Mark Sutton
Leah Barratt

In the following guest post, the authors examine two specific provisions of the new U.K. Economic Crime and Corporate Transparency Act 2023. The two provisions the authors examine are the Act’s new corporate offense of “failure to prevent fraud” and the reformed “identification principle.” The authors of this guest post are Mark Sutton, Partner at the Clyde & Co law firm, Leah Barratt, Senior Associate at Clyde & Co, and Frederica Johnston, trainee solicitor at Clyde & Co. A version of this article previously was published as a Clyde & Co client alert. I would like to thank the authors for allowing me to publish their article on this site. I welcome guest post submissions from responsible authors on topics of interest to this blog’s readers. Please contact me directly if you would like to submit a guest post. Here is the authors’ article.

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The Government’s promised crackdown on economic crime looks set to become a legislative reality through the introduction of the U.K. Economic Crime and Corporate Transparency Act (the “Act”).  Two of its most heralded provisions include the new corporate offence of “failure to prevent fraud” and a reformed “identification principle”. Together, they represent the cornerstone of the Government’s policy to increase the criminal accountability of corporate entities. The new U.K. Act received Royal Assent on 26 October 2023 and the reforms to the identification principle will take effect this Boxing Day, 26 December 2023. 

Following our previous article, we discuss below these two key changes brought about by the Act, what the reforms to the identification principle mean in practice, and the Act’s wider implications for entities and their insurers.

The failure to prevent fraud offence

What is the latest update?

In our first article, we explained that the new corporate offence aims to tackle fraud by holding organisations liable if their employees commit a fraudulent act with a view to the organisation itself benefitting. There was intensive debate between the House of Commons and the House of Lords as to which organisations should fall within the scope of the offence. The argument for broader application, to encompass smaller entities as well, was that fraud is indiscriminate: it can be committed by anyone, at any time, irrespective of an organisation’s size or resources. The opposing view was that bringing small or medium-sized enterprises (“SMEs”) within scope would expose those entities to an unfair administrative burden in terms of the added requirements to assess compliance risks under the Act.

The decision ultimately turned on the intended purpose of the offence, which was to improve accountability in larger, more complex organisations. The offence therefore only remains applicable to large organisations, being bodies which satisfy at least two of the three following criteria:

  1. more than £36 million in turnover;
  2. more than £18 million balance sheet total; and/or
  3. more than 250 employees.

However, whether the offence should apply to small and medium-sized organisations still remains under the microscope: the Government has promised to keep the threshold for the offence under review and it has included a delegated power within the Act with which to modify or remove the SME threshold in the future.

How can organisations prepare for the arrival of the new offence?

An organisation will have a defence if it can prove that it either had “reasonable procedures” in place to prevent fraud, or that it was reasonable not to have such procedures (such as where the risk of fraud is extremely low). The effective development and implementation of internal “reasonable procedures” to prevent fraud from taking place will therefore be critical to the new offence’s impact.

The Government has promised to provide guidance on what “reasonable procedures” might look like and we expect this during the first part of 2024. Whilst we await publication of this guidance, the commentary set out in our preceding article remains unchanged. Organisations must undertake extensive risk assessments and review their current fraud prevention practices to determine whether their anti-fraud policy is up to scratch or in need of improvement.

Reforms to the identification principle

The changes brought by the new Act do not end with the introduction of the failure to prevent fraud offence. One of the Act’s most instrumental cultural reforms is, arguably, the development to the identification principle which will come into force on 26 December 2023.

What is the identification principle?

The identification principle is a common law test which for years has only allowed liability to attach to the organisation itself if the offence was committed by an individual representing the “directing mind and will” of that organisation.

The principle has long faced widespread criticism. The company’s “directing mind and will” has usually been restricted in the UK to directors and senior officers.  This has meant that it has been difficult to prosecute larger organisations where the relevant decision-making is apportioned between several individuals across different divisions of the business.

How has the identification principle been amended?

Under Section 196 of the Act, an organisation will now be criminally liable when a “senior manager” has committed the offence. A “senior manager” is defined as being an individual who plays a significant role in:

(a) the making of decisions about how the whole or a substantial part of the body corporate’s activities are to be managed or organised; or

(b) the actual managing or organising of the whole or a substantial part of those activities.

