/>iThe trends driving directors and officers insurance, including M&A litigation, Dodd-Frank whistleblowers, subprime settlements and the Supreme Court’s interest in securities cases.
2011 has been an exciting year for directors and officers (D&O) insurance. Since the past is often a prologue to the future, as risk professionals look ahead to 2012, it can be useful to take a look back at a few of the major claim issues and hot topics in the D&O marketplace during the past year. These are the top five.
I. Ongoing Surge in M&A Litigation
As in 2010, plaintiffs' lawyers continued to file lawsuits arising out of mergers and acquisitions (M&A) in record numbers. Market research firm Advisen reported that, through August of this year, 352 lawsuits challenging such transactions had been filed in state and federal courts, in comparison to a total of 353 filings in all of 2010. Moreover, the 353 lawsuits filed last year were a record, representing a 58% increase from similar lawsuits filed in 2009.
Historically, lawsuits brought by the shareholders of the acquired company against its officers and directors alleging that they failed to maximize the stock's price in the transaction have often been resolved with corporate therapeutics (such as additional disclosures or safeguards) and relatively modest fee awards for plaintiffs' attorneys. But this continuing surge in M&A raises a number of issues for primary D&O carriers.
First, M&A lawsuits have traditionally been bread-and-butter cases for plaintiffs' attorneys -- they rarely generate exorbitant recoveries or lawyer fees, but they do provide steady cash flow. Recently, however, commentators have noted that Delaware Chancery Courts are less willing to approve standard fees for lawyers in relatively meritless actions, while awarding higher payouts to lawyers who can genuinely affect the fairness of a merger by causing significant additional disclosures supporting the deal.
If the defense costs of a company's officers and directors are covered under a D&O policy, the upshot may very well be increased litigation costs in combating these lawsuits -- particularly if multiple lawsuits are filed over a single transaction. As these multiple suits drag on, deeper erosion of the primary policy's limit of liability is inevitable. Settlement negotiations in M&A lawsuits may also become more difficult, particularly in connection with cases in which the company has clearly engaged in conduct detrimental to shareholders, as plaintiffs' attorneys have an extra incentive to hold out for larger fee awards, ultimately driving deal costs higher.
Finally, commentators have noted that the increase in M&A litigation has now transformed it into a high frequency/low severity exposure -- the opposite of traditional D&O claims. And while the low severity aspect may be refreshing, many insurers may not have accounted for the changing dynamic of this risk in their pricing models.
II. Dodd-Frank Whistleblower Provision
An important, but somewhat under-the-radar issue of the past year is the continuing speculation of the consequences on enacting the Dodd-Frank Act's whistleblower provisions. The SEC adopted the final rules implementing the whistleblower provision in May.
The reform authorized the SEC to reward whistleblowers between 10%-30% of the funds recovered in any successful enforcement action. There are a few eligibility restrictions, however. First, the information must be "original," meaning it is based upon the whistleblowers independent knowledge and not already known to the SEC or the public. The tip also must lead to a successful SEC enforcement action that brings in at least $1 million. In addition, several kinds of people are prohibited from recovering rewards under the whistleblower provisions, such as anyone who learns of a potential violation through privileged attorney/client communications and individuals convicted of crimes in connection with the disclosed violation.
But these limitations are unlikely to slow down the flood of tips the regulator expects to receive. Thus far, the SEC has already established a fund of approximately $452 million to fund anticipated payments.
Additionally, the SEC's final rules did not mandate that a whistleblower needs to report through a company's internal compliance programs, although it did provide several incentives for whistleblowers to do so. These developments are significant for D&O insurers, as many policies may provide coverage for internal investigations of officers and directors, but not the entities themselves. If, as widely expected, Dodd-Frank leads to an increase in whistleblower reports, D&O insurers can expect an increase in the number of investigations initiated by the SEC as well as additional suits brought by private litigants.
III. Subprime Litigation
Lawsuits arising out of the subprime crisis were first filed during 2007 and then rocketed upward in 2008. After dropping in 2009, there were only a handful of filings during 2010 and 2011. However, given that securities class actions typically take around three to three-and-a-half years to settle, this past year provided an inkling as to the continuing threat of losses for insurers arising out of litigation filed in the wake of the subprime crisis.
Most notably, in August 2011, Wells Fargo, on behalf of Wachovia, who it acquired it 2008, agreed to the settlement of Wachovia's consolidated preferred securities and bondholder litigation for $627 million. This is the largest subprime securities settlement to date. The figure represents a $590 million contribution on behalf of the Wachovia defendants, including the firm's directors, officers and underwriters, and a $37 million contribution on behalf of KPMG, Wachovia's auditor. Perhaps the most notable aspect of the Wachovia settlement was the plaintiffs' counsel's claim in its motion to approve the proposed $627 million settlement that the figure represented "roughly 30% to 50% of the reasonably recoverable total damages" that plaintiffs' counsel would have sought at trial.
