The number of securities class action lawsuit filings was up slightly in 2013 compared to 2012, although the 2013 filings remained well below historical averages. While securities litigation picked up in 2013 compared to the year before, the more interesting question going forward is what the impact of the Halliburton case now pending before the U.S. Supreme Court will be; if the Court sets aside the presumption of reliance at the class certification stage based on the “fraud on the market” theory, the landscape for securities class action litigation could be changed entirely. Depending on the outcome of the Halliburton case, annual class action securities litigation tallies like this one could look very different in future years.

 

There were 165 securities class action lawsuit filings in 2013, compared to 152 in 2012, representing a year-over-year increase of about 8.5%. 2013’s 165 filings were about 13.6% below the annual average of 191 filings for the period 1997-2012. 2013 was the fifth year in a row that the annual filings have been below the historical average.

 

The increase in the number of filings in 2013 compared to 2012 was largely the result of the increased levels of filings in the second half of the year. There were 89 new securities class action lawsuits filed in the second half of 2013 compared to 76 in the first half and compared to only 64 in the second half of 2012.

 

The 2013 securities class action lawsuits were filed against a wide variety of kinds of companies. The 2013 securities suit filings involved companies in 90 different SIC code categories. There were, however, concentrations of securities litigation activity in certain industries.  

 

As has been the case in recent years, a significant number of new securities suits involved companies in the life sciences industries.  There were 34 new securities suits against companies in the life sciences industries (represented by companies in the 283 SIC Code group [Drugs] and the 384 SIC Code group [Surgical, Medical and Dental Instruments and Supplies]).These 34 new suits against life sciences companies represented more than one-fifth (20.6%) of all 2013 filings. Of particular note is that there were 17 new filings in the SIC Code category 2834 (Pharmaceutical Preparations) alone, representing about ten percent of all 2013 filings.

 

Another area of concentration involved natural resources companies. There were a total of 13 new securities class action lawsuits against companies in the Mining, Crude Petroleum and Natural Gas categories (represented by the 1000 SIC Code series). There were also a total of eight new securities lawsuits filed involving companies in the 737 and 738 SIC Code categories (computer services and business services).

 

The 2013 securities lawsuits were filed in 34 different federal district courts but the vast majority of the lawsuits were filed in just a few federal districts. 50 of the 2013 securities lawsuits, or around thirty percent of all 2013 securities suits, were filed in the Southern District of New York. Another 23 lawsuits (about 14%) were filed in the Northern District of California and 13 suits (about eight percent) were filed in the Central District of California. There were eleven new lawsuits, representing 6.7% of all lawsuits, filed in the District of Massachusetts. These four federal districts alone accounted for 97 of the 165 filings during the year, or about 58.8% of all 2013 filings.

 

27 of the 2013 securities suit filings involved non-U.S. companies, representing about 16.3% of all filings. These figures are below 2012 levels, when there were 32 filings against non-U.S. companies representing 21 percent of all filings, and 2011 levels, when there were 61 filings against non –U.S. companies representing 32 percent of all filings. However even though down compared to the two prior years, the level of filings against non-U.S. companies in 2013 remained elevated compared to historical levels. (The average number of filings against non-U.S. companies during the period 1997-2009 was 17, representing an annual average of nine percent of filings.)

 

The non-U.S. companies that became involved in U.S. securities litigation in 2013 represented twelve different countries. The two countries with the largest number of companies were sued Canada, with eight companies, and China, with seven companies.

 

Merger-related litigation remained an important part of securities litigation filings in 2013, although down from levels seen in recent years. There were 14 merger objection lawsuit filed in federal courts in 2013, representing about 8.5% of 2013 filings. (There were of course many more merger objection lawsuits filed in state courts, but these state court filings are not part of the present analysis.) The number of 2013 federal court merger objection lawsuit filings was comparable to the equivalent figures in 2012, when there were 13 merger objection lawsuit filings. However, the number of 2013 merger objection lawsuit filings was down sharply compared to 2010 and 2011, when there were 40 and 43 merger objection lawsuit filings, respectively.

 

Though merger objection cases are down from recent years, there has been an uptick in securities lawsuit filings involving IPO companies. As I noted in a recent post (here), IPO activity in the U.S. during 2013 was at its highest levels since 2007. While the listing activity seems to bode well for the general economy as well as for the financial markets, the increased number of IPOs also led to an uptick in IPO-related securities litigation. There were a total of six new securities lawsuits filed between August 1 and year end involving companies that had completed IPOs in 2012 or 2013. These IPO-related filings were one factor in the increase of securities suits filings in the year’s second half, compared to the filing levels in the two preceding six-month periods.

 

As I also noted in a recent post (here), another factor behind securities lawsuit filings in 2013 was the increase of regulatory activity triggering follow-on securities litigation. As many as 13, or nearly eight percent, of the 2013 securities suit filings followed prior regulatory or enforcement activity against the defendants companies. These new lawsuits clearly represented a significant part of 2013 securities litigation activity; however, the fillings may be even more significant to the extent they represent a securities suit filing trend in which increased numbers of securities class action lawsuit filings arise in the wake of governmental investigative or regulatory activity. As I noted in my prior blog post, these kinds of lawsuit filings are arising in the wake of an increasingly diverse array of regulatory activity, as governments around the world step up the efforts.

 

Discussion

It is interesting to note that securities class action filing activity picked up in 2013 compared to 2012. However, the significance of this development pales by comparison to the potential significance of the Halliburton case now pending before the U.S. Supreme Court. If the Court’s reconsideration of the fraud on the market theory were to result in the Court setting aside the presumption of reliance at the class certification stage, it could become impossible for plaintiffs to have a class certified in a Section 10(b) misrepresentation cases. If that were to happen, the private securities class action litigation landscape would be completely altered. Annual analyses of class action securities litigation like this one could look very different, or even go out of existence.

 

With these kinds of potential changes looming, the subtle shifts in 2013 filings activity seem less important. Nevertheless, there are some noteworthy things to keep in mind about the 2013 securities litigation filings.

 

Even though there were slightly more securities class action lawsuit filings in 2013 than there were in 2012, 2013 continues a now several years-long trend of lower than average securities class action lawsuit filings. There has only been one year in the last nine – the credit crisis year of 2008 – when securities class action lawsuit filings were above the longer-term historical averages.

 

In my view, care should be taken in considering this apparent decline. The figures on which this impression is based represent absolute filing numbers only – that is, the figures represent only the number of lawsuits filed per year. These figures do not take into account changes in the number of publicly traded companies. The fact is that even with the recent uptick in IPOs there are still well more than a quarter fewer publicly traded companies than there were ten years ago. (Bankruptcies, mergers and going private transactions account for the decline in the number of public companies.)

 

It is hardly surprising that as the number of public companies has declined that the absolute number of securities lawsuits has declined as well. Though the  165 lawsuit filings in 2013 represent around 30 percent fewer filings than there were in 2004, that decline in the absolute number of lawsuit filings in roughly in line (although slightly greater than) the decline in the number of publicly traded companies. The decline in the number of lawsuit filings relative to the number of publicly traded companies is far less than the apparent decline in the absolute number of lawsuit filings might seem to suggest.

 

There are of course other factors at work affecting the numbers of securities lawsuit filings, beyond just the decline in the number of publicly traded companies. As a result of case law developments, particularly at the U.S. Supreme Court, the securities plaintiffs face a much greater burden trying to survive a motion to dismiss. These case law developments undoubtedly have had some deterrent effect on securities lawsuit filings. The Halliburton case could of course dramatically amplify this effect.

