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Managing risk
securities laws—in particular, sections
of the Securities Act, the Exchange
Act and SOX. Claims made against
directors and officers under these
statutes are frequently brought as class
action litigation, where damage awards
and settlement proceeds go directly to
shareholders allegedly harmed. There are
also statutes that may have industryspecific
application.
The Securities Act is designed to
prevent fraud in securities offerings
and to assure that investors receive full
disclosure in connection with the offer
and sale of securities by the company. As
such, the Act imposes a high standard of
conduct on directors and officers of the
company. Section 11(a) of the Act states
that a person who purchased a security
covered by a registration statement (e.g.,
an IPO and secondary public offering
of equity or debt) may recover damages
from, among others, the company and
its directors and officers who sign the
registration statement if the registration
statement:
• contained a misstatement of material
fact; or
• omitted to state a material fact that
either was required to be stated or was
necessary in order for the registration
statement not to be misleading (this
includes anyone who has consented
to be a director of the company and is
named as a director in the registration
statement, not just those who have
signed the registration statement)
While the company is strictly liable
for violations of Section 11, directors
and officers may avoid liability if they
are successful in establishing their own
defense. If the misstatement or omission
occurred in a part of the registration
statement not passed upon by an expert
(e.g., an auditor’s report), the director
or officer must demonstrate that he or
she had, after reasonable investigation,
sufficient grounds to believe that the
disclosure statements were true or that
material statements were not omitted. If
the misstatement or omission occurred
in a part of the registration statement
passed upon by an expert, a director or
officer need only show that he or she had
no reasonable grounds to believe that that
portion was materially untrue or omitted
to state a material fact. There is no
requirement under Section 11 to show that
directors and officers intended to defraud
investors.
A series of related court decisions
have been the subject of controversy
and discussion related to whether a
directors and officers (D&O) liability
insurance policy covers certain losses as
a result of violations of Section 11 (Level 3
Communications, Inc v Federal Insurance
Co, 272 F3d 908 (7th Cir 2001); Conseco,
Inc v National Union Fire Insurance
Company, Case No 49D130202CP000348,
Marion Circuit Court, Marion County,
Indiana (December 31 2002)). Taken
together, the decisions have generally
been interpreted by some practitioners
of D&O liability to distinguish between
coverage for the company (or issuer) and
coverage for individual directors and
officers. D&O insurance coverage for
individual defendant officers and directors
is generally viewed not to be endangered
by these decisions; however, the effect
of the collective decisions may affect the
nature and breadth of D&O insurance
coverage afforded to the company, and
modifications to such coverage may be
appropriate to assure affirmative coverage
for potential violations of Sections 11
and 12.
A related but separate issue is whether
D&O insurance policies should also
include affirmative coverage for violations
of Section 15 of the Securities Act. Section
15 provides that any person who is deemed
to control any person found liable under
Section 11 or 12 will share liability for
the damages imposed on the controlled
person. Companies undergoing an initial
public offering might seek such affirmative
coverage, particularly companies whose
directors and officers might be deemed to
be control persons following the IPO.
Turning to the Exchange Act,
the objective of this legislation is to
increase the information available to
public company investors through
the implementation of disclosure
requirements and to prevent unfair
practices in U.S. securities markets. As
discussed earlier, Rule 10b-5 has broad
application and includes statements or
omissions in the company’s Exchange
Act filings (e.g., Forms 10-K, 10-Q and
8-K). The rule prohibits any practice
to defraud investors, including making
any untrue statement of material fact or
omitting a material fact in the company’s
filings. Actions may be brought against the
company and/or its officers or directors by
private parties, the SEC or the Department
of Justice. In general, Rule 10b-5 liability
is broader than Section 11 liability as
applied to the directors and officers of the
company. Moreover, plaintiffs’ lawyers
must demonstrate “scienter,” which is an
intention by a defendant director or officer
to defraud.
Shareholder derivative suits: Another
frequent source of potential liability
and expense is what is commonly called
a “derivative suit.” These are lawsuits
brought by shareholders on behalf of the
company against individual directors and
officers and typically allege violations of
state and common law fiduciary duties
owed to the company or other wrongdoing.
Most shareholder derivative suits are
resolved through payment of fees to
plaintiff’s counsel and by the company’s
adoption of certain corporate governance
and management reforms negotiated
between the company and the plaintiffs,
the purposes of which are to strengthen
protections for investors and enhance
shareholder value.
Until recently, derivative actions had
rarely resulted in substantial monetary
recoveries. But within the last four years
there have been a number of derivative
actions with settlements exceeding $50
million. When monetary settlements
or damages are involved, such awards
generally go to the benefit of the company
itself and not directly to shareholders.
Shareholder derivative lawsuits, which
have been increasing in frequency, usually
settle in tandem with outstanding class
action litigation and are often called
“companion” or “tagalong” cases. These
suits are now often brought in multiple
jurisdictions and can sometimes involve
inconsistent outcomes (In Re Oracle Corp
Derivative Litigation, 2003 WL 21396449
(Del Ch June 17 2003)).
Two common bases of liability in
shareholder derivative actions include
violations of the duty of care and the duty
of loyalty, discussed in more detail below,
but may also include excessive officer
compensation, proxy violations, option
86 NYSE IPO Guide