D&O Claims Management Issues Involving Securities Fraud Class Actions
February 2006
By Joseph P. Monteleone and Nicholas J. Conca
Joseph P. Monteleone, Esq. is a partner in the New York office of Duane Morris LLP. Nicholas J. Conca, Esq. is a managing principal in the New York office of Integro Insurance Brokers.
Introduction
Somewhat contemporaneous with the enactment of the Private Securities Litigation Reform Act of 1995 (the Reform Act), but not a matter of cause and effect, was a broadening of coverage such that the oftentimes contentious coverage disputes of the 1980s and early 1990s have been greatly mitigated. This has enabled insurers and their insureds to focus more cooperative efforts in effective claims management, promoting efficiency, aiding cost-containment and, where appropriate, speeding the settlement process. More often, insurers are disputing the appropriate valuation of a settlement, rather than disputing coverage. Where coverage disputes continue to exist, the most frequently occurring ones involve attempts by insurers to rescind policies based upon misrepresentations in or in connection with the application for insurance. Insurers also continue to raise exclusion language particular to unentitled personal profit, as well as dishonesty and fraud.
Claims management refers to the process by which D&O insurers assess, monitor, and resolve claims against their insureds. Because D&O claims often involve complex litigation, such as in the case of securities litigation, the management process can be difficult, requiring the involvement of experienced professionals.
It is vital that those involved in the purchase and sale of D&O insurance—including insureds, underwriters, counsel, and brokers have an understanding of the playing field and the players. This article explores claims management in the context of securities litigation and identifies some of the problem areas and pitfalls that may arise in the claim-management process.
In the sections that follow, we examine recent trends in the frequency of these claims, as well as their severity as measured by reported settlement amounts. We will also explore the roles of the key participants in the claim process, to wit, plaintiffs and their counsel, the defendants and their counsel, the insurance broker, and those who represent the interests of the D&O insurers. Lastly, we analyze the key substantive and procedural issues attendant to coverage letters, litigation management and billing guidelines, settlement dynamics, and the claim closing process.
Claims Frequency
Despite the passage of the Reform Act over ten years ago, directors and officers and their insurers have seen at best mixed results in the way of effective “reform” in the area of securities fraud litigation, which remains the paradigm high severity D&O claim exposure. While there have been demonstrable increases in the percentage of actions filed that are disposed by way of dismissal or other summary adjudication prior to trial, there has been little overall impact on the totals of new cases filed with a range of 175 – 239 corporate defendants sued in the years 1997 through 2004, inclusive. The average for these nine (9) years is 202 and, although there were 176 new filings in 2005, there is no discernable downward trend over the course of these years. Even more disturbing to D&O insurers and other defense interests is the increasing severity of the cases settled during this same period. The frequency statistics, as well as those on severity to a certain extent, are for what we call “traditional” D&O litigation against corporate issuers and their directors and officers, and do not include the numerous suits filed in 2001 and later involving IPO allocations and laddering, research analyst conflicts, and late trading and market timing activities with regard to mutual funds. Also, large “corporate meltdowns” such as Enron, Worldcom, Global Crossing, and others count as a single filing, despite the fact that there have been numerous litigations and the vast majority of the settlement payments have been by the nontraditional defendants such as the investment banks involved in those suits. While these nontraditional types of claims seem to have abated after 2003—there were only three (3) such claims among the 176 filings in 2005—their actual and potential financial impact on D&O and especially E&O insurers has and may continue to be significant. Lest we forget, many of the same insurers that underwrite D&O insurance for commercial risks also write the E&O and some D&O coverages that have been implicated in these nontraditional claims.
The frequency number for 2005 is heartening, but a single year result does not a trend make. We experienced a similar down year in frequency in 2003, only to have a very significant upsurge in litigation activity in 2004. Nonetheless, the optimists among us, particularly the D&O underwriting executives who want their company management and reinsurers to remain enamored with and supportive of their books of business, will argue that at least two factors bode well for the future.
