On April 5, 2012, President Obama signed into law the Jumpstart Our Business Startups Act (commonly referred to as the JOBS Act). This legislation, which enjoyed strong bipartisan support in Congress, is intended to ease the IPO process for emerging growth companies and to facilitate capital-raising by reducing regulatory burdens and disclosure obligations. Among other things, the Act also introduces changes that could impact the potential liability exposures of directors and officers of both public and private companies. These changes could have important D&O insurance implications.

 

In the latest issue of InSights, I take a detailed look at the provisions of the JOBS Act and consider the Act’s possible impact on D&O liability and insurance. The InSights article can be found here.

On March 30, 2012, in a decision that may highlight the extent to which Canadian courts are increasingly willing to enforce securities laws in ways that may have extraterritorial effects, the Ontario Court of Appeals held that the liability regime under the Ontario Securities Act applies to Canadian Solar, a company whose shares trade only on NASDAQ and that do not trade on any Canadian exchange, and that has its principal place of business in China. A copy of the Court of Appeal decision can be found here.

 

Background

An Ontario resident initiated a putative class action lawsuit against Canadian Solar under the Ontario Securities laws, alleging that the company overstated its financial results. Section 138.3 of the Ontario Securities Act creates a cause of action in the event of a misrepresentation by a “responsible issuer.” The statute defines “responsible issuer” as a reporting issuer or “any issuer with a real and substantial connection to Ontario, any securities of which are publicly traded.”

 

Canadian Solar is not a “reporting issuer.” Its shares are listed only on NASDAQ. Its shares do not trade on any Canadian exchange. Canadian Solar’s principal place of business is in China. However, it is registered as a Canadian federal corporation with its registered office and executive offices in Ontario.

 

A motions judge held that Canadian Solar is “responsible issuer” within the meaning of the statute. Among other things, the motions judge held that Canadian Solar’s shares did not have to be publicly traded in Canada for it to come within the definition of “responsible issuer.” Canadian Solar appealed this aspect of the motions judge’s ruling, arguing that only a company whose shares were publicly traded in Canada came within the definition of a “responsible issuer.”

 

The Ruling of the Court of Appeals

In a March 30, 2012 opinion, written by Justice Alexandra Hoy for a three-judge panel, the Ontario Court of Appeal s held that “the general principles with respect to extraterritorial regulation do not require that the definition of ‘responsible issuer’ be interpreted as confined to issuers any of whose securities are publicly traded in Canada.” Justice Hoy added that “there is a sufficient connection between Ontario and Canadian Solar to support the application of Ontario’s regulatory regime to Canadian Solar.”

 

Among other things, in connection with the sufficiency of the connection to Ontario, the court also noted that the plaintiff , “an Ontario resident who placed his order in Ontario for shares of a corporation based in Ontario, would reasonably expect that his claim for misrepresentations in documents released or presented in Ontario would be determined by an Ontario court.”

 

Discussion

The Ontario Court of Appeals decision in the Canadian Solar case is interesting and potentially significant because of its holding that the secondary market misrepresentation damages class action under the Ontario securities laws could be asserted against a company even though the company’s securities were not publicly traded in Canada. Because all of the Canadian provinces have enacted legislation simalar to Ontario’s (similar at least in this respect), the decision could have implications across all of the Canadian provinces. There obviously are factors that made this situation somewhat distinct, if not perhaps unique; Canadian Solar is a Canadian registered corporation with both its registered office and its executive offices in Ontario. In addition, the plaintiff, an Ontario resident, purchased his Canadian Solar shares in Ontario.

 

Nevertheless, as noted in an April 4, 2012 memo from the Osler, Hoskin & Harcourt law firm (here), the Court’s decision “makes it clear that non-reporting issuers whose shares do not trade anywhere in Canada may nevertheless find themselves subject to Ontario’s liability regime for misrepresentations made in the secondary market, provided however that the issuer has a ‘real and substantial connection’ to Ontario.”

 

At a minimum, as discussed in a May 2012 memo from the Blake, Cassels & Graydon law firm (here), the Canadian Solar opinion provides “possible guidance that may be instructive to determining when a real and substantial connection exists for purposes of the statute.” In particular, the memo also notes, it appears that “there is no one factor that will insulate companies from Canadian securities law.”

 

The Blake law firm’s memo goes on to suggest that “it is feasible that the current state of the law may result in Ontario and other Canadian jurisdictions becoming the forum of choice for shareholders attempting to seek remedies even where the connection to Canada is tenuous.” What remain to be determined in future cases, as the Osler, Hoskin law firm’s memo notes, “is the extent of the connections that other foreign issuers will be required to have with the province before they will be considered ‘responsible issuers’ for purposes of” the statute.

 

In the wake of the U.S. Supreme Court’s decision in Morrison v. National Australia Bank, one of the questions that has been asked is whether another jurisdiction will emerge as an alternative forum in which aggrieved investors precluded from U.S courts can pursue their remedies. The Canadian Solar case provides an interesting point of view on the consideration of these issues, given that because the company’s shares trade on NASDAQ, an action against the company and its directors and officers under the U.S. securities laws is not precluded under Morrison. (Indeed, a separate action against the company has been filed in the United States, about which refer here.)

 

Nevertheless, the case does provide interesting additional insight into the possible availability of Canada as an alternative forum. This possibility was already the subject of a great deal of focus since Canadian courts have certified a global plaintiff class in the Imax case (about which refer here), and in the Arctic Glacier case (about which refer here). 

 

The possibility that the Canadian courts might emerge as an alternative forum of choice seems to be advanced by the Court’s holding that it is not preclusive of an action under the relevant laws that the defendant company’s share were not traded on a Canadian exchange. Of course there were many other factors involved in this case that supported the application of the Ontario laws here that are not going to be present in many other cases. Nevertheless, the case does reflect a willingness by Canadian courts to apply its laws to cases with significant foreign aspects as well.

 

Much has been written recently (including on this blog) about the growing prevalence of M&A related litigation. These lawsuits, typically launched by the target company shareholders, are filed shortly after a merger announcement and usually object to some aspect of the proposed merger or of the merger-related disclosure. But the merger objection lawsuit is not the only kind of lawsuit that mergers can produce – there is also the kind of lawsuit that can arise post-merger when, it is alleged, the merger was not successful.

 

In a recent example of this second kind of merger lawsuit, on May 2, 2012, plaintiffs filed a shareholder class action lawsuit in the Northern District of Illinois against Allscripts Healthcare Solutions and two of its officers. Allscripts is, according to the complaint, the “corporate result” of the merger of Allscripts-Misys Healthcare Solutions and Eclipsys Corporation, which was announced on June 9, 2010.

 

The complaint references the company’s April 26, 2012 filing on Form 8-K (here), in which the company “shocked the market” by reporting earnings sharply lower than guidance, as well as the termination of the Chairman of the company’s board of directors; the resignations of three other directors; and the resignation of the company’s CFO. According to the 8-K, the termination and resignations followed board discussions regarding the leadership of the company. The complaint alleges that in reaction to the news the company’s share price dropped sharply.

 

According to plaintiff’s counsel’s May 2, 2012 press release (here), the complaint alleges that during the class period:

 

Allscripts concealed that: (a) the process of developing a unified product offering after the Merger had suffered debilitating setbacks, including major undisclosed schisms among the most senior levels of the Company, which ultimately resulted in the loss of key personnel and harmful upheaval in Company leadership; (b) a material portion of Allscripts’ revenue and net income was predicated on the successful integration of these systems, and substantial business relationships had been destroyed by the Company’s inability to make material progress in this area; and (c) as a result of the foregoing, Allscripts lacked a reasonable basis for its claims of progress in post-Merger integration, sound operations, profitable results, and continued growth.

 

This latest lawsuit exemplifies the second type of merger-related lawsuit, typically filed post-merger and typically alleging that the merger did not live up to expectations. Perhaps the highest profile example of this type of lawsuit is the litigation filed in July 2002 in the wake of the failed AOL Time Warner merger. That litigation ultimately resulted in a settlement of $2.5 billion (not to mention extensive additional opt-out settlements), which is the seventh largest securities class action lawsuit settlement of all time.  

 

Another high-profile case of this same type is the lawsuit that was filed in 2000 following the December 1998 merger transaction that led to the formation of Daimler Chrysler. That case ultimately settled for $300 million.

 

Nor are high-profile mergers the only types of transactions that can produce this type of merger-related litigation. For example, in September 2011, shareholders filed a securities class action in the Northern District of California against Equinix and certain of its directors and officers, in which the plaintiffs disclosed that the company was having difficult with the integration of Switch & Data Facilities Company, which Equinix had acquired in April 2010. (To be sure, in March 2012, the court granted the defendants’ motion to dismiss, albeit with leave to amend.)  

 

My point here is that the merger objection cases are not the only type of litigation that mergers and acquisitions activity can generate. As these examples show, there is also the possibility that to the extent the merger does not live up to expectations (or rather – allegedly does not live up to expectations) there could be post-merger litigation as well. These post-merger suits may either allege (as was the case in the Daimler Chrysler litigation) that the merger related documents contained misrepresentations, or that the company made misrepresentations regarding its post-merger operations or merger-related integration (as was the case in the Equinix case and in the recently filed Allscropts case). At some level it is hardly surprising that litigation might arise post-merger from time to time, given that – depending on who you ask – “mergers have a failure rate of anywhere between 50 and 85 percent.”

 

Indeed the possibility of a lawsuit alleging that the merger did not live up to expectations is itself not the only type of post-merger litigation that can arise. Another variant that can sometimes arise is the post-merger lawsuit alleging that the surviving company failed to properly account for the transaction or to properly present the financials of the combined companies. An example of this latter type is the July 2011 lawsuit filed against JBI, Inc. and certain of its directors and officers, in which the plaintiff alleged that the company did not properly account for certain media credits it had acquired in connection with an acquisition transaction.

 

All of which serves to underscore a point which has long been known to D&O underwriters – that is, the mergers and acquisitions transactions provide context out of which litigation sometimes (perhaps frequently) arises. The recent rise in merger objection litigation has certainly amplified this point. But as the examples in this blog post demonstrate, there are other types of lawsuits beyond the merger objection cases that can arise in connection with or following a merger transaction.

 

Are We There Yet?: One of the huge by-products of the July 2010 enactment of The Dodd-Frank Act is the huge rulemaking burden that the Act imposed on a variety of federal agencies. As I have noted in a prior post (here), the agencies have been laboring under the rulemaking burdens, and in many cases have fallen far beyond their rulemaking deadlines the Act required.

 

Although there obviously is no joy in the exercise, the Davis Polk law firm has been diligently tracking the agencies’ rulemaking progress. In its May 2012 Dodd-Frank Progress Report (here) the law firm details the current status of the agencies’ rulemaking efforts.

 

Among other things, the study shows that as of May 1, 2012, a total of 221 Dodd-Frank rulemaking requirement deadlines have passed. Of those 221, 148 (67%) have been missed and 73 (33%) have been met with finalized rules. Regulators have not yet released proposals for 21 of the 148 missed deadlines.

 

Of the total of 398 rulemakings that Dodd-Frank required, 108 (27.1%) have been met with finalized rules and 146 rules have been proposed that would meet the requirement  (36.7% more). Rules have not been proposed to meet 144 (36.2%) rulemaking requirements.

 

The Dodd-Frank Act’s rulemaking juggernaut grinds onward. Your government at work. At the direction of Congress.

 

A great deal of the analysis of securities class action lawsuit settlements revolves around measures of aggregate, average and median settlement amounts. These data, while useful, are relatively unhelpful in trying to anticipate the outcome of any particular case, particularly at the outset. To try to develop a way to predict likely case outcome at the outset of a securities class action lawsuit, four academics conducted a detailed statistical analysis of securities class action settlements in order to identify factors that affect outcomes.

