The complaint filed in the Southern District of New York noted that Pfizer's alleged activities over a multiyear period not only resulted in the largest civil fraud settlement against a drug company and the largest criminal fine ever imposed in the United States for any matter, but that it caused tremendous related damages to the company–including legal expenses for private consumer actions, whistleblower lawsuits, as well as reputational damages.

Citing the possibility that further illegal activity could mean Pfizer would be barred from federal programs such as Medicare and Medicaid, the filing says that “immediate intervention is needed” to change the recurring bad behavior by Pfizer executives that it explained had been repeatedly overlooked by Pfizer directors.

Ivan Dolowich, a partner with Kaufman Dolowich Voluck & Gonzo LLP in New York, introduced a discussion of the case–and the potential worrisome trends it might represent for D&O insurers–during a session of the international conference of the Minneapolis-based Professional Liability Underwriting Society late last year.

“Most of us understand derivative cases to be 'follow-ons' to traditional securities class actions,” Mr. Dolowich said. He was referring to the commonly accepted notion that plaintiffs' lawyers pursue derivative cases as an additional, but lesser source of revenue to federal securities fraud class-action filings–an idea expressed frequently at prior PLUS conferences by both plaintiff and defense lawyers.

In contrast, “it seems like this [Pfizer] case could be the start of a shift in terms of severity,” Mr. Dolowich said, going on to ask Mr. Lebovitch if he views derivative litigation as a “fertile area” for plaintiffs' lawyers–separate and apart from those filed as class-action tagalongs.

Mr. Lebovitch said he did not. “I don't believe there should be dozens of derivative cases. I think for the most part they're not worth litigating. However, there are very good instances where investors should step in,” he said, referring to the Pfizer case.

Too many times, corporate lawyers and advisors predict “the world is coming to an end if so and so happens [and] directors are held liable,” noted Mr. Lebovitch, commenting on recent predictions suggesting that plaintiffs lawyers are becoming increasingly focused on derivative suits and that derivative-suit settlements are trending higher.

“I don't think that every ruling that says a director did the wrong thing…portends a fundamental shift in our capitalist system,” he said.

He noted that his firm typically represents large institutions as plaintiffs, explaining that such institutions file derivative suits to change behavior of corporate executives and directors that is damaging to the company, to institute meaningful corporate governance reforms, or to set examples for the overall market.

Mr. Lebovitch made his remarks days before his firm filed an amended complaint against Pfizer and minutes after other speakers on the PLUS panel commented on the D&O insurance implications of the settlement of another derivative lawsuit–the $118 million August 2009 settlement in the Broadcom case, a derivative suit arising from allegations of stock-option backdating.

SIDE A RESPONDS

As in any derivative suit, the shareholder plaintiffs bringing the Pfizer and Broadcom actions sued the directors and officers “in the name and for the benefit of” the company in which they hold shares, alleging harm done to the company through breaches of various duties.

D&O insurance experts explain that because plaintiffs in derivative actions sue directors and officers “on behalf of the company,” it is illegal in many states for the company to then indemnify directors and officers for derivative suit losses.

In an article published in NU in 2004, Dan Bailey, an attorney and coverage expert for the Columbus, Ohio-based law firm Bailey Cavilieri, explained the prohibition in the following way.

He said that in a derivative suit, “effectively, the company is asserting the claim, although the shareholder is prosecuting it against directors and officers.” Since that means that any settlement or judgment gets paid by the directors and officers back into the company rather than to the shareholder plaintiff, if the company could indemnify for such payments, “the money would go in a circle,” he said.

But statutes do allow companies to purchase insurance to protect directors and officers in these instances. Derivative suit losses typically implicate the Side-A coverage part of D&O insurance policies or separate Side-A-only policies–both of which cover individual directors and officers for non-indemnifiable losses.

Besides being non-indemnifiable as a matter of law, as in the case of derivative lawsuits, D&O losses can also be non-indemnifiable when a company is insolvent.

Excess Side-A-only carriers contributed $45 million to the Broadcom settlement, according to Steven White, vice president of executive assurance claims for Arch Insurance Company in New York, another panelist at the PLUS session.

Broadcom was one of a handful of backdating cases that had particularly bad facts alleging that defendants intentionally manipulated certain stock option grant dates to enrich themselves at the expense of their companies and shareholders–facts that resulted in restatements, severe shareholder class actions, and ultimately large shareholder derivative claim payouts as well, Mr. White said.

For the most part, the backdating cases represented a frequency issue rather than large severe settlements like Broadcom, according to Mr. White. The bulk of the backdating suits were filed solely as shareholder derivative suits because the stocks of the companies didn't really drop when companies reported issues with stock option backdating, and they settled quickly and for smaller amounts.

Larger derivative-suit settlements like the one in Broadcom, however, threaten Side-A towers and open the eyes of plaintiffs' lawyers, Mr. White suggested.

