Directors and officers of both public and private companies operate in difficult, complex, and evolving business, legal, and regulatory environments. Challenges and risk exposures are unavoidable, and the speed of change shows no sign of slowing. Accordingly, it is imperative that directors and officers stay abreast of issues impacting the risk landscape and continually analyze how best to protect themselves. The recently released NACD Board Leadership report prepared with Marsh, “Evolving Directors & Officers Liability Environment Emerging Issues & Considerations,” identifies core areas of change and associated insurance concerns for directors & officers (D&O).
Four areas being closely watched today are discussed below.
Securities regulations and resulting enforcement and claims will change over the course of President Trump’s administration, although the extent of the change remains to be seen. Deregulation for financial institutions and other organizations is likely. Although deregulation may ease the regulatory burden on businesses in an effort to stimulate growth, it could lead to a rise in resulting claims due a potential decrease in transparency and mandated corporate guidelines.
We may also see a shift in how government regulatory agencies handle purported wrongdoing—perhaps with the assessment of fewer corporate penalties while continuing to hold culpable individuals accountable. Based on some of the recent U.S. Securities and Exchange Commission appointments — including the SEC Chair and co-heads of the SEC Division of Enforcement —many expect that the agency will continue to aggressively pursue culpable individuals.
Generally speaking, activism is on the rise, including environmental activism, shareholder activism, and other forms. The first climate change-related securities class action was filed in late 2016, and more are expected to follow. Some anticipate that, as a result of the Trump administration’s withdrawal from the Paris Agreement, environmental activists’ drive to advance their agenda—whether through civil litigation, shareholder resolution initiatives, or other means—will increase. In addition, we expect there to be more initiatives driven by state regulatory actions and non-governmental organizations.
Increase in Securities Claims
According to NERA Economic Consulting, the number of securities class action filings in the first quarter of 2017 was significantly higher than in past years. The number for the first quarter of 2017 stood at 144 filings of federal securities class actions, which is up from 102 filings in the first quarter of 2016. If filings continue at this rate, we expect there to be close to 500 securities class action filings in 2017 alone, a 66 percent increase from 2016. The rise in filings can be attributed to several factors including, but not limited to: the increase in merger objection-related filings in federal court; the increase in the number of securities plaintiff firms; and, arguably, a race to the courthouse before any new regulatory changes are implemented.
Cybersecurity-related losses continue to be one of the most worrisome potential exposures for companies. Despite some significant recent cyberbreaches, the first traditional securities class action litigation against directors and officers was only recently filed. The complaint generally alleges that the defendants made materially false and/or misleading statements about the breach. It also claims failure to disclose material adverse facts about the company’s business and operations specific to data protection, and the discovery and potential impact of the data breaches.
On the other hand, there have been a number of derivative lawsuits filed against companies’ directors and officers for alleged mismanagement of cybersecurity incidents. To date, defendants in this type of litigation have largely been successful in getting these cases dismissed by invoking the business judgement rule, among other defenses. However, a notable, recent settlement of one of these derivative actions while on appeal will likely continue to fuel the plaintiff’s bar’s drive to pursue cybersecurity-related D&O claims.
While each of the above can be viewed as discrete risks, they each share a common thread: increased exposure to directors and officers. As a best practice, all directors should regularly review their D&O insurance program with their insurance advisors to ensure adequate protection in the wake of the increasingly risky environment in which we live. Directors and the officers of their companies should ask themselves probing questions about their insurance coverage:
Does my D&O insurance program provide sufficient limits of liability?
Am I protected by Side-A Difference In Conditions insurance? If so, are those limits sufficient?
How will my D&O insurance coverage respond in connection with a regulatory investigation? Will I be covered to the extent there is an internal investigation associated with an external regulatory investigation?
Does the selection of insurers on my company’s D&O “tower” make the most sense should I need to turn to the insurers for coverage?
How narrowly tailored is the exclusionary language in my policies? How favorable is the severability language?
By reviewing these questions in conjunction with their insurance programs on at least an annual basis, directors and officers will be more adequately prepared for the scenarios outlined above.
Corporate directors are confronted with a variety of recently proposed governance standards, while activist investor campaigns are challenging both board composition and board effectiveness by targeting individual directors. Given the high level of personal reputational risk and the associated long-term financial consequences now faced by directors, a hard look at the adequacy of company-sponsored director and officer (D&O) risk mitigation and board compensation strategies is timely.
The Bedrock of Certainty Shifts
Shifting stakeholder expectations are codified in the frequently conflicting governance standards published in recent years. Following the National Association of Corporate Director’s own 2011 Key Agreed Principles, there are now draft voting guidelines from Institutional Shareholder Services (ISS) and Glass Lewis & Co.; standards from groups such as the Office of the Comptroller of the Currency (regulator), CalSTRS (investor), the G20, and the Organisation for Economic Co-operation and Development (influencer); and, most recently, the Commonsense Corporate Governance Principles from a group of CEOs led by JPMorgan Chase & Co.’s Jamie Dimon.
