What to ask your D&O clients before a market correction

The latest stock market roller coaster ride should prompt brokers placing directors’ and officers’ liability to ask their clients about independent audits and internal controls.

The week ending Feb. 9 saw a “a steep and broad-based selloff” in the stock of publicly-traded companies, with the S&P 500 and TSX dropping 5.2% and 3.7% respectively, BMO Capital Markets reported this week.

“The markets got spooked last week,” Chris Mutcheson, head of financial lines, Canada at Allianz Global Corporate and Specialty AG, said Wednesday in an interview.

Although last week’s stock market drop is probably not going to cause major losses that would affect insurance lines, there could potentially be class-action lawsuits filed in Canada against directors and officers of companies “if there is a market pullback,” Mutcheson warned.

The Canadian Imperial Bank of Commerce, along with some CIBC directors and officers, were hit with a class-action lawsuit after the share price dropped from $106 to $67 between May 2007 and February 2008. That case is still before the courts. Allegations that CIBC misrepresented the bank’s exposure to subprime mortgages in the United States have not been proven in court.

Ontario law lets shareholders sue directors and officers of publicly-traded companies for misrepresentation in the secondary market.

“Whether it’s a single investor, or a group of investors who take issue with how the directors and officers are managing that particular entity, rightly or wrongly, they can take issue and bring [a lawsuit],” Bernard McNulty, head of claims for AGCS Canada, said Wednesday. He was commenting in general on D&O liability and not on the CIBC lawsuit.

To address such risks, McNulty said, brokers could step up their inquiries on the level of independent audit that goes on within an organization for which they are placing D&O liability coverage. Brokers should also ask clients about their corporate governance, including the controls, processes and risk management procedures at the board level, he advised.

Corporate directors and officers have a duty of care, which includes being “familiar with the financial status of the corporation by way of reviewing the financial statements regularly,” Marie-Pier Couturier and Shayan Kamalie, insurance defence lawyers for McCague Borlack LLP, wrote earlier in a blog post.

Recent market developments ranked fourth on the latest AGCS risk barometer released Jan. 16. The risk barometer, released annually, is based on surveys of risk managers worldwide.

BMO capital markets reported the TSX dropped from 15,606 on Feb. 2 to 15,066 on Feb. 9, while the S&P 500 dropped from 2,762 on Feb. 2 to 2,604 on Feb. 9. The TSX had risen to 15,367 by Wednesday afternoon.

Share prices on North American markets are still up from two years ago. The S&P 500 was nearly 2,700 on Wednesday, up from 1,902 in February 2016 and 2,320 in February 2017 . But the result was down from 2,870 on Jan. 29, 2018. The TSX was just about 12,000 in January, 2016, rising to just about 16,000 Jan. 4, 2018.

With two consecutive years of “strong results” in equity markets, there is an increase in volatility, Mutcheson said. The more an investor loses, the bigger the lawsuit is going to be if the investor decides to sue the directors and officers of the company.

“When you have improved your stock price, you have increased your exposure,” explained Mutcheson. “Any bit of news and noise” can cause a severe reaction in the stock market, he added.

There is also the potential for claims under errors and omissions policies for financial advisors if investors are “unhappy with the advice they got from their advisor,” Mutcheson said.

Managers of pension funds are also at risk if people who are about to retire or have retired are concerned the value of their pension has dropped.

“I think the markets should recover quickly and those claims probably will not materialize into anything significant,” said Mutcheson. “But I think that potential always steps up when you get a correction or a pullback.”