Capitalism is under siege today, in large part because of a crisis in business leadership.
Stories abound of CEOs ensnared in allegations of sordid behavior and boards of directors that elect to overlook the accusations. What used to be whispers of impropriety are now broadcast across the world via social media. The lack of leadership integrity has stained the reputations of so many companies that the public can’t help painting all business with a broad brush.
All of this has resulted in a sharp uptick in the volume of securities class-action lawsuits filed by shareholders against corporate directors and officers. In addition, event-driven claims against board directors and higher settlement values wrung by an invigorated plaintiff’s bar have given board directors—and D&O insurers—ample reason to worry about their wallets.
“A perfect storm is whipping up to alter the course of the D&O liability insurance market,” says Phil Norton, senior managing director in Gallagher’s management liability practice.
As a result, the D&O liability insurance market is hardening like quick-setting cement, resulting in much higher client risk retentions and policy pricing. Norton says rate increases are between 5% and 20%. “For years, the frequency of securities class actions was pretty stable,” Norton says. “This is no longer the case. Claims have rocketed in the past three years to exceed all years of the post-1995 period, except 2001 and 2002, the last time we had a big hard market for D&O.”
Class-Action Suits Boom
Corporate misdeeds are nothing new. From the savings and loan junk bond debacle of the 1980s through the Enron and WorldCom implosions of the early 2000s, senior executives who flout the rules and directors who are negligent in their oversight responsibilities have become a rogues’ gallery in the literature of business. Today, their number is exploding. In 2018, the Securities and Exchange Commission received a record 5,282 whistleblower reports, primarily from insiders at companies who identified illegal behavior.
In response, shareholders, customers and employees are holding these individuals accountable for their acts with more vigor. Securities class-action lawsuits against company directors and officers have more than doubled from just four years ago, according to a June 2019 report by insurer Chubb. In both 2017 and 2018, the volume of this litigation filed by plaintiffs in federal courts broke new records. Last year alone, approximately one in 12 public companies was the target of a securities class action, and among the S&P 500, the average was one in 10, according to Cornerstone Research.
These figures are the highest that Cornerstone has reported since 2008, when securities class actions surged because of the financial crisis. Aside from the increase in whistleblower reports and social movements like #MeToo, the reason for the current spike in litigation—in what is inarguably an extremely buoyant period of economic prosperity and growth—is an emboldened plaintiff’s bar.
“Newer law firms have entered the game, some in expectation of a potentially hefty payday, and they play it a lot differently,” Norton says. “Older, established law firms knew if they had a strong lawsuit they could settle for X percent of damages and if weaker they could settle for Y percent.”
Separate derivative class-action lawsuits also are being filed against boards of directors for unexpected events that occur under their watch. In such cases, directors are sued not for their actions per se but for their inaction. A shareholder derivative lawsuit targets board directors of Blue Bell Creameries for allegedly failing to enact measures to ensure the company’s ice cream products were free from contamination. In 2015, a deadly listeria outbreak linked to Blue Bell ice cream erupted, resulting in a major product recall. Plaintiffs subsequently sued the directors for breach of fiduciary duty on behalf of shareholders.
In June, the Delaware Supreme Court revived the shareholder lawsuit, which had been dismissed by lower courts. “The thinking behind these event-driven lawsuits is that board directors could have prevented or at least mitigated the loss through better management practices,” says Dan Bailey, member at law firm Bailey/Cavalieri, which often represents insurer defendants in D&O liability litigation.
Another factor in the current securities class-action boom is the U.S. Supreme Court’s decision in Cyan, Inc. v. Beaver County Employees Retirement Fund. The court ruled that securities plaintiffs could bring class actions under the Securities Act of 1933 in state courts, causing a paradigm shift in how defense lawyers defend these actions and the ways in which D&O insurers insure them. “State courts are generally viewed as a very pro-plaintiff forum when compared with federal courts,” Bailey says.