This definition will take into account the relevant individual’s roles and responsibilities within the organisation and their decision-making powers (rather than just their job title). The effect of this is to widen the pool of people who can be caught by the identification principle and with it, the number of individuals who will be capable of attributing criminal liability to their organisation.  Larger entities will therefore be well advised to consider whether mid-level managers and any other employee ranks could be considered a “senior manager” under the identification principle.  If they are, entities may wish to reflect on whether any training is necessary to help them understand their new exposure.

For now, these provisions only apply to the economic crimes listed in Schedule 12 of the Act, which include offences of bribery, fraud and false accounting.   However, further change may be on the horizon: the reforms tabled by the Criminal Justice Bill are likely to extend the identification principle yet further. 

The Criminal Justice Bill makes provision for corporate liability where a senior manager commits an offence whilst acting in the scope of their actual or apparent authority, for any crime.  The Criminal Justice Bill therefore goes further than the Act, which is confined to economic crimes. This means, in simple terms, that prosecutions for any criminal offences committed by senior managers in the course of their employment could be attributed to the organisation, if the Bill is enacted.   

What is the geographical scope of the reformed identification principle?

Unlike the failure to prevent fraud offence, the reformed identification principle will apply to all corporate bodies and partnerships established in the UK. A further distinction is that an organisation will not be liable for a relevant offence if the act or omission in question was carried out outside of the UK, unless the organisation would be guilty of the offence in the overseas country where it was committed.

What will the penalty be for corporations?

If a corporation is criminally convicted under the reformed identification principle, it will face a fine. The maximum fine will vary depending on the particular offence, but corporates risk an unlimited fine for the most serious of crimes. The individuals who are guilty of the same offence can also be subject to a criminal conviction and other penalties.

What are the consequences for the insurance industry?

As we foreshadowed in our previous article, it would be advisable for insureds, brokers and insurers alike to evaluate carefully their D&O and/or civil liability policy wording. Key points to consider might include the “Insured Persons” definition, the policy’s conduct exclusion, and the coverage triggers for pre-/investigation costs.

To reflect the new exposures which senior managers will face under the reformed identification principle, insured entities may also want to ensure that anyone who could be considered a “senior manager” under the reformed identification principle has cover under the entity’s management liability policy.  This means that insureds will need to examine the scope of the Insured Persons definition and confirm whether it extends cover to employees who carry out a senior management function (rather than merely directors and officers of the entity) if that is what is desired by the organisation.

In addition, insureds and brokers may wish to review the policy’s limit of indemnity to ensure it is sufficient to account for the increased exposure that the changes to the identification principle may bring about. 

Of course, the new exposures to entities and individuals do not stop there.  If the further reforms to the identification principle sought by the Criminal Justice Bill are enacted, any criminal offence committed by senior managers acting in their capacity as such could be attributed to the organisation.  The question that naturally follows is whether this exposure is a risk that entities are willing to bear themselves or whether there is a need for the organisation to procure appropriate cover from their insurers for this risk.

Whichever way those questions are answered, it is clear that with the failure to prevent fraud offence poised to come into force in 2024, insureds, brokers and insurers need a strong grasp of how their policies will respond to claims stemming from the new offence because it is only a matter of time before insurers will be called upon to support their clients.

Conclusion

The enactment of the Economic Crime and Corporate Transparency Act indicates the UK Government’s desire to build a strong legislative framework to hold large organisations to account for corporate crime.  Large organisations face a greater exposure for their employees’ actions and during the first part of 2024, large entities should take steps to evaluate whether they have reasonable procedures in place to prevent fraud prior to the Act coming into force.  In the meantime, the reforms to the identification principle will take effect from 26 December 2023 and as is traditional on Boxing Day, employees might once again look to their employer for a festive bonus. This year, senior managers, in particular, may get more than they bargained for.

