Size of D&O Settlements Exploding
The following summarizes many of those recent blockbuster settlements and judgments, as described in published reports:
1. A $2.83 billion dollar settlement in a shareholder class action against Cendant Corp. and its directors and officers. The lawsuit alleged that the defendants artificially inflated the company's stock price through an accounting fraud, which resulted in the company restating its financial statements for several years. The lead plaintiffs in the litigation were three of the country's largest public pension funds, New York State Common Retirement Fund, New York City's Pension Funds, and the California Public Employees Retirement System.
2. A $457 million settlement in a securities class action against Waste Management and its directors and officers. The lawsuit alleged that the defendants misrepresented material facts regarding the company's 1998 merger with USA Waste Services, Inc. and a 1999 accounting scandal which resulted in the company twice revising reported earnings and taking a $1.8 billion write-off.
3. A $454.5 million jury verdict in a lawsuit by two individuals against Comp USA, its former CEO, a principal shareholder and two affiliated companies of the shareholder. The plaintiffs in the lawsuit allegedly entered into an agreement with CompUSA to open CompUSA stores in Mexico. The jury found the defendants improperly breached that agreement and awarded the franchising deal to the principal shareholder defendant. The jury allocated the total damage award 65% to the former CEO, 25% to the principal shareholder, and 10% each to two affiliated companies of the principal shareholder.
4. A $259 million settlement in a shareholder class action against 3Com, U.S. Robotics, and various directors and officers of those companies. The lawsuit alleged the defendants misrepresented material facts regarding the companies' financial performance and 3Com's acquisition of U.S. Robotics. The alleged wrongdoing occurred both before and after the acquisition. Two of the lead plaintiffs were institutional investors.
5. A $230 million settlement in a shareholder derivative lawsuit against directors and officers of Computer Associates, Inc. The lawsuit alleged that the defendants breached their fiduciary duties and unreasonably jeopardized the company's financial condition by awarding to three executives $500 million in stock options. The settlement followed a ruling by the court that the three executives must return 9.5 million of the 20.25 million shares they received under what the court found to be a misinterpretation of the company's compensation plan.
6. A $220 million settlement in a securities class action lawsuit against Waste Management, Inc. and its directors and officers and auditor. The lawsuit alleged that the defendants overstated the company's profits over several years, resulting in a restatement of the company's financial statements with a $1.32 billion adjustment in previously reported profits for the preceding six years. A related shareholder derivative lawsuit was settled for approximately $23 million in total consideration.
7. At least a $193 million settlement in a securities class action against Rite Aid Corporation and its directors, officers and outside auditor. The lawsuit alleged that the defendants engaged in various earnings-inflating and expense-deflating accounting practices, which resulted in the company restating its financial statements for three years and removing approximately $1.5 billion of after-tax earnings from those financial statements. The settlement was funded with $43.5 million in cash and 20 million shares of common stock, with a guaranteed minimum value of $149.5 million. Claims against the former chairman, CFO and president of the company, as well as the company's auditor, were not released as part of the settlement and were subsequently pursued by plaintiffs.
8. A $165 million settlement in a state court breach of fiduciary duty class action against directors of Digex, Inc. The lawsuit alleged that the defendants breached fiduciary duties owing to Digex shareholders by agreeing to merger terms which were inadequate to the shareholders. The settlement was funded entirely with stock in the acquiring company (World Com).
9. A $142 million settlement in a shareholder class action against Informix Corporation, its directors and officers and accounting firm. The lawsuit, which purportedly resulted in the largest securities fraud settlement in the history of Silicon Valley, alleged that the defendants violated the federal securities laws by issuing materially false financial statements for three and one-half years. Those financial statements were eventually restated. Fifty-one million dollars of the settlement was paid in cash and the remaining $91 million was paid in company stock. The defendant accounting firm paid $34 million of the $51 million cash portion of the settlement.
10. A $123 million settlement in a securities fraud lawsuit against Medical Care of America, its predecessor companies (Corrections Corporation of America and Medical Care International) and their directors and officers. The lawsuit arose out of the company's revised earnings forecasts just two weeks after its merger. The settlement consisted of $47.5 million in cash and $75.4 million in common stock.
11. A $115.5 million settlement of shareholder class actions against Philip Morris Companies, Inc. and its D&Os. The lawsuits alleged the defendants failed to disclose material information regarding the addictive effects of nicotine in cigarettes and regarding alleged manipulation of the company's sales performance through "channel stuffing" of its products.
