D&O Litigation Trends in 2005
March 2005
Last year we wrote about a number of emerging
trends involving claims against directors and officers of publicly traded corporations.
We suggested that corporate officials were facing greater exposure to liability,
which we expected would continue in 2004. There have been few developments in
the past year to suggest that the potential exposure of directors and officers
is lessening.
by John
E. Black Jr. and David T. Burrowes
Boundas, Skarzynski,
Walsh & Black, LLC
While the D&O insurance market is prone to hard and soft market cycles of
differing durations, with the market now in a soft-pricing cycle, the exposure
to liability for directors and officers over the past 15 years is better described
by a line curving upward. Spectacular corporate busts, several of which were
fueled by questionable accounting—at best—and blatant fraud—at worst—captured
the public's attention.
The plaintiffs' class action bar, for many years the most vigorous prosecutor
of alleged corporate malfeasance, has been joined by a larger and better-funded
Securities and Exchange Commission (SEC) and a multitude of state attorney generals.
Institutional investors are increasingly vocal advocates for recovery of shareholder
losses and corporate governance changes. The U.S. Congress joined the fray by
passing the Sarbanes-Oxley Act of 2002 (SOx), employee whistleblowers are protected
and have a financial incentive to correct perceived wrongs, attorneys serving
companies are obliged to report suspected wrongs, and accountants must choose
between auditing or consulting. The federal and state judiciary, notably Delaware,
often seem guided by a post-Enron jurisprudential bias against directors and
officers.
Below we discuss the trends supporting increased liability exposures for
directors and officers.
A Rising Number of Securities Claims
The year 2004 showed a modest increase in the number of securities class
action filings over 2003. Cornerstone Research tallied 212 "traditional" filings
in 2004, up from 181 in 2003.1 Cornerstone's "traditional"
filing figures do not include the IPO laddering cases, the investment analyst
cases, and the mutual fund trading cases. Although SOx is credited with leading
many companies to consider delisting, the total number of issuers is relatively
unchanged since 2003. As a result, there was also a modest increase in the number
of filings per issuer. Of the total issuers listed on the NYSE, NASDAQ ,and
Amex, 2.8 percent were named as defendants in traditional securities class actions
filed in 2004, up from 2.4 percent in 2003. When considered over a 5-year period,
1 out of every 7 issuers was named as a defendant in a securities class action.
Within "traditional" securities class actions, Cornerstone developed a new
category: "mega" filings involving $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 preceding the end
of the class period to the trading day immediately following the end of the
class period. Cornerstone identified eight mega-filings in 2004, up from one
in 2003. Moreover, the disclosure dollar losses for all filings in 2004 totaled
$169 billion, a three-fold increase over $58 billion in 2003.
Several of the "mega" cases filed in 2004 (Merck, Pfizer, Marsh & McLennan,
and American International Group) attributed shareholder losses to misrepresentations
concerning a key product or business practice, as opposed to false financial
reports. Although there continued to be large numbers of restatements of financials
(over 400 in 2004), many did not result in a large stock drop or a shareholder
class action, perhaps due to the greater attention on financial reporting, both
internally and externally, as companies and their auditors prepared for the
SOx 404 certifications over the last 2 years since SOx became effective.
SOx 404 certifications are receiving considerable attention from analysts
and investors as companies have spent much time and money to meet SEC deadlines.
In short, 404 certifications attest (within the annual report) to the effectiveness
of a company's internal controls on financial reporting, and perhaps as significantly,
to the auditor's opinion as to the adequacy of the company's internal controls
on financial reporting. A recent full-page advertisement by PricewaterhouseCoopers
appeared in the Wall Street Journal setting
forth the goals of 404 certifications and suggesting that capital markets not
react simply to failed certifications, but to consider the bigger picture, including
how management responds to a failed certification and the transparency of management's
explanation behind the failed certification.
Apart from difficulties with 404 certifications, other trouble areas remain
in accounting estimates. For virtually any company, accounting estimates will
remain a source of potential abuse and potential shareholder or derivative litigation.
