Carriers and brokers selling Side-A directors and officersliability insurance coverage by delivering warnings about theincreasing severity of shareholder derivative lawsuits may beoverstating the trend, according to one attorney involved in amajor case.

“I don't think it's all of a sudden going to open thefloodgates, said Mark Lebovitch, a plaintiffs' lawyer for BernsteinLitowitz Berger & Grossmann LLP in New York, referring to ashareholder derivative action brought by Amalgamated Bank and othershareholders late last year against directors and officers of NewYork-based Pfizer, a large pharmaceutical company.

The stakes in the case arepotentially high, with the derivative lawsuit filing coming in thewake of a $2.3 billion settlement with the government arising fromwhat the U.S. Department of Justice found to be fraudulent andcriminal promotional activities used to sell 13 of Pfizer's mostimportant drugs.

Mr. Lebovitch's law firm is serving as counsel for the leadplaintiff, Amalgamated, and filing documents included on the lawfirm's Web site set forth allegations that defendants violatedfederal laws and breached their fiduciary duties by sanctioningillegal drug sales–through activities that included marketingoff-label uses and offering kickbacks to doctors.

The complaint filed in the Southern District of New York notedthat Pfizer's alleged activities over a multiyear period not onlyresulted in the largest civil fraud settlement against a drugcompany and the largest criminal fine ever imposed in the UnitedStates for any matter, but that it caused tremendous relateddamages to the company–including legal expenses for privateconsumer actions, whistleblower lawsuits, as well as reputationaldamages.

Citing the possibility that further illegal activity could meanPfizer would be barred from federal programs such as Medicare andMedicaid, the filing says that “immediate intervention is needed”to change the recurring bad behavior by Pfizer executives that itexplained had been repeatedly overlooked by Pfizer directors.

Ivan Dolowich, a partner with Kaufman Dolowich Voluck &Gonzo LLP in New York, introduced a discussion of the case–and thepotential worrisome trends it might represent for D&Oinsurers–during a session of the international conference of theMinneapolis-based Professional Liability Underwriting Society latelast year.

“Most of us understand derivative cases to be 'follow-ons' totraditional securities class actions,” Mr. Dolowich said. He wasreferring to the commonly accepted notion that plaintiffs' lawyerspursue derivative cases as an additional, but lesser source ofrevenue to federal securities fraud class-action filings–an ideaexpressed frequently at prior PLUS conferences by both plaintiffand defense lawyers.

In contrast, “it seems like this [Pfizer] case could bethe start of a shift in terms of severity,” Mr. Dolowich said,going on to ask Mr. Lebovitch if he views derivative litigation asa “fertile area” for plaintiffs' lawyers–separate and apart fromthose filed as class-action tagalongs.

Mr. Lebovitch said he did not. “I don't believe there should bedozens of derivative cases. I think for the most part they're notworth litigating. However, there are very good instances whereinvestors should step in,” he said, referring to the Pfizercase.

Too many times, corporate lawyers and advisors predict “theworld is coming to an end if so and so happens [and] directors areheld liable,” noted Mr. Lebovitch, commenting on recent predictionssuggesting that plaintiffs lawyers are becoming increasinglyfocused on derivative suits and that derivative-suit settlementsare trending higher.

“I don't think that every ruling that says a director did thewrong thing…portends a fundamental shift in our capitalist system,”he said.

He noted that his firm typicallyrepresents large institutions as plaintiffs, explaining that suchinstitutions file derivative suits to change behavior of corporateexecutives and directors that is damaging to the company, toinstitute meaningful corporate governance reforms, or to setexamples for the overall market.

Mr. Lebovitch made his remarks days before his firm filed anamended complaint against Pfizer and minutes after other speakerson the PLUS panel commented on the D&O insurance implicationsof the settlement of another derivative lawsuit–the $118 millionAugust 2009 settlement in the Broadcom case, a derivative suitarising from allegations of stock-option backdating.

SIDE A RESPONDS

As in any derivative suit, the shareholder plaintiffs bringingthe Pfizer and Broadcom actions sued the directors and officers “inthe name and for the benefit of” the company in which they holdshares, alleging harm done to the company through breaches ofvarious duties.

D&O insurance experts explain that because plaintiffs inderivative actions sue directors and officers “on behalf of thecompany,” it is illegal in many states for the company to thenindemnify directors and officers for derivative suit losses.

In an article published in NU in 2004, Dan Bailey, anattorney and coverage expert for the Columbus, Ohio-based law firmBailey Cavilieri, explained the prohibition in the followingway.

He said that in a derivative suit, “effectively, the company isasserting the claim, although the shareholder is prosecuting itagainst directors and officers.” Since that means that anysettlement or judgment gets paid by the directors and officers backinto the company rather than to the shareholder plaintiff, if thecompany could indemnify for such payments, “the money would go in acircle,” he said.

But statutes do allow companies to purchase insurance to protectdirectors and officers in these instances. Derivative suit lossestypically implicate the Side-A coverage part of D&O insurancepolicies or separate Side-A-only policies–both of which coverindividual directors and officers for non-indemnifiable losses.

Besides being non-indemnifiable as a matter of law, as in thecase of derivative lawsuits, D&O losses can also benon-indemnifiable when a company is insolvent.

Excess Side-A-only carriers contributed $45 million to theBroadcom settlement, according to Steven White, vice president ofexecutive assurance claims for Arch Insurance Company in New York,another panelist at the PLUS session.

Broadcom was one of a handful of backdating cases that hadparticularly bad facts alleging that defendants intentionallymanipulated certain stock option grant dates to enrich themselvesat the expense of their companies and shareholders–facts thatresulted in restatements, severe shareholder class actions, andultimately large shareholder derivative claim payouts as well, Mr.White said.