12. A $113.7 million settlement in a securities class action lawsuit against MicroStrategy, Inc. and its directors and officers. The lawsuit alleged that the defendants misrepresented the financial condition and performance of the company, resulting in a restatement of the company's financial statements for three years. As part of the settlement, the company issued notes to the class members for $80.5 million in cash and a distribution of company stock guaranteed to be worth at least $16.5 million. Some of the company stock was paid directly by the D&O defendants. The cash portion of the settlement was payable in five years, although the company is required to make interim payments of $3 million every six months.
13. A $111 million settlement of shareholder class action and derivative litigation against IKON Office Solutions and its directors and officers. The lawsuits alleged that the defendants artificially inflated the company's stock price by issuing misleading financial reports from 1996 through 1998, during which period the company acquired 220 corporations. The settlement does not resolve related shareholder litigation against IKON's auditor.
14. A $92.5 million settlement of federal and state shareholder class actions against The Boeing Company and its directors and officers. The lawsuits alleged that the defendants misrepresented and concealed information about the status of Boeing's commercial airplane production problems and the financial results of those operations. The entire cash settlement was paid by Boeing's D&O insurers.
Perhaps even more troubling than the size and frequency of these enormous settlements is the fact that this level of settlement inflation is occurring in securities class actions of all sizes. Smaller cases are often now settling for as much as 30% to 50% more than what would have been expected in 1999, partly due to the ripple effect caused by the record settlements summarized above.
Like most surprising phenomenon, this rather sudden explosion in the size of D&O settlements is attributed to a combination of several factors:
1. Financial Restatements. A disproportionate number of the large settlements involve companies that restated their financial statements for several reporting periods, resulting in a large drop in the companies' stock price. Restatement cases are inherently very difficult to defend since the defendants concede by announcing the restatement that they misrepresented to investors material information concerning the company's financial condition and performance. Frequently, the only issues debated in these types of cases is whether the defendants were sufficiently reckless in issuing the false financial statements and what are the damages caused by the false financial statements.
2. Institutional Investors. One of the major goals of the Private Securities Litigation Reform Act of 1999 ("Reform Act") was to encourage institutional investors to become more active as lead plaintiffs in securities class action so that the prosecution of these cases would be controlled by a true client rather than by professional plaintiff lawyers. In many instances, institutional investors have been unwilling to accept that role. However, especially in larger cases, several institutional investors are now agreeing to serve as lead plaintiff. In those cases, settlement negotiations on behalf of the plaintiff class are driven by a true desire to maximize shareholder recovery, rather than to merely maximize the fee for the plaintiff lawyers. Frequently, this has an inflationary effect on the size of the settlement.
3. Damages. The boom stock market in the late 1990s resulted both in the stock price and the number of shares traded for many companies increasing greatly. When adverse information about a company was ultimately disclosed, the inflated stock price frequently dropped dramatically. A large stock drop when combined with a high volume of trading during the class period yields extraordinary plaintiff-style damages. In many "routine" securities class actions today, it is common for plaintiffs to contend that damages exceed hundreds of millions of dollars, and in the larger cases the alleged damages may exceed several billion dollars. In the face of potential exposure of that magnitude, a settlement of tens of millions of dollars or even several hundred million dollars may appear reasonable to a defendant, even if that size of settlement is far in excess of historical settlement amounts.
4. Entity Coverage. In recent years, most large public companies added to their D&O insurance policies coverage for securities claims against the company, thereby eliminating the need to allocate loss in such claims between the insured director and officer defendants and the uninsured company defendant. Although this entity coverage is helpful in eliminating contentious allocation disputes between the insureds and the D&O insurer, the existence of such coverage appears to have had an inflationary effect on many securities claim settlements. Because both the D&O's and the company are fully insured, the defendants frequently seek to resolve the potentially catastrophic lawsuit at any price within the insurance limits and no longer have an economic incentive to aggressively negotiate the lowest possible settlement terms.
5. Plaintiff Leverage. In the immediate aftermath of the Reform Act, plaintiff lawyers expected more of their securities class actions to be dismissed by courts. As a result, in order to maintain their historic levels of income, the plaintiffs bar began to demand higher settlement payments in those cases that survived a motion to dismiss by defendants. Because most defendants in securities class actions are unwilling to submit the case to a jury trial, the defendants eventually agree to plaintiffs' inflated settlement demands. Boeyed by their settlement successes, the plaintiffs bar has steadily increased their demands to higher and higher levels.