In a January 25, 2023, opinion in the McDonald’s case that has become known as McDonald’s I, Delaware Vice Chancellor Travis Laster held, as discussed in detail here, that liability for breach of the duty of oversight can extend to corporate officers as well as to directors. While there have been subsequent cases that have raised breach of the duty of oversight claims against officers, there have been no published decisions analyzing the duty of oversight as pertains to officers — that is, until now.

In a short December 14, 2023, opinion that emphasizes the high bar for oversight claims against officers, Vice Chancellor Lori Will dismissed claims that the personal transportation device company Segway brought against its former President. VC Will expressly rejected any suggestion that the standard to plead an oversight breach claim against a corporate officer is any lower than the high standards applicable to oversight claims against directors. A copy of VC Will’s opinion can be found here.

Continue Reading Delaware Court: High Barrier for Oversight Claims Against Officers

In the latest installment in its D&O Insurance videos series, London-based insurer RisingEdge, in a panel discussion of D&O insurance experts, examines the five steps in the D&O insurance policy placement, implementation, and deployment process. The panel, which is moderated by RisingEdge CEO Philippe Gouraud, includes Lianne Gras of Howden; Robert Barnes of GAWS in London; and Ellie Fisher of RisingEdge. The five steps discussed in the video are: Insured Risk Mapping; Preparing the Submission and Engaging with the D&O Market; Quotation and Binding the Policy; The Policy Renewal; and You Have a Claim! The objective of the video is to “unpack and demystify the D&O policy placement process, and to provide these learnings in an accessible format.” The video can be found here.

Public company D&O insurance policies provide entity coverage (that is, insurance for the benefit of the insured organization) only for “Securities Claims.” But what is a “Securities Claim”? That is the question that Delaware’s courts have grappled with in a long-running dispute between the telecommunications company Verizon and its insurers.

The Delaware Superior Court had held in the ongoing dispute that a litigation trustee’s state law fraudulent transfer claims against Verizon were derivative claims and therefore qualified as a Securities Claim under the applicable policies. In a detailed December 15, 2023, opinion, the Delaware Supreme Court reversed the Superior Court, holding that the fraudulent transfer claim was a direct claim, not a derivative claim, and therefore did not meet the definition of a “Securities Claim.” As discussed below, the Supreme Court’s opinion, while clarifying, also highlights how intricate the question of what is a “Securities Claim” can be. A copy of the Delaware Supreme Court’s opinion can be found here.

Background

In March 2008, through a complex three-party transaction, Verizon spun-off certain telecommunications assets (landlines) to FairPoint. To accomplish the spin-off, Verizon sold the assets to Spinco, a wholly owned subsidiary of Verizon. In exchange for the assets, Spinco issued corporate debt notes to Verizon. Verizon then divested Spinco by spinning out its stock to Verizon’s stockholders. Spinco and FairPoint then merged, with FairPoint as the surviving entity. Spinco’s stock was cancelled and converted to “new” FairPoint stock. As a result of the transaction, FairPoint acquired ownership of the telecommunications assets, as well as the debt obligation to Verizon on the corporate debt notes Spinco has issued to Verizon. Verizon sold the notes to investment banks which in turn sold the notes to third-party buyers.

Following the completion of the transaction, FairPoint was unable to service its outstanding operating debt and the Spinco notes. In October 2009, FairPoint filed for Chapter 11 bankruptcy. The ensuing plan of reorganization created a trust with an appointed Trustee authorized to pursue litigation, including Spinco-related causes of action. In October 2011, the Trustee filed an action (the “FairPoint action”) against Verizon in which the Trustee sought to avoid alleged fraudulent transfers connected to the landline assets spinoff transaction. Verizon and related entitles ultimately settled the FairPoint action for $95 million. Verizon and related entities incurred approximately $24 million in attorneys’ fees defending the FairPoint action.

The Insurance Coverage Dispute

There were two D&O insurance programs relevant to the Fairpoint action. The first was a program of insurance, consisting of a primary policy and three layers of excess insurance, that was issued to Verizon for the policy period October 31, 2009, to October 31, 2010 (the “Verizon policy”). The second was a transaction-specific program of insurance, consisting of a primary policy and two layers of excess insurance, issued to FairPoint for the policy period March 31, 2008, to March 31, 2014 (the “FairPoint policy”). The primary policy in both programs was issued by the same insurer and the policy terms and conditions of the two primary policies was substantially the same. Significantly. Verizon was a named insured under the transaction-specific FairPoint policy.