 

Beyond these considerations another factor affecting the filing levels in 2013 was the absence of any cyclical trend or sector development of the kind that might drive securities litigation. The uptick in filings related to the credit crisis has long since faded, and there was nothing in 2013 like the Chinese reverse merger litigation (which accounted for so many lawsuit filings in 2011). The absence of these kinds of trends mean that there were fewer filings in 2013 than there were in years in which trends of this type drove litigation activity.

 

On the other hand, the rise in IPO-related litigation activity and the increase in securities litigation following-on after regulatory activity could both potentially represent important trends to watch in 2014 – depending of course on what happens with the Halliburton case.

 

It is generally understood that corporate directors act in a fiduciary role in performing their board duties. But to whom do directors owe their fiduciary duties? That was the question asked in a November 8, 2013 decision from the North Carolina Supreme Court, in which the Court reversed a trial verdict and post trial motion rulings and reaffirmed that directors’ duties generally are owed to the corporation itself rather than to the individual shareholders. A copy of the Court’s opinion in the case of Green v. Freeman can be found here. A December 20, 2013 memo by the Smith Anderson law firm can be found here. 

 

The case arose out of a failed business venture. The claimants sought to recover a total of $400,000 they had invested in the venture. At trial, the evidence showed that the various entities involved in the venture had not followed corporate forms. For example, the names of the entities were used interchangeably, there had been no shareholder or board meetings, and a corporate checking account was used to pay the personal expenses of the sole shareholder and chairperson of one of the entities.

 

The claimants sued the shareholder and chairperson as well as the other principals involved in the venture on a variety of theories. The jury found that the chairperson, Corinne Freeman, had controlled the entities involved in the venture and that the plaintiffs had been damaged by Freeman’s failure to discharge her duties as a corporate director or officer. The other claims against her were dismissed. Freeman appealed to the intermediate appellate court, which affirmed the lower court, and she appealed to the Supreme Court. The plaintiffs cross-appealed the dismissal of their other claims against Freeman.

 

In its November 8 opinion, the North Carolina Supreme Court, in a unanimous opinion written by Justice Mark Martin, reversed the lower court, holding that the claimants did not have a direct claim that Freeman had breached her fiduciary duties to them,  and remanded the case for further consideration of the dismissal of the plaintiffs’ other claims.

 

In reaching its decision, the Court confirmed that under North Carolina law directors are “required to act in good faith, with due care and in a manner they reasonably believe to be in the interests of the corporation.” If these duties are breached, a shareholder may sue the director – but in a derivative action only, not in a direct action. In general, under North Carolina law, shareholders and creditors “may not bring individual actions to recover what they consider their share of the damages suffered by the corporation.”

 

The only exceptions to these general principles are when the wrongdoer owed the claimant a special duty or the claimant suffered a special injury. The Supreme Court found that the plaintiffs were unable to bring themselves within either of these exceptions because they had never become shareholders. Even as creditors, the claimants had not produced sufficient evidence to bring themselves within these exceptions. In particular, the Court held that the plaintiffs had failed to present evidence that they had suffered an injury peculiar or personal to themselves sufficient to bring them within the persona injury exception.

 

The Court concluded that because the plaintiffs could not bring themselves within either of the exceptions to the rule that directors’ fiduciary duties generally are owed only to the corporation, the plaintiffs as a matter of law could not assert individual claims that belonged to the company. 

 

The Court did find that there was evidence sufficient to support the piercing of the corporate veil to allow the claimants to try to assert claims against Freeman. However,  the doctrine of piercing the corporate veil “is not a theory of liability” but rather “provides an avenue to pursue legal claims against corporate directors and officers” for which they would otherwise be shielded from liability by the corporate form. Because the Supreme Court had determined that the claimants breach of fiduciary duty claims were not viable, the Supreme Court remanded the case to the lower court for consideration of the issue of whether the piercing of the corporate veil would allow the claimants to recover under any of the other theories the claimants had asserted as the basis of liability.

 

The North Carolina Supreme Court’s decision is important (at least in North Carolina) because it confirms that, other than in exceptional circumstances, directors cannot be held liable in direct shareholder action for breaches of fiduciary duty, but can only be held liable derivatively to the corporation itself, because the directors owes fiduciary duties to the corporation, not to shareholders or creditors.

 

The clarification of these principles is important not only because it explainsto whom directors may be held liable, but it also clarifies the circumstances under which directors may be held liable as well. As the Smith Anderson law firm said in its memo about the case,

 

This distinction is important because under North Carolina law derivative claims are subject to more stringent requirements than direct claims face. Specifically, plaintiffs seeking to bring derivative claims must prior to filing suit make a demand on the company’s board of directors asking the company to assert the claim directly. Following such demand, if an independent committee of the board determines in good faith after conducting a reasonable inquiry that the claim should not be pursued, then the plaintiff cannot bring a derivative action asserting the claim.

 

The law firm concluded its memo by noting that the Supreme Court’s decision is “significant” because the Court, “which rarely has occasion to address corporate law issues, has reaffirmed the basic principles governing the duties of directors.”

 

Readers of this blog may find it useful to read the opinion in its entirety as the opinion provides a good review of the general principles governing the duties and liabilities of corporate directors. The case also underscores the importance of maintaining the corporate forms.

 

What could be more appropriate during this festive holiday season than another round of readers’ pictures of their D&O Diary mugs?

 

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

 

In our first picture, sent in by Mark Weintraub of Lockton  in Atlanta, depicts what appears to be a snowman cake holding a D&O Diary mug. However, Mark reports that the snowman is not made from cake, but rather from diapers, and was created for purposes a baby shower. Proving once again that the D&O Diary mug is suitable for every occasion, including some kinds of occasions that I certainly  never anticipated. (And can I just say, a snowman made of diapers?!?)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

In yet another appropriate tribute to the season, Todd Richardson took this picture outside the HCC offices in Connecticut during the course of one of the many recent snowy days there.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

In contrast to that snowy scene, Doug Esten of the LexisNexis Newsroom sent in this picture of his D&O Diary mug amidst a profusion of daisies. Doug reports that he took this picture in his garden in West Goshen, Pennsylvania, in mid-October.

 

 

 

 

 

 

 

 

 

 

 

The next mug shot was sent in by Ginny Fogg, the general counsel of Norfolk Southern. Ginny reports that the scene in the picture looks “over the Norfolk waterfront with the raised railroad bridge in the left background.”

 

 

 

 

 

 

 

 

 

 

 

 

 

Drew Kominos of the Denver Office of the Philadelphia Insurance Companies sent in this picture, taken in front of the City and County Building in Denver, which Drew reports is “center of life in the City.”

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Our final picture in this round was sent in by Tyler Smith and Brian Magnusson of Chubb. This picture, which depicts two D&O Diary mugs and as well as a host of other treasures, was taken at Chubb’s annual “mustaches for charity” competition. Brian reports that “by growing beards/mustaches over the last month, we raised over $10,000 for poverty-stricken, school children across the country.” Good for Brian, Tyler and their Chubb colleagues. All of us here at The D&O Diary are strongly in favor of moustaches in general, and particularly in connection with charitable endeavors.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Once again, I am absolutely delighted to see the range of pictures that readers have sent it. It is so much fun receiving back readers’ mug shots. My thanks to everyone that has sent in pictures.   

