Readers continue to send in photographs of their D&O Diary mugs. Readers also continue to demonstrate both creativity and a willingness to travel great distances to get just the right mug shot.

 

Readers will recall that in a recent post, I offered to send out to anyone who requested one a D&O Diary coffee mug – 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, and here), I published prior rounds of readers’ pictures. The pictures have continued to arrive and I have published the latest round below.

 

The first two photos in this collection display a sports oriented theme. The first picture, sent in by our good friend Paula Cobbett of Sullivan Brokers Wholesales Insurance Solutions was taken at an America’s Cup race on San Francisco Bay. Paula reports with respect to her picture that “the D&O Diary Cup still stands strong, even as America’s Cup looks as it might go to the KIWIs.”

 

 

 

 

 

 

 

 

 

 

The second sports shot, sent in by Mo Offereins of AON in Chicago, was taken at Conway Farms Golf Club in Lake Forest, Illinois, which is Mo’s home course, and which recently hosted of the 2013 BMW Championship.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Next up, Jacqueline Vinar of Alliant Insurance Services sent in several pictures from her recent family vacation in Rehoboth Beach, Delaware, including this shot of the famous Rehoboth Beach Water Tower. I must confess that the pictures from Rehoboth struck a chord with me, because my family vacationed there too when I was a child.

 

 

While I don’t have any mug shots from Asia this time, I still do have one great picture from a colorful international location. Clay Newton of FX Energy sent in this picture taken in front of the Palace of Culture and Science in Warsaw, Poland.

 

 

 

 

 

 

 

 

 

 

 

 

Finally, for their mug shot, Steven Robinson and Kyle Dougherty of the ACE Group in Philadelphia decided to visit the roots of the insurance industry in the United States, as detailed in this self-explanatory picture:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 I can’t tell you how much fun it is to get readers’ pictures. When I started this project, I had no idea where it would lead. I certainly didn’t expect that people would carry their mugs half way around the world just to collect a great mug shot on location, or that people would take their mugs with them on a family vacation. All of the shots are great, thanks to all who have sent them in. I look forward to receiving and publishing many more pictures.

 

I recently ordered another supply of mugs, so if there are more readers out there who would like to have a mug, please just let me drop me a note. Just remember, if you get a mug, you have to send back a picture. If you order a mug, please be patient, it may take a few days to mail the mug to you.

 

In a series of recent conversations with industry colleagues around the world, one of the recurring themes has been the growing risk of regulatory investigation and enforcement action companies outside the U.S. are facing. One very particular aspect of the companies’ growing risk is that it frequently is the case that the increased risk may not be connected to regulators in their home country. Increasingly the source of the risk may involve regulators from the U.S.

 

The extraterritorial reach of U.S. regulators was on display in a September 17, 2013 article in the New York Times Dealbook column entitled “Wielding Broader Powers, S.E.C. Visits Hedge Funds in London” (here). The article notes that the SEC, which has “actively pursued actions by American banks and other financial institutions overseas, is broadening its reach by asserting its purview to foreign hedge fund managers.” Relying on authority given to the agency in the Dodd-Frank Act, the SEC is “paying visits to more than a dozen hedge fund managers registered with the S.E.C. to determine whether they are in compliance with American regulations.”

 

According to the article, the agency’s actions are raising “concerns that the visits would lead to the importation of American-style regulation to British hedge funds that have American clients.” The article explains that the actions in London follow increased regulatory activity involving hedge funds in the U.S., including in particular several high profile insider trading prosecutions. The article also explains that the actions arguably are not entirely random as the hedge funds that have been contacted are the ones, for example, with large numbers of U.S. clients. But the information that the agency has requested is “voluminous.”

 

Another recent article from the New York Times Dealbook column also highlighted the overseas reach of U.S. regulators. A  September 16, 2013 article entitled “Complying with U.S. Tax Evasion Laws is Vexing for European Banks” (here) discusses the difficulties that Non-U.S. banks are having complying with a new U.S. law, the Foreign Account Tax Compliance Act. The article reports that “foreign banks and financial firms are increasingly finding that complying with the law is a major headache.” Among other things, the banks are finding that they must install new computer systems in order to comply with the law’s reporting requirements.

 

According to the article, the new U.S. tax law

 

effectively makes all foreign banks and foreign financial institutions arms of the I.R.S. by requiring them to disclose data on American clients with accounts containing at least $50,000, or to withhold 30 percent of the dividend, interest and other payments due those clients and to send that money to the I.R.S. The law applies to banks and financial institutions even if their home countries have secrecy laws. Those that do not comply could face significant fines or be locked out of doing business with American clients.

 

Nor is this overseas imposition of U.S. regulation on Non-U.S. companies limited just to companies in the financial sector. A September 17, 2013 Wall Street Journal article (here) detailed how the U.S. Food and Drug Administration, as part of its effort to block exports to the United States from the Indian drug manufacturing plant of Indian-based Ranbaxy Laboratories Ltd due to alleged safety violations, the U.S. agency has required the company “to hire a third-party expert to inspect the Mohali facility and certify to the FDA that any violations have been addressed and that the company has processes in place to ensure continuing compliance.”

 

The extraterritorial reach of the Foreign Corrupt Practices Act has been well-established, with numerous high profile actions involving non-U.S. companies and non-U.S. executives. A recent post on the International Trade Compliance Update blog (here) details recent SEC and U.S. Department of Justice “clarifications on the FCPA’s application to non-U.S. companies.” The blog post explains that “U.S. authorities can more often than not find a jurisdictional ‘hook’ allowing them to pursue an anti-bribery enforcement action, as evidenced by the numerous FCPA cases brought against non-U.S. companies. Furthermore, recent SEC matters involving foreign nationals illustrate the broad interpretation by U.S. authorities of the scope of conduct sufficient to establish personal jurisdiction in the civil context.”

 

Other examples of the reach of U.S. regulators outside of the U.S. abound. Among more recent examples are the U.S. enforcement actions relating to the J.P. Morgan “London Whale” trades and the Libor manipulation scandal. In both cases the misconduct took place outside the U.S. but the U.S. authorities, rather than deferring to the authorities where the wrongdoing took place, are either taking an active role in the enforcement action or taking the lead.

 

The long and short of it is that U.S. regulators are actively asserting their authority outside of the U.S. In an environment where there already is a growing perception of increasing regulatory risk, the U.S. authorities’ vigorous assertion of regulatory authority outside the U.S. represents a particularly hazardous part.

 

These developments not only have important compliance implications for many non-U.S. companies. They also raise important issues about the liability exposures of the potentially affected companies as well as for their directors and officers. The liability exposures include not only the potential regulatory and enforcement risk but also the possibility of follow on civil actions, brought by shareholders or others. The “others” that might bring claims include supervisory board members in those jurisdictions with the dual-board structure.

 

These issues in turn raise important D&O insurance implications. The issues also present a particularly difficult challenge for D&O insurance underwriters involved in underwriting companies outside the U.S. as they must attempt to understand and anticipate these kinds of actions from U.S. regulators and how they may affect the companies under consideration.

 

Over the coming weeks, I hope to have several opportunities to discuss these growing regulatory concerns with industry colleagues in Europe, In the U.S. and elsewhere. I think these growing concerns represent a significant development in the world of D&O, with particular importance for those working with companies based outside the U.S. but with significant involvement with U.S. clients and customers.

Not only have the number of 2013 filings of FDIC’s lawsuits against the former directors and officers of failed banks already exceeded any prior year’s filings, but the pace of filings in the second and third quarter this year exceed the filing rate in an any equivalent period during the prior three years, according to a new report from Cornerstone Research. The September 2013 report, which is entitled “Characteristics of FDIC Lawsuits against Directors and Officers of Failed Financial Institutions,” can be found here. Cornerstone Research’s September 16, 2013 press release about the report can be found here.

 

As a preliminary matter, it is worth noting that the report’s litigation filing figures are as of August 8, 2013, and its information about the number of failed banks is as of August 27, 2013. As reflected on the FDIC”s website, there have been additional lawsuit filings since August 8 (as noted here) and there have been additional bank failures since August 28 (as noted here). Where possible below, I have added parenthetical information to update the figures from the Cornerstone Research’s report to reflect these subsequent lawsuits and bank failures.

 

According to the Cornerstone Research report, during 2013, the FDIC’s pace of new lawsuit filings against directors and officers of failed banks has been elevated as compared to prior periods. As of August 8, there had been a total of 32 FDIC lawsuits filed against former directors and officers of failed banks during 2013. (As of September 13, 2013, the figure is up to 35). Those YTD figures already exceed the year-end failed bank lawsuit filing figures for 2012 (when there were 25) and 2011 (when there were 16). The filings during the second and third quarters of 2013 exceeded the filings during any equivalent prior period. If the filings continue their year to date pace, by year end there could be as many as 53 failed bank lawsuits during 2013. As of September 13, 2013, there have been a total of 79 lawsuits filed during the current bank failure wave.

 

Because the FDIC typically files its failed bank actions toward the end of the three-year statute of limitation period, and because the end of 2009 and the beginning of 2010 represented the high water mark period for bank failures, it is not entirely a surprise that the filings levels have picked up in recent periods. Of the 32 lawsuits filed this year through August 8, 2013, nine were against institutions that had failed in 2009 and the remaining 23 were involved institutions that failed in 2010.  

 

While failed bank lawsuit filings have been up during 2013, the number of new bank closures is down since the peak number of closures in 2010 (when there were 157 failed banks). According to the report, as of August 27, 2013, there had been 20 bank failures this year. (There have been two more bank failures since August 27, bringing the updated year to date total to 22.) The report projects that by year end 2013, there may have been as many as 31 failed banks this year. The report notes that between January 1, 2007 and August 27, 2013, there were a total of 488 failed banks. (With the two additional bank closures since August 27, the total is now up to 490).

 

About 15 percent of the banks that have failed have been the subject of an FDIC lawsuit. However, the figures are higher for the bank failures during 2009 and for 2010, as the bank failures from those years are now past or approaching the third anniversary of their closure date. With respect to the 2009 bank failures, 35 institutions, or about 25 percent of the failures that year, have already been the subject of an FDIC lawsuit. In addition, the directors and officers of a number of other banks that failed during 2009 reached settlements with the FDIC without a lawsuit being filed. Taking into account both the bank failures that resulted in lawsuits and the bank failures were there were settlements without lawsuits, at least 41 percent of the 2009 failed institutions have been the target of FDIC claims.

