nyseThe number of companies with shares listed on U.S. stock exchanges increased last year compared to 2012, which is the first annual increase in the number of publicly traded companies in the U.S. since 1997, according to information from the World Federation of Exchanges. As reflected in a February 5, 2014 Wall Street Journal article entitled “U.S. Public Companies Rise Again” (here), the number of companies with shares listed in the U.S. has been declining since “the go-go days of the Internet boom,” so the 2013 increase represents something of an exception to a longer term trend. The question is whether it represents a one-time anomaly or a directional change.

 

According to the data from the WFE, there were 5,008 companies listed on the U.S. exchanges as of year-end 2013, representing an increase of 92 companies from the 2012 year-end tally of 4,916. The 2012 figure represented the smallest number of public companies since 1991. The number of public companies peaked at 8,884 in 1997. In other words, the number of companies with U.S. listings declined 3,968 (44%) between 1997 and 2012.

 

Though the increase in the number of companies in 2013 was slight (representing an increase of about 1.87%), it is nevertheless significant. The increase occurred because the number of new listing exceeded the number of delistings for the first time in many years. The number of new listings reflects a vibrant market for IPOs. According to the Journal article, there were 230 IPOs in 2013, which was the highest number of IPOs since 2007.  The increased number of IPOs during 2013 was due to soaring stock indices; the IPO on-ramp provisions of the JOBS Act; and a generally healthier economy.

 

 

The reduced number of delistings is also in part a reflection of a healthier economy, meaning that fewer companies are going bankrupt.  However, the reduced number of delistings in 2013 was also a reflection of reduced M&A activity compared to recent years. In the recent analysis of 2013 securities class action litigation filings (here, see Figure 11), Cornerstone Research showed that between 1998 and 2012, the number of M&A deals “greatly exceeded” the number of IPOs each year, which goes a long way toward explaining the sharp drop in the number of U.S. listed companies during that period. Obviously, the dot-com crash and the credit crisis took out quite a number of U.S. listed companies as well.

 

The Journal article identifies another factor that may have contributed to the decline in the number of publicly traded companies between 1998 and 2012, or at least acted as a restraint on possible growth. That is, “emerging markets such as China lured more companies to their exchanges.” Between 2000 and 2012, the U.S. averaged just 177 listings annually, while the number of listings in China nearly tripled to more than 4,000. The Journal suggests optimistically that the U.S. markets have “at least temporarily stanched the bleeding from listings lost to foreign exchanges.” The article notes that at least during 2013 non-U.S. companies showed a renewed interest in listing in the U.S., citing several examples of non-U.S. companies that listed their shares on U.S. companies during 2013.

 

The more interesting question is whether the growth in the number of publicly traded companies during 2013 represents a directional shift or whether it was just a blip in the larger trend toward fewer U.S.-listed companies. The market volatility in the early weeks of 2014 could mean that prospective IPOs could be facing a less predictable environment. Whether or not this will reduce the number of completed IPOs of course remains to be seen, but it sure doesn’t help. Another factor that will affect the number of U.S. IPOs is the question whether the U.S. exchanges will continue to be able to attract non-U.S. companies to list their shares here.

 

Another dynamic that could significantly affect whether or not the growth in the number of publicly traded companies will continue in 2014 is the level of M&A activity. 2013 was the first year in many years where the number of IPOs exceeded the number of M&A transactions. However, M&A activity could pick up in 2014. According to the Journal, U.S. companies are “sitting on vast piles of cash, giving them ammunition for takeovers that could swallow up public companies. “ Private equity firms are also reloading with multimillion dollar funds that “could also remove more companies from the ranks of listed names.”  

 

Because of all the considerations, there are a number of possible outcomes. For example, the trend toward shrinking numbers of publicly traded companies could resume. Alternatively, the number of public companies could stabilize at or about current levels. Or the number of companies listed in the U.S. could increase again; however, it seems likely that even if there were to be an increase in the number of U.S. public companies, the increase would be relatively modest. As the Journal article puts it, “a return to the peak years of the 1990s isn’t expected.”

 

A number of important consequences flow from the reduced numbers of public companies over recent years. The first is that fewer companies in general means that the likelihood that any particular company will be sued is greater than is it was a couple of decades ago. As NERA Economic Consultants put it in their 2013 analysis of securities class action lawsuit filings (here), the decline in the number of publicly traded companies since 1998 means that “an average company listed in the U.S. was 83% more likely to be the target of a securities class action in 2013 than in the first five years after the passage of the PSLRA.”

 

The decline in the number of U.S. listed publicly traded companies also has important implications for the U.S public company D&O insurance marketplace. It is not just that there the universe of buyers is 44% smaller than it was in the late 90s. During that same time period, the number of D&O carriers has been increasing, as has their available underwriting capacity. In other words, an increased numbers of players are chasing premiums from a much smaller pool of insurance buyers. Some of the effects of this dynamic have been offset because many insurance buyers now buy a lot more insurance than they used to. But the inevitable result of these circumstances is that D&O insurance pricing has been under pressure, as will happen when supply exceeds demand.

 

While the primary D&O insurers have been able to resist these forces over the last 24 months or so (in part because of their claimed losses based on the surge in M&A litigation), overall and taking excess pricing into account, the increased numbers of D&O carriers and the reduced numbers of public companies has translated into downward pressure on pricing over time.

 

The slight increase in the number of publicly traded companies in 2013 is a positive note, although the upswing in IPOs has also meant an increase in the number of securities suits involving IPO companies as well. And as positive as the increase in the number of listed companies during 2013 may be, the increase is not yet large enough to represent a sufficiently larger pool of insurance buyers to shift the demand/supply ratio.

 

In any event, it is important to keep the changing numbers of public companies in mind. The fact that the number of public companies is more than 40% smaller than it was in 1998 is a very important consideration that is too often overlooked. All too often, discussions of litigation rates and other key trends continue as if the number of companies were constant. The public company D&O insurance community needs to keep the reduced numbers of U.S. public companies in mind when they think about their marketplace.

 

 

great lakes
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History shows that the places commerce favors change over time. In the United States, many of the cities that prospered in the 19th century faded in the 20th century as the logic of business shifted the location of prosperity. That same process will unfold again in the 21st century. Seemingly unlikely places will thrive in the decades ahead, for reasons that might not be immediately apparent now. And places that are booming now will fade, just as happened in the century just ended.

 

This dynamic was underscored in an article in the February 3, 2014 issue of Bloomberg BusinessWeek entitled “Data Factories Spring Up in Santa’s Backyard” (here).  In the past, technology companies had located their data centers first near universities with the skilled staff needed to run the facilities, and later near major urban centers, to be closer to the customers using the facilities. But more recently companies such as Google, Microsoft and Facebook have chosen to locate massive data centers in Scandinavia, to take advantage of the availability of cheap hydroelectric power to run the centers and of the abundant chilly waters to cool the centers’ heat sensitive servers.

 

The article describes the Swedish city of Luleå, 70 miles south of the Arctic Circle, where Facebook has developed a 300,000 square foot data center, to take advantage of the city’s inexpensive hydroelectricity and cool air. The article describes the town’s prosperous main street as “flanked by a park, high-end clothing shops and hotels.”

 

At the same time as seemingly unlikely locations such as Luleå are prospering because of their natural advantages, other areas are being forced to confront their natural limitations. An article in the February 10, 2014 issue of Time Magazine entitled “California Drying” (here, subscription required) states that 2013 was the driest year in California since it became a state in 1853. Communities throughout the state may run out of water altogether in two to four months. The Sierra Nevada snowpack, a crucial water source, is just 20% of its average.

 

Of course, the drought conditions in California could improve, but there is also a risk, the article explains, that the current drought “may represent a return to California’s bone-dry history.” The geographic area encompassing the state has “had multiple megadrougthts that lasted 10 to 20 years, as well as one that started in A.D. 850 and stretched for 240 years.” As a result of global climate shifts, the American West is “likely to get even drier.” In his January 17, 2014 state of the state address, California Governor Jerry Brown warned that the current drought may be “a stark warning of things to come.”

 

As if it were not enough that business prosperity in California must try to survive a hostile environment, businesses in the Bay Area are also being forced to confront actual hostility. Another article in the same issue of Time Magazine explains the street protests and social tensions that are arising in San Francisco as the city’s tech boom drives up rents and forces lower and middle income residents to have to move out of the city.

 

As the Time article puts it, “A combination of exploding wealth and limited space has led to an affordability crisis. Much of the angst among the have-nots is directed toward the region’s booming tech sector, which is attracting well-paid workers who once settled around San Jose and now regard the City by the Bay as the only place to be.” The have-nots are not taking this shift quietly. Confrontations between displaced locals and the private bus services the tech companies use to ferry worker from the city to their job sites have become frequent.

 

There may be solutions to the social tensions that the booming tech economy are creating, such as through the construction of additional affordable housing. But California’s water problems, if they persist or even worsen, are not easily solved. Changing social conditions can be accommodated, but life without sufficient water is simply not possible.

 

For large parts of the 20th century, a great deal of effort in the United States was focused on getting water to places where people wanted to be. In the 21st century, this process may have to reverse itself. The people may have to move to where the water is. When people realize that this may have to happen, they are going to notice something really important. That is, 21% of the world’s fresh water – and 84% of North America’s surface fresh water – is located in the Great Lakes.

 

There are a lot of people in very dry places in the American West who might want fresh water from the Great Lakes brought to their communities. However, due to a very far-sighted set of agreements among the eight states in the Great Lakes region called the Great Lakes Water Compact, the water in the Great Lakes hydrological system cannot be removed by human means from the Great Lakes water basin. In other words, if you want the water in the Great Lakes, you have to come to the Great Lakes — the water isn’t coming to you.  

 

It makes sense that the tech companies are moving their servers to where the electricity is cheap and the air temperatures are cooler. It may make even more sense for companies to move their employees to a location where there are actually sufficient quantities of fresh water.

 

And not only does the Great Lakes region have fresh water, it has some of the most reliably sustained winds in the country (particularly when proximity to urban centers is taken into account), capable of providing a reliable source of renewable energy. The availability of modern natural gas extraction technologies also means that the abundant natural gas in the region can help provide low cost and relatively low carbon impact energy, as well.

 

If employers were to move their operations to Cleveland, the crowds of locals gathered at the private bus stops wouldn’t be there to protest; they would be there to celebrate. Everyone in Cleveland would be so happy to have the jobs and the economic activity.

 

I am not the only one suggesting that California’s future may be in Cleveland. As Matthew Yglesias put it in a December 13, 2013 Slate article entitled “Move Silicon Valley to Cleveland” (here), it is time for the tech companies to move where they will be appreciated.  Cleveland, as Yglesias points out, has plenty of affordable housing and plenty of available office space. It even has a Federal Reserve Bank.