 

If there are still readers out there who would like to have a mug and have not yet ordered one, just drop me a note and I will be happy to send one along to you, as long as remaining supplies last. Just remember that if you order a mug, you have to send back a picture. Also, please be patient if you order a mug, it may be several days before we can mail out the next round of mugs.

 

Break in the Action: Over the next couple of weeks, The D&O Diary will be on a holiday publication schedule. We will resume our regularly publication schedule on January 6, 2014. Here’s wishing everyone a very festive and relaxing holiday season. I look forward to following up with everyone in the New Year.

 

For a period beginning in 2006, plaintiffs’ lawyers filed a wave of options backdating securities class action lawsuits. Almost all of these cases have now been resolved, although one case continues to grind through the appellate courts. Now that the cases are largely resolved, it may be time to calculate the final tally. In the accompanying guest post, Adam Savett, Director, Class Action Services at KCC, surveys the cases, their dismissal rates and their settlements. His guest post concludes with a link to his presentation on the options backdating-related securities litigation.

 

 

I would like to thank Adam for his willingness to publish his guest post on my site. I welcome guest posts and articles from responsible commentators on topics of interest to readers of this blog. If you are interested in publishing a guest post, please send me a note by e-mail. Here is Adam’s guest post:

 

 

 

Starting in 2006, and continuing for more than a year, a series of academic reports and articles in the Wall Street Journal suggested that a number of publicly traded companies had improperly retroactively dated the grant and exercise price of stock options issued to corporate officers to a time preceding a rally in the price of the underlying shares. The revelation of this practice, commonly called options backdating, led to much litigation. A substantial portion of that litigation took the form of securities class actions, typically filed against a publicly traded company (the issuer) and certain officers and directors of the issuer.

 

 

The first such securities class action was filed on May 19, 2005 against Brocade Communications.

 

 

Ultimately 39 federal securities class actions were brought which contained allegations that directors or officers had engaged in or allowed stock options backdating to occur.

 

 

Of those 39 cases, 31 ultimately settled and 8 were dismissed.

Some early prognosticators suggested that the entirety of the cases had little if any merit, and might ultimately collectively be settled for less than $1 billion. Though we appreciate any and all help from our prognosticators, most were significantly off in predicting outcomes in this group of cases.

 

 

The settlements were not insubstantial, having a combined value of more than $2.38 Billion, though a sizeable portion of that is from UnitedHealth Group’s $925.5 million settlement. The average of all of those settlements is approximately $77 million, while the median of the settlements is $18 million.

The dismissal ratio was also somewhat out of line with historical trends, with 82% settling, while historically only approximately 65% of securities class actions settle.

 

 

Now, nearly eight years later, the story is almost complete.

We have to say almost, as the plaintiffs in the Apollo Group litigation have appealed the dismissal of their complaint to the Ninth Circuit Court of Appeals.

 

 

Now, they are not the only plaintiffs to appeal, as plaintiffs in three of the other dismissed cases also appealed their dismissal orders. In the Cyberonics, Jabil Circuit, and Witness Systems, the plaintiffs all unsuccessfully sought reversal of the dismissal of their complaints. The dismissals in the Jabil & Witness Systems cases were affirmed by the Eleventh Circuit while the Cyberonics dismissal was affirmed by the Fifth Circuit.

 

 

While students of securities litigation know that each case is unique, and the Apollo Group case is pending before the Ninth Circuit, the decision to launch a fourth appeal after three defeats suggests a certain tenacity on the part of that law firm.

 

 

The opening brief was filed by the Plaintiffs on December 10, 2013 and the defendants answering brief is due to be filed in early January of next year. Oral argument has not yet been scheduled in the Apollo Group appeal for.

 

 

After the Ninth Circuit renders a decision, we will update our analysis to reflect the outcome. Our current analysis of these cases can be found here.

 

Of the different contexts within which securities class action lawsuits arise, one of the most significant is the bankruptcy context. As detailed in the following guest post from Michael Klausner and Jason Hegland of Stanford Law School, securities class action lawsuit arising in bankruptcy are different from cases involving solvent companies. Their guest post provides a detailed overview of the differences. The authors also reach some interesting conclusions about the importance of D&O insurance for the resolution of securities class action lawsuits arising in connection with bankrupt companies.

 

 

I would like to thank Mike and Jason for their willingness to publish their guest post on this site. I welcome guest posts from responsible commentators on topics of interest to readers of this blog. Anyone interested in publishing a guest post should contact me directly. Here is Mike and Jason guest post.

 

 

 

One out of every seven securities class actions filed since 2000 involves a company in bankruptcy. This important subset of class actions has some important features that warrant empirical examination. In this blog, we use our database of securities class actions filed from 2000 to the present to shed light on how cases involving bankrupt companies differ from cases against solvent corporations.[i] Specifically, we address the following questions.

 

·         Are cases involving bankrupt corporations more successful than cases against solvent corporations?

 

·         Is the timing of settlement affected?

 

·         How protective is D&O insurance for officers and directors when a company is bankrupt? Specifically, how much does D&O insurance pay out and how frequently do individual officers or directors make personal, out-of-pocket payments into a settlement?

 

·         Is there a basis for inferring that additional Side A coverage would have provided more protection for those individuals who paid into settlements?

 

Outcomes in Cases Involving Bankrupt Companies

As a company descends into insolvency, there may be incentives for management to shade financials or to describe its business in more rosy terms than is warranted. In addition, once a company has gone bankrupt, disclosures that were accurate when made may not look so accurate in hindsight. This could affect a judge’s ruling on a motion to dismiss and a jury’s view of a case if it went to trial. Thus, it would not be surprising to find that securities class actions involving bankrupt companies tend to be successful more often than cases against solvent companies.  On the other hand, perhaps plaintiffs’ attorneys over-rely on such hindsight bias—or are excessively affected by it themselves—and file weak cases against bankrupt companies only to see them dismissed for failure to plead intent with sufficient particularity. 

 

As shown in Table 1, the data indicate that cases involving bankrupt companies are in fact successful for plaintiffs more than are cases against solvent companies. Among cases filed since 2000, only 29% of cases involving bankrupt companies were dismissed or voluntarily dropped, compared to 46% of cases against solvent companies. The low rate of dismissal for these cases suggests that they may be more meritorious than cases against solvent companies. This inference is supported by the fact that cases involving bankrupt companies more often have parallel SEC enforcement actions in which severe penalties were imposed than do cases against solvent companies—specifically, 25% compared to 15%.[ii]

Table 1: Case Outcomes

(Cases filed 2000-2010 and resolved by 2013)

 

 

* Difference is rates of dismissal and settlement significant at the .001 level

Note: These are cases dismissesd on a motion to dismiss. Another 25 cases were dismissed on motions for summary judgment — one involving bankrupt companies and 24 involving solvent companies.

 

Settlement Timing

An explanation for the low rate of dismissal in these cases could be that they settle quickly, before the motion to dismiss is ruled on. The data show, however, that this is not the explanation. In fact, more often than cases against solvent companies, these cases tend to settle after the ruling on the first motion to dismiss.  Figure 1divides the litigation process into three phases: (a) early pleading, defined as the period before the ruling on the first motion to dismiss, (b) late pleading, defined as the period after an initial dismissal without prejudice but before a final ruling either to dismiss or to allow the case to proceed to discovery, and (c) discovery, defined as the period between a denial of the plaintiffs’ motion to dismiss and the end of trial. The graph shows that cases involving bankrupt companies tend to settle in the late pleading period and in the discovery period somewhat more often than do cases against solvent companies.[iii]  Moreover, our data also show that among cases that reach discovery, those involving a bankrupt company tend to settle later than do cases against solvent companies. 