 

For the 2010 bank failures, about 30 institutions, or about 19 percent, have already been the subject of an FDIC lawsuit. Another nine banks that failed in 2010 have settled with the FDIC without a lawsuit being filed, meaning that a total of at least 25 percent of the 2010 failed banks has been the target of an FDIC claim.

 

The lawsuits generally have targeted the larger failed institutions and those with a higher estimated cost of failure. Of the 75 lawsuits filed through August 8, 58 involved institutions that had total assets greater than $217 million, which is the median asset size of failed institutions since January 2007. The failed bank lawsuits so far in 2013 have generally targeted even larger institutions; the median total assets figure for the failed banks targeted in the first quarter was $644 million and the second quarter was $1.1 billion.

 

The 75 failed banks that were the target of lawsuits up to August 8 had a median estimated cost to the FDIC of $158 million. In the 69 of the complaints in which the FDIC stated a damages amount, the FDIC has claimed a total of $3.6 billion in damages, with the average damages claim of about $53 million and the median damages claim of $27 million.

 

The greatest number of the FDIC’s failed bank lawsuits has been filed against failed Georgia banks, which is hardly surprising given that Georgia had the largest number of failed banks. So far (as of August 8), Georgia has had 17 lawsuits, Illinois and California have had ten and Florida has had nine. Of the 76 lawsuits through August 8, 46 (or about 60.5%) are from just those four states.

 

The report includes a detailed summary (on page 10 of the report) of the ten FDIC failed bank lawsuits that have settled, including in most cases the settlement amounts, and in several of the cases, the amount that D&O insurance contributed toward the settlement 

 

One of the recurring D&O insurance coverage issues that has arisen during the current wave of failed bank litigation has been the question whether coverage for an action by the FDIC in its role as receiver of a failed bank against a failed bank’s directors and officers is precluded by the Insured vs. Insured exclusion found in most D&O insurance policies. The D&O insurers’ argument is that because the FDIC as receiver “stands in the shoes” of the failed bank, the exclusion precludes coverage to the same extent as if the action had been brought by the bank itself.

 

As discussed most recently here, a number of courts have found the language of the Insured vs. Insured exclusion to be ambiguous on the issue of whether it precludes coverage for an action by the FDIC. However, in a sweeping 18-page August 19, 2013 opinion (here), Northern District of Georgia Richard W. Story held that the Insured vs. Insured exclusion unambiguously precludes coverage for an action brought by the FDIC in it is capacity as receiver of a failed bank against the failed bank’s former directors and officers.

 

Although this ruling will not put an end to the coverage disputes, it represents a significant ruling on which D&O insurers will seek to rely in disclaiming coverage for FDIC failed bank lawsuits. Significantly, Judge Story rejected a number of the arguments on which the FDIC typically relies in trying to argue that the Insured vs. Insured exclusion does not preclude claims brought by the FDIC as receiver.

 

A special hat tip to Joe Monteleone and his blog The D&O E&O Monitor for the link to Judge Story’s opinion

 

Background

Community Bank & Trust failed on January 29, 2010. As noted here (second item), on February 24, 2012, the FDIC filed an action against two former officers of the bank. The complaint alleges that Charles Miller, the bank’s senior head of retail lending, violated his legal duties in approving loans in violation of the bank’s loan policies. Trent Fricks, the bank’s CEO, is alleged to have breached his duties in failing to supervise the loan officer and in failing to take corrective measures.

 

The bank’s D&O insurer agreed to defend the individual defendants under a reservation of rights and initiated a separate lawsuit seeking a judicial declaration that it had no duty to defend or indemnify the individuals. The insurer filed a motion for summary judgment in the coverage lawsuit, seeking a ruling as a matter of law that coverage for the FDIC lawsuit was precluded. The FDIC argued that the policy provisions on which the insurer sought to rely were ambiguous and that it was entitled to further discover of the insurer’s internal communications about insurer’s own interpretation of the policy provisions.

 

In moving for summary judgment, the insurer relied on its policy’s Insured vs. Insured exclusion, which, in pertinent part precludes coverage for loss “on account of any Claim made against any Insured … brought or maintained by or on behalf of any Insured or Company in any Capacity.”

 

The August 19 Opinion

In his August 19, 2013 opinion, Judge Story held that the FDIC was not entitled to further discovery because the policy’s insured vs. insured exclusion unambiguously precluded coverage. Judge Story noted that under FIRREA, the FDIC as receiver succeeds to “all rights, titles, powers and privileges of the insured depositary institution,” which means, in the language of the U.S. Supreme Court in its 1994 decision in O’Melveny & Myers v. FDIC, that the FDIC, as a failed bank’s receiver, “steps into the shoes” of the failed bank.

 

Judge Story noted further that in the O’Melveny case, the Supreme Court held that because the FDIC steps in the shoes of the failed bank, any defenses that could have been raised against the bank can be raised against the FDIC. Judge Story said that:

 

In this case, this Court finds that the FDIC has stepped into the shoes of CB&T, and under O’Melveny, whatever claims would have been good against CB&T are also good against the FDIC. The Insured vs. Insured exclusion expressly excludes from coverage suits brought by an insured against another insured. If CB&T had sued Miller and Fricks, the exclusion would have applied to absolve Plaintiff from a duty to provide coverage for Miller and Fricks. As such, the exclusion applies equally to the FDIC.

 

Judge Story went on to note that other than in the context of a derivative suit (for which the Insured vs. Insured exclusion as an express coverage carve back), “it is exceptionally rare for someone other than the FDIC … to raise a claim on behalf of a federally insured bank.” The fact that “the only party that could bring an action on a federally insured bank’s behalf is the FDIC” demonstrates that “the exclusion speaks specifically to this circumstance.”

 

The FDIC sought to rely on a number of court decisions that had held that the Insured vs. Insured exclusion does not apply to the FDIC. Judge Story observed that none of those decisions were binding on him, while the Supreme Court’s O’Melveny decision “strongly indicates that the exclusion should be given effect.” He also noted that it is hard to discern the supposed “majority of opinions” on which the FDIC sought to rely since “the language of the exclusions among the cases is different.”

 

In a particularly noteworthy aspect of his ruling, Judge Story declined to follow a line of insurance coverage decisions from the S&L Crisis era which had held that the Insured vs. Insured exclusion did not preclude coverage for the FDIC’s lawsuits. Among other things Judge Story noted that “in none of those cases did the insured vs. insured exclusion state that it applied to claims brought ‘on behalf of’ an insured as is the case here.” He noted further that the outcomes of other cases interpreting the exclusion’s applicability to FDIC lawsuits “usually turns more on the language of the exclusion rath than the adoption of the courts of a supposed majority or minority rule.” 

 

Judge Story also rejected the FDIC’s argument that the exclusion did not apply because its purpose was to preclude coverage for collusive suits and its lawsuit was not collusive. Judge Story said “this Court cannot refuse to give effect to an unambiguous term of the policy based on an assumption of why the language was put in the policy.”

 

Finally, Judge Story declined to follow cases that had held that public policy considerations argued against applying the exclusion to preclude coverage for claims brought by the FDIC. He said that he “disagrees with the notion that it is appropriate to rewrite a contract between private parties in the name of saving the taxpaying public money. Again, there is no rule that the federal insurance fund should always win.”

 

Discussion

Judge Story’s ruling stands in interesting contrast to the January 4, 2013 ruling of Northern District of Georgia Judge Robert L. Vining, in insurance coverage litigation arising out of the FDIC’s failed bank lawsuit against former directors and officers of Omni National Bank of Atlanta, that because of the “multiple roles” in which the FDIC acts in pursuing claims against the former directors and officers of a failed bank, there is “ambiguity” on the question whether the FDIC’s lawsuit triggers the insured vs. insured exclusion. (For further background on Judge Vining’s decision, refer here).

 

Similarly to Judge Vining, in October 2012, District of Puerto Rico Judge Gustavo Gelpi declined to dismiss a direct action the FDIC had brought under the Puerto Rico direct action statute against the D&O insurer of the failed Westernbank, noting that the FDIC has authority under FIRREA to act on behalf of a number of different constituencies and therefore that “the FDIC”s role as a regulator sufficiently distinguishes it from those whom the parties intended to prevent from bringing claims under [the Insured vs. Insured] Exclusion.” (For more about Judge Gelpi’s decision, refer here.)

 

Notwithstanding these prior rulings, Judge Story found that the Insured vs. Insured exclusion unambiguously precluded coverage for the FDIC’s action as receiver of the failed bank against the bank’s former directors and officers. The fact that the various courts have reached such divergent conclusions suggests that this D&O insurance coverage question remains an unsettled and disputed issue. Indeed the fact that two judges in the same federal district could reach such diverging opinions shows just how unsettled this issue is.

 

Though the issue has been and remains an unsettled question, Judge Story’s opinion in the Community Bank & Trust coverage litigation nevertheless remains an important decision. Among other things, he firmly rejected a number of arguments on which the FDIC typically relies in trying to argue that the exclusion does not apply to the agency’s failed bank lawsuits. His refusal to follow the S&L Crisis era decisions on the issue could prove useful for the agency in other coverage disputes. The D&O insurers undoubtedly will also rely on Judge Story’s rejection of the FDIC’s argument that the exclusion only applies to collusive suits, as well as his rejection of the public policy arguments, in contending in other cases that the Insured vs. Insured exclusion precludes coverage for the FDIC”s failed bank lawsuits.

 

As Joe Monteleone observed in his blog post about Judge Story’s ruling, “this is a very significant win for insurers in the current round of coverage litigation with the FDIC involving bank failures since 2007.”

 

As important as the ruling is, Judge Story’s opinion will be no means put an end to the coverage disputes on the question whether the exclusion applies to the FDIC’s failed bank lawsuit. It is not just that a judge in the same judicial district reached a contrary conclusion on the same issue. It is also that Judge Story himself emphasized that the various cases on the issue are best understood as a reflection of the specific policy language at issue. Because even Judge Story himself found that the outcome of the question depends on the specific policy language involved, the parties to similar coverage disputes will continue to argue whether or not the specific language in their case does or does not operate to preclude coverage. But though the parties will continue to argue, the insurers do now have one more case on which to rely in arguing that the Insured vs. Insured exclusion precludes coverage for an FDIC failed bank lawsuit.

