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

In May 2003, I was fortunate enough to to attend the Berkshire Hathaway annual meeting in Omaha, Nebraska. (Full disclosure: I attended the meeting because I was then and remain now a Berkshire shareholder.) While at the meeting I struck up a conversation with some other attendees, who turned out to be a group of doctors who had attended medical school together, and who now invest together, and who every year have a reunion of sorts at the Berkshire annual meeting.

There are many people like these investing docs who hang on Buffett’s every word, perhaps hoping to replicate in some small way Buffett’s phenomenal investing success. The good news is that it isn’t necessary to go to Omaha to get Buffett’s own words about his approach to investing and business, as all of his Berkshire shareholders’ letters from 1977 to 2007 can be found on the Berkshire website, here.

But while the shareholder letters are available online, they are presented chronologically and are not indexed. There is not even a search function on the website, so other than going through a lot of words written over a lot of years, it is very difficult to find what Buffett has written about, say, zero coupon bonds, and difficult to see how his views on any given topic have changed over the years.

The great news for Buffett devotees is that there is a terrific alternative to laboring through 30 years' worth of Buffett’s letters to Berkshire shareholders. George Washington University Law Professor Lawrence Cunningham has read through all of them for us, and has distilled 30 years’ worth of Buffett’s commentary into a thematically arranged, absolutely wonderful book entitled “The Essays of Warren Buffett: Lessons from Corporate America,” which was recently released in a second edition (here). Professor Cunningham has added a brief introductory essay and afterword, but otherwise the book consists of the essence of Buffett. (It does also include an excerpt from one of Berkshire Vice Chairman Charlie Munger’s Letter to Wes.co shareholders and an amusing parody written by Buffett’s mentor, Ben Graham.)

Cunningham has done a masterful job distilling Buffett’s writings and organizing them according to topic. This arrangement not only facilitates a quick reference to Buffett’s comments on any given topic, but it also provides insight into how Buffett’s views on the topic may have evolved over time.

One thing that clearly emerges from a sustained reading of Buffett’s writing is that he is not only interested in developing the right investments and the right assets, he also wants to have the right sort of owner. Indeed, the reason Buffett has written the letters over the years is to develop and maintain “rational owners”; in the 1988 shareholders' letter, Buffett makes this explicit when he says that “all of our policies and our communications are designed to attract the business-oriented long-term owner and to filter out possible buyers whose focus is short-term and market-oriented.” From his essays about stock splits and dividends, it is also clear that the reason Berkshire has never split its shares and does not pay dividends is because of Berkshire wants to “avoid policies that attract buyers with a short-term focus on our stock price.” He wants investors focused on business values, not the company’s short-term share prices, and while a stock split or dividend might increase trading in Berkshire shares, “a hyperactive stock market is the pickpocket of enterprise.”

Buffett’s writings about the kind of owners he wants also dovetails with his extensive writings about the kind of managers owners should want. He is particularly concerned about the widespread practice of announcing earnings targets, noting the “many instances in which CEOs engaged in uneconomic operating maneuvers so that they could meet earnings target they had announced.’ He also says that investors should

beware of companies displaying weak accounting. If a company still does not expense options, or if its pension assumptions are fanciful, watch out. When managements take the low road in aspects that are visible, it is likely they will are following a similar path behind the scenes. There is seldom just one cockroach in the kitchen.

He adds that “managers that always promise to ‘make the numbers’ will at some point be tempted to make up the numbers.”

This thematic arrangement of Buffett’s writings facilitates insight into the many ways his past experience unquestionably continues to inform his decision making. For example, we might well wonder about Buffett’s view on the current subprime crisis, but when you read his commentary from the late 80s about junk bonds and the Wall Street wizards who created them, you don’t have to wonder very much about what he might think about, say, CDOs backed by subprime mortgages. In his 1990 letter, Buffett wrote about junk bonds that “as usual, the Street’s enthusiasm for an idea was proportional not it its merit, but rather to the revenue it would produce.” Buffett also commented:

In the final chapter of The Intelligent Investor Ben Graham [wrote]:"Confronted with a challenge to distill the secret of sound investment into three words, we venture a motto, Margin of Safety.” Forty-Two years after reading that, I still think those are the right three words. The failure of investors to heed this simple message caused them staggering losses.

Buffett went on to write later:

The banking business is no favorite of ours. When assets are twenty times equity – a common ratio in this industry – mistakes that involve only a small portion of assets can destroy a major portion of equity. And mistakes have been the rule rather than the exception at many major banks. Most have resulted from a managerial failure we described last year when discussing the “institutional imperative:” the tendency of executives to mindlessly imitate the behavior of their peers, no matter how foolish it may be to do so.

Buffett’s prescience on the problems with derivates has already been the matter of commentary on this blog here.

Anyone who needs persuasion that Buffett truly is a financial master who has the added gift to be able to explain complicated things simply should review the segments of the book discussing zero coupon bonds and the difference between accounting goodwill and economic goodwill.

In addition to Buffett's business wisdom and the clarity of his prose style, the other thing that comes through in these essays is how funny Buffett is, and in that respect Cunningham is to be complimented for managing to capture within a volume devoted to Buffett’s business writings the basic humorousness of the shareholder letters. I’m sure everyone has their favorite Buffett humor stories, but mine include the story told in the  1986 letter about the tailor who went to see the Pope, whose friends asked him what the Pope is like. Buffett writes that “our hero wasted no words: ‘He’s a forty-four medium.’” Another favorite that also makes it into this collection is the story about the man who asked his vet what to do for his horse that limped sometimes but seemed fine at other times. Buffett states that “the vet’s reply was pointed: ‘No problem – when he’s walking fine, sell him.’”

Cunningham’s book also captures my own personal favorite, from the 1985 letter. I have actually quoted this story previously on this blog, but I like it so much, I am reproducing it again here:

An oil prospector, moving to his heavenly reward, was met by St. Peter with bad news. “You’re qualified for residence”, said St. Peter, “but, as you can see, the compound reserved for oil men is packed. There’s no way to squeeze you in.” After thinking a moment, the prospector asked if he might say just four words to the present occupants. That seemed harmless to St. Peter, so the prospector cupped his hands and yelled, “Oil discovered in hell.” Immediately the gate to the compound opened and all of the oil men marched out to head for the nether regions. Impressed, St. Peter invited the prospector to move in and make himself comfortable. The prospector paused. “No,” he said, “I think I’ll go along with the rest of the boys. There might be some truth to that rumor after all.”

In any compendium, there are necessarily going to be some omissions, and while Cunningham’s inclusions are comprehensive and the overall product deserving of praise, I think the volume would be even more complete were it to include selections from Buffett’s writing over the years about insurance. The insurance business has been the segment on which Buffett has concentrated the most, and his reasons for his focus on this industry convey a lot about his approach to investing and his understanding of how business cycles work. In particular, Buffett’s many comments about “float” and the insurance “cycle” convey a lot about what his overall approach to investing and business. Greater inclusion of his insurance writings would also provide greater context for Buffett’s comments about September 9/11, which is included in this volume.

This volume also excludes Buffett’s writing about his investment in Gen Re. This is a serious omission in my view. Gen Re was by far Buffett’s largest investment, and the company lost over $7 billion dollars in the early years that he owned it. Buffett’ trenchant comments about the losses represent a very public statement about what he learned from the experience, clearly one of the more significant of the losses he faced. His pointed comments about the reason for the losses underscore some of his most important business principles.

It is also a personal gripe that though this volume omits Buffett’s writings generally about insurance, somehow the book manages to include every single instance where Buffett has said that his company does not carry D&O insurance. I have always thought that these statements are dangerous for mere ordinary mortals. It is fine for Buffett and his billionaire board members to disdain D&O insurance, but persons of more ordinary means can ill afford to run the risk of uninsured board service. Every time I read Buffett’s comments about D&O insurance, I feel like they should include a warning that “Readers should be cautioned to recall that he is one of the wealthiest people on the planet and his personal net worth is greater than the policyholders' surplus of most insurance companies’; readers should not attempt this trick at home.”

While I think this volume of essays is a worthy introduction to Buffett’s views and business philosophy, a lot of the writing will lack context for many readers. To know why Buffett quotes Ben Graham, and what he means by it, it is really necessary to understand more about Buffett’s days in graduate school and his early days working for Graham. His comments about many of his investments, such as Capital Cities/ABC or Solomon Brothers, require a great deal of prequel and sequel in order to appreciate fully what Buffett is saying. So I would recommend as a companion to this volume of essays Roger Lowenstein’s excellent biography of Buffett (here). Even though Lowenstein’s book is now 13 years old, it still conveys a lot about how Buffett got there, which is of course what most people – like those investing docs who attend the Berkshire annual meeting every year – are interested in.

But these last quibbles with the content, such as they are, are minor. The book itself is quite an accomplishment; it is that rare business book that is worthwhile and entertaining and enjoyable to read.

Special thanks to Professor Cunningham for calling my attention to the book.

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One of the recurring suggestions in would-be reformers' standard litany of proposed changes for litigation relief is the introduction of auditor liability caps. For example, the Committee on Capital Markets Regulation interim report (about which refer here) proposed the “elimination or reduction of gatekeeper litigation, either through a cap on auditor liability or creation of a safe harbor for certain auditor practices.” Similarly, in early 2007, the European Commission launched a study (about which refer here) on “whether there is a need to reform the rules on auditor liability in the EU.”

