How Courts and Claims are Altering the D&O Landscape

Claims frequency, claims severity, subprime, securities fraud and Stoneridge key issues on the horizon

From the vantage point of early 2008, insurers writing directors and officers coverage can look back on the prior year and developments at what may prove to be a transitional period in terms of the frequency, type and severity of claims experience. Among the key events and dynamics worth exploring are claims frequency; claims severity; the evolution of the subprime lending crisis; growth of opt-out and lone institutional investor plaintiffs; and Stoneridge.

Claims Frequency

After a number of sequential seesaw years in the earlier part of this decade, claim frequency in the area of securities fraud class actions trended downward beginning in 2005. One should always hesitate to quickly declare a trend one way or the other upon a few weeks’ or months’ results, but those who rejoiced (or lamented as the case may be) over the “trend” in 2005 and 2006, must take note of what has taken place beginning in mid-2007.

Although results vary slightly among various surveys by economics experts, class action frequency has undeniably returned to the levels seen prior to 2005, i.e., in excess of 200 companies sued in a given year. Those are Enron-era corporate meltdown numbers and, while it would be both hypocritical and premature for those who criticized the quick promulgation of the low frequency trend in 2005 and 2006, two interesting observations can be made in perusing the recent filings.

First, the San Diego-based Coughlin Stoia firm brought a very substantial number of these suits. This firm, formerly headed by the notorious Bill Lerach (now about to serve a two-year prison sentence), appears to continue to be a dominant player.

Second, taking a somewhat broad view of what may constitute a suit related to the subprime lending crisis, it appears that a significant number, but not a majority, are so related. That suggests subprime may be a significant driver of frequency now and throughout 2008, but we may still be looking at close to 200 new class actions even without this activity.

When examining the principal reasons most credit for the prior downturn in frequency — stable economy and stock market; impact of Sarbanes-Oxley; and turmoil in the plaintiff’s bar — arguably only the Sarbanes-Oxley factor may clearly be operative in the coming year. The verdict is still out on the economy and securities markets and witnessing the emergence of Coughlin Stoia and others, the plaintiff’s bar’s troubles (if indeed they ever were a real issue) seem to be over.

Claims Severity

Despite the fact that most of the worst corporate meltdowns in the earlier part of this decade, such as Enron and Worldcom, were settled in prior years, severity continues to trend upward. A recent study by PriceWaterhouse Coopers in 2007 reports that the mean (average) settlement in 2007 for D&O is $80.3 million; up from a $62.3 million value in 2006. While that represents a 29 percent increase, the 2007 figure includes the admittedly “outlier” Tyco settlement at $3.2 billion.

Median settlement values are a bit more heartening, remaining at a level between $7 and $8 million as in 2006. Nonetheless, both the median and mean values establish that settlement amounts continue to be at least steady, if not on a definite increase. This should be a cause of concern to defendant and insurer interests, especially because the corporate meltdowns no longer appear to be a significant contributing factor.

Interestingly, there continues to be a relatively high number of cases that are successfully defended, i.e., are disposed through either dismissal or summary judgment. Given the toughened pleading standards established through Supreme Court decisions in Tellabs and Dura Pharmaceuticals, dismissal and summary judgment rates should continue at least at the same level. However, what that means is that plaintiffs will undoubtedly hold out for larger settlements in those cases that survive motion practice. Settlement values have always been low from the perspective of plaintiffs’ counsel, typically less than 10 percent of maximum plaintiff claimed damages. Even if the typical settlement moves from just a single digit percentage number to a low two-digit number, say 10-12 percent, this will likely foster a continuing trend of increased severity on both a mean and median basis.

Then perhaps it is time for the analysts and others to shift their focus from mean and median settlement values to the total settlement payments in a given year. It is uncertain whether that will result in a more favorable picture but, if higher settlement values are more than offset by the number of dismissals and summary judgments, isn’t that a better scenario for defendants and their insurers?

Subprime Lending: Now a Credit Crisis

It appears that not a day goes by without some new article or mention of the so-called subprime lending crisis.

The insurance industry continues to ruminate, speculate and otherwise fret over this crisis without much thought to defining and, consequently, accurately measuring it. At this point, it appears that what began earlier this year as a problem confined largely to subprime lenders in the home mortgage market has now evolved into an overall credit crunch with demonstrable global implications. Further, as credit drives the United States and ultimately the global economy, the potential impact can be devastating to a wide variety of economic interests.

Any economic downturn can lead to an increase in claims activity against various types of defendants under various insurance policies, but it is still far from certain how extensive and severe the impact in this area will be. For insurers, the D&O impact has already begun to manifest, but the likely impact in the errors and omissions (E&O) arena remains somewhat inchoate and speculative.

Given the expansion of the problem beyond the narrow scope of subprime lending activities, it will now be virtually impossible to define what may be a claim related to the “crisis.” While it is not our area of expertise here to further speculate by means of an economic forecast, there are key points to consider that few of the commentators thus far have addressed.

First, insurers in the D&O and E&O arena are properly focused upon the frequency and severity of claims, particularly litigation. The more widespread the impact of this credit crunch, the more likely it can be successfully argued in many instances that there was not much one insured could have done to foresee, disclose or otherwise manage the risk and avoid litigation. This makes the litigation less attractive to prospective plaintiffs and their counsel.

