D&O Litigation Trends in 2004
February 2004
This year, 2004, will see no end to the rising
number of federal and private prosecutions of directors and officers, ever increasing
settlement costs, and close judicial scrutiny of board decisions. Only a cultural
change can curb the flow.
by John
E. Black Jr. and David T. Burrowes
Boundas, Skarzynski,
Walsh & Black, LLC
A number of trends in litigation against directors and officers of publicly-traded
corporations that emerged in 2002 and 2003 appear likely to continue in 2004.
The last 2 years have been marked by significant developments in response to
the spate of corporate scandals following the downturn of the 1990s stock boom.
The Sarbanes-Oxley Act of 2002 (SOx) prescribed corporate governance changes,
enhanced disclosure requirements, imposed heightened criminal penalties, and
created new bases for action against directors and officers.
The Securities and Exchange Commission (SEC) and state attorneys general
have strengthened their efforts to prosecute directors and officers and related
professionals. Investors and regulators also have come to closely question previously
accepted practices at public corporations, the financial sector, and professional
advisers, and have not hesitated to bring civil and criminal actions against
directors and officers and their professional advisers. Some of the trends likely
to continue in 2004 are discussed below.
The Number of Securities Claims Continues to Rise
Although the Private Securities Legislation Reform Act of 1995 (PSLRA) was
adopted partly to eliminate "strike suits" and reduce securities litigation
costs, the number of securities fraud suits filed against issuers and their
directors and officers since its adoption has risen: from 122 in 1996 to 224
in 2003. However, with the growth in the total number of issuers since the adoption
of the PSLRA, the number of class-action filings per issuer has been relatively
stable. According to Cornerstone Research, since 1998, the percentage of filings
per issuer has ranged from 2.4 to 3.0 percent (2002).1
The industry that faced the largest exposure from securities fraud suits
through the 1990s—both by frequency and settlement value—was the high technology
industry. However, that trend appears to have waned slightly beginning in 20022,
perhaps reflecting the increasing focus by the SEC and the N.Y. attorney general
on practices in the financial services industry.
The SEC Has Stepped-Up Prosecution of Directors and Officers
The SEC has become more vigorous in prosecuting securities violations and
accounting fraud. The number of SEC enforcement actions increased from 484 in
2001 to 598 in 2002.3 In fiscal year 2003 (ending
September 30, 2003), the SEC filed 679 enforcement actions, and 199 of those
involved financial fraud or reporting violations.4
The SEC has also sought heightened personal accountability of officers and
directors, announcing in 2002 its intention to expand its pursuit of officer
and director bars, i.e., barring certain directors and officers from serving
on boards. The number of officer and director bars sought by the SEC since 2000
has steadily grown: 38 in 2000, 51 in 2001, 126 in 2002, and reaching 170 in
2003. Following SOx, the standard to support an officer and director bar dropped
from "substantial unfitness" to mere "unfitness." Moreover, through amendment
of the 1933 and 1934 securities acts, SOx provided the SEC with the administrative
power to issue bar orders within a cease and desist proceeding. Previously,
the authority to issue bar orders rested with the federal courts.
The SEC especially has been vigorous since August 2003. As noted recently
by Bruce T. Carton, executive director of the ISS Securities Class Action Services,
in the 15 business days between September 24 and October 14, the SEC brought
10 insider-trading cases, prosecuting traders who reaped profits as low as $922.5 The SEC has also departed from its long-standing reticence to bring subpoena
enforcement actions, filing 5 such actions since mid-August. Moreover, as discussed
in a recent article by Russell G. Ryan, assistant director of the SEC's Division
of Enforcement, in the last year the SEC has taken a much harder line on settlements.6 The SEC's $500 million penalty settlement with WorldCom was 50 times higher
than a previous penalty paid by a public company in an accounting fraud case,
and the SEC has been demanding substantially higher civil penalties in other
accounting fraud cases and in Regulation FD cases.
Penalties levied against Schering-Plough ($1 million) and its CEO ($50,000)
resulted from the perception that body language and demeanor shared with analysts
unfairly disclosed material nonpublic information concerning Schering-Plough's
quarterly earnings.7 The SEC is expected to continue
enforcement aimed at companies that engage in earnings guidance and which lead
to so-called whisper numbers in advance of earnings releases. Moreover, the
sizes of the penalties are likely to grow.
SOx also authorized disgorgement of remuneration and court-ordered freezes
on extraordinary payments pending investigation. Greater SEC enforcement tools
and penalties necessarily have the effect of raising the stakes for the accused,
which leads to greater costs of defense and increased values of settlements
(that typically involve neither admissions nor denials of wrongdoing).
