Ill-gotten gains, hackers and Robocop as well as the U.S. Supreme Court’s continuing interest in securities class action litigation; the US landscape is never dull. This article takes a look at some of the trends that emerged in 2014 and what may be on the horizon in 2015.
Following the numerous sizeable and highly publicized data breaches taking place in 2014, including at Target, Michaels, Ebay, JP Morgan and several other banks, Home Depot and, of course, Sony Pictures, there can be little doubt that cyber risks are a major concern for US regulators, lawmakers and corporate America. The cost to prevent, respond and mitigate against cyber attacks is significant and rising, and the common view is that it is not a matter of if, but when, a company will be targeted by hackers.
Cyber risks are, perhaps unsurprisingly, under increasing scrutiny by federal and state regulators in the U.S. In 2015, we can expect more regulatory actions against companies that have incurred a data breach.
Companies that have a data breach must comply with a complex web of regulations. 46 states and the District of Columbia currently have notification laws that apply in the event of a data breach, and which states’ laws will apply is determined by the residence of the individual whose information was taken. In addition, a number of federal statutes apply in this area and new federal legislation is expected this year. All this means that companies must often navigate through multiple laws following a data breach and may be subject to exposure for failing to properly comply with applicable regulations.
Public companies and their directors and officers (D&Os) may also face exposure to regulators if they fail to properly address and disclose cyber risks in their public filings. The sufficiency of cyber disclosures has already been the subject of an SEC guidance issued in October 2011 regarding when a public company is required under current rules governing SEC filings to disclose cyber risks to the company’s operations, liquidity and financial condition. The SEC’s guidance specified what a company should disclose regarding known and potential cyber risks, including a description of its relevant insurance coverage.
A company’s failure to follow this guidance could lead to regulatory action.
In addition to regulatory action, companies and their D&Os may face an increasing amount of shareholder litigation following a breach. At least for the near future, shareholder lawsuits will likely be in the form of shareholder derivative actions brought on behalf of the company against its D&Os.
To date, a number of cyber-related derivative actions have been filed, including cases against Target and Wyndham D&Os. In those cases, shareholders allege that the D&Os breached their fiduciary duties of care and loyalty, and wasted corporate assets by failing to take reasonable steps to protect customer information, implement sufficient controls and caused the company to conceal breaches from investors and customers. If the D&Os failed to implement sufficient systems and consciously oversee the company’s operations, they could be found liable for harm to the company.
However, shareholders will face a number of formidable hurdles in pursuing derivative actions. For example, the business judgment rule protects a director’s informed and good faith decision unless there is no rational business purpose. Also, shareholders must first make a demand that the board take action against the D&Os and show bad faith if that demand is declined. These are difficult standards for shareholders to meet in many cases.
In a recent decision in the Wyndam derivative action, the court found that the board’s refusal of a shareholder’s demand was protected by the business judgment rule. The board had implemented a cyber security program before the breach, and it had made an informed decision to reject the shareholder demand. Thus, at a minimum, D&Os must implement sound reporting and control systems regarding cyber risks to avoid liability following a data breach.
The plaintiff securities bar certainly has its eye on cyber risks, but to date there have been few securities class actions following a cyber breach. This is likely because in most cases, there has not been a statistically significant stock drop after disclosure of a breach. However, as cyber attacks increase in number and severity, and the markets begin to better understand and appreciate their impact on public companies, stock prices may react more strongly to such news and investors may sue.
US Business Litigation Trends
During 2014, the US economy strengthened, the stock markets rose and business litigation receded to numbers not seen since well before the subprime/credit crunch crisis in 2007-2008. The number of new filings as well as average settlement amounts decreased for most types of business lawsuits.
The 170 new securities class actions filings in 2014 was slightly above the 167 cases filed in 2013, which is well below the average annual filings of 189 since 1997. The average settlement in such actions also dropped significantly from $55 million in 2013 to $34 million in 2014. It is important to keep in mind, however, that there were almost twice as many public companies in the US in 1998, so it is actually more likely now that companies trading on a US exchange will be sued.
There were no new major filing trends in 2014, and previous trends such as Chinese reverse mergers and subprime lawsuits, appear to have run their course.
The number of new shareholder derivative actions also fell to 164 in 2014, which is well below the annual average of 233 over the past 10 years. The number of derivative settlements is also down substantially, although we have seen some noteworthy settlement payments in the past few years, including a $275 million payment to resolve the Activision shareholder action in December 2014.
