Directors and Officers Liability and Insurance : The D & O Diary : Kevin LaCroix : Securities Laws, Corporate Fraud, D & O Litigation

The subprime litigation wave has been rolling along for well over a  year, so it might be expected that by now we have seen many of the likely litigation variations. I suspect there are hosts of new variations yet to come, but the most recent subprime-related lawsuits are substantially similar to prior lawsuits. Yet each one, briefly noted below, also involves some interesting additional variations on previously established subprime litigation themes.

Royal Bank of Canada Auction Rate Securities Lawsuit: On May 12, 2008, plaintiffs’ counsel announced (here) an auction rate securities-related class action lawsuit against Royal Bank of Canada and its subsidiaries, RBC Dain Rauscher and RBC Capital Markets Corporation. A copy of the complaint can be found here.

While there have been numerous prior auction rate securities lawsuits (about which refer here) and while the allegations in the RBC lawsuit appear substantially similar to the prior auction rate securities lawsuits, this lawsuit does present a couple of additional interesting elements.

The first is the lawsuit’s timing. The preceding auction rate securities lawsuits came in a rush between March 17, 2008 and April 21, 2008. There had been no new auction rate lawsuits since April 21, and the lengthening interval might have been interpreted to suggest that the filing onslaught had played itself out. The RBC lawsuit suggests that we may not yet have seen the last of the auction rate securities lawsuit filings.

The other interesting thing about the RBC lawsuit is that RBC itself is, obviously, a Canadian company. At a PLUS Chapter event in Montreal last week, there was a great deal of discussion about whether Canadian companies will feel the litigation effects of the subprime meltdown. The lawsuit against RBC suggests that at least Canadian companies with U.S. operating units exposed to subprime-related issues may find themselves swept up in the U.S.-based subprime litigation wave.

Indeed, RBC is not even the first Canadian company to be named in an auction rate securities lawsuit, as Oppenheimer, another Canadian company, was hit with an auction rate securities lawsuit in April 2008 (about which refer here). Even if Canadian companies are not being sued in Canadian courts on subprime-related issues, they are finding themselves involved in U.S.-based litigation.

Huntington Bancshares/Sky Financial/Waterfield Mortgage:  Huntington Bancshares, a Columbus, Ohio-based bank holding company, has previously been sued in a subprime-related securities class action lawsuit (about which refer here). The plaintiffs alleged in the prior lawsuit that, due to Huntington’s July 2007 acquisition of Sky Financial, Huntington had a much greater exposure to subprime mortgages than it had disclosed, allegedly harming a class of person who acquired Huntington shares between the time of the merger and the end of the class period in November 2007.

On May 7, 2008, Huntington was sued in a separate lawsuit in the United States District Court for the Southern District of Ohio (complaint here). In this most recent lawsuit, Huntington is sued as successor in interest to Sky Financial. The lawsuit is filed on behalf of the former shareholders of Waterfield Mortgage Company, whose shares Sky Financial had acquired in an October 2006 stock for stock-and-cash merger transaction.

The May 7 complaint, which also names as defendants Sky Financial’s former CEO and former CFO, alleges that the Sky Financial and the individual defendants violated Sections 11 and 12 of the ’33 Act through alleged false and misleading statements in the registration and proxy documents issued in connection with the Waterfield acquisition. The complaint alleges that Sky Financial had an undisclosed lending relationship that resulted in a significant residential mortgage exposure for Sky Financial.

This most recent Huntington lawsuit involves a different set of plaintiffs asserting claims based on a different set of representations yet involving a defendant bank that has already been drawn into the subprime litigation wave. There will likely be other lawsuits like this one ahead, as litigation emerges to fill in the interstices of the circumstances surrounding the subprime meltdown. So far, the most noteworthy attribute of the subprime litigation wave has been its breadth. Perhaps in the months ahead, as the wave spreads to fill in other gaps, the most pronounced aspect of the litigation wave will be its depth.  

Special thanks to Adam Savett of the Securities Litigation Watch blog (here) for a copy of the Huntington/Sky/Waterfield complaint.

Run the Numbers: With the addition of these two new subprime-related securities class action lawsuits, the current tally (refer here) of subprime and credit-related lawsuits stands at 79, of which 39 have been filed in 2008. With the addition of the RBC auction rate securities lawsuit, there have now been 16 auction rate securities lawsuits, all of which have been filed in 2008.

Subprime Litigation Down Under: According to a May 12, 2008 Wall Street Journal article (here), Centro Retail Ltd. and its management company, and Centro Properties Company Ltd. and its management company, collectively  an Australian shopping center group, have been named as defendants in two class action lawsuits filed in Australian federal court based on alleged misleading statements in Centro’s disclosure documents between August 9, 2007 and February 15, 2008.

As discussed in the May 13, 2008 issue of The Australian (here), the recently filed lawsuits, brought by the Maurice Blackburn firm, are actually the second set of lawsuits announced against Centro. As discussed here, lawsuits had previously been announced against Centro and its property trust by the Slater & Gordon law firm. Both sets of lawsuits relate to Centro’s alleged misrepresentations regarding its leverage and its vulnerability to adverse credit developments, as a result of which the company experienced a severe share price decline.

While the spread of subprime-related shareholder class action litigation to Australia is interesting in and of itself, one specific aspect of these two sets of lawsuits is particularly interesting to me. That is, both sets of lawsuits are proceeding in reliance on third-party litigation funding.

According to Slater & Gordon’s April 22, 2008 press release (here), its lawsuits are being funded by “U.S based litigation funder Commonwealth Legal Funding LLC.” According to the press release, litigation funders “take a percentage of the net amount recovered, after expenses and after legal fees, for advancing all expenses and accepting the risk of any adverse award.” (The law firm itself recovers a court-approved hourly rate.)

The Maurice Blackburn firm’s separate set of actions is being funded by Australian-based IMF (Australia) Ltd. IMF is actually a publicly traded company whose shares trade on the Australian stock exchange. IMF’s May 9, 2008 press releases announced the filing of the lawsuits against Centro can be found here and here.

It isn’t clear how the existence of these two competing ventures will be reconciled. One might argue that the free market should be allowed to decide; along those lines, the Slater & Gordon press release touts the “significant” advantage its funder affords, in that “it takes a lower amount of the net amount recovered, from 15 to 30 percent, compared to the top rate of 40 per cent for the other proposal.”

One of the time-honored traditions in international financial circles is to rail against the excesses of the U.S. litigation system. But for all of our litigation extremes, litigation funding is one innovation that has not caught on in this country. It obviously has, by contrast, caught fire in Australia, and according to a March 20, 2008 Legal Week article (here), it also apparently has spread to the U.K.

As to whether litigation funding might catch on in the U.S., the WSJ.com Law Blog has an interesting post discussing the issue here. The Re: The Auditors Blog also has an interesting post on the topic here.

Australia has been setting the pace on innovation lately, as, among other things, the Slater & Gordon firm itself recently became the world’s first publicly traded law firm (refer here).

Opt-Out Options for the Little Guy: In a recent post (here), I discussed Columbia Law School Professor John Coffee’s recent paper in which he speculated that that we might be moving to a two-tier securities litigation system in which institutional investors with large financial interests at stake might increasingly seek to opt out from class litigation. The class itself, Coffee speculated, might increasingly be populated only by smaller investors whose financial stakes were too slight to justify opting out or to attract the interest of plaintiffs’ attorneys.

But an aspiring plaintiffs’ attorney’s recent publicity bid suggests that there may be enthusiasm for encouraging the little guys to opt-out too. In a May 12, 2008 press release suggestively entitled “Study Finds Many Bear Stearns Employees Should Opt-Out of Class Actions” (here), Brett Sherman of the Sherman Law Firm seeks to point out to Bear Stearns employees that investors who opted out of prior cases have had a higher percentage recovery of their investment losses.

The press release cites a variety of sources regarding opt-out litigation (including, in a twist that feels odd to me, my own InSights article about opt outs). None of the studies specifically find, as the press release title suggests, that Bear Stearns employees should opt out. Rather, Sherman himself asserts that “the only reasonable conclusion is that Bear Stearns employees with substantial losses have a dramatically better chance to recover a higher percentage of losses in individual opt out cases rather than as participants in class actions.”

