Expert Commentary

D&O Litigation Trends in 2007

Last year, 2006, marked the lowest number of securities actions filed against directors and officers in the last decade, although the size of settlements continued to increase.

Professional, D&O, and Fiduciary Liability
May 2007

The number of securities actions filed against directors and officers dropped dramatically in 2006 to 115, a significant departure from the average number of actions filed annually over the prior decade. In every year from 1997, the average number of securities complaints filed against directors and officers of publicly traded corporations ranged from 174 to 497. This was the lowest number of filings since 1996, when only 112 actions were filed, and the number of securities actions filed in 2006 was half of the average number of complaints filed annually since the adoption of the Private Securities Litigation Reform Act (PSLRA) in 1995. Much debate among securities commentators has focused on the possible causes for this drop and whether it is a watershed or aberration.

In 2006 the trend of ever increasing securities claim settlements continued. Due in part to the backlog of very large securities cases built up in prior years, the aggregate value of all settlements reached a new high—$17.1 billion. However, the average settlements also were higher in 2006—both in so-called mega-cases and in other securities actions.

Below we discuss these and other trends from 2006 that may continue into 2007.

A Falling Number of Securities Class Actions

The significant drop in the number of securities class action filings in 2006 continued a trend that first appeared during the second half of 2005, and sharply contrasted with filings in 2004 and 2005. Cornerstone Research tallied 212 "traditional" filings in 2004, 176 in 2005, and just 90 in 2006.1 Cornerstone's "traditional" filing figures do not include the initial public offering (IPO) laddering cases, the investment analyst cases, and the mutual fund trading cases.

Options backdating class actions (20 filed in 2006 through December 11) are the newest category of suits excluded by Cornerstone from the list of "traditional" filings. Including the options backdating suits in the 2006 numbers brings the total number of companies sued to 110, by any measure a considerable drop-off from immediate past years. The drop in the number of filings is seen also when considered in the context of the number of filings per issuer. Of the total issuers listed on the N.Y. Stock Exchange (NYSE), NASDAQ, and Amex, 2.8 percent were named as defendants in traditional securities class actions filed in 2004, a figure that dropped to 2.4 percent in 2005 and reached 1.5 percent in 2006.

As noted in past years, the Cornerstone report identifies a further category of shareholder class actions: "mega" filings involving a $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 immediately preceding the end of the class period to the trading day immediately following the end of the class period. Cornerstone identified 8 mega-filings in 2004, 5 in 2005, and just 1 in 2006. The disclosure dollar losses for all filings in 2006 totaled $52 billion (including the options backdating cases), the lowest level since 1997 and a significant decrease from the totals represented by traditional filings in 2004 ($142 billion) and 2005 ($93 billion). The decreased total number of filings and decreased share price volatility in 2006 contribute to the decreased disclosure dollar loss.

What explains this downward trend? A number of factors may be contributing to the downturn in filings. First, the Sarbanes-Oxley Act of 2002 (SOx) and subsequent Securities and Exchange Commission (SEC) rulemaking may have been successful in encouraging corporate executives, audit committee members, and board members not to push the envelope with "creative accounting" and in prompting auditors to address irregularities more aggressively.

Another factor might be the relative absence of volatility in the past 2 years compared to prior years. In the boom period of the 1990s, it seems that many companies relaxed corporate standards as they sought to meet demanding earnings expectations. The current drop in total filings may also be the result of a bursting of the technology bubble from the boom period beginning in the late 1990s. A large number of relatively immature companies were first publicly traded during the boom period and those companies appear to have contributed a significant number of the shareholder class actions filed between 1998 and 2004. Yet another factor may be the impact of the federal indictment of the Milberg Weiss firm on charges of kickbacks to lead plaintiffs and the increasing scope of Enron-related litigation headed by the Lerach Coughlin firm, which appear to have distracted both plaintiffs' securities law firms.

We suspect that the drop is the result of a combination of these factors. While the timing of the downturn coincides with the investigation of the Milberg Weiss, we believe the plaintiffs' class action bar has a sufficiently deep bench alongside Milberg Weiss and Lerach Coughlin so that any sizable stock drop coupled with the indicia of misrepresentations to the market will continue to attract multiple filings by other lawyers.

