Corporate Governance

The Chamber of Commerce and Excessive Litigation: Be Careful What You Wish For (Part 5)

By J. Robert Brown

We are discussing the recent report,  ?Securities Class Action Litigation: The Problem, Its Impact, and The Path to Reform,? published by the Institute for Legal Reform of the Chamber of Commerce.

The Report also mentions that the lawsuits "pointlessly transfer money from one innocent investor to another."  This has been a popular argument of late.  Essentially, so this argument goes, settlements entail the payment from the company (and the current owners), who had no role in any fraud, to the past owners (although there is of course some overlap in the two groups).  So one group of innocent shareholders (those in the present) are paying another group of innocent shareholders (those injured in the past). 

The first problem with this argument is that it would justify a system where the present owners would never pay for the bad behavior of the past managers.  In other words, based upon this rational, there should never be recovery for fraud in a private action.  But the argument goes much further.  The same argument has been used to oppose the system of fines imposed on companies for fraud by the SEC (see the views of former Commissioner Atkins).  After all, fines are paid by innocent shareholders in the present for bad behavior in the past.   Yet the Chamber Report explicitly favors government enforcement, nowhere reconciling why transfers in the private sector are somehow pointless while transfers in the public sector are apparently not.   

In any event, the main problem with the argument is that most payments made to settle these cases come not directly from the company but from the insurance carriers under D&O policies, something one would never know reading the Chamber Report (some of the mega suits exceeded insurance amounts but this is not the norm).  Insurance involves shared risk among all of the companies in the same pool.  In other words, the settlement comes from the pool of funds maintained by the carrier.  It does not reduce the net value of the company settling and does not involve a transfer from present to past shareholders.  Moreover, the recovering shareholders paid for the protection in the form of D&O premiums back in the year when the fraud occurred.   

Of course, future shareholders may suffer from an increase in the cost of D&O insurance as a result of a settlement.  But that is highly problematic and not easily quantified.  Moreover, the amount of the increase may be small relative to the amount paid to the past shareholders.  Did the Chamber Study address this issue?  It had only this to say: 

• Even when a company's insurance covers the settlement and litigation costs, the company ultimately ends up footing much of the bill because insurance premiums inevitably increase to reflect the higher risk of liability.  These spiraling expenditures in part explain why insurance costs for a Fortune 500 company are over six times higher in the United States than in Europe.
  

Perhaps but this is a noticeably unsupported proposition.  To the extent there is a settlement, the quote suggests that premiums will increase.  It offers no actual authority for the proposition and is, in fact, wrong.  As Kevin  LaCroix (of D&O Diary fame), explained:  

• I agree with your criticism of the Chamber report?s statement that ?insurance premiums inevitably increase to reflect the higher risk of liability.? This statement is simply not true. If it were true, insurance rates now would be much higher than five years ago, because of dramatically higher average claims severity. Instead, rates now are less than half of what they were in 2003. The largest determinant of insurance pricing is the availability of capital and related competition. Capital is abundant and competition is fierce, as a result of which buyers enjoy much lower rates than five years ago, despite much higher average claims severity. The mechanism that establishes insurance prices is much more complex and multifaceted than the Report?s statement suggests. Obviously there is a connection but it is neither as direct nor as ?inevitable? as the Report suggests.
  

In other words, the report largely ignores the single most important issue in the entire securities litigation area -- the role of insurance and when it does mention the subject, it gets the facts wrong.

The Report has little to say about insurance because the topic represents an "inconvenient truth." First, focusing only on the cost of insurance is not very sexy and may not be excessive relative to other types of commercial insurance.  Thus, for companies with market capitalization over $10 billion, a recent report put their D&O costs at an average of $3 million, hardly the crisis levels claimed by the report.  

Second, those companies that pay the D&O premiums and are never sued may well, as a matter of economics, be the losers in the system.  They pay the insurance proceeds year after year, with no amount ever returned to shareholders (past or present).  A settlement in a securities suit at least returns some of the amount paid in insurance premiums back to shareholders.   

Finally, the focus on insurance gives rise to possible reforms not at all in line with what the Chamber is seeking.  By paying settlement amounts from insurance, the argument is strong that companies do not have sufficient incentive to reduce instances of fraud.  One way to solve the problem would be to eliminate insurance and severely restrict indemnification, making the responsible parties pay for any fraud.  These types of reforms, however, are absent from the Chamber's report. 

Full post as published by The Race to the Bottom on September 04, 2008 (boomark / email).