Mr. Bailey is a member of the Columbus, Ohio, law firm of Bailey Cavalieri LLP. Mr. Bailey specializes in D&O liability insurance, corporate, and securities law. He is a frequent lecturer and has authored and coauthored several books dealing with D&O liability issue.

This material is not intended to provide legal advice as to any of the subjects mentioned but is presented for general information only. Readers should consult knowledgeable legal counsel as to any legal questions they may have.

The D&O claims environment is now and will likely continue to be more active and dynamic than recent years. The frequency of D&O claims in several important areas, and the potential for significant D&O exposure in other areas, has increased with few signs of relief on the horizon. These developments are largely not a result of new statutes, rules, or case law, but instead reflect changing economic conditions, regulatory diligence, and creative tactics by the plaintiffs' bar.

Whether these troubling developments continue or even worsen depends in large part upon the “Trump factor.” The new Administration's potential impact on future D&O claims activity cannot be overstated. Stock market performance, the heath of the U.S. economy, the focus of regulatory enforcement activity, and the future composition of the U.S. Supreme Court and the federal judiciary, all of which directly impact D&O liability exposures, may be significantly changed in the next few years. Whether those changes actually occur and how those changes increase or decrease D&O exposures is yet to be seen, but executives and their insurers now face one of the most unpredictable futures in recent history.

The following summarizes many of the recent developments involving D&O claims and identifies some of the related D&O insurance issues that arise as a result of these recent developments. During these uncertain times, it is especially important for those who advise and insure directors and officers to carefully monitor and react to these and other developments.

1. Securities Class Action Litigation. The single biggest development relating to D&O claims activity is the resurgence of securities class action litigation. The frequency of this litigation reached record levels in 2016, and 2017 numbers are even greater. According to some studies, the number of securities class action filings in 2016 was more than 40 percent greater than the number in 2015. The filing rate during the second half of 2016 was the highest for any semi-annual period since 1996, and that trend is continuing into 2017.

This increase in securities class action frequency is primarily attributable to four dynamics. First, and most troubling, is the increased volatility in the U.S. securities markets leading up to and following the presidential election. Although the Dow Jones Industrial Average surpassed 20,000 for the first time, the broader market has been quite unstable, with many companies experiencing significant drops in market price. That type of volatility fuels securities class actions because the plaintiffs' bar can typically allege with some credibility that a company's sudden stock drop was attributable to information that was known and should have been disclosed by company executives at an earlier date. The larger the stock drop, the greater the potential damages in the class action. So, as volatility in the market increases, both the frequency and severity of the resulting securities class actions increases. Given the general turmoil created by the Trump Administration, this volatility is likely to continue and perhaps increase for the foreseeable future.

Second, the type of securities class action lawsuit that experienced the largest increase in filing activity during 2016 was merger-related litigation. Although the higher frequency of this type of claim is likely to continue, the severity of this type of claim is likely to remain modest. These M&A-related claims do not reflect a new exposure for directors but merely reflect a change in litigation strategy by the plaintiffs' bar. In the past, virtually all M&A-related claims were filed in state court alleging breaches of fiduciary duty by the directors of the target company. However, largely because of the Trulia decision by the Delaware Chancery Court in January 2016, most plaintiff lawyers now prefer to file merger-related claims in federal court, alleging misrepresentations and omissions by directors and officers in connection with the merger violated federal securities laws, rather than alleging breaches of fiduciary duty by the target's directors and officers. Prior to the Trulia decision, the vast majority of state court M&A-related claims were quickly settled pursuant to which the company agreed to make some additional disclosures to the shareholders in connection with the transaction, and the plaintiff lawyers received a modest fee award. But the Delaware court concluded in Trulia that this type of disclosure-only settlement in M&A claims is highly suspect because the shareholders receive very little, if any, benefit from the settlement but grant to the defendants broad releases. As a result, most M&A-related D&O claims are now filed as securities class actions in federal court, where the plaintiffs' bar hopes to enjoy greater flexibility in structuring settlements.

Third, the number of securities class actions against foreign issuers materially increased in 2016. This development reflects an increased scrutiny by plaintiff lawyers of foreign companies, many of which lack the experience, discipline, and culture to comply with rigorous U.S. regulations of public companies. As the U.S. dollar continues to strengthen, it seems likely that foreign countries will continue to access the U.S. capital markets more often, thereby fueling a continuation of these foreign company securities class actions.

