Middle-Market Companies Replace Enrons, Tycos As Securities Suit Targets

Between dramatic musical lead-ins, and interspersed among comments of other experts on securities litigation on the video, Mr. Lerach, a member of the Milberg Weiss firm in San Diego, predicted that a large number of securities cases were just waiting to be filed against smaller companies.

"This may be the single most important new litigation trend [and] of extreme interest to the insurance industry," he said.

Having never faced off against the renowned adversary of large companies, the buyers of insurance for midsized companies in the audience may have been unmoved by his remarks. But there was a definite chill in the room when an insurance executive from the largest writer of D&O insurance gave his prediction about trends in lossesand correspondingly, in premium rates for this line of coverage.

"I dont know where this is all going," said John Keogh, vice president Domestic General Insurance division of American International Group and president and chief executive of National Union.

That ominous uncertainty of an expert followed closely on the heels of absolute certainty from Mr. Lerach and warnings from a defense lawyer that complacency about securities litigation would get executives from small and midsized companies into trouble.

During the video of a presentation that AIG hosted earlier this year for key producers, Mr. Lerach said: "I think youre going to see a larger number of cases being brought against smaller companies. I just sense that is where this is going to go."

Mr. Lerach and other speakers later filled in more details explaining that his "sense" was more of a matter of economics. And Mr. Keogh assured attendees that Mr. Lerachs "sense" was in fact a message.

"Hes telling you where hes going to go," Mr. Keogh said.

Detailing trends over the last few years which have institutional investors taking control of securities litigation, Mr. Lerach said that a "winner-takes-all concept" prevails among plaintiffs law firms that specialize in the securities litigation arena because of the provisions of the Private Securities Litigation Reform Act of 1995.

"The class action falls into the hands of one law firm, leaving eight or 10 other firms" with high levels of expertise to pursue alternative courses of action. These firms can bring 401 (k) cases or they can bring individual private actions, rather than class actions. Alternatively, they can set their sights elsewhere, he said.

In other words, Mr. Lerach is going to "live off the small fish while he baits the whale," said Mr. Keogh, who spoke in person at the seminar.

Thomas Kavaler, a partner from Cahill Gordon and Reindell in New York, explained that plaintiffs firms work on a contingency fee basis for the large multibillion-dollar class actions that take years and years to be resolved. In the meantime, since theyre carrying expenses on these bigger cases for a period of five or more years, it makes sense to take on the smaller cases, which he explained ultimately have quicker settlement payout because the smaller companies and their insurers cant afford to have them drag on.

"You have to understand the business model of the plaintiffs side of the bar to understand why smaller companies are at greater risk," he said. When the "race-to-the-courthouse model" went away, with the Reform Act subsequently requiring the lead plaintiff to be the shareholder with the largest interest, the plaintiffs bar responded in various ways. One way was to market themselves to the large pension funds and other institutional investors who have become lead plaintiffs, he said.

"A whole separate model is to find a company that you can sue where there is no CALPERS," he said, making a reference to the California Public Employees' Retirement System, an active lead plaintiff. "So the plaintiff lawyer brings this action against the small company, where he figures theres not going to be competition from other plaintiffs lawyers. This is my small company to sue. You go find your own low-hanging fruit to pick."

The plaintiffs firms "need the cash flow," Mr. Keogh said. The big notable cases take a lot of time and a lot of money, he said. He explained that when big pension funds control the headline class actions, "theyre in it for the big bucks" and theyre not going to settle quickly.

Speaking specifically to the smaller company representatives, Mr. Kavaler stressed, "Its a myth to think that theres any connection whatsoever between wrongdoing and litigation."

"Everybody says, Were not going to get sued. Were not Enron. Were not Tyco. Were not WorldCom. We dont havepervasive corporate fraud," he said, alluding to some of Mr. Lerachs video-taped remarks about rampant fraud in the corporate world.

But "it doesnt matter," he said, going on to explain how he believes a plaintiffs lawyer thinks. If "you announce something, anything," you can become the defendant in a securities suit, he contends.

"Im not talking about [announcing] a multibillion-dollar restatement," he said, but something more seemingly benign. "We lost a big account. We got a big account. We made less this quarter than last year. We made more this quarter than last year. Whatever you announce, you think of it as a prospective statement, youre informing shareholders. You even think of it as good news."

"The plaintiffs lawyer thinks backwards. He looks at what you announced today and then he [combs through] your prior public filings to see if he can find anything that is arguably inconsistenteven an omission. You announce that you invented the widget. He looks back to see if you disclosed anywhere that youre [developing] the widget. If you didnt, he says you failed to disclose."

