Article 1: Why Are There Fewer Securities Suits?

Since 1998, the average number of securities class action lawsuits filed in each year has averaged around 220, with a high of 271 in 2002 and a low of 205 in 1999.  However, in 2005, there were only 176 securities class actions filed, representing a nearly 20% decrease from that prior average.  Even more startling, only 82 securities class action lawsuits have been filed through August 2006, which annualizes to approximately 120 suits per year, or about a 45% decrease from the historical average.

This dramatic drop in the frequency of securities class action litigation has been well documented, but it is far less clear why this surprising development is occurring.  Numerous theories have been cited as reasons, but each theory has limited validity when carefully analyzed.  The real answer appears to be that there is no one reason for this dynamic, but instead a number of contributing factors have converged.  Each of those factors has separately caused a modest reduction in filings, but all of those factors combined have resulted in the very significant reduction in filings.

Each of those factors is briefly discussed below.  As explained, many of those factors are not permanent, and therefore it seems highly unlikely that the reduced level of securities class action filings will continue for an extended period of time.  Much like the dramatic reduction in securities class action filings during the two years immediately following enactment of the Private Securities Litigation Reform Act of 1995 (“PSLRA”), this recent reduction in securities litigation activity is likely to be temporary.  As a result, neither D&O insurers nor their insureds should overreact to this recent development by unduly adjusting their underwriting, pricing and coverage standards or expectations.  Just as the soft D&O insurance market in the late 1990s (which was primarily attributable to the large reduction in securities filings in 1996 and 1997) gave rise to unexpected losses and a major insurance market correction beginning in 2001, an over-reactive softening of the market today in response to this development will likely cause another significant market correction in a few years.


A.     Stock Volatility

Heightened stock price volatility typically results in more securities class action filings since more companies experience large and sudden stock drops which plaintiff lawyers can use as evidence of an alleged “corrective” disclosure of previously misleading information.  Since mid-2003, the stock volatility for the U.S. equities market has been relatively low, as measured by a weekly range.  Unlike the period 1999 through 2002, when the stock market volatility was quite high due to the “bubble burst” and the market’s heightened sensitivity to scandals, fewer companies have experienced significant stock drops during the last three years.  Therefore, there have been fewer opportunities for plaintiffs to allege that a stock’s market price was artificially inflated by directors and officers.

However, this reduced stock market volatility does not fully explain the recent reductions in securities class action filings since the reduction in filings began in 2005 and accelerated in 2006, whereas the stock market volatility reduction began in 2003.  In any event, to the extent this is a contributing factor, it may be disappearing.  Beginning in the second quarter of 2006, the stock market volatility increased dramatically to the highest levels of the last three years.  Volatility indicators have increased by more than 50% since the end of the first quarter of 2006, which has been described as a “radical” change in volatility over a relatively short time period.  See, www.smartoptionsreport.com/archives/2006/20060705.  Thus, to the extent reduced stock volatility contributed to the reduced securities filings, a reversal of that trend appears likely during the coming months.


B.     Enhanced Corporate Governance

The extraordinary attention given to corporate governance issues in the aftermath of Enron, Worldcom and other highly-publicized corporate debacles, as well as the Sarbanes-Oxley Act of 2002 (“SOX”), have undoubtedly improved to some extent director and officer sensitivity to potential wrongdoing and enhanced governance behavior.  Higher quality governance performance may reduce securities litigation filings to some extent, but it appears unlikely that this is a major contributing factor to the reduced filings.  For example, the number of restatements by corporations continues at near record levels, which suggests that misleading financial disclosures by companies are far from rare.  In addition, many of the enhanced governance practices do not directly relate to disclosure issues and therefore do not directly affect securities class action litigation.  Besides, it is odd that it took nearly four years following the disclosure of the Enron scandal and enactment of SOX for the dramatic reduction in securities litigation filings to occur.  That rather long time delay suggests other intervening events are also contributing to the current litigation environment.