Fourth, the industry segment that experienced the largest growth in securities class actions in 2016 was the life sciences industry, which experienced an 86 percent D&O claims increase. Because many of these companies are heavily dependent upon regulatory approvals and are highly susceptible to regulatory sanctions, these companies can suffer dramatic and sudden consequences without warning, resulting in very large and immediate stock drops. That fact pattern will inevitably generate securities class action litigation, which often will have a large settlement value due to the large alleged damages, as evidenced by the large stock drop.

Insurance Considerations: Because the size of settlements in securities class actions has and will likely continue to grow as the size of the stock drop and thus the size of damages grows, insureds should reevaluate the adequacy of their D&O insurance program limits of liability. Even if a company's existing limits are viewed as adequate for any reasonably predictable class action exposure, directors and officers today face greater risk for parallel or unrelated claims in the same policy year, so it is more important than ever that a D&O insurance program be large enough to accommodate multiple and potentially severe claims from different sources and perhaps based on different facts.

2. M&A Claims. There are far fewer state court M&A objection cases today in light of the Delaware Trulia case discussed previously. Several courts outside of Delaware have followed the Trulia decision and rejected disclosure-only settlements in these types of cases. But, an intermediate appellate court in New York declined to follow Trulia and approved a disclosure-only settlement. in Gordon v. Verizon Communications, Inc., 2017 N.Y. App. Div. LEXIS 740 (N.Y. App. Div. Feb. 2, 2017). More state court M&A objection cases may be filed in New York as a result of this ruling.

Although the vast majority of M&A-related claims (whether filed in state or federal court) are resolved for little if any financial payment, some M&A-related claims have very high settlement values. The most important criteria in separating meritless merger claims versus high exposure merger claims is the existence of perceived conflicts by the target's decision makers or advisors. Such conflicts prevent the defendants from relying upon important defenses such as the business judgment rule and state exculpation statutes and thus expose the defendants to potentially enormous damages. Ironically, these perceived conflicts of interest can almost always be prevented with careful planning and advice from qualified advisors. But, if anyone involved in the decision process ignores this simple loss prevention concept, a routine and meritless D&O claim can become an extremely expensive claim to defend and settle.

Insurance Considerations: M&A claims in federal court alleging securities law violations are more likely than state court claims to continue after the transaction closes. The terms and size of the run-off D&O insurance program purchased by the target company should be examined in light of this dynamic. If the preexisting D&O insurance program is simply converted to run-off, the preexisting M&A claim may significantly dilute the limits of that run-off program when that claim is subsequently settled. As a result, fresh limits for the run-off program are likely preferred. Also, the target's D&Os should confirm that a solvent entity is obligated to indemnify them post-closing for any liabilities they incur arising out of conduct pre-closing.

3. Derivative Suits. Shareholder derivative lawsuits continue to be filed with greater frequency than historical experience. However, recent developments relating to derivative litigation have generally been positive for the defendant directors and officers in three respects.

First, the concern that arose in late 2014 relating to more frequent mega derivative settlements has not materialized—so far. Since late 2014, only one mega derivative settlement was announced—a $90 million settlement in early 2017.

Second, most derivative lawsuits continue to be dismissed by the courts based upon the plaintiffs' failure to satisfy various procedural requirements, such as making a pre-suit demand on the board of directors, or based upon various state law defenses, such as the business judgment rule and state exculpation statutes.

Third, pursuant to recently-enacted Section 115, Delaware General Corporation Law, many public companies chartered in Delaware have adopted a forum selection bylaws provision, which requires all proceedings relating to internal affairs (such as state law director and officer liability claims) to be adjudicated only in Delaware courts. Although clearly enforceable under Delaware law, some observers have questioned whether courts in other states will enforce such an exclusive forum selection provision, thereby depriving courts in those other states from exercising jurisdiction over claims by shareholders in those other states. However, courts in New York, Texas, California, Illinois, Ohio, and Missouri, among others, have now upheld the validity of such forum selection bylaw provisions. As a result, there now is a high likelihood that such provisions will be enforced by courts outside of Delaware.

