Many small-cap companies–those with the lowest levels of market capitalization–are currently facing a Catch-22 situation that impacts members of their boards of directors.
They need to find ways to cut costs in these tough economic times and yet, when they cut back on or eliminate their directors and officers liability insurance policies, they risk not having a quality board of directors and they put their company's finances in jeopardy.
Since the implementation of Sarbanes-Oxley, holding a position on a company's board of directors has become an even more challenging task. Today, increased scrutiny from shareholders, the plaintiffs' bar and active regulatory oversight has resulted in increased exposure to liability and attracting qualified board members has become very difficult.
Yet, many small-cap companies continue to reduce D&O limits, expressing confidence that their executives will not be dragged into securities litigation. They maintain that, as small operations, their companies are better positioned than larger ones to keep a firm grip on governance controls.
Managements of these smaller firms reason that governance controls will mitigate any problem that could foster a securities claim.
Unfortunately, such reasoning is not foolproof. Even if company controls are infallible, frivolous lawsuits are still a possibility. Unwarranted claims can generate significant legal costs and lead to nuisance settlements in order to resolve the claim as quickly and cheaply as possible.
Managements at smaller companies may also be lulled into a false sense of security, believing their typically tight-knit group of investors often made up of family and friends would never launch a securities fraud lawsuit. However, the nature of relationships can change, creating issues within the group that lead to litigation as a means to resolving internal conflicts.
Would a disgruntled family member be less likely to file a claim than any other investor or employee?
Statistics show that small and midsize companies are especially vulnerable to an uninsured, or underinsured, D&O loss.
Consider these findings, based on research by the Stanford Law School Securities Class Action Clearinghouse in cooperation with Cornerstone Research, with additional analysis by Carpenter Moore Insurance Services Inc. (Securities Class Action Settlements: 2008 Review and Analysis, published in March 2009):
o Of the 521 securities lawsuits settled from 2004 through 2008, 239 or 46 percent targeted companies with market caps of less than $500 million.
o Those cases were resolved for $7.1 million on average, with a median settlement of $3.9 million. However, it is important to note that over 5 percent of these cases settled for $20-to-$50 million.
o Almost 70 percent of settled cases included Generally Accepted Accounting Principles allegations, one of the highest proportions in all post-Reform Act years.
The report goes on to state that an "unprecedented wave of securities class action lawsuits filed against firms in the financial sector occurred during 2008," with the "majority of these case filings related to the subprime liquidity crisis."
The report concludes by stating that "given the recent stock market decline, securities class action filings in 2008 have returned to levels well above the 10-year average."
While the stock market currently seems to be on the rebound, from September of 2008 through February of 2009 the stock market experienced unprecedented volatility, losing more than 40 percent of its value. Because of the long-tail nature of D&O claims, this volatility remains a viable threat. And there is concern within the markets that commercial real estate, unemployment, home foreclosures and corporate bankruptcies have not yet hit bottom.
Although financial institutions appear to be the predominant focus of the plaintiffs' bar, history suggests other industries may become the target of future litigation once these attorneys have exhausted the bulk of lucrative settlements from the financial sector. Therefore, companies within other sectors are certainly not immune from future litigation. As a result, going without D&O insurance represents a risky move for virtually any company in any industry that may catch a plaintiffs' attorneys' interest.
Even some coverage reduction alternatives that companies are considering in lieu of complete coverage elimination have pitfalls. For example, companies may consider expanding the indemnification provisions within company by-laws. However, the downside to this action is that legal restrictions would bar indemnification by companies that are in bankruptcy or facing derivative-action claims, leaving the executives to fend for themselves.
Another alternative companies consider may be to purchase reduced limits to cut expenses, but this carries the risk of depleting valuable financial resources when litigation costs far exceed reduced insurance coverage.
Additionally, D&O insurance buyers should understand that their decision to trim policy limits is not one they can easily reverse, until their coverage renews in 12 months. Many insurers would become suspicious in such a change of plans, viewing it much like an attempt to insure the front of a building that is ablaze in back.
Insurers that would agree to provide additional limits midterm likely would insist on a warranty that there is no reason to suspect a claim is pending. Depending on the jurisdiction, the policyholder might have to bear the cost of fighting a coverage denial and may ultimately have to settle its coverage dispute for a fraction of its additional limits.
As companies face some tough cost-cutting decisions, reducing or eliminating D&O coverage may appear to be a viable option as a means to reduce expenses in today's economic environment. However, such an action could create some extraordinarily tough problems ahead.
By keeping coverage in place during a soft market, companies are more likely to receive good terms and conditions and potentially build a strong carrier relationship creating marked advantages when the market once again hardens.
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