that precondition indirectly, it does not require courts to ignore a defendant’s direct, more salient evidence showing that the alleged misrepresentation did not actually affect the stock market’s price and, consequently that the Basic presumption does not apply.

 

The Court concluded by saying with respect to the Basic presumption of reliance that “defendants must be afforded an opportunity before class certification to defeat the presumption through evidence that an alleged misrepresentation did not actually affect the market price of the stock.”

 

In a separate opinion in which he concurred in the Court’s judgment, Justice Thomas, joined by Justices Scalia and Alito, argued that Basic should be overruled noting that “Logic, economic realities, and our subsequent jurisprudence have undermined the foundations of the Basic presumption.”

 

Discussion 

Because the Court did not, as Justice Thomas urged in his separate opinion (a dissenting opinion in all but name), overturn Basic, the Court’s second Halliburton opinion will not have the dramatic impact on class action securities litigation that it might have. Nevertheless, the Court’s ruling will have a significant impact on class certification in misrepresentation cases under Rule 10b-5. It will introduce a significant level of inquiry and dispute at the class certification stage, and it will result in some cases in the denial of class certification motions in cases in which class certification might have been granted in the past.

 

At a practical level, there will be a lot of issues for the lower courts to sort out. There undoubtedly will be significant disputes regarding the type of evidence that is permitted to address the issue of price impact. There will be disputes about the quantum of evidence the defendants must provide in order to rebut the presumption. There undoubtedly will be issues surrounding the type and scope of discovery permitted as the parties wage a battle of experts on the price impact issue. The lower courts could be wrestling with these issues for years.

 

Because the price impact dispute will require the parties to present expert analyses on the question of whether or not the alleged misrepresentation affected the share price, the dispute could prove costly, particularly as the parties and the courts sort out the issues noted in the preceding paragraph. These processes could significantly increase defense expenses at an earlier stage of the proceedings. Justice Ginsburg, in a concurring opinion in which Justices Breyer and Sotomayor joined, noted that because the Court recognized that “it is incumbent upon the defendant to show the absence of price impact,” the Court’s holding “should impose no heavy toll on securities fraud plaintiffs with tenable claims.” Her opinion makes no comment with respect to the additional costs defendants undoubtedly will incur at the class certification stage in an effort to try to rebut the presumption.

 

Another consequence of the Court’s opinion is that it may affect the way that plaintiffs plead their cases. The Basic presumption only applies to misrepresentation cases under Rule 10b-5. It does not apply to cases in which the allegedly misleading statement is an omission. In omissions cases, the plaintiffs rely on a different presumption, the Affiliated Ute presumption, which arguably is unaffected by the Court’s holding in this case. In addition, the Basic presumption does not apply to cases in which the plaintiffs allege violations of Sections 11 and 12 of the ’33 Act. In order to try to avoid the procedural hurdles that the Court’s opinion in Halliburton introduces, plaintiffs may seek to cast their cases as omissions cases or may prefer to pursue ’33 Act claims rather than claims under the ’34 Act and Rule 10b-5. 

 

From an insurance perspective, the Court’s holding in this case will not have the disruptive impact that it might have had if the Court had overturned Basic. The Court’s ruling that defendants may seek to rebut the presumption of reliance by showing the absence of price impact may result in classes being certified in fewer cases, which would be beneficial for defendants and their insurers. However, the dispute of price impact issues could increase overall defense expenses, perhaps significantly, which could have its own impact on D&O insurers. Whether the ruling will result in fewer cases being filed remains to be seen.

 

In the end, the insurance marketplace will have to wait and see how these issues play out, and in the interim it seems unlikely there will be any immediate changes in the way D&O insurance is underwritten and priced. There will, however, be some discussion in the marketplace about the extent of coverage available for the kind of price impact event studies that the Halliburton court discussed. At least one carrier has already introduced, in anticipation of the Halliburton ruling, an endorsement providing that no retention is applicable to the cost of an event study. There may be other marketplace developments along these lines as the marketplace responds to the Court’s ruling.

 

Very special thanks to the several readers who sent me copies of the Halliburton decision.  

 

delaware2As I noted in a recent post (here), in response to a recent Delaware Supreme Court decision upholding the facial validity of fee-shifting bylaws, proposed legislation was  introduced in the Delaware General Assembly to limit the Supreme Court’s ruling and to restrict the ability of Delaware corporations to utilize their bylaws to shift the costs of litigation to unsuccessful shareholder litigants.

 

However, as discussed in detail in a June 20, 2014 memo from the Skadden Arps law firm entitled “Fee Shifting: Bylaws: The Current State of Play” (here), the legislative proposal has now been withdrawn, in order for representatives of the Delaware bar to study the use of fee-shifting bylaws, in anticipation that the Delaware legislature will take up the issue again in 2015. Broc Romanek’s discussion on his TheCorporateCounsel.net blog of the recent action withdrawing the proposed legislation can be found here.

 

Background

As I discussed in a recent post (here), in a May 8, 2014 decision in ATP Tour, Inc. v. Deutscher Tennis Bund, the Delaware Supreme Court upheld the facial validity of a nonstock corporation’s bylaw provision shifting attorneys’ fees and costs to unsuccessful plaintiffs in intra-corporate litigation. Because the court’s holding seemed to be equally applicable to stock corporations as well as to nonstock corporations, the decision appeared to open the way for all Delaware corporations to adopt fee-shifting bylaws. The possibility that companies might be able to shift litigation costs to unsuccessful shareholder claimants potentially could have transformed shareholder litigation.

