How the merits matter: directors' and officers' insurance and securities settlements.

• Author: Baker, Tom

This Article seeks what may be the holy grail of securities law scholarship--the role of the "merits" in securities class actions--by investigating the relationship between settlements and directors' and officers' (D&O) liability insurance. Drawing upon in-depth interviews with plaintiffs' and defense lawyers, D&O insurance claims managers, monitoring counsel, brokers, mediators, and testifying experts, we elucidate the key factors influencing settlement and examine the relationship between these factors and notions of merit in civil litigation. We find that, although securities settlements are influenced by some factors that are arguably merit related, such as the "sex appeal" of a claim's liability elements, they are also influenced by many that are not, including, most obviously, the amount and structure of D&O insurance. The virtual absence of adjudication results in payment to the plaintiffs' class for every claim surviving the motions stage and, as importantly, a lack of authoritative guidance about merit at settlement. Without such adjudication, the weight of various factual patterns is untested, and the validity of competing damages models remains unknown. Parties structure their settlement by reference to other settlements, but these are opaque and subject to the same set of distortions. In this murky environment, plaintiffs and defendants collude to pressure the D&O insurer to settle on terms that may not reflect the ultimate merits of the claim. More adjudication, we argue, would be the best solution to the problem, but barring that, disclosure of D&O insurance and settlement terms would offer some improvement.

INTRODUCTION I. SHAREHOLDER CLASS ACTION LAW AND PROCEDURE A. Substantive Law B. Procedural Stages 1. Investigation and Filing 2. Class Certification and Lead Plaintiff Selection. 3. The Motion to Dismiss, Discovery, and Settlement II. WHAT WE TALK ABOUT WHEN WE TALK ABOUT MERITS III. FIELD RESEARCH ON SETTLING SHAREHOLDER CLASS ACTIONS A. Liability and Damages in Securities Settlements 1. Liability 2. Damages B. The Role of D&O Insurance in the Settlement Process 1. Limits 2. Layers a. The Arrangement of the Tower b. Firebreaks C. Other Incentives: Defendants and Counsel IV. DISCUSSION A. More Adjudication B. More Disclosure C. Less Entity-Level D&O Insurance CONCLUSION INTRODUCTION

In an article announcing the retirement of Bill Lerach, the famous and widely reviled plaintiffs' lawyer, the Wall Street Journal concisely summarized the debate surrounding securities class actions. On one side, the reporter wrote, are those who claim securities class actions force defendant corporations to settle "regardless of the underlying merits of the claim," and on the other are those who argue that such lawsuits "help keep corporate America accountable" by detecting, punishing, and deterring fraud. (1) Lerach, the newspaper suggested, was that controversy personified. (2) But the controversy is much bigger than one man, and it has hardly been put to rest.

The question, as it was powerfully framed by Janet Cooper Alexander, is do the merits matter in the settlement of securities class actions? (3) In other words, do the merits of claims determine the amounts paid at settlement, or are they essentially irrelevant? Alexander's answer was that the merits do not matter. (4) Her argument played an important role in changing the law, providing rhetorical support and academic credibility to interest groups lobbying to make securities class actions more difficult for plaintiffs to bring--an endeavor that succeeded in 1995 with the enactment of the Private Securities Litigation Reform Act (PSLRA). (5) Indeed, Alexander's article is still widely cited even though its empirical foundation has been undermined, (6) perhaps because her basic claim--that the merits do not matter in securities litigation--is so widely believed. (7)

Because the merits question is now so loaded--taking a firm position on it is like declaring a political allegiance or picking a fight--researchers approach it with considerably more caution. (8) Their results, not surprisingly, are ambiguous. Studies since the PSLRA have found that securities lawsuits are now more often dismissed, but the additional dismissals may include meritorious and nonmeritorious suits alike, therefore leaving researchers unable to conclude that only the meritorious survive. (9) Securities claims now take longer to settle, perhaps suggesting that plaintiffs' lawyers are bringing better claims and pushing them harder, (10) and claims featuring easily identifiable indicia of wrongdoing or fraud--such as earnings restatements, insider selling, and concomitant regulatory investigations--settle higher than claims without such features. (11) Insofar as such indicia correlate with the merits of a securities claim, (12) these studies may support the proposition that at least some meritorious claims settle higher than nonmeritorious claims. (13) But, as the researchers acknowledge, the correlation is far from perfect--some fraudulent conduct will not leave behind such a tangible trace--preventing us from drawing a strong conclusion about the merits of securities claims.

