Of the different contexts within which securities class action lawsuits arise, one of the most significant is the bankruptcy context. As detailed in the following guest post from Michael Klausner and Jason Hegland of Stanford Law School, securities class action lawsuit arising in bankruptcy are different from cases involving solvent companies. Their guest post provides a detailed overview of the differences. The authors also reach some interesting conclusions about the importance of D&O insurance for the resolution of securities class action lawsuits arising in connection with bankrupt companies.
I would like to thank Mike and Jason for their willingness to publish their guest post on this site. I welcome guest posts from responsible commentators on topics of interest to readers of this blog. Anyone interested in publishing a guest post should contact me directly. Here is Mike and Jason guest post.
One out of every seven securities class actions filed since 2000 involves a company in bankruptcy. This important subset of class actions has some important features that warrant empirical examination. In this blog, we use our database of securities class actions filed from 2000 to the present to shed light on how cases involving bankrupt companies differ from cases against solvent corporations.[i] Specifically, we address the following questions.
· Are cases involving bankrupt corporations more successful than cases against solvent corporations?
· Is the timing of settlement affected?
· How protective is D&O insurance for officers and directors when a company is bankrupt? Specifically, how much does D&O insurance pay out and how frequently do individual officers or directors make personal, out-of-pocket payments into a settlement?
· Is there a basis for inferring that additional Side A coverage would have provided more protection for those individuals who paid into settlements?
Outcomes in Cases Involving Bankrupt Companies
As a company descends into insolvency, there may be incentives for management to shade financials or to describe its business in more rosy terms than is warranted. In addition, once a company has gone bankrupt, disclosures that were accurate when made may not look so accurate in hindsight. This could affect a judge’s ruling on a motion to dismiss and a jury’s view of a case if it went to trial. Thus, it would not be surprising to find that securities class actions involving bankrupt companies tend to be successful more often than cases against solvent companies. On the other hand, perhaps plaintiffs’ attorneys over-rely on such hindsight bias—or are excessively affected by it themselves—and file weak cases against bankrupt companies only to see them dismissed for failure to plead intent with sufficient particularity.
As shown in Table 1, the data indicate that cases involving bankrupt companies are in fact successful for plaintiffs more than are cases against solvent companies. Among cases filed since 2000, only 29% of cases involving bankrupt companies were dismissed or voluntarily dropped, compared to 46% of cases against solvent companies. The low rate of dismissal for these cases suggests that they may be more meritorious than cases against solvent companies. This inference is supported by the fact that cases involving bankrupt companies more often have parallel SEC enforcement actions in which severe penalties were imposed than do cases against solvent companies—specifically, 25% compared to 15%.[ii]
Table 1: Case Outcomes
(Cases filed 2000-2010 and resolved by 2013)
* Difference is rates of dismissal and settlement significant at the .001 level
Note: These are cases dismissesd on a motion to dismiss. Another 25 cases were dismissed on motions for summary judgment — one involving bankrupt companies and 24 involving solvent companies.
An explanation for the low rate of dismissal in these cases could be that they settle quickly, before the motion to dismiss is ruled on. The data show, however, that this is not the explanation. In fact, more often than cases against solvent companies, these cases tend to settle after the ruling on the first motion to dismiss. Figure 1divides the litigation process into three phases: (a) early pleading, defined as the period before the ruling on the first motion to dismiss, (b) late pleading, defined as the period after an initial dismissal without prejudice but before a final ruling either to dismiss or to allow the case to proceed to discovery, and (c) discovery, defined as the period between a denial of the plaintiffs’ motion to dismiss and the end of trial. The graph shows that cases involving bankrupt companies tend to settle in the late pleading period and in the discovery period somewhat more often than do cases against solvent companies.[iii] Moreover, our data also show that among cases that reach discovery, those involving a bankrupt company tend to settle later than do cases against solvent companies.
Figure 1: Settlement Timing—By Phase of Litigation
(Settlements in cases filed 2000-2010)
At first glance, the fact that these cases do not settle earlier may be surprising, since the assets available for recovery by the plaintiff class and the plaintiffs’ attorney shrink as the case proceeds. Every dollar spent on defense costs is a dollar that will be unavailable in a settlement. On the other hand, the bankruptcy process and the involvement of separate defense lawyers for the company and for individual defendants may create complications that delay settlement. In addition, perhaps defense lawyers use the shrinking nature of potential settlement funds as leverage, continuing to threaten to extend the litigation (at no cost to themselves), in order to secure a lower settlement for their clients.
Individual Payments into Settlements
Apparently reflecting plaintiffs’ attorneys’ search for deep pockets (or just pockets), more individual defendants are named in cases involving a bankrupt company than in cases involving a solvent company. On average, six individual defendants are named in cases involving a bankrupt company, compared to five individuals where the company is solvent.[iv] The same pattern appears with respect to naming outside directors as defendants. Where the company is bankrupt, outside directors are named in 43% of cases, compared to 39% of cases against solvent companies, and when outside directors are named, more of them are named in cases involving a bankrupt company.[v] (The apparent search for pockets is reflected in the naming of third parties as well. Auditors and underwriters are named in 43% of cases, compared to 19% of cases involving solvent companies.)
