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Size of D&O Settlements Exploding

Until just two or three years ago, even the most costly directors & officers (D&O) liability claims were resolved for less than $100 million. However, since mid-1999, the size of D&O settlements, particularly in securities class action lawsuits, has increased dramatically. Since 1999, there have been nearly 20 settlements in excess of $100 million, with at least one-third of those being in excess of $200 million.

The high-tech industry historically has represented by far the greatest frequency and severity risk in securities class action cases. However, enormous settlements are now also occurring in other industries, some of which have been historically viewed as relatively safe underwriting risks.

Perhaps even more troubling than the size and frequency of these enormous settlements is the fact that this level of settlement inflation is occurring in securities class actions of all sizes. Smaller cases are often now settling for as much as 30 to 50 percent more than what would have been expected in 1999, partly due to the ripple effect caused by the record settlements summarized above.

Reasons For The Surge In Cost

Like most surprising phenomenon, this rather sudden explosion in the size of D&O settlements is attributed to a combination of factors:

Financial Restatements

A disproportionate number of the large settlements involve companies that restated their financial statements for several reporting periods, resulting in a large drop in the companies’ stock price.

Institutional Investors

Where institutional investors have been willing to accept the role of lead plaintiffs in securities class actions (as encouraged by the Private Securities Litigation Reform Act of 1999), settlement negotiations are largely driven by a desire to maximize shareholder recovery. This tends to increase the size of the settlement.

Damages

In many securities class actions today, it is common for plaintiffs to contend that damages exceed hundreds of millions or even billions of dollars. A settlement of tens of millions of dollars or even several hundred million dollars thus may appear reasonable to a defendant.

Entity Coverage

The addition of D&O coverage for securities claims against the company has eliminated the need to allocate loss between the insured director and officer defendants and the uninsured company defendant. This entity coverage appears to have had an inflationary effect on many securities claim settlements. Because both the D&Os and the company are now fully insured, defendants no longer have an economic incentive to aggressively negotiate the lowest possible settlement terms.

Plaintiff Leverage

Following passage of the Private Securities Litigation Reform Act, plaintiff lawyers expected more of their securities class actions to be dismissed by courts. As a result, in order to maintain their historic levels of income, the lawyers are demanding higher settlement payments in cases that survive the defendant’s motion to dismiss. Many defendants eventually agree to plaintiffs’ inflated settlement demands to avoid a jury trial.

This trend towards larger settlements is likely to continue into the foreseeable future. If the current trend continues, there will be approximately a 25 percent increase in the number of securities class action filings as compared with historical experience.

Consequences for Insureds

From a D&O insurance perspective, the unprecedented size of recent settlements and the growing frequency of D&O securities class actions have several consequences:

• Limits of Liability. It is now clear that if a company purchased an appropriate level of D&O insurance two to three years ago, that company needs to purchase higher limits today.
  
• Premium Increases. The larger verdicts and settlements combined with lower investment returns has both D&O insurers and their reinsurers now increasing premiums in order to maintain the viability of this important insurance product. These increases are expected to last for several years, both at the primary and excess coverage layers.
  
• Policy Terms. Many D&O insurers believe further amendments to the policy form are necessary. Examples of policy provisions that may be requested by insurers include co-insurance, pre-determined allocation in lieu of entity securities coverage, pre-approved defense counsel, and retrospective additional premium arrangements.
  
• Insurer Claim Involvement. Many D&O insurers are becoming more closely involved in the defense of securities claims. This increased involvement may include more frequent meetings with defense counsel, insureds, and expert witnesses; retaining separate experts to perform a damages analysis for the benefit of the insurer; and conducting independent investigations and analysis of key aspects of the case.

Conclusion

A new era of catastrophic D&O exposure now exists. Companies should expect the cost and terms of their D&O insurance policies to eventually reflect the increased losses which have been and will be paid by insurers in this new environment. What unfolds in the coming years will depend in part upon the extent to which securities class actions defendants can successfully contest the trend toward escalating settlement amounts. 

This article was excerpted from an upcoming supplement to The D&O Book and written by Dan A. Bailey of Arter & Hadden Law firm in Columbus, Ohio. Mr. Bailey is an expert in the field of director and officer liability and insurance law.

riskVue | The webzine for risk management professionals
July 2002