The Laddering Claims generally allege two types of wrongdoing:

1. Undisclosed Commissions. The complaints allege that the IPO securities underwriters received greater compensation from investors than was disclosed in the IPO Prospectus, thereby rendering the Prospectus false and misleading. This undisclosed compensation took the form of additional commissions or "kickbacks" from certain investors in exchange for preferential allocation to those investors of shares in the IPO. Frequently, this alleged arrangement involved either investors agreeing to pay the securities underwriters excessive commissions on transactions in other securities, or investors agreeing to pay additional commissions after the IPO based upon the investors' profits in the IPO. Claims relating to undisclosed compensation are in virtually all of the Laddering Claims, although such allegations do not technically constitute "laddering." It is doubtful this alleged wrongdoing will result in significant liability exposure since, among other things, such misrepresentations do not appear to be material (i.e., would not have changed a reasonable investor's investment decision).
2. Laddering/Tie-In Agreements. The Laddering Claims also allege that securities underwriters required investors in IPOs to agree, as a condition to receiving a favorable allocation of shares in the IPO, that the investors would purchase additional shares in the after-market immediately following the IPO. This would result in increased demand for the stock and thus an immediate increase in the market price following the IPO.

Data relating to IPOs in 1999 and 2000 suggest that the laddering or tie-in agreements may have been somewhat common. For example, in 1999, the average first-day price gain of IPOs was 60% and in 2000 the average was approximately 55%. Stated differently, securities underwriters routinely under-priced IPOs, thereby allowing investors in the IPO rather than the issuing company to reap a significant percentage of the money available from the market with respect to newly issued securities. Plaintiffs will likely argue that since the issuing companies tolerated this apparently widespread practice even though it seemingly was contrary to the companies' interests, executives of the issuing companies arguably knew about and benefited from the laddering practices. In response, issuing companies will contend they were unaware of the tie-in agreements and believed the rapid rise in their stock's market price shortly after the IPO was simply a reflection of the strong market reaction to the company. In fact, at least one now-bankrupt issuing company has filed suit in Florida against its IPO underwriters alleging the underwriters intentionally underpriced the IPO to deprive the issuing company of proceeds from the IPO and to allow preferred customers of the underwriters huge profits from the stock run-up following the IPO.

A few of the more recent Laddering Claims allege a third type of wrongdoing based upon a perceived conflict between the research analysts and the investment bankers within a securities underwriting firm. In order to increase the market price for a new issuance, securities underwriters allegedly would hype the securities through their research analysts, who would use their purportedly objective and independent evaluations and recommendations to manipulate the market for the new securities.

The first significant public disclosure of the undisclosed commission and laddering practices occurred in a December 6, 2000 Wall Street Journal article entitled "Seeking IPO Shares, Investors Offer to Buy More in After-Market." That article stated that regulators were investigating the alleged practices and identified several specific securities underwriters who allegedly were engaged to some extent in the suspect conduct.

The first Laddering Claim was filed in January 2001, approximately one month after the December 6, 2000 Wall Street Journal article. Since then, securities class actions involving IPOs by more than 170 different issuers have been filed. The number of Laddering Claims filed per month has been steadily increasing, and that trend is expected to continue until December 2001, at which time the statute of limitations for bringing such claims will likely expire (i.e., one year after the December 6, 2000 Wall Street Journal article). It is thus reasonable to estimate that class action Laddering Claims will eventually be filed with respect to IPOs involving more than 225 different issuing companies.

Although all of the Laddering Claims focus on conduct of the securities underwriters, most of those Claims include as defendants not only the securities underwriters, but also the issuing company and certain directors and officers of the issuing company. The claims against the issuer and its D&Os are primarily premised upon alleged misrepresentations in the IPO prospectus. The claim against the issuing company is premised upon the strict liability standards in Section 11 of the Securities Act of 1933, and the claim against the D&Os is premised upon the allegation that the D&Os either knew or should have known of the undisclosed commission arrangements and/or laddering agreements.A plaintiff in a Section 11 claim against the issuing company and its D&Os is not required to show reliance, causation or scienter. Rather, the existence of a material misrepresentation or omission in the Registration Statement (which includes the prospectus) is sufficient to establish a prima facie case under Section 11. There are two principle defenses potentially available to at least some of the defendants in a Laddering Claim under Section 11. First, defendants are not liable to any purchaser who knew of the misrepresentation or omission at the time he acquired the securities. Thus, institutional investors and others who participated in or otherwise knew about the alleged kickbacks and tie-in agreements should be excluded from the class. This may eliminate a large portion of the class of investors who purchased directly in the IPO since most if not all of the investors who were allocated shares in the IPO may have known about, if not participated in, these practices.