 

In their April 30, 2012 paper entitled “Predicting Securities Fraud Settlements and Amounts: A Hierarchical Bayesian Model of Federal Securities Class Action Lawsuits” (here), Northwestern University Business Professor Blakeley McShane, Juridigm Principal and Vice President Oliver Watson, U. Penn Law Professor Tom Baker and Fordham University Law Professor Sean Griffith set out to create a “predictive model to forecast case outcomes based exclusively on information available at the time the lawsuit is filed.”

 

Their model, described in their paper, “estimates (i) the probability of the settlement versus dismissal of a securities class action lawsuit and (ii) the amount for which the class action will settle conditional on the settlement.”

 

A great deal of the authors’ paper is devoted to a description of the methodology used to derive the data on which their analysis is based. Another significant part of the paper is devoted to a description of their analytic methodology, which, as their title suggests, employs high level statistical approaches and techniques. A detailed description of the authors’ data derivation and statistical methodologies is beyond the scope of this blog (which is another way of saying that I know my limits).

 

For purposes of understanding the authors’ conclusions, it is useful to note that the authors derived a data set of nearly 1200 securities class action lawsuits and associated case resolutions. Among other critical steps taken to derive their data set, the authors focused exclusively on cases filed post-PSLRA that were filed five years or more before the starting date of their analysis. (The five year cut-off was used to ensure the likelihood that the cases in the data set had been finally resolved). Essentially, the authors looked at cases filed between 1996 and 2005 that otherwise survived the authors’ filters and sorting criteria.

 

The authors also derived several of their own measures using variety of data sources. For example, in order to determine the “notoriety” or “newsworthiness” of a particular company or case, the authors considered the number of Google News Archive hits associated with the company in the year prior to the lawsuit filing.

 

Using these and other data points and applying selected statistical methods to develop their model, the authors identified a number of variables predictive of whether a case is settled or dismissed, and variables predictive of the settlement amount if a case is settled.

 

The variables the authors identified that indicate that a case will most likely settle include “a number of classes or types of securities associated with the case, a higher return on the S&P 500 during the class period, whether or not GAAP violations were alleged and having an individual plaintiff listed.” Factors that indicate that a case is less likely to settle (that is, more likely to be dismissed) include “longer filing times, higher market capitalization, a higher company return during the class period, having an institutional plaintiff listed, and greater public notoriety (as measured by the number of Google hits in the year prior to filing).”

 

The variables the authors found that positively impact the settlement amount include “the total number of securities, the length of the class period, market capitalization, the company return during the class period, whether or not earnings were restated, whether or not the case was a Securities Act Section 11 case, whether or not insider trading was alleged, the existence of an institutional plaintiff, and the number of Google hits.” Factors associated with lower settlement amounts include “longer filing times and not having an institutional investor listed (i.e., having only an individual plaintiff listed or having no plaintiff listed).”

 

The authors also found that though GAAP cases are more likely to settle, the GAAP cases that do settle do not have higher settlement amounts. The authors speculate that this is likely due to the fact that an allegation of a GAAP violation significantly bolsters the merits of the case, which increases the chances the case will survive a dismissal motion. The authors suggest that this makes it more appealing for plaintiffs to take on a GAAP violation case even if the potential damage award is relatively low.

 

At the same time, Rule 10b-5 cases are less likely to settle (that is, more likely to be dismissed) but those that do settle have higher settlement amounts. The authors attribute this to the greater damages available to Rule 10b-5 plaintiffs. The authors suggest that plaintiffs rationally might be willing to pursue cases with a lower survivability probability when the cases are likelier to have larger settlements, assuming the cases survive dismissal. Cases without institutional plaintiffs are more likely to survive motions to dismiss, which the authors interpret to suggest both that institutional investors select the high potential value cases and that plaintiffs’ lawyers exercise more care regarding the merits of cases with only an individual plaintiff.

 

The authors also noted a number of differences among the various circuits and industries. For example, the authors note that the eleventh circuit appears to have modestly lower settlement amounts whereas the ninth and tenth circuits have modestly higher settlement amounts. Similarly, utilities have somewhat higher settlement amounts.

 

Discussion

I have necessarily summarized here the authors’ much more detailed analysis. The only way to fully understand and appreciate the authors’ predictive analysis, as well as the ways in which the authors’ conclude that the various factors are predictive, is to read their paper in full, which I recommend.

 

I do note that the ability to predict case outcomes at the outset is important for a number of process participants, including in particular the affected D&O insurers. Among other things, D&O insurers must have reliable means to assess and predict case outcomes at the outset in order to try and set case reserves appropriately. In addition, D&O insurers whose coverage attaches only in the excess layers will want to be able to assess cases at the outset in order to try to determine the likelihood that losses associated with any particular claim will penetrate their attachment point. For the involved D&O insurers, the authors’ predictive model could provide a useful tool.

 

The authors’ model could prove a useful tool for the defendant companies themselves as well as for their defense counsel. It is critically important for companies and their counsel in setting their litigation strategy to have an accurate understanding of the seriousness of the claim.  The authors’ model may provide a useful way for companies and their counsel to make a realistic assessment of the seriousness of the case in order to try to set defense strategy appropriately.

 

If I were to make one suggestion to the authors in order to make their analysis more accessible, it would be to expand their summary description of the relevant factors so that the factors are not only identified but also so that the nature of their relevance is more apparent. For example, it is of course important for the authors to state in the summary of their conclusions that, for example, “the length of the class period” is a relevant factor positively impacting settlement. It would be even more helpful for the non-mathematician reader for the authors to explain in the conclusion section how the variation of the length of the class period affects the settlement (that is, is it a shorter or a longer class period that positively affects the settlement?). A more detailed explanation in the paper’s discussion section of the authors’ specific conclusions with respect to each of the identified factors would make the authors’ otherwise somewhat intimidating paper more approachable to a wider variety of readers and would make the authors’ conclusions both clearer and more useful for those trying to understand the implications of the authors’ analysis.

 

I would like to thank Professor Tom Baker for providing me with a copy of this interesting paper.

 

UPDATE: Following my publication of this post, and in particular in response to my comments about the paper, one of the paper’s authors, Blakeley McShane, contacted me with a supplement to the article, to provide further explanation of the paper and its conclusions. Because I think the supplement significantly aids an understanding of the paper, I have reproduced the supplement in full below. My thanks to McShane for taking the time to prepare a detailed supplement and for his willingness to allow me to publish it here. Here is the supplement: 

 

Thank you for your interest in our paper “Predicting Securities Fraud Settlements and Amounts: A Hierarchical Bayesian Model of Federal Securities Class Action Lawsuits” which is forthcoming in the Journal of Empirical Legal Studies. We really enjoyed reading your write-up of our results and wanted to follow up on your last paragraph where you requested a more friendly description of the effect of each variable. We will attempt to be as clear as possible and focus on our “best guess” of the effect of each variable (i.e., the dots in Figures 8a and 9a respectively). Of course our estimates are subject to uncertainty (indicated by the thick and thin lines of Figures 8a and 9a) but we will ignore that for the purpose of this discussion.

 

First, let’s begin by discussing the data. Our principal data source comes from the Riskmetrics Group’s Securities Class Action Services Division which tracks securities fraud class action lawsuits on a commercial basis. Nonetheless, as you mentioned, a substantial amount of processing as well as augmentation with data from other sources was required. This is detailed in Section II of our paper so we will just give a brief description of each of the variables that are “statistically significant” in either of the two stages of our model (i.e., the settlement versus dismissal stage and settlement amount conditional on settlement stage).

• Total Securities: The number of different securities (e.g. stocks, bonds, etc.) associated with the case.
• Filing Time: The length of time from the end of the class period until the filing date.
• Class Length: The length of the class period.
• Market Capitalization: The market capitalization of the plaintiff firm.
• Company Return: Roughly speaking, the percentage return on the plaintiff firm’s stock during the class period (see Section II.C for full details on how we constructed this variable).
• S&P 500 Return: The percentage return on the S&P 500 during the class period.
• GAAP: Whether or not GAAP violations were alleged in the case.
• Restated: Whether or not the allegation mentions that the company’s financial statements were restated.
• 10b5: Whether or not the case was a Rule 10b-5 case.
• Section 11: Whether or not the case was a Securities Act Section 11 case.
• Plaintiff: The plaintiff variable has three values. If one or more institutions are listed as the plaintiff, we set out Plaintiff variable equal to “Institutional”. If no institutions are listed but one or more individuals are, we set it equal to “Individual”. Finally, if nothing is listed in the database, we set it equal to “Unknown”. Of course, this does not mean there is no plaintiff in the case; rather, it means Riskmetrics has not obtained the information for this variable. This is potentially informative for whether or not a case settles and for how much it settles for if it does settle, but probably says more about Riskmetrics’ priorities in gathering data than anything else. In particular, given the nature of Riskmetrics’ business, they are most highly incented to collect complete data for cases which settle and especially those which settle for large amounts. Consequently, we would, for example, a priori expect Empty plaintiff cases (i) to be less likely to settle and (ii) to settle for less when they do settle.
• Insider Trading: Whether or not insider trading was alleged in the case.
• Google Hits: A measure of the newsworthiness or notoriety of the case. In particular, the number of Google News Archive associated with the company name in the year prior to the filing date (see Section II.E for full details on how we constructed this variable).

 

With the variables defined, let’s begin with the factors that predict settlement amount conditional on a case settling. We identified eleven “statistically significant” predictors of the settlement amount:
• Total Securities: A 1% increase in total securities is associated with a 0.25% increase in the settlement amount.
• Filing Time: A 1% increase in the filing time is associated with a 0.1% decrease in the settlement amount.
• Class Length: A 1% increase in the length of the class period is associated with a 0.1% increase in the settlement amount.
• Market Capitalization: A 1% increase in market capitalization of the plaintiff firm is associated with a 0.4% increase in the settlement amount.
• Company Return: A 1% increase in plaintiff firm’s return over the class period is associated with a 0.2% increase in the settlement amount.
• Restated: Restated financial statements are associated with a 20% increase in the settlement amount.
• Section 11: Securities Act Section 11 cases are associated with a 45% increase in the settlement amount.
• Individual Plaintiff: Individual plaintiff cases are associated with a 35% decrease in the settlement amount relative to cases with an institutional plaintiff.
• Unknown Plaintiff: Unknown plaintiff cases are associated with a 40% decrease in the settlement amount relative to cases with an institutional plaintiff.
• Insider Trading: Insider trading cases are associated with a 30% increase in the settlement amount.
• Google Hits: A 1% increase in the number of Google News hits is associated with a 0.05% increase in the settlement amount.

Many of these variables make intuitive sense. For instance, the total number of securities, market capitalization, and number of Google hits are associated with the size of the firm and hence how much damage can be done and how large a settlement can be extracted. Similarly, the longer the class length, the greater the number of securities traded during the period and, hence, the larger the damages. The higher damages for Section 11 cases (all other things being equal) may reflect the fact that plaintiffs do not need to prove scienter to succeed. The filing time result has a plausible basis as there is often a rush to file the “best” cases. Interestingly, some “merits” variables such as Restated and Insider Trading, which in theory should only affect whether or not a case settles or is dismissed, also impact the settlement amounts thus suggesting that decisions over whether or not there were damages versus how great those damages were may not be entirely independent. The Company Return finding is somewhat surprising, since a lower return during the class return would indicate larger damages from the alleged fraud. Our hypothesis is that that this finding is picking up on the capacity of the defendant to pay. Other things being equal, a company that recently made money is going to be better able to pay a settlement. Finally, the result for the identity of plaintiff is consistent with Riskmetrics’ business model as outlined above.

