"PAPER" SETTLEMENTS: TOO GOOD TO BE TRUE?
With increasing frequency, class action claims against directors and officers and their corporation are being settled through use of a so-called "paper" settlement, in which the corporation issues securities to the plaintiff class in settlement to the plaintiffs' claims. Such a settlement can provide substantial benefits to all parties involved in the litigation and can constitute a "win-win" resolution of an otherwise problematic D&O lawsuit.
The plaintiff class is benefited to the extent the distributed securities have value. The plaintiffs' lawyer can use that value to justify a fee award, which typically is paid with cash contributed by or on behalf to the defendants. The corporation and the defendant D&Os settle the litigation without incurring a loss for financial reporting purposes. Finally, the D&O insurer's coverage obligations are lessened.
Although the concept of using securities to settle class action lawsuits is not new, the willingness of plaintiffs' counsel to agree to this type of settlement appears to have increased in the last year. A paper settlement is obviously advantageous when the defendants' ability to pay a large cash settlement is limited - whether because of the corporation's small liquidity or relatively low D&O insurance coverage. However, even large corporations with substantial liquidity and high D&O limits of liability have successfully used this form of settlement recently.
Forms of Paper Settlement
The three alternative forms of paper settlement most frequently used are described below:
Stock Distribution. The corporation agrees to distribute to the class members treasury shares of common or preferred stock of the corporation. This is the simplest form of paper settlement to administer and value. Assuming an organized trading market exists for the stock being distributed, the value of that stock is simply determined by the market trading price as of the date of distribution.
In order to minimize the number of shares distributed (while maximizing the nominal settlement value to the plaintiff class for purposes of justifying a plaintiff attorney fee award), a stock distribution settlement frequently takes the form of a "claims made" settlement under which stock is distributed at a defined ratio only to those plaintiff class members who properly submit a proof of claim. The fewer proofs of claim submitted, the fewer shares actually distributed by the corporation. However, plaintiffs' counsel, when justifying its fee award, assumes all members of the class will properly submit proofs of claim and therefore plaintiffs' counsel uses the potential settlement value to the entire class as the proper benchmark for determining a fee award.
Rights Distribution. The corporation agrees to distribute to the class members rights to purchase shares of stock of the corporation at a defined discount price. Typically, these rights may be exercised for a period of 30 to 60 days after court approval of the settlement. If exercised, a plaintiff class member purchases a defined number of shares at a discount price determined either by a defined percentage of the stock trading price as of the end of the rights period or a defined amount per share below such trading price. For example, a "rights" settlement may permit a class member to purchase (for a period of 30 days following court approval of the settlement) 1 share of common stock for every 10 shares of stock purchased by that class member during the class period at a purchase price of 5% (or alternatively $2.00) less than the stock's trading price at the end of the right's exercise period.
From the corporation's standpoint, this form of paper settlement is recently preferred over a simple distribution of stock because the corporation receives cash from the plaintiff class through the discounted purchase by class members of the shares of stock. Particularly for companies interested in raising additional capital, a "rights" settlement can be extremely attractive since the larger the settlement, the more capital is raised by the company. This type of settlement creates value to the plaintiff class to the extent the plaintiffs purchase shares at a discount and because the plaintiffs pay no brokerage commission in connection with the transaction.
If a corporation believes it already is fully capitalized and that further sale of shares would detrimentally over-capitalize the company, a "rights" settlement can be followed by an open market repurchase by the corporation of the same amount of shares as sold pursuant to the "rights" settlement.
Warrants Distribution. The corporation agrees to distribute to the class members warrants to purchase shares of the company at a defined purchase price over an extended period of time. Unlike a "rights" settlement, which permits the plaintiff class members to purchase shares at a discount over a relatively short period of time, a "warrants" settlement permits the class members to purchase at a defined price (typically not a discounted price) over an extended period of time (e.g. two or three years). The purchase price is typically determined by the average trading price of the company stock for the 30-day period immediately following court approval of the settlement.
A "warrants" settlement creates greater risk and higher potential benefits than does the "rights" settlement. With a "rights" settlement, the maximum value of the settlement is pre-determined by the defined discount price. Under a "warrants" settlement the ultimate value can range from zero to an unlimited amount, depending upon the market price of the company stock during the warrant period. As a result, warrants are more difficult to value. Recently-promulgated SEC regulations relating to disclosure of executive compensation include detailed rules with respect to the valuation of warrants issued to executives as compensation. Those regulations likely will be viewed by courts as persuasive authority in valuing a "warrants" settlement.
Notwithstanding these greater risks and valuation issues, plaintiffs' attorneys frequently prefer warrants over rights because the warrants arguably create greater potential benefit and thus justify a higher fee award for plaintiffs' counsel.