Settlement Size Continues To Grow

While the rate at which new cases have been filed is dropping, there continues to be a large pipeline of significant cases to be resolved. According to NERA Economic Consulting and Cornerstone, the size of securities class action settlements in 2006 continued to grow.2 In 2006 mean and average settlement size increased from the records set in 2005. Last year, 2006, offered up four settlements in excess of $1 billion and more over $100 million than in any other single year. Mean settlement size increased from $5.2 million in 2004 to $7.0 million in 2005 and reached $7.3 million in 2006. The average settlement size over the same period (excluding the billion dollar settlements in Enron, WorldCom, Cendant, AOL Time Warner, Royal Ahold, and Nortel Networks) increased from $20 million in 2004 to $25 million in 2005 and jumped to $34 million in 2006. Leading off 2007, CMS Energy announced that it was settling the shareholder suit filed against it in 2002 for $200 million. The current "top 10" list of the largest settlements now also includes 3 settlements of claims involving non-U.S. issuers.3

As explained in the NERA report, settlement size continues to be largely a function of the magnitude of alleged investor losses and the ability to pay, using post-class period market capitalization as a proxy for ability to pay. Average investor losses of settling cases in 2004, 2005, and 2006 were $1.7 billion, $2.6 billion, and $7.5 billion, respectively. Comparing post-class period market capitalization of settled cases with the settlement amount, NERA calculates a 0.2 percent increase in settlement amount for each 1 percent increase in market capitalization.

The presence of institutional investors as lead plaintiffs continues to yield higher settlement figures as well. According to Cornerstone, the average settlement in cases involving institutional investors as lead plaintiffs was $9 million, more than double the average settlement in cases not involving institutional investors as lead plaintiffs ($4.3 million). In addition, institutions assumed a higher profile in 2006, serving as lead plaintiffs in over 50 percent of all settlements. However, it is not clear whether the boost in the average size of settlements in which institutions act as lead plaintiffs and the boost in cases led by institutional investors is the result of institutional involvement or the size of the market capitalization loss at issue combined with the merits of the claim attracting institutional involvement.

SEC and DOJ Enforcement and the McNulty Memo

The drop-off in the total number of shareholder class actions in 2006 was not matched by a drop-off in the total number of SEC enforcement actions between 2005 and 2006, although there were considerably fewer SEC civil proceedings initiated in 2006 than in 2005. In fiscal year 2005 (ending September 30, 2005), the SEC initiated 947 investigations and 629 enforcement actions (335 civil proceedings and 294 administrative proceedings.4 In fiscal year 2006, the SEC initiated 914 investigations and filed 574 enforcement actions (218 civil proceedings and 356 administrative proceedings).5 The SEC's enforcement cases yielded over $3.3 billion in penalties and disgorgement orders in 2006, including resolution of claims involving AIG (alleged improper accounting relating to reinsurance deals with GenRe) for $800 million and Fannie Mae (alleged improper smoothing of earnings) for $400 million.

It remains to be seen what change occurs in practice, but directors, officers, and their corporations may see a less aggressive approach by the SEC and the U.S. Department of Justice (DOJ) with respect to pursuing waivers of the attorney-client privilege and the attorney work-product doctrine. Much attention has been given in recent years to the "Thompson Memorandum"6 and its impact on the defense of claims against directors and officers. The Thompson Memorandum was a binding directive to U.S. prosecutors outlining various factors they should consider in weighing the degree of a corporation's cooperation in determining whether to pursue a criminal indictment against the corporation.

Two factors (among several) were the corporation's willingness to produce otherwise privileged and protected materials as well as the corporation's advancement of legal expense incurred by individuals under investigation or indictment. The advancement of legal expenses was perceived by the government to be action by the corporation shielding wrongdoers.

In December 2006, the DOJ announced changes in the directives contained in the Thompson Memorandum in the recently prepared McNulty Memorandum.7 Under the Thompson Memorandum, corporations defending civil shareholder class actions and responding to federal investigators were often faced with a Hobson's choice between waiving the protections and producing documents or facing possible government prosecution. Waiving the privilege with the government often meant producing the same material to civil plaintiffs, the result of which would likely drive up settlement values as plaintiffs would possess documents not otherwise available absent the waiver.8

The McNulty Memorandum outlines a series of procedures to be followed by prosecutors when seeking a waiver of the attorney-client privilege and the production of material protected by the attorney work-product doctrine. Prosecutors will need to justify their reasons for requesting that corporations give up protected material and obtain the approval of the U.S. attorney (with respect to so-called Category I material) and the Deputy Attorney General (with respect to Category II material—generally considered to be core work-product). In addition, prosecutors are not to consider a corporation's refusal to produce Category II material as an indicia of noncooperation.