 

The Great Lakes region is of course known for its harsh winters. As I type this blog post, I am looking out my window at a fairly impressive winter storm that has already dumped about eight inches of snow. But you know what? That eight inches of snow represents an astonishing quantity of water that has been brought to the Great Lakes from outside the region. The winter weather replenishes the hydrological system.

 

The winters here in the Great Lakes region are harsh. And they last a long time. But I grew up in Virginia, and I have managed to acclimate.There is something about having all four seasons that makes you more realistic about life. And then there is the great secret that few outside the Great Lakes region appreciate – that is, this area is absolutely beautiful for the rest of the year. (I have previously documented the splendid pleasure of a Great Lakes summer, here).

 

Here’s the thing. The time to get in on the coming Great Lakes region land rush is now. The abundant, low-priced real estate is not going to last once everyone figures out that they are going to have to move to Cleveland  (or Milwaukee or Toledo or Buffalo or Erie, Pa.) for the water. The smart money is already going there.

 

Sure, go ahead, laugh. When you get thirsty enough, you won’t think this is funny at all.

 

Do you want to talk about earthquakes now, or should we save that for later?

 

 

PrintEven though (as have been well-documented by other observers) securities class action litigation filings increased in 2013, overall corporate and securities litigation filings during 2013 declined for the second year in a row, according to a February 4, 2014 report from the insurance information firm, Advisen. Though the corporate and securities filing activity in 2013 was below levels seen in more recent years – as credit crisis-related litigation swelled litigation levels – the litigation levels last year were above historical averages as well as above pre-credit crisis levels. The report, which is entitled “D&O Claims Trends: 2013 Wrap-Up & Possibilities for 2014,” can be found here.

 

As a preliminary matter, it is important to understand the terminology that Advisen uses. Unlike some other public reports, which only analyze securities class action litigation, the Advisen reports includes a variety of other types of corporate and securities litigation in its analysis The Advisen analysis  also includes regulatory actions; individual securities actions; breach of fiduciary duty actions; merger objection cases; and derivative cases. In addition, unlike other public sources, the Advisen report includes actions filed in both federal and state court, as well as actions filed outside the United States. For these reason, the information in the Advisen report may appear different than other recently published reports on securities litigation  

 

The most significant finding in the report is that for the second year in a row, overall corporate and securities lawsuit filings were down in 2013 compared to the prior year. There were 1,344 new corporate and securities lawsuit filed in 2013, compared to 1,677 in 2012, a decline of about 20 percent. The filing levels for both of the two most recent years were well below the peak of 2,041 new corporate and securities lawsuit filings in 2011. However, the 2013 filings still exceed the filings for any year prior to 2009 and also exceed the ten-year average of 1,285. These figures suggest that while 2012 and 2013 involved a decline in annual filing levels, the figures for those years also represent an easing of the litigation activity that attended the credit crisis. While the filing figures are down from the elevated levels following the crisis, they remain eat higher levels compared to historical norms from years prior to  the crisis.

 

All categories of litigation that Advisen tracks declined in 2013, except for securities class action lawsuit filings, which rose slightly. The Advisen report suggests that, in addition to the winding down of the financial crisis litigation, the decline may be due to the fact that there are fewer publicly company targets. In addition, there were fewer merger objection cases filed in 2013 and in 2012 compared to 2011, because there were fewer merger transactions in those years than there were in 2013.

 

For several years, Advisen has tracked the decline in the number of securities class action lawsuits as a percentage of all corporate and securities lawsuits filed. As recently as 2007, securities class action lawsuits represented about 23 percent of all corporate and securities lawsuit filings. By 2011, however, this figure has dropped to 10 percent. In the last two years, this figure has risen slightly, and in 2013, securities class action lawsuit represented about 13 percent of all lawsuit filings. However, the report notes that “although in the past two years securities class actions have been creeping up slowly as a percentage of total events, they are still a long way away from pre-credit crisis levels.”

 

The number of settlements fell for the second year in a row as well. But while the number of settlements declined, the average settlement during the year rose significantly from $13.2 million in 2012 to $51.5 million in 2013. (It is important to keep in that the universe of cases that Advisen tracks is both broad and diverse and the averages are calculated across a wide variety of different kinds of cases.) The 2013 figures were largely a reflection of several very large securities class action lawsuit settlements. The average securities class action settlement in 2013 was $82 million, compared to $33 million in 2012.

 

The findings in the Advisen report, as well as the overall corporate and securities litigation trends in 2013 and the likely litigation possibilities in 2014, will be the subject of free one-hour Advisen webinar to be held February 4, 2014 at 11 am EST. I will be participating in the webinar, along with Jack Flug of Marsh, Dennis Kearns of QBE and Jim Blinn of Advisen. Information about the webinar, including registration, can be found here.

 

 

minnI have frequently noted that among the many exposures a company experiencing a data breach could encounter is the possibility of a shareholder suit alleging that the company’s board breached their fiduciary duties by failing to take sufficient steps to protect the company from a breach and its consequences. This possibility has now been realized in connection with the recent massive data breach at Target — shareholder plaintiffs have now filed at least two shareholder derivative suits against the company’s directors and officers, as well as against the company itself as nominal defendant.

 

Both of the lawsuits were filed in the United States District Court for the District of Minnesota. The first of the two complaints, which can be found here, was filed on January 21, 2014. The second, which can be found here, was filed on January 29, 2014. The first complaint alleges claims for breach of fiduciary duty and waste of corporate assets. The second complaint alleges breach of fiduciary duty, gross mismanagement, waste of corporate assets and abuse of control.

 

Though the second complaint asserts additional claims not raised in the first complaint, the two filings generally are similar. Basically, the two complaints alleged that the defendants were aware of how important the security of private customer information is to customers and to the company, as well the risks to the company that that a data breach could present. The complaints allege that the company “failed to take reasonable steps to maintain its customers’ personal and financial information,” and specifically with respect to the possibility of a data breach that the defendants failed “to implement any internal controls at Target designed to detect and prevent such a data breach.”

 

Both complaints emphasize not only the failure to take steps to prevent a breach, but also allege that the defendants “aggravated the damage to customers by failing to provide prompt and adequate notice to customers and by releasing numerous statements meant to create a false sense of security to affected customers.”

 

The complaints allege that the failure to prevent the breach and then to timely report accurate information about it have “severely damaged the company,” noting that the company is currently under investigation by the United States Secret Service and the Department of Justice, and has been hit with numerous consumer class action lawsuits. Both of the derivative suit complaints allege that the class action lawsuits threaten the possibility of hundreds of millions of dollars of damages to the company. The complaints seek monetary damages and injunctive relief “by way of significant corporate and managerial reforms to prevent future harm to the Company by disloyal directors and officers.”

 

Given the magnitude of the Target breach and the amount of publicity it has garnered, it may not be all that surprising that these complaints have been filed. Nor are these the first D&O lawsuits filed against directors and officers of a company that experienced a significant data breach; several D&O lawsuits were filed against Heartland Financial’s directors and officer after that company experienced a significant breach of credit card information. And it remains to be seen whether or not these lawsuits (and others that may be filed against Target officials relating to the breach) will prove to be successful; the defendants will have a number of defenses, including among other things the fact that the plaintiffs filed their suits without first bringing a demand to the board for the board itself to pursue the claims on the company’s behalf.

 

Just the same, these lawsuits are significant if for no other reason than that they show how a data breach can lead directly to a D&O claim. For some time now, the public discussion of about privacy and network security have included the message that these concerns are board level issues. As the Target D&O lawsuits show, among the consequences that can follow from a significant data breach is an attempt by the company’s shareholders to hold the company’s senior officials liable for the harm that the data breach caused the company.

 

These lawsuits are not the first D&O lawsuit based on a cyber security breach, but they surely will not be the last. Indeed, the terrible problems that Target has experienced following its breach clearly represent an important message to other companies about the disruptive effect a serious data breach can have, and highlight the importance for other companies’ executives to take steps to protect against a similar development at their companies. Shareholders at companies experiencing future data breaches may allege that “even after the massive problems at Target” the company’s executives failed to take steps to protect the company or failed to have a plan in place for the company to deal with the situation if the company did experience a breach.

 

It is particularly interesting that both complaints emphasize (and seek to have liability based upon) the company’s reactions to and public disclosures following the breach. These allegations highlight the fact that shareholders may seek to hold company officials responsible for the failure to prevent the breach but also for the way that the company conducts itself as it responds to the breach.

 

Special thanks to Rick Bortnick of the CyberInquirer blog for sending me a copy of the complaint in the first filed derivative lawsuit. Speaking of Rick Bortnick, you can find his thougthts, along with those of Ann Longmore of Willis and Jonathan Fairtlough of Kroll, on the topic of “D&O Liability in Data Privacy and Cyber Security Situation in the US” from the January 2014 issue of Financier Worldwide, here. 

 

California AG Law Suit for Late Data Breach Notification: As if the threat of shareholder litigation were not enough to worry about, there are other litigation concerns for companies experiencing data breaches to worry about as well. As discussed in a January 30, 2014 post on the Information Law Group blog (here), the California Attorney General’s office has filed a complaint against Kaiser Foundation Health Plan Inc. for the company’s alleged delay in providing notifications required under California law notification to affected persons following the company’s September 2011 loss of a hard drive containing sensitive personal information. It appears that the company delayed notification until it had completed its forensic investigation some months after the loss.

 

Among other things, the California AG’s recent suit shows that data security issues and requirements are becoming an increasingly important priority for regulators, as well as for shareholders. In addition, the lawsuit underscores the fact that the way that the company responds to a data breach can itself be a source of litigation exposure.

 

Game Notes:

1. Way to go, Denver. Now everyone knows what it would look like if the Cleveland Browns were ever to play in a Super Bowl. That is, a team in an orange uniform would fail to execute, turn the ball over (repeatedly), miss tackles (repeatedly), and give up big plays on special teams. Take nothing away from the Seahawks, they played great and absolutely deserved to win big. But Denver kicked their own butt. Peyton Manning picked an odd time to start channelling his inner Brandon Weeden.

 

2. Lousy game, lousy commercials. The only commercial that succeeded universally in our group was the Cheerios ad where the little girl negotiated for a puppy. The women in our group all liked the ad with the puppy and  the Clydesdale.  Every single person who had anything to do with the Stephen Colbert/pistacho ad should be fired, as should anyone that thought the Bud Lite/Arnold Schwarzenegger ad was a good idea. There were way too many truly awful ads. Who even knows what the ridiculous ad with the cross between the doberman the chihuahua was trying to sell? And can I just say, the exploitation of the American flag and of our need to stand by our vets in order to sell beer and cars makes me very  uncomfortable. 

