A review of recent trends in securities class actions and related derivative litigation demonstrates that directors and officers of publicly traded corporations may want to consider carefully reviewing mechanisms to protect themselves from liability in those cases. While the number of filed securities class actions has decreased, directors and officers should be concerned that: (1) the average cost of settling a securities class action has doubled since the beginning of 2006, and there have been a number of cases where portions of the settlement payments are being made by directors personally; and (2) settlements of derivative actions, which usually required reforming corporate procedures and paying attorneys’ fees, have, in some recent cases, included substantial payments, some of which are being made by directors. All of this suggests that directors and officers would do well to take proactive steps to protect themselves.
Some good news … a decrease in the number of securities class actions
As widely reported in the press, the number of securities class actions filed in 2006 declined from those filed in 2005. Many attribute this decrease to amendments to the federal securities laws, which significantly increased the pleading standards in those actions for plaintiffs (the Private Litigation Securities Reform Act of 1995) and prevented an “end run” around those standards to state court (Securities Litigation Uniform Standards Act of 1998).
But, the cost of an average settlement of a securities class action has increased
While the number of cases has declined, the cost of settlements has increased. For example, in 2006 there were, for the first time, five class actions that were settled for more than $1 billion. That trend seems to be continuing, as demonstrated in May 2007, when Tyco International Ltd. reached a $3 billion settlement with its shareholders. Attorneys for the shareholders announced that it was the largest class action settlement ever by a single corporation.
A national consulting firm, Cornerstone Research, recently released a study that revealed that the average amount of a settlement has also increased. For example, even when the $5 billion cases are set aside, the average settlement of a securities class action reached an all-time high of $45 million in 2006 — more than twice the average through 2005.
Some directors are paying for portions of settlements out of their own pockets
Although class action settlements have traditionally been paid by the corporation and the Directors and Officers Liability (D & O) insurance carrier, there have been several recent settlements in which outside directors have personally paid a portion of the settlement:
- In Re Worldcom, Inc. Securities Litig., 02 Civ. 3288 (S.D.N.Y.) — Twelve outside directors paid $24.75 million (with D & O carriers paying an additional $36 million) to settle 35 separate class actions;
- In Re Enron Corp. Securities Litig., Civil Action No. H-01-3624 (S.D. Tex.) — Ten outside directors contributed $13 million to a $168 million settlement to settle a series of class actions; and
- In Re Enron Corporation ERISA Litig., Civil Action No. H-01-3913 (S.D. Tex.) — a group of outside directors paid $1.5 million as a portion of the settlement.
While some have argued that these are exceptional cases that should not be of concern, it is difficult to ignore the increasing cost of settlement in securities class actions.
An increasing number of derivative actions
Directors and officers need to follow the trends in recent derivative actions as well. Traditionally, derivative actions (suits by a shareholder in the name of the company against directors and officers, typically charging a breach of fiduciary duty) were infrequently filed after securities class actions. However, in 2006, Cornerstone Research found that approximately 45 percent of the securities class actions had a “tag along” derivative suit, a significant change from prior years.
Settling derivative actions is becoming more expensive
Settlement trends in derivative suits are also changing. In the past, those cases frequently settled for a reform of corporate governance procedures and a payment of attorneys’ fees. However, the following settlements in derivative cases suggest that the format of the traditional settlement may be changing:
- HealthSouth Corporation’s settlement of class action and derivative litigation in Alabama in February 2006 included a payment of $445 million;
- Tenet Healthcare Corporation settled class actions and derivative cases in California in January 2006 by, among other things, paying $215 million (which included a payment of $1.5 million by two former executives);
- Oracle Corporation settled a derivate action in California in November 2005 for $122 million (which included a payment of $100 million to a charity by Oracle’s founder Larry Ellison);
- Weststar Energy, Inc.’s settlement of class actions and derivative litigation in April 2005 included a payment of $32.5 million ($1.25 million was paid by individual defendants); and
- i2 Technologies, Inc. settled class actions and derivative cases in Texas in May 2004 by, among other things, paying $84.85 million.
In addition, five former outside directors of Just for Feet paid a total of $41.5 million to settle a bankruptcy trustee’s state court breach of fiduciary duty claim. Just for Feet had previously declared bankruptcy and settled a securities class action lawsuit for $24.5 million (in response to claims of accounting fraud), leaving only $100,000 in insurance.
Directors and officers should take proactive steps to protect themselves
What should a director or officer do to avoid these sorts of problems? Things to be considered include:
- following the trends in class actions and derivative cases;
- constantly monitoring the corporation’s compliance programs — watchful vigilance is required;
- reviewing the company’s indemnification agreements to assure appropriate coverage;
- carefully considering the corporation’s D & O insurance for issues such as the type, amount and scope of coverage, and fully understanding who controls the process in settlement negotiations; and
- when problems arise (such as government investigations, private actions, and even internal investigations), considering whether separate counsel is necessary.