If true, this would be a monumental rate of recovery, and strike fear into the heart of every insurer with any sort of potential exposure to litigation arising out of the credit crisis. In contrast, according to NERA Economic Consulting's "Mid-Year 2011 Securities Litigation Report," the average rate of investor losses recovered through securities class action settlements in 2010 was a mere 2.4%.
Additionally, on June 30, Washington Mutual entered into a $208.5 million settlement arising out of the bank's failure during the credit crisis. Then, just a few days after the Wachovia settlement, National City Corp. announced that it had also reached an agreement to settle its subprime related class action lawsuit pending against it for a total of $168 million. To date, settlements arising out of the subprime litigation wave total over $3.2 billion.
However, there were notable victories for many subprime defendants in 2011 as well. First and foremost, BankAtlantic was successful in overturning a jury verdict entered against it at trial, based on a post-trial motion. Additionally, Barclays, HomeBanc, and Regions Financial have all successfully moved to dismiss pending securities suits against them arising out of the subprime credit crisis. Bank of America also successfully sought dismissal of a pair of subprime related securities claims brought by former Merrill Lynch shareholders, who became Bank of America shareholders following the bank's acquisition of Merrill in January 2009.
IV. The Supreme Court's Continued Interest in Securities Cases
Beginning in 2005, the Supreme Court has issued several opinions concerning challenges to various aspects of U.S. securities laws. These rulings have revealed a trend towards restricting the overall scope and breadth of such lawsuits, including heightened pleading requirements, stronger loss causation standards and restrictions on who can be sued for securities fraud. The Chief Justice John Roberts court issued several decisions that showed this trend continued into 2011.
In Janus Capital Group, Inv. v. First Derivative Traders, by a 5-4 majority decision, the court gave a narrow interpretation to the term "maker" for purposes of Rule 10b-5. The result was that an investment advisor who controlled a mutual fund and drafted its public statements could not be held liable for knowing misrepresentations made by the fund.
In Matrixx Initiatives, Inc. v. Siracusano, in a unanimous ruling, the court declined to overrule an existing Supreme Court precedent that required that "misleading statements or omissions" are actionable in a securities fraud case if there is a "substantial likelihood that the disclosure of the omitted facts could have been viewed by a reasonable investor as having significantly altered the 'total mix' of information made available." Matrixx sought to have the court attach a degree of materiality to the test, and require an additional allegation of "statistical significance" in connection with its failures to make public disclosures.
Similarly, in Erica P. John Fund, Inc. v. Halliburton Company, the court refrained from altering the established presumption of reliance in favor of investors in securities class actions based on "fraud on the market" theory. In another unanimous opinion, the court found that for class certification purposes, securities holders who allege they were defrauded did not have to prove that the alleged fraud actually caused their losses. Reaffirming the "fraud on the market" theory, the Supreme Court held that an investor presumptively relies on the misrepresentations if that information is reflected in the market price of the stock at the time of the relevant transaction.
The Matrixx and Halliburton cases could have been seized upon to undermine prior precedent and question, or even reject, the "fraud on the market" theory. Instead, these decisions indicate that the Roberts court has no interest in changing the current framework under which securities litigations proceed.
V. Chinese "Reverse Merger" Litigation
The first half of 2011 saw a continuing trend of securities litigations being filed against companies domiciled in China, with much of the activity concentrated on reverse mergers. A reverse merger is often a less expensive alternative to the more traditional process of taking a corporation public through an initial public offering (IPO).
In short, a privately held company purchases a publicly owned operating shell company, and merges the private company into the public shell, all the while retaining voting and operational control over the new entity. Because the shell company is already registered with the SEC, as the surviving entity in the merger process, it is able to avoid registration requirements set forth by the SEC that would otherwise be applicable to a company going public via an IPO. There is nothing illegal or fraudulent about the reverse merger process itself. But both plaintiffs' attorneys and government agencies have continued to scrutinize Chinese companies seeking access to U.S. markets.
Cornerstone Research reported in its mid-year 2011 review that of the 94 total federal securities class actions filed in the first half of the year, 24 were filed against Chinese companies arising out of reverse merger transactions. Only seven such suits were filed in total in 2010. Securities class action plaintiffs typically assert misconduct in the auditing and accounting methods utilized by Chinese companies in the lead up to the reverse merger process. This comes as a result of the differences between tax accounting and financial reporting requirements of China and the United States. The SEC suspended trading of several reverse merger entities in April and May, and published an investor bulletin warning of the dangers of investing in reverse merger companies in June.
It is too early to predict the extent of the potential exposure for this wave of litigation. However, recent commentators have noted that many Chinese companies have only a bare minimum of D&O insurance and that some existing policies may not afford coverage at all for claims made under U.S. securities laws.
Looking ahead to 2012, the heightened scrutiny and the threat of additional lawsuits in the United States could lead to a hardening of the D&O market for Chinese companies. Only time will tell.
---------
Michael B. Chester is a principal and James R. Steel, III is an associate with the law firm Boundas, Skarzynski, Walsh & Black, LLC in New York.