The decision has produced severe repercussions for companies undertaking an initial public offering of stock, as it also permits investors to file securities class actions challenging the veracity of stock registration statements. “If a company’s stock price plummets in a short period of time from its initial trading price, shareholders are likely to file a class action alleging that it did not disclose material information,” says Rodger Laurite, practice leader for executive lines at Lockton Companies.
IPOs have always been risky for D&O insurers from a liability standpoint, and now they’re even riskier. “We’ve seen huge self-insured risk retentions for IPO-bound companies—as much as $25 million in some cases—and insurance pricing four to five times higher than just two to three years ago,” Laurite says.
The industry has taken note. “There’s just an elevated level of litigation, larger D&O settlements, and rising concern over these big derivative lawsuits and the impact of the Cyan Supreme Court decision,” says Priya Cherian Huskins, senior vice president and D&O liability expert at Woodruff-Sawyer.
Bailey concurred: “Like most D&O lawsuits, the cases eventually result in a settlement, but the settlements we’re seeing are much higher across the board.”
Society’s New Standards
With the rise of corporate social responsibility and a new generation of workers who want to find value and meaning in their organization has come a general public with seemingly less tolerance for bad behavior. And that extends to the board. “Although some people would argue that boards are fiduciaries with duties to shareholders and not to society, this is increasingly seen as too narrow a view,” says Marc Goldstein, head of U.S. research at proxy advisory firm ISS. “More people now would agree that directors have a responsibility not just to ensure that companies comply with the law but also to meet broader societal expectations. If companies fail to do that, they will lose their social license to operate, resulting in consequences that hurt shareholders.”
What are these societal expectations? For one thing, few people nowadays will tolerate a CEO who makes a disparaging comment about a particular class of people, disputes the existence of climate change, or is charged with sexual misconduct. Such individuals become an overnight celebrity of the worst kind—lampooned in viral social media messages and by late-night talk show hosts, resulting in consumer boycotts that take an axe to revenues and profits. “No company wants to be identified as a bad actor in an age where these things can be instantly publicized to hundreds of millions of people, squandering reputations, income, talent recruitment, and retention,” Goldstein says.
Bad actors seem to be in the news more often. The public shaming of Wells Fargo is an example. Following revelations that employees had fabricated fake customer accounts to augment their sales figures and thereby obtain higher bonuses, the bank’s stock nosedived, prodding shareholders to file a derivative class action against board directors for breach of fiduciary duty. Wells Fargo ultimately agreed to a reported $240 million settlement, paid almost entirely by the bank’s D&O insurers and reinsurers. The plaintiffs’ counsel called the settlement “the largest insurer-funded cash component of any shareholder derivative settlement in history.”
More recently, PG&E Corp. has experienced its share of public humiliation for its accountability for the catastrophic Camp Fire in the California mountain community of Paradise that killed 86 people in 2018. Following the release of federal filings indicating the electric utility had delayed a safety overhaul of a high-voltage transmission line implicated as the cause of the wildfire, the company’s stock fell precipitously. A class-action lawsuit subsequently filed by shareholders stated that, by failing to warn them of lax compliance with safety regulations, PG&E had artificially inflated its stock price. A derivative shareholder lawsuit was subsequently filed against the company’s board of directors for breach of fiduciary duty.
In April, PG&E set aside $2.5 billion to cover the cost of a settlement. A.M. Best disclosed that the power utility’s specialty D&O insurers, which include ACE American, Allianz Global Risks, and Argonaut, among others, are exposed, but the ratings agency does not expect the losses to affect the companies’ ratings because of their policies’ significant sublimits.
A different failure of leadership befell Wynn Resorts, after dozens of sexual misconduct allegations over a 20-year period were made against the company’s former CEO and namesake, Steve Wynn. The revelations resulted in a substantial stock price decline, inducing a shareholder securities class-action lawsuit and follow-up derivative lawsuit. The company also came under attack by the Massachusetts Gaming Commission for creating a culture in which executives helped hide the sexual misconduct allegations against Wynn and employees were afraid to pursue complaints.