The Royal Ahold case was built on overestimating the value of future rebates
to be paid by suppliers. Fannie Mae faces liability for misstating the financial
impact of derivative investments and hedging. Restating estimates of oil reserves
led to securities suits filed against Royal Dutch Petroleum/Shell and El Paso
Corp. As companies are called on to recognize on their financial statements
the cost of employee stock options, many companies may find that they are later
charged with wrongdoing in the manner in which the expense of those options
was estimated. Another problem area may emerge in estimates of pension liabilities,
or in the manner in which companies switch between traditional, cash-balance,
and 401(k) plans.
SEC Enforcement and the Impact of Cooperation
The SEC has stepped up its prosecution of securities violations and accounting
fraud. In fiscal year 2003 (ending September 30, 2003), the SEC filed 679 enforcement
actions (up from 484 in 2001 and 598 in 2002).2 Similar enforcement numbers in fiscal 2004 are expected. The SEC's new strategy
to be proactive rather than reactive has led to a number of industrywide investigations
undertaken in the wake of disclosure of problems with one company. An example
of this is seen in the SEC's investigations into accounting practices in retail
industries following revelations of over-stated income with the food retailer
Royal Ahold.
In 2002 the SEC announced its intention to pursue director and officer bars
based on individual malfeasance. The number of officer and director bars sought
by the SEC has grown from 51 in 2001 to 126 in 2002, totaling over 300 in the
past 2 fiscal years, 2003 and 2004.3 SOx enhances
the threat of a director or officer bar, permitting the SEC to pursue bar in
an administrative proceeding (no longer exclusively within the federal courts)
and reducing the standard to support the bar from "substantial unfitness" to
mere "unfitness."
The SEC has not been reticent about seeking civil penalties, which the SEC
may waive or enhance depending on the target's cooperation with the SEC's investigation.
A company that cooperates may avoid millions of dollars in civil penalties and
save its executives from a lengthy bar. 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 SEC arguably protected
by the attorney work-product doctrine.4
However, companies and directors and officers face a tension between cooperating
with the SEC's investigators and undermining the defense of shareholder class
actions. Several decisions in the past year have supported discovery requests
by plaintiffs for materials previously produced by defendants to government
investigators, including In re LaBranche Sec. Litig.,
333 F Supp 2d 178 (SD NY Aug 27, 2004) (finding that to refuse the requested
discovery would cause plaintiffs "undue prejudice"). In the past month, McKesson
agreed to settle a shareholder class action against it for $960 million after
losing on several occasions arguments aimed at protecting documents produced
to the government, or to seal portions of trials addressing those materials
in order to prevent further disclosure of the materials.
The battle over internal investigations and materials produced to government
investigators should continue, but numerous decisions already support discovery
of those materials notwithstanding claims of privilege, as well as the limits
on discovery imposed by the PSLRA. In re Royal Ahold
N.V. Sec. & ERISA Litig., 220 FRD 246 (D Md March 12, 2004), represents
a double loss for defendants concerning the protection of documents sought by
plaintiffs. First, the defendants lost claims of privilege over requests for
documents produced to the government. Second, the defendants lost arguments
concerning the PSLRA discovery bar applicable before decision on a motion to
dismiss. The court found that because the discovery bar did not apply to the
ERISA plaintiffs, the securities plaintiffs would be severely disadvantaged
should they not have access to the same materials produced to the ERISA plaintiffs.
A statutory response has been proposed: the Securities Fraud Deterrence and
Investor Restitution Act of 2004 (H.R. 2179) includes provisions aimed at preempting
state law on the privilege issue in the context of production to the government
pursuant to a non-waiver agreement.5 However, until
such a statute is adopted, plaintiffs will pursue documents produced to the
government and the government will press for cooperation in the form of full
and complete document production and the waiver of privilege.
In addition, shareholders have increasingly exercised their right under Delaware
law to inspect corporate books and records, utilizing 8 Del. C. Sec. 220 to
conduct informal discovery outside of litigation. The Delaware Chancery Court,
in Cohen v El Paso Corp., 2004 WL 2340046 (Oct
18, 2004), concluded that the federal discovery stay imposed by the PSLRA did
not preempt the court from hearing a shareholder's Section 220 action.
