Boards were just beginning to bask inthe milder securities class-action litigationclimate. After record numbersof suits in the early part of the decade, the numberof cases was dwindling to the point thatdirectors wondered if a permanent change hadoccurred. There were numerous reasons forsuch optimism. Courts were holding plaintiffsto higher standards in their allegations of securitiesfraud. The stock market was fairly steady,and instances of accounting fraud and insidertrading were decreasing. To top it all off,Milberg Weiss—enemy number one to manycorporate defense lawyers—was being tornapart by its own scandal and fraud case. In otherwords, things were good.
Then something happened in the secondhalf of 2007 to break the relative calm. The subprime-mortgage crisis unfolded, and concernsabout the economy caused stock-market volatility—a chief accelerant to securities classactions—to pick up. More than 100 companieswere sued for securities-related allegations inthe second part of the year, compared to 116 inall of 2006, reversing a downward trend of eightconsecutive quarters of below-average litigationactivity.
The reversal of fortune has many boardmembers wondering if this augurs a returnto days when an onslaught of securitiescases put many companies on the defensive.They are asking: What’s causing theshift in litigation? What are the issues beinglitigated? And what should they be on thelookout for?
Surprisingly, there is some cause foroptimism. Experts, including JosephGrundfest, a professor at Stanford UniversitySchool of Law and director of its SecuritiesClass Action Clearinghouse, believethat the recent increase is a temporary bliprather than the beginning of a trend. Theycite a number of positive developments inlitigation that favor corporate defendantsover the long-term. In fact, Grundfest saysthat if you rule out specific events, such asstock-options backdating or subprimerelatedcases, the downward trend in class-actionlitigation might continue. Corporateofficers are possibly just behaving better,he suggests. “Most corporate managersare not engaging in risky behavior the waythey used to be. Accounting is more precise.Books are better kept, the probabilityof getting caught is much higher than itused to be, and the price you pay is muchgreater.”
Going the Distance
One of those positive developments wasthe jury verdict in favor of JDS UniphaseCorp. following five years of shareholderlitigation. Last November in U.S. DistrictCourt in Oakland, Calif., a jury, citinginsufficient evidence to show wrongdoing,ruled that four former executives were notguilty of insider trading and securitiesfraud.
The defendants’ victory may emboldenother companies to proceed to trial. This is“an important landmark in modern securitieslitigation,” says Grundfest, a formercommissioner of the Securities andExchange Commission (SEC). “Thesecases rarely go to trial, and for the defendantsto win a total victory in a case thatclaimed $20 billion in damages demonstratesthat not every case that makes it pastsummary judgment has merit. The interestingquestion is how and whether this trialresult might cause plaintiffs to modulatetheir settlement demands or emboldendefendants to take cases to trial.”
In its year-end report, the SecuritiesClass Action Clearinghouse cited the JDSUniphase case as one of the defining eventsin class-action litigation, along with theguilty plea of former Milberg Weiss Bershad& Schulman partner William Lerach, andthe surge in filings related to the subprimemortgagemarket crisis. A fourth developmentthat bears note was the SupremeCourt decision in Tellabs v. Makor thatrequires plaintiffs to show stronger evidenceof fraud than previously sought.
“The scandal and indictments at Milberg Weiss may have had the greatest effect no reducing class-action litigation, especially securities class action.” –Steven Hantler, American Justice Partnership
Experts such as Grundfest believe thereasons for the decline over the last fewyears stem from better accounting practices,a more stable stock market, andincreased federal enforcement activity.
The nature of class actions is also changing.The Stanford report found a “moderatedecline” in the percentage of filingsthat allege misrepresentations in financialstatements and a notable drop in the numberof alleged insider-trading cases. Therecent surge in new securities litigation ismore event-driven, the result of the subprimecrisis. Strip out those cases and barringany new event, Grundfest expects thenumber of class-action filings will continueto remain low.
