Securities class action (SCA) lawsuits are being filed at aheated pace that hasn't been seen in more than two decades.

According to CornerstoneResearch, there were a record 325 SCAs filed in the first threequarters of 2017.

Filings in the first half of 2017 were up 49% over the secondhalf of 2016, and represented the highest number of SCA filingsover a six-month period since Cornerstone Research began trackingthe data in 1996.

What makes these numbers remarkable is that the stock market hasbeen strong with indices trading at record levels, having reboundedin the almost 10 years since the financial crisis in 2008. Inaddition, the Sarbanes-Oxley Act has had a positive impact oncompanies' internal controls over financial reporting, whichaccording to research firm AuditAnalytics has led to a drop in financial restatements.

PricewaterhouseCoopers noted in its 2016 studyon securities litigation that there was no apparent relationshipbetween the performance of the S&P 500 index in 2016 and thenumber of new SCAs filed, although in prior years there had been aninverse relationship.

Factors accounting for the rise

A variety of factors appear to be driving the rise in SCAfilings, from changes in the law governing mergers and acquisitionsto a disproportionate number of filings by smaller-tier plaintiff'sfirms. We could be witnessing the lawsuit equivalent of astock-picker's market: second- or third-tier plaintiffs' firms thatare identifying target companies for early settlements, as we oftenwitnessed before the enactment of the Private Securities Litigation Reform Act.

As a natural result, this wave of SCA filings may havesignificant implications for Directors and Officers (D&O)liability insurers, who find themselves increasingly exposed toD&O claims involving SCA lawsuits. D&O insurers shouldtherefore be aware of these trends, and should take certain stepsto ensure they can effectively handle such claims and underwritethese risks.

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A significant factor contributing to the increase in SCA actionsis the growth in federal merger-objection lawsuits, which challengeM&A deals on grounds that the company's board of directorsbreached their fiduciary duties by failing to maximize shareholdervalue or failed to make adequate disclosures. The majority of theselawsuits are resolved through settlements in which the targetcompany agrees to make additional disclosures in its proxystatement and improvements in corporate governance (corporatetherapeutics).

Shift to federal court

There also has been a shift in the filing of SCAs from statecourt to federal court as a direct result of the Delaware Court ofChancery's decision in In re Trulia, Inc., whichnoted disclosure-only settlements would be viewed with greaterscrutiny. This heightened scrutiny is unappealing to plaintiffs'class action attorneys, which is the reason the plaintiffs' bar isfiling an increasing number of Section 14(a) proxy lawsuits underthe 1934 Exchange Act. These federal securities-fraud lawsuitsallege disclosure violations and pose potential liability anddamages against the target company and its directors and officers,as well as the purchaser in certain cases.

In contrast to Section 14(a) proxy litigation, shareholderplaintiffs are filing Delaware Section 262 appraisal actions withincreasing frequency. These actions differ from the Section 14(a)proxy suits because under Delaware Section 262, the target has noliability, as the purchaser pays the difference in value betweenthe price offered in the M&A transaction and the court'sappraisal.

Yet another factor contributing to the rise of SCA lawsuits isthe number of cases brought against companies that areheadquartered outside the United States but whose shares trade onU.S. exchanges. According to Cornerstone Research's 2017 mid-yearreport, the number of SCA filings against non-U.S. companies is onpace to be at its highest level since 1997.

Certain industries being targeted

In addition, certain industries are being targeted at a higherrate. As reported by Cornerstone Research, a total of 69 securitiesclass action lawsuits were filed in the first half of 2017 againstlife sciences companies (companies in the fields of biotechnology,pharmaceuticals, and healthcare), which exceeds the number of SCAfilings against life sciences companies in all of 2016.

Another plausible explanation for the significant uptick in SCAlawsuits is the number of cases brought by second- and third-tierplaintiffs' firms. These law firms often target small-cap ormid-cap companies, and they became more active in the years sincethe global financial crisis in 2008.

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Today, SCA lawsuits filed by these firms make up a sizeableportion of the total SCAs filed. These firms also often pursue astrategy of filing lawsuits in the wake of bad news about a companyor a decline in the company's stock price. Second- and third-tierplaintiffs' firms are increasingly bringing SCAs on behalf ofretail investors, while the first-tier firms appear to be focusingon bringing larger cases on behalf of institutional clients.

How SCA lawsuits are resolved

Of the 226 SCA lawsuits brought in the first half of 2017, 95were merger objection lawsuits, which represents more thanone-third of the total number of cases. Moreover, there are anincreasing number of SCA lawsuits arising out of regulatoryviolations (although this number fell slightly in 2015 and 2016according to NERA Economic Consulting), with fewer suits allegingthat a company issued misleading earnings figures or insidertrading violations.

The outcomes of SCAs are of no small importance to D&Oinsurers, who may fund defense costs above the retention, as wellas any covered settlement or judgment. According to NERA, motionsto dismiss were filed in an overwhelming majority (94%) of SCAsbetween 2000 and 2016.

The court granted the motion with or without prejudice 44% ofthe time, granted in part and denied in part 30% of the time, anddenied the motion 25% of the time. In addition, a substantialnumber of SCAs are settled. In 2016, approximately 113 SCAs weresettled, which represents approximately 43% of all filings fromthat year.

What does this mean for D&O insurers?

The impact of the rise in SCAs on D&O Insurers is difficultto predict, but certain actions are worth taking given thesetrends.

1. Given the significant costs to defend SCAs,D&O underwriters should evaluate pricing levels andensure their policies contain sufficient self-insuredretentions. SCAs have become increasingly costly todefend, and these costs quickly erode retention levels, eventhrough the motion-to-dismiss phase.

2. Insurance claim departments must bepro-active in handling SCA claims tendered under theirpolicies, and ensure that they have sufficient resources toeffectively monitor these actions.

3. It might be necessary for D&O insurersto re-evaluate claim strategies, including closercoordination with defense counsel and pursuit of early resolutionstrategies to avoid unnecessary defense costs which can erode asignificant portion of the retention and/or policy limits.

As SCA lawsuits continue at a record pace, companies that arethe targets of these lawsuits will likely seek coverage under theirD&O policies, making it important for insurers to be aware ofthese ongoing trends, carefully review their policies, and consultwith counsel.

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Ivan J. Dolowich ([email protected]) is co-managing partner atKaufman Dolowich & Voluck LLP and Co-Chair of the InsuranceCoverage & Litigation Practice Group; Michael K. Rappaport([email protected]) is vice president andclaims counsel at Sompo International Insurance and Carla Caliendo([email protected]) is assistant vice president,claims counsel at Sompo. Andrew A. Lipkowitz, associate, KaufmanDolowich & Voluck, provided research for thisarticle.