Perhaps if, as Coffee speculates, institutional investors will increasingly opt out of class actions, and if, as Sherman advocates, the little guys decide to opt out too, no one will be left in the class. The issue here is clearly potential class members’ perception that opt-outs recover a greater percentage of their investment loss. To the extent that perception is widely shared, class counsel may face significant pressure to show a greater percentage recover of investment loss. Otherwise, the class action itself could become an empty vessel.

Of course it remains to be seen whether either large or small potential class members actually do opt out in material numbers. But assume for the sake of argument that they do. All those who have reviled the class action litigation procedure for so many years might want to contemplate the procedural morass that would attend a multitude of individual opt-out actions. Class litigation does offer certain efficiencies whose loss we might one day mourn.

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The heightened pace of securities lawsuit filings in 2008 (as previously noted here) continued in April, when there were 22 new securities class action filings. The subprime litigation wave was a significant factor in the filing activity level, as ten of the 22 cases were subprime or credit crisis related. Of the 10 subprime cases, seven pertained to auction rate securities.

The heightened April activity followed the increased activity levels in March. The March and April combined two-month total of 48 new securities lawsuit filings represents the largest two-month filing total since July and August 2004, when 51 new cases were filed.

According to Cornerstone Research (here), the average annual number of new securities class action lawsuit filings for the period 1996 through 2006 was 194. The total number of new 2008 year to date securities class action lawsuit filed through the end of April is 75. If the filing levels for first four months of 2008 were to continue for the remainder of the year, the year end 2008 total of new filings would be 225, which not only exceeds the 1996 to 2006 average, but is approximately the same number of filings as in 2002, the year of the corporate scandals. If the IPO Laddering cases are excluded from the analysis, the 2002 filing level represented the highest annual number of filings since the passage of the PSLRA.

First-Filed Tyco Opt-Out Case Partially Settles: As detailed on the Securities Litigation Watch blog (here), the first filed Tyco Opt-Out action has partially settled. The lawsuit was filed on behalf of the State of New Jersey and several NJ pension funds (refer to the plaintiffs' 373-page second amended complaint, here).

According to the New Jersey Attorney General's April 30. 2008 press release (here), Tyco itself agreed to pay $73.25 million to settle the plaintiffs' claims against the company's former GC Mark Belnick and four former Tyco directors. The settlement does not relate to the plainiffs' claims against former Tyco CEO Dennis Kozlowski or former CFO Mark Swartz, as well as the plaintiffs' claims against another former Tyco director and the company's former auditor, PricewaterhouseCoopers. A May 1, 2008 Law.com article discussing the settlement can be found here.

I have added the Tyco opt-out settlement to my table of opt-out settlements, which can be accessed here. A detailed list of the various pending Tyco opt-out cases, compiled by Adam Savett of the Securities Litigation Watch, can be found here.

Section 404 Compliance Costs Decline: According to a recent Financial Executives International survey of 185 publicly traded companies (press release here), Section 404 compliance costs were lower in 2007 compared to prior years. Because the study depends on survey results, and the composition of the survey participants varies from year to year, the survey does not permits absolute costs comparisons on a year to year basis. However, the survey does show that the number of internal and external people hours required to comply with Section 404 declined for survey respondents in 2007 compared to the prior hear. The auditors annual attestation fees also decreased as a percentage of the annual audit fee.

A May 1, 2008 Wall Street Journal article commenting on the survey report can be found here. The FEI Financial Reporting Blog discusses the survey report  here.

Noises Off: While no one will mistake his letters for those of Warren Buffett, the annual letter of A.S. Perloff, the Chairman of Panther Securities P.L.C. register high on the entertainment value scale. The latest letter, part of the Panther 2007 year-end preliminary financial report, can be found here. To my ears at least, Perloff’s “ramblings” sound rather like the discourse from someone who might have had one glass of claret too many, but the letter is no less entertaining for that. Read and enjoy.

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I have previously noted (most recently here) the increasing significance of opt-out actions as a part of securities lawsuit resolution. Columbia Law School Professor John Coffee, in a March 27, 2008 paper entitled “Accountability and Competition in Securities Class Actions: Why ‘Exit’ Works Better Than ‘Voice’” (here) examines the opt-out phenomenon and concludes that while the increased recoveries in opt-out actions compared to class recoveries will encourage competition among plaintiffs’ counsel, shareholder litigation could become even costlier to resolve.

Coffee also concludes, contrary to what others have “prematurely predicted,” that shareholder class action lawsuits “will not die or whither away, but that the current system of shareholder class action lawsuits may be abandoned in favor of a “two-tier system,” in which “the largest investors will opt-out and sue in state court individual actions, with the class action becoming the residual vehicle for smaller investors.” These possibilities have enormous implications for the future of securities litigation, which Coffee’s paper explores.

Coffee opens his paper comparing the changes wrought by the opt-out phenomenon with prior legislative efforts to reform class action litigation. Specifically, Coffee notes that unlike legislative efforts to give the class greater control, such as the lead plaintiff provision of the PSLRA, the increasingly utilized opt-out option may offer true oversight, actual competition, and even lead to better results for the plaintiff class.

In analyzing these developments, Coffee adopts terminology from the writings of economist Albert O. Hirschman. Hirschman describes two ways in which organizational behavior may be modified: (i) participants can be given greater “voice”; or (ii) participants can be given increased ability to “exit” the system. Coffee contrasts the legislative reforms, such as the lead plaintiff provision, designed to give class members greater “voice,” with the alternative of “exit” offered by the opt-out option. Coffee concludes that “ ‘exit’ works better than ‘voice,’” at least within realm of securities class actions.”

A critical component of Coffee’s analysis is that “when institutional investors exit the class and sue individually, they appear to do dramatically better – by an order of magnitude!” Coffee views this as an “optimistic development” because the opt-out outperformance can “kickstart active competition” among plaintiffs’ attorneys, by contrast to the PSLRA reforms which have had the perverse effect of reducing competition.

As Coffee notes, these developments have significant implications for the future of class litigation, as large institutional investors increasingly may conclude that their interests are better served by proceeding separately. Coffee specifically notes that the current wave of subprime-related cases are “particularly likely to produce a high rate of opt-outs,” because of the predominance of institutional investors among purchasers of the kinds of asset-backed securities that are at the heart of many of these lawsuits.

Coffee speculates that defendants (and indeed all class litigants) may seek to employ adaptive practices to offset these developments. Among other possibilities Coffee reviews are such practices as advancing the time of the opt-out decisions before the settlement is reached; structuring the settlement in a way to give class members “priority” over individual recoveries, such as given them a security interest in company assets to the extent of the settlement amount; including a “most favored nation” provision in class settlements so that class members are entitled to increase their recovery if opt-outs reach a higher settlement; or even reducing the settlement amount in respect of each opt-out.

In the final analysis, each of these potential adaptations has shortcomings. Over the long run, Coffee anticipates, “increased opting out will place class counsel under increased competitive pressure to improve the class settlement.” For that reason, Coffee concludes that “greater competition is coming.”

I very much agree with Professor Coffee that the emergence of significant opt-out settlements represents a watershed development in securities class action litigation, with the potential to have an enormous impact. However, I think it does still remain to be seen how widespread the opt-out phenomenon will prove to be.

The increased recovery percentages (so far) in the high profile opt out actions do provide obvious incentives for institutional investors to become more focused on their opt-out opportunities. But so far the significant opt-out activity has been limited to “mega” cases where the aggregate recoveries, for both the class and the opt-out litigants have run into the hundreds of millions and even the billions of dollars. It is entirely possible that rather than becoming a universal phenomenon affecting all, most, or even many securities class actions, significant opt-out activity will be limited only to a small handful of cases where the dollars involved reach this rarified range. Without more, it seems premature to project that shareholder litigation is about to enter a two-tier system where institutional litigants have abandoned class resolutions altogether.