 

Figure 1: Settlement Timing—By Phase of Litigation

(Settlements in cases filed 2000-2010)

 

 

 

 

At first glance, the fact that these cases do not settle earlier may be surprising, since the assets available for recovery by the plaintiff class and the plaintiffs’ attorney shrink as the case proceeds. Every dollar spent on defense costs is a dollar that will be unavailable in a settlement. On the other hand, the bankruptcy process and the involvement of separate defense lawyers for the company and for individual defendants may create complications that delay settlement. In addition, perhaps defense lawyers use the shrinking nature of potential settlement funds as leverage, continuing to threaten to extend the litigation (at no cost to themselves), in order to secure a lower settlement for their clients.

 

Individual Payments into Settlements

            Apparently reflecting plaintiffs’ attorneys’ search for deep pockets (or just pockets), more individual defendants are named in cases involving a bankrupt company than in cases involving a solvent company. On average, six individual defendants are named in cases involving a bankrupt company, compared to five individuals where the company is solvent.[iv] The same pattern appears with respect to naming outside directors as defendants. Where the company is bankrupt, outside directors are named in 43% of cases, compared to 39% of cases against solvent companies, and when outside directors are named, more of them are named in cases involving a bankrupt company.[v]  (The apparent search for pockets is reflected in the naming of third parties as well. Auditors and underwriters are named in 43% of cases, compared to 19% of cases involving solvent companies.)

 

            Being named a defendant, of course, does not mean an officer or director will have to contribute to a settlement. The D&O policy provides protection, so long as limits remain and a defendant’s conduct does not result in an exclusion from coverage under the terms of the policy. In total, across all cases involving bankrupt companies, insurers paid roughly $2 billion into settlements, for an average of $13,500,000 per case (or $17,000,000 if one excludes cases in which, for whatever reason, there was no insurance payment). This is a crude measure of the amount individuals would have paid out-of-pocket if they had no insurance, since settlement amounts could have been lower in the absence of insurance. But it is clear that without D&O insurance, individual officers and directors likely would have had to contribute toward settlement out of their personal assets much more frequently, and in some cases the costs to the individuals could have been severe.

 

            Table 2 shows that out-of-pocket payments are rare. But the incidence of out-of-pocket payments is greater where the company is bankrupt than where it is solvent—11% of cases compared to 3% of cases. A close look at the 19 cases in which individuals made out-of-pocket payments where the company was bankrupt reveals that in at least some of these cases, the explanation is either that the settlement was much larger than the policy limits one would expect, as in Enron and Global Crossing, or that the conduct involved was not covered, as in Refco, where individual defendants’ misconduct landed them in jail. There are a few cases, however, in which there were no reports of glaringly fraudulent conduct, where the settlement was not unusually large and where the carrier paid a portion of the settlement, and yet individuals paid as well. While some of these cases may have involved conduct-based coverage issues, the problem may have been insufficient limits.

 

Table 2:  Individual Payments into Settlements

(Settlements in cases filed 2000-2010)

 

Note: Significant at  .001 level

 

The experience of outside directors in these cases warrants analysis as well. In earlier publications, one of us investigated outside director liability in all types of litigation: securities class actions, state fiduciary duty suits and SEC enforcement actions.[vi]  The basic finding was that outside director liability is very rare. This is due to two factors: the protection provided by D&O insurance and the difficulty of proving a case against outside directors. Some people misunderstood that article to say that outside directors were not exposed to liability risk and therefore did not need D&O insurance—the opposite of the causal relationship I intended. As shown here, D&O insurance clearly protects outside directors from out-of-pocket payments.

 

            Table 3 provides data on the liability experience of outside directors. Consistent with the earlier research, settlements of securities class actions rarely result in payments by outside directors—a total of 12 cases out of 409 settlements in cases in which outside directors were named. All but one of these cases involved bankrupt companies. Thus, while liability for outside directors is rare, where it occurs it is nearly always when the company is bankrupt.[vii]

 

Table 3: Individual Payments by Outside Directors

(Settlements in cases filed 2000-2010 in which outside director was named)

 

 

 

 

Significant at .001 level

 

Side A Coverage 

            When a company is bankrupt, Side A of a traditional policy and in some cases a separate Side-A-only policy may be all that stand between a settlement demand and a personal, out-of-pocket payment. The fact that there have been only 19 cases since 2000 involving bankrupt companies in which individuals made such payments suggests that Side A protection is effective.  In nine of these 19 cases, insurance paid into the settlements—just not enough to cover the full settlement. On average insurance paid 73% of the total amount paid in those settlements. As stated above, it is possible that additional Side A limits would have protected some of the individuals that made out-of-pocket payments.

 

*****

            In sum, cases involving bankrupt companies are different from cases against solvent companies. They are dismissed less often and they therefore settle more often. They also take longer to settle than do cases involving solvent companies. Finally, and not surprisingly, officers pay into settlements in these cases somewhat more often than they do in cases against solvent companies. On the whole, however, D&O insurance provides substantial protection to individuals in these cases, and additional Side A coverage might have provided full protection for the individuals that paid out of pocket apparently.

[i] Cases included in this study were filed between 2000 and 2010 and resolved by 2013. There are 1,779 cases in the sample, 55 of which are ongoing and are therefore excluded for certain purposes below.

 

[ii] All comparisons in this paragraph are statistically significant at the .001 level in univariate tests and multivariate tests in which we control for factors that associated with dismissal.

 

[iii] This difference is of borderline statistical significance (p < .1), in univariate and multivariate tests, when comparing early pleading settlement vs. settlement in the two later periods. If we look at cases filed since 2005, the difference between cases involving bankrupt companies and cases involving solvent companies is somewhat greater.

 

[iv] Statistically significant at the .001 level.

 

[v] Statistically significant at the .005 level.

 

[vi] See Black, Cheffins & Klausner, Outside Director Liability, 58 Stanford Law Review 1055 (2006); Klausner, The Risk of Liability for Outside Directors, PLUS Journal 2006, p. 1.

 

[vii]There were two additional cases involving solvent companies, where individuals who were technically outside directors paid into settlements. In one of these cases, the individual was affiliated with the controlling shareholder and in another he was a founder and former CEO and therefore more involved in company management than a typical outside director.

 

The U.S. Supreme Court has already taken up a case this term that potentially could alter the way private securities cases are litigated. The Court has now granted cert in a different case that could have a significant impact on ERISA stock-drop litigation. On December 13, 2013, the Court granted the petition of defendant Fifth Third Bank for a writ of certiorari in order to consider the “presumption of prudence” that the lower courts have developed with respect to ESOP fiduciaries’ decision to invest in or to maintain investments in employer stock.

 

Many ERISA stock drop lawsuit defendants have been able to rely on the presumption – often called the Moensch presumption – to obtain dismissal of the cases against them. However, a split has developed in the circuit courts over the procedural stage at which the presumption applies and how the presumption may be rebutted. The way the Court decides this case could significantly affect the ability of many ERISA lawsuit defendants to rely on the presumption at the motion to dismiss stage to try to get the cases against them dismissed. Background regarding the presumption and the details of the circuit split can be found in a recent memo from the McDermott, Will & Emery law firm (here).

