A New Reality In Securities Litigation

In the early years of the new Millennium, bubbles have becometrends which have become the new reality in the securitieslitigation arena. What were previously passed off as one-timeevents are happening with such frequency and pervasiveness thatthey have become part of the new liability landscape for directorsand officers and their insurers.

Reality Number 1: Bubbles Are NowConstant.

First it was initial public offering allocation cases, then itwas analyst claims, then accounting scandals, and now mutual fundcases. Each new year brings a new scourge to the liabilitymarketplace that can be disclaimed as a bubble. However, thesebubbles have become so commonplace that they are part of the newliability landscape in securities litigation.

In 2001, a record 312 initial public offering allocation caseswere filed, according to Cornerstone Research. Plaintiffs allegedthat investment bankers and companies unfairly allocated shares ininitial public offerings to selected clients. In addition, numerousanalyst cases were filed in which plaintiffs alleged that analystsproduced research reports and ratings that lacked objectivity orreasonable factual basis, purportedly to garner business forinvestment banking divisions of their firms.

In 2002, numerous cases were filed involving accountingirregularities at major firms. Targets included Enron, WorldCom,Adelphia, HealthSouth, Xerox, Tyco, ImClone and even accountingfirms, such as Anderson. Accounting and restatement cases nowcomprise a majority of shareholder class action claims, as morefully discussed below in Reality Number 2.

In 2003, New York Attorney General Elliot Spitzer commenced abattery of inquiries into mutual fund trading practices,culminating in numerous highly publicized internal or externalinvestigations at firms including Fred Alger Management, AllianceCapital Management Holding LP, Bank of America Corporation, BankOne, Federated Investors Inc., Janus Capital Group Inc., PutnamInvestments, Strong Capital Management Inc. and Morgan Stanley.These have prompted some firms to suspend employees following aninvestigation, while others have offered restitution for anyadverse impact on the fund.

A central issue in these investigations is late trading, inwhich an investor purchases shares at a days trading price butafter the 4 p.m. close, thereby allowing the trader to profit frominformation not available to others. Another issue is market timingtrading, whereby an investor makes rapid trades in mutual fundshares, which affect the value of the shares of other fundparticipants. Many funds prohibit or limit market timing trading,and may so state in their prospectus. Thus, while marketing timingtrading is not illegal, it may be in violation of theserepresentations.

Reality Number 2: Accounting Allegations.

In 1996, 47 percent of all private securities class actionscontained accounting irregularity allegations, according toPricewaterhouseCoopers. In 1997 through 2002 the percentage jumpedto 68 percent, with restatements playing a major role. While therewere only 23 cases filed in 1996 in connection with a restatement,there were 69 cases in 2002, a 200 percent increase. Whether thiswas in response to recently heightened pleading standards or otherfactors, the reality is that accounting irregularities are a partof todays new securities litigation landscape.

Two major categories of accounting issues are raised most oftenin litigation. Of securities class actions filed in 2002, 82percent alleged misrepresentations in financial documents and 50percent alleged a GAAP violation, according to CornerstoneResearch. In addition, 50 percent of the GAAP cases allegedimproper revenue recognition, while 47 percent of those casesalleged an overstatement of assets, including inventory andaccounts receivables, according to Cornerstone.

Reality Number 3: Severity of Settlements.

Severity has become the watchword for securities class actioncases. The average shareholder class action settlement in 2002 was$19.9 million, an increase of 12 percent from 2001 and an increaseof 40 percent from the average value from 1996 through 2000,according to a recent PricewaterhouseCoopers study. CornerstoneResearch put the 2002 value at $24.3 million, up from $16.6 millionin 2001; Tillinghast put the 2002 value at $23 million, 35 percentmore than the 2001 settlement value of $17.18 million. Fortyindividual settlements each exceeded $10 million in 2002, and 106settlements totaled an aggregate sum over $2.1 billion dollars,according to Cornerstone Research. Hence, severity is a reality insecurities class action litigation today.

Reality Number 4: Criminal Prosecutions.

The United States Department of Justice and the various stateattorneys general have stepped up criminal investigations andprosecutions to unprecedented levels. While there were only fourcriminal proceedings relating to securities cases filed in 1996,there were 14 in 2000 and 39 in 2002, according to aPricewaterhouseCoopers study. Investigations, indictments andconvictions, or guilty pleas, are more frequent than ever beforeand are concomitant with civil proceedings in many cases.

Thus, the new reality for securities litigation in the newmillennium appears to be that litigation bubbles are part of thecyclical nature of the industry; settlement values are significantand show no signs of diminishing; accounting irregularities aremajor drivers of these claims; and criminal prosecutions are partof the new liability landscape.

The issue becomes whether and to what extent directors andofficers, or entity, insurance policies provide coverage. Examiningthe more recent mutual fund cases, each case will turn on its ownfacts, and each insurance policy is unique. Hence generalities andpredictions are impossible. However, the following are some issuesthat may be germane in the mutual fund claims.

A variety of policies may pertain to the mutual fund situations.The fund may have a directors and officers liability policy for itsexecutives, and an errors and omissions policy for the entity andits employees. In addition, there may be an employment practicesliability policy. The fund may have a parent with similar D&Oand EPL policies. In addition, executives at both the parent andfund level may be outside directors, with D&O coverageavailable to them by virtue of the outside directorship clauses inthe D&O policy provided by the main board which they serve.

Also under investigation are banks, hedge funds and brokerageoperations, all of which may have similar policies.

While any or all of these policies may be in place, the questionof whether claims will be paid under these policies will turn onthe presence or absence of certain exclusions and on certain termsand conditions. Exclusions might include:

Known wrongful act/dishonesty exclusions: Many of these D&Oand E&O policies exclude known wrongful acts, dishonesty orfraud. Some cases may include allegations that late trading was aprivilege granted intentionally and knowingly to key clients.

Profit, remuneration exclusions: Many of these D&O andE&O policies exclude acts for improper personal profit,remuneration and financial advantage. This is pertinent as somecases may include allegations that insureds realized individualprofits, were engaged in self-dealing, or otherwise profiteddirectly from the practice of market timing or late trading.

Compensation exclusion: Many E&O policies exclude the returnof compensation. This may be relevant in cases where funds returnmanagement fees earned, a form of compensation.

Fines and penalties excluded: Many D&O and E&O policiesexclude fines and penalties. Regulators are seeking fines andpenalties in some cases.

Fraud in the application: Some cases allege that transgressionshave been going on for some period of time and that some were beingcommitted knowingly. Applications may contain warranty statementsafter the transgressions, raising application warrantyquestions.

Loss required: Many D&O and E&O policies cover thelosses of the insureds. The issue becomes whether the return ofmanagement fees and other gain constitutes a loss of theentity.

Carol Zacharias is a senior vice president and counsel tothe Diversified Risk division of ACE USA. The views expressedherein are her own and do not represent those of ACE USA or anyother company.

Reproduced from National Underwriter Property &Casualty/Risk & Benefits Management Edition, November 26, 2003.Copyright 2003 by The National Underwriter Company in the serialpublication. All rights reserved.Copyright in this article as anindependent work may be held by the author.