Over the past 10 years, there has been a record increase in the filing of securities litigation against foreign companies that issue securities in the United States, most commonly via American Depository Receipts (ADRs). Between 2014 and 2018, 202 cases against foreign companies were filed in the United States, representing a 41% increase in filings, with nearly every region experiencing a major jump in the number of suits. 26 of these cases have specifically been filed against Latin American companies.
In a correlated manner, the average settlement value of these actions has also increased at an astonishing rate over the past five years. From 2014 to 2019, total settlements increased 581% from US$657 million (2008-2014) to US$4.5 billion (2014-2018). The average settlement value for actions brought in Latin America is US$16.8 million; however, it is worth noting that there is an outlier — the settlement value entered into by Petrobras in the action arising out of the Lava Jato scandal, valued at US$3.3 billion.
Our experience corroborates these findings, having seen more and more US securities actions filed against our clients’ insureds in Latin America. As an example, in addition to the Petrobras class action mentioned above, over the past years, we have dealt with US securities actions filed against Argentina’s largest real estate company, Peru’s largest construction company, and a Brazilian mining giant.
Given the increased prevalence, and potential exposure, arising out of US class actions filed against Latin American companies, we believe it would be useful to provide a brief overview of the most common type of securities action filed against Latin American companies in the United States, Section 10b-5 actions brought under the 1934 Securities Exchange Act, and a common problem (re)insurers face in adjusting these claims in the context of D&O (re)insurance and these policies’ willful misconduct exclusion.
The United States Congress enacted the 1934 Securities Exchange Act in response to the stock market crash of 1929 and the resulting Great Depression. The key provision of the Securities Exchange Act is Section 10(b), which, along with Security Exchange Commission (SEC) Rule 10b-5(b) promulgated thereunder, broadly prohibits deception, misrepresentation, and fraud “in connection with the purchase or sale of any security” based on any public corporate statement. Specifically, Rule 10b-5 prohibits the use of any “device, scheme, or artifice to defraud,” and creates liability for any misstatement or omission of a material fact, or one that investors would think was important to their decision to buy or sell a security.
Claims brought under Section 10(b) of the Securities Exchange Act are subject to a heightened pleading standard. Specifically the Second Circuit, which is the judicial circuit encompassing New York City where the vast majority of these actions are filed, has found that in order to succeed under these provisions, a plaintiff bears the burden to prove that (1) the defendant made a material misrepresentation or omission; (2) with scienter; (3) a connection between the material misrepresentation or omission and the purchase or sale of a security; (4) reliance by the plaintiffs on the alleged material misrepresentation or omission; (5) economic loss suffered by the plaintiffs; and (6) loss causation.
A particularly interesting discussion can be had on the scienter requirement in 10b-5 claims and its relation to the willful misconduct exclusions typically found in D&O policies. Black’s Law Dictionary defines scienter as “a mental state consisting in an intent to deceive, manipulate, or defraud. In this sense, the term is used most often in the context of securities fraud.” Thus, scienter is a term comparable to the concept of dolo in Latin American jurisdictions.
Furthermore, in the Second Circuit, “a strong inference of scienter can be established by alleging facts either ‘(1) showing that the defendants had both motive and opportunity to commit the [alleged] fraud or (2) constituting strong circumstantial evidence of conscious misbehavior or recklessness.’” Further backing this jurisprudence, the US Supreme Court has found that “every Court of Appeals that has considered the issue has held that a plaintiff may meet the scienter requirement by showing that the defendant acted intentionally or recklessly.”
At the same time, recklessness is defined as “conduct whereby the actor does not desire harmful consequence but nonetheless foresees the possibility and consciously takes the risk; gross negligence; recklessness involves a greater degree of fault than negligence but a lesser degree than intentional wrongdoing.” As such, recklessness is a term comparable to the concept of culpa grave in Latin American jurisdictions.
Therefore, a guilty verdict in a 10b-5 action necessarily has the effect of triggering the willful misconduct exclusions typically found in D&O (re)insurance policies, which have the effect of precluding coverage for claims arising out of an insured’s intentional misconduct or gross negligence.
This leads to a scenario where (re)insurers and their insureds have conflicting interests in the litigation, with the (re)insurers potentially wishing to see litigation through to the end to assure that any potential indemnities are properly paid and with the insured, understandably, wishing to settle the matter to save themselves time, money, and the threat of an adverse judgment. However, it must be noted that because willful misconduct exclusions may only be applied once a final judgment confirming the insured’s guilt is rendered, (re)insurers must continue advancing defense costs to the insured. These defense costs also play an important equation in the decision of whether to settle a case or not, as they are quite costly—running an average, in our experience, of approximately US$20 million through trial.
Given the above, it is not only necessary for (re)insurers to conduct an intricate cost-benefit analysis when presented with a US securities claim in order to determine the strategy they wish to pursue in terms of defending or settling the action, but it is also important for underwriters to reconsider their pricing models for D&O (re)insurance policies issued to Latin American entities with exposure to the US securities market, especially when considering the current trend of US securities litigation against foreign companies becoming not just more prevalent, but more expensive as well.
This topic made for a lively discussion at this year’s annual Miami Latin American Claims (Re)Insurance Forum, where industry leaders gathered to give their perspectives on this notable trend. A particularly interesting point was raised regarding expert discovery. Usually, experts’ reports on damages, which are key to engaging in settlement negotiations, occur after fact discovery is completed, which in turn is a costly and time-consuming part of litigation. However, this extra expense could be avoided, and settlements could potentially be entered into quicker, if expert’s damages reports were set to be produced after fact discovery.
Find out more about the other topics discussed at this year’s Miami Latin American Claims (Re)Insurance Forum.
1 Why D&O Costs Are Soaring for Foreign Filers
3 GAMCO Inv’rs, Inc. v. Vivendi Universal, S.A., 838 F.3d 214, 217 (2d Cir. 2016).
4 In re Bear Stearns, Inc. Securities, Derivative, and ERISA Litigation, 763 F.Supp.2d 423 (S.D.N.Y.2011).
5 Tellabs, Inc. v. Makor Issues & Rights Ltd., 551 U.S. 308, 319 (2007).
Authors: Alex Guillamont, Head of Latin America and Caribbean and Javier Vijil, Associate at Kennedys’ regional hub in Miami.