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Risk Scenario

It Happened Here

An ill-advised merger sparks shareholder lawsuits and major losses.
By: | April 22, 2014 • 8 min read
Risk Scenarios are created by Risk & Insurance editors along with leading industry partners. The hypothetical, yet realistic stories, showcase emerging risks that can result in significant losses if not properly addressed.

Disclaimer: The events depicted in this scenario are fictitious. Any similarity to any corporation or person, living or dead, is merely coincidental.

A Promising Prospect

Hal Landis walked into the boardroom at Stratton Bank headquarters in Chesapeake, Va. with a glow building inside of him.

Scenario_ItHappenedHere

The chairman and CEO of the bank, he carried in his briefcase paperwork that detailed the possible acquisition of Stratton by Manhattan-based Global Corp.

Global Corp., with about $100 billion in assets, liked the look of the mid-sized Stratton, which held about $30 billion in assets.

With its roots as a lender to the conservative farmers and fishermen of the Middle Atlantic, Stratton had a reputation for producing modest, steady returns and never taking unnecessary risks.

“Shall we get started everyone?” Landis said with a confident grin.

At 63, Landis was in good shape physically and financially, and with what Global was offering on a per-share basis, he couldn’t help but fantasize about the sort of retirement he might now be able to afford if this deal went through.

Scenario_Aon

Scenario Partner

Two hours later, the rest of the board of directors was won over. They voted to accept Global’s offer, conditional on the approval of that corporation’s board of directors.

The Global board meeting to discuss the Stratton acquisition did not go quite as smoothly.

The audit committee had barely completed its report on Stratton’s financials when Augie Desmond, a junior staffer in the bank’s risk management department, spoke up.

“Mr. Bedford,” Desmond began, addressing the bank’s chairman, the formidable Alan Bedford.

Eyebrows were raised. It wasn’t common for junior employees to punctuate Global meetings with unsolicited remarks or questions.

“Nice working with you kid,” the CFO said to himself.

“Yes, Mr. …” Bedford began.

“Desmond, sir, Augie Desmond, from risk management,” Desmond said.

“Yes, Mr. Desmond?” Bedford said, throwing a questioning look at Desmond’s boss, CRO John Fairmount.

“I have serious concerns about this acquisition, sir,” Desmond said.

“There was a piece in the Journal today on a steam-generating solar plant in Nevada,” Desmond said.

Fairmount shot Desmond a look.

“Sorry John,” Desmond said. “I didn’t have time to tell you.”

Desmond continued.

“According to a report from Stanford, the heat from the plant is killing wildlife — lots of it — including the state bird,” Desmond said.

“Wha….?” Bedford began.

“The solar company, Daedalus, is based in Virginia,” Desmond said. “Stratton is the primary advisor on the company’s upcoming IPO. Daedalus is applying for a second permit, an even bigger plant with about $30 million in investment. If the politicians get hold of this thing, and they will …”

“What thing?” Bedford said.

“The bluebird thing sir, that’s the state bird. If this second plant application goes south, that solar company is at serious risk and so is Stratton — I don’t like it sir … I don’t like it one bit.”

“Mr. Desmond what is your background?” Bedford asked.

“I have a Master’s Degree in astrophysics from MIT,” Desmond said.

“And how long have you been in the banking industry?” Bradford said.

“Three months sir,” Desmond said.

“I’ll take that under advisement,” Bedford said.

Without much further debate, they followed the recommendation of the audit committee and approved the Stratton acquisition.

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Nevada Down

The meeting of the Stratton Bank stockholders to vote on the approval of the Global Corp. offer was held in the conference rooms at the Chesapeake Madison Hotel. Before the vote, the floor was opened up for discussion.

Scenario_ItHappenedHere

As he was at every meeting, Smitty Ackles, a shareholder and crabber from Havre de Grace, was first to the mike.

With his enormous gut protruding from between the bands of his cherry red suspenders, Ackles stood at the mike, smiling with wizened eyes at Hal Landis.

“Good afternoon, Mr. Landis,” Smitty said.

“Good afternoon, Mr. Ackles,” Landis said in what the audience recognizes as their standard opening schtick.

There are chuckles throughout the room.

“What I’d like to know, Mr. Landis, is why in the world the shareholders should accept this deal? We have been doin’ alright for 35 years, nobody’s complainin’ about their returns. Why do it?”

“Well, a 20 percent premium on our shares is one reason,” Landis said.

“Not worth it,” countered Ackles. “These boys from New York will bring more trouble than they’re worth, I guarantee you.”

“I’ve known you since you were a boy, Hal Landis, and I’m here to tell you, you’re making a mistake,” Smitty said before ambling away from the mike.

