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ST. PAUL, Minn.-In a high-stakes securities fraud trial, directors and officers liability reinsurer Genesis Insurance Co. played a daring and unprecedented hand that could have cost the company 10 times more than if it had folded and walked away.
Instead, last week the reinsurer came away with a court victory that it hopes will embolden other defendants and D&O insurers to fight securities fraud allegations triggered by share price downturns.
Genesis persuaded both a computer manufacturer facing a class-action lawsuit and the company's D&O insurers to fight the allegations that about 1,200 shareholders leveled after the company's stock price fell precipitously in 1994. The shareholders sought up to $28 million of damages.
Genesis and parent company General Reinsurance Corp. of Stamford, Conn., fully reinsured an excess insurer for policyholder Tricord Systems Inc. of Plymouth, Minn.
The decision to fight the allegations rather than settle them was rare in itself. Less than 4% of such cases go to trial, policyholder and insurer attorneys agree.
But, the enticement that a Genesis unit offered the policyholder and its D&O insurers to wage the battle was unheard of: Minus any primary limits remaining after the primary insurer paid defense costs, Genesis and Gen Re would pay the full amount of any jury award against the computer maker if it lost the case. That included relieving the London market, which wrote an excess layer of coverage, of any obligation to contribute to such an award.
The risk: If the jury had awarded the full damages the plaintiffs sought, Genesis and Gen Re would have had to contribute at least $26.5 million.
On top of that, the two reinsurers would have been responsible for picking up any defense costs that exceeded Tricord's primary limits. Defense costs counted against policy limits, and the primary insurer was not obligated to pay any defense costs that exceeded those limits.
If Tricord and its insurers had accepted a $4.6 million pretrial settlement offer by the plaintiffs, the reinsurers' share would have been about $2.6 million, or one-tenth of what they risked going to trial, according to Kevin LaCroix, president of Genesis D&O Liability Insurance Program, a Beachwood, Ohio-based unit of Genesis.
And, the settlement would have been covered fully by Tricord's $6 million of D&O insurance.
The Home Insurance Co. of New York wrote a $2 million primary layer. Progressive Casualty Co. of Mayfield Village, Ohio, wrote $3 million of limits excess of $2 million. Genesis and Gen Re fully reinsured Progressive. The London market wrote $1 million of limits excess of $5 million.
On June 16, though, a federal court jury in St. Paul, Minn., found that Tricord and a current and a former officer could not have predicted Tricord's revenue downturn in 1994 before they issued a far more optimistic revenue projection.
The shareholders have not decided whether they will appeal, said shareholder attorney Karl Cambronne, a partner with Chestnut & Brooks P.A. in Minneapolis. He said the shareholders had filed a "right-eous case."
Genesis' unusual gamble has been discussed in insurer and defense attorney circles for a while because of the tension these types of cases create between policyholders and their D&O insurers, said D&O insurer attorney Mike Gassmann, a partner with Drinker Biddle & Reath L.L.P. in Washington.
Even though policyholders and their insurers contend that many such cases have little merit, "historically, there's not been much incentive to the insurer or the insured-especially the insured-to take one of these cases to trial," Mr. Gassmann said. That's because the risk of being held liable for damages that far exceed policy limits has been so great, he said.
Because of policyholders' and insurers' common goal of holding down settlements, there has been some policyholder grumbling that an insurer should take the financial risk of litigating one of these cases, Mr. Gassmann said.
The Private Securities Litigation Reform Act of 1996, which is designed to discourage frivolous securities fraud allegations, did not apply to this case because it was pending before Congress passed the act. And, it's too early to assess whether the law is deterring some claims and holding down the value of settlements, Mr. Gassmann said.
Even with the securities reform act, "true litigation reform will come only if you're willing to fight these suits," said Mr. LaCroix of Genesis. "The way to reform the system now is to take the case to the jury."
But, Mr. LaCroix and policyholder and insurer attorneys do not expect D&O insurers to take over the defense of every securities fraud lawsuit filed against their policyholders and relieve them of any court judgment that exceeds policy limits.
"Clearly, it's a strategy you could use only in exceptional cases and use only when you feel there's a high degree of success," Mr. LaCroix said. "We'll use creative ways to avoid getting sucked into the same dance" of settling meritless cases rather than putting policyholders at risk of being held liable for damages their D&O policies do not cover.
"To the extent these and other strategies will produce this success, we'll look into it," he said, noting that Tricord and all of its D&O insurers ended up "better off" by litigating this case.
Even The Home benefited. The defense costs totaled about $900,000, of which The Home contributed about $750,000, according to Mr. LaCroix. Tricord, which was a named defendant but is not covered by the D&O policy, is responsible for the remaining $150,000.
Mr. Gassmann agreed that insurers will not be rushing to the courthouse steps with this strategy. "Clearly, this is not going to happen in every case."
