Prepared by
Dan A. Bailey

The material in this outline is not intended to provide legal advice as to any of the subjects mentioned but is presented for general information only. Readers should consult knowledgeable legal counsel as to any legal questions they may have.

Since 1998, the average number of securities class action lawsuits filed in each year has averaged around 220, with a high of 271 in 2002 and a low of 205 in 1999. However, in 2005, there were only 176 securities class actions filed, representing a nearly 20% decrease from that prior average. Even more startling, only 82 securities class action lawsuits have been filed through August 2006, which annualizes to approximately 120 suits per year, or about a 45% decrease from the historical average.

This dramatic drop in the frequency of securities class action litigation has been well documented, but it is far less clear why this surprising development is occurring. Numerous theories have been cited as reasons, but each theory has limited validity when carefully analyzed. The real answer appears to be that there is no one reason for this dynamic, but instead a number of contributing factors have converged. Each of those factors has separately caused a modest reduction in filings, but all of those factors combined have resulted in the very significant reduction in filings.

Each of those factors is briefly discussed below. As explained, many of those factors are not permanent, and therefore it seems highly unlikely that the reduced level of securities class action filings will continue for an extended period of time. Much like the dramatic reduction in securities class action filings during the two years immediately following enactment of the Private Securities Litigation Reform Act of 1995 (“PSLRA”), this recent reduction in securities litigation activity is likely to be temporary. As a result, neither D&O insurers nor their insureds should overreact to this recent development by unduly adjusting their underwriting, pricing and coverage standards or expectations. Just as the soft D&O insurance market in the late 1990s (which was primarily attributable to the large reduction in securities filings in 1996 and 1997) gave rise to unexpected losses and a major insurance market correction beginning in 2001, an over-reactive softening of the market today in response to this development will likely cause another significant market correction in a few years.

A. Stock Volatility

Heightened stock price volatility typically results in more securities class action filings since more companies experience large and sudden stock drops which plaintiff lawyers can use as evidence of an alleged “corrective” disclosure of previously misleading information. Since mid-2003, the stock volatility for the U.S. equities market has been relatively low, as measured by a weekly range. Unlike the period 1999 through 2002, when the stock market volatility was quite high due to the “bubble burst” and the market’s heightened sensitivity to scandals, fewer companies have experienced significant stock drops during the last three years. Therefore, there have been fewer opportunities for plaintiffs to allege that a stock’s market price was artificially inflated by directors and officers.

However, this reduced stock market volatility does not fully explain the recent reductions in securities class action filings since the reduction in filings began in 2005 and accelerated in 2006, whereas the stock market volatility reduction began in 2003. In any event, to the extent this is a contributing factor, it may be disappearing. Beginning in the second quarter of 2006, the stock market volatility increased dramatically to the highest levels of the last three years. Volatility indicators have increased by more than 50% since the end of the first quarter of 2006, which has been described as a “radical” change in volatility over a relatively short time period. See, www.smartoptionsreport.com/archives/2006/20060705. Thus, to the extent reduced stock volatility contributed to the reduced securities filings, a reversal of that trend appears likely during the coming months.

B. Enhanced Corporate Governance

The extraordinary attention given to corporate governance issues in the aftermath of Enron, Worldcom and other highly-publicized corporate debacles, as well as the Sarbanes-Oxley Act of 2002 (“SOX”), have undoubtedly improved to some extent director and officer sensitivity to potential wrongdoing and enhanced governance behavior. Higher quality governance performance may reduce securities litigation filings to some extent, but it appears unlikely that this is a major contributing factor to the reduced filings. For example, the number of restatements by corporations continues at near record levels, which suggests that misleading financial disclosures by companies are far from rare. In addition, many of the enhanced governance practices do not directly relate to disclosure issues and therefore do not directly affect securities class action litigation. Besides, it is odd that it took nearly four years following the disclosure of the Enron scandal and enactment of SOX for the dramatic reduction in securities litigation filings to occur. That rather long time delay suggests other intervening events are also contributing to the current litigation environment.

C. Dura Supreme Court Decision

In April 2005, the U.S. Supreme Court in the Dura Pharmaceuticals case ruled that plaintiffs in a securities fraud lawsuit must prove a causal connection between the alleged misrepresentations and a subsequent stock drop. As a practical matter, the decision requires plaintiffs to prove that a significant stock drop occurred immediately following a corrective disclosure by the company. Although most securities class actions are premised upon such an immediate stock drop, the Dura decision has resulted in a few more cases being dismissed and other cases not being filed. However, the number of cases which have not been filed as a result of Dura is probably not a large number.