 

On May 22, 2014, the Delaware Corporate Law Council proposed an amendment to the DCGL that according to the amendment’s synopsis is “intended to limit the applicability of [the Delaware Supreme Court decision in ATP Tours, Inc. v. Deutscher Tennis Bund] to non-stock corporations, and to make clear that such liability may not be imposed on holders of stock in stock corporations.”

 

As discussed in the recent Skadden law firm memo, the legislative proposal, like the Delaware Supreme Court’s decision in the ATP Tour case, “became the subject of much attention and debate from the media and legal commentators and prompted a significant amount of lobbying effort.” Legal reformers argued that the ATP Tour decision “gives corporations a means to protect their stockholders against the high costs of litigation by deterring the filing of abusive, duplicative suits.”

 

The Latest Legislative Development

On June 18, 2014, the legislative proposal was withdrawn and the Delaware Senate introduced a resolution addressing the issue of fee-shifting bylaws.  The resolution notes that Delaware law is “balanced and flexible” and “protects legitimate interests of all stakeholders.” The resolution further notes that “maintaining balance, fairness and predictability requires attention to ensure that statues, court rules, and judicial doctrine … do not encourage meritless litigation and impose unnecessary costs.” At the same time, the resolution notes, various groups have “expressed concern about the potential unintended consequence of permitting stock corporations to adopt such bylaws and the chilling impact it could have on meritorious litigation.”

 

The resolution goes on to state that Delaware’s governor and legislature “strongly support a level playing field that provides the ability for stockholders and investors to seek relief” and that the proliferation of fee-shifting bylaws “will upset the careful balance that the State has strived to maintain.”

 

In recognition of the “complexity and importance” of these issues, the Senate resolution calls upon a number of groups to continue their “ongoing examination” of the State’s laws “with an eye toward maintaining balance, efficiency, fairness and predictability.” The examination is expressly requested to include whether the adoption of legislation relating to fee-shifting bylaws would be appropriate for the General Assembly to consider in 2015.

 

The groups urged to conduct this examination include the Delaware State Bar Association, its Corporation Law Section, and the Council of that Section.

 

Discussion 

For the time being, it is unclear whether or not fee-shifting bylaws will be permitted in Delaware. The Skadden law firm’s memo urges caution for companies considering the adoption of fee-shifting bylaws. As the memo notes, “there is a significant risk that adoption of fee-shifting bylaws could generate a meaningful adverse reaction from, among others, governance advocates, proxy advisory firms, and some stockholders.”

 

Even though the Delaware legislature will not be acting until 2015 at the earliest, there are good reasons for companies to proceed cautiously in considering the adoption of a fee-shifting bylaw. The law firm memo outlines a number of specific items for companies to consider in that regard, including, for example, the company’s stockholder profile and its relationship with its shareholder base.

 

While the memo urges caution on fee-shifting bylaws, the law firm continues to believe that companies should consider the adoption of forum selection bylaws. As I discussed in a recent post (here), even though questions continue to surround the possibility that companies might be able to try to control abusive shareholder litigation through the use of fee-shifting bylaws, the adoption of forum selection bylaws has become increasingly common as a possible way to try to “reduce the cost and risk of multi-jurisdictional stockholder litigation.”

 

More About Forum Selection Bylaws: A lawsuit filed on June 19, 2014 in the Delaware Chancery Court raises interesting questions about the extent of the ability of corporations and their boards to adopt forum-selection bylaws. According to a June 20, 2014 Law 360 article entitled “First Citizens Sued Over ‘Only in NC’ Forum Choice Bylaw” (here, subscription required), the City of Providence, Rhode Island, a shareholder of First Citizens BankShares, has filed a lawsuit challenging the validity of a bylaw recently adopted by First Citizens that designates North Carolina as the exclusive forum for a wide variety of shareholder suits, even though the company is organized under the laws of Delaware.

 

According to the article, the dispute arises out of the planned merger of First Citizens and South Carolina-based First Citizens South. The bylaw designating North Carolina as the exclusive forum for shareholder litigation was adopted the day before the merger was announced. In its lawsuit, the City of Providence seeks a judicial declaration that the bylaw is invalid under Delaware General Corporation Law provisions giving the Delaware Chancery Court exclusive jurisdiction for many shareholder claims against Delaware corporations. The City of Providence alleges that First Citizens’ board breached their fiduciary duties by adopting the bylaw and seeks to have the court declare the bylaw invalid and unenforceable.

 

As discussed here, in June 2013, the Delaware Chancery Court upheld the validity of a bylaw adopted by Chevron’s board that designated Delaware as the exclusive forum for adjudication of various shareholder disputes. This latest lawsuit against First Citizens raises the interesting question of whether or not boards of Delaware corporations appropriately may adopt bylaws designating a forum other than Delaware as the exclusive forum for shareholder disputes. The City of Providence alleges in its lawsuit challenging First Citzens’ recently adopted bylaw that the company’s bylaw improperly deprives the company’s shareholders of their rights to avail themselves of Delaware’s courts.

 

It will be interesting to see how broadly the Delaware courts will extend the rights of boards to adopt forum selection bylaws and in particular to see whether or not the Delaware court will conclude that the board’s authority in that regard includes the right to designate a forum other than Delaware as the exclusive forum for shareholder disputes.