In addition to compliance with and consideration of legislation and voluntary initiatives such as The Board Challenge, companies and their board members should look to their directors’ and officers’ liability (D&O) insurance, and potentially their cyberliability policies, in the event of litigation or potential privacy liability exposure. In fact, shareholder diversity derivative litigation already is among the trends impacting the rise in D&O insurance premiums.3
This year alone, at least seven diversity-related shareholder derivative suits have been filed in federal courts across the country, including against Oracle, Monster Beverage Corporation, and Facebook.4 Although it is too early to predict the outcome – no dispositive motions have thus far been filed – companies may incur substantial fees to defend against them.
Shareholder derivative suit allegations
Of the seven derivative actions filed to date, six have been filed by a single law firm out of La Jolla, California, against California-based companies, and the allegations in each of these cases are essentially identical. The complaints allege that the boards have violated federal and state laws, and breached their fiduciary duties, by refusing to appoint Black or minority5 individuals to the boards and other executive management positions. The complaints also allege that the boards have filed false and misleading proxy statements regarding the companies’ commitment to diversity and that the boards have breached their duties by continually rehiring the same auditors. As recently as September 1, 2020, a new lawsuit against Danaher Corporation was filed by a different law firm in the U.S. District Court for the District of Columbia, which suggests that this trend of derivative suits might not be limited to one geographical location or one plaintiffs’ class action firm.
Among other remedies, the plaintiffs demand the resignation of board members and executive officers to make room for diverse candidates; “disgorgement” of the current board’s compensation (including stock gains); a commitment to promoting hiring, advancement, and pay equity to minorities; required annual diversity, affirmative action, anti‐discrimination, and anti‐harassment training of board members and executive officers; termination of auditors; punitive damages; and attorney’s fees.
California’s AB-979
On September 30, 2020, California Governor Gavin Newsom signed into law California’s Assembly Bill 979, which requires any public company with its principal offices located in California, whether foreign or domestically incorporated, to comply with the following requirements:
- No later than the close of the 2021 calendar year, the company must have a minimum of one director from an underrepresented community; and
- No later than the close of the 2022 calendar year, a company with more than four but fewer than nine directors must have a minimum of two directors from underrepresented communities, and a company with nine or more directors must have a minimum of three directors from underrepresented communities.6
AB-979 defines a “director from an underrepresented community” as “an individual who self-identifies as Black, African American, Hispanic, Latino, Asian, Pacific Islander, Native American, Native Hawaiian, or Alaska Native, or who self identifies as gay, lesbian, bisexual, or transgender.” Companies may increase the size of their boards in order to comply with the law. AB-979 builds on California’s AB-826, signed into law in 2018, which requires at least one woman to sit on any corporate board with its principal offices located in California.
Under AB-979, no later than March 1, 2022, and each year following, California’s secretary of state must publish reports that detail the number of companies in compliance with AB-979’s requirements, the number of companies moving their principal executive offices to or from California, and the number of public companies that were subject to the law during the preceding year but are no longer publicly traded. As a penalty for noncompliance, AB-979 allows California’s secretary of state to impose fines in the amount of $100,000 for a first violation or failure to timely file board member information pursuant to AB-979, and $300,000 for any subsequent violation.
Public companies based primarily in California should be aware of AB-979’s requirements and begin planning ahead to comply with AB-979 by December 31, 2021. Failure to comply could not only result in fines but also generate additional litigation.
D&O insurance coverage
Although the plaintiffs in the shareholder derivative lawsuits may face significant legal hurdles in litigating their claims, even if the goals are to shine a spotlight on a company or effect change promptly, defense of litigation can be costly and settlements or judgments may include monetary amounts, including damages and plaintiffs’ attorneys’ fees. For large public companies like those targeted by these recent derivative suits, prolonged litigation could also result in a separate wave of shareholder securities claims. Knowing your D&O coverage should be part of an overall strategic plan.
Traditional D&O policies provide three types of coverage:
- The “Side A” insuring agreement covers defense costs, damages, settlements, and judgments arising from claims made against individual directors and officers when the company cannot or is legally unable to provide indemnification.
- The “Side B” or “corporate reimbursement” insuring agreement reimburses the company for defense costs, damages, settlements, and judgments arising from claims or suits made against individual directors and officers when the company indemnifies them.
- The “Side C” or “entity coverage” insuring agreement provides coverage for defense costs, damages settlements, and judgments arising from claims or suits brought directly against the company as an entity. Public companies are typically covered only for securities claims under Side C, but private companies may have broader coverage.
Shareholder derivative suits are typically treated as securities claims and are thus covered under D&O policies. Even if some carriers argue that certain of the remedies sought by plaintiffs may be excluded or uninsurable as a matter of applicable law, D&O policies should cover damages and other non-excluded amounts, as well as the defense costs. The lawsuits are brought against the directors and officers, with the company being a nominal defendant. Although defense costs incurred by directors and officers in shareholder derivative actions should be indemnifiable, monetary settlements and judgments typically are not, because the company would essentially be paying itself back. Thus, the Side A D&O coverage is critical to covering a diversity-related derivative judgment or settlement. Follow-on securities class actions are typically indemnifiable and thus generally fall under Side B (for claims asserted against directors and officers) or Side C (for claims asserted against the company).