That said, even if the phenomenon proves to be limited only to a small subset of securities cases, the opportunities and incentives involved could still affect the overall outcome of many securities cases. Just the threat of material opt-outs could affect the class action settlement dynamic. As Professor Coffee notes, some adaptive behavior is likely, as litigants seek to suppress or minimize the prospects for opt-outs. The likeliest adaptive behavior is that class settlements overall could be driven upward, as all class settlement participants seek to remove the incentive to opt out by improving the class settlement itself.

We are already in an era of increasing average claim severity. The emergence of the opt-out phenomenon can only amplify these trends. In any event, the developments related to opt-outs also present important implications for D&O insurers’ severity assumptions and for insurance purchasers’ assumptions about limits adequacy. The direct and indirect impacts from the emergence of significant opt out activity could make historical assumptions in this regard obsolete.

Very special thanks to Professor Coffee for his permission to cite and quote his paper, which, he emphasizes, is preliminary only.

Hat tip also to Werner Kranenburg of the With Vigour and Zeal blog (here) for the link to Professor Coffee’s paper.

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In prior posts (most recently here), I have written about the increasing importance of opt-out settlements in the context of securities class action litigation. Along the way, numerous readers have inquired whether I am aware of a publicly available resource that is tracking the securities lawsuit opt-out settlements. I am not aware of any public resource, but because there clearly is an interest in having this information available, I have gone ahead and compiled all of the opt-out settlement information of which I am aware. My list of the opt-out settlements can be found here.

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In the latest in the series of significant opt-out settlements, two different state pension funds have announced settlements with Qwest in their separate securities actions against the company. In both instances, the funds announced that their separate settlements far exceeded the amounts that they would have recovered in Qwest's $400 million class action settlement (refer here regarding the class action and its settlement) and it now appears that the aggregate amount Qwest has agreed to pay opt-out claimants exceeds the amount it agreed to pay the class.

In a November 21, 2007 press release (here), the Colorado Public Employees' Retirement Association (PERA) announced a $15.5 million settlement of its separate action against Qwest. And in a November 21, 2007 announcement (here), the Alaska Permanent Fund Corporation (APFC) announced that the Alaska Department of Law had reached a $19 million settlement (net of fees and costs) on behalf of APFC, which will receive $13 million from the settlement, and on behalf of the Alaska State Department of Revenue and the Alaska Retirement Management Board, which together will split the remaining $6 million. Press article describing the Colorado settlement can be found here and regarding the Alaska settlement can be found here.

There are several significant features of these opt-out settlements. The first is what the settling funds themselves said about how they fared by proceeding separately rather than participating in the class settlement. Colorado PERA (which is Colorado's largest pension fund and the 25th largest public pension fund in the country) said that its recovery in the class settlement would only have been $400,000, or less than one cent on the dollar of the fund's investment losses, meaning the fund increased its recovery more than 38 times by pursuing a separate action.

The AFPC for its part said that the state's combined recovery in the class settlement would only have been $422,000, on combined investment losses of approximately $89 million. While the state recovered only a quarter of its investment losses through its separate action, it recovered 45 times what it would have recovered in the class settlement. (The AFPC is the investment fund that receives and invests royalties from the Alaska pipeline. With over $38 billion in assets, the fund paid a fiscal 2007 dividend of $1,654 to each qualifying Alaskan state resident.)

The second significant thing about these opt-out settlements is what the funds said about their motivations in pursuing separate actions. Colorado PERA's press release said that it "elected to forego the class recovery" because of its concerns about "excessive attorneys' fees and an inadequate recovery" - it also reported that its counsel (the Entwistle & Cappucci firm) charged only a 5 percent fee, compared to the 15 percent fee awarded to class counsel. Although Alaska was less explicit in describing its motivations for opting out, the AFPC announcement does underscore the amount by which the state increased its recovery by opting out and also points out that the state has previously obtained opt-out settlement recoveries against WorldCom ($14 million) and AOL Time Warner ($45 million). Alaska's opt out settlement with AOL Time Warner is discussed in a prior post here.

The third significant thing about the funds' opt-out settlements is what their actions may say about their willingness to pursue their own actions in the future. Colorado State Treasurer Cary Kennedy (a PERA board member) said, referring to its opt-out settlement, that "Colorado's public employees should take comfort in the fact that PERA continues to be vigilant in protecting their retirement." PERA's Board Chair added that "being involved in cases such as the separate proceeding against Qwest demonstrates our ongoing commitment to protecting the [members'] benefits." (It should be noted that PERA has been active generally in securities litigation, having served, for example, as lead plaintiff in the Royal Ahold class action.) Similarly, an Alaskan state attorney is quoted in the news article as saying that "we have a system in place to monitor cases that get filed and then decide whether we should get actively involved."

According to the Alaska press release, Entwistle & Capucci represented not only the Alaska and Colorado funds, but also the Florida State Board of Administration and the New York State Teachers' Retirement System. These latter two funds do not appear to have made any recent announcements regarding their funds' separate actions.

As discussed in an earlier post on The D & O Diary (here), there have been prior significant settlements involving Qwest class action opt outs. For example, the California State Teachers' Retirement System previously entered a $46.5 million opt-out settlement that included a $1.5 million contribution on behalf of former Qwest CEO Joseph Nacchio. According to press reports (here), Qwest also reached separate settlements with the New York City Employees' Retirement System and Stichting Pensioenfunds of Netherlands and the Teachers' Retirement System of Louisiana. The amount of these other settlements has not been publicly disclosed.

In its October 30, 2007 filing on SEC Form 10-Q (here), Qwest disclosed that the aggregate amount claimed by various persons opting out from the class settlement is "in excess of $1.9 billion." Qwest went on to state that "we have entered into settlement agreements with all of those persons." Qwest added that in connection with those settlements, "we have agreed to pay up to an aggregate of approximately $411 million, including applicable interest, on or before June 30, 2008." Although Qwest's disclosure does not explicitly state that the $411 million amount includes the Colorado and Alaska settlements, the disclosure's wording ("agreements with all of those persons") suggests that the $411 million does include those two settlements.

It should be noted, with all due emphasis, that the $411 million in opt out settlements exceeds the $400 million that Qwest agreed to pay in the class settlement.

As I have noted at greater length here, the emergence of these opt-out settlements presents a host of potentially significant complicating problems for current and future securities class action litigants. The involvement of public pension funds with significant investment losses, who now have a track record of having substantially increased their recoveries by having proceeded separately, suggests that significant opt out actions could become a regular part of larger class action settlements. At a minimum, these developments may raise potentially serious concerns about the continuing utility of class actions, especially if the perception becomes more widespread that, as viewed by Colorado PERA, class actions entail higher fees and lower recoveries.

All of these concerns are exacerbated if public officials are convinced they can garner valuable publicity and advance their own political interests by pursuing separate actions on behalf of state funds. The fact that the aggregate amount of the Qwest opt out settlements apparently exceeds the amount of the class settlement puts the issue in even sharper focus; indeed, the fact that Alaska is now on its third significant opt-out settlement, and has procedures in place to govern its future opt out decisions, makes it even more emphatic that opting-out may now be more routine and could become standard practice for public pension funds.

The possibility of continuing significant opt-out litigation after class settlement has been achieved threatens to increase both litigation costs and settlement expense in civil securities litigation. At a minimum, class litigants, eager to try to deter opt-outs, will feel pressure to increase class settlement amounts, in an effort to try to reduce attrition from the class. And, at some point, opt-outs may trigger the standard "blow up" provisions in many class settlement provisions, by which the class settlement in set aside of a specified percentage of class members opt out.

From the beginning, one of the questions about these opt-out settlements has been whether they are merely an attribute of the massive corporate scandals from earlier in the decade. The thought was that perhaps as the corporate scandal cases work their way through the system, the opt-out phenomenon might die down. However, the massive cases now arriving in connection with the subprime lending meltdown may create their own dynamic. The scale of the investment losses in at least some of the subprime cases may create the same incentives to opt-out as existed in the cases arising from the corporate scandals.

