D&O Insurers May Feel Adverse Consequences From High Court Rulings

With multibillion-dollar estimates of professional liability losses related to the credit crisis proliferating, insurers heard more bad news, as experts said recent pro-defendant Supreme Court rulings may do little to lower securities class-action payouts.

In fact, one prominent plaintiffs' lawyer said that with the January Supreme Court decision in Stoneridge Inv. Partners, LLC vs. Scientific-Atlanta Inc. eliminating his ability to go after third parties that help corporations carry out fraudulent financial schemes, he'll probably tag members of audit committees of corporate boards--and their directors and officers liability insurers--for bigger portions of damages.

"The world is now safe essentially for you to help a company 'cook the books' because folks like me can't get to them," said Sean Coffey, a plaintiffs' lawyer with Bernstein Litowitz Berger & Grossman in New York, giving his assessment of the January Supreme Court ruling.

By a 5-3 vote, the U.S. Supreme Court in Stoneridge affirmed lower-court decisions throwing out a lawsuit by shareholders of Charter Communications Inc., a cable television company, against two of the its equipment suppliers. The shareholders had sued the two suppliers--Motorola and Scientific-Atlanta--for alleged involvement in deceptive transactions that helped Charter inflate its earnings.

The shareholders alleged that Charter made agreements with the suppliers to pay inflated prices for cable boxes. The suppliers then turned around and used the excess cash to advertise on Charter's cable system--boosting Charter's revenues to meet securities analysts' expectations.

Mr. Coffey, summing up the implications of the Supreme Court decision in favor of the suppliers, said that in the pre-Stoneridge world, in a similar case tried to a jury verdict, he would have put an extensive list of culpable parties into the jury room for proportionate fault. The list would include "senior management that cooked the books, the audit committee that looked the other way, and the third parties that helped management...and lied to the auditors, plus the auditors."

With the third parties now beyond his reach, "Who's going to pick up that fault?" he asked. "It's going to be apportioned to remaining defendants."

"The audit committee is going to be hit with a bigger number then they would if those other people were at the table," he said, assuming that members of the audit committee either knew or were reckless.

Mr. Coffey made his comments during the Professional Liability Underwriting Society D&O Symposium this month, where bad news seemed to come at every turn for corporate boards, executives, and their D&O and professional liability insurers. In addition to negative assessments of Stoneridge, attendees heard:

o Gloomy predictions about the impact of the subprime crisis on D&O and E&O insurers, including insurance loss estimates that now reach as high as $9 billion.

o Statistics that show evidence of a reversal of a two-year decline in securities fraud class actions.

o Defense lawyers saying that well-known adversaries from the plaintiffs' bar, who are now facing the prospect of jail time for alleged involvement in kickback schemes, were preferable to a new crop of converted product liability lawyers who have stepped into the securities arena.

(See related links at the end of this article for more details on these three trends.)

In addition, an SEC representative, although rejecting a notion advanced by Mr. Coffey that Stoneridge will put more onus on the government to bring cases against aiders and abettors of corporate frauds, said that bringing such cases has been--and remains--a high priority for the SEC.

"Our decision-making about bringing these cases was never governed by what the private bar was or was not doing in this area," said Mark Schonfeld, director of enforcement in the SEC's New York office.

Citing SEC actions against Adelphia Communications as "the best example" of what the agency has done, he said the SEC brought cases against individual audit partners and managers, and counterparties to transactions designed to cook Adelphia's books, noting that they were ironically the same as those involved in Stoneridge--Motorola and Scientific-Atlanta.

"Regardless of what the private bar is able to do under existing law, we continue to have this focus on a broad array of counterparties that can contribute to an accounting fraud," he said.

Lawyers speaking at the PLUS conference also said a Supreme Court decision handed down last year in Tellabs Inc. v. Makor Issues & Rights, which had been widely hailed as a win for corporate directors and officers and their insurers, has had no practical impact in the real world.

The Supreme Court decision--which set the legal barrier for bringing securities cases higher than the 7th Circuit from which the case originated--rejected the idea that a complaint could survive if it simply "alleges facts from which a reasonable person could infer" that a defendant acted with intent to defraud.

