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Spurred by well-publicized troubles in the insurance and pharmaceutical industries, U.S. securities class actions increased in number and size in 2004, according to a study by Cornerstone Research and Stanford University Law School. The study found a 17 percent increase in the number of cases filed, back to about the level of 2002 after a slowdown in 2003. In all, there were 212 securities class actions filed in 2004 compared with 181 in 2003 and 226 in 2002. The average number of cases filed annually since the passage of the Private Securities Litigation Reform Act of 1995 was 190, making 2004 a busier than usual year. Many of the traditional types of suits remained popular. Accusations of misrepresentations in financial documents, benefiting from insider trading, and accounting irregularities topped the list of allegations as in other years. NONTRADITIONAL CASES Alongside these traditional cases, filings not based directly on financial misrepresentations continued to gain popularity. “Typically, a class action securities fraud lawsuit arises from allegations that the issuer lied about its financial performance,” said Professor Joseph Grundfest of Stanford Law School, a former member of the Securities and Exchange Commission. Some of the largest, he noted, were triggered by allegations relating to insurance industry sales practices and the safety of prescription drugs. In October, New York Attorney General Eliot Spitzer filed a civil suit against leading insurance broker Marsh & McLennan for alleged “bid rigging.” Marsh, represented by Davis Polk & Wardell, quickly brought in a new management team including general counsel Peter Beshar, formerly of the New York office of Gibson, Dunn & Crutcher, to settle with the attorney general. News of the lawsuit and corresponding investigation into the industry immediately dropped Marsh’s stock price and that of insurers that investors feared would be targeted by Spitzer. Securities class actions filed by Milberg Weiss Bershad & Schulman and Wolf Haldenstein Adler Freeman & Herz among others followed soon after Spitzer’s announcement. “These lawsuits do not allege the traditional form of misrepresentation,” Grundfest said. Typically, securities actions arise when a company announces a shortfall in past earnings or deceives investors about its prospects. “These suits depart from the traditional paradigm,” said Joseph McLaughlin of Simpson Thacher & Bartlett. “The crucial difference,” he said, “is that [plaintiffs] are contending that the improper business practice misled the financial community.” The Marsh suits blame the insurer for failing to disclose to investors that its contingency fee arrangements, the centerpiece of Spitzer’s investigation, exposed the carrier to civil and criminal liability. The accusations were not directly related to financial performance. MERCK AND VIOXX Likewise, securities suits filed against drug maker Merck for its recall of the pain reliever Vioxx followed an untraditional approach. In most pharmaceutical related securities suits, a drug falters during the regulatory approval process and triggers class actions accusing the company of failing to disclose fully the possibility of failure. In September, Merck recalled Vioxx, one of its best selling drugs, after tests revealed that it could endanger patients. Plaintiffs have accused the company of failing to disclose the safety concerns associated with a drug that had received regulatory countenance and been in the market for several years. Specifically, plaintiffs claim Merck touted the safety of Vioxx in public filings and statements when concerns appeared in the past. While product liability claims may far outweigh the securities actions for Merck, its sharp drop in the stock market lost investors billions. Fred Isquith of Wolf Haldenstein Adler Freeman & Herz explained that these cases are different from the usual securities filing but are not new. “Typically,” he said, “the most important types of misrepresentations are direct financial representations … that tend to deal with historical results.” The financial fraud at WorldCom (now MCI) is a prime example. The company had overstated earnings by billions and was forced to restate its shortfalls after news of its fraud became public. The insurance and pharmaceutical cases of 2004, said Isquith, deal with “misrepresentations of revenue streams.” In the case of pharmaceutical makers, he explained, a recall undermines a company’s future earnings, thereby reducing its value in the stock market. A company’s failure to disclose the threat of a recall or known safety concerns in its financial statements is grounds for a securities fraud claim, he explained. In the case of the insurance brokers and carriers, he said, these companies failed to report the nature of their business — the contingency fee arrangements that Spitzer found problematic. The failure to disclose a questionable business practice that could one day face regulatory scrutiny hid the threat of future revenue shortfalls from investors, Isquith said. “It is a little different than direct financial fraud,” he explained, where companies simply lie about their earnings or future prospects, but not uncommon. In recent years, securities suits have arisen from similar industry-wide events. In 2003 and 2004, mutual funds became targets of securities fraud claims when Spitzer and other regulators revealed “market timing” and other questionable practices in the industry. Those filings relied on corporate misbehavior rather than allegations of deceptive financial disclosures. “It’s a further evolution to apply securities law” outside the traditional format, said McLaughlin of Simpson Thacher. “We’ll have to see whether courts will accept” these attempts.

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