By Seth B. Brickman
The 2008 financial crisis has had an incalculable impact on our economy and some experts suggest it will take at least a generation to recover. This impact has not been lost on the world of management liability.
In 2006, a Towers Watson directors' and officers' survey indicated that 14 percent of companies had experienced a claim in the past 10 years, a number that more than doubled to 34 percent by 2011.
While the industry has been maturing since the 1970's, the dramatic rise in management liability claims during that five-year period is projected to continue accelerating for a variety of reasons.
Vastly tightened credit markets limit access to capital, declining sales cause layoffs and both contribute to a rise in personal and corporate bankruptcies. The inability to pay back loans brings litigation from lenders trying to protect positions before bankruptcy.
Lower profits lead to a cascading effect in which one struggling company not paying its suppliers leaves the suppliers unable to meet credit terms extended by lenders, creating crises of liquidity.
Individual shareholder suits become more prevalent as results dwindle and deals that seemed prudent at the time appear differently through the prism of today's economy. With less economic expansion, companies are competing for the same piece of the pie, leading to yet another reason for an increase in disputes.
As reduced access to investment capital threatens the continuing operations of struggling start-ups, the higher cost of new capital has resulted in a heavy dilution of existing shareholders. Initial investors feel short changed by the diminished returns from future mergers and acquisitions activity.
Throughout this evolution, courts have begun to take differing views on what is considered the fiduciary duty of today's directors and officers. The Business Judgment Rule has traditionally provided the men and women who run businesses the protection to make good-faith business decisions.
In Unocal Corp. v Mesa Petroleum, the Delaware Supreme Court ruled, in essence, that it assumes decision makers were reasonable, informed, and acting in the best interests of the company. The burden is on the plaintiffs to prove otherwise.
But recently, the doctrine of "entire fairness" has come into play, putting the burden on the directors and officers to prove a transaction is the product of both fair dealing and fair price.
Just believing the actions of directors and officers to be in the shareholders' best interest doesn't necessarily make it so, exposing business leaders to liability or, at a minimum, the need to defend their actions.
Government regulatory agencies have ratcheted up their efforts in recent years as well. In the soft market, insurers have been asked to provide better coverage for these investigations, in addition to defense costs when the allegations or investigations become actual claims made. Sarbanes-Oxley and Dodd-Frank have buoyed SEC proceedings.
With many policies now including Wells Notices and subpoenas in expanded claim definitions, insurers have shared in the cost for this increased activity. And the bill is steep. People usually think in terms of legal fees, but in an electronic age the costs of e-discovery can be staggering.
A survey recently commissioned by consulting firm FTI found that among respondents, 40 percent reported spending more than $500,000 on e-discovery.
Many carriers continue to respond to this perceived gap in coverage by offering expanded coverage for the investigations that don't typically trigger a D&O policy. New endorsements have been drafted either modifying the definition of a claim, or adding sublimits. Some carriers have even introduced entirely new policy forms.
One area of more regulation involves foreign business operations, or the Foreign Corrupt Practices Act (FCPA). As U.S. companies turn to foreign markets for expansion, the number of firms doing business overseas has risen dramatically.
Companies have responded with voluntary compliance and self-policing -- likely driven by self-interest more than ethics -- hoping that prosecuting agencies will go lighter on them.
These investigations have found coverage with some carriers even offering specific grants for FCPA fines and penalties, though predominantly on the private company side where the threat is not as pronounced.
But carriers need to take into account their liberal use of final adjudication wording in conjunction with this coverage grant, given that criminal and intentional acts exclusions would typically have saved them a few dollars.
In 2012, little has been the subject of more rampant speculation than the Jumpstart Our Business Startups (JOBS) Act. The new legislation exempts companies with less than $1 billion in annual revenues from certain disclosure requirements, allowing for the online process of capital raising called crowdfunding.
Crowdfunding will now allow companies to sell stock and solicit equity investments in very small dollar amounts from small investors through online portals. Reduced disclosure requirements will likely translate into an increase in misrepresentation claims down the road, particularly with less sophisticated investors.
Some underwriters have been a bit alarmist, noting that the JOBS Act has the potential to create an entirely new form of shareholder class actions for private companies. Indeed there are provisions in the Act for investors who feel they have been misled.
However, with investments being much smaller and investors likely to be far less sophisticated these fears remain to be unearthed. Will this type of investor have the resources to pursue a recovery? Some likely forms of claims might not even be covered if private company forms do not currently include "road show" coverage.
Additional rulemaking by the government is clearly needed, and even investment banks are holding back on the possibilities of performing research on companies that are candidates to go public until FINRA, Wall Street's self-regulator, weighs in.
Also, while there has been a trend of insureds and brokers increasingly asking for public company provisions on their private D&O policies, with changes in legislation, requesting coverage for loss arising from claims under the Securities Act of 1933 is suddenly not seeming all that unreasonable.
Last, is the continually developing exposure in the cyber security arena. Whether the obvious financial institutions and health care providers, or even the more simple retailers, having exposure here where there once was none, cyber security will certainly have bearing on management liability coverage.
The recent SEC guidance for disclosure on cyber issues sets the best practices for public firms. Private companies would be wise to take note, particularly if they do business with a publicly traded firm and because these best practices could be the standard in assessing liability.
The exposure a public firm faces as a result of its trading partners will require disclosure as well. Clients of private companies may well expect adherence to the SEC guidelines and take action in the event of a failure to do so.
When a company experiences a cyber event, shareholders can argue the directors and officers breached their fiduciary duty by not adequately preparing the company. Any company without some focus on cyber security exposures and what the potential financial loss could be, whether directly or in terms of investigations, is opening itself up to potential exposure.
Companies are becoming wise to this issue. As recently as 2007, a Chubb survey found that 63 percent of private companies surveyed did not purchase D&O coverage, nor employment practices liability coverage.
Awareness appears to have risen dramatically. According to the 2011 Towers Watson D&O survey, 69 percent of all directors and officers -- an increase from 57 percent from the previous year -- made inquiry into the scope and/or amount of coverage they carry in the past 12 months.
In addition, 25 percent of public companies surveyed and 14 percent of private and nonprofit companies said they increased their D&O limits at renewal.
The survey also found that regulatory claims again topped the list of D&O liability concerns, followed by direct shareholder and investor lawsuits, and derivative shareholder/investor litigation.
The market has seen and is bearing double digit premium increases in some classes and states. But what makes this mild firming different from past hard markets is the amount of available capacity still out there. Many carriers hope this is not just a temporary phase before a return to soft market conditions.
Perhaps the only constant is the shifting environment in which underwriters and brokers must operate. One thing for certain is this: The industry will continue to face challenges in terms of a corporate body that is alert to the litigation remedy and availability of the D&O policy as an asset.
Incidence of claims rose 20 percent in the last five years in an industry only spanning 50 years of age.
It is becoming increasingly clearer that along with the awareness of individual directors and officers (and the plaintiff's bar) continuing to rise, claims will invariably continue to increase.
SETH B. BRICKMAN, AAI, RPLU, works with Business Risk Partners overseeing the firm's portfolio of management liability solutions for agents and brokers nationwide serving middle market clients.
October 11, 2012
Copyright 2012© LRP Publications