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IPO claims: A crisis in the making

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The resurgence of IPOs in Southern California over the past three years has created a boon for the local economy, injecting billions of dollars into the region.

Inevitably, some of the unintended beneficiaries are the law firms specializing in filing shareholder class action securities litigation. Perhaps more disappointing is a less recognized beneficiary -- the group of insurers that are not paying a large and critical component of IPO class action claim damages, yet which charge the same premiums as the insurers who are paying the full claims.

Public companies rely on Directors & Officers Liability (D&O) policies to defend securities litigation. The policies are, of course, contracts, but all contracts must be interpreted when called into question. A D&O policy should be tailored to fit the unique risk exposures associated with individual companies -- nothing "off the shelf" should be acceptable.

However, several D&O insurers have recently taken a very narrow view of critical policy definitions to deny coverage for liability arising from the public sale of company securities.

The Securities Act of 1933 mandates the filing of registration statements with the SEC for all companies that issue public securities, such as IPOs. Section 11 of the 1933 Act makes every person who signs a registration statement -- whether a director, officer, accountant or underwriter -- strictly liable for facts or representations found in or omitted from the registration statements, thus creating broad personal liability for all "signers."

Attorneys for defrauded investors will often rely on Section 11 to recover damages incurred in conjunction with the sale of securities under a registration statement. This line of reasoning has become so widespread that companies often find themselves the target of lawsuits, often without merit.

Furthermore, the standard of proof is lower than in many areas of the law, making it more attractive to the plaintiff law firms.

The revival of IPO filings means more new company registrations, which, not surprisingly, means more litigation over misrepresentations in registration statements.

Moreover, securities claim settlements hit record levels during 2004, and 2005 embraced this trend given the large settlements in the WorldCom and Enron cases.

As the average settlement value of securities claims increases, so does the potential for severe damages associated with Section 11 securities lawsuits, which threaten public company financial stability. Financial stability would obviously be further threatened if reliability on the insurance purchased to defend against these lawsuits eroded. Recent case law has emerged that allows insurance companies to challenge repayment of Section 11 damages that are commonly alleged.

Two notable court cases have cast doubt on the availability of insurance protection for Section 11 securities claims. The first case, Level 3, involved a group of shareholders that sued their company's management after the sale of their minority position, alleging the failure of management to disclose material information regarding a pending IPO that would have significantly inflated the sale price of the securities and, in turn, the profit of the selling shareholders. The injured shareholders demanded recovery of $11 million for their lost profit.

When the company sought reimbursement under their D&O policy, the claim was cleverly denied. The insurance company reasoned that the damages incurred by the company did not constitute a loss under the D&O policy definition of a "loss;" a position that was supported in the courts.

In agreeing with the insurance company, the court determined the damages were "restitutionary in nature" and that the difference in the share prices was unfairly obtained by the company due to the withholding of material information. The distinction relied upon by the court was that restitutionary damages restore ill-gotten financial gain and are uninsurable. Contrast this to damages that are insurable when they restore the injured party back to its original financial position.

Another prominent case, Conseco, involved buyers of securities in a secondary offering. Plaintiffs claimed that the value of the securities was artificially inflated due to misstatements in the registration statements, and, therefore, "overvalued."

The court agreed with the insurance company in finding that the definition of "loss" in the D&O policy would not encompass the $120 million settlement, as part of this sum constituted recovery of funds wrongfully acquired -- a gain in share price from misstatements -- and uninsurable damages.

Public companies that issue securities via a registration statement are easy targets for Section 11 securities claims and related settlements. And, in spite of collecting premiums under D&O policies, certain insurance companies are finding ways to deny payment for damages for such claims.

Oddly, many of the insurers that have pursued these coverage denials are willing to modify their policy language to curtail or eliminate this maneuvering. Learning the issues, reviewing the policy language in question, and working with a broker (and preferably involving outside counsel familiar with these issues) that has negotiated modified language with opportunistic insurance companies is critical to clarifying coverage intent for Section 11 claims. Company management is encouraged to invest the time with their insurance broker to review and analyze the protection granted by their D&O policy in this and other critical areas.

Hopefully, the D&O policy is never called on to perform. However, after litigation is filed is the wrong time to learn of competitive deficiencies in the contract. This is especially proving the case for some recent IPO filers.

Comtois is an account executive in Barney & Barney's Executive Risk Practice. Niedernhofer is a principal and team leader of the Executive Risk Practice. For more information, call (858) 587-7144 or e-mail johnn@barneyandbarney.com.>

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