In 2012, the Federal Court of Australia’s decision in ASIC v Healey sent shockwaves through the boardrooms of large Australian companies and beyond. All seven non-executive directors as well as the Chief Executive Officer of Centro Group were found by the Court to have breached their duties of skill care and diligence in failing to notice significant errors in the company’s financial statements. The follow-on shareholder class action was settled in 2012 for $200 million (AUS).
To this day, that remains the largest shareholder class action settlement in Australia. Yet in one key respect, the Centro case conformed to the classic U.S. securities class action model unlike many Australian securities claims brought and settled both before and since. The feature in question was the inclusion as co-defendants alongside Centro itself, of a number of its directors and officers. It’s perhaps no exaggeration to say that it’s the absence of this feature in many other such cases which may be a significant contributory factor to the crisis of multimillion dollar settlements which the Australian D&O insurance market is currently having to address.
To understand how and why this has happened it is necessary to look back to the origins of the way in which securities claims first came to be covered under D&O insurance and how the insurance has since been developed to respond to categories of claims under Australian securities laws, which it was arguably never originally designed or intended to cover.
The U.S. coverage problem that Side C was designed to solve
At first blush it seems curious that one of the most severe forms of liability for a publicly listed company came to be the only type of ‘entity cover’ offered under a form of liability insurance originally only designed (as the name suggests) to protect directors and officers. The story begins in the United States where for many decades (as is still true today) both the frequency and severity of class action lawsuits is greater than anywhere else on the world.
Side C cover was introduced into D&O insurance contracts to cater to a very specific problem. In situations where litigation was brought against both covered and non-covered individuals and/or entities, it was difficult to allocate the amount of defense costs and damages or settlements between loss covered under the insurance contract and that which was not. To take a simple example, assume a listed company is sued alongside its CEO and CFO in relation to allegations concerning misleading financial statements. And $5 million (USD) is spent defending the claim, which is ultimately settled for $20 million. How much of both the costs and the settlement would be covered under the D&O policy?
To cater for these disputes, D&O polices would invariably include allocation clauses. These tended to run on similar but not identical terms and provide that the parties would use their best endeavors to reach a settlement of this type of controversy often by reference to the “relative legal and financial exposures of the parties” concerned or some variant of this. Failing such agreement, the parties would submit the dispute to resolution often by the courts (allocation clauses along these lines are still an extremely common means in D&O contracts of resolving disputes as to covered and uncovered loss other than for securities claims).
It was precisely because the stakes were (and continue to be) especially high in securities class actions that allocation clauses proved inadequate as a means of resolving the controversy between covered and non-covered loss. The issues frequently ended up before the U.S. Courts and in the 1990s and early 2000s various leading cases such as Nordstrom and Caterpillar produced doctrines such as the larger settlement rule. These were more or less unfavorable to insurers, but still left areas of uncertainty. To resolve these uncertainties, insurers introduced the concept of Side C cover in the late 1990s. In return for an additional premium, and often subject to a larger deductible, insurers agreed to cover not just the directors and officers but also the entity for securities claims thereby effectively eradicating the need for allocation clauses on the basis that insurers would cover the whole of the loss in every case.
The development of Side C cover
The solution proved popular with companies and was also good for directors, since they could be certain they wouldn’t be left with unfunded elements of defense costs or settlements while insurers and companies battled out allocation issues. That logic holds as true today as it did when the cover was first introduced.
The assumption which underlay the introduction of Side C cover in the U.S. also continues to hold true for the overwhelming majority of U.S. securities claims in which the plaintiffs invariably join as co-defendants, not just the company but a least one of its directors or officers. This is done for good reason under U.S. securities laws where it’s generally a requirement to establish ‘scienter,’ i.e. knowledge of material facts or information among senior management insiders which was deliberately withheld or concealed from the shareholders. Indeed we haven’t been able to find evidence of a single Federal U.S. class action lawsuit in which the entity alone has been named as the sole defendant in a class action lawsuit.
At some stage after the introduction of Side C cover and in prevailing soft market conditions especially outside the U.S., coverage terms were broadened both generally and in one specific and highly relevant respect: The requirement that the entity be sued alongside at least one co-defendant director or officer as a trigger for cover was dropped. Instead, cover was extended to include so called “pure entity claims,” (i.e. claims where it wasn’t necessary for there to be any individual co-defendants named in the suit). Presumably insurers were prepared to grant this extension on the basis that they thought the additional risk to which they would be exposed was slight, given their understanding as to the claimants’ need to establish scienter (as explained above).
Over the past five years and more, D&O policies providing pure entity cover for securities claims have become commonplace in Australia and indeed throughout the world.
The problem with Pure Entity claims in Australia
What insurers may have failed to take into account is the significant difference between the legal basis on which the majority of Australian Class Action lawsuits proceed, compared with their U.S. cousins. In Australia it’s not necessary for claimants to allege that the relevant misleading, deceptive or unconscionable conduct was committed by individual directors. It’s only necessary for claimants to prove that the company delayed the release of information to the market or that such information was materially incorrect or misleading. Under ASX listing rules specific to the disclosure of market sensitive information, there’s no requirement for the omission to be deliberate or negligent for the action to succeed. Significantly, claimants are relieved of the scienter burden and hence of the need to name directors or officers as defendants at all.
There’s a small but highly specialized and well-established group of Australian plaintiff law firms supported by an active litigation funding market which has proved itself very adept at pleading shareholder claims in a way which takes full advantage of the seemingly low threshold under ASX rules for bringing successful claims.
My impression is that a high proportion of the total number of class action lawsuits commenced in Federal and/or State Courts in Australia over the past five years have been pure entity claims. Given the average settlement value of a shareholder claim has been estimated at $62 million, I strongly suspect that a significant amount has been paid out by D&O insurers to settle claims which appear to have no direct connection to the liability of directors or officers. It’s for this reason the Australian D&O market has arguably been distorted by a quirk in this class of liability insurance that was never intended to cover quite this exposure.
A possible solution
It may be argued that this is a problem which doesn’t really need a solution other than market forces. After all, there was no obligation on D&O insurers to extend securities cover to pure entity claims in the first place. To the extent they have done so, and seemingly mispriced the corresponding premiums, perhaps they should be viewed as the authors of their own misfortune. True as this may be, the risk for directors is the baby gets thrown out with the bathwater while the market rebalances.
If listed companies cannot buy sufficient or indeed any type of Side C cover (as that cover was originally conceived) it means that individuals asked to serve as directors or officers may have to run the risk that, in the event of another Centro type claim, they may face precisely the gap in cover as a result of allocation uncertainties that existed in the U.S. in the early 1990s. Centro was, it will be remembered, insolvent so that, in effect, in that case the insurance was the only remaining safety net for the directors.
Would it not be preferable for companies to have the option to negotiate Side C cover on a more restricted basis that didn’t provide pure entity cover, but instead built in a pre-determined percentage allocation as between the company and its directors in the event they are both named in the same proceedings? That could be agreed on a sliding scale from 100% downwards both as to defense costs and settlements depending on risk appetite, market conditions and pricing. For those who had the desire and ability to continue to buy pure entity Side C cover they would have the ability to do so.