 

Congress has recognized that Employee Stock Ownership Plans (ESOPs) and Eligible Individual Account Plans (EIAPs), which invest in employer stock, further an important public policy goal by encouraging employee ownership. The courts in turn have held that fiduciaries of these types of plans should not be subject to liability for investing in employer stock, as that was the reason the plans were created, consistent with the Congressional objective of fostering employee ownership. In a 1995 decision, Moensch v. Robertson (here), the Third Circuit concluded that fiduciaries of plans that required or encouraged investment in employer stock were entitled to a presumption that they acted prudently under ERISA by investing in the employer stock. This presumption could only be overcome by a showing that the plan fiduciaries abused their discretion by continuing to invest in the employer stock.

 

Several circuit courts have adopted the Moench presumption of prudence; however, the courts continue to disagree on whether the presumption can be raised at the motion to dismiss stage and how the presumption can be rebutted. The Supreme Court has now agreed to take up a case that will address these questions – and could even address the question of whether there should be a presumption at all.

 

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

 

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

 

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

 

The plaintiffs appealed to the Sixth Circuit, which reversed the district court. In a September 7, 2012 opinion written by Judge Jane Stranch for a three-judge panel (a copy of which can be found here), the Court held that the district court had erred in concluding that the presumption of reasonableness applied at the motion to dismiss stage. The Sixth Circuit considered the presumption to be evidentiary, subject to factual rebuttal, and therefor not appropriate to consider and apply at the motion to dismiss stage. The Sixth Circuit court also declined to adopt the more demanding standard for rebuttal of the presumption that certain other circuit courts have adopted – that is, that the presumption may be rebutted only by a showing that fiduciaries continued to invest in the employer stock though it faced a “dire situation” – preferring a test providing that in order to overcome the presumption the plaintiffs must  show that the “a prudent man acting in a like capacity” would not have undertaken or continued the investment.

 

In its cert petition, the bank argued that the Sixth Circuit’s rulings created a split in the circuits requiring the Supreme Court to step in. The bank also argued that the appellate court had interpreted the presumption in a way that unjustifiably puts ESOP fiduciaries at risk of liability and that is inconsistent with the Congressional policy of encouraging stock ownership. In their opposition, the plaintiffs argued that there is no circuit split and that in fact the seeming differences between the Sixth Circuit and the other circuit courts was simply a reflection of the underlying facts in the respective cases and the important differences between the various plans involved.

 

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

 

Discussion

The Supreme Court’s decision to take up the Fifth Third Bank ERISA case potentially could prove significant for other ERISA stock-drop case defendants. As the Morrison Foerster firm said in its December 16, 2013 memo about the Supreme Court’s decision to take up the Fifth Third Bank case, the presumption of prudence is "an important first line of defense in ERISA stock drop litigation."  If the Court concludes that the presumption cannot be raised at the motion to dismiss stage or may be rebutted at the pleading stage based on the lower rebuttal standard defined and applied by the Sixth Circuit, it could prove to be more difficult for ESOP fiduciaries to obtain dismissal of the ERISA stock-drop lawsuit filed against them.

 

As Cleveland-based Keycorp (which itself has been the target of the same kind of ERISA stock-drop lawsuits) argued in its amicus brief in support of Fifth Third Bank’s cert petition, the standards the Sixth Circuit adopted have make it  “far too easy for plaintiffs to get a meritless claim under ERISA past the pleading stage.”

 

The problem for companies subject to these kinds of cases is that even if the cases are entirely lacking in merit, the underlying allegations often go to the heart of the employer’s business operations. Discovery in these cases can be wide-ranging and expensive. The cost of discovery alone can compel corporate defendants to try to settle the case.

 

In addition, there is a tension at the core of these cases. Imbedded in the underlying allegations is a suggestion that when a company suffers reverses or its stock price drops, the ESOP fiduciaries have fiduciary obligation to liquidate plan holdings in the company stock, the ownership of which was the very reason the ESOP was formed in the first place.

 

As the Employee Benefits Law Report blog noted in a recent post about the Fifth Third Bank case, “a Supreme Court ruling that the presumption of prudence does not apply at the initial stage, or a ruling that the presumption does not apply at all, would seemingly eviscerate the statutory boundaries that favor ESOPs and likely have a significant chilling effect. Employers would have to consider whether the ESOP model remains viable and is worth the risk.”

 

The risk that the Supreme Court might jettison the presumption cannot be disregarded. The presumption is a creation of the circuit courts; while lower courts have felt compelled to grapple with it, the Supreme Court will not be so constrained. The Supreme Court certainly is not constrained to the narrower question of when the presumption applies or how it may be rebutted.

 

The situation here may be analogous to the circumstances in which the Supreme Court took up the “cause and effect” test in the Morrison v. National Australia Bank case. There may have been decades of circuit court case law interpreting the “cause and effect” test for the determination of the jurisdiction of the U.S. securities laws, but the test itself was an invention of the lower courts — like the presumption of prudence here. The Supreme Court could, as it did in the Morrison case, simply disregard the work of the lower courts and examine the question afresh based on the relevant statutory language; the fact that the DoL has urged the court to take that approach could encourage the Court to do so.

 

In any event, those of us in the professional liability insurance world now have yet another U.S. Supreme Court case to watch out for this term. As the Morrison Foerster firm said in its memo about the case, "regardless of its outcome, the case bears watching by officers, directors, and employees whose responibilities may expose them to ERISA claims for breach of fiduciary duty in connection with employee investments in company stock." The case will likely be argued around March 2014 and will be decided be the end of the current term in June.

 

The Federal Insurance Office (FIO) has – nearly two years overdue – finally published its long awaited report to Congress on its recommendations for the modernization of insurance regulation in the United States. The broadly ranging 65-page report identifies limitations in the current state-based regulatory model but does not recommend that federal regulation should displace state regulation entirely. Rather, the report proposes a hybrid model, where the current state-based system is generally preserved except where the need for greater uniformity or the requirements of an increasingly global insurance industry are best served by regulation at the federal level.

 

The FIO’s December 2013 report, entitled “How to Modernize and Improve the System of Insurance Regulation in the United States,” can be found here. The FIO’s December 12, 2013 press release about the report can be found here.

 

Section 502 of the Dodd-Frank Act created the FIO as a unit within the U.S. Department of Treasury to monitor all aspects of the insurance industry and, among other things, to identify issues contributing to systemic risk. Section 502 (p) of the Act expressly provided that “not later than 18 months after the date of the enactment of this section, the [FIO’s] Director shall conduct a study and submit a report to Congress on how to modernize and improve the system of insurance regulation in the United States.” The Act was enacted in late July 2010, and the modernization report was officially due on January 21, 2012, nearly two years ago. In preparing the report the FIO solicited public comment and also held public hearings as well.

 

The Dodd Frank Act was of enacted in the wake of the global financial crisis, in order to try to address the issues that were thought to have caused the crisis. As the FIO’s recent report acknowledges, one of the critical developments at the peak of the crisis was the near collapse of insurance giant AIG. However, it is worth noting that the problems that led to AIG’s near demise did not involve its insurance operations (which were and are regulated at the state level), but rather involved the company’s alternative financial products division (which theoretically at least was regulated at the federal level).

 

Thus even though a critical part of financial crisis was the near collapse of one of the largest participants in the global insurance industry, that development in and of itself does not present a case for setting aside the current model of insurance regulation in the United States. Indeed, the insurance industry generally weathered the financial crisis in reasonable good order, which could be interpreted to make the case for preserving the current regulatory model.

 

On the other hand, as the FIO report notes, the current balkanized regulatory model, involving as it does 56 different insurance regulators (if the regulators in the District of Columbia and territories are included in the count) “creates inefficiencies and burdens for consumers, insurers, and the international community.” The report observed that “the need for uniformity and the realities of globally active, diversified financial firms compel the conclusion that federal involvement of some kind in insurance regulation is necessary.”