 

3. Halftime conversation: “Who is Bruno Mars?” (Still unsure.)

 

4. What do you think Pete Seeger would think of Bob Dylan hawking Chryslers?  

 

As the March 5, 2014 date for oral argument before the United States Supreme Court in the closely-watched Halliburton case approaches, the briefing process in the case has continued to unfold. On January 29, 2014, the Erica P. John Fund, the respondent (the plaintiff in the underlying action) filed its merits brief in the case, arguing that the Court should uphold the fraud on the market theory. But while the plaintiff contends that the Court should preserve the status quo, other commentators are looking ahead considering what the securities litigation world might look like if the Supreme Court overturns Basic v. Levinson (the 1988 decision in which the Court first recognized the fraud on the market theory).

 

As well-analyzed by Alison Frankel in a January 30, 2014 post on her On the Case blog (here), the plaintiff has urged the court to uphold Basic based on the history of the securities laws and the principles of stare decisis, and out of deference to Congress and regulators. The plaintiff  side-steps the debate whether the “efficient market hypothesis” on which the fraud on the market theory is based is valid, arguing that the debate is “irrelevant” and contending  that at the heart of Basic v. Levinson is “the simple economic truth” in “the proposition that developed markets generally respond to material information.”

 

The plaintiff argues that in adopting the securities laws in the wake of the Great Depression, Congress recognized, consistent with the fraud on the market theory, that a company’s share price incorporates all publicly available information about the company. According to the plaintiff, the Supreme Court itself recognized as much in several cases prior to the Basic case. And since Basic was decided, the Court has expressly endorsed the fraud on the market theory several times – including just three years ago in a unanimous decision in the Halliburton case itself, when the case was previously before the Court.

 

In other words, the plaintiff argues, the Supreme Court could only dump the fraud on the market theory by reversing its own precedent and overlooking an established body of its own case law. For the Court to overturn its own statutory precedent is an event so rare that, according to the plaintiff, it has been over 50 years since the last time the Court did so.

 

Not only would the Court have to overturn its own precedent, but it would implicitly override Congress, which has revised the securities laws numerous times since Basic was decided but has not altered the fraud on the market theory. “Congress,” the plaintiff argues “has expressly considered overturning Basic, and could have done so at any time over the past quarter century,” but instead it left the current arrangements in place. In addition, the plaintiff argues, both the SEC and the Department of Justice rely on the fraud on the market theory in connection with their enforcement of the securities laws.

 

The most fundamental reason for leaving Basic alone, the plaintiff argues, is that if the fraud on the market theory is discarded, “securities-fraud class actions and many individual fraud actions simply could not be brought in 10(b) and 10b-5 cases based on affirmative misrepresentations.” As a result, “most defrauded investors would be left without any legal recourse from fraud.” Were this to happen, “the legal landscape would be worse for the change.”

 

The reason that the plaintiff emphasized the importance of the fraud on the market theory in misrepresentation cases in particular is that in a case based on alleged omissions rather than alleged misrepresentations, the claimant does not have to depend on the fraud on the market theory to establish a presumption of reliance. Instead, in an omissions case, the claimant simply does not have to establish reliance. In a case that preceded Basic, the 1972 decision in Affiliated Ute Citizens v. United States, the Supreme Court said that proof of reliance is not necessary to support a claim based on alleged omissions.

 

In light of this case law, many commentators have speculated that if the Supreme Court were to overturn Basic and make it impossible for plaintiffs to pursue Section 10(b) misrepresentation cases as class actions, the plaintiffs will simply recast their allegations and contend that investors were misled by the defendants’ omissions, instead of trying to contend that the defendants’ misrepresentations had misled investors.

 

However, it could be far trickier for the plaintiffs to pursue this approach that the commentators are suggesting. As Claire Loebs Davis notes in a January 28, 2014 post on the D&O Discourse blog (here), Affiliated Ute “does not offer a quick fix” to the potential elimination of the fraud on the market theory.   Rule 10b-5, she argues, does not simply create a cause of action for omissions as well as for false and misleading statements; rather, she emphasizes, the provision refers to “false or misleading statements and omissions of material fact necessary to make statements made not misleading.”

 

In other words, omissions are only actionable if they cause an affirmative statement to be false or misleading because of the information that was omitted. It is not enough for a plaintiff to argue that something material was omitted; the omitted information must have made an affirmative statement materially misleading. Accordingly, she argues, “plaintiffs cannot simply recast their securities fraud allegations as ‘omission’”; plaintiffs “may only state a claim under 10b-5(b) based on an affirmative misstatement – whether that affirmative statement was misleading because of what it said, or because of what it did not say.”

 

She concludes her post by noting ‘that “one thing is clear: Affiliated Ute does not offer a straightforward solution for plaintiffs’ lawyers if the Halliburton Court takes away the fraud-on-the-market presumption. Whether they phrase their allegations as claims of affirmatively false statements or statements made false by omission, they are still claims based on statements, not omissions, and current law requires that plaintiffs find a way to show class-wide reliance.”

 

Davis’s commentary is both noteworthy and very interesting. Some commentators considering the possible outcomes of the Halliburton case have tried to suggest that not that much would change if the Supreme Court were to dump the fraud on the market theory, since, they suggested, plaintiffs could simply plead their claims as omissions cases and rely on Affiliated Ute to avoid the reliance problem. Davis’s post suggests that it may not be that simple and that even in an omissions case the plaintiffs will have to establish class-wide reliance.

 

 

Considered on an absolute basis, securities class action lawsuit filings were up about nine percent in 2013 compared to 2012, although the number of 2013 lawsuits was about 13 percent below annual filings averages for the years 1996-2012, according to a new report from Cornerstone Research and the Stanford Law School Securities Class Action Clearinghouse. However, as the report also notes, the number of publicly traded companies has been declining steadily since 1997. Thus, while the absolute numbers of filings in 2013 may have been below historical averages, the number of securities lawsuits filed in 2013 relative to the reduced number of publicly traded companies represents a higher rate of litigation when compared to historical filings rates.

 

The Cornerstone Research report, which is entitled “Securities Class Action Filings: 2013 Year in Review,” can be found here. The January 28, 2014 press release accompanying the report can be found here. The statistics and analysis in the Cornerstone Research report are consistent with my own review of the 2013 securities class action lawsuit filings, which can be found here.

 

Owing to some methodological variances (which I discuss here), there are differences between the figures reported in the Cornerstone Research report and those recently reported in a similar analysis by NERA Economic Consulting. However, while the two reports differ in their details, the reports are directionally consistent and reach similar conclusions.

 

According to the Cornerstone Research report, there were 166 new federal securities class action lawsuits filings in 2013, compared to 152 in 2012, representing an increase of nine percent. The increase in filings in 2013 is largely a factor of a surge in filings in the year’s second half. There was a 21 percent increase in number of filings in the second half of 2013 compared to the first six months of the year. Though the number of filings was up in 2013 compared to 2012, the 166 filings during the year still are well below the 1997-2012 average number of filings of 191. The annual number of filings has not exceeded the historical average since 2008.

 

This generally downward trend in the absolute number of securities class action lawsuit filings may be due in part to the steady decline in the number of publicly traded companies. As detailed in Figure 10 in the Cornerstone Research report, the number of publicly traded companies in the U.S. has declined by 46 percent sine 1998. The report itself states that “the decline in listed companies is one explanation for the recent relatively low levels of filings activity compared to historical averages.”

 

Indeed, when the number of 2013 filings is considered relative to the remaining number of publicly companies, it is apparent that the 2013 filing activity is actually up compared to historical filing rates. During 2013, approximately 3.3% of all U.S.-listed companies were hit with a securities class action lawsuit. This figure is not only up from the 3.1% rate in 2012, but it is also above the 1997-2012 average annual lawsuit filings rate of 2.85%. Thus, taking into account the decline in the number of publicly traded companies, rather than simply considering the absolute number of lawsuit filings, the 2013 securities class action lawsuit filings are actually up compared to historical averages. Figure 10 in the report also show that the filing rate during the period 2006 to 2013, while ebbing and flowing when considered annually, has been generally upward.

 

Though the number of public companies is declining as a result of bankruptcies and mergers, there was an uptick in 2013 the number of companies listing their shares for the first time. The report notes that the 150 IPOs completed in 2013 represented the highest annual number of initial offerings since 2008. The press release accompanying the report quotes Dr. John Gould, Senior Vice President of Cornerstone Research, as saying that “the sharp increase in IPOs in 2013 may provide fuel for a new wave of filings in the next few years.” Indeed. as I previously have noted on this blog (refer here), the recent increased IPO activity already contributed to increased securities suit filings activity during the second half of 2013.

 

While the number of annual securities suit filings ebbs and flows over time, it seems that litigation activity increasingly is targeting smaller companies. The report shows that the median market cap of companies subject to a securities class action lawsuit has dropped from around $1 billion in 2008 to $697 million in 2013. By the same token, in 2013 only about 3.4% of companies in the S&P 500 were hit with a securities suit, compared with a historical annual average of about 5.9% of S&P 500 companies. Similarly, only 4.7% of the S&P 500 market capitalization was subject to a new securities suit filing in 2013 compared with the historical average of 10.6%.

 

Filings against Non-U.S companies declined in 2013 compared to the two prior years. In 2013, there were 30 suits against non-U.S. companies, representing 18 percent of all securities suit filings, compared to 32 suits in 2012 representing 21 percent of securities suit filings and 62 suits in 2011 representing 33 percent of filings. The 2011 numbers were elevated by a surge of class action lawsuit filings against U.S.-listed Chinese companies. The surge has abated but even so in 2013 China remained the country with the largest number of companies hit with securities suit filings.

 

Healthcare, biotechnology and pharmaceutical companies together accounted for 21 percent of total filings in 2013. Filings against energy companies also increased in 2013. (My own analysis confirmed these industrial sector frequency observations, as discussed in my year end survey of 2013 securities lawsuit filings.)

 

As I have noted on this site, many of these historical filings patterns and metrics could be changed significantly by the Halliburton case now before the U.S. Supreme Court. As Stanford Law Professor Joseph Grundfest is quoted as saying the press release accompanying the report, if the Supreme Court throws out the “fraud on the market” theory in the Halliburton case, “it will become impossible to certify a large number of Section 10(b) class actions.” If this were to happen, the report notes, “the entire ecology of the market for class action securities fraud litigation is likely to undergo a dramatic change.”

 

Professor Grundfest is quoted in the press release as saying that if the Supreme Court dumps the fraud on the market theory “Large investors with substantial losses in the biggest of the frauds will likely be able to litigate their clams on an individual basis, but small investors will have to look to Congress to fashion an alternative remedy.”

 

Discussion

For far too long, public discussion of whether securities suits are increasing or decreasing has focused solely on the absolute number of filing. I have long thought that the number of filings can only be assessed in comparison to the number of publicly traded companies. In confirmation of an analysis that also appeared in the recent report from NERA Economic Consulting, the Cornerstone Research report shows that the number of publicly traded companies has fallen by almost half since the enactment of the PSLRA. So while the absolute number of securities suits are (and have been for several years) below longer term historical annual average numbers of annual filings, the trend in the number of lawsuits relative to the declining number of publicly traded companies has actually been increasing in recent years.