But while these initiatives are only at the proposal or study phase, the U.K. has moved forward to permit “auditor liability limitation agreements,” under legal provisions that recently went into effect. The newly effective provisions are part of the Companies Act of 2006 (refer here for the Act’s text). The auditor liability limitation provisions are contained in Sections 532 to 538 of the Act, which took effect on April 6, 2008, according to the Act’s implementation timetable (here). For background regarding the Act, refer here.

The Act allows auditors to limit their liability by contract, provided that their client’s shareholders approve. Section 534(1) of the Act allows auditors to limit their liability “in respect of any negligence, default, breach of duty or breach of trust, occurring in the course of an audit of accounts.” The limitation cannot cover more than one financial year and it must be approved by a resolution of shareholders. Under Section 537, the liability limitations are not effective except to the extent they are “fair and reasonable” in the particular circumstances.

The Act itself does not specify the particular kinds of limitations that are allowable nor does it prescribe the form the limitation is to take. However, a working group of the Financial Reporting Council, the supervisory body for U.K. auditors, has proposed “draft guidance” (here) suggesting ways that the limitation agreement might be framed. The FRC guidance document even includes specimen language to be used as a reference in preparing limitation agreements.

The FRC guidance suggests three alternative ways the auditor’s liability might be limited: (a) proportionality, “where the auditor’s liability is limited to his share of the company’s loss, taking into account the liability of others”; (b) fair and reasonable, “where the auditor’s liability is limited to such amount as is fair and reasonable in accordance with Section 537 of the Act”; or (c) monetary cap, “where the auditor’s liability is limited to a particular amount, which is either stated or calculated in some way, e.g.. as a multiple of audit fees.”

The Act’s auditor liability limitation provisions represent an interesting experiment, but it will be even more interesting to see how widespread the acceptance of auditor liability limitations agreements becomes. The Act’s requirements themselves may deter widespread adoption, particularly the one-year time limitation and the requirement for shareholder approval. One might also conjecture that there might be some stigma associated with a company’s agreement to limit its auditor’s liability, to the extent the existence of an agreement is interpreted to suggest that the only way the company could procure an auditor’s services was by granting the auditor a liability limitation. There is also legal uncertainty surrounding such issues as the extraterritorial effect of any limitations, which may be of particular concern for auditors of companies that have shareholders, creditors or other business partners outside the U.K.

It is probably also relevant that the auditor liability provisions were adopted as part of the Companies Act, which also contains provisions defining directors’ duties and incorporating new statutory procedures for bringing claims against directors. One wonders whether a company’s directors, newly sensitized to their duties and potential litigation risks, will be comfortable relieving their auditors of liability to the company for negligence or other misconduct. Even though the liability limitation has to be approved by shareholders, you can imagine the second-guessing and accusations that might surface if problems do arise later.

Within its draft guidance document, the FRC anticipates that companies may well wrestle with the question whether (or even why) they should agree to limit their auditor’s liability, and expressly observes that directors “will wish to establish that it is in the company’s interest to enter into a liability limitation agreement.” The guidance document does not attempt to suggest what interest a company would have in limiting its auditor’s liability.

Along with the question of what the take-up of the limitation agreement will be for U.K. companies is the question whether other jurisdictions will adopt the U.K. approach or similar auditor liability limitation provisions. A March 2006 report by Michael Gass and Ashwani Kochlar of Edwards Angell Palmer & Dodge entitled “U.K. Gives Auditor Liability Agreements a Greenlight, But U.S. is Unlikely to Do the Same” (same) takes a look at the new U.K. provisions and considers the possibilities for reform efforts in the U.S. The report concludes that current U.S. reform efforts are “ill-timed” and that given the turmoil in the financial markets, “garnering attention and support to adopt proposals … will be challenging” – unless one of the Big Four accounting firms implodes, in which case “all bets are off.”

The CorporateCounsel.net Blog also has an interesting post here discussing the newly effective U.K. provisions and expressing skepticism for the likelihood of auditor liability reform in the U.S. anytime soon.

Readers interested in the topic of auditor liability caps may want to refer back to my earlier post, here, in which I discuss the very interesting alternative proposal of George Washington University law professor Lawrence Cunningham. Professor Cunningham suggests having the audit firms issue bonds to the capital markets as a way to provide financial protection for their liability risks. 

U.K. Government to Appeal BAE Systems Ruling: In a recent post (here), I reviewed the April 10, 2008 decision by the U.K.’s High Court of Justice against the British government’s decision to terminate the investigation of alleged bribery involving BAE Systems in connection with a Saudi arms deal.

On April 22, 2008, Transparency International, on its own behalf as well as on behalf of several other organizations, wrote (here) to the U.K. Attorney General “urging the government not to appeal the judgment.” The letter stated that “halting the investigation has caused untold damage, both to the reputation of the U.K. and to global efforts to improve governance and combat corruption.” The letter also urged that the action to drop the investigation has “reduced [the U.K.’s] standing among its peers” in the OECD, and any move by the government to appeal “would compound the reputational damage to the U.K.” and would undermine the implementation of the United Nations Convention Against Corruption.

Nevertheless, on April 22, 2008, the Serious Fraud Office announced (here) that it will “seek permission to appeal to the House of Lords” against the lower court’s April 10 judgment. The SFO’s announcement quoted the current SFO director as saying that the April 10 judgment “raises principles of general public importance affecting, among other things, the independence of prosecutors and the role of the court in reviewing a prosecutor’s evaluation of the public interest in a case like this.”

It is very hard to argue that the U.K.’s efforts to suppress the BAE Systems investigation will not undermine its efforts elsewhere to fight corrupt practices. The unmistakable message is that the U.K. only cares about small scale corruption involving the less powerful, those whom the U.K. feels it can safely push around; but that these impediments can be overcome if the bribe is large enough and the corrupt official powerful enough. Nothing could do more to breed cynicism over anticorruption efforts that for the U.K. government to successfully suppress this investigation.

Hat tip to the Sox First blog (here) for the links to the Transparency International and Serious Fraud Office announcements.

Time Out for an Idol Thought: I was delighted to learn that my former partner from the Ross, Dixon & Bell law firm, Bill Hopkins, now apparently known by his nom de plume Will Hopkins, is a finalist in the American Idol songwriting competition. The WSJ.com Law Blog has an excellent interview of Bill, er, Will, here.

Hopkins, we shall call him, left active law practice to try to write music about the same time I left the law firm to become involved on the business side of insurance. Everyone must follow their own muse, I suppose.

Speakers' Corner: On Monday April 28, 2008, I will be speaking as a panelist at the C5 Conference on Securities Litigation in London, on a panel entitled "Liability Never Goes Away:Managing Risk and Tackling D&O Liability" The conference features a number of very distinguished speakers. A copy of the seminar materials, including conference agenda, can be found here. If you are attending the conference, I hope you will make it a point to greet me.

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As reflected in my running tally of options backdating lawsuit settlements (which can be accessed here), a number of the options backdating-related derivative lawsuits have settled for some combination of an agreement to pay the plaintiffs’ attorneys’ fees, some adjustment to the company officials’ options grants, and the company’s adoption of corporate governance reforms. But two April 7, 2008 opinions by Judge William Alsup of the United States District Court of the Northern District of California in separate options backdating derivative cases may raise potentially troublesome questions whether settlements in this form, without some cash payment directly to the corporation, are sufficient. As a minimum, the two opinions have important implications for the way settlements are presented to the court, and could also have important effects on the settlement dynamic in other cases going forward.

The first and most detailed of the two opinions relates to the options backdating derivative suit filed on behalf of Zoran Corporation, about which lawsuit I first wrote here. In a June 5, 2007 opinion in the Zoran case (here), Judge Alsup had previously denied the defendants’ motion to dismiss, as I previously discussed here.

Following the dismissal denial, the parties to the Zoran case entered settlement negotiations, resulting in a February 26, 2008 stipulation of settlement, which the parties presented to the court on March 3, 2008. At the preliminary approval hearing, the plaintiffs’ damages expert, at the court’s request, presented a report calculating the plaintiffs’ maximum damages as $16 million (including prejudgment interest), which incorporated both the alleged damaged cause to company by the defendants’ option grants as well as by option grants to the rank-and-file employees.

The proposed Zoran settlement involved: the payment of up to $1.2 million of the plaintiffs’ attorneys’ fees and costs; the repricing or cancellation of certain of defendants’ options, which repricing or cancelation was represented to the court to have a value of $1.65 million; the company’s adoption of certain corporate governance reforms; and the grant of a broad claims release.

In an April 7, 2008 opinion (here) that contains some remarkably harsh language, Judge Alsup denied the parties’ request for preliminary approval of the settlement.

The parties undoubtedly knew the settlement was in trouble when Judge Alsup opened his analysis by stating that the class action procedure can “lend itself to abuse” and “one form of abuse is a collusive settlement.” Judge Alsup said that a collusive settlement “usually comes with a cash award to counsel, a broad release of claims, and a cosmetic non-cash recovery for the abused shareholders.” Courts, Judge Alsup notes, must take care that absent shareholders are treated fairly; here, he concludes, the settlement “falls short of deserving preliminary endorsement.”