Securities Law Issues
In a rights or warrants type of settlement, the underlying stock ultimately issued to the plaintiff class members in a paper settlement typically must be fully tradeable by the plaintiff class immediately after issuance. If the shares must be newly registered with the SEC (which is an expensive and time-consuming process), the viability of a rights or warrants type settlement may be limited.
However, the securities distributed in exchange for the plaintiffs' release of their claims (i.e. shares of stock in a stock distribution type settlement or the rights or warrants) will likely be exempt from SEC registration under the federal securities laws. Section 3(a)(10) of the Securities Act of 1933 exempts from the registration requirements any securities (including rights or warrants) which are issued in exchange for the release of claims where the terms and conditions of such issuance and release are approved, after a hearing as to the fairness of the settlement, by a court. Thus, in most instances, the rights and warrants issued pursuant to a paper settlement likely are exempt from registration even though the underlying shares of stock issued upon exercise of the rights or warrants may need to be registered.
D&O Insurance Coverage Issues
Depending upon the form of the settlement, various D&O insurance issues may arise with respect to a paper settlement.
- Is the value of the securities issues pursuant to a paper settlement considered covered loss incurred by the defendant D&Os? Issuers typically contend that the paper value is not covered under the policy. Since D&Os cannot personally issue corporate securities, the D&Os are not "legally obligated to pay" that value. The insureds, on the other hand, may argue that the securities distribution is in reality a form of corporate indemnification of the defendant D&Os since the securities distribution was in consideration for release of the D&O claims. In response, D&O insurers typically argue that corporate reimbursement coverage under the policy exists only to the extent the defendant D&Os are "legally obligated to pay" the loss and that since so such legal obligation exists to the D&Os under a paper settlement, no corporate reimbursement coverage exists. In addition, as explained below, the insurers may argue the paper distribution does not constitute loss to the corporation.
- Does the value of the securities issued pursuant to a paper settlement deplete and/or exhaust the applicable retention or deductible? Insureds may argue that even if the D&O insurer should not reimburse the corporation for the value of the securities issued, at a minimum such value should deplete or exhaust the corporate reimbursement retention or deductible. D&O insurers uniformly take the position that the D&O retention or deductible is depleted and/or exhausted only by loss otherwise covered by the D&O policy. If the value of the distributed securities does not constitute covered loss, such value does not deplete or exhaust the deductible.
- Does the value of the securities issued pursuant to a paper settlement constitute the corporation's contribution to the settlement for allocation purposes? Insureds frequently argue that even if the value of the distributed securities is not covered loss, that value should be treated as the corporation's contribution towards settlement of the litigation for purposes of determining an allocation of loss between the corporation and the defendant D&Os. Insureds may argue that the D&O insurer should pay 100% of the cash component of the paper settlement since such a payment would result in the D&O insurer paying only a relatively small percentage of the total settlement value. The insureds thus contend that the D&O insurer is receiving and extremely favorable allocation - even though the insurer funds 100% of the cash component of the settlement.
- D&O insurers typically contend that the loss to the corporation does not equal the value to the class members of the distributed securities. From an accounting standpoint, the corporation will not realize either a reduction in its assets or an increase in its liabilities as a result of the securities distribution. Although shareholders of the corporation may realize some loss because their interests are diluted by virtue of the securities distribution, that shareholder loss arguably does not constitute loss to the corporation. Accordingly, insurers argue that the value of he distributed securities should not be considered when determining a fair and reasonable allocation and that only the cash component of the settlement should be allocated between claims against the corporation and claims against covered D&Os.
- Does the corporation's costs in repurchasing its stock in the open market following the securities distribution constitute loss either covered by the D&O policy or attributable to the corporation for allocation purposes? Insureds may argue that such stock repurchases would not have occurred but for the paper settlement and, therefore, the cost of such repurchases should be part of any coverage analysis. In response, D&O insurers argue: (1) the defendant D&Os are not "legally obligated to pay" such stock repurchase cost and therefore such costs are not covered, and (2) such costs are not incurred to settle the claims and therefore such costs are irrelevant in any allocation analysis. The D&O insurer's typical view is that those costs are incurred voluntarily by the corporation based on the corporation's business decision that it is in the best interests of the company and its shareholders to reduce the number of outstanding shares following consummation of the stock settlement.
Because paper settlements are increasing in frequency, D&O insurers and the insured may find it desirable to address these coverage issues through policy wording amendments. Although D&O insurers presumably would contend that the existing policy forms now adequately answer all of these coverage issues, it may be advantageous to explicitly address these issues with policy wording in order to avoid uncertainties and unrealistic expectations.
In summary, paper settlements can be a cost-effective method for both insureds and D&O insurers to resolve D&O class action lawsuits. Although potentially troublesome coverage issues may arise, the position of the insureds and the D&O insurer is typically vastly improved in this type of settlement than in a standard cash settlement because the serious coverage disputes usually involve only plaintiffs' attorney fees and settlement administration costs (i.e. the cash portion of the paper settlement).