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

Lawsuits alleging violations of the securities laws showed a strong comeback in the third quarter of 2009, according to an Advisen report released on October 14, 2009 (here). The report, the latest in a quarterly series from Advisen, reports that securities lawsuit filings were up "solidly" in the third quarter after a relative decline in the second quarter. Advisen’s report is directionally consistent with my own prior analysis of third quarter securities class action lawsuit filings, which can be found here.

One absolutely critical thing to understand about the Advisen report is that it uses its own unique terminology. As reflected on page 2 of the report, the report uses the term "securities suit" to describe a broad range of lawsuits beyond just securities class action lawsuits. As used in the report, the term "securities suits" includes, beyond the class actions, regulatory and enforcement actions; collective actions outside the United States; lawsuits alleging common law torts, contract law violations and breaches of fiduciary duty; derivative actions; and any other "securities-related suit" that impacts management liability insurance policies other than ERISA liability suits.

In addition, the report uses the phrase "securities fraud suits" to describe regulatory and enforcement actions brought by the SEC and other regulatory and enforcement agencies. Importantly this category of "securities fraud suits" also includes "cases brought by private parties alleging violations of securities laws that are not styled as class actions."

The report notes with respect to the broader category of "securities suits," as that term is used in the report, that there were 169 "securities suits" in the third quarter, which represents an 11 percent increase over the second quarter of 2009.

The report also notes that there were 55 new securities class action lawsuits in the third quarter of 2009, up from 38 cases in the second quarter, but down from 59 in the third quarter of 2008. The securities class action filing rate through the first three quarters of 2009 annualizes to 220 new lawsuits, which is "below the 230 filed in 2008 but well within its historical range."

The class action securities cases were, however, only the second largest subcategory among the larger group of "securities cases" (as that term is used in the report) filed in the third quarter. The largest subcategory among "securities cases" in the third quarter was "securities fraud cases" (which, again, is the term that the report uses to describe securities-related regulatory and enforcement actions, as well as private securities suits that are not filed as class actions), of which there were 70, up from 50 in 2Q09.

Overall, the securities class action lawsuits continue to represent an increasingly smaller proportion of all "securities suit" filings. The report notes that the proportion of securities class action lawsuit filings as a percentage of all "securities suits" has "been on a long downward trend." Whereas in the past, securities class action lawsuits have represented a majority of all "securities suits," in the third quarter, securities class action lawsuits represented just 33 percent of all "securities suits."

The report also notes that though filings against financial firms "remained strong" in the third quarter, new filings were more "widely dispersed" among other sectors than in the first half of the year. The report also notes that new Madoff and credit crisis-related suits "dropped substantially" in the third quarter compared to the first half of the year.

The report also notes the "long-term trend of growing numbers of suits against non-U.S. companies." Specifically, the report notes "the number of large securities suit filings against non-U.S. companies" are on a "long-term growth path."

With respect to potential insurance, the report notes that there is a growing number of "securities suits" that potentially trigger insurance coverage other than D&O insurance. The report notes that this trend "started in 2008 and continued in 2009," largely due to the filing of credit crisis and Madoff-related lawsuits. These cases may even be excluded by D&O policies but covered by E&O or fiduciary liability policies.

The Advisen report introduces a couple of nifty new features this quarter. First, the report includes a "Sector Impact Metric," which is designed to show the degree to which "securities suits" hit various industrial sectors over the past decade. The other new feature is the "Market Cap Impact Metric," which measures the market capitalization loss experienced by companies with securities class action lawsuits.

Speaker’s Corner: On Friday, October 16, 2009 at 11 am EDT, Advisen will be hosting a webinar to discuss the third quarter, in which I will be participating along with Arthur J. Gallagher’s Phil Norton, Zurich’s Paul Schiavone, and Advisen’s David Bradford. The session will be moderated by Advisen’s Jim Blinn. In addition to reviewing trends of securities litigation during the third quarter, the panel will discuss appropriate D&O limits.Registration for the webinar can be found here.

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In a July 31, 2009 report , Advisen became the latest group to confirm that securities litigation declined in the second quarter of 2009, noting in its report entitled "Securities Litigation Drops in Q2 2009" (here) that securities lawsuit filings "fell off in the second quarter from the frantic first quarter." Advisen’s July 31, 2009 press release describing its study can be found here.

