When the Cornerstone Research and the Stanford Law School Securities Class Action Clearinghouse released their "2006 Mid-Year Assessment" earlier this week, the Report showed a 45% decline in the number of securities lawsuits filed in the first half of 2006 compared to the prior year period. According to the Report, the 61 securities class action lawsuits filed in the first half of 2006 represents the lowest level of securities lawsuit activity since 1996. The Report suggested a number of possible reasons for the decline, including the dissipation of the ill effects from the boom and bust period of the late 90s; the cleansing effects of Sarbanes Oxley; and the absence of stock market volatility. A prior D & O Diary post discussing the Report may be found here.

The D & O Diary finds the Report’s explanations for the litigation decline plausible, but insufficient. There is another possible explanation that, while cynical, may come closer to the truth.

Another hot topic in the securities law arena shows that sometimes only a cynical view can get at the truth. For years, academics had had been aware of a statistical pattern showing that share prices often rose quickly after options were granted. The early researchers speculated that corporate executives who knew that good news was on the horizon and made sure that options were granted beforehand. According to the May 30, 2006 Wall Street Journal(subscription required) article describing his research, when Erik Lie (now a Professor at the University of Iowa Business School) examined options grants as part of his doctoral research, he "found a striking pattern in which prices fell before the grant date, and rose soon afterward. He also discovered that the stock market as a whole also often rose following option grants at certain companies." Dr. Lie found it "uncanny" how good the executives apparently were at predicting future stock prices. He became suspicious, and when he released his research, he suggested that at least some of the awards had been timed retroactively. Other academics thought his explanation to "sinister" and rejected it. It was not until his research appeared in a front page Wall Street Journal article that his cynical explanation for a widely observed phenomenon was accepted. Professor Lie was just cynical enough to be able to explain a widely observed but inexplicable set of facts.

Perhaps a similarly cynical view may also explain the decline in securities lawsuit filings.

An alert D & O Diary reader commented that the decline actually began in September 2005. It was this observation that raised the possibility to me that the answer to the frequency decline may lie in the Milberg Weiss indictment. Paragraphs 26 and 27 of the First Superseding Indictment (which may be found here) provide as follows:

26. During the time relevant to this Indictment, MILBERG WEISS brought numerous class actions and shareholder derivative actions against publicly traded companies and other major businesses. These lawsuits generated hundreds of millions of dollars in attorneys’ fees for MILBERG WEISS. To bring these lawsuits, MILBERG WEISS needed persons who would agree to serve as named plaintiffs, and whom the courts would likely approve to represent absent class members or shareholders.

27. Beginning at least as early as in or about 1981 and continuing through at least 2005, in order to facilitate the recruitment of named plaintiffs, MILBERG WEISS, BERSHAD,SCHULMAN, and others known and unknown to the Grand Jury agreed to and did secretly pay kickbacks to named plaintiffs in class actions and shareholder derivative actions in which MILBERG WEISS served as counsel. Specifically, MILBERG WEISS, BERSHAD, SCHULMAN, and others known and unknown to the Grand Jury agreed to and did pay to certain individuals a substantial portion of the attorneys’ fees MILBERG WEISS obtained in actions in which such an individual served, or caused a relative or associate to serve, as a named plaintiff for MILBERG WEISS.

These of course are mere allegations and the defendants are entitled to a presumption of innocence. But if we assume for the sake of argument that these allegations are true, several things are clear: Milberg Weiss "needed" the paid plaintiffs because without them they could not have made hundreds of millions of dollars in fees. Milberg Weiss certainly would not have paid people to serve as plaintiffs if there were people willing to do it for free. Lacking volunteers, the firm employed mercenaries. The paid plaintiffs were an indispensable component in the firm’s ability to produce inventory — leading one to wonder whether production would have ceased or at least declined if the component supply were cut off?

Milberg Weiss now stands accused of paying kickbacks. Milberg Weiss may have drawn the prosecutors’ attention because of its prominence, and perhaps even because of the scale of its reliance on paid plaintiffs, but if it happened, is it possible that they were the only firm relying on paid plaintiffs? Or is it more likely that in the highly lucrative but highly competitive world of the plaintiffs’ securities bar that these practices were widespread?

The indictment alleges that the practice of paying plaintiffs continued "through at least 2005," right about the time it started to look as if the prosecutors were serious about pursuing Milberg Weiss criminally. The grand jury investigation was well publicized, so it became pretty clear that paying plaintiffs could lead to trouble, and, it may be presumed, the practice stopped. Right about the time that the securities lawsuit frequency started to decline.

Is it possible that securities lawsuit frequency is declining because the threat of criminal prosecution has disrupted supply of a key component in the plaintiffs’ lawyers’ most important product – that is, without the ability to pay people to serve as named plaintiffs, the plaintiffs’ lawyers can’t find anyone else to do it so they are producing fewer lawsuits? Is it possible that the lawsuits that depended on paid plaintiffs just aren’t getting filed?

The D & O Diary is interested in your comments.

D & O Insurers’ Exposure to Backdating Lawsuits: According to John Degnan, the Chief Administrative Officer of Chubb, "[t]he early hype about the impact of backdated stock options on D & O insurers may be overblown." According to news reports, Degnan cites several reasons why Chubb’s exposure may be limited:

In most cases, Chubb is only an excess carrier, so it’s not immediately exposed to costs related to directors’ and other executives’ legal costs as they defend backdating allegations, he explained. (Excess of loss insurance only kicks in when losses breach certain thresholds).

Chubb has also limited the maximum payouts on the D&O policies it writes. Limits are now "far lower" than they were when the corporate scandals of earlier this decade struck, Degnan added.

Chubb usually only insures one chunk of potential losses on each D&O policy it underwrites. That should help it avoid lots of different losses piling up, Degnan said.

Share price drops in the backdating scandal have been limited so far, which should keep securities class action lawsuits to a minimum, he also noted.

Most of the claims Chubb has received so far come from derivative lawsuits, which are harder for plaintiffs to win and usually result in smaller settlements, Degnan said

Nineteen companies have notified St. Paul Travelers of stock option-related claims or potential claims under their policies covering directors or officers, according to Chief Operating Officer Brian MacLean. Of those, St. Paul Travelers is the primary insurer at only one company, and there is a $10 million limit on that policy, he said."We believe that based on the facts today this is not going to be a big issue for us," he said. McLean’s comments may be found here.