Recent “opt-out” settlements challenge D&O severity, limits assumptions

A recent wave of individual institutional investor securities lawsuit “opt-out” settlements is raising troubling new questions about both D&O carriers’ claims severity assumptions and D&O policyholders’ limits adequacy.

An opt-out action involves a separate lawsuit brought by an individual investor who elects not to participate in the settlement of a securities class action lawsuit brought on behalf of all investors that supposedly have been harmed as a result of alleged securities fraud. In a series of recent settlements of opt-out actions, individual investors have secured massive individual settlements, the expense of which for the settling defendants must be added on top of the cost of defending against and resolving the class action lawsuit.

For example, in Time Warner’s class action litigation, the class reached a settlement of $2.65 billion. Although the settlement represented one of the largest class action settlements, several individual institutional investors elected to opt out of the class settlement. Over the past few months, several of the investors who opted out have announced very large individual settlements, in each case accompanying their announcement with the added assertion that their individual recovery greatly exceeded what they would have recovered from the class settlement.

Thus, the state of Alaska announced a $60 million settlement with the Time Warner defendants, which it said represented “50 times what we would have gotten if we remained in the class.” The California State Teachers’ Retirement System (CalSTRS) announced that it had reached a $105 million settlement in its individual action against the Time Warner defendants, which CalSTRS said represented 6.5 times what it would have recovered from the class settlement. And then on Feb. 28, 2007, the University of California, in what is believed to be the largest opt-out settlement in history, announced a $246 million settlement with Time Warner, which the amount also represented a large multiple of what the University would have recovered in the class settlement.

Institutional investors also have recently announced significant settlements in individual actions involving Qwest Communications and WorldCom, in each case, after the individual investors had chosen to opt out of very large shareholders’ class action settlements. According to the settling parties, each of the individual settlements represented a much larger recovery than the parties would have recovered from their share of the class action settlement.

The emergence of large separate opt-out settlements represents a potentially very significant development in securities fraud litigation. Certainly, if institutional investors perceive that they can substantially increase their recovery by proceeding individually rather than participating in the class action settlement, the utility of class action litigation could be significantly reduced, for all parties. If a company is forced to defend itself against both a class lawsuit and multiple individual lawsuits, the costs of defense escalate. And if individual investor recoveries really do exceed class recoveries as a percentage of putative investor loss, then the aggregate cost of final resolution could escalate significantly as well.

To be sure, the incentive for an individual investor, or his or her counsel, to pursue a separate action rather than participating in a class action may be limited to cases where the prospective recovery is very large. According to the National Economic Research Associates, the median securities fraud class action settlement in 2006 was $7.3 million. With half of all class actions settling below $7.3 million, there may be relatively few occasions when individual investors (or their lawyers) have sufficient financial incentive to pursue individual actions.

Nevertheless, at least with respect to the larger cases, the emergence of opt-out settlements could require a reassessment of the range of potential D&O claim severity. It may no longer be sufficient for D&O carriers to look at class action settlement data alone to assess the probable range of claims severity. The possibility of additional opt-out cases, with the added defense and settlement expense, also must be taken into account.

The added potential exposure could also have important implications for policyholders’ D&O limits selection. The limits required to defend a company and its directors and officers in a multi-front war involving both a shareholder class actions and separate individual investor actions could be significantly higher than has been assumed in the past. Similarly, the aggregate cost required to resolve a class lawsuit and separate individual actions could be significantly greater than the cost of resolving the class action lawsuit alone.

Yet the emergence of these large individual investor opt-out settlements is a relatively recent phenomenon. For that reason, there may be good reason to hesitate before jumping to too many conclusions about the likely future impact of those settlements. All of the recent opt-out settlements were in connection with the huge cases arising from the wave of corporate scandals that emerged earlier in the decade. It is entirely possible that once the cases arising from the corporate scandals have worked their way through the system, the individual investors may be less interested in pursuing separate actions.

The long-term significance of opt-out settlements may remain to be seen. But in the meantime, it is difficult to argue with the recent assessment of Columbia Law School professor John Coffee, who called the recent emergence of large opt-out settlements “probably the most significant new trend in class action litigation.”