 

The interpretation of the significant coefficients for the model which predicts whether a case settles or is dismissed is somewhat more complicated than that for the settlement amount model. This is because each case is associated with a “latent score” giving the probability of dismissal: cases with high scores are very likely to settle and cases with low scores are very likely to be dismissed. The tricky part is that the relationship between the latent score and the probability is non-linear. Instead, it follows an S-shaped curve called a logistic curve:

With a logistic curve, the increase in the probability of settlement associated with a small change in the latent score depends on the original latent score: at the extremes, the change in probability is quite small whereas in the middle it is quite large. For example, an increase of 0.1 from -4.0 to -3.9 hardly changes the probability as can be seen in the above figure (the probability only goes from 1.8% to 1.9%). Similarly, an increase of 0.1 from 4.0 to 4.1 hardly changes the probability as can be seen in the above figure (the probability only goes from 98.2% to 98.4%). On the other hand, in the middle of the curve, small changes can have a substantial impact. For example, an increase of 0.1 from 0.0 to 0.1 changes the probability substantially from 50% to 52.5%. In the descriptions which follow, the increase in probability will be for the middle of the curve where the “action” is.

 

We identified ten “statistically significant” predictors of the probability of settlement:
• Total Securities: A 1% increase in total securities is associated with a 0.4% increase in the probability of settlement.
• Filing Time: A 1% increase in the filing time is associated with a 0.02% decrease in the probability of settlement.
• Market Capitalization: A 1% increase in market capitalization of the plaintiff firm is associated with a 0.02% decrease in the probability of settlement.
• Company Return: A 1% increase in plaintiff firm’s return over the class period is associated with a 0.15% decrease in the probability of settlement.
• S&P 500 Return: A 1% increase in plaintiff firm’s return over the class period is associated with a 0.3% increase in the probability of settlement.
• GAAP: Allegations of GAAP violations are associated with a 13% increase in the probability of settlement.
• 10b5: Rule 10b-5 cases are associated with a 25% decrease in the probability of settlement.
• Individual Plaintiff: Individual plaintiff cases are associated with an 8% increase in the probability of settlement relative to cases with an institutional plaintiff.
• Unknown Plaintiff: Unknown plaintiff cases are associated with a 60% decrease in the probability of settlement relative to cases with an institutional plaintiff.
• Google Hits: A 1% increase in the number of Google News hits is associated with a 0.02% decrease in the probability of settlement.

Again, many of these results have an intuitive basis. The result for filing has the same intuition as for settlement amounts: many of the “best” cases are filed early. While we had no a priori expectation for the market capitalization result, perhaps bigger firms are better able to defend themselves; regardless, the effect is weak. Nonetheless, this as well as the result for Google Hits may be a result of the “plaintiff selection effect” whereby plaintiffs select cases which are more likely to be dismissed but will settle for a large amount conditional on surviving the motion to dismiss. This is consistent with the results presented above. Not surprisingly, as the company’s return during the class period goes down (potential evidence of fraud), the likelihood of settlement goes up; this is exacerbated when the market as a whole (as measured by the S&P 500) goes up during the same period. GAAP violations are a classic merits variable and therefore associated with increased likelihood of settlement. A combination of Riskmetrics’ incentive in gathering data as well as the plaintiff selection effect are likely at play in explaining the plaintiff results (i.e., Riskmetrics’ is more likely to gather plaintiff information for cases which settle and, further, institutional plaintiffs are more likely to become involved in cases with larger damages potential). Riskmetrics’ incentives are also likely to explain the number of securities result, as Riskmetrics will be more likely to gather all of the securities information for cases that actually do settle. Finally, the lower probability of settlement of 10b5 cases likely reflects the greater difficulty of proving the knowledge required (scienter) as compared to, for example, Section11 cases.

 

We hope this is more interpretable and clarifies matters some. Thank you again for your interest in and coverage of our work

 

On April 25, 2012, Cornerstone Research released a report written by Stanford Business School Professor Robert Daines and Cornerstone Research Principal Olga Koumrian entitled “Recent Developments in Shareholder Litigation Involving Mergers and Acquisitions – March 2012 Update” (here). This memorandum is the latest in a series of recent papers documenting the growth in merger related litigation in the United States. The research described in this paper is consistent with the prior reports but it also contains some new additional insights.

 

The report opens with a number of observations about the incidence of litigation in connection with mergers valued at $500 or greater during the period 2007 to 2001. The report shows that while in 2007 only about 53% of such deals attracted litigation, by 2011 almost all deals (96%) of those deals attracted litigation.

 

In addition, with respect to the deals of that size that attracted litigation during that period, the number of lawsuit per deal also increased between 2007 and 2011. Thus, while in 2007, the average number of lawsuits per litigated deal was 2.8, in 2011, the average number of lawsuits per litigated deal was 6.2 million. The report also shows that these trends were not limited just to the largest deals; during 2010 and 2011, for deals valued between $100 million and $500 million, 85% of the deals attracted litigation, and the average number of lawsuits per litigated deal was 4.1.

 

The absolute count of lawsuits involving deals with values of $500 million or greater also nearly doubled during that period, with 289 lawsuits filed in 2007 and 502 lawsuits filed in 2011.

 

The authors also note that as of March 2012, 67 lawsuits have already been reported for thirteen out of seventeen deals announced during January and February 2012. 

 

Certain deals attracted far more than the average number of lawsuits. A table in the report shows that fifteen deals with a valuation of $100 million or greater during the period 2007-2011 attracted fifteen or more lawsuits. Interestingly, of these fifteen, twelve of these deals were announced in 2010 or 2012. The report notes that size alone does not explain which deals attracted these large numbers of suits, and that in fact several relatively small acquisitions attracted fifteen or more lawsuits.

 

The report also shows that deals in certain industries seem to attract the most numbers of lawsuits. Thus, deals in the energy industry attracted an average of 8.6 lawsuits per deal, and deals in the consumer goods industries attracted an average of 6.0 lawsuits per deal.

 

There is a common perception that there is a “race to file” these lawsuits after deals are announced. However, the report shows that while filings arrive quickly after deal announcements, the time to filing has not accelerated in any material way since 2007. Indeed, the proportion of lawsuits filed in the first week after the deal announcement declined from 55 percent in 2007 to 39 percent in 2011. In all years studied, “a significant percentage of lawsuits were filed more than four weeks after a deal’s announcement.”

 

One phenomenon that has been the subject of discussion with respect to this type of litigation is whether or not there has been a “flight from Delaware” as claimants seek to pursue claims in the courts of other states. This study shows that with respect to merger litigation involving Delaware corporations, the share of M&A lawsuits filed in Delaware was higher in 2011 (45%) than in 2007 (34%) and that the percentage has increased steadily since 2008. However, according to the report, the “most striking trend in venue choice” is that challenges to the same deal in both Delaware and some other venue (as opposed to just Delaware alone or to some other venue alone) are now more common than in 2007. Most lawsuits brought in non-Delaware courts were filed in California, Texas and New York, “likely reflecting where many deal targets are headquartered.”

 

The report shows that M&A shareholder lawsuits “typically settle and often settle quickly.” Of the 2010 and 2011 lawsuits where the authors were able to track the resolution, 28 percent were voluntarily dismissed, four percent were dismissed by the court, and 67 percent settled. This represents a “significant change in outcomes observed a decade ago.” A prior study cited in the report shows that in 1999 and 200, 59 percent of cases were dismissed and only 28 percent settled. Of the 202 unique settlements involving 2010 and 2011 deals, 194 were reached before the merger closed. The median time between lawsuit filing and settlement was forty-four days.

 

Settlement terms have also changed over time. Whereas during 1999 and 2000, the majority of settlements (52%) involved cash awards and only 10% involved additional disclosures only, only 5% of 2010 and 2011 lawsuits related to M&A deals involved cash payments, and a large majority (83%) involved additional disclosure only settlements.

 

The average fee awards in connection with the M&A suits in 2010 and 2011 in connection with deals valued at $500 million or greater was $1.2 million. However, this average was pulled upward by some larger awards. Only 23% of plaintiff fee awards were $1 million or higher, while 44 percent were at or under $500,000 or under. Of the largest plaintiffs few awards, several were associated with settlements that did not involve any payment to shareholders. Average fees per deal fluctuated between 2007 and 2011, and while the average fees as a percentage of deal value in 2010 and 2011 remained higher that in 2007, the average fees as a percentage of deal value declined in 2010 and 2011 compared to 2009.

 

Discussion

The analysis in the Cornerstone Research report corroborates many of the observations noted in prior analyses of these same topics. That is, M&A related litigation is becoming increasingly more prevalent, and each deal is attracting an increasing number of lawsuits. At a minimum, the Cornerstone Report helps explain why M&A related litigation has become increasingly more expensive to defend. The impact of M&A litigation settlements and of plaintiffs’ fee awards on the cost of this litigation is less clear, but overall the implication is that the growing frequency of this type of litigation remains a very significant corporate and securities litigation trend, with important implications for D&O insurers.

 

One very important consideration to be kept in mind when comparing the various reports regarding M&A litigation is that each of the reports has used its own deal size definition to define the merger transactions that are the basis of each report’s analysis. The definitions used in the various reports are not necessarily consistent. At a minimum, the differences in the definitions used can make comparisons between the reports challenging. In any event, it is important in considering the analysis in any one of the reports to keep clearly in mind what definitions the report has used in determining what merger transactions to include the study.

 

The FDIC’s Latest Failed Bank Lawsuit: On April 20, 2012, the FDIC filed its latest failed bank lawsuits against ten former directors and officers of the failed First Bank of Beverly Hills. In its complaint (here), which the FDIC filed in its capacity as receiver for the failed bank, the FDIC seeks to recover losses of at least $100.6 million the bank allegedly suffered on nine poorly underwritten acquisition, development and construction loans and commercial real estate loans from March 2006 through July 2007.

 

The bank failed on April 24, 2009, or just short of three years prior to the date the FDIC filed its lawsuit. The complaint asserts claims against the ten defendants for negligence, gross negligence and breach of fiduciary duties. The complaint alleges that the defendants approved or allowed the loans in question in willful disregard of the bank’s own loan policies and with “willful blindness” to the risks and imprudence of the loan decisions. The complaint alleges that at the same time the defendants were approving these risky strategies, they were “weakening the Bank’s capital position by approving large quarterly dividend payments to the Bank’s parent company,” of which several defendants were shareholders. The complaint alleges that the individual defendants “lined their own pockets” with these dividends.

 

The FDIC’s lawsuit against the former directors and officers of the First Bank of Beverly Hills is the 29th the FDIC has filed as part of the current wave of failed bank litigation, and the fifth so far involving a failed California bank. In its latest website update, the FDIC announced that as of April 25, 2012, the agency has authorized lawsuits in connection with 58 failed institutions against 493 individuals for D&O liability, inclusive of the 29 filed D&O lawsuits naming 239 former directors and officers. Given the large number of failed banks like the First Bank of Beverly Hills approaching the third anniversary of their closure, it seems likely that we will be seeing a flurry of new FDIC failed bank lawsuits in the months ahead.

 

In the meanwhile, the FDIC continues to take control of additional failed banks. This past Friday evening, the FDIC closed five additional banks, the most the FDIC has closed in a single day this year. These additional closures bring the 2012 year to date number of bank closures to 22. This flurry of bank closures is a little bit surprising as up to this point, the pace of closures had begun to suggest that the FDIC was winding down its new bank closures. The five closures on Friday night suggest that there may still be a number of bank failures yet to come.

 

For Almost As Long As Our Country Has Existed, Man Has Dreamed of Traveling to Cleveland: NASA announces its plan to put a man on a bus to Cleveland. Get the details here.

 

The final stop on The D&O Diary’s Asian Tour was the island city-state of Singapore. Located only about 60 miles north of the equator, Singapore is a sun-drenched commercial center that has managed despite its slight size to become one of the world’s wealthiest countries.