Being named a defendant, of course, does not mean an officer or director will have to contribute to a settlement. The D&O policy provides protection, so long as limits remain and a defendant’s conduct does not result in an exclusion from coverage under the terms of the policy. In total, across all cases involving bankrupt companies, insurers paid roughly $2 billion into settlements, for an average of $13,500,000 per case (or $17,000,000 if one excludes cases in which, for whatever reason, there was no insurance payment). This is a crude measure of the amount individuals would have paid out-of-pocket if they had no insurance, since settlement amounts could have been lower in the absence of insurance. But it is clear that without D&O insurance, individual officers and directors likely would have had to contribute toward settlement out of their personal assets much more frequently, and in some cases the costs to the individuals could have been severe.
Table 2 shows that out-of-pocket payments are rare. But the incidence of out-of-pocket payments is greater where the company is bankrupt than where it is solvent—11% of cases compared to 3% of cases. A close look at the 19 cases in which individuals made out-of-pocket payments where the company was bankrupt reveals that in at least some of these cases, the explanation is either that the settlement was much larger than the policy limits one would expect, as in Enron and Global Crossing, or that the conduct involved was not covered, as in Refco, where individual defendants’ misconduct landed them in jail. There are a few cases, however, in which there were no reports of glaringly fraudulent conduct, where the settlement was not unusually large and where the carrier paid a portion of the settlement, and yet individuals paid as well. While some of these cases may have involved conduct-based coverage issues, the problem may have been insufficient limits.
Table 2: Individual Payments into Settlements
(Settlements in cases filed 2000-2010)
Note: Significant at .001 level
The experience of outside directors in these cases warrants analysis as well. In earlier publications, one of us investigated outside director liability in all types of litigation: securities class actions, state fiduciary duty suits and SEC enforcement actions.[vi] The basic finding was that outside director liability is very rare. This is due to two factors: the protection provided by D&O insurance and the difficulty of proving a case against outside directors. Some people misunderstood that article to say that outside directors were not exposed to liability risk and therefore did not need D&O insurance—the opposite of the causal relationship I intended. As shown here, D&O insurance clearly protects outside directors from out-of-pocket payments.
Table 3 provides data on the liability experience of outside directors. Consistent with the earlier research, settlements of securities class actions rarely result in payments by outside directors—a total of 12 cases out of 409 settlements in cases in which outside directors were named. All but one of these cases involved bankrupt companies. Thus, while liability for outside directors is rare, where it occurs it is nearly always when the company is bankrupt.[vii]
Table 3: Individual Payments by Outside Directors
(Settlements in cases filed 2000-2010 in which outside director was named)
Significant at .001 level
Side A Coverage
When a company is bankrupt, Side A of a traditional policy and in some cases a separate Side-A-only policy may be all that stand between a settlement demand and a personal, out-of-pocket payment. The fact that there have been only 19 cases since 2000 involving bankrupt companies in which individuals made such payments suggests that Side A protection is effective. In nine of these 19 cases, insurance paid into the settlements—just not enough to cover the full settlement. On average insurance paid 73% of the total amount paid in those settlements. As stated above, it is possible that additional Side A limits would have protected some of the individuals that made out-of-pocket payments.
In sum, cases involving bankrupt companies are different from cases against solvent companies. They are dismissed less often and they therefore settle more often. They also take longer to settle than do cases involving solvent companies. Finally, and not surprisingly, officers pay into settlements in these cases somewhat more often than they do in cases against solvent companies. On the whole, however, D&O insurance provides substantial protection to individuals in these cases, and additional Side A coverage might have provided full protection for the individuals that paid out of pocket apparently.
[i] Cases included in this study were filed between 2000 and 2010 and resolved by 2013. There are 1,779 cases in the sample, 55 of which are ongoing and are therefore excluded for certain purposes below.
[ii] All comparisons in this paragraph are statistically significant at the .001 level in univariate tests and multivariate tests in which we control for factors that associated with dismissal.
[iii] This difference is of borderline statistical significance (p < .1), in univariate and multivariate tests, when comparing early pleading settlement vs. settlement in the two later periods. If we look at cases filed since 2005, the difference between cases involving bankrupt companies and cases involving solvent companies is somewhat greater.
[iv] Statistically significant at the .001 level.
[v] Statistically significant at the .005 level.
[vi] See Black, Cheffins & Klausner, Outside Director Liability, 58 Stanford Law Review 1055 (2006); Klausner, The Risk of Liability for Outside Directors, PLUS Journal 2006, p. 1.
[vii]There were two additional cases involving solvent companies, where individuals who were technically outside directors paid into settlements. In one of these cases, the individual was affiliated with the controlling shareholder and in another he was a founder and former CEO and therefore more involved in company management than a typical outside director.