Shareholder litigation and class action suits play a key role in protecting investors and regulating big businesses. But Directors and Officers liability insurance shields corporations and their managers from the financial consequences of many illegal acts, as evidenced by the recent Enron scandal and many of last year’s corporate financial meltdowns. Ensuring Corporate Misconduct demonstrates for the first time how corporations use insurance to avoid responsibility for corporate misconduct, dangerously undermining the impact of securities laws.
As Tom Baker and Sean J. Griffith demonstrate, this need not be the case. Opening up the formerly closed world of corporate insurance, the authors interviewed people from every part of the industry in order to show the different instances where insurance companies could step in and play a constructive role in strengthening corporate governance—yet currently do not. Ensuring Corporate Misconduct concludes with a set of readily implementable reforms that could significantly rehabilitate the system.
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About the Author
Tom Baker is professor of law at the University of Pennsylvania and the author of several books, including The Medical Malpractice Myth, also published by the University of Chicago Press. Sean J. Griffith is the T. J. Maloney Professor of Business Law at Fordham University.
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Ensuring Corporate MisconductHow Liability Insurance Undermines Shareholder Litigation
By TOM BAKER SEAN J. GRIFFITH
THE UNIVERSITY OF CHICAGO PRESSCopyright © 2010 The University of Chicago
All right reserved.
Financial crises present opportunities for introspection. Beyond the initial concern over what happened and why, they present an opportunity to reflect on the regulatory framework as a whole and to consider the effectiveness of each element of the law affecting business, to ask what aspects of the regulatory structure work well and what aspects may benefit from some correction. In this book, we take the opportunity afforded by the recent financial crisis to reflect on the effectiveness of shareholder litigation in regulating corporate conduct.
Shareholder litigation forms an important part of the structure of law and regulation affecting American business. Because public regulators cannot oversee every company at every moment and cannot anticipate or even respond to every report of a potential wrong, a variety of remedies are left in the hands of shareholders themselves. Shareholders who have suffered at the hands of a corporation in which they have invested can sue—either as a class or on behalf of the company itself—to right these wrongs. They thus assume, with their counsel, the role of "private attorneys general," with strong personal incentives to detect and prosecute corporate wrongdoing. The lawsuits they bring fill an important gap in the regulatory framework affecting American business.
Shareholder litigation exerts its regulatory effect through the mechanism of deterrence. That is, prospective wrongdoers realize, through the threat of litigation, that they will be made to account for whatever harms they cause and, thus internalizing the cost of their conduct, forswear bad acts. This basic mechanism of deterrence explains much civil litigation. Corporate officers and directors, understanding that they may be held liable to their investors for the harms they cause, refrain from engaging in conduct that will harm investors and induce them to sue. In this way, shareholder litigation regulates corporate conduct.
The problem with this story in the corporate context is that officers and directors are typically covered under a form of insurance, known as "Directors' and Officers' Liability Insurance" or "D&O insurance," that insulates them from personal liability in the event of shareholder litigation. D&O insurance also protects the corporation itself from liabilities it may have in connection with shareholder litigation. This insurance disrupts the deterrence mechanism by transferring the obligations of the prospective bad actor (the officer, director, or the corporation itself) to a third-party payer (the insurer). An actor that is no longer forced to internalize the costs of its actions is no longer deterred from engaging in harmful conduct—managers who are no longer personally at risk for investor losses are less likely to take care in avoiding them, and corporations that are no longer at risk from shareholder litigation are less likely to monitor the conduct of their managers—and the regulatory effect of shareholder litigation is diminished, distorted, or destroyed.
Unless, that is, the insurer does something to prevent this outcome. The introduction of D&O insurance essentially establishes the D&O insurer as a third-party intermediary in the regulatory dynamic. If shareholder litigation is to deter bad corporate acts, it must be through the intermediary agency of D&O insurers who will have an opportunity to influence corporate conduct through the insurance relationship. Because they are the ones ultimately paying for the harms caused by their corporate insureds, insurers have ample incentive to exert this sort of constraining influence, and they have the means to do so. We identify three ways in which the insurance relationship may influence corporate conduct—through underwriting, monitoring, and the settlement of claims. The question thus becomes what influence D&O insurers do in fact exert through this relationship and whether this influence is sufficient to reintroduce the deterrence mechanism, thus preserving the effectiveness of shareholder litigation as a regulatory device.
There is a lot riding on this question. Indeed, if D&O insurers fail to preserve the deterrence mechanism, then shareholder litigation would seem to have little chance of regulating corporate conduct and thus would appear to be, as critics have long contended, mere waste, a tax on business that supports an unnecessary plaintiffs' bar. In order to answer this question then, we must examine corporate and securities law through the lens of liability insurance.