 

Prior to boarding my flight to Singapore, I purchased a bottle of water, drank about half of it, and stuck the unfinished bottle in a side pocket of my backpack. As I boarded the flight, I stuck the backpack in the overhead compartment. I guess the lid popped off of the water bottle, and all of the remaining water spilled out. Now, if you are about to spend four hours sitting next to a total stranger, it is a very poor idea to start things off by dumping about eight ounces of cold water on them. I was vigorously cursed out in a language I was unable to identify, and all of my apologies were disdained — even though during the course of the flight it became apparent that my damp seat mate spoke English fluently.  Fortunately, no permanent harm was done, and this episode, though embarrassing, did not otherwise affect my Singapore visit.

 

The whole country of Singapore covers an area only slightly larger than Chicago, but with double the population. It is also one of the world’s wealthiest countries, with the highest percentage of U.S. dollar millionaires of any country in the world (15.5% of all households). It is a global trade, financial and manufacturing center. As a result, and despite its equatorial location, it has a tidy, orderly, prosperous feel.If you were suddenly dropped there,  and if it were not for the cars driving on the right-hand side, you would probably guess you were in a particularly well-off suburb of Miami. I suspect that most Americans would find Singapore a particularly comfortable place to visit.

 

As far as I can tell, the basic institutional unit in Singapore is the shopping mall. There not only seems to be an endless supply of upscale malls, but they all seem to be busy as well. Singapore’s two casinos have only been open for less than four years, but, flush with Chinese gamblers, Singapore is already a larger gambling market than Las Vegas. The Marina Sands Singapore Casino, which sort of like a massive, three-hulled cruise ship tipped on its end, with a gigantic skateboard stretching across the towers, dominates the downtown Marina district. 

 

My stay in Singapore was relatively brief, much shorter than my visits to my other Asian destinations, but I was there long enough to get a strong sense of the essential commercial energy of the place. Location is one of the country’s natural advantages; its proximity to India and China and to the emerging economies of South East Asia makes it the natural hub for regional commerce. As a result, the city is extraordinarily cosmopolitan. At the PLUS event that was the reason for my visit, there were attendees not only from Singapore itself, but a wide variety of other countries, including India, Malaysia, Thailand, Mauritius, and United Arab Emirates, among many others.

 

One of the literal high points on my brief visit was a ride on the Singapore Flyer, which, depending on who you ask, may be the highest ferris wheel in the world. It does in any event provide some astonishings views of the city, of the Singapore harbor, and of Indonesia to the South and Malaysia to the North.

 

In addition to the climate, economy and atmosphere, another reason to visit Singapore is its food. I can’t recall the last time I enjoyed so many interesting meals in such a short amount of time. Among many other local specialties I enjoyed is rendang, a spicy meat dish with a lot of kick, mee siam, a spicy seafood noodle dish, and tandoori murgh (yogurt marinated chicken). A particular high point for me was the opportunity to sample a rich diversity of local dishes while sitting on the verandah of the Singapore Cricket Club, a local landmark, as the guest of my good friend, Aruno Rajaratnam, whose hospitality helped make my Singapore visit so enjoyable.

 

One particularly interesting area to explore and to eat is Holland Village, a small enclave of shops, restaurants and bars in the western end of the urban center. There is a lively, street-café feel to the area, but the main attraction is the several indoor food courts where you can quickly sample a wide-variety of regional foods. On a warm, sunny afternoon, it was a very pleasant to sit in a shady café drinking Tiger Beer and watching the incredibly diverse local populace stroll by.

 

The PLUS event in Singapore was extraordinarily successful. The event was held at The American Club and it drew a standing-room only crowd. As I noted above, many of the attendees had traveled a long way just to attend. It is clear that there is a great deal of interest among the insurance professionals in South East Asia in the networking and educational opportunities that PLUS affords. It was a privilege for me to be able to address and to meet so many Asian insurance industry professionals. I congratulate the PLUS leadership for taking the initiative in launching the Asian events, and I congratulate the local committee that organized the events, particularly Aruno Rajaratnam and Shasi Gangadharan. I can only hope that the two events this past week in Hong Kong and Singapore are just the first of many PLUS Events in Asia. I also hope that PLUS will continue to offer our Asian industry colleagues the opportunity to become a part of our professional community. On a personal note, it was personally gratifying to learn how many of my industry colleagues in South East Asia are loyal readers of The D&O Diary.

 

What I Learned in Asia: The world is incredibly large, rich and diverse. But as large as the world is, it is still possible for me to start the day in Singapore and have dinner at my home in Ohio. Modern technology and transport have shrunk the world. Nor is this merely a geographic phenomenon. I found in my business meetings during my travels that my Asian counterparts are dealing with many of the same challenges and issues as I am every day.

 

However, one important difference is the pace of economic activity in Asia, which is far beyond anything I have ever experienced. In many ways, business growth in the developed economies all too often is about taking existing business away from competitors. In Asia, there is true, organic economic growth. The future opportunities in the growing economies of South East Asia and in the newly developing countries, like, for example, Cambodia and even Myanmar, are enormous.

 

One particular regret I have about my Asian trip is that I was not able to take any of  my kids with me to see what I saw. I think it is going to be incredibly important for our future work force to understand what is happening in Asia and in the larger global economy. Today and increasingly in the future, our young people will be competing not only with their counterparts down the street but also with their counterparts on the opposite side of the world. We all need to recognize that the global counterparts are extraordinarily motivated and are also positioning themselves to compete in an economy that they fully understand is global.

 

Our Asian counterparts are training their work force to be adaptable and to be able to function in a variety of languages and cultures. To be sure, one advantage we have in the United States is that the rest of the world is racing to learn our language. But at the same time, I fear that we have been too slow to recognize that is not going to be enough simply to expect the rest of the world to speak English. Our future work force will have to be culturally adaptable. Our chronic cultural parochialism could put our work force at a substantial disadvantage in the global economic competition.

 

However, if the increasingly global economy presents a challenge, it also represents an opportunity. That is, there may be an opportunity to participate in the developing economies’ growth – which could be a positive spin on the possibility that future growth and many of the future jobs will in Asia, rather than at home. It will under any circumstances be critically important for our future work force here to be able to function globally.

 

An additional note is that Asia is far from a block or economic unit. To the contrary, cultural differences, natural geographic and resource advantages, as well as differences in political and legal systems, will have an enormous impact on how different Asian countries will fare going forward. To cite but one example of this, it will be critically important to see which countries strike the appropriate balance between the ability of economic participants to extract profits and the ability of those participants to shift “external” costs onto their society. For example, in China, the willingness to allow businesses to prosper while society chokes on the fumes ultimately could undercut the country’s long run success.

 

One of the side effects of the wealth creation that has followed economic development in Asia is the emergence of a rising middle class. With the growth of the middle class has come a convergence around a common set of life styles, living patterns and even values. At its most superficial, this convergence includes the emergence of global brands with nearly universal appeal. But it also includes rising expectations about housing, education, and health care, as well as about the free flow of information and ideas.

 

As a result of this convergence, it is not just technology and transport that have shrunk the world. Rather, it is an increasingly shared set of experiences, expectations and aspirations that characterize ever greater parts of the world. The growing global economy may include both challenges and opportunities; but at its most basic level, it may mean that we live in a more integrated world. Although a global economy seems to mean global competition, there will also be possibilities for global collaboration within a more integrated world.

 

I find the possibilities for global collaboration the most interesting of all. Indeed, if there is a common thread through all of the business meetings on my trip, it is the common assumption that collaboration presents the greatest promise, both in and with Asia. Throughout my Asian travels, I was struck with how enthusiastic everyone I  met was about finding ways to collaborate. I left Asia with three hopes; one, that I might return again soon;two, that the apparently extensive prospects for collaboration in Asia might quickly bear fruit; and three, that I am able to stay in close touch with my many new Asian friends.  

 

More Singapore Pictures:

The Marina Sands Casino, Singapore:

 

Looking out to the Singapore Strait (from the Singapore Flyer):

 

 

 

 

 

 

 

 

 

 

 

A Country of Shopping Malls: 

 

The D&O Diary’s Asian mission continued this week, with Hong Kong the next stop on the itinerary following Beijing. If Beijing is a Chinese city wearing a new Western-style business suit, then Hong Kong is a Western city with a Chinese heart.

 

Hong Kong is topographically complicated; it is divided by bays, harbors and waterways; and it includes islands, peninsulas and even a bit of the mainland. All in, it is physically smaller than Los Angeles, though its population of 7 million is nearly double that of L.A. On Hong Kong Island, the city spreads along the slopes of rugged mountains covered with lush vegetation. Packed into every bit of buildable ground, Hong Kong is a densely populated urban area with crowded streets jammed with traffic.

 

Despite the density and slope, however, Hong Kong is still a surprisingly walkable city. At the second story level, a network of walkways connects much of the central city, by-passing the busy city streets. In addition, a clever center city escalator system connects the lower business district along the waterfront with the residential area in the “Mid-Levels.”

 

One basic thing you need to know about Hong Kong (that I did not) is that it has a humid, subtropical climate. Its latitude and climate are both about the same as Honolulu. I definitely did not pack the right clothes at all. Hong Kong is also yet another island locale with right hand drive vehicles, along with Great Britain, Japan, Ireland, Australia, Bermuda, New Zealand and Singapore. The currency is the Hong Kong dollar, which currently is valued at about 7.7 HK$ to the US$. Invoices and bar bills are simply presented in dollars, which can induce heart attacks late at night when you get a bar bill for $250 for a couple of rounds of drinks.

 

Upon arrival on a steamy Saturday, we set out for an afternoon walk, starting amongst the thick foliage of the Hong Kong Park and of the Zoological and Biological Gardens. Our roving stroll quickly revealed the incredible diversity of Hong Kong’s sights and sounds. First, in one of those chance events that makes travel so interesting and rewarding, we happened upon a musical rehearsal at St. John’s Cathedral , which is close by the parks. The church’s cool interior was a welcome relief against the humid afternoon heat, and we were treated to a rehearsal of the musical ensemble Die Konzertisten . The ensemble was rehearsing Leonard Bernstein’s Chichester Psalms, which the choir and orchestra were going to be performing in concert that evening.

 

We then strolled into an area of narrow pedestrian lanes and alleyways lined with shops and vendors selling clothes, toys, leather goods and shoes, and vegetables and fruit. Butchers carved meat right out along the street and fish vendors displayed tanks full of lobsters, crabs and assorted other kinds of sea life. You can buy fried or dried octopus, fermented bean curd, curry fish balls , put chai ko (a sweet pudding cake), and  chee cheong  fun (rice noodle roll stuffed with meat). Or maybe you might just want to walk past and content yourself with wondering what, say, snake meat might taste like.

 

After wandering through this colorful street market scene, the thought did occur to us that it would be awfully nice to find a place to sit down and have something cool to drink. Almost simultaneously with the thought, we found ourselves in the Soho neighborhood, full of restaurants and bars. We went into the Globe Pub on Graham Street, which turned out to be every bit as British as if it were in Notting Hill. We sat at the bar and drank draft Old Speckled Hen ale. Though it was evening in Hong Kong, back in merry England it was still early afternoon, so we were able to watch an English Premier League game live. The bar was full of vocal Arsenal fans, who were disappointed that the Gunners played to a nil-nil draw against London rivals Chelsea. After the game, we returned to our hotel quite persuaded that Hong Kong is a fabulous town.

 

The next morning dawned clear and bright, so we took the Peak Tram to the top of Victoria Peak. At about 1,800 feet, the Peak (as it is known locally) is the highest mountain on Hong Kong Island. Oddly and incongruously, the tram terminates near the top at a modern shopping mall. Outside the mall, a paved pathway winds around the Peak through parklands and near some very high end residential real estate. The path affords glorious panoramic views of the harbor and the Kowloon Peninsula to the North and of the South China Sea to the South.

