Expert Commentary

D&O Litigation Trends in 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.

Professional, D&O, and Fiduciary Liability
February 2004

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."


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.

1 Securities Class Action Case Filings—2002: A Year in Review.

2 PricewaterhouseCoopers LLP, 2002 Securities Litigation Study.

3 The Sarbanes-Oxley Act: The First Year, House Committee on Financial Services, at 15.

4 William H. Donaldson, Chairman, U.S. Securities and Exchange Commission, Remarks to the Practising Law Institute (November 6, 2003), (last accessed 1/26/04).

5"SEC Everywhere," Bruce Caton, (last accessed 1/21/04)

6 "SEC Enforcement Activities," Section of Business Law Bulletin, May 2003

7 SEC Litigation Release, September 9, 2003, (last accessed 1/25/04)

8 Securities Class Action Case Filings—2002: A Year In Review.

9 Securities Litigation Update—The Pension Fund Factor, Steven Skalak and Daniel Dooley.

10 The other major companies that agreed to governance reforms as part of or in connection with shareholder claim settlements were Siebel Systems, Sprint, Hanover Compressor, Homestore and Computer Associates.

11 No. 02 Civ. 3288 (DLC) (SDNY).

12 According to the December 2003 ISS's SCAS Alert, "Puncturing the Myths of Opting Out", (last accessed 1/21/04), the pension funds for Alabama, California, Illinois, Ohio, and West Virginia opted out of the Enron federal class actions and filed individual state court actions in September 2002, and the Ohio and California pension funds opted out of the AOL class action and filed individual state court actions in July 2003.

13Small v Fritz, 30 Cal 4th 167 (2003) (recognizing legally cognizable state law action for damages, long refused under federal law, based on forbearance to sell stock induced by fraud or negligent misrepresentation).

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

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.

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