Wynn is far from the only executive to incur sexual harassment charges in the #MeToo era. Others include Harvey Weinstein, Papa John’s founder John Schnatter, Fox News CEO Roger Ailes, and CBS’s Les Moonves. Sexual harassment allegations by six women against Moonves led to his resignation in September 2018. Meanwhile, CBS was roundly criticized in the press for the former CEO’s severance package—a whopping $184 million payout, unless it was determined by an independent investigation that he was “fired for cause.” In December 2018, the investigation confirmed Moonves had indeed been fired for cause, eliminating his severance.
Google’s parent company, Alphabet, also has been in the crosshairs of intense media scrutiny after Sergey Brin, the company’s president, reportedly gave a $90 million severance package and a “hero’s farewell” to Andy Rubin, creator of the company’s Android operating system, upon Rubin’s 2014 resignation. What was not disclosed was why Rubin resigned—he’d been accused of coercing another employee into a sexual act. According to The New York Times, Rubin is one of three former Google executives accused of sexual misconduct who received substantial exit packages, all shielded by the company. A subsequent class-action lawsuit accused Alphabet’s board of directors of maintaining a “culture of concealment” that led to “coverups of a longstanding pattern of sexual harassment and discrimination by high-powered male executives.”
In the wake of these revelations, thousands of Google employees staged a walkout in New York, Silicon Valley, Berlin, London and a handful of other cities, many chanting, “Time’s up,” referencing the global movement against sexual harassment.
“Clearly, the country is looking for corporate America to have better oversight of these troubling issues,” Huskins says. “The law doesn’t require board directors to succeed in their oversight; it just requires them to make a good faith effort in trying.”
Boards of directors have a legal responsibility to govern the companies they serve based on the organization’s vision and mission. As fiduciaries on behalf of shareholders of a public company, this purview includes oversight of executive behavior. Only the board can fire the CEO. Taking such a step becomes more challenging when the directors are personal friends with the CEO. Other difficulties may rear when boards are composed of long-tenured individuals of the same age, gender and race. All-male boards have been in the crosshairs of investors for the past five years.
“Tenure is the enemy of diversity in a sense, as the chances are that a long-tenured board is likely to be mostly older, white, male directors,” Goldstein says. “When they’re there for 15 years and longer and fail to step aside, it’s hard to add women and people of color.”
The lack of diversity on boards of directors has become an increasingly intolerable issue for institutional investors like State Street Global Advisors. Two years ago, the firm commissioned a bronze statue in Manhattan’s financial district of a young girl staring down Wall Street’s giant symbolic bull. The message presented by the statute—Fearless Girl, by American sculptor Kristen Visbal—to the then-787 public companies with all-male boards was clear: recruit women now. More than 300 of these companies have since heeded the demand. Those that didn’t were rebuked by State Street. The firm also announced it will vote against the entire slate of directors on a company board’s nominating committee if there is not at least one woman on the board and it has not engaged in successful dialogue with State Street on gender diversity for three consecutive years.
ESG, short for environmental, social and governance, is now front and center for many large institutional investors concerned about the material impact on corporate performance of negative information about a company’s workplace culture, environmental record, and executive behaviors. Larry Fink, CEO of BlackRock, the world’s largest asset management firm, has repeatedly stated that a company’s ability to manage ESG risks is directly related to its long-term financial prosperity. As Fink wrote in his annual 2019 letter to CEOs, “Society is increasingly looking to companies, both public and private, to address pressing social and economic issues. These issues range from protecting the environment to retirement to gender and racial inequality, among others.”
Many other investors have the same opinion. “Boards of directors are continually hearing from shareholders that ESG is something they care deeply about,” says Courteney Keatinge, director of ESG research at proxy advisory firm Glass Lewis. “Shareholders are not shy about voting against them for their failure to take actions on issues they consider material, like leadership integrity and talent diversity.”