 

However, the FIO does not suggest that the limitations in the current system imply that a federal regulator should displace state regulation completely. The report observes that the creation of a new federal regulatory agency to regulate all or part of the $7.3 trillion insurance sector “would be a significant undertaking.” For the federal government to amass the “personnel, resources and institutional expertise to execute such an endeavor” would require a substantial and unequivocal commitment from the political branches of government.

 

The report concludes that “the proper formulation of the debate” is not whether insurance regulation should be state or federal, “but rather whether there “are areas in which federal involvement in regulation under the state-based system are warranted.”

 

With this approach, and based on an extensive overview of the current state of the industry and the current approach to regulation, the report recommends a number of steps that could be taking to modernize and improve the regulatory system. The steps are divided into two categories: short term steps for the states to take; and steps toward direct federal involvement in regulation in certain areas.

 

Among other things, the report suggests that states should come up with new policies related to resolving failed insurers; monitor the impact of different rate-regulation and market conduct examination practices; develop plans to reduce losses in natural disasters. The report also suggests that the states should develop a uniform regime for the oversight of reinsurance captives. In addition, the report suggests that the states “should move forward cautiously with the implementation of principles-based reserving.”

 

As far as regulation at the federal level, the report recommends, among other things, the development and implementation of federal standards and oversight for mortgage insurers; in order to effect uniform treatment of reinsurers, develop provisions for reinsurance collateral requirements; and identify issues or gaps in the regulation of large national and internationally active insurers. The report also proposes that the FIO will study and report on the use of personal information in insurance pricing. The FIO also proposes to make recommendations pertaining to the availability of certain types of insurance for military personnel and Native Americans. The FIO will also monitor state progress on modernizing the collection of surplus lines taxes “and determine whether federal action may be warranted in the near term.”

 

According to news reports (here), the industry has generally been supportive of the FIO’s approach, although there clearly is wariness of the steps toward federal regulation that the report recommends. In addition, as noted in a December 14, 2013 memo about the report from the Nelson Levine de Luca & Hamilton law firm (here), one of the more “surprising” aspects of the report is its suggestion that “if states do not reform their laws and processes to meet the recommendations of the report, they could face federal action. “ The memo went on to note that the report suggests that “Congress should strongly consider direct federal involvement if states do not implement the FIO’s recommendations.”

 

The report includes several recommendations that may be of particular interest to readers of this blog. For example, among the report’s recommendations for the state is the proposal that the states should “develop corporate governance principles that impose character and fitness expectations on directors and officers appropriate to the size and complexity of the insurer.” The report explains this recommendation by noting:

 

Many U.S.-based insurers are expanding rapidly in geography, size and complexity, thereby imposing even greater de­mands on leadership. For example, internationally active insurers are increasingly engaged in sophis­ticated enterprise risk management practices to measure and understand risks posed to the enterprise from any angle or perspective. With standards appropriately scaled to the size and complexity of the firm, state regulators should adopt director and officer qualification standards that require individuals serving in those roles to have the expertise to assess strategies for growth and risks to the enterprise. For an insurer that exceeds size and complexity thresholds, state regulators should adopt an approach designed to ensure that individuals nominated to serve in the firm’s leadership ranks have sufficient capacity to understand and challenge an insurer’s enterprise risk management.

 

Another recommendation in the report that will be of interest to this blog’s readers is its suggestion that “the National Association of Registered Agents and Brokers Reform Act of 2013 should be adopted and its implementation monitored by the FIO.” This proposed legislation, which can be found here, is intended to create a uniform agent and broker licensing clearinghouse is supported by the Independent Insurance Agents and Brokers of America. (More information about this proposed legislation can be found here.)

 

The FIO report contains a wealth of information, including some very interesting data showing how important the insurance industry is in the United States. Among other things, the report states that 2012 U.S. insurance premiums totaled $1.1 trillion, representing 7 percent of the country’s GDP. Insurers directly employ 2.3 million people in the U.S, representing 1.7 percent of non-farm payrolls. As of year-end 2012, insurers reported $7.3 trillion in total assets, including $6.8 trillion in invested assets

 

Special thanks to a loyal reader for sending me a copy of the FIO report.

 

And in the End: The Beatles ended their Abbey Road album with the simple song called “The End.” The song features short but memorable lyrics – “And in the end, the love you take is equal to the love you make – and a sonic quality that make the track truly unforgettable. In a December 13, 2013 post on Something Else Reviews entitled “Deep Beatles: ‘The End,’ from Abbey Road (1969)” (here), music journalist Kit O’Toole takes a closer look at the song, which she says “serves as more than a mere final track to an album”; the song, she says, “effectively summarizes [the Beatles’] career trajectory as well as the end of the 1960s.”

 

The song features one of the only drum solos that Ringo Starr has ever recorded, as well as the dueling guitar solos featuring the other three Beatles. As O’Toole says, “after the angst expressed in ‘Carry That Weight’ and the ‘You Never Give Me Your Money’ reprise, ‘The End’ injects pure adrenaline and joy in the proceedings.”

 

Even if you think you know the song, read O’Toole’s account of how the song was recorded and how the pieces came together, and then listen to the song again on the embedded video link below. (The video starts with “Golden Slumbers” and ends with “The End”.)

 

O’Toole ends her article quoting Paul McCartney as saying “I’m very proud to be in the band that did that song and that thought those thoughts and encouraged other people to think them to help them get through little problems here and there.” It really is a great song.

 

After you have watched the video, you might want to visit the website for Abbey Road Studios (here) which has a webcam set up on the famous Abbey Road cross walk. If you check out the webcam shot during the daytime (London time) you won’t have to wait long to see random groups of people trying to recreate their version of the Abbey Road album cover.

 

//www.youtube.com/embed/hc5YuMsDTRE

Largely as a result of changes in the industry following the enactment of the Affordable Care Act, health care organizations have seen their D&O insurance rates increasing and the available terms and conditions tightening, according to a December 10, 2013 report from Marsh. Moreover, these changes are likely to continue in 2014, according to the report. A copy of the Marsh report, entitled “As Reform Takes Effect, Health Care D&O Rates Increase,” can be found here (registration required). Marsh’s December 11, 2013 press release about the report can be found here. Hat tip to Claire Wilkinson at the Insurance Information Institute blog (here) for the link to the Marsh report.

 

According to the report, since the 2010 passage of the ACA, health care organizations have been undergoing rapid consolidation, as they seek to form accountable care organizations (ACOs), which are joint ventures or affiliations “aimed at better coordinating services, reducing costs and improving the quality of care.” Because the formation of these ACOs expressly contemplates that the participating organizations will collaborate and share information, “some insurers have expressed concerns about the antitrust issues.”  

 

Among the insurers’ concerns is that, while the Federal Trade Commission and the Department of Justice have developed antitrust safe harbors for federally recognized ACOs, the extent of protection available under the safe harbors is “untested,” particularly in connection with private antitrust litigation.

 

As a result of these concerns, D&O insurers have been raising their rates for health care organizations, as well as restricting the coverage available under their policies for antitrust claims. According to the report, average primary D&O rate for smaller health care organizations (those with assets of $150 million or under and fewer that 1,000 employees) increased by 12.7% in the third quarter of 2013. 96% of organizations in this sector renewed their insurance with rate increases. Average primary D&O insurance rates for midsize and large health care organizations increased by 9.6%, with a median increase of 7.0%. 96% of all midsize and large health care organizations renewed with an increase during the third quarter.