Indeed, at a panel on which I participated at the recent PLUS International Conference, one of the leading plaintiffs' attorneys, who was also on the panel, said that many institutional investors (particularly European investors) were not interested in pursuing class cases at all in connection with the subprime mess, but were solely interested in individual or group actions. And as Adam Savett has noted on his Securities Litigation Watch blog (here), narrow class certification rulings are forcing other institutional investors to initiate their own separate lawsuits. With these kinds of concerns looming, we may get to the place where class litigation, long reviled by would-be corporate reformers, starts to look pretty good compared to a piecemeal process with separate investors pursuing claims separately. But at a minimum, these events and trends raise troubling questions about the future of securities class action litigation.

In a couple of months, the various consulting groups will be issuing their annual reports discussing developments in securities class action settlements. But their standard analysis, focusing exclusively on class settlements, may no longer be a sufficient basis upon which to understand what is happening in terms of total securities lawsuit severity. We have indeed entered a brave new world.

Options Backdating Case Going Back, Back to California: In an April 11, 2007 opinion (here), the federal court in California dismissed the CNET options backdating derivative case with leave to amend, later specifically instructing the parties to cooperate to allow the plaintiffs to conduct a books and records inspection under applicable Delaware law before the plaintiff refilled an amended complaint.

The parties have been involved in extensive books and records proceedings is Delaware and in a November 21, 2007 opinion (here) in the Delaware Chancery Court, Chancellor William B Chandler III granted the plaintiff's books and records request, providing lively commentary along the way. Among other things, the Chancellor said that "it is about time the defendant...provides the requested documents, " -- and, he added, quoting The Notorious B.I.G., it is time that the case gets "going, going/back back/to Cali Cali."

The Delaware Corporate and Commercial Litigation Blog has a detailed and interesting discussion of the opinion here. Special thanks to blog author Francis Pileggi for forwarding a link to his post.

So What's on Your iPod?: For those of you who may be wondering what Chancellor Chandler is listening to on his iPod, the song he quotes in the opinion, "Going Back to Cali," is from the Notorious B.I.G.'s posthumous double-album entitled "Life After Death," which Rolling Stone listed as #483 on its list of the greatest 500 albums of all time. According to Wikipedia, the song "Going Back to Cali," reflects the East Coast/West Coast feud that may have led to Mr. B.I.G's as-yet-unsolved March 1997 murder.

The "Cali" in the song apparently is a shorthand reference to "California," which would explain, sort of, the Chancellor's reference to the song in his opinion, as that is the state to which the CNET case will now be returning. Many of the song's lyrics are unsuitable for this family-oriented blog. Suffice it to say that Mr. B.I.G apparently believed that West Coast females possess certain physical characteristics that he regarded positively. He also apparently believed that the West Coast offered attractive leisure time alternatives. However, he also felt antagonism (apparently reciprocated) against certain West Coast rivals, and this rivalry included mutual threats of physical violence.

It must be said that Chancellor Chandler's musical allusion reflects a remarkably ecumenical taste in music. Not to mention a phenomenally broad diversity of resources on which to draw for guidance in his judicial decision-making.

And Finally: The D & O Diary's stock of literary allusions is considerably narrower than Chancellor Chandler's. The "brave new world" referenced in this post's title is an allusion to the line from the Shakespeare's The Tempest, in which Miranda exclaims "What brave new world/That has such people in it!" (To which Prospero replies " 'Tis new to you.")

There is a sense in which this reference is particularly apt; the island on which Miranda and her father have been exiled is traditionally thought to be Bermuda, which is also where many of the financial consequences from heightened securities lawsuit severity could be felt.

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In the latest issue of InSights, entitled "Opt-Outs: A Worrisome Trend in Securities Class Action Litigation " (here), I review recent opt-out settlement developments, take a look at whether or not the current trend will continue, and examine what the trend may mean for D&O carriers and policyholders.

Prior D & O Diary posts on class action opt-out can be found here and here.

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The Ohio Attorney General, Marc Dann, issued a March 7, 2007 press release (here) announcing a $144 million net settlement in the opt-out action filed against the Time Warner defendants on behalf of the Ohio Bureau of Workers' Compensation and five state pension funds. As explained further below, the gross amount of the settlement is $175 million.

According to news reports (here), the net settlement proceeds will be distributed as follows: State Teachers Retirement System of Ohio, $66.5 million; Ohio Public Employees Retirement System (OPERS), $62.3 million; Ohio Bureau of Workers' Compensation, $8 million; Ohio Police and Fire Retirement System, $4.1 million; School Employees Retirement System of Ohio, $2.5 million; and Ohio Highway Patrol Retirement System, $290,778. Hat tip to the Best in Class blog (here) for the settlement proceeds distribution.

Dann stated in the press release that the settlement "will yield $135 million more than the pension funds would have received had we remained a party to the class action suit." In other words, Ohio's net recovery in the opt-out settlement represents 16 times more than the $9 million Ohio believes it would have recovered from the class settlement. Ohio's net recovery of $144 million represents 36% of its estimated $400 million investment loss.

The decision to opt-out from the Time Warner class action settlement had actually been made by Dann's predecessor, Republican Jim Petro. (Dann, a Democrat, was sworn in as AG on January 7, 2007.) At the time of the opt-out decision, Petro said (here) explaining his decision to opt-out, "the class action suit, you get peanuts at the end of it." In an unusual gesture, Dann went out of his way in the press release to praise his Republican predecessor: "Jim Petro did the right thing by opting out of the class action. His decision put me in a very strong negotiating position."

Ohio was represented in its opt-out action by the Lerach Coughlin firm and the Cleveland law firm of Benesch, Friedlander, Coplan & Aronoff. According to news reports (here), the $144 million is Ohio's net recovery from a gross settlement of $175 million. The remaining $31 million will pay expenses and attorneys. Petro had agreed to a 17.5% contingency fee to Lerach Coughlin and hourly compensation to Benesch. Dann said he negotiated the Lerach Coughlin fee down by $3 million and that firm agreed to pay Benesch from its contingency fee. Dann said this was a signal to other future outside counsel that he "will drive a harder bargain in the future." (I guess the plaintiffs' bar has been warned; let that $31 million be a lesson.)

A couple of things about Dann's press release strike me as particularly troublesome. The first is the grandstanding tone. For example, Dann is quoted as saying "Today, we are sending a loud and clear message to corporate American and to Wall Street: we will not tolerate fraud, stock manipulation, or deceit in this state." There is much more in a similar vein that I cannot bring myself to quote here. Dann clearly felt comfortable mining this settlement for political capital. If other state or local politicians perceive that they might be able to use opt-out settlements to buff up their images as protectors of the little guy and scourges of corporate fat cats, watch out. Given Dann's comments about attorneys' fees and sending messages for future cases, he anticipates that there will be a next time.

The other troublesome note is the care Dann's press release takes to validate the Ohio settlement among the other recently announced opt-out settlements: "Mr. Dann said the amount of the settlement is proportionate to or greater than those reached by plaintiffs who have filed and settled similar cases against AOL/Time Warner." A March 8, 2007 issue of the Cleveland Plain Dealer quotes Bill Lerach (here) as saying that Dann would not settle for anything less than the 36 percent of investment loss that the University of California (also represented by Lerach) recovered in its separate opt-out action. Clearly, there is some benchmarking going on in the Time Warner opt out cases, which undoubtedly will weigh on remaining settlement negotiations in other Time Warner opt out cases. The greater concern is that some kind of universal standards are being set that could affect negotiations in other cases, or future cases.

In any event, the $175 million Ohio gross settlement, taken together with the gross amounts of the other previously announced Time Warner opt-out settlements (refer here), brings the total value of the publicly announced Time Warner opt-out settlements to $730 million. Based on the information on the Stanford Law School Class Action Clearinghouse website (here), a class action settlement of $730 million would rank as the ninth larges class action settlement ever. The aggregate attorneys' fees (which by the way do not have to approved by a court) undoubtedly are similarly staggering. Settlements (and attorneys' fees) of this magnitude obviously will attract keen interest in opting-out as a securities lawsuit strategy, particularly if others share the view of Ohio's former Attorney General that a class action settlement only gets you "peanuts."

