On the Frontiers of Corporate Litigation and Liability: Inversion Transactions and a Proposed Duty to Warn

 Among the developments dominating the business headlines in recent weeks have been two unrelated stories – the rising wave of so-called “inversion” transactions in which U.S. companies acquire foreign firms to avoid U.S. tax laws and the revelation of previously undisclosed problems with the ignition switches in certain GM cars that allegedly resulted in numerous passenger deaths. While these stories are unrelated, both are generating a great deal of concern in Washington. And both represent potentially significant developments at the frontier of corporate litigation and liability.

Inversion Transactions 

On July 18, 2014, drug maker AbbVie became the latest company to enter into a business deal as part of the trend of U.S. companies acquiring overseas firms to establish headquarters outside the U.S. and avoid U.S .tax laws. As discussed in a July 19, 2014 Wall Street Journal article about the transaction (here), AbbVie will pay a total of $54 billion to acquire Shire PLC. Shire is based in Dublin and incorporated in the U.K. tax haven Jersey. By moving its headquarters overseas, AbbVie will, according to the Journal, by 2016 lower its tax rate to 13% from the current 22%. The move will also allow the company to avoid U.S. taxes upon the repatriation to the U.S. of profits earned overseas.

As discussed here, this type of transaction is known as an “inversion.” AbbVie joins a growing list of about 50 U.S. firms that have reincorporated overseas through inversion in the last 10 years, most of them since 2008. Because the transactions appear calculated to avoid U.S. taxes, they have become increasingly controversial, particularly among U.S. lawmakers.

As discussed in a July 15, 2014 Wall Street Journal article (here), the Obama administration is calling for Congress to pass legislation to restrict U.S. companies’ ability to participate in inversion transactions. Last week, U.S. Treasury Secretary Jacob Lew sent a letter to Congressional leaders calling on them to “enact legislation immediately…to shut down this abuse of our tax system.” However, the various members of Congress disagree on the appropriate solution. And there are those who are defending corporation’s resort to inversion transactions as the appropriate business response to U.S. tax laws and tax policies.

While it is hardly surprising that inversion transactions are controversial in Washington, it would seem given the tax benefits that they would be popular with shareholders, and that the last thing that would happen would be for a company announcing an inversion transaction to get hit with a shareholder suit. However, the environment for U.S. companies not only includes high rates of corporate taxation, but it also involves a certain inevitability about shareholder litigation. In this country’s litigious environment, even a transaction seemingly as beneficial for a company as an inversion apparently can generate a shareholder suit.

According to a July 17, 2914 St. Paul Pioneer Press article (here), on July 2, 2014, a shareholder of Minnesota-based Medtronic has filed a class action lawsuit in Hennepin County District Court challenging the company’s planned $42.9 billion acquisition of Ireland-based Covidien, which will result in a new company to be called Medtronic PLC. The shareholder plaintiff contends that the transaction, in which Medtronic shareholders will receive shares in the new company in exchange for their existing Medtronic shares, will result in a “substantial loss” for Medtronic shareholders. The plaintiff alleges that the shareholders will have to pay taxes on any gains on their shares, but the transaction will not generate cash out of which to pay the taxes. According to the article, the lawsuit alleges that “Medtronic shareholders will be forced to pay taxes on any gains in Medtronic stock.”

Washington lawmakers are scrambling to try to find the right response to the loss of U.S.-based companies and of U.S. tax revenues to lower tax jurisdictions. However, while lawmakers struggle to find the right legislative response, companies will continue to have significant incentives to consider these kinds of transaction, particularly where their competitors have pressed ahead with these types of deals and lowered their tax burdens. As the Medtronic lawsuit shows, companies pursuing these kinds of transaction not only risk attracting the ire of Washington lawmakers, but also may face the possibility of shareholder litigation.

GM Ignition Switches and the Failure to Warn 

According to a documents released by federal safety regulators on July 18, 2014, U.S. automobile manufacturer GM knew for over 11 years about problems with the ignition switches in as many as 6.7 million vehicles but did not warn consumers or recall the switches until earlier this year.  As a result of the defect, the ignition switches can slip out of gear, shutting down the engine and knocking out power steering and brakes. Drivers can lose control of their cars, and if they crash, the air bags will not deploy. The list of recalls includes 2.6 million older small cars with faulty switches that GM has blamed for at least 13 deaths.

Like the inversion transactions, GM’s problems with the ignition switches have attracted the attention of Washington lawmakers. A Senate committee has been holding hearings and has taken testimony from key GM officials, including GM CEO Mary Barra and General Counsel Michael Millikin, as discussed here.