In 1995, the PSLRA provided public companies with a safe harbor for forward-looking
statements, but also provided for the removal of that safe harbor for a period
of 3 years if the issuer was the subject of a settled enforcement action with
the SEC. In practice, however, the SEC policy evolved to permit the waiver of
the safe harbor disability. Recent trends suggest the SEC is less likely to
permit the waiver and to provide for more effective use of the PSLRA safe harbor
disability. A collateral consequence of a settlement with the SEC may be greater
exposure to liability in the 3 years following given the lack of a safe harbor
for forward-looking statements.
As part of its effort to enforce the securities laws aggressively, the SEC
is more visibly bringing criminal actions against prominent directors and officers.
The trial of Dennis Kozlowski, the former CEO of Tyco, began in early January
2004; the trial of Martha Stewart began in late January 2004; and the trial
of Richard Scrushy, former CEO of HealthSouth, is scheduled for this month.
Former Enron executives may expect to face additional indictments, especially
in the wake of Andrew Fastow's plea agreement and anticipated cooperation.
The Size of Securities Claim Settlements Continues To Grow
Since the adoption of the PSLRA, the costs of shareholder class settlements
have increased: the average settlement increased from $7.0 million in 1996 to
$24.3 million in 2002 and the median settlement increased from $3.5 million
to $6 million.8 In addition, the size of "mega-case"
settlement has increased dramatically. Two of the largest securities class action
settlements in history occurred in 2003: Lucent ($563 million) and Oxford Health
($300 million).
The magnitude of settlements of post-PSLRA class action lawsuits appears
to be driven, in part, by the size of each company's market capitalization.
Another factor may be the involvement and direction of more sophisticated parties,
with institutional investors often serving as lead plaintiffs in the litigation.
The PSLRA provides that the plaintiff with the largest financial interest in
the securities lawsuit may act as lead plaintiff.
According to Cornerstone Research, 30 percent of all settlements under the
PSLRA involved an institutional investor as a plaintiff. The median settlement
amounts in cases in which the plaintiff has been an institutional investor have
consistently been higher than in cases in which no institutional investor acted
as lead plaintiff. A recent PriceWaterhouseCoopers report indicated that, in
2003, 15 settlements averaging over $120 million were reached in securities
cases in which a pension fund served as lead plaintiff, compared to the average
settlement of $7.5 million in the other 85 cases in which a pension fund did
not serve as the lead plaintiff.9
Corporate Governance Reforms Are Becoming Part of Securities Litigation
Settlements
Companies are increasingly including governance reforms as part of shareholder
claim settlements. At least six major companies in 2003,10 including MCI, announced significant corporate therapeutics as part of shareholder
settlements, including bolstering board independence levels and better oversight
of executive compensation. In August 2003, a court-appointed monitor for MCI,
which is in bankruptcy and under separate court supervision for a substantial
securities fraud case, issued a report outlining 78 governance reforms.
The Fragmentation of Securities Claims and Settlements
Settlements of securities class actions are becoming increasingly fragmented,
as constituencies other than the shareholder plaintiffs have to be satisfied
for a global settlement to be achieved. It is becoming more common for corporations
that have been sued by shareholders for securities fraud to also be sued, in
separate litigation, by pension funds or employees for either Employee Retirement
Income Security Act (ERISA) violations, state law securities violations, or
common law fraud.
The sharp decline of the stock market resulted in an increasing number of
underfunded pension plans and more than half of the public pension plans are
underfunded, up 20 percent from a few years ago. Employees who have lost retirement
savings as a result of their investment in company stock have been filing ERISA
class actions against the company that parallel the pending securities class
action on behalf of all investors. The actions typically allege that the company
and its officers violated their fiduciary duties under ERISA by making false
statements that induced employees to invest in the stock at artificially inflated
prices.
For example, hundreds of employees devastated by losses in their 401(K) retirement
savings plan filed class actions under ERISA against WorldCom and its management.
Plaintiffs in these lawsuits claimed, among other things, that WorldCom and
its directors and officers exerted "undue" influence over employees to encourage
them to invest in the company's stock. Similar parallel ERISA class actions
have been filed against Enron, Qwest, and Global Crossing.
In addition, some plaintiffs' securities law firms have also been working
to persuade pension funds to opt out of class actions in favor of pursuing individual
securities actions. Notably, on November 17, 2003, the U.S. District Court in In re: WorldCom, Inc. Securities Litigation,
found that the prominent plaintiffs' class action law firm, Milberg Weiss Bershad
Hynes & Lerach LLP, had "engaged in an active campaign to encourage pension
funds not to participate in the class action and instead to file individual
actions with Milberg Weiss as their counsel."11 Prior to WorldCom, several other pension firms had opted out of securities class
actions since September 2002.12
The institutional plaintiff opt-out trend is magnified by the amendment of
Federal Rule 23(e)(3), permitting late opt-outs. In short, under the amendment
effective December 1, 2003, in any case certified under 23(b)(3), a court may
refuse to approve a class settlement absent extending the opportunity for class
members to opt out of the settlement. Plaintiffs may wait for the class settlement
to be negotiated, and then press for opt-out rights while negotiating a separate
settlement. The amendment, aimed at abuses in the mass tort class action practice,
has spawned unintended consequences in securities class actions, including constraining
settlements as defendants grapple with institutional investors threatening opt-out
rights.