 

Further background regarding the coverage disputes involving the Insured vs. Insured exclusion can be found here and here.

 

Living in the 21st Century: This past Friday night, Mrs. D&O Diary and I were out to dinner with some friends. During our dinnertime conversation, we discussed the question of why these days so many people take pictures of their food and then post the pictures on the Internet. I don’t think we came to a table consensus on the issue, but during the discussion I did take of few pictures with my phone of my wife’s grilled green beans appetizer (pictured). Still not sure why people take picture of their food and post the pictures on the Internet.

 

The picture by the way was taken at Felice’s Urban Cafe, a modest sort of hipster healthful foods-type restaurant installed in a retrofitted house on Larchmere Boulevard in Cleveland. For my main dish, I had the Lake Erie Walleye. It was awesome. Readers who find themselves in the Cleveland area and who want to give Felice’s a try are welcome to give me a call. If you like, we can take pictures of our food with our cell phones and post the pictures on the Internet – and then we can try and figure out why?  

 

I want to make sure that all readers – particularly those based outside the U.S. — are aware of an upcoming Professional Liability Underwriting Society (PLUS) event.

 

On October 9-10, 2013, PLUS will be sponsoring an educational and networking event in Zurich. The Professional Liability Regional Symposium will address a wide range of issues relating to the liabilities of directors and officers and to the insurance implications arising from those liabilities. The program includes a number of interesting sessions and a stellar lineup of speakers. The program is the inaugural PLUS event in Continental Europe.

 

I will be participating as a moderator of two of the panels at the event. Both panels feature leading European D&O insurance professionals and attorneys. The first panel, which will take place on October 9, is entitled “Corporate Officials’ Liability Exposures: Identifying Current and Emerging Risks and Developing D&O Insurance Solutions.” The second panel, scheduled to take place on October 10, is entitled “Increasing Regulatory Oversight and Investigation: Implications for Liability and Insurance.” The event will also include a keynote presentation from Noona Barlow of AIG who will talk about European D&O Coverage issues, and David Birmingham of DB Consulting, who will discuss Managing the Risk of the Long Arm of U.S. Enforcement.

 

In addition to the educational sessions, the event will afford a great opportunity for networking. The event’s first day will include a networking reception. In the past few days, I have spoken to numerous industry colleagues in London and in Continental Europe who are planning on attending the Zurich event. I hope that other D&O insurance professionals from around Europe and around the world will also plan on going to Zurich for the conference and taking advantage of the opportunity to attend the informative sessions and to meet industry colleagues. Further information about this event can be found here. I look forward to everyone there.

 

A federal court has denied the motion of the accountants of the failed Colonial Bank’s holding company to dismiss the claims the FDIC, in its capacity as the failed bank’s receiver, had filed against them. As discussed here, the FDIC’s November 2012 lawsuit was the first the agency had filed against a failed bank’s accounting firm as part of the current failed bank litigation wave. The FDIC alleged that the accountants should have but failed to detect the scheme of bank employees to make and then hide fraudulent loans to failed mortgage lender Taylor Bean & Whitaker.

 

Middle District of Alabama Judge W. Keith Watkins’s September 10, 2013 opinion, which can be found here, discusses important questions concerning what law governs the question  whether the misconduct and knowledge of former bank employees can be imputed to the FDIC as receiver. Judge Watkins determined, in reliance on the U.S. Supreme Court’s 1994 opinion in O’Melveny & Myers v. FDIC, that state law governs the question, but declined to rule on the question whether under Alabama the bank employees’ misconduct and knowledge could be imputed to the FDIC as receiver in this case.

 

When Colonial Bank failed in August 2009, it was the sixth largest U.S. bank failure of all time (as discussed here). In is complaint against the accountants, the FDIC alleges Colonial’s failure was triggered by the massive, multi-year fraud against the bank by the bank’s largest mortgage banking customer, Taylor Bean & Whitaker.

 

As I detailed in a prior post, here, In April 2011, Lee Farkas, Taylor Bean’s ex-Chairman, was convicted of wire fraud and securities fraud. Prior to Farkas’s conviction, two Colonial Bank employees pled guilty in connection with the Taylor Bean scheme. As reflected here, on March 2, 2011, Catherine Kissick, a former senior vice president of Colonial Bank and head of its Mortgage Warehouse Lending Division, pleaded guilty to conspiracy to commit bank, wire and securities fraud for participating in the Taylor Bean scheme. As reflected here, on March 16, 2011, Teresa Kelly, the bank’s Operations Supervisor and Collateral Analyst, pled guilty on similar charges.

 

In the criminal cases against the bank employees, the government alleged that the two bank employees caused the bank to purchase from Taylor Bean $400 million in mortgage assets that had no value. The employees also allegedly engaged in fraudulent actions to cover up overdrafts of Taylor Bean at the bank. The employees are also alleged to have had the bank engage in the fictitious trades with Taylor Bean that had no value. As Judge Walker said in his September 10 opinion in the FDIC’s suit against the accountants, “Like cat-skinning, bank fraud lends itself to multiple approaches.”

 

In its complaint against PwC, the bank’s holding company’s outside auditor, and Crowe Horvath, with performed internal audit for the bank’s holding company, the FDIC alleges that while Taylor Bean was carrying out its “increasingly brazen” fraud, PwC “repeatedly issued unqualified opinions” for Colonial’s financial statements, and Crowe “consistently overlooked serious internal control issues” – and, more the point, both failed to detect the fraud. The complaint alleges that if the firms had detected the fraud earlier, it would have prevented losses or additional losses that the bank suffered at the hands of Taylor Bean. The complaint asserts claims against the firms for professional negligence, breach of contract, and negligent misrepresentation. The complaint alleges that in the absence of the firm’s wrongful acts, the Taylor Bean fraud would have been discovered by 2007 or early 2008, and “losses currently estimated to exceed $1 billion could have been avoided.”

 

The accountants moved to dismiss, arguing that the misconduct and knowledge of the individual criminal defendants could be imputed to the FDIC, because as receiver it stepped into the bank’s shoes. The accountants also argued that because their services were performed for the holding company and not the bank, the FDIC as the failed bank’s receiver lacked standing to assert negligence and breach of contract claims against them.

 

In their motions, the accountants argued that federal law governed the question of whether the individuals’ knowledge and misconduct can be imputed to the FDIC, and that under federal law, the knowledge and misconduct could be imputed to the FDIC and therefore that the FDIC was estopped from asserting the failed bank’s claims.

 

Judge Watkins ruled, in reliance on the O’Melveny decision, that state law governed the imputation question. Judge Watkins noted that “when it considered virtually the same question presented by this case – whether the knowledge and conduct of a bank’s insiders could be imputed from the bank to the FDIC acting as receiver – the Supreme Court concluded the [sic] FIRREA did not offer an answer and that state law therefore governed.”

 

However, because Judge Walker found that there are factual questions whether or not the individual criminal defendants were acting within the scope of their authority when the participated in the scheme to defraud, he could not grant the dismissal motion based on the imputation of the individuals’ knowledge and misconduct.

 

Judge Walker also found that there is a factual question whether or not the bank had standing to assert the negligence claims the bank’s holding company’s accountants. Judge Walker also found that there is a factual question whether or not the holding company’s intended to make the bank a third party beneficiary of the accounting services agreement between the holding company and the accountants sufficient to allow the FDIC as the failed bank’s receiver to be able to assert breach of contract claims.

 

Readers of this blog may recall that in August 2012, certain former Colonial Bank directors and officers agreed to settle the securities class action lawsuit that had been filed against them in connection with allegations surrounding the bank’s collapse. The $10.5 million settlement was to be funded entirely by D&O insurance. The securities suit settlement is discussed here. Significantly, the settlement did not include the bank’s offering underwriters or its outside auditors.

 

Among the individual defendants party to the securities suit settlement was Colonial’s colorful and controversial former Chairman and CEO, Bobby Lowder. In addition to Colonial, Lowder has long been associated with Auburn University and its storied football program. I discussed Lowder’s Colonial Bank and Auburn connections in a prior post, which can be found here.

 

Coincidentally, Judge Watkins (according to Wikipedia) attended Auburn as an undergraduate; however, in an educational move that undoubtedly creates complicated loyalties during the college football season, he attended the University of Alabama for law school. Regardless of his loyalties as between Auburn and Alabama, he undoubtedly will be rooting for Alabama against Texas A&M this Saturday.

 

As I also noted in a prior post (here), in July 2012, the FDIC as receiver for Colonial Bank, as well as the bankrupt bank holding company on its own behalf, filed an action against the bank’s bond insurer. Among other things, the complaint alleges that the losses caused by the misconduct “constitute recoverable losses under the Bonds up to the full aggregate limits of liability of the Bonds.” The complaint states that the bond insurer “has neither accepted nor denied the Plaintiffs’ claims under the Bonds.” The complaint alleges that the insurer “has failed to investigate the claims and losses in a reasonable and appropriate manner.” In September 2012, the parties jointly moved the court to revise the schedule in the case to permit them to engage in settlement discussion.

 

There is a great deal of information available about the liabilities of publicly traded companies, as well as about the D&O insurance implications arising from those liabilities. It can be a bit of a challenge to locate the same of information concerning private companies. For that reason, it is fortunate that Advisen and AIG have teamed up to produce a new report focused just on private companies.

 

The report, entitled “The Private Eye: Spotlight on the U.S. Private D&O Market”  (here) provides a brief overview of the liabilities of directors and officers of private companies as well as of the private company D&O insurance marketplace. The report also includes useful information about private company D&O insurance buying patterns and the results of a D&O insurance buyer survey. The report also includes a brief review of emerging exposures as well an analysis of D&O insurance pricing trends.

 

The report’s analysis of D&O insurance buying takes a look at patterns over the last ten years. Among other things, the report shows that the average premium paid by private companies with annual revenues of up to $50 million is $15,851 for an average policy limit of $2.6 million. Companies with revenues between $50 million and $100 million pay an average of $50,000 for average limits of around $5 million. Industries that pay higher premiums include manufacturing, transportation, communications, utilities and the general services sector.

 

According to the report, the “most useful” metric for analyzing premiums and buying patterns is the average rate per million paid by private companies. The report presents a graphic analysis of the rate per million paid by industry and year, as well as by company size and year. The report shows that over time since 2003, the rate per million paid by private and non-profit companies of all sizes has tended downward. The biggest declines during that period have been for companies with revenues over $1 billion. As shown later in the report, the rates have started to trend up in more recent years.