 

Graphical information in the report shows that for all health care organizations, both primary D&O premiums and overall premiums have been increasing steadily since the fourth quarter of 2011.

 

Along with these rate increases, some insurers have been restricting the coverage available under their policies for antitrust claims. These restrictions include in some instances the introduction of sublimits and/or coinsurance for antitrust claims. According to the report, at least one insurer has taken “a particularly aggressive stance” by restricting availability of antitrust coverage to a maximum of $5 million across all financial and professional lines, and imposing a mandatory coinsurance of 20% to 30%.

 

The article notes that in addition to the antitrust concerns, the health care industry’s shift to the accountable care model entails a number of other liability risks. For example, the establishment of provider networks raises the possibility of “contractual liabilities and lawsuits from customers, competitors, and regulators over such issues as errors in providing nonmedical services.” An ACO also could assume “higher risks related to the pricing of services, medical expenses in excess of agreed capitation levels, or contract mismanagement for its members.”

 

As a result of these changes and heightened risks, D&O insurers are seeking a great deal more renewal underwriting information, particularly with respect to ACO formation and strategy. Among other things, they are seeking additional information about contractual terms, data security, and indemnification and insurance relationships between counterparties.

 

In addition to the D&O issues, another concern ACOs will face are the “managed care errors and omissions (E&O) inherent in population management strategies. These issues may arise as efforts to control costs lead to quality of care concerns. These kinds of issues will require many organizations that in the past may not have purchased managed care E&O insurance to add the coverage to their professional liability insurance program.

 

The article concludes with as the industry continues to transition to accountable care, risks and exposures will continue to emerge. As a result, health care organizations “should be prepared to face additional rate increases as they renew their D&O insurance program in 2014” and to address underwriters’ questions about their strategies for the formation of ACOs.

 

The article notes that D&O insurers will be closely monitoring developments in the consolidated Blue Cross Blue Shield antitrust litigation pending before Judge David Proctor bin the Northern District of Alabama (about which refer here). The report notes that “as a protracted legal struggle is expected, the case will likely have no immediate impact on pricing – but it has added to the antitrust concerns for underwriters.”

 

For those of you looking ahead to 2014, one date you will want to note on your calendar is January 29, 2014. That is the effective date of the Brazilian Clean Companies Act, a new anti-bribery statute that signals Brazil’s intention to crack down on corruption. The Act represents an operational and compliance challenge for Brazilian companies and for foreign companies doing business in Brazil. It also represents a potentially significant development in the risk environment for D&O insurers doing business in Brazil.

 

Following highly publicized public protests last year, the Brazilian Senate approve the Clean Companies Act on July 4, 2013. Brazilian President Dilma Rouseff signed the Act into law on August 1, 2013. The Act subjects Brazilian companies and foreign entities with a Brazilian registered office, branch or affiliate i to civil and administrative sanctions for bribery of domestic or foreign public officials. Violations of the Act can be sanctioned by civil fines of as much as 20 percent of a company’s gross billings, or if the prior year’s revenue cannot be calculated, of up to R$ 60 million (about US$26 million).

 

A December 6, 2013 memo from the Morrison & Foerster firm describing the Act can be found here. An August 9, 2013 memo from the Covington & Burling law firm with a detailed description of the Act can be found here.

 

The Brazilian Act has certain features in common with the U.S.’s Foreign Corrupt Practices Act and the U.K.’s Bribery Act. Like those two statutes, the Act has an international reach, applying to acts committed both in Brazil and abroad. Because of this international applicability, companies “can expect Brazil to cooperate more with US and UK regulatory authorities than it does today,” according to a memo about the Act by São Paulo attorney Gabriela Roitburd.

 

At the same time, there are important differences between the Act and the FCPA and the Bribery Act. Unlike the Bribery Act, the Clean Companies Act is a “strict liability” statute. In order for sanctions to be imposed on a company, prosecutors are not required to show that company representatives acted with criminal or corrupt intent. In addition, according to the Morrison & Foerster memo, “a company cannot avoid liability under [the Clean Companies Act] by proving that it had ‘adequate procedures’ in place.” However, companies can mitigate potential fines based on cooperation with Brazilian authorities and by having effective internal compliance procedures. Companies will also receive a cooperation credit for voluntary disclosure.

 

Unlike under the FCPA and the Bribery Act, the Clean Companies Act does not impose criminal liability on legal entities for acts of bribery. Violations of the Act can result only in the imposition of civil and administrative sanctions (which, though not involving criminal sanctions, nonetheless potentially can be quite harsh). The Act does not alter existing laws under the Brazilian Criminal Code imposing criminal liability on individuals for acts of bribery. In addition, unlike under the FCPA, the Clean Companies Act does not contain an exception for so-called “facilitation payments.”

 

Discussion

The extent of the changes that may follow the Act’s effective date is uncertain. In the words of the São Paulo attorney Gabriela Roitburd, “how aggressively Brazilian authorities will enforce the Act and in which areas they will focus their efforts remain to be seen.” Skeptics might well question the extent to which the Act alone will change anything.

 

Just the same, there are reasons to suspect that the Act could represent a very significant development. The Act’s enactment not only took place in the midst of a highly charged political environment, but it also follows a period in which Brazilian authorities have already started cracking down on corrupt activities; based on examples cited in its memo, the Morrison & Foerster law firm notes, with respect to existing enforcement activities, that “authorities are not shying away from pursuing big, powerful targets.” The memo goes on to observe that “the risks involved in sectors that require significant interaction with public officials have multiplied.”

 

There is a larger context within which the Act’s enactment takes on a more global significance. As the Morrison & Foerster memo notes, the Act “represents a firm statement of intent from the Brazilian government to align itself with global trends and tackle corruption head on.” It is this sense in which the Brazilian’s adoption of the Act represents a part of a “global trend” that the Act takes on a greater significance.

 

During numerous conversations with industry colleagues outside the U.S. this fall, I have heard over and over again that regulators outside the U.S. are becoming increasingly active and that there has been an upsurge in claims notifications involving regulatory and enforcement actions outside the U.S. The Brazilian adoption of the Act seems to set the stage for an augmentation of this current trend.

 

Ranked by GDP, Brazil has the world’s sixth largest economy. It is the largest economy in South America. Its enactment of this statute potentially will have an impact on other counties and economies, perhaps even outside of Latin America. To the extent, Brazilian’s adoption of the Act encourages other countries to try to crack down on bribery and corruption, it could accelerate the already pronounced trend toward greater regulatory activity around the world.

 

At a minimum, the Act’s adoption raises the possibility of greater regulatory and enforcement activity in Brazil, involving both Brazilian companies and foreign companies doing business in Brazil. The possibility of this increased regulatory and enforcement activity in turn raises the possibility of increased D&O claims activity, as companies targeted by prosecutors seek to have their defense costs and other expenses reimbursed by their insurers. The possibility (noted above) for collaboration between Brazil and both the U.S. and the U.K. on anticorruption enforcement further reinforces the possibilities for greater D&O claims activity.

 

Brazil’s adoption of the Act is significant in and of itself, for what it means for the country’s efforts to try to crack down corruption. It potentially is also emblematic of a more global move toward greater regulatory enforcement. These developments in turn have important significance for companies doing business in Brazil and for the larger global economy. All of these developments have important implications for the global D&O insurance industry.