The Supreme Court required that the inference of evil intent must be "the strongest inference" that can be drawn for a case to advance.

"In my world, it doesn't make a damn bit of difference," said Evan Chesler, a defense lawyer for Cravath, Swaine & Moore in New York, noting that the only effect has been "to weed out a few oddball cases."

"I read Tellabs 30 times, and I can't understand what...it means. I don't understand...balancing these inferences," he said, suggesting that such "nuances" are beyond comprehension for federal judges who "are just mere mortals."

"They get up in the morning. They read the pleadings...They scratch their heads [and] say, "Do I think there's enough here to give this plaintiffs' lawyer a shot past the pleading stage?'"

"That's the standard in most federal courts," no matter what the Supreme Court said, he added. "Most judges will not throw out a case if they think there's enough smoke around that there might actually be an ember somewhere in the pile."

With other defense and plaintiff lawyers agreeing with Mr. Chesler, just about the only good news to emerge for insurers at the conference was the description of a recent victory at trial from the lawyer who defended the case known as JDS Uniphase.

"The merits matter" in securities cases, according to Jordan Eth, a partner for Morrison Foerster, a defense firm in San Francisco. "You can't just say [there was] $500 million of insider trading all in one month, and a $90 billion market-cap loss, therefore you lose," he said, reporting that despite those seemingly bad facts, the jury delivered a defense verdict.

"Jurors take it much more seriously. It's not a one-day focus group. It's a four-week trial. The merits do matter [and] the people do matter," he said, referring to the fact that a group of credible and likeable defendants were instrumental in convincing the jury to find in their favor.

Mr. Eth tried to urge PLUS attendees to shed traditional damage models in which they simply multiply potential damages by some percentage representing the chance of losing, and decide to settle because the calculation results in a big number.

Mr. Chesler agreed. "A trial is a trial," he said. "A credible witness increases your chances of winning, whether the subject matter happens to be securities fraud or patent infringement or breach of contract."

"In courtrooms, as opposed to conference rooms, trial results are binary. You win or you lose," he said, predicting that more cases will go to trial because institutional investors, who now serve as lead plaintiffs, will push for them.

Jeffrey Rudman, a defense attorney for Wilmer Hale in Boston, said he does not foresee the same trend, or the corresponding decrease in settlement payouts for insurers.

"Securities fraud cases involve individuals as defendants in a way that patent cases do not. There are reputational outcomes in play," Mr. Rudman said. In addition, the very fact that insurers provide large amounts of insurance for securities cases, and not patent cases, means "there are more acute table stakes," he said.

At a later session, Evan Rosenberg, senior vice president for Chubb & Son in Warren, N.J., took issue with an idea expressed by Mr. Eth that the D&O insurers who had written policies for JDS Uniphase came out winners.

"The defense costs on that case almost blew out the tower anyway," Mr. Rosenberg said. "Even when you win, you lose."

Bain Head, a broker and senior vice president for McGriff, Siebels & Williams in Houston, said defense costs are likely to be significant for D&O insurers on the hook to pay losses related to the subprime crisis.

Although Ms. Head speculated that recent analysts' estimates of $8-to-$9 billion in D&O and E&O losses arising from the subprime crisis are too high, reasoning that the lists of financial institutions that analysts use to derive the estimates include firms that don't buy traditional D&O limits, she still believes a "several-billion-dollar loss" is likely, which will be isolated to a small few number of primary carriers.

Even if a lot of cases are dismissed, "there are still going to be significant defense costs," which will hit the primary carriers on D&O programs, she added.

Lending further credence to multibillion-dollar insurance loss figures, both Ms. Head and Mr. Rosenberg said the financial institutions industry is not the only one likely to face lawsuits and regulatory scrutiny.

"I think everyone in the audience is saying, 'Stop talking about subprime. We're way past subprime. This really is a credit crisis," Mr. Rosenberg said, predicting that even specialty retailers will soon face fallout from the subprime debacle. "What you're seeing now is individuals saying, 'I can pay my mortgage and stay in my house for another month, or pay my credit card.' People are going to make choices on whether to purchase big items."

The whole private equity marketplace is being pulled into the crisis as well, he said. Many deals have been scrapped because the company that was the target is experiencing financial difficulty, or the private equity firm can't raise the money, he said.