First, the industry may see a positive influence from the Sarbanes-Oxley Act (SOX) enacted on July 31, 2002, if in fact such a positive influence is not already reflected in the litigation frequency for 2005. Although it is difficult to measure what impact, if any, SOX has had and will have on the frequency and severity of securities litigation, many are hopeful that the enhanced compliance environment created by SOX will mitigate the incidences of corporate wrongdoing giving rise to these claims. We indeed may be seeing the beginning of such a beneficial impact, but it would be wise to wait a few additional good years before drawing firm conclusions. After all, SOX notwithstanding, the number of filings in 2002, 2003, 2004 and 2005 were 231, 186, 213, and 176 respectively.
Second, we may be seeing some benefit from the relatively more stable securities markets subsequent to the bursting of the Internet bubble and the concomitant more rapid loss of market capitalization among many publicly traded companies. To the extent the loss of market capitalization at issue in these litigations represents a maximum potential exposure for defendants, these maximum exposures are reduced significantly from those that we were seeing just a few years ago. Although cases historically settle for a very small percentage of these market cap losses, this would seem to indicate that settlement values are going to be reduced even further in the future. Nonetheless, this litigation still presents the potential for lucrative recoveries to both the plaintiffs and their counsel and, thus, any deterrent effect by way of reduced settlement values is highly questionable.
Claims Severity
At this point early in 2006, we have yet to see any comprehensive, researched analyses of the securities class action settlements through the end of 2005. We do, however, have several analyses for settlements through the end of 2004 and some excellent anecdotal documentation of settlement activity that took place during 2005.
The median settlement amount for all settlements taking place in the post-Reform Act era (1997-2004) has been in the range of $6-6.2M. However, the mean or average settlement value increased drastically in 2004 from prior years. The average settlement for the period 1996 – 2004 was $19.2M, but settlements in 2004 increased by more than 28 percent to $24.6M. This inflationary trend has led to only settlements of $100M or more being commonly referenced as “mega settlements”. There were six such settlements in 2004.
It is difficult to assess what will be the comparable number for 2005 because a number of settlements that have been announced via press release are still pending court approvals. However, there were eight (8) court-approved mega settlements in the first six (6) months of 2005, and the year totals may be as high as seventeen (17). Regardless of how the number and dollar value of the 2005 settlements are ultimately refined, it is fairly evident that 2005 will present another significant increase in severity over the 2004 Cornerstone data.
In trying to assess in its early stages what a given case may be worth, it is interesting to note that as the actual settlement values have increased, the recovery as a percentage of the maximum claimed damages has decreased typically to a single digit figure in the range of 2-4 percent. Likewise, the percentage of plaintiff attorney fees awarded (which almost always are deducted from the corpus of the settlement fund) have likewise decreased from historical ranges of 25-33 percent to numbers as “low” as 10-12 percent in some of the mega settlements.
Another developing phenomenon is the increasing emergence of institutional plaintiffs as class representatives in this litigation. These institutions are generally public employee pension funds with somewhat long-standing political and other ties to a number of the predominant plaintiff law firms practicing in this arena. Settlements in class actions led by these institutional representatives have proven to be somewhat larger than individually-led class actions. In the latter case, the class counsel is usually much more in control of the direction of the litigation than its “client” and consequently more inclined to accept an earlier and lesser settlement amount.
While we await the compilation of 2005 severity data, it should be noted that 2006 has opened with the first announced class action settlement, that involving Tenet Health Care, weighing in at $215M.
Plaintiffs and Their Counsel
The process of claim management begins when a claim is made (usually in the form of a lawsuit) against insured directors and officers. While employment-related claims have surpassed shareholder actions as the most frequently asserted claims against directors and officers according to recent Tillinghast surveys, the shareholder suits remain the force that drive the need for and the cost of the insurance.
The high frequency and severity of shareholder claims is largely due to the sophistication and entrepreneurial prowess of the plaintiffs' bar.1 There are now approximately thirty U.S. law firms that specialize in prosecuting shareholder class actions, but since the passage of the Reform Act at the end of 1995, there has been a greater concentration of this litigation in the hands of the most competent practitioners. Two very well-qualified firms in particular are involved as a lead or participating counsel in over half the cases filed. These law practices can be quite lucrative, with typical fee awards ranging from 10-33 percent of the settlement funds, when awarded on a contingency basis or some variation thereof.
