The D & O Diary : Directors and Officers Liability and Insurance : The D & O Diary : Kevin LaCroix : Securities Laws, Corporate Fraud, D & O Litigation

Driven by the growing wave of subprime-related litigation (particularly a spate of auction rate securities lawsuits), the number of new securities class action lawsuit filings surged in March 2008. The total number of new securities class action lawsuit filings -- 25 – matches the number of new filings in November 2007, which in turn represented the highest monthly total of new filings since January 2005.

The 25 new securities lawsuits in March included 14 new subprime-related suits, taking account the new auction rate securities filed against J.P. Morgan Chase on March 31, 2008 (about which refer here). Of the 14 subprime-related suits, eight (including the new J.P. Morgan Chase lawsuit) were brought on behalf of auction rate securities investors against the companies that sold them the instruments. The remaining lawsuits (both those that are subprime-related and those that are not) were brought on behalf of public company shareholders against the companies and their directors and officers, other than one lawsuit brought on behalf of mutual fund investors.  

Largely because of the subprime-related litigation, many of the March lawsuits were filed in the United States District Court for the Southern District of New York – a total of 11 of March’s 25 new securities lawsuits were filed in the S.D.N.Y. Six of the new securities lawsuits filed in March involved companies domiciled overseas.

With the addition of the 25 new lawsuits in March, the total number of new securities lawsuits filed in the first quarter of 2008 totaled 52, of which 24 are subprime-related. All of the auction rate securities lawsuits were filed in March. (A complete list of the subprime-related lawsuits can be found on my running tally of subprime lawsuits, which may be accessed here.)

The 52 new securities class action filings in the first quarter of 2008, if extrapolated across four quarters, imply an annual filing rate of 208 new securities class action lawsuits, which is consistent with historical norms. (According to Cornerstone’s year-end 2007 securities analysis, here, the average number of securities class action filings during the period 1997 to 2006 is 1994). However, while this filing rate is consistent with historical levels, it is well above the annual levels seen in the most recent years, particularly 2006 (116) and 2007 (166).

Again, largely due to the number of subprime-related filings, the S.D.N.Y had the largest number of first quarter filings, with 21. The federal district with the next highest numbers of filings, D.Mass., had only five.

The companies sued in new securities lawsuits in the first quarter represented 31 different Standard Industrial Classification (SIC) Code categories, which might suggest that a broad diversity of companies were sued, but in most of those 31 categories only a single company was sued. The SIC Code categories with the largest numbers of companies sued were SIC Code category 6211 (Security Brokers and Dealers), with 7 companies sued, and 6021 (National Commercial Banks), with 6 companies sued. In all 29 companies in the 6000 SIC Code series (Finance, Insurance and Real Estate) were sued in the first quarter.

Nine of the companies sued for the first time in the first quarter of 2008 were domiciled overseas, representing eight different countries (including Switzerland, in which two of the companies are domiciled; the other seven countries had only one each.)

Six on the companies sued for the first time in the first quarter of 2008 had completed an initial public offering less than 12 months before the date of the first-filed lawsuit.

A final word about my lawsuit count: I am largely dependent on publicly available sources for my information about securities class action filings, although I have been able to supplement my information with data and links supplied by readers. (I am always grateful when readers bring information to my attention). I have compared my count to the information available on the Stanford Law School Securities Class Action Clearinghouse website (here) and have elected to omit certain cases that the Stanford site has included, largely because at least three of the cases listed on the Stanford site do not involved publicly traded companies. I will say that the diversity and variation of cases that have arisen in the last few months have created some very difficult categorization issues, and reasonable minds clearly could differ as to whether any particular case should or should not be “counted.”

While the securities class action lawsuit filing rate has fluctuated since mid-2007, the evidence remains consistent that the "lull" in filings that occured between mid-2005 and mid-2007 is over. It does remain to be seen if the filings will continue at their current rate, especially whethter factors such as the auction rate securities crisis will continue to drive litigation. On the other hand, the litigation activity is being driven by so many different aspects of the current crisis, it seems probable that subprime and other credit-related litigation will continue to accumulate. The more interesting question may be the extent to whcih the credit crisis litigation will spread beyond the financial sector.

A Further Thought about Securities Class Action Settlements: Earlier today I posted about the new Cornerstone report on 2007 class action settlements. The report is interesting and includes useful analysis and information. But upon reflection, it occurred to me that it is increasingly the case that class action settlement data alone may not provide all of the information necessary to understand the costs involved in resolving securities lawsuits. As I have noted in numerous prior posts (refer here), class opt outs are an increasingly important part of securities lawsuit resolution, a development that gained considerable momentum during 2007. Indeed, as I note here, the aggregate amount required to settle the Qwest opt-out actions actually exceeded the amount of the class settlement, and the amount paid in settlement of other opt actions is also very substantial.

For that reason, any assessment of the total costs involved in securities case resolution cannot be limited to class action settlements alone. The costs involved with separate opt-out actions must also be considered.

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On March 31, 2008, Cornerstone Research released its review and analysis of 2007 securities class action settlements. Cornerstone’s press release can be found here and the full report can be found here. The Cornerstone Report differs in certain particulars from the previously released NERA Economic Consulting report (about which refer here), but the two reports are directionally consistent.

Cornerstone’s press release emphasizes that the aggregate dollar value of all settlements was down 60% compared to 2006, but the full report emphasizes that, when the four largest settlements are removed from the analysis, the aggregate value of all settlements in 2007 exceeded all prior years except the unprecedented year of 2006.

The full report also highlights that the median securities class action settlement reached an all-time high of $9.0 million in 2007, compared to a median of $6.9 million for the years 1996 through 2006. The increase in the median settlement in 2007 is “partly due to the fact that the percentage of cases settling for $10-20 million increased substantially from prior years.” On the other hand, the number of settlements in excess of $100 million declined from 14 in 2006 to only nine in 2007.

According to the Cornerstone report, the average securities class action settlement fell from $105 million in 2006 (excluding the Enron settlement) to $62.7 million in 2007. But the 2007 average still exceeded the average of $54.7 million for the years 1996 through 2006.

The Cornerstone report examines the factors affecting settlement amounts and concludes that the presence of institutional investors lead plaintiffs and the existence of parallel shareholders’ derivative lawsuits both tend to have an upward effect on settlement values.

The press release quotes Stanford Law Professor Joseph Grundfest as saying that “it seems clear that the aggregate dollar value of settlements over the next two or three years is likely to decline significantly because the inventory of large cases in the pipeline just isn’t there. The interesting open question is whether the subprime crisis will cause an uptick in securities fraud settlement activity that might, given the settlement cycles in the litigation industry, only become apparent three to five years from now.”

The differences between the analysis in the Cornerstone and NERA Economic Consulting reports appears to be due at least in part to the different methods the two studies used to categorize settlements by settlement year, with one report categorizing the settlements by the year in which the settlement was announced and the other report categorizing the settlement by the year in which it was approved.

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As the markets for various types of subprime-related assets have seized up, many companies find themselves faced with complicated issues concerning asset valuation and disclosure. These issues have in turn both subjected companies to the possibility of litigation and encouraged investors to target the entities and institutions that sold them the assets in the first place. The extent of the asset valuation and disclosure issues suggests that the turmoil, and the ensuing litigation, will continue to spread.

One example where the valuation and disclosure issues have already led to litigation involves the securities class action lawsuit filed in the United States District Court for the District of Minnesota on March 28, 2008 against MoneyGram International and certain of its directors and officers. A copy of the plaintiffs’ attorneys’ press release can be found here and a copy of the complaint can be found here.

The complaint against Moneygram relates to the company’s January 14, 2008 press release (here) in which the company stated that it had completed its valuation of its investment portfolio as of November 30, 2007, as a result of which the company said that it had “experienced net unrealized losses of $571 million from September 30, 2007, bringing cumulative net unrealized losses to $860 million.” The company also announced that it has commenced a process to “realign is portfolio away from asset-backed securities,” as a result of which it had realized in January a loss of $200 million on asset sales of $1.3 billion.

According to the plaintiffs’ lawyers’ press release, the complaint alleges that the defendants “concealed from the investing public” that:

(a) the Company lacked requisite internal controls to ensure that the reserves for the Company’s investments in asset-backed securities were adequate, and, as a result, the Company’s projections and reported results issued during the Class Period were based upon defective assumptions and/or manipulated facts; and (b) the Company concealed the extent of its potential losses arising from its exposure to asset-backed securities containing uncollectible debt.

The prospect of securities litigation arising from asset valuation and disclosure issues is a potentially very substantial problem, because so many companies are facing these same kinds of issues due to asset-backed securities in their investment portfolio. Similarly, companies holding auction rate securities are facing particularly challenging valuation and disclosure issues, and as I have previously noted (most recently here), these challenges are not limited to companies in the financial sector, but indeed are widely dispersed throughout the economy. For example, a March 28, 2008 Wall Street Journal article entitled “’Auction Rates’ Clip Tech Firms’ Profits” (here) discusses the financial impacts that a variety of technology companies are facing because of the companies’ inability to convert their auction rate securities holdings into cash.

One measure of the depth of the problems arising from the failure of the auction rate securities market is that it is not just companies whose balance sheets are under pressure. Many households and individuals are also now about to recognize their own personal balance sheet hits due to the auction rate problem. According to a March 29, 2008 Wall Street Journal article entitled “UBS Plans Auction-Rate Price Cut” (here), UBS is going to lower the values of the auction rate securities held by its customers. The reduced values, which will be based on computer models and “will range from a few percentage points to more than 20%” will be reflected on their customers’ forthcoming statements.

As I have previously noted (most recently here), investors have already filed a number of class action lawsuits against the companies that sold them auction rate securities, and on March 27, 2007, Citibank became the latest to be sued in a securities class action on behalf of investors for its sale of auction rate securities (see press release here and complaint here). The reduction of the carrying values of auction rate securities on investors’ statements will likely further bestir investors and could lead to even more litigation. But making no adjustments could create a different set of issues and lead to greater problems later.

The question of how best to reflect the valuation of assets for which there is no current market is one that potentially affect participants at all levels of the economy. And while there undoubtedly will be more lawsuits on behalf of investors against the companies that sold them the auction rate securities, a potentially greater litigation threat may arise from shareholders who may contend they were misled about a company’s balance sheet exposure to these kinds of assets. There could well be a great deal of litigation in which it is alleged, as asserted in the complaint in the MoneyGram case, that a company failed to disclose the “extent of its potential losses arising from its exposure to asset-backed securities containing uncollectible debt.”

The extent of the problem shall be revealed in the fullness of time. But meanwhile the subprime-related securities class action litigation still continues to accumulate. With the addition of the MoneyGram and Citigroup lawsuits, my running tally of subprime-related securities lawsuits (which can be accessed here) now stands at 61, 23 of which have been filed in 2008, and seven of which are filed on behalf of auction rate investors against the companies who sold them the securities.

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As I have noted in prior posts (most recently here), due to increasing average claims severity and escalating defense expense, excess D & O insurance is an increasingly important factor in the resolution of claims involving directors and officers of public companies. The greater involvement of excess D & O insurance has also meant an increasing number of claims disputes involving excess D & O insurers.

A recurring issue has been the question of the excess carrier’s obligations when the primary carrier has paid less than its full policy limits as a result of a compromise with the primary carrier. A March 25, 2008 opinion (here) by California’s intermediate appellate court held, that given the policy language involved, an excess D & O insurance policy was not triggered where the underlying insurer neither paid nor was obligated to pay its full policy limit of liability.

For the policy period March 15, 1999 through March 15, 2000, Qualcomm had $40 million of D & O insurance, structured with a primary layer of $20 million and an excess “follow form” layer of $20 million above the primary $20 million. During the policy period, Qualcomm employees and former employees brought lawsuits asserting rights to unvested company stock options. Qualcomm later settled these lawsuits and sought reimbursement from its D & O insurers for its defense expense and the settlement amounts.

Qualcomm ultimately reached a compromise with its primary D & O insurer, whereby Qualcomm gave the primary insurer a full policy release in exchange for the primary carrier’s payment of $16 million. Even with this $16 million payment, however, Qualcomm still had unreimbursed defense expense of $3.6 million and also had an additional unreimbursed $9 million in settlement expense.

In October 2006, Qualcomm sued its excess D & O insurer for breach of contract and declaratory relief, seeking compensatory damages as well as a judicial declaration that the excess carrier was obligated to indemnify Qualcomm for more than $9 million in unreimbursed expenses. The excess carrier contended, among other things, that the underlying policy had not been “exhausted” as required by the excess policy. The excess policy’s exhaustion clause provided that the excess carrier “shall be liable only after the insurers under each of the Underlying policies have paid or have been held liable to pay the full amount of the Underlying Limit of Liability.”

The trial court sustained the excess carrier’s demurrer (in effect, granted the carrier’s motion to dimiss) without leave to amend on the grounds that the excess policy had not been triggered, and Qualcomm appealed.

On appeal, Qualcomm argued that an excess carrier was liable for losses exceeding the actual limits of underlying primary insurance, even where the primary carrier settled for less than the actual policy limit. Qualcomm also argued that denying excess coverage in the circumstances presented would be contrary to public policy because such a denial would work a forfeiture, provide a windfall to the excess carrier, and encourage litigation by discouraging settlement.

The court of appeals declined “to reach a broad holding on public policy considerations” and instead concluded that “the literal policy language in this case governs.” The court said that the excess policy was not triggered because Qualcomm’s pleadings “establish that the primary insurer neither paid the ‘full amount’ of the liability limit nor had it become legally obligated to pay the full amount of the primary limit.” The court said that

the exhaustion clause here compels us to conclude that the parties expressly agreed that [the primary carrier] was required to pay (or be legally obligated to pay) no less than $20 million as a condition of [the excess carrier’s] liability. Because [the primary carrier] did not so pay, [the excess carrier’s obligations] did not arise.

The Qualcomm decision is consistent with the 2007 decision in the Comerica case, about which I wrote here, and which the Qualcomm court said presented “factual circumstances almost identical to those present in this case." This developing line of case authority has important implications both for the claims resolution and for the insurance acquisition processes.

Let me say at the outset that I am not attempting to criticize the position taken by the excess carrier in the Qualcomm case. Given the court’s ruling, it would be difficult to suggest that the carrier’s legal position was not well founded, and I do not propose to do so here.

In general, however, a claims outcome where a policyholder is stuck with millions of dollars of unexpectedly uninsured claims, after having funded a coverage gap as a result of a compromise with the primary insurer, and after having paid substantial insurance premiums, is highly undesirable from the policyholder’s perspective. Indeed, everyone involved in the D & O insurance industry, including ultimately even excess D & O insurers, has an interest in avoiding claims outcomes where policyholders gets “stuck,” as the value component of the insurance equation—the very thing that insurers’ sell – depends on the policyholders’ not getting “stuck.”

By the same token, the industry could be doing its customers and itself a service by keeping track of claims activity that produces adverse policyholder outcomes, whether it is a primary carrier that is hotboxing the policyholder into making a compromise or an excess carrier that is refusing to play along. Our industry could be improved were it to keep track of the carriers whose claims decisions result in policyholders getting “stuck” – by keeping track the industry might ensure that claims decisions involve not only detached legal analysis but also due consideration of the concrete business assumptions on which our industry ultimately depends.

At a minimum, it is increasingly clear that policyholders should consider only global compromises, involving all insurers, as any other arrangement could leave the policyholder exposed.

The Qualcomm decision has lessons for the policy acquisition process as well. The outcome in the Qualcomm case was a direct reflection of the excess policy’s exhaustion trigger language. While alternative language was not generally available at the time Qualcomm placed the D & O program involved in that case, many excess D & O carriers now offer exhaustion trigger language that reduces the restrictions on the kinds of payments that could trigger the excess carrier’s payment obligation. Indeed, many policies recognize payment by the policyholder as satisfying the underlying limit. The need for these issues to be address in the insurance placement process underscores the need to have skilled insurance professionals involved in the D & O insurance acquisition process.