In considering the settlement, Judge Alsup turned first to the substance of the plaintiffs’ claims (the implication being that the claims appeared to be meritorious), and to a declamation upon the plaintiffs’ expert’s $16 million damages estimate. Judge Alsup then addressed each of the settlement components, finding each component lacking.

First, Judge Alsup noted that the parties were not proposing to restore to the corporation the gains the defendants made from the sale of options, but rather that certain other options would be canceled or repriced. The option cancelation was represented to have very substantial value to the corporation, but the two sides’ experts had reached different conclusions about the value. Judge Alsup found that by using the most conservative valuation method and valuation date, the value of the cancellation was only $216,955, a small fraction of the value both sides had represented to the court.

The court next turned to the repriced options, with respect to which Judge Alsup noted, with incredulity, that the options had actually been repriced in December 2006, which was not only over a year before the settlement was presented to the court, but was even before the plaintiff filed the consolidated amended complaint. The court said that “it should have been plainly disclosed that the defendants were proposing to settle based on an old concession rather than a new consideration.” The court went on to note that “even if the flaw could somehow be ignored,” the value of the repriced options had been “exaggerated.” If a “meaningful” valuation date were used, the value of the repriced options is “zero.”

Judge Alsup had similar concerns with respect to the corporate governance reforms, in that several of the reforms “were already adopted by Zoran’s board well before the parties sat down to discuss settlement terms.” The reforms in any event “do not compensate the company for damages suffered by the company as a result of defendants’ backdating.” The reforms are “hard to accept in lieu of some substantial portion of the $16 million in damages asserted by the plaintiffs’ expert.” Judge Alsup also found that the claim release was overbroad, and swept in circumstances that were not asserted in the amended complaint.

In concluding that the settlement was inadequate, Judge Alsup stressed that “the corporation would recover no cash, all the cash is going to counsel,” and even the supposed value of the $16 million of the foregone benefits is “illusory” and he concluded that this “low end settlement” did not deserve approval.

Judge Alsup was clearly troubled that he had been obliged on his own to ferret out the settlement’s weaknesses, many of which were contrary to counsels’ representations.

Judge Alsup concluded his opinion with a rather stern lecture on counsels’ “duty of candor,” which he said requires counsel to “lay out the weaknesses as well as the strengths” of the settlement. He also stressed that it is “unfair to try to slip a weak or collusive settlement past the judge, hoping he or she will sign off or will not stumble upon the right questions.” A $1.65 million settlement, while at the low end, might be adequate, but the “main vice is that the proposal does not come even close to the $1.65 million settlement it was advertised to be.”

Many of the problems the court identified clearly were the result of communications issues. The parties perhaps could have avoided some of the difficulties by making joint valuation presentations that were scrubbed and scrutinized ahead of time. The court was also clearly upset to discover upon inquiry (rather than being told) that some of the remedies proposed had been undertaken prior to the settlement agreement; better communication around these settlement components potentially could have averted some of the court’s concerns.

But there are other aspects of the court’s commentary that are not merely the consequence of poor communication. First and foremost, Judge Alsup appeared to be troubled by how little the corporation would be getting, and in particular that the corporation would be getting no cash. He was also troubled that the settlement’s putative $1.65 million value, even if valid, was at the “low end” of plaintiffs’ damages analysis. In a sign that may have important implications for other settlements, he was also clearly skeptical that the noncash portions of the settlement – including even the corporate governance reforms, to which he attached little value --had value commensurate with the claimed injuries to the corporation.

But while there clearly are important implications from Judge Alsup’s ruling in the Zoran case, before fully considering those implications, it is important also to review Judge’s Alsup’s opinion (here), also dated April 7, 2008, in the CNET Networks options backdating-related derivative lawsuit, which provides even further context.

In his CNET Networks opinion, Judge Alsup refused even to consider the parties’ proposed settlement. Judge Alsup had previously granted defendants’ motion to dismiss (refer here), on the grounds that demand was not excused, but stayed the case to allow the plaintiffs to seek discovery through the Delaware courts and to attempt to replead. In response to an inquiry from the court about status, the parties advised the court that settlement negotiations were underway, and the parties then presented a joint motion to lift the stay for the limited purpose of seeking a preliminary approval of a settlement. Judge Alsup said that it found these actions “disappointing” because the parties did not, as they had represented to the court they would, complete discovery, nor did plaintiff file an amended complaint. Instead the parties sought to settle the case, about which Judge Alsup said

any settlement, at this early stage, seems very premature, for the Court could not be in a position to evaluate a settlement until we know what claims are viable and what depositions, discovery, and damage assessments show about the strength and magnitude of those claims. At this stage, moreover, plaintiff has no standing at all to negotiate on behalf of the corporation and its shareholders. Plaintiff has never been excused from the demand requirement. Plaintiff is not in any way authorized to release claims on behalf of any shareholders or the corporation. It would be hard to see how plaintiff could do so intelligently without first framing the claims and then performing sufficient due diligence through formal discovery and investigation, including a full damage report. Now, any legitimate settlement reached later may be tainted by what could appear to have been collusion. To deal with this eventuality, all notes and materials generated by or during the recent settlement discussions should be preserved. For the Court’s views on collusive settlements see In Re Zoran Corporation Derivative Litigation.

Judge Alsup went on to note that “the best way to tee up this case for settlement is to find out first whether the plaintiff even has standing to sue (the demand issue) and thus to release claims on behalf of the corporation,” and then to evaluate which options were backdated and the dollar value to the corporation of these claims. “It would,” Judge Alsup said, “be very hard to evaluate a settlement without due diligence, including depositions and documents.”

Judge Alsup’s two opinions taken together represent a strong statement that, because of the court’s responsibilities to absent class members, the court must take its obligation to review proposed settlements very seriously. The court clearly should not be expected just to rubber stamp a settlement to which the parties’ representatives have agreed. In order to get settlement approval, and avoid the suggestion of collusion, the parties will have to show certain key considerations: first, and at a minimum, that the plaintiff even has standing to represent the class and enter the settlement; second, that the settlement is proportionate to the injury to the corporation that the plaintiff has claimed; third, that the claimed values to the corporation are supported; and fourth, that the corporation is fairly compensated for its damages and its release of claims.

Even though Judge Alsup’s opinions technically have no precedential effect beyond the immediate cases themselves, the strength of the language he used, the seriousness of the concerns he noted, and the possibility of similar questions undermining other settlements could well have an in terrorem effect on other litigants in other cases. Certainly no litigant would want to take a chance that a court might suggest that their proposed settlement could be “collusive.” Even though many of the aspects of these opinions are a reflection of the particular circumstance involved, the opinions also bespeak more general principles that could have broad influence. In particular, Judge Alsup’s statement in the CNET Networks case that he could not even consider a proposed settlement until the plaintiff first establishes its right to enter a settlement and presents an adequate factual record and damages analysis suggests that cases must have progressed past a certain stage before the parties can even proffer a proposed settlement to the court.

There are several interrelated issues arising from Judge Alsup’s requirement for a damages analysis, his requirement that the settlement be proportionate to the alleged harm, and his obvious concern in the Zoran case that no cash was going to the corporation. The overall suggestion is that a few gestures and payment of some legal fees may not be enough. There may actually need to be some cash going to the corporation, proportionate to the alleged harm. Judge Alsup’s unwillingness to recognize significant value to the corporation for the corporate governance reforms may be particularly troublesome.

As I noted at the outset, many of the options backdating derivative cases that have been settled so far have been resolved on terms similar in many respects to the components of the Zoran settlement. The likely reason why there is no cash payment to the corporation in many of these cases is that D&O insurers balk at funding amounts they contend represent a disgorgement or a return of an ill-gotten gain. The individual defendants, for their part, resist making out of pocket payments for which insurance is unavailable. The parties thus perforce attempt to cobble together an agreement that resolves the case without any cash transfer other than the payment of plaintiffs’ counsel’s fees.

Judge Alsup’s opinion, particularly his repeated use of the word “collusive” and statement that the value to the corporation from the Zoran settlement was “illusory” could introduce a great deal of tension into this negotiation dynamic. Both insurance carriers and individuals could face heightened pressure to make cash contributions to the corporation to resolve these cases. Insurers will likely continue to resist any payment on their part, owing to policy exclusions for disgorgement and the return of ill-gotten gains.

Another important implication is that the parties must be prepared to substantiate their settlement, and that discovery, depositions, damages assessments and other procedures may be required to satisfy these requirements. These procedures could prove costly for all concerned – particularly for the D&O insurers, who not only will foot the bill for increased defense expense, but also ultimately could be called upon to pay the plaintiffs’ fees as well, as part of any eventual settlement.

Notwithstanding the foregoing, of the parties involved, the participants that may face the biggest problems if these cases become more difficult to resolve are the plaintiffs’ lawyers. There is a suggestion in both of these cases that the plaintiffs’ lawyers are starting to find the cases tiresome and just want them to go away. Indeed, one of the things that clearly seemed to be bothering Judge Alsup in these cases is that the plaintiffs’ lawyers were settling (too) cheap or walking away without even doing what the Judge at least believes to be minimally required. The plaintiffs’ lawyers piled into these kinds of cases with enthusiasm but they may now be repenting their involvement. The implication of Judge Alsup’s opinion may be that the plaintiffs’ lawyers may be challenged to extricate themselves.