Secondly, people tend to look for deep-pocket defendants when misfortune strikes them. Among the potential claim areas are the following:

• A wide assortment of D&O and E&O claims against the so-called subprime or predatory lenders themselves from borrowers and other parties. When someone lends on the basis of “no assets, no income, no job = no problem,” they may face big litigation exposures when the underpinnings of the loans collapse. These claims have already become manifest.
• Claims against the investment banks and hedge funds that provided the financial backing for these loans, directly or indirectly, through collateral securities. Again, these claims are already here against major institutions such as Merrill Lynch and Citigroup.
• Rating agencies such as Standard & Poor’s and Moody’s. Historically, these claims have never enjoyed success. That does not dictate, however, whether some enterprising plaintiff lawyers will take their own stab at it.
• The usual suspects among professional advisors, namely lawyers and accountants.
• ERISA litigation brought against fiduciaries of pension and welfare funds that invested in the CDOs (collateralized debt obligation) and other vehicles securitizing the bad loans. We have already seen a few of these.
• Various interests in the area of residential construction, including but not limited to builders and mortgage brokers.

Opt-out and individual institutional plaintiffs

Until recently, the almost universally preferred route for plaintiffs in securities fraud litigation has been the class action mechanism. Most plaintiffs who could be included in the class were content to have the lead plaintiff’s counsel represent their interests and secure what, at least in counsel’s opinion, was the best possible settlement.

Under the applicable securities laws and procedures in the class action arena, an investor typically does not get an opportunity to “opt out” of a class settlement until there is at least preliminary court approval of the settlement and notices are sent out to potential class members. The possibility of opt outs are usually dealt with by the parties by inserting an “upset” or “blow” provision in the settlement agreement. These provisions in most cases use a relatively small percentage number (5 percent is fairly common) and provide that if more than that percentage of eligible shares opt out, then any of the settling parties may withdraw from the settlement.

Historically, there have not been many practical problems in this area. Usually, the number of opt outs was small and did not approach the level of the upset/blow percentage. Further, some opt outs never in fact actually pursue separate litigation after they opt out. Thus, D&O insurers rarely have had to be concerned about making additional payments (other than some trailing defense expenses) after they funded the class settlement.

However, as institutional plaintiffs have moved to the forefront in many securities actions, a fair number have elected to either pursue separate actions from the outset or else later opt out from the class settlement. In the case of going forward alone from the beginning, these investors can do so in state court as opposed to federal because the Securities Litigation Uniform Standards Act of 1998 (SLUSA) only applies to class actions and preempts class actions from being brought and maintained in a state court. Many plaintiffs find state courts attractive because they are not bound by any of the restrictions of the Private Securities Litigation Reform Act of 1995 (PSLRA) such as discovery stays and lead counsel/lead plaintiff provisions. Many state courts are also more plaintiff-friendly forums in several other respects such as potential jury pools.

There is a definite problem here, but no easy solution. Insurers can attempt to settle with finality by obtaining full claim releases to deal with any claims other than those of the settling class, but there is little reason for an insured to give such a release. Additional consideration is possible, but this would be a mutual problem for the insurer and insureds.

Thus, we may be seeing more instances of full program losses, i.e., exhaustion of all available primary and excess limits, by a combination of class and individual claims. Also, excess insurers may be less inclined to compromise viable coverage and rescission positions without being able to achieve some finality to their payments.

Stoneridge

In January 2008, the Supreme Court decided the case of Stoneridge Investment Partners LLC v. Scientific-Atlanta Inc. This decision is being hailed as a victory for investment banks, lawyers, vendors and accountants and, to a large extent, it is. Some caution should be noted for the latter group, though.

As the Court noted, the securities statutes provide an express private right of action against accountants and underwriters in certain circumstances and the implied right of action under these laws continues to cover secondary actors who commit primary violations. Thus, while accountants will most likely not be exposed to liability to securities holders for misstatements in quarterly financial statements, they may still be vulnerable for knowingly false statements on annual financial statements filed by public companies with the SEC.

Similar concerns would exist with other professionals such as lawyers and investment banks, whose statements and work product may find their way into filed financial disclosures. It can be expected that investor-plaintiffs will contend that they relied on these reports to their detriment. The Stoneridge decision, however, will probably have no effect (beneficial or otherwise) on D&O liability since directors and officers have not been brought into securities class actions under a theory of “scheme liability.”

Enterprising plaintiff lawyers will also likely take some comfort in Justice Kennedy’s dicta that the arrangements here between Charter Communications and its suppliers “took place in the marketplace for goods and services, not in the investment sphere.” One should not be surprised to see future attempts to distinguish Stoneridge and return to the good old days of billions of dollars in settlement recoveries against the alleged “schemers” in situations argued to be akin to Enron and Worldcom. Of course, that is not to say that those “attempts” will be successful.

Perhaps the most interesting question and possibly dynamic now is whether insurers will more readily be willing to write investment bank E&O policies and more expansive coverage for large law firms and accounting practices. The debacles for these defendants and their participating insurers in the wake of Enron, Worldcom and other corporate meltdowns remain somewhat fresh. Indeed, many insurers even shied away from Side A only D&O for investment banks, particularly in consideration of the fact that derivative settlements would be non-indemnifiable under Delaware law and many other jurisdictions.

Topics Lawsuits Carriers Claims Professional Liability