The siege of State Farm

(Fortune Magazine) -- For State Farm Insurance - the nation's leading auto and home insurer - coping with once-in-a-lifetime disasters is everyday business. Risk analysis is what it does, and its actuarial staffs are prepared for every eventuality.

Almost. When Hurricane Katrina struck the Gulf Coast in 2005, it infamously brought a storm surge the likes of which the nation had never seen, causing more flood damage in one event than all the storms combined for as far back as there was data (37 years). Even that risk State Farm had anticipated. What it hadn't foreseen was that the storm surge would gut the home of a plaintiffs lawyer named Richard F. "Dickie" Scruggs, as well as those of his family, friends, and neighbors in Pascagoula, Miss.

Scruggs was someone who could render all of State Farm's actuarial calculations irrelevant, because he had the power and know-how to force it to rewrite its contracts retroactively. He had been the scourge of Fortune 500 companies for two decades, precisely because he tended to change the rules of any game he chose to play.

Scruggs's multifront assault on the tobacco industry in the mid-1990s - encompassing numerous lawsuits, public relations campaigns, and political pressure -- forced the industry to agree to pay the states $246 billion over 25 years. His fee, collected during the same period, is expected to exceed $800 million.

As many readers know by now, Scruggs's assault on the insurance industry went catastrophically awry. In March he pleaded guilty in federal court in Oxford, Miss., to conspiring to bribe a judge there, and he is under investigation for attempted bribery of a second judge. He did not respond to written questions sent to his counsel.

While the bribery accusations have attracted most of the media attention, the story of Scruggs's siege upon the insurance industry is more jaw-dropping still. These were lawsuits in which the law itself played only a bit part. Victory was to be secured by aggregating pressure points, of which the most valuable were press attacks, threats of legislation harmful to the target or its industry, and the instigation of paralyzing state and federal investigations of the target.

Notwithstanding Scruggs's initial reliance on legal arguments that have been rejected by every federal appeals judge who has considered them, he still managed to squeeze out of State Farm $150 million for policyholders who, from a cold, contractual perspective, were probably entitled to only a fraction of that.

In fact, the main difference between the fabulous success of Scruggs's tobacco campaign and the fiasco of the insurance sequel may have less to do with tactics than with his opponents. Cigarettes are an addictive carcinogen, and people tended to look the other way when manufacturers complained about Scruggs's methods. Homeowners insurance, on the other hand, is an essential product. Even if the industry's managers sometimes acted in blindered or heavy-handed ways, adults had to acknowledge that there was something here worth saving. Though the industry still got clipped, this time it was allowed to press charges.

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Hurricane Katrina made landfall in Mississippi on Aug. 29, 2005, with sustained winds of about 120 miles an hour. Those winds pummeled the coast for some four hours - and then came the surge. Gulf waters gradually rose as high as 28 feet above sea level near Pass Christian, with waves on top that. When the waters receded, the narrow strip of coast they had raked was unrecognizable. The storm tide had obliterated everything except the mighty live oaks. For nearly 60 miles, shoreside homes were razed to their concrete foundations, or slabs.

The populace faced an awful reality: Since homeowner policies don't cover flood damage, damage from storm surge was covered only to the degree that residents had purchased federal flood insurance. Most residents didn't have it, and even those who did weren't covered for more than $350,000, the statutory cap.

With armed National Guardsmen patrolling the streets and coastal residents facing each new 90-degree day without reliable sources of water, food, or power, Scruggs stepped into the breach. He hatched an audacious, demagogically appealing plan: Make the private insurers pay, no matter what their contracts said.

In the tobacco campaign, Scruggs had formed an alliance with then-Mississippi attorney general Mike Moore. For the insurance campaign, he formed a de facto alliance with Moore's successor, Jim Hood. On Sept. 15, barely two weeks after the storm, Hood sued the five insurers doing business in the region to invalidate their flood-exclusion clauses as "unconscionable." Alternatively, he argued that the clauses didn't pertain to storm surge because they didn't use the specific words "storm surge." (State Farm's seemingly air-tight clause excluded coverage for "flood, surface water, waves, tidal water, tsunami, seiche, overflow of a body of water, or spray from any of these, all whether driven by wind or not.") In an interview, Hood acknowledges that before suing he met with Scruggs and several other lawyers, and "they helped us draft the complaint."