According to my tally (which can be found here), there have been a total of 166 options backdating lawsuits filed. To date, only a small portion of these cases (less than a third) have been settled or otherwise resolved. The vast majority, well over one hundred, of these cases remain pending. Of course it remains to be seen, but I suspect that Judge Alsup’s opinions in these two cases will prove to have introduced significant challenges for parties trying to move these pending cases toward resolution.

Very special thanks to Zusha Elinson of The Recorder for providing me with copies of these opinions. Elinson’s April 24, 2008 article in The Recorder about the opinions entitled “Alsup Rejects Easy Options Deals” can be found here (Full disclosure: I was interviewed in connection with the article).

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Next up as targets in the ever-growing wave of subprime-related class action lawsuits are closed-end funds that issued auction preferred securities. The auction marketplace for these securities, like the market for auction rate municipal bonds, has broken down, and investors who bought the securities are now suing the closed end funds that issued the instruments.

First, some background. According to the Investment Company Institute’s web page describing and explaining closed end funds (here), closed end funds are managed investment companies that issue a fixed number of shares. The shares trade on the open market. In addition to these common shares, many closed end funds also issue preferred shares. The owners of the preferred shares are paid dividends, but they do not participate in the fund’s gains and losses. The sale of preferred shares gives the fund leverage, by permitting the fund to make additional investments, hoping to improve the common shareholders’ returns. For auction rate preferreds, the dividend rate is set through periodic auctions, typically held every seven or 28 days.

According to a March 9, 2008 New York Times article entitled “As Good as Cash, Until It’s Not” (here), the marketplace for municipalities’ auction rate notes is $330 billion, and the market for closed end fund auction rate preferred securities is $65 billion. But more to the point, investors in auction rate preferred securities, like investors in municipalities’ auction rate notes, have discovered that due to the February 2008 breakdown of the auction rate marketplace, investors find they are “stuck” with their investments and unable to sell them through the auction market.

But auction rate preferred investors are, according to the Times article, faring “far worse than investors stuck with municipal issues,” because many municipal note investors are receiving a penalty rate of up to 12 percent or more, a rate that is “much higher than the caps on closed-end notes, which are currently around 3.25 percent.” The closed end issuers “have no incentive to redeem their notes since the interest rate resulting from the failed auction is so low.”

A March 30, 2008 New York Times article entitled “If You Can’t Sell, Good Luck” (here) explains that auction rate preferred investors’ difficulties put the closed-end fund issuers “in something of a conflicted position,” because the common shareholders’ returns are enhanced by the leverage from the preferred securities investment. While the preferred holders would like their shares to be redeemed, the “common shareholders would lose out on extra income generated by the preferred share structure.”

Under these circumstances, it is hardly surprising that the class action securities attorneys have now gotten involved. According to their press release (here), on April 21, 2008, the plaintiffs’ attorneys’ filed a purported securities class action lawsuits in the United States District Court for the Southern District of New York against the Calamos Global Dynamic Income Fund, on behalf of investors who acquired “Auction Rate Cumulative Preferred Shares” (ARPS) in the fund’s September 17, 2007 offering of $350 million of the securities. The complaint, which can be found here, also names as defendants the two investment banks that led the offering.

According to the press release, the complaint alleges that the offering documents omitted that:

(i) the purported “auctions” used by Calamos Fund to get the dividend rates were not bona fide auctions at all, but rather a mechanism to maintain the illusion of an efficient and liquid market for the ARPS so that the Calamos Fund could continue to earn fees from the so-called auctions and from the ongoing stabilizing of the market because of the lack of buyer demand; (ii) the default interest rate set as a consequence of a failed auction is less than the interest rate paid when auctions of certain competing municipal auction rate securities (“MARS”) offered directly by municipal issuers fail; (iii) the ARPS suffer from an additional disadvantage compared to MARS because the ARPS are securities which exist in perpetuity until such time as the Fund calls them due while MARS have a set due date; and (iv) the default interest rate as set would cause the ARPS to trade at a discount to their par value if, and when, the auctions began to fail.

The complaint further alleges that as a result of the auction rate marketplace failure “auction rate securities that were once offered as ‘cash equivalents’ are now illiquid, resulting in economic losses and severe hardships for investors.”

As I have previously noted (most recently here and here), there already is a growing wave of auction rate securities class action lawsuits. However, this most recent lawsuit differs from the prior actions, and not merely because it involves closed end fund auction rate preferred securities rather auction rate notes issued by municipalities. The new lawsuit is also different because it targets the issuer; in the prior auction rate lawsuits, the plaintiffs targeted the broker dealers that sold the securities, not the municipalities that issued the securities.

One thought I had while reviewing the Calamos complaint is that many of these auction rate lawsuits may present some interesting issues related to damages. In most instances, the instruments are continuing to pay interest according to their terms. With respect to the closed end fund notes, the securities are backed by real assets held in the funds, which would seem to suggest that the instruments retain substantial economic value. Even if the auction rate market itself proves to be permanently broken, it would seem that there should be strong economic incentives all the way around for a secondary market for these shares to develop. Of course, whether a fully functional secondary market emerges, and whether the marketplace requires a significant discount for these shares to trade, remains to be seen. But right now, calculating the alleged damages does seem to pose some challenging issues, particularly some mechanism to trade the shares develops while these cases are pending.  

Subprime Litigation Wave Hits Credit Suisse: On April 21, 2008, plaintiffs’ counsel also initiated a securities class action lawsuit in the United States District Court for the Southern District of New York against Credit Suisse Group and certain of its directors and officers. According to the plaintiffs’ attorneys’ press release (here), the complaint alleges that the “defendants failed to write down known impaired securities containing mortgage-related debt.” Specifically, the complaint alleges that

(a) that defendants failed to record losses on the deterioration in mortgage assets and collateralized debt obligations (“CDOs”) on Credit Suisse’s books caused by the high amount of non-collectible mortgages included in the portfolio; (b) that Credit Suisse’s internal controls were inadequate to ensure that losses on residential mortgage-related assets were accounted for properly; and (c) that Credit Suisse’s traders had put incorrect values on CDOs and other debt securities, concealing the exposure the Company had to losses.

The complaint (which can be found here), also alleges that on February 19, 2008, the company announced (here) fair value reductions of $2.25 billion following its repricing of its asset-backed positions, triggering a sharp decline in the company’s share price.

The plaintiffs’ lawyers have engineered the purported class on whose behalf the action is brought, in a clear attempt to avoid jurisdictional challenges and other concerns. The purported class includes all shareholders who purchased Credit Suisse ADRs on the NYSE, and all U.S. residents or citizens who purchased Credit Suisse stock elsewhere. This purported class excludes non-U.S. investors who purchased their securities outside of the United States.

This class composition seems tailored to match the composition of the class recently certified in the Converium securities lawsuit (as discussed in greater detail on the Securities Litigation Watch blog, here). This class composition also avoids many of the so-called “f-cubed” litigant problems (involving foreign domiciled shareholders who bought their shares in a foreign company on a foreign exchange). Avoiding this issue could eliminate friction at the lead plaintiff, motion to dismiss, and class certification stages. It does raise questions about the foreign litigants and their apparent inability to seek class remedies of the type that other securityholders in the same company are able to pursue in the U.S. Whether that triggers these securityholders to file a bunch of individual actions, as happened after the foreign litigants were excluded from the Vivendi lawsuit (as also discussed on the Securities Litigation Watch blog, here), remains to be seen.

For further background about the “f-cubed” issue, refer to my prior posts, here and here.

Run the Numbers: With the addition of these two new lawsuits, the current tally of subprime and other credit crisis related lawsuits, which can be accessed here, now stands at 76, 36 of which have been filed in 2008. Of the 38 so far in 2008, 15 (including the Calamos lawsuit described above) are auction rate securities lawsuits.

Excess D&O Insurance Coverage Issues: In several posts (most recently here), I have examined the increasingly important emergence of coverage disputes involving excess D&O insurance. In the latest issue of InSights, entitled “Excess Liability Insurance: Coverage Disputes and Possible Solutions” (here), I take a more comprehensive look at the coverage issues involving excess D&O insurance.

Speaker’s Corner: On April 22, 2008 at 1:00 P.M. EDT, I will be participating in a one-hour webinar sponsored by Merrill Corporation entitled “The Subprime Ripple Effect: Preparing for the Wave of Litigation.” The other participants include Thomas Reilly, the former Massachusetts Attorney General and a shareholder in the Greenburg Traurig law firm, and Mark Kindy, EVP of Strategy and Operations for Merrill Corp. Registration (which is free) can be accessed here.

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I have previously noted (most recently here) the increasing significance of opt-out actions as a part of securities lawsuit resolution. Columbia Law School Professor John Coffee, in a March 27, 2008 paper entitled “Accountability and Competition in Securities Class Actions: Why ‘Exit’ Works Better Than ‘Voice’” (here) examines the opt-out phenomenon and concludes that while the increased recoveries in opt-out actions compared to class recoveries will encourage competition among plaintiffs’ counsel, shareholder litigation could become even costlier to resolve.

