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.
One of the few downsides to board service is the exposure to liability that directors of all corporations potentially face, day in and day out, as they perform their fiduciary duties. The chance of being sued for a major merger decision is now 90 percent; but that well known statistic is just the tip of an even larger iceberg. The Court of Chancery for the state of Delaware, where some one million corporations are incorporated (among them most major public companies), hears more than 200 cases per year, most of them involving director and officer liability. And given the high esteem in which Delaware courts are held, these influential D&O liability decisions impact the entire nation.
Why did we get involved? Since its founding in 1977, NACD has striven to serve members in many ways. Through research reports, webinars, and live events, we provide directors with the information, insights, and networks they need to become effective board leaders. Yet there is another important way in which NACD has been helping directors over the years. From time to time, when directors express concerns about pending policy matters, we amplify those concerns to the powers that be—including all three branches of the federal government as well as state courts, particularly Delaware’s. In this way, we can be the “voice of the director.”
In our Rural/Metro brief, we spoke on behalf of the directors in this case (who, because they had settled out of court, could not directly represent themselves); far more importantly, however, we spoke on behalf of all directors in every state, addressing the legal principle at issue. We urged the Delaware Supreme Court to reverse Chancery’s finding that Rural/Metro’s directors had breached their fiduciary duties when they approved the company’s sale. NACD believes the Court of Chancery’s decision may expose directors of Delaware corporations to an unreasonable risk of litigation and personal liability for good-faith decisions made on the basis of their reasonable business judgments and in consultation with expert advisors.
Will our line of reasoning in the Rural/Metro amicus brief prevail? Whatever the outcome, NACD’s messages is likely to keep Delaware’s courts focused on standards of good faith rather than an ideal but unreachable goal.
In this regard, we can take heart from precedent. The Rural/Metro friend-of-the-court brief was the second one NACD has filed in recent years. The previous amicus brief, written in 2008 and presented by the law firm of Sidley Austin LLP, addressed the issue of indemnification in the matter of Bohnen v. Troy Corp. 962 A.2d 916 (Del. 2008). NACD asserted that the indemnification protection of former directors should continue past their years of service in legal matters that involved those same years.
Initially, the court could not consider our brief for technical reasons. However, NACD’s position was ratified in 2009 when, in response to concerns expressed by various parties including NACD, the Delaware legislature amended Section 145(f) of the Delaware General Corporate Law. As revised, Section 145(f) provides that a director’s right to receive indemnification or advancement pursuant to a company’s charter or bylaws generally “shall not be eliminated or impaired … after the occurrence of the act or omission that is the subject of the … indemnification or advancement.”
Even now the issue of indemnification remains current. Late last month, in the case of Blankenship v. Alpha Appalachia Holdings Inc., C.A. No. 10610-CB (Del. Ch. May 28, 2015), the Delaware Court of Chancery upheld and clarified the rights of former directors and officers to receive advance defense costs when they are named in litigation connected to their past board service. As stated in a recent article from Gibson Dunn, “This decision reaffirms the strong protection of director and officer indemnification and advancement rights under Delaware law.” The decision in this case cites Section 145 of the Delaware Code more than a dozen times, which demonstrates that NACD is truly making a difference for directors and the companies they serve.
In 2012, initial public offerings (IPOs) did not quite make the rebound analysts had predicted. In the year of the botched Facebook offering, just 128 IPOs were made. Although quadruple that of 2008, this marks a decrease from 154 IPOs in 2011. Last May, the Economist observed that this decline was part of a larger trend: the decline in popularity of the public company.
Since 1997, the number of U.S. public companies has fallen by 38 percent. Additionally, the average number of IPOs has declined from 311 per year between 1980 and 2000, to 99 per year between 2001 and 2011. In addition to companies actively not going public, in the last year several well-known businesses “went private,” such as Quest Software, CKE Restaurants, Burger King, and J. Crew.
In addition to the obvious distinctions of private companies—a lack of shareholders and adherence to regulation—NACD’s recently released 2012—2013 Private Company Governance Surveyfound many lesser-known differences. This survey features responses from over 550 individuals who serve private company boards. Some of the contrasts include:
Private company boards are smaller. On average, private company boards have 7.3 members—a decrease from 8.9 members in 2011. For the past several years, public company boards have consistently maintained an average of 8.8 members.
Public company directors are more likely to receive continuing boardroom education. In 2012, 82 percent of public company directors received continuing education in the last 12 months, compared to 57 percent of private company directors. This may be connected to company policy, however: 83.1 percent of public directors were reimbursed for education expenses, while only 54.5 percent of private company peers were.
Trend in the private company boardroom: D&O Insurance. Additional directors and officers liability insurance was obtained by just 15 percent of private company directors in 2008. In 2012, this figure jumped to 50.4 percent. In comparison, 42.8 percent of public company directors purchased additional D&O insurance in 2012.
Nominating and governance committees are much less prevalent at private companies. Similar to public company counterparts, audit and compensation committees are nearly ubiquitous at private companies. However, just 49.2 percent of private company survey respondents indicated that their board had a committee dedicated to nominating and governance.
Private companies employ different mechanisms to ensure director turnover. The most commonly used method of director turnover at private companies is director evaluation. Age limits and term limits are both used by nearly one-fifth of respondents. At public companies, the most prevalent mechanism to renew and replace directors is age limits, closely followed by evaluations. Term limits are used by just 6.5 percent.
Generally, private company boards maintain less diverse composition. Compared to 27.4 percent of public companies, 38.5 percent of private companies do not have any female directors. With respect to minority directors—based on race and ethnicity—70.3 percent of private companies have no such representation, compared to 51.8 percent of public boards.