 

The report also incorporates a client survey. As the report itself emphasizes the survey of over 260 private company D&O insurance buyers is heavily weighted toward larger companies, with well over half of the respondents representing companies with over $1 billion in revenues and only about 17% of respondents representing companies with revenues under $250 million.

 

The survey of these generally larger companies showed that over 90 percent of respondents purchase D&O insurance, with around a third of the respondents buying limits of $10 million or less. On the other hand, 16% of these mostly larger company respondents purchased limits of greater than $96 million.

 

Among the survey respondents reporting an increase in limits purchased, the most common reason for the increase was to buy a separate tower of A-Side insurance or to an excess layer of A-Side protection. The report notes that “this uptick in A-Side D&O purchase is further evidence of the product’s heightened importance.”

 

The survey also noted that only 17 percent of respondents had been the subject of a D&O claim during the previous three years. Of those who suffered a claim, 48 percent were shareholder suits, 33 percent were client lawsuits, and vendor lawsuits represented 21 percent. 50 percent of the claims that resulted in a settlement were resolved for under $250,000 with only 25 percent settling for greater for greater than $1 million. On the other hand, from interpreting the bar graph in the report, it does look as if just about 20 percent of the claims settled for over $5 million, which is consistent with the oft-stated principle that D&O claims tend to be low frequency and high severity. Interestingly, 88% of the respondents who reported a claim reported satisfaction with the claims handling process.

 

The survey also revealed that there are a host of emerging boardroom concerns, including cyber liability, M&A, and private equity litigation, as well as claims relating to the Fair Labor Standards Act. The report includes a brief survey of these and other emerging issues.

 

The report also includes an overview of current private company D&O insurance pricing trends. The report notes that “private company D&O rates are increasing across the board,” with a consistent increase in renewal premiums and rate per million over the last 18 months. Advisen’s own data analysis shows that while rates remain below 2008 levels, pricing has been on the rise since the third quarter of 2001.

 

The report also notes that “anecdotally, carriers tell us that rate increases of around ten percent are being achieved” during 2013 on private company D&O insurance accounts, “with up to 30 percent rate increases being applied at renewal on certain accounts” – although this analysis does not account for companies that change hands between insurers on renewal, which may be renewing at rates reflecting little or no increase. Overall, the increases are not necessarily focused just on “claim-afflicted accounts,” but rather are the result of a “re-underwriting process” across the entire portfolio. Underwriters are assessing premiums, retentions and coverage in order to try to “reflect the actual risk profile of private and non-profit accounts.”

 

The report also includes a brief overview of private company D&O claims trends. The report notes that “private company D&O claims are varied in the source and in their process.” While there is a perception that shareholders are the principle source of D&O claims, “this perspective overlooks the fact that the plaintiffs in D&O claims 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.” The report concludes with a brief review (with claims examples) of private company liability exposures in four areas: bankruptcy; shareholder suits; consumer suits; and competitor actions.

 

Those who work frequently will find this report useful. Though the data in the report have a definite emphasis toward larger companies, even those practitioners who do not regularly work with private companies with, say, revenues over $1 billion, will find this report worthwhile. In particular, practitioners may find it helpful to be able to cite this report to help their private company D&O insurance clients understand recent pricing trends, to be able to put the premium increases they are seeing on their renewals into context.

 

Practitioners may also find it helpful to refer to the claims information showing that D&O claims originate from a wide variety of claimants, which helps to explain why smaller companies that have few shareholders nevertheless should consider buying D&O insurance.

 

We can certainly hope that Advisen will continue to produce this report on an annual basis and perhaps in future years provide more detailed information with respect to companies with revenues under $250 million—that is, information that would be relevant and of interest to the vast majority of private companies and to their advisors.

 

As many readers will recall, a couple of years ago there was an intense barrage of securities litigation class action lawsuit filings against U.S.-listed Chinese companies. Many of the cases involved Chinese companies that obtained their U.S. listings by way of a reverse merger with publicly traded shell, and almost all of the cases involved alleged accounting improprieties or violations. The wave of Chinese reverse merger case filings diminished in last year and seemed to have come to an end

 

However if the suit recently filed in the Southern District of New York against PetroChina Company, Ltd. and four of its directors and officers is any indication, a new round of securities lawsuits against U.S.-listed Chinese companies could be in the offing, this time involving corruption allegations. Indeed, given the sequence of events involved and the growing global focus on anti-corruption investigation and enforcement, the trend might not be limited just to Chinese companies. 

 

As well-detailed in a September 6, 2013 memo from the Morrison Foerster law firm entitled “Corruption Allegations in China Lead to a Shareholder Class Action in the U.S.” (here),, the company itself, the Chinese government and various media sources have recently disclosed a corruption investigation involving several PetroChina officials, as well as officials affiliated with China National Petroleum Corporation (CNPC), PetroChina’s controlling shareholder. Among persons implicated in the apparent corruption investigation is a former CNPC senior manager who was a purported ally of Bo Xilai, the disgraced former Chinese politician whose own corruption trial was just completed. Subsequent reports suggested that the investigation had been extended to the former Chairman of PetroChina and CNPC.

 

According to their September 3, 2013 press release, (here), plaintiffs’ lawyers filed an action in the Southern District of New York against the company and four of its officials. According to the press release, the plaintiffs’ complaint, a copy of which can be found here, alleges that the defendants made misled investors by failing to disclose that:

 

(1) the Company’s senior officials were in non-compliance with the Company’s corporate governance directives and code of ethics; (2) as a result, the Company was subject to investigation and disciplinary action by various governmental and regulatory authorities; (3) the Company’s financial statements were materially false and misleading as they contained direct references to the Company’s Code of Ethics, and statements regarding its compliance with regulations and internal governance policies; (4) the Company lacked adequate internal and financial controls; and (5), as a result of the foregoing, the Company’s financial statements were materially false and misleading at all relevant times.

 

The law firm memo points out that there have been prior securities class action lawsuits against U.S.-listed Chinese companies containing corruption allegations. But perhaps more significant is the fact China is in the midst of a campaign, led by its new Premier Xi Jingping,  against public corruption. The lawsuit against PetroChina shows that “Chinese companies have been, and remain, on the radar screen of the U.S. securities plaintiffs’ bar.” As China’s campaign against corruption continues, the potential liability extends not only to heightened regulatory scrutiny, but also includes the possibility that shareholders will “seek to hold companies and their executives accountable for shareholder losses as a result of the alleged corruption and its fallout.”

 

According to the law firm memo, it is not just China’s government that is focusing on corrupt activities; governments around the world are stepping up enforcement of anti-bribery laws.  As this enforcement activity expands, so too does the possibility of follow on civil litigation against companies involved in a corruption investigation in their home country whose shares trade in the U.S. This possibility of follow on civil litigation seems to include in particular the possibility of further suits against U.S.-listed Chinese companies caught up in the current campaign against public corruption.

 

Continued Heightened U.S. Securities Suit Filing Activity Against Non-U.S. Companies: One of the more interesting phenomena in the U.S class action securities arena has been the level of filings targeting non-U.S. companies. Following the U.S. Supreme Court’s 2010 decision in Morrison v. National Australia Bank, there was much speculation that filings against non-U.S. companies were likely to decline. As it turned out, though, in 2011 and 2012, largely driven by the flood of lawsuits against Chinese reverse merger, the percentage of all securities suits involving non-U.S companies was well above historical norms. Indeed, in 2011 33% of all filings involved non-U.S. companies as did 21% of all 2012 filing, both figures above any prior year in percentage terms, as shown here.

 

In the first half of 2013, it seemed that the rate of filings against non-U.S. companies declined compared to 2011 and 2012 – although still well above historical levels –with about 14.9% of first half filings involving non-U.S. companies. But so far in the year’s second half, the pace of filings against non-U.S. companies seems to have picked up again. Of the roughly 36 new securities lawsuits filed since June 30, 2013, seven have involved non-U.S. companies, or about 20% –roughly on par with the percentage of 2012 filings that involved non-U.S. companies.

 

The 17 securities class action lawsuits filed so far during 2013 against non-U.S. have involved companies from nine different countries, but the country with the most companies sued in U.S. securities class action lawsuits is China, with five so far this year. (As well as one more from Taiwan.) Coming in a close second behind China is Canada, with four. As the case discussed above shows, though new filings associated with the Chinese reverse merger companies have died down, Chinese companies continue to attract the attention of the U.S. plaintiffs’ securities bar.

 

Canadian Courts May Attract Securities Claims, But Claimants Still Must Show They Belong There: Much has been written (on this site and elsewhere) about the possibility that Canada might become a destination for would-be securities plaintiffs. That perspective gained an apparent boost in March 2012, when the Ontario Court of Appeals held that the liability regime under the Ontario securities laws applied to a company whose shares traded only on the NASDAQ stock market.

 

However, in a September 4, 2013 decision by the Quebec Superior Court in a securities class action lawsuit filed by a Facebook IPO investor underscores that would-be claimants must still meet jurisdictional requirements and show that the Canadian court is the appropriate forum. Though the case was decided under Quebec law, rather than the Ontario law that has applied in many of the recent Canadian securities cases, it still highlights that there are practical and prudential constraints on the availability of Canadian courts as a securities litigation destination.

 

As reflected in the Quebec court’s September 4, 2013 Judgment (here), a Canadian claimant who lost money investing in the Facebook IPO filed suit in Quebec against Facebook, certain of its directors and officers, and its offering underwriters. The claimant alleged that she had been induced to purchase Facebook shares based on misrepresentations in the offering documents.

 

The defendants moved to dismiss the case on the grounds that the claimants’ allegations lacked a sufficient connection to Quebec to support jurisdiction, and that even if the Court had jurisdiction, it should nevertheless dismiss the case in favor of similar cases already pending in New York, based on the doctrine of forum non conveniens. The claimant argued that her claims had a sufficient connection to the province to support jurisdiction in its courts, because she had suffered injury there. In support of her claims, the claimant offered statements from her brokerage account showing the purchase of the shares and the subsequent sale of the shares at a loss.