In these regards, individual shareholders are guided by the proxy votes cast by large institutional investors, which are posted online before a company’s annual shareholders meeting. The votes can affect a board’s composition, since shareholders have the right to vote on director elections.
“There has certainly been a huge shift from ESG being seen as this altruistic thing to green the environment, to ‘we’re not going to invest in this company,’” says Leah Rozin, senior manager of research at the National Association of Corporate Directors. “As this shift occurs, boards are definitely more focused on ESG, which is something I keep hearing in my conversations with board members.”
Her sentiments are affirmed by the NASD’s most recent survey of public and private board directors. In the study, half the respondents said they believe it is important to ensure ESG efforts are strongly tied to a company’s strategy.
The Public Will Be Heard
In addition to institutional investors and shareholders, employees are stepping up to positively affect the running of companies, as in the Google walkout. Employees at Wayfair recently engaged in a similar work stoppage to protest the company’s sale of furniture to a federal detention center for migrants, which compelled many of its customers to call for a boycott. Amazon employees have not been reticent, expressing their disapproval of the company’s sale of facial recognition software to the U.S. government. In a letter to Amazon CEO Jeff Bezos, employees said they “refuse to contribute to tools that violate human rights,” pointing toward the use of the software by police to target black activists and by ICE to track down immigrants.
Consumers are not immune to these developments and are increasingly using their buying power to effect change. A 2018 study by KRC Research and Weber Shandwick indicates that more consumers are voting with their wallets in support of companies that take a stand on issues like climate change and against those that fail to take action. The study found 83% of consumer activists in the United States and United Kingdom believe it’s more important to support companies that do the right thing via “buycotts,” as they’re called. Fewer (59%) said it is more important to participate in boycotts. Such buycotts are growing so fast they’re expected to outpace more traditional boycotts, the study posited.
Many companies are taking the initiative to respond to ESG pressure. Among them are dozens of insurance companies like Chubb that will no longer underwrite or invest in coal-fired power plants, citing their impact on air quality.
“Chubb recognizes the reality of climate change and the substantial impact of human activity on our planet,” says Evan Greenberg, chairman and CEO of Chubb. “Making the transition to a low-carbon economy involves planning and action by policymakers, investors, businesses and citizens alike. The policy we are implementing today reflects Chubb’s commitment to do our part as a steward of the Earth.”
The truth is that most companies by far are doing the right thing. “You don’t often hear about the businesses mitigating ESG,” Keatinge says. “You only tend to hear about the situations in which management failed to account for ESG risks.”
The same can be said about most boards of directors. They, too, are aware of the need to exercise greater care and caution about leadership integrity and management culture.
“After what we’ve seen happen at Wells Fargo, PG&E and Wynn Resorts, boards are very conscious of the impact of ESG risks on the company’s reputation and financial performance,” says Sheila Hooda, an independent board member at Mutual of Omaha Insurance Company, ProSight Global and Virtus Investment Partners. “There is increasingly more transparency, reporting and disclosures around ESG.”
Along the same lines, she cited the additional impact of investor, customer, supply chain and employee activism, largely due to technology and accelerated information dissemination. “Employees at Amazon, Google and Wayfair became empowered in ways that were uncommon a few years ago,” Hooda says. “Many boards have elevated ESG as a key risk on their agendas.”
Therese Tucker shares this perspective. “Board directors are fiduciaries to shareholders and the company’s long-term value creation,” says Tucker, founder, CEO and board director at publicly traded BlackLine, a provider of finance and accounting automation software solutions. “Consequently, anything that has a potential adverse impact like ESG, workforce diversity or sexual harassment is a key part of the board’s oversight responsibility.”
She added, “It is up to the board and the CEO to set the tone that strict adherence to leadership integrity and ethical behavior is a priority of the highest order.”
Russ Banham is a Pulitzer-nominated financial journalist and best-selling author.