The most telling statistics supporting the proposition that D&O liability claims are largely driven by the plaintiffs' bar are (1) the location where most D&O claims are filed, and (2) the identities of the plaintiffs. The litigation is heavily concentrated in Federal courts in California and New York. This is not because they provide a better forum than other jurisdictions, but because many of the shareholder plaintiffs' attorneys' offices are located there.
With respect to the identities of the plaintiffs, one might wonder how a plaintiffs' attorney finds his or her clients. After all, in order for an attorney to file a shareholder class action, he or she must be retained to represent the interests of a shareholder or group of shareholders. So, how do these law firms find shareholders to represent? The answer is that they appear to have ongoing relationships with individuals or, as has been the developing trend after passage of the Reform Act, entities, which collectively own shares in virtually every corporation traded on the various stock exchanges and in the NASDAQ market.
The entities that are represented are typically public employee pension funds with which a number of these prominent plaintiff firms have close political connections. A number of studies have suggested that recoveries by way of settlement are typically larger when there is such an institutional plaintiff in control of the litigation because there is less willingness to settle earlier and for a lesser amount than when the lead plaintiff is an individual. In the latter situation, the plaintiff counsel typically has more control over its “client”.
To make matters worse (or better, from the plaintiffs' bar's perspective), advances in computerized database and telecommunications technology now allow the plaintiffs' bar to file lawsuits with great speed and precision. To illustrate, the typical triggering event for a shareholder class action is often the corporation's dissemination of “bad news” to the public. This is usually some announcement that results in a decline of the corporation's stock price, such as a projected reduction in earnings. Through their attorneys, shareholders will then assert that the corporation and its directors and officers failed to timely apprise the investing public of the “bad news,” thus artificially inflating the corporation's stock price.
Within a very short period of time from the corporation's issuance of the “bad news,” a complaint can be filed, although the Reform Act now requires a greater amount of due diligence on the plaintiffs' part in order to avoid a dismissal of the action. With the aid of computerized stock-tracking databases, plaintiffs' counsel usually can learn of the corporate announcement immediately and then can draft the core of a complaint within a few hours, leaving only their due diligence process to refine the allegations. Sometimes, when the alleged wrongful conduct of the corporate directors and officers is particularly egregious, other plaintiffs' attorneys will jump into the fray by filing so-called “cookie-cutter” suits. These are often nothing more than substantively identical copies of the original pleading.
After the lawsuits are filed, the plaintiffs' attorneys sometimes form a litigation committee and divide up the labor for proceeding with the action. The attorney who filed the original action will usually be appointed chairman of the litigation committee, and thus will do the greatest amount of work on the matter and receive the largest fee. The Reform Act does embody a rather elaborate process for the selection of the “lead plaintiff” and “lead counsel” who presumably control the prosecution of the litigation. However, wherever possible the plaintiffs' bar seeks to engage in a coordinated effort in pursuing these cases.2 Specifically, the plaintiffs' bar attempts to ensure that several attorneys get a “piece of the pie.”
Defendants and Their Counsel
Because D&O policies are typically not of the duty-to-defend variety, insurers do not appoint counsel to represent the insured directors and officers in the event of a claim. Rather, the insureds choose their own counsel and the insurer has only the right to withhold consent to the incurring of defense costs if the counsel choice is unreasonable. This process is sometimes favored by insured directors and officers because it affords them the freedom to engage the services of counsel with whom they, or the corporation they serve, have a long-standing relationship.
Usually it is preferable to have one law firm represent the interests of both the directors and officers and the corporation. Joint representation tends to cut costs by avoiding the duplication of effort that is caused by several law firms representing multiple defendants. Consent to counsel usually only becomes a contentious issue where there are no legitimate conflicts in interests in the insurer's view, yet each insured is insistent upon his, her, or its own counsel.
