On June 21, 2007, the U.S. Supreme Court issued its decision in the Tellabs Inc. v. Makor Issues & Rights Ltd.
securities case. For corporations faced with the threat of a securities class-action lawsuit, the court's decision may help trim the number of frivolous suits that reach the courtroom.
However, the decision also ensures that investors will not lose their ability to recover losses in cases of serious misconduct. The decision achieved a balance between the competing interests of investors and corporate executives.
For risk managers and corporate general counsel, though, the Supreme Court's decision in the Tellabs case has raised another issue: Will this have an impact on our directors' and officers' liability insurance?
The short answer is that the decision should probably have very little impact on the need for D&O coverage, the coverage itself or pricing.
In 2002, Makor Issues & Rights brought a securities fraud class-action lawsuit in U.S. District Court against Tellabs, a manufacturer of equipment for fiber-optic cable networks. The lawsuit alleged that Tellabs had violated the Securities Exchange Act of 1934.
In particular, it claimed that Richard Notebaert, Tellabs' CEO from August 2000 to June 2002, misrepresented the strength of the company's product sales and its projected earnings, thereby artificially inflating the company's stock. Tellabs denied these allegations.
Under U.S. securities law, in order to bring a lawsuit to trial, the plaintiffs must prove scienter--that is, intent must be present. The plaintiffs must demonstrate that company executives knew about and concealed poor financial results that would drive down the stock price.
The case was dismissed by the District Court, which found that the plaintiff hadn't made a strong enough case that Notebaert had acted with intent. Makor Issues & Rights, the court said, had not met the "strong inference" threshold which was required by the District Court for a case to go to trial.
The plaintiffs appealed their case to the 7th U.S. Circuit Court of Appeals. The appeals court, using a more investor-friendly interpretation of U.S. securities law and scienter, reversed the District Court's decision and held that the plaintiffs adequately pleaded scienter. The 7th Circuit noted that the plaintiff's complaint against Tellabs alleged "facts from which, if true, a reasonable person could infer that the defendant acted with the required intent." Tellabs appealed the 7th Circuit's reversal to the U.S. Supreme Court.
In June, the Supreme Court reversed the reversal and, in the process, formulated guidelines to help federal courts determine when securities class-action claims are frivolous and should be dismissed.
Frankly, there was a need for the development of uniform guidelines. The existing securities litigation playing field was uneven, with some U.S. District Courts employing more stringent guidelines for securities class-actions than others. With Tellabs, the Supreme Court took an important step toward articulating a "middle-of-the-road" standard that offers long overdue clarity and consistency.
Under the Supreme Court's decision, a complaint must plead facts "rendering an inference of scienter at least as likely as any plausible opposing inference."
"Reasonable" or "permissible" inferences of intent are not sufficient cause for a lawsuit; intent must be "cogent" and "compelling."
Importantly, the High Court's decision affirms the point that the defense position needs to be considered in weighing the merits of a case--thus requiring the trial court to review all the facts alleged in a complaint, both the plaintiff's and the defendant's.
The decision gives lower courts standards with which to weigh allegations at an early stage, granting them greater discretion to consider the circumstances surrounding news that is released to the investing public, as well as internal reports, budgets and other communications that may, in theory, contradict that public information.
WHO OR WHAT WILL BE AFFECTED?
The constitutional function of the Supreme Court is to implement the intention of Congress. In Tellabs, the Supreme Court discussed what it felt Congress intended when it passed the Private Securities Litigation Reform Act of 1995. The court concluded that one purpose of the act was to reduce the number of frivolous securities class-action lawsuits brought under federal securities laws while still providing relief for investors with legitimate claims.
For example, because the High Court observed in Tellabs that omissions and ambiguities will "count against inferring scienter," suits asserting purely ambiguous allegations such as insider trading patterns or contradictory internal communications are less likely to survive a motion to dismiss.
But we should be clear about one thing. The decision is unlikely to affect cases with allegations of serious misconduct, such as manipulations of revenue recognition, hiding expenses, roundtrip transactions or other forms of fraudulent conduct that can be tracked to senior management. And it certainly won't have an impact on the larger and more spectacular cases such as Enron and WorldCom.
Historically, the typical public corporation has an 8 percent probability of facing at least one shareholder class-action lawsuit over a five-year period. From 2000 to 2006, nearly 1,900 federal securities fraud lawsuits were filed in the United States against public companies and their directors and officers. The Tellabs opinion may reduce that number, but it is unlikely to affect the bulk of securities class actions and most certainly won't have a material impact on total dollars paid in those lawsuits. Hence, the need for directors' and officers' liability insurance will remain.
Earlier efforts to curb the proliferation of frivolous securities suits further suggest that the overall impact of Tellabs will be limited. The Private Securities Litigation Reform Act of 1995 was followed by an initial decline in private securities class-action filings from 213 in 1995 down to 110 in 1996.However, in subsequent years this trend immediately reversed--filings increased to 201 and 277 in 1997 and 1998, respectively.
Although there is clear promise that the Supreme Court's decision may result in fewer frivolous securities suits, experience tells us that it is the serious, not the frivolous, claim that drives overall directors' and officers' liability insurance costs. The Tellabs ruling slightly favors policyholders and insurers, but the impact is not a windfall one way or the other.
The Tellabs decision marks an important starting point toward a uniform standard for federal courts in reviewing securities class-action complaints when they're confronted with motion-to-dismiss challenges based on deficiencies in alleged intent. It will undoubtedly trim some lawsuits from the court dockets early in the litigation process, and it may also discourage other federal securities suits from being filed.
However, Tellabs does not spell the end of securities class-action lawsuits. In fact, the High Court emphatically reminded all affected parties that securities lawsuits are here to stay. Such lawsuits, the Court said, serve as "an indispensable tool with which defrauded investors can recover their losses" and, as such, are "crucial to the integrity of domestic capital markets."
How will Tellabs affect your company's directors' and officers' liability insurance coverage? Time will ultimately provide the answer, but a court decision alone hasn't ever recently influenced the normal ebb and flow of a market. Tellabs won't be the exception. In the end, it is the actual claims experience and the dollars paid out that drives insurance conditions.
ANTHONY GALBAN is a senior vice president with Chubb & Son, and the global directors' & officers' product manager for Chubb Specialty Insurance.
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October 1, 2007
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