"The company that sold out and now can't consummate [the deal] may get a D&O lawsuit if it was publicly traded, and private equity investors may decide to bring an action," he said.

Randall Bodner, a partner for Ropes & Gray in Boston, said shareholders in public companies have already brought some actions in situations where private equity deals were being offered at prices as high as double the stock market price, and then went away.

"Should the public company have made better disclosures to the market when the deal was announced to better apprise them of that risk?" he asked, explaining why directors and officers have to worry about litigation.

Like Mr. Rosenberg, Mr. Bodner predicted broad fallout from the current credit crisis.

"This is a Wall Street crisis that originates on Main Street. People really care about it--and judges are people, too," he said, predicting a lower dismissal rate for subprime cases than for the options backdating cases that impacted the D&O market last year.

Mr. Bodner also said that a "bulked up" enforcement staff at the SEC in the "post-Enron, post-Spitzer" world, along with ambitious state attorneys general and an "alphabet soup" of other regulatory agencies (including the Department of Justice, the Federal Bureau of Investigation and the Department of Labor, which will be involved with ERISA claims) will raise the dollar impact of the subprime crisis, but that a portion of those costs aren't covered by insurance.

Both Mr. Bodner and Ms. Head said any fines or penalties arising from such investigations are not insurable, and that many companies do not have coverage for other costs associated with regulatory investigations.

"Defense costs can literally run into the tens of millions of dollars," Mr. Bodner said. "I have one client whose copying costs for the SEC were $9 million."

Mr. Schonfeld confirmed that the subprime meltdown "has become a priority for this year" at the SEC, with a dozen publicly announced investigations currently ongoing, which "run the gamut of the mortgage underwriting and securitization process from beginning to end."

On the civil litigation front, Mr. Chesler said cases have expanded well beyond simple borrower-vs.-lender suits in which borrowers allege they were misled about the terms and conditions of loans.

Investors in special-purpose vehicles for securitizations of these loans are suing issuers of securities, the underwriters of those issuances, the auditors, and even the rating agencies, he noted.

Mr. Chesler predicted that "investor-vs.-investor" suits will be the next wave of litigation. Where people invested in public companies, which themselves were invested in the SPVs, "there's a question as to whether those secondary-level investors have viable claims against first-level investors for not adequately disclosing the nature of the risk," he said.

In addition, "if the tentacles of this problem are as long as some suggest, there will inevitably be a wave of insolvencies" and litigation arising from that, he said.

Mr. Rosenberg said there has historically been a lag between the time when the financial-institutions segment of the D&O insurance market has problems and the eventual strengthening of rates across the entire commercial D&O market.

"This is not going to get better in 12 months. I don't see the credit crisis diminishing for probably 24 months," he said. "So the rational underwriters would start making those decisions today-- flattening rates out generally, raising them where you need to, so we don't have to be in a position where we're jacking prices up multiple percents, restricting coverage--the usual behavior."

"Unless there's a single event that wipes out a lot of capital very quickly, we're not going to see that for awhile," he said, noting that with billions of dollars in excess capital in the industry, rates will continue to fall.

"If I were to look at a specific risk and tell [the broker] I need a flat renewal or an increase, then nine times out of 10, I'm going to lose that business," he said.

At a separate session, John Doyle, president of AIG Executive Liability in New York, noted that relationships are also a factor in how business is priced and where it is placed, noting that some newer markets "are led by people who have been at a half-dozen places in the past 15 years."

Stephen Sills, chief executive officer of Darwin Professional Underwriters in Farmington, Conn., noted that there are 30-plus carriers offering a lot of capacity, with no one having enough market dominance to dictate the way the rest of the market moves.

"If someone suddenly decides they're going to pull out of a class, what's the difference? Chances are it has no impact," Mr. Sills said. "It's like taking your hand out of a bucket of water. You couldn't tell it was there before."

"The market continues to roll on unless there's universal pain," he said.

John Lupica, president of ACE USA in Philadelphia, said he continues to see pricing that he saw 22 years ago, because underwriters forget to get pricing for systemic shocks like subprime or options backdating issues.

D&O Insurers May Feel Adverse Consequences From High Court Rulings

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