When conflicts among the various defendants arise, separate representation sometimes is warranted. A conflict might occur if one or more directors and/or officers are actually implicated in wrongdoing, as opposed to the typical situation where the board and executive officers are collectively sued as a group. The “innocent” insureds may want to distance themselves from the “guilty” party or parties or may entertain the possibility of asserting cross-claims against them.
There is also the situation where a director or officer terminates his or her relationship (either voluntarily or involuntarily) with the corporation, and the parties choose to separately defend the claims asserted against them. In this situation, the corporation may refuse to indemnify the terminated director or officer, which may affect the coverage available to that individual. The outcast director or officer thus may seek separate representation.
There may be other reasons for directors or officers to retain separate counsel to represent their interests. For example, an insured individual may simply desire the guidance and expertise of a trusted personal lawyer.3 In any event, the overriding goal is to avoid unnecessary duplication of effort among the various attorneys. One strategy that has been employed is for one law firm—usually the corporation's counsel—to spearhead the defense of the action, with the other firms playing a supporting role. If the action proceeds to trial, a time when the conflicts among the various parties come to the forefront, each attorney goes his or her own separate way and defends his or her client accordingly.
Separate from the significant role outside litigation counsel plays in representing the directors and officers in an action is the role of the corporation's general counsel. General counsel's involvement can be multi-faceted, including roles as (1) liaison between the corporation, its directors and officers, and outside counsel, (2) liaison between the insureds and the D&O insurer, and (3) litigation counsel on behalf of the corporation. Although the general counsel may assist greatly in the defense of the matter, most D&O policies (which exclude from the definition of loss salaries paid to corporate officers) will not cover the costs associated with the general counsel's activities in connection with the claim.4
With respect to insurance-coverage issues, there are others who individually or jointly may represent the interests of the insureds. These include the corporate risk manager, the insurance broker, and, occasionally, outside coverage counsel.
Risk managers often are responsible or partially responsible for the corporation's purchase of D&O insurance and may be uniquely qualified to negotiate with the D&O insurer on coverage issues. Moreover, since the risk manager intimately may be involved in the purchase of the D&O insurance, he or she may have a favorable relationship with the insurer, which can foster the negotiation process.
In certain circumstances, insureds may want to retain coverage counsel, in addition to litigation counsel, to represent the insured directors and officers with respect to D&O coverage issues. Separate retention of counsel, although occurring now with more frequency, is still somewhat unusual because most practitioners in the defense bar are well acquainted with the law pertaining to D&O coverage. If defense counsel is experienced in this area, there would be no need for insured directors and officers to retain separate counsel to represent their interests vis-à-vis the D&O insurer.
The Role of the Insurance Broker
Insurance brokers also should play a part in the claim process. In addition to their role of assessing the corporation's D&O insurance needs and marketing the insurance, brokers should take an active part in monitoring any claim and facilitating communications between the insureds and the insurer. Brokers who have a legal background or who have served as claims professionals themselves can be particularly adept at facilitating the claims process.
For the broker and his or her client, the claims process should begin at the time the D&O policy is first negotiated. The broker's initial responsibility is to negotiate a D&O policy that contains terms and conditions that satisfy the client's needs. Companies often have unique exposures depending on their industry sector, market capitalization, corporate governance protocols, and other factors. The D&O policy, which generally will be a heavily manuscripted contract, needs to be tailored to the risks of the particular client. The scope of coverage should be sufficiently broad to minimize the potential that the insurer could deny coverage or rescind the policy in the event of a claim. In particular, the policy's insuring agreements, definitions, and exclusions must all be evaluated and modified as needed.
Once the policy is negotiated the broker must educate the insured client about the operation of the policy and the claim process. To avoid any surprises, this education should begin well in advance of any claims being made. The client should be provided with sufficient information to fully understand and appreciate the types of claims that may be brought, as well as the role of the parties and the process the parties will undergo in litigating and settling the claim.
Among the broker's most important responsibilities is its obligation to provide zealous claims advocacy on behalf of its client. If a claim is made and tendered to the insurer, the insurer may seek to deny (or otherwise limit) coverage under the D&O policy. In that case, the broker must ensure that the insured's rights are protected. This will require the broker's analysis of the coverage position, advising the client regarding his or her conclusions and making concrete recommendations for the pursuit of coverage. The broker should also be prepared to aggressively negotiate with the insurer's legal and claims representatives in connection with the coverage issues. This process should result in the client receiving its maximum entitlement to coverage under the policy.