Second, D&Os who exercise reasonable due diligence with respect to drafting and approving the Registration Statement are not liable under Section 11. This due diligence defense, though, is not available to the issuing company, which is strictly liable for misrepresentations or omissions in the Registration Statement whether or not the issuer knew or should have know of the false statements. It appears likely that D&Os would be able to satisfy this due diligence defense if they relied upon the securities underwriter when disclosing in the Registration Statement the amount of commissions paid by investors to the underwriter and if the D&Os did not participate in or otherwise know about the underwriter's laddering activity. In that case, the only material liability exposure of a D&O insurer for settlements and judgments in Laddering Claims would be under the entity securities coverage.

The primary defense potentially available to the issuing company relates to loss causation. Plaintiffs can only recover as damages under Section 11 the decline in the value of the securities due to the alleged misstatement or omission in the Registration Statement. Such damages are measured as the price at which the securities were purchased by the plaintiff (not to exceed the price at which the securities were offered to the public) less (i) the price at which the securities were sold by the plaintiff (if the securities were sold before the lawsuit was filed), (ii) the price as of the date the lawsuit was filed (if the securities are still held by the plaintiff as of that date), or (iii) the price at which the securities were sold by the plaintiff after the lawsuit was filed (if the resulting damages are less than as calculated at the date the lawsuit was filed). Plaintiffs who purchased in the IPO and who sold their shares at an increased price as a result of the laddering arrangements suffered no loss and cannot recover under Section 11. For those who purchased securities in the offering and who subsequently sold the securities at a loss, defendants will argue that the full price decline in the securities should not be attributable to the laddering arrangement, but to other general market conditions and business developments which greatly reduced the perceived value of many companies' securities. In other words, for those investors that suffered a loss, a large part of that loss arguably was not attributable to the laddering arrangement, but to other market and business factors.

In addition to these legal defenses, there will obviously be several very significant factual issues in the Laddering Claims. For the defendant D&Os, the most important factual issue is whether those individuals knew about the undisclosed compensation and tie-in arrangements. Because executives of an issuing company routinely participate in meetings with securities underwriters regarding the pricing of the IPO and, to some extent, the allocation of shares in the IPO, some people have speculated that many issuer executives knew about and perhaps benefited from these improper arrangements. The extent to which such speculation is true or false will be the primary factor in determining the liability exposure of D&Os in Laddering Claims.

From the standpoint of the issuer company and the securities underwriter, a primary factual issue will be whether an improper agreement in fact existed between the securities underwriter and the investors. Securities underwriters will likely argue that they simply allocated IPO shares to their best customers and, at most, the investors simply acknowledged their "expression of interest" in after-market purchases. It seems doubtful that documented evidence will exist showing a clear linkage between the amount of shares allocated to an investor and that investor's subsequent purchases in the after-market. In fact, one could argue that securities underwriters had a legitimate interest in trying to place IPO shares with long-term investors instead of investors who would immediately sell their shares in the after-market, thereby contributing to a volatile and downward pressure on the stock price. Thus, obtaining an expression of interest in subsequent purchases can arguably serve as a legitimate indicator of an investor's long-term interest in and commitment to the securities. Plaintiffs' ability to establish the existence of improper laddering agreements will probably be largely dependent upon locating disgruntled employees or other "insiders" who are willing to testify as to the existence of verbal agreements. Early signs indicate that a number of such witnesses may be available to plaintiffs.

Laddering Claims frequently include an after-market cause of action under Section 10(b) of the Securities Exchange Act of 1934, in addition to the IPO cause of action under Section 11. The factual basis for the Section 10(b) cause of action is the same as the Section 11 cause of action (i.e., secret agreements to artificially inflate the price of either the IPO or securities in the after-market). However, the Section 10(b) cause of action is frequently against only the securities underwriters since the issuing company and its D&Os were not involved in the alleged after-market manipulation (there is no strict liability under Section 10(b) like under Section 11). However, if evidence demonstrates that D&Os were aware of or participated in such agreements, they will have Section 10(b) exposure as well. Recoverable damages in the Section 10(b) claim will likely be much greater than the Section 11 claim.

The vast majority of the Laddering Claims have been filed in the Southern District of New York and have been transferred to Judge Shira Sheindlin. Although all of these cases will likely not be consolidated into one case due to the unique factual issues in each case, Judge Sheindlin has indicated that no more than 10 (and perhaps far fewer) cases will initially proceed through a Motion to Dismiss as "test" cases, with the remaining cases temporarily stayed. The first Motion to Dismiss in one of the test cases will likely be filed in the Fall, 2001, and a ruling is not expected until early 2002. Until then, discovery in all of the cases should be stayed.