 

After we descended, we went to the waterfront and took the famous Star Ferry across Victoria Harbor to Kowloon. With a bit of wandering, we found our way to Kowloon Park, a cool, shady oasis on a muggy afternoon. We didn’t know that we had wandered into the Sunday afternoon singles’ scene for young South East Asians. The park was full of young men and women in their late teens and early 20s – Malays, Thais, Vietnamese, Cambodians, and a host of other ethnic groups and nationalities that I could only guess at. Many of the women were wearing head scarves and others were wrapped in colorful silks fabrics. Some groups sat on fabric ground covers and chatted. Others were playing music and dancing. One group of gently swaying and elaborately dressed women played drums, tambourines and bells. I felt as I were from another planet.

 

As the afternoon light faded, we took the ferry back to across to Hong Kong Island, and hopped into a cab to go back to Soho for dinner. Seconds after we jumped out, I realized I had left my backpack in the cab. Shock and surprise gave way to distress as it sunk in that in a city as massive as Hong Kong where there are literally thousands of essentially identical taxi cabs, there was no chance I would ever see my backpack again.

 

We went to get some (excellent) Thai food but not even a couple of Singha beers could raise my spirits. As I picked at my Pad Thai, I slowly remembered all of the things I had been carrying in my bag – my camera (with all of the pictures from my trip); guide books (borrowed from the Shaker Heights Public Library); a CD play with a Berlitz Mandarin language  CD in it (also borrowed from the library); a memory stick with my presentation; important traveling accessories, like a corkscrew and a bottle of aspirin and several packages of gum. And then – I remembered the envelope. The envelope with the cash. Over 400 U.S. dollars, plus US$300 worth of Singapore dollars. My spirits, already low, plunged to new depths. (I know you are thinking — what kind of idiot carries around that much cash in a backpack? Well, apparently the same kind of idiot that would leave a backpack in a taxi cab. That is to say, a complete and total idiot.)

 

Back at the hotel, I told the concierge what had happened. He was friendly and polite and he dutifully took down all of the information. He said that he would call the taxi commission and that he would let me know if he learned anything useful. However, the look on his face pretty much told me that I was never going to see my backpack again.

 

When I went up to my room, I picked up my iPad for a quick email check. To my astonishment, in my inbox was an email with the following Re line: “Your Missing Bag in a Hong Kong Taxi.” The email, from a woman whose email domain was “christiandior.fr,” said

 

My husband and I just got in a taxi in Hong Kong where we found your missing bag. We got your name card from your bag and tried to call you without success. Now we left the bag with the taxi driver Mr. [name] (you could find attached his Driver ID card picture), his phone no is : [phone number]. Please contact him asap. Good luck!

 

Attached to the mail was a photo of the driver’s taxi license, with his name, the name of his taxi company, his taxi ID number, and the driver’s picture.

 

I ran back downstairs to the concierge. He called the driver’s cell phone number and got him on the phone. They quickly figured out that the cab was not far from my hotel. Within minutes, I was reunited with my bag. The driver went home with a tip so big that he couldn’t stop thanking me. After the driver left, the concierge said, “I have been working at this hotel for a long time. Guests are always leaving things in taxicabs. Of course we always try to do whatever we can, but this is the very first time that anyone actually got their stuff back.” 

 

The whole sequence reaffirms my faith in humanity. The lengths to which the lovely French woman went to try to find me fills me with a sense of gratitude and indebtedness. And then there’s the driver. He not only returned my bag, but he returned all of its contents – including every last one of the US and Singapore dollars. All I can say that as unlucky as I was to leave my bag in the cab, it was incredibly good fortune that these two were there to protect me from my stupidity. By the way, the pictures accompanying this post were nearly lost forever.

 

My Hong Kong sojourn also included the highly successful inaugural meeting of the Professional Liability Underwriting Society in Asia. It was a standing-room only event at the Royal Hong Kong Yacht Club. I thoroughly enjoyed the chance to meet and to address so many industry colleagues from Hong Kong and from all across Asia. I was also delighted to learn that so many of them are loyal readers of The D&O Diary. (The Internet is such an amazing thing).

 

I came away from Hong Kong with very warm feelings for the place. It is a dynamic city of incredible charm as well as a seemingly endless supply of diverse sights and sounds. Put Hong Kong down as a new entry on the list of favorite travel destinations. The next time I visit, though, I will remember to put my valuables in the hotel room safe. And friends, if on some future occasion you should find yourself riding with me in a cab, before we exit the vehicle, please ask me to make sure that I remembered to take all of my belongings.

 

More Hong Kong Scenes:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

In a prior post,  I discussed Fordham Law Professor Richard Squire’s April 2012 article entitled “How Collective Settlements Camouflage the Costs of Shareholder Litigation” (here). After my post appeared, Professor Squire communicated to me his concerns about my comments regarding his paper. Because his comments and concerns about my post were quite substantial, it seemed that the best approach would be simply for Professor Squire to publish his response in full in a separate blog post. I have set out Professor Squire’s response below. I am very grateful to Professor Squire for taking the time to present his views in full here. I encourage readers to review Professor Squire’s paper as well. As Professor Squire indicates at the conclusion of his guest post, he and I will be participating in a session at Fordham Law School on May 8, 2012 to discuss his paper. Information about the session can be found here . Here is Professor Squire’s response:

 

 

I am most grateful to Kevin both for devoting a full blog entry to pay my current article on D&O insurance, titled “How Collective Settlements Camouflage the Costs of Shareholder Litigation,” and for giving me here the chance as a guest blogger to respond to his comments. This has been a valuable opportunity for me to learn more about the D&O field from Kevin, a recognized expert whose knowledge of the market for D&O insurance greatly exceeds my own. 

 

 

In his generously extensive comments about my article, Kevin identifies several places in which he thinks I describe the dynamics of D&O insurance settlements accurately. At the same time, however, he expresses numerous concerns with my proposed method for reforming such settlements. In this blog entry, I wish to focus on his concerns, and in particular to say why I think several of them are not warranted or are addressed by other aspects of my article that Kevin’s comments do not mention. 

 

 

To provide context, it will be useful to begin with a summary of my article, which has five interrelated points as follows:

 

 

1.      In a shareholder lawsuit against a defendant with one or more D&O insurance policies, the current practice is to require any settlement of the suit to be a single, collective resolution that binds all defense-side parties, meaning the defendant and each of its insurers.

 

 

2.      The current system of collectivized settlements encourages strategic liability-shifting among defense-side parties. This strategic behavior imposes a variety of costs on shareholders, only some of which have been previously recognized by judges and academic commentators.

 

 

3.      The collective action problem we see in shareholder lawsuit settlements is not inevitable.  Rather, it is “contrived” in the sense that it is a byproduct of how D&O insurance contracts are written and enforced.

 

 

4.      At least in theory, settlements could be de-collectivized in a manner that greatly reduced or eliminated the costs to shareholders from strategic liability-shifting. My article describes such an approach, which I calls “segmented” settlements.

 

 

5.      Even if de-collectivizing the settlement process would benefit shareholders, corporate managers would oppose it because the change would reduce the managers’ ability to use D&O insurance to shift settlement liability to insurers and thus to insulate corporate earnings reports from the impact of the managers’ conduct that gives rise to shareholder litigation.

 

 

Kevin’s comments suggest that he agrees with me on points 1, 2 and 5. Most of his criticisms of my paper are aimed at points 3 and 4—my arguments that settlements could in theory be de-collectivized and that such a change would benefit shareholders.  His comments also stress how “policyholders” would resist my proposal, though in so doing he does not acknowledge the degree to which he and I are in agreement on this point as long as by “policyholders” we mean the corporate managers who actually make the decisions to buy D&O insurance on behalf of themselves and their corporations.

 

 

Since most of Kevin’s concerns are focused on the desirability of my alternative system of segmented settlements, I will illustrate my proposal here with a very simple example. Imagine a corporate manager who is covered by a single D&O policy with a limit of $1 million. This means that if the manager is sued in a shareholder lawsuit, the insurer is responsible for the first $1 million in liability, and the manager is responsible for the excess, if any. Under the current system of collective settlements, the insurer could not settle with the plaintiff unless the plaintiff also agreed to waive his rights to collect from the manager, including his right to collect damages in excess of the $1 million policy limit. Conversely, the manager and plaintiff could enter into a settlement for, say, $1.2 million, and then use the “duty to contribute” (a duty not previously identified in the academic literature, but whose existence and importance Kevin confirms) to force the insurer to “tender” (pay) its $1 million policy amount in support of the settlement. In this way, any settlement must be “collective”—i..e, jointly binding on both the insured (the manager) and the insurer. 

 

 

One of the main problems with this system of collective settlements is that it can lead to plaintiff overcompensation. Since the manager and plaintiff can enter into a settlement whose costs are borne mostly by a third party—i.e., the insurer—they can jointly gain at the insurer’s expense by entering into a settlement that exceeds the expected damages at trial. In my article I call this the “cramdown” dynamic.  The manager’s incentive to engage in this settlement is that it avoids the risk of a trial at which the total damages in case of a verdict for the plaintiff may exceed the $1M policy limit by a large amount, leaving the manager with greater personal liability than she incurs by settling. 

 

 

Under a system of “segmented” settlements, by contrast, the manager and insurer could settle separately out of the case, and by so doing could neither shift liability onto the other nor bind the other in a settlement without the other’s consent. So, for example, the insurer could settle separately with the plaintiff, in which case the insurer would pay the plaintiff a settlement amount and the plaintiff in exchange would waive his right to collect the first $1 million in damages awarded at trial (if any). If the manager did not also settle, then a trial would occur, but only damages awarded in excess of $1 million would be collectible. Conversely, the manager could settle separately from the insurer, whereby the plaintiff would waive his right to collect any damages awarded that exceed $1 million. Under this system, “cramdown” settlements could not occur, and collective-action costs would be reduced for the reason that defense-side parties would no be able to shift liability onto each other.

 

 

Many corporate defendants have not just one D&O policy, but rather a primary policy plus one or more excess policies, forming an insurance “tower.” Adding these additional insurance layers increases the opportunity for strategic conduct but does not otherwise alter the basic conflict of interests created by a collectivized settlement approach nor the benefits of the alternative approach I describe.

 

 

With that overview for context, I’ll now turn to Kevin’s specific concerns and criticisms.

 

 

Holdouts:  Kevin argues that strategic holding out by insurers would still occur under if settlements were de-collectivized. To illustrate, he gives an example of a case in which all defense-side parties have settled except for one mid-level insurer.  I actually anticipate something close to this hypothetical on pages 29 and 30 of my article.  Contrary to Kevin’s argument, under the system I describe a mid-level insurer in that position would not have an incentive to hold out, as by doing so the insurer could not externalize liability onto the policyholder or other insurers.

 

 

To make the example concrete, let’s assume a policyholder with a tower of five D&O policies worth $1M each.  We’ll assume further that all defense-side parties, including the policyholder, have settled with the plaintiff except for the excess insurer occupying the $2M to $3M slice of the tower. This means that if a trial occurs, the plaintiff could collect only those awarded damages (if any) that fall between $2M and $3M, and these would be collectible solely from the holdout insurer.  Thus, regardless of whether the holdout insurer ultimately settles or goes to trial, no damages liability can be shifted to the policyholder.  

Kevin expresses in connection with this example a concern that defense costs (i.e., attorneys’ fees and similar expenses) might reduce this "sole remaining layer" of coverage, leaving the policyholder exposed (though, to be sure, only to defense costs plus damages in the $2M to $3M range—i.e., the unsettled remaining slice).  I anticipate this concern on pages 29-30, but I offer a simple solution:  "We can predict that [if settlements were de-collectivized] liability policies would be written so that the non-settling insurers in such cases [in which the policyholder had separately settled] bore the defense-side trial expenses without regard to policy limits, as otherwise those insurers could externalize onto other defense-side parties some of the costs of their refusal to settle."   

