Class action securities fraud litigation is waning. Mary-Pat Cormier and Greg Pendleton of law firm Edwards Wildman Palmer L.L.P. discuss new public company litigation trends and urge directors, officers, and their insurers to heed the changing rules of the road.

Federal securities fraud class action litigation declined materially in 2012. There were just 152 such filings in 2012, 36 less than in 2011; moreover, the fourth quarter of 2012 saw only 25 filings, “the lowest number … in any quarter in the last 16 years,” according to a report on 2012 filings by Cornerstone Research.

But while corporate America might herald that drop, directors and officers of public companies should be aware that new litigation trends are emerging and are likely to grow in 2013 and beyond. That is, although garden-variety stock-drop class actions are winnowing, less traditional filings are on the rise.

What, then, is buoying the overall number of suits against public companies? What are the new risk exposures for officers and directors and, by extension, their D&O carriers?

Industry observers cite “opt-out” suits and shareholder derivative cases among the new drivers of public company litigation. With impending leadership changes at the U.S. Securities and Exchange Commission and the U.S. Department of Justice, and what we expect to be attendant increases in governmental investigations and enforcement actions, the number of claims related to the Foreign Corrupt Practices Act also is likely to climb.

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'Opt-out' litigation

Traditionally, few class members elected to “opt out” of pending securities class actions, as the time and monetary costs associated with doing so did not outweigh the benefits of increased recoveries. Within the last 12 months, however, a growing number of investors — and, critically, institutional investors — are choosing to proceed with their own litigation against the allegedly bad-acting company and its directors and officers.

Pfizer Inc. is the most recent high profile defendant in “opt-out” litigation. Several years ago, Pfizer and certain of its directors and officers were sued in a stock-drop class action by disgruntled investors who claim that Pfizer failed to adequately disclose the cardiovascular risks of its once-celebrated drugs Celebrex and Bextra. The class action, which remains pending in New York federal court, alleges that when the risk profiles of those drugs became public, Pfizer's stock lost upward of $65 billion in market capitalization. In November 2012, a number of mutual funds and public pension funds, including the California Public Employees' Retirement System, opted out of the class action. The plaintiffs have evidently deemed their chances of securing a satisfactory recovery from Pfizer to be improved by proceeding independently.

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Shareholder derivative suits

Shareholder derivative lawsuits are brought on behalf of the corporation against its directors and officers; their purpose is to remediate harm done to the corporation by those directors and officers. These suits frequently involve allegations of wasting corporate assets, misstating accounting records, self-dealing and directing corporate activity that culminates in criminal, civil or regulatory fines and sanctions. Frequently, shareholder derivative litigation is preceded by a “books and records demand” whereby shareholders seek to enforce their rights to inspect corporate accounts and minutes.

2011 and 2012 saw a number of notable shareholder derivative settlements and judgments:

• In late 2012, for $9 million and an agreement to adopt certain corporate reforms, Motorola Inc. settled a shareholder derivative suit that had been proceeding in parallel with a stock-drop class action.

• In 2011, Pfizer entered into a $75 million shareholder derivative settlement; the suit was filed after Pfizer paid $2.3 billion in 2009 to settle criminal and civil charges alleging that it illegally marketed drugs for a period of several years.

• In 2012, Southern Peru Copper Corp. was subjected to a judgment of more than $2 billion in a shareholder derivative suit alleging that its board caused the corporation to acquire a 99.15% interest in a Mexican mining company for much, much more than it was worth. The Southern Peru case included an attorneys fee award of $304 million, 15% of the total damages awarded in the case. (According to the defendants, the fee award equated with a billable rate of over $35,000 per hour for the plaintiffs' attorneys.)

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FCPA enforcement actions and follow-on litigation

The Foreign Corrupt Practices Act is a federal statute proscribing payments to foreign officials for the purpose of obtaining or retaining business. It is jointly enforced by the SEC and the DOJ. The FCPA applies to all U.S. persons and companies doing business overseas, including public companies and their officers, directors and employees. It also applies to foreign firms and persons who cause corrupts payment to take place within the United States. In addition to its anti-bribery provisions, the FCPA contains accounting provisions that require corporations to “(a) make and keep books and records that accurately and fairly reflect the transactions of the corporation and (b) devise and maintain an adequate system of internal accounting controls.”

