D&O Litigation Trends in 2007
May 2007
Last year, 2006, marked the lowest number
of securities actions filed against directors and officers in the last decade,
although the size of settlements continued to increase.
by John
E. Black Jr. and David T. Burrowes
Boundas, Skarzynski,
Walsh & Black, LLC
The number of securities actions filed against directors and officers dropped
dramatically in 2006 to 115, a significant departure from the average number
of actions filed annually over the prior decade. In every year from 1997, the
average number of securities complaints filed against directors and officers
of publicly traded corporations ranged from 174 to 497. This was the lowest
number of filings since 1996, when only 112 actions were filed, and the number
of securities actions filed in 2006 was half of the average number of complaints
filed annually since the adoption of the Private Securities Litigation Reform
Act (PSLRA) in 1995. Much debate among securities commentators has focused on
the possible causes for this drop and whether it is a watershed or aberration.
In 2006 the trend of ever increasing securities claim settlements continued.
Due in part to the backlog of very large securities cases built up in prior
years, the aggregate value of all settlements reached a new high—$17.1 billion.
However, the average settlements also were higher in 2006—both in so-called
mega-cases and in other securities actions.
Below we discuss these and other trends from 2006 that may continue into
2007.
A Falling Number of Securities Class Actions
The significant drop in the number of securities class action filings in
2006 continued a trend that first appeared during the second half of 2005, and
sharply contrasted with filings in 2004 and 2005. Cornerstone Research tallied
212 "traditional" filings in 2004, 176 in 2005, and just 90 in 2006.1 Cornerstone's "traditional" filing figures do not include the initial public
offering (IPO) laddering cases, the investment analyst cases, and the mutual
fund trading cases.
Options backdating class actions (20 filed in 2006 through December 11) are
the newest category of suits excluded by Cornerstone from the list of "traditional"
filings. Including the options backdating suits in the 2006 numbers brings the
total number of companies sued to 110, by any measure a considerable drop-off
from immediate past years. The drop in the number of filings is seen also when
considered in the context of the number of filings per issuer. Of the total
issuers listed on the N.Y. Stock Exchange (NYSE), NASDAQ, and Amex, 2.8 percent
were named as defendants in traditional securities class actions filed in 2004,
a figure that dropped to 2.4 percent in 2005 and reached 1.5 percent in 2006.
As noted in past years, the Cornerstone report identifies a further category
of shareholder class actions: "mega" filings involving a $5 billion or greater
disclosure dollar loss. Cornerstone defines "disclosure dollar loss" as the
total decline in the market capitalization of the defendant company from the
trading day immediately preceding the end of the class period to the trading
day immediately following the end of the class period. Cornerstone identified
8 mega-filings in 2004, 5 in 2005, and just 1 in 2006. The disclosure dollar
losses for all filings in 2006 totaled $52 billion (including the options backdating
cases), the lowest level since 1997 and a significant decrease from the totals
represented by traditional filings in 2004 ($142 billion) and 2005 ($93 billion).
The decreased total number of filings and decreased share price volatility in
2006 contribute to the decreased disclosure dollar loss.
What explains this downward trend? A number of factors may be contributing
to the downturn in filings. First, the Sarbanes-Oxley Act of 2002 (SOx) and
subsequent Securities and Exchange Commission (SEC) rulemaking may have been
successful in encouraging corporate executives, audit committee members, and
board members not to push the envelope with "creative accounting" and in prompting
auditors to address irregularities more aggressively.
Another factor might be the relative absence of volatility in the past 2
years compared to prior years. In the boom period of the 1990s, it seems that
many companies relaxed corporate standards as they sought to meet demanding
earnings expectations. The current drop in total filings may also be the result
of a bursting of the technology bubble from the boom period beginning in the
late 1990s. A large number of relatively immature companies were first publicly
traded during the boom period and those companies appear to have contributed
a significant number of the shareholder class actions filed between 1998 and
2004. Yet another factor may be the impact of the federal indictment of the
Milberg Weiss firm on charges of kickbacks to lead plaintiffs and the increasing
scope of Enron-related litigation headed by the Lerach Coughlin firm, which
appear to have distracted both plaintiffs' securities law firms.