 

All of this may be changed dramatically with the Supreme Court’s consideration of the Halliburton case. If the Supreme Court should dump the fraud on the market theory without providing another way for securities plaintiffs to establish class-wide reliance, the number of Section 10(b) misrepresentation securities class action lawsuits could drop significantly (although whether replaced by other kinds of suits would remain to be seen). Depending on the outcome of the Halliburton case, future annual analyses of securities lawsuit filing patterns and trends could look very different.

 

A Little Experiment: I believe that many of this blog’s readers are in New York this week for the PLUS D&O Symposium. In order to test this theory, I would like to ask readers who are attending the conference (and who have read this far in this blog post) to drop me a short email note at kevin.lacroix@rtspecialty.com . I wonder how many emails I will get? In any event, if you are at the conference and you see me around the event venue, please say hello.  

 

In general, and at least in the United States, executives at public companies don’t need to be convinced that their companies need to have D&O insurance. That is not always true with officials at private companies. Some officials at some private companies – particularly very closely held private companies – are skeptical that they need the insurance. These individuals believe they will not see any claims that would trigger the insurance.

 

Many of those who resist the need for D&O insurance are affiliated with companies that have only a very small number of shareholders. These company executives look at the ownership structure and conclude their company could never have a D&O claim. This perspective overlooks the fact that the plaintiffs in D&O claim include a much broader array of claimants than just shareholders. D&O claims plaintiffs also include customers, vendors, competitors, suppliers, regulators, creditors and a host of others. In our litigious age, just about anybody is a prospective claimant.

 

These issues – including both the reluctance of some private company executives to purchase D&O insurance and the breadth of risks that private companies face – are detailed in the results of the Chubb 2013 Private Company Risk Survey. The Chubb survey updates a prior survey the company conducted three years previously. For the most recent survey, the company commissioned an outside survey firm to conduct a telephone survey of 450 private company representatives in the U.S. The survey report can be found here.

 

The report concludes that “private companies increasingly are at risk of professional and management liability from a vast range of events, including costly lawsuits, governmental fines, data theft and other criminal activities.” Despite these risks, “a large percentage of company decision makers are not taking steps to protect themselves with professional management liability insurance – even though a dramatically growing number of managers are concerned about the risk.”

 

In detailing the exposures that private companies face, the report shows that in the three years prior to the survey, 44% of private companies experienced at least one loss event related to D&O liability, EPL, fiduciary liability, employee fraud, workplace violence or cyber liability. The likelihood of a claim was greater for larger companies; 76% of companies with more than 250 employees had experienced a loss event. But even the smallest companies had significant levels of loss activities; 33% of companies with only 25-49 employees had experienced a loss event.

 

The survey also showed that significantly more private company officials expressed concerns about their company’s risks and exposures than respondents had in the prior survey. Nevertheless, the purchase rate for D&O, EPL and other management liability insurance policies has changed little during the period between the surveys. One reason the report cited for the low purchase rate is that many respondents believe that their risks are covered under their general liability (GL) policy. For example, 65% of the respondents mistakenly believe that their company’s GL policy provides D&O liability insurance protection.

 

As noted above, many private company executives believe that D&O insurance is for publicly traded companies, but as a private company they don’t need it because they believe their company will never have a D&O claim. However, the survey report shows that D&O lawsuits are almost as common for private companies as for public companies. In the past ten years, D&O claims have affected 27% of private companies, compared to 33% of public companies. Thirteen percent of the survey respondents had experienced a D&O related event in the last three years.

 

The companies that have had D&O-related events learn quickly that D&O claims are expensive. The survey report show that the average total costs for D&O lawsuits for private companies (including judgments, settlement, fines and legal fees) is $697, 902. Two survey respondents reported D&O claims losses of $10 million. The report shows that the D&O claimants include not only shareholders or other owners but also vendors, competitors, employees, suppliers, regulators and governmental authorities, as well as others.  Despite the magnitude of these claims exposures, only 28% of private companies purchase D&O insurance.  

 

In my experience, the one group of private company executives from whom you will never hear the statement that their company doesn’t need D&O insurance are executives from companies that have had a D&O claim. They know how costly these kinds of claims are to defend. D&O claims may not happen frequently in the life of a company – indeed, among the many  private company D&O claims I have been involved in over my many years in the industry, most involved companies that were experiencing their first-ever D&O claim. Frequently, the claims involve disputes they never anticipated and that they had never previously experienced.

 

Pricing for D&O insurance has been increasing in recent months, largely due to the insurers’ adverse claims experience (which should tell you something right there). Even at the recently increased pricing levels, the purchase of D&O insurance is still relatively advantageous to the buyer. For their premium payment, D&O insurance buyers obtain coverage that is quite broad. Private company D&O insurance policies are materially broader than D&O insurance for public companies. In particular, the entity coverage under a private company D&O policy is significantly broader than the entity coverage under public company D&O insurance policies. The entity coverage in public company D&O insurance policies is generally limited just to securities claims. However, private company D&O policies contain no such limitation, so the private company D&O insurance policy provides significant balance sheet protection for the insured entities.

 

The survey report shows other areas where private companies are vulnerable and perhaps not appropriately insured. For example, 28% of survey respondents reported plans to reduce or eliminate employee benefits in the year ahead, and 25% reported the likelihood of merger or acquisition activity, which are both factors that potentially could increase fiduciary liability risk. Nevertheless, only 26% of companies purchase fiduciary liability insurance – again apparently out of a mistaken belief that their company’s GL policy protects them for their fiduciary liability exposures.

 

The report also shows that private companies have significant employment-related risks. The report showed that 25% of the survey respondents had experienced an EPL-related event in the last three years and that 45% of respondents are concerned about a lawsuit for wrongful termination, sexual harassment, discrimination or retaliation. The average total costs associated with an EPL event was $70,267, yet despite the claims and concerns, only 30% of companies surveyed purchase EPL insurance, again out of the mistaken belief that the company’s GL policy protect against the exposure.

 

Another interesting finding in the survey has to do with private companies’ perceptions of Cyber Risk. The survey reports that 27% of managers are concerned about cyber risk. Citing outside sources, the report notes the significant costs for companies experiencing cyber risks. Despite these concerns and risks, the survey reports that 90% of companies do not purchase cyber insurance.

 

As the survey report notes, the “bottom line” is that “private companies are vulnerable.” Whether or not a company should purchase insurance is an important business decision for company executives to make. It may be a rational business decisions to do without insurance, at least for some companies. However, the decision is less likely to be made correctly if it is based on an under-appreciation of the risks and exposures that the company faces or if it is based on a mistaken belief that other types of insurance will protect the company from the exposures that the management liability insurance policies are designed to protect against. Private company executives who fully understood their company’s risk exposures and the absence of insurance coverage under GL policies for these exposures are likelier to appreciate the need to purchase management liability insurance protection, including in particular D&O, EPL and Fiduciary Liability insurance.

 

Beyond the question of whether or not to buy the insurance, there are a host of choices that private companies choosing to purchase D&O insurance must make. These issues include such considerations as whether or not to buy separate or combined limits for the various management liability coverage lines, or whether to have the insurance structured on a duty to defend basis or a reimbursement basis. These insurance-related issues are discussed in an earlier post about private company D&O insurance (here), which is part of my series of posts on the Nuts and Bolts of D&O Insurance (about which refer here).

 

The Week Ahead: This upcoming week I will be attending the PLUS D&O Symposium in New York. On Tuesday, January 27, 2014, I will be moderating a panel entitled “Not Just Securities Class Actions: Regulatory Actions, Derivative Actions and Breach of Fiduciary Claims.” Joining me on the panel will be Sharon Binger, the assistant regional director for the SEC in New York; Damian Brew from Marsh; Joe Finnerty from DLA Piper; and Mary McIvor from AIG.

 

I will also be around the event venue during the entirety of the conference, and I hope that readers who see me there will make a point of saying hello, particularly if we have not previously met. I look forward to seeing everyone in New York.  Information about the D&O Symposium can be found here.

 

Coming Attractions: While I am out of the office and on the road this upcoming week, I will be having some significant back end work done on this blog. Though there will be a few minor changes to the blog’s appearance, most of the changes will be behind the scenes. Essentially, I am moving the blog off of an antiquated blogging platform to a more flexible and robust platform. Among other things, the changes should mean fewer technological glitches and also more control on my end on how the blog appears to readers.

 

Because my hosting service (LexBlog) will be switching the site over to the new blogging platform on Wednesday and Thursday this upcoming week, I will not be adding any new content those days. The site should remain fully accessible without interruption while the changes are implemented, I just won’t be posting anything new between Tuesday and Friday. I am hoping that these changes will facilitate improvements to the site’s appearance, performance and functionality. Please keep an eye out for the changes, which should be in place by or before next weekend.

 

In many jurisdictions, corporate officials sued for their actions undertaken in their corporate capacity may be able to defend themselves in reliance on the “business judgment rule.” This rule is designed to prevent courts from second-guessing the decisions of directors and officers. The defense has become particularly important in connection with the extensive litigation the FDIC is now pursuing against the former directors and officers of failed banks.

 

Among the many questions that have arisen in the FDIC’s failed bank cases as individual defendants have tried to rely on the protection of the business judgment rule is whether or not the defense protects officers as well as directors (about which refer here) or whether it affords less protection to the directors and officers of banks than it does to corporate officials at other kinds of companies (about which refer here). The business judgment rule represents something of a hot topic now given that  the Georgia Supreme Court will be considering  questions recently certified to it from both the Northern District of Georgia (about which refer here) and from the Eleventh Circuit (about which refer here) on issues pertaining to the scope of the rule’s protections under Georgia law. Many of the recent case decisoins on the topic, as well as the questions that have been certified to the Georgia Supreme Court, have to with the extent of the rule’s limitations. Disturbingly, some courts seem to be reducting the business judgment rule’s protections.

 

 

While I have had occasion to post items on this blog about the business judgment rule, I have not stepped back and taken a comprehensive look at the rule and where it fits in the larger picture of directors’ and officers’ liability litigation. In the course of doing some Internet research, I noted that D&O maven Dan Bailey of the Bailey & Cavalieri law firm had recently published an article on the topic. Dan’s article notes a “disturbing trend” in the case law toward the dilution of the business judgment rule’s protections. Because I think this is a very important topic, I approached Dan to see if he would be wiling to publish his article as a guest post on this site. Fortunately, Dan agreed, and his article appears below.

 

 

I would like to thanks Dan for his willingness to publish his article as a guest post on this site. I welcome guest posts from responsible commentators on topics of interest to readers of this blog. If you would like to publish a guest post, please contact me directly. Here is Dan’s guest post. 