The Cleveland Plain Dealer (here) reports that negotiations on the Ohio settlement began on February 27, with Time Warner's attorneys offering $30 million, and by the following afternoon the parties had reached the $175 million deal. Time Warner was represented by Cravath Swaine & Moore (which Dann called "a fancy New York law firm) and Jones Day. The settlement does not resolve the state's case against Ernst & Young, AOL's accountant.

Oxley Surveys His Work: Speaking of retired Ohio Republicans, Michael Oxley , as reported in the March 2, 2007 International Herald Tribune interview (here), while addressing at a conference of 200 accountants in Paris, had some choice words to say about his best known legislative legacy, the eponymous Sarbanes Oxley Act. Among other things, Oxley, in repsonse to questions about the statute's impact, acknowledged that if he knew then what he knows now, "I would have written it differently and [Sarbanes] would have written it differently."

Oxley went on to explain that the statute was not the product of "normal times." He says that "Everybody felt like Rome was burning. People felt like they were getting cheated. It was unlike anything I had ever seen in Congress in 25 years in terms of the heat from the body politic. And all the members were facing it." Oxley now says that he felt at the time that Section 404 could spell trouble, but said that with the pressure on the Bush administration, there was no question that a bill needed to be passed, however imperfect.

Oxley also said that the decision to prosecute Arthur Andserson was a "White House decision." The Bush administration made the decision to "give the death penalty to Arthur Anderson" because "they had to look really tough." Oxley says now that "virtually anyone would agree it was a terrible decision" because it "eliminated a major accounting firm" and sent a chill through the accounting industry, causing accountants to revert to "extremely conservative practice."

Hat tip to Houston's Clear Thinkers blog (here) for the link to the Oxley article.

Mow Down The Laws Just to Get the Devil?: Oxley's frank acknowledgement that Arthur Anderson was sacrificed for mere political effect has made me reflective. The politicians feel they must protect us from the fraudsters, or, rather, that they must be seen as protecting us from the fraudsters, but who protects us from the politicians?
This all reminds me of one of the scenes in A Man for All Seasons , the play based on the life of Thomas More, the 16th Century English chancellor and author. In the scene, More's wife Alice, and his son-in-law William Roper, urge More to arrest an informer who had sought to curry favor with More by providing information (this excerpt taken from the complete text of the play, which may be found here ) :

ALICE: While you talk, he's gone!

MORE: And go he should, if he was the Devil himself, until he broke the law!

ROPER: So now you'd give the Devil benefit of law!

MORE: Yes. What would you do? Cut a great road through the law to get after the Devil?

ROPER: I'd cut down every law in England to do that!

MORE: Oh? And when the last law was down, and the Devil turned round on you --where would you hide, Roper, the laws all being flat? This country's planted thick with laws from coast to coast -- man's laws, not God's -- and if you cut them down --and you're just the man to do it -- d'you really think you could stand upright in the winds that would blow then? Yes, I'd give the Devil benefit of law, for my own safety's sake.

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A frequently repeated - but demonstrably false - statement about securities class action lawsuits is that, while public pension funds have served as lead plaintiffs in securities fraud lawsuits, private institutional investors, such as banks, mutual funds, and insurance companies, have not. However, as Adam Savett points out (here) on the Securities Litigation Watch blog, private institutional investors do indeed seek to serve as lead plaintiffs, and his blog post cites several specific instances where mutual funds, insurance companies and banks have done just that.

Savett's observations are relevant to the discussions I have been having in response to the recent wave of institutional investor opt-out settlements. (See my most recent post on opt-out settlements here.) The usual line of analysis goes that because the recent opt-out settlements have involved public pension fund opt-outs, the threat of future opt-out exposure is limited to companies that have significant public pension fund investor ownership. But this assumption could prove to be very misleading.

As Savett's blog post substantiates, private institutional investors will choose to take an active litigation role when they see it in their interests to do so, and there is no reason why they might not elect to opt-out of a class settlement, just as they might elect to see to serve as a lead plaintiff. However, unlike Savett, I am unable to support my assertion with concrete examples. Watch this space - if I learn of an example of a private institutional investor entering into a significant securities opt-out settlement, I will post it to this blog.

Readers who might think that the Amalgamated Bank's recent opt-out settlement with Time Warner (refer here) is an example of a private institutional investor opt-out settlement may want to take a closer look at Amalgamated. According to its website (here), Amalgamated Bank was founded in 1923 by the Amalgamated Clothing Workers of America and serves working class consumers and trade unions. In addition to normal banking functions, the bank also administers union-related trust funds and multi-employee benefit plans. The bank is owned by UNITE HERE, a trade union of textile and hospitality trade workers. Readers can reach their own conclusions, but I am not prepared to describe Amalgamated Bank as a private institutional investor.

Readers who are aware of any private institutional investor opt-out securities settlements are encouraged to let me know.

UPDATE: Adam Savett points out that the Lerach Coughlin law firm's web site's list of the opt out plaintiffs the firm represents in the AOL Time Warner lawsuit (here) include a number of private institutional investors, including mutual funds and insurance companies. To my knowledge, none of these plaintiffs have yet settled with the defendants, but their involvement suggests it is only a matter of time before we start seeing private institutional investor opt out settlements.

SUPPLEMENTAL UPDATE: At least one of the institutional investors that has settled with Time Warner appears to be a private institutional investor. According to Time Warner's 2006 10-K (here, refer to page 53), Time Warner has reached a settlement of the opt out action filed by DEKA Investment GmbH, which from its website (here) appears to be an investment fund company for institutional investors. The amount of DEKA's settlement is not disclosed. Hat tip to Adam Savett for the link.

A Fraudster's Take on Fraud: Readers who may have missed it over the weekend will definitely want to go back and read Herb Greenberg's March 3, 2007 column in the Wall Street Journal entitled "My Lunch With 2 Fraudsters" (here, subscription required). The column reports on Greenberg's lunch interview with Sam E. Antar of Crazy Eddie's infamy and Barry Minkow of ZZZZ Best infamy. It comes as no surprise to me that Sam did most of the talking. Readers may recall my prior post (here) about Sam's views on preventing fraud. Sam also maintains the White Collar Fraud blog (here). Sam has quite a lot to say, a small portion of which comes through in Greenberg's column. Sam makes no bones about the fact that as the architect of the Crazy Eddie's securities fraud, he is a criminal. Among other interesting observations, Sam told Greenberg:

As criminals, we built false walls of integrity around us. We walked old ladies across the street. We built wings to hospitals...We wanted you to trust us. Simply said ...if you want to be an investor, you cannot accept information at face value. "Unexamined acceptance" is the greatest cause of investor losses.

Professor Larry Ribstein has an interesting commentary (here) on his Ideoblog about Sam's remarks.

Welcome to the Drug and Device Law Blog: The D & O Diary would like to welcome, and to encourage readers to read, the Drug and Device Law Blog, which may be found here. This new blog is written by Jim Beck of the Dechert law firm and Mark Herrmann of the Jones Day law firm. (Full disclosure: Mark and I were at Michigan Law School together, and Mark's wife is my dentist. Small world.) The blog take a very lawyerly approach to legal issues affecting the drug and medical devices industries, although it should be noted that many of the blog's posts are of more general interest. A particularly noteworthy recent post (here) discussed the recent Supreme Court punitive damages case and explored its implications for punitive damages awards in future class action cases.

Mark is also the author of the Curmudgeon's Guide to Practicing Law, a humorous and irreverant guide to surviving the practice of law (big firm style). According to the WSJ.com Law Blog (here), the Guide is "a well-written and clear guide on how to be an effective law-firm associate. It's also funny."

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In recent posts (most recently here and here), I have commented on the worrying trend toward institutional investor opt-out cases and the massive settlements that have followed. In a February 28, 2007 press release (here), the University of California announced the latest of institutional investor opt-out settlement, a $246 settlement on the University's behalf with Time Warner, of which the University's counsel, the Lerach Coughlin law firm, will receive about $37 million.

The University stated in its press release that its settlement is "believed to be the largest publicly announced payment in an opt-out securities claim in history." The University estimated that the settlement represents "between 16 and 24 times the amount that it would have received through the class settlement." The University estimates that its investment loss on its Time Warner stock was about $555 million, so the school recovered about 44 cents on for each dollar of investment loss.