This proliferation of standards reflects differing stakeholder expectations and gives direct rise to new risks for directors. With these new risks and expectations emerge associated questions about the adequacy of current governance strategies, company-sponsored reputation-risk-mitigation packages, and director compensation.
Because the board is the legal structure administering governance, the standards that boards choose to guide their oversight have legal force. Furthermore, detailed, prescriptive standards have instrumental force.
For instance, ISS and CalSTRS are promoting highly prescriptive standards. ISS is exploring specific “warning signs” of impaired governance, including monitoring boards that have not appointed a new director in five years, where the average tenure of directors exceeds 10 or 15 years, or where more than 75 percent of directors have served 10 years or longer. CalSTRS expects two-thirds of a board to be comprised of independent directors, and defines director independence specifically as having held no managerial role in the company during the past five years, equity ownership of less than 20 percent equity, and having a commercial relationship with the company valued at no more than $120,000 per year.
The Commonsense Corporate Governance Principles released this summer was an effort to share the thoughts of the 5,000 or so public companies “responsible for one-third of all private sector employment and one-half of all business capital spending.” Certain background facts may lead some stakeholders to discount the Principles. For example, in addition to Dimon, the list of signatories was comprised mostly of executives who hold the dual company roles of chair and CEO. Also, according to the Financial Times, eyebrows have been raised by CEO performance-linked bonuses of about 24 to 27 times base pay at BlackRock and T. Rowe Price, two asset manager companies with executives who were signatories. Coincidentally, these asset manager companies were ranked among the most lenient investors with respect to the executive pay of their investee companies, according to the research firm Proxy Insight.
These standards can be deployed by checklist, and boards can be audited for compliance to the specifics of the adopted standards. But, more importantly, the very existence of these standards lends them authority through expressive force. What they express—or signal, in behavioral economic parlance—is intent, goodwill, and values. Signaling is valuable in the court of public opinion.
Personal Protection Strategies
As reported in NACD Directorshipmagazine earlier this year, activists often wage battle in the court of public opinion to garner public support when mounting an attack against a company. Emphasizing the personal risks, the Financial Times reported in August that “Corporate names are resilient: when their images get damaged, a change of management or strategy will often revive their fortunes. But personal reputations are fragile: mess with them and it can be fatal.”
Make no mistake: this risk is personal. A director’s damaged personal reputation comes with material costs. Risk Management reported in September that the opportunity costs to the average corporate director arising from public humiliation were estimated at more than $2 million.
Among the many governance standards, pay issues are the third rail of personal reputation risks. “If companies don’t use common sense to control pay outcomes, [shareholders have to question] what else is going on at the organization and the dynamic between the chief executive and the board,” an asset manager with Railpen Investments told the Financial Times recently. Clawbacks may be the most disconcerting pay issue because the tactic places directors personally between both the investment community and regulators.
Governance standards just over the horizon may give boards succor, and reputation-risk-transfer solutions may have immediate benefits. Since 2014, the American Law Institute (ALI) has been developing a framework titled, “Compliance, Enforcement, and Risk Management for Corporations, Nonprofits, and Other Organizations.” Members of the project’s advisory committee include representatives from Goldman Sachs & Co., HSBC, Google, Clorox, and Avon Products; diverse law firms offering governance advisory services; law schools; regulators including the Department of Justice; and representatives from a number of prominent courts. According to the ALI, the project is likely to hold an authority close to that accorded to judicial decisions.
The ALI work product remains a well-protected secret, but the project is expected to recommend standards and best practices on compliance, enforcement, risk management, and governance. It can be expected that the ALI standards will reflect the legal community’s newly acquired recognition of the interactions between the traditional issues of compliance, director and officer liabilities, and economics; and the newer issues of cognitive and behavioral sciences. Such governance standards will likely speak to the fact that while director and officer liability will be adjudicated in the courts of law, director and officer culpability will be adjudicated in the courts of public opinion.
Insurance Solutions Available Now
Boards that qualify for reputational insurances and their expressive force can mitigate risks in the court of public opinion. An NACDDirectorshiparticle noted earlier this year, “ . . . these reputation-based indemnification instruments, structured like a performance bond or warranty with indexed triggers, communicate the quality of governance, essentially absolving board members of damaging insinuations by activists.”
Given the increased personal reputational risks facing directors and the long-term financial consequences arising, it may be time for an omnibus revisit of the adequacy of both director compensation and company-sponsored D&O risk mitigation strategies in the context of an enhanced, board-driven approach to governance, compliance, and risk management.