On the same day Hood sued, Scruggs launched a private litigation campaign premised on exactly the same theories. In October he formed the Scruggs Katrina Group (SKG), composed of his and four other law firms, and by December it had filed five suits, one against each coastal insurer. (State Farm was the market leader, with a 30% share.)

Scruggs's legal theories may have started out as little more than guff, but the insurers soon gave him better material to work with through their myopia and missteps. The first was the industry's handling of the wind/water conundrum. It stood to reason that coastal homes had suffered wind damage before being demolished in the surge, and it was clear that insurers were on the hook for presurge wind damage. But once the surge reduced everything to a slab, it was impossible to tell what had happened beforehand. If adjusters couldn't detect objective evidence of wind damage, they offered zero money.

That was clearly unfair, and the companies' intransigence enraged residents. U.S. Congressman Gene Taylor of Bay St. Louis, whose own home had been wrecked in the surge, likened insurance executives to child molesters in his speeches, suggesting that they be required to register when they moved into a Mississippi neighborhood.

Then, in mid-October, a State Farm employee gave Scruggs a gift in the form of a heavy-handed act that he could use to vilify the whole company. It turned the litigation upside down, transforming it from an outlandish oddity, from the insurers' perspective, into a potentially grave predicament. On Oct. 17, Lecky King, a co-manager in State Farm's Gulfport catastrophe (or "cat") office, fired one of the ten engineering firms State Farm had hired to inspect certain homes in the surge zone and give expert opinions on what was wind damage and what was water. King had come across two engineering reports, both performed by Forensic Analysis Engineering Corp., which she claimed had been incompetently performed. FAEC's engineers, for instance, had attributed damage solely to wind where adjusters had previously documented extensive flood damage.

The firm's president talked King into giving the company another chance by having a second engineer reinspect each site. The two FAEC engineers who had written the controversial reports left FAEC, and at least 20 of their reports were revised after reinspection. The dispute ever since has been whether King was angry about shoddy work or about the reports' conclusion: wind damage, for which State Farm would be liable.

As it happened, certain moments in King's meltdown had been witnessed by two claims adjusters at the cat office, sisters Cori and Kerri Rigsby. They lived in the coastal community of Ocean Springs, and the home of their mother, Patricia Lobrano, had been gutted by storm surge. Lobrano's insurer was State Farm. When the Rigsby sisters noticed that some policyholders had two sets of conflicting engineering reports in their files in the cat office, they suspected fraud. They began secretly photocopying documents and showing them to their mother.

Lobrano called Scruggs, who had represented her husband in the 1980s. In February 2006, she and her daughters met with Scruggs at his offices on Oxford's central square, and Lobrano hired him to handle her claim against State Farm.

A few days later Scruggs showed attorney general Hood copies of two engineering reports for the same property. Hood began a criminal investigation of State Farm. Soon after, U.S. Attorney Dunn Lampton, based in Gulfport, also started one.

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Though Scruggs was acting appropriately - there could have been criminal activity - he was also aware of the enormous boost a criminal inquiry would bring to the value of his cases. Typically the first thing a criminal defense attorney tells a client is to speak to no one about the facts of the case and to invoke his Fifth Amendment right to silence if called to testify. The concern is that even if the client is innocent, any misstatement under oath may be interpreted by prosecutors as perjury. (Ask Martha Stewart or Lewis Libby.)

While taking the Fifth can't be used against you in a criminal proceeding, it can be used against you - and your employer - in a civil case. So the plaintiffs could now call King as a witness and trigger her invocation of the Fifth. (King did eventually take the Fifth in depositions, as did at least two State Farm colleagues.) That left State Farm in an untenable trial position, since a jury would surely assume the company had acted criminally, walloping it with punitive damages.

Next, on April 26, Scruggs filed a federal whistleblower suit against all five coastal insurers on the Rigsbys' behalf. Here the Rigsbys alleged that the insurers were fraudulently shifting their Katrina liabilities to the National Flood Insurance Program by pressuring engineers to characterize wind damage as flood damage. When a whistleblower suit is filed, the Justice Department automatically begins a civil investigation, and if the claim proves valid, the whistleblower gets 15% to 25% of the money the government recoups. Since the flood program was paying billions to Katrina claimants, the sisters stood to make tens of millions. Now there were three government inquiries (including Hood's and Lampton's).