 

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The business judgment rule (BJR) has served for decades as the single most important protection against personal liability for directors and officers. First developed by courts over a century ago, this common law defense prevents courts from second-guessing the quality of a business decision by directors and officers. The two primary underpinnings of the BJR are:

 

1. Courts should not substitute their inexperienced business decisions for the good-faith decisions of independent and diligent business exexcutives, who have a far greater ability to make appropriate business decisions based on their extensive commerical knowledge, experience and training.

 

2. Executives should be encouraged to take prudent risks for the benefit of the company and its constituents, and should not be stymied by the fear of personal liability if a decision ultimately harms the company.

 

The BJR generally applies to business decisions made by disinterested and reasonably informed directors and officers who honestly and rationally believe their decision was in the best interest of the company. If the BJR applies, directors and officers should not be liable for the quality or results of their decisions, but only the process used to make the decision.

 

As summarized below, several recent cases and litigation tactics demonstrate this important defense for directors and officers is not full proof, and suggest a disturbing trend (outside of Delaware) toward diluting the benefit of the BJR. At a minimum, these cases and tactics highlight the volatile liability exposure which directors and officers face despite the BJR and the need for strong D&O financial protections to address that exposure.

 

A. BJR Inapplicable to Officers

Most courts and commentators have assumed without much discussion or analysis that the BJR rule applies to both directors and officers. But, several recent decisions by federal district courts in California ruled that the BJR applies only to independent directors, not officers.

 

The Delaware Supreme Court[1] and federal courts in Florida,[2] New York,[3] Illinois[4] and Georgia[5] have made the BJR available to officers. But, more than two decades ago a federal court in Pennsylvania, applying Delaware law,[6] and a California appellate court[7] stated the BJR is not applicable to officers. Commentators Sparks and Hamermesh, in a 1992 article, suggested a somewhat limited applicability to officers:

 

While there are no cases directly on point, the concept of an officer as the repository of delegated management authority by the board suggests that the availability of a business judgment rule defense may only be available to a corporate officer when that officer is operating within the scope of the delegated authority …  As a result, officers face a dual risk. Liability may attach if the officer is adjudged in hindsight to have acted outside the scope of his or her delegated authority or to have failed to act on a matter that was not (sic) within his or her expected areas of responsibility.[8]

 

More recently, five decisions by federal district courts in California ruled that the business judgment rule applies only to independent directors, not officers.

 

Although these cases are arguably driven by a California statute which codifies the BRJ only for directors, these cases reflect the potential for a disturbing judicial abandonment of an important protection for officers. In FDIC v. Perry, 9] the FDIC alleged that the CEO of IndyMac Bank breached his fiduciary duties to the failed bank by allowing IndyMac to generate and acquire more than $10 billion in risky residential loans, resulting in more than $600 million in losses to the bank. The CEO argued the lawsuit should be dismissed based on the business judgment rule. The court ruled that under California law, both the common law and statutory business judgment rule applied only to directors, not officers, and therefore the court refused to dismiss the lawsuit.

 

With respect to the common law business judgment rule, the court found no prior decision in California which applied the business judgment rule to officers. The court noted one California case which held the business judgment rule did not apply to “interested directors who effectively were acting as officers,” although the inapplicability of the business judgment rule in that prior case could be explained by the directors’ “interested” status rather than the directors’ de facto officer status. Without explanation, the court rejected the notion that the general judicial policy of deference to business decisions should apply to officers, which is obviously disturbing since courts are generally ill-equipped to substitute their business decisions (using the benefit of 20/20 hindsight) for the real-time business decisions of executives.

 

With respect to the California statutory business judgment rule, the court observed that the statute provides that directors who perform their duties as directors in accordance with the statutory standards have no liability for failing to properly discharge their duties as such. The statute, though, does not mention officers. In explaining the statute’s omission of officers, the court cited to the legislative committee’s comments to the statute, which seems to acknowledge that officers were intentionally excluded from the statute for the following reason:

 

Although a non-director officer may have a duty of care similar to that of a director, his ability to rely on factual information, reports or statements may, depending upon the circumstances of the particular case, be more limited than in the case of a director in view of the greater obligation he may have to be familiar with the affairs of the corporation.

 

In FDIC v. Hawker,[10] a California district court likewise ruled that the California statutory business judgment rule does not apply to officers because the statute references only directors and because the legislative comments to that statute do not include officers. However, the court ruled that the common law business judgment rule did not justify a dismissal of the claim against officers because issues of fact existed as to the conduct of the officers. That ruling implicitly suggests that the common law business judgment rule can apply to officers if the subject conduct of the officers falls within the scope of the common law business judgment rule.

 

In an unreported August 1, 2011 ruling in National Credit Union Administration v. Siravo, Case No. CV-10-01597 (C.D. Cal.), a different Federal District Court judge in California also ruled that the business judgment rule did not apply to officers, based on the plain language of the California statutory business judgment rule which applies only to directors.

 

In FDIC v. Van Dellen,[11] a California Federal District Court again ruled that officers are not protected by the business judgment rule both because the codification of the rule in California Corporations Code Section 309 only refers to directors and because prior California authority did not extend to officers the judicial policy of deference to a director’s exercise of good faith business judgment in management decisions.

 

In FDIC v. Faigin, 12] a California Federal District Court followed FDIC v. Perry and held that the business judgment rule does not apply to officers.

 

The wisdom of excluding officers from the BJR is certainly debatable. Officers are more knowledgeable and involved in the company’s operations than independent directors, thereby suggesting a more rigorous standard of conduct than applicable to directors. But, the underlying justifications for the business judgment rule (i.e., courts are ill-equipped to second-guess business decisions and should encourage prudent risk-taking) equally apply to claims against directors and officers.

 

B. BJR Inapplicable to Bank Directors and Officers

The BJR generally applies to directors and officers of any non-profit, private or public company because the underpinnings of the BJR are not dependent upon the type of organization. However, a recent decision by a district court in Georgia concludes that the BJR should not apply in a lawsuit by the FDIC against directors and officers of a failed bank.[13] In denying the defendant directors’ and officers’ motion to dismiss, the court concluded that the widespread impact of a bank failure justified a harsher standard on directors and officers of a failed bank than applicable to other types of organizations, and therefore directors and officers of the failed bank should not enjoy the protections of the BJR:

 

[W]hen a bank, instead of a business corporation fails, the FDIC and ultimately the taxpayers bear the pecuniary loss. The lack of care of the officers and directors of banks can lead to bank closures which echo throughout the local and national economy. To some extent, the failure of bank officers and directors to exercise ordinary diligence lead to the financial crisis that continues to affect the national economy…. [T]his is not a case where shareholders are suing their own officers and directors, but instead it is a case where the FDIC as receiver is seeking damages following allegedly negligent banking practices. A case where the FDIC is receiver “is not simply a private case between individuals [but rather a case that] involves a federal agency appointed as a receiver of a failed bank in the midst of a national banking crisis.”

 

Although the court recognized that federal courts in Georgia have “uniformly” applied the BJR to protect bank officers and directors, the court did not apply the BJR to a claim by the FDIC against the failed bank directors and officers. However, the court certified that question to the Georgia Supreme Court. One month later, the 11th Circuit Federal Court of Appeals certified the same question to the Georgia Supreme Court in a different lawsuit by the FDIC against directors and officers of a failed bank.[14]

 

C. BJR Inapplicable to Intimidated Directors

One of the key elements of the BJR is the requirement that the defendant director or officer must be disinterested (i.e., the business decision must be based on the corporate merits of the decision rather than extraneous considerations or influences). Courts most frequently find this requirement lacking, and thus the BJR inapplicable, where the director or officer has a conflict of interest with respect to the decision, such as a personal financial interest in the decision or a close familial or business relationship which may impact the decision.

 

A recent Delaware Chancery Court decision ruled that otherwise disinterested directors may be considered “interested” and thus lose the BJR protection by allowing another “interested” director to intimidate them into making a particular decision.

 

In New Jersey Carpenters Pension Fund v. Info GROUP, Inc.,[15] a director who owned 37% of the company’s outstanding stock encountered a personal cash liquidity crisis and concluded that the best option to address that liquidity crisis was to promptly sell the company, regardless of whether the timing, price or process of the company sale was in the best interests of the company. The director lobbied the other directors to pursue a sale even though the rest of the Board (consistent with the advice of an investment banker) believed the market conditions would make it difficult to obtain a good price for the company.

 

The conflicted director intensified his efforts to bring about a sale of the company by repeatedly threatening other directors with lawsuits if they failed to sell the company, being generally disruptive at board meetings and waging a public campaign to fire the CEO. Eventually, the Board was “overwhelmed” by the conflicted director and pursued a sale of the company. As explained in an email from one director to another, the majority of the directors apparently “just want to dump the company and run…based on the pain, trauma, time, and everything else.” The conflicted director continued to disrupt the sale process by influencing the list of potential bidders, conducting unsupervised negotiations and leaking confidential information about the sale to various parties. Ultimately, the Board accepted an offer to purchase the company at a price per share below the then current market price.

 

In addition to finding the BJR inapplicable to the conflicted director, the court refused to dismiss the claims against the other directors based on the BJR because “it is reasonable to infer that [the conflicted director] dominated the Board Defendants through a pattern of threats aimed at intimidating them, thus rendering them non-independent for purposes of [applying the BJR to their] voting on the Merger.”

 

Although the extreme facts of this case may explain the court’s ruling, the notion that directors may lose their BJR protection by reason of a dominating or intimidating director or control person is disconcerting. The line between frank discussions/disagreements and intimidation/domination can become blurred. When dissenting views or disagreements arise, the Board should be extra cautious to create a clear and credible record that whatever decision is ultimately made is supported by legitimate and compelling business reasons and is not influenced by extraneous considerations.

 

D. BJR Inapplicable to Uninformed Directors

Another key element of the BJR is the requirement that the defendant directors and officers make an informed decision by conducting a reasonably diligent investigation before acting. Typically, this requirement is satisfied if the directors spend considerable time in making the decision and obtain advice from qualified experts. However, a recent federal Third Circuit Court of Appeals ruling reversed the dismissal of claims against directors of a bankrupt non-profit company based on the BJR even though the defendant directors received the advice of counsel, conducted several meetings and pursued various options before making the challenged decision to file for bankruptcy protection.

 

In Official Committee of Unsecured Creditors v. Baldwin, 16] the court of Appeals ruled that the District Court improperly granted a motion for summary judgment in favor of the defendant directors based on the BJR, notwithstanding the directors’ apparent diligence. The Court of Appeals ruled that plaintiffs presented credible evidence that the Board (i) received numerous red flags that senior officers upon whom the Board relied in making its decision were neither competent nor diligent, (ii) eschewed a viability study prior to filing bankruptcy, and (iii) diverted assets to another charitable organization which had an interlocking Board with the bankrupt company. As a result, triable issues of fact existed which precluded summary judgment in favor of the defendant directors.

 

This decision demonstrates that all aspects of a Board’s decision should be reasonable and thorough. Although it is unusual for a court to second-guess the adequacy of the directors’ diligence, if any part of the decision-making process is less than robust, the BJR may not be available even if all other aspects of the decision-making process are proper.