 

In its September 4 ruling, the court granted the defendants’ motion. The court held that the claimant’s brokerage account records did not show where her Facebook share transactions had occurred or where she paid for the shares. The court said that “nothing in the record indicates that the sales transactions occurred in Quebec,” adding that under Quebec statutory principles, “the Facebook shares would have been notionally delivered either at the NASDAQ exchange in New York or at Facebook’s head office in California.” On this basis, the court concluded that the claimant’s alleged overpayment and loss would have occurred in the United States. The court said that “there is no basis to conclude that a real and substantial connection exists between the alleged facts of her motion and this Court,” and so the Court lacked jurisdiction.

 

The court when on to say that even were there jurisdiction, the court would have declined the jurisdiction (“a tenuous jurisdiction at best”) in favor of the Southern District of New York, under the principles of forum non conveniens. The court noted that the consolidated New York actions raised the same allegations; that the putative class in the consolidated action included the claimant and the class of Quebec purchasers she purported to represent; that New York law would govern the claims; that the underwriting defendants are domiciled in New York; and that any judgment would have to be executed in the United States.

 

Canadian courts may still represent a potentially attractive forum for prospective securities law claimants. However, this case shows that there are certain basic requirements involved in order for would-be securities claimants to have access to its courts. To be sure, this action was decided under the law of Quebec, and not under the law of Ontario, where much of the high-profile securities litigation in Canada has taken place. However, the legal principles involved in this case are basic and do not appear to be unique to Quebec. While this case may have no precedential effect in Ontario or elsewhere in Canada, it does suggest that prospective securities litigants who want to try to pursue their claims in Canadian courts are going to have to meet some basic prerequisites.

 

What are the Legal Obligations That Reps and Warranties Insurance Insures?: As I have noted in prior posts, most recently here, M&A reps and warranties insurance is becoming an increasingly common component of M&A transactions. As I have also recently noted, the product is not always well understood. Among the elements that are not always fully understood are the legal undertakings in the merger agreement that provide the obligations to which the insurance applies.

 

An August 2012 memorandum from the Venable law firm entitled “What to Expect When You’re Selling Your Company – Indemnification” (here) explains the indemnification undertakings provided in the typical merger transaction. As the memo notes, the seller in the merger transaction provides the buyer with a host of representations and warranties about the seller’s business. The seller is required to stand behind those reps and warranties through an indemnification provision in which the seller agrees to reimburse the buyer for the losses it suffers as a result of the representations turning out to be inaccurate or untrue.

 

The memo points out that there a variety of considerations to be taking into account in providing the indemnification undertaking. These include the question of how long after the transaction the reps and warranties should “survive”; what “caps” or maximum amounts will be allowed for reps and warranties-related losses; whether or not there will be “baskets” (minimum threshold amounts) that must be suffered before the indemnification obligation is triggered; how the losses associated with third-party claims will be handled (including in particular, who will control the defense); and specification of the types of losses to which the indemnification applies (including in particular unanticipated losses).

 

The memo’s authors also note that another consideration with respect to the indemnification has to do with escrows or holdbacks, which are amounts set aside out of the transaction proceeds to provide a source of funds to pay indemnification amounts. This aspect of the indemnification arrangement is one place where the reps and warranties insurance can provide significant value for the deal participants, as the insurance may be accepted as an alternative to escrow amounts, allowing the parties to reduce the amount of funds required to be held in escrow.

 

The authors also highlight a number of other features that should be considered in connection with the indemnification provisions in the merger transaction documents, including for example an materiality requirement. As the authors note, the indemnification provisions can be critically important to how the merger transaction plays out after the closing. From my perspective, the potential benefits of the reps and warranties insurance should be an important part of that dialog. The authors’ memo provides a good, brief background of the context within which the insurance product fits.

 

Ways to Maximize Coverage for Corruption Probes: One of the significant trends over the past several years has been the growth in the number of Foreign Corrupt Practices Act investigations and enforcement actions. These types of regulatory and prosecutorial actions can be enormously expensive. For example, Wal-Mart Stores recently disclosed that it expects to spend more than $150 million in connection with anti-bribery investigations of its Mexican operations, on top of the $150 million it has already spent.

 

Given the magnitude of the expenses involved, companies have every incentive to try to ensure that they have taken steps to maximize the amount of insurance coverage available. A September 5, 2013 Law 360 article (here, subscription required) provides a number of “tips” for companies to consider in trying to allow companies to position themselves to maximize coverage.

 

The first of the tips discussed in the article is for the company to make sure that its D&O insurance policy does not have an express exclusion for loss relating to anti-bribery and corruption claims. These exclusions, sometimes referred to as the commissions exclusion (because the exclusion’s list of the types of things exclude often leads often by specifying “commissions”), formerly were a standard part of D&O insurance policies. Though these exclusions are now less common they still sometimes appear on some policies. Even where these exclusions appear, the insurers often will agree to remove them upon provision of a completed supplemental questionnaire. Even if the carrier will not agree to remove the exclusions, companies “should try to limit the FCPA exclusion to encompass limited types of conduct or seek carve-outs for nonindemnifiable claims against individual insureds.”

 

Because much of the expense associated with an anti-bribery event can arise from the company’s own internal investigation, the commentators quoted in the article also suggest the company’s try to ensure that their D&O insurance policies provide coverage for internal investigations. While this coverage is often subject to a sublimit, “some coverage is better than no coverage.”

 

The commentators also note that the question of who is insured may also be important, as they persons caught up in an anti-bribery investigation may or may not have officer or director titles, but nevertheless may be functioning in equivalent positions in other jurisdictions. A related issue is ensuring that the conduct of insured persons is severable, so that the misconduct of any on insured person does not preclude coverage for insured persons who were not involved in the misconduct.

 

The commentators also note that in this context, it may be particularly important for the companies caught up in the anti-bribery investigation to be attentive to the notice requirements under the policy. Even if at the outset the matter may not meet the policy’s definition of Claim, it could be very important to submit the matter as a notice of potential claim, to set a coverage anchor in the then-current policy. If the company waits until the matter matures into a full-blown claim, the company may then have to turn to an insurance policy that has been narrowed in the interim.

 

Though the article does not discuss the issue, companies should also think about how their policies would respond to follow-on civil actions brought by shareholders, which are a frequent accompaniment of an FCPA investigation or enforcement action. These claims, which typically take the form of the traditional shareholder derivative action, are more likely to fall within the policy’s coverage – at least if the policy does not contain the kind of commissions exclusion noted above. Though these kinds of claims are more likely to be covered, the possibility of these kinds of claims do raise practical questions about the adequacy of limits of liability (if for example the follow-on claim were to arise at the same time as an FCPA enforcement action) as well as about policy structure (that is, ensuring that the company’s insurance program includes supplemental Side A coverage to protect against the non-indemnifiable settlement of any derivative claim).

 

The Origins of the Financial Crisis: On September 7, 2013, The Economist magazine posted the first of what will eventually be five articles on the origins and consequences of and the lessons of crisis. The first article, entitled “Crash Course” (here), focuses on the origins of the crisis.

 

The article of course focuses on the problems that financiers created. But though “failures in finance were at the heart of the crash,” the bankers “were not the only people to blame.” Among others, “central bankers and other regulators bear responsibility too, for mishandling the crisis, for failing to keep economic imbalances in check and for failing to exercise proper oversight of financial institutions.”

 

According to the article, the regulators ‘ “most dramatic error” was allowing Lehman Brothers to fail, because it multiplied the panic in markets. Ironically, the decision to allow Lehman to collapse “resulted in more government intervention, not less” because “regulators had to rescue scores of other companies.”

 

But, the article notes, regulators made mistakes long before Lehman failed, “most notably by tolerating global current-account imbalances and the housing bubbles that they helped to inflate.” Asia’s excess savings and European banks’ aggressive acquisition of “dodgy American securities” financed by borrowing from American money-market funds exacerbated the imbalances and fueled the real estate bubble. Internal imbalances within the Eurozone fueled credit flows from Europe’s core to its periphery, leading to overheated real estate markets in places like Ireland and Spain.

 

Central banks, the article says, could have done more to address all of this. The Fed did nothing to stem the housing bubble and the European Central Bank did nothing to restrain the credit surge on the periphery.

 

But of all of the regulators’ shortcomings, lax capital was the “biggest.’ Though international bodies had been redefining the amount of capital that banks had to set aside relative to their assets, the rules were not sufficiently rigid in defining capital strictly enough, and so the banks smuggled in forms of debt that lacked sufficient loss-absorbing capacity. Banks, in turn, operated with little equity, leaving them vulnerable when things went wrong.

 

In a concluding paragraph that suggests the likely direction of the next article in the series, the article notes that the central bankers and regulators were not along in making misjudgments. Politicians and humble consumers “joined in the collective delusion that lasting prosperity could be built on ever-bigger piles of debt.”

 

Upcoming PLUS Global Events: I want to make sure that all readers – particularly those based outside the U.S. — are aware of a couple of upcoming PLUS events.

On October 9-10, 2013, PLUS will be sponsoring an educational and networking event in Zurich. The Professional Liability Regional Symposium will address a wide range of issues relating to the liabilities of directors and officers and to the insurance implications arising from those liabilities. The program includes a number of interesting sessions and a stellar lineup of speakers. I will be participating as a moderator of two of the panels at the event, including sessions addressing current and emerging D&O liability trends and liability and insurance issues arising from regulatory and investigative proceedings. The event’s first day will include a networking reception. I hope that D&O insurance professionals from around Europe and around the world will plan on attending and take advantage of the opportunity to attend the informative sessions and to meet industry colleagues. Further information about this event can be found here.

 

PLUS is also sponsoring an educational session in Hong Kong on September 24, 2013. This regional symposium includes a number of panels addressing important topics such as the lessons of the U.S. litigation against Chinese companies; the changing regulatory and enforcement environment; and the liability and insurance issues arising from White Collar crime investigations and prosecutions. The day’s events conclude with a networking session following the last panel. I attended the inaugural PLUS event in Hong Kong in April 2012, which was a terrific success. I hope that industry professionals from around the region will plan to attend this PLUS event. A good turnout will help to ensure that PLUS will continue to offer these kinds of events in the region. Further information about the event can be found here.

 

Every fall, I take a step back and survey the most important current trends and developments in the world of Directors’ and Officers’ liability and D&O insurance. This year’s survey is set out below. Once again, there are a myriad of things worth watching in the world of D&O.