"Cases like that get filed everyday," Mr. Kavaler insisted. "For every Tyco or WorldCom that they get involved in that goes on for yearsthey have an inventory of ordinary, garden variety cases where they make some allegation that you would think, as a businessperson, is ridiculous."

"You may ultimately get that complaint dismissed. But until you do, its hanging over your head"and costing money to get it resolved, he said.

Going on to detail what he referred to as the "Kabuki theatre" atmosphere of class action litigation, he said that while motions to dismiss are successful in a significant number of securities fraud cases, "they are also considerably more expensive then you can imagine." He spoke of how plaintiffs lawyers amend their complaints, and the difficulties that even innocent officers and directors can encounter with uneducated jurors.

Bottom line, he said, "once youve been down this road once or twice," you realize that the idea "maybe I ought to settle should occur to you right after you see your name" on the case filing.

Indeed, he said that 95 percent of all securities cases are settled. "But some are settled well and some are settled poorly," he said, advising that in order to know when to settle "at the exact right moment, for the exact right terms," inexperienced companies that "get invited to this [securities litigation] party will want very experienced chaperones," such as qualified defense lawyers and insurers.

Mr. Keogh then got up to unabashedly proclaim that his motive is typically to convince brokers and clients to buy their D&O insurance from AIG. Taking on what he said was more of a teaching role at the seminar, however, he reported several facts of interest to small and midsized companies:

72 percent of the restatement cases since the passage of Sarbanes-Oxley were for companies with revenues under $500 million

Roughly one-third of the bankruptcies filed in 2003 so far are for firms with revenue between $50 million and $500 million.

"Where theres a bankruptcy, there will be a suit against the Ds and Os," he said.

Mr. Keogh also said that the Sarbanes-Oxley Act creates a road map for plaintiffs firms, he said. Noting that the cost of being a public company increased dramatically as a result of the Act, and that increased costs can lead to noncompliance, he said if something happens to cause a companys stock to drop, the subsequent "fishing expedition" by the plaintiffs firm will include seeing if the company directors and officers complied with the various responsibilities set forth by the Act.

"The reality of our society is that where theres more responsibility, [there] comes potential liability," he said, noting that while the Act was needed, unintended consequences will develop and make small companies particularly vulnerable for noncompliance.

During the question-and-answer portion of the session, Mr. Keogh and Mr. Kavaler both admitted that they had not yet encountered any cases arising specifically from Sarbanes-Oxley violations. But Mr. Kavaler insisted that the specificity of the rules of the Act create a potential land mine for companies. "Even if you got it almost perfect, you got it wrong," he said.

Responding to a question about the impact of all the litigation trends on the D&O insurance market, Mr. Keogh said hes often asked whether he believes D&O pricing is adequate today.

"I dont know. Theres all of this new ground being broken," he said. "The trajectory on loss costs has been something we couldnt imagine a few years ago. And I dont know where its going."

During his presentation, Mr. Keogh said the environment "has never been more treacherous for directors and officers" of companies of all sizes. Components of that treacherous environment, he said, include:

A regulatory environment in which attorneys general "are out to prove they are on the watch." (A few months ago, "the mutual fund industry would have been viewed as an innocuous, low-risk class" by D&O underwriters, he observed.)

A judicial environment in which courts have become pro-plaintiff and anti-insured.

An erosion of the exemption from liability that used to prevail in Delaware courts for directors and officers who exercised reasonable business judgment.

A multitiered attack of a number of plaintiffs law firms for one stock drop event. The scenario Mr. Keogh described had those firms which dont get the big class action bringing three different types of suits: derivative suits (on behalf of the corporation against the board), private individual actions in state courts and separate suits alleging breaches of fiduciary duty if company stock was in 401(k) plans.

He also took note of the fact that in the mega-cases, like Enron, the $300 million D&O policy is insufficient to satisfy plaintiffs. So theyre going after the banks and law firms alleging they conspired and worked with Enron in committing fraud.

Mr. Lerach "wants $44 billion from the banks for aiding and abetting," Mr. Keogh said. "If hes successful, from the point of view of insurance carriers, how do you write a financial institution anymore? You would have to know all the clients of the financial institution."

And "what if you [the insurer] were on all 12 of those banks" providing coverage?" he asked, pointing to the aggregation of limits. "Are reinsurers going to stay in the D&O business when they start to face catastrophic losses like that?"

Returning specifically to the pricing question, recognizing that pricing depends on projected loss costs, he said, "The prospect of loss costs as respects D&O insurance flattening over the next 18-24 months–Id bet against."

Reproduced from National Underwriter Property & Casualty/Risk & Benefits Management Edition, November 14, 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.