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Derivative Suits: Recent Developments
Numerous studies and articles document the alarming increase during the last few years in the size of settlements in securities class action lawsuits. As a result, directors, officers, insurers, brokers, and others focus almost exclusively on securities class actions when evaluating risks and structuring D&O insurance programs. Although largely ignored in that analysis, shareholder derivative lawsuits are also very important liability exposures particularly for directors since directors are named as defendants in derivative suits far more frequently than in securities class actions and since settlements and judgments in derivative suits are usually not indemnifiable by the company.
Derivative lawsuits are brought by shareholders on behalf of the company and seek to recover damages incurred by the company as a result of mismanagement, breach of one or more fiduciary duties, or other wrongdoing by directors and officers. Any settlement or judgment is paid to the company, not to the shareholders. Historically, settlements in derivative suits have been far less than settlements in securities class actions for two reasons. First, recoverable damages to the company are usually far less than potentially recoverable damages to members of the class (which are calculated based on the number of shares sold by the company or traded in the open market).
Second, defendant D&Os usually have more and better defenses to a derivative lawsuit than to a securities class action. As a result, according to a recent study by Advisen, about half of derivative suits are dismissed, as compared with only 10-15% of securities class actions being dismissed. Examples of some of the defenses available in a derivative suit that are not applicable to securities class actions include the following:
- Business Judgment Rule. If directors and officers make informed and disinterested decisions and believe in good faith they are acting in the best interest of the company, this defense applies. In essence, directors and officers are liable only for faulty procedures in making a business decision, not for making a poor-quality decision.
- Exculpation Statutes. In most states, statutes exist which relieve directors (usually not officers) from liability to the company or its shareholders for breach of their fiduciary duty of care if they acted in good faith.
- Reliance. When making decisions, directors are entitled to rely in good faith on advice from informed committees and experts.
- Pre-Suit Demand. A shareholder who wishes to file a derivative suit is required first to make a demand on the company's directors to bring the suit directly by the company, unless the shareholder alleges with particularity facts specific to each director which create a reasonable doubt that the directors could have properly exercised their independent and disinterested business judgment in responding to the demand. If in response to that pre-suit demand the disinterested members of the Board
conclude after a thorough and independent investigation that it is not in the company's best interest to prosecute the proposed claim, the shareholders are usually prohibited from prosecuting the derivative suit on behalf of the company.
Despite these potential defenses, derivative lawsuits are frequently brought in tandem with securities class actions or when the company arguably suffers large direct losses due to perceived wrongdoing by directors or officers. Unlike the securities class action lawsuit, though, settlements and judgments in derivative suits are usually not indemnifiable and are therefore covered only under 'Side-A' of the D&O insurance policy. With the increased sensitivity of directors and officers to the threat of personal settlement contributions and the increased popularity of D&O insurance policies affording coverage for only non-indemnifiable losses (ie, 'Side-A' policies), it is now more important than ever to monitor developments in derivative suits. The following discussion summarizes some of the noteworthy recent court rulings and settlements in this area.
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