Verizon sought coverage under both of the policies for the FairPoint Action settlement and for its defense costs. When the insurers declined to pay these amounts, Verizon filed a breach of contract action against the insurers.

The policies define a “Securities Claim” as a claim made against any Insured:

(1) alleging a violation of any federal, state, local or foreign regulation, rule or statute regulating securities (including but not limited to the purchase or sale or offer or solicitation of an offer to purchase or sell securities) which is: (a) brought by any person or entity alleging, arising out of, based upon or attributable to the purchase or sale or offer or solicitation of an offer to purchase or sell any securities of an Organization; or (b) brought by a security holder of an Organization with respect to such security holder’s interest in securities of such Organization; or

(2) brought derivatively on the behalf of an Organization by a security holder of such Organization.

Verizon argued that the Trustee’s fraudulent transfer claim came within paragraph (2) of the definition, contending that the Trustee was a “security holder” within the meaning of the Bankruptcy Code and that the fraudulent transfer action was brought “derivatively.”  The insurers disputed these arguments.

Relevant Case Law

The Delaware Supreme Court has actually previously addressed the question of the meaning of the definition of the term “Securities Claim” in a public company D&O insurance policy – and not only that, the prior case involved Verizon and arose out of a prior telecommunications asset transfer gone bad. The prior case even involved the exact question of whether or not a bankruptcy trustee’s fraudulent transfer claim came within the applicable policy’s definition of “Securities Claim.”

As discussed here, in the prior case (the Idearc case) the Delaware Supreme Court held in 2019 that underlying bankruptcy trustee’s fraudulent transfer claim did not meet the definition of “Securities Claim” as specified in the applicable policy.

As Delaware Superior Court Eric Davis was to observe as part of his consideration of the issues in the subsequent FairPoint coverage action, the definition of “Securities Claim” at issue in the Idearc case was, in Judge Davis’s view, “critically different” from the definition at issue with respect to the FairPoint action. The definition at issue in the earlier case provided as follows:

(1) alleging a violation of any federal, state, local or foreign regulation, rule or statute regulating securities (including but not limited to the purchase or sale or offer or solicitation of an offer to purchase or sell securities) which is: (a) brought by any person or entity alleging, arising out of, based upon or attributable to the purchase or sale or offer or solicitation of an offer to purchase or sell any securities of an Organization; or (b) brought by a security holder of an Organization with respect to such security holder’s interest in securities of such Organization; or

(2) brought derivatively on the behalf of an Organization by a security holder of such Organization, relating to a Securities Claim as defined in paragraph (1) above.

As Judge Davis noted, the policy language at issue in the FairPoint action dispute did not contain the italicized phrase shown above in the paragraph (2).

The Superior Court’s Rulings in the FairPoint Action

In two sets of rulings (discussed here and here) Judge Davis held that, notwithstanding the Delaware Supreme Court’s prior ruling in the Idearc case that a bankruptcy trustee’ fraudulent transfer action did not meet the applicable definition of “Securities Claim,” that the trustee’s fraudulent transfer action in connection with the Fairpoint bankruptcy did meet the applicable policy definition of “Securities Claim.”

Crucial to his decision as Judge Davis’s determination that the difference in policy language between the definition of “Securities Claim” in the policy at issue in Idearc action and the definition of the term in the FairPoint action. As noted in the preceding section, the policy at issue in the Idearc policy had the italicized phrase at the end of the definition while the policy at issue in the Fairpoint did not.

Judge Davis concluded because of the difference, Verizon, in arguing that the underlying fraudulent transfer claim met the definition of “Securities Claim,” did not have show a “regulating securities” element. Judge Davis concluded because the underlying fraudulent transfer action met the applicable policy’s definition of “Securities Claim,” the policies at issue covered the Verizon’s costs incurred in defending and settling the underlying action. The insurers appealed.