That is precisely what this book seeks to do. In the pages that follow, we examine shareholder litigation through the lens of liability insurance in order to evaluate whether shareholder litigation accomplishes its regulatory objective. Through extensive interviews with professionals working in this area, we analyze each of these three ways in which insurers may preserve the deterrence function of shareholder litigation and we evaluate how well each works in achieving that end. The short answer, unfortunately, is not very well. As it is currently structured, D&O insurance significantly erodes the deterrent effect of shareholder litigation, thereby undermining its effectiveness as a form of regulation. The situation is not without hope, however, and we end by offering three narrowly tailored corrections that a rule maker such as the Securities and Exchange Commission (SEC) might enact to rehabilitate the deterrent effect of shareholder litigation, notwithstanding the presence of liability insurance.
But this brief preview of the analysis to come has taken much for granted. From this point onward we will be more careful. In the remainder of this chapter, we explain our assumptions and define some of the terms that we will use throughout the book. We also describe our empirical methodology and lay out, in some detail, the questions that we will confront in each chapter. Finally, we preview our policy prescriptions, recommending relatively simple reforms of SEC rules in order to prevent D&O insurance from subverting the deterrence function of securities litigation.
Throughout this book, we use the term "shareholder litigation" to encompass all civil actions brought by current or former shareholders of a corporation against the corporation or its managers for losses the shareholders have suffered as a result of actions taken by the corporation or its managers. This definition excludes criminal actions brought by prosecutors or other public authorities as well as enforcement actions brought by regulatory agencies, such as the SEC. It includes, principally, claims brought by shareholders under either federal securities law or state corporate law.
Among these claims, securities class actions represent, by far, the largest potential source of liability. Shareholders filed 10 federal securities class actions in 008, thirty-three more than they had filed in 007 and eighteen more than the average number of class actions filed per year from 1997 through 2007. Allegations in 94 percent of these claims were centered on misrepresentations in financial statements. In 2008, 2.23 percent of all companies listed on the NYSE, Nasdaq, and Amex at the beginning of the year became defendants in securities class actions filed later that year, down from 2.32 percent the year before and in line with the 2.24 percent average going back to 1997. These numbers are somewhat higher for Standard and Poor's 500 companies, 9.2 percent of which were sued in a securities class action in 008, up from 5.2 percent in 2007 and the highest since 12.0 percent were sued in 2002.
In securities class actions, current or former shareholders are given the right to sue the corporation collectively for misrepresentations that allegedly induced the shareholders to trade. The allegations underlying such claims typically revolve around misrepresentations in financial documents or in the company's projections concerning future results. Shareholders who trade on the basis of this false information suffer losses when the market price of the security reverts to its "true" underlying value—that is, the price at which a trade might have occurred had it not been for the false information released by the defendants. Securities law thus gives investors the right to sue for this difference in price, which can grow to extremely large amounts once aggregated over the total number of shares transacted during the period of the misrepresentation.
In addition to federal securities class actions, shareholder claims can be brought against corporate defendants under state corporate law. These actions may be representative in form, as when a class of shareholders is deprived of a right, such as voting, that the shareholders possess in common, or they may take the form of shareholder derivative suits when the underlying harm is suffered primarily by the corporation itself and only derivatively by the shareholders, such as when a manager is vastly overcompensated or otherwise wastes corporate funds. Individual or representative claims brought under state corporate law often seek injunctive relief—for example, an order enjoining an unfair reorganization or requiring the board of directors to solicit additional bids in a merger transaction. Derivative suits, by contrast, are most often brought seeking damages. The damages in derivative suits, however, are limited to losses caused by the underlying misconduct—the amount of loss suffered by the corporation, for example, in overpaying its managers or in wasting assets in a particular transaction—not to losses measured by share price fluctuations. Therefore, damages in derivative suits typically do not grow to the size of losses alleged in securities litigation. Additionally, a number of substantive rules and procedural requirements operate as barriers to recovery in derivative suits. As a result, state corporate law litigation is often viewed as secondary to securities law claims. Indeed the phenomenon of the "tagalong derivative suit," discussed in chapter 2, illustrates the way in which state corporate law claims often follow in the wake of more significant federal claims.
Regardless of how state corporate law and federal securities law claims compare in terms of relative importance, for purposes of this research we treat the two basic types of claims together under the rubric of shareholder litigation. Both types of claims feature shareholders seeking relief from the corporation or its managers for investment loss. Both types of claims principally involve monetary damages, not administrative sanctions or criminal penalties. And both types of claims focus on misconduct by the corporation or its managers leading to losses suffered by shareholders. Not all aspects of these claims are identical, and going forward we will be careful to make the distinction when an argument or line of analysis applies to one but not the other. Nevertheless, the claims seem to share the same basic functions, of both compensating shareholders for losses suffered at the hands of the corporation's managers and deterring conduct that might cause such losses in the first place.
