D&O liability: insuring against merger objection suits

The number of securities class action lawsuits filed against directors and officers may be below historical averages, but cases of another kind – those brought against the directors of companies being acquired, known as ‘merger objection’ lawsuits – are springing up like weeds, according to a new report from the research firm Advisen.

The Advisen report, ‘Merger objection lawsuits: a threat to primary D&O insurers?’, notes that, until recently, directors’ and officers’ (D&O) insurers haven’t needed to worry too much about this kind of litigation because defense costs were usually low. Settlements were not normally big because the suits would typically seek an injunction and reimbursement of attorney fees. Today, however, ‘hundreds are being filed,’ says Dave Bradford, executive vice president and co-founder of Advisen. ‘They’re almost a cost of doing business. If you’re a company of a certain size and you announce you’re being acquired or merging with another company, you can almost expect to be sued.’ Indeed, the number of merger objection suits filed in the US has spiked from 18 in 2003 to 334 in 2010. This is not the result of increased M&A activity, either: transaction announcements dropped sharply, from 375 to around 252, between 2007 and 2010.

So what has caused the spike? According to Bradford and Dan Bailey, chair of the D&O liability practice group at Bailey Cavalieri in Columbus, Ohio, the plaintiff’s bar is largely to blame. With fewer securities class action lawsuits being filed, lawyers representing shareholders in merger objection cases are after the attorney fee awards that often accompany decisions in the plaintiffs’ favor, which amount to around $500,000 per case, on average, Advisen reports.

Another contributory factor is the recession, which has led to more deals being done ‘at depressed prices relative to pre-recession valuations,’ the report states. ‘Not surprisingly, shareholders sometimes were dissatisfied with the outcomes.’ There’s also a degree of opportunism, with plaintiff attorneys aggressively pursuing cases in the knowledge that ‘companies are often willing to quickly settle suits that threaten to hold up a deal,’ Advisen notes. And while suits may still settle for relatively small amounts, D&O liability insurers still need to be wary of multiple costs being caused by just one event: a single deal can trigger many lawsuits in multiple jurisdictions.

Characteristics of merger objection cases

Unlike typical class action lawsuits brought by a subset of shareholders who bought stock during a specific period, merger objection suits are usually brought by all the company’s shareholders. The allegations differ, too.

‘The plaintiffs in [merger objection] cases claim the defendant directors breached their fiduciary duties in their investigation, evaluation and negotiation of a merger,’ explains Bailey. ‘They allege that, because the board didn’t do its job properly, the price paid to the shareholders was inadequate. It’s often alleged that there’s a conflict of interest for some of the board members and, as a result, the directors are looking out not for the shareholders’ best interests but for their own.’ That’s unlike class action suits, which allege the directors and officers failed to disclose a material fact and the plaintiffs/shareholders bought the company’s stock at an inflated price as a result.

Perhaps most significant for directors – and their insurers – are the differences in the relief shareholders seek in these actions and the exposure defendants face. ‘In class action cases, directors and officers are exposed to huge damages because each share that’s bought during the period has a multi-dollar loss, so you multiply the number of shares by some dollar loss per share and you get these huge numbers,’ explains Bailey. ‘In [merger objection] cases, the damages are usually lower because they amount to what the purchase price would have been if the defendants had done their jobs properly. The shareholders are seeking a bump-up in the price paid to them for their shares.’ For this reason, merger objection cases are often referred to as ‘bump-up’ claims.

Bradford, who has spent 30 years in the insurance industry as an underwriter and product developer, describes the other types of relief shareholders in merger objection cases request. ‘Usually the shareholders are looking for some kind of injunctive relief,’ he says. ‘They’re looking for something to change: they want a better deal, a broader auction process, a wider search for bids on the company. They usually don’t want [the merger] to stop dead-cold.’  Sometimes shareholders demand something as simple as more information about the merger.

While merger objection claims don’t pose as great a risk to directors as class action suits, one feature is important: where they’re filed. Unlike securities class action lawsuits typically filed in federal court, some 80 percent of merger objection suits are filed in state court.

‘Sometimes cases involving the same announcement will be filed in federal court and several state courts,’ says Bradford. ‘That’s one of the worst aspects of these suits: there’s no process to consolidate them like there is for securities class action suits. That’s why they’re annoying – you have to deal with them individually.’ And the average number of jurisdictions is growing. ‘In some instances, as many as six different jurisdictions are involved,’ adds Bradford.

The cost of objection

While merger objection suits don’t usually result in huge damages awards, ‘they do take some cost to defend and to pay the plaintiff,’ says Bailey. According to the Advisen report, therefore, D&O insurers ‘need to be concerned about the aggregation of losses arising from one event.’

Kevin LaCroix of OakBridge Insurance Services says the prevalence of these suits ‘changes the way we think about the needs of the D&O insurance policy. Our default analysis is toward the securities class action lawsuit exposure but, increasingly, it is other types of lawsuits that are producing corporate and securities litigation. You are going to have higher frequency and lower severity claims producing heightened loss for the primary and first level excess carriers.’

Many D&O liability policies contain what’s called a bump-up exclusion, says Bailey. ‘That doesn’t mean the directors and officers lose coverage for a bump-up claim,’ he says. ‘The exclusion provides that the policy is not going to pay for the transaction costs. But the defense of the directors and officers who get sued will be covered and usually the settlement will be covered.’ Merger objection suits have almost become an occupational hazard for directors, according to Bradford, but board members in the throes of a merger or acquisition can do a couple of things to lessen their chances of being named in one. ‘First, you have to make sure none of the directors or officers has a conflict and none of them is involved with the acquiring company or other companies that would benefit from the transaction,’ he suggests. ‘If the conflict is significant enough, the directors at issue need to recuse themselves from discussions and from voting on the transaction.’

The other thing directors can do is disclose the imminence and the particulars of the merger or acquisition to the shareholders, Bradford adds. ‘Do this as soon as possible,’ he advises.