The Size of Securities Claim Settlements Continues To Grow
As 2004 progressed, we increasingly expected that the average settlement
value of a securities class action would turn out to be higher in 2004 than
that in 2003. In 2004, three new settlements made the "top ten" list of largest
settlements: Citibank's agreement to pay $2.6 billion to resolve shareholder
and bond claims filed following the collapse of WorldCom; Raytheon's $460 million
settlement (composed of cash and stock warrants); and Bristol-Meyers Squibb
(also notable for its agreement to pay $300 million to shareholders while defending
on appeal a dismissal of the claim). Bristol-Meyers also agreed to pay $100
million in civil penalties to the SEC. January 2005 added yet another top ten
settlement: McKesson's $960 million agreement noted above. NERA's recent report
summarizing shareholder class action settlements in 2004 confirmed our expectation:
the average settlement rose 33 percent from 2003 to 2004, increasing from $20.3
million in 2003 to $27.1 million.6
An equally notable development at the end 2004, and in January 2005, were
two settlement agreements by outside directors in the Enron and WorldCom cases
calling for payment of millions funded directly out of the directors' pockets,
not from D&O insurers or other sources. The advent of the directors' individual
and non-indemnified settlements may be traced to the bounties by institutional
investors, which reportedly provide the plaintiffs' counsel a greater contingent
fee percentage, perhaps as much as 50 percent, of settlement dollars paid by
individuals. Some would attribute the institutional investors' aggressive behavior
to political motivations. Others would view the heightened passion as traceable
to recognition of the fiduciary duties owed by the managers of the institutional
funds to the funds' participants. Regardless of the cause, this development
has been the source of great consternation among directors.
The settlement size of post-PSLRA class action lawsuits continues to be driven,
at least in part, by the size of the market capitalization loss. Another factor
is the involvement and leadership of institutional investors as plaintiffs.
NERA identifies several other factors, the presence of which drives valuations
up: the depth of the defendants' pockets or ability to pay, whether there are
co-defendant third-parties (typically accountants), Section 11 claims, and restatements
or other accounting irregularities.7 Since the advent
of the PSLRA, the presence of institutional investors acting as lead plaintiff
has resulted in significantly larger settlements.8 The settlement figures may be skewed by the inclusion of the two multibillion
dollar settlements, Cendant and WorldCom (Citibank), but one conclusion may
be drawn: the presence of an institutional investor acting as lead plaintiff
ought to be a warning sign concerning the level of aggressiveness in settlement
negotiations.
Separate Settlements and the Role of the Opt-outs
Last year, we noted that securities class actions were increasingly fragmented
due to the presence of separate constituencies (class shareholder plaintiffs,
class opt-outs, and ERISA plaintiffs) contributing to the difficulty of settling
such claims. The possible collapse of the recent WorldCom settlement involving
ten former directors and their agreement to pay a total of $18 million out of
their own pockets points to the complex nature of separate settlements. The
plaintiffs scuttled the deal with the directors after the court rejected a provision
in the settlement that attempted to modify the judgment reduction feature of
the PSLRA. In short, the PSLRA places the risk of an under-valued settlement
upon the plaintiff, giving the non-settling defendants the benefit of an allocation
of fault resulting from a trial.
Institutional investors, typically state employee retirement funds, are aggressively
pursuing separate actions, often in state court, as parallel proceedings to
federal securities class actions. Plaintiffs frequently press for settlement
terms that provide for escalating payments should other plaintiffs secure better
terms from the defendants. A "most favored nation" clause, if demanded by plaintiffs,
often undercuts defendants' ability to settle, as the settlement payment amount
lacks certainty, a critical point for settling parties.
Post-Enron Jurisprudence
The Walt Disney Company derivative litigation concerning former CEO Michael
Ovitz's executive compensation continues in Delaware Chancery Court. The trial,
which began in 2004, recently concluded, but a decision could be months away.
