Claims Against Directors

Companies going through insolvency proceedings are a major source of directors’ and officers’ (D&O) liability claims, but class-action lawsuits — alleging misrepresentation prior to drops in stock prices — can also give rise to such claims, some experts warn. Some new developments affecting D&O insurers include a December 2015 Supreme Court of Canada ruling on Ontario’s Securities Act, the collapse of commodity prices and a pollution clean-up order issued against directors of a Cambridge, Ontario manufacturer of helicopter components, insurance professionals suggest.

“Historically the primary source of D&O liability was statutory liability in the event of insolvency of a company,” writes Paul Emerson, vice president, liability claims for Berkshire Hathaway Specialty Insurance (BHSI) in Canada, in a statement to Canadian Underwriter. Those statutory liabilities, Emerson suggests, could include unpaid wages, taxes and contributions to pension plans.

“Where a company is insolvent and seeks protection from its creditors, the D&O policy can become the only tangible source of potential recovery for shareholders,” reports Shara Roy, a partner with law firm Lenczner Slaght Royce Smith Griffin LLP.

Roy, whose practice areas include insolvency and securities regulatory actions, says individual directors and officers can be named both in shareholders’ lawsuits and in regulatory proceedings.

“More recently, liability for breach of corporate governance legislation, derivative claims and claims under oppression remedy legislation have given rise to D&O liability claims,” Emerson reports.

In Ontario, an oppression remedy gives a plaintiff the right to sue in order to “recover for wrongs done to the individual complainant by the company or as a result of the affairs of the company being conducted in a manner that is oppressive or unfairly prejudicial to or that unfairly disregards the interests of the complainant,” wrote Justice Robert Blair, of the Court of Appeal for Ontario, in a decision released May 26, 2015 in Rea v. Wildeboer.

A derivative action gives a complainant, such as a shareholder, the right to “apply to a court for leave to bring an action,” on behalf of a company, to “recover for wrongs done to the company itself,” Justice Blair added.

Over the past three years, frequency levels in Canadian D&O claims “have been fairly consistent,” reports Paul Shore, international practice leader, management liability for The Navigators Group Inc. Shore notes there has been an increase in the size of settlements being sought by plaintiffs.

“In the last 18 months, just from what I have personally experienced on our book, I think the plaintiff law firms have become a lot more confident, a lot more aggressive, especially those companies that have cross-border shareholders and operating exposure,” Shore adds. “There has been a lot more aggression, a lot more digging in by the plaintiff law firms to really push higher settlements than what was previously the case.”

Stamford, Connecticut-based Navigators operates a Lloyd’s insurer, which covers D&O risk for about 185 Canadian clients.

STATUTORY LIABILITY

At Ottawa-based underwriting agent Encon Group Inc., the most common type of D&O liability claim is still employment practices liability, reports Tanya Banfield, Encon Group’s vice president of D&O claims.

“It has been that way for many years, probably since D&O liability insurance was first started,” Banfield says. Employees “are generally a corporation or an entity’s biggest exposure,” she adds.

Employment laws vary by province, notes Kenneth Thornicroft, a professor of law and employment relations for the University of Victoria’s Gustavson School of Business.

In British Columbia, there are more than 100 different statutory provisions which “provide for statutory liability in some circumstances” for directors and officers, adds Thornicroft. Examples include tax and environmental laws.

“Provincial ministries of environment have recognized new ways to expand their powers and authority to extract more fines and penalties,” Emerson writes.

In Ontario, the Ministry of the Environment and Climate Change can impose clean-up orders on directors and officers. For example, in 2012, MOE issued remediation orders against aircraft components maker Northstar Aerospace Inc. Until 2010, Northstar operated a site, in Cambridge, which was contaminated, both by trichloroethylene from Northstar’s manufacturing activities and by contaminants from a different property. A cleanup order was imposed on Northstar, but the firm was granted protection under the Companies’ Creditors Arrangement Act. The cleanup order was then imposed on 13 Northstar directors, who unsuccessfully appealed to the province’s Environmental Review Tribunal. Instead of seeking judicial review, the directors reached a settlement.

