Are lower securities lawsuit filing levels temporary or permanent?

In early July, Stanford University Law School Class Action Clearinghouse and Cornerstone Research jointly issued their mid-year 2007 report on securities class action filings. The report confirmed that 2007 year-to-date filings remain at about the same levels as in 2006 — that is, well below historical averages for the period 1996 to 2005. The report also raises the question of whether lower filing levels are temporary or represent a permanent shift to a reduced level of securities class action filings.

The report proposes two alternative explanations for the continued lower filing levels. The first is the “less fraud” hypothesis, and the second is the “strong stock market” hypothesis.

The less fraud view, supported by Stanford Law Professor Joseph Grundfest, is that (according to Professor Grundfest) “increased enforcement activity and a heightened awareness among corporate insiders may have led to a shift in the incidence of securities fraud litigation.”

The strong stock market hypothesis is premised on the observation that the nation has enjoyed several years of strong stock market performance characterized by low stock market volatility. Volatility has been correlated in the past with securities class action activity.

Those two possible explanations lead to “differing expectations for future levels of class action filings,” according to the report. The less fraud theory suggests a permanent shift toward lower filing levels, but the strong market suggests that the current lower level of securities class action filings is only temporary. Indeed, the report quotes one of the report’s co-authors, John Gould, as saying “if the market goes south, I would not be surprised to see the number of filings move back to the 200 per year level.”

The report’s presentation of two alternative viewpoints about possible future filing levels allows room for reasonable minds to differ. That said, there are a number of reasons to be skeptical, based on the limited data available, that we have moved to a permanently lower level of fraudulent corporate activity and of securities class actions filings.

First, given the low stock market volatility that the Cornerstone Report itself details, the marketplace’s reaction to adverse public disclosure has been more restrained than in the past. Recent media commentary has specifically examined the lack of marketplace reaction to the latest accounting scandals.

Second, the historically low interest rate environment has enabled many companies to use low-cost debt to avert crises that could have otherwise required disruptive disclosures. As interest rates rise and credit becomes less freely available and more expensive, and as volatility levels revert to the historical mean, more companies may be compelled to make more disruptive disclosures. At that point, the stock market may prove to be less forgiving than in the recent past.

Third, changed marketplace conditions could lead back to historical filing levels. Until we know for sure whether the current filing levels are the result of unusual market conditions, there may be reason to withhold judgment of Professor Grundfest’s view that we have passed some epochal threshold on the occurrence of fraudulent activities.

There may also be substantial grounds on which to question whether the ongoing Milberg Weiss investigation is a contributing cause of the reduced filing levels. In the Milberg Weiss criminal investigation, federal prosecutors are examining whether the firm made improper kickback payments to investors so that they would agree to serve as plaintiffs in securities class action lawsuits.

It is important to note that reduced filing levels emerged in mid-2005, at the same time that a grand jury returned its first indictment in the Milberg Weiss investigation. In addition, the two most prominent plaintiffs’ securities class action lawyers (Mel Weiss and Bill Lerach) at the two most prominent plaintiffs’ firms (the Milberg Weiss firm and the Lerach Coughlin firm), as well as the firms themselves, have been highly preoccupied by the criminal prosecution. In addition, it seems highly improbable that the behavior the Milberg Weiss investigation has targeted (kickback payments to class plaintiffs) was limited exclusively to that firm. All of those factors suggest that the Milberg Weiss investigation and the scrutiny of kickback practices could have had some disruptive recent impact on the filing activity levels.

Without a doubt, it is a very short step from Professor Grundfest’s statement that there may have been a “permanent shift” in the filing levels to the conclusion that there has been a permanent shift in directors’ and officers’ exposure and that D&O pricing levels should be reduced commensurately. But the Cornerstone economist’s observation in the report that changed market conditions could lead us right back to the 200 class actions filings a year level represents a strong cautionary warning to the D&O industry. If future changes in market conditions should translate into a return to historical filing levels, any carriers that had previously acted upon a presumption of a permanent reduction in D&O risk could quickly find themselves facing substantial losses.

The cause and consequences of recent lower levels of securities class action filings remains the subject of significant disagreement, as reflected in the contrasting viewpoints presented in the Cornerstone Report itself. Because the historically low class action filing levels may be the result of temporary market conditions and other factors (such as the Milberg Weiss investigation), it may be at best premature to conclude that the nation has entered a new and permanent era of reduced corporate fraud and lower class action filing levels. It will be important to watch what happens as market conditions change in the weeks and months ahead. Whether and to what extent the present pattern will continue remains to be seen.

Kevin M. LaCroix is an attorney and a director of the OakBridge Insurance Services, Beachwood, Ohio, office. An earlier version of this article appeared on LaCroix’s Internet Web blog, the D&O Diary. http://dandodiary.blogspot. com. E-mail: klacroix@oakbridgeins.com. Phone: 216-378-7817.