In addition, as discussed in a July 16, 2014 post on the Corporate Crime Reporter (here), three U.S senators have introduced legislation that would criminalize the concealment of danger. Senators Bob Casey, Richard Blumenthal, and Tom Harkin (all Democrats) have introduced a bill entitled the Hide No Harm Act that would hold “responsible corporate officers” criminally accountable if they knowingly conceal “serious dangers” that lead to consumer or worker deaths or injuries.

The draft legislation (a copy of which can be found here) requires corporate officials who acquire knowledge of a “serious danger” involving a product or service of the company to  inform “an appropriate Federal agency” of the danger, and as soon as practicable, to warn affected employees and other individuals who may be exposed to the danger. The draft bill defines “serious danger” as a danger “not readily apparent to a reasonable person” that “has an immediate risk of causing death or serious bodily injury.”

The bill defines a “responsible corporate officer” as an “employee, director or officer of a business entity” that has “the responsibility and authority … to acquire knowledge of any serious danger” and “the responsibility to communicate information about the serious danger” to the appropriate federal agency and to employees and other individuals.

An individual who “knowingly violates” the duty to warn specified in the legislation “shall be fined … imprisoned under this title, or both.” The bill provides further that if a fine is imposed, “the fine may not be paid, directly or indirectly, out of the assets of any business entity or on behalf of the individual.”

The draft bill also provides civil liability protections against retaliation directed at individuals who report serious dangers to federal agencies, employees or other individuals.

The point of the legislation is obviously to impose liability directly on corporate officials for withholding information about serous dangers. According to the Corporate Crime Reporter, “under existing law, while the company eventually could face criminal fines, individual officers who knew about the deadly defect – but did not inform the public or federal regulators – cannot face any criminal charges.” The article cites other instances in addition to the GM ignition switch situation in which corporate officials have withheld information about allegedly unsafe products, including Pfizer’s alleged withholding of information about Vioxx and Toyota’s alleged withholding of information about its vehicles acceleration pedals.

While this legislation is part of a larger trend to try to hold corporate officials personally liable for corporate misconduct, it is noteworthy that the bill would impose liability only on individuals who knowingly withhold information. The legislation does not seek to impose liability simply because the individuals held senior positions at the company and had overall responsibility for the company’s operations.

The proposed bill will now proceed through the legislative process. Even though the bill is sponsored only by Democratic senators, it could make it through the Democrat-controlled Senate. But even if that were to happen, the possibility that the bill would survive the Republican-controlled House of Representatives seems less likely.

Though the legislation’s prospects are uncertain, the draft bill does represent a significant new type of potential liability for corporate officials. Individuals who face the kind of criminal charges this bill would create would of course incur significant defense expenses. These individuals likely would look to their company’s D&O insurance for payment of these expenses. D&O insurance typically will pay the individuals’ defense expenses after indictment. However, if this proposed legislation were to become law, it could be important for the bodily injury/property damage exclusion found in most D&O insurance policies to be modified, to ensure that the exclusion would not preclude coverage for these kinds of defense expenses.

Cybersecurity, the Financial System and Management Responsibility: Another development on the frontier of corporate litigation and liability has been the emergency of cybersecurity as the source of potential liability for corporate officials. As I have previously noted on this blog, earlier this year the boards of Target (here) and Wyndham (here) were hit with shareholder suits as a result of significant cyber breaches at those companies. And last month, SEC Commissioner Aguilar stressed in a speech that cybersecurity oversight is an important board responsibility, warning that boards that disregard that responsibility do so at their own risk.

On July 16, 2014, Treasury Secretary Jacob Lew became the latest official in the current administration to weigh in on emerging cybersecurity issues. In a speech at the Delivering Alpha Conference in New York (a copy of which can be found here), Lew said that “cyber attacks on our financial system represent a real threat to our economic and national security.” He emphasized that “our cyber defenses are not what they need to be.” And while he acknowledged that the government can and should be doing more, he also stressed that “far too many hedge funds, asset managers, insurance providers, exchanges, financial market utilities, and banks can and should be doing more.”

Lew acknowledged that corporate officials are now doing more to try to address cybersecurity concerns, but he also stressed that “cyber security cannot be the concern of only the information technology and security departments. It should be the responsibility of management at all levels.” He also emphasized that if you are a business leader “you should know how strong your company’s defenses are, you should know if there are response plans in place” and “you should be getting regular reports on cyber security threats and what your company is doing to respond to these threats.”

And You Think You Have a Lot of Complications to Juggle: How about an axe, a machete and a cleaver? Or an apple, an egg and a bowling ball? Or Water? It’s Monday. Do yourself a favor — watch the video and have a laugh, along with Ron and Nancy. (Special thanks to a loyal reader for sending me a link to the video) 

 Read other items of interest from the world of directors & officers liability, with occasional commentary, at the D&O Diary, a blog by Kevin LaCroix.

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