 

How Will the Interrelatedness Issue Continue to Affect D&O Claims?: One of the most vexing issues that can arise in the D&O claims context is the question of whether or not two claims are interrelated. The typical context in which the question arises is that there have been two (or more) claims filed in separate policy periods. If the claims are related, they trigger coverage under only a single year’s policy, with the subsequent claims deemed to have been made at the time of the first related claim. If the claims are not related but instead are separate, multiple policies are triggered.

 

 

Because the determination of the interrelatedness issues can have an enormous impact on the amount of insurance available to resolve claims, it is a frequently litigated issue. Another reason the issue is so frequently litigated is that there are few reliable guideposts to help sort out disputes over relatedness. The court decisions in this area are all over the map and often very fact-intensive.

 

This issue has been around (and has been a problem) for years. Bur for whatever reason, it just seems that more and more lately, the D&O insurance coverage disputes increasingly are focused on interrelatedness issues. A number of recent posts on this blog have involved case developments in lawsuits involved disputes over the interrelatedness issue (refer for example here and here).

 

One particularly important context in which the interrelatedness issue has arisen in recent years is in the litigation involving the financial crisis. Many of the companies involved in the crisis have been hit with multiple lawsuits, often filed over the course of several years. The question whether these various lawsuits are separate and trigger multiple insurance policies or programs, or whether they are interrelated and therefore trigger only a single policy or program, has arisen in connection with many of the high-profile companies involved in credit crisis litigation.

 

One noteworthy case that raises these issues and involving the failed IndyMac bank is now pending in the Ninth Circuit. As discussed here, in June 2012, Central District of California Judge R. Gary Klausner concluded, based on the relevant interrelatedness language, that a variety of lawsuits that first arose during the bank’s 2008-2009 policy period were deemed first made during the policy period of the bank’s prior insurance program, and by operation of two other policy provisions were excluded from coverage under the 2008-2009 program. The upshot of Judge Klausner’s opinion is that only a single insurance tower of $80 million will apply to the various claims, rather than two $80 million insurance towers.

 

Judge Klausner’s coverage decision took on even greater significance in December 2012, when the FDIC obtained a $168.8 million jury verdict against three former IndyMac officers (about which refer here). The verdict may be of little value to the FDIC if only a single $80 million tower of insurance is available for the various claims arising out of IndyMac’s collapse. Prior settlements and defense fees have largely eroded the single $80 million tower Judge Klausner said applies to the various IndyMac claims.

 

Judge Klausner’s coverage decision is now on appeal to the Ninth Circuit. The parties have been filing their legal briefs over the summer. The bank’s former directors and officers have argued to the appellate court that Judge Klausner erred in ruling that all of the various claims were interrelated and therefore triggered only a single insurance tower. A number of other parties are also challenging the ruling, including the FDIC and the trustee for the bankruptcy of the bank’s holding company. The insurers have argued that all of the claims are interrelated and therefore that only a single tower of insurance was triggered.

 

The parties are in the final stage of the briefing process and it will be many months before the case is decided. Because of the stakes involved and because of the high profile nature of the case, the Ninth Circuit’s ruling in the case will be closely watched and could be very influential. Just the same, the decision is also likely to be very dependent on the specific circumstances involved. The likelihood is that even after the Ninth Circuit issues its opinion that interrelatedness issues will continue to vex insurers and policyholders alike.

 

What are the D&O Insurance Implications of the SEC’s New Policy Requiring Admissions of Wrongdoing?: On August 19, 2013, in connection with its entry into a settlement with New York-based hedge fund adviser Phillip Falcone and his advisory firm Harbinger Capital Partners, the SEC for the first time implemented its new policy requiring defendants seeking to settle civil enforcement actions to admit wrongdoing, in contrast to the long-standing practice of allowing defendants to resolve the enforcement actions with a “neither-admit-nor-deny” settlement.

 

The SEC’s new policy requiring – in “egregious” cases — wrongdoing admissions in order to settle an enforcement action not only has important implications for the enforcement action itself, but potentially also has important implications for related civil or criminal proceedings. Another issue that inevitably will also arise is the question of the impact of factual admissions on the continuing availability of D&O insurance..

 

The SEC and the Harbinger defendants, including Falcone, had actually reached an earlier  settlement in principle to resolve the case that reflected the traditional “neither admit nor deny” approach. However, in July 2013, the SEC advised Harbinger that the SEC Commissioners had voted to reject the deal. The vote apparently reflected the SEC’s new policy, announced in June by new SEC Chair Mary Jo White, that going forward the SEC would require defendants settling enforcement actions to admit wrongdoing, at least in “egregious” cases.

 

In the revised settlement, Falcone and the Harbinger entities agreed to extensive admissions of wrongdoing. The factual admissions are set out in a detailed Annex to a Consent that Falcone signed on August 16 on his own behalf and on behalf of the Harbinger entities. The admissions are also set out verbatim in the proposed Final Consent Judgment filed with the Court. Pursuant to the settlement, the defendants agreed to pay a total of over $18 million in disgorgement, civil penalties and interest. As part of these payments, Falcone himself must pay over $11.5 million. Falcone also agreed to a five-year ban from the securities industry.

 

The admissions in the Consent are comprehensive – the defendants basically admitted all of the SEC’s allegations. Moreover, it appears that in pursuing its new settlement approach, the SEC will be requiring other defendants to provide similar admissions in order to settle SEC actions against them. For example, there are reports that the agency is seeking to require J.P Morgan to provide admissions of wrongdoing in connection with the agency’s actions against the firm in connection with the “London Whale” case.

 

The SEC’s admissions requirement has a number of significant implications. First, it means that, at least in the SEC enforcement actions where the agency will require admissions that the cases will be much harder to resolve. The defendants, wary of the possible impact the admissions could have in other proceedings, will be reluctant to provide admissions. One consequence of the new policy could be that the SEC will be compelled to try more cases, which could strain the agency’s resources.

 

A defendant’s provision of admissions potentially could have enormous consequences for related proceedings. The recitation in the Consent that the Harbinger defendants have been provided no assurances about the possibility of criminal proceedings has to be particularly chilling, especially for Falcone. The admissions in the Consent may or may not suffice to draw criminal charges, but at least some commentators have suggested that criminal charges could follow.

 

Another question about the admissions is their collateral effect in related civil proceedings. As it happens, there is a pending civil action that Harbinger investors had filed against Falcone and the funds that could provide an early test of the civil litigation collateral estoppel consequences of admissions in an SEC enforcement action. In an August 20, 2013 post in her On the Case blog (here), Alison Frankel examines the possible impact that the admissions could have on the fund investors’ pending civil action. As she explains, despite the differences between the cases, the admissions could bolster the plaintiffs’ allegations.

 

Yet another issue that the admissions raise is the question of their impact on the availability of D&O insurance. The specific question is whether the admissions are sufficient to trigger the fraud and criminal misconduct exclusion in the D&O policy. The wording of these exclusions varies, but they typically preclude coverage for loss arising from fraudulent or criminal misconduct, but only after a final adjudication determines that the preclusive conduct has taken place. If the admissions were found to be sufficient to trigger this exclusion, coverage would no longer be available for the wrongdoer, and the insurer arguably could even have the right to try to recover amounts that had already been paid.

 

On the one hand, there would seem to be reason to be concerned that a settlement of this type represents a “final adjudication.” The specific factual admission to which the defendants agreed were not only stated in the public court record, but they are incorporated verbatim into the Final Consent Judgment filed with the court. Upon the Court’s entry of the Judgment, there would seem to be grounds upon which it could be argued that there had been a final adjudication. (A related question is whether this adjudication occurred in “the underlying proceeding” as many policy exclusions require.)

 

On the other hand, there is a question whether the admissions satisfy the exclusion’s misconduct requirement. While the admissions represent an extensive concession that the defendants engaged in wrongdoing – and while the admissions expressly recite that the defendants acted “improperly” and “recklessly” — at no point do the defendants admit to “fraud” or to any other level of conduct that would expressly trigger the typical D&O policy’s conduct exclusion.

 

A related issue that could arise is the question of exactly how bound the admitting parties are by their admissions. The Harbinger defendants’ Consent specifically recites that nothing in the agreement affects the defendants “right to take legal or factual positions in litigation or other proceedings or other legal proceedings in which the Commission is not a party.” In effect, the Harbinger defendants seemed to have tried to preserve the right to argue that while they made certain admissions for purposes of the SEC enforcement action, they did not make those admissions for all purposes and for the benefit of all other parties who might seek to rely on them. The Harbinger defendants might well argue that notwithstanding their admissions in the Consent, they have the right to contest the factual matters in other proceedings, including for example, in the context of an insurance coverage dispute.

 

The Harbinger settlement represents a significant development with important potential implications for other defendants in SEC proceedings. The admissions these defendants may be required to provide in order to settle the enforcement action pending against them could have important collateral consequences, many of which at this point remain uncertain. Among other questions that likely will also have to be addressed is whether admissions of this type have any impact on the continued availability of insurance coverage for the defendants that provide these kinds of admissions.

 

What are the D&O Insurance Implications of the Massive Derivate Lawsuit Settlements?: In April 2013, the parties to the News Corp. shareholder derivative litigation agreed to settle the consolidated cases for $139 million,to be funded entirely by D&O insurance.

 

There have been several shareholder derivative suit settlements that were nearly as large as the News Corp. settlement but none quite as big:

 

  • The El Paso/Kinder Morgan merger-related derivative suit settled in September 2012 for $110 million (refer here).
  • In 2005, the Oracle derivative suit settled based on Oracle CEO Larry Ellison’s payment of a total of $122 million (refer here and here).
  • In September 2009, the parties to the Broadcom Corp. options backdating-related shareholders’ derivative suit agreed to settle the case, as to most but not all of the defendants, for $118 million (as discussed here).
  • In September 2008, the parties to the 2002 AIG shareholders’ derivative lawsuit agreed to settle the case for a payment of $115 million (about which refer here).

 

In addition, in December 2007, the UnitedHealth Group options backdating-related derivative lawsuit settled for a total nominal value of approximately $900 million, as discussed here. However, the value contributed to the settlement consisted of individual defendants’ surrender of certain rights, interests and stock option awards, not cash.

 

These settlements are all dwarfed by the $2.876 billion judgment entered in June 2009 against Richard Scrushy in the HealthSouth shareholders’ derivative lawsuit in Jefferson County (Alabama) Circuit Court, and the $1.262 billion judgment that Delaware Chancellor Leo Strine entered in October 2011 in the Southern Peru Copper Corporation Shareholder Derivative Litigation (about which refer here). Both of these case outcomes involve judgments following trial, rather than settlements.

