D&O Litigation Trends in 2006
June 2006
For the past 2 years, we have suggested that
corporate officials were facing greater exposure to liability. In 2005 little
occurred to indicate that the potential exposure faced by directors and officers
is decreasing.
by John
E. Black Jr. and David T. Burrowes
Boundas, Skarzynski,
Walsh & Black, LLC
Four lawsuits joined the list of top 10 settlements in 2005. Median and mean
settlement values continued to rise. More securities lawsuits went to trial
in 2005 than in the past 10 years combined. Several senior executives of former
Fortune 100 companies have been tried or face trials in 2006. Regulators continue
to aggressively pursue perceived stock manipulators and recently have started
to target outside directors. Suits involving foreign corporations have been
an increasing target of shareholder litigation.
There are some signs that this trend may be abating. Perhaps due to less
volatility in the stock market, the impact of Sarbanes-Oxley (SOx), and the
efforts of regulators, the frequency with which securities class action suits
were commenced decreased in 2005.1 Moreover, the
market capitalization and disclosure dollar losses associated with those suits
was lower than at any point prior to 2000. However, whether the decrease in
securities claims filed reflects a trend downward or is merely an aberration
from prior years remains to be seen.
Below we discuss the trends in securities litigation against directors and
officers in 2005 and entering 2006.
The Size of Securities Claim Settlements Continues To Grow
In 2005 the average settlement of a securities class action was greater than
in 2004, continuing the trend from prior years. The average settlement in 2005
was $28.5 million, up from $27.8 million in 2004. The median settlement also
increased from 2004 to 2005, going from $6.3 million to $7.5 million in 2005—according
to Cornerstone, the largest such single-year increase in history. Thus, the
average settlement amount increased in smaller, as well as larger cases.
Two of the settlements in 2005 were the largest securities settlements in
history: in Enron, $7.165 billion was paid to resolve shareholder and bond claims
and, in WorldCom, $6.156 billion was paid to settle. The Enron and WorldCom
settlements effectively doubled the largest prior settlement. Moreover, 2005
saw the addition of four new settlements in the "top five" list of largest settlements.
In addition to Enron and WorldCom, AOL Time Warner settled class action securities
litigation for $2.5 billion, and Royal Ahold agreed to pay $1.091 billion to
settle securities litigation.
The settlement size of post-Private Securities Litigation Reform Act (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 codefendant third parties (typically accountants),
Section 11 claims, and restatements or other accounting irregularities.2 Since the advent of the PSLRA, the presence of institutional investors acting
as lead plaintiff has resulted in significantly larger settlements.3
| 1 |
Enron |
$7.16 Billion |
| 2 |
WorldCom |
$6.16 Billion |
| 3 |
Cendant |
$3.53 Billion |
| 4 |
AOL Time Warner |
$2.5 Billion |
| 5 |
Royal Ahold |
$1.1 Billion |
Increasing Civil Trial Activity
The frequency with which plaintiffs have taken federal securities class action
cases to trial has markedly increased. The general rule in securities litigation
has been that such cases typically are dismissed or settled before trial. According
to the Stanford Class Action Securities litigation database, of the 2,284 issuers
sued in securities litigation from the effective date of the PSLRA in 1996 until
mid-July 2005, over 1,300 have settled. In that same period, only eight securities
class actions based on post-PSLRA conduct have gone to trial (in whole or in
part). However, in what appears to be a trend toward litigating securities class
action suits through trial, six cases have been tried since October 2004 (including
one in June and July).4
We intend to track the results as this trend develops. Below is our first
scorecard on the results of the post-PSLRA cases which have been taken to trial.
Only two have yielded a defense verdict.
TABLE
1
SEC Enforcement and the Impact of Cooperation
The SEC has continued to step up its prosecution of securities violations
and accounting fraud. In fiscal year 2005 (ending September 30, 2005), the SEC
filed 974 enforcement actions (up from 679 in 2004).5 In 2002 the Securities and Exchange Commission (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 2004.6 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.7
Regulators Increasingly Target Outside Directors
In the wake of the massive accounting scandals at Enron and WorldCom, the
SEC announced that it would pursue enforcement actions against outside directors
who ignore corporate wrongdoing. The SEC's proclamation represents a fundamental
shift in the SEC's enforcement policies with respect to outside directors. An
SEC enforcement action against a former outside board member at Chancellor Corporation
exemplifies the SEC's new stance. In Chancellor, the SEC alleged that the company
improperly booked $19 million in revenue and improperly wrote off $1.4 million
in related-party payments. The SEC further alleged that the company fired its
auditing firm that disagreed with its accounting practices and replaced the
auditors with an auditor who was willing to sign off on the company's accounting.