The December 15, 2023, Opinion

In an opinion written by Chief Justice Collins J. Seitz, Jr. for a unanimous five-judge panel, the Delaware Supreme Court reversed Judge Davis’s rulings, holding that the bankruptcy trustee’s fraudulent transfer claims were direct, and not derivative, as understood by securities and corporate law, and therefore were not “Securities Claims” within the meaning of the policies.

The Supreme Court concluded that the underlying fraudulent transfer claims were direct, not derivative, because “the creditors suffered the harm by the fraudulent transfer, and the remedy benefits the creditors, not the business entity.” The court added that “a business entity’s insolvency does not convert direct claims like fraudulent transfer claims into derivative claims.”

The Supreme Court also directly addressed Judge Davis’s differentiation between the language at issue in the Idearc case and the language at issue in the FairPoint case. The Supreme Court noted that the Judge Davis had concluded that the difference in language meant that Section 2 of the definition of the term “Securities Claim” (the section on which Verizon sought to rely in arguing that the underlying claim was a “Securities Claim”) “was no longer tethered exclusively to securities law-related claims.”

The Supreme Court disagreed, noting that the difference between the policy language in the two policies did not “transform the definition of a Securities Claim into a new definition that imports bankruptcy law.”

The Supreme Court added that “by isolating one section of the definition and ignoring the other, it is easy to lose sight of the bigger picture – both sections of the definition relate to a Securities Claim as understood by securities law and state corporate law.”

The Court said “As understood under securities and corporate law, Sections (1) and (2) of the Securities Claim definition operate together to provide insurance coverage for direct and derivative securities law claims and follow-on state corporate derivative claims based on the same allegations. The Litigation Trust’s direct state law fraudulent transfer claims do not fall within either definition of a Securities Claim.”

Discussion

If nothing else, the scope and long history of this case shows just how intricate the interpretation of the term “Securities Claim” can be. On the other hand, the Supreme Court’s decision does have a common sense element to it – that is, the meaning of the term Securities Claim is to be determined by reference to the meaning of the term as commonly understood under corporate and securities law. The Supreme Court underscored this point when it emphasized the word “Securities” in referring to a Securities Claim.

Judge Davis had found that the definition of “Securities Claim” is broad enough to encompass the underlying bankruptcy trustee’s fraudulent transfer claim. In doing so, he had to deal with the Supreme Court’s prior decision in the Idearc case. To do so, he concluded that the differences in policy language between the policies at issue in the prior case and the language at issue in the present case was sufficient to bring the fraudulent transfer claim within the definition of Securities Claim.

In reversing Judge Davis, the Supreme Court in effect concluded that the differences in wording between the two policies was still not enough to transform the underlying fraudulent transfer claim into a Securities Claim. Even more fundamentally, the Supreme Court concluded that the fraudulent transfer claim was a direct, and not derivative, action, and therefore regardless of the differences in policy wording, the bankruptcy trustee’s fraudulent transfer claim was not a “Securities Claim.” (It probably is worth noting that Justice Seitz, who wrote the opinion for the Supreme Court in this case, also wrote the majority opinion in the Idearc case as well.)

This is not the first time the Delaware Supreme Court has cleaned up some of the more policyholder-friendly decisions of the Delaware Superior Court. Among other cases, the Supreme Court reversed a decision for policyholders in Idearc case. As discussed here, in 2021, the Delaware Supreme Court reversed a Superior Court ruling that an appraisal action is a “Securities Claim,” and is therefore covered under a D&O Insurance policy.

While I am sure it is reassuring to insurers that they can pursue appeals to the Supreme Court and that at the high court the Superior Court’s more policyholder-favorable decisions can be reconsidered and even in some cases reversed, I am also sure that to the insurers the entire process is burdensome, expensive, and vexing. Notwithstanding the outcome of this latest Delaware coverage foray, I suspect many insurers are still considering whether they ought to modify their policies so as to avoid the Delaware court coverage ordeal.

Special thanks to a loyal reader for providing me with a copy of the Delaware Supreme Court’s opinion.

