MERGERS & ACQUISITIONS: D&O EXPOSURES AND INSURANCE
The level of merger and acquisition ("M&A") activity in 1996 reached a record level with a reported $650 billion in announced transactions. It appears that 1997 will be more of the same. Companies in virtually every industry group are susceptible to an M&A transaction and thus all D&Os should understand and prepare for the cataclysmic consequences of being involved in such an actual or proposed transaction.
Recent D&O survey results confirm that D&O claims susceptibility and frequency materially increase if a company is involved in an M&A transaction. Although directors and, to a lesser extent, officers of the target company are the most likely defendants in such litigation, the D&Os of the acquiring company may also be sued under certain circumstances. The type of D&O claims which may be filed include:
1. Resist Hostile Takeover. Directors of a target company who resist a hostile takeover attempt can be quite vulnerable to judicial attack. Disgruntled shareholders typically allege that the directors breached their fiduciary duty by resisting the takeover proposal, thereby denying the shareholders the opportunity to sell their shares at the much higher offer price. The amount of recoverable damages in such a claim can be enormous, and therefore the settlement value of such a claim can be quite large even if the liability exposure is relatively small.
The good news is that recent judicial authority, particularly in Delaware, generally gives significant deference to directors when deciding an appropriate response to a hostile takeover bid. For that reason, among others, the frequency of hostile takeover attempts is much lower today than during the merger mania of the 1980's. Although hostile takeover attempts are less frequent and related D&O claims more defensible today, such litigation is still routinely filed as part of a hostile takeover and settlements or at least a plaintiff attorney fee award in such litigation can be significant.
2. Approve Friendly Takeover. The directors of a target company who approve an acquisition of their company also are frequently sued by shareholders, who allege that the directors failed to make an informed decision regarding the adequacy of the purchase price or failed to "shop" the company. These cases are typically less severe than the hostile takeover case since the potential recoverable damages are usually much less. Shareholders in this type of litigation frequently seek a bump up in the purchase price, as opposed to the entire acquisition premium which is at issue in D&O lawsuits involving hostile takeovers. These types of cases usually either settle for a relatively modest amount or eventually are dismissed for lack of merit.
3. Pre-Acquisition Mismanagement. After a company is acquired, the new owners and their appointed managers may determine that the directors and officers of the acquired company mismanaged the company prior to the acquisition and therefore may sue the prior D&Os for the injury caused to the company. These claims are not common since the acquiring company typically conducts a thorough due diligence investigation before agreeing to purchase the company. However, this type of claim is brought occasionally and is particularly problematic for the defendant D&Os since they no longer control the company or its indemnification or insurance programs.
4. Disclosure. M&A activity may also result in class action securities lawsuits against the target D&Os which allege that the defendants did not accurately, completely and in a timely manner disclose the existence of the M&A negotiations or other related material information about the transaction. Courts have refused to articulate a bright-line rule for determining when M&A negotiations must be publicly disclosed. D&Os are thus placed in a dilemma, not wanting to disclose the existence and terms of the negotiations either prematurely or delinquently. If disclosure is too early and the transaction does not occur as disclosed, shareholders who purchased stock after the disclosure will allege they were injured because the defendants artificially inflated the stock price by the premature disclosure. If disclosure is too late, shareholders who sold their stock prior to the disclosure will allege they were injured since they sold their stock prior to the large price increase following the merger announcement.
This disclosure exposure exists with respect to D&Os of both the target company and the acquiring company. In addition, this exposure exists not only with respect to the timing of voluntary disclosures, but also with respect to the D&Os response to inquiries from analysts or reporters regarding rumored negotiations. D&Os of both the acquiring and target companies have been sued for securities violations when they falsely denied the existence of merger negotiations in order to maintain the confidentiality of those negotiations.