However, he predicted that other D&O insurers will at least look at this case and consider the same strategy when they face securities fraud litigation they consider meritless.
But, The Home's attorney, Dan A. Bailey, does not expect other insurers to follow Genesis' lead. The case will "get their attention," but other insurers will not bear such a risk, predicted Mr. Bailey, a partner with Arter & Hadden in Columbus, Ohio.
"It remains to be seen whether this victory will encourage other insurers to make similar arrangements," said D&O insurance policyholder attorney Carolyn Rosenberg, a partner at Sachnoff & Weaver Ltd., the Chicago firm that represented Tricord.
The case may have a bigger impact on future plaintiffs. "It may discourage future suits from being brought, and it may encourage more responsible settlements," Ms. Rosenberg said.
Policyholder attorney Sarah Wolff of Sachnoff & Weaver, who represented Tricord at trial, said the case also sends a signal that a drop in stock price alone is not enough to support a securities fraud lawsuit.
The case centered on when Tricord and two officers in 1994 knew that the company's revenues would be far lower than projected.
Tricord on July 1, 1994, slashed its projected annual revenue figure to $90 million from an estimated $120 million to $125 million. That day it also estimated that its second-quarter revenues would fall $10.5 million shy of the $27.5 million projection Tricord issued two months earlier.
Tricord's initial annual projection would have been a 50% to 56% improvement over 1993 revenues of $80 million. The revised estimate represented a 12.5% improvement.
The day of the announcement, the company's stock price plunged nearly 50% to $5.625 a share from the previous day's closing at $10.75.
Combining two lawsuits into a class action, the federal court in St. Paul certified as a class 1,200 shareholders who purchased Tricord stock from April 20 through June 30 of that year.
On April 20, 1994, then-Tricord President and Chief Executive Officer James Edwards told securities analysts during a discussion about the company's first-quarter results that he expected Tricord would be able to generate the $120 million to $125 million in revenue that Wall Street had estimated.
Mr. Edwards did tell the analysts, though, that Tricord's revenues from its largest customer would fall by about 50% in 1994. He said the customer, Sequent Computer Systems Inc. of Beaverton, Ore., would generate $10 million to $12 million in revenue. In 1993, Sequent generated about $23 million, or more than 28%, of Tricord's total revenue.
Tricord, which currently produces computer software, then was a manufacturer of computer network servers. Sequent purchased Tricord's servers and resold them under its own name to end-users.
The plaintiff shareholders argued that Tricord knew in January 1994 that it could not meet Wall Street's revenue projections.
For example, Mr. Cambronne, the shareholder attorney, said Tricord engineered a deal to deliver a large quantity of unusable computer servers to Sequent by the end of the first quarter for the sole purpose of bolstering Tricord's 1994 first-quarter revenues by $4 million.
As part of the deal, Tricord agreed to service the servers later so that Sequent could resell them.
In addition, Tricord led analysts to believe its relationship with Sequent was "never better," even though it was "on the skids," Mr. Cambronne said.
He was asked why Sequent would agree to the computer shipment deal to bolster Tricord's revenues.
He replied both companies wanted to present their relationship as more solid than it was. Mr. Cambronne also noted that Tricord at the same time promised to buy back millions of dollars of old Tricord inventory Sequent could not move.
Ms. Wolff, Tricord's attorney, said those arguments were meritless for several reasons.
The first-quarter shipment had been negotiated for months, and Sequent faced losing a 3% price discount if it did not take delivery that quarter, she explained.
In addition, Tricord by contract sold unconfigured computer servers to Sequent. After Sequent had sold the equipment, Tricord configured the servers to meet individual customers' requirements, Ms. Wolff explained.
The $3 million buyback agreement was economically beneficial for Tricord in two ways, Ms. Wolff said.
Tricord agreed to pay about half of the amount Sequent had paid for the equipment, Ms. Wolff said. Tricord then was able to use the old inventory for parts in new equipment, she said.
In addition, under the arrangement, as each product line in Sequent's older inventory was depleted, Tricord was allowed for at least one year to directly market that line for use with Microsoft Corp.'s Windows NT software, Ms. Wolff explained.
That was a lucrative provision for Tricord, she said. Before then, only Sequent could market those servers for that application.
If Sequent's business dealings hurt Tricord's stock price, then Tricord's stock price would have reflected that in late April right after Mr. Edwards revealed Sequent would generate sharply lower revenue for Tricord in 1994, Ms. Wolff said.
Tricord's revenue downturn in 1994 was attributable to unanticipated competition from Compaq Computer Corp., the later-than-expected availability of Microsoft's Windows NT software that year and weaker-than-expected growth in international sales, Ms. Wolff and Mr. LaCroix said.
In Re Tricord Systems Inc. securities litigation, U.S. District Court for the District of Minnesota, 3rd Division; No. 3-94 Civ 746.