According to a March 1, 2007 New York Sun article (here), the University of California settlement was only one of five large institutional investors that recently reached opt-out settlements with Time Warner. The five settlements collectively totaled approximately $400 million. In addition the University of California, Time Warner also reached settlements with Amalgamated Bank, the California Public Employees Retirement System, and two pension funds for Los Angeles County.

The Sun article also notes that the payouts in the opt-out settlements "could rile some small investors because the institutions claim they are getting vastly better settlements than they would have if they remained in the class." The Sun article quotes Columbia Law School Professor John Coffee as saying that the discrepancy in per-share recovery between the class and the opt-outs is an "embarrassing distinction," but one that is not easily rectified, since any party has the right to opt-out. Coffee also said that the opt-outs could reduce the amounts companies are willing to pay out to the main pool of investors.

The five institutional investor opt-out settlements mentioned in the Sun article, together with the previously announced $105 million CalSTRS settlement with Time Warner, brings the total amount of just these six opt out settlements to $505 million, more than 20% of the $2.4 billion settlement for the entire class.

In a prior post (here), guest blogger Rick Bortnick and I discussed the problems created by the possibility of large opt out settlements following prior class settlements. But Professor Coffee's remarks in the Sun article raise the possibility that it may become increasingly difficult to reach a class settlement at all, as settling defendants seek to reduce the amount they pay in class settlement in order to preserve assets to settle with opt outs, while class members seek to avoid any "discrepancy" in the value of class and opt out settlements, and as individual plaintiffs stream out of the class to see if they can improve their recovery by proceeding individually.

Notwithstanding these troublesome thoughts, we still don't know whether or not the opt-out settlements will become a standard part of securities fraud litigation or will prove to be an exclusive attribute of the mega-cases growing out the wave of corporate scandals earlier in this decade. To take one example, the size of the recoveries for both for the University of California and its counsel was directly related to the massive size of the University's investment loss. Would institutional investors, or for that matter, plaintiffs' lawyers, be as interested in going it alone if the potential recovery is significantly less substantial?

All of these questions remain to be seen. In the meantime, it is hard to disagree with Professor Coffee's statement in the Sun article that the flood of securities opt-out settlements is "probably the most distinctive new trend in class action litigation."

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My recent posts on securities fraud opt-out litigation settlements (here and here) provoked a number of interesting responses, including one comment that was so detailed that I thought it would make an interesting guest blog post. The commentator accepted my invitation to be a D & O Diary guest blogger. I am pleased to present the latest D & O Diary guest post, below.

Our guest blogger today is Richard Bortnick of the Philadelphia law firm, Cozen O'Conner. Here is Rick's guest post, in the indented text below -- the comments following the indented text are mine:

The potential implications of the recent high dollar opt-out settlements, as discussed in your postings here and here, should not be taken lightly. To the contrary, while certainly not a trend, they could portend the dawning of a new era in shareholder litigation and lead to a dangerous future of far greater exposure for corporate defendants and, in some cases, their D&O insurers (if not by the individual defendants themselves). In short, these latest developments suggest that a class action settlement may not be the end of the day for the defense side, both with respect to defense costs and indemnity expense. As Yogi Berra once said, "it ain't over till it's over," and it may not be over until the last large opt-out plaintiff has settled or presented its case to a jury.

In the past, a good percentage of shareholders who opted-out of a class action settlement did so for either moral or personal reasons partially or wholly unrelated to money. As such, opt-outs generally were not a concern to the defense side, and all interested persons were able to cap and account for the costs of shareholder litigation. Of course, this is not to suggest that the issue of opt-outs was ignored in the settlement documentation. Rather, virtually every class action settlement agreement contains (and has forever contained) a provision pursuant to which the settling defendants could "blow up" the settlement if shareholders owning a certain percentage of shares elected not to participate in the settlement. A typical "blow provision" contains opt-out percentages ranging from 2%-5% or more. While the enumerated percentage may have been triggered in a few stray cases, neither the company nor its D&O insurer felt the threat of future exposure justified their invoking their rights under the "blow provision." The settlement, for all intents and purposes, put a cap on the amount of money a company and its D&O insurer knew they would spend for a claim and allowed them to reserve and ultimately pay a liquidated amount.

In light of recent developments, however, this may no longer be the case. Indeed, the number and, more importantly, the potential severity of opt-out claims and settlements may have a profound impact on whether and how companies, their D&O insurers and other categories of defendants (i.e., accountants, attorneys, underwriters, etc.) respond to a situation where the "blow provision" is implicated.

Let's assume that shareholders who own 3% of a public company defendant's stock elects to opt-out and go it alone in private litigation (or in combination with a sufficient number of other shareholders so as to constitute a "mass action," but not a "class action"). What are a company and its D&O insurer to do? How about a non-settling accounting or law firm? At present, there is no simple solution, no "magic bullet" to avoid additional, and potentially severe, exposure both for defense and indemnity.

Moreover, such a situation could have implications on the proposed class action settlement, as the company and its D&O insurer (as well as, where applicable, settling accountants, attorneys, etc.) may invoke the settlement agreement's "blow provision," and elect simply to "roll the dice" and try the class action, although that may be the least attractive option to someone who likes certainty and hates surprises. Of course, a decision to blow up a settlement could have wide-ranging business (and marketing) implications, particularly for a D&O insurer which develops a reputation of being a company which blows up settlements and leaves its insureds exposed to personal liability by way of a jury trial or otherwise. And, in any event, from where will the money to defend and ultimately settle the opt-out case come? The company? The D&O insurer which had not exhausted its policy's limit as part of the class action settlement? The company's outside accountants, attorneys, and whoever else had a hand in the transaction that gave rise to the lawsuit? Or, perhaps, the D&O's themselves. In the few mega-opt-out cases to date, the plaintiffs pursued recovery from virtually everyone person and entity with any potential for exposure. And, we assume that most of these categories of defendants paid something toward the settlement.

One alternative might be to negotiate in the class action settlement a provision which allows the defendants to reduce the settlement amount they are to pay ( i.e., a "clawback"), should the number of opt-outs exceed an agreed number. As a second alternative or as an adjunct, the class action settlement could be on an "opt in" basis, whereby class members must take affirmative steps to become part of a class and a class action settlement. Or thirdly, the D&O insurer could decide to exhaust (if it hasn't done so already) and leave the opt-outs behind, to fight with the Company and the D&O's (although, this is not a realistic approach from a cash-flow standpoint). Quite simply, none of these choices is attractive, and none address the underlying problem: what do we do with the opt-outs?

The implications for plaintiffs' counsel could be equally as profound. In a class action settlement situation, class counsel must apply to the court for an award of attorneys' fees, and the quantum awarded is within the full discretion of the presiding judge. Depending on the size of the settlement and, oftentimes, the amount of work performed by plaintiffs' counsel, courts have been known to award attorneys' fees of anywhere between 7% and 30% (or more) of the gross settlement figure. Regardless of the quantum, however, the ultimate decision on attorneys' fees was not one the lawyers or their clients were empowered to make. The final decision belonged to the court. In stark contrast, in the case of a "mass action" or individual opt-out action, the opt-out plaintiffs and their counsel are free to negotiate any fee arrangement they choose, without court involvement or intervention, capped only by governing ethical rules and the parties' respective views. To the point, unlike in a class action setting, court approval of their private fee arrangement is unnecessary.

Assuming the recent spate of opt-outs is not an anomaly, the evolution of this process ultimately could lead to a regime whereby (1) smaller or less well-known plaintiffs' counsel prosecute the class action aspect of a securities fraud litigation and then apply to the court for a fee award if/when a settlement is reached, while (2) the bigger, more well known plaintiffs' firms transform a good portion of their practice to representing large, typically institutional, opt-out clients, thereafter negotiate a huge settlement with the defendants (and their D&O insurer?), and then collect whatever amount they have pre-negotiated with the client(s). Equally inviting to prospective opt-out counsel, they oftentimes would be relieved from having to devote the time, resources and money typically necessary to prosecute a securities fraud claim, as all of the work, including paper discovery and depositions, already will have been completed by the class action counsel in the context of the class action litigation. In other words, work much less and recover much more. Now that's capitalism!

