A New Reality In Securities Litigation

In the early years of the new Millennium, bubbles have become trends which have become the new reality in the securities litigation arena. What were previously passed off as one-time events are happening with such frequency and pervasiveness that they have become part of the new liability landscape for directors and officers and their insurers.

Reality Number 1: Bubbles Are Now Constant.

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

In 2001, a record 312 initial public offering allocation cases were filed, according to Cornerstone Research. Plaintiffs alleged that investment bankers and companies unfairly allocated shares in initial public offerings to selected clients. In addition, numerous analyst cases were filed in which plaintiffs alleged that analysts produced research reports and ratings that lacked objectivity or reasonable factual basis, purportedly to garner business for investment banking divisions of their firms.

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

In 2003, New York Attorney General Elliot Spitzer commenced a battery of inquiries into mutual fund trading practices, culminating in numerous highly publicized internal or external investigations at firms including Fred Alger Management, Alliance Capital Management Holding LP, Bank of America Corporation, Bank One, Federated Investors Inc., Janus Capital Group Inc., Putnam Investments, Strong Capital Management Inc. and Morgan Stanley. These have prompted some firms to suspend employees following an investigation, while others have offered restitution for any adverse impact on the fund.

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

Reality Number 2: Accounting Allegations.

In 1996, 47 percent of all private securities class actions contained accounting irregularity allegations, according to PricewaterhouseCoopers. In 1997 through 2002 the percentage jumped to 68 percent, with restatements playing a major role. While there were only 23 cases filed in 1996 in connection with a restatement, there were 69 cases in 2002, a 200 percent increase. Whether this was in response to recently heightened pleading standards or other factors, the reality is that accounting irregularities are a part of todays new securities litigation landscape.

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

Reality Number 3: Severity of Settlements.

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

Reality Number 4: Criminal Prosecutions.

The United States Department of Justice and the various state attorneys general have stepped up criminal investigations and prosecutions to unprecedented levels. While there were only four criminal proceedings relating to securities cases filed in 1996, there were 14 in 2000 and 39 in 2002, according to a PricewaterhouseCoopers study. Investigations, indictments and convictions, or guilty pleas, are more frequent than ever before and are concomitant with civil proceedings in many cases.

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

The issue becomes whether and to what extent directors and officers, or entity, insurance policies provide coverage. Examining the more recent mutual fund cases, each case will turn on its own facts, and each insurance policy is unique. Hence generalities and predictions are impossible. However, the following are some issues that 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 its executives, and an errors and omissions policy for the entity and its employees. In addition, there may be an employment practices liability policy. The fund may have a parent with similar D&O and EPL policies. In addition, executives at both the parent and fund level may be outside directors, with D&O coverage available to them by virtue of the outside directorship clauses in the D&O policy provided by the main board which they serve.

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

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

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

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

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

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

Fraud in the application: Some cases allege that transgressions have been going on for some period of time and that some were being committed knowingly. Applications may contain warranty statements after the transgressions, raising application warranty questions.

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

Carol Zacharias is a senior vice president and counsel to the Diversified Risk division of ACE USA. The views expressed herein are her own and do not represent those of ACE USA or any other company.

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

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A New Reality In Securities Litigation

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