5. Mismanagement of Acquisition. D&Os of the acquiring company can also incur liability exposure in connection with the management of the acquired company or the disclosure of the likely effects or actual results of the transaction. This exposure has proven particularly problematic when the acquisition is part of a diversification program of the acquiring company since D&Os of the acquiring company frequently have little experience with respect to management of a company in a completely new industry or market.
Because these transactions often arise with little advance warning, companies should structure their existing D&O insurance program with the expectation that they will be involved in an M&A transaction either as an acquiring or as a target company.
The following summarizes issues to consider in either capacity.
A. ACQUIRING COMPANY
The principle D&O insurance issue for acquiring companies is the extent to which the insurer is entitled to receive notice and to underwrite the acquisition mid-term. Preferably, the D&O policy should provide for automatic coverage to newly acquired subsidiaries unless the acquired subsidiary exceeds a large reporting threshold (e.g. 25% of the parent company's assets). If the reporting threshold is exceeded, policies vary as to whether the insurer is entitled to charge an additional premium only or to also impose additional terms and conditions to the policy mid-term. In any event, coverage for the newly acquired subsidiary typically applies only with respect to wrongful acts taking place after the date of acquisition.
B. TARGET COMPANY
Because the D&Os of the target company may be replaced or removed following the acquisition, they should purchase prior to the acquisition a pre-paid, non-cancelable extended run-off insurance policy which cannot be amended or affected in any way by the acquiring company or subsequent management. In light of applicable statute of limitations in various jurisdictions, the term for this run-off policy often is four to six years. To assure the availability of this coverage, some D&O policies provide that in the event the parent company is acquired, the insurer is obligated to afford at least three years of run-off coverage or at least issue a quotation for an extended run-off policy.
When structuring a run-off policy, the following issues should be considered:
- Is corporate reimbursement coverage desired? If so, who is the insured organization? For example, if the target company is merged into the acquiring company, does the acquiring company become the new insured organization under the run-off policy?
- If the acquiring company or the surviving company sues the prior D&Os for mismanagement, will the insured v. insured exclusion in the run-off policy eliminate coverage? Should claims by the acquiring company and/or the surviving company be excepted from this exclusion?
- Should a presumptive indemnification provision exist in the run-off policy? If the surviving company is permitted but refuses to indemnify the insured D&Os, will the D&Os be required to personally fund the large corporate reimbursement deductible pursuant to the presumptive indemnification clause?
- How does the run-off policy respond to a claim for a continuous wrongful act which commences prior to the acquisition and continues after the acquisition? Although the run-off policy generally does not cover claims for wrongful acts after the acquisition, should coverage exist for inter-related wrongful acts which begin before and end after the date of acquisition? How does the surviving company's ongoing policy respond to such interrelated wrongful acts? If the run-off policy and the continuing policy for the surviving company are issued by different insurers, will the two insurers each try to deny coverage? If the policies are issued by the same insurer, does that insurer have concerns about stacking of both policies' limits of liability?
- Should any securities or employment practices entity coverage which may exist in the target company's D&O policy be deleted from the run-off policy in order to avoid unnecessary dilution of the run-off limit of liability?
- Will the run-off policy have a new limit of liability or an extension of the existing limit under the target company's policy?
If the target company is a subsidiary being divested by the parent company, additional complications arise since the run-off coverage should be independent from and unaffected by acts of both the selling parent company and the acquiring company. A claim for pre-acquisition wrongdoing may implicate both the run-off policy and the policy issued to the selling parent company. If the same insurer issued both policies, stacking of limits issues will exist; if different insurers issued the policies, fighting between the insurers regarding their respective obligations should be expected. At a minimum, difficult allocation issues between the respective policies are likely.
Companies are encouraged to analyze and negotiate with their D&O insurer at least some of these issues before the M&A transaction arises. Because a crisis management atmosphere may develop once an acquisition is announced, waiting until that time before any of these issues are considered further increases that crisis atmosphere and potentially jeopardizes the quality and availability of an appropriate risk management response to the transaction.