The refusal to advance fees (to curry favor with government prosecutors) by KMPG drew the ire of Judge Lewis Kaplan in United States v. Stein, 435 F. Supp. 2d 330 (S.D.N.Y. 2006); 440 F. Supp. 2d 315 (S.D.N.Y. 2006), declaring the Thompson memorandum to be unconstitutional as it directed prosecutors to pressure KPMG not to pay the legal expenses of its employees facing criminal prosecution for selling allegedly illegal tax shelters. In response, the McNulty Memorandum states that prosecutors "generally should not" consider whether the corporation is advancing fees when considering the degree of the corporation's cooperation with investigators and prosecutors.9

Judicial Developments

On January 5, 2007, the U.S. Supreme Court granted certiorari of a Seventh Circuit decision addressing the appropriate pleading standard for alleging scienter and ordered expedited briefing on the matter. [Makor Issues & Rights, Ltd. v. Tellabs, Inc., 437 F.3d 588 (7th Cir. 2006), cert. granted, Tellabs, Inc. v. Makor Issues & Rights, Ltd., 127 S. Ct. 853 (Jan. 5, 2007) (No. 06-484).] The Court heard arguments on the case on March 28, 2007.

At issue is the manner in which a court is to weigh competing inferences when deciding whether a complaint alleges sufficient facts to support a strong inference of scienter, as required by the PSLRA. The Seventh Circuit, in Tellabs, concluded that a court should "allow the complaint to survive if it alleges facts from which, if true, a reasonable person could infer that the defendant acted with the required intent."10 As presented by the petitioner's brief for certiorari, the Seventh Circuit's decision is at odds with six other circuit courts allowing "innocent inferences to play a significant role in evaluating whether a complaint alleges" sufficient facts to support a strong inference of scienter.

Although not directly part of the question presented for decision, the Supreme Court may use Tellabs as an opportunity to address the different approaches by the circuit courts when considering whether allegations of "motive and opportunity" may alone suffice in support a strong inference of scienter. The issues are significant as the adequacy of the complaint is tested in virtually all shareholder class actions by the defendants' motion to dismiss. If a complaint survives the motion to dismiss, the settlement stake increases markedly. Few cases are disposed of by a defense summary judgment, and fewer still ever reach trial.

A Supreme Court decision in Tellabs arguably raising the required pleading standard would likely increase the rate at which courts grant motions to dismiss cases on the pleadings in jurisdictions that have been more favorable to plaintiffs. Although dismissal rates have generally doubled since PSLRA,11 there remain significant variances between the dismissal rates in the different circuit courts, ranging from 5 percent in the Tenth Circuit to 31 percent in the Fourth Circuit (for cases filed from December 15, 2000, to December 15, 2004). Perhaps the post-Enron judicial climate will render another decision supporting defense efforts in this area, following the decision in Dura Pharmaceuticals v. Broudo, 544 U.S. 336 (2005), on loss causation.

The Delaware Supreme Court, in Stone v. Ritter, 911 A.2d 362 (Del. 2006),12 offered academics plenty more to discuss and debate concerning director good faith as a basis for liability. The so-called triad of fiduciary duties, including a free-standing duty of good faith, was introduced in 1993 in Cede & Co. v. Technicolor, Inc., 634 A.2d 345, 361 (Del. 1993) (Technicolor II), joining the director duties of loyalty and of care. Following Technicolor II, Delaware's exculpatory legislation, 8 Del. Section 102(b)(7), characterized "actions taken not in good faith" as falling outside the protections afforded by the business judgment rule.

In 1996, In re Caremark Int'l Inc. Derivative Litigation, 698 A.2d 959 (Del. Ch. 1996), elevated the debate about good faith in the context of director oversight of corporate activities. A reading of Stone leads to the conclusion that director good faith is now subsumed under the duty of loyalty. From a liability standpoint, Stone notes that acts taken in bad faith breach the duty of loyalty. Apart from calling for a reorganization of textbooks on corporate law and director duties, the case is instructive in assessing director oversight and responsibility.

Of greater value perhaps, is the 2006 opinion, In re Walt Disney Co. Derivative Litigation, 906 A.2d 27, 65 (Del. 2006) (affirming trial court judgment for the defendants), in which the Delaware Supreme Court distinguished the "duty of good faith" from the "duty of care," explaining that "grossly negligent conduct, without more, does not and cannot constitute a breach of the fiduciary duty to act in good faith." Disney now offers a bright line rule: exculpation exists for gross negligence and negligence, but not for a conscious disregard of duty.

Outlook for the Future

Merger and acquisition (M&A) activity poses special risks to D&O underwriters. The U.S. economy is in the midst of a very active M&A environment, pushed largely by aggressive buying of public companies by private equity. Companies that face a greater risk of attracting the interest, often unwanted, of private equity buyers may share several features, including strong cash flows, high cash balances, and low dividend yields.13 In addition to cash, a low market capitalization and low stock performance relative to its peers will attract private buyers.