The Insurers' Representatives
Because of the complexity of the D&O claims-handling process, most D&O insurers employ in-house claims counsel. When a claim is first made against an insured director or officer and notice is provided to the insurer, the claims counsel should conduct an investigation of the matter and evaluate coverage on behalf of the insurer. This process entails a review of the relevant pleadings, an analysis of the subject policy's terms and conditions, and, where appropriate, interaction with the insureds to determine the relevant facts (as opposed to the allegations by the plaintiffs). When the coverage investigation is complete, the insurer may either accept or decline coverage. The usual course of action, however, is for the insurer to conditionally provide coverage pursuant to a reservation of the insurer's rights.
After the initial coverage evaluation is undertaken, claims counsel will monitor the underlying action, occasionally participating in the formulation of litigation strategy. As the action progresses towards resolution (i.e., settlement or judgment), claims counsel must assess the potential liability exposure of the insureds.
Depending upon the severity of a given claim, claims counsel will either handle the matter in-house or retain the services of outside coverage counsel or monitoring counsel. If the claim presents unusually complex coverage issues or requires a labor-intensive investigation, outside coverage counsel is a valuable asset for the insurer. Generally, outside counsel will have greater resources of manpower and research facilities than in-house claims counsel.
The D&O underwriter may also play a supportive role in the claim-management process. Underwriters have a significant function in developing positive relationships between the D&O insurer, the brokerage community and their major insureds. The underwriter is responsible for analyzing the risk to be insured by the policy and determining the appropriate pricing of the policy. Theoretically, coverage issues should be resolved according to the plain meaning of the insurance contract, and not based upon any pre-existing business relationship between the D&O insurer and the insured. However, there is today much greater integration of claims and underwriting functions by responsible D&O insurers, and this facilitates business resolutions of difficult claim situations rather than protraction of disputes through hard and fast legal positions.
As a practical matter, the business of issuing D&O insurance is quite competitive, and the preservation of good relations with insureds is important to an insurer's survival. Underwriters who have fostered a positive and cooperative relationship with insureds during the underwriting/policy-issuing process can facilitate communications between claims counsel, the broker and the insured. Some input on the part of the underwriter is often welcomed by claims counsel, particularly if it assists claims counsel in better understanding the insured's business or communicating the insurer's coverage position to the insured.
Substantive and Procedural Claims-Handling Issues
Coverage Letters
Once a claim is made against an insured director or officer, and assuming there is not a basis(es) for an outright denial of coverage, the insurer will frequently send a reservation-of-rights letter to the insured. Such letters set forth all of the coverage issues relating to the claim. Because insureds sometimes misunderstand the meaning and purpose of the reservation-of-rights letter, the receipt of such a letter can be a source of frustration for insureds.
Reservation-of-rights letters are in many respects a mechanism by which an insurer may extend the time within which it can deny coverage. Under the law, an insurer must either accept or deny coverage as soon as it possesses sufficient information concerning the claim to render a decision relative to coverage. If an insurer unreasonably delays in communicating its coverage position to the insured, or fails to raise any policy defenses of which it was on notice at the time it assumed the defense of a claim, the insurer may waive its right to deny coverage (or may be estopped from denying coverage). Practically speaking, however, a determination regarding coverage is sometimes impossible to make prior to the final resolution of the claim. A well-crafted reservation-of-rights letter protects the insurer's interests until sufficient information is available for the insurer to adopt a coverage position.
Although a reservation-of-rights letter is vital to the protection of the insurer's interests, an overly forceful letter can alienate the insured and hinder the claim-management process. The insurer must walk a fine line between preserving its rights under the law and maintaining a cordial and cooperative relationship with its insured.