In addition to the scores of class action lawsuits, there are a variety of other civil regulatory investigations, criminal investigations and congressional hearings currently underway with respect to the so-called laddering practices. These investigations, proceedings and hearings not only create additional expenses for all parties involved (including issuing companies), but also create the risk that findings or evidence from these proceedings and hearings will be useful to the plaintiffs in the securities class actions. However, at least the SEC has stated they believe the issuers are the victims here, not the culprits.

An important issue for issuer companies and their D&Os in the Laddering Claims is the extent to which they can recover losses incurred in such litigation from the securities underwriters, who are the true culprits to the extent any wrong-doing occurred. Such a claim against the securities underwriters may be premised upon either of two different theories.

First, issuing companies and securities underwriters invariably enter into an Underwriting Agreement in connection with an IPO. Those agreements typically contain cross-indemnification provisions, pursuant to which the issuing company and the securities underwriters agree to indemnify each other for certain losses arising out of the IPO. However, the scope of the indemnity flowing from the issuer to the securities underwriter is typically much broader than the indemnity from the securities underwriter to the issuer. Frequently, the limited indemnity from the securities underwriter applies only to loss incurred by the issuing company and its D&Os based upon untrue statements or omissions in the Prospectus which were made in reliance upon written information provided by the securities underwriter. Although such a provision may apply with respect to disclosure of commissions, it may not apply with respect to the non-disclosure of the alleged tie-in agreements since there was no written information provided by the securities underwriter to the issuing company relating to the existence or non-existence of such agreements. Even if the indemnity agreement by the securities underwriter is technically triggered with respect to the Laddering Claims, an additional issue arises as to whether such an indemnification obligation is enforceable. According to the SEC and several courts, it is against public policy to indemnify for many types of violations of the federal securities laws since such indemnification would defeat the deterrent effect intended by the securities laws. Courts have also recognized, though, that such a public policy prohibition does not apply to settlements pursuant to which the parties disclaim any wrongdoing, or to claims for contribution by one wrongdoer against another wrongdoer. Similarly, indemnification may be available to an issuer for its strict liability under Section 11 since the issuer committed no wrongdoing.

As an alternative basis for recovery against the securities underwriters, issuing companies and their D&Os can seek contribution pursuant to Section 11(f) of the 1933 Act. Generally, defendants are jointly and severably liable to plaintiffs under Section 11, and therefore any one defendant can be liable for the entire amount of a plaintiff's loss even though several defendants caused that loss. As a result, Section 11(f) entitles a defendant to recover from other defendants to the extent that the defendant paid more than its proportionate share of the total loss. The allocation of loss among defendants for purposes of this contribution claim is likely based upon the concept of relative fault. Thus, issuing companies and their D&Os may have a strong claim for contribution against the securities underwriters under Section 11(f) for all or most of any settlement or judgment incurred in Laddering Claims since the securities underwriters' relative fault is far greater than the other defendants. A contribution claim under Section 11(f), though, applies only to the amount of any settlement or judgment, and does not apply to defense costs, whereas an indemnification claim under the Underwriting Agreement typically would apply also to defense costs.

Issuing companies, their D&Os and their insurers should be sure that these claims for indemnification and contribution against the securities underwriters are appropriately preserved and pursued at an early date in the Laddering Claim. D&O insurers generally take the position that any coverage under the Policy is excess of any recoveries from the securities underwriters (as a result of the insurer's subrogation rights under the Policy) and therefore the Insureds should pursue such recoveries as soon as possible. If such claims for indemnification and contribution are lost as a result of the Insureds' delinquency in pursuing such claims, a coverage defense may arise under the Policy since the Insureds would have impaired the insurer's rights to subrogation.

In practice, the securities underwriters are routinely either not responding to requests from the issuer for contribution and indemnification, or indicating that a decision with respect to such a request is being deferred until a later date. In response, the issuer defendants are preserving their rights against the securities underwriters through correspondence, but are not asserting cross claims in the pending litigation, consistent with the traditional defense strategy of avoiding public fights between co-defendants which may benefit the plaintiff. However, in the context of Laddering Claims, one could argue that such a traditional strategy should not apply and that by asserting cross claims for indemnification and contribution, the issuer defendants would be emphasizing the fact that any wrongdoing was committed solely by the securities underwriters.