For the most part, the backdating cases represented a frequencyissue rather than large severe settlements like Broadcom, accordingto Mr. White. The bulk of the backdating suits were filed solely asshareholder derivative suits because the stocks of the companiesdidn't really drop when companies reported issues with stock optionbackdating, and they settled quickly and for smaller amounts.

Larger derivative-suit settlements like the one in Broadcom,however, threaten Side-A towers and open the eyes of plaintiffs'lawyers, Mr. White suggested.

“In that case, you had an A-B-C tower of $100 million and youhad an A-tower on top of that. Damages were so enormous that theygot into that upper layer,” he explained.

“Now you have some real Side-A claims being paid,” he continued,noting that the Side-A tower was “a real benefit to the Ds and Oswho were being insured.”

Last week, Kevin LaCroix, a broker for Oakbridge InsuranceServices in Beechwood, Ohio, and the author of the “D&O Diary”blog (www.dandodiary.com/), highlightedthe Broadcom settlement as the “first instance outside of aninsolvency” in which excess Side-A insurers were called upon tocontribute significantly toward a settlement.

Mr. LaCroix, who offered his observations during a review ofsecurities litigation trends on a Webinar hosted by New York-basedAdvisen, advised brokers and insurers that the Broadcom situationis “something to talk about with your clients,” identifyingcoverage of the settlement as “an important real-world example touse” to emphasize the benefits of Side-A coverage.

“There have only been a handful of large [derivative]settlements, but they are all fairly recent,” Mr. LaCroix said.

In a Sept. 1, 2009 entry on his blog, Mr. LaCroix also cited a$900 million derivative settlement for UnitedHealth Group in abackdating case, and a $115 million settlement in a derivative suitagainst American International Group to underscore the trend towardhigher payouts. The same blog item also revealed that plaintiffs'attorneys netted $11.5 million in fees in connection with theBroadcom settlement.

Numbers like that last figure are “incentivizing the plaintiffs'bar,” Mr. White said during the PLUS conference, adding that theplaintiffs' fee awards for derivative suits “don't quite align withthe securities class-action awards, but they're getting there.”

In this regard, “the legacy” of the stock-option backdatingcases continues to live on even though the backdating issues havenow died out, he said.

Mr. Lebovitch agreed that “the era of the options backdating–ofdozens of derivative suits being filed everyday–is gone.”

“Options backdating was just a unique situation in history wherethere was a broad, industrywide moral failing,” he said, assertingthat once the practice was revealed, nearly everyone involvedrealized how wrong it was.

For the most part, then, Mr. Lebovitch's firm did not filederivative actions related to backdating activities. “However,there are very good instances where investors should step in” andfile derivative cases, he said, going on review the allegations ofthe Pfizer complaint.

ACCOUNTABILITY SOUGHT

“I think there are times when it's good to hold peopleaccountable for what they did–to make examples of people. That willsend a better message than a fear of ever holding directorsresponsible because then the foundations of the business judgmentrule [might be] eroded,” Mr. Lebovitch told D&O underwriters atthe PLUS conference.

Throughout the session, the lawyer and other panelistsrepeatedly referred to the “business judgment rule”–a legal conceptthat essentially protects directors from liability if they performtheir duties in good faith, while being mindful of protecting theinterests of the corporation–saying that the rule is “alive andwell” and that it protects directors and officers 99 percent of thetime.

But the rule “does not protect the judgment to engage inunlawful conduct,” according to Mr. Lebovitch, who said “that's whywe filed the lawsuit” against Pfizer's directors andofficers–noting that Pfizer was fined several times since 2002 forsimilar offenses but continued to engage in what he calledreprehensible behavior.

The government also repeatedly imposed “corporate integrityagreements” requiring semiannual reports to the board about effortsto comply with federal marketing laws, he said.

Pfizer's recurring violations in light of these agreementssuggests that board members decided to “essentially gamble with anefficient breach of criminal laws”–in other words, to make a betthat the fines that would be imposed on the company for continuedillegal marketing activities would be small in comparison to therevenues netted from engaging in those activities, heexplained.

Mr. Lebovitch quoted Judge Douglas Woodlock–a district courtjudge in Massachusetts who presided over a Pfizer sentencinghearing last October–to underscore the need for personalaccountability in such cases.

While the judge said he was aware of the government's claim thatthe sentence amounted to the largest criminal fine ever imposed, headded that “the problem with sentencing a corporation is that ithas no soul to damn nor body to kick.”

The corporation pleaded guilty, but the judge said he wasuncomfortable with the fact that no individual was held accountablewhen the corporation paid its $2.3 billion fine.

“You can understand why big investors like Amalgamated Bankstepped up,” filing a derivative suit to essentially say “someindividual should be held accountable,” Mr. Lebovitch said.

Ric Marshall, chief analyst for The Corporate Library inPortland, Maine, a firm that analyzes and rates corporategovernance practices, assessed Pfizer's activities as an “outlier”in corporate America.

“It's like Madoff. This is not the way business normallyhappens, but it is an extreme case–and an extreme case on a levelthat should really cause us all to think hard about the rights thatwe give to corporations,” Mr. Marshall said, noting that duringmuch of the period in question, Pfizer's chief executive served aschair of the Business Roundtable–an association of CEOs of leadingU.S. companies.

“We need to think really hard about the fact that corporationscan become so powerful,” Mr. Marshall said. “There's no such thingas a capital crime for corporations. We can't send them to theelectric chair.”