 

E. Circumvent BJR

A more subtle way plaintiffs are now avoiding the applicability of the BJR is by bringing traditional D&O mismanagement claims as federal securities law claims. The BJR only applies to common law breach of fiduciary claims (which are usually asserted in shareholder derivative lawsuits), and does not apply to federal securities law claims (which are usually asserted in securities class action lawsuits).

 

Historically, plaintiffs have had little ability to remedy D&O mismanagement through a securities law claim. In 1977, the U.S. Supreme Court ruled that a federal securities law claim must be based upon deceptive conduct (i.e., misrepresentations and omissions of material facts), rather than on allegations of mismanagement.[17] For more than 30 years, that ruling effectively eliminated attempts by the plaintiffs’ bar to circumvent the BJR through the assertion of mismanagement claims in the guise of a securities claim.

 

However, more recently plaintiffs are again testing the bounds of what is mismanagement and what is deceptive misconduct. In the aftermath of several high-profile incidents of sudden and accidental events (e.g., explosions, coal mine collapses and natural disasters), plaintiffs have tried to assert a securities class action in lieu of or in addition to a derivative lawsuit for mismanagement. If successful, this strategy both circumvents the powerful BJR defense and creates the potential for recovery of huge damages to a large class of shareholders.

 

An example of this strategy is the D&O litigation arising out of the 2010 Gulf of Mexico oil spill. Although the Deepwater Horizon rig explosion and resulting oil spill was sudden and unexpected, securities class actions were filed against the directors and officers of British Petroleum (BP), alleging that prior to the explosion and spill the defendants misrepresented and failed to disclose information regarding the adequacy of BP’s safety programs and BP’s resulting risk exposure. The defendant D&Os argued to the court, among other things, that the securities claims should be dismissed because the true nature of the alleged wrongdoing was merely mismanagement. With surprising ease and with little analysis, the court rejected the defendants’ argument, noting that the plaintiffs alleged the defendants launched an ongoing public relations campaign before the Deepwater Horizon incident to improve BP’s safety image with investors and that the subsequent alleged safety misrepresentations were not limited to the Deepwater Horizon catastrophe.[18]

 

The line articulated by the courts in these cases between mismanagement (which is subject to the BJR) and deception (which is not subject to the BJR) appears very thin. In almost any situation involving alleged mismanagement, plaintiffs now seem able to also successfully allege a securities claim based on deception. In other words, creative plaintiffs are more likely now to circumvent the protections of the BJR by converting a mismanagement claim into a securities law claim. If this litigation strategy continues, directors and officers will be facing an increasing number of securities claims arising out of unexpected events which harm the company and its shareholders.

 

F.  Fewer Inexpensive Derivative Settlements

In response to the strong protection afforded by the BJR, shareholder derivative lawsuits are frequently settled by (i) the company agreeing to certain governance reforms and other corporate “therapeutics,” and (ii) the defendant directors and officers (through their insurers) agreeing to pay a modest plaintiff attorney fee award. Although this type of settlement structure creates questionable benefit to the company and primarily benefits only the plaintiff attorneys, the fee payment by the D&O insurer can be justified in many cases in light of the potentially large defense costs which would be incurred absent the modest settlement.

 

The continued viability of this common settlement practice may be questionable in some jurisdictions in light of recent case law which refused to approve this type of settlement arrangement. For example, in one case the court refused to approve a $2.85 million plaintiff fee award in a derivative suit settlement involving only corporate reforms. The Court found the corporate reforms to be “cosmetic” and “far too meager” in light of the alleged wrongdoing. To justify these reforms, plaintiffs’ counsel argued at the settlement approval hearing that after substantial discovery the plaintiffs are unable to prove the alleged wrongdoing. In a colorful summary of why the proposed plaintiff fee was rejected, the court stated:

 

By approving this Stipulation of Settlement, the court would be compensating Plaintiffs’ counsel handsomely and encouraging plaintiffs’ attorneys in the future to go on fishing expeditions against corporations. Sometimes when an attorney goes fishing he catches a fish, and sometimes he does not – but when he does not, he should not eat filet mignon afterwards.[19]

 

In another recent case, 20] plaintiffs dismissed their derivative lawsuit because the company’s Board took certain actions requested by the plaintiffs in their lawsuits. Plaintiffs’ counsel requested a fee award from the court because they contended their derivative lawsuit was the catalyst for the Board’s actions. The defendants disagreed, contending the Board’s actions were taken independent of the derivative lawsuit. The Court found the derivative lawsuit was meritless and would have been dismissed by the court if plaintiffs had not voluntarily dismissed it. As a result, the court refused to award any fees to plaintiffs’ counsel.

 

Likewise, the Seventh Circuit Court of Appeals ruled in 2012 that a derivative lawsuit should be dismissed because it “serves no goal other than to move money from the corporate treasury to the attorneys’ coffers.” The derivative lawsuit alleged that two directors of the company also served on the boards of other companies that allegedly competed with the company, in violation of antitrust laws. The Court of Appeals noted that neither the Department of Justice, the Federal Trade Commission nor any consumer had complained about the interlocking directorships. As a result, the court concluded the lawsuit was a meaningless effort by the plaintiff lawyers to generate a fee and therefore should be rejected:

 

The only goal of this suit appears to be fees for the plaintiffs’ lawyers. It is impossible to see how the investors could gain from it—and therefore impossible to see how Sears’ directors could be said to violate their fiduciary duty by declining to pursue it…. It is an abuse of the legal system to cram unnecessary litigation down the throats of firms whose directors serve on multiple boards, and then use the high cost of anti-trust suits to extort settlements (including undeserved attorneys’ fees) from the targets.[21]

 

These cases suggest the ability to settle derivative suits by agreeing to corporate reforms and a plaintiff attorney fee payment may be increasingly limited in certain situations. That may result in plaintiffs litigating derivative suits longer, more aggressively attacking the BJR and insisting on a monetary component to the settlement in order to show greater benefit to the company and thus a larger plaintiff fee award. In other words, these seemingly pro-defendant rulings may ironically increase the erosion of the BJR and the defendants’ loss payments in future derivative suits.

 

G.  Parallel Derivative Lawsuits

As a result of a decrease in securities class action litigation in the last few years, the plaintiffs’ bar is now pursuing other types of litigation against companies and their directors and officers (including shareholder derivative lawsuits) in an attempt to replace the lucrative fees which they would otherwise earn in large securities class action settlements. Although the settlement amounts in derivative lawsuits are usually far less than securities class action settlements, this increase in derivative litigation is resulting in an increase in court decisions analyzing the BRJ. Not surprisingly, some of those decisions apply the BJR broadly and some apply it narrowly. This risk of adverse BJR rulings is aggravated by an increase in parallel derivative lawsuits in different states asserting the same claims, as described below.

 

Because derivative lawsuits assert breaches of state law fiduciary duties, those lawsuits are typically filed in state courts. Unlike the MDL procedure in the federal court system where securities class actions are litigated, there is no defined procedure for consolidating or coordinating multiple derivative lawsuits in multiple states. Therefore, the same derivative lawsuit can be, and with increasing frequency is, prosecuted in multiple states. Defendants are forced to defend identical derivative lawsuits by different shareholders around the country, thereby significantly increasing the defense costs in those cases, creating the potential for inconsistent rulings in those lawsuits, and making it much harder for defendants to reach a global settlement in all of those multiple lawsuits.

 

A recent ruling by the Delaware Supreme Court[22] involving parallel derivative lawsuits in Delaware and California highlights the challenges and opportunities in defending these multi-jurisdictional derivative claims. In that case, nearly identical shareholder derivative lawsuits were filed in both California and Delaware. The California cases were dismissed by the court because the plaintiffs failed to first make a demand on the company’s board of directors to pursue the claims. Defendants then sought to dismiss the nearly identical Delaware derivative lawsuit based upon the California court ruling. However, the Delaware Chancery Court ruled that it was not compelled to follow the California ruling and refused to dismiss the Delaware case. On April 4, 2013, the Delaware Supreme Court reversed that ruling and held that Delaware courts should follow the prior ruling in California if the two cases are essentially the same, even if the cases largely involve issues under Delaware law. As a result, plaintiffs do not get two-bites-at-the-apple if one case is dismissed or settled before the other case.

 

The Pyott decision does not eliminate or discourage plaintiff lawyers from filing overlapping derivative cases in multiple states. In fact, the Delaware Supreme Court in Pyott also rejected the Chancery Court’s related ruling that the California shareholder plaintiffs were inadequate representatives of the company to prosecute the derivative suit due to their rush to file their complaint without conducting a reasonable investigation. But, the Pyott decision can help defendants to resolve those multiple-cases at one time whether or not all of the plaintiffs participate in the resolution. The Decision can also help defendants and their D&O insurers when negotiating a settlement in the multi-state lawsuits by creating a reverse auction negotiation environment. Consistent with this Decision, one plaintiff in one of the cases can settle the derivative suit with defendants, and once the settlement is approved by the court, the remaining derivative suits in other states will likely be dismissed. As a result, any one plaintiff is incentivized to settle for an amount less than the settlement demands of the competing plaintiffs, thereby potentially precluding the competing plaintiffs from sharing in the fee award.

 

H.  Procedural Assertion of BJR

Even if the BJR otherwise applies, there is a question as to when during the course of the litigation a defendant director or officer can assert the defense. Courts have debated whether the BJR is an affirmative defense and therefore whether the rule can be raised in a motion to dismiss. As acknowledged by a district court in Florida, “courts that have considered this subject concur that it is ‘debatable’ whether a court should consider the protection of the business judgment rule on a motion to dismiss.”[23] If the applicability of the rule appears on the face of the complaint and is not dependent on additional evidentiary facts, it is likely that a court will allow the rule to be asserted in the context of a motion to dismiss.[24] However, courts “traditionally disfavor application of the business judgment rule at the motion to dismiss stage because application of the rule generally requires a fact-intensive analysis that would be incompatible with notice pleading.”[25]

 

I. Conclusions

The BJR remains an important and strong defense in Delaware and many other states. In the context of executive compensation, M&A transactions and other volatile D&O decisions, courts in those states continue to protect directors and officers from liability under most situations. However, as explained above, plaintiff lawyers in search of fees are assaulting this important liability shield with various tactics, and some courts in some states are supporting those efforts. Time will tell if these developments are long-term trends or short-term aberrations

 

The recent erosion by some courts of the BJR may be a reaction, in part, to the recent economic environment and a sense that someone should be held responsible for causing or contributing to the credit crisis and related Great Recession. However, as explained by the Delaware Chancery Court in a recent derivative lawsuit against directors and officers of Citigroup relating to their alleged involvement in the subprime mortgage collapse, the justifications for the BJR equally apply regardless of the size of the losses in the derivative lawsuit or other external circumstances:

 

Citigroup has suffered staggering losses, in part, as a result of the recent problems in the United States economy, particularly those in the subprime mortgage market. It is understandable that investors, and others, want to find someone to hold responsible for these losses, and it is often difficult to distinguish between a desire to blame someone and a desire to force those responsible to account for their wrongdoing. Our law, fortunately, provides guidance for precisely these situations in the form of doctrines governing the duties owed by officers and directors of Delaware corporations. This law has been refined over hundreds of years, which no doubt included many crises, and we must not let our desire to blame someone for our losses make us lose sight of the purpose of our law. Ultimately, the discretion granted directors and managers allows them to maximize shareholder value in the long term by taking risks without the debilitating fear that they will be held personally liable if the company experiences losses. This doctrine also means, however, that when the company suffers losses, shareholders may not be able to hold the directors personally liable.[26]

 

If this more balanced view (which continues to be endorsed by Delaware courts) is rejected with increased frequency by courts in other states, the liability exposure of directors, officers and their insurers will significantly increase over time, which could have a disturbing impact on the quality of corporate governance.

