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It may not be quite the “perfect storm” for underwriters of directors and officers liability insurance, but it sure looks like one on a lot of days lately. With hundreds of securities class actions filed each year in ever-increasing numbers — notwithstanding a drop in the actual number of public companies — there has probably never been a more likely time for a publicly held insured company and its board to be targeted with a securities fraud class action.

The number of securities class actions is on the rise, and the cost of disposing of them is increasing as well. According to a recent study, only 1 percent of securities class actions go to trial, and only 19 percent are dismissed during motion practice, leaving fully 80 percent to be resolved by settlement.

Plaintiffs attorneys are increasingly using allegations of accounting fraud to avoid dismissal of their claims at the pleading stage and to obtain much higher settlement amounts than in non-accounting cases. Recent statistics demonstrate that cases involving accounting fraud allegations, particularly those involving restatements, settle for much larger amounts on average than non-accounting cases. A study of securities class actions filed last year revealed that nearly two-thirds of all claims involved allegations of accounting fraud.

Indeed, a series of mega-settlements have boosted the average settlement cost to approximately $24 million per case. To make matters worse for underwriters, the median settlement amount has also been on the rise. The end result? More claims and more funds expended to resolve them, including the defense costs. Suffice it to say, the cost of defending securities actions is not headed downward.

To address the challenges for companies and their insurers in the current environment, we suggest three strategies for managing risk and protecting capital.

ANALYSIS AND EDUCATION

Clearly, the best possible outcome is to avoid securities fraud claims entirely. A vast number of accounting fraud allegations, including even those involving restatements of financials, can potentially be defused by disclosure in a company’s public filings. This is particularly true for companies that work with distributors or are themselves distributors of products.

Given these facts, one significant means of minimizing risk is to focus on an insured’s or potential insured’s accounting and disclosure policies and practices. This can be as simple as analyzing all relevant policies and procedures or as elaborate as meeting with the insured’s accounting team and experienced counsel to review risks and issues relating to the company’s accounting.

From a risk prevention standpoint, education and training should also be considered key elements of this process. Education on accounting risks and issues related to fraud and litigation should be provided for the insured’s accounting team, senior executives and board of directors. Their training should include practical counsel that encourages robust disclosure of key accounting policies and their application. With the Sarbanes-Oxley Act requiring senior management to attest to the accuracy of a company’s financial statements, companies now have an added incentive to implement these initiatives.

EXPERIENCE COUNTS

Second, when an insured is targeted with securities fraud allegations, it is crucial that the insured be represented by experienced, skillful counsel. Already a number of insurers require their clients to select from a panel of approved counsel. But this is not enough.

Analysis of public court orders and settlement terms make clear that some plaintiffs counsel consistently achieve outstanding results in both motion practice and in settlement amounts. Insurers and their policyholders would be well served to consider carefully the objective results achieved by defense counsel in similar cases. This means checking into counsel’s record for obtaining dismissals on the pleadings, defeating class certification and winning motions for summary judgment. Moreover, with securities class actions 80 times more likely to be resolved in mediation rather than the courtroom, it is also essential to scrutinize counsel’s track record for resolving cases efficiently and cost effectively.

IMPORTANCE OF TEAMWORK

Finally, if securities litigation cannot be avoided, and experienced, effective counsel has been retained, it is imperative that the insurer and defense counsel team up to provide the insured with the highest quality representation possible. This means working collaboratively and cohesively to identify and address litigation issues and risks. Both D&O underwriters and seasoned defense counsel will bring to the table a wealth of experience and insight — everything from knowledge of particular judges and plaintiffs counsel to analysis of legal and factual arguments that have prevailed in other securities actions.

To this end, many top-notch firms and insurers are creating pleading databases to capture and leverage existing legal research and briefing. Moreover, many insurers and defense counsel find value in meeting to discuss case strategy at the outset of litigation. Such open communication and teamwork will improve the quality of legal representation and help avoid the prospect of unpleasant surprises for the insurer or the policyholder.

While there is no substitute for thoughtful and disciplined underwriting, insurers can minimize the risk inherent in existing policies with focused training and education of the insured’s senior management team, rigorous standards for retention of defense counsel and constructive communication and partnering with defense counsel.

A version of this article was first published in National Underwriter in November. Paul R. Bessette is a partner at Akin Gump Strauss Hauer & Feld in San Francisco and chair of the firm’s securities litigation group. He can be reached at [email protected] Steven S. Kaufhold is a partner in the securities litigation group. He can be reached at [email protected].

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