 

 

Kevin earlier in his post had expressed “trepidation” about the “world of academic analysis,” which seems to him “unbound by constraints that operate in the world to which I am accustomed.” But there is nothing otherworldly about my simple solution to the holdout problem with respect to defense costs. Under most other types of liability insurance (such as auto and homeowners insurance), defense costs do not count toward the policy limit.  It is D&O insurance that is unusual in its use of "burning candle" policies. Thus, by suggesting that defense costs would no longer count toward policy limits in situations in which the policyholder has settled out of the case, I am incorporating a solution to the cost-shifting hazard that will already be familiar to people with real-world knowledge of liability insurance.  

 

 

After presenting his holdout hypothetical, Kevin goes on to write that my proposal would "substitute a different cramdown dynamic for the existing one" and would "put the insurers in the position where they were jockeying to force loss costs elsewhere, including in particular onto their insured."  It seems to me that his concerns here stem from this same misunderstanding about how holdouts would be handled under my proposal.  For this reason, I don’t think these concerns are warranted.  Under my proposed system, defense-side parties would have significantly less ability to engage in strategic cost-shifting than they do now.

 

 

Distributional Impact:  Kevin observes that the distributional impact of separate settlements would be to reduce liability for primary insurers and increase it for excess insurers.  This observation is accurate, as my article acknowledges at several points. But it is not grounds for concern, as the excess insurers would adjust by charging higher premiums ex ante, and so they would not on net be worse off.  However, because the current system’s cramdown dynamic would be eliminated, overall settlements would be lower, as there would be a reduction in plaintiff overcompensation (a phenomenon which Kevin acknowledges occurs under the current system).  So overall insurance costs will be lower, a benefit to policyholders.

 

 

Expected Trial Liability:  Kevin devotes several paragraphs to criticizing my reliance on the concept of "expected trial liability" (meaning expected damages if the case goes to trial).  In particular, he criticizes my article for arguing that this figure is "objective" rather than "subjective" and can be reduced to a "single knowable measure."  Here I think Kevin is attacking a straw man.  Nowhere does my article claim that expected trial damages are knowable with certainty ex ante or that parties will form identical estimates of them.  To the contrary, I acknowledge that estimates will differ, and on pages 35 and 36 I model what settlement negotiations look like when they do.

 

 

Similarly, Kevin criticizes me for not taking into account "myriad factors" that affect negotiations, including "whether some insurers believe they have unique coverage defenses."  But on pages 37-40 I do model the impact of coverage exclusions on settlement negotiations.  

 

 

To be sure, I don’t model the impact of another factor Kevin identities—namely, the pendency of related lawsuits.  But the fact that a model does not include every conceivably relevant factor does not mean that we can derive no insight from its results.  Indeed, the article’s models are what revealed to me how the cramdown effect under the current system can lead to plaintiff overcompensation, a result whose accuracy Kevin confirms.  More generally, while Kevin calls into question the usefulness of abstract models in the study of complex insurance negotiations, he does not identify any specific results produced by the article’s models that he thinks are inaccurate or unrealistic.

 

 

Delay:  Kevin worries that separate settlements would introduce delay.  But delay results from holdout problems, and de-collectivizing the settlement process would greatly reduce the advantages to holding out.  Indeed, under my system, as each defense-side party settles out of the case, the incentive both for the plaintiff and for the remaining defense-side parties to settles increases.  This is because each settlement reduces the plaintiff’s potential recovery at trial but not the trial expenses that both sides would have to incur if trial occurred.  Returning to the example above involving the mid-level insurer holdout, that insurer’s incentives to settle are maximized when it is the only defense-side party left in the case, since at that point it will bear all of the defense-side trial costs.   And the plaintiff’s incentive to settle is maximized as well since the damages recoverable at trial have been pared down to a thin slice, but winning that slice would still require the plaintiff to incur the full costs of putting on his case.  Since there is no advantage to anyone under my proposed system of delaying resolution of a lawsuit, we can expect less rather than more delay than we see now.

 

 

Achievability:  Kevin criticizes me for writing that "segmented settlements could easily be achieved contractually," a statement he says "lacks a connection to the insurance marketplace" because insurance buyers would resist such a change.  But all I meant was that nothing prevents segmented settlements as a matter of contract law.  I acknowledge full well that D&O insurance buyers—i.e., corporate managers—benefit from the current system of collectivized settlements. See, for example, my abstract:  "Yet corporate managers probably prefer the status quo."  That’s why on pages 42 and 43 I argue that, if reform were to occur, it probably would have to be initiated by courts. 

 

 

Reinsurance:  In my article I make the uncontroversial observation that excess insurance and reinsurance are substitutes:  both help insurers diversify their risk exposure. A simple example will illustrate.  Imagine that Company A buys a $10 million primary policy and a $10M excess policy.  Meanwhile, Company B buys a $20M liability policy, and its insurer then purchases coverage for the top half of this policy from a reinsurer.  In both cases we have a division of risk between two insurers.

 

 

I think it interesting that in the D&O market we see Company As rather than Company Bs—that is, we see towers rather than reinsurance. I raised the question in my article whether this might reflect a preference among insurance buyers for a system that encourages covered settlements through the cramdown dynamic. Kevin criticizes me on this point, arguing that there are "a finite number of reinsurers and they require a spread of risk every bit as much as the insurers do."  But the fact that currently there is a relatively small number of reinsurers is not a criticism of my hypothesis; rather, it is a restatement of the question my hypothesis seeks to answer—i.e., the question why this particular insurance market has developed to rely on towers rather than reinsurance. And his claim that reinsurers also "require a risk spread" is misleading since reinsurance is, by definition, risk-spreading, as my example of Companies A and B illustrate.

 

 

Finally, Kevin claims that the presence of towers is explained solely by the preferences of insurers, but this claim is in tension with his earlier claim that D&O insurance is a buyers’ market, and it fails to explain why the carriers should prefer the tower model over the reinsurance model.

 

 

***

 

As I said at the beginning of my comments, I am most grateful to Kevin for not only highlighting my article on his blog but also giving me the chance to respond as a guest as I’ve done here. As Kevin mentioned, he and I will be co-panelists at a conference at Fordham Law School (where I’m privileged to teach) next month, where I’ll have the opportunity to be able to discuss these matters with him further. I hope Kevin’s readers have found my exchange with him interesting. If any reader has any comments or questions on the subject matter discussed here, I’d welcome hearing from you at rsquire@law.fordham.edu.  

 

 

The D&O Diary is on assignment in Asia this week, with a first stop in Beijing and with other Far Eastern stops scheduled after that. Even traveling “over the top,” Asia is very far away. When the flight progress monitor shows your plane traveling over Irkutsk and Ulan Bator, you know you are far from home.

 

Beijing is a vast, sprawling, teeming city. At first blush, it is a thoroughly modern city, its wide boulevards lined with ranks of modern steel and glass office towers. Yet inside the Forbidden City or the Temple of Heaven (both of which, like the city itself, are huge), Beijing reveals itself as an ancient city with a long and fascinating history. And yet again, in the warren-like hutong neighborhoods (at least the ones that remain), with their narrow alleys and winding passageways, Beijing can feel daunting, mysterious and even a little dangerous.

 

With the city’s ubiquitous modern buildings and traffic congestion, it is something of a shock to suddenly find yourself standing in Tiananmen Square, facing the entrance to the Forbidden City, the enormous portrait of Chairman Mao hanging over the entry gate (pictured above). It is hard to believe that barely forty years ago, more than a million people gathered in the Square waving Little Red Books, and that only 23 years ago a single soul faced down a Red Army tank. The street where the lone protestor stood is now clogged with tour buses, Porsche SUVs and Mercedes sedans. The Square itself is full of tour groups and vendors hawking Mao hats and “genuine” Rolex watches.

 

The Forbidden City is an enormous complex of buildings, courtyards and temples that defies easy description. Its grounds are larger than those of the Palace at Versailles. I visited it twice on this trip and still feel as if I only saw a very small part. Many of the buildings were dazzlingly restored for the 2008 Beijing Olympics, and during my visit the courtyards were full of blooming fruit trees and blossoming flowers.

 

Over the centuries, twenty-four Ming and Qing emperors lived in the Forbidden City, but the tour guides seem to concentrate on the last Ming emperor, Chongzhen, who slew his own family and then hanged himself in 1644 to avoid capture by rebel armies and the oncoming Manchu invaders, and Puyi, “the Last Emperor,” who abdicated in 1912 and who fled the Forbidden City in 1924.

 

Emerging at the Northern gate of the Forbidden City, you suddenly leave behind the venerable vestiges of the country’s imperial past and plunge into the tumult of the city’s jarring present. Vendors, beggars with shocking wounds and deformities, school kids, and tourists jostle and push along a walkway not nearly large enough for the crowds. Beijing can be simply overwhelming at times.

 

Perhaps detecting my sensory overload, my tour guide suggested that we retreat to a tea house. We had to take a city bus (fare = 1 yuan, about 16 cents) to where he had parked his car in a hutong. We then drove through back streets to a quiet tea house, where a chatty young woman performed a simple tea ceremony. We sampled seven different varieties of tea – this one for longevity, that one for your complexion, this one for serenity. Perhaps it was the soothing effect of the warm drink, but I wound up buying an enormous quantity of tea and even a couple of tea cups and saucers. After the tea, the guide (happy to increase his tea-sotted client’s fee) took me on a tour of the Yonghe Temple, a Qing-dynasty Buddhist monetary that still houses chanting and incense-burning monks. 

 

The tea-induced serenity proved short-lived. With 19.6 million people, Beijing is well more than twice as large as New York City. It is almost incomprehensible that it is only the third largest city in China. With 23 million people, Shanghai is the second largest, and with nearly 29 million, Chongqing is the largest. The sheer scale is beyond anything I have ever experienced.

 

Beijing is also a city of five million vehicles, and at any moment it is easy to believe that all five million are out on the roads at the same time – but that is a mistaken impression. Each weekday, traffic regulations bar one-fifth of the cars from the inner city based on vehicle registration number, and trucks are banned altogether during the daytime. But even with these restrictions, the roads are jammed at all hours. Picture the worst traffic you have ever seen in, say, L.A., multiply times ten, and then allow for the fact that rules of the road are viewed as purely advisory. A red left-turn arrow does not mean no left turn; it means jockey for position until you see an opening and then go for it (and for Beijing drivers, an “opening” means only ten or fewer pedestrians directly ahead).

 

Contemporary Beijing has many other attributes of any modern city. I was surprised and disappointed to find that the Westin hotel in which I was staying felt like a Westin hotel anywhere, and  the Financial District in which it was located had the exact feel of say, Tyson’s Corner, Virginia or Stamford, Connecticut, except with even less charm.  On the cross street adjacent to the hotel were a Starbuck’s, a KFC, a Pizza Hut and a TGI Friday’s. I felt as if I were in a containment zone for Americans hoping to have as little contact with China as possible.

 

Fortunately, the area near my hotel is not representative. There are several areas full of restaurants and street life. One afternoon, we had lunch in a lakeside restaurant in the Back Lakes area (pictured left), where we were served plate after plate of spicy, delicious food – chicken with walnuts; mushrooms in a spicy sauce; saffron rice dusted with crushed, fragrant flowers, thick noodles flecked with bits of pork; a gigantic fish with its head and fins still intact; and plates of sweet and savory dumplings. And what would a visit to Beijing be without a meal of Peking Duck? We enjoyed a very special meal at the famous Da Dong Roast Duck restaurant, a multicourse (and breathtakingly expensive) extravaganza that culminated in the table-side carving of the wood-roasted duck. I saw just enough of the city on these outings to know that there is an incredible diversity of things to see and do, but I just did not have the chance to explore these areas the way I would have liked. Stuck in the American containment zone, I was simply (and disappointingly) out of position to fully explore the parts of the city with a pulse.

 

My Beijing sojourn did include the obligatory excursion to the Great Wall. Sixty miles north of Beijing, past the sixth and last of the city’s ring roads, the flat plain gives way to jagged mountains shrouded in mists. A Ming dynasty section of the Wall bristles along a rugged ridge-top. Today, a chair lift sweeps visitors up to the top, but to see the guard towers at the highest elevations, you still must scramble up a long, steep incline of uneven steps. When you finally reach the top, panting and sweating, you are greeted by a wise-cracking vendor in a Mao hat:”Where you from? Ohio? Cool! You need cold beer, Ohio, only eight yuan [about $1.30], very cold.”

