Securities Fraud Lawsuit Severity Soars, Even While Frequency Declines

While the number of securities fraud lawsuits declined in 2006 (see here and here), the average size of securities fraud lawsuit settlements increased by 37% relative to 2005, even excluding the impact of the Enron settlement, according to a January 2, 2006 study by National Economic Research Associates (NERA). The study, entitled “Recent Trends in Shareholder Class Action Litigation: Filings Plummet, Settlements Soar” (here), also found that there were more settlements over $100 million in 2006 than in 2005, which was itself a record-breaking year. There were four settlements in 2006 over $1 billion, even though prior to 2006 there had only been 3 settlements over $1 billion. Seven of the ten largest settlements have occurred in 2005 and 2006.

The average securities class action settlement in 2006 was $86.7 million, which is 17.7% greater than the 2005 average settlement of $73.6 million. (As The D & O Diary previously noted, here, the annual averages reported in NERA’s studies may differ from averages reported elsewhere, because NERA assigns settlements to the year in which they are first finally approved, while some other analysts assign settlements to the year in which they are first announced.) These averages reflect in part the inclusion of the mega-settlements over a billion dollars. If the annual averages are normalized by excluding the billion dollar settlements from both 2005 and 2006, the 2006 average of $34 million is still about 37% above the normalized 2005 annual average of $25 million.

But while these average figures are impressive, averages can be skewed by a relatively few data points at the extremes. As the NERA study notes, a median is “more descriptive of typical cases.” The median settlement also rose to $7.3 million in 2006, about 4.2% above the 2005 median settlement of $7.0 million. The $7.5 million 2006 median is also 21% greater than the five-year $6.2 million median for the period 2002-2006.

The NERA study also examines the declining frequency of securities fraud lawsuit; while this trend has been reported elsewhere (for example, in the Cornerstone study also released on January 2, here), the NERA study adds the interesting observation that the percentage decline is not uniform amongst the federal circuits. The NERA study notes:

The largest drop in absolute terms has come from the Ninth Circuit, where, compared to a peak of 68 in 2004, there have been only 27 shareholder class action suits filed through December 15, 2006. However, every circuit has fewer standard filings in 2006 than the average level from 1998-2004. The drop is smallest in the Second Circuit, which in 2006 has seen fully 87% of the filings it typically received over 1998-2004.5 The rest of the circuits as a group have received only about half of their typical 1998-2004 filings. All but two of the circuits had a decline of at least one-third from 2005 to the projected 2006 figures.

In examining the possible reasons for the decline in securities fraud lawsuit frequency in 2006, the NERA study cites this differential impact as possible evidence that improved corporate behavior as a result of Sarbanes Oxley is probably not the explanation. The decline would be more uniform if Sarbanes Oxley were the cause. (The study examines and rejects the hypothesis that the lack of geographic uniformity is a result of the regional distribution of companies in different industries.) The NERA study speculates that the Milberg Weiss indictment and the Lerach firm’s distraction with the Enron litigation may possibly explain the decline.

The study also notes that since the 1995 passage of the Private Securities Litigation Reform Act, the chances are much greater that securities fraud cases will be dismissed. More than 38% of the cases filed between 1999 and 2004 were dismissed (although this figure may be overstated because it includes dismissals without prejudice and cases that are still on appeal).

The NERA study noted that the biggest single factor determining settlement size is the magnitude of investor loss; average investor losses ballooned from $140 million to $2.5 billion in 2003. Other factors that can increase the size of the settlement include the involvement as plaintiffs of multiple classes of securities holders (such as bondholders or options investors, as well as equity shareholders); the presence of accounting improprieties (which increase expected settlements by more than 20%); and the presence of an IPO (which increases expected settlements by approximately a third). Companies in the health services sector also pay significantly higher settlements than defendants in other industries.

D & O insurers will likely cite the increasing annual average and median settlement levels to counter arguments that D & O insurance premiums should decline as a result of the declining claim frequency. It undoubtedly is hard for the carriers to imagine dropping prices while dollars are flying out the door to fund mega-settlement. But if the carriers were reserving appropriately (admittedly, a big “if”), they should have reserved for these losses years ago, and so the current payouts should not be affecting current calendar year results. In addition, the current settlements involve cases filed years ago. The premiums to be collected now will go to fund losses to be incurred in the future. The NERA study documents that the single most significant predictor of settlement size is the magnitude of investor losses; the Cornerstone study (here) documents that the investor losses in cases filed in 2006 are down significantly from the investor losses involved in the cases filed in the late 90s and early part of this decade. In other words, future settlements should be expected to start trending downward as the cases filed this year move toward resolution. And in any event there are significantly fewer cases to start with, so aggregate losses should also be expected to trend downward.

Nevertheless, as I have previously discussed at length (here), there may still be compelling reasons why carriers may be justified in continuing to resist price decreases. These other considerations include the fact that while the number of securities fraud lawsuits is down, overall claims activity is up (including, for instance, the nearly 130 shareholder derivative claims filed in connection with the options backdating scandal, and the wave of derivative lawsuits growing out of private equity takeovers and arising from activist hedge fund activity). There are other developing threats as well, including among other things, increased activity under the Foreign Corrupt Practices Act. (My prior post, here, details these additional evolving exposure areas).

But while carriers may reasonably try to contend that there are reasons to hold the line on pricing, carriers undoubtedly will continue to face pressure to lower their rates, particularly if securities fraud lawsuit activity remains at its current lower levels.

A CFO.com article discussing the NERA study can be found here.