In short, a new opt-out regime may be upon us, and companies and their D&O insurers alike, as well as class counsel and their class members, should be sensitive to the possibility that the number of litigated opt-out cases could escalate and cause heretofor non-existence problems for all of them, absent a reasonable and realistic solution. It may be that nothing can be done, short of legislated changes to Rule 23 of the Federal Rules of Civil Procedure governing class actions, and complimentary judicial activism. But people need to begin talking about the problem now, before the
whole team of horses has left the barn.

Reading Rick's comments made me wonder how likely it is that defendants or their insurers would ever elect to exercise the "blow provision" or if they did, what would cause them to do it? Would it be opt outs of a certain number? Or of a certain size? Clearly, there would have to be some development that convinced them that they were not getting the benefit from the class settlement for which they thought they had bargained, and that they would be better off without the class settlement. That still seems only a theoretical possibility, even with the magnitude of the recent opt out settlements.

I also wonder how much the opt-out phenomenon is a D & O insurance problem. Most of the recent prominent opt out settlements have come in association with mega class action settlements, where the class settlement (plus defense expense) far exceeded the amount of the D & O insurance. Perhaps one exception is the recent Qwest opt-out settlement, where insurers for Joseph Naccio reportedly (here) contributed $1.5 milllion on his behalf in settlement of the individual investor opt-out claim against him. But even with that exception, I wonder whether D & O insurers have been called upon to make significant contributions to the recent wave of opt out settlements, since the policies for the companies involved were long ago depleted in connection with the class settlement and defense expense.

And along those lines, I think it is important to note that the settling defendants in the recent CalSTRS opt-out settlements in the Qwest and AOL Time Warner cases involved numerous non-D & O defendants, including investment banks and auditors. We don't know how much each of these defendants contributed. But in view of these defendants' contributions toward settlement, the companies' contribution might well have been relatively slight, particularly if CalSTRS remains a shareholder of the companies.

These considerations make me wonder how big of a problem opt outs may be (or become) for D & O insurers. Based on the publicly available details of the recent prominent opt outs settlements, I don't think there is enough data to know for sure. But the threat of opt out cases dragging on after the class case has been settled unquestionably has important implications for D & O insurers' severity assumptions. It also has important implications for D & O policyholders' limits selection. (My prior post, here, has further thoughts about opt outs and severity assumptions and limits selection.)

I also wonder whether the apparent proliferation of opt out settlements may be an artifact of the massive corporate frauds from earlier in this decade, and whether opt out settlements will largely fade out as those cases finally work their way through the system. On the other hand, a more depressing possibility is that the plaintiffs' bar has developed a lasting addiction to opt out cases and that institutional investor opt outs will go on even after the last of the mega cases is finally resolved. Although I appreciate the sentiment of Rick's suggestion that revisions to Rule 23 may be needed, I wonder what specific revisions could eliminate the opt out curse. You can't make anyone join a class of which they do not want to be a part.

A final thought: all those would-be reformers who want to do away with class litigation need to take a good hard look at the alternative to resolving everything in one lawsuit. The alternative is not pretty.

In any event, special thanks to Rick for his excellent guest blog post. The D & O Diary is always interested in responsible readers' guest post submissions on appropriate topics. Authors interested in submitting a guest post should feel free to contact me any time.

"I never said half the things I really said": Rick's reference to baseball great Yogi Berra made me reflect that although Berra was a fifteen time All-Star and league MVP three times, and appeared in fourteen World Series (including ten championships), he is now mostly remembered for his Yogiisms, a list of which may be found here.

We here at The D & O Diary find these words good rules to live by: "You can observe a lot by watching" and "If you can't imitate him, don't copy him." Alas, it is true, as Berra observed, that "a nickel ain't worth a dime anymore."

A philosophical defense of Berra and his penchant for unintentionally funny comments can be found here. Baseball purists may prefer Berra's career player stats, here.

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In a widely-circulated and much discussed February 7, 2007 Wall Street Journal op-ed column entitled "The Class Action Market" (here, subscription required), former SEC Commissioner and Stanford Law Professor Joseph Grundfest (pictured above) takes a look at the declining number of securities fraud lawsuits in 2006 (see prior D & O Diary posts here and here) and reaches the startling conclusion that perhaps it is time to do away with private securities lawsuits altogether.

Grundfest's views are based on his position that the declining number of suits is due to improved corporate behavior. As he says, "perhaps fewer companies are being sued for fraud because there is less fraud." He attributes this to the "government's criminal and civil enforcement strategy." Not only has this enforcement activity been effective, Grundfest writes, but as a means to protect shareholders' interests, it is superior to private securities class actions, since private suit recoveries are diminished by the amount of the plaintiffs' attorneys' fees. "Investors," Grundfest writes, "could come out ahead if they simply allowed the SEC to control the process and eliminated the private bar's cut of the action."

In addition to the elimination of the lawyers' costs, the exclusiveness of SEC enforcement would provide superior deterrence: "Private litigation does not have an equivalent deterrent effect because it can't threaten executives with jail and because damages are almost always paid by corporations and insurers, not the executives who cause the fraud." In summary, Grundfest writes, "the private class action can be viewed as an expensive, wasteful and unnecessary sideshow that generates little deterrence and offers questionable levels of compensation."

Grundfest's proposal to eliminate private securities lawsuits is not entirely original. {UPDATE: Please see the comment below about the origin of this idea; The D & O Diary stands corrected!}The idea of disimplying a private cause of action under Section 10 was circulated in the early stages of the work of the Committee on Capital Markets Regulation (popularly known as the Paulson Committee), as discussed here. Grundfest is a highly respected figure in the securities law arena, and for that reason his views are likely to attract significant attention. But that does not necessarily mean that the private securities lawsuits will disappear any time soon.

First of all, we don't hear the SEC clamoring to increase its workload; to the contrary, the SEC clearly depends on the private securities bar as a way to outsource part of the burden of enforcing of the securities laws. The SEC's hands are already pretty full; the SEC could not take on categorically increased responsibilities without a major hike in its budget and in the size of its enforcement staff. {UPDATE: As Adam Savett notes on the newly revitalized Securities Litigation Watch blog (here), the SEC went so far as to state in its amicus brief in the Tellabs case that "meritorious private actions are an essential supplement to criminal prosecutions and civil enforcement actions brought, respectively, by DOJ and the SEC." Savett presents additional "gentle rebuttal" against Grundfest's proposal as well. }

In addition, the introduction of an exclusive public remedy for securities fraud entails significant costs. While shareholders may have to pay attorneys in order to be able to pursue lawsuits, those costs at least are borne by the most interested parties rather than by taxpayers as a whole. And how would taxpayers and corporate American react to a greatly enlarged securities regulator? There is a thin line between respect and fear, and an enlarged and empowered SEC would be even more fearful than it is now. Could deterrence become oppression?

And while Grundfest is correct that the SEC's enforcement activity has a greater deterrent effect than private litigation, that does not mean that private litigation has no deterrent effect. Most corporate officials want to do the right thing, and they also want to be perceived as doing the right thing. For the typical CFO or CEO, nothing could be more mortifying than finding their name linked in the press to the word "fraud," even if the accusation comes only from a plaintiffs' lawyer. This deterrent effect is real and an important part of life for most corporate officials.

Without a doubt, the securities class action lawsuit has been abused. It is an expensive and cumbersome tool for the enforcement of the securities laws. But it nevertheless continues to have an important role to play in protecting investors' rights. Simply put, investors who are angry don't have to depend on the government to redress their economic grievances; they can do something about it themselves. For all of the excesses of securities class action lawsuits over the years, it is still a tool of empowerment for investors. Readers who find my defense of the securities class action surprising should understand that I simply prefer the continued availability of a private remedy to the prospect of an even more enlarged and even more empowered SEC with a monopoly on the right to protect shareholders' rights. There was a time, before the courts implied a private right of action, when the sole agent for enforcing the securities laws was the SEC, but private litigants whose interests were not redressed sought a private right of action in order to be able to pursue actions that SEC had not taken up. Without a private cause of action, investors would have no remedy if the SEC failed to act.