 

The Mutianyu section of the Wall that we visited was built in very rugged terrain, and is surrounded by thick forest. On the day of our visit, the woods were full of flowering trees and I can only imagine how beautiful the view is on a clear day. As it was though, a thick mist obscured the view. The clouds closed in and a fine rain began to fall shortly after we returned to the bottom.

 

To descend to the bottom, we did not take the chair lift back but instead we rode a toboggan that traveled along a curved metal track. The slope is steep, and as I careened along at breakneck speeds, I thought to myself that the momentum could easily carry me off the track and into the woods. I suppose life-threatening pleasures are just part of the checklist when on travel to distant lands. Fortunately, no one was killed, in our group at least, and after several in our group had filled their backpacks with souvenir tee shirts, chopsticks, and straw hats, we gathered for lunch in a restored old schoolhouse. Along the serving table were heaping plates of duck, pork, and noodles, toether with enormous bottles of beer.

 

Somehow the metal toboggan run seems to me like a metaphor for Beijing itself. The city’s incredible pace and dazzling prosperity are very impressive, but there is a dark edge to the city’s vitality. In ways that are readily apparent, the city is literally choking on its prosperity. All the Gucci and Cartier stores and speeding Audi A6s with tinted windows cannot hide – and indeed may even underscore – the fact that all is not well.

 

One cultural difference many Americans visitors to Beijing often note is that it is quite common for people on the street to hawk loudly and spit onto the pavement. Some Americans may find this unpleasant or even rude but after just a few days in the city, I began to better understand the behavior. After only one day, my throat was scratchy. By the second day my throat was sore. After that, I found that I had to keep popping throat lozenges just to get by. I am sure that before too long I would be hawking and spitting just like a native.

 

I had arrived during a particularly clear interlude (as shows in many of my pictures). But the thicker air soon settled back in. Nearby buildings nearly disappeared in the haze. The sun faded into a diffuse, low wattage glimmer behind a blanket of smog.

 

Nor is the foul air the only sign that all is not well. At first it seemed trivial to me, but the fact that the government has blocked Facebook, Twitter and Google, along with many other parts of the Internet, really does show that for all of its apparent prosperity and dynamism, China remains a closed and controlled society. In several different conversations, I heard complaints about difficulties getting housing, health care and educational services. Inflation is becoming an increasing concern as well. When the yuan was eight to the dollar, Beijing may have been a bargain, but at 6.3 yuan to the dollar, it is no longer cheap. Several different business people shared with me their concerns about rising prices and shrinking or disappearing margins, as well as the scarcity of credit. After years of growth at a breakneck pace, there are increasing concerns that the economy could be headed off the tracks.

 

In the end, Beijing remains for me an immense puzzle of conflicting impressions. Because it is so vast and multi-faceted, even after a week there, I felt that I had barely scratched the surface. One very special experience while I was there illustrates the challenge of trying to get to the heart of the place.

 

Early one morning, I took a cab to the Temple of Heaven, now a huge park with walkways, pavilions and gardens, as well as the actual temple buildings where Ming and Qing emperors fasted and prayed annually for a bountiful harvest. The temple buildings, though 19th century restorations, are beautiful, but the grounds and gardens are the main attraction. Wandering amongst the blossoming trees and surrounded by families and school children, it was easy to feel as if I were indeed in a blessed place.

 

Near one of the ornate pavilions (pictured to the left), a group of traditional musicians attracted my attention. I sat and listened to them for a long time. Their music sounded strange to my ears; there seemed to be no rhythm or melody, at least that I could discern. The singing sounded, to me, tuneless and off-key. I found the music strange and absolutely fascinating. I would have liked to have spoken to the musicians, to know more about their music and their instruments. But as it was, I hesitated even to take their pictures for fear of being intrusive or causing offense.

 

Like the music, I found Beijing itself interesting and enigmatic, a complex puzzle with many surfaces and hidden meanings. The only thing I know for sure is that I must go back, to try to get closer to the heart of a fascinating city.

 

A containment zone for Americans :

 

 

 

 

 

 

 

 

 

 

Tianamen Square, genuine Rolex watches, you buy, how much? 

 

 

 

 

 

 

 

 

 

 

The Hall of Prayer for Good Harvests at the Temple of Heaven:

 

 

 

 

 

 

 

 

 

 

Flames Must be Fully Clothed at All Times:

 

 

 

 

 

 

 

 

 

 

And if your relics have a persistent problem, we can get them extra strength anti-itching powder:

 

 

 

 

 

 

 

 

 

 

We Make Our Dumpling By the Book: 

 

 

 

 

 

 

 

 

 

 

At those other tourist sites,  you have to put up with a lot of uncivilized sightseeing: 

The negotiated resolution of securities class action lawsuits – and absent dismissal, there is rarely any other types of securities suit resolution – is always complicated and occasionally messy, and often involves inefficiencies and sometimes produces distortions and even excesses. Anyone who has ever been through a securities suit settlement negotiation likely will have had the thought that there has to be a better way for resolving the cases.

 

In an April 12, 2012 paper entitled “How Collective Settlements Camouflage the Costs of Shareholder Lawsuits” (here), Fordham Law School Professor Richard Squire catalogues the many shortcomings in the current securities class action settlement process and sets out his proposal to improve the process and to eliminate process inefficiencies and excesses. UPDATE: Please note that Professor Squire also completed a separate response to this blog post in a seprate guest post of his own. His guest post can be found here.

 

According to Squire, securities class action settlements suffer from a “collective action problem,” owing to the fact that current practices and law require a single case resolution that collectively binds the defendant and all of its D&O insurers – even though the D&O insurance itself is “segmented” in a tower of insurance with the insurers in the different layers having different settlement positions and differing perspectives and interests regarding the settlement.

 

Among other things, Squire notes that insurers in the primary layers and lower level excess layers are often compelled to contribute toward settlement when the settlement demand (or more accurately, the settlement opportunity) exceeds their layer. This compulsion, Squire notes, is often effectively given legal force through a rarely identified but nonetheless very real “duty to contribute.” These forces lead to a number of ills, including “plaintiff overcompensation at insurer expense”; overpriced liability insurance; and lawsuits of doubtful merit.

 

Identifying the requirement for collective settlements as the source of the problem, Squire proposes allowing “segmented settlements” – that is, allowing each defense-side party (and in particular each of the carriers in the D&O insurance tower) to “settle with the plaintiffs separately for its respective slice of the damages ranges.” Under this approach, trial would occur unless all slices settled and the plaintiff would collect at trial only those awarded damages (if any) that fell within the unsettled slice.

 

Squire postulates that this approach would eliminate the conflict of interest between the defense-side parties, “removing the cramdown dynamic that can lead to plaintiff overcompensation.” The elimination of this dynamic will, Squire contends, ultimately lead to more shareholder lawsuit settlements being paid by corporations rather than by insurers, an outcome Squire that further contends would “benefit shareholders, as it would improve the accuracy of a firm’s reported earnings as a measure of the contribution of that firm’s managers to overall shareholder wealth.”

 

I have set out below my thoughts about Squire’s proposal. I note at the outset that I approach commenting on academic papers with trepidation. Even though D&O insurance and D&O claims resolution are areas to which I have devoted my entire professional life, the world of academic analysis, even with respect to a topic within my area of expertise, seems unbound by constraints that operate in the world to which I am accustomed. My usual trepidation is even greater where, as here, I am already committed to commenting in person on the academic analysis in a public forum. Specifically, on May 8, 2012, I will be attending a conference at Fordham Law School at which I will be participating in panel in with my friends Tom Baker of U.Penn. Law School and Sean Fitzpatrick of Endurance Risk Solutions. The purpose of the panel is to discuss Professor Squire’s paper.

 

As a threshold matter, I will say that an important aspect of Squire’s analysis for which I give him high marks is his understanding of the central importance of D&O insurance in the securities class action settlement process. All too often, commentators under-appreciate the significance of the role that D&O insurance plays in the process. A particularly important insight Squire has with respect to the role of D&O insurance is that the different D&O insurers’ interests and positions in the settlement process differ based on where they are in the insurance tower.

 

Squire’s understanding of the role of D&O insurance is particularly accurate when he describes the “cramdown” effect – that is, the pressure that the insured company and the upper level excess carriers can bring to bear on the primary and lower level excess insurers to force the lower level insurers to throw in their limits. Squire perceptively describes what is too often unconsidered, which is the presumed “duty to contribute” that compels lower level insurers to tender their limits where there is pressure to settle a case at a number beyond their limit of liability.

 

Squire is also on target with his identification of the undesirable consequences this dynamic can produce. It can, as he notes, produce plaintiff overcompensation (which he also correctly notes, inures disproportionately to the benefit of the plaintiffs’ lawyers) and it can result in higher priced liability insurance. And the opportunity for further occasions of overcompensation undoubtedly attracts additional lawsuits.

 

Having identified these problems with the current system, the question is whether Squire’s proposed solution would in fact solve the problems in an appropriate and acceptable way, a question to which I turn below. However, having noted above the respects in which I agree with Squire’s understanding of the process and the dynamic, I must also as a preliminary matter identify the respects in which my understanding differs from Squire’s. These considerations may or may not alter the ultimate merits or demerits of Squire’s proposed solution to securities suit settlement; but to the extent these considerations might (and they well might, given that much of Squire’s analysis depends on these understandings and assumptions), it is worth my setting out here my differing understandings.

 

First and foremost, D&O insurance provides a contractual way for companies to manage their indemnification obligations, and to ensure that these indemnification obligations can be honored even if the company itself is unable to do so when the need arises. Because D&O insurance derives from the indemnification obligation, and because the company’s indemnification obligation includes both the obligation to provide for defense expense and for indemnity amounts, the D&O insurance policy has always provided coverage for both defense expense and for settlements and judgments.

 

Second, companies buy D&O insurance in a marketplace that has been “soft” for almost all of the last 25 years. During that time, dozens of new insurers have entered the marketplace, while at the same time there are many fewer public companies than there were even a short time ago. With an abundance of insurance capacity chasing a dwindling number of insurance buyers, the marketplace is heavily tilted in the favor of the buyers. Buyers expect and get very broad coverage for prices that remain advantageous for the buyer. Owing to the constraints of competition, insurers have a limited ability to impose defensive measures or to constrain coverage. The insurers’ options are two-fold: either to play ball or to sit out the game. Most decide to continue to play.

 

Third, as a result of the number of persons insured under D&O policies and the number of insurers that are involved in the typical D&O insurance tower, there are in connection with any securities class action settlement many participants, each with their own counsel. Often there are other parties (auditors, underwriters) who are named as defendants but who are strangers to the D&O policy. Not only are the insurers’ interests not aligned but often the insured persons’ interests are not aligned, and the insured persons’ interests often differ from the other named defendants. The carriers’ interests differ not only according to their attachment point in the insurance tower, but also based on situation specific factors such as how much defense expense has been expended and what the anticipated defense expense burn rate will be. The various carriers’ approach to settlement may also depend upon whether they believe they may have coverage defenses that potentially affect their payment obligations.

 

Not only are there a host of negotiating parties, there often are a host of proceedings involved, other than just the securities class action lawsuit. If a securities suit is serious enough to implicate the excess insurance, there will almost always be multiple other actions ongoing at the same time – usually a parallel derivative suit, often a pending SEC investigation or enforcement action, sometimes even a DoJ investigation or prosecution. The existence of these other proceedings can complicate the settlement dynamic in myriad ways. Serious securities class action settlement negotiations usually do not take place in a vacuum.

