The frequency of U.S. federal and state securities class actions (SCA) have been increasing markedly in recent years. At the time of writing, there have already been 372 suits filed so far.
There are several drivers of this growth, but principal among them is the shift of venue of merger objection lawsuits – lawsuits filed by dissatisfied shareholders of a company that is soon to be or has recently been acquired by another company – from the State Court of Delaware to Federal Courts, mainly the Second and Third circuit.
This shift began about three years ago, after several Delaware judges voiced their disinclination to rule in favor of plaintiffs in these cases. Actions started being filed in Second and Third circuit courts, which have, thus far, been seen as more open to such claims.
It is now fair to say that there is a high chance that mergers and acquisitions involving U.S.-traded entity will result in a federal security class action being filed.
While the vast majority – more than 90% – of these claims are dismissed, there is still a hefty price tag attached to defending these actions. And these claims can hit D&O programs.
Even if we take merger objection suits out of the equation, the number of what we might call “core” SCA filings is still at heightened levels – about 55% higher than the ten-year-average.
And it isn’t just domestic issuers that are on the hook for these claims. While just 17.1% of companies listed on U.S. exchanges are registered outside of the U.S., they accounted for 25.5% of SCA activity in 2017.
Another driver of the record number of SCAs has been the emergence of second and third tier of U.S. plaintiff law firms. This trend began after the global financial crisis of 2007, when the major “white shoe” firms – those in the top tier – became heavily occupied with large cases, creating a bottleneck. This created an opportunity for new entrants to litigate some of the cases their more established counterparts were unable to take on.
In the intervening years, those financial crisis-related cases have begun to dry up. Nature abhors a vacuum, and these emergent law firms now compete for a smaller pool of strong cases, while working hard to put together class actions whenever there is a fall in stock price or a hint of a misstatement in company disclosures.
The effect of this has been two-fold. Not only has it led to a higher frequency of class actions, but also a higher rate of dismissal – because of a deterioration in the underlying strength of the cases being brought. In the first half of 2018, more than two-thirds (67%) of cases were dismissed, compared with 46% in the whole of 2017.
If we delve deeper, we begin to see the effect that this trend has had on smaller companies with U.S. listings.
While plaintiff firms used to focus on those larger companies that might be deemed to have “deeper pockets,” the need for law firms to maintain a pipeline of cases means there has been a rise in actions against small or micro-cap companies. A significant number of these cases are dismissed. But the prevailing soft market conditions have meant that self-insured retentions have been eroded to the point that defence costs, even in cases where claims are dismissed, fall upon the D&O program.
At the same time, U.S. defence attorney rates are rising, which again means that cases that might previously have been expected to have been contained within self-retention levels are busting through to the D&O program.
Of course, this leads underwriters and brokers to question both pricing and retention levels. It affects the overall health of the D&O market and is something clients must be aware of too.
On top of this, a recent judgement is also affecting the D&O landscape and the underlying risk for directors and officers.
Earlier this year, in the case of Cyan Inc. vs Beaver County Employees Retirement Fund, the U.S. Supreme Court ruled that cases alleging breaches of sections 11 and 12 (a) of the 1933 Securities Act cannot be removed from the jurisdiction of state courts. Previously, these cases could be brought in either federal or state courts, but defence attorneys frequently succeeded in moving them to federal courts, often by consolidating complaints.
Federal court judges have many years’ experience of dealing with these cases, but their state court counterparts more often than not do not. This could have implications for the D&O market. State court judges might be more inclined to hear cases that the federal judiciary would likely have dismissed, for example. Or they could award significantly higher damage awards than the federal courts. It’s not yet certain how this will all turn out. But it’s possible that there may be extra pressure on defendants to settle claims – that might otherwise be expected to be dismissed – early. Or defendants may find themselves bearing the costs of going though discovery.
Anecdotally, the outcome for defendants is less favourable in state court, and there is a lower dismissal rate – this is particularly true of California state court cases.
Clients with U.S. listings will be keeping an eye on all of these developments. And as we head towards what might be a tipping point in the D&O pricing cycle, brokers and underwriters must ensure they are prepared for any changes in the D&O marketplace.