Coffee also concludes, contrary to what others have “prematurely predicted,” that shareholder class action lawsuits “will not die or whither away, but that the current system of shareholder class action lawsuits may be abandoned in favor of a “two-tier system,” in which “the largest investors will opt-out and sue in state court individual actions, with the class action becoming the residual vehicle for smaller investors.” These possibilities have enormous implications for the future of securities litigation, which Coffee’s paper explores.

Coffee opens his paper comparing the changes wrought by the opt-out phenomenon with prior legislative efforts to reform class action litigation. Specifically, Coffee notes that unlike legislative efforts to give the class greater control, such as the lead plaintiff provision of the PSLRA, the increasingly utilized opt-out option may offer true oversight, actual competition, and even lead to better results for the plaintiff class.

In analyzing these developments, Coffee adopts terminology from the writings of economist Albert O. Hirschman. Hirschman describes two ways in which organizational behavior may be modified: (i) participants can be given greater “voice”; or (ii) participants can be given increased ability to “exit” the system. Coffee contrasts the legislative reforms, such as the lead plaintiff provision, designed to give class members greater “voice,” with the alternative of “exit” offered by the opt-out option. Coffee concludes that “ ‘exit’ works better than ‘voice,’” at least within realm of securities class actions.”

A critical component of Coffee’s analysis is that “when institutional investors exit the class and sue individually, they appear to do dramatically better – by an order of magnitude!” Coffee views this as an “optimistic development” because the opt-out outperformance can “kickstart active competition” among plaintiffs’ attorneys, by contrast to the PSLRA reforms which have had the perverse effect of reducing competition.

As Coffee notes, these developments have significant implications for the future of class litigation, as large institutional investors increasingly may conclude that their interests are better served by proceeding separately. Coffee specifically notes that the current wave of subprime-related cases are “particularly likely to produce a high rate of opt-outs,” because of the predominance of institutional investors among purchasers of the kinds of asset-backed securities that are at the heart of many of these lawsuits.

Coffee speculates that defendants (and indeed all class litigants) may seek to employ adaptive practices to offset these developments. Among other possibilities Coffee reviews are such practices as advancing the time of the opt-out decisions before the settlement is reached; structuring the settlement in a way to give class members “priority” over individual recoveries, such as given them a security interest in company assets to the extent of the settlement amount; including a “most favored nation” provision in class settlements so that class members are entitled to increase their recovery if opt-outs reach a higher settlement; or even reducing the settlement amount in respect of each opt-out.

In the final analysis, each of these potential adaptations has shortcomings. Over the long run, Coffee anticipates, “increased opting out will place class counsel under increased competitive pressure to improve the class settlement.” For that reason, Coffee concludes that “greater competition is coming.”

I very much agree with Professor Coffee that the emergence of significant opt-out settlements represents a watershed development in securities class action litigation, with the potential to have an enormous impact. However, I think it does still remain to be seen how widespread the opt-out phenomenon will prove to be.

The increased recovery percentages (so far) in the high profile opt out actions do provide obvious incentives for institutional investors to become more focused on their opt-out opportunities. But so far the significant opt-out activity has been limited to “mega” cases where the aggregate recoveries, for both the class and the opt-out litigants have run into the hundreds of millions and even the billions of dollars. It is entirely possible that rather than becoming a universal phenomenon affecting all, most, or even many securities class actions, significant opt-out activity will be limited only to a small handful of cases where the dollars involved reach this rarified range. Without more, it seems premature to project that shareholder litigation is about to enter a two-tier system where institutional litigants have abandoned class resolutions altogether.

That said, even if the phenomenon proves to be limited only to a small subset of securities cases, the opportunities and incentives involved could still affect the overall outcome of many securities cases. Just the threat of material opt-outs could affect the class action settlement dynamic. As Professor Coffee notes, some adaptive behavior is likely, as litigants seek to suppress or minimize the prospects for opt-outs. The likeliest adaptive behavior is that class settlements overall could be driven upward, as all class settlement participants seek to remove the incentive to opt out by improving the class settlement itself.

We are already in an era of increasing average claim severity. The emergence of the opt-out phenomenon can only amplify these trends. In any event, the developments related to opt-outs also present important implications for D&O insurers’ severity assumptions and for insurance purchasers’ assumptions about limits adequacy. The direct and indirect impacts from the emergence of significant opt out activity could make historical assumptions in this regard obsolete.

Very special thanks to Professor Coffee for his permission to cite and quote his paper, which, he emphasizes, is preliminary only.

Hat tip also to Werner Kranenburg of the With Vigour and Zeal blog (here) for the link to Professor Coffee’s paper.

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When the United States Supreme Court issued its June 21, 2007 opinion in the Tellabs case, media commentators generally viewed it as a defense victory. My own view (expressed here), was that the decision represented more of a draw, and that the practical impact would vary from Circuit to Circuit. The suggestion that Tellabs was not a comprehensive defense victory was arguably reinforced in the ongoing Tellabs case itself, when (as discussed here) the Seventh Circuit, reconsidering the case on remand from the Supreme Court, reaffirmed its prior reversal of the district court’s dismissal of the case.

An April 16, 2008 opinion (here) from the First Circuit in the Boston Scientific securities lawsuit provides even further support for the view that Tellabs by no means put the plaintiffs’ lawyers out of business, and indeed, that in some circuits – the First Circuit, for example – Tellabs may even put the plaintiffs in a better position than the were prior to Tellabs. I discuss the First Circuit’s opinion in the Boston Scientific case in detail below, but the critical point here is that the while the district court, applying the First Circuit’s pre-Tellabs standard, had dismissed the case, the First Circuit, applying the Tellabs standard, reversed the district court and remanded the case for further proceedings.

The background regarding the Boston Scientific case can be found here. In a nutshell, the complaint alleges that in late 2003, the company became aware of serious problems in Europe with its TAXUS stent, which at the time had not been introduced in the U.S. The company allegedly experienced serious problems, allegedly of the same kind as the prior problems in Europe, after the stent was introduced in the U.S. in March 2004. The plaintiffs allege that the company sought to soft-pedal the problems by representing that they were due to physician unfamiliarity with the stent, while the company allegedly knew that the problems were actually due to manufacturing defects. The defendants allegedly withheld the true information while TAXUS sales drove up the company’s share price, allegedly in order to permit the defendants to unload their shares of the company’s stock at the inflated prices. After the company announced a series of stent recalls, its share price fell and the securities litigation ensued.

In an opinion dated June 21, 2007 (here), issued ironically the same day as the U.S. Supreme Court issued its opinion in the Tellabs case, the district court granted the defendants’ motion to dismiss. Among other things, the district court held that the plaintiff failed, as required under the PSLRA, to plead facts supporting a “strong inference” that as of the time of the stent recall and manufacturing changes, the defendants had the requisite scienter. The plaintiffs appealed.

The First Circuit, in an opinion written by Judge Sandra Lynch, noted that “the district court did not have the benefit of the Tellabs opinion, which reversed a higher standard for scienter imposed by the prior law of the circuit. We apply Tellabs and that leads us to a different result.” The court went on to note that “while there is support for the defendants’ inferences, we think, at this stage, that plaintiff’s inferences are at least equally strong.”

The First Circuit also reversed the district court’s holding as to reliant on the view that the plaintiffs’ allegations were essentially just “fraud by hindsight.” In addition, the First Circuit said that while the plaintiffs’ insider trading allegations are “on the weaker end of the spectrum…a finder of fact could reasonable ask why [the defendants] would have sold so much stock at a time when the company appeared to be soaring on the strength of TAXUS.” On these and other bases, the First Circuit concluded that “plaintiff has pled enough to give rise to inferences that are at least as strong as any competing inference regarding scienter.”

In reversing the district court, the First Circuit expressly acknowledged that Tellabs has reversed “a higher standard” that the First Circuit itself had previously “imposed” as the “law of the circuit.” This specific statement is an explicit recognition that, in the First Circuit at least, the Tellabs standard not only did not advance the defendants’ interests, but it arguably aids’ plaintiffs’ interests by imposing a lower threshold pleading requirement.

At a minimum, the First Circuit opinion in the Boston Scientific case underscores that the Tellabs opinion represents something less than that the watershed defense victory it was initially portrayed to be. The decision also highlights that even after Tellabs, in certain circumstances, plaintiffs will be able to continue to meet the PSLRA’s pleading requirements – particularly in certain circuits.

Another Options Backdating Securities Lawsuit Dismissal: In the latest dismissal motion ruling in an options backdating-related securities lawsuit, Judge Susan Illston of the United States District Court for the Northern District of California, in an April 14, 2008 opinion (here) in the UTStarcom case (about which refer here), granted the defendants’ motion to dismiss, and directing the plaintiff to file an amended complaint by May 16, 2008.

Judge Illston found that while the plaintiff had adequately pled loss causation, he had not adequately pled scienter. In rejecting the plaintiff’s scienter allegations, Judge Illitson found that “none of these factual allegations is cogent and compelling…because each could equally support the inference that the stock option had been backdated through innocent bookkeeping error.”

