Don't Let Class-Action Decline Fool You, Insurance Big Warns D&O Underwriters

Sharp declines in securities fraud class actions that threaten to lull directors and officers liability insurers into complacency deserve closer scrutiny, one leading insurer has warned.

John Degnan, vice chairman of Warren, N.J.-based Chubb Corp., gave a new perspective on widely reported statistics that show securities class actions plunging 38 percent in 2006.

The former New Jersey attorney general told D&O underwriters and brokers gathered here at the recent Professional Liability Underwriting Society's Annual D&O Conference to pay attention to the lessons of the past, urging them to remain vigilant about potential changes in a currently calm D&O landscape.

Mr. Degnan echoed other speakers at earlier sessions who pointed to a good economy, a less volatile stock market, several favorable court rulings, and the positive consequences of the Sarbanes-Oxley Act for corporate disclosure as drivers of a D&O environment that seems to be a "perfect calm"--after the "perfect storm" that D&O insurers found themselves caught up in earlier in the decade.

So often are the years when the D&O industry was "buffeted by [a] confluence" of negative events--like a bursting dot.com bubble, a series of mega-scandals in corporate America, and a lack of D&O insurer underwriting discipline--described as a "perfect storm," he said, "I can only assume I was invited to speak today because [actor] George Clooney [who starred in the movie of that name] was not available."

Warning against the tendency to invoke easy descriptors like "perfect storm" and "perfect calm," he noted that even the improving case filing numbers being reported now are suspect when examined in the context of a declining number of public companies.

"We should not overlook ongoing merger and acquisition activity in the last decade, not to mention an increasing number of going-private transactions," he said, noting that the number of public companies dropped 30 percent from 1997 to 2006--from roughly 9,300 to 6,500.

The frequency of securities suits adjusted for this consolidation is very close to the level of a decade ago, he said.

In addition, he said, while class actions are down, when shareholder derivative suits are added to the total, overall D&O claim frequency was actually up--not down--in 2006. (Derivatives suits are brought by shareholders on behalf of the company, naming directors and officers as defendants.)

Mr. Degnan and others speaking at the conference noted that cases involving allegations of options backdating have been filed as derivative suits (rather than class actions, because they typically haven't fueled massive stock drops), and that backdating cases now number somewhere between 130 and 140.

These backdating cases are excluded from the January publication of securities class-action statistics by the Stanford Law School Securities Class Action Clearinghouse (a joint project between Stanford Law School and Cornerstone Research), which announced the often-cited 38 percent decline in securities class actions, he noted.

In the past, the report similarly excluded cases involving initial public offerings in one year, equity analysts' cases in another, and mutual fund market timing cases in yet another, he added.

Comparing this type of analysis to the "old insurance industry trick" of "but-for" earnings reports (referring to reports by insurers that exclude the impacts of asbestos charges or natural catastrophes to present more favorable results to investors), he said "we have to be skeptical of securities claims data."

"At some point, we need to accept that systematic events have become the norm," he added.

Mr. Degnan also noted that while derivative claims have historically been viewed as lacking the severity potential of securities class actions, an increase in the number of A-side only policies being written by D&O carriers heightens the impact of these cases. (A-side policies specifically provide coverage in situations where a company can't indemnify directors and officers--most notably covering derivative suits.)

"Have we adequately accounted for what may be a strategic shift by the plaintiffs bar toward derivative litigation?" he asked, noting that plaintiffs' lawyers may see derivatives case filings as a way to overcome pleading standards and discovery obstacles imposed for federal securities class-action filings.

"The perfect calm could turn out to be merely the eye of a larger storm," he said.

During his presentation, Mr. Degnan also noted that an additional factor that depressed the number of class actions in 2006 was the May 2006 indictment of Milberg Weiss--one of the most active plaintiffs firms in filing securities class actions.

However, while many observers note the overall drop in securities suits in 2006 roughly equals the post-indictment drop in Milberg Weiss filings, he said, other firms are poised to fill the void.

Highlighting some other factors that could potentially increase D&O claims going forward--the inevitable downturn in the economy, an uptick in regulatory activities occurring under the Foreign Corrupt Practices Act, and the growing role of private equity firms in capital markets with potential new exposures, for example--Mr. Degnan sounded a final note of caution, reminding PLUS attendees that the D&O market was a "picture of health" in 1997.

But the industry responded "with a race to the bottom" in D&O pricing and abandoned good sense in the negotiation of policy terms, he said, urging discipline and vigilance.