Derivative Suits: Newest Threat to Board Members or ‘Same Old-Same Old’?

We all know that securities class action suits are highly predictable, high-dollar exposure for directors and officers of public companies. The “high dollar” part is unfortunate; the predictability, however, at least makes it easier to plan for—and mitigate the risk of—these types of suits.

When securities class action suits are filed against directors and officers of public companies, it’s quite common to see derivative suits brought against these same directors and officers as almost a by-product of the securities class action suit.

For example, if a company’s stock falls precipitously, a class action suit follows, and we’d expect one or more derivative suits to be filed on the same underlying facts.

However, at Woodruff Sawyer, we’ve noticed a possible uptick in the number of derivative suits that are being filed for reasons unrelated to stock drops generating securities class action suits.

In this post, we’ll dive into the basics of a derivative suit, why it’s gaining popularity, what the current landscape looks like, and how to prepare.

What is a Derivative Suit?

First, a quick reminder of the nature of derivative suits. Derivative suits are brought by current shareholders under state corporate law and allege that directors and/or officers have breached their fiduciary duties to the shareholders.

The suits are styled as “derivative” because the shareholders aren’t bringing the suits directly. Rather, the shareholder is bringing the suit on behalf of the corporation that is being injured by the reported misconduct of the directors and officers.

This mechanism exists because a corporation is a legal fiction that can’t bring suit on its own. In these cases, a shareholder can step in for a corporation to say the board’s breach of fiduciary duty is harming the corporation itself.

One process point: before a derivative suit can be filed, a shareholders is expected to bring his or her concerns to the board in the form of a demand. If the board refuses the demand or does not act upon it, the shareholder would then seek redress in court by filing suit.

There’s also the notion of “demand futility,” as in the board is so intrinsically tied to the problem that it would be futile to bring the demand to the board. In these cases, the shareholder would typically go directly to court.

Why are Derivative Suits Especially Problematic?

No one likes to be sued, but derivative suits are especially threatening for individual directors and officers. This is because, unlike securities class action suits, there is much less clarity about what can and cannot be indemnified by a corporation in the case of settlements and judgments of derivative suits.

This is especially the case where the alleged breach is the breach of the duty of loyalty. This gap is normally addressed by D&O insurance, which has the ability to reimburse for loss in instances where a corporation could not.

What Caused Derivative Suits to Become More Popular with the Plaintiffs’ Bar?

There are many reasons why derivative suits are brought today beyond the typical sidecar cases to securities class action lawsuits. Their popularity may have gained ground in the not-so-distant past with a notable scandal in the mid-2000s: options backdating.

The options backdating event takes us back to about 2006 when multiple corporations were wrapped up in the “options backdating scandal.” The situation involved companies choosing the price at which they were going to grant their stock options, and then pretending that they granted options on that date when in fact they had not (the grants were “backdated” to accomplish this).

While more than 200 companies turned out to have an options backdating problem, only about 10 percent of these companies saw a significant stock drop on the announcement. And, as a result, only about 10 percent had securities class action lawsuits related to options backdating.

But almost all of the companies with options backdating problems had a derivative suit. And, these derivative suits settled for cash—in some cases a lotof cash. As a result, the plaintiffs’ bar learned that a precipitous stock drop isn’t a prerequisite for a lucrative lawsuit against a public company’s directors and officers.

The Current Derivative Suit Landscape, and How to Prepare

Today, there are a lot of entry points to this type of litigation. One only has to look at such cases involving Facebook, HP, Target and others to see the multitude of scenarios involving derivative suits.

So, what should Ds and Os do when faced with the new, more complex landscape of derivative suits? Do you need more coverage?

Yes, derivative suits are concerning, but the concern lies mainly in their lack of predictability. Having said that, we don’t believe there is an immediate need to dramatically increase your D&O insurance limits at this time as a solution.

Most derivative suits are settled for nuisance values, and your insurance limits are typically calculated against the securities class action exposure – probably a robust enough number to accommodate most derivative suit settlements.

Having said that, an extra $5 million or $10 million in limits to accommodate the derivative suit trend may be prudent based on the economics of the purchase of these additional limits. In our recent “Focus on D&O Insurance Limits" report, we discuss limits in more detail, including what not to do.

When structuring your D&O insurance program, the threat of derivative suits—and the fact that the settlement or judgment may not be indemnifiable by the corporation—is an argument in favor of having adequate amounts of separate Side A limits. As a reminder, Side A is part of a D&O insurance program that responds when a corporation cannot indemnify its directors and officers.

To the extent that a corporation is not interested in insuring its balance sheet (which today is dropping Side B and Side C insurance), be careful about dropping the Side A insurance limit too low.

You can learn more about the Side A standalone in this overview on D&O insurance, and in this post I wrote for the D&O Notebook.

Additional tips for managing risk in the face of derivative suits include:

1. Pay attention—and document paying attention—to fiduciary duty issues. Build a record that makes it obvious to a judge that directors deserve the deference of the business judgment rule.
2. Consider choice of forum provisions, so that these cases are brought in your state of incorporation (Delaware, for many companies), and not elsewhere.

Here at Woodruff Sawyer, we’re keeping a close eye on this trend of derivative suits, and will continue to update readers on what we’re seeing.

The views expressed in this blog are solely those of the author. This blog should not be taken as insurance or legal advice for your particular situation. Questions? Comments? Concerns? Email: phuskins@woodruffsawyer.com.