There are more chuckles, but nobody really listens to Smitty. Stratton shareholders approve the deal 2,010 to 15.

Not even a week later, the Nevada Department of Environmental Protection issues a surprise ruling that condemns the second Daedalus plant.

A study from the University of Nevada confirms what the Stanford researchers found. The plant is linked to the deaths of 1,000 Mountain Bluebirds, the state bird. Deaths of other birds number in multiples of that.

Geddy Hayes, an influential Nevada State Senator from Sparks, picked up the football and ran with it. Hayes, a gifted speaker, worked his magic from the Senate floor and killed any remaining chance the second Daedalus plant had.

The application for the plant, which the solar company spent millions on, went under.

Hayes wasn’t done with Daedalus. He pressured state regulators into burdening the existing plant with new regulations — to the point that it began to lose money.

On a Monday afternoon, Hal Landis sat in his office with CFO Dylan Reed, watching a cable news financial report.

The Daedalus IPO launched the previous week and did fairly well, with the share price rising 17 percent by week’s end. The following week was a different story.

Losses suffered by the Daedalus plant are being reported, along with the losses from the failed application for the second plant.

One week after the IPO launch, Daedalus shares are down 30 percent and are in freefall.

“How bad do you think this is for us?” Landis asked Reed.

“I don’t know, I’ve never been in this position before,” Reed said.

“None of us have,” Landis said.

Within two days, Stratton is set upon in a class action by attorneys for disgruntled Daedalus shareholders, who report millions in investment losses.

Poll Question

Who within your company has input on the topic of risk management?

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Damages

The acquisition of Stratton by Global is set to close in the third quarter. In its second quarter financials, Stratton reports a multimillion dollar write down in connection with the Daedalus fiasco.

Scenario_ItHappenedHere

Weakened by the reputational hit of the Daedalus shareholder class actions, Stratton also begins to notice some alarming revenue declines.

This time, at the Global board meeting where the decision to follow through on the Stratton acquisition will be made, it’s Augie Desmond’s boss, John Fairmount, who speaks first for the risk management department.

“Mr. Bradford, it’s our opinion that we should absorb any frictional costs and abandon this acquisition,” Fairmount said.

“Based on what data?” asked Global’s CFO, Daniel Silberstein, who championed the acquisition from day one.

Fairmount turned to Desmond.

“We’ve run an algorithm that ties share price to reputational damage. Call it a reputational risk index, if you will,” Desmond said.

“Based on what we’re seeing with Stratton, we see share price deterioration tied to reputational problems plaguing the bank for at least the next six quarters,” Desmond said.

Bradford shot Fairmount a look that said, “Again with this kid?”

Bradford and Silberstein aren’t swayed. They like Stratton’s basic book of business a lot. The bank hasn’t had a quarter in 20 years when it didn’t return a dividend.

Global’s board votes 13 to 4 to go ahead with the acquisition.

In the first six months following the acquisition year, Stratton shows a revenue decline of 20 percent over the previous year.

The solar deal in Nevada that went sour is poisoning the bank’s brand with its largely conservative retail banking customers.

A sizable chunk of Global shareholders are fed up. Rather than start an internecine war with their own management, they take action against Stratton.

The allegations are that Stratton failed to disclose the risk of the Daedalus exposure to the Global board and bungled the crisis management of the failed IPO.

———-

Two years ago, if you’d asked Hal Landis who his insurance broker was, he couldn’t have told you. Now he knows him very well.

“You have $10 million in general liability coverage,” the broker explained to Landis over the phone.

“Right,” Landis said.

“Between the Daedalus IPO shareholder actions and the Global shareholder actions, you’re looking at $15 million in potential liability,” the broker said.

“Do you see any indications that your own shareholders could take action against the board?” he asked.

“Not to date,” Landis said.

“You have that much in your favor,” he said. “For the time being.”

“Well, we can self-insure the $5 million on top of the policy if we have to,” Landis said.

“Sure,” the broker said. “But I can’t think of an admitted carrier who will even talk to us next year.”

“What’s an admitted carrier?” Landis said.

“It’s a carrier who’s not going to charge you your right arm in premium,” said the broker.

No longer fantasizing about a rosy retirement, Landis wonders how long he’ll have a job.

Poll Question

How is your company managing increasing operational exposures from regulatory oversight?

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Bar-Lessons-Learned---Partner's-Content-V1b

Risk & Insurance partnered with Aon to produce this scenario. Below are Aon’s recommendations on how to prevent the losses presented in the scenario. These lessons learned are not the editorial opinion of Risk & Insurance.

1. Risk management requires an open mind: Ignoring stakeholders that voice legitimate concerns carries a double-edged risk. The first risk is the magnitude of the exposure brought up by a colleague or shareholder that’s being overlooked. The second is the fact that an issue was raised publicly, thereby documenting a concern that went unheeded by management.

