Directors and officers insurance claims experts–who should be resting comfortably on news of plummeting securities class actions–are instead feeling increased pressure, squeezed by a dizzying array of potentially negative legal trends challenging the future of their business. “There is a total state of confusion,” said Michael Mitrovic, vice president of claims for American International Group and president of AIG Worldwide Financial Services in New York.

Mr. Mitrovic was referring to what he views as some of the negative impacts of the Sarbanes-Oxley Act–the 2002 law that set rules of corporate governance and public company financial disclosure–as well as penalties for executives involved in corporate fraud.

“I have never seen in the history of doing this business so much animosity between the boards and managements. And part of it is occasioned by provisions in Sarbanes-Oxley” requiring insiders and outsiders to report perceived wrongdoing, he noted.

When financial regulators show up at the door, board members who are moved by fear of criminal or civil prosecution “are going to give up managements,” he said, adding that managements no longer talk to boards, and in some cases shop their companies without board knowledge.

“Acrimony between boards and management is going to continue to engender and foster litigation,” he predicted in remarks delivered at the D&O Symposium of the Minneapolis-based Professional Liability Underwriting Society in February.

More typically, D&O experts at the New York conference cited SOX as one of the positive factors driving a widely reported 38 percent plunge in securities fraud class actions in 2006. The drop was reported in January by the Stanford Law School Securities Class Action Clearinghouse, a joint project between Stanford Law School and Cornerstone Research.

The “total state of confusion” that Mr. Mitrovic described during his anti-SOX monologue seemed to spill over throughout the PLUS conference.

Joseph Cotchett–a lawyer for Cotchett, Pitre, Simon & McCarthy in Burlingame, Calif., who brings securities cases on behalf of plaintiffs–said securities class actions are poised for an even greater freefall.

“This case is going to drive down the filings of class actions by 50 percent,” Mr. Cotchett predicted, referring to the impact of a Second Circuit ruling last year decertifying a class of cases against securities underwriters known as initial public offering laddering cases and raising the requirements for class certification.

The decision in “IPO is the wave of the future,” he added. “Scheme liability [or liability for aiding and abetting financial fraud] is going to be tightened dramatically, and fraud on the market is gone,” he continued, referring to the potential erosion of two theories central to bringing securities class actions.

Mr. Cotchett also said the “greed factor” that induces plaintiffs' lawyers to bring class actions is being reined in.

“There has been a movement to bring that pendulum back, brought on by some indictments we've seen,” he said, referring to the May 2006 indictment of Milberg Weiss, one of the most active plaintiffs firms in filing securities class actions. The firm was charged with paying secret kickbacks to individuals who agreed to act as defendants. “I think that's going to have a very serious effect–perhaps rightly.”

Mr. Mitrovic, whose firm insures defendants, speaking at a later session than Mr. Cotchett, said that “in defense of Milberg Weiss, I don't believe in killing an ant with a baseball bat.”

Expressing sympathy for embattled plaintiffs' lawyers alleged to have paid kickbacks, Mr. Mitrovic described what he sees as “regulatory overexuberance,” as enforcement agencies go after individuals with intensity, trying “to ruin careers.”

Agreeing that the firms may have been too powerful, there are other ways to reduce their efforts to manageable levels, he said. “Give them fines. Have them enter into consent decrees not to do something like that…In the scheme of wrongdoing, [this] doesn't excite emotions in me to want to kill these people off completely.”

The investigation into the kickback schemes is “the single biggest reason why class actions have dropped off,” he added, suggesting that pundits miss the boat when they instead point to SOX requirements, better regulatory and criminal oversight, a good economy, and a low level of stock market volatility as the main contributors.

Further contributing to the overall state of confusion in the D&O world has been an influx of derivative suits over options backdating activities that were not on anyone's radar screen as an emerging issue at last year's PLUS conference.

Jeffrey Rudman, a defense attorney for Wilmer Cutler Pickering Hale and Dorr in Washington, speculated that the number of companies implicated, which he put at 140 at the time, would double or triple.