Whistleblower suits are initially filed under seal, without notifying the defendants, so as not to compromise the government's investigation. Accordingly, State Farm remained unaware of the moles within its midst.

In May, Scruggs filed a mass suit on behalf of 476 State Farm policy-holders. Then, over the first weekend in June 2006, the Rigsbys downloaded more than 6,000 pages from the company's electronic database and made two copies of each. On Monday morning they gave one set to Hood, one to U.S. Attorney Lampton, and put the third aside for later delivery to Scruggs.

The sisters have claimed that they performed this operation - now known as the data dump - at their own impetus. They initially testified that they copied the files of policyholders listed on a certain internal State Farm document, but Cori later admitted that she also used a list of Scruggs's 476 clients in the mass suit. She claimed not to recall where she got it.

The morning after the data dump, the Rigsbys told a State Farm supervisor what they'd done, and they were terminated. Scruggs then hired them as "consultants," paying each $150,000 a year out of SKG expenses. They were assigned only vaguely defined duties and no prescribed hours.

Hiring the Rigsbys was ethically precarious, because they were important eyewitnesses in the whistleblower case, in some of the SKG cases, and in the criminal inquiries. It's a federal crime to pay fact witnesses for their testimony. SKG lawyers later defended the hirings this way: It's permissible to pay expert witnesses for their time, so they were paying the Rigsbys for their expertise about claims adjusting after a storm.

Now that the Rigsbys' cover was blown, Scruggs used them in the public relations front of his campaign. In the run-up to Katrina's first anniversary, Scruggs made the Rigsbys available for a series of punishing press interviews, kicked off on Aug. 25 by a ten-minute segment on ABC's 20/20. Here's the lead-in: "Tonight we're going to hear from two State Farm adjusters who say that the company systematically cheated many of its own customers to avoid paying to rebuild the homes of people who lost everything."

The sisters stood to recover tens of millions of dollars if they could prove fraud. But their whistleblower suit was still under seal, so the journalists didn't know about it.

By now Scruggs was also scoring victories on a third front: politics. Two U.S. Congressmen had become his clients: Representative Taylor from Bay St. Louis, and Scruggs's brother-in-law, then-Senator Trent Lott, whose shoreside Pascagoula home had been damaged. (If a conservative is a liberal who's been mugged, then a liberal is a conservative whose insurance claim has been denied.) Lott and Taylor began supporting legislation that uncannily furthered Scruggs's ends. Each declined comment on whether they discussed those activities with Scruggs beforehand.

In May 2006, Taylor introduced an amendment to require the Department of Homeland Security to investigate whether coastal insurers defrauded the federal flood program after Katrina - the theory of the Rigsbys' whistleblower suit. When Taylor's amendment stalled in the House, Lott attached it to the Homeland Security appropriations bill in July, which was certain to pass. That same month he telephoned Charles Chamness, the president of the National Association of Mutual Insurance Companies, with a message so startling that Chamness memorialized it in a letter. "Your comment that you will dedicate your next term of office to 'bringing down State Farm and the industry,' through all means available to you, including legislation designed to harm the property/casualty insurance industry, was very unsettling, to say the least," Chamness wrote. Lott and Taylor then joined an effort to repeal an antitrust exemption the industry had enjoyed for 60 years.

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All the momentum until now had been with Scruggs. But in September 2006, when a company called E.A. Renfroe sued the Rigsbys, the pendulum began its return arc. Though the Rigsbys had been acting as State Farm claims adjusters, their direct employer was Renfroe, which contracts out claims adjusters to major carriers. Renfroe sued the Rigsbys in federal court in Birmingham, Ala., for allegedly violating their employment contracts by supplying confidential files to Scruggs. Renfroe sought damages and the return of the documents.

The Renfroe suit posed a personal financial threat to Scruggs. Since the Rigsbys could not bankroll their own defense, Scruggs and SKG had to hire lawyers to defend them, and Scruggs told them he'd indemnify them if they had to pay damages. On the defensive, Scruggs began settlement talks with State Farm, and by early November they reached a tentative deal. State Farm would pay about $80 million to 640 policyholders and another $26.5 million to the SKG lawyers. But State Farm refused to cut any checks until all other Hood-Scruggs actions were resolved: Hood's civil suit, a class action SKG had filed in July for 32,000 policyholders, and Hood's criminal inquiry.

