Failure to adopt good corporate governance practices, investor non-disclosure leading to securities fraud suits and enactment of legislation similar to the U.S. Foreign Corrupt Practices Act in the People’s Republic of China[1] have all arisen over recent months to cause substantial exposures to Chinese companies and their directors and officers so as to warrant the purchase of a comprehensive program of D&O insurance. Yet, the anecdotal evidence appears to indicate that these companies are thus far largely without this insurance.[2]

As the McCarter & English authors (see footnote 2) aptly note, the widespread purchase of D&O insurance will usually follow the development of good corporate governance practices. While the Chinese are studying and quickly implementing the best of these practices that they have studied globally, the litigation risks and exposures are already here, particularly in the case of companies undergoing the reverse merger transactions and subsequent IPOs that we discussed in my May 25 post.

The Chinese have made many societal and economic changes with lightning speed over the past two decades, and this is one area that they need to quickly tackle. Here are some of the key points for both the buyers and sellers to be aware.

• Good corporate governance does not preclude, or perhaps even mitigate, the possibility of a securities fraud class action. Indeed, among U.S. companies, while those with excellent corporate governance practices may fare well in shareholder derivative litigation involving alleged breaches of fiduciary duty to the corporation, there seems to be little correlation between those practices and avoiding securities fraud litigation based upon non-disclosure or inadequate disclosure to the investment community. Moreover, although settlement values in derivative actions are rising, it is still the securities fraud class action that poses the largest monetary risk to directors and officers and the corporation.
• Even where suits with relatively little merit are brought, significant defense expenses and a possible plaintiffs’ fee award or settlement may be incurred before the litigation is concluded. These exposures can easily exceed $1M even in meritless cases.
• Care needs to be taken in putting together a program that will adequately insure a Chinese company’s domestic exposures in China and those internationally in jurisdictions such as the U.S. Only a handful of insurers have established presences on an international basis and there may be a need to coordinate various layers of primary and excess insurance written by a large number of insurers to ensure that no gaps result.

My educated guess is that the landscape with respect to D&O insurance for Chinese companies will rapidly change, and there will soon be little need for articles and broking efforts to educate companies as to the wisdom of the purchase. In the interim, it appears millions of dollars are being borne in defense expenses alone that could have been covered under a well-structured D&O insurance program.

[1] See my earlier posts on D&O and China on March 15, 2011 and May 25, 2011. Suffice it to say that a few short years ago one would not hear D&O and China mentioned in the same instance, let alone now having a D&O blog address the topic three times over a four month period.

[2] An excellent article, “Chinese Businesses Should Not Overlook D&O Insurance”, in the New York Law Journal of July 7, 2011 by J. Wylie Donald, Harley Lewin and Zhenggui Li of McCarter & English discusses the apparent lack of interest in D&O insurance on the part of Chinese companies and reasons therefore.