Subprime Time
Stanford’s Clearinghouse, in conjunctionwith Cornerstone Research of Boston,found a total of 166 federal securities classactions were filed in 2007, up 43 percentfrom 2006. The overall number was stillbelow the historical ten-year average of 194cases. The financial services sector led theway in securities suits last year with 47 filings;of those, 25 were related to the subprime-market disclosure issues. (The consumernon-cyclical and communicationssectors followed with 36 and 33 companiessued, respectively.)
NERA Economic Consulting reports that the first subprime-relatedshareholder class action was filedin February against New Century FinancialCorp. By December, the total numberof subprime-related actions had more thanquadrupled. But subprime cases aren’texpected to drive an onslaught of litigationinto 2008 and beyond. “When litigationrelated to the subprime crisis is excludedfrom the calculation—on the assumptionthat the subprime crisis is a non-recurringevent—the resulting core-litigation rateremains well below historical terms,” saysGrundfest.
Steven Hantler, former general counselto DaimlerChrysler, and chairman of theAmerican Justice Partnership, a nonprofitgroup backed by major corporations, agreesthat the subprime cases are indicative of theevent-driven securities class-action environment.Having watched the development ofnumerous class-action cases, he says thereare common characteristics that readily typify probable class actions. “When I amasked to forecast what’s likely to happen,”Hantler says, “all I do is look in the newspaperto what kind of injury abounds.”
The increase in the number of lawsuitsillustrates his point: there are victims—inthis case, homeowners—losing their propertyto banks and mortgage companies.The David versus Goliath angle is amplefodder for reporters and televisionproducers, he contends. The trial bar iscomprised “of some of the most sophisticatedentrepreneurs in this country.” Hesays that securities suits are following thepattern of product liability cases, where aseries of events drives an increase in cases.For a product-liability example, he saysthe plaintiff bar could pursue toy manufacturersbecause of lead paint found ontoys.
“They’re probably retaining medicalresearchers now to do studies on the longtermeffects [of lead exposure] on children,assuming that children have been exposedto lead,” he says. Look no further than thelitigation over breast implants in the 1990s,he suggests. Study after study found thatthere was no correlation between siliconebasedbreast implants and major disease.Even so, before the scientific researchcould be completed, juries in Houston,San Francisco, Alabama, and elsewhereawarded plaintiffs millions of dollars. Twomanufacturers, including Dow Corning,went bankrupt. “The litigants’ lawyers createdthe science and publicized it to thepublic, where it became almost engrainedin our culture. ‘Breast implants were bad,’they said. You had victims—innocentwomen—and you had the big, bad profiteeringchemical companies.”
The Milberg Weiss Implosion
The recent decline in securities classactionsuits could be the result of the criminalcharges brought against one of themost notorious class-action litigation firms,according to some observers. Senior partnersof Milberg Weiss Bershad & Schulman,including Melvyn I. Weiss, oncedescribed by Fortune magazine as “Mr.Class Action,” were indicted on conspiracycharges for allegedly orchestrating ascheme by which the law firm paid kickbacksto named plaintiffs in securitiesclass-action cases. At least seven defendants,including former Milberg Weisspartners Lerach, David Bershad, andSteven Schulman, and former class-actionplaintiffs who received kickbacks from thefirm, have pled guilty; Weiss maintains hisinnocence and his criminal trial will beheard in Los Angeles federal court. Theresult of their indictments on class-actionlawsuits in general, according to Hantler,“was a great disinfectant,” against what heconsiders a culture of underhanded tacticsand the filing of frivolous cases by somelaw firms.
“The scandal and indictments at MilbergWeiss may have had the greatest effecton reducing class-action litigation, especiallysecurities class action,” Hantler says.“It was a mill. They generated hundreds oflawsuits. When the scandal escalated [tocriminal indictments], the spigot stoppednot just at Milberg Weiss, but also at otherfirms. It had an effect. It made them allmore cautious.”
While in 2003 Milberg Weiss was ratednumber one in the country for the totalnumber of settlement dollars it amassed,by 2006 it had slid to fourth in the rankings.Even so, in RiskMetrics’ most recentrankings, Milberg Weiss still had total settlementsupward of $1.6 billion. The leadingfirm in the country, Coughlin StoiaGeller Rudman & Robbins, collected $7.3billion on behalf of its litigants, per Risk-Metrics.