We suspect that the drop is the result of a combination of these factors.
While the timing of the downturn coincides with the investigation of the Milberg
Weiss, we believe the plaintiffs' class action bar has a sufficiently deep bench
alongside Milberg Weiss and Lerach Coughlin so that any sizable stock drop coupled
with the indicia of misrepresentations to the market will continue to attract
multiple filings by other lawyers.
Settlement Size Continues To Grow
While the rate at which new cases have been filed is dropping, there continues
to be a large pipeline of significant cases to be resolved. According to NERA
Economic Consulting and Cornerstone, the size of securities class action settlements
in 2006 continued to grow.2 In 2006 mean and average
settlement size increased from the records set in 2005. Last year, 2006, offered
up four settlements in excess of $1 billion and more over $100 million than
in any other single year. Mean settlement size increased from $5.2 million in
2004 to $7.0 million in 2005 and reached $7.3 million in 2006. The average settlement
size over the same period (excluding the billion dollar settlements in Enron,
WorldCom, Cendant, AOL Time Warner, Royal Ahold, and Nortel Networks) increased
from $20 million in 2004 to $25 million in 2005 and jumped to $34 million in
2006. Leading off 2007, CMS Energy announced that it was settling the shareholder
suit filed against it in 2002 for $200 million. The current "top 10" list of
the largest settlements now also includes 3 settlements of claims involving
non-U.S. issuers.3
As explained in the NERA report, settlement size continues to be largely
a function of the magnitude of alleged investor losses and the ability to pay,
using post-class period market capitalization as a proxy for ability to pay.
Average investor losses of settling cases in 2004, 2005, and 2006 were $1.7
billion, $2.6 billion, and $7.5 billion, respectively. Comparing post-class
period market capitalization of settled cases with the settlement amount, NERA
calculates a 0.2 percent increase in settlement amount for each 1 percent increase
in market capitalization.
The presence of institutional investors as lead plaintiffs continues to yield
higher settlement figures as well. According to Cornerstone, the average settlement
in cases involving institutional investors as lead plaintiffs was $9 million,
more than double the average settlement in cases not involving institutional
investors as lead plaintiffs ($4.3 million). In addition, institutions assumed
a higher profile in 2006, serving as lead plaintiffs in over 50 percent of all
settlements. However, it is not clear whether the boost in the average size
of settlements in which institutions act as lead plaintiffs and the boost in
cases led by institutional investors is the result of institutional involvement
or the size of the market capitalization loss at issue combined with the merits
of the claim attracting institutional involvement.
SEC and DOJ Enforcement and the McNulty Memo
The drop-off in the total number of shareholder class actions in 2006 was
not matched by a drop-off in the total number of SEC enforcement actions between
2005 and 2006, although there were considerably fewer SEC civil proceedings
initiated in 2006 than in 2005. In fiscal year 2005 (ending September 30, 2005),
the SEC initiated 947 investigations and 629 enforcement actions (335 civil
proceedings and 294 administrative proceedings.4 In fiscal year 2006, the SEC initiated 914 investigations and filed 574 enforcement
actions (218 civil proceedings and 356 administrative proceedings).5 The SEC's enforcement cases yielded over $3.3 billion in penalties and disgorgement
orders in 2006, including resolution of claims involving AIG (alleged improper
accounting relating to reinsurance deals with GenRe) for $800 million and Fannie
Mae (alleged improper smoothing of earnings) for $400 million.
It remains to be seen what change occurs in practice, but directors, officers,
and their corporations may see a less aggressive approach by the SEC and the
U.S. Department of Justice (DOJ) with respect to pursuing waivers of the attorney-client
privilege and the attorney work-product doctrine. Much attention has been given
in recent years to the "Thompson Memorandum"6 and
its impact on the defense of claims against directors and officers. The Thompson
Memorandum was a binding directive to U.S. prosecutors outlining various factors
they should consider in weighing the degree of a corporation's cooperation in
determining whether to pursue a criminal indictment against the corporation.