But while the Advisen report is consistent with the report released earlier by Cornerstone Research (refer here), NERA Economic Consulting (refer here), as well as my own prior report (here), the Advisen report takes a slightly different approach to the topic and as a result contributes an important additional perspective.

It is absolutely critical to note at the outset that in using the term "securities lawsuit," the Advisen report is describing a category broader than just securities class action litigation. In addition to the securities class action litigation, the Advisen report uses the term "securities lawsuit" to include shareholder derivative litigation; breach of fiduciary duty litigation; "securities fraud" litigation, which includes regulatory actions brought by the SEC; as well as other kinds of litigation.

Using this broad definition, the Advisen reports that there were 121 "securities lawsuit" filings in the second quarter, down from 212 in the record-setting first quarter. Overall the first half "securities lawsuit" filings were within although slightly below historical norms.

The Advisen report notes that there were 37 new securities class action lawsuit filings in the second quarter, down from 70 in the first quarter. The 107 first half securities class action lawsuit filings would translate into 214 filings on an annualized basis, "in line with most recent years."

In speculating on the reasons for the first half decline, the Advisen report comments that the first half filings seem to have been "frontloaded" into the first quarter of the year. The report also states that "the second quarter could represent a lull in litigation activity while law firms worked on the flood of suits from the first quarter." The report does note (as I also observed, here) that "the first few weeks of the third quarter have seen a surge in securities suits once again."

The Advisen report also states that there were 41 settlements/awards in securities lawsuits in the second quarter of 2009, including the $2.9 billion jury award against Richard Scrushy in the HealthSouth shareholders’ derivative lawsuit. Taking the Scrushy award into account, the average settlement/award in the second quarter was $101.5 million, but if the Scrushy award is disregarded the average settlement/award drops to $60.0 million. The average securities class action settlement in the second quarter was $74.5 million, a quarterly average amount the report describes as "quite high."

The report has a number of other interesting observations, many of which have been noted in the previously released reports, including the concentration of the litigation activity in the financial sector; the increasing level of litigation involving foreign domiciled companies; and the elevated levels of activity involving the Ponzi scheme allegations.

Advisen Webinar: Advisen will be hosting a free webinar to discuss the findings in its second quarter report on August 3, 2009 at 11 am EDT. I will be participating in the call along with David Bradford and John Molka of Advisen, Randy Hein of Chubb and Tripp Sheehan of Marsh. For further information about the call and to register, refer here.

About Those July Securities Filings: The Advisen report mentions that in the first month of the third quarter, securities class action lawsuit filings seem to have ramped up again. Just to detail that point, by my count, there were at least 16 new securities class action lawsuits filed in July, which is a filing rate that is back at historical levels.

With respect to the new July filings, it is also interesting to note how few of these new lawsuits were in the financial sector. While five of the new lawsuits involve financial companies, the other eleven did not, which is sort of the exact opposite of the equivalent proportions for the first half of the year. Of the eleven new suits involving nonfinancial companies, as many as seven involved companies involved in the life sciences sector.

The other interesting thing about these July filings is how many of them involve purported class periods ending dates that are well in the past, as I previously noted here. To cite the most recent example, the purported class period in the July 30, 2009 securities class action lawsuit filing against International Game Technology (refer here) ends on October 30, 2008.

The July filings seem to me to be consistent with the hypothesis that the downturn in securities class action filings during the second quarter was just a temporary lull. In addition, the July filings are inconsistent with the hypothesis that the plaintiffs’ lawyers are running out of targets to sue. Rather, the July filings suggest to me, as I have speculated elsewhere, that the plaintiffs’ lawyers ran into a logjam during the second quarter and as they ran up a backlog of cases to be filed against nonfinancial companies. All of the evidence so far in the third quarter is entirely consistent with this final hypothesis.

One Thing the Plaintiffs’ Lawyers Were Up to During the First Half: As I also noted elsewhere, though the plaintiffs’ lawyers’ may not have been filing new securities class action lawsuits during the second quarter, they were by no means idle. A July 31, 2009 press release (here) by the Tramont Guerra & Nunez firm, issued in response to the various published reports regarding the decline in second quarter filings, provides some insight into at least one particular way the plaintiffs’ lawyers were otherwise occupied during the second quarter.