As discussed above, absent evidence indicating that defendant D&Os actually knew of the alleged wrongdoing by the securities underwriters, the exposure to Insureds under D&O policies issued to the issuing companies should be limited to (i) defense costs, which should not be extraordinary under any one policy since most of the issuer defendants are engaging as defense counsel a law firm which represents numerous other issuer defendants thus allowing common defense costs to be spread among numerous policies; and (ii) a modest settlement on behalf of the issuing company defendant (assuming entity coverage exists), if the motion to dismiss is unsuccessful. Based upon the somewhat limited information now available and absent surprising new discoveries, it appears likely that the average settlement amount per issuer company should be very modest. Thus, only the primary layer of insurance will likely be exposed in most instances.

Although this level of loss per policy is not catastrophic, the aggregate effect to the entire D&O insurance market may well be catastrophic. For example, if the average paid loss per policy for a Laddering Claim is $2 million to $3 million, and if there are ultimately a total of 200 Ladder-ing Claims (which is probably a conservative projection), the total paid loss by the D&O insurance market for Laddering Claims would be $400 million to $600 million. Such a result would have huge consequences to the entire market, including insurers that do not have direct exposure for Laddering Claims, since the reinsurers who would bear a large portion of this total loss would need to distribute such loss among the entire market. In addition, such a catastrophic result could cause the collapse of some smaller D&O insurers that heavily participated in IPO D&O programs on a primary basis.

The Laddering Claim phenomenon may contain a small silver lining for the D&O insurance industry. Although the total number of securities claims filed in 2001 is well ahead of the rate of filings in previous years, the number of non-Laddering Claims filed in 2001 is well below prior years' experience. Stated differently, the securities class action plaintiffs bar appears to be devoting a significant amount of its time and resources towards Laddering Claims, somewhat to the exclusion of more traditional securities class action lawsuit. If the issuer defendants and the D&O insurers are successful in transferring to the securities underwriters the vast majority of loss in the Laddering Claims, the net effect may be to deflect the attention of a large segment of the plaintiffs bar away from D&O insurance for a limited time.

From a D&O insurance underwriting perspective, the current environment presents an unusual and challenging dilemma. For companies that went public in the last three years but which have not yet been named in a Laddering Claim, there is a substantial possibility that a Laddering Claim will be filed against them before December 6, 2001 (i.e., the one-year anniversary following the initial Wall Street Journal article publicly disclosing the alleged wrongdoing). If the D&O insurance policy issued to such a company is up for renewal prior to December 6, the D&O underwriter for that policy should carefully consider the appropriate response to that likely exposure. Some of the options which are being utilized, depending upon the circumstances, include (i) extending rather than reinstating the limit of liability; (ii) requiring as a condition to renewal that the Insureds give notice under the expiring policies of the potential Laddering Claim; (iii) applying a separate, higher retention and/or a sublimit to any new Laddering Claim filed after policy renewal; and (iv) making at least the entity coverage for any new Laddering Claim excess of any indemnification and contribution from the securities underwriter, and withholding payment under the policy until the indemnification/contribution claim against the securities underwriters is fully resolved at the Insureds' sole expense.

From a D&O insurance claims handling perspective, one of the biggest challenges will be to resist the efforts of plaintiffs and perhaps the securities underwriter defendants to negotiate a "global" settlement. The liability exposure of any one issuing company and its D&Os is highly fact specific and will vary greatly between IPOs, particularly with respect to recoverable Section 11 damages. A global settlement will almost by necessity ignore many of those factual issues (which most likely will result in larger settlement payments on behalf of the issuing company and its D&Os). Instead, each Laddering Claim should be separately evaluated and its settlement (at least with respect to the issuing company and its D&Os) should be separately negotiated in order to avoid excessive settlement payments.

To the extent the allegations in the Laddering Claims are true, responsibility should be placed almost entirely on the securities underwriters and to a far less extent on the issuing company (under the strict liability rules of Section 11). No meaningful exposure should be assigned to D&Os of the issuing company, absent evidence that D&Os actually knew about or participated in the wrongdoing. However, because of the large number of Laddering Claims which have been and which are likely to be filed, even a relatively modest amount of covered loss by each issuing company will result in an aggregate loss to the D&O insurance industry of $100s of millions in paid loss. Thus, this phenomenon may have huge implications to the D&O insurance market in general, and to the continuing viability of some D&O insurers who were heavily involved in IPOs as a primary insurer. The proliferation of Laddering Claims, when combined with the staggering increase in the magnitude of many recent securities class action lawsuits in other contexts, further confirms that a major contraction of D&O insurance is justified, both with respect to pricing and scope of coverage.