Two factors (among several) were the corporation's willingness to produce
otherwise privileged and protected materials as well as the corporation's advancement
of legal expense incurred by individuals under investigation or indictment.
The advancement of legal expenses was perceived by the government to be action
by the corporation shielding wrongdoers.
In December 2006, the DOJ announced changes in the directives contained in
the Thompson Memorandum in the recently prepared McNulty Memorandum.7 Under the Thompson Memorandum, corporations defending civil shareholder class
actions and responding to federal investigators were often faced with a Hobson's
choice between waiving the protections and producing documents or facing possible
government prosecution. Waiving the privilege with the government often meant
producing the same material to civil plaintiffs, the result of which would likely
drive up settlement values as plaintiffs would possess documents not otherwise
available absent the waiver.8
The McNulty Memorandum outlines a series of procedures to be followed by
prosecutors when seeking a waiver of the attorney-client privilege and the production
of material protected by the attorney work-product doctrine. Prosecutors will
need to justify their reasons for requesting that corporations give up protected
material and obtain the approval of the U.S. attorney (with respect to so-called
Category I material) and the Deputy Attorney General (with respect to Category
II material—generally considered to be core work-product). In addition, prosecutors
are not to consider a corporation's refusal to produce Category II material
as an indicia of noncooperation.
The refusal to advance fees (to curry favor with government prosecutors)
by KMPG drew the ire of Judge Lewis Kaplan in United
States v. Stein, 435 F. Supp. 2d 330 (S.D.N.Y. 2006); 440 F. Supp. 2d
315 (S.D.N.Y. 2006), declaring the Thompson memorandum to be unconstitutional
as it directed prosecutors to pressure KPMG not to pay the legal expenses of
its employees facing criminal prosecution for selling allegedly illegal tax
shelters. In response, the McNulty Memorandum states that prosecutors "generally
should not" consider whether the corporation is advancing fees when considering
the degree of the corporation's cooperation with investigators and prosecutors.9
Judicial Developments
On January 5, 2007, the U.S. Supreme Court granted certiorari of a Seventh
Circuit decision addressing the appropriate pleading standard for alleging scienter
and ordered expedited briefing on the matter. [Makor
Issues & Rights, Ltd. v. Tellabs, Inc., 437 F.3d 588 (7th Cir. 2006), cert. granted, Tellabs,
Inc. v. Makor Issues & Rights, Ltd., 127 S. Ct. 853 (Jan. 5, 2007) (No.
06–484).] The Court heard arguments on the case on March 28, 2007.
At issue is the manner in which a court is to weigh competing inferences
when deciding whether a complaint alleges sufficient facts to support a strong
inference of scienter, as required by the PSLRA. The Seventh Circuit, in Tellabs, concluded that a court should "allow
the complaint to survive if it alleges facts from which, if true, a reasonable
person could infer that the defendant acted with the required intent."10 As presented by the petitioner's brief for certiorari, the Seventh Circuit's
decision is at odds with six other circuit courts allowing "innocent inferences
to play a significant role in evaluating whether a complaint alleges" sufficient
facts to support a strong inference of scienter.
Although not directly part of the question presented for decision, the Supreme
Court may use Tellabs as an opportunity to address
the different approaches by the circuit courts when considering whether allegations
of "motive and opportunity" may alone suffice in support a strong inference
of scienter. The issues are significant as the adequacy of the complaint is
tested in virtually all shareholder class actions by the defendants' motion
to dismiss. If a complaint survives the motion to dismiss, the settlement stake
increases markedly. Few cases are disposed of by a defense summary judgment,
and fewer still ever reach trial.
