Welcome to 2020, where BigLaw’s partner rates are expected to regularly cross the $2,000 an hour threshold for the first time! Associate rates have also skyrocketed — and now routinely exceed $1,000 an hour. As D&O insurers, brokers and policyholders continue to arm-wrestle over the adequacy of premium pricing in a hardening market after years of underpricing, one significant element of D&O loss experience has gone relatively unchallenged: the costs of defending D&O claims, particularly for shareholder class action and derivative cases against publicly-traded companies.

Earlier this month, Citi Private Bank’s Law Firm Group released its quarterly flash report for 2019, based on its survey of 190 law firms. According to Citi, it was a very good year for law firms — particularly among the AmLaw 200 largest law firms, whose numbers were materially better than smaller law firms. Here are some data points from Citi’s report:

• overall, BigLaw revenue grew by 5.3% in 2019, while expenses increased only 4.8%;
• billing rates increased an average of 4.5%, the most significant rate increase since 2008, before the Great Recession; and
• demand grew more slowly in 2019 (1.1%) than in 2018 (2%).

Bottom line: in a year of slowing demand for legal services, BigLaw rates are increasing at a percentage rate not seen since 2008. What gives?

Basic economic theory suggests that if the rate of demand growth for BigLaw services across a wide range of practice areas is slowing, the cost of legal services should be flat or increasing at a slower rate — and certainly not increasing at an accelerated rate. So why are BigLaw hourly rates divorced from the gravitational pull of economic theory?

To be fair, the biggest law firms offer a wide variety of legal services to a global clientele, and are able to command the highest rates for that work. And BigLaw partners are generally talented lawyers who are, and should be, well paid to help clients work through tough problems. But does that general deference alone explain the increasing hourly rates for public company D&O defense work?

Well, it can’t be results-based. Securities class actions are almost never tried to verdict, and so these cases are either dismissed on motion (that is, at the motion to dismiss or class certification stage of the litigation) or through settlement. No single BigLaw firm or small cadre of defense law firms can demonstrate uniquely better results in getting cases dismissed or cases settled at unexpectedly low sums. Dismissal rates generally correlate to the developed jurisprudence in a given Circuit, and settlements are predicted by such experts as NERA and Cornerstone as a percentage of alleged plaintiff damages — not on the identity of defense counsel.

Moreover, the defense bar is splintered in a way which the plaintiff’s bar isn’t; no handful of defense law firms dominates the vast majority of all securities class action cases in the same way that a few law firms dominate the shareholder plaintiff bar. The last time a single law firm or cadre of defense firms dominated the defense side of securities cases was in the 1990s, when the vast majority of securities class actions were filed in the Northern District of California, and defendant companies were defended by a small group of law firms based in San Francisco and Palo Alto. Our imaginary economics professor would opine that a large and diffuse set of legal service providers would not have the market clout to unilaterally raise the price of their services — particularly in a period of slowing demand for legal services.

As an aside, a pernicious consequence of this system, of course, is the lack of actual litigation. Securities class actions generally settle soon after the trial court denies the defense motion to dismiss, because the defendants and their insurers understandably fear that runaway defense costs will leave too little insurance proceeds to settle later. But this dynamic gives the defendants little to no leverage in settlement negotiations, and means defendants and their insurers must settle without knowing the real facts and damages. And the plaintiff lawyers know that. Not surprisingly, then, settlement values as a percentage of plaintiff-style damages are steadily increasing.

So, why are the hourly rates for securities class action defense lawyers so high? The answer may be that there simply is no downward driver on hourly rates in D&O policies — either through an explicit contractual term or through greater influence over defense-counsel selection and economics in particular cases — so D&O defense lawyers can charge more or less whatever they want. Publicly-traded policyholders are able to select their own defense counsel, and arguably have limited interest as to whether the hourly rates are reasonable if the lawsuit is likely to cost or settle for more than the self-insured retention.