The UTstarcom dismissal is the latest in a series of options backdating-related securities lawsuit dismissals, as discussed in my recent post (here) commenting on other recent dismissals. I have added the UTStarcom dismissal to my running tally of the options backdating lawsuit dismissals, denials, and settlements, which can be accessed here.

Special thanks to Adam Savett of the Securities Litigation Watch blog (here) for copies of the Boston Scientific and UTstarcom opinions.

A Reflective Moment: The coincidence that both of the opinions cited above were both written by women made me wonder something – how many female members of the federal judiciary are there? The answer, determined after a little bit of Internet research, is that there are a lot of female federal judges, although women clearly are still underrepresented on the U.S. Supreme Court, the First Circuit, and several other federal courts. A slightly outdated list of women in the federal judiciary can be found here.  

The list includes, among others, Leonie M. Brinkema, now a district court judge on the United States District Court for the Eastern District of Virginia. I had the privilege of seeing Judge Brinkema, while she was still known to some as “Dee Dee”, appear in court when she was an AUSA (and I was a clerk for a federal judge). She was the most skilled and effective advocate I ever saw in action.  

I learned many things from watching her, including the lesson that you did not have to be loud or obnoxious to be an effective advocate, a very important lesson for a young attorney to learn. If others of my brethren (and sistren) at the bar could also have learned the same lesson, I might still be involved in the active practice of law. Judge Brinkema is perhaps best known for presiding over the trial of 9/11 conspirator Zacharias Moussaoui, whom she told at his sentencing to life imprisonment that he would "die with a whimper."

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Add corporate debt to the type of lending caught up in the current credit crisis, and add both commercial real estate financing companies and private equity firms (or at least one that recently completed a high profile public offering) to the kinds of companies now ensnared in the current wave of lawsuits. The latest round of lawsuits suggests just how far afield these cases may spread before all is said and done.  

The iStar Lawsuit: The lawsuit filed on April 14, 2008 in the United States District Court for the Southern District of New York against iStar Financial and certain of its directors and officers represents these latest variants in the evolving course credit crisis litigation wave. A copy of the plaintiffs’ lawyers’ press release about the iStar lawsuit can be found here, and the complaint can be found here.

The iStar lawsuit is brought on behalf of shareholders of the company who bought their shares in the company’s December 13, 2007 secondary offering, in which the company raised more that $227 million. According to the complaint, the offering documents failed to disclose that the company was at the time of the offering experiencing negative effects from the credit market turmoil and failed to recognize more that $200 million of losses on its “corporate loan and debt portfolio.”

On February 28, 2008, the company reported (here) a fourth quarter 2007 loss of 478.7 million, due in part to $134.9 million in charges associated with the “the impairment of two credits that are accounted for as held-to-maturity debt securities in its Corporate Loan and Debt portfolio.” and due to the fact that the company had increased its loan loss provisions by $113 million.

The Blackstone Lawsuit: In another example of the far flung effects from the current market turmoil, investors who bought shares of The Blackstone Group, L.P in the firm’s June 25, 2007 IPO have filed a lawsuit in the United States District Court for the Southern District of New York against the company and certain of its directors and officers.

According to the plaintiffs’ lawyers’ April 15, 2007 press release (here), the complaint alleges that the offering documents failed to disclose that Blackstone’s “portfolio companies were not performing well and were of declining value and, as a result, Blackstone’s equity investment was impaired and the Company would not generate anticipated performance fees on those investments or would have fees ‘clawed-back’ by limited partners in its funds.”

The complaint (which can be found here) alleges that in the company’s March 10, 2008 announcement (here)of fourth quarter and year end financial results, the company announced “announced that it was writing down its investment in Financial Guaranty Insurance Company by $122 million.”

Financial Guaranty Insurance Company is a bond insurer that has been struggling due to downgrades of its own credit rating. FGIC’s travails have already resulted in a prior securities class action lawsuit against the company’s other significant investor, The PMI Group. My prior discussion of The PMI Group securities litigation can be found here.

These events and ensuing lawsuits represent the latest extension of the circumstances that originated with the subprime lending meltdown but now are increasingly widespread. I recently highlighted (here) the turmoil (and ensuing litigation) that had affected the student lending sector. The extension of the effects and of the litigation, first to the commercial lending sector and to a commercial real estate financing company, and next to a private equity firm that went public only a short while ago amidst great hoopla and now has been sued for it, are merely the latest developments in what clearly promises to be an increasingly encompassing phenomenon.

As I have noted before, observers who persist in viewing the credit crisis and ensuing litigation as an exclusively “subprime”-related problem will not only fail to comprehend what has already occurred, but will likely underestimate what may lie ahead.

Another Auction Rate Securities Lawsuit: Another related recent development in this area is the lawsuit filed on April 14, 2008 on behalf of auction rate securities investors against Wells Fargo & Co. The plaintiffs’ attorneys’ press release can be found here and a copy of the complaint can be found here.

With the addition of the iStar, Blackstone and Wells Fargo lawsuits, my current tally of credit crisis-related securities lawsuits, which can be accessed here, now stands at 73, 33 of which have been filed in 2008. Thirteen of 73 lawsuits are brought on behalf of auction rate securities investors.

More Suits Against Securitzers: In earlier posts (here and here), I noted the emergence of securities class action lawsuits brought on behalf of investors against the investment banks and related entities that securitized mortgages and other types of debt into financial instruments in which the investors invested and in which they lost money.

The latest of these lawsuits was brought on March 19, 2008 in New York Supreme Court by the City of Ann Arbor Employees’ Retirement System on behalf of investors who purchased Mortgage Pass-Through Certificates as part of a December 12, 2006 offering of the instruments. Named as defendants are Citigroup Mortgage Loan Trust, which organized the offering of certificates backed by pools of mortgages, and 18 mortgage loan trusts, in which the mortgages were held. The defendants have removed the lawsuit to the United States District Court for the Eastern District of New York. Background regarding the lawsuit can be found here. A copy of the removal petition, to which the complaint is attached, can be found here.

The complaint alleges that the offering documents misrepresented the underwriting standards used in connection with the mortgage origination, and also misrepresented the various criteria used to qualify loans and properties. As a result, the complaint alleges, the offering documents misrepresented the risk profile of both the secured assets and the certificates.

The Citigroup lawsuit is substantially similar to the lawsuits previously brought against affiliates of Nomura (about which refer here), Countrywide (refer here) and Wachovia (refer here). This latest complaint is also similar to those prior complaints in that the plaintiffs (who in each case are represented by the Coughlin Stoia firm) sought to initiate each lawsuit in state court. My detailed analysis of the jurisdictional issues involved can be found in the post linked above regarding the Nomura lawsuit.  

Though the defendants have uniformly sought to remove these cases to federal court, in the Countrywide case, the earliest of these cases to be filed, the federal court granted the plaintiffs’ motion to remand the cases to state court. As noted in my discussion of the Countywide remand decision here, the federal court’s remand of the case to state court was based on the grant of concurrent jurisdiction to state courts for ’33 Act liability cases, a jurisdictional grant the federal court found has not been eliminated by subsequent legislation.

I have previously speculated that the plaintiffs’ strategy for pursuing these cases in state court is to avoid the requirements of the PSLRA, an impression that is reinforced by the fact that the plaintiffs’ lawyers did not issue a press release at the time they filed these state court complaints. Whether other defendants’ attempts to remove these lawsuits to federal court will ultimately prove to be successful remains to be seen, but the prospect of significant nationwide securities litigation going forward in state court seems fraught with the potential for uncertainty, opacity and complexity.

You’re Such a Lovely Audience, We’d Like to Take You Home With Us: As your reward for reading this far, I am going to share a wonderful little secret with you. Stanford Law School, which has long maintained its excellent Securities Class Action Clearinghouse (here) has now started the Stanford Global Class Action Clearinghouse (here). The new site is devoted to tracking the development of class action litigation throughout the world. While the site is new and is only just getting started, it already has very interesting materials and shows great promise. We can only hope its sponsors and guardians develop and maintain this new site as well as the predecessor.

Hat Tip to my good friends at the Drug and Device Law Blog (here) for the link to the new site.

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A lawsuit filed late last week against First Marblehead Corporation underscores that the current lawsuit onslaught so often referred to as the “subprime” litigation wave is, and really has been for awhile, about so much more than just subprime. Although we are probably stuck with the “subprime” label as a shorthand way to describe these developments, the label encompasses a credit crisis that goes far beyond subprime lending.

First Marblehead is a Massachusetts-based company in the business of underwriting, packaging and securitizing student loans. Operating out of First Marblehead’s offices is a nonprofit organization called The Education Resources Institute (“TERI”) that provides guarantees of student loans that First Marblehead originates. On April 10, 2008, plaintiffs’ lawyers filed a securities class action lawsuit in the United States District Court for the District of Massachusetts against First Marblehead and certain of its directors and officers. A copy of the plaintiffs’ counsel’s April 10 press release can be found here. A copy of the complaint can be found here.