Following the guidelines of the ALI’s project once they are published is a rational strategy. After all, the work product will be one that will have already been “tested” informally in the community comprising the courts of law, and will be designed to account for the reality of the courts of public opinion. And no firm today has natural immunity to reputation damage—even Warren Buffett’s Berkshire Hathaway appears to be in the ISS crosshairs. Reputational insurances which, like vaccines, boost immunity, are available to qualified boards to counter all that is certain to come at them in this upcoming proxy season. And for those who insist on both belts and suspenders, hazardous duty pay may seal the deal.
Nir Kossovsky is CEO of Steel City Re and an authority on business process risk and reputational value. He can be contacted at firstname.lastname@example.org. Paul Liebman is chief compliance officer and director of University Compliance Services at the University of Texas at Austin. He can be contacted at email@example.com.
Every corporate director knows the importance of M&A in the grand scheme of enterprise. With some 40,000 significant transactions announced annually, M&A is hard to ignore. Yet there are persistent risks that directors need to understand and mitigate through insightful questions and the dialogue that ensues.
Risk: Not all bets will pay off—at least not right away. Buying a company means placing a bet on the future. Given the level of unpredictability involved, there is some chance that the merger will fail to achieve its goals and/or fail to return incremental value to shareholders. It is commonly cited that “80 percent of all mergers fail” to add value; however, this percentage is an exaggeration. Event studies that compare transactions over time present a more realistic picture by showing that incremental financial value is not assured. For example, a study conducted by Kingston Duffie, publisher of the digital magazine Braid, indicates that companies actually lost 4.8 percent of their value when they spent at least five percent of their market capitalization on M&A during the 18-month period between October 2014 and March 2016. The interactive graphic included in the study shows differentiated performance during the period—high for Stamps.com Inc., medium for Starwood Hotels & Resorts Worldwide Inc., and low for EV Energy Partners. Your company could experience returns like any one of these.
Question for Directors:If this merger ends up havinga slightly negative result for our shareholders, what are the compelling strategic reasons to do this deal? When do we believe that deal synergies will materialize?
Risk: As a director, you could be named in a lawsuit—especially if you are voting on the sale of a company. In 2015, lawsuits were brought in 87.7 percent of completed takeovers. Although most cases settle, some do go to trial. In a trial setting there are four main standards for judging director conduct in the sale of the company, ranging from lenient to stringent:
The business judgment rule (trusting the decision as long as directors have no conflicts of interest and are reasonably well informed).
The Unocal standard (protecting anti-takeover moves only if a threat is real).
The Revlon standard (requiring an auction process once a company is in play).
Entire fairness (requiring both a fair price and a fair process).
In addition, when a company has promised its shareholders the right to have the company appraised, the court itself can impose its own valuation. In the original Dell go-private transaction, the court retroactively forced the company to pay aggrieved stockholders what the court deemed to be a missing increment to their premium.
Question for Directors:How can we find assurance that sale is in the best interest of the company and its owners, and that we have chosen an optimal price? How can we ensure that there is a litigation-ready record of our deliberations in this regard?
Risk: You could lose your board seat. According to a study by Kevin W. McLaughlin and Chinmoy Ghosh of the University of Connecticut, there is a higher rate of retention for directors from the acquiring firm (83 percent) following a merger, with the most likely survivors being individuals who serve on more than one outside board. Only about one-third of directors from the target board (34 percent of the inside directors and 29 percent of the outside directors) continue to serve after the merger.
This October, when Dell Inc. and EMC Corp. officially merge (assuming full regulatory clearance following their recent shareholder approval), many who serve on the EMC board may not be on the post-merger Dell board, including retiring EMC Chair-CEO Joe Tucci. When the merger was first announced last October, a spokesman for Elliott Management Corp. stated in a press release, “Elliott strongly supports this deal. As large stockholders, we have enjoyed a productive and collaborative dialogue with Joe Tucci and EMC’s Board and management. We are confident that this Board has worked tirelessly to evaluate all paths for the company and that today’s transaction represents the best outcome for stockholders.”
Saying goodbye to some or all of these incumbents this fall will seem to be an ironic outcome for creating value. And yet that is how it must be. Fiduciaries are not self-serving, but rather they serve on behalf of shareholders to promote the best interests of the company. As such, they need to be ready to move on when that is the best outcome for the corporation. Still, it is disruptive (and not always creatively so) to be a trusted voice of wisdom for the future one day, and mere history the next.
Question for Directors: If we sell this company and our board must merge or disband, who among us will be most useful in steering the combined company in the next chapter?
These are not easy questions. But by asking them, directors can help their companies beat the tough M&A odds.