According to a running count on “The D&O Diary,” a blog maintained by former PLUS President Kevin LaCroix, 154 companies had been tagged for alleged involvements in backdating schemes. These firms face derivative suits rather than class actions, but among them, there were 29 also facing class actions as of March 20.

Mr. Cotchett, whose practice focuses on bringing derivative actions–suits brought by shareholders on behalf of the company, naming directors and officers as defendants–wholeheartedly agreed with Mr. Rudman. However, insurance experts at later sessions dismissed his prediction.

Some also said that insurance claims payouts for derivatives cases are lower than class actions, and that policy exclusions and even potential rescission actions might work to lower the insurance industry bill.

Kevin Gadbois, executive vice president of Great American Insurance Group in Schaumburg, Ill., wasn't among them.

“You might not be worried about paying a $100 million judgment or settlement, but these cases are not free,” he said, pointing to defense costs as a major issue for insurers–especially when multiple parties retain their own lawyers (the company, the audit committee, those who approved the options, and those who got them).

If the total number of cases goes to 450 three years from now, “it's going to take a major hit out of the D&O industry just to get these through the system,” he added.

As for coverage denials, “I can't even spell rescission anymore. The market does not allow rescission actions,” he said, adding that the D&O industry has gone from one extreme (“saying, if these guys are crooks and the guy who signed the application is a crook,” then the policy is voided) to the other (believing that if “one poor guy didn't know anything,” the insurer has to pay tens of millions on his behalf).

All this took place before:

o A stock market dive, blamed on troubled subprime mortgage lenders, that has already fueled a handful of new class actions.

o The 5th U.S. Circuit Court of Appeals in New Orleans ruled on March 19 that a class action against investment banks for their advisory roles that allegedly led to Enron's collapse cannot move forward.

o A Florida district court ruled in favor of insurers on a hot D&O coverage issue on March 14.

o The U.S. Supreme Court hears a case regarding procedural hurdles for bringing securities class actions. (The hearing was scheduled to take place after this article went to press.)

In addition, this all took place against the backdrop of premium declines that experts say are likely to continue (see page 13).

Denise Amantea, a partner with insurance broker Woodruff-Sawyer in San Francisco, dismissed the idea that backdating cases will triple. “Most of our [client] companies have had to at least do some internal investigation,” she said. If some are doing investigations now and will report later, “that is news to me. I just don't see that many cases coming to light.”

Explaining why she believes derivative suits vastly outnumber class actions, she suggested that the stock drops that fuel class actions are not occurring because backdating disclosure isn't something shareholders care about.

“It happened a long time ago,” she said. “But they do care when boards force out CEOs who they view as good leaders of the company. That's where you see the stock dropping” and class actions, she added.

Sean Coffey, a plaintiffs' lawyer with Bernstein Litowitz Berger & Grossman in New York, said while it's unclear whether derivative cases will be profitable for plaintiffs' firms, angry institutional investors are pushing the cases. “We are bringing these [backdating] cases because our clients are mad. They view this as stealing, and they want us to do something about it.”

Mr. Cotchett agreed, noting that members of pension funds he represents, such as teachers, make only $65,000 per year, and they're outraged by the millions given away in backdated options to executives at companies in which their funds invest.

While Mr. Rudman and others insisted that most of the backdated options actually went to engineers at technology companies making roughly $85,000 per year, many conference speakers worried about a potential new crop of derivative cases on the horizon–over executive compensation generally–that may result from a new SEC disclosure rule (affecting public companies for fiscal years after Dec. 15, 2006) and media attention to the disclosures.

In such cases, Mr. Gadbois worried not just about outraged shareholders, but about Delaware judges who might be swayed to second-guess business judgments and allow cases to proceed.

Giving an example of a Yale-educated judge making $150,000 per year, reviewing a case about “a guy with a bachelor's degree from nowhere taking $140 million out of a company for one year's work,” he said there's a natural tendency for the judge to work backward from the premise that the executive was overpaid to conclude, therefore, that directors approving compensation failed to act with due care.