Special thanks to John McCarrick of the Edward Angell Palmer & Dodge law firm for providing me with a copy of the Qualcomm decision. I should add that the views expressed in this post are solely my own.

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In a sweeping 581-page report (here), the examiner appointed in connection with the New Century Financial Corporation bankruptcy found that New Century “engaged in a number of significant improper and imprudent practices related to its loan originations” that “created a ticking time bomb that detonated in 2007.”

Bankruptcy examiner Michael J. Missal issued his report as part of the investigation he undertook at the request of New Century’s bankruptcy trustee to examine “any and all accounting and financial statement irregularities, errors and misstatements.” The report is dated February 29, 2008, but it was unsealed on March 26, 2008 at the request of former New Century Employees.

The examiner’s report concludes that New Century “had a brazen obsession with increasing loan originations, without due regard to the risks associate with that business strategy.” The report also concludes that New Century “engaged in at least seven wide-ranging accounting practices in 2005 and 2006” that “resulted in material misstatements of the Company’s financial statements.” The examiner did not find sufficient evidence to conclude that New Century engaged in earnings management or manipulation “although its accounting irregularities almost always resulted in increased earnings.”

The report also states that New Century’s outside accounting firm, KPMG, “contributed to certain of these accounting and financial reporting deficiencies by enabling them to persist and, in some instances, precipitating the Company’s departure from applicable accounting standards.”

The report states that as a result of New Century’s accounting failures New Century understated its repurchase reserve in the third quarter of 2006 by 100%, and reported a quarterly profit of $63.5 million when it should have reported a loss.” In addition, the accounting errors resulted in the payment of performance bonuses to key executives in 2005 “that were at least 300% more than they should have been.” New Century also made “a number of false and misleading statements in its public filings, press releases and other communications.”

Based on his investigation, the examiner believes that “several causes of action may be available to the estate.” First, the report concludes that the estate may be able to assert causes of action against KPMG for “professional negligence and negligent misrepresentations.” Second, the estate may be able to assert causes of action against former officers “to recover certain of the bonuses… that were tied, directly or indirectly, to the incorrect financial statements.” These causes of action, the report states, “could seek million of dollars of recoveries.”

The examiner also considered whether the company’s former officials breached their fiduciary duties, and whether the estate has possible claims against the officials. The report notes that any assertion of these claims would have “strong defenses to overcome, particularly the business judgment rule and statutory and other limitations.”

While the examiner’s conclusions may (and undoubtedly will) be the subject of substantial debate, the report’s analysis of the company’s loan origination practices and accounting shortcomings is remarkably detailed. The sheer sweep and magnitude of the report and the depth of its detail could make New Century the poster child for the excesses of the subprime lending boom, evoking inevitable comparisons with Enron as the byword for an entire era. Indeed, the report suggests a number of echoes from that earlier period, including in particular the accounting firm’s supposed complicity in the company’s alleged excesses.

The fallout from the subprime meltdown will continue to accumulate in the months and years to come, but the New Century bankruptcy examiner’s report may represent the first installment on the history of the era.

A March 26, 2008 Bloomberg.com article discussing the examiner’s report can be found here. A March 27, 2008 Wall Street Journal article discussing the report can be found here.

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Subprime litigation may be all the rage, but the consolidated IPO Laddering case is back in the news, a seemingly distant reverberation from a long-gone era that may nonetheless still vex the same investment banks caught up in the current subprime crisis. The consolidated Initial Public Offering Securities Litigation is going forward in the district court after the Second Circuit reversed the district court’s grant of class certification (refer here regarding the Second Circuit’s reversal). On remand back to the district court, the plaintiffs have amended their Master Allegations and Complaints in the six focus cases, and the defendants moved to dismiss.

In a March 26, 2008 opinion (here), Judge Shira Scheindlin substantially denied the defendants’ motion to dimiss and also made is unmistakably clear that the litigation is going forward.

Judge Scheindlin’s rulings in the March 26 opinion are largely consistent with her prior rulings in the case, and, indeed, in significant parts of her opinion she simply repeats her prior ruling and states “I see no reason to reconsider this decision.” However, in two particular areas, intervening Supreme Court case law required Judge Scheindlin to reassess her prior analysis. Judge Scheindlin made it clear that the intervening case law did not change her view of the case.

First, Judge Scheindlin reexamined the plaintiffs’ scienter allegations in light of the Tellabs decision. The plaintiffs assert two separate claims under Section 10(b). One is asserted solely against the Underwriter defendants and is based on alleged market manipulation (based on the alleged tie-in arrangement that required IPO share buyers to purchase additional shares at higher prices). The other Section 10(b) claim is asserted against all defendants and alleges misrepresentations and omissions regarding the alleged manipulation scheme.

With respect to the market manipulation claim, Judge Scheindler reaffirmed her prior ruling, reiterating that the alleged conduct was so obviously manipulative that “it could not have been done inadvertently,” and therefore the inference of scienter was at least as compelling as the competing inference.

With respect to the misrepresentation allegations, Judge Scheindlin focused on the allegation that the issuer defendants’ officers and directors allegedly held shares that were inflated by the price manipulation. She viewed this consideration with the fact that each of the issuer defendants used “inflated shares as currency” to acquire target companies, as well as the fact that two of the issuer companies (from among the six focus companies) “raised additional capital through secondary offerings.” Judge Scheindlin said that “when these and other allegations against each issuer are viewed as a whole, they are sufficient to plead scienter in each case.”

Judge Scheindlin also reconsidered her prior ruling on the issue of loss causation, in light of the Supreme Court’s decision in the Dura case. Judge Scheindlin found that the intervening case law does “not support a reversal of my earlier decision.” Judge Scheindlin said

the misstatement and omissions concealed the alleged market manipulation that caused plaintiffs’ losses, and without such misstatements and omissions, plaintiffs’ losses could not have occurred. Further, plaintiffs’ losses are those that could be expected to result from the concealment of the market manipulation scheme. Plaintiffs have thus pled loss causation.

Judge Scheindlin did grant the defendants’ dismissal motion on two narrow grounds. First, consistent with her prior rulings in the case, she dismissed claims brought under Section 11 by those plaintiffs who sold their securities for a price in excess of the initial offering price. Second, she dismissed certain plaintiffs who purchased their shares outside the previously certified class period.

And so the Initial Public Offering Securities Litigation will grind on, a vestige of an earlier time and place, its significance seemingly eclipsed by more recent and more momentous events. Yet the collective litigation nonetheless remains significant. Its sheer bulk and scale makes the prospect of any definitive global resolution challenging, a prospect even further complicated by the Second Circuit’s class certification ruling. The current circumstances make future course of the litigation seem even more uncertain.

I welcome readers thoughts on the immediate procedural direction likely in the litigation, as well as any views about where the litigation ultimately is headed.

Special thanks to Edward Carleton of the Boundas Skarzynski Walsh & Black law firm for providing a copy of the March 26 opinion.

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Add Merrill Lynch and Morgan Stanley to the growing list of companies that have been sued in securities class action lawsuits by investors for allegedly deceptive representation in connection with the sale of auction rate securities. According to the plaintiffs’ attorneys’ March 25, 2008 press release (here), the plaintiffs’ have filed a securities class action lawsuit in the United States District Court for the Southern District of New York against Merrill Lynch and its asset management company on behalf of investors who purchased auction rate securities from Merrill Lynch between March 25, 2003 and February 13, 2008.  A copy of the complaint can be found here.

According to the press release, Merrill Lynch “offered and sold auction rate securities to the public as highly liquid cash-management vehicles and as suitable alternatives to money market mutual funds.” The complaint alleges that Merrill Lynch failed to disclose that  

(1) the auction rate securities were not cash alternatives, like money market funds, but were instead, complex, long-term financial instruments with 30 year maturity dates, or longer; (2) the auction rate securities were only liquid at the time of sale because Merrill Lynch and other broker-dealers were artificially supporting and manipulating the auction rate market to maintain the appearance of liquidity and stability; (3) Merrill Lynch and other broker-dealers routinely intervened in auctions for their own benefit, to set rates and prevent all-hold auctions and failed auctions; and (4) Merrill Lynch continued to market auction rate securities as liquid investments after it had determined that it and other broker dealers were likely to withdraw their support for the periodic auctions and that a “freeze” of the market for auction rate securities would result.

According to news reports (here), plaintiffs also filed a separate but substantially similar lawsuit against Morgan Stanley, raising more or less the same allegations on behalf of a class of investors who purchased auction rate securities from Morgan Stanley during the same class period as proposed in the Merrill Lynch lawsuit. I have not located the Morgan Stanley complaint itself, but will add a link when I get a copy.

UPDATE: A copy of the plaintiffs' lawyers' March 25, 2008 press release announcing the Morgan Stanley auction rate securities lawsuit can be found here and a copy of the complaint can be found here.

These two new lawsuits join a group of similar lawsuits, all filed by the same law firm on behalf of auction rate securities investors, against Deutsche Bank, Wachovia, TD Ameritrade and UBS. The law firm’s webpage describing these various lawsuits can be found here.

With the addition of these two new subprime-related securities class action lawsuits, my running tally of subprime related securities lawsuits, which can be accessed here, now stands at 59, of which 21 have been filed in 2008. Two of these 59 represent lawsuits brought on behalf of investors against mortgage-backed asset securitizers, six are class action lawsuits on behalf of auction rate securities investors, two are brought on behalf of mutual fund investors, and the remaining 49 of which are brought on behalf of public company shareholders.

Subprime Litigation Wave Hits Regions: Birmingham, Alabama-based Regions Financial Corporation has been hit with a couple of different subprime-related lawsuits as the subprime wave continues to spread beyond New York, California, and Florida, the states where the subprime litigation originally was concentrated.

First, according to a March 25, 2008 Birmingham News article (here), the Catholic Medical Mission Board, a Regions shareholder, has filed a shareholders’ derivative lawsuit against Regions, as nominal defendant, and certain Regions directors and officers, alleging that the defendants failed to disclose the extent of Regions’ lending exposure to residential homebuilders, which permitted company insiders to sell their shares in company stock at inflated prices. According to the news report, the complaint alleges that "Regions Financial's stock was artificially inflated because the defendants directed the company to hide the true extent of its subprime exposure.’

The derivative complaint (which can be found here) asserts claims for breach of fiduciary duty, waste of corporate assets, unjust enrichment, and breach of Section 10(b) of the ’34 Act.

Second, Regions has also been hit with a lawsuit filed under ERISA on behalf of its participants in the Regions defined contribution plan. A copy of the complaint can be found here. The complaint alleges that the offered plan participants Regions stock and investment options in Regions Morgan Keegan funds “when it was imprudent to do so.” The complaint also alleges that the investment in Regions stock and the Regions Morgan Keegan funds was maintained “when it was no longer prudent to do so.”  The complaint alleges that the defendants knew or should have known that these investments were imprudent because of Regions and the funds heavy investment in or vulnerability to subprime mortgage investments, loans and securities. The complaint also alleges that the defendants failed to communicate the risks of investing in the plan and also failed to communicate conflicts of interest.

As noted on my running tally of subprime related litigation (which can be accessed here), with the addition of the Regions ERISA litigation, my running tally of subprime-related ERISA lawsuits now stands at 11.

I have not been keeping a running tally of subprime-related derivative litigation (basically because the primarily state court oriented litigation is hard to track), but there has been substantial subprime related derivative litigation, involving, among others, Bear Stearns, American International Group, and Countrywide.

Special thanks to alert reader Rob Lichenstein for the links to the two Regions lawsuits and the Birmingham News article.

About the Bear Stearns Deal: If as I do you find many of the articles discussing the updated Bear Stearns deal confusing, you will want to read a couple of interesting posts on the Conglomerate blog, that provide insight into a couple of points about the revised deal that have received significant press attention.

First, there has been a great deal of discussion in the press about the possibility that the improved buyout offer may have resulted in part from drafting errors in the initial deal documents. BYU law professor Gordon Smith deconstructs this issue in a detailed Conglomerate blog post here (here), with helpful citations and cross-references to other blogs. Smith’s analysis of the differences between the original and the revised deal documents raise some interesting questions about what J.P. Morgan seems to have sought by offering revised terms. Bottom line, in exchange for the improved merger price, J.P. Morgan has eliminated the provisions that would have kept the deal open for a full year, and also obtained a 39.5% ownership interest as a means to try to ensure that the deal is concluded.

Second, and with respect to that 39.5% ownership interest transfer, Smith has a separate post on Conglomerate (here), that explores the Delaware case law behind the 39.5% interest and the limitations on share transfers to lock in shareholder merger approvals. As Professor Smith’s post notes, there is no automatic cutoff under Delaware law whereby a company can sell up to 40% of itself without shareholder approval, and suggestions to that effect in the mainstream media are “what is known in the law biz as ‘wrong.’” Practitioners have evolved the 40% rule of thumb, but “none of this has been tested in court.”

More About the FCPA: Regular readers know that I have frequently commented (most recently here) on the growing importance of Foreign Corrupt Practices Act enforcement proceedings and follow on civil litigation. Two recent publications provide significant additional information on this topic.

First, a March 25, 2008 Law.com article entitled “Today, No Bribe is Too Small” (here), takes a look at the expanding reach of enforcement activities. As the title suggests, the article looks at some seemingly small corrupt transactions that have attracted regulatory attention. The article states that “it seems that no bribe is too small to earn the attention of the department.” The article also focuses on regulatory actions that have been taken by middlemen and third party contractors, and how those seemingly remote actors’ actions have come back to haunt the sponsoring company.

Second, in a much more detailed look at recent FCPA enforcement activity, Porter Wright attorney Tom Gorman has recently posted a running series on the issues involved in recent FCPA regulatory actions on his SEC Actions blog. The most recent post can be found here. Taken collectively, these posts present an excellent overview of the current state of FCPA regulatory actions.

Finally, readers who recall my recent post (here) about the civil litigation arising from potentially problematic activities involving Alcoa’s operations in Bahrain will be interested to note that the U.S. Department of Justice has initiated a criminal investigation of the activities, and in that connection has asked for the entry of stay in the civil proceedings,  as discussed in a March 21, 2008 Wall Street Journal article entitled “U.S. Opens Alcoa Bribery Probe” (here).

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The subprime litigation wave is growing in amplitude and volume, as four companies have found themselves the targets of a total of five new subprime-related securities class action lawsuits, joining the now quite lengthy list of companies that have been swept up in the wave. With the addition of these five new securities lawsuits, as well as the numeous other suits filed in just the last few days, it appears that the subprime litigation wave is building dangerous momentum

Wachovia:  The first of these new lawsuits was actually filed back on January 31, 2008, against Wachovia Corporation , certain of its officers and directors, a related Wachovia unit that issued certain securities involved in the lawsuit, and the offering underwriters that underwrote Wachovia’s May 2007 preferred securities offering. (As noted further below, Wachovia was also named in a separate securities lawsuit relating to auction rate securities).

The Wachovia lawsuit flew under the radar screen at the time that it was filed because the plaintiffs’ lawyers chose to file the lawsuit in New York Supreme Court (Nassau County), though the defendants have removed the action under the Securities Litigation Uniform Standards Act (SLUSA) and the Class Action Fairness Act (CAFA). A copy of the removal petition, to which the initial complaint is attached, can be found here.

The complaint assert claims based on allegedly false and misleading statements in the registration and prospectus issued in connection with Wachovia’s $750 million May 2007 offering of preferred securities. The complaint alleges that the registration statement failed to disclose that Wachovia’s "portfolio of collateralized debt obligations ("CDOs") contained billions of dollars worth of impaired and risky securities, many of which were backed by subprime mortgage loans." The complaint also alleges that the defendants failed to "properly account for highly leveraged loans such as mortgage securities." Finally, the complaint alleges that the complaint failed to disclose that Wachovia was "heavily involved in option adjustable rate mortgages (ARMs)…that would become toxic (for both Wachovia and the borrowers) once house prices stopped increasing at a rapid rate."

