Risk Management

If Mergers Pick up, Can Lawsuits Be Far Behind?

Recent tepid litigation against directors and officers may have led to a false sense of security about lawsuits to come.
Caroline McDonald and David KatzJanuary 25, 2013

The lull in mergers and acquisitions over the past year has been accompanied by a similar lull in corporate conversations about the lawsuit risks that directors and officers face. Tamped down by infrequent M&A activity, litigation has waned, leading to a marked disinterest in D&O coverage among corporate insurance buyers.  

While concern about D&O risks has been minimal among public issuers, it has been nearly non-existent in the private sector. In fact, the most recent D&O survey by Towers Watson, issued last March, which polled 401 representatives of all major industries and service sectors, found that nonprofit organizations such as universities and hospitals (32%) and private organizations (19%) were far more likely to respond that they were not sure how their primary D&O program was structured, compared with public companies (5%).

Overall, nearly two-thirds of the survey participants say they have not had any claims against their D&O liability policy in the last 10 years. Of the third that have experienced claims, nonprofits reported the highest number (48%), followed by public companies (36%) and private companies (17%), according to the study. 

Has the tepid claims history produced a false sense of security about a coming wave of lawsuits against corporate executives and directors that may be in the offing, as some insurance folks might contend?  

On the surface, it wouldn’t appear so. Class-action lawsuits, which largely target big public companies but may be an indicator of broader trends in litigation, have been on the downswing.  Overall, there were 152 federal securities class actions filed in 2012, according to a report just released by Cornerstone Research and Stanford Law School. That’s 21% below the annual average of 193 filings made between 1997 and 2011.

The number of filings fell from 88 in the first half of 2012 to 64 in the second half – a 27% decrease on the heels of substantial reduction in filing activity in the fourth quarter of 2012. The 25 filings in those three months represent the lowest number of filings in any quarter during the last 16 years, according to the study.

What’s more, while merger and acquisition activity has been the main target of D&O-related lawsuits over the past few years, the suits have been in decline because of waning M&A activity.  Compared with the last two years, federal filings associated with M&A transactions fell sharply to 13 cases in 2012, from 43 cases in 2011 and 40 cases in 2010. After the unusual jump in federal M&A filings in 2010 and 2011, these cases are now being pursued almost exclusively in state courts, according to Cornerstone.

An M&A Surge?
As in many other things, however, past activity may be a poor predictor of future events.  Indications are that M&A activity stands to improve—at least in certain industry sectors. Late last year, PricewaterhouseCoopers predicted that a continued access to capital and financing, stronger balance sheets and heightened divestiture activity will mean more deals in 2013.

Corporate cash levels remain steady at $1.1 trillion for the S&P 500. This would indicate more opportunities for expansion through M&As, according to PwC. The accounting firm acknowledges that there may be a lull in first quarter M&A activity following the flurry of deals in the fourth quarter of 2012. But renewed optimism will lead to a stronger year for M&As in 2013, according to PwC.

In that case, finance chiefs would do well to take an interest in their D&O coverage. Chances are high that any company involved in M&A activity could see a class action, or, more likely, a smaller-scale lawsuit. If there’s a merger, acquisition, or takeover, “a civil lawsuit is filed every time. It’s guaranteed they’re going to get sued,” observes Will Fahey, senior vice president, corporate markets with Zurich, a leading carrier of D&O liability coverage.

To be sure, underwriters like Zurich have an interest in pointing out the risk that corporate board members and senior management may be sued. But D&O liability insurance is widely bought by organizations to indemnify such people for losses that may result from a legal action through their service as a director or officer.

M&As present opportunities for litigation against directors and officers and possibly the company itself – both private and publicly traded – observes Richard Betterley, president of Betterley Risk Consultants. Boards can be blamed for paying too much for an acquisition or for bad judgment.

But while D&O risks do differ according to whether a company is publicly traded or privately held, they are not as different as “non-publicly traded company leadership thinks,” he says. Private company leaders often believe D&O coverage is more of a necessity for companies with shareholders.

Betterley notes that private companies aren’t exempt from the same kind of lawsuits that public companies see, since private companies “have partners, they have investors, and they have bank relationships.” Like public companies, privately held companies have exposures to price-fixing and antitrust allegations as well, he says.

Lawsuits for privately held companies can stem from any number of business problems, “such as a product introduced to the marketplace that wasn’t successful,” he says. A company without shareholders could have a suit brought by bankers, other investors, distributors, or subcontractors who might be involved in that product or its delivery, Betterley explains.

More Attention to D&O
Despite the lag in M&A-related activity and the resulting downturn in lawsuits against top management and board members over the past few years, more directors and officers are asking questions about their D&O coverage. Sixty-nine percent made inquiries about their coverage in 2011 compared to 57% in 2010, Towers Watson found.

William G. Passannante, co-chair of the insurance recovery group at Anderson Kill, a law firm that defends corporate policyholders, observes that executives and directors of publicly held companies tend to be more knowledgeable about their insurance coverage than their peers at private companies are. They sometimes make suggestions to risk managers about options they have seen used for other boards, he says.

To make sure they’re adequately covered, Passanante recommends that CFOs and other members of senior management find out who in the organization is responsible for purchasing insurance “and ask them if you have appropriate and the best reasonable available coverage for a director and officer in my position in this company – and ask them to confirm that you do.”

That’s an exercise that should be done regularly “because what’s available in the market changes, the forms change, and the exclusions change,” he adds.

A passing acquaintance with the coverage itself also wouldn’t hurt. D&O liability insurance is bought by organizations to cover their directors and officers for losses that may stem from a legal action taken against them in connection with their roles as D’s and O’s.

While experts agree that standard D&O policies provide decent coverage as far as they go, there are areas in which boards and top management could be vulnerable to personal loss. For example, directors and officers may find their personal assets at risk if a bankrupt company is unable to compensate them for their legal fees – and if recoveries under the company’s D&O policy are determined to be assets of the bankruptcy estate.

Such cases are where so-called “stand-alone Side-A D&O” coverage comes in. Filling a gap in traditional policies, they protect executives against non-indemnifiable claims—those for which the company cannot legally or financially provide protection.

Whether a company is publicly traded or privately held, its ability to indemnify or “hold harmless” its executives and boards is controlled by the law of the state where the company is headquartered or incorporated.

Corporate risk managers typically buy Side-A coverage as part of a bigger traditional insurance package that also includes protection for D’s and O’s against indemnifiable losses (B-Side coverage) and coverage for the company itself (C-Side coverage).

While any company may want to consider buying Side-A coverage for their officers and directors, Betterley says, such insurance is purchased mainly by publicly traded companies. The managements of private organizations, he adds, may “believe they have more control of their company than one that’s publicly held.” Whether that turns out to be true in 2013 remains to be seen.

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