As for coverage for this exposure, Professor Michael Klausner of Stanford Law School said “there are serious arguments that, at least in some [backdating] cases, carriers will be able to make to avoid coverage.” He cited the potential application of intentional fraud and illegal remuneration exclusions as examples.

Ms. Amantea worried about coverage denials springing from the definition of a claim itself. She noted, for example, that clients are racking up costs for internal investigations running in the millions of dollars. “Isn't there any underwriter in the room who will cover those?” she asked.

Experts note that not only are costs of self-initiated investigations not covered claims, but also that costs of complying with informal SEC and Department of Justice investigations are also not covered. (A recent report by Priya Cherian Huskins of Woodruff-Sawyer on the firm's Web site noted that some carriers are starting to cover costs of informal investigations that later mature into formal ones.)

Other potential coverage battles loom over whether carriers will deny claims they deem to be “disgorgement of ill-gotten gains,” and when and if insured-versus-insured exclusions will kick in.

An officer receiving a well-timed option “doesn't view his stock options as ill-gotten gain or illegal remuneration,” Ms. Amantea pointed out.

She makes a good ethical argument, according to Mr. Mitrovic, urging carriers and brokers to engage in forthright dialogues over such issues. “If you've been granted options, and somebody above you–you're CEO–has decided to backdate those options, but you didn't have any say in it…that might be worth discussing,” he said.

Along with backdating issues, Mr. Cotchett's forecast of a 50 percent drop in class actions was also a subject of intense debate at the PLUS conference. Lawyers argued over legal specifics of a Dec. 5, 2006 ruling in In Re: Initial Public Offering Securities Litigation, which prompted his forecast, along with his predictions for the potential demise of popular theories used to bring cases.

Mr. Rudman explained that the key holding in the decision was that a federal district court judge had erred in granting class-action status to six focus cases out of 310 consolidated class actions–known as laddering cases–alleging wrongdoing by securities underwriters in allocating IPO shares to customers.

The district court had allowed “some showing” that the elements of Rule 23 of the Federal Rules of Civil Procedure governing class actions had been satisfied to certify the class, rather than finding that “each and every element” of the rule had been satisfied.

The ruling provoked discussion among the lawyers at PLUS over whether, going forward, class actions alleging fraud and intentional misrepresentation in connection with securities will be able to rely–as they do now–on the theory of efficient markets (that prices reflect all available material information), or whether courts will instead require a showing that stock purchasers were aware of, and directly relied on, misstatements.

Lawyers said they will also anxiously wait for a decision from the U.S. Supreme Court, which agreed to review a case from the Seventh Circuit, Tellabs Inc. v. Makor Issues & Rights. Arguments were heard on March 28.

At issue is a provision of the Private Securities Litigation Reform Act, which sets forth pleading requirements and procedures for bringing securities class actions to federal court.

The provision that is the focus of Tellabs requires a complaint alleging securities fraud to state “with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind.” In other words, facts must be presented, and plaintiffs lawyers must “connect the dots” to show that a defendant acted with either knowledge of misstatement or reckless indifference, Mr. Coffey explained.

While courts have already considered the question of what constitutes “the required state of mind” (producing a split among the circuits, with the 9th Circuit imposing the most stringent requirement of “deliberate or conscious recklessness”), Mr. Coffey said Tellabs shifts the focus.

“This appeal, in my view, turns on one word 'a'” immediately proceeding the words “strong inference,” he said, explaining that defendants have been pushing for an interpretation of the pleading standard that would require that an inference of evil intent must be “the strongest inference” that can be drawn from a set of facts–”that there can't be innocent explanations. If there are [innocent explanations], then the court has to weigh them,” Mr. Coffey said.

In Tellabs, the 7th Circuit rejected this approach. “We will allow the complaint to survive if it alleges facts from which, if true, a reasonable person could infer that the defendant acted with reasonable intent,” the court said.

If the Supreme Court decides instead that it has to be “the” strongest inference, “that's going to cut down on these cases,” Mr. Coffey said.

Special Reports /

Emerging Exposures Could Put D&O Insurers In A Tight Spot On Claims

Related Stories

Recommended For You