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As risk managers prepare for their January 2007 directors and officers liability coverage renewals, they have some evidence that securities class action litigation problems are no longer spiraling out of control.
That evidence, however, is uncertain at best and fleeting at worst, according to D&O insurance market observers.
The good news for insurance buyers, potential defendants and D&O underwriters is that--unlike most of the past 10 years--claim frequency has dropped significantly over the past two years, according to claim tracking organizations.
For example, research by the Stanford Law School Securities Class Action Clearinghouse of Palo Alto, Calif., in cooperation with Cornerstone Research of Boston, shows that claim filings this year are on pace to number fewer than 119, compared with 194 on average each year from 1996 through 2005. In 2005, 176 new claims were filed, compared with 213 the year before (see story, page 14).
Various factors might be converging to suppress claim filings, said some attorneys, insurers, brokers and consultants. Among them are tighter regulations designed to prevent fraud, smaller market capitalization losses and the legal troubles being juggled by a leading plaintiffs' law firm.
But many observers are not convinced that the two-year drop in claim frequency is a trend, or that it will continue.
"Many of those factors are not permanent, and therefore it seems highly unlikely that the reduced level of securities class action filings will continue for an extended period of time," said Dan A. Bailey, a partner with Bailey Cavalieri L.L.C. of Columbus, Ohio.
"Much like the dramatic reduction in securities class action filings during the two years immediately following enactment of the Private Securities Litigation Reform Act of 1995, this recent reduction in securities litigation activity is likely to be temporary," Mr. Bailey said.
John Gould, a vp with Cornerstone, is not ready to call the drop-off in filings a trend. Indeed, referring to the average of 200 annual filings during the past 10 years, he said: "It's hard for me to think that's not going to continue" just because of the number of filings over the "last six months to a year."
To Carol A.N. Zacharias, senior vp and underwriting counsel for ACE USA in New York, the drop-off appears to be part of a long-term "pattern of dips."
That means reacting to those numbers would be "a dangerous path" for insurance buyers to travel, said Gary Dubois, a New York-based executive with Ariel Reinsurance Co. Ltd. of Bermuda. "I think it's too early for risk managers and their in-house clients--directors and officers--to make any presumptions that this is a long-term trend."
Underscoring that assessment, many observers noted that claim severity bucked all of those factors and continued to rise dramatically through year-end 2005.
While the factors holding down claim frequency might begin working eventually on severity, they also might prove to be no match against the forces that are driving up the average cost of claims, observers said. Those forces include a growing percentage of lead plaintiffs that are institutional investors with fiduciary responsibilities. Compared to individuals, institutional investors have the financial strength to reject a quick settlement and wait for a much larger offer or force their cases to go to trial, where awards typically exceed settlements.
A Stanford Clearinghouse official concurs that claim frequency has fallen over too short a period to label the reduction a trend.
But Stanford Clearinghouse Director Joseph Grundfest said the "strongest theory" that would explain the drop in claim frequency is a "changed governance and litigation environment" since the Enron Corp. and WorldCom Inc. scandals.
Those scandals and the resulting Sarbanes-Oxley Act on corporate financial responsibility "have caused corporations to engage in less activity that would stimulate class action litigation," said Mr. Grundfest, who is a former commissioner of the U.S. Securities and Exchange Commission.
Market cap losses down
That is a partial explanation for the recent dramatic reduction in market capitalization losses, according to the Stanford Clearinghouse and Cornerstone. The researchers found that the so-called disclosure dollar loss--or the market capitalization loss that investors sustained the day after an organization announced it had misrepresented its financial reports--dropped markedly the first half of 2006 and for all of 2005 compared with losses from 1996 through 2004 (see chart).
Also contributing to the market loss reduction is that suits over the boom and bust of U.S. equities starting in the late '90s largely have been resolved and the U.S. stock market has been far less volatile in recent years, the researchers said.
But, Mr. Bailey asserted, Sarbanes-Oxley likely has had only limited impact on the frequency of securities class action filings.
"The number of restatements by corporations continues at near record levels, which suggests that misleading financial disclosures by companies are far from rare," Mr. Bailey noted.
Indeed, Sarbanes-Oxley eventually could become a helpful tool for plaintiffs' attorneys, said Carl Pursiano, a New York-based senior vp of management liability at Liberty International Underwriters, a unit of Liberty Mutual Group Inc.
For example, some companies' inability to comply with the section of the law on internal controls will become an important element of plaintiffs' cases, Mr. Pursiano predicted. In effect, he said, "SOX will map the way for plaintiffs."
As for the reduction in market capitalization losses, several D&O market observers said those losses will spike again.
"It's a matter of time until the market shifts to a bear market mode and/or a recession occurs," Mr. Pursiano said.
Another factor several observers say has contributed significantly to the reduction of claim filings is the legal troubles that have beset leading plaintiffs' law firm Milberg Weiss Bershad & Schulman L.L.P. of New York. Los Angeles federal prosecutors in May indicted the firm and two partners for allegedly paying $11.3 million in illegal kickbacks to individuals for serving as plaintiffs in numerous cases. Numerous attorneys have since left the firm.
Insurance brokerage executive Steve Shappell noted that Milberg Weiss typically was the claim filings volume leader among all plaintiffs' attorneys. In 2005, Milberg Weiss filed 91 cases, or more than half of the 176 securities class action cases. Through the first half of 2006, the firm represented plaintiffs in 17, or 27.9%, of case filings.
"So for them to be distracted is a very substantial factor," said Mr. Shappell, a managing director in Denver in the legal and claim practice at Aon Corp.'s Financial Services Group.
But Mr. Bailey disagrees."In virtually all securities class actions, several different plaintiff law firms separately file a complaint and then compete against each other for the role of counsel for the lead plaintiff," he said. "The absence of Milberg now simply means that other plaintiff law firms have a better chance of being designated as counsel for the lead plaintiff."
A plaintiffs' bar representative said the drop-off in securities class action filings is an aberration that would rebound to historical levels.
Plus, when considering the number of related shareholder derivative action lawsuits and cases that allege violations of the Employee Retirement Income Security Act, securities fraud litigation has grown during the current decade, said Kevin P. Roddy, president of the Washington-based National Assn. of Shareholder & Consumer Attorneys.
In a recent white paper on trends in securities class action lawsuits, ACE's Ms. Zacharias noted that the number of pending federal court ERISA cases grew to 216 in 2004 from 134 in 2002.
Tony Galban, senior vp and global D&O underwriting manager at Warren, N.J.-based Chubb Specialty Insurance, a unit of Chubb Corp., agrees that "there aren't fewer cases per se." Instead, there has been a shift in the types of fraud claims filed against corporate executives.
Mr. Galban said he sees "a lot of parallels between this period and 10 years ago" after the passage of the PSLRA, when the number of securities cases filed in federal court dipped as some were moved into state courts. But, eventually, the number of federal filings "came back with a vengeance."
So, the drop-off in class actions means that plaintiffs' attorneys are still active and handling as many cases as their resources will allow, said Mr. Roddy, an attorney with Wilentz, Goldman & Spitzer P.A. in Woodbridge, N.J.
In addition, the attorneys who left Milberg Weiss will need time at their new firms "to get geared up and get results," Mr. Roddy said.