“A number of directors had not been on the board at the time when contamination occurred and yet were held liable by the (then) Ministry of the Environment,” Roy reports.

The Northstar case “set off a lot of alarm bells,” says Andrea Laing, a Toronto-based partner with Blake, Cassels & Graydon LLP who focuses on commercial litigation. “I am frequently seeing directors looking to ensure that they have adequate coverage.”

Shore suggests there could be more pollution clean-up orders issued against directors, “given there may well be increase insolvencies for companies in mining and oil and gas, which are more than likely going to be the majority of those implicated on pollution type claims.”

The 13 Northstar directors were not covered by an environmental impairment liability policy, and their D&O policy excluded remediation, said Brian Rosenbaum, Aon Risk Solutions’ national director, legal and research practice, during a presentation in 2014 at the RIMS Canada conference in Winnipeg.

“This is something the insurance community quickly worked on to ensure affirmative coverage for this type of incident,” Shore reports.

Shore notes that in lawsuits giving rise to D&O liability claims in Canada, plaintiffs “typically” allege misrepresentation or incorrect disclosure guidance on the part of directors and officers.

One of the “biggest reasons” for D&O claims in Canada is Part XXIII.1 of Ontario’s Securities Act, which took effect 10 years ago, Laing suggests.

Section 138.3 (1) of Part XXIII.1 “creates a statutory cause of action for misrepresentation in the secondary securities market in favour of any person who acquires or disposes of the securities of an issuer between the time the document containing the representation was released and the time the misrepresentation was corrected,” wrote Justice George Strathy — then of the Ontario Superior Court of Justice — in a decision released in 2012.

At the time, Justice Strathy (who has since been appointed chief justice of Ontario) ruled that a class-action lawsuit (filed by representative plaintiffs Howard Green and Anne Bell) against the Canadian Imperial Bank of Commerce (CIBC) was time-barred. That decision was overturned, in February 2014, on appeal. In a divided ruling released December 4, 2015, four of seven Supreme Court of Canada judges ruled that the shareholders’ lawsuit against CIBC could proceed.

INDIVIDUAL DEFENDANTS

Along with CIBC, four individuals — including Gerald McCaughey, chief executive officer of CIBC until September 2014 — were named as co-defendants.

Court records indicate that CIBC’s share price dropped 37% between May 31, 2007 and February 28, 2008. The bank had been exposed to the United States residential mortgage market. As a result of the deterioration of those investments, CIBC incurred after-tax losses of more than US$6 billion.

In their lawsuit, Green and Bell are essentially alleging that CIBC officials failed to disclose, in 2007, the bank’s exposure to the U.S. mortgage market. The allegations have not been proven in court.

CIBC’s appeal was heard February 9, 2015. In the same hearing, the Supreme Court of Canada also heard appeals in two separate shareholder class-action lawsuits, filed in Ontario, alleging misrepresentation. One was against Toronto-based electronics vendor Celestica Inc. and the other was against motion picture firm IMAX Corporation of Mississauga, Ontario.

Plaintiffs suing IMAX, Celestica and CIBC – initially before separate lower court judges – “pleaded an intention to claim damages under the statutory cause of action,” under Ontario’s Securities Act, “for alleged misrepresentations in respect of shares trading in the secondary market.”

The issues on appeal in all three cases were similar. Appeals were heard by one panel – comprised of five Court of Appeal for Ontario judges – which issued its ruling in February, 2014.

In its 133-page ruling (cited as CIBC v. Green) published December 4, the Supreme Court of Canada ruled that the lawsuit against IMAX could proceed, but the one against Celestica cannot. In the lawsuit against IMAX, individual defendants include CEO Richard Gelfond, chairman Bradley Wechsler and Kenneth Copland, a director from 1999 through 2012 who had served as chair of the board’s audit committee.

Court records indicate that on August 10, 2006, IMAX’s share price dropped 40%. That was the day after IMAX disclosed it was responding to an inquiry, from the U.S. Securities and Exchange Commission, on the timing of its revenue recognition. Plaintiffs allege that IMAX misrepresented its 2005 earnings, “in particular with respect to the number of theatre systems installed by the Company during Q4 2005, and the revenue recognized for such theatre systems.” Those allegations have not been proven in court.

