Tuesday, July 10, 2007

Cornerstone Releases Mid-Year Securities Filings Report

Photo Sharing and Video Hosting at Photobucket In a prior post (here), I took a preliminary look at the securities class action filings for the first half of 2007. In a July 10, 2007 press release (here), Stanford Law School and Cornerstone Research released their own mid-year report discussing the year-to-date filings through June 22, 2007. The full Cornerstone Report can be found here. (The Cornerstone Report’s analysis differs slightly from mine because my analysis included all filings through June 30.)

Cornerstone’s Report confirms that securities filings remain “well below historical averages for the fourth consecutive six-month period.” The press release contains a quotation from Stanford Law Professor Joseph Grundfest that after two years, the lower filing level “is starting to look like a permanent shift, not a transitory phenomenon” – although the Report itself contains conflicting projections about the possible levels of future filings, as discussed below.

The Report projects a year-end 2007 filing level of 124 class actions (consistent with my prior projection), which is well below the 12-month filing average of 203 class actions for the period from the second half of 1996 through the first half of 2005. The Report analyzes these levels in relation to the number of publicly traded companies by comparing the number of filings to the number of issuer companies. The Report states that the projected 2007 “number of filings per issuer” of 1.6% is well below the 2.3% average of filings per issuer during the period from the second half of 1996 through the first half of 2005.

The Report proposes two alternative (but not mutually exclusive) explanations for the continued lower filing levels. The first is the “less fraud” hypothesis, and the second is the “strong stock market” hypothesis. The “less fraud” hypothesis is based on the view (in Professor Grundfest’s words) that “increased enforcement activity and a heightened awareness among corporate insiders may have led to a shift in the incidence of securities fraud litigation.” The “strong stock market” hypothesis is premised on the observation that we have now enjoyed several years of strong stock market performance characterized by historically low stock price volatility. (Volatility has been correlated in the past with securities class action activity.)

These two possible explanations lead to “differing expectations for future levels of class action filings.” The “less fraud” theory suggests a permanent shift, but the “strong market” suggests that the current lower level of securities class action filings is only temporary. Indeed, one of the Report's co-authors, John Gould, is specifically quoted as saying “if the market goes south, I would not be surprised to see the number of filings move back to the 200 per year level.”

The Report’s quotations from Professor Grundfest also include his refutation of that the prosecution of the Milberg Weiss firm and two of its partners (so far) is “chilling” the securities class action plaintiffs bar. He rejects the suggestion that “the prevalence of alleged questionable, unethical or illegal kickback or fee splitting activity is so pervasive in the class action bar that the Milberg indictment chilled other plaintiffs and law firms from instituting class actions.”

The Report also details that the total market capitalization losses on cases filed in the first half of 2007 are slightly above losses associated with 2006 filings, although the losses continue at levels well below those observed in the 2000-2002 period.

The Report’s analysis of the possible reasons for the lower lawsuit filing levels is interesting. I remain skeptical that we have moved to a permanently lower level of fraudulent activity. I am inclined to think that given the low stock market volatility that the Report itself details, the marketplace is now just reacting less to adverse public disclosure. (Herb Greenberg details this phenomenon in his July 7, 2007 discussion in the Wall Street Journal, here, about the lack of marketplace reaction to accounting scandals).

I also think the historically low interest rate environment has enabled many companies to use low-cost debt to avoid crises that could have otherwise required disruptive disclosures. As credit becomes less freely available and more expensive, and as volatility levels revert to the historical mean, more disruptive disclosures may be required and the stock market may prove less forgiving than it may have been in the recent past. For that reason, I personally am inclined against Professor Grundfest’s view that we have passed some epochal threshold on the occurrence of fraudulent activity. I am much more inclined to the alternative view that changed marketplace conditions could lead right back to historical filing levels.

I also have to respectfully disagree with Professor Grundfest’s rejection of the possibility that the Milberg Weiss criminal investigation is a contributing cause to the reduced filing levels. I start with the fact that the reduced filing levels first emerged in mid-2005, at the same time that the grand jury returned its first indictment in the Milberg Weiss investigation (about which refer here). I add the observation that the most prominent lawyers at the two most prominent plaintiffs’ law firms, as well as the firms themselves, have been highly preoccupied by the criminal prosecution. I also add the common sense observation that it is extremely improbable that the behavior that is the target of the Milberg investigation was limited exclusively to that law firm. All of these factors added together mean to me that the Milberg Weiss criminal proceeding, and the scrutiny of the kickback practices, has had to have had some impact on the filing activity levels.

The quotation in the Cornerstone Report to the effect that changed stock market conditions could lead us right back to the 200 filings a year level represents a strong precautionary warning to the D & O industry. It would be a very short step from Professor Grundfest’s statement that there may have been a “permanent shift” in the filing levels to the conclusion that there has been a permanent shift in D & O exposure, and that D & O pricing appropriately should be reduced commensurately. Carriers that were to act on this seeming logic could quickly find themselves instead in a very serious trouble if instead of permanently lower frequency levels, the filing levels were to revert to historical norms.

The Report’s observations about the level of investor losses associated with 2006 and 2007 filings are also interesting. Most of the discussion within the D & O industry in recent months about the lower frequency levels has usually been accompanied by observations that severity levels are at all time highs. But as the level of investor loss associated with class action filings falls well below levels from the era of the corporate scandals earlier this decade, and as the cases associate with the corporate scandals work their way out of the system, the severity levels should be expected to decline. It may be that in the months and years ahead we will see severity levels fall below their current record high levels.

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