This rather sudden explosion in the size of D&O settlements is attributed to a combination of several factors:

·   Financial Restatements. A disproportionate number of 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 because the defendants, by announcing the restatement, concede that they misrepresented to investors material information concerning the company's financial condition and performance. Frequently, the only issues debated in such cases are whether the defendants were sufficiently reckless in issuing the false financial statements and the amount of damages caused by the false financial statements.

·   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 heightened 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.

·   Damages. The boom stock market in the late 1990s resulted in a great increase in both the stock price and the number of shares traded for many companies. 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 action period yields extraordinary plaintiff-style damages. In many “routine” securities class actions today, it is common for plaintiffs to contend that damages are in excess of hundreds of millions of dollars, and in the larger cases the alleged damages may exceed several billion dollars. In the face of a 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.

·   Entity Coverage. In recent years, most large public companies added coverage for securities claims against the company to their D&O insurance policies. By doing so, they eliminated the need for insurers to allocate loss in such claims between the insured directors and officers and the uninsured company. 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 directors and officers and the company are fully insured, they frequently seek to resolve the potentially catastrophic lawsuit at any price within the insurance limits. In other words, there is no longer an economic incentive to aggressively negotiate the lowest possible settlement terms.

·   Plaintiff Leverage. Following passage of the Reform Act, plaintiff lawyers expected more of their securities class actions to be dismissed by the courts. As a result, in order to maintain their historic levels of income, the plaintiffs bar began to demand higher settlement payments in cases that survived the defendant's motion to dismiss. Because most defendants in securities class actions are unwilling to submit the case to a jury trial, they eventually agree to the inflated settlement demands of the plaintiffs. As a result of their settlement successes, plaintiffs' attorneys have steadily increased their demands to higher levels.

Changes in Securities Class Action Litigation

Recent securities class action 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.

Historically, the high-tech industry was subject to the greatest frequency and generally the greatest severity in securities class action cases. Recent securities class actions now are focusing on a wider range of industries as target defendants. 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, underwriters view no industry as being “safe” from the huge exposures presented by securities class action litigation.

In addition, a larger percentage of the lawsuits now focus on allegations of accounting fraud, with revenue recognition issues emerging as particularly significant causes of litigation. Also, growing percentage of the post Reform Act filings allege insider trading during the class action period.

Although the Sarbanes-Oxley Act of 2002 represents an unprecedented change in corporate governance practices, it has not directly resulted in either more suits being filed or larger monetary exposures in the suits that are filed. It is likely, however, that at least some courts will look to the corporate governance practices mandated by the Act when defining the fiduciary duties of directors and officers. Therefore, there may be some indirect effect on at least derivative suit settlements.

In addition, the judgments and settlements summarized do not reflect any ERISA-related actions, such as the Tagalong claims (see discussion beginning on Page A.3-5 of the Risk Management section of this volume).

Impact on D&O Coverage

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 more difficult to identify the proper amount of D&O coverage limits a particular company should purchase. It is now clear, however, that whatever limits were purchased two to three years ago, higher limits need to be purchased today. Stated differently, if a company that was adequately insured does not increase its D&O limits, that company is likely to be underinsured today.

·   Premium Increases. Many D&O insurers have suffered significant dislocations to underwriting profitability as a result of increased settlement amounts. Not only has the amount of losses incurred by insureds exploded, but the percentage of 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 a declining stock market and lower investment returns, most D&O insurers and their reinsurers now believe significant premium increases are necessary in order to maintain the financial viability of this important insurance product. As a result, insureds could be faced with significant D&O primary and excess premium increases for several years. Unlike the past, insurers providing high levels of primary or excess coverage now feel far more exposed to potential loss than ever before.

·   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, insurers hope to better assure defendant behavior consistent with their intended insurer-insured partnership. Examples of policy provisions which may be requested by insurers for this purpose include coinsurance, predetermined allocation in lieu of entity securities coverage, preapproved defense counsel, and retrospective additional premium arrangements.

·   Insurer Claim Involvement. In light of the greater potential cost of claims and the perception that at least some insureds may not have the incentive or ability 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 the insureds, interviews of key witnesses and 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 both independent investigations and analysis of key aspects of the case. Insureds and their counsel should benefit from this increased involvement as a means to further the common goal of minimizing the ultimate cost of litigation. If insurers experience resistance, however, new policy terms that expressly grant various claim-handling rights to the insurer may begin to appear.

     Although companies should expect the cost and terms of their D&O insurance policies to eventually reflect the trend toward increased losses paid by insurers, the magnitude of these changes in the coming years may depend upon the extent to which the defendants in securities class actions successfully contest the escalating settlement amounts.