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

The unexpected resignation of an outside director may indicate that a company is about to experience tough times, according to a recent academic study. The research shows that a company experiencing a surprise director departure is likelier to face a number of different future adverse events.

Among other things, a company with a surprise outside director departure has a "significantly higher likelihood of being named in a federal class action securities fraud lawsuit." The study’s authors call this risk of future adverse events following a director’s departure the "dark side of outside directors."

These findings are set forth in a March 2010 paper entitled "The Dark Side of Outside Directors: Do They Quit When They Are Needed Most?" (here) by Rüdiger Fahlenbrach of the Ecole Polytechnique Fédérale de Lausanne, Angie Low of the Nanyang Technological University and René M. Stultz of Ohio State University. Hat tip to the Harvard Law School Forum on Corporate Governance and Financial Reform for the link to the paper. I note here that the author’s paper is copyrighted – a notation that the authors require from anyone quoting their paper.

The Authors’ Analysis

The authors note that among the remedial measures imposed following the era of corporate scandals last decade were requirements for increased numbers of independent directors on corporate boards. Though these measures had salutary purposes, the addition of increased numbers of independent directors also has "costs" as well as benefits.

Among these "costs" is what the authors refer to as "a dark side" of increased outside director involvement arising because of outside directors’ "incentives." That is, outside directors have "incentives to leave when they anticipate that the firm on whose board they sit will perform poorly and/or disclose adverse information."
 

The directors have incentives to quit "to protect their reputation or to avoid increases in the workload when the firm on which board they sit is likely to experience a tough time." As the authors put it, outside directors are "more likely to quit when they expect the firm to perform poorly or to disclose bad news, so they can at least partly and possibly totally escape the reputation loss."

Because outside directors have these incentives, an unexpected director resignation from a company’s board may indicate that the company may be poised for future adverse events.

The authors tested this hypothesis by examining "surprise director departures." The authors tracked resignations by directors whose ages were below the average director retirement age and then plotted the resignations against future events at the companies from whose boards the directors had resigned.

The authors found that following "surprise director departures" the firms involved experienced "significantly worse stock and accounting performance," and "are significantly more likely to suffer from an extreme negative return event, are significantly more likely to restate earnings, and have a significantly higher likelihood of being named in a federal class action securities lawsuit."
 

These results, the authors concluded, are "consistent with the directors leaving in anticipation of adverse events to protect their reputation or to avoid an increased workload."

Discussion

The authors’ analysis of the "dark side" of increased outside director involvement is interesting, because it suggests that the outside directors readiness to head for the exits when the going gets tough undermines the very reasons for which increased outside director involvement was required in the first place. As the authors put it, their analysis suggests that "outside directors are more likely to resign precisely when experienced outside directors are needed the most."

The authors’ findings about the increased risk of securities litigation following a director’s resignation are particularly interesting. Back when I was part of a D&O underwriting facility, my colleagues and I were constantly involved in trying to identify factors that were positively correlated with the risk of securities litigation. The authors’ analysis suggests that a surprise outside director departure is such a factor.

Specifically, the authors found that a surprise outside director departure (that is, one that is not explained by the director having reached the average age for director retirement) is "highly statistically and economically significant" in terms of litigation risk. The authors specifically found that the surprise departure of an outside director increases the probability of a securities class action lawsuit filing by 31% to 35%, with the likelihood increasing as firm size increases; if a company’s stock and accounting performance were poor in the prior year’ and if the firm raised relatively more external financing in the prior year.

The authors’ work raises important questions about the role of outside directors. However, for D&O underwriters, the authors’ analysis about the correlation between surprise director resignations and securities litigation risk may be the most interesting finding. At a minimum, the authors’ analysis suggests a potentially important new underwriting criterion.

Questioning Rating Agencies’ First Amendment Defenses: In a recent post, I discussed the latest decision questioning the applicability of rating agencies’ first amendment defenses. Left unanalyzed in these cases is the larger question of why rating agencies’ ratings opinions are thought to be entitled to first amendment protection in the first place.

In a June 9, 2010 Am Law Litigation Daily article (here), Susan Beck questions both the rating agencies’ entitlement to rely on the First Amendment and the limitations of the judicial decisions to date where courts have found the First Amendment defense inapplicable because the ratings were given only to a small group of sophisticated investors. Beck asks, with respect to the latter point, "Why should big, sophisticated investors like CalPERS have more redress under the law than small (and large) investors who buy securities in public offerings?"

Beck also suggests that "the premise of First Amendment protection for credit ratings is shaky." After reviewing and questioning the case authority on which the rating agencies rely in asserting their First Amendment defenses, Beck concludes "I'm hoping that the next judge to address the First Amendment question reads the case law differently and concludes that a credit rating, by itself, is not a matter of public concern that deserves Constitutional protection. That's not only fair, it's right."

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On April 1, 2008, the Wilmer Hale law firm released a report entitled “West Coast Securities Litigation & Enforcement” (here), in which the law firm reports, among other things, that “investors sued 44 public companies in the West in 2007, a striking 56 percent increase over 2006, reversing what some had hoped was a permanent post-Enron decline in securities class actions.” A copy of the law firm’s April 1 press release about the report can be found here.

The report attributes the “surge” in filings against West Coast companies to the “subprime crisis” which “precipitated lawsuits.” The report also attributes the apparent “upswing in filings” to the “increased capacity of the dozen-plus law firms that bring most of these class actions.”

The report notes that while there were more lawsuits filed, there were also more lawsuits dismissed (29) than settled (18) in the Ninth Circuit during 2007, from which the report happily concludes that “last year’s spike in filings was the product of opportunistic lawyers filing in a falling stock market, and not an indication that corporate malfeasance is on the rise.”