These forum selection bylaw provisions can be helpful in defending derivative lawsuits by preventing plaintiffs from filing identical derivative suits in multiple states, thereby avoiding the significant increase in the costs to defend multiple lawsuits as well as the risk of inconsistent rulings in the various lawsuits. Interestingly, defendant D&Os in some situations are not invoking their company's forum selection provision to dismiss claims in other states if the defendant D&Os believe it is strategically wise to litigate or settle the case in the other state rather than Delaware. In other words, a forum selection bylaw provision gives the defendant D&Os maximum flexibility in selecting their preferred forum to defend and settle derivative suits against them, and removes from plaintiff lawyers that discretion.

However, the forum selection bylaw provision may not contain a fee-shifting feature as well, which requires a shareholder who files a D&O claim outside of Delaware to pay the attorney fees incurred by the defendants to enforce the forum selection provision. That fee-shifting portion of the provision was held unenforceable by the Delaware Chancery Court as a violation of Section 109, Delaware General Corporation Law, which was enacted in 2015 to prohibit a “loser pay” fee-shifting bylaw provision applicable to D&O claims. Solak v. Sarowitz, 2016 Del. Ch. LEXIS 194 (Del. Ch. Dec. 27, 2016).

Insurance Considerations: Because derivative settlements typically are non-indemnifiable Side A losses, companies should reexamine the adequacy of their Side A insurance program limits and terms. As the frequency and severity of various other types of D&O claims increase, there is a higher likelihood that the underlying ABC insurance limits will be significantly eroded or exhausted before the derivative lawsuit is settled, in which case the only financial protection available to the defendants in the derivative lawsuit would be the Side A insurance program.

4. SEC Enforcement. SEC enforcement activity reached a record level in the 2016 fiscal year. Ninety-two actions were brought against public company defendants, most often alleging misrepresentations in company disclosures. Whether that level of enforcement activity against public companies and their directors and officers will continue under the Trump administration is an open question, but the SEC clearly is now equipped to be a formidable opponent in these proceedings for two reasons in particular. First, the vast majority of SEC proceedings in 2016 were brought as administrative proceedings, which means that the defendants' liability is adjudicated by an administrative law judge who is an employee of the SEC and who is frequently perceived as having a bias towards the views of the SEC. These administrative proceedings have been harshly criticized and challenged as unconstitutional but are still the SEC's forum of choice.

Second, the whistleblower program established by the Dodd-Frank Act, which rewards and incentivizes individuals to provide confidential information to the SEC to assist its enforcement activities, has had a transformative effect on the agency's enforcement efforts, according to the SEC. In 2016, for example, the SEC received 4,218 whistleblower tips and paid $57 million as awards to thirteen whistleblowers. Those 2016 awards represent six of the ten largest awards ever paid, evidencing the increasing value of whistleblower tips to the SEC.

Insurance Considerations: Insurers and insureds should particularly consider two coverage issues relating to SEC enforcement matters. Some D&O insurers now offer entity investigation costs coverage, which supplements the investigation costs coverage typically afforded for directors and officers under the D&O policy. The SEC targets the company more frequently than directors and officers in its investigation efforts. Costs incurred by the company in connection with an SEC investigation are frequently quite large, but those entity costs typically are not covered under a D&O policy. Adding this additional entity coverage under the policy can be quite useful to the company, although a meaningful additional premium is usually charged and the additional coverage can result in a significant erosion of the limits otherwise available for directors and officers.

A second coverage issue to consider is whether an adjudication of fraud in the SEC proceeding will trigger the conduct exclusion for purposes of a parallel securities class action lawsuit arising out of the same conduct. Fraud exclusions in D&O policies today usually require the adjudication of fraud to occur in “the,” “an,” “any” or “such” proceeding. Which of these seemingly innocuous words are used in a particular exclusion may affect whether the adjudication in the SEC proceeding results in loss of coverage in the related securities class action.

5. Criminal Proceedings. Since late 2015, much has been said about increased D&O criminal exposures in light of the so-called Yates Memorandum, which strongly incentivized companies to provide to the Department of Justice relevant facts relating to director and officer criminal misconduct and required U.S. Attorneys to investigate individual culpability in any corporate investigation. Since then, a number of officers have been indicted, but it is not clear whether those indictments were the result of increased DOJ vigilance. For example, the indictment of executives at Volkswagen and Takat relating to disguising emission levels and airbag defects involved such highly-publicized incidents that criminal charges may have been made independent of the Yates Memorandum.