While the litigation picture therefore looks fairly rosy by US standards, there are a number of trends to watch which could significantly increase FI/D&O exposures, particularly if the economy and stock markets take a turn for the worse, as they are bound to do.
First, the number of foreign companies sued in US courts continues to go up, despite the U.S. Supreme Court’s 2010 ruling in Morrison v. National Australia Bank, which held that that the U.S. securities laws do not apply extraterritorially to so-called F-cubed plaintiffs. Plaintiffs continue to target companies issuing American Depository Receipts in the US markets, and Chinese and European companies were a particular focus this past year.
Another trend to watch is the potential rise in IPO securities class actions. The number of US IPOs in 2014 was higher than since 2000 (at the end of the tech bubble). We might be seeing the same kind of irrational exuberance in the markets that led to a record number of 309 IPO securities class actions in the early 2000s. If a company’s share price falls after an IPO, investors may sue, as they did following Alibaba’s September 2014 US IPO. These types of cases often have a lower pleading standard and may be harder to dismiss at an early stage.
More positively, fee-shifting provisions in corporate bylaws could have a dampening effect on shareholder derivative lawsuits by requiring non-prevailing parties in intra corporate lawsuits to pay attorneys’ fees and costs. However, we may see new legislation that limits or precludes such provisions this year.
Finally, the US Supreme Court continues to take an active interest in securities class actions and has issued a number of decisions favorable to defendants in the past few years. In June 2014, however, in Halliburton Co v Erica P John Fund Inc., the Supreme Court declined to overturn the fraud on the market doctrine and the presumption of reliance for 10(b) misrepresentation cases. This decision has not been the “game changer” defendants had hoped for, and it has had a relatively limited impact to date. However, a March 2015 decision in Omnicare Inc. v. The Laborers District Council Construction Industry Pension Fund could have a more significant impact on claims brought under Section 11 of the Securities Act of 1933, which may be on the rise due to the increasing numbers of IPOs. In Omnicare, the Court vacated a ruling (with the effect that the judgment was rendered void) that a Section 11 plaintiff need only allege that an opinion was “objectively false”, regardless of the issuer’s understanding at the time the statement was made. That court held that a statement of opinion in a registration statement may not support Section 11 liability merely because it is ultimately found incorrect, and an issuer may be held liable under Section 11 for an opinion in a registration statement if the issuer did not hold the professed belief or failed to disclose material facts about the basis for the opinion that rendered it misleading.
Continuing Regulatory Aggression
Increasing regulatory aggression remains an enduring theme and we continue to see exposures not only with respect to the high costs involved in responding to regulatory actions, but also from follow on shareholder litigation.
The SEC’s 2014 report shows that it filed 755 enforcement actions, up from 686 the year before. These high numbers are largely the result of the expanded powers and resources given to regulators in the aftermath of the subprime crisis, including the SEC’s very successful whistleblower program, new technological tools to detect fraud such as the SEC’s Accounting Quality Model or “Robocop” initiative, and the continuing aggressive enforcement of the FCPA, money laundering and insider trading laws.
A number of recurring coverage issues impacting claims under FI/D&O policies were addressed by US courts in 2014.
For example, recent decisions have addressed coverage for settlement payments to resolve regulatory and civil claims for disgorgement or restitution. It is well-established under US law that the return of ill-gotten gain is uninsurable under applicable public policy rules or simply does not constitute insurable “damages” or a “loss’ as those terms are used in an insurable policy. In some recent decisions, however, US courts have held that coverage might be available for such settlement payments if the insurer could not conclusively establish that the payment constituted the insured’s return of ill-gotten gain it actually received, rather than the insured’s payment to resolve its liability for funds obtained by a third party.
Another increasingly common coverage issue is whether multiple actions or investigations are interrelated and therefore constitute a single claim in the policy period when the first claim was made. In Biochemics v. Axis, the District Court of Massachusetts held in January 2015 that there was no coverage under a D&O policy for an SEC investigation and action as the insured company was served with a subpoena before the policy period. In W.C. and A.N. Miller Development v. Continental, the District Court of Maryland found in November 2014 that a 2010 action to enforce a judgment was interrelated with a 2006 adversary action and therefore the claim was not first made in the 2010 policy period.
Further, coverage issues often arise in the context of bankruptcy actions. For example, in the MF Global bankruptcy case, a New York bankruptcy court held in September 2014 that D&O policy proceeds were not assets of the estate and therefore could be accessed by the D&Os. The court reasoned that when a policy provides direct coverage to a debtor, the proceeds are property of the estate, but when a policy covers D&Os exclusively, the proceeds are not.