The complaint alleges claims only under the ’33 Act, and expressly asserts that the state court has concurrent jurisdiction under Section 22 of the ’33 Act in connection with plaintiff’s claims. The plaintiff in the Wachovia law suit seems to be pursuing the same state court strategy that I discussed at length in my prior post (here) analyzing the class action securities lawsuits that investors have filed against the securitizers who created mortgage backed assets. Significantly, the Coughlin Stoia firm is involved in both those cases and the Wachovia case. Given the sophistication of the firm involved, one must assume that these state court filings are part of a conscious strategy on the firm’s part.

Though defendants have removed the Wachovia case to the United States District Court for the Eastern District of New York, it remains to be seen whether or not the plaintiffs will be able to have the case remanded to state court. As I noted here, the plaintiffs in the Luther v. Countrywide case, a ’33 Act class action lawsuit filed against mortgage backed asset securitizers, succeeded in having their case remanded back to state court. The court in Luther case concluded that concurrent jurisdiction provisions in the ’33 Act prohibit the state court’s case’s removal to federal court.

My theory on these state court lawsuits has been that the plaintiffs intend to argue that the provisions of the PSLRA to not apply to their state court ’33 Act lawsuits. The fact that the plaintiffs’ lawyers issued no press release at the time they filed the complaint tends to reinforce this impression. But regardless of their theory they seem to be making a comprehensive effort to bring these cases in state court. The involvement of state courts in these lawsuits will be very interesting to watch.

Lehman Brothers: On February 22, 2008, a Lehman Brothers shareholder filed a purported securities class action lawsuit in the United States District Court for the Northern District of Illinois, alleging that Lehman Brothers made certain misrepresentations or omissions about its exposure to subprime mortgages during the class period from September 13, 2006 through July 30, 2007. A copy of the complaint can be found here.

There are a variety of very odd things about this lawsuit, and almost all of these odd features repeat the same odd attributes of the subprime-related securities class action lawsuit was previously filed against Morgan Stanley, as I discussed in my prior post here.

The first odd feature about this lawsuit is that it does not name the company, its directors or its senior managers as defendants in the lawsuit. The sole named defendant is the company’s Chief Financial Officer, yet no misrepresentations or omissions are attributed directly to him. The allegations against the CFO are attributed solely to his position within the company. There are no allegations that the CFO sold shares of stock. It is not particularly clear why the CFO should be named as defendant while other officials are not.

The allegations regarding the alleged misrepresentations are sparse, and are essentially limited to a few occasions when the company supposedly downplayed its exposure to subprime mortgages. The class period ends at an odd time, too; the class period end is not in January 2008, when the company said that it has lost $5.9 billion on its mortgage related positions, but on July 30, 2007, when an equity analyst downgraded the company.

The named plaintiff is also an odd representative for the purported class. Though the class period purports to run from September 13, 2006 to July 30, 2007, the named plaintiff did not even buy his shares until July 15, 2007, making him an unlikely representative for a class of that duration. Moreover, the complaint itself refers to events and statements at or about the same time that the plaintiff bought his stock which surely raised questions about subprime-related exposures in general and subprime exposures at Lehman brothers in particular.

The plaintiff also chose to file his complaint in the Northern District of Illinois, though Lehman’s headquarters are in Manhattan.

But regardless of the complaint’s numerous anomalies, the complaint does represent a subprime-related securities class action lawsuit, and so, as noted further below, I have added it to my running tally of subprime-related securities lawsuits.

Schwab: On March 18, 2008, plaintiffs filed a securities class action lawsuit in the United States District Court for the Northern District of California against the Schwab Corporation, certain of its directors and officers, and as well as the underwriter and investement adviser associated with two Schwab YieldPlus Funds. The lawsuit is filed on behalf of investors who purchased Schwab YieldPlus Investor Funds Investor Shares and Schwab YieldPlus Funds Select Shares during the period March 17, 2005 through March 18, 2008. A copy of the plaintiffs’ counsel’s press release can be found here.

The complaint alleges that the defendants issued untrue statements regarding the lack of diversification of the funds and the extent of the funds’ exposure to subprime-backed securities. The complaint alleges that while the funds advertised themselves as a safe alternative to money market funds, they were in fact critically exposed because more than 50 percent of the funds assets were invested in the mortgage industry. The plaintiffs allege that the funds have lost over 18 percent of their value since mid-2007 and 11 percent since January 2, 2008. The plaintiffs allege that the defendants violated Section 11 of the ’33 Act based in misrepresentations in the funds’ offering documents.

The Schwab funds are actually the second mutual funds to be sued in connection with the subprime crisis; as discussed here, the earlier lawsuit involved Morgan Keegan.

Special thanks to a loyal reader for copies of the Wachovia and Lehman Brothers complaints.

More Auction Rate Securities Litigation: As readers may recall, in an earlier post (here), I speculated that lawsuits related to  auction rate securities may represent the next wave in subprime securities litigation. Last week, I noted (here) the securities class action lawsuit that had been brought against Deutsche Bank on behalf of auction rate securities investors. Auction rate securities investors have now filed two additional securities class action lawsuits, one involving Wachovia, and the other involving TD Ameritrade.

With respect to TD Ameritrade, the plaintiffs filed a securities class action lawsuit in the United States District Court for the Southern District of New York on behalf of persons who purchased auction rate securities from TD Ameritrade and an affiliate between March 19 2003 and February 13, 2008 and who continued to hold the securities. A copy of the plaintiffs’ attorneys’ March 19, 2008 press release can be found here, and a copy of the complaint can be found here

The complaint alleges that the defendants failed to disclose:

(1) the auction rate securities were not cash alternatives, like money market funds, but were instead, complex, long-term financial instruments with 30 year maturity dates, or longer; (2) the auction rate securities were only liquid at the time of sale because TD Ameritrade and other broker-dealers were artificially supporting and manipulating the auction rate market to maintain the appearance of liquidity and stability; (3) TD Ameritrade and other broker-dealers routinely intervened in auctions for their own benefit, to set rates and prevent all-hold auctions and failed auctions; and (4) TD Ameritrade continued to market auction rate securities as liquid investments after it had determined that it and other broker dealers were likely to withdraw their support for the periodic auctions and that a "freeze" of the market for auction rate securities would result.

With respect to Wachovia, the plaintiffs filed a securities class action lawsuit in the United States District Court for the Southern District of New York on behalf of all investors who purchased auction rate securities from Wachovia and an affiliate between March 19, 2003 and February 13, 2008 and who continue to hold the securities. A copy of the plaintiffs’ counsel’s March 19, 2008 press release can be found here and a copy of the complaint can be found here. The allegations against Wachovia are substantially similar to the allegations against TD Ameritrade.

An additional lawsuit has been brought on behalf of an investor in auction rate securities, although in this case it is an individual action rather than a class action. On March 18, 2008, plaintiffs filed a lawsuit in the United States District Court for the Western Disrict of Texas against Wells Fargo and Wells Fargo Investments, alleging that the defendants violated the securities laws and breached their fiduciary duties in connection with the plaintiffs’ purchase of $2 million of auction rate market preferred shares. A copy of the complaint can be found here. (Hat tip to Courthouse News Service for a copy of the complaint.)

The plaintiffs contend that the Wells Fargo investment adviser referred to the securities as "bonds" that were "represented to be without risk." The plaintiffs claim that the defendants said that the securities could be redeemed on 7 days notice, but that when the plaintiffs sought to redeem the securities on March 11, 2008, they were told that no market exists for the securities. The complaint seeks recovery of $2 million plus punitive damages.

Some Observations and Tallies: Even for those that have been paying only intermittent attention, it is pretty clear that the pace of subprime-related litigation activity has picked up significantly over the last few days. Even without regard to these five new securities class action suits listed above, we had already seen a notable number of new subprime securities suits just in the last week, including for example, new lawsuits against SocGen, PMI Group, Deutsche Bank, and, most significantly, Bear Stearns. Adding these five new subprime-related securities class action lawsuits listed above to the list reinforces the impression that the litigation wave is gathering dangerous momentum, with the likelihood that even greater activity is yet to come.

With the addition of these new lawsuits to my running tally of subprime- related securities class action litigation, which can be accessed here, the current total of subprime securities lawsuits now stands at 56, of which 18 have been filed in 2008. Two of these 56 represent lawsuits by investors against mortgage backed asset securitizers, three are class action on behalf of investors in auction rate securities, and two relate to mutual funds, as noted above. The remaining 50 lawsuits were brought by shareholders of publicly traded companies.

More About Credit Default Swaps: In yet another prior post (here), I noted that problems arising from credit default swaps could be another source of litigation arising from the credit crisis. The March 20, 2008 Wall Street Journal is reporting (here) that Merrill Lynch has sued a unit of Security Capital Assurance, seeking to prevent SCA from avoiding its financial obligations to insure as much as $3.1 billion on seven credit default swaps.

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In Bear Stearns’ March 16, 2008 announcement (here) of J.P. Morgan’s acquisition of the company, Alan Schwartz, Bear’s CEO, is quoted as saying that “this transaction represents the best outcome for all our constituencies based upon the current circumstances.” Apparently, a few of those constituencies take a different view.. In addition to the securities class action lawsuits and employees’ ERISA lawsuit noted in yesterday’s post, a Bear shareholder has also filed a New York state court lawsuit (complaint here) alleging that Bear and its senior officials breached their fiduciary duty to shareholders. (Hat tip to the Courthouse News Service for the complaint.)

The relatively short complaint, which bears certain indicia of having been prepared in haste, is not presented as a derivative lawsuit, but rather as a direct claim, and is filed as a class action on behalf of all Bear shareholders. Among other things, the complaint alleges that the company “allowed itself to be sold to the lowest bidder…at the lowest possible price,” which, the complaint alleges, “is far below Bear Stearns’ value.” The complaint quotes a statement from the Wall Street Journal that the deal constitutes a "fire sale."

Schwartz’s statement that the deal was the best for “all constituencies” is noteworthy for its seeming distinction from the usual formulation that it is the obligation of a corporation’s board to maximize the interests of the shareholders. In this context, the obligations to the shareholders are usually referenced as their Revlon duties, as noted on the Delaware Corporate and Commercial Litigation blog (here). One constituency that was particularly interested in outcome of this transaction is composed of the federal regulators. Another constituency consists of Bear’s creditors and counterparties, whose anxieties apparently triggered the crisis that led to the company’s sale. These constituencies are likelier to agree with Schwartz’s characterization of the transaction.  

The constituency that consists of Bear’s shareholders, or at least the ones who have retained plaintiffs’ attorneys, see things differently. Whether or not Bear’s shareholders have a legal basis on which to protest under Delaware law is the subject of an interesting post by BYU law professor Gordon Smith on the Conglomerate blog (here). In the post, Smith refers to a prior Delaware case in which minority shareholders complained that the majority shareholder should have pursued bankruptcy rather than foreclosure (effectively, sale, as here). Smith concludes that because “there is no hint of self-dealing” in this instance, the board’s actions will be evaluated under the business judgment rule. Smith states that stockholders may be upset, “but Delaware corporate law will not come to the rescue.”

A number of other legal scholars added comments to Smith’s original post, and I recommend reading all of the comments, which are particularly interesting and thoughtful.

The Bear shareholders’ initiative to realize what they contend is (or was) Bear’s actual value may be frustrated by a quirk of Delaware law. As noted on the DealBook blog (here), because J.P. Morgan is offering stock, “there are no appraisal rights under Section 262 of the Delaware General Corporate Law Code.” If it had been a cash deal, shareholders could have gone to Delaware court for a determination of the fair value of their stock. It is in a way too bad that they cannot, because that would have made for an interesting leagl proceeding – arguably right up there with defining the value of a “burned and hairy hand.” (Readers who do not recognize this allusion should refer to the video clip below.)

As the DealBook blog details, the merger agreement (which can be found here) has a number of other interesting features, including the fact that the deal has no material adverse change clause, so J.P. Morgan has no “out.” On the other hand, Bear Stearns apparently retains what is in effect a “put,” providing Bear the right, even if Bear’s shareholder vote down the transaction, to require J.P. Morgan to reenter negotiations. (This provision may suggest one of the reasons why Bear’s shares are trading so far above the merger price – for further thoughts about which refer here..)

Readers of this blog will also be interested to note that in Section 6.6 of the merger agreement, Bear Stearns’ directors and officers are entitled to six years of tail D & O coverage. (All of those insurance markets clamoring to provide the tail coverage should form an orderly line, please.). In addition, Bear’s directors and officers are given full indemnification from J.P. Morgan. I suspect these provisions, and especially the J.P. Morgan indemnity, were particularly attractive to the Bear Stearns senior officials involved in the negotiations. While one might suppose that the very attractiveness of the indemnity put the Bear Stearns officials in a potentially conflicted position (as the terms represented a form of consideration valuable to the officials but not to Bear’s shareholders), in the end the J.P. Morgan indemnity might prove quite valuable to Bear’s shareholders in a roundabout sort of way, if you follow my drift….

In any event, it may come as little surprise that the SEC is reportedly investigating trading ahead of Bear’s collapse last Friday. According to a March 18, 2008 Bloomberg.com article (here), “U.S. regulators are investigating whether traders illegally sought to force Bear Stearns Cos. shares into a tailspin last week by spreading false information about the firm's finances.”

For its part, the SEC released today “Answers to Frequently Asked Questions Concerning The Bear Stearns Companies, Inc.” (here), which, among other things explains the role of the SEC staff in the Bear Stearns/J.P. Morgan transaction.

More About Credit Default Swaps: In an earlier post (here), I wrote about the rising litigation threat from credit default swap transactions, particularly due to the growing counterparty risk. A March 17, 2008 Time.com article entitled “Credit Default Swaps: The Next Crisis?” (here) takes a closer look at CDSs and concludes that the instruments “could soon become the eye of the credit hurricane.”

Among other things, the article notes that the market for these instruments exploded to $45 trillion in mid-2007 – by contrast to the mortgage market, which is “only” $7.1 trillion. The article details the conditions that have rattled the marketplace, and concludes that the “potential repercussions are far-reaching.”

Those prone to concerns that we could be facing a period of significant economic adversity may be reassured that we have many safeguards in place that did not exist, for example, in 1929 and 1930. But, as the article concludes, none of these safeguards “are directly targeted at CDS.”

More About Foreign Litigants: In earlier posts (refer here), I have discussed the problem of foreign litigations who purchased their shares in foreign companies on foreign exchanges (the so-called “f-cubed” litigants) who are suing the foreign companies in U.S court under U.S. securities laws. In a recent post on the Securities Litigation Watch blog (here), Adam Savett takes a look at the recent decision in the Converium case, in which the court denied class certification to all putative class members who were neither U.S. citizens nor purchased shares on U.S. exchanges. As I noted on post discussing the recent U.S lawsuits filed against SocGen, it appears that the plaintiffs’ counsel in that case conformed their putative class to conform to the limitations adopted by the Converium court.

Break in the Action: The D & O Diary will be on a reduced publication schedule for the next few days. We will resume our normal publication schedule some time after March 25.

A Burned and Hairy Hand:: The reference above to “the value of a burned and hairy hand,” is an allusion to the standard Contracts law case of Hawkins v. McGee, a case made famous (or perhaps infamous) in the classic scene from the movie The Paper Chase. I suspect that few law students have actually endured anything like this famous scene (I actually enjoyed law school), but for some reason the scene has become an archetypical representation of the legal classroom. Here is Professor Kingsfield in all of his sadistic glory:

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We knew it was coming but it sure got here fast. On March 17, 2008, plaintiffs’ counsel initiated a securities class action lawsuit in the United States District Court for the Southern District of New York against Bear Stearns and certain of its directors and officers. A copy of the plaintiffs’ lawyers’ press release can be found here, and the complaint can be found here.