While there is no perfect method of crafting reservation-of-rights letters, one way the insurer can fulfill the twin goals of preserving its legal rights and preserving its relationship with the insured is to communicate the need for the letter before it is sent. This can be done either orally or in writing. Some insurers prepare “pre-reservation of rights” communications, which are sent in advance of or incorporated within the actual reservation letter. These pre-reservation letters serve two purposes: (1) they apprise the insured in advance of the insurer's reservations, and (2) they soften the blow of the reservations in the letter and the potential for declination of coverage.
Litigation Management and Billing Guidelines
One of the most important features of a D&O policy is that it provides coverage for defense costs incurred by the insured directors and officers. D&O policies generally do not impose upon an insurer a duty to defend its insureds, which would require the insurer to retain counsel for the insureds. Rather, the insureds retain their own counsel and the insurer has an obligation to pay the defense costs incurred in defending the insured directors and officers in connection with covered claims. This creates a number of important coverage issues that the insured should understand.
First, as initially discussed previously, the insureds select their own defense counsel, rather than having the insurer provide counsel. This is preferable to most directors and officers because it allows them to choose counsel with whom they, or the company they serve, have a relationship.
The selection of counsel, however, is subject to the consent of the D&O insurer. Consent is generally granted unless the selected counsel clearly is unqualified, by virtue of inexperience or lack of staffing, to handle the litigation. Consent also may be withheld if counsel seeks an excessive hourly rate or refuses to abide by reasonable and necessary litigation-management guidelines. Although D&O litigation often involves complex issues that demand the attention of experienced practitioners, the defense bar has become accustomed to insurers' and insureds' demands for cost-effective service. Some defense attorneys may even be willing to cut their rates in the face of an objection by the D&O insurer.
Second, because D&O policies are typically not of the duty-to-defend variety and since defense costs generally are included within the definition of loss, the defense costs incurred will deplete the policy's limit of liability. From the insurer's point of view, it is thus critical that defense costs be closely monitored. This is important from a cost-containment standpoint and because the insurer has an obligation to police the policy proceeds to ensure that they are not unnecessarily eroded.
For this reason, insurers often require that defense counsel adhere to specific litigation-management guidelines. Defense counsel will be asked to follow criteria for staffing, for specific tasks such as motions or depositions, court appearances, for retention of experts, and for periodic reporting on litigation status.
Third, there may be an issue regarding whether the insurer has an obligation to pay, or will voluntarily pay, the insureds' legal fees as they are incurred. In the mid-1980s, the courts almost universally held that D&O policies required the insurers to pay defense costs on a contemporaneous basis. Recently, however, the legal trend has been that unless the policy specifically states that the insurer will pay defense costs as incurred, the insurer may await the final resolution of the claim to pay such costs. In that regard, however, most of the D&O policies available today affirmatively provide for the advancement of defense costs.
Fourth, issues concerning allocation frequently arise in connection with an insurer's payment of defense costs. If defense counsel jointly represents the corporation and the insured directors and officers, an allocation of defense costs is needed. Case law, however, provides that if a given task is reasonably related to the defense of a covered party (i.e., a director or officer), even if it incidentally benefits a non-covered party (i.e., the corporation), the fee for that task must be borne by the insurer.
Insureds frequently argue that because the defense of the insured individuals is indistinguishable from the defense of the corporation, all of the defense fees incurred should be covered. On the other hand, insurers may maintain that the respective defenses are indeed separable and a reasonable allocation can be derived. Along these lines, the insurers may also assert that to accept the insureds' argument as valid would provide the corporation with a free defense for which the insurer is not obligated.
Of course, most allocation disputes have been virtually eliminated in the area of securities claims with the advent of “entity coverage” for these claims. Unlike other types of claims under the D&O policy, the corporation now may garner coverage for its own liability and cost of defense in connection with securities claims.
Whatever the parties may argue and however heated these disputes may become, the parties should never lose sight of the fact that it is the plaintiffs who are the true adversaries. Too often in this litigious insurance climate insureds and insurers allow their differences to distract them from the underlying litigation, which is, after all, the main focus of the defense. It cannot be stressed strongly enough that the insured-insurer relationship must be united against the plaintiffs. Any disputes that may exist should be subordinated to the primary objective of a zealous defense of the insureds.
