Directors and officers of American public companies face many substantial risks, not just the risk of their companies’ success or failure in the marketplace. Every year, hundreds of directors and officers are sued, most notably in securities fraud class actions filed by professional plaintiff law firms. For decades, it has seemed every time a company’s stock price drops by more than 10 percent in a two-day period, one or more plaintiff firms are likely to bring an action.
For a corporate director or officer, worrying about one’s own prospective liability can create an unfortunate distraction from the primary goal of delivering shareholder value. Executives can be further confused and distracted if they pay too much attention each year, when noted consultants and commentators release statistical studies examining fluctuations in filing volume during the previous year, and offering sweeping opinions as to the causes, the historical and social significance, and the consequences of such statistical fluctuations, however great or small they may be.
Comfort from Commentators?
For example, commentators famously opined in 2007, “increased enforcement activity” by the SEC and the DOJ had resulted not only in “less fraud,” but that this downward movement was in fact a “permanent shift.” Notwithstanding these optimistic projections, in 2008 the number of securities fraud class-action filings increased by almost 28 percent to 224, which tied 2002 for a 10-year high. In 2009, the number of discrete filings went back down somewhat to 178, which is still higher than the average volume for the previous five years (174), and once again commentators seem to be rushing to say that the corporate waters are evidently safe again.
ADDITIONAL STORIES IN THE DIRECTOR’S GUIDE TO LIABILITY:
Litigation 101: You’ve Been Sued. Now What?
The Ultimate Insurance Check List
Avoiding the “F” Word: How Your External Auditor Can Help You Avoid Fraud
The D&O Glossary: Litigation Terminology Every Director Should Know
Experience, however, suggests otherwise. Indeed, the only consistent identifiable trend in filing volume over the last couple of decades appears to be that, in general, years in which securities class action filing volume went down have been followed by years in which the number of filings increased again. As Grace Lamont, the U.S. securities litigation and investigations practice leader for PricewaterhouseCoopers, said in an April 1, 2010 press release: “Although 2009 saw a decline in the total number of federal securities class action lawsuits, neither financial services firms nor companies in other sectors should take this as license to drop their guard. Far from being a trend, the decline may simply be a lull as the plaintiffs’ bar refocuses following two years of intense financial-crisis-related filings.”
More importantly for an individual director or officer, the number of securities fraud class action filings in a given year has no logical or identifiable link to the likelihood that a particular company will suffer a securities fraud class action. If the company experiences a sudden drop in stock price, then the company is likely to be sued.
And not even the most optimistic commentator predicts that plaintiff lawyers are ever simply going to stop filing cases. To the contrary, in recent years the statistical studies of securities class action filings, while still important, have become progressively less relevant as a measure of the broadening risks faced by corporate directors and officers today.
Risk: Competition Among Plaintiffs
The conviction and imprisonment of several of the key leaders of the securities plaintiffs’ bar several years ago created a vacuum into which numerous enterprising attorneys have attempted to leap. Plaintiff firms and especially institutional plaintiffs have become more aggressive than ever, making cases harder to settle. Defendants paid $3.8 billion in settlements in 2009, which was up 35 percent from 2008. Plaintiff firms out to make a reputation have proven to be more willing than ever before to call defendants’ bluff and take cases to trial. Unfortunately, plaintiffs have been persistent and had considerable success tapping into current anti-corporate sentiment and winning verdicts in cases against Vivendi, Household Finance, Apollo Group (jury verdict, later reversed on appeal), Charles Conaway of Kmart (in a suit by the SEC, even though Conaway had previously won a bankruptcy-related arbitration), Gregory Reyes the CEO of Brocade (convicted for the second time, after his prior conviction was overturned) and Richard Scrushy of Healthsouth ($2.9B judgment in a corporate derivative suit, even though Mr. Scrushy had previously won a criminal trial in 2005). With stakes that can run into the billions, the company’s only viable strategy may be to pursue settlement and hope its insurers will assist and not impede the process.
Risk: The Credit Crisis
Although many optimists now speak of the “credit crisis” as if it was a thing of the past, it is important to bear in mind about 80 percent of the subprime and credit crisis cases are still pending. About 15 percent of the cases have been dismissed, many without prejudice to re-filing by plaintiffs, and only about 5 percent of the cases have been settled (11 credit crisis securities class actions have settled for a total of $858.5 million).
Throughout 2009 and into 2010, the effects of the credit crisis spread far beyond the financial sector, and cash flow problems have led to increased bankruptcy filings and related securities fraud suits. Business bankruptcy filings were up 52% for 2009 over 2008. One example of this type of a seeming knee-jerk response from the plaintiff bar involves a company called Idearc. When, arguably as a result of the economic downturn, the company had to write off $47 million in receivables, it filed for bankruptcy protection and experienced a 10b-5 suit for allegedly misrepresenting its credit policies. Other non-financial companies which have recently entered Chapter 11 bankruptcies and seen their directors and officers sued under Rule 10b-5 include MRU, Charter Communications and Nortel Networks. Of course, bankruptcy situations can lead to many other types of claims, including claims by bankruptcy trustees and creditors, as well as suits by laid-off employees.