According to the press release, the complaint alleges that during the class period between December 14, 2006 and March 14, 2008, defendants issued false and misleading statements, as a result of which “Bear Stearns stock traded at artificially inflated prices … reaching a high of $159.36 per share in April 2007.” The press release further states that:

In late June 2007, news about Bear Stearns’ risky hedge funds began to enter the market and its stock price began to fall. On March 10, 2008, information leaked into the market about Bear Stearns’ liquidity problems, causing the stock to drop to as low as $60.26 per share before closing at $62.30 per share. On March 13, 2008, news that Bear Stearns was forced to seek emergency financing from the Federal Reserve and J.P. Morgan Chase hit the market and Bear Stearns stock fell to $30 per share. Then, on Sunday, March 16, 2008, it was announced that J.P. Morgan Chase was purchasing Bear Stearns for $2 per share. By midday on Monday, March 17, 2008, Bear Stearns stock had collapsed another 85% to $4.30 per share on volume of 75 million shares.

The press release states that the defendants’ statements during the class period “due to defendants’ failure to inform the market of the problems in the Company’s hedge funds due to the deteriorating subprime mortgage market, which would cause Bear Stearns to have to rescue the funds, cause the Company and its officers possible criminal liability and hurt the Company’s reputation.”

The principals at JP Morgan clearly anticipated this development. According to a March 17, 2008 Law.com article (here), JP Morgan is “setting aside $6 billion to cover potential litigation” as well as other transaction and severance costs arising out of JP Morgan’s acquisition of Bear Stearns JP Morgan’s own March 16 press release (here) announcing the transaction does not mention any reserve or set aside for transaction expenses, but the March 18, 2008 Wall Street Journal (here) also says that “J.P. Morgan plans to set aside about $6 billion in reserves to cover the potential exposure and other costs.”

(Perhaps it is an idle thought but one does wonder why the $6 billion was not applied directly to the acquisition price. …)

Yet another possibility that may yet arise is that individual Bear Stearns investors might choose to pursue their own litigation separately. According to the March 17, 2008 Wall Street Journal (here), there are individual investors whose losses from the Bear Stearns collapse approach $1 billion. According to the March 18, 2008 Wall Street Journal (here), “billionaire investor Joseph Lewis, one of Bear Stearns's biggest shareholders, with a 9.4% stake, rejected [J.P. Morgan’s] offer, saying it doesn't represent the true value of Bear Stearns. Mr. Lewis, though a spokesman, said the offer ‘is derisory, and I do not believe that shareholders will approve it.’” Certainly individual losses of that magnitude, if nothing else, raise the possibility of their proceeding on their own rather than as part of a larger shareholder class.

Update: According to news reports (here), an action has also been filed against Bear Stearns and its executives on behalf of Bear Stearns employees alleging that they "breached their fiduciary duties to plan participants by allowing their retirement savings to be invested in the company's stock despite knowing such an investment was imprudent."  The complaint alleges that the investment bank failed to disclose material adverse facts regarding its financial well-being, the potential consequences of its "substantial entrenchment in the subprime mortgage market," that the firm's stock price was artificially inflated and heavy investment of retirement savings in company stock would inevitably result in significant losses to the plan and its participants.

Securities Suit Against Deutsche Bank for Auction Rate Securities: On March 17, 2008, a different plaintiffs’ firm launched a securities lawsuit in the United States District Court for the Southern District of New York against Deutsche Bank and its wholly owned broker–dealer subsidiary, on behalf of a class of persons who purchased auction rate securities from Deutsche Bank and the broker dealer between March 17, 2003 and February 13, 2008, inclusive (the “Class Period”), and who continued to hold such securities as of February 13, 2008. A copy of the plaintiffs’ counsels’ press release can be found here and a copy of the complaint can be found here. 

According to the press release, the plaintiffs allege that the defendants violated the securities laws “by deceiving investors about the investment characteristics of auction rate securities and the auction market in which these securities traded.” The press release states that the defendants failed to disclose that:

(1) the auction rate securities were not cash alternatives, like money market funds, but were instead, complex, long-term financial instruments with 30 year maturity dates, or longer; (2) the auction rate securities were only liquid at the time of sale because Deutsche Bank and other broker-dealers were artificially supporting and manipulating the auction rate market to maintain the appearance of liquidity and stability; (3) Deutsche Bank and other broker-dealers routinely intervened in auctions for their own benefit, to set rates and prevent all-hold auctions and failed auctions; and (4) Deutsche Bank continued to market auction rate securities as liquid investments after it had determined that it and other broker dealers were likely to withdraw their support for the periodic auctions and that a “freeze” of the market for auction rate securities would result.

The auction rate securities purchasers’ lawsuit against Deutsche Bank is not the usual class action securities lawsuits brought against a publicly trade company by its own shareholders. The Deutsche Bank auction rate securities lawsuit is, however, subprime-related and it is a class action that alleges violations of the federal securities laws. For those reasons, I have added it to my running tally of subprime-related securities lawsuits, which can be found here. On a going forward basis, I will try to keep the parallel tallies too, taking into account the different kinds of litigation within the larger running tally.

With the addition of the Bear Stearns and Deutsche Bank securities lawsuits, the current tally of subprime-related securities lawsuits now stands at 51, twelve of which have been filed so far in 2008. Of these 51, two are securities lawsuits filed by mortgage–backed securities investors against the asset securitizers, and one (as noted above) was filed by purchasers of auction rate securities. The remaining 48 are more traditional securities class action lawsuits by public company shareholders.

Bear Ironies and Morgan Echoes: Bear Stearns shareholders can be forgiven if they fail to appreciate it, but there is a certain irony that Bear Stearns was the bailout recipient last Friday. This weekend’s whirlwind meetings involving the Fed and the lions of Wall Street present an uncanny echo of the closed door meetings at the New York Fed on September 23 1998, when government officials and Wall Street bankers were struggling to avert the collapse of Long Term Capital Management that all feared might trigger global financial panic. As colorfully told in the prologue of Roger Lowenstein’s excellent book about LTCM, When Genius Failed (here), the government’s rescue efforts nearly aborted because one Wall Street bank refused to cooperate in the government’s rescue plan - none other than Bear Stearns, whose then CEO and current Chairman James Cayne refused to play along.

This past weekend’s events also harken back to an even earlier episode, one in which JP Morgan Chase’s founder and primary namesake played the central role. As described in Robert Bruner and Sean Carr’s readable recent book, The Panic of 1907 (here), a capital crisis that originated from a liquidity drain following the 1906 San Francisco earthquake culminated in October 1907 in runs on a series of New York banks. J.P. Morgan himself, in effect functioning as the central banker in the absence of any more formal institution, caused his firm to intervene to provide liquidity to the Trust Company of America, declaring, to his colleagues “This is the place to stop the trouble, then.”

A century later, his firm is once again playing a central role in an effort to avert a financial crisis, and while some may argue that an important difference is that in 1907 Morgan didn’t acquire any of the rescued banks, it is a fact that one of the steps Morgan took in 1907 was a U. S. Steel-led buyout of Tennessee Coal, Iron & Railroad Company, a move claimed at the time was designed to avoid a collapse that could have undermined the stock market. The TCI & R rescue efforts, for which he and his firm were later criticized and subjected to a congressional investigation, ultimately proved to be good both for the Morgan firm as well as for the financial markets.

UPDATE: CFO.com has an excellent March 18, 2008 article entitled "J.P. Morgan Returns to Its Rescue Roots" (here) going into much greater detail about J.P. Morgan's storied past.

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One of the standard provisions of the typical D & O insurance policy is a clause requiring the insurer’s prior consent to settlement. This clause can be the source of tension between carriers and policyholders, and policyholders and their counsel sometimes view the clause as little more than an impediment. However, a March 13, 2008 opinion (here), the New York Court of Appeals makes it clear that policyholders who disregard the settlement consent requirements do so at peril to coverage under the D & O policy.

The insurance coverage dispute in the case arose out of the securities analyst/conflict of interest investigation that unfolded earlier in this decade. Among the investment banks targeted in investigation was Bear Stearns. On December 20, 2002, Bear Stearns entered a settlement in principle with the regulators in which it agreed to pay a total of $80 million, with $25 million allocated as a penalty, $25 million in disgorgements, $25 million for independent research, and $5 million for investor education.

On April 21, 2003, Bear Stearns executed a consent agreement in which it acceded to the entry of final judgment in the SEC’s pending enforcement proceeding. Bear Stearns also agreed to payment of the $80 million and explicitly agreed not to seek insurance coverage for the $25 million penalty.

Three days after executing the settlement agreement, Bear Stearns sent letters to its D & O carriers requesting the carriers’ consent to the settlement. Bear Stearns sought coverage for $45 million of the settlement (which represented the settlement amount, excluding the penalty, in excess of the policy’s $10 million self-insured retention). The insurers disclaimed coverage and initiated a declaratory judgment action.

In October 2003, the federal court presiding over the regulatory enforcement action entered judgment on the terms to which Bearn Stearns previously had agreed.

The insurers disputed coverage on a number of grounds, but because the Court of Appeals opinion addresses only the consent to settlement issue, that is the sole issue I discuss in this post.

Bear Stearns’ primary D & O insurance policy had a provision specifying that:

The Insured agrees not to settle any Claim, incur any Defense Costs or otherwise assume any contractual obligation or admit any liability with respect to any Claim in excessof a settlement authority threshold of $5,000,000 without the Insurer's consent, which shall not be unreasonably withheld . . . The insurer shall not be liable for any settlement, Defense Costs, assumed obligation or admission to which it has not consented.

The New York Supreme Court (trial court) found that triable issues of fact existed whether Bear Stearns breached the consent to settlement clause. The Appellate Division modified the lower court’s opinion in certain other respects, but affirmed the Supreme Court on the consent to settlement issue. The Appellate Division then certified the case to the New York Court of Appeals.

The Court of Appeals, in an opinion written by Justice Victoria A. Graffeo, held that “Bear Stearns breached [the consent] provision when it executed the April 2003 consent agreement before notifying the insurers or obtaining their approval.” The Court of Appeals said that it was “unpersuaded by the contention that a triable issue of fact exists because the federal court did not approve the settlement until it entered a final judgment in October 2003.”

Judge Graffeo specifically noted that

As a sophisticated business entity, Bear Stearns expressly agreed that the insurers would "not be liable" for any settlement in excess of $5 million entered into without their consent. Aware of this contingency in the policies, Bear Stearns nevertheless elected to finalize all outstanding settlement issues and executed a consent agreement before informing its carriers of the terms of the settlement. Bear Stearns therefore may not recover the settlement proceeds from the insurers.

The Court of Appeals reversed the Appellate Court and granted the carrier’s motion for summary judgment. Because of its ruling on the consent provision, the Court of Appeals did not reach the other issues on which the carriers disclaimed coverage.

There may well have been additional grounds that could also have precluded coverage here, but it is still an arresting development – and a cautionary tale – that the Court of Appeals precluded coverage altogether based solely on the failure to obtain advance consent to settlement. Significantly, the Court of Appeals enforced the consent provision without superimposing any requirement for the insurer to show that it was prejudiced in any way by the failure to obtain consent. The Court of Appeals focused strictly on the policy’s language.

Companies and their counsel sometimes regard the consent settlement requirement as if the language were merely precatory, or perhaps even as optional if they believe settlement circumstances suggest the need to press ahead without bringing the carrier into the loop. It is not an unprecedented development for a carrier to learn of a settlement only after the fact. But the Bear Stearns opinion provides unambiguous notice to companies and counsel that they disregard the policy’s advance consent requirement at peril of precluding coverage.

The larger lesson here is that the carrier should be kept in the loop. Indeed, the better practice, the one likeliest to produce the best claim outcomes, is for companies and their counsel to treat the carrier as a collaborative partner in the claims process. While there are unfortunate situations where the carrier does not respond appropriately, even in those situations the policyholder will be better off (for example, before a court if coverage litigation ensures) if the policyholder has consistently maintained professional and timely communications with the carrier.

And whatever else may be said, it is clear, at least in New York, that the D & O policy provision requiring the carrier’s advance consent to settlement means what it says, and policyholders should take care to comply with its requirements.

Special thanks to a loyal reader for providing a copy of the New York Court of Appeals opinion.

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The wave of subprime-related securities class action litigation has continued to spread, as plaintiffs’ lawyers have filed new securities lawsuits against two different companies.

First, according to their March 12, 2008 press release (here), plaintiffs’ lawyers have filed a securities class action lawsuit in the United States District Court for the Northern District of California (complaint here), against residential mortgage insurer The PMI Group. The lawsuit follows the company’s March 3, 2008 announcement (here), in connection with its fourth quarter earnings release, that it would delay filing its Form 10-K for year-end 2007 due to delays in obtaining 2007 financial results from recently downgraded bond insurer FGIC , in which PMI Group has a 40% ownership interest.

According to the plaintiffs’ attorneys’ press release, the complaint alleges that the defendants failed to disclose to investors that:

(a) the Company’s investment in FGIC was materially impaired as FGIC’s bond insurance arm, Financial Guaranty, had significant exposure to defaults on bonds it insured due to the plunge in value of mortgage debt; (b) the Company was materially overstating its financial results by failing to properly value its investment in FGIC and by failing to write down that investment in a timely fashion in violation of Generally Accepted Accounting Principles (“GAAP”); (c) the Company was not adequately accounting for its loss reserves in violation of GAAP, causing its financial results to be materially misstated; (d) the Company failed to engage in proper underwriting practices for its book of business related to insurance written in 2005 through most of 2007; (e) the Company had far greater exposure to anticipated losses and defaults related to its book of business related to insurance written in 2005 through most of 2007 than it had previously disclosed; (f) given the deterioration and the increased volatility in the subprime market, the Company would be forced to tighten its standards and stop writing insurance policies to certain categories of borrowers which would have a direct material negative impact on its book of business going forward; and (g) given the increased volatility in the subprime market, the Company had no reasonable basis to make projections about its incurred losses or about its new insurance written.

The second of the new securities class action lawsuits involves Société Générale. As I noted in a prior post (here), SocGen has previously been sued in a French court on behalf of 130 individual investors and certain companies. But according to their March 12, 2008 press release (here), plaintiffs’ lawyers in the U.S. have now filed an action in the United States District Court for the Southern District of New York under. U.S. securities laws against SocGen and its Chairman and CEO. The complaint can be found here.

According the plaintiffs’ press release, the plaintiffs allege that the defendants

·        made false and misleading statements and concealed material adverse information regarding SocGen's exposure to subprime loans, collateralized debt obligations ("CDOs") and SocGen's internal controls

·        touted SocGen's conservative management, risk control, and expertise in risk analysis and structured finance, including CDO vehicles

·        misled investors by announcing that it had "very little exposure" to the subprime segment

·        ignored or failed to act upon numerous alerts which should have led to the uncovering of Jerome Kerviel's massive irregular trading activity from 2005 through early 2008

The press release states that the case “also involves alleged insider trading by SocGen’s top U.S. executive and board member, Robert A. Day (I discussed Day’s trading in the company’s shares at length in my prior post, here).

One of the interesting features of the SocGen securities lawsuit is the class of investors on whose behalf the lawsuit purports to be brought. The complaint describes the class as consisting of all purchasers of the company’s American Depositary Receipts (which trade on the OTC market), and “all U.S. citizens who purchased SocGen securities on any exchange,” between August 1, 2005 and January 23, 2008.

