The Public D&O Market continues to be a seller's (hard) market. There are many factors, spanning a number of years, that led to the current market conditions, including deteriorating D&O insurer profitability (stemming from both increased losses and decreased investment returns), social inflation, the Cyan decision, and the many disruptions caused by the pandemic, to name just a few. Instead of dwelling on the past, the purpose of this piece is to discuss the current D&O-related trends and developments and provide an update on the state of the D&O market.
Federal Court Securities Class Action Filings
During the three-year period starting in 2017, the annual number of federal court securities class action lawsuit filings (SCA filings) reached or neared historically high levels. However, in 2020, the number of SCA filings declined relative to the 2017-2019 period, and the decline has continued so far in 2021.
In 2020, there were 324 SCA filings, representing a decline of nearly 20% compared to the 402 SCA filings in 2019. Through the first eight months of 2021, there have been a total of 146 federal SCA filings, representing a 27% decline for the same time in 2020.
Notably, the rise in the number of SCA filings in the years 2017-2019 period and the decline in the number of SCA filings in 2020 and 2021 reflect changes in the plaintiffs’ bar’s approach to merger objection litigation. As a result of Delaware case law developments in 2016, plaintiffs’ lawyers shifted the forum in which they filed M&A-related lawsuits from state court (particularly Delaware state court) to federal court. Through 2019, most of these merger objection lawsuits were filed in federal court as class action lawsuits alleging violations of the federal securities laws. Beginning in 2020 and continuing in 2021, plaintiffs’ lawyers began filing the federal court merger objection suits as individual actions, rather than as class actions, almost certainly as a way for the plaintiffs’ lawyers to try to avoid judicial scrutiny of their mootness fee strategy.
If the merger objection lawsuits are disregarded and only the “traditional” SCA filings are considered, the decline in the number of SCA filings for the first six months of 2021 as compared to same time in 2020 is about 18%.
SPAC-Related Securities Class Action Litigation
The surge in SPAC-related shareholder litigation began in late 2020 and intensified in 2021. D&O insurers have become very wary of the amount of scrutiny being focused on SPACs by both private plaintiffs and regulators. According to SPACInsider, there were 248 SPAC IPOs in 2020; YTD 2021 (through September 3, 2021), there have been 423 completed SPAC IPOs. With that much financial activity concentrated in one sector, a certain amount of SPAC-related litigation was bound to develop, and we have witnessed a notable amount of litigation activity, with more likely to follow.
By our count, through September 3, 2021, there have been a total of 22 SPAC-related SCA filings, compared to only four during the full-year 2020. There have also been a total of eight SPAC-related shareholder derivative lawsuits filed.
It is important to note that almost all of the lawsuits filed this year were filed after the SPACs’ intended merger target had been announced (and in most cases, the lawsuit was not filed until after the merger was completed). This suggests that much of the SPACrelated litigation may be yet to come. According to SPACInsider, there are over 440 SPACs seeking a business combination target as of September 3, 2021. Over the coming months, as SPACs announce their business combinations and as the mergers are completed, there may be an increasing number of companies that experience litigation activity.
In August, the same set of plaintiffs’ lawyers flied derivative lawsuits against three SPAC boards and sponsors. The lawsuits allege that the defendant SPACs are actually investment companies that unlawfully failed to register with the SEC under the Investment Company Act of 1940. The plaintiffs’ theory is that all that these SPACs have done since their IPO is invest their offering proceeds in Treasury securities or T-bill backed money market funds – which in essence, is what SPACs have done over the last several years.
In response to these lawsuits, a coalition of 63 Wall Street law firms joined a statement criticizing the actions and panning the underlying theory that the SPACs involved are really Investment Companies within the meaning of the 1940 Act. It remains to be seen whether the plaintiffs’ lawyers involved will file any more of these Investment Company Act lawsuits and how these lawsuits will fare.