The trend towards larger loss payments by D&O insureds and insurers is likely to continue into the foreseeable future. According to the Stanford Law School Securities Class Action Clearinghouse, the number of federal securities class action lawsuits which have been filed in each year from 1997 through 2000 was generally consistent with the number of cases filed before the Reform Act. However, the year-to-date number of filings for 2001 is significantly higher than prior years. If that trend continues for the remainder of 2001, there will be approximately a 25% increase in the number of securities class action filings when compared with historical experience.
These recent filings reflect several changes in the plaintiffs' approach to securities class action litigation. The jurisdiction in which the most federal securities class action cases are now filed is the Southern District of New York, not the Northern District of California. This development is driven in part by the harsher pleading requirements in California and in part by the diversification of targeted defendant industries, as discussed below. In addition, a larger percentage of the lawsuits focus on allegations of accounting fraud, with revenue recognition issues emerging as particularly significant causes of litigation. Also, an even larger percentage of the post Reform Act filings allege insider trading during the class period.
In addition, recent securities class actions are focusing on a wider range of industries as target defendants. Historically, the high-tech industry represented by far the greatest frequency and generally the greatest severity in securities class action cases. However, as demonstrated by the list of large settlements set forth above, enormous settlements are occurring not only in the high-tech arena, but also in numerous other industries, some of which were historically viewed as relatively safe underwriting risks. Today, there is no "safe" industry from the huge exposures presented by securities class action litigation.
From a D&O insurance perspective, the unprecedented size of recent settlements and the growing frequency of D&O securities class actions have several consequences:
- Limits of Liability. It is always difficult to identify the proper amount of D&O limits a particular company should purchase. However, it is now clear that if a company purchased an appropriate level of D&O insurance 2-3 years ago, that company needs to purchase higher limits today. Stated differently, if a company that was adequately insured does not increase its D&O limits, that company is underinsured today.
- Premium Increases. D&O insurers have suffered a "double whammy" to their underwriting profitability as a result of these increased settlement amounts. Not only has the amount of loss incurred by their insureds exploded, but the percent of that loss paid by the insurer has similarly increased as a result of entity coverage and other policy enhancements which have become popular during the latest "soft" insurance market. When combined with lower investment returns, most D&O insurers and their reinsurers now believe significant premium increases are necessary in order to maintain the viability of this important insurance product. Insureds should anticipate continuing and significant D&O premium increases for several years. This dynamic exists not only at the primary and lower excess layers of coverage, but also at the higher excess levels of coverage. Unlike the past, those higher levels are now far more exposed to potential loss and therefore appropriately need higher premiums.
- Policy Terms. Many D&O insurers believe further amendments to the policy form are necessary in order to realign the interests of the insureds and the insurer in the defense and settlement of large claims. By creating economic incentives for insureds to negotiate the lowest possible settlement and otherwise to minimize the amount of loss, the insurers hope to seek to assure appropriate defendant behavior consistent with the intended insurer-insured partnership. Examples of policy provisions which may be requested by insurers for this purpose include co-insurance; pre-determined allocation in lieu of entity securities coverage; pre-approved defense counsel; and retrospective additional premium arrangements.
- Insurer Claim Involvement. In light of the greater potential severity of claims and the perception that at least some insureds may not be sufficiently incentivized to aggressively seek the lowest possible settlement, many D&O insurers are becoming more closely involved in the defense of securities claims. Examples of this increased activity may include more frequent status/strategy meetings with defense counsel and insureds; interviews of key witnesses and the insureds; review of a more comprehensive set of documents; attendance at important depositions; meetings with defendants' expert witnesses; retaining separate experts to perform a damages or other important analysis for the benefit of the insurer; and conducting independent investigations and analysis of key aspects of the case. Insureds and their counsel should not resist, but welcome this increased involvement as a means to further the common goal of minimizing the ultimate cost of the litigation. If insurers do experience resistance, additional policy terms will likely appear that expressly grant to the insurer various claim-handling rights.
In summary, a new era of D&O catastrophic exposure now exists. Companies should expect the cost and terms of their D&O insurance policies to eventually reflect the increased losses which have been and inevitably will be paid by insurers in this new environment. The magnitude of these market changes in the coming years will depend in part upon the extent to which the defendants in securities class actions successfully contest the trend toward escalating settlement amounts.