Opining on derivative contracts, Warren Buffet famously said in his 2002 Annual Report to shareholders, “In my view, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal”. Well, the financial crisis a few years later seems to have proven Warren right – no shock there.
In the world of D&O insurance, “derivative” refers to specific type of lawsuit that is brought by the shareholders of a company against the executives and directors (D&Os) of that company, but on behalf of the company itself. To simplify, existing shareholders want the individual D&Os to make the company whole for alleged and egregious mismanagement.
This is not a new exposure for companies, D&Os or their insurers, but it sure seems to have taken a turn due north on the risk-o-meter. The unofficial top three settlements (not including judgments) that have the largest cash component have now occurred in the last 24 months.
- $275 million Activision Blizzard (2014)
- $139 million News Corp. (2013)
- $130+ million Freeport-McMoRan (2014)
Boom. Those cash components are either funded by the personal assets of the individual D&Os and/or (and more likely) a D&O insurance program.
Important to note, in these cases, the Side A portion of the contact and/or any Excess Side A would pay. When it comes to the latter, the premium collected by insurers these days is likely 75% less than it was in 2002.
When is Derivative Litigation an Issue?
Yeah, but, this is only real if a company and its executives get themselves in a real jam right?
Well, that may not be hard to do. Derivative litigation does not necessarily need to be rooted in alleged accounting fraud, insider selling, or even inadequate disclosure. The real exposure can be (gulp) good old-fashioned allegations of mismanagement and failed corporate governance!
- M&A transactions gone bad
- Costly FCPA or other regulatory (civil or criminal) investigations and/or settlements
- Mishandling of cyber security issues
- Mishandling of environmental issues
- Whistleblower issues/cover-ups exposed
- Questionable executive compensation programs
- And on and on
As you see, many D&Os can look at this list and see that exposure is present in many areas !
And just so the company doesn’t feel left out – any defense and investigation costs leading up to these settlements likely has been funded by the company itself, or perhaps their D&O insurers.
While we certainly don’t see D&O insurers folding up shop the way Berkshire Hathaway folded its financial products division pre-crisis, there may come a time where the cost of Side A D&O insurance levels off because it is no longer seen as “free premium.”