COVID-19 Related Litigation
Although the pace of COVID-19 related lawsuit filings has definitely slowed in recent months, coronavirus-related actions do continue to be filed. The question is whether they will continue as a meaningful litigation phenomenon. By our count, since the coronavirus outbreak, there have been a total of 34 COVID-19-related SCA filings. The defendants in these lawsuits generally fall into one of three categories:
- Companies that experienced coronavirus outbreaks in their facilities (such as cruise ship lines, private prison systems, and meat packing companies);
- Companies that allegedly tried to promote their ability to profit from the pandemic (such as vaccine development companies, personal protective equipment production companies, and online education services companies); and
- Companies whose finances or operations were disrupted by the pandemic (real estate development companies, hospital systems).
In addition to the SCA filings, there have also been 12 COVID-19-related shareholder derivative lawsuits, almost all against companies that had previously been the target of SCA suits. In addition, the SEC has filed ten enforcement actions alleging COVID-19-related securities violations. The SEC actions have largely been against penny stock companies that allegedly ran pump-and-dump schemes based on the companies’ attempts to drive up their share prices by promoting the companies’ abilities to profit from the pandemic.
The pace of COVID-19-related SCA filing activity has slowed. Of the 34 COVID-19 related securities class action lawsuits, only ten were filed in 2021. But while the pace of securities lawsuit filings has slowed, as COVID-19 has evolved, COVID-19-related actions may evolve going forward.
SPAC / Cybersecurity Disclosures and SEC Enforcement
Over the last several weeks, SEC Chair Gary Gensler has signaled a number of areas that will be the subject of regulatory attention at the agency, including, for example, cryptocurrency, online trading platforms for retail investors, and meme stock trading. Several recent enforcement actions suggest that, among other things, SPACs and cybersecurity disclosure could also be important areas of enforcement priority for the agency. After several public statements by Gensler and other agency officials expressing concerns about SPACs, the agency has initiated a number of SPAC-related enforcement actions.
On July 13, 2021, the agency settled administrative charges against Stable Road Acquisition Corp. (a SPAC), its CEO, and its proposed business combination target, Momentus (an early-stage space travel company). The agency separately filed a civil enforcement action against Momentus’ CEO. The agency asserted securities law violations against the defendants for allegedly falsely stating that Momentus’s rocket system had been successfully tested in space. The SPAC and SPAC CEO were also charged for inadequate due diligence in connection with the proposed merger with Momentus. In connection with the filing of the settled charges, Gensler took the unusual step of issuing a separate statement about the charges, noting that “This case illustrates risks inherent to SPAC transactions, as those who stand to earn significant profits from a SPAC merger may conduct inadequate due diligence and mislead investors.”
The SEC filed a second SPAC-related enforcement action in late July 2021 when, in conjunction with the presentation of a criminal indictment against electric vehicle company Nikola’s founder, Trever Milton, the SEC filed parallel enforcement charges against Milton. Nikola completed its merger with a publicly traded SPAC in June 2020. The SEC enforcement action and the indictment relate to Milton’s alleged misrepresentations about the operability of the company’s vehicle prototype, the source of parts used in constructing the company’s “Badger” vehicle, the company’s production of hydrogen, and the company’s development of parts that had actually been acquired from another company (many of the allegations in the SEC enforcement action are also alleged in a separate securities class action lawsuit that was filed against Nikola in September 2020).
In addition to the agency’s SPAC-related enforcement activities, the SEC has recently stepped up its enforcement activity in connection with cybersecurity disclosures. The first of these recent cybersecurity enforcement actions involved settled charges filed in June 2021 against title insurer First American Financial Corp. After the company learned from a journalist’s inquiry about a vulnerability in the company’s online systems that potentially exposed hundreds of millions of title and escrow records, the company issued a press release and statement about the vulnerability. However, the company officials responsible for the press release and statement were unaware that the company’s IT security officials had discovered the vulnerability earlier but had not disclosed nor remediated the issue prior to the journalist’s questions. In its statement about the settled charges, the agency said that it is the responsibility of every issuer to “maintain disclosure controls and procedures designed to ensure that information required to be disclosed by an issuer in reports it files or submits under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified by the Commission’s rules and forms.”