EXECUTIVE COMPENSATION: LITIGATION AND INSURANCE RISKS
Shareholder activists have for several years criticized the reasonableness of many highly lucrative executive compensation arrangements in various companies. Until recently, that criticism has been limited almost exclusively to discussions at shareholder meetings and in meetings between institutional investors and corporate representatives. Now, though, that debate is moving into the courtroom, as shareholders are now more frequently bringing lawsuits against directors who approve and senior officers who receive such lucrative compensation. Examples include:
- Walt Disney Co. shareholders filed in January 1997 lawsuits in both California and Delaware attacking the estimated $93 million in cash and stock options paid to former company president Michael Ovitz when he left the company after only one year on the job. Disney shareholders are also reportedly considering filing a lawsuit attacking a new ten year employment contract with CEO Michael Eisner which, among other things, awards to Mr. Eisner new stock options currently valued at $195 million (in addition to his existing stock options currently valued at approximately $358 million).
- Coca Cola Co. shareholders sued the company's directors, alleging they breached their fiduciary duty by approving a compensation package for CEO Roberto Goizueta, which included options to purchase 1 million shares of company stock.
- Green Tree Financial Corp. shareholders filed, in January 1997, a derivative lawsuit against the company's directors and officers alleging that $28.5 million and $65.1 million bonuses paid to CEO Lawrence Coss were unreasonable and excessive.
Courts have historically deferred to the business judgment of the directors with respect to compensation issues and have been highly reluctant to impose liability for compensation-related decisions. The Delaware Chancery Court recently confirmed that deference in the Coca Cola case referenced above, where the Court dismissed the lawsuit because the Court believed that reasonable, disinterested directors could have concluded that the CEO's services and the resulting benefits to the corporation justified the magnitude of compensation actually awarded. However, as the size of many executive compensation packages reach astronomic levels and as courts are asked to review those sometimes shocking arrangements with more frequency, courts can be expected to become increasingly uncomfortable with blindly deferring to the judgment of disinterested directors.
This increase in compensation litigation also raises some important insurance coverage issues which have largely been ignored in the past. D&O policies historically contained a "remuneration" exclusion which applied to claims for illegal remuneration paid without obtaining necessary shareholder approval. Because shareholders rarely approve compensation issues, this exclusion was extremely narrow. In recent years, D&O policies have generally broadened this exclusion by including it within the "personal profit" exclusion. Numerous variations of that exclusion now exist and thus D&O policies will respond to executive compensation litigation in vastly different degrees. For example:
- Does the exclusion apply only to the direct D&O insuring clause or also to the corporate reimbursement insuring clause? Several policy forms do not apply the exclusion to loss which is indemnified.
- Does the exclusion apply only with respect to the claim against the recipient of the excessive compensation, or also to the claim against the directors who approved the compensation? Many D&O policies appear to apply the exclusion to both the recipient and the approving directors, although the conceptual justification for this exclusion would appear to apply only to the recipient (i.e. prevent the recipient from realizing a windfall by retaining the illegal compensation).
- Who determines whether the compensation is illegal for purposes of the exclusion? Most D&O policies apply the exclusion if an officer "in fact" obtains illegal compensation, thus allowing the insurer to determine in the first instance whether the exclusion applies. A few policies contain a much narrower exclusion, eliminating coverage only if the illegal nature of the remuneration is determined by a judgment or if the recipient agrees to repay the remuneration as part of a settlement.
- Does the exclusion apply only to the amount of the illegal remuneration or to other loss related to the alleged illegal remuneration? Some D&O policies contain a broad form exclusion, which prefaces the exclusion with language such as "based upon, arising out of...," while other policies contain a narrower exclusion, using the word "for" at the beginning of the exclusion.
Insureds should understand the scope and effect of this increasingly important exclusion when the policy is being purchased. Those who wait until the executive compensation claim is filed before considering these issues may be surprised and disappointed at how little coverage, if any, exists.