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In 2012, "nearly all large U.S. M&A deals were challenged by the plaintiff's law firms." - Cornerstone Research

Critical Issue Report

D&O liability suits: Increasing the odds

Alarming litigious trends may impact D&O rates and availability

By Michael J. Moody, MBA, ARM

Corporations take a variety of approaches to fulfilling their strategic goals. One approach—mergers and acquisitions (M&A)—enables the acquiring organization to gain some strategic advantage, without investing the time and effort of starting a similar operation themselves.

Most mergers involve significant due diligence on the part of both parties. But despite this pre-merger activity, many mergers don't go well.

While M&A activity had slowed during the recent financial crisis, it appears that 2013 will be an active year. KPMG LLP is predicting increases due to companies holding record levels of "cash on hand," interest rates at historic lows, and a rebounding stock market. According to KPMG, "Despite many uncertainties, the current economic environment appears relatively resilient." As a result, they are optimistic about the "deal environment." Corporations must find better ways to deploy their cash, and acquisitions are one method of doing so.

Troubling trends

Despite the upbeat forecast, parties to a merger need to proceed with caution. Why? A recent report provided by Cornerstone Research, an organization that provides information to the legal profession, indicates that in 2012, "nearly all large U.S. M&A deals were challenged by the plaintiff's law firms." According to their research, "Lawsuits on behalf of shareholders were filed in 96% of M&A deals valued over $500 million and 93% of transactions valued over $100 million." The results of their study were reported in "Shareholder Litigation Involving Mergers and Acquisitions."

As the Cornerstone report states, it seems unlikely that "96% of target boards did a bad job selling the firm." They reason that plaintiffs are beginning to file where there are no underlying problems. The Cornerstone Research documented that it is not shoddy due diligence on the part of the boards or management. Rather, it is a troubling trend that involves plaintiffs' legal representatives. Insurance and legal experts alike agree that this alarming increase in M&A litigation is due to the large attorney's fees that are typically part of the settlements.

More specifically, when Cornerstone looked at all of the M&A suits filed between 2010 and 2011 (and resolved before March 2012), it found that none went to trial. However, 67% of these cases were settled and 28% were voluntarily dismissed, while 5% were dismissed on their merits. These are important numbers when you consider that Cornerstone estimates that the average legal fee reported for these cases was $1.2 million, regardless of any monies that went to the shareholders. They indicate that by far the most common settlement over that period resulted in additional disclosures to the financial statements of the company being acquired and no cash payout to shareholders.

Concern from the insurance industry

For years, D&O underwriters focused much of their attention on federal securities class action suits as their primary problem area. This situation is changing rapidly as more D&O underwriters are coming to the realization that litigation arising from M&A activity is their number one concern. Today, with the frequency of these types of claims on the rise, underwriters are paying much more attention to this litigious environment. One of the most difficult challenges in developing a loss mitigation strategy is that a single transaction often turns out to yield multiple claims that are filed in several different jurisdictions, thus adding to the overall defense expense.

The D&O insurance industry is painfully aware of this problem; however, there are few immediate resolutions to the issue. There has been a proposal put forth by the U.S. Chamber Institute for Legal Reform as well as the Bar of the City of New York. In essence, the proposal—which would require litigation at both the federal and state levels—would attack the problem from several directions.

First they would deal with the number one issue surrounding this matter—that of multiple files in different jurisdictions. The Chamber Institute recommends that the various state laws that allow for lawsuits arising out of M&A activities against companies and their officers and directors must be filed in the company's state of incorporation.

Since it is estimated that about two-thirds of all large corporations are incorporated in Delaware, one would expect the plaintiffs' attorneys would be more reluctant to file suit there, since it is noted for its business-friendly environment.

Without radical changes in the way that M&A litigation is handled, underwriters will be forced to make significant changes in their offerings. Rate increases have already begun to be seen. If changes are not made, steeper rate increases can be expected. Further, limits and scope of coverage will also be modified to deal with the problem. It is not out of the question that, without changes in state and federal laws, underwriters will begin to exclude coverage for M&A activities. While this would not happen overnight, it certainly could impact 2014 renewals.

Conclusion

The last half dozen years have seen significant changes in the D&O liability insurance market, all to the advantage of the corporate insurance buyer. Premiums for D&O coverage have been falling or at best stayed flat, while the limits of liability have been increasing and the scope of coverage has been expanded. During this time frame, underwriters have done a good job maintaining D&O as a profitable line of coverage for their companies. This, however, could come to an abrupt halt, should the defense costs associated with M&A claims continue to escalate.

It's pretty clear that the M&A deals will continue, at least for the next few years. One of the key parts of any M&A activity is the availability of appropriate D&O liability coverage. It is now time for the insurance and legal professions to come together and resolve this situation, before serious consequences occur with regards to D&O coverage. It is time to free plaintiffs' counsels that are involved with these frivolous lawsuits that are based on nothing more than groundless claims, so that they can return to chasing ambulances and other worthy endeavors.

The author

Michael J. Moody, MBA, ARM, retired as the managing director of Strategic Risk Financing, Inc. (SuRF), a firm that had been established to advance the practice of enterprise risk management. As a regular columnist, he continues to actively promote the concept of enterprise risk management by providing current, objective information about the concept, the structures being used, and the players involved.

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