For some time now, one of the hottest bets in the U.S. economy has been the electric vehicle industry. Until recently, manufacturers struggled to meet consumer demand. However, as 2023 progressed, something unexpected happened. Consumer demand for electric vehicles began to decline. A number of factors – including heightened interest rates – contributed to this development, but the perception of declining demand has set off alarm bells, particularly among EV manufacturers’ suppliers.

In an example both of how the declining demand can affect EV suppliers and the way that the decline can translate into securities litigation, on December 13, 2023, a plaintiff shareholder filed a securities suit against electric vehicle semiconductor supplier ON Semiconductor after the company announced declining sales of its automotive business segment products because of declining consumer EV demand. A copy of the plaintiff’s complaint can be found here.

Continue Reading Semiconductor Company Hit with Securities Suit as EV Demand Declines

While academics and others may be asking whether it is time to “say RIP to ESG,” the fact is that though some observers may be done with ESG, ESG is not done with us. A recent action by a U.K. regulator shows that companies remain susceptible to investigations and other regulatory actions for their sustainability and other product or business-related claims. In a December 12, 2023 press release (here), the U.K. Competition and Markets Authority (CMA) announced that it has started a formal investigation into the London-based consumer products company Unilever to examine the company’s “green” claims about “a number” of its products.

As discussed below, this latest regulatory action underscores the fact that companies seeking to burnish their green credentials could be subject to scrutiny and even possible regulatory action. A December 13, 2023, Wall Street Journal article about the CMA’s investigation can be found here.

Continue Reading Unilever Under U.K. Investigation for Possible “Greenwashing” Product Claims

Today it is time for a post from the Annals of Securities Fraud. That is because Monday, December 11, 2023, marked the 15th anniversary of the arrest of Bernie Madoff in connection with one of the largest securities frauds in U.S. history. The scale of Madoff’s Ponzi scheme fraud is still, even after all of these years, just astonishing. Prosecutors estimated that the paper losses totaled nearly $65 billion, and have said they believe that the scheme defrauded as many as 37,000 people in 136 countries.  

What has been interesting in the scheme’s wake has been the efforts to recover funds to compensate Madoff’s victims. Irving Picard, the court-appointed trustee overseeing the liquidation of Madoff’s firm, has recovered approximately $14.6 billion. And perhaps even more interesting, Picard’s recovery efforts are continuing to this day, 15 years after Madoff’s arrest, as reported in David Thomas’s December 12, 2023 Reuters article, here.

Continue Reading Bernie Madoff Ponzi Scheme: Still Crazy After All These Years

As I have documented on this site, many COVID-related securities suits have been filed since the initial outbreak of the pandemic in March 2020. At the core of many of these lawsuits are corporate claims that the defendant companies were positioned to profit from the pandemic. The U.S. Department of Justice now reports that a biotech executive has pleaded guilty to securities fraud and other charges in connection with his company’s false claims at the outset of the pandemic that it had developed a new blood-based test for COVID-19. A copy of the Department of Justice’s December 8, 2023, press release about the guilty plea can be found here.

Continue Reading Biotech Exec Pleads Guilty to COVID-Related Securities Fraud

There was a time, not that long ago, when class action securities lawsuits were mostly about accounting and financial disclosure-related issues. In more recent years, securities suits increasingly are about operational issues, in which unfortunate business developments are the basis of securities fraud allegations — a phenomenon that has been called “event-driven litigation.” In the latest example of this kind of litigation, a plaintiff shareholder has filed a securities class action lawsuit against General Motors alleging that the company, which sustained a product recall related to its vehicle airbags and suffered a significant setback in its driverless vehicle development efforts when one of its driverless vehicles struck a pedestrian, misled investors about vehicle safety issues. A copy of the plaintiff’s December 8, 2023, complaint can be found here.

Continue Reading Vehicle Safety Issues Trigger Securities Suit Against GM

The risks and opportunities that AI presents have emerged quickly and may be evolving even faster; the whole AI phenomenon has developed much more quickly than legislators’ and regulators’ ability to respond. Among the many AI effects that regulators and other observers are struggling to assess is the extent of the AI-related litigation potential, including but not limited to the prospects for AI-related corporate and securities litigation.

Continue Reading SEC Chair Warns Against “AI Washing”