By narrowing the class to include only investors who bought ADRs on the OTC and U.S. investors in general regardless of where they bought their SocGen securities, the plaintiffs clearly are seeking to avoid the jurisdictional and class certification issues that can arise in U.S. class actions against overseas companies involving overseas investors who bought their shares overseas.

As I have discussed in prior posts (most recently here), courts have wrestled with the so-called “f-cubed” litigants (foreign investors who bought their shares in foreign companies on foreign exchanges) and those issues have created complicated jurisdictional and class certification issues (as discussed here and here). The SocGen plaintiffs’ complaint seems calculated to try to avoid these issues, and possibly even to try to avoid conflicts with the prior French lawsuit.

The exclusion of the “f-cubed” litigants from the purported class does raise the question of where these investors are left, particularly if they would like to pursue remedies under U.S. securities laws. Clearly, they retain the option of bringing individual or group actions – what might be called the “left out” actions, by contrast to the more common “opt out” actions. As noted on the Securities Litigation Watch blog, here, that is what has happened with the overseas investors who were precluded from the class in the Vivendi class action; they have filed extensive individual actions.

While the subprime litigation wave has involved lawsuits against a wide variety of kinds of companies, the lawsuit against The PMI Group is the first case of which I am aware involving a residential mortgage insurer – although the lawsuit arises in part due to The PMI Group’s investment in troubled bond insurer FGIC, and there have been numerous prior subprime-related lawsuits against bond insurers.

In any event, as reflected in my running tally of subprime related securities lawsuits (which can be accessed here), the addition of these two lawsuits brings the total of subprime-related securities lawsuits to 49, ten of which have been filed in 2008.

Federal Securities Class Action to Proceed State Court: As discussed at length in a prior post (here) concerning two securities class actions that have been launched against mortgage-backed asset securitizers, the plaintiffs’ lawyers filing these actions chose to file the lawsuits in state court, in reliance on the concurrent state court jurisdiction under the ’33 Act. As I also noted in the prior post, the defendants in Luther v Countrywide Home Loans Servicing removed the case to federal court.

In a February 28, 2009 order (here), Judge Mariana R. Pfaelzer held that the lawsuit had not been properly removed to federal court, and granted the plaintiffs’ motion to remand the case back to state court.

The defendants had based arguments in support of removal on the Class Action Fairness Act of 2005, which provides that a state court class action is removable to federal court where the amount in controversy is greater than $5 million and any class member is a citizen of a state different than the defendant. The parties agreed that the conditions were met in this case. In seeking remand, the plaintiffs relied on the express provision of Section 22(a) of the Securities Act of 1933 that prohibits the removal from state court to federal court of an action under the ’33 Act.

In reliance on principals of statutory construction, Judge Pfaelzer concluded that the specific principals in the ’33 Act must control. She said that “the Court continues to harbor significant doubt that CAFA provides removal jurisdiction in the face of the 1933 Act’s absolute prohibition on removal. Accordingly, the Court must remand the case to state court.”

Given the language in Section 22(a), Judge Pfaelzer’s decision seems correct. However, the outcome seems undesirable. There is no way to know for sure why the plaintiffs’ lawyers seek to proceed in state court. As I discussed in my prior post, the likeliest explanation is that the plaintiffs intend to take the position that the provisions and requirements of the PSLRA do not apply to a ’33 Act case in state court. It certainly does seem like putting federal securities class actions in state court opens up a can of worms. It will be interesting to see (but difficult to track) what happens with these class action lawsuits.

Speakers’ Corner: On Friday, March 14, 2008, I will be participating in a webcast sponsored by RiskMetrics Group entitled “Securities Litigation – What European Investors Need to Know.” The panel will be moderated by Adam Savett, of the Risk Metrics Group and author of the Securities Litigation Watch blog. Also on the panel will be Eric Belfi of Labaton Sucharow and an additional guest speaker. Information regarding the webcast can be found here.

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You will never read a headline that says “Financial Institution Fires Rogue Trader Who Racked Up Massive Gains.” Therein lies the fundamental tension in financial institution risk management. It is not a merely cynical view that financial institutions tacitly tolerate control lapses as long as gains result – indeed, some of the leading commentators place the blame for the current credit crisis squarely under the heading of failed risk management, caused by practices that flourished during years of investment gains.

For example, in a March 11, 2008, Financial Times article (here), one commentator attributes the current crisis to “the biggest failure of ratings and risk management ever.” Similarly, the Seeking Alpha blog, commenting (here) on the contributions that hedge funds have made “to the evaporation of the essential capital equity value of the large financial institutions,” notes that in the lead-up to the current crisis, hedge funds created outsized gains “without managing the risks” and that banks themselves created their own in-house hedge funds to “avoid risk management, technology burden, and regulatory charges.” Many of the recent massive write-downs relate to “devalued subprime assets which had not been monitored properly and which turned out to be cheap due to low risk management standards or lack of risk management at all.”

The most fundamental control weakness may be the system of compensation that rewards risk taking. As noted in a January 28, 2008 Washington Post op-ed column (here), “bankers bet with their bank’s capital, not their own. If the bet goes right, they get a huge bonus; if it misfires, that’s the shareholders’ problem.” CFO.com noted in a March 11, 2008 article (here) that “sidelining caution in favor potential profit is not particularly difficult in a culture built on producer worship.” The CFO.com article goes on to describe practices at various financial institutions that defeated the institutions’ highly touted risk controls.

Within this environment, it is hardly surprising that individuals might feel emboldened to take extraordinary risks, and occasionally produce inconveniently large losses. The infamous case of Soc Gen trader Jérôme Kerviel (discussed previously here) is the best known recent example. An even more recent albeit less spectacular example involved Evan Brent Dooley, who lost $141.5 million for MF Global Ltd. in one day’s wrong way bets on the direction of the price of wheat.

In the February 29, 2008 Wall Street Journal article (here) about the incident, Dooley “blamed the trading loss on the computer he was using. The system ‘failed on a lot of things,’ he said, including problems in ‘settling limits.’” Indeed, the same article quotes MF Global’s CEO as “acknowledging that existing internal controls could have stopped Mr. Dooley’s trades from being processed – but were turned off in a few cases to allow for speedier transactions by brokers at the firm who traded for themselves or took customer order by phone.”

Large losses often produce lawsuits, and so it comes as no surprise that plaintiffs’ lawyers have launched a securities lawsuit against MF Global, its corporate parent, and certain of its directors and officers. A copy of the plaintiffs’ lawyers’ March 10, 2008 press release can be found here. The plaintiffs’ complaint (here) focuses on the statements in the company’s Registration Statement and Prospectus, prepared in connection with the company’s July 19, 2007 IPO, particularly the sections headed “Disciplined Approach to Risk.” The complaint alleges that the statements in the Registration Statement and Prospectus about risk controls were false and misleading.

UPDATE: On March 12, 2008, plaintiffs' attorneys' announced (here) that they had filed a securities class action lawsuit against Societe General and certain of its directors and officers, on behalf of Soc Gen shareholders (both those who purchased their shares in the U.S. as well as those who purchased their shares overseas), alleging among other things that defendants had made mispreresentations and omissions, including allegations that defendants had misleadingly  "touted SocGen's conservative management, risk control, and expertise in risk analysis and structured finance." The plaintiffs specifically refer to the company's "lack of sufficient controls " that permitted Kerviel's unauthorized trading.

The complaint alleges that the defendants not only misrepresented the company’s risk controls, but “failed to disclose that in an effort to speed trades and to be ‘efficient’, MF had suspended or eliminated its own internal risk management technical and human controls and supervision, and failed to disclose that it eliminated credit and risk analysis and buying power limits and controls from its systems, effectively allowing any MF employee to place order without regard to the account’s satisfaction or margin requirements, collateral or ability to pay.”

Companies with problems arising from the activities of a single trader are not the only ones facing securities litigation allegations based on alleged breakdowns in controls. As the CFO.com article linked to above catalogues, many financial institutions’ recent massive write-downs may be tied to exposures arising from the breakdown or circumvention of controls. Allegations based on these control failures are a common feature of many of the subprime-related securities class action lawsuits.

These allegations have arisen in lawsuits against companies as diverse as Ambac Financial Group (which plaintiffs allege, among other things, lacked requisite internal controls to ensure that underwriting guidelines were followed); Accredited Home Lenders Holding Company (against which it is alleged, among other things, that management actively encourage circumvention of internal guidelines); and Countrywide Financial Corporation.

To be sure, many if not most of the subprime-related securities lawsuits also contain allegations of accounting and financial fraud, but underlying the financial disclosure allegations are claims based on breakdowns in controls. Shareholders who believed that prior gains were the product of a controlled risk environment may well object when they learn of losses arising from the circumvention of claimed risk controls.

The circumvention of controls may ultimately proved to be the unifying theme in subprime litigation, arising not just in claims involving public companies and their shareholders, but also in claims involving securitizers, mortgage originators, bond insurers, rating agencies, hedge funds, and a multitude of other marketplace participants. But as the MF Global case proves, the damages that can arise from control breakdowns are hardly limited to the subprime context alone. The MF Global case also shows how quickly damages can accrue – whether the breakdown involves a single trader or more systemic activity.

Evading Constraints: An American Heritage?: Those contemplating the origins of the conduct described above may want to consider an historical explanation.  In Throes of Democracy (here), a new history of America during the years 1829 to 1877, by Walter A. McDougall, the Pulitzer-Prize winning historian from the University of Pennsylvania, Mr. McDougall writes that “Americans tolerate and even encourage corruption, so long as it appears creative in the sense of evading artificial constraints, hastening development and expanding opportunity.” He adds that “since the United States has been the most dynamic nation on earth…it is only to be expected that every age of American history is awash in old and new forms of corruption at every level of business and government.”

McDougal’s words may provide an explanation of sorts, but not a defense.

Now This: Others may be spellbound by the news involving Eliot Spitzer, but personally I am more consumed with the recent information regarding Dawn Wells. Wells, you may recall, played the part of Mary Ann in the TV show “Gilligan’s Island.” According to news reports (here – check out the picture), Wells is “serving six month’s unsupervised probation after allegedly being caught with marijuana in her car.”

Those of you who think this news provides additional information relevant to the perennial “Mary Ann or Ginger” debate should also be aware that at the time of her arrest, Wells was on her way home from a party for her 69^th birthday. 

The official Dawn Wells website may be found here.

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Last week, I added a post (here) discussing the March 2, 2008 paper entitled “How the Merits Matter: D&O Insurance and Securities Settlements” (here) by Connecticut Law Professor Tom Baker and Fordham Law Professor Sean Griffith. In response to my invitation, Professor Griffith prepared a reply to my comments, which is as follows:

Before beginning, I’d like to thank Kevin for his careful and thoughtful reading of our paper and for his many kind words and comments. Kevin’s comments have improved all of our papers in this area, and they will surely improve this one. I do, however, have a few remarks to make in response to three comments Kevin made towards the end of his write-up. I’ll address: (1) the impact of disclosure on insurance, (2) the possibility that additional disclosure will increase the incidence of lawsuits against corporate insureds, and (3) the ways in which additional disclosure will make the world a better place.

1.         In his review of our paper, Kevin writes that Baker and I “do not seem to have reviewed the idea of compelled disclosure with anyone in the insurance industry.” Not so. We have indeed run the idea of additional disclosure by folks in the insurance industry. In fact, I well remember one of the first conversations I had on this subject. I was working on an earlier paper (here) that proposed mandatory disclosure of D&O insurance details when I received a voicemail message from one of the broker’s I’d been talking to. He excoriated me on the message, offering a stream of expletives that would have made George Carlin blush. He’d read my draft (or, at least the title) and, I gathered, was rather displeased at the prospect of public disclosure of D&O insurance information. This, I believe, is the general reaction, of folks in the insurance industry to the proposal, although their reactions are typically more calmly expressed.

I am neither surprised nor particularly bothered by this reaction. First, it is hardly surprising that more transparency within a market would make an intermediary’s life more difficult. Intermediaries will worry that their profit margins will be eroded away if their customers can see the price paid by comparable companies. Buyers will insist that brokers get them an equally good deal as a competitor or justify why they can’t. But why is that a bad thing? What’s bad for the broker looks good for the consumer. Moreover, brokers often say that they do more than just price a coverage package. If that’s really true, then there will be a place in the market for them post-disclosure. They’ll still be providing a service that’s not available elsewhere. But if it’s not true, then the broker’s role starts to look like waste, and why wouldn’t we then want to disintermediate the market and, perhaps, let risk managers build their own coverage towers?

Second, moving to the insurer’s perspective, I’m not sure that disclosure would be bad. It might be a problem if the insurer is offering discounts for some clients but not others on the basis of factors that are not risk-related, perhaps because a buyer’s price on their D&O program is tied to the fact that they’re buying a (more expensive) general liability policy from the same insurer. (Some suggested to us that tying arrangements of this sort occur in the D&O market.) If we had a disclosure rule, we can expect buyers to demand the same D&O premiums as all similarly situated companies, which would make it harder to engage in tying arrangements. The only valid basis for an insurer to offer different prices would be differences in risk. Underwriters would be in the position of having to articulate why Company A is a better risk than Company B. This would obviously be good for the buyer, but I suspect in the long term it would be good for the seller too. It would focus underwriters on what matters—risk-assessment—and inhibit their ability to make sales that discriminate on some other basis (like tying). From the insurer’s perspective, that’s probably a good thing because insurance that is sold with better risk assessment up front is less likely to lead to losses down the road than insurance that is sold on some other basis.

Now, I don’t know how any of that would ultimately play out. I’m just skeptical of the gloom-and-doom-for-the-industry story. I suspect that those within the industry who are doing what the industry is supposed to do—assessing risk and tailoring coverage—will survive. Also, to be honest, my concern is not so much with the insurance industry as it is with the corporations buying the insurance. And, frankly, when anyone other than the consumer complains about market reform, that’s usually a sign that market reform is a good idea. Producers and (especially) intermediaries have shown themselves across industries and throughout history to be opposed to reforms that enhance competition. I suspect that this market reform would benefit the consumer in a variety of ways, not just in the bottom line price paid by insureds, but more about that in my response to #3, below.

2.         Second point. Disclosure would be bad for corporate insureds, Kevin suggests, because the additional disclosure will make them “lawsuit targets.” In other words, the incidence of lawsuits will go up if plaintiffs lawyers know more about corporate insureds’ coverage packages.

We here this objection fairly often, but I think it’s easily disproven. Here’s how: First, everybody knows that virtually every public company in the US carries D&O insurance. Second, everybody knows that average settlements are much less than average coverage limits (in spite of the rare high profile above-limits settlement, just look at Tillinghast, Cornerstone, or NERA—average limits far exceed average settlements). Those two things being true, plaintiffs’ lawyers needn’t fret about insurance when they file claims. They can reasonably assume that coverage will be there. Moreover, insurance coverage is one of the first disclosures that the parties must make once they’re in litigation. If, in the rather unlikely event that a corporate defendant is not well covered, the plaintiffs’ lawyer can drop the claim before their sunk costs have gotten too large. Bottom line: currently, plaintiffs’ law firms reasonably assume that most corporate defendants will have sufficient D&O coverage to fund claims, and they file any time they can put together the basic elements of liability. If Tom and I got the disclosure rule we want, true, plaintiffs law firms would know the coverage profile of the corporate defendant, and they’d file any time they could put together the basic elements of liability. In other words, the additional disclosure would not be a boon to the plaintiffs’ bar, and the incidence of suit would be about the same.

3.         Kevin also remarks that although we, as academic researchers, would benefit from additional disclosure (true!), we haven’t really specified how additional disclosure would deter securities violations. 

            First, regarding Tom’s and my self-interest. Yes, if we got the disclosure rule we want, we’d crunch the data in more papers. But, let’s face it, we’re not going to get famous doing this. And Tom and I both have tenure, so we don’t really have career incentives that distort our devotion, putting it somewhat grandly, to truth and justice. We want the additional disclosure because we think it would be good for the world and we write the papers because we think the world ought to know what’s good for it.