With respect to the company's outside director, Rudolph Peselman, the SEC alleged
that Peselman knew that the auditors had been replaced because of their disagreement
with the company's accounting practices and that the company had written off
$1.4 million in related-party payments. In spite of this knowledge, Peselman
approved the company's financial statements, "completely neglect[ing] his duties
as a director and an audit committee member," according to the SEC.8 Based on his oversight, the SEC sought to bar Peselman from serving as an officer
or director. In 2005 Peselman and the SEC reached a settlement whereby Peselman
agreed to a permanent bar from serving as an officer or director.
Heralding the change in the SEC's enforcement policies with respect to outside
directors, former SEC enforcement chief Stephen Cutler deemed the Chancellor
case the "first salvo in this area." Cutler explained that, "[t]his case signifies
the commission's willingness to pursue cases against outside directors who were
reckless in their oversight of management and asleep at the switch."9 More recently, Alan Beller, former director of SEC's Division of Corporate Finance,
confirmed that a number of SEC ongoing investigations involve outside directors.10
SEC actions against outside directors for so-called oversight failures are
civil in nature. Criminal liability against an outside director generally requires
that the director willfully or knowingly violated the securities statutes at
issue. Accordingly, it is not surprising that in oversight cases there have
been no criminal prosecutions against an outside director to date.11
Conversely, criminal sanctions have been imposed against outside directors
for insider trading and self-dealing. When an outside director is found to have
engaged in insider trading, out-of-pocket payments are not uncommon. In such
cases, the SEC may seek disgorgement of trading profits, civil penalties, and
an officer and director bar. Similarly, in cases involving self-dealing, the
SEC may seek disgorgement of the gains and possibly a civil penalty as well.
Increasing Activity Involving Foreign Corporations
The last several years have seen a substantial increase in the number of
SEC enforcement actions and securities class action lawsuits against foreign
filers. According to PriceWaterhouseCoopers 2004 Foreign Securities Litigation
Study, a record 29 foreign issuers on U.S. exchanges were sued in private U.S.
securities class action lawsuits in 2004. In addition, total foreign settlements
in 2004 totaled $522,450,000, an increase of almost 6 percent from the 2003
total settlements of $494,600,000.12 Since the
enactment of SOx, the number of SEC enforcement actions against foreign registrants
and entities has continued to increase. In 2002 there were three enforcement
actions against foreign registrants or entities as reported in the SEC Litigation
Series Releases.13 In 2003 and 2004, the number
of enforcement actions increased to seven. In 2005 there were a record 15 SEC
enforcement actions against foreign registrants or entities. There was a modest
decrease in the number of securities class action lawsuits filed against foreign
issuers in 2005, from 29 suits in 2004 to 25 suits in 2005.
While several foreign jurisdictions have enacted legislation allowing litigation
styled on U.S. securities class actions in recent years,14 the United States remains at the center of securities class action litigation.
For the most part, it appears that the English Rule in many countries that shifts
the winner's fees to the loser, together with limitations on contingent fee
arrangements, has so far limited the interest of the plaintiffs' bar in such
countries to pursue securities class action litigation. In addition, several
U.S. court decisions in recent years have opened the doors to U.S. courts (and
class recoveries) for foreign investors. U.S. courts have provided jurisdiction
for the claims of purchasers of American Depository Receipts (ADRs) of foreign
companies.
More recently, U.S. courts are permitting class actions against foreign companies
to include—within the class—the claims of foreign purchasers of the shares of
the foreign company purchased on foreign exchanges.15 A clear consequence of such decisions is to broadly expand the size of the class,
and therefore expand the exposure of the issuer and its officer and directors
to U.S. litigation costs.
A Decreasing Number of Securities Claims
The year 2005 was the lowest year for securities action filings since 1997.
Cornerstone Research tallied 176 "traditional" filings in 2005, down from 213
in 2004.16 As the total number of issuers has not
materially changed since 2004, there was also a modest decrease in the number
of filings per issuer. Of the total issuers listed on the NYSE, NASDAQ, and
Amex, 2.4 percent were named as defendants in traditional securities class actions
filed in 2005, down from 2.8 percent in 2004. Of these "traditional" securities
class actions, 10 were "mega" filings involving $10 billion or greater disclosure
dollar loss and represented 67 percent of the total disclosure dollar loss in
2005. This is a decrease from the 16 mega-filings in 2004 (that represented
77 percent of the total disclosure dollar loss in 2004).
Conclusions
The 2005 data suggests that corporate officers and directors continue to
experience significant exposure to liability in both private litigation and
government enforcement actions. While there was a decrease in the number of
private securities class action suits, it is too soon to surmise whether the
data reflects a downward trend or is merely an aberration. The corporate scandals
of the last several years have resulted in increased liability for outside directors
and officers, from both government regulators and private plaintiffs. Finally,
SEC proceedings against foreign corporations have increased significantly, although
there was a small decrease in the number of securities class actions against
such corporations.
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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