2. Risk by association: Operational risk is such a pressing risk for financial institutions in part because of the number and variety of business partners and clients they take on as part of their basic operation. An inadequate knowledge of the technology, practices and risk exposures of any given business partner can result in reputational and other damages should that business partner fail or incur a sizable liability.

3. Transparency: Companies that fail to properly assess their risk and report it to business partners face increasingly painful regulatory sanctions. A blunt assessment of an organization’s exposures is the first step in that process. Being forthright in communicating risk factors is the second.

4. Analyze cover: Regulatory pressures and a rapidly changing business environment necessitate that financial institutions assess their insurance coverage more frequently than ever before.

5. Risk management is a process, not a program: There is nothing static about risk management. New processes, products and distribution channels in the financial services industry mean that the nature of operational risk is changing constantly. Risk management needs to keep pace with that change or risk losing relevance and value.

Partner Resources

Operational Risk Solutions

Regulation and the Financial Industry



Dan Reynolds is editor-in-chief of Risk & Insurance. He can be reached at dreynolds@lrp.com.
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You Be the Judge

Is a Student an Employee of a Martial Arts Academy?

A injured student at a martial arts studio claims he is an employee for the purposes of workers' comp.
By: | April 21, 2014 • 2 min read
You Be the Judge

A martial arts student and member of the “black belt club” at Fred Bauer’s Martial Arts Academy was an assistant instructor for lower ranked students. Experienced academy students customarily instructed other students as part of their own development. The student was given a key to the studio, along with five other students.

The student arrived at the academy and opened the studio, having agreed to fill in for another student who had volunteered to instruct a class. A car barreled through the studio’s window that faced the parking lot, striking the student.

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The student sought workers’ compensation benefits. The academy asserted that he was not covered by workers’ compensation because no employment relationship existed. The student said that he received reduced monthly tuition rates for himself and his son. The academy owner said that the student assisted with training others but did not receive complimentary or reduced-cost lessons in exchange for doing so. The student did not produce evidence at trial showing that he received compensation from the academy.

The student did not include the academy on a list of employers in documents related to his separate lawsuit against the driver of the car. He also did not mention the academy when asked on direct examination at trial about his employment at the time of the accident. The student did not report his alleged employment with the academy on his tax returns or credit card, job, and home refinancing applications.

The trial court concluded that the student did not establish that he was an employee of the academy and dismissed his claim for benefits. The student appealed, arguing that an employment contract existed and that the trial court failed to recognize that a bartering arrangement could qualify as compensation sufficient to establish an employment relationship.

Poll Question

Was the trial court correct in dismissing the student’s claim?

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The court explained that when evaluating whether an employment relationship existed the emphasis is on whether the parties entered into a contract for hire. The court explained that while forms of consideration other than a paycheck can serve to establish an employment relationship, the student did not establish that a bartering arrangement existed. Therefore, the student and academy had not entered into a contract for hire.

How the court ruled: A. The Ohio Court of Appeals held that a the student did not establish that he was an employee at the time his injuries occurred and affirmed the dismissal of his claim. Beal v. Fred Bauer a/k/a Bauer’s Martial Arts Academy, No. C-130258 (Ohio Ct. App. 02/21/14).

B is incorrect. The court found conflicting evidence as to whether an employment contract existed. The trial court properly weighed the evidence and resolved the conflicting testimony in favor of the academy.

C is incorrect. The court found that the student did not establish that a bartering arrangement existed.

Editor’s note: This feature is not intended as instructional material or to replace legal advice.

Christina Lumbreras is a Legal Editor for Workers' Compensation Report, a publication of our parent company, LRP Publications. She can be reached at riskletters@lrp.com
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Sponsored: Aspen Insurance

Minimize the Risks of Client Lawsuits

Approach client communications as if you were writing directly to a future jury. If a client ever sues, it could save the day.
By: | April 7, 2014 • 4 min read
SponsoredContent_Aspen

When a top litigator prepares a case for a trial, part of the process is mapping out a clear, written story to put in front of a jury. Professionals looking to avoid or minimize the impact of client lawsuits would be smart to follow that lead, according to Christopher Piety, underwriting counsel, Professional Lines Risk Management, Aspen Insurance.

“Just like when a talented lawyer faces a jury, the better prepared you are, the stronger your case will be and the more likely you will prevail,” Piety said. “That means being very clear when writing an email or a letter to a client. Approach these communications as if you were writing directly to a future jury.”