            Okay, so why would additional disclosure be good for the world? Or, more concretely, how would it deter securities law violations? 

As we said in the papers about underwriting, disclosure of D&O pricing, limits, and coverage structure would enable financial analysts to use this information as a proxy for downside risk and, on the basis of that proxy, to change their valuation of corporate insureds. With enough people in the market using this information (which one might assume on the basis of the efficient capital markets hypothesis), insurers’ collective assessment of a prospective insured’s risk should have a direct impact on the prospective insured’s share price. And, last step, because managers care about share price, anything that has an effect on it (e.g., wobbly corporate governance structures) is something they’re likely to address. So disclosure of D&O pricing, limits, and coverage structure would improve corporate governance. 

What’s different in this paper is that we think the required disclosures should be broadened. Not only should corporations be made to disclose their limits, pricing, and coverage structure on a regular basis (with each renewal), but also any time a corporation settles a securities claim, they should be required to disclose how the settlement is funded. E.g., What amount comes from insurers? What amount comes from the company? Putting this information together with information about the corporate insured’s coverage package, financial analysts and capital market participants ought to be able, as we say in the paper, to assess “which corporations are likely to have engaged in bad acts and which have not.” In other words, which corporations got stuck settling a nuisance claim and which allowed some form of fraud to occur.

How would analysts be able to draw this conclusion? Consider a settlement well within total limits to which a corporate insured nevertheless contributes a substantial amount. The insured’s contribution in this case might indicate that the insurers were able to cash in their coverage defense for savings off of their full exposure. Granted it might indicate other things as well, but if I were a financial analyst, I’d want to know why did the company pay when it had more limits available. And if the insurers had a strong coverage defense, doesn’t that suggest that there was some merit to the plaintiffs’ claim (i.e., that it was not just a nuisance suit)? And if there was some merit to the plaintiff’s underlying claim, have the problems that led to the claim been fixed or management just back to business as usual, denying all the while that the plaintiffs’ claim had any basis at all. Either way, this information would make me reconsider my valuation of the insured corporation’s shares. Again, with enough people in the market acting on this information, the corporation’s share price ought to be effected. And, because managers care about share price, this creates an incentive for managers to actually avoid the kind of things that lead to fraud claims. In other words, disclosure, in the context of both underwriting and claims, gives the market what it needs to provide deterrence. If the information disclosed is useful to capital market participants (we obviously believe that it would be), they will use it in ways that create natural incentives for managers to mend their ways. In my view, that’s the big payoff of all of our research in this area.

Thanks again to Kevin for his comments and for the lively debate as this project has evolved.

I would like to thank Professor Griffith for taking the time to write a detailed response to my prior post. I hope other readers will post their thoughts, comments and reactions to Professor Griffith’s observations by using the “Comment” feature in this blog’s right-hand column. I look forward to hearing readers’ reactions to Professor Griffith’s observations.

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There are a variety of different ways that the subprime-related litigation might be categorized. For example, the lawsuits might be grouped by type of defendant (as in my prior discussion of lawsuits against the mortgage-backed asset securitzers, here). The lawsuits might also be grouped by type of mortgage-backed asset involved (as in my discussion of lawsuits involving auction rate securities, here). Still another approach might be to look at lawsuits involving certain kinds of mortgages (as in my discussion of Option ARM mortgages, here).

An entirely different way to look at subprime-related litigation might be to follow the developments involving just a single mortgage related financial structure and to trace the litigation in which allegations relating to the structure have been raised. As shown below, just one financial structure has produced significant investor losses and left a spate of litigation in its wake.

The Mantoloking CDO: When the Mantoloking CDO 2006-1 was created in November 2006, it appeared as just one of many collateralized debt obligations (CDOs) listed in the December 4, 2006 Nomura Securities research report (here) describing recent structured finance pricings. As described in the report, the Mantoloking CDO was a $765 million CDO holding asset backed securities (ABS), on which the lead underwriter as Merrill Lynch.

Metro PCS: According to its subsequent court filing, on May 25, 2007, Metro PCS acquired $20 million in auction rate securities “consisting of Class A-2 Senior Priority Floating Notes from the Mantoloking CDO 2006-1, Ltd.” Metro PCS acquired the securities when Merrill Lynch, acting on as the company’s investment advisor, made the investment, as part of what eventually became approximately $134 million of CDO-related auction rate securities in which Merrill invested on the company’s behalf.

In the company’s October 18, 2007 Petition against Merrill Lynch filed in the Dallas County (TX) District Court (here), Metro PCS alleged that Merrill Lynch failed to advise of the company of the intended purchases prior to the acquisition of the Mantoloking securities. The company also alleges that the securities themselves were not authorized under the company’s investment guidelines. The company also alleged that Merrill Lynch had undisclosed conflicts of interest, in that it not only underwrote the initial CDO issuance, but continued to act as the sole dealer for the CDO. The company further alleges that Merrill Lynch itself had significant investments in the CDO and therefore had a vested interest in trying to maintain a market for the CDO’s securities, as a way to protect its investment.

In its February 27, 2008 financial release (here), Metro PCS disclosed that as a result of the latest round of write-downs, it was as of December 31, 2007 carrying the auction rate CDO securities investments for which it paid $134 million at a balance sheet valuation of only $36 million.

The Bear Stearns Hedge Funds: Investors in the Mantoloking CDO apparently also included the two now-bankrupt Bear Stearns hedge funds that are the center of so much controversy (and litigation). The October 22, 2007 Business Week cover article about the hedge fund’s collapse (here) reports that as the hedge funds’ condition and results deteriorated, the hedge funds’ managers “sought out increasingly esoteric bonds and other lightly traded securities that offered higher yields.” As a result, the hedge funds “were big buyers of so-called CDOs-squared – CDOs that invest in other CDOs.” The article reports specifically that “the funds at one time held $135 million of securities issued by the Mantoloking CDO, a CDO-squared.”

On December 19, 2007, when the hedge funds’ largest equity investor, Barclays Bank, sued Bear Stearns Asset Management and the two hedge funds’ individual managers (complaint here), Barclays alleged, among other things, that the hedge funds’ managers had caused the hedge funds “to become a dumping ground for especially risky assets, including numerous CDO-squared securities and other toxic assets.”

MIND C.T.I. Ltd.: The effects of the Mantoloking CDO spread far and wide, its reach including Israel-based communication services provider MIND C.T.I. Ltd.. In its February 27, 2008 filing on Form 6-K (here), MIND reported among other things that the company has as much as $20.3 million invested in asset-backed auction rate securities, on which the company had been unable to obtain third-party valuations, and for which the company may be taking asset-impairment charges in its forthcoming audited financial statements. The company noted that “the complexity of the valuation is derived from the fact that this security is collateralized by 126 structured finance transactions.”

The company’s 6-K also reports that on February 20, 2008, the company had filed a Statement of Claim with the Financial Industry Regulatory Authority (FINRA) and commenced an arbitration “against the international bank and certain employees thereof that invested …funds on behalf of the company.” According to the 6-K, the claim alleges, among other things, that:

the bank was supposed to invest the funds in highly liquid, highly safe, 28-day auction-rate securities, but -- without the Company's authorization -- invested the funds in collateralized debt obligations (CDOs). In particular, the claim alleges that the bank invested the funds in a security called "Mantoloking CDO" without telling the Company that this was a CDO investment until after the purchase had already occurred. The claim also describes how, after the fact, the bank advised that the security, which has a stated maturity date in the year 2046, had been rolled "due to failed auction."

According to the 6-K, the FINRA claim includes causes of action for fraud, violation of NASD rules (in particular NASD rules relating to suitability), violation of Section 10 of the ’34 Act, misrepresentation, and breach of fiduciary duty. The 6-K reports that the claim seeks “damages and other relief from all the respondents, including return of all funds plus compensatory and punitive damages.” The 6-K does not identify the “international bank” named in the FINRA arbitration claim.

While the Mantoloking CDO seems to have generated considerable pain for its investors, the CDO was just one of many hundreds of CDOs launched into the marketplace in the last several years. Some of the investors in these other CDOs undoubtedly have experienced some of the same kind of pain the Mantoloking CDO investors have felt, and there likely will be more pain to come. If the sequence of events surrounding the Mantoloking CDO is any indication, the investors in other CDOs can also be expected to pursue litigation to redress their grievances. Just looking at how much litigation the Mantoloking CDO alone has spawned or contributed to, it certainly appears that a formidable amount of CDO-related litigation activity could be involved.

A prior post in which I discuss CDOs squared in much greater length, including the increased risk associated with CDOs squared, can be found here.

Very special thanks to Uri Ronnen of AccountingClues for the links above regarding the Mantoloking CDO.

More UBS Lawsuits: According to news reports (here), on March 5, 2008, Pursuit Partners, a Connecticut-based hedge fund, has initiated a Connecticut state court lawsuit against UBS alleging that the hedge fund made CDO investments last year based on “fraudulent concealment of material information.” The suit alleges that UBS had been in talks with Moody’s and as a result knew that changes in the rating agency’s rating methodology were imminent, yet UBS continued to market the CDOs as if the change would not occur.

The hedge fund contends that when the new rating methodology was announced on October 10, 2007, the $50 million in CDO securities in which the hedge fund has invested were “reduced to junk status,” which triggered a default clause in the underlying derivatives contract, and the hedge fund lost its entire investment. The hedge fund says that “UBS took both sides of a derivatives contract, allowing it to liquidate the CDOs without sustaining a loss of its own.”

The hedge fund’s allegations are similar to the allegations raised against UBS by HSH Nordbank (about which I previously wrote, here), in which HSH Nordbank claimed that UBS had structured a CDO-related transaction so that UBS could profit to the investor’s detriment. HSH Nordbank also claims that UBS’s Dillon Read unit had stuffed the CDO with troubled loans as a way to reduce its own losses.

In addition to the Pursuit Parnters and HSH Nordbank lawsuits, UBS has also been sued by a physician who claims that UBS sold him auction rate securities from a closed end mutual fund, Eaton Vance Limited Duration Funds. According to the March 9, 2008 New York Times article entitled "As Good as Cash Until It's Not" (here), UBS put all of the doctor's charitable foundation's $1.35 million cash in auction rate securities.  The doctor claims that the foundation now can no longer "help prevent AIDS in Africa or provide indigent people with laser vision correction ."

You certainly do start to get the impression that there are a lot of angry investors out there.

Subprime-Related Derivative Complaint: As I documented elsewhere (here), shareholders’ derivative lawsuits were a significant part of the options backdating-related litigation. By contrast, there have been relatively few shareholders’ derivative lawsuits filed in connection with the subprime meltdown. Perhaps the most notable subprime-related derivative lawsuit so far is the action filed last year against AIG, as nominal defendant, and certain of its directors and officers (about which refer here).

On March 4, 2008, an investment fund manager filed a shareholders’ derivative lawsuit in Delaware Chancery Court against Bank of America, as nominal defendant, and certain of its directors and officers. The complaint (here) relates to the company’s January 22, 2008 announcement (here) that it would take a fourth-quarter 2007 write-down of $5.44 billion due to the devaluation of the company’s mortgage-backed securities, primarily CDOs.

The complaint alleges that the company underwrote and invested in CDOs but failed to inform investors of the associated risks, and failed to set aside adequate reserves for possible losses. The complaint also alleges that the company issued misleading disclosures about its exposure to subprime-related losses. The complaint further alleges that the company soft-pedaled its exposure to subprime mortgages.

The complaint alleges that the defendants breached their fiduciary duties, engaged in reckless and gross mismanagement, and wasted corporate assets.

It is not entirely clear why this lawsuit was brought as a derivative lawsuit rather than as a direct claim for damages. As a derivative claim, the lawsuit will be subject to certain defenses, including in particular the demand requirement.

Hat tip to the Courthouse News Service (here) for the copy of the complaint.

Now This: In addition to being the name of a CDO, Mantoloking is also the name of an oceanfront community in New Jersey, population 423 (2000 Census).  According to Wikipedia (here), Mantoloking is "the wealthiest community in the state of New Jersey," and its past residents included Katherine Hepburn and Richard Nixon. The current surfing conditions at Mantoloking can be viewed here.

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Add credit default swap counterparty litigation to the growing list of subprime-related litigation categories.

Credit default swaps have, of course, already been drawn into the subprime litigation wave to a certain extent. For example, as I previously noted (here), Swiss Re has been sued in a subprime related securities lawsuit in connection with its write-down in the valuation of certain credit default swaps. And I also previously noted (here) litigation between an institutional CDO investor and the CDO originator where the investor also had credit default obligations for the CDO.

But according to news reports earlier this week (here), Citibank and Wachovia have each been sued in separate lawsuits brought by a credit default swap counterparty. A closer look at the pleadings in the lawsuits suggests we may be seeing a great deal more of this kind of litigation ahead.

First, some definitions.  As explained in Wikipedia (here), a credit default swap is an agreement between two parties under which one party (the seller) agrees, in exchange for a periodic payment, to provide the buyer with protection in the event of a default or other credit event involving an underlying instrument. A credit default swap is like insurance, except that there is no requirement that the buyer actually hold the underlying instrument, so credit default swaps are often used as a means so speculate on interest spreads.

Both Citigroup and Wachovia entered credit default swaps with a hedge fund incorporated in the Bailiwick of Jersey (one of the Channel Islands) The hedge fund, previously known as CDO Master Fund Ltd., is now known as VCG Special Opportunities Master Fund Limited. During 2007, the hedge fund entered two credit default swaps, one with Citibank and one with Wachovia, that are now the subject of litigation.

According to the hedge fund’s January 12, 2008 Amended Complaint against Wachovia (here), on May 21, 2007, the hedge fund entered a $10 million credit default swap with Wachovia in connection with a Class B tranche of a collateralized debt obligation. The hedge fund was to be paid a 2.75% per annum fee for the swap, to be secured by a deposit of $750,000. According to the hedge fund’s allegations, during the course of 2007, Wachovia demanded that increasing amounts of collateral, which by November 2007 cumulated to an amount in excess of the swap’s notional $10 million face value.

The hedge fund kept pace with the demands for additional collateral until the demands exceeded $8,920,000, at which point the hedge fund initiated the dispute resolution mechanisms in the agreement, and ultimately initiated litigation in New York Supreme Court, which Wachovia removed to federal court.

The hedge fund contests that there has been an event of default or any other event that would trigger their payment obligation under the swap. Wachovia for its part submitted a notice of termination, foreclosed on the collateral, and counterclaimed (here) against the hedge fund for the “deficiency.” Wachovia bases its justification for the demands for the increased collateral on the absence of any commercial market for the CDO. The hedge fund’s lawsuit seeks to rescind the swap, on the grounds of fraud and mistake; and also seeks damages for fraud, breach of contract and breach of the covenant of good faith and fair dealing; and unjust enrichment. Wachovia’s counterclaim alleges breach of contract.

The hedge fund’s lawsuit with Citibank is based on more or less the same dispute, albeit in connection with a different credit default swap. According to the hedge fund’s February 14, 2008 complaint (here), the notional value of the Citibank default swap was also $10 million, and Citibank ultimately “extracted” (according to the complaint) collateral of $9,960,000 from the hedge fund. 