 

Aside from the question its sheer size is the fact that the News Corp. settlement was funded entirely by D&O insurance. This large settlement represents not only a serious and unwelcome development for the specific carriers involved but also represents an unwelcome event for the D&O insurance industry in general, for what it might represent as far as the severity potential of shareholders’ derivative litigation.

 

In the past, going back ten years or so, shareholders’ derivative suits typically did not present the possibility of significant cash payouts for settlements or judgments. As the significant examples above show, that clearly has changed.

 

This trend gained particular momentum with the options backdating scandal. Many of the options backdating cases were filed as derivative suits rather than as securities class action lawsuits (largely because the options backdating disclosures did not always result in the kinds of significant share price declines required to support a securities class action lawsuit). As illustrated by the Broadcom case mentioned above, some of the options backdating derivative suit settlements included very substantial cash components

 

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The inclusion of a significant cash component has also been a feature of the settlements of some of the merger objection suits that have been filed as part of the current upsurge in M&A-related lawsuit that have been filed in recent years, as illustrated by the El Paso settlement mentioned above.

 

For many years, D&O insurers have considered that their significant severity exposure consisted of securities class action lawsuits. The undeniable reality is that in at least some circumstances, derivative suits now represent a severity risk as well. And the settlement amounts themselves represent only part of the D&O insurers’ loss costs. The D&O insurers also incur millions and possibly tens of million of defense cost expense in these derivative suits

 

Another issue is that these settlement amounts represent so-called “A Side” losses. That is, the losses are paid out under the portion or the D&O insurance policy that provide insurance for nonindemnifiable loss. A derivative suit settlement is not indemnifiable, at least under the laws of many jurisdictions, because if it were to be indemnified, the company’s would make the indemnity payment to itself. For the “traditional” D&O insurance carriers, there is perhaps no particular pain associated with the fact that the loss is paid under the “Side A” portion of the policy, as opposed the other policy coverage (that is, the “Side B” or “Side C” coverage that are more typically called into play). But these days many companies carry –in addition to their traditional D&O insurance that includes all three coverages (that is, they include Sides A, B and C coverage) — additional layers of excess Side A insurance.

 

The increasing risk of this type of settlement represents a significant challenge for all D&O insurers, but particularly for those D&O insurers concentrating on providing Excess Side A insurance. Those insurers will have to ask how they are to underwrite the risks associated with these kinds of exposures, and how they are to make certain that their premiums adequately compensate them for the risk.

 

Will By-Law Forum Selection Clauses Withstand Judicial Scrutiny and Help to Diminish the Multi-Jurisdiction Litigation Curse?: Over the past several years, one of the more troublesome litigation trends has been the rise of multiple lawsuits involving the same circumstances but filed in separate jurisdictions. As a way to try to avert the inefficiencies and added expense associated with multi-jurisdiction litigation, reformers suggested that a provision could be added to company by-laws requiring shareholders to litigate claims in a specified jurisdiction (usually Delaware). The boards of a number of companies adopted forum selection by laws.

 

The first judicial challenge to a forum selection bylaw resulted in a set back for the idea. As discussed here, in January 2011, a judge in the Northern District of California refused to enforce a forum selection by-law that had been adopted by Oracle, because it had not been approved by shareholders, but rather had been adopted only by the company’s board of directors.

 

However, on June 25, 2013, in a judicial development that may help ease the curse of multi-jurisdiction litigation, Chancellor Leo E. Strine, Jr. of the Delaware Court of Chancery held that forum selection bylaws adopted by Chevron and Federal Express are statutorily and contractually valid. A copy of the Chancellor’s opinion can be found here.

 

According to Chancellor Strine’s opinion in the Chevron case, in the last three years over 250 publicly traded companies adopted forum selection bylaws. Chancellor Strine recites in his opinion that Chevron’s board adopted the bylaw due to concerns about “the inefficient costs of defending the same claim in multiple jurisdictions” and in order to “minimize or eliminate the risk of what they view as wasteful duplicative litigation.”

 

Chancellor Strine’s determination that Chevron and Fed Ex’s forum selection by-law are valid is of course far from the final word. The Delaware Supreme Court may yet take a different view. In addition, the question will still remain whether or not the courts of other jurisdictions will enforce the forum selection clause when faced with a motion to dismiss a case pending in their courts. Whether or not the bylaws are valid under Delaware law will not necessarily be determinative of whether the bylaws are in fact enforceable elsewhere.

 

Nevertheless, in the wake of Chancellor Strine’s opinion, a number of companies have acted to adopt their own bylaws. It will be very interesting to see if these by-law provisions prove to be effective in diminishing the curse of multi-jurisdiction litigation.

 

How Far Will Courts Extend the Broad Judicial Support for the Enforceability of Arbitration Clauses?: In the latest in a series of decisions in which it upheld the enforceability of arbitration agreements, the U.S. Supreme Court ruled on June 20, 2013 that an arbitration agreement with a class action waiver is enforceable even it meant that an individual’s cost of pursuing a claim exceeded the economic value of the individual’s potential recovery. A copy of the Court’s opinion in American Express Co. v. Italian Colors Restaurant can be found here.

 

Although the decision is consistent with other recent Supreme Court rulings, it has its own important implications – and it also raises a question of just how far the principle of broad enforceability of arbitration agreements can be taken. In particular, does the broad enforceability of arbitration agreements reach far enough to include the enforceability of arbitration agreements and class action waivers in corporate articles of incorporation or by-laws?

 

The question about the inclusion of arbitration provisions and class action waivers in corporate by-laws is not far-fetched. In fact, at least one court has already held these kinds of by-law provisions to be enforceable. As discussed here, in May 8, 2013, a Maryland Circuit Court held that Commonwealth REIT could enforce a by-clause requiring shareholders to arbitrate their claims.

 

In a July 8, 2013 Law 360 article commenting on the Commonwealth REIT decision (here, subscription required), Andrew Stern, Alex J. Kaplan and Jon W. Muenz of the Sidley Austin law firm note that though it remains to be seen how other courts will address the question of the enforceability of arbitration clauses in corporate bylaws, the Maryland decision “should be seen as, at the very least, a significant incremental victory for boards and trustees who view arbitration as an effective means to manage the typically highly public nature of corporate activism.” At a minimum, the authors note, the decision could be seen – at least for Maryland companies — as “a green light for boards … to include broad arbitration clauses in their bylaws without seeking shareholder approval.”

 

The Maryland trial court decision has no precedential value and may or may not be followed by other courts. Nevertheless, the fact remains that at least this one court did enforce a by-law arbitration clause. As the law firm memo’s authors state, this decision does represent an “incremental victory” for those who advocate for the inclusion of these types of provisions in corporate bylaws as a way to forestall costly and burdensome shareholder litigation.

 

With the U.S. Supreme Court’s willingness to enforce arbitration agreements including class action waivers in commercial and consumer contracts, and with case law developments like the one in Maryland, more companies may be encouraged to attempt to use their bylaws as a way to control shareholder litigation. We undoubtedly will see more – both from companies and from the courts – on the topic of arbitration clauses in corporate bylaws.

 

What Will Be the Impact of the Conflict Minerals Disclosure Rules?: Among the many hundreds of pages of the Dodd-Frank Act was a provision unrelated to the financial crisis that triggered the legislation. Congress included in the Act a provision directing the SEC to promulgate rules requiring companies to disclose their use of conflict minerals originating in the Democratic Republic of Congo (DRC) or an adjoining country. It has taken some time for the regulatory process to unfold, but the conflict mineral disclosure requirements are now in effect. The consequences for companies could be significant.

 

On August 22, 2012, the SEC adopted the conflict mineral disclosure rules. The SEC’s August 22, 2012 press release can be found here and the rule itself can be found here. The specific minerals at issue are tantalum, tin, tungsten and gold. The countries covered by the disclosure rules are, in addition to the DRC, Angola, Burundi, Central African Republic, the Republic of Congo, Rwanda, South Sudan, Tanzania, Uganda and Zambia (the “Covered Countries”)

 

The rule applies not just to companies with SEC reporting obligations (including both domestic and foreign issuers) but it also applies to any company that uses the specified minerals if the minerals are “necessary to the functionality or production” of a product manufactured by or “contracted to be manufactured” by the company. Companies are required to comply with the new disclosure rules for the calendar year beginning January 1, 2013, with the first disclosures due May 31, 2014 and subsequent disclosures due annually each year after that.

 

Many companies had deferred preparations to meet the disclosure obligations in the hope that a pending legal challenge to the rules might succeed. However, in a July 2013 order, Judge Robert Wilkins of the District Court for the District of Columbia struck down the legal challenge. An appeal of the ruling has already been filed. However, as Broc Romanek wrote in a July 24, 2013 post on his TheCorporateCounsel.net blog (here), the ruling means “the SEC’s rules go forward as they currently exist (ie. no de minimis exception, etc.).” He adds that, despite the appeal, “with the first report due May 31, 2014, all companies should be operating on the assumption that the rules are indeed the rules and start preparing now.”

 

In a recent post (here), I detailed how extraordinarily difficult the conflict minerals determinations and disclosures may be for many companies. There is a lot of risk here for the companies involved. First and foremost, companies face a serious potential PR risk. Companies found to be out of position on conflict minerals could face a publicity firestorm from humanitarian groups and activist investors. Although it remains to be seen, adverse publicity could prove to be a problem not just for companies that must declare their use of conflict minerals but even for those that are unable to declare themselves conflict mineral free.

 

As with any disclosure requirement, there is also a significant litigation risk as well. Companies compelled to reveal their use of conflict minerals could well be the target of shareholder suits. A particularly difficult problem would involve companies that had declared themselves to be conflict free that are later shown have been using conflict minerals after all. The negative publicity and likely share price decline could be followed by a securities class action lawsuit. Activist shareholders could also launch derivative suits against companies based on allegations such as the failure to implement adequate procedures to ensure that the company’s products were conflict mineral free.

 

Of course, whether any of these kinds of suits actually emerge remains to be seen. However, the disclosure deadline that had seemed so far in the future is now rapidly approaching. In coming months, we will be hearing more about companies’ struggles to ready themselves for the disclosure requirements. In addition, questions surrounding companies’ preparations for the conflict minerals disclosure requirements increasingly will become a part of the D&O insurance underwriting process.