 

The extent to which coverage would be available for any particular company under its D&O insurance for matters of the kind described above will of course depend on the nature of the specific allegations raised and the particular wording of the company’s policy. The extent of coverage available for investigative costs is a recurring issue, and the extent of coverage for investigations and enforcement actions involving the entity is particularly dependent on policy wording. In connection with enforcement actions, fines and penalties typically would not be covered, so enforcement action-related coverage questions would most likely involved defense cost protection. To the extent enforcement actions under the Brazilian Clean Companies Act lead to follow on civil litigation (as has happened in the U.S.  following FCPA enforcement actions), the related civil actions would involved further costs for which the insured persons would seek D&O insurance coverage.

 

It is not news that the choices CEOs make can significantly impact the companies they lead. But at least according to a recent academic study, CEOs’ ability to affect their companies is not limited just to the decisions they make in their corporate posts, but also includes decisions they make in their personal lives. According to the study’s authors, CEOs’ decisions and actions in the personal lives can affect their companies’ performance. As shown below, CEOs’ personal decisions can also lead to shareholder claims against their companies.

 

In a December 3, 2013 post on the Harvard Law School Forum on Corporate Governance and Financial Regulation entitled “The Impact of CEO Divorce on Shareholders” (here), David Larker and Allan McCall of the Stanford University Accounting Department and Brian Tayan of the Stanford Graduate Business School examine the impact that CEO divorce can have on a corporation. The authors summarized their findings by saying that “recent events suggest that shareholders pay attention to matters involving the personal lives of CEOs and take this information into account when making investment decisions.”

 

(The authors’ recent blog post is abbreviated version of their more detailed October 1, 2013 paper entitled Separation Anxiety: The Effect of CEO Divorce on Shareholders, which can be found here).

 

The authors note that there are at least three potential ways that CEO divorce might impact a corporation and its shareholders. The first is that the property settlement associated with their divorce — in which the CEO might be forced to sell personal shares in their company – could affect a CEO’s control or influence. The share sale could “reduce the influence that he or she has over the organization and impact decisions regarding corporate strategy.”

 

Second, CEO divorce can affect the productivity, concentration and energy levels of the CEO. The authors cite prior research the concluded that employee divorce can affect firm productivity. In the extreme, the authors note, the distraction of divorce can lead to premature retirement. (The authors’ paper cites the example of A.G. Lafley, who stepped down early from his post as Proctor and Gamble’s CEO following his divorce filing).

 

Third, CEO divorce can influence a CEOs attitude toward risk. A sudden change in a CEO’s wealth can affect the executive’s risk appetite and therefore affect decision making. The authors’ research suggests that both the board of directors and shareholders need to consider the consequences to the corporation when a CEO and spouse separate. In some cases, the board might want to consider a change in CEO compensation to “restore” the CEO’s incentives so they are consistent with the original expectations and the company’s risk tolerance.

 

It is interesting to me that in their summarization of their findings, the authors did not limit their conclusions simply to matters pertaining to CEO divorce but rather stated more generally that shareholders should pay attention to matters “involving the personal lives of CEOs.” Indeed, recent events suggest that shareholders should be concerned not just CEO divorce but CEOs’ personal relationships as well.

 

A recent example where a CEO’s relationship caused problems at the executive’s company and even lead to the filing of a securities class action lawsuit arose at the IT outsourcing company iGate Corporation. On May 20, 2013, the company disclosed that its Board had terminated its CEO Phaneesh Murthy after an internal investigation revealed the CEO had a relationship with a subordinate employee in violation of company policy and the CEO’s employment contract. The company’s shares declined nearly 10 percent on this news. Then on May 22, 2013, the company further disclosed that the CEO’s termination was “for cause” and that the former CEO was not entitled to severance under his contract. The company’s shares slid further on this news.

 

As discussed here, on June 14, 2013, plaintiff shareholders filed a securities class action in the Northern District of California against iGate and its former CEO. The plaintiffs alleged that the defendants had failed to disclose that (i) the Company’s Chief Executive Officer and President was involved in an improper relationship with a subordinate employee in violation of iGATE’s explicit policies to the contrary; and (ii) the CEO’s improper conduct created a risk that he would be terminated from the Company, jeopardizing the Company’s future success.

 

Although the circumstances at iGate may seem to have their own distinct features, the departure of a CEO amid allegations of an improper relationship is not unprecedented, nor is the arrival of a shareholder lawsuit following the CEO’s departure.

 

For example, former H-P CEO Mark Hurd denied that he had a personal relationship with an outside publicist for the company, but (as discussed here) the board’s investigation into the publicist’s sexual harassment allegations ultimately led to Hurd’s resignation based on allegations that Hurd submitted expense report that had been falsified to obscure his relationship with the publicist. Following these events, an H-P shareholder filed a shareholders derivative lawsuit against the company’s board in the Northern District of California, alleging mismanagement and breach of fiduciary duties. (The case ultimately was dismissed, refer here). 

 

Of course, neither of these cases related to CEO divorce, which is the topic of the academics’ paper. But they do show how the CEO’s personal relationships generally can affect their company and can even lead to shareholder claims. The authors’ study shows how a CEO’s decisions in their personal life can affect corporate performance and investment risk. The difficulty for investors (and indeed for D&O insurance underwriters) who might want to understand this risk is that their interest in this kind of information runs directly into the CEO’s right of personal privacy.

 

The study’s authors have no difficulty identifying investors’ interest in knowing information about CEO’s personal lives. The authors understandably are more hesitant when it comes to describing company’s corresponding disclosure obligations in that regard. The authors note that companies do not always disclose when a CEO gets divorced, and that reports often only come out later when, for example, the CEO sells shares to satisfy the terms of the divorce settlement. In the end, the authors avoid any prescriptions about corporate disclosure obligations but simply pose the questions, “Is divorce a private matter, or should companies disclose this information to shareholders? If so, how detailed should this disclosure be?”

 

If the disclosure questions are awkward when it comes to CEO divorce, the questions are even trickier when it comes to issues such as CEOs’ personal relationships. Clearly, where a CEO has had a relationship (or engaged in any other behavior) that violates company policies, that is a matter that must be disclosed to investors. A CEO’s personal relationship arguably might trigger a disclosure obligation when a personal relationship has a clear and direct impact on company performance. However, beyond that, I think just about everyone would recognize that other details of CEO’s private life generally are off limits.

 

Just the same, the interests of investors (and of D&O underwriters) are affected by the choices that a company’s CEO makes, and that is true not just of the CEO’s corporate choices but even of their personal choices. We have all grown used to the notion that a company’s compliance environment starts with the “tone at the top.” Given the CEO’s rightful expectation to privacy, there may be no realistic way to try to underwrite the likelihood that a CEO’s personal life will lead to problems affecting corporate performance (or lead to shareholder lawsuits). However, a company’s culture, and the CEO’s role in that culture, can be underwritten.

 

This discussion does remind me of an earlier post I wrote years ago concerning another academic study in which the authors found an inverse correlation between the value of a CEO’s house and the future performance of their company. As discussed here, the study’s authors found a "significantly negative stock performance following the acquisition of very large homes by company CEOs," a negative trend that persists for several years after the home purchase.

 

All of which says to me that while in general the choices a CEO makes in their personal life often are nobody else’s business, the fact is that at least some of a CEO’s personal choices might nevertheless tell you something about the company they are running. As a minimum, as the authors of the CEO divorce study conclude, the CEO choices in their personal lives can affect corporate performance and therefore represent a form of corporate risk.