There are a number of interesting things about these circumstances. Perhaps the most interesting is that according to the complaints, the hedge fund has approximately $50 million of capital under management. In other words, the notional amount of just these two swap contracts alone represented 40% of the hedge fund’s capital. I am going to go out on a limb and guess that the hedge fund had other contracts too. But whether or not the hedge fund had other contracts, it is hardly surprising that, given its limited capital,  the hedge fund reached a point where litigation seemed like a better option than any further collateral advances; the fund’s managers may have decided they had nothing to lose by fighting

But even more interesting than the hedge fund’s huge vulnerability to just these two transactions is the fact that a couple of major financial players like Wachovia and Citibank were accepting what amounts to insurance from a thinly capitalized pocket portfolio incorporated in the Bailiwick of Jersey. Certainly if they had been placing insurance as such they would never in a million years have transacted with an offshore insurer whose total capital was both so small and such a small percentage of the exposure. Perhaps a belated realization of these shortcomings explains the banks’ demands for additional collateral…

But whatever may have led two of the world’s largest banks to accept guarantees from a small, thinly capitalized hedge fund, these circumstances at a minimum demonstrate something that I suspect we will be reading about a lot more in the coming days – that is, “counterparty risk.”

There are several important things to be recognized about counterparty risk. The first is that it is not a prerequisite to a credit default swap transaction that either party holds the instrument to which the swap relates. The practical consequence of this fact is that the aggregate notional value of all swaps in force far exceeds the value of the underlying instruments. Here’s a number that we all need to contemplate – according to the Wall Street Journal’s March 4, 2008 article (here) about the above-described litigation, the market for swaps totals $45 trillion (that’s trillion with a “t”), an amount that is “comparable to all the bank deposits world wide.” That, my friends, represents a whole lot of counterparty risk.

Another important thing to be recognized about counterparty risk is that, according to the Journal article, hedge funds have in recent years become the predominant players in this market. The Journal says that hedge funds accounted for 60% of the credit default swap trading in high-grade debt and 80% of the low grade debt in the 12 months ending in April 2007.

While many of the hedge funds involved in this marketplace may be better capitalized than the hedge fund described above, the very fact that two banks like Wachovia and Citibank dealt with this fund at all, despite the low ratio of its capital to the notional value of the swap transaction, suggests that a certain amount of business (who knows, perhaps a considerable amount of business) involved hedge funds, and perhaps others, who like the hedge fund described above, will be challenged to respond to calls for additional collateral.

The same turmoil that caused Wachovia and Citibank to call for additional collateral in these transactions is undoubtedly resulting in countless similar communications throughout the marketplace. The longer the disruption in the underlying marketplace continues, the more abrupt the calls will be. The pressures that the principal firms face to protect their own balance sheets adds greater urgency to each of those calls. And the previously hidden but now revealed demon within each transaction motivating those calls is the suddenly frightening prospect of counterparty risk. The particularly frightening aspect of these circumstances is that all of the calls are going out more or less simultaneously – and counterparties with limited capital will find themselves forced against the same wall as the hedge fund described above.

The litigation will be bad. The financial consequences could be worse.

Indispensible Reading: The best way I can think of to end this really depressing blog post is to reward everyone who has read this far and suggest that the best way to put the circumstances described above in context is to read University of Virginia Graduate Business School Professors’ Robert Bruner and Sean Carr’s eminently readable and deeply thought-provoking book, The Panic of 1907 (refer here for more information).

Even though their book describes circumstances from a century ago, there is a chillingly familiar resonance to the events addressed in their book. Among other things, in their efforts to explain how financial panics arise, the professors describe the following factors:

It begins with a highly complex financial system, whose complexity makes it difficult for anyone to know what might be going wrong; by definition, the multiple parts of the financial system are linked, which means that trouble in one institution, city, or region can travel easily and quickly to others. Buoyant growth in the economy makes the financial system more fragile, in part due to the demand for capital and in part due to the tendency of some institutions to take on more risk than is prudent. Leaders in government and the financial sector implement policies that advertently or inadvertently elevate the exposure to risk of crisis. An economic shock hits the financial system. The mood of the market swings from optimism to pessimism, creating a self-reinforcing downward spiral. Collective action by leaders can arrest the spiral, though the speed and effectiveness with which they act ultimately determines the length and severity of the crisis.

Read the book. It is worth reading in and of itself, but under the present circumstances, the book is simply indispensible.

A very grateful hat tip to Floyd Norris, of the New York Times (whose column, here, discussed the Panic of 1907) and whose blog, Notions of High and Low Finance (here), specifically referenced the professors’ book.  

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Although there have been some significant exceptions in recent years, it is still generally the case that securities class action settlements are largely funded by D & O insurance. Yet the impact of D & O insurance on the process and ultimate value of securities lawsuit settlements is little understood outside the small world of practitioners in this area. In an excellent March 2, 2008 paper entitled “How the Merits Matter: D & O Insurance and Securities Settlements” (here), Connecticut Law School Professor Tom Baker and Fordham Law Professor Sean Griffith take a closer look at the role of D & O insurance on securities lawsuit settlements.

In this paper, the authors use a technique they have employed in their prior studies of D & O insurance (about which I previously commented here) – that is, in order to understand that actual workings of the D & O insurance industry, they have interviewed a wide variety of involved participants. In this case, they interviewed over fifty persons, including plaintiffs’ attorneys, defense counsel, insurance claims professionals, insurer’s monitoring counsel, and others. As a result of this practical approach, the authors have developed a realistic understanding of the actual settlement dynamics, and what emerges is a perceptive overview of the actual settlement process.

They describe a dynamic where the plaintiffs’ lawyers’ principle objective is to survive the motions to dismiss, and having passed that barrier, to maneuver the case to settlement. The question that often arises is whether the merits of the case matter to the ultimate amount of settlement. However, the absence of any significant trial-based data means there are no “experienced-based” ways to measure the plaintiffs’ likelihood of success on the merits.

The authors found that in the absence of trial-based data, the case settlements are influenced by a number of factors, including, for example, the presence or absence of “sex appeal” or the magnitude of potential damages involved. Case characteristics that might provide “sex appeal” include “SEC investigations, criminal charges, suspicious stock purchases program… and a variety of other case specific facts that cast the defendants’ motives or honesty in a bad light.” On this basis, a number of the individuals the authors interviewed expressed the view that the merits do sometimes matter.

But in addition, there are other “non-merits” factors that may affect the settlement, and “the most significant non-merits factor in the securities class action context is the ability to pay,” and the “willingness to pay that matters is, more often than not, that of the D & O insurer.”

The most significant value of the authors’ research and analysis is their detailed explanation of the role of D & O insurance in the securities lawsuit settlement process. The authors do a commendable job explaining the factors that limit the insurer’s ability to influence the process; the dynamics that drive plaintiffs’ and defendants’ counsel to align against the insurer; the effect that D & O limits and program structure have on the process; and how the other participants’ motivations interact with those of the D & O insurer.

Among the authors' more provocative conclusions is their suggestion that "plaintiffs and defendants collude to pressure the D & O insurer to settle on terms that may nore reflect the ultimate merits of the claim."

The authors note  that “settlements are largely funded, often entirely, by D & O insurance,” as a result of which “insurance companies are the real parties in interest.” The consequence of this is that “the outcomes of securities class action lawsuits … are driven not by the opinion of a judge or the decision of a jury, but by the consent of the insurers.”

With this dynamic, and in the absence of trial-based data, the sole settlement reference points are prior settlements. Because of this, the authors note, “insurers are bargaining not in the shadow of the law, but in the shadow of prior bargains, at a further remove from decisions by judges or juries on the merits.”

In the end, the authors say that they “cannot draw a strong conclusion about whether the merits do or do not matter.”

They do conclude on the basis of their research that “non-merit factors contribute significantly” and accordingly they explore a couple of alternatives for making the merits matter more: first, they suggest, but sensibly quickly reject, the idea of requiring a specified number or percentage of securities cases to go to trial; and second, they advocate “mandatory disclosure of (1) the amount and structure of a corporation’s insurance coverage, and (2) information on how settlement and defense costs are funded.”

The authors’ advocacy of the compelled disclosure of D & O insurance information is clearly borne of their own frustration at the lack of access, as research academics, to this kind of information. It may be unfair to point out that few others are demanding disclosure of this kind of information. But it does seem fair to point out that even though the authors’ study of settlements was based on interviews with industry practitioners, they do not seem to have reviewed the idea of compelled disclosure with anyone in the insurance industry. If they had, I doubt they would find anyone who would support the idea.

In particular, insurance professionals would like have two areas of concern regarding the compelled disclosure of this information: (1) the impact of the disclosed information on an already complex commercial insurance environment; and (2) the possible impact of the disclosure of insurance information on which companies become lawsuit targets. The authors neither consider nor discuss these practical concerns.

I also wonder about the authors’ suggestion that compelling this information would do anything to make the merits matter more or to deter securities law violations. The authors’ own research shows that a multitude of factors can sometimes affect settlement amounts, including, for example,  the presence or absence of coverage issues or the existence of business considerations that compel a company to throw money at a case to make it go away, even without significant insurer contribution. The disclosure of the kind of information the authors advocate would of course provide research academics with extensive additional information to contemplate, but the possibility that this kind of disclosure would significantly affect the settlement dynamic, much less deter securities law violations, seems remote.  

In any event, the authors’ extensive review of the securities lawsuit settlement process makes a valuable contribution, particularly in their explanation of the role of D & O insurance in that process.

Special thanks to Professors Baker and Griffith for providing me with a copy of their excellent paper.

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As I have previously observed (most recently here), life sciences companies remain favored targets of the plaintiffs’ class action securities bar. Even during the two-year securities lawsuit filing lull between mid-2005 and mid-2007, lawsuit filings against life sciences companies continued more or less unabated. Indeed, as I noted here, during 2007, a year in which subprime-related securities lawsuits predominated, pharmaceutical companies were nevertheless among the most frequent sued. 

But while life sciences companies may be frequent securities lawsuit targets, that does not mean that all or even most of those lawsuits are meritorious. The recent dismissals of two securities lawsuits pending against two high-profile life sciences companies underscores the hurdles these lawsuits face.

Guidant: In an Order dated February 27, 2008 (here), Judge Sarah Evans Barker of the United States District Court for the Southern District of Indiana granted defendants’ motion to dismiss the securities class action lawsuit filed against Guidant Corporation and certain of its former directors and officers. Background on the consolidated Guidant securities lawsuit can be found here.

In their consolidated complaint (here), the plaintiffs allege that the defendants knew and intentionally concealed material information including the fact that there were defects in certain Guidant implantable defibrillators and pacemaker devices; that some patients were experiencing serious health issues (and in one instance, death) resulting from those defects; and that disclosure of those defects would have negatively affected both revenue and the company’s then-pending merger with Johnson & Johnson. (The company ultimately merged not with J & J, but with Boston Scientific.) The plaintiffs allege that defendants made false and misleading public statements about the defective devices and the planned J & J merger to keep Guidant’s stock at artificially inflated levels, in violation of Section 10(b) of the ’34 Act and Rule 10b-5 thereunder.

The defendants sought to have the complaint dismissed first on the ground that the complaint failed to satisfy the PSLRA’s heightened pleading requirements for alleging misleading statements, and second, on the grounds that the plaintiffs had not pled particularized facts giving rise to a strong inference of scienter.

The plaintiffs urged that the defendants’ statements were misleading because they “failed to disclose material information about known product defects (and in some cases, because the statements were intended to enhance then-pending merger negotiations with J & J, which would have been jeopardized had Defendants disclosed the defects).” In rejecting this argument, Judge Barker said “there is no affirmative independent duty for a company to disclose all information that could potentially affect its stock price, unless such silence renders an affirmative statement misleading.” She observed that the plaintiffs “have not demonstrated with the requisite particularity how omission of product defect information rendered any affirmative statements misleading.” Judge Barker then went on to note that several of the statements on which the plaintiffs attempt to rely “can be understood as immaterial, non-actionable corporate puffery.”

The plaintiffs also sought to rely on the Guidant’s ultimate product defect disclosures, arguing that the disclosures were partial and contained “half-truths” intended to minimize the impact. Judge Barker found, however, that “it is unclear precisely what facts were omitted from these disclosures that – in Plaintiffs’ opinion – would have more fully and truthfully informed the investing public about Guidant product defects.” Judge Barker went on to note that the plaintiffs “appear to argue” that the company was required “to ‘ring an alarm bell’ of sorts,” but, Judge Barker said, the relevant law “does not require a company to make such a statement – nor does omission of such a statement constitute fraud.”

Judge Barker also found that the plaintiffs had failed to allege sufficient facts to support a strong inference of scienter. The plaintiffs largely relied on the defendants’ stock sales, but Judge Barker found that the plaintiffs “have not demonstrated – as they are required to do – that such sales were dramatically out of line with prior trading practices at times calculated to maximize the personal benefit from undisclosed inside information.” 

Judge Barker further rejected plaintiffs’ arguments that defendants, as a result of their positions within the company, had knowledge of falsity of the company’s statements. Judge Barker found that plaintiffs’ arguments “are entirely conclusory and do not demonstrate with any particularity that any Individual Defendant had knowledge of product defects.” She concluded by noting that “attribution of scienter to Defendants, without particularized allegations indicating how or when Defendants came to possess information about product defaults, constitutes impermissible pleading of ‘fraud by hindsight’.”

Special thanks to a loyal reader for a copy of the Guidant opinion.

Pfizer: In an order dated February 28. 2008 (here), Judge Lewis Kaplan granted the defendants’ motion to dismiss the plaintiffs’ complaint in the consolidated securities class action lawsuit pending against Pfizer and certain of its current and former directors and officers. The complaint alleges that prior to the company’s December 2, 2006 announcement (here) that it was terminating its Phase III trials on torcetrapib, a developmental drug intended to reduce heart disease by raising “good” cholesterol, the company failed to disclose facts that lessened the likelihood that torcetrapib ultimately would prove safe and effective.

The plaintiffs allege that the misleading statements were designed to avoid Pfizer’s erosion of market share due to its impending loss of patent protection by principal Pfizer drugs, and in order to maximize the severance package for Henry McKinnell, the company’s then-Chairman and CEO. Further background regarding the case can be found here. A copy of the consolidated amended complaint can be found here.

In support of their allegations that the defendants’ statements about torcetrapib’s efficacy were misleading, the plaintiffs relied on a variety of sources (including as noted further below, an anonymous blog post). Judge Kaplan found that at most these statements support only an inference that the evidence available during the class period concerning torcetrapib’s efficacy was inconclusive – which the court found would not support an inference that the defendants’ statements were materially misleading. Judge Kaplan found that defendants were “entitled to take an optimistic view” and “need not present an overly gloomy or cautious picture” as long as the public statements “are consistent with reasonably available data.” Judge Kaplan further found that in any event “the conflicting evidence of torcetrapib’s efficacy were part of the total mix of information available to the marketplace.”

In attempting to establish that the defendants’ statements about torcetrapib were misleading, the plaintiffs also cited concerns about the blood pressure side-effects. Judge Kaplan found that the plaintiffs had failed to plead facts supporting the view that the defendants did not believe these side effects were manageable. Judge Kaplan said that “torcetrapib’s ultimate failure is not evidence that the side effects were thought to be unmanageable at the time the alleged miststaments were made. Fraud by hindsight is not sufficient to establish liability under Rule 10b-5.”

Judge Kaplan also found that plaintiffs had failed to establish scienter. The plaintiffs had argued that the defendants had a motive to mislead because Pfizer had a “desperate need to assure the financial community of the existence of a new blockbuster drug.” Judge Kaplan observed that “this is not a unique motive” and “it is a way of saying, in a manner tailored to a pharmaceutical company, something that is true for all profit enterprises – each has an incentive to portray the likelihood that it will continue to prosper.”

Judge Kaplan further noted that with respect to the alleged motive to maximize McKinnell’s severance package that “if scienter could be pleaded on that basis alone, virtually every company in the United States that experiences a downturn in stock prices could be forced to defend securities fraud actions.”

Judge Kaplan granted the motion to dismiss and denied the plaintiffs’ motion for leave to amend, but without prejudice to a renewed motion for leave to amend supported by a proposed amended complaint.

Hat tip to the Courthouse News Service (here) for a copy of the Pfizer decision.

