Although there have been some significant exceptions in recent years, it is still generally the case that securities class action settlements are largely funded by D & O insurance. Yet the impact of D & O insurance on the process and ultimate value of securities lawsuit settlements is little understood outside the small world of practitioners in this area. In an excellent March 2, 2008 paper entitled “How the Merits Matter: D & O Insurance and Securities Settlements” (here), Connecticut Law School Professor Tom Baker and Fordham Law Professor Sean Griffith take a closer look at the role of D & O insurance on securities lawsuit settlements.

In this paper, the authors use a technique they have employed in their prior studies of D & O insurance (about which I previously commented here) – that is, in order to understand that actual workings of the D & O insurance industry, they have interviewed a wide variety of involved participants. In this case, they interviewed over fifty persons, including plaintiffs’ attorneys, defense counsel, insurance claims professionals, insurer’s monitoring counsel, and others. As a result of this practical approach, the authors have developed a realistic understanding of the actual settlement dynamics, and what emerges is a perceptive overview of the actual settlement process.

They describe a dynamic where the plaintiffs’ lawyers’ principle objective is to survive the motions to dismiss, and having passed that barrier, to maneuver the case to settlement. The question that often arises is whether the merits of the case matter to the ultimate amount of settlement. However, the absence of any significant trial-based data means there are no “experienced-based” ways to measure the plaintiffs’ likelihood of success on the merits.

The authors found that in the absence of trial-based data, the case settlements are influenced by a number of factors, including, for example, the presence or absence of “sex appeal” or the magnitude of potential damages involved. Case characteristics that might provide “sex appeal” include “SEC investigations, criminal charges, suspicious stock purchases program… and a variety of other case specific facts that cast the defendants’ motives or honesty in a bad light.” On this basis, a number of the individuals the authors interviewed expressed the view that the merits do sometimes matter.

But in addition, there are other “non-merits” factors that may affect the settlement, and “the most significant non-merits factor in the securities class action context is the ability to pay,” and the “willingness to pay that matters is, more often than not, that of the D & O insurer.”

The most significant value of the authors’ research and analysis is their detailed explanation of the role of D & O insurance in the securities lawsuit settlement process. The authors do a commendable job explaining the factors that limit the insurer’s ability to influence the process; the dynamics that drive plaintiffs’ and defendants’ counsel to align against the insurer; the effect that D & O limits and program structure have on the process; and how the other participants’ motivations interact with those of the D & O insurer.

Among the authors’ more provocative conclusions is their suggestion that "plaintiffs and defendants collude to pressure the D & O insurer to settle on terms that may nore reflect the ultimate merits of the claim."

The authors note  that “settlements are largely funded, often entirely, by D & O insurance,” as a result of which “insurance companies are the real parties in interest.” The consequence of this is that “the outcomes of securities class action lawsuits … are driven not by the opinion of a judge or the decision of a jury, but by the consent of the insurers.”

With this dynamic, and in the absence of trial-based data, the sole settlement reference points are prior settlements. Because of this, the authors note, “insurers are bargaining not in the shadow of the law, but in the shadow of prior bargains, at a further remove from decisions by judges or juries on the merits.”

In the end, the authors say that they “cannot draw a strong conclusion about whether the merits do or do not matter.”

They do conclude on the basis of their research that “non-merit factors contribute significantly” and accordingly they explore a couple of alternatives for making the merits matter more: first, they suggest, but sensibly quickly reject, the idea of requiring a specified number or percentage of securities cases to go to trial; and second, they advocate “mandatory disclosure of (1) the amount and structure of a corporation’s insurance coverage, and (2) information on how settlement and defense costs are funded.”

The authors’ advocacy of the compelled disclosure of D & O insurance information is clearly borne of their own frustration at the lack of access, as research academics, to this kind of information. It may be unfair to point out that few others are demanding disclosure of this kind of information. But it does seem fair to point out that even though the authors’ study of settlements was based on interviews with industry practitioners, they do not seem to have reviewed the idea of compelled disclosure with anyone in the insurance industry. If they had, I doubt they would find anyone who would support the idea.

In particular, insurance professionals would like have two areas of concern regarding the compelled disclosure of this information: (1) the impact of the disclosed information on an already complex commercial insurance environment; and (2) the possible impact of the disclosure of insurance information on which companies become lawsuit targets. The authors neither consider nor discuss these practical concerns.

I also wonder about the authors’ suggestion that compelling this information would do anything to make the merits matter more or to deter securities law violations. The authors’ own research shows that a multitude of factors can sometimes affect settlement amounts, including, for example,  the presence or absence of coverage issues or the existence of business considerations that compel a company to throw money at a case to make it go away, even without significant insurer contribution. The disclosure of the kind of information the authors advocate would of course provide research academics with extensive additional information to contemplate, but the possibility that this kind of disclosure would significantly affect the settlement dynamic, much less deter securities law violations, seems remote.  

In any event, the authors’ extensive review of the securities lawsuit settlement process makes a valuable contribution, particularly in their explanation of the role of D & O insurance in that process.

Special thanks to Professors Baker and Griffith for providing me with a copy of their excellent paper.