According to the press release, Finra’s dispute resolution statistics show an 82% increase in the arbitration claims for the first half of the year, with the majority of claims filed for breach of fiduciary duty and misrepresentation. Finra’s statistics can be found here. As I said, the plaintiffs’ lawyers were not idle.

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 The 2009 securities lawsuit filings have been characterized by an overall decline in filing activity, particularly in the second quarter, as well as the continued prevalence of lawsuits against financial sector issuer-defendants, according to a July 20, 2009 study by the Stanford Law School Securities Class Action Clearinghouse in cooperation with Cornerstone Research. The study, which is entitled "Securities Class Action Filings: 2009 Mid-Year Assessment" can be found here. A July 20 press release describing the study can be found here. My own prior study of the first half securities lawsuit filings can be found here.

According to the Cornerstone study, there were 87 securities class action lawsuits filed in the first half of 2009, which represents a 22.3 percent decline from the 112 securities suits that were filed in both the first half and the second half of 2008. The first half filings project to an annual filing rate of 174 securities class action, which would represent a 22.3 percent decrease from 2008 and an 11.7 percent decrease from the annual average for the 12 years ending in December 2008.

The drop in new filings was particularly pronounced in the second quarter of 2009, as only 35 of the 87 new filings occurred during the second quarter. The Cornerstone Report notes that over the same period, there was "a similarly dramatic decline" in the stock market volatility measured by the Chicago Board Options Exchange Volatility Index. The report also suggests that the "decline in market volatility raises the possibility of a return to the subdued levels of filing activity observed from the third quarter of 2005 to the second quarter of 2007."

Filings against companies in the financial sector predominated in the first half of 2009, as financial companies were named as defendants in 66.7 % of the first half filings. Slightly less than 50% of the first half filings were related to the credit crisis, as 42 of the 87 first half filings contained allegations related to the credit crisis.

The 2009 mid-year report contains a couple of new metrics. The first measures the number of unique issuers whose exchange-traded securities were involved in class action lawsuits. The metric shows that the number of lawsuits against unique exchange traded issuers has declined even more rapidly than the overall number of new lawsuits. The decrease is "driven by a large number of filings related to non-exchange trade securities and private companies" in the first half of 2009. These suits relate to Ponzi scheme allegations as well as other filings "related to mortgage-backed securities, preferred stock and open-ended mutual funds."

The other new metric in the mid-year report measures the number of filings against defendant corporations headquartered outside the United States. The metric shows that the number of suits against non-U.S. companies has been gradually increasing over the years, from only 6.8 percent of all filings during the period 1997 through 2003 to 13.8 percent in 2008. This upward trend continued in the first half of 2009, with 20.7 of all filings against non-U.S. companies, largely due to cases against foreign domiciled companies in the financial sector. Interestingly, this increase in litigation activity has coincided with a decrease in the share of foreign companies listed on the major U.S. exchanges.

In terms of the potential damages involved in the first half filings, the report’s detailed analysis shows that the 2009 filings are characterized by a decrease in losses associated with announcements at the ends of class periods and an increase in overall market capitalization losses for the entire class periods.

The report notes that since the end of 2008, there has been an "unprecedented" concentration of new Ponzi-scheme related filings. The Madoff scandal has resulted in five filings in the second half of 2008 and 15 in the first half of 2009, and there were four additional Ponzi scheme-related filings unrelated to Madoff in the first half of 2009.

The report concludes with an observation of the heightened number of bank failures during 2009, adding the observation that only 21 of the 45 banks that had failed through June 30, 2009 were publicly traded, and only one of the bank failures has resulted in a securities class action lawsuit.

The report’s new metric related to number of lawsuits against unique exchange-traded issuers is particularly useful for observers of public company litigation trends. Though the numerous lawsuits against private firms and mutual fund companies are interesting and important, those developments are less likely to affect the overall market for public company directors and officers liability insurance. In that respect, the Cornerstone report’s observation that the decline in lawsuits against unique publicly traded companies is even more pronounced than the overall decline in lawsuit filings is a particularly significant observation. The addition of this new metric is a particularly useful and welcome addition to Cornerstone’s reporting on litigation activity.

The report’s suggestion that the decline in lawsuits is linked to a decline in market volatility is also particularly interesting, as is the observation that lower volatility may mean a return to the low filing activity of the period mid-2005 through mid-2007. My own view, expressed in my prior post (here), is that the decline in lawsuit filing activity during the second quarter arose because plaintiffs’ lawyers found themselves in a logjam, due to the onslaught of Madoff-related litigation and the fact that many of the previously filed credit crisis cases had reached critical procedural stages.