Settlement Dynamics
It continues to be a rare event that s securities fraud class action proceeds to a trial on the merits. From time to time, advocates emerge for the proposition of putting plaintiffs to the test to see how they fare under recent case law establishing more difficult loss causation requirements and the need to establish the qualifications of expert witnesses and the credibility of their theories of damages. Despite this, few defendants and their insurers are willing to heed the call and allow a jury to decide the defendants' fate. The stakes are simply too high for each side to cavalierly allow matters to be tried if they are not otherwise disposed upon motion practice. While almost all of the handful of cases that have been tried have resulted in defense verdicts, plaintiffs will aver, with some arguable degree of credibility, that only the weakest plaintiff cases have preceded to trial. That is likely because the stakes were reasonably low for defendants in case there was a plaintiff verdict, and the upside for plaintiffs was sufficient to forego what they would view as an unreasonably low settlement offer, even for a weak case.
Thus, between the extremes of the rare cases that are tried on the merits and the significant amount of cases that conclude with defendants prevailing upon a motion to dismiss or for summary judgment, are the large number of cases that conclude with a settlement.
With the allocation disputes over corporate vs. individual liability that were prevalent until the late 1990s now a historical phenomenon due to the widespread availability of entity coverage under the D&O policy, settlement negotiations have taken on a brand new complexion in securities litigation.
First, without allocation as an issue, it is inevitable that the D&O insurers are going to fund most, if not all, of the settlement in the overwhelming majority of these claims. Significant corporate contributions typically do not come into play unless there is a viable possibility of having the policy rescinded or coverage issues that may result in a significant non-insured component to the claim.
The recent decision in Cutter and Buck5 shows that rescission, although a difficult remedy for an insurer to achieve, can be had under the right set of circumstances and with the right language in the policy concerning representations and severability with respect to statements made in or information and documents furnished in connection with the application for insurance. Rather than litigate a rescission case to the ultimate conclusion, however, most policyholders and insurers will try to achieve a negotiated resolution.
In major securities cases, the inevitable result will be a resolution wherein the insurers contribute something to a settlement and the policyholder makes up the difference in light of the underlying rescission or coverage issues. These resolutions are much easier described in theory than they are amenable to being implemented in reality, particularly where there is a tower of primary and excess insurance involved.
Although defense counsel would argue that zealous pursuit of D&O coverage serves both of his or her clients' interests, they should bear in mind that unnecessary depletion of the policy, resulting from the corporation's refusal to contribute its fair share toward the settlement, can be harmful to the directors and officers. For instance, if other unrelated claims should be asserted against the insureds during the policy period, the insureds may be underinsured or totally uninsured because the policy proceeds were used to settle a single claim.
There is also the issue of how visible the insurer should be during settlement negotiations with the plaintiffs. One school of thought is that the insurer should maintain a low profile during the settlement process. Under this theory, there is no need for the insurer to become embroiled in the underlying litigation because its presence represents a “deep pocket” that potentially can drive up the settlement value of the case. Additionally, if there is an ongoing coverage dispute between the insurer and the insureds, there is no useful purpose in bringing that fact to the forefront through the insurer's interaction with plaintiffs' counsel during settlement negotiations.
On the other side of the equation are those who believe that the insurer should be involved in the settlement process every step of the way. Under the Federal Rules of Civil Procedure and most state procedural laws, the plaintiffs are entitled to the directors' and officers' insurance information through discovery and/or mandatory disclosure. Therefore, the plaintiffs will be aware of the D&O insurance available to the individual defendants whether or not the insurer participates in the settlement negotiations. If there is significant participation by the insurer, the defendants and the insurer can give the appearance of a united front committed to vigorously defending the suit. As the theory goes, this joint effort may provide the defendants with a more secure bargaining position, which in turn may lower the settlement value of the case. Even more importantly, a higher profile affords the insurer the opportunity of closely monitoring the terms of settlement, thus placing the insurer in a better position to protect its own interests.