Given the potential cost and uncertainty of litigation, companies and their boards should carefully review the terms of their D&O policies and consider the following:
- Crisis coverage. Some D&O policies provide a sublimit of liability to hire a public relations or crisis management firm to address certain types of losses resulting from adverse publicity due to shareholder activity. Although this may not be relevant for large public companies with sophisticated crisis teams in-house or on call, it is worth looking into, especially for smaller or private companies with more limited resources.
- Definition of “Loss.” Loss typically includes defense costs, damages (including punitive, exemplary, and multiplied damages, if insurable under applicable law), judgments, and settlements, and may cover awards of plaintiffs’ attorneys’ fees. Many D&O policies also cover certain civil fines and penalties if the loss is insurable under applicable law. Loss typically excludes amounts that are uninsurable under law or against public policy and also may exclude “disgorgement” or “restitution,” although in some cases, what may be asserted by an insurer as “disgorgement” or “restitution” may be more accurately characterized as a measure of damages and thus potentially covered under the policy. Exclusions for specific remedies or monetary amounts should not affect coverage for other non-excluded amounts. A D&O policy should continue to respond to defense costs and compensatory damages even if plaintiffs seek fines, penalties, or punitive damages that are uninsurable in a particular state jurisdiction.
- Insured versus Insured exclusions. All D&O policies contain an exclusion for claims brought by one insured against another, but virtually all have an exception for (meaning that the policy will continue to cover) independent derivative lawsuits.
- Fraud or “Conduct” exclusions. D&O policies contain exclusions for fraudulent or criminal conduct, although most modern D&O policies require that there must be a final, non-appealable adjudication establishing that an insured actually committed the excluded conduct. Although the current diversity-related derivative actions allege misrepresentations in the company’s public filings and statements, it is unlikely that these exclusions will bar coverage given that most derivative litigation settles prior to a final adjudication. The conduct exclusions in some D&O policies also may include willful violation of laws or rules. To the extent a claim alleges such conduct, the insurer likewise should not be able to apply the exclusion unless there is a final, non-appealable adjudication establishing that an insured willfully committed the violation. Moreover, D&O policies are intended to cover claims for violations of both existing and future laws.
Other considerations
Companies placing or currently renewing their D&O policies should also consider the following:
- How large is the self-insured retention?
- Is the company able to purchase additional Side A-only or difference-in-conditions coverage?
- Does the D&O policy cover the cost of shareholder derivative demand investigations?
Cyberliability coverage
An additional potential risk of the increased focus on corporate diversity initiatives is the heightened risk of privacy violations or claims related to increased collection and retention of diversity-related information, particularly when combined with the current pandemic-related virtual work environment that most companies are mandating and the increased activity by cybercriminals. These risks may be covered by cyberliability insurance.
Cyberliability insurance is a relatively new form of insurance and is continuing to evolve. The scope of coverage and insurance policy language can vary substantially from insurer to insurer and as between policies issued to different types and sizes of companies. Most cyberliability insurance policies cover certain of the costs companies incur in responding to privacy incidents, defense costs, damages, settlements, and judgments in civil litigation arising from alleged privacy violations, as well as defense costs, civil fines and penalties, and consumer redress funds in regulatory proceedings arising from alleged privacy violations.
Companies should undertake a holistic review of their D&O and cyberliability insurance policies, as well as other insurance policies in their portfolio, as part of sound risk management practices and board governance. In addition, companies preparing for placements or renewals should leave extra time for negotiations given the current market climate. If you have any questions about the content of this article or the current state of your company’s coverage for D&O claims, shareholder derivative action liabilities, or otherwise, please contact one of the authors of this article or any other member of Reed Smith’s Insurance Recovery Group.
- Anne Steele, Zillow, Nextdoor and Other Companies Pledge to Add Black Directors, Wall St. J. (Sept. 9, 2020).
- See theboardchallenge.org.
- Priya Cherian Huskins, Corporate Diversity Disclosures and Board Accountability, Woodruff Sawyer Insights (July 29, 2020), available at woodruffsawyer.com/corporate-diversity-disclosures.
- See Complaint, Klein v. Ellison, No. 20-cv-4439 (N.D. Cal. July 2, 2020) (Oracle); Complaint, Ocegueda v. Zuckerberg, No. 20-cv-04444 (N.D. Cal. July 2, 2020) (Facebook); Complaint, Falat v. Sacks, No. 8:20-cv-01782 (C.D. Cal. September 18, 2020) (Monster Beverage).
- The complaints do not define “minority.”
- leginfo.legislature.ca.gov/billText.
Client Alert 2020-533