The Chancery Court's 2003 ruling in the case, 2003 WL 21Z67266 (Del Ch May 28,
2003), has already been the subject of several commentaries concerning the business
judgment rule and the protection it affords to the decisions of board members.
While the defendants may succeed with their arguments that the Disney board
acted appropriately in approving the compensation package negotiated with Mr.
Ovitz, the trial has resulted in substantial negative publicity for the company.
The civil case against the Worldcom bankers and bond underwriters (other
than Citibank, which settled the claim for over $2.6 billion) is set for trial
in New York this year, perhaps beginning this month. While few defendants have
an appetite for risk of liability coupled with negative publicity, this litigation
is becoming more challenging to resolve short of trial due to the fragmentation
of the claims and the willingness of institutional investors to vigorously pursue
the litigation.
Another Delaware Chancery Court matter, In re Emerging
Communications, Inc. Shareholders Litigation, 2004 WL 1305745 (Del Ch
May 3, 2004, revised June 4, 2004), arguably makes the defense of director conduct
more difficult. Companies currently face increasing pressure to fill their boards
with active and informed directors. Companies must identify a "financial expert"
to sit on the board's audit committee. At the same, court decisions, such as
that in Emerging Communications, suggest a greater
standard of care based on the individual board member's background. The decision
considered the role and deliberations of director Salvatore Muoio, an investment
banker with "specialized expertise or knowledge" equal to that possessed by
the financial advisors retained to provide the board committee with a fairness
opinion concerning a merger transaction. The case supports the view that a director,
in defending a decision as being taken in good faith, may not rely upon an expert's
fairness opinion if the director knew, or reasonably should know, the transaction
is unfair.9
The PSLRA requires that a securities plaintiff alleging Rule 10b-5 violations
plead facts, stated with particularity, which give rise to a strong inference
of scienter. The manner in which courts have addressed the pleading standards
called for by the PSLRA have differed, with most concluding that the Ninth Circuit
imposed the highest standards, thus leading to more successful motions to dismiss.
In 2004 the Ninth Circuit Court of Appeals, in Nursing
Home Pension Fund, Local 144 v Oracle Corp., 380 F3d 1226 (9th Cir 2004),
examined the management style and trading behavior of Chairman and CEO Larry
Ellison. The decision reversed the district court's dismissal (on motion to
dismiss) and suggested less tolerance for alleged corporate malfeasance than
was previously thought to be the case and as reflected by the heightened pleading
standards articulated in the 1998 Silicon Graphics decision. Other federal cases decided in the past year reflecting a willingness
to take a closer look at alleged securities fraud include Barrie v Intervoice-Brite, Inc., 2005 WL 57928
(5th Cir Jan 12, 2005) (reversing district court dismissal for failure to satisfy
pleading standards), and Phillips v Scientific-Atlanta,
Inc., 374 F3d 1015 (11th Cir 2004) (declining to decide whether the group-pleading
doctrine, permitting plaintiffs to aggregate allegations against individuals
based on their position within the company, survives the enactment of the PSLRA,
but upholding the district court's decision that the complaint satisfied the
pleading standards as to each defendant).
Conclusions
Perhaps it is true, as Yogi Berra once suggested, that "the future ain't
what it used to be." We do not anticipate that D&O exposure will soon diminish.
Too many forces are aligned against directors and officers to suggest that the
frequency and severity of claims will soon decrease, notwithstanding very real
efforts to foster financial transparency. With merger activity on the rebound,
we are also reminded that the $960 million McKesson settlement announced last
month concerned shareholder litigation filed following revelations that McKesson's
1999 acquisition of HBOC was tainted by misrepresentations in HBOC's financial
statements. With the current emphasis on getting the numbers right and the use
of SOx 404 certifications, companies recognize that the weaknesses in the internal
controls on financial reporting of their merger and acquisition partners become
their own weaknesses once the deal is done. While some help for defendant directors
and officers may be on the way from the U.S. Supreme Court in a Dura Pharmaceuticals decision on loss causation,
the potential exposure for serving as a director or officer does not seem to
be waning.10
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 and phone number
is (312) 946-4214.
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