This leads us to consider the regulatory function of shareholder litigation. What, in the larger picture, is shareholder litigation meant to accomplish? Two possibilities present themselves. The basic goal of shareholder litigation may be to compensate shareholders, to make them whole for losses suffered at the hands of the corporation and its managers. Alternately, the purpose of shareholder litigation may be to deter bad acts in the first place, to create incentives for corporations and managers to avoid claims. The perspective we choose on this question will have important implications for our policy analysis. So, which is it, compensation or deterrence?
Compensation or Deterrence?
Like other forms of civil litigation, shareholder litigation may be supported by either of two public policy justifications: compensation or deterrence. According to the compensation rationale, shareholder litigation is meant to make shareholders whole for losses they suffer at the hands of the corporation and its managers. Alternately, according to the deterrence rationale, shareholder litigation is meant to create incentives for the corporation and its managers to prevent conduct leading to certain kinds of loss. These two rationales are independent—the success or failure of one does not depend upon the other—so one or both or neither may in fact apply to justify shareholder litigation. Let us take a moment to examine each, starting with the compensation rationale.
Although the compensation rationale makes a great deal of intuitive sense, an emerging consensus among most corporate and securities law scholars rejects compensation as a justification for shareholder litigation. Three forceful critiques of the compensation rationale compel this conclusion. First, shareholder litigation often involves mere "pocket shifting" since many plaintiffs are also shareholders of the corporate defendant and the corporate defendant, directly or indirectly, funds most settlements. Second and related, over time, diversified shareholders generally will not benefit from the most common form of shareholder litigation—the prototypical 10b-5 class action involving a nontrading corporation and alleging fraud on the market—because the plaintiffs' losses will be offset by gains to other groups of investors, which may, in the long run, include the plaintiffs themselves. Third, most shareholder litigation recovers only a small fraction of total shareholder loss and does so at very high transaction costs, suggesting that it is at best a very inefficient means of providing compensation for investors who have been harmed.
The first critique—that settlements and damages paid in shareholder litigation typically amount to pocket shifting and are therefore of no economic value—focuses on the fact that many plaintiffs are also shareholders. This is so in the context of many securities law claims, especially those for which the plaintiff class consists of those who purchased shares at a price allegedly inflated by fraud and who remain shareholders through the bringing of the suit. But it also applies to those 10b-5 claims for which the plaintiff class consists of those who sold shares at an allegedly deflated price as long as the plaintiffs do not sell all of their shares and thus remain invested in the corporate defendant, as will often be the case for fund holders and other long-term diversified shareholders. In these cases, the plaintiffs are essentially suing themselves and, if they "win," merely moving dollars from one pocket to another, minus very substantial litigation costs.
The pocket-shifting critique applies not only to many securities claims but also to many state corporate law claims, especially derivative suits for damages. In fact, as we shall describe in greater detail in chapter 2, state law forbids indemnification of derivative suit settlements precisely because of pocket-shifting concerns (since the indemnification would essentially amount to a payment from the corporation to make whole a manager defendant who had just paid a settlement to the corporation). Nevertheless, as we shall see, state law permits such settlements to be insured, and, as a result, corporations now fund the settlements indirectly (through the insurance premium), even if they cannot fund them directly (through indemnification). This kind of circular wealth transfer is pocket shifting in the extreme. It is the type of transaction from which no one benefits, at least in compensation terms, except perhaps attorneys, who, on the plaintiff's side, receive a portion of the settlement and, on the defendant's side, receive hourly fees. From the actual plaintiff's perspective, however, this is not a good deal. Plaintiffs clearly do not benefit from compensation when they effectively pay it themselves minus whatever portion they pay out in attorneys' fees and other costs.
Excerpted from Ensuring Corporate Misconduct by TOM BAKER SEAN J. GRIFFITH Copyright © 2010 by The University of Chicago. Excerpted by permission of THE UNIVERSITY OF CHICAGO PRESS. All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
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Table of ContentsAcknowledgments
Chapter 1. Introduction
Chapter 2. Shareholder Litigation
Chapter 3. An Introduction to Directors’ and Officers’ Liability Insurance
Chapter 4. The Puzzle of Entity-Level D&O Coverage
Chapter 5. Pricing and Deterrence
Chapter 6. Insurance Monitoring and Loss-Prevention Programs
Chapter 7. The D&O Insurer at Defense and Settlement
Chapter 8. What Matters in Settlement?
Chapter 9. Coverage Defenses and Disputes
Chapter 10. Policy Recommendations: Improving Deterrence