Hood says he made it clear to State Farm that he would not combine discussions of the civil and criminal cases. (A prosecutor is never supposed to use the criminal process to exert leverage in a civil case.) "I set 'em at the table and pointed at every one of the State Farm people," says Hood. "I said... 'I don't even want to talk about the criminal investigation.'"

But according to the state's deputy insurance commissioner, who was present at some of the negotiations, Hood's linking of the civil and criminal matters was at times both explicit and outrageous. At a meeting in January 2007, Hood said, "If they don't settle with us, I'm going to indict them all, from [State Farm CEO] Ed Rust down," the deputy later testified.

"That was not said," Hood insists. "There was never any use of our criminal justice system to coerce any settlement. State Farm is the one trying to tie the two together, not us."

State Farm was tying the two together, and because it was, by December, Hood was apparently coming under pressure to drop his criminal inquiry from an unexpected source: Scruggs. According to a statement later given to the FBI by an attorney named Timothy Balducci, Scruggs was impatient to put his hands on the $26.5 million in attorney fees State Farm was refusing to release until Hood's criminal inquiry was resolved. Scruggs offered Balducci and his business partner $500,000 if they'd meet with Hood and persuade him to drop his investigation, according to Balducci. State Farm attorneys have suggested in court that Balducci told Hood that if he didn't call off the probe, Scruggs would fund a different candidate to run against him for attorney general in the next year's primary.

Hood has acknowledged meeting with Balducci but has denied receiving any "threat." He did not respond to Fortune's questions about the meeting, but he e-mailed this statement: "The decision on whether to indict State Farm Insurance Company was based solely on the advice of senior prosecutors in our office.... I do what I think is right for the working people of Mississippi."

A cascade of settlements were suddenly finalized in mid-January. On Jan. 23, Hood and State Farm settled Hood's civil case in a way that required State Farm to offer certain settlement terms in the SKG class action. That class action was settled the same day, with State Farm agreeing to offer at least one-half policy limits to all policyholders with slabs - an offer worth between $50 million and $80 million for class members. The settlement also called for an additional $10 million to $20 million payday for the SKG attorneys, on top of the $26.5 million. Then Hood signed an agreement dropping the criminal inquiry "in light of" State Farm's settlement of his civil case and paying his office $5 million, which was said to represent the cost of his inquiry. Two days later State Farm released $26.5 million in fees to SKG for the 640 individual cases that had been settled earlier.

The deal began to unravel immediately. The Renfroe case against the Rigsbys (Scruggs was paying for their defense and on the hook for their damages) was going forward. And Renfroe was now seeking criminal contempt sanctions against Scruggs for circumventing one of the judge's orders in that case.

On Feb. 19, Scruggs wrote a stunningly raw letter to State Farm attorney Sheila Birnbaum. "Our disappointment at your lack of resolve in securing dismissal of the Renfroe matter cannot be overstated," he wrote. "Nor will it be without consequences." He threatened to pull out of the class-action deal.

Birnbaum held firm. "We are appalled by your continued distortions of what occurred during settlement negotiations, threats, and not-so-subtle suggestions that various 'consequences' will be visited upon State Farm if we do not do your bidding," she wrote back. Then she explained what, to any lawyer, had been so shocking about Scruggs's letter: "How can you condition a settlement that would result in substantial benefits for class members on the dismissal of a lawsuit pending in Alabama, in which class members have no interest, without creating a conflict of interest?"

Nonetheless, on March 12, Scruggs did pull out of the settlement. And when he did, State Farm cut his legs out from under him. It took essentially the same deal that it had proposed in the SKG class action to the state insurance commissioner and offered to make it available to policyholders through the auspices of his office. Policyholders would get all the benefits Scruggs and Hood had won for them; the only difference was that SKG wouldn't get the extra $10 million to $20 million in class-action fees. By the end of 2007, State Farm had paid out $73.4 million to policyholders that way.