 

[1] Kelly v. Bell, 266 A.2d 878, 879 (Del. 1970).

 

[2] AmeriFirst Bank v. Bomar, 757 F. Supp. 1365, 1376 (S.D. Fla. 1991).

 

[3] Detwiler v. Offenbecher, 728 F. Supp. 103, 149 (S.D.N.Y. 1989).

 

[4] Selcke v. Bove, 258 Ill. App. 3d 932, 196 Ill. Dec. 202, 629 N.E.2d 747 (Ill. App. 1st Dist. 1994).

 

[5] FDIC v. Blackwell, 2012 U.S. Dist. LEXIS 109676 (N.D. Ga. Aug. 3, 2012).

 

[6] Platt v. Richardson, 1989 U.S. Dist. LEXIS 7933 (M.D. Pa. June 6, 1989).

 

[7] Gaillard v. Natomas Co., 208 Cal. App. 3d 1250, 256 Cal. Rptr. 702, 711 (1989).

 

[8] Sparks & Hamermesh, Common Law Duties of Non-Director Corporate Officers, 48 Bus. Law. 215, 234–35 (1992).

 

[9] 2011 U.S. Dist. LEXIS 143222 (C.D. Cal., Dec. 13, 2011).

 

[10] 2012 U.S. Dist. LEXIS 79320 (E.D. Cal. June 7, 2012).

 

[11] 2012 U.S. Dist. LEXIS 146648 (C.D. Cal. Oct. 5, 2012).

 

[12] 2013 U.S. Dist. LEXIS 94899 (C.D. Cal. July 8, 2013).

 

[13] FDIC v. Laudermilk, 2013 U.S. Dist. LEXIS 166924 (N.D. Ga., Nov. 25, 2013). Cf, FDIC v. Adams, 2013 U.S. Dist. LEXIS 168211 (N.D. Ga., March 21, 2013) (BJR applies to claims under Georgia law by FDIC against directors and officers of failed bank).

 

[14] FDIC v. Skow, 2013 U.S. App. LEXIS 25490 (11th Cir. Dec. 23, 2013).

 

[15] 2011 Del. Ch. LEXIS 147 (Del. Ch., Sept. 30, 2011).

 

[16] 2011 U.S. App. LEXIS 19312 (3d Cir., Sept. 21, 2011).

 

[17] Santa Fe Industries, Inc. v. Green, 430 U.S. 462 (1977).

 

[18] In re BP p.l.c. Sec. Litig., 758 F. Supp. 2d 428 (S.D. Tex., Feb. 13, 2012).

 

[19] In re Cirrus Logic, Inc., 2009 U.S. Dist. LEXIS 131583 (W.D. Tex., Jan. 8, 2009).

 

[20] Central Laborers’ Pension Fund v. Blankfein, 2011 N.Y. Misc. LEXIS 4555 (Sup. Ct. NY, Sept. 21, 2011).

 

[21] Booth v. Crowley, et al., 2012 U.S. App. LEXIS 11927 (June 13, 2012).

 

[22] Pyott v. La Municipal Police Employees’ Retirement System, 2013 Del. LEXIS 179 (April 4, 2013).

 

[23] Lancer Offshore, Inc. v. Citgo Group Ltd., 2008 U.S. Dist. LEXIS 25740 (S.D. Fla. Mar. 31, 2008).

 

[24] FDIC v. Briscoe, 2012 U.S. Dist. LEXIS 153603 (N.D. Ga. Aug. 14, 2012); FDIC v. Spangler, 2011 U.S. Dist. LEXIS 147188 (N.D. Ill. Dec. 22, 2011).

 

[25] Data Key Partners v. Permira Advisors LLC, 2013 Wisc. App. LEXIS 640 (Wisc. App. Aug. 1, 2013). See also, Colgate v. Disthene Group, Inc., 2013 Va. Cir. LEXIS 9 (Buck. Co. Cir. Ct., Feb. 4, 2013) (applicability of business judgment rule is an issue of proof for trial and is not properly addressed by demurrer).

 

[26] In re Citigroup Ins. Shareholder Der. Lit., 964 A.2d 106, 139 (Del. Ch. 2009).

 

In my year-end survey of corporate and securities litigation, one of the trends I noted regarding the litigation that had been filed in 2013 was the rise in lawsuit filings following in the wake of governmental investigations and regulatory actions, particularly with respect to investigations and regulatory actions outside the United States. If two recently filed lawsuits are any indication, this lawsuit filing trend has continued as we have headed into the New Year.

 

On January 21, 2014, plaintiffs’ lawyers filed a securities class action lawsuit in the District of Utah against Nu Skin Enterprises and its CEO and CFO in the wake of news reports that governmental authorities in China are investigating the sales practices of the company’s representatives of that country. The plaintiffs’ lawyers January 21, 2014 press release about the lawsuit can be found here.

 

 The Wall Street Journal reported on January 16, 2014 (here) that the previous day the China People’s Daily newspaper had published reports that the company was operating an illegal pyramid scheme in the country. The Journal alsoreported that the allegations were being investigated by China’s State Administration of Industry and Commerce. In a January 16, 2014 press release (here), the company responded to the allegations. The company’s share price declined sharply on the news of the investigations.

 

In their complaint (here), the plaintiff shareholders allege that Nu Skin and its executives “failed to disclose either its fraudulent sales practices and non-compliance with laws and regulations in China, or their potential impact on the company.” The complaint alleges further that the defendants “knew that the Company’s operations in China were an illegal pyramid scheme in violation of Chinese law and, as such, the business operations and prospects were false and would tumble [sic] when the illegal practices came to light.” The plaintiffs allege that the defendants’ misrepresentations and omissions violated Sections 10(b) and 20 (a) of the Exchange Act as well as Rule 10b-5.

 

In a separate lawsuit, on January 15, 2014, plaintiffs filed a shareholders’ derivative action in Cook County (Illinois) Circuit Court against certain current and former directors and officers of Archer Daniels Midland Company, as well as against the company as nominal defendant. The plaintiff’s complaint relates to the company’s December 20, 2013 settlement with the U.S. Department of Justice and the SEC in connection with allegations that between 2002 and 2008 the company’s subsidiaries in Germany and Ukraine had been involved in a scheme to bribe Ukrainian officials in order to obtain tax refunds from the Ukrainian government, in violation of the Foreign Corrupt Practices Act (FCPA).

 

As reflected in the company’s December 20, 2013 press release (here), entered into a non-prosecution agreement with DOJ and a consent decree with SEC and has agreed with these agencies to monetary relief totaling approximately $54 million. The SEC’s press release regarding the settlement can be found here.

 

In their complaint (redacted version here), the plaintiff shareholder allege that the individual defendants  — despite operating in countries with “less-developed legal and regulatory frameworks” — allowed the company “to operate in these countries without implementing or maintaining any of the internal controls for the Company’s compliance with the requirements of the FCPA” The complaint further alleges that “as should be expected when there is no one ensuring compliance, ADM repeatedly violated the FCPA.”

 

The complaint alleges that “the defendants’ failures to implement any internal controls at ADM designed to detect and prevent FCPA violations have severely damaged the FCPA,” referencing the company’s settlements with the DoJ and the SEC. The complaint asserts claims for breach of fiduciary duty, waste of corporate assets and unjust enrichment. The complaint seeks to compel the company to institute remedial measures, as well as the entry of a judgment “against the Individual Defendants and in favor of the company for the amount of damages sustained by the company as a result of the Individual Defendants’ breach of fiduciary duty, waste of corporate assets, unjust enrichment, and aiding and abetting breaches of fiduciary duties.”

 

There are several noteworthy things about these lawsuits, including the fact that both of the lawsuits were filed after the defendant companies had been hit with regulatory actions involving company operations overseas. It is also worth noting that both of these companies have extensive overseas operations and that both of them derive a significant portion of their revenue from their overseas operations. In a world in which regulators both inside and outside the U.S. are increasingly active in investigating and enforcing regulations in connection with companies’ operations outside the U.S., companies that operate globally are facing a growing prospect for regulatory and investigative actions involving their overseas operations. As these cases highlight, among the risks for U.S. companies associated with this growing investigative and regulatory exposure is the likelihood of follow on civil litigation in the U.S.

 

To be sure, the possibility of a follow-on civil action in the wake of an FCPA investigation is nothing new; indeed, it is a phenomenon that I have frequently noted over the years on this blog (refer for example here). I have even previously noted that actions of this type, while frequently filed, are not always successful (refer for example here). But while this type of follow on suit is not new, these kinds of actions are representative of and part of the rise in civil lawsuits in the U.S. against U.S. companies following on after an investigative or regulatory action involving operations outside the U.S.

 

The Nu Skin action is particularly noteworthy in several respects. First, it arises out of the investigation of the overseas operations of a U.S. company by an overseas regulator. Second, it involves an area of regulatory oversight and scrutiny that in the past may not have been as likely to give rise to a regulatory investigation, but that may represent the increasing regulatory and investigative exposure that U.S. companies face in connection with their overseas operations.

 

As both U.S. and non-U.S. regulators focus increased regulatory scrutiny on operations in these countries outside the U.S., the likelihood is that regulatory investigative and enforcement actions will continue to increase. As these regulatory and investigative actions increase, the likelihood is that the follow in civil action will continue to increase as well.

 

In earlier posts (here and here) I detailed the growing threat of regulatory enforcement outside of the U.S., including in particular the rise of cross-border regulatory and enforcement collaboration.

 

Knowing it When You See It: An article in the January 20, 2014 New Yorker entitled “The Billionaire’s Playlist”  (here) describes how Russian oligarch and philanthropist Leonard Blavatnik first accumulated his wealth by acquiring aluminum assets in the aftermath of  the collapse of the Soviet Union. Blavatnik had a number of American investors in his enterprise at the time, including the billionaire entrepreneur Sam Zell.