One issue in the trilogy of cases was the interpretation of Section 138.8 of the Securities Act, which stipulates that “no action may be commenced” for misrepresentation “without leave of the court.”

All seven Supreme Court of Canada judges hearing the appeals agreed that in order to commence an action for misrepresentation in the secondary securities market, under Ontario’s Securities Act, there must be “a reasonable possibility that the action will be resolved at trial in favour of the plaintiff.”

Insurance Bureau of Canada (IBC) — which had intervener status in CIBC’s appeal — “took the position that the test for granting leave should be an onerous, rigorous test so that only cases with merit should be allowed to proceed to the starting line in Ontario, and on that point, the Supreme Court of Canada agreed with us,” says Alan D’Silva, a partner with Stikeman Elliot, which represented IBC.

For insurers writing D&O liability, the Supreme Court of Canada’s decision “is generally a good development,” D’Silva adds.

“Canadian shareholder class-action litigation became a reality when secondary market liability was introduced in 2006, with consistent and steady activity since,” writes BHSI’s Paul Emerson. “While there have been fewer filings in 2015, the inventory of unresolved class actions should now be able to proceed in light of the recent decisions by the Supreme Court of Canada in the Green v. CIBC trilogy of cases. We anticipate a return to the stream of filings in future years, albeit perhaps with a shift by shareholder counsel to focus on higher severity cases while the courts continue to interpret the boundaries of the relatively new securities legislation. In this space, defence costs have been quite volatile, in light of uncertainty regarding the proper test for leave to commence statutory actions and applicable limitation periods.”

The provisions allowing such lawsuits under Ontario’s Securities Act have liability caps, notes Blake, Cassels & Graydon’s Andrea Laing.

“There is a liability limit in the statute which is $25,000 or 50% of the directors’ compensation from the issuer in the previous year, but we are seeing that plaintiffs’ lawyers are having some success in persuading the courts that in addition to certifying statutory claims under the Securities Act, they are also bringing common law misrepresentation claims,” Laing reports. Common law misrepresentation claims, she adds, are not based on the Securities Act, but “are just kind of run-of-the-mill negligent misrepresentation claims that anyone could make and they have suggested to courts that they should also certify these claims and the problems with these common law claims is they are not subject to the caps under the legislation.”

This, Laing suggests, “is of particular concern to underwriters and to directors and officers themselves, in that they thought there would be a fairly low cap on directors and officers liability, but plaintiffs’ lawyers are having some success in persuading courts to certify misrepresentation claims based on public disclosures which are not subject to these liability limits and are effectively finding ways to work around the caps.”

Misrepresentation lawsuits “tend to be filed in Ontario, but the other provinces and territories have their own equivalents to part XXIII.1,” Laing adds. “It has been a bit slower in some of the other provinces, but we are starting to see secondary market class-action claims being launched in B.C. and Quebec in particular, but also other provinces.”

In lawsuits alleging misrepresentation or incorrect disclosure guidance, plaintiffs’ law firms “look at isolated one-day stock drops as their initial focus for a securities class action,” reports The Navigators Group’s Paul Shore.

“Mining was a focus over the last couple of years,” Shore adds. “Oil is going to be a focus this year, next year and the coming years.”

At press time, the price of West Texas Intermediate Crude oil dropped below US$30 per barrel. WTI was trading at US$59.82 this past June and US$95.08 in 2011, BMO Capital Markets reports.

Oil and gas “is going to be a challenging sector for insurers, as well as for the companies themselves,” Shore predicts. “If oil stays below $40 for the next six months, and all of a sudden they release results that are below everyone’s expectations, then it’s quite easy to point the finger at the directors and officers.”

Some shareholders’ lawsuits arise from “poorly timed acquisitions” in both mining and oil and gas, Shore suggests.

“You have those companies that unfortunately made an acquisition at the wrong time, like the gold companies buying assets based on $1,900 to $2,000 an ounce and then it quickly goes to $1,200 and stays there,” Shore reports. “Oil companies, prior to the last 12 months, may have made big acquisitions and bets when oil was $100, so I think you are going to get those companies struggling now to justify why they potentially overpaid for such an asset.”