 

A final point about securities suits that should be emphasized is that securities class action lawsuits go to trial so rarely that the possibility of trial can safely be disregarded for most practical purposes. Everyone involved in the case knows it will never go to trial. There are very good reasons that these cases very rarely go to trial. The most important is that the theoretical damages almost always exceed the available insurance and in many cases outstrip the defendant company’s financial resources as well. A less dramatic constraint is that trials are costly, burdensome, and unpredictable and would constitute a huge distraction on senior company management. By the same token, the company could ill-afford a judicial determination that conduct that would preclude coverage has taken place. The plaintiffs have their own concerns; the expense of a complex jury trial could be enormous yet at the same time involves the risk of a defense verdict.

 

Together with these preliminary observations about D&O insurance and about the settlement process, I should also add the following observations on Professor Squire’s understandings and assumptions about D&O insurance.

 

First, Professor Squire assumes that corporate buyers consciously and deliberately structure their D&O insurance in multi-layered tiers because that creates “conflicts of interest among insurers that serve the interests of corporate managers,” as, he postulates, the conflicts “actually make insurance-covered settlements more likely.” There may be some buyers out there who are so canny that they manage their insurance buying decisions with these calculations in mind.

 

My own experience is that most insurance buyers would prefer to buy fewer, larger layers of insurance, because that would afford claims administrative simplicity, eliminate the headaches that always arise in the claims context when the insured company has to fight its way through multiple layers, and would simplify the insurance acquisition process.

 

The reason that D&O insurance programs are layered is because of the carriers’ preferences, not the buyers’ preferences. No D&O insurer could sustain the concentration of risk that would be involved with exposing outsized amounts of capital to any single large corporate exposure. Professor Squire assumes away this concern by saying that insurers could issue a single policy and simply “protect themselves from this risk through reinsurance.” However, there are a finite number reinsurers and they require a spread of risk every bit as much as the insurers do. The layering of D&O insurance is an inevitable by-product of an insurance marketplace where any given company’s insurance needs exceed the ability of any one insurer (or even one insurer and its reinsurers) to absorb all of the concentrated exposure associated with one risk.

 

Professor Squire also sees something amiss with the fact that D&O insurance policies cover both defense expenses and indemnity amounts. From my perspective, this arrangement is a natural reflection of the outgrowth of D&O insurance as a way for companies to contractually manage their indemnification obligations. In any event, the typical insurance buyer would consider it a strange notion indeed that their D&O liability insurance would not provide defense expense protection or at least that they would have to buy a defense cost policy separate from their liability policy.

 

With respect to Professor Squire’s analyses of the settlement dynamic, I note that in all of Professor Squires hypothetical settlement examples (and all of his examples are in fact hypothetical), he refers to the “expected trial liability” or “the actuarially fair settlement amount.” These are abstractions. There is no such thing in the securities context as “expected trial liability,” simply because there is effectively no data to describe such a thing. (For the same reason, talk of a party’s “bias to toward trial” or “aversion to trial” is equally inapposite.) By the same token, the idea that there is an objectively knowable amount equivalent to an “actuarially fair settlement amount’ is equally unwarranted.

 

What we actually have is a much rougher, much more approximate concept that usually is described as “what cases like this settle for.” Basically every single person in the settlement room will have their own version of this number, as well as their own concept of what features of the case make the comparables relevant. These points of reference are subjective, not objective; rarely the subject of agreement between the parties, at least at the outset; dependent on a host of assumptions; and allow for a range of possible outcomes that might constitute reasonable case resolutions depending on the myriad of factors.

 

In addition, the procedural posture of the case matters; the existence of related pending actions matter; the level of defense expenditure and the anticipated defense expense burn rate matters; the extent to which the defendants’ interests are aligned matters; whether some insurers believe they have unique coverage defenses matters; these and many other features matter and will influence the settlement dynamic and possibly affect the outcome of negotiations.

 

My point is that the settlement dynamic is complex and multifaceted. The very idea that settlement negotiations can be reduced to a mathematical formula with a few variables that explain outcomes in all cases – or even one case – is an interesting theory, as is the idea that settlement outcomes might be measured against a single, knowable measure that represents the “fair” outcome.  The idea that settlement of the class action could be taken in isolation from the myriad other factors – for example, the existence of other related pending proceedings – is an interesting hypothesis.

 

Turning to the specifics of Professor Squire’s proposal that settlements should be segmented rather than collective, I have the following observations. It is possible that the alternative settlement arrangement Professor Squire has proposed could work to produce settlements that are fairer to all participants and that could eliminate the many ills that Professor Squire has identified. I suspect his proposal would be particularly attractive to the carriers that are most routinely in the primary and first level excess layers. It would less attractive to the insurers that are most often in the upper excess layers. And it would be extremely unattractive to policyholders.

 

First, with respect to the upper level excess participants, if all defense side participants have to negotiate their own settlements, there could be an unfortunate dynamic that forces the excess to the settlement table and forces them to pony up money that they otherwise shouldn’t have to pay and wouldn’t pay now. This effect, the direct result of reducing the protection to the excess carrier from the underlying layers, would increase the loss costs of the excess insurers. This would likely make excess insurance more expensive and partially or entirely offset any savings that might be available if primary and lower level excess carrier loss costs were reduced. In other words, to eliminate the cramdown effect, the segmented settlement process would substitute a “cram-around” effect, or maybe a “cram-up” effect.

 

Second, the possibility of a settlement holdout will not be eliminated. But the process when there is a holdout will change. Let’s consider the possibilities. Assume that all of the other participants have settled except one middle layer insurer. Sure, there would be a lot of pressure on the holdout. But there would be enormous pressure on the policyholder, too. Every additional dollar of defense expense incurred will reduce the sole remaining layer, forcing the policyholder toward a possible trial with ever-dwindling amounts of defense costs protection and little or no insurance remaining for any judgments that might result. For all the reasons outlined above, the policyholder could never run this trial risk, and so could be forced to contribute to settlement to avoid the range of unpalatable outcomes. Indeed, crafty insurance players aware of this possible dynamic might become strategic obstructionists, in order to compel the policyholder to absorb settlement costs and possibly allow the obstructing insurer to negotiate a discount settlement deal.

 

My concern is that one almost inevitable outcome of the segmented settlement process that Professor Squire has proposed is that policyholders would be compelled to contribute more frequently and in much greater quantities toward settlement. To the extent I read Professor Squire’s proposal correctly, he fully anticipates this process effect. For example, he says “If the settlements were segmented, more of them would be paid for by corporations rather than by their insurers.” Indeed, as I understand his analysis, he reckons this as one of the positive factors supporting his proposal, because it would force more companies to recognize in their securities litigation loss costs in their financial statements.

 

However, if I am right about the way that this settlement dynamic would work out, the introduction of a segmented settlement process would simply substitute a different cramdown dynamic for the existing one. The new dynamic would be particularly pernicious as it would threaten to put the insurers in the position where they were jockeying to force loss costs elsewhere, including in particular onto their own insured. I am at a loss to see how this could ever be viewed as an appropriate or desirable arrangement of affairs between an insurer and a policyholder. No insurer interested in maintaining its reputation as a good corporate citizen would ever propose such a thing. No well-informed policyholder would ever propose such a thing, either.

 

Another practical concern is that requiring segmented settlements would prolong cases. Process participants jockeying for position would have every incentive to try to game the system, hoping that the eroding limits and the ongoing litigation burden will compel other participants, particularly the policyholder, to pony up to get rid of the case. Company management would be burdened and distracted by a complex multistage process that never seems to end and distracts them from the things they need to do to make their businesses successful. Litigation is bad enough as it is, but one settlement deal ends it. If multiple deals were required, it could go on and on and on… And all of these problems would be magnified enormously if there are other related procedural matters pending. 

 

My most important objection to Professor Squire’s proposal is that it is commercially impractical. He simply asserts that “segmented settlements could easily be achieved contractually.” This statement lacks a connection to the insurance marketplace. The theoretical possibility that in the long run segmented settlements might lower insurance costs or reduce the number of lawsuits will have no meaning to an insurance buyer, when compared to the very real possibility that the segmented settlement arrangement would cause the buyer to have to absorb loss costs that would otherwise be covered. No company would ever agree to do it — nor should any company ever agree to it.

 

All of that said, there unquestionably are serious ills with the current securities suit settlement process, many of which ills Professor Squire identifies in his paper. I am not sure I know how to remedy these ills. One possibility that Professor Squire considers and rejects is the possibility of a quota share arrangement, where the various carrier participants’ interests are arranged vertically, rather than horizontally. Under this arrangement, each carrier would share ratably in each dollar of loss costs, so the carriers’ interests in trying to save loss costs would be aligned in a way that would eliminate the conflict of interest problems Professor Squire identifies.

 

The shortcoming of the quota share approach is that it would be very difficult for all of the participating insurers to cede control to a single decision maker. In the absence of a single point of control, the claims process could be reduced to chaos. But on the plus side, there are multiple places in the insurance world now where quota share arrangements already are in place and functioning successfully. There is a lot to be said for an insurance arrangement that already actually exists as a possible solution for an insurance-related problem.

 

I would like to thank Professor Squire for allowing me the opportunity to read his interesting and thought-provoking paper and for allowing me to comment about his paper here. I enjoyed reading his paper and writing this comment – it kept from going crazy on a very long plane flight. I hope that readers of this blog will review the Professor’s paper on their own and will post their thoughts and comments about his paper here using this site’s comment feature.

 

And in Other News: With a long plane flight on Saturday, I not only had the leisure to type out this long blog post, but I also had the opportunity to read the Financial Times weekend edition at length and in full. With a more thorough reading than I am usually able to enjoy, I gleaned a couple of very interesting observations from articles in the paper.

 

First, in a April 14, 2012 article entitled “Unorthodox Behavior Rattles Russian Church” (here), the article’s author notes the following about Kirill I, the patriarch of the Russian Orthodox Church: “Last week bloggers discovered that a photograph of the patriarch on the Church’s website had been altered to remove a $30,000 Bruguet watch from the churchman’s wrist. While someone had used Photoshop to erase the offending object, they had forgotten to erase the watch’s reflection on a nearby mahogany table.”

 

And in an April 14, 2012 article entitled “Who Needs the Shard When You Have Shakespeare?” (here), commenting on the latest addition to the London Skyline (now under construction), the article’s author notes that

 

The skylines of European cities have traditionally told us something about what they believe in, and they still do. Until Harold Macmillan eased restrictions on buildings exceeding the height of St. Paul’s, London’s skyline consisted of two 100m-high buildings: St. Paul’s and the Big Ben clock tower. It was easy to see what London stood for: the Church and parliamentary sovereignty and not necessarily in that order. The skyline of modern London, with its dozen or so buildings more than 100m-tall, also sends a message. It is best summed up by the London Eye, which proclaims the city less a workplace than a tourist attraction. The rest of the buildings are about money.

 

On the Road Again: This upcoming week I will be a panelist at a session in Beijing co-sponsored by the American Bar Association Torts and Insurance Practice Section and by the China Council for the Promotion of International Trade. Information about the conference, which is entitled “Doing Business in the United States: What you Need to Know about Investing, Product Liability and Dispute Resolution,” can be found here. I will be on a panel entitled “Directors and Officers Liability, Securities Issues and Class Action Exposure” with my good friend Perry Granof, as well as Patrick Zeng of Zurich China, whom I am looking forward to meeting for the first time on this trip.

 

From Beijing, I will be going on to Professional Liability Underwriting Society (PLUS) Chapter events in Hong Kong and Singapore. Perry Granof will also be joining me educational sessions at these PLUS Chapter Events, as will my old friend Joe Monteleone. To those readers who may be attending the PLUS Chapter events, I am looking forward to seeing you. If we have not met before, I hope you will please take the opportunity to introduce yourself.

 

With the distances, time differences and commitments involved, I am not sure what sort of publication schedule will be possible over the next few days. The D&O Diary’s normal publication schedule should resume the week of April 30, 2012.