How Collective Settlements Camouflage the Costs of Shareholder Lawsuits

By Squire, Richard | Duke Law Journal, October 2012 | Go to article overview

How Collective Settlements Camouflage the Costs of Shareholder Lawsuits


Squire, Richard, Duke Law Journal


ABSTRACT

Corporations insure against liability in shareholder lawsuits by buying tiered coverage from multiple insurers who each cover a distinct segment of the potential damages range. Rather than negotiating to settle individually with the plaintiff, the insurers seek to reach a single, collectively binding settlement agreement. This combination of segmented coverage and collective settlements produces a conflict of interests: the corporation's managers and some insurers are better off if the case settles pre-trial for the expected damages, while other insurers are better off going to trial. To force reluctant insurers to settle, courts have created a duty that can require an insurer to pay its policy amount when the plaintiff makes a settlement demand that exceeds that amount and another insurer or the corporation is willing to pay the rest. This "duty to contribute" biases negotiations toward settlements that overcompensate plaintiffs, thereby encouraging lawsuits of doubtful merit. The conflict of interests in settlement negotiations could be eliminated by allowing defense-side parties (defendants and their liability insurers) to settle separately their respective segments of the damages range. But this "segmented" approach to settlements is contrary to the private interests of managers because it eliminates the justification for the duty to contribute. That duty forces insurers to pay for settlements that they think are excessive or contractually uninsurable, thereby shielding corporate earnings reports--and managers' incentive-based pay--from the costs of shareholder lawsuits resulting from the managers' conduct.

TABLE OF CONTENTS

Introduction

  I. Structural Conflict When Settlements Are Collective
     A. Liability and Insurance in Shareholder Litigation
     B. The Settlement-Trial Liability Gap
     C. The Conflict-Control Devices Now in Use
        1. Settlement Demands Within the Policy Limit: The
           Duty To Settle
        2. Demands Above the Cap: The Duty To Contribute
 II. The Social Costs of Defense-Side Conflict Control
     A. Plaintiff Overcompensation Under the Duty To
        Contribute
     B. Insurer Underspecialization
     C. Overspending on Defense Lawyers
III. Eliminating the Structural Conflict Through Segmented
     Settlements
     A. The Mechanics of Segmented Settlements
     B. Segmentation's Economic Benefits
     C. Other Reform Proposals: Strict Liability and
        Vertically Sliced Towers
 IV. Reform Obstacles: Old-Fashioned Judges and Profit-Smoothing
     Managers
     A. Judicial Conservatism and the Duty To Defend
     B. Collective Settlements as Reputation and
        Compensation Shields
        1. Insurer Resistance Due to Plaintiff or Insurer
           Overconfidence
        2. Insurer Resistance Due to Coverage Exclusions
        3. Segmentation's Impact on Towers and Profit Reports
     C. Reform's First Step: Reversing the Bias of the Duty
        To Contribute
Conclusion
     Appendix

INTRODUCTION

Liability insurance makes defendants overeager to settle risky lawsuits. If a lawsuit goes to trial, the damages award could be greater than the coverage limit on the defendant's liability policy, forcing the defendant to pay the excess. But the plaintiff will usually be willing to settle before trial for a discounted amount that factors in the possibility of a verdict for the defendant. Settling pre-trial thus compresses the liability burden, increasing the proportion that falls within the insurance policy limit and hence is borne by the insurer. This opportunity to concentrate liability on the insurer can make the defendant better off settling before trial even when the plaintiff's settlement demand exceeds the expected (that is, risk-discounted) damages. And the insurer has the opposite bias: it often is better off going to trial, even when the plaintiff is willing to settle for less than the expected damages. …

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