Other commodity prices have dropped as well. For example, BMO reports that nickel, which was trading at US$7.65 per pound in 2014, was down to US$3.96 in December.

BEAR MARKET

At press time, the S&P/TSX composite index was below 12,200, compared to 15,524.75 this past April.

“Recent volatility of the Canadian markets suggests a real potential for new claims,” Emerson reports.

“Financial pressures could lead to aggressive accounting practices to represent stronger than actual performance. Further, in the normal course, securities class actions are launched almost immediately after a drop in share price or discovery of an error. In light of the recent performance of the TSX owing to the current commodity price environment, and the growing tail of shareholder wealth disappearing, there may well be claims forthcoming before limitation periods are triggered. The merits of claims related to long-term share value decreases will certainly be subject to testing, but there is no question that masses of unhappy shareholders will have expectations that are difficult to manage,” Emerson explains.

Another trend in D&O claims is breach of privacy legislation, which “can result in massive administrative penalties,” Emerson notes. “These laws are not well-tested and the jurisprudence is in its infancy. But increased cyber risk activity and confirmed civil rights of action for breach of privacy legislation foreshadow a new, real area of risk for directors and officers.”

For example, there are lawsuits pending as a result of the hacking this past August of online dating service Ashley Madison, notes Michael Parent, a professor of marketing at the Telfer School of Management at the University of Ottawa.

“When I look at what is perhaps the Number 1 thing on directors’ minds today, that would be cyber security,” adds Parent, a former director of the Centre for Corporate Governance and Risk Management at the Beedie School of Business at Simon Fraser University.

In the Ashley Madison lawsuit, “the question will be, did the directors and officers of those organizations take reasonable care to protect their data, and/or if warned about a possible breach, take reasonable action to protect that data or to remediate the impact of the breach?” says Parent.

Privacy breaches can result in lawsuits where both a corporation and individual defendants are named, suggests Imran Ahmad, who leads the cyber security practice of law firm Cassels Brock & Blackwell LLP.

Breaches can result from employees losing USB keys or hackers deliberately targetting a corporate computer system, Ahmad suggests.

“The question is, ‘What does the board and what does management have to do to make sure they can mitigate any exposure that they have?'” says Ahmad.

Directors could be held personally liable if they failed to ensure employees were properly trained or if they failed to ensure that the firm had “steps in place to make sure that the information was secure,” Ahmad warns.

In the event of a privacy breach, a D&O claim could include legal fees and remedial action such as credit monitoring for people whose data was compromised, Ahmad suggests.

“Although they may not be successful in terms of bringing a case against those directors and officers, you still have to pay your lawyers, you still have to prepare your materials, you still have to respond to the materials that are being filed, so there is a cost to that,” he adds.

BREACH NOTIFICATION

Recent amendments to Canada’s Personal Information Protection and Electronic Documents Act (PIPEDA) could require organizations to notify certain individuals and organizations of certain breaches of security safeguards that create a risk of significant harm and to report them to the federal privacy commissioner.

Those amendments were passed into law this past June, but do not come into force until regulations are in place.

Amendments to PIPEDA “dealing with breach reporting, notification and recordkeeping will be brought into force only after related regulations outlining specific requirements are developed and in place,” a spokesperson for the Office of the Privacy Commissioner of Canada told Canadian Underwriter, referring a question on timelines to the department of Innovation, Science and Economic Development (ISED).

“Options regarding next steps, including consultations, are being developed,” a spokesperson for ISED Canada wrote in an e-mail to Canadian Underwriter, when asked whether the federal government plans to develop regulations to bring those amendments into force.

Commenting in general, Parent notes that corporate directors have both a fiduciary duty and a duty of care.

“The duty of care basically says that, as a director, the standard that you are held to is not perfection or even the standard of the highest performing director in your sector, but rather, ‘have you obtained good or appropriate information?'” Parent reports.

He adds the test of the duty of care depends – among other things – on whether or not a director has “critically reviewed” information and whether or not he or she has made a “reasonable” decision under the circumstances.

“Anybody can be sued,” Parent notes. “All it takes is a lawyer and some money. It does not mean (the allegations) will stand to reason or be upheld by the courts.”