Expert Commentary

D&O Litigation Trends in 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.

Professional, D&O, and Fiduciary Liability
March 2005

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).


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

1Securities Class Action Case Filings—2004: A Year in Review (the report identifies class action filings as of December 20, 2004).

2The Sarbanes-Oxley Act: The First Year, House Committee on Financial Services, at 15; William H. Donaldson, Chairman, U.S. Securities and Exchange Commission, Remarks to the Practising Law Institute (November 6, 2003).

3Stephen M. Cutler, Director, Division of Enforcement, U.S. Securities and Exchange Commission, The Themes of Sarbanes-Oxley as Reflected in the Commission's Enforcement Program, (September 20, 2004) (last accessed 1/27/05).

4Michael Bobelian, Royal Ahold Case Shows Benefits of Cooperating with the SEC, New York Law Journal (November 8, 2004).

5Section 4(e)(1) of H.R. 2179 would amend Section 24 of the Securities Exchange Act of 1934, 15 U.S.C. Section 78x.

6Elaine Buckberg, Todd Foster, Ronald Miller, and Stephanie Plancich, Recent Trends in Shareholder Class Action Litigation: Bear Market Cases Bring Big Settlements, NERA Economic Consulting (February 14, 2005).

7Elaine Buckberg, Todd Foster, and Stephanie Planich, Recent Trends in Securities Class Action: 2003 Update, NERA Economic Consulting (April 23, 2004) (last accessed 2/7/05).

8Laura E. Simmons, Ellen M. Ryan, Post-Reform Act Securities Lawsuits—Settlements Reported through December 2003, Cornerstone Research (2004), page 9, Figure 9. (last accessed 2/7/05).

9Fenwick & West LLP, Corporate and Securities Law Update (Nov. 9, 2004), (last accessed 2/7/05).

10Broudo v Dura Pharmaceuticals, Inc., 339 F3d 933 (9th Cir 2003) cert. granted 124 S Ct 2904 (June 28, 2004) (No. 03-932).

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

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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