A second recent SEC cybersecurity enforcement action involved the U.S.-listed U.K. education services firm Pearson plc. In March 2019, the company discovered that an intruder had accessed and downloaded data pertaining to students and school officials. The company provided breach notices to the affected individuals but elected not to disclose the incident in its next SEC report; instead, the company’s report merely said, repeating prior disclosure statements, that a data breach could cause damage to customer experience and the company’s reputation. The SEC later alleged that the company “referred to a data privacy incident as a hypothetical risk, when, in fact, the 2018 cyber intrusion had already occurred.” The SEC also alleged that the company failed to disclose the incident in a subsequent media inquiry. The SEC settled administrative charges against the company in August 2021. The company agreed to take remedial steps and paid a $1 million civil penalty.
These enforcement actions against First American and Pearson underscore that cybersecurity-related disclosure issues are an important agency priority and that the SEC is prepared to take actions relating to cybersecurity disclosures.
On August 30, 2021, the agency announced settled administrative charges against eight broker dealers and investment advisors. The firms agreed to pay civil penalties to resolve the enforcement actions arising from cybersecurity incidents that led to the exposure of personally identifiable information of thousands of customers and clients. According to a September 1, 2021 memo from the Skadden law firm, these most recent enforcement actions, together with the prior cybersecurity disclosure-related enforcement actions, “signal that cybersecurity will continue to be a priority area for the SEC.”
The White House’s July 2021 Executive Order makes it clear that unfair competition and antitrust enforcement are going to be priorities for the Biden Administration. It seems likely that, as a result of the Executive Order, there will be increased antitrust oversight, scrutiny, and enforcement activity. These possibilities seem to present many companies with a heightened risk of legal action by regulators. These possibilities may also translate into an increased risk of D&O claims. In many antitrust enforcement actions and civil antitrust lawsuits, the main target, or one of the main targets, is going to be the company itself. Given that public company D&O policies typically provide insurance coverage for the corporate entity for securities claims only—and an antitrust enforcement action typically will not include an alleged violation of the securities laws—the policy will likely not respond to such actions.
One area where the D&O policy may be more responsive is in connection with civil actions that follow antitrust enforcement actions, particularly follow-on securities class action lawsuits. Some recent examples of securities class action activity following an antitrust enforcement include the securities suits filed against various generic drug businesses following civil and criminal charges based on alleged price-collusion in the industry. Similar securities litigation against companies in the poultry business also followed in the wake of price-collusion enforcement activity in that industry.
The initiatives in the Executive Order not only mean increased competition-related scrutiny, rulemaking, and enforcement, but the initiatives may also translate into increased risk of D&O claims activity.
Board Diversity Initiatives
In the wake of social unrest, many settled practices were subjected to scrutiny and concern. This scrutiny drew attention to the lack of diversity in many corporate board rooms. Board diversity questions have in turn led to legislation, regulatory actions and litigation.
The most specific legislative action addressing board diversity issues are two California bills that have been enacted into law: the 2018 California legislation requiring board gender diversity and the 2020 legislation mandating the inclusion of boards of California-headquartered companies of representatives from “underrepresented communities.” Both of these bills have been subjected to legal challenges, and in June 2021, the Ninth Circuit revived the previously dismissed legal challenge to the board gender diversity statute.
A development of even greater potential impact relates to the Nasdaq “comply or explain” board diversity guidelines, which the SEC approved in August 2021. Under the Nasdaq guidelines, each Nasdaq-listed company (other than Foreign Issuers, Smaller Reporting Companies, and Companies with Smaller Boards) is required, according to timetables specified in the guidelines, to have, or to explain why it does not have, at least two members of its board of directors who are “Diverse,” including at least one Diverse director who self-identifies as Female and at least one Diverse director who self-identifies as an Underrepresented Minority or LGBTQ+. The SEC-approved Nasdaq guidelines are also subject to legal challenge.
In addition to legislation and regulatory action, board diversity issues have also been the subject of litigation. In late 2020 and early 2021, the boards of ten companies were targeted by shareholder derivative suits in which the shareholder plaintiffs alleged that the board members breached their fiduciary duties by failing to elect or appoint diverse board members. These lawsuits have fared poorly. In 2021, courts granted motions to dismiss lawsuits filed against the boards of Facebook, The Gap, Oracle, the Danaher Corporation, NortonLifeLock and OPKO Health.
Although the California statutes and the Nasdaq guidelines have been subjected to legal challenges, and although the board diversity lawsuits have fared poorly so far, board diversity issues remain a high-profile issue and a concern for many companies.