Risk: New Suits on Older Stock-Price Drops
Another significant development has been the growing number of recently filed suits against non-financial companies where the proposed class period ended in 2007 and 2008 (e.g., Nokia, CRM Holdings, Stryker Corporation, Bidz.com, Liz Claiborne, Coach, Inc., Rackable Systems and Sprint Nextel). These cases, which take advantage of the lengthened limitations periods granted by the Sarbanes-Oxley statute (SOX), should remind companies which experienced bad news within the last two years that they can’t afford to ignore the ongoing potential exposure.
Risk: Diversity of Securities Litigation
Apart from securities class actions themselves, directors and officers may be faced with other increasingly expensive (and increasingly common) securities-related litigations, such as corporate derivative suits, merger and acquisition challenges and securities fraud suits brought individually by large institutional plaintiffs. These actions do not fit directly within the rubric of “securities fraud class actions,” and are thus frequently omitted from the annual reviews and commentary, but they may present significant problems for directors and officers nonetheless.
Risk: Legislative Efforts
Following the 2008 elections, Congress has been considering legislation that could greatly expand potential liability for companies doing business in the U.S., including measures which would override recent specific U.S. Supreme Court decisions. One such bill would lower pleading standards for all civil litigation, so plaintiffs could more easily survive motions to dismiss and then bludgeon corporate defendants with onerous discovery demands. Another proposed bill would create a civil cause of action for aiding and abetting securities fraud, thus undoing the Supreme Court’s Stoneridge decision. Each of these measures could drastically increase exposure to directors and officers.
Risk: More Vigorous Enforcement
The risks are not limited to private litigation. Directors and officers also must not ignore the recent increases in government enforcement activity at the state and federal levels. This is particularly true as costs involved in responding to government inquiries and proceedings are skyrocketing, partly because the government’s efforts can be more unpredictable than private plaintiffs and are not motivated purely by economic incentives.
Areas in which the government has become demonstrably more active over the last year or two include the pursuit of SOX 304 compensation “clawback” claims by the SEC and Foreign Corrupt Practices Act-related enforcements being pushed by the SEC and the Department of Justice. The SEC’s use of SOX 304 (separate and apart from its increased insider trading enforcement efforts) in 2009 included two highly publicized instances in which they sought the return of compensation from executives against whom they had not alleged any personal wrongdoing. Having stepped up their enforcement of SOX 304 in recent years against individuals who were alleged to have been at the heart of stock options backdating schemes (in suits relating to United Health, Mercury Interactive, Broadcom, Maxim and others), in 2009 the SEC surprised many observers by suing the CEOs of CSK Auto and Beazer Homes USA, respectively, without even alleging these individuals were aware the financials they certified had been incorrect.
On the FCPA front, enforcement has reached record levels against both individuals and corporations (40 in 2009, 26 DOJ actions and 14 brought by the SEC; these numbers are up from 2 and 3 respectively in 2004). The SEC is in the process of forming a separate unit dedicated solely to FCPA enforcement. Last year saw three criminal trials against four individuals, all of whom were convicted. This increased governmental enforcement has also resulted in a growing number of related securities fraud class actions and corporate derivative suits against large multinational companies including Siemens and Baker Hughes.
Increased Litigation Risk Abroad
U.S. companies and their foreign divisions and subsidiaries are more exposed than ever abroad, as more and more countries beef up regulation and add class and collective action litigation statutes. In addition to increased securities regulation exposure, companies and their directors and officers are increasingly exposed to liability and criminal charges from a variety of other types of statutes. This point was recently driven home when the Criminal Court of Milan on February 24, 2010 sentenced three officers of Google to six months in prison for violating Italy’s privacy laws. Google’s chief legal officer, chief privacy counsel and former CFO were each found guilty of violating Italy’s Personal Data Protection Code by allowing the posting of a video showing high school students bullying another student with Down syndrome. In today’s “small” world of global commerce and communication, executives in particular need to be sure that their policies are sufficient to fully protect them from the laws of all potentially relevant jurisdictions. In some countries, effective protection can only be accomplished by locally admitted policies, but fortunately some carriers have practical solutions available.
Managing Risk
So what should our clients, and the management liability insurance buyers’ market in general, take from all of this? First, our clients should not allow themselves to be complacent where their D&O insurance coverage is concerned. Any D&O policyholder needs to understand the ins-and-outs of their coverage, both the primary policy and any and all excess policies, and especially the potential differences among the terms of these policies. Additionally, and at least as importantly, insureds need to reassure themselves (gathering information from reliable sources with actual relevant experience) they will be fairly treated by the claims departments of the insurers into whose hands they are entrusting themselves.
As exposures proliferate and potential liabilities continue to grow, it will be more important than ever to have state-of-the-art policies and claims handling. Pursuing commercially sensible resolutions to potential disputes whenever possible is a must—until the rest of the D&O market is up to speed, it’s up to the client and the brokers to understand the terms of their policies and to know what to expect from their coverage and their claims service in the event a significant claim occurs.
Lawrence Fine is senior vice president, chief technical office, of Complex D&O/Fiduciary Claims, and Mark Curley is senior vice president for Director & Officer Claims, at Chartis Insurance.