I also happen to disagree that the SEC's enforcement activity alone explains the decline in the number of lawsuits; unlike Professor Grundfest, I think the Milberg indictment is part of the explanation, not for its affect on the Milberg firm alone, but for its effect on the entire plaintiffs' bar (see my prior post here). I also think the current relatively healthy economy is also part of the explanation. Look at the auto parts industry; that sector has been under pressure lately, and not too surprisingly, just about every public auto parts company has been sued in a securities class action lawsuit in the last 18 months. Just this week, subprime lenders announced deteriorating results, and like clockwork one of the companies (New Century Financial) was sued in a securities class action lawsuit. (here). There are numerous causes for the decline in securities lawsuits, many of which appear to be temporary, so to the extent that Grundfest's proposal depends on his theory that SEC enforcement activity alone explains the declining number of lawsuits, the proposal should be viewed with caution. Certianly, if the downturn proves to be temporary, the basis of his argument is eroded.

I am surprised that we have not heard a reaction out of the plaintiffs' bar yet. I suspect we will before too long.

For a good discussion of Grundfest's column, see the Truth on the Market blog (here).

CalSTRS Completes Another Opt-Out Settlement: As I previously noted (here), the increasing prevalence of institutional investor opt-out settlements has important implications for projected severity assumptions and even for appropriate D & O insurance limits. In the latest example of this phenomenon, the California State Teachers' Retirement System (CalSTRS) announced (here) on February 7, 2007 that it had reached a $105 million settlement of the $135 million investment losses it claimed in its individual action, brought after the retirement fund opted out of the $2.65 billion class settlement. (Refer here for a description of the class settlement.) CalSTRS announcement in the AOL Time Warner case come just days after it announced a $46.5 million settlement in the case it filed against Quest.

In an article on CFO.com (here), counsel for CalSTRS is quoted as saying that if CalSTRS had not opted out of the class, it would have recovered only $15.5 million to $16 million. In other words, its recovery of its investor loss supposedly was increased 6.5 times by pursuing a separate action. The $105 million settlement represents about 78% of its claimed investment loss.

As I noted in my prior post linked above, separate settlements of this type, even if limited exclusively to the largest securities lawsuits, could have an enormous impact on the complexity and cost of private securities litigation.

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In the latest of the securities class action opt out settlements, California's teacher pension fund reached a $46.5 million settlement in its separate case against Qwest Communications, its accountants and investment banks, and certain former directors and officers. According to news reports (here), the parties resolved the pension fund's case, which was pending in the San Francisco Country (Cal.) Superior Court, in December 2006, but the settlement only recently came to light as a result of a California Public Records Act request of the Associate Press. The pension fund had opted out of the $400 million settlement of the class action lawsuit against the Qwest defendants. A description of the class settlement as well as a number of the opt out lawsuits may be found here.

The settlement reportedly included a $1.5 million payment on behalf of Qwest's former CEO Joseph Nacchio. According to Nacchio's counsel (here), Nacchio's settlement contribution was "made with insurance funds." Nacchio is scheduled to go to trial in federal court in Denver on March 19, 2007, on a 42-count insider trading indictment, in which it is alleged that Nacchio sold $101 million of Qwest stock based on inside knowledge that the company would not meet revenue targets. A February 4, 2007 Denver Post article discussing the criminal case against Nacchio can be found here.

The $46.5 million settlement with the California State Teachers' Retirement Systems' (CalSTRS) is apparently only one of several settlements that the Qwest defendants have recently reached with opt-out plaintiffs. According to a February 3, 2007 Rocky Mountain News article entitled "Qwest Quietly Settles Lingering Lawsuits" (here), the Qwest defendants have also reached settlements in undisclosed amounts with the New York City Employees' Retirements System, Stichting Pensioenfunds of Netherlands, and the Teachers' Retirement System of Louisiana.

According to the statement of its Chief Executive in a January 31, 2007 CalSTRS press release (here), the pension fund will receive "about 30 times more than it would have recovered if it had taken part in the class action." CalSTRS is one of the largest public pension funds in the country, second only to the California Public Employment Retirement System (CalPERS).

A copy of CalSTRS complaint against the Qwest Defendants may be found here, and the December 29, 2006 Amended Settlement Agreement can be found here.

The CalSTRS opt-out settlement in Qwest follows the December 2006 opt out settlement by the State of Alaska in connection with claims against AOL Time Warner (refer here). The State of Alaska reportedly received a settlement of $50 million on its claimed investor loss of $60 million, or about 83 cents on the dollar. The attorney for the State of Alaska claimed that the state received "50 times more than we would have gotten if we had remained in the class." The lawyer also said that the state was able to take advantage of Alaska's favorable blue sky laws. (A description of the AOL Time Warner class settlement can be found here.)

These opt-out settlements follow the settlement by five New York City public pension funds that did not join the $6.1 billion World Com settlement. According to news reports (here), the pension funds received $78.9 million on their $130 million claimed fraud losses to their equity and bond portfolio. The city's counsel claimed that the funds wound up with "three times more than they would have received if they joined the class action."

The emergence of large separate opt-out settlements represents a potentially very significant development in securities fraud litigation. Certainly if institutional investor defendants perceive that they can substantially increase their recoveries by pursuing their claims individually rather than collectively in the form of a class action, the utility of the class litigation, at least for institutional investors, could be significantly reduced.

While class lawsuits have been demonized for years, they do offer unarguable advantages in certain respects, most obviously when they afford the opportunity to resolve numerous disputes in a single proceeding. Following the adoption of the Private Securities Litigation Reform Act of 1995, there are certain procedural advantages to the federal securities class action litigation, most significantly the stay of discovery while motions to dismiss are pending. If a company is forced to defend itself in multiple proceedings in multiple courts, particularly if it is also forced to defend a class lawsuit also, the costs and complexity of defense escalate enormously. And if individual investor recoveries really do exceed class recoveries as a percentage of investor losses, then the aggregate cost of final resolution could escalate significantly as well.

But some caution may be required before it can be conclusively determined that opt-outs will fare better than class members. Typically, the percentage of a plaintiffs' attorney's fee recovery in an individual case is higher, because it is applied against a smaller fund. (A class attorney can accept a lower percentage because the fund is so much larger, and the resulting fee is larger as well.) So the individual plaintiffs' recovery net of fees would have to take this larger plaintiffs' fee percentage into account.

From the plaintiffs' attorney's point of view, the prospective class fee will almost always be larger than the prospective fee representing an opt out investor, and indeed a plaintiffs' lawyer's incentive to take on an opt out case is going to be limited to cases where the individual investor's prospective recovery is very large. To put this into context, the median 2006 securities class action settlement, according to NERA (here), was $7.7 million. If half of all settlements are below $7.7 million, there are going to be relatively few instances where the potential incremental benefit from an opt out case will sufficiently outweigh the associated friction costs. There are not going to be very many occasions where there will be plaintiffs' lawyers eager to pursue these cases, either. So, on its face, the opt out lawsuit would appear to be a phenomenon restricted to only the largest cases and settlements.

Nevertheless, in these largest cases, the emergence of opt out cases could require a reassessment of the assumed range of claims severity. In assessing potential severity, it may not be sufficient to look at class action settlement data alone. It may also be necessary to crank into the calculus the possibility of opt-outs, with the potential for heightened defense expense and settlement exposure. This dimension of added exposure could also have important implications about D & O insurance limits adequacy. The limits required to defend the company and its directors and officers in a multi-front war with opt-out institutional investors and the class, and required to settle all of the lawsuits (particularly if opt-outs expect recover percentages approaching 100% of investor losses), could be significantly higher than may have been assumed in the past.

The Lies, Damned Lies Blog takes a closer look at the plaintiffs' firms involved in the CalSTRS opt out settlement with the Qwest defendants, here.

UPDATE: On February 7, 2007, CalSTRS announced (here) a separate $105 million settlement in its separate opt out action involving its claims investor loss at AOL Time Warner. Refer here for a more detailed discussion of CalSTRS AOL Time Warner settlement.

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