D&O Insurers May Feel Adverse Consequences From High Court Rulings

With multibillion-dollar estimates of professional liabilitylosses related to the credit crisis proliferating, insurers heardmore bad news, as experts said recent pro-defendant Supreme Courtrulings may do little to lower securities class-action payouts.

In fact, one prominent plaintiffs' lawyer said that with theJanuary Supreme Court decision in Stoneridge Inv. Partners, LLC vs.Scientific-Atlanta Inc. eliminating his ability to go after thirdparties that help corporations carry out fraudulent financialschemes, he'll probably tag members of audit committees ofcorporate boards--and their directors and officers liabilityinsurers--for bigger portions of damages.

"The world is now safe essentially for you to help a company'cook the books' because folks like me can't get to them," saidSean Coffey, a plaintiffs' lawyer with Bernstein Litowitz Berger& Grossman in New York, giving his assessment of the JanuarySupreme Court ruling.

By a 5-3 vote, the U.S. Supreme Court in Stoneridge affirmedlower-court decisions throwing out a lawsuit by shareholders ofCharter Communications Inc., a cable television company, againsttwo of the its equipment suppliers. The shareholders had sued thetwo suppliers--Motorola and Scientific-Atlanta--for allegedinvolvement in deceptive transactions that helped Charter inflateits earnings.

The shareholders alleged that Charter made agreements with thesuppliers to pay inflated prices for cable boxes. The suppliersthen turned around and used the excess cash to advertise onCharter's cable system--boosting Charter's revenues to meetsecurities analysts' expectations.

Mr. Coffey, summing up the implications of the Supreme Courtdecision in favor of the suppliers, said that in the pre-Stoneridgeworld, in a similar case tried to a jury verdict, he would have putan extensive list of culpable parties into the jury room forproportionate fault. The list would include "senior management thatcooked the books, the audit committee that looked the other way,and the third parties that helped management...and lied to theauditors, plus the auditors."

With the third parties now beyond his reach, "Who's going topick up that fault?" he asked. "It's going to be apportioned toremaining defendants."

"The audit committee is going to be hit with a bigger numberthen they would if those other people were at the table," he said,assuming that members of the audit committee either knew or werereckless.

Mr. Coffey made his comments during the Professional LiabilityUnderwriting Society D&O Symposium this month, where bad newsseemed to come at every turn for corporate boards, executives, andtheir D&O and professional liability insurers. In addition tonegative assessments of Stoneridge, attendees heard:

o Gloomy predictions about the impact of the subprime crisis onD&O and E&O insurers, including insurance loss estimatesthat now reach as high as $9 billion.

o Statistics that show evidence of a reversal of a two-yeardecline in securities fraud class actions.

o Defense lawyers saying that well-known adversaries from theplaintiffs' bar, who are now facing the prospect of jail time foralleged involvement in kickback schemes, were preferable to a newcrop of converted product liability lawyers who have stepped intothe securities arena.

(See related links at the end of this article for more detailson these three trends.)

In addition, an SEC representative, although rejecting a notionadvanced by Mr. Coffey that Stoneridge will put more onus on thegovernment to bring cases against aiders and abettors of corporatefrauds, said that bringing such cases has been--and remains--a highpriority for the SEC.

"Our decision-making about bringing these cases was nevergoverned by what the private bar was or was not doing in thisarea," said Mark Schonfeld, director of enforcement in the SEC'sNew York office.

Citing SEC actions against Adelphia Communications as "the bestexample" of what the agency has done, he said the SEC brought casesagainst individual audit partners and managers, and counterpartiesto transactions designed to cook Adelphia's books, noting that theywere ironically the same as those involved in Stoneridge--Motorolaand Scientific-Atlanta.

"Regardless of what the private bar is able to do under existinglaw, we continue to have this focus on a broad array ofcounterparties that can contribute to an accounting fraud," hesaid.

Lawyers speaking at the PLUS conference also said a SupremeCourt decision handed down last year in Tellabs Inc. v. MakorIssues & Rights, which had been widely hailed as a win forcorporate directors and officers and their insurers, has had nopractical impact in the real world.

The Supreme Court decision--which set the legal barrier forbringing securities cases higher than the 7th Circuit from whichthe case originated--rejected the idea that a complaint couldsurvive if it simply "alleges facts from which a reasonable personcould infer" that a defendant acted with intent to defraud.