The complaint alleges that during the class period of August 10, 2006 to April 7, 2008, the defendants made material misrepresentations “concerning the performance and quality of First Marblehead’s securitizations, its ability to perform additional securitizations, TERI’s ability to adequately guarantee [First Marblehead’s] student loans, and the Company’s financial results and its ongoing operations.” The complaint alleges that the company “misrepresented the level of default rates in its portfolio,” and “disregarded that TERI was underreserved and unable to adequately insure” the company’s loans. According to the complaint, TERI filed for bankruptcy protection on April 7, 2008, and the company’s stock plunged.

The First Marblehead lawsuit has nothing directly to do with subprime lending itself. Indeed, the occurrence of credit-related litigation essentially unrelated to subprime lending is really nothing new – First Marblehead is not even the student loan company to be sued in a securities class action lawsuit as part of the current litigation wave, given the lawsuit filed in January 2008 against SLM Corporation (“Sallie Mae”), about which refer here.

The student lending cases, like the auction rate securities litigation, are about the secondary and tertiary consequences in the credit marketplace following on the consequences first triggered by the subprime lending meltdown. But the spread of litigation to other types of credit and other kinds of companies underscores the dark possibilities for a crisis that began in the residential real estate lending sector to spread across the entire economy and activate a much broader array of litigation.

It is probably worth noting that the turmoil that has hit the student lending sector is not limited just to the student loan organizations themselves; companies that invested in student loan-backed securities are also experiencing financial and accounting difficulties as a result of their investment in these securities. For example, in a situation that encompasses both the student loan problems and the breakdown of the auction rate securities marketplace, Winnebago, in its March 20, 2008 fiscal second quarter earnings release (here), disclosed that it owned $54.2 million of auction rate securities collateralized by student loans. As a result of the auction rate securities market failure, the company deemed these securities as not currently liquid, and reclassified them on the company’s balance sheet as long-term investments. In its April 9, 2008 10-Q (here), the company recorded a temporary impairment charge to these securities of $3.4 million.

The fact that the student loan turmoil would affect a company as unrelated to the sector as Winnebago demonstrates how far afield the effects of the current crisis have and may yet spread. The essential point here is that as long as observers continue to describe and think about the current developments as merely subprime-related, they will not only fail to appreciate the extent of what has already happened, but also likely underestimate the possibilities of what may lie ahead.

Another Auction Rate Securities Lawsuit: And speaking of auction rate securities, on April 11, 2008, plaintiffs’ lawyers filed yet another lawsuit on behalf of auction rate securities investors against the companies that sold them the investments. As reflected in the plaintiffs’ lawyers’ press release (here), the latest lawsuit involves Oppenheimer Holdings. The Oppenheimer lawsuit is the twelfth of these auction rate securities lawsuits to be filed.

Run the Numbers: Like everyone else, I too am trapped by the now-established convention of referring to the current credit-related lawsuit onslaught as the “subprime” litigation wave, and as a reflection of that convention, I have added the First Marblehead and Oppenheimer lawsuits to my running tally of the “subprime”-related litigation, which can be accessed here. With the addition of these two new lawsuits, the current tally now stands at 70, of which 30 have been filed in 2008. As noted, 12 of these lawsuits involve class action auction rate securities litigation.

Subprime Litigation: The Grandaddy of Them All?: Although the crisis commonly referred to as the “subprime” meltdown is relatively recent, subprime loans have been around for a while. Indeed, problems with subprime loans are also nothing new. Even though the current wave of subprime-related litigation did not get started until February 2007, there were subprime-related lawsuits before that. These earlier lawsuits may provide some interesting perspective on the current round of litigation.

As described in an April 9, 2008 Wall Street Journal article entitled “Subprime Lender’s Failure Sparks Lawsuit against Wall Street Banks” (here), American Business Financial Services was in the subprime loan origination business. It funded its operations through the securitization of loans, but, in addition, it also raised operating cash by selling notes through direct sales to individual investors.

According to the allegations in subsequent litigation, ABFS underestimated the number of its loans that would be paid off early as a result of refinancing, reducing the company’s cash flow, and ultimately leading to the company’s bankruptcy. The noteholders, of which there may have been as many as 22,000, lost millions.

The Journal article describes the Pennsylvania state court lawsuit that the bankruptcy trustee has filed against the Wall Street banks that sponsored ABFS’s securitizations, as well as against the company’s former directors and officers. But this trustee lawsuit follows two earlier lawsuits, one brought by the company’s shareholders and one brought on behalf of the company’s noteholders.

The ABFS shareholder securities litigation, background about which can be found here, was initiated in January 2004, following the company’s disclosure that the Department of Justice was investigating the company’s loan transactions and securitization agreements. The plaintiff shareholders alleged that the company and certain of its directors and officers misrepresented the company’s financial condition by artificially altering the company’s loan default ratio, to understate the level of the company’s troubled loans. In a June 2, 2005 memorandum opinion and order (here), the court granted the defendants’ motion to dismiss, on the ground that the plaintiffs did not adequately allege that the statements at issue materially misleading, nor did the plaintiffs’ allegations create a “strong inference” that the defendants acted with scienter.

The noteholder litigation, by contrast is going forward, albeit in a narrowed state. The background regarding the ABFS noteholder litigation can be found here. The noteholders also claimed that the defendants misrepresented the company’s financial condition. In two orders (here and here), the court dismissed the plaintiffs’ allegations concerning the company’s loan delinquency rates, as well as the plaintiffs’ solicitation claims under Section 12. A much-narrowed case is going forward.

The course of these earlier lawsuits casts an interesting light on the current wave of lawsuits. The ABFS shareholder lawsuit dismissal is a reminder that even a lawsuit involving a bankrupt company that is the subject of a DoJ investigation, and in connection with which shareholders lost substantially all their investment, still has to survive the formidable pleading requirements to which securities lawsuits are subject. Even the noteholders, whose plight may be particularly sympathetic, have seen their petition for redress of grievances substantially narrowed.

The fate of these earlier lawsuits is a reminder that merely because lawsuits are filed, even lawsuits filed in the context of significant financial losses and regulatory investigations, does not mean that the lawsuits will succeed. It may be important to keep in mind as the current wave of lawsuits continues to accumulate that these lawsuits will face the same formidable pleading barriers as did the ABFS lawsuits, and some of these lawsuits, like the ABFS lawsuits, will not survive or will only survive on a greatly narrowed basis.

Tellabs in the Ninth Circuit: Readers interested in following the implementation of the Supreme Court’s Tellabs decision in the lower courts will want to review the April 10, 2008 decision (here) in the Skechers USA securities litigation, in which the Ninth Circuit affirmed the district court’s dismissal of the lawsuit, in reliance on Tellabs.

However, the complications that may yet attend the implementation of the Tellabs decision in the lower courts is also suggested by the dissenting opinion in the Skechers appeal (here), in which the dissenting judge, applying the same Tellabs standard to the same facts, reached the opposite conclusion, finding that the district court’s dismissal ought to be reversed.

In the end however, while the Ninth Circuit’s majority and dissenting opinions in the Skechers case are interesting, they ultimately are of little value to the larger question of how Tellabs may be implemented in the lower courts, because the majority opinion is designated as “Not for Publication,” as a result of which it may not be cited. I have previously (here) decried the truly regrettable practice of courts designating opinions as not for publication or citation. Our entire system of jurisprudence relies on the usefulness of prior decisions to help resolve future cases, and it is fundamentally inconsistent with this arrangement for courts to try to remove decisions from this time-honored tradition and process.

Special thanks to a special friend of The D&O Diary for copies of the Ninth Circuit opinions.

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In an April 9, 2008 opinion (here) written by Chief Judge Frank Easterbrook, the Seventh Circuit held that there was no coverage under Arthur Anderson’s fiduciary liability policy for the firm’s settlement of a retiree pension benefits dispute.

The dispute arose after the firm’s Enron-related difficulties undercut the firm’s ability to honor retirees’ demands for lump-sum payment of retirement benefits. Litigation ensued. The retirees claimed, among other things, that the firm had breached its duties under ERISA. The firm retained defense counsel and also (through its broker) provided notice of claim to its fiduciary liability insurer. The plaintiffs then voluntarily dismissed the lawsuits and initiated arbitration proceedings instead. (The full details of the underlying retiree dispute and of the communications between the firm’s representatives and the insurer are set out at length in the district court’s summary judgment opinion, here.)

In November 2002, Arthur Anderson “proposed a compromise to all retirees and wrote to its insurers that it needed at least $75 million from them to fund a settlement.” The firm asked its primary fiduciary liability insurer to tender its full $25 million policy limit. The insurer responded that the arbitration claim did not allege negligence or breach of any fiduciary duty, but rather that it was a “pure contract action” for benefits due, for payment of which coverage is precluded under the terms of its policy. (The relevant policy provisions are set out in the district court opinion linked above.)

In January 2003, the firm settled with most of the retirees for $168 million, and it ultimately settled with the rest of the retirees in 2006 for a further $63 million. In February 2003, the fiduciary liability insurer initiated an action for a judicial declaration that it was not required to defend or indemnify Arthur Anderson.

The district court held (here) that the policy does not require the insurer to fund the settlement but that (as later summarized by the Seventh Circuit), the insurer’s “failure to provide a defense coupled with its delay in filing the declaratory judgment action might require it to pay anyway.” Following a jury trial, the district court entered judgment in the insurer’s favor except to hold that the insurer was liability for $5 million toward the arbitration settlement. Both sides appealed.