There is little evidence to date to show that the purported increased focus on executive criminal wrongdoing has, in fact, resulted in many, if any, criminal indictments. But, the mere threat of that potential exposure is sobering news for executives and should serve as a strong incentive to avoid even the appearance of criminal wrongdoing.

Insurance Considerations: D&O policies typically contain at least defense costs coverage for criminal proceedings. If an insured person refuses to provide testimony or documents in a claim based upon his Fifth Amendment privilege against self-incrimination, is coverage for that person jeopardized? Some case law concludes that an insured's assertion of the Fifth Amendment privilege breaches the insured's duty to cooperate with the insurer and thereby jeopardizes coverage. To address that potential coverage limitation, the D&O policy could include a provision that prohibits the insurer from raising a coverage defense based upon the assertion of that privilege.

6. Foreign Corrupt Practices Act. The policing of foreign anti-bribery activity has been a very high enforcement priority by the Department of Justice and the SEC. For example, in 2016, a record $2.43 billion in fines and penalties were assessed for violations of the Foreign Corrupt Practices Act (FCPA). It seems likely that enforcement priority will continue even under the Trump administration. To date, though, the enforcement focus has primarily been against corporations rather than against individuals. For example, in 2016, only one FCPA criminal claim was asserted against an individual and only eight civil FCPA claims were asserted against individuals. It would not be surprising, though, that as FCPA investigations of and charges against companies continue to increase, more individuals will be swept into those investigations and proceedings.

Insurance Considerations: What, if any, coverage exists for fines and penalties? Historically, D&O policies excluded virtually all fines and penalties (other than civil fines for an unintentional violation of the FCPA). More recently, many policies cover any fine or penalty for an unintentional violation of law.

7. Cyber Claims. Unquestionably, cyber-related losses and claims are one of the most troubling future exposures for companies. It is virtually impossible for companies to prevent cyber attacks. Loss mitigation, rather than loss prevention, seems to be the only strategy available for most companies.

In contrast, the liability exposure of directors and officers for cyber-related claims may be much less. Despite several very large and highly-publicized recent cyber intrusions at large companies, only one securities class action lawsuit has been filed against directors and officers relating to any cyber attack to date. That case, which was recently filed against Yahoo! and its executives, is quite unusual because it is based upon cyber attacks against the company which were not disclosed for nearly two years and which allegedly compromised more than one billion customer accounts. Most importantly, a noticeable stock drop in Yahoo!'s stock price occurred soon after the company's announcement. In all other cyber attack situations involving other companies, no significant and immediate stock drop followed an announcement of the cyber attack. Typically, a company's initial disclosure of the attack is rather vague because the extent of the attack is not fully known during those early days of the investigation. As more information is disclosed to investors over time, the company's stock price either is not impacted by the further disclosures or gradually decreases over time. Under either scenario, there is no clear evidence that an alleged misrepresentation caused a stock price inflation and therefore a securities class action lawsuit is very unlikely.

In contrast, companies that suffer large cyber-related losses will more likely attract shareholder derivative lawsuits against its directors and officers for alleged mismanagement related to the cyber incident. However, to date this type of derivative litigation has generally been successfully defended by invoking the business judgment rule, the applicable state exculpatory statute for directors, and other state law defenses for the defendant directors and officers. A cyber incident will rarely involve conflicts of interest and therefore should rarely give rise to large derivative litigation settlements.

The area of greatest potential exposure for directors and officers in this context does not arise from acts or omissions by directors and officers prior to the attack, but rather from conduct of directors and officers once the attack is identified. Disclosures regarding the scope, effect and cause of the attack, and the response by management immediately following the attack, can potentially create either securities class action or shareholder derivative litigation. Therefore, companies should develop and implement long before a cyber attack actually occurs effective protocols and action plans that describe what should and should not be done if a cyber attack against the company occurs. Careful advanced planning in this area can provide a unique opportunity to minimize the potential personal liability of directors and officers for post-attack conduct.

Insurance Considerations: D&O policies typically do not contain a cyber exclusion, so full coverage should exist for most cyber D&O claims. The one policy provision that should be considered in this regard is the “loss of use” portion of the property damage exclusion in D&O policies. That exclusion should clearly apply only to claims for the loss of use of damaged tangible property, rather than loss of use of any tangible property.