A Supreme Court decision in Tellabs arguably
raising the required pleading standard would likely increase the rate at which
courts grant motions to dismiss cases on the pleadings in jurisdictions that
have been more favorable to plaintiffs. Although dismissal rates have generally
doubled since PSLRA,11 there remain significant
variances between the dismissal rates in the different circuit courts, ranging
from 5 percent in the Tenth Circuit to 31 percent in the Fourth Circuit (for
cases filed from December 15, 2000, to December 15, 2004). Perhaps the post-Enron
judicial climate will render another decision supporting defense efforts in
this area, following the decision in Dura Pharmaceuticals
v. Broudo, 544 U.S. 336 (2005), on loss causation.
The Delaware Supreme Court, in Stone v. Ritter,
911 A.2d 362 (Del. 2006),12 offered academics plenty
more to discuss and debate concerning director good faith as a basis for liability.
The so-called triad of fiduciary duties, including a free-standing duty of good
faith, was introduced in 1993 in Cede & Co. v. Technicolor,
Inc., 634 A.2d 345, 361 (Del. 1993) (Technicolor
II), joining the director duties of loyalty and of care. Following Technicolor II, Delaware's exculpatory legislation,
8 Del. Section 102(b)(7), characterized "actions taken not in good faith" as
falling outside the protections afforded by the business judgment rule.
In 1996, In re Caremark Int'l Inc. Derivative Litigation,
698 A.2d 959 (Del. Ch. 1996), elevated the debate about good faith in the context
of director oversight of corporate activities. A reading of Stone leads to the conclusion that director good
faith is now subsumed under the duty of loyalty. From a liability standpoint, Stone notes that acts taken in bad faith breach
the duty of loyalty. Apart from calling for a reorganization of textbooks on
corporate law and director duties, the case is instructive in assessing director
oversight and responsibility.
Of greater value perhaps, is the 2006 opinion, In
re Walt Disney Co. Derivative Litigation, 906 A.2d 27, 65 (Del. 2006)
(affirming trial court judgment for the defendants), in which the Delaware Supreme
Court distinguished the "duty of good faith" from the "duty of care," explaining
that "grossly negligent conduct, without more, does not and cannot constitute
a breach of the fiduciary duty to act in good faith." Disney now offers a bright line rule: exculpation
exists for gross negligence and negligence, but not for a conscious disregard
of duty.
Outlook for the Future
Merger and acquisition (M&A) activity poses special risks to D&O underwriters.
The U.S. economy is in the midst of a very active M&A environment, pushed largely
by aggressive buying of public companies by private equity. Companies that face
a greater risk of attracting the interest, often unwanted, of private equity
buyers may share several features, including strong cash flows, high cash balances,
and low dividend yields.13 In addition to cash,
a low market capitalization and low stock performance relative to its peers
will attract private buyers.
Pressure from shareholders to deliver value will present considerable derivative
suit activity, joining the over 100 options backdating derivative suits filed
in the last year. The options backdating claims may be largely restricted to
pre-SOx activity (given the stock option announcement rules change in August
2002). However, the pressure of private equity and the interest of institutional
investors in a large number of corporate decisions may well lead to considerable
derivative litigation in the near term.
In addition to the risk that the selling corporation's shareholders will
complain, there is also the risk of buyer's remorse or allegations of breached
representations and warranties by the seller. In this area, the 2006 Delaware
Chancery Court decision in ABRY Partners V, LP
v. F&W Acquisition LLC, 891 A.2d 1032 (Del. Ch. 2006) (provision was
unenforceable as against public policy to the extent it restricted buyer's claims
based on intentional misrepresentations made by the seller in the agreement)
is instructive, finding that a buyer is free to press a claim for full compensatory
damages when a seller intentionally misrepresents facts embodied in a contract,
notwithstanding limiting language within the contract to the contrary.
There continues to be a great deal of shareholder interest in executive compensation,
which seems likely to grow as companies prepare to comply with new SEC rulemaking
calling for greater disclosure of all compensation (including retirement benefits
and severance agreements) for their five most highly compensated individuals.