 

The article cites Zell as saying that he “found the climate extraordinarily difficult.” Zell described his involvement by saying “We were making small investments, doing a lot of different things to see if we could function [in Russia].” Zell said, “We concluded that we could not.” Asked we not, Zell said, “Start with the Foreign Corrupt Practices Act and go from there.”

 

Many insurance buyers now regularly include a separate component of Side A insurance as part of their D&O insurance program. However, even though it has become an increasingly common part of many companies’ D&O insurance programs, Side A D&O insurance is not always fully understood. In the following guest post, Robert F. Carangelo and Paul A. Ferrillo of the Weil. Gotshal & Manges law firm take a look at the “myths and realities” of Side A D&O insurance.

 

I would like to thank Robert and Paul for their willingness to publish their article on this site. I welcome guest post contributions from responsible commentators on topics of interest to readers of this blog. Anyone interested in submitting a guest post should contact me directly. Here is Robert and Paul’s guest post:

 

 

Almost like King Solomon’s mines, there is no greater mystery in the world of Directors and Officers (D&O) insurance than that of “Side A” D&O insurance. As described by a good friend and mentor, it is like “some ethereal layer of D&O insurance that sits on top of a traditional tower of D&O insurance. Sometimes it is there. Sometimes it is not. Almost ‘Houdini-like.’” Though amusing, this comment actually reflects the views of many sophisticated professionals in the D&O and securities litigation spaces. This article will serve as the legend to the “map” of Side A D&O insurance for Directors and companies to use to better understand its myths and realities, including what it covers and what it does not cover, and what type of Side A insurance is worth purchasing.

 

 

By way of background, Side A D&O insurance (also referred to as “Coverage Part A”) covers non-indemnifiable (or “not indemnified,” depending on the wording) Loss[i], meaning that a Company (1) cannot advance or indemnify its directors and officers under its bylaws, or (2) is financially unable to do so (such as when a company files a proceeding under Chapter 11 of the United States Bankruptcy Code).

 

 

The latter proposition in pretty simple: no money in the corporate treasury means no advancement or indemnity – and that is why Side A D&O insurance exists from “dollar one” of the D&O tower of insurance. It provides coverage for the Directors and Officers only (not the company), and most Side A policies contain some language to clarify that it is not an asset of the estate.

 

 

The former proposition is often misunderstood. For a company organized under the laws of Delaware, the settlement of a shareholder derivative action is non-indemnifiable, but defense costs associated with a shareholder derivative action are indemnifiable. A judgment against a Director that he or she committed “bad faith” under Delaware Law also is non-indemnifiable (and also is outside of Delaware’s raincoat provisions). Most other things are indemnifiable (like the settlement of a securities class action against a solvent company), and that is why there is a lot of confusion about when the Side A policy is available (or not).

 

 

Various Side A D&O Products

 

Though there are some variations around the edges of each insurance policy, there are generally three different types of Side A D&O coverage.

 

 

Side A Excess D&O insurance is exactly what that phrase says. It is excess Side A coverage above the company’s traditional D&O tower (which itself has Side A coverage, Side B Company Reimbursement Coverage, and Side C Corporate Entity coverage imbedded therein). It generally follows the form of the underlying primary D&O insurance policy, but again only on a Side A basis (note that not all Side A policies truly follow form and should be checked for “liberalization” endorsements). Buyers should be careful, as sometimes Side A excess D&O carriers include exclusions or restrictions in definitions or elsewhere rather than putting them up front. Companies buy traditional Side A excess D&O coverage to supplement their traditional tower of insurance by providing some “sleep insurance” in case of a corporate calamity like a restructuring, and to provide for a separate pot of insurance for the settlement of a shareholder derivative action.

 

 

Side A Excess Difference in Conditions (DIC) coverage is a little different. It is excess Side A D&O insurance, but it tends to be a bit broader, and tends to have fewer exclusions, like, for instance, the traditional “insured versus insured” exclusion or a “pollution exclusion” that are normally contained in a primary D&O policy. Side A DIC could respond when the Company itself refuses to advance or indemnify. Side A DIC coverage also can drop down and fill in gaps in a tower of insurance when an underlying carrier fails or refuses to pay for any reason under a policy, or attempts to rescind or avoid coverage. Side A DIC coverage also provides coverage if an underlying excess carrier becomes insolvent. Side A DIC coverage is not a one-trick pony, and is therefore useful to have in a company’s risk management toolbox.

 

 

Independent Director Side A D&O coverage (or “IDL”) is Side A excess coverage for independent directors only. It is not shared with officers, or inside directors. It thus is a separate source or pool of D&O insurance to help settle “the bad case” against the independent directors, for example, in a shareholder derivative action or a bankruptcy proceeding. Side A IDL is more commonly procured by bigger companies, which have boards generally consisting mostly of independent directors.

 

 

How Much Side A Excess Insurance Should You Buy?

 

This is a question that we often get asked by companies. Unfortunately, the question usually comes after it is too late:

 

 

·        After the filing of a major shareholder litigation, with corresponding shareholder derivative litigation, driven by a large stock drop;

 

 

·        After the commencement of a major regulatory investigation; or

 

 

·        After the need arises to file for Chapter 11.

 

 

As we have counseled in prior articles (see, e.g., Berkovich and Ferrillo, “Securing The Directors and Officers Liability Insurance Lifelines”, available here), these are obviously the worst times to try to purchase additional Side A coverage to protect the directors and officers, mainly because: (1) carriers generally will not offer additional coverage when conditions are bleak, and (2) the cost will be prohibitive.

 

 

There is no “correct” answer as to how much Side A coverage a company should have, and in what form because that calculation depends on many factors. But assuming a Company has sufficient resources to fulfill its risk management needs under ideal circumstances (and to protect its most valuable assets, e.g., its people), here are some observations and guidelines based on experience gleaned from difficult situations companies have faced over the last several years:

 

 

·        Many companies do not buy enough insurance to cover their most dangerous exposure: their market capitalization risk in the event a company suffers a dramatic stock drop due to “bad news,” e.g., a failed product, a missed quarter, or worse yet, inaccurate or fraudulent financial statements.

 

 

·        There are metrics to find out what “enough” means. Some brokers use bench-marking (i.e., comparing companies of the same size to see what the “the other guy” buys). Others do market capitalization analyses using average settlement figures used by NERA and Cornerstone. The most sophisticated D&O brokers use both. Understand though that those metrics normally only cover “settlement costs” of securities class actions and derivative actions. In a worst-case scenario, there also could be millions of dollars in defense costs from both the litigations themselves, and from the costs of the inevitable regulatory investigations. These fees erode the limits of the traditional insurance coverage, which makes an adequate supply of Side A coverage even more important (especially for the independent directors). Lastly, another metric is simply a rule of thumb to which some companies adhere, i.e., if a Company buys $200 million in traditional insurance coverage, it will allocate 1/3 of that coverage for Side A Excess coverage (in some form of product described above). We do not ascribe perfection to any particular analysis. Instead we urge consideration of all of these methods in making an adequate purchase of Side A Excess D&O insurance. Because the worst news a director needs to hear after learning that the company needs to restate its financial statements is that its management also did not buy enough insurance (or the right type of insurance) to cover the costs of the litigation and regulatory investigations.

 

 

·        Buy Your Side A From Experienced, Claims-Paying Carriers: Another common (but frustrating) misconception is that all Side A carriers are alike, and that all Side A carriers pay claims. We can tell you from experience that this misconception has been the source of much frustration for public companies, their D&O insurance brokers and their securities lawyers. So how can you better understand which carriers pay claims and which do not? Sophisticated D&O brokers who have been involved with major shareholder and merger disputes often deal with numerous carriers, so they can often give very good advice. Ask other risk management professionals who they use as Side A carriers, and learn from their experience. Finally, ask your securities litigators (who often see many Side A carriers in mediations) who they prefer to see on their side of the table, and who they do not want. This is too important a question to ignore or take for granted. Experienced (paying) carriers have credibility that can make a real difference. If things are bad enough that you have to rely on Side A coverage, having a carrier that has the respect of the plaintiff bar, defense bar and mediators alike can prove invaluable. Resolving tough claims is always easier when defense counsel and the carriers work well together and trust each other. Reputation is important. A Side A claim is no place to break in an inexperienced carrier.

 

 

·        When in Doubt, Err Towards Side A DIC Coverage: For the reasons set forth above, it is simply more useful than standard Side A Excess Coverage (without the DIC feature).

 

 

·        Buy Side A in “Big Chunks”: From a securities litigator’s perspective, there is nothing more harrowing than entering into a mediation process (in the attempt to settle “a bad case”) and learning that there are 15-20 D&O carriers sitting around the table with you, all of whom may have the same view as you, or, more likely, differing views as to what the underlying case is worth, and what coverage exclusions apply (or not) to the case. For a Fortune 100 company that buys a lot of D&O, that situation might not be avoidable, but we have seen multiple D&O carriers show up for much smaller companies (extending limits of $5 to $10 million per layer). In this insurance market, it is possible to buy more than $50 million in Side A limits from the same carrier. At least one carrier offers up to $100 million in limits. Obviously, for resolving matters, fewer carriers are much better and ultimately worth the additional costs.

 

 

·        Counterparty Risk to Inexperienced A-Side Carriers: Overlayering limits does not help mitigate counterparty exposure. Actually, it increases it. Fewer layers allow you to cherry pick your carriers. Start with claims behavior, look at surplus, solvency, and what other programs your enterprise has with them—how much of their skin is in your game? Small specialty Side-A-only carriers have less to lose by stonewalling or foot dragging, but with only the relatively modest Side A premiums to rely on, it is easy to see how they may balk when asked to pay millions. “Go to” primary carriers that pay claims make the best Side A play—too much is at stake, and with their bigger piece of the premium pie, they have the resources to deliver. As we see it, you are far better off buying a bigger Side A tower with larger layers than risking a Tower of Babel through over-layering a smaller one. Let the DIC features do their job and offset counterparty risk.

 

 

·        Negotiate Your Side A Terms Hard: In the current environment, the Side A D&O market is very competitive, with some carriers even agreeing to forego an “insured versus insured” exclusion (which is very important in bankruptcy settings). One carrier has gone even further. If a company buys its primary policy and its Lead Side A excess DIC policy from this carrier, it in essence “deletes” the “insured versus insured” exclusion up the whole tower of insurance. That could potentially be a huge advantage for directors and officers involved in a corporate meltdown or bankruptcy. If possible, such wording should be sought out by companies since it makes their Side A coverage more user-friendly in the event something bad happens.

 

 

We hope the above helps to decipher Side A D&O insurance. But given that judgment calls must be made in this process, it is always wise to consult not only with your securities lawyers, but also with a sophisticated D&O broker to get additional advice. This is too important an area to leave to chance.

 

[i] For purposes of this article, the term “Loss” means defense costs, expert costs, judgments and settlements.