D&O insights: When lawyers charge $1,800 an hour, who pays?

(Bloomberg Opinion) — Elon Musk was on to something when he complained that the cost of insurance to protect company directors and officers (D&O) from shareholder litigation has gotten out of control. The impulsive Tesla Inc. boss may be an unlikely spokesperson for the unfairness of these spiraling fees, but they reveal something about this age of corporate misadventure and trigger-happy lawyers. It’s bad for shareholders, companies and insurers alike.

When executives get sued, the payouts can be steep. Take the recent 270 million-euro ($320 million) settlement between Volkswagen AG and its directors’ and officers’ insurers over former executives’ alleged mishandling of Dieselgate. In the U.S., Wells Fargo & Co.’s D&O insurers agreed to fork out $240 million in 2019 over the bank’s fake customer accounts scandal.

Securities law is becoming an enormous catchall. It’s no longer just accounting issues that bosses have to worry about. It’s cybersecurity breaches, data privacy lapses, environmental calamities and sexual impropriety too. Social media is another potential minefield: Musk and Tesla’s board was sued earlier this year over his tweets.

For years insurers underpriced D&O policies, which cover negligence but not criminal behavior by executives. They’ve incurred losses as the frequency and severity of claims has soared. It’s no wonder they’ve been hiking their rates. The average D&O premium paid by U.S. listed companies has risen 56% in the past year, according to broker Aon Plc. U.K. company D&O rates jumped an eye-watering 130% in 2020 to levels last seen in the wake of Enron’s collapse, according to another insurance broker, Marsh. Rates for FTSE-100 companies have almost quadrupled, it said.

Punchy premiums

Emerging sectors like cannabis, cryptocurrency and blank-check companies are having particular difficulties finding adequate coverage because insurers have less visibility on what the potential risks might be. Several SPAC mergers involving electric-vehicle companies have already sparked shareholder lawsuits, including at Canoo Inc., Nikola Corp. and Lordstown Motors Corp. The U.S. Securities and Exchange Commission has emboldened disgruntled shareholders by raising doubts about whether the very optimistic financial projections SPAC executives tout enjoy legal protection.

Insurers are also getting pickier about who they cover and by how much. Sometimes they push back: Chubb Ltd. is sparring with the former chief executive officer of Wirecard AG over who should pick up his legal bills following the German fintech’s collapse.

Large companies are generally able to swallow these costs, albeit reluctantly. However, smaller businesses might have no choice but to accept lower coverage limits or a higher deductible, potentially hindering their ability to attract talented directors and stifling the good kind of corporate risk-taking. Some firms may even decide that becoming a public company just isn’t worth the hassle.

Few boards are willing to go without D&O coverage altogether, something Warren Buffett famously insisted on at Berkshire Hathaway Inc. so as to make directors more wary of “messing up.” Fortunately, some firms have found innovative workarounds to this insurance headache.

Musk’s surprising response was to offer to insure fellow board members himself before backtracking after proxy advisors objected due to the potential for conflicts of interest. The chairman of medical technology company Pulse Biosciences Inc. did something similar.

A better option might be to create what’s called a captive insurer, an in-house insurance subsidiary that underwrites the company’s D&O risk. Canadian cannabis company Hexo Corp. set aside C$30 million ($24 million) to do so in a move it estimates will save up to C$15 million in yearly premiums.

Rocketing D&O premiums are also the result of the sheer volume and expense of the securities litigation companies are getting hit with nowadays, some of which is meritless. Such complaints remain elevated compared to historic levels even though the number of new U.S. class action cases fell by a fifth last year, partly due to there being fewer contested M&A deals during the pandemic. Wider availability of litigation finance has helped fuel more lawsuits and some top corporate lawyers now charge more than $1,800 per hour.

Legal liability

There may be some relief in sight as higher premiums lure more competition. But companies hoping for outright price cuts may be disappointed unless policymakers do more to rein in spurious lawsuits. Boards can help too by improving corporate governance.

There will always be tension between shareholders’ important right to seek legal redress and ensuring companies don’t spend all their time in court. Soaring D&O premiums indicate that balance is increasingly out of kilter. Only the lawyers can be content.

Related:

• Insurer must cover union leader’s defense in extortion & conspiracy case
• Specialty insurance: Do you know everything you need to know?
• Real-world EPL, D&O lawsuits: Did you know they’re insurable?

Copyright 2024 Bloomberg. All rights reserved. This material may not be published, broadcast, rewritten, or redistributed.