For many years prior to the Dura decision, a majority of federal circuit courts which addressed this loss causation issue rendered opinions consistent with the Dura decision. In other words, in most federal circuits, the Dura decision did not constitute new or different legal standards. In addition, the number of historical securities class action cases which did not involve an immediate stock drop following a corrective disclosure was relatively low. Also, since the Dura decision was issued, plaintiffs have been relatively successful in limiting the scope and effect of that decision in a number of subsequent cases. As a result, the Dura decision does not explain the recent large reduction in securities filings, although the decision probably caused a modest decrease in filings.

D. Milberg Weiss Indictment

In May 2006, after a lengthy and highly-publicized criminal investigation, a federal grand jury indicted the Milberg Weiss law firm and two of its senior partners. The indictment alleges the defendants made improper payments to certain named plaintiffs in securities class actions prosecuted by the Milberg Weiss law firm primarily in the 1990s. Since that indictment, many attorneys have left the firm and the firm has filed very few if any new securities class actions. Arguably, this development contributed to the recent decrease in securities filings for two reasons.

First, the indictment arguably put a stop to improper payments to the named plaintiffs in securities class actions, and thus plaintiff lawyers are now having greater difficulty in locating willing shareholders to serve as the lead plaintiff. This argument appears to have little validity. Institutional investors are now serving as the lead plaintiff in securities class actions with far greater frequency, and those institutional investors are sufficiently incentivized to serve in that role without any improper payments to them. Besides, the alleged wrongdoing by the Milberg law firm occurred many years ago, and there is no allegation or indication that those practices continued into more recent times. In any event, because the criminal investigation has been pending for several years, any chilling effect created by the criminal investigation likely occurred well before the recent reduction in securities filings.

Second, since the Milberg law firm historically has filed more securities class actions than any other plaintiff firm, the number of new securities filings arguably has been reduced as a result of that firm not filing new cases since the indictment. In fact, the drop in the number of securities class action filings in 2006 generally equates to the drop in securities class action filings by the Milberg law firm. However, it seems highly unlikely this development explains the recent reduction in filings or will cause a future reduction in filings. In virtually all securities class actions, several different plaintiff law firms separately file a complaint and then compete against each other for the role of counsel for the lead plaintiff. Although Milberg frequently won that competition in the past, the absence of Milberg now simply means that other plaintiff law firms have a better chance of being designated as counsel for the lead plaintiff. In any event, many of the lawyers at the Milberg firm have left the firm to either join other firms or form new firms, and those lawyers continue to be actively involved in prosecuting securities class action lawsuits. Thus, any inactivity by or demise of the Milberg law firm has not and will not create a void among qualified plaintiff lawyers who remain capable and interested in prosecuting securities class actions.

E. Stock Option Backdating

Beginning in the spring of 2006, allegations began to surface that a number of companies backdated or otherwise manipulated the granting of stock options to executives and/or other employees. Those allegations have continued to escalate, with more than 100 companies now being investigated for wrongdoing with respect to stock option issues. Not surprisingly, shareholder litigation arising out of these allegations has been prolific. However, very few of the lawsuits have been securities class actions since very few of the target companies experienced a material stock price drop following disclosure of the investigation and alleged wrongdoing. For example, only approximately 15 securities class action lawsuits have been filed, although more than 100 companies are being investigated. In contrast, nearly 60 companies and their directors and officers have been sued in shareholder derivative lawsuits, which allege breach of fiduciary duties under state law and which do not require a stock drop.

Arguably, the plaintiffs’ bar has been devoting its attention and resources towards these shareholder derivative lawsuits, resulting in fewer securities class action lawsuits being filed in other contexts. However, the significant drop in securities filings started well before the stock option backdating scandal surfaced and, in any event, it is doubtful that the stock option shareholder derivative lawsuits have been so demanding that plaintiff lawyers have been unable or unwilling to bring unrelated securities class action lawsuits. In any event, securities class action lawsuits are typically far more lucrative for plaintiff lawyers since the damages and thus the settlements and plaintiff fees in that type of litigation are typically far greater than in shareholder derivative lawsuits. Thus, given a choice, plaintiff lawyers far prefer prosecuting class actions rather than shareholder lawsuits.

F. Conclusions

It is far from clear what is causing the recent decrease in securities class action filings. No one event or dynamic credibly explains this surprising development, although several unrelated factors each appear to contribute to some extent to the decrease. However, one thing is very clear: based on historical experience and legal precedent, it is extremely unlikely this decrease will be permanent. Therefore, neither D&O insurers nor insureds should overreact to this seemingly temporary reprieve from higher-frequency securities litigation.