Student Blogger - Securities Class Actions: How the Merits Matter
Professor Tom Baker recently presented his paper (co-author Sean Griffith), "How the Merits Matter: Directors' and Officers' Insurance and Securities Settlements," at the Law and Economics Workshop. This is a forum where academic working papers are presented and discussed among interested faculty and students.
Professor Baker's paper attempts to answer a popular question: Do the merits affect the settlement amounts in securities class actions? He takes a new approach, applying qualitative research to the question instead of the usual empirical research. Professor Baker interviewed a range of people involved in the settlement process, including plaintiffs' lawyers, defense lawyers, D&O insurance claims managers, and mediators. These suits involve insurers because almost all companies purchase directors' and officers' (D&O) insurance to indemnify the corporation. Through these interviews, he sought to understand "how" the merits matter in the settlement process. How do the parties reach a settlement?
His interviews show that the parties involved typically try to guess what the case will be worth to a jury—the "sex appeal"—and base their settlement negotiations around those amounts. This is certainly a proxy for merits as the typical factors include things like whether there would be a government investigation. However, the parties rarely have prior jury awards on which to base their settlements (almost all securities cases settle). The parties must rely on previous settlement agreements for their predicted jury results, which are likewise based on other settlement agreements. Baker criticizes this system, arguing that there should be more litigation so the parties can more accurately assess the values of the cases, or at least more accurately assess what a jury believes them to be worth.
It is not clear that a system with no adjudication is broken. As long as the parties to the settlement are considering the same sorts of factors that juries would, then maybe the parties are already doing an adequate job of incorporating the merits into the settlement. The parties involved may even be better at determining the "merits" than a jury would due to their expertise in addressing the issues.
In addition, Professor Baker found the parties' settlement was often influenced by the insurance structure. D&O insurance contracts are tiered with the primary insurer only providing the first layer of coverage ($10 million or so). Anything in excess of that amount would be covered by the next tier insurer with even more tiers above that. The plaintiffs' lawyers have an incentive to settle within an insurance tier. Seeking a higher amount and moving to the next tier involves another insurer and makes the settlement harder to achieve. At the same time, the defense counsel (representing the corporation) has the goal of settling the case at any amount because then the corporation will pay nothing. The defendant corporation's only exposure is if there is a judgment greater than the insurance. This makes the defense counsel more than happy to offer the maximum amount in an insurance tier to encourage a plaintiff will settle. In effect, the defense and plaintiffs' lawyers will collude to force an insurer to accept a settlement at the max amount in the tier. The insurance tiers end up functioning as "fire breaks" in the settlement. Once the parties are discussing settlement in a tier, the settlement will likely reach the maximum amount.
An interesting result of this may be that securities class actions are settling for less than they should be. The damages in a securities class action should be correlated to the market capitalization of companies because the damages are often how far the stock has dropped as a result of the fraud. But as Professor Baker's study suggests, the actual settlement amounts appear to track the D&O insurance limits. Since the increase in market capitalization of companies has outpaced the growth in D&O insurance limits, the settlement amounts are growing slower than the predicted damages.
To eliminate D&O insurance structure's effect on settlement, Professor Baker suggests corporations should not be able to insure themselves against these suits (entity-level insurance). Instead, corporations should only be able to purchase D&O insurance that will be used to indemnify directors and officers if they are held personally liable. This would align the insurer's and defense counsel's interests because now the corporation's money is on the line. The defense counsel would no longer have an incentive to push for settlement at the maximum in an insurance tier just to encourage the plaintiffs' lawyers to settle.