It is extremely rare for a public company merger transaction to go ahead without a glitch. Rather, public company directors and officers (D&Os) face the almost inevitable prospect of dealing with at least one objection lawsuit.
In the past five years, there has been a material change in how and where merger objection lawsuits are filed. Up until 2016, most were filed in Delaware Chancery Court, alleging violations of Delaware law, but in 2016 the Delaware court became publicly adverse to that type of litigation, a sentiment expressed in the Trulia case, forcing plaintiffs’ attorneys to file merger objection claims in federal court based on alleged violations of Section 14 of the Securities Exchange Act of 1934.
From 2016 to 2017, federal filings of securities class action (SCA) suits jumped from 298 to 426, with the most marked increase being in merger objection filings (2016: 92; 2017: 205), according to NERA Academic Consulting. From 2017 through 2019, yearly SCA suits hovered in the 420s, dominated by merger objection filings and Rule 10b-5 filings – a regulation under the Securities Exchange Act of 1934, which targets securities fraud.
For D&O insurers, one of the more troubling aspects in the way public company litigation developed over that period (2016-2019) was the uptick in more complex filings, according to Paul Manguson (pictured), public D&O product manager at Travelers. The more complex filings alleging violations of Rule 10b-5, plus Section 11 and/or 12 infringements, are more difficult to defend, have lower dismissal rates, and higher median settlement values. This, in turn, caused an uptick in the severity of public company D&O insurance claims, which has triggered firming market conditions.
In 2020, there were 326 federal SCA suits filed, marking a decrease of 22% from 2019, according to NERA’s ‘Recent Trends in Securities Class Action Litigation: 2020 Full-Year Review.’ The most common allegation (in 35% of claims) related to misled future performance – a new trend compared to the past five years when the most common complaints involved accounting issues, regulatory issues, or missed earnings guidance. However, despite the decrease in aggregate SCA filings, the average settlement value in 2020 was $44 million, more than a 50% increase over the 2019 average of $28 million, highlighting an uptick in the severity of cases filed.
“2020 was a very different year,” said Manguson. “There were some challenges in the court system. The courts, like all businesses, had to grapple with new issues like remote working and providing expanded digital and virtual access in the courtrooms. It’s reasonable to think that may have had an impact on the SCA filings.
“M&A activity is very impactful in terms of the SCA filings count, and, in 2020, M&A activity was different than it has been in the past five years. It was very much a tale of two halves. Deal activity in the first half of the year was at historic lows, but the second half of the year saw about a 90% increase over the first, which more than made up for the slowdown. That’s interesting because it’s not an even distribution. It’s very much back-end loaded, and how that plays out in terms of D&O claim activity is yet to be determined.”
Overall, the 2020 deal volume in dollars on a year-over-year basis was only about 5% less than 2019. The deals that did go through tended to be larger, with a higher dollar value. This ties into another issue that can drive D&O claims, particularly in the pandemic-driven economic recession, which is bankruptcy.
“Interestingly, bankruptcy filings were down year-over-year in 2020, likely as a result of accommodative policies from the Federal Reserve, and ample liquidity in the credit markets. That definitely helped businesses stay afloat […] and probably opened up the doors for increased acquisitions in the second half of the year,” Manguson told Insurance Business. “Also, if you think about the second half of the year and why M&A activity picked up, by that time it had become second nature, to a certain extent, for a lot of businesses to operate remotely or within the new abnormal of COVID.”
As the US pushes through its COVID-19 recovery, it’s uncertain how long the Federal government will sustain its accommodative monetary policy and how that will play out in the credit markets. All of that uncertainty presents public company D&O exposure.
“There’s a lack of visibility in general, now and in the near-term, around changing consumer behaviors and potential disruptions in the supply chain, specifically for key components of production that impact multiple industries,” Manguson added. “That’s something that’s going to be notable, and D&O insurers will observe closely.”