Running afoul of the FCPA can be an unpleasant experience. In addition to being subjected to civil and criminal investigations and suits (and their attendant litigation costs, fines and penalties), public companies implicated in FCPA violations are often the targets of “follow-on” shareholder and stock drop suits. These suits typically allege that the corporate officers and directors failed to notice or prevent FCPA violations, resulting in massive penalties and losses levied against the company. Advisen Ltd. estimates that follow-on shareholder suits “are likely in 20% to 30% of (FCPA) investigations.”

Notable 2012 FCPA actions include filings against Eli Lilly & Co. ($29 million settlement); Tyco International Ltd. ($26 million settlement); Pfizer Inc. ($45 million settlement); and Smith & Nephew P.L.C. ($22 million settlement). Follow-on FCPA shareholder derivative suits were settled in 2012 by Johnson & Johnson Services Inc. and the Halliburton Co. Inc., among others.

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Risk exposures for corporate officers, directors and their insurers

The challenges of managing and funding opt-out litigation, shareholder derivative litigation, and FCPA enforcement actions and investigations are considerably different for public companies and their insurers than for stock-drop class actions.

The class actions from which opt-out plaintiffs remove themselves continue unabated. Thus, the company and its insurers must manage not only the original class action, but all the opt-out cases as well. This means that resolution will have to be reached in a piecemeal — and more complicated and costly — fashion, and discovery burdens likely will be compounded. It also presents an increased exposure to possible reputational damage. In light of the increased costs, more layers of excess insurance will be impacted, and insurers will be tasked with monitoring, evaluating and funding a growing number of suits stemming from the same wrongful conduct.

Shareholder derivative litigation presents its own unique risk issues. Such litigation frequently proceeds alongside traditional stock-drop class actions. When the class action proves large and costly, a company's blended D&O coverage can be exhausted. Directors and officers will thus have to ensure that the company has adequate Side A insurance to cover their defense costs and any settlements or judgments in the shareholder derivative case. Insurers, for their part, will have to carefully examine coverage issues attendant to derivative litigation, such as whether or not their respective policies cover books and records demands or special litigation committees, and whether or not the damages constitute uninsurable disgorgement or insurable loss.

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Finally, the shifting landscape at the DOJ and SEC has brought FCPA exposure to the fore. Since 2009, the DOJ has approximately doubled the number of attorneys working on FCPA cases. The SEC, for its part, recently created a specialized unit to enhance FCPA enforcement. Leadership changes are also afoot. Lanny Breuer, the assistant attorney general for the DOJ's criminal division, will step down on March 1; similarly, Robert Khuzami, the director of the SEC's enforcement division, relinquished his post in early January. Successors have not been named for either position. President Obama also has nominated Mary Jo White to serve as the Chairman of the SEC.

When the dust settles, we expect that FCPA investigations and related litigation will trend upward. D&O insurance can cover regulatory investigations and defense costs in enforcement actions (often for individuals only, rather than also for the corporate entity), but will not cover fines or penalties.

The decline in class action securities litigation signifies a shift in tactics by shareholder plaintiffs and securities litigators. Public companies and their insurers should heed the new rules of the road.

Mary-Pat Cormier is a partner at Edwards Wildman Palmer L.L.P., where she practices civil litigation. Ms. Cormier focuses her practice in the area of financial services and securities litigation, including disputes arising out of both coverage and bad faith claims handling against professional and specialty lines liability carriers, banking, creditors' rights, and limited partnership disputes. She can be reached at mcormier@edwardswildman.com or (617) 951-2225.

Greg Pendleton is an associate at Edwards Wildman Palmer L.L.P. Mr. Pendleton represents insurance carriers and other business entities in a variety of claims and coverage disputes, as well as in commercial litigation. He can be reached at gpendleton@edwardswildman.com or (617) 239-0764.