“In that case, you had an A-B-C tower of $100 million and you had an A-tower on top of that. Damages were so enormous that they got into that upper layer,” he explained.

“Now you have some real Side-A claims being paid,” he continued, noting that the Side-A tower was “a real benefit to the Ds and Os who were being insured.”

Last week, Kevin LaCroix, a broker for Oakbridge Insurance Services in Beechwood, Ohio, and the author of the “D&O Diary” blog (www.dandodiary.com/), highlighted the Broadcom settlement as the “first instance outside of an insolvency” in which excess Side-A insurers were called upon to contribute significantly toward a settlement.

Mr. LaCroix, who offered his observations during a review of securities litigation trends on a Webinar hosted by New York-based Advisen, advised brokers and insurers that the Broadcom situation is “something to talk about with your clients,” identifying coverage of the settlement as “an important real-world example to use” to emphasize the benefits of Side-A coverage.

“There have only been a handful of large [derivative] settlements, but they are all fairly recent,” Mr. LaCroix said.

In a Sept. 1, 2009 entry on his blog, Mr. LaCroix also cited a $900 million derivative settlement for UnitedHealth Group in a backdating case, and a $115 million settlement in a derivative suit against American International Group to underscore the trend toward higher payouts. The same blog item also revealed that plaintiffs' attorneys netted $11.5 million in fees in connection with the Broadcom settlement.

Numbers like that last figure are “incentivizing the plaintiffs' bar,” Mr. White said during the PLUS conference, adding that the plaintiffs' fee awards for derivative suits “don't quite align with the securities class-action awards, but they're getting there.”

In this regard, “the legacy” of the stock-option backdating cases continues to live on even though the backdating issues have now died out, he said.

Mr. Lebovitch agreed that “the era of the options backdating–of dozens of derivative suits being filed everyday–is gone.”

“Options backdating was just a unique situation in history where there was a broad, industrywide moral failing,” he said, asserting that once the practice was revealed, nearly everyone involved realized how wrong it was.

For the most part, then, Mr. Lebovitch's firm did not file derivative actions related to backdating activities. “However, there are very good instances where investors should step in” and file derivative cases, he said, going on review the allegations of the Pfizer complaint.

ACCOUNTABILITY SOUGHT

“I think there are times when it's good to hold people accountable for what they did–to make examples of people. That will send a better message than a fear of ever holding directors responsible because then the foundations of the business judgment rule [might be] eroded,” Mr. Lebovitch told D&O underwriters at the PLUS conference.

Throughout the session, the lawyer and other panelists repeatedly referred to the “business judgment rule”–a legal concept that essentially protects directors from liability if they perform their duties in good faith, while being mindful of protecting the interests of the corporation–saying that the rule is “alive and well” and that it protects directors and officers 99 percent of the time.

But the rule “does not protect the judgment to engage in unlawful conduct,” according to Mr. Lebovitch, who said “that's why we filed the lawsuit” against Pfizer's directors and officers–noting that Pfizer was fined several times since 2002 for similar offenses but continued to engage in what he called reprehensible behavior.

The government also repeatedly imposed “corporate integrity agreements” requiring semiannual reports to the board about efforts to comply with federal marketing laws, he said.

Pfizer's recurring violations in light of these agreements suggests that board members decided to “essentially gamble with an efficient breach of criminal laws”–in other words, to make a bet that the fines that would be imposed on the company for continued illegal marketing activities would be small in comparison to the revenues netted from engaging in those activities, he explained.

Mr. Lebovitch quoted Judge Douglas Woodlock–a district court judge in Massachusetts who presided over a Pfizer sentencing hearing last October–to underscore the need for personal accountability in such cases.

While the judge said he was aware of the government's claim that the sentence amounted to the largest criminal fine ever imposed, he added that “the problem with sentencing a corporation is that it has no soul to damn nor body to kick.”

The corporation pleaded guilty, but the judge said he was uncomfortable with the fact that no individual was held accountable when the corporation paid its $2.3 billion fine.

“You can understand why big investors like Amalgamated Bank stepped up,” filing a derivative suit to essentially say “some individual should be held accountable,” Mr. Lebovitch said.

Ric Marshall, chief analyst for The Corporate Library in Portland, Maine, a firm that analyzes and rates corporate governance practices, assessed Pfizer's activities as an “outlier” in corporate America.

“It's like Madoff. This is not the way business normally happens, but it is an extreme case–and an extreme case on a level that should really cause us all to think hard about the rights that we give to corporations,” Mr. Marshall said, noting that during much of the period in question, Pfizer's chief executive served as chair of the Business Roundtable–an association of CEOs of leading U.S. companies.

“We need to think really hard about the fact that corporations can become so powerful,” Mr. Marshall said. “There's no such thing as a capital crime for corporations. We can't send them to the electric chair.”