This closer scrutiny has led to the rash of options-backdating cases filed beginning
in May 2006, following the mid-March 2006 article in the Wall Street Journal, which reported on
the practice as a result of a 2005 study that indicated that senior executives
were recognizing profits on stock options at a far higher pace than the market.
These complaints typically have been brought as derivative actions, with only
a few actions brought as securities claims.
The current cycle of acquisition activity by hedge funds is likely to be
followed in coming years by a cycle of IPOs as private money seeks profit from
its current buying activity. And while the IPOs of tomorrow will again pose
D&O underwriting risks, many of the newly listed companies will be mature businesses,
unlike many of the IPOs during the late 1990s and early 2000s.
1Securities
Class Action Case Filings—2006: A Year in Review, Cornerstone Research
(the report identifies class action filings identified as of December 18, 2006)
("Cornerstone report").
2Todd Foster, Ronald I. Miller and Stephanie Plancich,
Recent
Trends in Shareholder Class Action Litigation: Filings Plummet, Settlements
Soar, NERA Economic Consulting (January 2007) (the report includes
settlements reported as of December 15, 2006) ("NERA report").
Securities
Class Action Settlements—2006 Review and Analysis, Cornerstone Research
("2006 Cornerstone settlement report").
3Nortel Networks I ($1.143 million), Royal Ahold,
NV ($1.1 million) and Nortel Networks II ($1.074 million), as reported in the
NERA report. According to a December 26, 2006, press release, the settlement
of Nortel I and II totaled an estimated $2.45 billion; the Nortel settlements
have also recently gained the approval of Canadian courts overseeing part of
the litigation.
4U.S. Securities and Exchange Commission,
2005
Performance and Accountability Report.
5U.S. Securities and Exchange Commission,
2006
Performance and Accountability Report.
6Larry D. Thompson, U.S. Deputy Attorney General,
Principles
of Federal Prosecution of Business Organizations (Jan. 20, 2003).
7Paul J. McNulty, U.S. Deputy Attorney General,
Principles of Federal Prosecution of Business Organizations (Dec.
12, 2006).
8In re Royal Ahold N.V.
Sec. & ERISA Litig., 2004 WL 502558 (D. Md. March 12, 2004), supported
the civil discovery of materials produced to government investigators notwithstanding
claims of privilege. The SEC reportedly rewarded Royal Ahold's cooperation by
not seeking a penalty against the company when the company waived the attorney-client
privilege and produced documents to the government arguably protected by the
attorney work-product doctrine. As noted above, Royal Ahold now joins the list
of top ten largest civil settlements at $1.1 billion. In addition, McKesson
agreed to settle a shareholder class action against it in 2005 for $960 million
after losing arguments aimed at protecting documents produced to the government.
9Paul J. McNulty, U.S. Deputy Attorney General, Principles of Federal Prosecution of Business
Organizations (Dec. 12, 2006), at 11.
10437 F.3d at 602.
11NERA Report, supra,
n.2, comparing 2-year dismissal rates of cases filed in 1991–1995 (19.4 percent)
with cases filed in 2001–2004 (38.2 percent).
12Shareholders' derivative suit against AmSouth
Bancorporation's directors alleging the bank had paid $50 million in fines and
penalties to the federal government because the defendants "had utterly failed
to implement any sort of statutorily required monitoring, reporting or information
controls that would have enabled them to learn of problems requiring their attention." Id. at 364. The case was dismissed
for failure to satisfy the demand requirement, a decision affirmed by the Delaware
Supreme Court.
13Chris Kraeuter,
Why
Private Money Likes Chips (Sept. 15, 2006, Forbes.com).
David T. Burrowes,
a principal with Boundas, Skarzynski, Walsh & Black, LLC, since its inception
in 2003, has particular expertise with professional liability claims and insurance
policies, particularly directors and officers liability, employment practices
liability, and insurance company and brokers' errors and omissions. Mr. Burrowes
received his BA degree from UCLA and his JD from Vanderbilt University. He has
been admitted to practice in California and in Illinois. His e-mail address
is dburrowes@bswb.com and phone number
is (312) 946–4214.
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