The Supreme Court required that the inference of evil intentmust be "the strongest inference" that can be drawn for a case toadvance.

"In my world, it doesn't make a damn bit of difference," saidEvan Chesler, a defense lawyer for Cravath, Swaine & Moore inNew York, noting that the only effect has been "to weed out a fewoddball cases."

"I read Tellabs 30 times, and I can't understand what...itmeans. I don't understand...balancing these inferences," he said,suggesting that such "nuances" are beyond comprehension for federaljudges who "are just mere mortals."

"They get up in the morning. They read the pleadings...Theyscratch their heads [and] say, "Do I think there's enough here togive this plaintiffs' lawyer a shot past the pleading stage?'"

"That's the standard in most federal courts," no matter what theSupreme Court said, he added. "Most judges will not throw out acase if they think there's enough smoke around that there mightactually be an ember somewhere in the pile."

With other defense and plaintiff lawyers agreeing with Mr.Chesler, just about the only good news to emerge for insurers atthe conference was the description of a recent victory at trialfrom the lawyer who defended the case known as JDS Uniphase.

"The merits matter" in securities cases, according to JordanEth, a partner for Morrison Foerster, a defense firm in SanFrancisco. "You can't just say [there was] $500 million of insidertrading all in one month, and a $90 billion market-cap loss,therefore you lose," he said, reporting that despite thoseseemingly bad facts, the jury delivered a defense verdict.

"Jurors take it much more seriously. It's not a one-day focusgroup. It's a four-week trial. The merits do matter [and] thepeople do matter," he said, referring to the fact that a group ofcredible and likeable defendants were instrumental in convincingthe jury to find in their favor.

Mr. Eth tried to urge PLUS attendees to shed traditional damagemodels in which they simply multiply potential damages by somepercentage representing the chance of losing, and decide to settlebecause the calculation results in a big number.

Mr. Chesler agreed. "A trial is a trial," he said. "A crediblewitness increases your chances of winning, whether the subjectmatter happens to be securities fraud or patent infringement orbreach of contract."

"In courtrooms, as opposed to conference rooms, trial resultsare binary. You win or you lose," he said, predicting that morecases will go to trial because institutional investors, who nowserve as lead plaintiffs, will push for them.

Jeffrey Rudman, a defense attorney for Wilmer Hale in Boston,said he does not foresee the same trend, or the correspondingdecrease in settlement payouts for insurers.

"Securities fraud cases involve individuals as defendants in away that patent cases do not. There are reputational outcomes inplay," Mr. Rudman said. In addition, the very fact that insurersprovide large amounts of insurance for securities cases, and notpatent cases, means "there are more acute table stakes," hesaid.

At a later session, Evan Rosenberg, senior vice president forChubb & Son in Warren, N.J., took issue with an idea expressedby Mr. Eth that the D&O insurers who had written policies forJDS Uniphase came out winners.

"The defense costs on that case almost blew out the toweranyway," Mr. Rosenberg said. "Even when you win, you lose."

Bain Head, a broker and senior vice president for McGriff,Siebels & Williams in Houston, said defense costs are likely tobe significant for D&O insurers on the hook to pay lossesrelated to the subprime crisis.

Although Ms. Head speculated that recent analysts' estimates of$8-to-$9 billion in D&O and E&O losses arising from thesubprime crisis are too high, reasoning that the lists of financialinstitutions that analysts use to derive the estimates includefirms that don't buy traditional D&O limits, she still believesa "several-billion-dollar loss" is likely, which will be isolatedto a small few number of primary carriers.

Even if a lot of cases are dismissed, "there are still going tobe significant defense costs," which will hit the primary carrierson D&O programs, she added.

Lending further credence to multibillion-dollar insurance lossfigures, both Ms. Head and Mr. Rosenberg said the financialinstitutions industry is not the only one likely to face lawsuitsand regulatory scrutiny.

"I think everyone in the audience is saying, 'Stop talking aboutsubprime. We're way past subprime. This really is a credit crisis,"Mr. Rosenberg said, predicting that even specialty retailers willsoon face fallout from the subprime debacle. "What you're seeingnow is individuals saying, 'I can pay my mortgage and stay in myhouse for another month, or pay my credit card.' People are goingto make choices on whether to purchase big items."

The whole private equity marketplace is being pulled into thecrisis as well, he said. Many deals have been scrapped because thecompany that was the target is experiencing financial difficulty,or the private equity firm can't raise the money, he said.

