Corporate directors and officers may want to consider carefully reviewing mechanisms to protect them from liability in securities class actions and related derivative actions. The good news for directors and officers about these cases has been widely reported in the press — the number of securities class actions filed last year declined. Many attribute this to the 1995 and 1998 amendments to the federal securities laws which, respectively, significantly increased the pleading standards in those actions for plaintiffs (the PLSRA) and prevent an end run around those standards to state court (SLUSA).

Other trends however offer less comfort for directors and officers. While the number declined the cost of settlements increased. For example, in 2006 there were for the first time five settlement over $1 billion, more than twice the average through 2005. That trend seems to be continuing with the recent announcement of a nearly $3 billion settlement in the Tyco litigation.

The average settlement also increases. In 2006 the average settlement in a securities class action was $45 million (excluding the billion dollar cases). This is an all-time high which is more twice the average through 2005 according to Cornerstone Research.

The increasing cost of settling securities class actions follows reports of twelve outside directors paying $24.75 million as part of the Worldcom securities settlement, ten outside directors paying $13 million as part of the Enron securities settlement and outside directors paying another $1.5 million as part of the Enron DOL/ERISA litigation settlement. While some have argued that these are exceptional cases which should not be of concern, it is difficult to ignore the increasing cost of settlement in securities class actions.

Other trends are equally disturbing. Until recently derivative actions — suits by a shareholder in the name of the company and against directors and officers typically charging a breach of fiduciary duty — infrequently followed along with securities class actions. Last year however Cornerstone found that approximately 45% of the securities class actions had a tag along derivative suit, a significant change from prior years.

Settlement trends in derivative suits are also changing. Traditionally those cases settled for a reform of corporate governance procedures and attorney fees. Consider the following settlements in derivative cases:

–Healthsouth settled in February 2006 with a payment of $445 million;

–Tent Healthcare settled in January 2006 with a payment of $215 million

–Weststar Energy settled in April 2005 with a payment of $32.5 million; and

–i2 Technologies settled May 2004 with a payment of $84.5 million.

Consider also the results in the Just For Fee litigation which was recently concluded. That action was brought by a bankruptcy trustee appointed in the chapter proceeding for the bankrupt company. Following guilty pleas by three former executives the trustee brought a breach of fiduciary duty suit against former directors. The case settled with payments totally $41.5 million — a settlement not paid for by the D&O insurance which had been all but depleted by the time suit was filed,

All of this suggests that directors and officers would do well to take proactive steps to protect themselves. They should review with their counsel trends in their duties and obligations in addition to those involving the scope of their liability. In addition, compliance programs should be carefully reviewed along with provisions and arrangements concerning indemnification. D&O policies should also be reviewed, focusing on questions such as the amount and scope of coverage, rescission and severability.

The SEC announced the filing of a settled enforcement action centered on a pervasive corporate accounting fraud. The settlement appears to bring into play the SEC’s policies on corporate penalties and cooperation. The settled civil injunctive action was filed against New Jersey based BISYS Group, Inc., a leading provider of products and support services to financial institutions such as insurance companies, banks and mutual funds. According to the SEC’s complaint the company repeatedly utilized improper accounting techniques over a period of years to inflate its income. Those actions resulted from what the complaint called an improper focus on meeting Wall Street expectations and lax internal controls in one division which experienced rapid growth, largely through acquisition.

The SEC’s complaint details a series of improper accounting practices primarily in one division but also found in other areas which occurred from at least July 2000 through December 2003. As a result the company’s reported financial results were overstated for the fiscal years ended June 30, 2001, 2002 and 2003 by about $180 million. Based on two restatements of its financial statements, BISYS overstated pretax income by 69%, 58% and 43% for fiscal years 2001, 2002 and 2003 respectively. For the same periods the company overstated EPS by 73%, 62% and 46%. The complaint alleges that the company inflated its income through an improper focus on meeting Wall Street expectations and lax internal controls in its insurance services division which experienced rapid growth during the period. The company used a variety of improper accounting practices to inflate its income, including:


–Improperly recording commissions previously earned by an acquired company, but not yet paid, as its own revenue, contrary to GAAP and its own revenue recognition policies; 

–Not adequately reserving against a substantial aging receivable balance;

–Improperly accounting for renewal commissions;

–Improperly accounting for bonus commissions;

–Increasing the rate at which commissions were accrued on certain products;

–Booking unsupported revenue entries with offsetting expense accruals toward the end of a quarter; and

–Failing to maintain proper internal controls in its insurance division


BISYS profited by over $19.6 million thought he sale of convertible notes and the issuance of stock and options either for cash or in acquisitions at an inflated price according to the complaint. The action was settled with the entry of a statutory injunction prohibiting future violations of the books, records and internal control provisions of the federal securities laws and the payment of approximately $25 million in disgorgement and prejudgment interest. 

What is perhaps most notable about this case is what was omitted from the settlement. First, the SEC did not allege violations of the antifraud provisions despite what appears to be the pervasive nature of the scheme and the involvement of top management. In addition the SEC did not impose a penalty on the company. Under its announced policies on corporate penalties a key consideration is whether the company profited from the improper acts. This may have resulted from the cooperation of the company which the SEC acknowledged in its press release, although it did not detail what was entailed.