C.     Dura Supreme Court Decision

In April 2005, the U.S. Supreme Court in the Dura Pharmaceuticals case ruled that plaintiffs in a securities fraud lawsuit must prove a causal connection between the alleged misrepresentations and a subsequent stock drop. As a practical matter, the decision requires plaintiffs to prove that a significant stock drop occurred immediately following a corrective disclosure by the company. Although most securities class actions are premised upon such an immediate stock drop, the Dura decision has resulted in a few more cases being dismissed and other cases not being filed. However, the number of cases which have not been filed as a result of Dura is probably not a large number.

For many years prior to the Dura decision, a majority of federal circuit courts which addressed this loss causation issue rendered opinions consistent with the Dura decision. In other words, in most federal circuits, the Dura decision did not constitute new or different legal standards. In addition, the number of historical securities class action cases which did not involve an immediate stock drop following a corrective disclosure was relatively low. Also, since the Dura decision was issued, plaintiffs have been relatively successful in limiting the scope and effect of that decision in a number of subsequent cases. As a result, the Dura decision does not explain the recent large reduction in securities filings, although the decision probably caused a modest decrease in filings.

D.     Milberg Weiss Indictment

In May 2006, after a lengthy and highly-publicized criminal investigation, a federal grand jury indicted the Milberg Weiss law firm and two of its senior partners.  The indictment alleges the defendants made improper payments to certain named plaintiffs in securities class actions prosecuted by the Milberg Weiss law firm primarily in the 1990s.  Since that indictment, many attorneys have left the firm and the firm has filed very few if any new securities class actions.  Arguably, this development contributed to the recent decrease in securities filings for two reasons.

First, the indictment arguably put a stop to improper payments to the named plaintiffs in securities class actions, and thus plaintiff lawyers are now having greater difficulty in locating willing shareholders to serve as the lead plaintiff.  This argument appears to have little validity.  Institutional investors are now serving as the lead plaintiff in securities class actions with far greater frequency, and those institutional investors are sufficiently incentivized to serve in that role without any improper payments to them.  Besides, the alleged wrongdoing by the Milberg law firm occurred many years ago, and there is no allegation or indication that those practices continued into more recent times.  In any event, because the criminal investigation has been pending for several years, any chilling effect created by the criminal investigation likely occurred well before the recent reduction in securities filings.

Second, since the Milberg law firm historically has filed more securities class actions than any other plaintiff firm, the number of new securities filings arguably has been reduced as a result of that firm not filing new cases since the indictment.  In fact, the drop in the number of securities class action filings in 2006 generally equates to the drop in securities class action filings by the Milberg law firm.  However, it seems highly unlikely this development explains the recent reduction in filings or will cause a future reduction in filings.  In virtually all securities class actions, several different plaintiff law firms separately file a complaint and then compete against each other for the role of counsel for the lead plaintiff.  Although Milberg frequently won that competition in the past, the absence of Milberg now simply means that other plaintiff law firms have a better chance of being designated as counsel for the lead plaintiff.  In any event, many of the lawyers at the Milberg firm have left the firm to either join other firms or form new firms, and those lawyers continue to be actively involved in prosecuting securities class action lawsuits.  Thus, any inactivity by or demise of the Milberg law firm has not and will not create a void among qualified plaintiff lawyers who remain capable and interested in prosecuting securities class actions.


E.     Stock Option Backdating

Beginning in the spring of 2006, allegations began to surface that a number of companies backdated or otherwise manipulated the granting of stock options to executives and/or other employees.  Those allegations have continued to escalate, with more than 100 companies now being investigated for wrongdoing with respect to stock option issues.  Not surprisingly, shareholder litigation arising out of these allegations has been prolific.  However, very few of the lawsuits have been securities class actions since very few of the target companies experienced a material stock price drop following disclosure of the investigation and alleged wrongdoing.  For example, only approximately 15 securities class action lawsuits have been filed, although more than 100 companies are being investigated.  In contrast, nearly 60 companies and their directors and officers have been sued in shareholder derivative lawsuits, which allege breach of fiduciary duties under state law and which do not require a stock drop.