Analysis: On the one hand, it is hard to generalize based only on two case dispositions. But on the other hand, these two high-profile cases in many ways embody the kinds of securities lawsuit allegations that life sciences companies all too frequently are required to confront. The fact is that publicly traded life sciences companies often face significant and unanticipated challenges, of both a regulatory and clinical nature, in the drug development process. And even drugs or devices that have been introduced into commercial distribution can experience unexpected adverse developments. Either kind of setbacks can trigger significant stock price declines.

Even though these kinds of obstacles are fundamental and arguably unavoidable parts of the business and regulatory environment for life sciences companies, all too often these reverses result in securities lawsuits, supported only by allegations that the reverses occurred and therefore company management must have known about the problems from which the reverses arose.

Each of the district court judges in these two cases implicitly recognized these considerations in their rejection of the “fraud by hindsight” allegations. In each case, the courts effectively said that it is not enough to state a claim under the federal securities laws to allege that problems arose and that the defendants must have known about the problems. The courts’ unwillingness to accept fraud by hindsight allegations is significant, as without this recognition, life sciences companies could face significant liability exposures based on the uncertainties and unpredictabilties inherent in their business.

However, because of the stock price volatility that inevitably follows these kinds of adverse developments, life sciences companies likely will continue to attract the unwanted attention of plaintiffs’ securities’ attorneys. The more interesting question is whether these kinds of lawsuits will succeed. The district courts’ recent decisions in the Guidant and Pfizer cases suggest that these kinds of cases may face substantial hurdles in order to survive a motion to dismiss.

A Blog Too Far: One of the interesting twists in the Pfizer lawsuit is the plaintiffs’ unsuccessful attempt to rely on the scribblings of an anonymous blogger to establish the alleged falsity of the defendants’ statements. Judge Kaplan found that “there is no reason to believe that the author of this blog, identified only as RADmanZulu, is likely to have known the relevant facts.” The plaintiffs contended that RADmanZulu was a former Pfizer vice president, but Judge Kaplan said that “the blog post, plaintiffs’ purported source, does not contain any information about RADmanZulu’s identity, and plaintiffs do not articulate any other basis for their belief.” (Some of RADmanZulu’s postings appear in the comments on this blog post, here.)

Moreover, with respect to the specific factual allegations drawn from the blog post, Judge Kaplan noted that “RADmanZulu’s allegation does not claim to be based on personal knowledge and lacks detail that might suggest personal knowledge.” Ultimately, in reaching his conclusion that the plaintiffs had “not pleaded with particular facts sufficient to support their allegation that defendants’ statements were materially misleading,” Judge Kaplan found that the plaintiffs’ factual allegations “are not based on an adequate source or are unsupported by the purported source.”

We here at The D & O Diary choose to believe that Judge Kaplan was not saying that RADmanZulu’s statements were inadequate merely because they appeared on a blog. Rather, it appears that Judge Kaplan found RADmanZulu’s factual allegations inadequate because they were anonymous and unsupported. That is why everyone here at The D & O Diary eschews anonymity and wherever possible tries to provide factual support for our statements.

Bloggers everywhere have a mutual interest in maintaining the credibility of the blogging medium, and while some bloggers will choose anonymity for their own purposes, overall blogging credibility depends on a fundamental sense of personal responsibility with which anonymity may be inconsistent. (We should also add that maintaining anonymity on the Internet is a lot less feasible than some Internet users may casually assume.)

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Warren Buffett’s annual letter to Berkshire Hathaway shareholders has become a capitalist cult classic, eagerly awaited each year not only by Berkshire shareholders but also by a broader audience of readers keen to read Buffett’s observations about both his company and the larger business and economic environment. This year’s letter (here), issued after market close on February 29, 2008, does not disappoint, as it brims with commentary on a variety of matters, as well as about the performance of Berkshire itself. But to an unusual extent, this year’s letter may be as noteworthy for what it omits as for what it includes, as I discuss further below. (Full disclosure: I own BRK.B shares, although not nearly as many as I wish I did.)

Buffett’s letter is of course a part of the Berkshire 2007 annual report, and the letter does contain quite a few interesting nuggets about Berkshire. Even though Buffett seemingly goes out of his way to detail his past investing errors (particularly emphasizing his failed Dexter Shoes investment as well as his failure to buy a Dallas TV station), the overall effect is to reinforce Buffett’s astonishing investing success. For example, after documenting his lapses at length, he almost parenthetically mentions the company’s 2007 sale of its 1.3% interest in PetroChina, acquired during 2002 and 2003 for $488 million, for which Berkshire received $4 billion – a staggering 820% gain in approximately five years.

On the other hand, Buffett’s letter also emphasizes that although Berkshire’s insurance businesses had another “excellent year” in 2007 (producing underwriting profit of $3.37 billion, on top of $3.8 billion in 2006), it is “a certainty that insurance industry profit margins, including ours, will fall significantly in 2008.” Buffett’s bases for this conclusion are that “prices are down and exposures inexorably rise.” If natural catastrophes occur, “results could be far worse.” Buffett warns Berkshire’s shareholders “to be prepared for lower insurance earnings during the next few years.”

Buffett also provides a detailed explanation of Berkshire’s growing derivatives exposure. The existence of these contracts in Berkshire’s portfolio may strike some as contradictory, as Buffett has for years railed against derivatives as, among other things, “financial weapons of mass destruction” (as he called them in his 2002 shareholders’ letter). He has bemoaned for years the losses Berkshire sustained in winding down Gen Re Securities derivatives operation (on which Buffett reported in his 2006 letter that Berkshire had sustained a cumulative pre-tax loss of $409 million).

Buffett nevertheless reports in this year’s letter that Berkshire had entered a total of 94 derivative contracts (up from 62 in 2006), apparently in the form of credit default swaps and futures put options on four stock indices. (The stock indices put represents a bet that these indices will close at far-forward dates at levels above where they stood when Berkshire entered the contracts.) While Buffett’s willingness to enter these contracts seems surprising given his long-standing and often-expressed hostility to derivatives generally, he emphasizes that with respect to each of the contracts, Berkshire is holding the cash – which means not only that Berkshire has no counterparty risk, but also that Berkshire has the opportunity to earn investment income in the interim. It is also important to contrast Berkshire’s current portfolio of 94 derivative contracts with the 23,318 contracts that were formerly held by Gen Re Securities. 

Buffett does warn that the mark-to-market accounting required on the derivative contracts “will sometimes cause large swings in reported earnings.” Buffett compares this exposure to Berkshire’s catastrophe insurance exposure and Berkshire’s long-standing willingness to “trade volatility in reported earnings in the short run for greater gains in net worth in the long run.” I have more to say below about Buffett’s comparison between the derivatives portfolio and Berkshire’s catastrophe reinsurance business.

Buffett’s commentaries about Berkshire’s performance are interesting, but Buffett’s letters are valued for far more than their observations on Berkshire’s own performance. Most readers scour Buffett’s letters for his discourse on larger topics, and his most recent letter has much to offer in that regard. In this year’s letter, Buffett returns to some of his familiar themes and also launches into some new topics.

The first familiar theme Buffett sounds relates to problems in the residential mortgage sector. Buffett commented on this topic in last year’s letter, where he decried “weakened lending practices” and mortgage loan structures that subjected borrowers to potentially escalating repayment obligations. In this year’s letter, Buffett has a “told-you-so” tone when he references the “staggering problems” that “major financial institutions” have recently experienced. He comments that “our country is experiencing widespread pain” because of the “erroneous belief” that “house price appreciation” would “cure all problems.” Buffett notes that

As house prices fall, a huge amount of financial folly is being exposed. You only learn who has been swimming naked when the tide does out – and what we are witnessing at some of our largest financial institutions is an ugly sight.

Another recurring theme Buffett revisits in this year’s letter is the U.S. trade deficit and its impact on the dollar’s valuation. In last year’s letter, while reporting on Berkshire’s direct foreign exchange gains, he bemoaned the U.S.’s transformation into a net debtor country as a result of which the country is now shipping “tribute” overseas in the form of an interest income burden that finances what he called U.S. “over-consumption.” Buffett returns to this topic in this year’s letter, specifically commenting on how these circumstances have led to the emergence of sovereign wealth funds:

There has been much talk recently of sovereign wealth funds and how they are buying large pieces of American businesses. This is our doing, not some nefarious plot of foreign governments. Our trade equation guarantees massive foreign investment in the U.S. When we force-feed $2 billion daily to the rest of the world, they must invest in something here.  Why should we complain when they choose stocks over bonds?

In last year’s letter, Buffett did note that Berkshire had “come close to eliminating our direct foreign exchange position,” on which Berkshire had earned roughly $2.2 billion between 2002 and 2006 in investments in 14 different currencies. In this year’s letter, Buffett notes that in 2007 Berkshire had only one direct currency position, in the Brazilian real. Buffett also noted that Berkshire had invested in bonds denominated in currencies other than dollars, citing as a specific example euro-denominated Amazon.com bonds Berkshire purchased in 2002 for $162 million, that were redeemed in 2007 for $253 million (having paid 6 7/8 % interest in the interim).

Yet, Buffett emphasizes, Berkshire’s assets “will always be concentrated in the U.S.,” citing as justification “America’s rule of law, market-responsive economic system, and belief in meritocracy,” which Buffett contends, “are almost certain to produce ever-growing prosperity for its citizens.”

One standard feature of Buffett’s annual letter is a penultimate portion in which he skewers some particular foible of the financial scene. Last year, Buffett targeted the “2-and-20 crowd” of hedge fund “helpers” whose fees enrich themselves at their clients’ expense. This year, in a section of the letter captioned “Fanciful Figures – How Public Companies Juice Earning,” Buffett targets “the investment return assumption a company uses in calculating pension expense.”

Buffett notes that the 2006 average assumed pension return among the 363 S & P companies that have pensions is 8%. Buffett compares this assumed 8% return to the 5.3% average annual increase in the Dow Jones average during the 20^th century. In order for the Dow Jones average to continue to grow at just a continued 5.3% annual rate in the 21^st century, the Dow Jones average would have to close at 2,000,000 on December 31, 2099. And the companies that are projecting a 10% return “are implicitly forecasting a level of about 24,000,000 on the Dow by 2100.” Buffett characterizes the “helpers” who make these kinds of assumptions as “direct descendants of the Queen in Alice in Wonderland” who has “believed as many as six impossible things before breakfast.”

The reason for these high investment return assumptions, Buffett notes, “is no puzzle,” as they allow CEOS to “report higher earnings,” securing the knowledge that “the chickens won’t come home to roost until long after they retire.”

Having disparaged corporate pension fund accounting, Buffett then moves on to “public pension promises” for which “funding is woefully inadequate.” The “fuse on this time bomb is long,” but the promises that politicians find so easy to make “will be anything but easy to keep.”

Buffett’s annual letter is always entertaining and informative, and this year’s letter is no exception. But it strikes me that there are omissions from this year’s letter, some of which seem to me to be particularly conspicuous.

First, Buffett’s letter makes absolutely no reference to the recent “finite reinsurance” criminal trial that resulted in guilty verdicts against four former Gen Re officials (as well as one former AIG officer). Buffett’s silence on this matter is at one level understandable, as his name did arise in trial testimony, and as news reports suggest (here) that the criminal investigation is continuing. But given the fact that the former CEO and former CFO of Berkshire’s largest subsidiary were found guilty of criminal wrongdoing, Buffett’s lack of any reference to the verdicts (even to say that he could not comment) seems like a significant omission.

Buffett did implicitly draw a seeming contrast between prior Gen Re management (the ones on trial) and current Gen Re management; Buffett said that current management is doing “first-class business in a first-class way” despite “costly and time consuming legacy problems.” Buffett also commented that he learned to his regret that when he acquired Gen Re in 1998, it was no longer the “Tiffany of reinsurers” as it had been previously. Buffett made similar comments in the 2001 and 2002 Berkshire annual reports. (Full disclosure: I was for ten years an employee of a Gen Re operating subsidiary, and for that reason I feel obliged to forebear from any further commentary on these circumstances.)

Second, other than commenting on the mortgage lending industry’s lamentable shortcomings, Buffett provides no further commentary on the subprime crisis. Other insurers reporting their earnings in recent weeks have felt compelled to address both their potential insurance loss exposure to subprime-related liabilities and their companies’ investment portfolio vulnerability to subprime investment losses. On the one hand, Buffett’s credibility is such that if Berkshire had significant exposure in these areas, we would all expect him to have said something about it. On the other hand, given the prominence of these issues, it does not seem too much to have expected him to address these issues, and, again, his failure to comment on these topics seems like an omission.

Third, and related to the topic of subprime, Buffett’s letter makes no reference to Berkshire’s recent high profile entry into the municipal bond insurance business, in the wake of turmoil involving the traditional monoline insurers. While we may perhaps look forward to reading about this development in next year’s letter, this initiative did unfold in late 2007, and I would have expected some commentary about it in this year’s letter, especially given the high profile nature of the move.

But while Buffett did not mention Berkshire’s move into municipal bond insurance, his commentary on the problems public pension funds may face does put Berkshire’s move into providing municipalities with default guarantee protection in an interesting perspective. As Floyd Norris of the New York Times observes on his blog, Notions on High and Low Finance (here), “Why, you might wonder, would Mr. Buffett want to put Berkshire Hathaway into the business of insuring municipal bonds issued by such governments?”

One final apparent omission from Buffett’s letter is that he does not mention Berkshire’s recent acquisition of 3% interest in Swiss Re, or Berkshire’s agreement to assume 20% of Swiss Re’s property and casualty reinsurance business for the next five years. (Refer here for background on these transactions.) On the one hand, the Swiss Re transactions represent 2008 business, and so I suppose we should just be patient and wait until next year’s letter to see what Buffett says about the transactions. But the particular reason that Buffett arguably ought to have discussed the Swiss Re transactions, and in particular the timing of the Swiss Re transactions, is his commentary in this year’s letter about the likely future prospects of the insurance industry. I agree with Buffett that we should all “be prepared for lower insurance earnings over the next few years.” Given these prospects, the timing of the Swiss Re transactions cries out for further explanation.

A Final Observation: Perhaps others might be unwilling to find any relation between the two companies’ respective positions, but I find Berkshire’s increased derivatives exposure somewhat disconcerting in light of AIG’s recent $11.2 billion mark-to-market derivatives portfolio write-down. It may also fairly be argued that Berkshire’s volatility exposure is much smaller than is AIG’s. But after years of Buffett’s lectures about the evils of derivatives, Berkshire’s growing derivatives exposure seem incongruous.

Questions may also be raised about the appropriateness of the analogy Buffett draws between Berkshire’s volatility exposure as a catastrophe reinsurer and the potential volatility from Berkshire’s growing derivatives portfolio. The Wall Street Journal’s March 1, 2008 Breaking Views column (here) put its finger precisely on the problem in its commentary on AIG’s write-down, by pointing out that logical shortcoming of insurers’ putative qualifications to assess and accept risk from these financial instruments:

Insurers say they are experts at managing just this sort of high-severity, low-probability risk. They argue that insuring against floods, hurricanes, and earthquakes has given them peerless expertise in managing it.

But since there’s no market in acts of nature, insuring against them can’t lead to massive mark-to-market write-downs, as financial exposures can. And there’s a big difference between acts of nature, which can be modeled statistically, and the behavior of complex structured-finance instruments packed with assets that have little historical performance data, which frequently confounds statisticians.

The Journal column ends with the observation that “AIG isn’t alone in falling for this false analogy.” 

To be sure, Buffett did not claim that Berkshire’s expertise in underwriting catastrophe reinsurance qualified the company to underwrite derivatives, only that Berkshire’s willingness to accept the volatile results of catastrophe reinsurance was comparable to its willingness to accept volatile impacts from its derivatives portfolio, in exchange for the long run net worth benefits.

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