The opt-out phenomenon is fueled further in California where plaintiffs seek
relief under state law. In 1998 Congress passed the Securities Litigation Uniform
Standards Act (SLUSA), in part to direct exclusive jurisdiction over securities
class actions to the federal courts. Nonetheless, institutional plaintiffs,
such as the California State Teachers' Retirement System (CalSTERS), often elect
state law remedies and sue in state court, although doing so gives up rights
under Section 10(b) of the 1934 Securities Exchange Act. California jurisprudence
in this area is also growing separately in neighboring counties through separate
appellate districts (the First, overseeing San Francisco and San Mateo Counties
preferred by plaintiffs, and the Sixth, overseeing Santa Clara County preferred
by defendants). Protection of holders (as distinguished from buyers and sellers
of securities) was also recognized by the California Supreme Court and will
likely lead to further civil litigation.13
Greater Judicial Scrutiny of Director and Officer Conduct
As noted in the August 2003 Expert Commentary,
courts appear to be scrutinizing more closely decisions by directors challenged
by shareholders in derivative lawsuits, particularly in the areas of director
independence and care. Since that Commentary, additional opinions continue to
signal that courts in the post-Enron era have little patience for directors
who do not take seriously their duties. Recent decisions by district courts
in In re Abercrombie & Fitch Co. Securities Litigation,
2003 WL 22705131 (SDNY Nov. 17, 2003), and In re Sears,
Roebuck and Co. Securities Litigation, 2003 WL 22454021 (ND Ill Oct.
24, 2003), seem to indicate that courts may now be moderating the heightened
pleading requirements under the PSLRA for scienter (i.e., fraudulent intent).
The PSLRA requires that the plaintiff plead facts, stated with particularity,
which give rise to a strong inference of scienter. In both cases, the courts
liberally allowed the plaintiffs to make assumptions about the defendants' knowledge
by virtue of their executive positions. In Sears,
the plaintiffs argued they had established a strong inference of scienter because
the individual defendants were executive officers and must have known the information
that made alleged misstatements misleading about the risk level of balances
in accounts in Sears' credit card portfolio, the delinquencies in those accounts,
and the amount of "charge-offs" of unpaid accounts. Holding that the plaintiffs
adequately pleaded scienter, the court noted that "officers of a company can
be assumed to know of facts 'critical to a business's core operations or to
an important transaction that would affect a company's performance.'"
Similarly, in Abercrombie, the court found
a "sufficient basis" for pleading scienter against three individual officers.
Because of allegations that one of three individual defendants (Fogel) knew
of a particular Wall Street expectation of 15-17 percent same-store growth and
because the Abercrombie management was "small and tightly knit," the court concluded
it was "reasonable for the plaintiffs to assume, at the pleading stage, that
this knowledge was shared by Jeffries and Johnson."
Conclusions
The rising tide of federal and private prosecutions of directors and officers,
with ever increasing settlement costs, and the close judicial scrutiny of board
decisions, does not yet appear to have reached its high watermark. The emphasis
of the activity is, of course, to provide greater protection to investors through
more transparent financial reporting. The drivers for achieving this are legislative—through
the imposition of greater internal controls, encouragement of whistleblowers,
and required certifications by corporate officers and independent auditors—and
prosecutorial—through greater publicizing of problems within public companies
and increasing the potential exposure of corporate directors and officers to
civil and criminal liability.
The hope is that a new culture of transparency will take hold, so that future
corporate financial problems will not fester and grow quarter after quarter
and will not be as substantial as in recent years. However, until that new culture
develops, it appears that the current trends likely will continue in 2004.
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 agents' errors and omissions. Mr. Burrowes
received his B.A. degree from UCLA and his J.D. from Vanderbilt University.
He has been admitted to practice in California and in Illinois. His e-mail address
is and phone number
is (312) 946-4214.
Opinions expressed in Expert Commentary articles are those of the author and are
not necessarily held by the author's employer or IRMI. Expert Commentary articles
and other IRMI Online content do not purport to provide legal, accounting, or other
professional advice or opinion. If such advice is needed, consult with your attorney,
accountant, or other qualified adviser.