Arguably, the plaintiffs’ bar has been devoting its attention and resources towards these shareholder derivative lawsuits, resulting in fewer securities class action lawsuits being filed in other contexts.  However, the significant drop in securities filings started well before the stock option backdating scandal surfaced and, in any event, it is doubtful that the stock option shareholder derivative lawsuits have been so demanding that plaintiff lawyers have been unable or unwilling to bring unrelated securities class action lawsuits.  In any event, securities class action lawsuits are typically far more lucrative for plaintiff lawyers since the damages and thus the settlements and plaintiff fees in that type of litigation are typically far greater than in shareholder derivative lawsuits.  Thus, given a choice, plaintiff lawyers far prefer prosecuting class actions rather than shareholder lawsuits.


F.     Conclusions

It is far from clear what is causing the recent decrease in securities class action filings. No one event or dynamic credibly explains this surprising development, although several unrelated factors each appear to contribute to some extent to the decrease. However, one thing is very clear: based on historical experience and legal precedent, it is extremely unlikely this decrease will be permanent. Therefore, neither D&O insurers nor insureds should overreact to this seemingly temporary reprieve from higher-frequency securities litigation.




Article 2: Structuring Side A Programs: Traps For The Unwary

The popularity of Side A D&O insurance policies (which insure only non-indemnified losses incurred by directors and officers) continues to increase.  As both outside directors and officers become more familiar with the extraordinary protections available through a broad and high-quality Side A policy, it is not surprising that directors and officers are requesting, and public companies are now purchasing, this type of coverage with greater frequency.  However, there appears to be considerable confusion and misunderstandings in the market regarding what to look for in a preferred Side A policy and how to structure a multi-tiered Side A program.  Unlike many standard D&O policy forms, there is a vast difference between various Side A policies available in today’s market, and some of the common notions regarding how to structure a traditional D&O insurance program do not apply to structuring a Side A D&O insurance program.

The following discussion identifies some of the unique issues which should be considered when structuring and purchasing a Side-A insurance program.


A.     Scope of Coverage

Not all Side A policies are created equal.  There is a wide diversity of Side A products available, ranging from a standard D&O policy form which simply deletes the coverage for the company under “Side B” and “Side C,” to a specifically tailored broad Excess DIC Side A Policy with extraordinarily broad coverage terms.  Examples of provisions contained only in the broadest Side A policy forms, such as the recently revised “Premier” CODA policy form, include the following:

• The policy is non-rescindable in whole or in part for any reason;
• No presumptive indemnification (coverage applies if the Company rightfully or wrongfully refuses to indemnify);
• No ERISA exclusion (a few Side A policies also broaden the insured capacity to include wrongdoing by Insureds as ERISA fiduciaries, as distinct from wrongdoing as directors and officers, but that broadened “capacity” coverage may unnecessarily dilute the Side A coverage for the directors and officers if the Company maintains adequate fiduciary liability insurance);
• No pollution exclusion, and the bodily injury/property damage exclusion does not apply to pollution claims;
• Very narrow insured v. insured exclusion (exclusion applies only to Claims brought by or on behalf of the Company, not Insured Persons, and only if such Claim is made with the approval or assistance of at least two current senior executive officers; the exclusion does not apply to Claims made after the Parent Company has a change of control or to Claims by bankruptcy trustees, etc. or to Claims outside the U.S. or Canada, or to Claims by whistleblowers or to Defense Costs);
• Conduct exclusions (fraud, illegal personal profit, improper remuneration) not applicable to Defense Costs;
• Broad difference-in-conditions (“DIC”) provisions (coverage drops down if underlying insurers rightfully or wrongfully refuse to pay, are insolvent, rescind coverage or are legally not permitted to pay loss because of the Company’s bankruptcy);
• Coverage follows any broader provision in any underlying insurance;
• No consent from the Insurer required for Defense Costs;
• Notice to the Insurer of a potential claim constitutes a “Claim” (defense costs coverage applies to potential Claims).

If the Side A policy does not include all of these features, it does not afford the broadest coverage available for non-indemnified losses incurred by directors and officers.

B.     Stacking Multiple Side A Policies

Many companies are now choosing to purchase several layers of Excess DIC Side A coverage within their D&O insurance program.  Too often, though, unintended coverage gaps exist in such multi-layered programs due to the way in which those Side A policies are stacked on top of each other.

