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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
Managing risk plan violations, related party transactions, misappropriation of corporate opportunities and corporate waste: • Duty of care—Directors and officers owe the company and its stockholders a duty of care. They must act on an informed basis and in a manner that they reasonably believe to be in the company’s best interests, exercising the degree of care that an ordinarily prudent person in a similar position would exercise. The duty of care focuses on the decision-making process. When directors or officers are accused of breaching their duty of care, generally the “business judgment rule” shields their decision by presuming that in making the decision, the directors and officers were informed, acted in good faith and honestly believed that the decision was in the best interests of the company and its stockholders. To support application of the business judgment rule, directors and officers generally should be proactive and attentive, regularly attend board meetings, meaningfully evaluate alternatives and deliberate as a board with adequate and complete information. Where appropriate, the board of directors should also consider retaining financial advisors, counsel and other experts to provide input and guidance. • Duty of loyalty—Directors and officers owe the company and its stockholders a duty of loyalty. Again, they must act in good faith and in the reasonable belief that their actions are in the best interests of the company. Loyalty issues arise when a director or officer has a conflict of interest or lacks independence with regard to a particular business decision or personally profits from an opportunity at the expense of the company. In evaluating claims for breaches of the duty of loyalty, courts generally will examine the decision-making process but may also evaluate the substance of the business decision to determine fairness to the company and its stockholders. To help avoid liability, interested directors should disclose potential conflicts and opportunities to other directors and abstain from deliberations and voting on any decisions where an actual conflict exists and consider abstaining where the appearance of a conflict exists. Frequency and severity of securities class action suits: The average public company faces a 6.4% probability that it will face a securities class action lawsuit in a given five-year period. And if an IPO is involved, class action lawsuits settlements are on average 35% higher. It is important to recognize recent trends in securities class action litigation. An understanding of these trends can impact decisions concerning directors and officers liability (D&O) insurance, including limits purchased, coverage selection and premium trends. (Note: The information that follows is taken from Recent Trends in Securities Class Action Litigation: 2012 Full-Year Review, a publication by NERA Economic Consulting, a unit of Oliver Wyman Group. Marsh and Oliver Wyman are both wholly owned subsidiaries of Marsh & McLennan Companies.) In 2012, there were 207 federal securities class action filings, the lowest level since 2007, with a notable slowdown in filings in the second half of 2012. Filings from 2010 to 2012 were driven in large measure by a spike in merger objection suits, which comprised, on average, 28% of Number of federal filings 550 500 450 400 350 300 250 200 150 100 50 0 132 1996 201 275 240 234 198 274 237 1997 1998 1999 2000 2001 2002 2003 252 total filings during this period. While the number of filings has fluctuated, the number of publicly listed companies in the United States has continued to decrease. The result is that the average listed company in the United States was 68% more likely to be the target of a securities class action lawsuit in the last five years (2008 to 2012) than it was from 1996 to 2000. The average cost of resolving these lawsuits has also increased. In 2012, the average settlement value (excluding settlements over $1 billion) was $36 million, up from $35 million from 2007 to 2011. Typically, plaintiffs’ attorneys’ fees and expenses make up approximately one-third of settlement values. 8.3 Indemnification Marsh Generally, indemnification of officers and directors is governed by the law of the state of incorporation. All 50 states provide for corporate indemnification and address situations where the company may indemnify its officers and directors and situations where the company must indemnify its officers and directors. To understand when indemnification is permitted by the company, look to the company bylaws or charter. Federal securities filings and number of companies listed in the United States (January 1996–June 2012) 8,783 8,884 8,448 8,200 7,994 7,289 6,757 6,154 187 Cases, excluding IPO laddering Listings 132 196 5,001 5,401 5,262 5,118 4,964 245 208 2004 2005 2006 2007 2008 2009 232 225 207 2010 2011 2012 Filing year Note: Number of companies listed in the United States is from Meridian Securities Markets; 1996–2011 values are year-end; 2012 is as of June. 6,097 6,029 6,005 5,936 9000 8000 7000 6000 5000 4000 3000 2000 1000 0 NYSE IPO Guide Number of companies listed in the United States 87
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