Pressure from shareholders to deliver value will present considerable derivative suit activity, joining the over 100 options backdating derivative suits filed in the last year. The options backdating claims may be largely restricted to pre-SOx activity (given the stock option announcement rules change in August 2002). However, the pressure of private equity and the interest of institutional investors in a large number of corporate decisions may well lead to considerable derivative litigation in the near term.

In addition to the risk that the selling corporation's shareholders will complain, there is also the risk of buyer's remorse or allegations of breached representations and warranties by the seller. In this area, the 2006 Delaware Chancery Court decision in ABRY Partners V, LP v. F&W Acquisition LLC, 891 A.2d 1032 (Del. Ch. 2006) (provision was unenforceable as against public policy to the extent it restricted buyer's claims based on intentional misrepresentations made by the seller in the agreement) is instructive, finding that a buyer is free to press a claim for full compensatory damages when a seller intentionally misrepresents facts embodied in a contract, notwithstanding limiting language within the contract to the contrary.

There continues to be a great deal of shareholder interest in executive compensation, which seems likely to grow as companies prepare to comply with new SEC rulemaking calling for greater disclosure of all compensation (including retirement benefits and severance agreements) for their five most highly compensated individuals. This closer scrutiny has led to the rash of options-backdating cases filed beginning in May 2006, following the mid-March 2006 article in the Wall Street Journal, which reported on the practice as a result of a 2005 study that indicated that senior executives were recognizing profits on stock options at a far higher pace than the market. These complaints typically have been brought as derivative actions, with only a few actions brought as securities claims.

The current cycle of acquisition activity by hedge funds is likely to be followed in coming years by a cycle of IPOs as private money seeks profit from its current buying activity. And while the IPOs of tomorrow will again pose D&O underwriting risks, many of the newly listed companies will be mature businesses, unlike many of the IPOs during the late 1990s and early 2000s.

1Securities Class Action Case Filings—2006: A Year in Review, Cornerstone Research (the report identifies class action filings identified as of December 18, 2006) ("Cornerstone report").

2Todd Foster, Ronald I. Miller and Stephanie Plancich, Recent Trends in Shareholder Class Action Litigation: Filings Plummet, Settlements Soar, NERA Economic Consulting (January 2007) (the report includes settlements reported as of December 15, 2006) ("NERA report"). Securities Class Action Settlements—2006 Review and Analysis, Cornerstone Research ("2006 Cornerstone settlement report").

3Nortel Networks I ($1.143 million), Royal Ahold, NV ($1.1 million) and Nortel Networks II ($1.074 million), as reported in the NERA report. According to a December 26, 2006, press release, the settlement of Nortel I and II totaled an estimated $2.45 billion; the Nortel settlements have also recently gained the approval of Canadian courts overseeing part of the litigation.

4U.S. Securities and Exchange Commission, 2005 Performance and Accountability Report.

5U.S. Securities and Exchange Commission, 2006 Performance and Accountability Report.

6Larry D. Thompson, U.S. Deputy Attorney General, Principles of Federal Prosecution of Business Organizations (Jan. 20, 2003).

7Paul J. McNulty, U.S. Deputy Attorney General, Principles of Federal Prosecution of Business Organizations (Dec. 12, 2006).

8In re Royal Ahold N.V. Sec. & ERISA Litig., 2004 WL 502558 (D. Md. March 12, 2004), supported the civil discovery of materials produced to government investigators notwithstanding claims of privilege. 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 government arguably protected by the attorney work-product doctrine. As noted above, Royal Ahold now joins the list of top ten largest civil settlements at $1.1 billion. In addition, McKesson agreed to settle a shareholder class action against it in 2005 for $960 million after losing arguments aimed at protecting documents produced to the government.

9Paul J. McNulty, U.S. Deputy Attorney General, Principles of Federal Prosecution of Business Organizations (Dec. 12, 2006), at 11.

10437 F.3d at 602.

11NERA Report, supra, n.2, comparing 2-year dismissal rates of cases filed in 1991-1995 (19.4 percent) with cases filed in 2001-2004 (38.2 percent).

12Shareholders' derivative suit against AmSouth Bancorporation's directors alleging the bank had paid $50 million in fines and penalties to the federal government because the defendants "had utterly failed to implement any sort of statutorily required monitoring, reporting or information controls that would have enabled them to learn of problems requiring their attention." Id. at 364. The case was dismissed for failure to satisfy the demand requirement, a decision affirmed by the Delaware Supreme Court.

13Chris Kraeuter, Why Private Money Likes Chips (Sept. 15, 2006,

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

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