In a traditional D&O insurance program, each excess layer of insurance consists of a “follow form” excess policy which generally follows the terms of the primary policy and any more restrictive underlying excess policy.  Liability attaches to each excess policy only if all of the underlying limits are paid in full by the underlying insurers (or perhaps the Insureds).  That same approach should not be used with respect to multiple layers of Side A Excess DIC policies for two reasons.

First, the lowest level or “lead” Excess DIC Side A policy should be treated conceptually as the primary or base policy for purposes of all of the other Excess DIC Side A layers in the program.  That means that those other excess DIC policies should designate the base DIC policy (not the true primary policy) as the “followed policy,” and only the underlying Side A policy should be listed as “underlying insurance” in the Side A policies excess of the base Side A policy.  By doing so, the higher level Side A policies will drop down on top of the base Side A policy whenever the base Side A policy drops down pursuant to its DIC provisions, regardless whether the policies underlying the base Side A policy are exhausted.  If the policies underlying the base DIC policy are listed as “underlying insurance” in the higher level Side A policies, the entire Side A program may not drop down into a lower layer when a DIC event occurs.

Second, several provisions in the standard excess follow-form policy should be amended or deleted.  For example, the “attachment” language should be amended so the DIC provisions in the base Side A policy apply when a DIC event occurs with respect to an underlying Side A policy.  Sample language to accomplish that result is:

Except as otherwise expressly provided in the Base DIC Policy with respect to difference-in-condition (DIC) coverage, liability for any covered Loss shall attach to the Insurer only after the insurers of the Underlying DIC Policies shall have paid, in applicable legal currency, the full amount of the Underlying DIC Limit.

Absent this type of provision, each Side A policy would not drop down into a lower Side A policy if a DIC event occurs with respect to the lower Side A policy (e.g., the insurer of the lower Side A policy is insolvent, wrongfully denies coverage, etc.).  In other words, each Side A policy should DIC not only into the policies underlying the base Side A policy, but also into any underlying Side A policy.  In addition, the standard language in excess follow-form policies which state that the excess policy follows the most restrictive terms in any underlying policies should be deleted in order to maximize the value of the DIC coverage.


C.     Quota Share Side A Programs

Large D&O insurance programs are now more frequently being structured with large quota share layers, for a variety of reasons.  Using a quota share structure for large Side A programs can create unintended coverage limitations.

Each participant in a quota share program typically is liable for only that participant’s quota share percentage of the total loss which is covered under the quota share layer.  The liability of any one insurer in the quota share program is not increased if another insurer in the quota share does not pay a loss for any reason.  If an insurer in the quota share program does not pay a covered loss, a gap in coverage exists.

Such a result should be unacceptable to Insureds in a Side A program, which is intended to eliminate rather than create gaps in coverage.  Conceivably, a Side A quota share program could state that if an event that would normally trigger DIC coverage occurs with respect to another insurer in the quota share program, all of the other quota share Side A insurers will fill the gap created by the non-paying insurer.  However, it is doubtful all participating insurers in the Side A quota share program would agree to such a provision.  Absent such a provision, the Insureds are better protected by multiple layers of Excess DIC Side A policies (with each policy potentially dropping down into a lower level Side A policy if a DIC event occurs with respect to the lower level Side A policy), as opposed to a quota share Side A program.


D.     Separate Limits for Directors and Officers

In response to the many highly publicized huge D&O claims recently, there is increasing interest by independent directors in Side A policies which only protect a company’s independent directors, not its officers.  This Independent Director Liability (“IDL”) policy, which is typically excess of one or more standard Side A policies, can provide valuable additional protection for the independent directors in two respects.  First, the limit of liability under an IDL policy is not eroded by losses incurred by officers, who typically have far greater exposure than directors in light of their greater knowledge about and involvement in the company’s operations.  Second, IDL policies usually have even fewer and narrower exclusions than a standard broad-form Side A policy.  For example, some IDL policies do not contain any fraud or illegal personal profit exclusions.