"The company that sold out and now can't consummate [the deal]may get a D&O lawsuit if it was publicly traded, and privateequity investors may decide to bring an action," he said.

Randall Bodner, a partner for Ropes & Gray in Boston, saidshareholders in public companies have already brought some actionsin situations where private equity deals were being offered atprices as high as double the stock market price, and then wentaway.

"Should the public company have made better disclosures to themarket when the deal was announced to better apprise them of thatrisk?" he asked, explaining why directors and officers have toworry about litigation.

Like Mr. Rosenberg, Mr. Bodner predicted broad fallout from thecurrent credit crisis.

"This is a Wall Street crisis that originates on Main Street.People really care about it--and judges are people, too," he said,predicting a lower dismissal rate for subprime cases than for theoptions backdating cases that impacted the D&O market lastyear.

Mr. Bodner also said that a "bulked up" enforcement staff at theSEC in the "post-Enron, post-Spitzer" world, along with ambitiousstate attorneys general and an "alphabet soup" of other regulatoryagencies (including the Department of Justice, the Federal Bureauof Investigation and the Department of Labor, which will beinvolved with ERISA claims) will raise the dollar impact of thesubprime crisis, but that a portion of those costs aren't coveredby insurance.

Both Mr. Bodner and Ms. Head said any fines or penalties arisingfrom such investigations are not insurable, and that many companiesdo not have coverage for other costs associated with regulatoryinvestigations.

"Defense costs can literally run into the tens of millions ofdollars," Mr. Bodner said. "I have one client whose copying costsfor the SEC were $9 million."

Mr. Schonfeld confirmed that the subprime meltdown "has become apriority for this year" at the SEC, with a dozen publicly announcedinvestigations currently ongoing, which "run the gamut of themortgage underwriting and securitization process from beginning toend."

On the civil litigation front, Mr. Chesler said cases haveexpanded well beyond simple borrower-vs.-lender suits in whichborrowers allege they were misled about the terms and conditions ofloans.

Investors in special-purpose vehicles for securitizations ofthese loans are suing issuers of securities, the underwriters ofthose issuances, the auditors, and even the rating agencies, henoted.

Mr. Chesler predicted that "investor-vs.-investor" suits will bethe next wave of litigation. Where people invested in publiccompanies, which themselves were invested in the SPVs, "there's aquestion as to whether those secondary-level investors have viableclaims against first-level investors for not adequately disclosingthe nature of the risk," he said.

In addition, "if the tentacles of this problem are as long assome suggest, there will inevitably be a wave of insolvencies" andlitigation arising from that, he said.

Mr. Rosenberg said there has historically been a lag between thetime when the financial-institutions segment of the D&Oinsurance market has problems and the eventual strengthening ofrates across the entire commercial D&O market.

"This is not going to get better in 12 months. I don't see thecredit crisis diminishing for probably 24 months," he said. "So therational underwriters would start making those decisions today--flattening rates out generally, raising them where you need to, sowe don't have to be in a position where we're jacking prices upmultiple percents, restricting coverage--the usual behavior."

"Unless there's a single event that wipes out a lot of capitalvery quickly, we're not going to see that for awhile," he said,noting that with billions of dollars in excess capital in theindustry, rates will continue to fall.

"If I were to look at a specific risk and tell [the broker] Ineed a flat renewal or an increase, then nine times out of 10, I'mgoing to lose that business," he said.

At a separate session, John Doyle, president of AIG ExecutiveLiability in New York, noted that relationships are also a factorin how business is priced and where it is placed, noting that somenewer markets "are led by people who have been at a half-dozenplaces in the past 15 years."

Stephen Sills, chief executive officer of Darwin ProfessionalUnderwriters in Farmington, Conn., noted that there are 30-pluscarriers offering a lot of capacity, with no one having enoughmarket dominance to dictate the way the rest of the marketmoves.

"If someone suddenly decides they're going to pull out of aclass, what's the difference? Chances are it has no impact," Mr.Sills said. "It's like taking your hand out of a bucket of water.You couldn't tell it was there before."

"The market continues to roll on unless there's universal pain,"he said.

John Lupica, president of ACE USA in Philadelphia, said hecontinues to see pricing that he saw 22 years ago, becauseunderwriters forget to get pricing for systemic shocks likesubprime or options backdating issues.

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