AIG arguably had an opportunity to use the defense counsel panel it originated in the late 1980s to bargain for controlled defense rates in exchange for inclusion on AIG’s panel, but it elected not to do that. Because AIG was the D&O market giant at the time, no other insurer had the market clout to insist on a rates concession or to influence defense counsel selection or the economics in particular cases if the D&O market leader wasn’t going to insist on it.

Since then, the D&O insurance industry appears to have more or less accepted the reality of top-tier hourly rates and staffing practices for defense firms as part of its loss experience. Interestingly, though, there’s almost no market wide data on defense costs available to insurance company actuaries to use in projecting the expected costs of defending and settling public company D&O cases. Unlike the reported data for settlements of securities class action and derivative cases, there are no court filings announcing the amount of defense costs incurred in these cases, and D&O insurers don’t publish these numbers on their own.

Moreover, when defense costs are paid under a mix of primary and excess D&O policies, no single insurer’s payout numbers reflect the entirety of defense costs incurred in connection with that claim. And even where the defense costs are contained in a single limit of liability, those defense costs might include the costs of simultaneously defending multiple D&O actions or other proceedings, whether related or not, and therefore may not reflect the precise cost of defending a single action.

So that pretty much sums up what we don’t know. So what are the questions we should be asking? Here are some, for starters:

First, unless someone can show me data supporting a contrary conclusion, I’d have to say there is no correlation between hourly rates and case outcomes. Am I wrong about that?

Second, if one accepts the conclusion directly above, then what is the rational explanation for paying the highest hourly rates to defend small, middle market public company D&O cases where the hourly rate levels result in costs of defense equaling or exceeding the settlement values of those smaller cases? Of course, this point doesn’t apply to mega-D&O shareholder cases, which really do require the relative sophistication and ample attorney resources of the largest defense firms — and the attendant cost.

Third, I believe that for smaller and mid-size cases, there is a relatively small group of full-time securities defense lawyers who would appreciate a rational defense-counsel market and who could and would work within their BigLaw firms to keep rates and staffing practices down, and to provide viscous defense budgets — if the supply of work were greater and more predictable than it is without a rational market. Isn’t now the time to be exploring an alternative bench of defense lawyers?

Fourth, if D&O underwriters are seeking to price their D&O premiums — particularly for middle market public companies — without reference to empirical data showing the costs of defending these cases, an established key driver of loss experience for such cases, then those underwriters (and their actuary counterparts) are missing a material cost element of their loss calculation. And since the sub-$1 billion market cap companies represent well over 40% of the new securities cases filed each year (and the sub-$2 billion market cap cases represent 2/3 of all cases filed), that’s a significant portion of a D&O risk portfolio. Is anyone collecting and analyzing that data?

Fifth, is there a reason why risk managers and brokers who want to make the case for more favorable premium pricing for D&O risks can’t take the opportunity to demonstrate a thoughtful plan to manage D&O defense costs when claims do arise — whether by such techniques as “Dutch auction”[1] pricing negotiations, flat fee billing for portions of D&O cases, and other creative cost-mitigation efforts — all of which could be a constructive place to start those discussions with D&O underwriters?

To be fair to the large law firms defending shareholder D&O litigation, a number of those firms already have been willing to agree to flat fee arrangements to cover discrete portions of the defense including, for example, briefing and arguing motions to dismiss and for class certification. And some law firms will agree to a rate discount (usually in the range of 10%). These law firms recognize the need to bring predictability and cost-containment into shareholder D&O litigation, and they should be acknowledged for those efforts.

BigLaw defense firms have some tremendously-talented lawyers in their ranks, and among those, some are specialists who ought to be regularly considered to defend D&O securities class action and derivative actions. The larger question being considered in this post is whether the defense of public company D&O cases can be accomplished under rational economic principles and therefore undertaken at a more reasonable cost.

[1] In this context, a “Dutch auction” process requires otherwise-qualified defense firms to make bids to identify the lowest available cost (whether by hourly rate schedule or flat fee proposals) of defending the D&O claim among this group of defense firms.