Thus, an Excess DIC Side A IDL policy which sits on top of all of the other policies in a D&O insurance program can provide valuable “fail safe” coverage for outside directors in case the rest of the program is exhausted or otherwise unavailable for a Claim.

Despite these attractive features, few companies have purchased an IDL policy, for a variety of reasons.  In an attempt to make that valuable additional coverage for independent directors more popular, CODA recently introduced a creative new Side A policy which combines the attractive features of a broad IDL policy with CODA’s standard “Premier” Side A policy for directors and officers.  Under this new policy form, if the standard limit of liability applicable to all directors and officers is exhausted, the Side A policy automatically affords an additional limit of liability only for the independent directors without an additional premium.  That additional limit is excess of all other policies in the Company’s D&O insurance program, including any policies specifically excess of the Side A policy, subject to a DIC provision if any of those other policies fail to pay loss.  A priority of payment provision is included within the policy, thus maximizing the total amount payable under both limits of liability in the event directors and officers incur covered loss which is subject to both the standard limit and the additional IDL limit.

In addition, this new policy states that the fraud, illegal personal profit and improper remuneration exclusions do not apply to claims against independent directors.  As a result, by purchasing the new CODA Premier policy, not only do directors and officers obtain the extraordinary coverage available under a broad Side A policy, but the independent directors obtain the separate limit and other additional benefits normally available only through a separate IDL policy.

CODA also recently introduced an innovative Side A policy form which only covers current and former officers of a company.  Similar to an IDL policy for outside directors, this unique policy protects the insured officers against limit of liability erosion by reason of losses incurred by the independent directors.

The Officer Liability policy contains all of the broad features contained in CODA’s standard Premier Side A policy, but the limit of liability is dedicated only for the benefit of officers.  Coverage under the policy extends to officers in their capacity as an officer or director of the Company, as well as other employees if the other employees are codefendants with the officer.

The Officer Liability policy or the IDL policy can be purchased alone or in tandem.  If both types of policies are purchased in tandem for the same layer in the D&O insurance program, the Insureds can maximize the personal protection afforded the directors and officers without making either the directors or the officers more attractive targets for the plaintiffs since neither the directors nor the officers would have more insurance coverage than the other.  Also, it may be advisable to purchase each type of policy from the same insurer if possible in order to reduce the potential for allocation disputes between the two policies when a non-indemnified claim is made against both directors and officers.

The need for specialized coverage protecting only independent directors and only officers is very real in light of the increasing frequency of partial settlements, pursuant to which some but not all of the defendant D&Os are settled.  As demonstrated by the highly-publicized settlement in the Enron D&O settlement, the proceeds of a standard D&O policy may be used to settle the claims against some Insureds (such as the outside directors in the Enron situation) without settling the claims against other Insureds, thereby leaving the other Insureds with little or no insurance to defend and settle the remaining claims against them.  The separate IDL limit of liability and the Officers Liability policy not only protect against that situation, but also afford extremely broad Side A coverage for the Insureds.


E.     Overlapping Insurers

Another issue that arises when purchasing Excess DIC Side A coverage is whether it is prudent to purchase the Side A policy and one or more of the underlying policies from the same insurer.  Such a practice is generally not advisable since it reduces the value of the DIC coverage.  Among other things, the DIC coverage in the Excess Side A policy protects against an underlying insurer wrongfully refusing to pay a loss or becoming insolvent.  Obviously, such coverage has questionable value to the extent one of the underlying insurers is also the Excess DIC insurer.  In that situation, the insurer is insuring the risk that it will wrongfully refuse to pay or become insolvent.  In addition, an insurer which issues both an underlying policy and an excess DIC policy may be incentivized to push a loss into the excess policy for a variety of reasons, and thus may be more inclined to deny coverage under the underlying policy since there would be no risk the Excess DIC insurer will subrogate against the underlying insurer to challenge the denial (i.e., the insurer will not subrogate against itself).

In other words, in order to maximize the value of the DIC coverage and to minimize the risk of creating artificial coverage dynamics in a claims situation, all of the Excess DIC Side A policies should be purchased from insurers that do not participate in the underlying D&O insurance program.