The filings so far in July have in fact been characterized by the number of lawsuits outside the financial sector, many with class period ending dates considerably before the filing dates, which does suggest that plaintiffs’ lawyers are to a certain extent working off a backlog. Of course, the pace and nature of the second half filing activity overall remains to be seen.

ABA TIPS Panel: The Financial Collapse -- What Caused It and How Will It Continue To Impact Corporations and Their Boards?: The American Bar Association Tort Trial & Insurance Practice Section (TIPS) Task Force on Corporate Governance will hold this meeting at the ABA Building in Chicago on July 30, 2009 as part of the ABA Annual Meeting, to discuss the 2008 financial collapse and how corporations can manage risk throughout the remainder of the ongoing crisis.

I will be participating in this free session, which will be chaired by my good friend Kim Hogrefe from Chubb. The panel will also include Fiona Phillip of Howrey LLP and Dr. Faten Sabry of NERA Economic Consulting. The event will be followed by a reception. More information about the event, including event registration can be found here.

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The numbers are unambiguous – there were more securities lawsuits filed in the second half of 2008 than there were in the first half. Nevertheless commentators and observers continue to repeat the mistaken conclusion that there were fewer lawsuits filed in the second half, and even to try to discern some significance from a decline that never, in fact, occurred.

Here are the facts. As reflected on the Stanford Law School Clearinghouse Securities Class Action Clearinghouse website, which helpfully indexes the securities class action filings by quarter (here), there were 112 securities lawsuits filed in the first half of 2008 and 114 in the second half.

Not only were there more lawsuits filed in the second half of the year, but there were more lawsuits filed in the fourth quarter (65) than any other quarter during the year. Indeed, there were more lawsuits filed in December (30) than any other month during the year.

Clearly, the fact that securities lawsuit filings in fact accelerated at the end of 2008 potentially has far different implications for the future than the mistaken impression that lawsuit filings were declining.

The source of the impression that there were fewer lawsuits in the second half of 2008 is the year-end securities lawsuit filing Report jointly published by the Stanford Law School Clearinghouse and Cornerstone Research. The Report, which can be found here, considered only lawsuit filings through December 15, 2008. As I noted at the time the Report was first published (here), by omitting the last two weeks’ lawsuit filings, the Report not only excluded at least 12 lawsuit filings from its analysis, but it also reached a conclusion, inconsistent with the actual aggregate year-end data, that lawsuit filings had declined in the year’s second half. When lawsuit filing data through December 31 are considered, it is clear that the number of filings did not decline in the year’s second half.

What difference does it make whether or not lawsuit filings declined in the second half? Well, a discussion of the reasons for a lawsuit filing decline is a far different conversation that a debate over the reasons why lawsuit filings accelerated in the year’s final quarter and month. The repetition of the impression that lawsuit filings were declining when in fact they were accelerating not only perpetuates a misunderstanding of what actually happened, but it also allows the possibility that decisions could be made or conclusions reached based on a faulty premise.

Unfortunately the conclusion that securities lawsuit filings declined in the second half of 2008 continues to be repeated. As reflected in a February 9, 2009 Business Insurance article (here), industry observers continue to distract themselves and perhaps others as well debating the reasons for a lawsuit filing decline that never happened, when in fact the actual discussion ought to be the reason why lawsuit filings actually accelerated at the end of the year.

The danger from this mistaken conclusion is apparent in the remarks of one leading industry observer at a recent conference. As quoted in the Business Insurance article, the observer noted, in apparent reliance on the Cornerstone report, that “in this last quarter, there were actually fewer cases filed. It got better, not worse at the end of the year.” The world certainly looks a lot different if you think things recently “got better”; unfortunately, they didn’t get better, they got worse.

The D&O insurance industry has a hard enough time behaving rationally and making sense of what has actually happened. It would be extremely unfortunate if the industry were to become even further confused by a conclusion that unsupported by full-year data.

I entreat readers to do everything they can to make sure that the misimpression about securities lawsuit filing activity levels is not perpetuated. The industry faces too many other challenges to have to deal with the added burden of laboring under misimpressions.

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