Grundfest isn’t convinced that indictmentsagainst Milberg Weiss had such achilling effect. “The last time I looked,”Grundfest argues, “there was no shortageof plaintiff class-action attorneys andthere’s no shortage of capital to fund classactionlitigation. The indictments [ofMilberg Weiss partners] having a macroeffect doesn’t make sense to me. A betterexplanation may be that if the behavior forwhich Milberg Weiss partners wereindicted was much more pervasive thanwe’d known, and that behavior haschanged as a result of the prosecution,that could have a chilling effect. In whichcase, isn’t that good for business?”
Bumps in the Road
The long-term outlook for securities litigationisn’t entirely positive, however. AdamSavett, director of securities class-actionservices at RiskMetrics, points to another litigation trend that corporate boards andofficers should be aware of: internationalinstitutional investors becoming increasinglyactive here in the United States.Legal observers say this trend is beingdriven in part by a growing number of affiliationsbetween U.S. and overseas lawfirms. In some instances, these firms havereached out to provide “educational” campaignsto international institutional investors.For example, Schiffrin BarrowayTopaz & Kessler in November announceda strategic alliance with Man-Barak Advocates& Solicitors, an Israeli-based lawfirm. Schiffrin Barroway has similar affiliationswith law firms located in Germanyand Italy.
RiskMetrics’ SCAS studied the issueand found that since 2000 there has been asteady rise in the percentage of U.S. securitiesclass actions with international institutionalinvestors as the lead plaintiffs. Whilesome 17 countries have filed at least oneclaim, the most activity originates frominvestors in Canada, Australia, TheNetherlands, and Israel. A fifth countrythat bears watching, according to Savett, isSouth Korea, which now allows securitiesclass-action suits to be filed in its countrybut so far has seen no activity.
Settlement Values Rise
Some researchers aren’t convinced thatthe recent increase in securities suits is ahiccup, based on non-recurring events.NERA’s year-end research reports thateven after excluding subprime and optionsbackdating cases, the number of standardsecurities suits increased nearly 40 percentfrom 2006, according to study co-authorStephanie Plancich, a senior consultant atNERA. She says it is too early to determineif 2007 was an aberration or a change inthe underlying trend. “Filings are back upto 2005 levels,” Plancich says. Average settlementshave also increased in size:NERA reports the average settlement paidto resolve a shareholder class actionpeaked last year at $33.2 million. Themedian settlement also increased to thenew high of $10 million.
If securities litigation continues to bedriven by event-based cases, there areissues now on the horizon that could portendnew class actions. Global climatechange and injury caused by tainted productscould pose threats.
Meanwhile, lawmakers have called onthe Securities and Exchange Commissionto hold a roundtable to review the impactof securities class-action lawsuits on U.S.competitiveness. A letter written to SECChairman Christopher Cox from CongressmenVito Fossella (R-N.Y.) andGregory Meeks (D-N.Y.) asked Cox tohold such a roundtable, but no date hasbeen set. While both lawmakers have beenquoted in news reports saying they supportthe right of defrauded shareholders to joinin legal actions, they expressed concernabout the possibility of an increase in sizeand frequency of securities class-actionlawsuits. Fossella also requested that theSEC conduct a review of securities litigationto see if it is deterring fraud and providingrelief to harmed investors—ineffect, is it doing its job? The last timeCongress addressed securities suits in a bigway was with the Private Securities LitigationReform Act of 1995. While the 1995Act included sweeping changes, many criticshave labeled it ineffective at stoppingfrivolous securities suits.
In the face of litigation threats, what arecorporate directors and officers to do?Stanford’s Grundfest offers this advice:“Take a good and careful look at yourindemnification and the corporation’sinsurance policy. Directors who do everythingthey can to prevent litigation need toknow that in the event of a suit, they canmount a proper defense.” Secondly, hesays, officers and directors need to undertakewhat is “rational and reasonable tominimize the risk of litigation—thatmeans using plenty of common sense andhaving a healthy respect for process.”