Pulling out of the class action was one of two grave miscalculations Scruggs made in March 2007. The other involved a dispute within SKG over how to divvy up the $26.5 million in fees State Farm had paid for the 640 individual cases. Attorney John Jones of Jackson, Miss., had been shocked when Scruggs told him that his firm's share would be only $1 million. Jones thought his firm had taken the laboring oar in developing legal theories, writing briefs, and preparing witnesses. In a Jan. 25 e-mail, Scruggs's partner Sidney Backstrom explained to Jones that legal theories didn't have much to do with the victory. "The whistleblowers came to Dick," he wrote, "and they were the sole basis for Hood's interest, which really was 80% of why SF wanted to settle."

In March, Jones's firm sued SKG in state court in Oxford. The case was assigned to circuit judge Henry Lackey, who happened to have been something of a mentor to Tim Balducci, the attorney who handled special projects for Scruggs. Scruggs asked Balducci to approach Lackey privately and see whether he could persuade his friend to send the case to arbitration, which Scruggs preferred to a court battle. Balducci agreed, though he knew, he later acknowledged, that this sort of secret approach to a judge could cost him his bar license.

On March 28, Balducci met with Lackey and said he'd consider it a "personal favor" if Lackey would rule for Scruggs. He added that when Lackey retired, he hoped he would take an "of counsel" position at Balducci's firm - a sinecure for which Lackey would get a monthly stipend. Though he kept a poker face at the meeting, Lackey later notified the FBI and offered to tape-record further calls with Balducci.

While that crisis festered beneath the surface, another erupted in plain view. On June 15, Judge William Acker Jr., overseeing the Renfroe case, recommended that Scruggs be prosecuted for criminal contempt for allegedly violating an order he had entered requiring return of all the documents the Rigsbys had taken. Acker suggested that Scruggs disobeyed the order to further a plot in which "Scruggs and Hood had teamed up to bully State Farm into civil and criminal settlements." (A contempt charge was brought, but later dismissed.)

Still, Scruggs fought on. In June he filed 180 new cases against State Farm, plus a civil racketeering suit for 20 policyholders who had not been told about revisions in their engineering reports. As if on cue, attorney general Hood also reentered the picture. He filed a new civil suit against State Farm and soon started a new criminal inquiry. This time State Farm fired back immediately: On Sept. 13, it sued Hood in federal court in Jackson, seeking to enjoin his criminal inquiry. Ordinarily that would have been a nearly impossible case to win: Case law generally prohibits the target of a state criminal inquiry from asking a federal court to stop the probe. But given the extraordinary facts of this case - the history of parallel activity between Hood and Scruggs, Judge Acker's contempt order, and Hood's written agreement to drop the investigation - a judge issued a restraining order the next day.

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At a taped meeting Sept. 21, Judge Lackey asked Balducci for $40,000 in exchange for the order he wanted. After contacting Scruggs's office to get the green light, Balducci agreed. He delivered the last payment Nov. 1. The FBI arrested him and within minutes flipped him. Wearing a wire at Scruggs's office that afternoon, Balducci discussed with Scruggs whether Lackey's draft order read the way he wanted and told him Lackey wanted an extra $10,000. "Uh, I'll take care of it," Scruggs said.

As the probe continued, Balducci told the FBI that he had helped Scruggs try to bribe a different judge, in Jackson, in 2006.

In the 40 days before Election Day, Scruggs, a close associate, and two SKG lawyers contributed $472,000 to the Democratic Attorneys General Association, which in turn gave $550,000 to attorney general Hood's campaign. Hood's total donations for that period were about $739,000, and his total for the year was $2.1 million. Hood won.

On Nov. 28, Scruggs was indicted for conspiring to bribe Judge Lackey, and on March 14 pleaded guilty. His plea deal ensures that he'll serve no more than five years for attempting to bribe Lackey. It does not address the Jackson attempted bribery accusation; that investigation continues.

Scruggs's plea does end his morally ambiguous career in the law, one in which he won great riches for himself and accomplished some astounding outcomes for clients, certain of which, like curtailing cigarette advertising, benefited society.

But there was little out of character about the transgression that brought Scruggs down. And since the insurance assault was modeled upon the tobacco template, it makes one yearn mightily to one day hear the unexpurgated version of that yarn.

At presstime, Scruggs wasn't talking.