Sexual Misconduct Allegations
Going back to 2017, when a plaintiff shareholder filed a shareholder derivative action against the board of 21st Century Fox (a suit that settled for $90 million the same day as the complaint was filed), there has been a series of D&O claims filed against companies who are alleged, or whose boards are alleged, to have permitted an atmosphere in which sexual misconduct was tolerated or to have misrepresented to investors the measures the company had taken to prevent or respond to misconduct.
Some of these earlier claims remain pending or have only recently been resolved. For example, in late July 2021, the parties to the L Brands shareholder derivative lawsuit, in which the plaintiffs alleged that the company’s senior management permitted a hostile work environment where women were demeaned or disadvantaged in terms of their pay and opportunities for promotion, agreed to settle the case for a payment of $90 million and the company’s agreement to adopt a number of remedial measures.
The securities class action lawsuit filed in August 2021 against the gaming company Activision Blizzard (Activision) suggests that the risk of these types of claims is continuing. In July 2021, Activision had been named as a defendant in a state court civil rights complaint by the California Department of Fair Housing and Employment (DHFE). In response, the company issued a statement saying that while it took allegations of misconduct seriously, the DFHE complaint was “meritless” and painted a “false” picture of the company’s past and does not accurately portray the company’s workplace. In response to Activision’s statement, over 2,000 current and former employees signed a petition saying that the company’s response was “abhorrent and insulting” and that the company’s characterization of the DFHE complaint as “meritless and irresponsible” was “simply unacceptable.” Activision workers staged a walkout. The company issued a statement apologizing for the “tone deaf” response to the DFHE complaint and a management shakeup ensued. The securities suit alleges that the company and senior management had failed to inform investors about the reality of its workplace environment and the risks it presented to the company’s reputation and for the possibility of regulatory action.
Even though it has been several years since the #MeToo movement first emerged, the Activision lawsuit shows that the risk of D&O claims arising out of allegations of sexual misconduct or harassment, or of a hostile workplace, continues.
Current Hard Market for D&O Insurance
The D&O insurance marketplace has been in a “hard market” for several years now—that is, a market in which insurance buyers face elevated premiums and retentions, lower available limits and potentially more restrictive coverage than in years past. The current hard market began in 2018, accelerated in 2019, and was further exacerbated by the coronavirus outbreak in early 2020. While there was some speculation at the end of last year that the hard market might start to reverse course by mid-year 2021, that has not happened.
While we unquestionably remain in a hard market for D&O insurance, there are signs that suggest that the market could move into the next phase of the cycle. For starters, price increases have started to moderate. Generally, pricing is continuing to increase, but the magnitude of the increases is decelerating. Another sign pointing toward a potential shift to the next phase in the cycle is the number of new entrants that have come into the marketplace in recent months. These new insurers (and the amount of fresh capital they bring to the market) could provide a healthy dose of competition. This process may already have started. There are some signs of easing on high attachment excess layers and on Excess Side A layers; the increased limits factors on these layers have—in some instances and for some accounts—lessened compared to earlier this year.
The D&O insurance business, like the insurance marketplace as a whole, is reliably cyclical, and inevitably, at some point, the cycle will change, and the market will start to soften. For now, though, the hard market continues. Most buyers continue to see price increases or at least prices at significantly elevated levels compared to the recent past. Most buyers continue to see significantly elevated retentions as well. Certain segments of the D&O insurance market, such as for companies conducting an IPO, SPAC offering or de-SPAC transaction, are disrupted, and coverage in those sectors is available only at higher premiums and retentions and potentially narrower coverage than in years past.
When the market will start to move into the next phase of the cycle is difficult to predict. It does seem likely that the current hard market for D&O insurance will continue at least for the rest of this year.
The disrupted market conditions mean that now, more than ever, policyholders need the assistance of an experienced and knowledgeable adviser for their D&O insurance placement. This is a time when specialized D&O insurance expertise and deep knowledge of the insurance market are indispensable.
This Article is provided for general information purposes only and represents RT ProExec’s opinion and observations on the Public D&O Market and does not constitute professional advice. No user should act on the basis of any material contained herein without obtaining professional advice specific to their situation.
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