The report also considers 2007 settlement developments and concludes that “it has become cheaper to settle in the Ninth Circuit,” based on the fact that in 2007, the median West Coast settlement was $6 million, the “lowest point since 2004” and 40% below the national median of $9.6. The report concludes because of the lower settlement figures that “the recent wave of California cases appears weaker than those filed in New York and elsewhere and –as in the past – negotiated settlements reflect the financial condition of the defendant issuer or the magnitude of the market loss.” The report also notes that “favorable dismissal rates may have – indeed, should have – encouraged plaintiffs’ lawyers to scale back their expectations.”

The report also has a number of interesting observations about the backlog of pending options backdating cases. The Ninth Circuit courts have been “far less receptive to those cases than have courts in the other regions.” In addition, West Coast issuers “have successfully defended a large number of [options backdating-related] derivative actions; by year end, courts had dismissed 14 such cases and allowed only two to proceed.” The report notes that West Coast courts have thrown out a number of options backdating-related securities lawsuits, while courts in other jurisdictions have permitted these cases to go forward.

The report concludes with a number of observations about the activities of the SEC’s West Coast enforcement offices, which offices apparently remain active.

The law firm’s report is interesting, but many of the report's statistical observations consist of numerators yearning for denominators to give their existence meaning.

First, while the number of lawsuits against companies based in the Ninth Circuit may well have increased 56% percent between 2006 and 2007, lawsuits overall increased 43% (going from 116 lawsuits in 2006 to 166 in 2007, according to Cornerstone, here). The report’s feature stat would be significantly less compelling had the report more accurately stated that increase in the number of lawsuits on the West Coast in 2007 was 13% greater than the increase nationwide.

Second, the methodology used to conclude that California companies were 63% likelier to be sued than companies elsewhere in not revealed. For example, is report saying that the ratio of California companies sued to the total number of companies in California is 63% higher than the same ratio for all other states? Or is the report just making some comparison about the raw numbers of 2007 lawsuits against companies inside and outside California? It would have been helpful for the report to specify its methodology, because this particular conclusion is, well, challenging, given that 52 of the 166 securities lawsuits in 2007 were filed in the Southern District of New York, far more than any other federal district. (Refer here for my full analysis of the 2007 lawsuit filings.)

Third, the report seems to imply that the West Coast companies are being sued because they are located on the West Coast.. The report is written by the law firm's West Coast office and is clearly intended for West Coast companies, and the statistical analysis is clearly intended to convey meaning for those companies as West Coast companies.

But if plaintiffs’ lawyers really were targeting West Coast companies as West Coast companies in 2007, you would expect the lawsuits against the West Coast firms to have continued in 2008. Actually, the exact opposite has happened. While West Coast companies arguably were sued frequently in 2007, they have been sued infrequently in 2008. Through the first quarter of 2008, only six companies located in the Ninth Circuit have been sued in securities lawsuits, even though the number of filings overall in the first quarter  (52) was up compared the number of filings in 2006 and 2007, as I detailed in yesterday’s post.

The increased number of lawsuits against West Coast companies in 2007 can only have meaning for those companies as West Coast companies if the reduced number of lawsuits against West Coast companies so far in 2008 also has meaning for the companies as West Coast companies. The strong suggestion is that something other than geography alone explains both ends of this equation.

(As an aside, the potential role of geography in predicting securities lawsuit frequency was a recurring statistical question in my former life as a D & O underwriter. Brokers in the Midwest contended that Midwestern companies were less likely to be sued, and therefore all Midwestern companies should receive a D & O insurance premium discount. We could never prove that geography alone was an accurate predictor of securities litigation frequency; rather, what we found was that geography coincided with some other factor – usually industry – that was the true frequency predictor. An esteemed former colleague who taught me everything I know on this topic referred to this phenomenon as “multicollinearity “.)

The report also strains when it attempts to use the 2007 dismissals and settlements to analyze the 2007 filings.

Obviously, the cases that were dismissed or settled in 2007 were mostly filed before 2007. The fact that cases filed before 2007 were dismissed in 2007 really doesn’t tell you whether or not the cases filed in 2007 are meritorious or if “corporate malfeasance” is or is not “on the rise.” It is likely that the cases dismissed or settled in 2007 were actually filed over the course of several calendar years, so the raw numbers of dismissals, settlements and filings in a single calendar year may have little or no meaningful interrelationship, and further data (such as, for example, the total number and filing dates of pending cases) is required to make any useful comparisons or even to try to conclude, for example,  that West Coast courts have become "less receptive."  

The fact that median settlements in 2007 in the Ninth Circuit were lower than prior years’ median settlements tells you only that the median was lower. It does not tell you whether or not the 2007 settlements were “cheaper” than settlements in prior years in the Ninth Circuit or than 2007 settlements elsewhere, as these kinds of comparisons require not only the dollar figure at which the cases settled, but also the amount of investor loss that was at stake for each case category compared. Without further information, there is no way to know whether or not the lower 2007 median is simply due to smaller cases being settled in 2007 than in prior years in the Ninth Circuit, or in 2007 elsewhere. There is certainly nothing about the lower 2007 median alone that analytically supports the view that 2007 cases filed in California are “weaker than those filed in New York and elsewhere.”

The report’s commentary about the options backdating cases is interesting, and the most useful addition I can make to the report’s analysis about option backdating case dispositions is to refer readers to my running list of options backdating settlements, dismissals and denials, which can be accessed here.

And finally, because I can’t seem to write a concluding paragraph for this post without discretion making me hit the delete button, that’s a wrap.

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