Whether the insurer maintains a high or low profile, it should always review the settlement agreement to ensure that appropriate releases are obtained from the plaintiffs in favor of the insurer (separate agreements usually are entered into between the insurer and the insureds). The absence of the insurer's participation in drafting the settlement agreement opens the door to mischief, because defense counsel then may draft the settlement agreement to allocate the bulk of liability for the settlement to the insured directors and officers.
The Closing Process
The agreement upon a settlement figure is only the first step in a long, arduous process of administering and closing the settlement. It is not unheard of for more than a year to elapse between verbal agreement on a settlement figure and the closing of the claim. In the interim, many problems can arise, such as disputes over:
·the structure of the settlement
·the terms of the settlement agreement
·the selection of an administrator of the settlement
·the payment of interest accrued from the settlement fund
·the structure and timing of the execution of releases among the parties
·the payment by the D&O insurer of defense counsel's fees that are incurred during the settlement process.
These are only some of the issues that can hinder the settlement process and claim closure. The parties should address and attempt to resolve as many of these issues as possible before disputes arise. If the settlement in its general form is agreeable to all parties, the details should not present major stumbling blocks to the final resolution of the matter. The parties should always have their respective interest ardently represented, but they should also avoid making minor points deal breakers. The parties should always weigh the down-side risk of conceding a particular issue and, if legal interests are not impaired, should not stand on principle at the risk of destroying the settlement.
Although the tendency for insurers is to close the file as quickly as possible, insurers should patiently await the final outcome of the settlement payout. Problems and disputes never seem to end until the last check is tendered. Insurers therefore need to resist the temptation of closing a claim file until there is no longer the prospect of further issues that would require extending or reopening the matter.
Conclusion
The insured's understanding of the claims-management process is critical to development of a collaborative relationship between the insured and insurer. Although one can never be completely versed in all the contingencies that might arise until he or she has experienced a D&O claim firsthand, the broker and insurer need to educate the insured about the risks and issues involved in a D&O claim. This can be accomplished through pre-claim or even pre-policy inception meetings with the insured wherein these topics are addressed. Brokers and underwriters should never assume that the insured understands all of the issues discussed in this monograph.
Direct pre-claim contact between the insured and claims professionals can also foster the relationship between the insured and insurer when a claim ultimately is made. Such interaction eliminates the surprise and uncomfortable feelings associated with new players entering the game. In summary, the primary goal is for the insured and insurer united in interest to work as a team to successfully defend the claim.
End Notes
1 The term “plaintiffs' bar” refers to those practitioners who are regularly involved in the prosecution of civil fraud class-action suits for violations of federal securities laws. There are other sources of claims under a D&O policy apart from class-action securities matters where a formally or loosely organized segment of the bar does not traditionally operate. However, because securities claims are of paramount importance to most professionals having an interest in D&O insurance, we focus our comments solely on this group of lawyers.
2 We acknowledge that there may be nothing legally or ethically wrong with the operation of plaintiffs' lawyers' practice in this area. Some commentators assert that the plaintiffs' bar is serving the function of a private attorney general or substitute for the SEC. This may be particularly true where the regulators or Justice Department are not inclined to or are otherwise limited in being able to pursue such claims.
3 While the D&O insurer can never preclude an insured from retaining a particular lawyer or law firm, it can assert its rights under the policy by deciding whether to pay unreasonable and/or unnecessary costs that result from the retention of counsel who may not be qualified or not required due to an absence of a viable conflict issue. The individual director or officer would still be free to continue with that counsel, but at his or her own expense.
4 Even if the in-house general counsel's salary or other costs could be construed as covered defense expenses under the policy, applicable law and cannons of ethics clearly support the fact that the corporation is that counsel's true, if not only, client. Because the directors and officers cannot be the clients of the general counsel, it would be inappropriate to allocate any of those costs to the D&O insurer for coverage of the individual insured defendants.
[5]Cutter & Buck, Inc. v. Genesis Ins. Co., 306 F. Supp.2d 988 (W.D. Wash., 2004), aff'd, 144 Fed. Appx. 600, 2005 U.S. App. LEXIS 15980 (9th Cir. August 1, 2005).
[6]