Piety explained that in the wake of several recent sizeable professional liability claims, lawyers and other professionals (i.e., accountants, architects and engineers) must deliver clear, concise written communications, to create a record of what happened along the way. “On some of the larger claims that I’ve been involved in, whether it is with lawyers, accountants, architects or engineers, it really boils down to managing client expectations. And to do that requires effective written documentation,” he said.

For example, Piety said that in a recent professional liability claim, a lawyer did nothing wrong other than failing to put into writing advice that the circumstances of the client’s case changed, which typically translates to an added risk that the desired outcome may not be achieved.

SponsoredContent_Aspen“When you write an email or letter, it’s critical to include specifics. It will go a long way to avoid potential trouble, especially if the situation ends up in court,” Piety said. “A good defense is a strong offense.”
– Christopher Piety, underwriting counsel, Professional Lines Risk Management, Aspen Insurance

“The attorney didn’t spell out in writing that the evidence no longer supported the client’s seven-figure expected outcome,” Piety said. The client eventually dropped the case and then sued the lawyer for malpractice, claiming that the attorney’s failures cost them a positive result. Without written documentation advising the client about the risks, the attorney could not prove the client had been advised.

Screen for Bad Apples

“Professionals need the courage to ‘fire’ a potential problem client should any serious red flags emerge,” Piety said. “Not every piece of business is a good one.” Along those lines, he offered a few bits of advice to avoid potential problems when choosing clients:

  • Obvious Red Flag: A potential client that “burned through” multiple professional services firms. Worse, have they sued any of them?
  • Reputation Check: After completing a credit check and/or litigation search, research the potential client’s reputation in the local business community.
  • Financial Stability: Check to see if the client is financially sound.  Sometimes, problem clients manage to transfer their financial problems to their professionals in the form of unpaid fees and/or malpractice claims.
  • Available Staff: Make sure your firm is prepared and staffed to properly do the work requested.

Clarity is Critical

“When you write an email or letter, it’s critical to include specifics. It will go a long way to avoid potential trouble, especially if the situation ends up in court,” Piety said. “A good defense is a strong offense.”

SponsoredContent_Aspen

Professionals need to carefully detail the scope of work when starting a new project or case, particularly if the client is also new. From a risk management perspective, it’s most critical to completely outline limitations and risks.

In addition, specific risks to various types of professionals may include:

  • Law Firms: Never offer guarantees for specific results, and understand that silence can be interpreted by a jury as agreeing with a client’s unrealistic expectations.
  • Architects and Engineers: Specify what you will and will not be responsible for. Never agree to indemnify anyone outside the firm.
  • Accountants: Advise clients and others using your work that attest engagements only provide limited assurance of no material misstatement in the financials, but do not guarantee the absence of fraud or financial problems with the attest client’s business.

Communicate Frequently

“Throughout the entire business relationship, it’s a good idea to document any ongoing changed circumstances, no matter how seemingly small, and advise clients of any new related risks and/or performance limitations,” Piety said. He outlined these examples:

  • Accountants: Quickly advise clients in writing when the client’s own poor record-keeping is causing the audit work to be more expensive and/or creating risk of material misstatement requiring additional client action.
  • Lawyers: Advise clients in writing when discovering evidence that may potentially change the value of the case.
  • Architects and Engineers: Communicate in writing when change orders on a project require expensive design changes that may negatively impact the overall project budget.

“Just like when a talented lawyer faces a jury, the better prepared you are, the stronger your case will be and the more likely you will prevail. That means being very clear when writing an email or a letter to a client. Approach these communications as if you were writing directly to a future jury.”

Act Promptly

Piety said the failure to act quickly often causes confusion, which can in turn lead to unnecessary and unforeseen problems. To stop that from occurring, he offered these insights:

  • Communicate immediately, via writing, any emerging issues that affect a client’s expectations and your ability to meet them.
  • Clients who fail to pay in a timely manner or seem unhappy early on in the relationship probably have an issue that should be addressed immediately.

In the end, only by having a clear written record of what actually occurred can professionals ensure they will reduce, or even prevent, the threat of a claim. Do not give your future opponent an opportunity to fill in the gaps with their own version of reality designed to sway a jury against you.

“Always focus on the fundamentals because fundamentals are what will really help a defense,” Piety concluded. “In so many cases, written communication will prove to be the critical factor between winning and losing.”

This article was produced by Aspen Insurance and not the Risk & Insurance® editorial team.
This article is provided for news and information purposes only and does not necessarily represent Aspen’s views and does constitute legal advice. This article reflects the opinion of the author at the time it was written taking into account market, regulatory and other conditions at the time of writing which may change over time. Aspen does not undertake a duty to update the article.


Aspen Insurance is a business segment of Aspen Insurance Holdings Limited. It provides insurance for property, casualty, marine, energy and transportation, financial and professional lines, and programs business.
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