 

How Will the Mass of Failed Bank Litigation Finally Play Itself Out?: The peak of the recent financial crisis is now nearly five years in the past. Though banks are still continuing to fail, we can hope that the worst of the bank failure wave is now behind us. Along those lines, in its most recent Quarterly Banking Profile, the FDIC reported that the number of “problem institutions” continues to decline — although still troublingly high.

 

Though we can hope that the number of bank closures will continue to decline, the litigation that the FDIC is filing against the banks’ former directors and officers continues to mount. As of the agency’s latest report on August 8, 2013, the agency has filed 76 lawsuits against the directors and officers, including 32 so far this year. (By way of comparison, the agency filed 25 lawsuits during all of 2012.)

 

The number of failed bank lawsuits is likely to grow. As of August 8, 2013, the FDIC has also authorized suits in connection with 122 failed institutions against 987 individuals for D&O liability. The number of suits authorized is inclusive of 76 lawsuits that the agency has already filed naming 574 former directors and officers. In other words, there is a backlog of as many as 46 additional lawsuits yet to be filed. In addition, for some time now, the FDIC has increased the number of lawsuits authorized each month. There could be many more lawsuits yet to be authorized and filed.

 

The FDIC has already authorized lawsuits to be filed in connection with about 25% of all the 485 banks that have failed since January 1, 2008. (By comparison, during the S&L crisis, the agency filed D&O lawsuits in connection with about 24% of bank failures). With a total of 76 lawsuits actually filed, the agency has now filed suit in connection with about 15% of bank failures.

 

Given the litigation already filed and the lawsuits yet to come, there is and will continue to be a mountain of failed bank litigation to work its way through the courts. These cases are a burden for the courts and for the litigants. They also represent a challenge for the D&O insurers involved as these claims move toward resolution. The losses associated with these cases will continue to weigh on the insurers’ financial results, which in turn will affect their premiums and their risk appetites.

 

A mass of D&O litigation was also one of the side-effects of the S&L Crisis. Insurance coverage disputes from those cases contributed many of the important judicial decisions applicable to the interpretation of D&O insurance policies. As illustrated above in connection with the IndyMac case, there likely will be significant judicial interpretations of the D&O policy language as a result of coverage disputes arising from the current bank failure litigation wave as well. In any event, the bank failure related litigation will be working its way through the courts for years.

 

How Will Cyber Security Threats Affect the Liabilities of Corporate Directors and Officers?: it is not news that cybersecurity risks represent a significant concern for just about every company involved in the current economy. Prior posts on this site (for example, here) have detailed the liability exposures that these risks represent for all of these companies and for their directors and officers. But while these issues are not new, it seems that as time progresses, the volume on these issues has been turned up.  It now seems clear that cybersecurity is going to be one of the hot button issues for the foreseeable future, both in the media and for the affected companies.

 

The heightened scrutiny of cybersecurity issues has a number of important implications for potentially affected companies, and not just from an operational standpoint. These developments also have important implications for public company’s public disclosure statements, and, as a consequence, for the company’s potential regulatory and litigation exposures.

 

Indeed, according to a February 21, 2013 memo from the King & Spalding law firm entitled “Cybersecurity: The New Big Wave in Securities Litigation?” (here), “it is likely that this issue will continue to gain momentum among both government regulators and opportunistic plaintiff lawyers seeking to catch the next wave of shareholder litigation.” In particular, the failure to promptly disclose a cyber breach “may put a company at risk of facing formal SEC investigations, shareholder class actions, or derivative lawsuits.”

 

As the memo notes, the SEC “has already taken a firm stand on cybersecurity disclosures, and clearly views this issue as ripe for enforcement actions.” In October 2011, the SEC’s Division of Corporate Finance issued “Disclosure Guidance” on cybersecurity related issues. Among other things, the Guidance clarified that the agency expects companies to disclose the risk of cyber incidents among their “risk factors” in their periodic filings and also expects companies to disclose material cybersecurity breaches in their Management Discussion and Analysis.

 

The law firm memo notes that so far, the SEC’s Guidance “seems to have had little impact on corporate disclosure,” and that in many instances companies experiencing cyber breaches are “choosing to keep those events confidential.” However, “given the increasing awareness of this hot issue,” it seems “likely” that the SEC “will increase pressure on companies to disclose such events.” The memo adds that “companies that have experienced significant cybersecurity breaches should prepare themselves for potential SEC investigations and lawsuits.”

 

In addition to the risk of SEC enforcement action, companies experiencing cyber breaches also face the possibility of a securities class action lawsuit. However, the memo notes, a company experiencing a cyber breach “will likely not be a target of a securities class action unless the disclosure of the breach can be linked to a statistically significant drop in the company’s share price.” In that respect, it is worth noting that several high profile companies announcing cyber breaches have not experienced a significant drop in their stock price following the announcement. (For example, recent announcements by Facebook, Apple and Microsoft that they have been the target of sophisticated cyber attacks did not affect the companies’ share prices.) Nevertheless, it seems likely that at least some companies experiencing cyber breaches or subject to cyber attacks will also suffer a drop in their share price, and “thus result in securities class action litigation.” (For further analysis of the effect of a cyber breach disclosure on share prices, refer here.)

 

Companies that do not experience a share price decline following a cybersecurity incident may not get hit with securities class action litigation, but they are still susceptible to derivative lawsuits alleging, for example, that company directors breached their fiduciary duties by failing to ensure adequate security measures. As the law firm memo notes, shareholder may claim that senior management and directors “were either aware of or should have been aware of the breach and the company’s susceptibility to hacking incidents.” Of course, any lawsuit of this type would face significant hurdles, including the requirement to make a formal demand on the board as well as the business judgment rule.

 

In any event, it is clear that cybersecurity issues are going to be an increasing source of scrutiny for companies and their senior officials. This heightened scrutiny not only means that companies will be under pressure to take steps to ensure that their networks and information are secure, but also means that the companies will face pressure both to “disclose the risks associated with potential cybersecurity breaches and provide timely updates when actual breaches occur.” Companies that fall short on these disclosure expectations “will face a substantial risk of regulatory scrutiny and shareholder litigation.”

 

As Rick Bortnick discussed in a guest post on this site (here), cyber security disclosures have already been the source of securities class action litigation, in the high profile case involving Heartland Payment Systems. Although that case was dismissed, Bortnick points out how different the circumstances and disclosures involved in that case might look if viewed through the prism of the SEC”s 2011 Disclosure Guidance.

 

Among other implications from these developments is that cybersecurity disclosure seems likely to be the subject of greatly increased scrutiny, suggesting that this disclosure – particularly precautionary disclosure forewarning investors of the possible adverse effects the company could expect in the event of a serious cyber attack – should become a priority for reporting companies.

 

Finally, these developments and the possible regulatory and litigation implications underscore the fact that cybersecurity exposures represent an important issue to be addressed as part of every company’s corporate insurance program. Indeed, the SEC itself considered the question of insurance for cybersecurity exposures to represent such a critical issue that, in its Disclosure Guidance, it specifically identified the insurance issue as one of the topics companies should address in their disclosure of cybersecurity issues.

 

The insurance issues related to cybersecurity include not only the question of whether companies should acquire dedicated cyber and network security insurance, but also includes the question of the protection available to the companies’ senior officials under their management liability insurance policies. These issues relating to the scope of a company’s insurance protection for cyber-related risks present specific questions directors should be asking company management.

 

How Will These Trends and Developments Affect the Market for D&O Insurance?: As should be apparent from this discussion, there is a great deal happening in the World of D&O. Nor do the above trends and developments noted above represent everything that is happening. The surge in M&A litigation, in which virtually every merger or acquisition attracts at least one lawsuit, continues unabated. The SEC whistleblower program, which recently announced that it had made its second whistleblower bounty award, threatens an upsurge in whistleblower-driven enforcement actions and related securities claims. Anti-bribery enforcement actions are but one of the many regulatory risks involved in an increasingly global economy. And all of these developments arise following the wave of litigation relating to the subprime meltdown and the credit crisis that continues to work its way through the courts.

 

Given everything that is going on, it is hardly surprising that the D&O insurance carriers might be taking a more defensive position. Indeed, many companies – including both public and private companies — have seen the cost of their D&O insurance go up at their most recent renewal. The pricing increases are more concentrated in the primary D&O insurance policies; the increased pricing trend is less pronounced for excess insurance coverage.

 

In addition, in at least some cases and for some kinds of risks, carriers have started to try to pull back on terms and conditions as well. In some instances, this may consist of an attempt to increase retentions. In other cases, carriers have identified certain terms that they will no longer offer.

 

But though there are some areas where carriers are attempting to pull back, overall the coverage that remains available for most insurance buyers is broad. In addition, ample capacity remains available in the marketplace. Indeed, the sheer number of available market participants, augmented by the arrival of new players, raises the possibility that the premium increase and tightening of terms (however slight) could prove to be short-lived.

 

How all of this ultimately will play out remains to be seen. The one certainty is that the World of D&O will continue to be interesting to watch.

 

D&O Diary Readers Get Discount for ACI D&O Conference: On October 21 and 22, 2013, I will be co-Chairing the American Conference Institute’s D&O Liability Conference in New York. The event has a comprehensive agenda covering the current state of the D&O insurance marketplace as well as important developments in the world of directors’ and officers’ liability. The conference will feature an impressive line-up of knowledgeable speakers discussing topics that will be of particular interest to this blog’s readers. Background information regarding the conference, including the program agenda and registration details, can be found here.

 

Readers of The D&O Diary are eligible for a $200 discount when registering for the conference. In order to obtain The D&O Diary discount, readers should reference “DOD200” when registering by calling 888-224-2480 or online at www.AmericanConference.com/DandO

 

Have a Look Before You Leave: If you are not a regular reader of this blog, you may not have seen any of the photos that readers have taken of their D&O Diary mugs and that I have been posting on this site over the summer. The pictures are a lot of fun. The most recent post of readers’ mug shots, which contains links to all of the prior galleries, can be found here. Before you leave, take a moment to have a look at the great pictures that readers have been sending in.

 

Season’s End: According to the calendar, summer does not officially end for another three weeks or so. But for me, summer ends with the last sunset before leaving Lake Michigan for the season. Summer’s end is always bittersweet.But just the same, I welcome autumn’s approaching arrival and look forward to the opportunity to see and greet many of this blog’s readers at a variety of industry events on the calendar this fall..