In this Article, we confront the issue of merits in securities class actions. (14) But we do not ask whether the merits matter. Our question, instead, is how the merits matter. How do the participants in securities class actions understand the merits, and how do they talk about them? How do they use the idea of merit in settlement negotiations? And what do they view the role of merit to be in shaping outcomes at settlement?

Because our research question is qualitative--asking how the settlement process works--our research methods are also qualitative, not quantitative. (15) Our basic tool is the semistructured interview, in which we ask questions, but also allow our participants simply to talk, to describe the settlement process in their own words, and to illustrate their explanations with stories and anecdotes. (16) During 2006 and 2007, we interviewed over fifty people involved in the process of settling securities claims, including plaintiffs' and defense lawyers, claims managers at directors' and officers' (D&O) liability insurance companies, insurers' monitoring counsel, claims-side brokers, mediators, and testifying experts. (17) In addition, we read their trade literature and participated in industry conferences. In short, we entered the field in an effort to understand it from the perspectives of those working within it. (18)

A principal focus of our research was the role of D&O liability insurance. D&O insurance covers losses that corporations and their directors and officers incur in connection with corporate and securities litigation. (19) Virtually all U.S. public corporations buy D&O insurance, (20) and the vast majority of securities claims settle within or just above the limits of the defendant corporation's D&O coverage. (21) As a result, it is not a stretch to assert that the principal party at interest in most securities class actions is the D&O insurer. Our research focused largely on uncovering the interests of this party, in discovering how it understands "merit," and how these interests and understandings influence the settlement of securities litigation.

In emphasizing the centrality of liability insurance in determining substantive legal outcomes, this Article continues a theme from our prior work, and indeed it may be viewed as the conclusion of a trilogy on the interaction between law and insurance in the corporate and securities law context. (22) In the first article, we described how insurers evaluate risk in underwriting D&O policies and analyzed the implications of the policies' role in furthering the deterrence objectives of corporate and securities litigation. (23) In the second article, we investigated the relationship between insurer and insured during the life of the policy; we found that D&O insurers do almost nothing to monitor the risky activities of their corporate insureds and that, as a result, D&O insurance is a pure risk-spreading form of insurance, raising the attendant moral-hazard concerns. (24) In this third and final Article, we inquire into the role of the D&O insurer at settlement, asking whether the deterrence function of securities law is reintroduced through an insistence on merits at settlement or whether other dynamics at settlement subvert deterrence.

A common theme underlying our work in this area is the extent to which liability insurance preserves or subverts the deterrence objectives of corporate and securities law. Scholars customarily treat deterrence as the principal objective of civil damages in corporate and securities litigation. (25) Because D&O insurance funds the settlement of corporate and securities litigation, any deterrent effect of settlement can only be achieved by the insurance intermediary. (26) In order for civil litigation's potential damages awards to deter, D&O insurers must in some way preserve the deterrent effects of the liability regime. Do they? Our prior research was not optimistic on this point. (27) And we are no more optimistic here, finding that D&O insurance clouds the role of the merits in the settlement process. Moreover, putting this insight together with those gleaned in our prior research, we ultimately conclude that, absent disclosure, D&O insurance significantly undermines the deterrence function of shareholder class actions.

The Article proceeds as follows: Part I provides a brief background on shareholder litigation and its procedural stages. Part II discusses competing definitions of the merits in securities class actions. Part III reports our findings on the role played by merits in securities settlements, how the settlement process works, and how ideas about merit ultimately translate (or fail to translate) into a settlement amount. Part IV applies our findings to the debate over merit and...