The Seventh Circuit affirmed the district court except to reverse as to the $5 million payment required toward the settlement. The Seventh Circuit found first that there was no coverage under the fiduciary liability policy for the retirees’ arbitration claim, because it did not allege negligence or breach of a fiduciary duty, but rather was limited exclusively to an alleged breach of contract. The Seventh Circuit also held that the policy’s “benefits due” exclusion also precluded coverage. Judge Easterbrook commented that “the settlement reflects the present value of the pension promise…rather than damages for anyone’s misconduct,” and he noted further that:

No insurer agrees to cover pension benefits; moral hazard would wipe out the market. As soon as it had purchased a policy, the employer would simply abandon its pension plan and shift the burden to the insurer. Knowing of this incentive, the insurer would set as a premium the policy’s highest indemnity, and no “insurance” would remain. Illinois would not read a policy in a way that made it impossible for people to buy the insurance product they want (here, coverage of negligence and disloyalty by pension fiduciaries).

The Seventh Circuit also found that the firm’s failure to obtain the insurer’s prior consent to the settlement provided another preclusion to coverage. Judge Easterbrook noted that “Arthur Anderson didn’t ask for the consent or even the comments of its insurer; it presented the deal to them as a fait accompli. By cutting [the insurer] out of the process, Arthur Anderson gave up any claim of indemnity.”

Having decided that there was no coverage under the policy, the Seventh Circuit then went on to consider whether Illinois principles of “equitable estoppel” nonetheless barred the insurer from asserting its defenses to coverage, as a result of the insurer’s delay in providing a defense and bringing its declaratory judgment action.

The Seventh Circuit first considered the question of what constitutes “delay,” noting that “treating eight months,” the period of the insurer’s putative delay, “as excessive is questionable.” Judge Easterbrook also noted that had the firm complied with the policy’s advance consent to settlement requirement, the insurer could have filed its declaratory judgment before the settlement.

In the end, the Seventh Circuit concluded that the question whether eight months constitutes delay is irrelevant, since at no point did the firm ever ask the insurer “to send a team of lawyers to represent it”; rather, the firm “made it clear that it would control both the defense and the law firm conducting the defense.” By “not tendering its defense," the firm “gave up and basis for demanding immediate action by the insurer.” Judge Easterbrook noted that:

An insured’s need to have legal assistance for its defense from the outset of a suit is the main justification for the rule that Illinois has adopted. When the insured does not want the insurer to supply a defense (lest the insurer also control the defense), it has no complaint if the insurer takes a while to contemplate the question of indemnity. The urgent need is for a defense to the pending suit; liability for indemnity (the coverage question) can safely be decided later.

Finally, Judge Easterbrook concluded that the insurer did not in the end have a duty to defend as the arbitration complaint was “based on contract and nothing but.”

There are several noteworthy things about Judge Easterbrook’s opinion. The first pertains to his commentary that adverse consequences might follow if the insurer were compelled to fund the settlement. It is the very rare court that is willing to consider not only that in some circumstances compelling the insurer to pay might not only undermine the existence of the market for that type of insurance, but could even constitute a “moral hazard.” Judge Easterbrook’s analysis evinces an unusually developed understanding of the insurance mechanism’s fundamental components.

The court’s analysis of the consent to settlement requirement is also noteworthy; indeed, the Seventh Circuit’s discussion of this issue in many ways mirrors the analysis of the recent New York Court of Appeals opinion (discussed here) in which the New York court also enforced the consent to settlement opinion strictly according to its terms. These two holdings underscore not only that the provision means what it says but also that it will be enforced according to its terms. These rulings unmistakably highlight that policyholders who fail to follow the policy’s requirement for advance consent to settlement do so at peril to their insurance coverage.

There is a further important lesson from this case, one that is similar to the lesson of the prior New York case, and that is that nothing good comes from a policyholder’s failure to keep the insurer in the loop. Indeed, if there is one common element in almost every litigated coverage dispute, it is that at some point preceding the litigation, there was some breakdown in communications between the policyholder and the insurer.

There are no guarantees that carriers will respond appropriately even when they are provided with full information. But the single most important way for policyholders to reduce the possibility of a litigated dispute with their insurer is to maintain full and professional communications with their insurer. Indeed, point number on in my list of “Seven Ways Counsel Can Help Clients with D&O Claims” (here) is to “Keep the Carrier Informed.”

Finally, I note that the Seventh Circuit’s discussion of the “benefits due” exclusion is an important accompaniment to my analysis (here) of the insurance implications of the U.S. Supreme Court’s opinion in the LaRue case. As Judge Easterbrook’s opinion makes clear, these policies are not intended to provide a substitute funding mechanism for companies’ benefit obligations to their employees. However, the policies are intended to provide companies with indemnity protection when an insured’s alleged or actual negligence or breach of a fiduciary duty harms a plan participant’s interests. For that reason, it is analytically consistent for insurers to offer, as some now do, an endorsement to their policies to carve out from the benefits due exclusion an agreement to cover a plan participant’s claim of harm to their individual plan investment interests, of the kind recognized in the LaRue decision.

Special thanks to a loyal reader for providing me with a copy of the Seventh Circuit’s opinion.

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On April 8, 2008, PricewaterhouseCoopers released its 2007 Securities Litigation Study, which can be found here. The PwC study follows prior reports from NERA Economic Consulting (refer here) and Cornerstone Research (refer here and here). The PwC study differs from the other studies in certain details but the studies are all directionally consistent.

The PwC study observes that “after a two-year decline and a sluggish start to the year, total federal class actions filed in 2007 against foreign and domestic companies increased once more, reversing the previous downturn.” The PwC has some interesting thoughts about the prior downturn and the causes of the reversal; the study speculates that “much of the decrease in the 2006 numbers” was due to “the preoccupation of the plaintiffs’ bar with stock options matters filed primarily as derivative matters.” The study also observes that the upswing in 2007 “comes as no surprise” given that “the stock options matters appear mostly to have dissipated.”

The report also notes that the deterrent effect of Sarbanes Oxley “may have led to a lower number of overall cases” but adds that the economy may also have been a factor and “during hard times, the increased pressure to produce good financial results is more likely to lead to bad behavior which could result in higher levels of litigation” as a result of which “over the next few years” we could see “above the recent average number of filings.”

The study has a number of interesting observations about the role of accounting issues in securities lawsuits. Among other things, the study notes that while there have been a “burgeoning number of restatements in recent years,” the number of restatements associated with federal securities class actions is “relatively small” – the report notes that in 2007, the number of securities lawsuits associated with restatements fell to 29, from 47 in 2006. The report notes that this analysis supports the view that “market reaction to restatements is declining” and also supports the view that “the market does not react to all restatements.”

Somewhat differently than the recently released Cornerstone Research settlement analysis (here), the PwC study finds that the total value of settlements did not significantly change between 2006 and 2007. The PwC study also reports an average 2007 settlement of $56.3 million, compared to an average settlement of $57.5 million in 2006. Due to the few number of billon dollar settlements in 2007, if settlements greater than $2.5 billion are excluded, the average 2007 settlement was $28.3 million, compared to $57.5 million in 2006. 

The study includes commentary on a number of interesting topics, including the growth of subprime-related litigation and the growing importance of institutional investors in securities class action litigation. The study also includes interesting commentary on the increased prominence of hedge funds, about which the study notes:

As the subprime fallout continues into 2008, this will be one area to watch. Not only could litigation against hedge funds by investors increase, but large institutional investors such as pension funds – which have added hedge funds to their portfolios over recent years and which are increasingly active in shareholder lawsuits – may also begin to focus with similar activism on hedge funds in order to recover losses associated with the subprime crisis.

The PwC also has extended discussion of the issue of the growing importance of Foreign Corrupt Practices Act investigations and enforcement proceedings, a topic on which I have frequently commented on this blog (most recently here).

The study also has an interesting discussion of concerns facing foreign issuers. Among other things, the study notes that “the number of foreign IPOs climbed to 55 in 2007, surpassing the record of 34 IPOs set in 2006.” China “accounted for 55% of the foreign IPOs.” With these foreign listings has come litigation activity. According to the study, the number of 2007 securities lawsuits against foreign issuers increased by 93%, to 27 cases, in 2007, from 14 cases in 2006 (but short of the 30 cases filed in the record year of 2004). The report states that ten of these cases were against Chinese companies, of which five involved IPO-related allegations. My prior post discussing Chinese IPOs can be found here.

The report also has an interesting discussion of the growth of “global class actions,” involving both securities lawsuits in the US involving foreign domiciled companies, as well as the increasing number of lawsuits now being filed outside the U.S.

One concluding observation about the PwC’s settlement analysis. The study’s analysis of class action settlement data is interesting and useful, but I am concerned that as a result of trends in opt-out litigation and settlements, the study of class action settlements alone may no longer be sufficient to understand the full extent of companies’ potential loss severity exposure. To refer to but one example, in connection with the Qwest securities litigation, the aggregate value of the individual opt out settlements actually exceeded the amount of the class action settlement. (see my prior analysis of the Qwest opt out settlements here).

While the emergence of class action opt outs as a material issue is relatively reason, and for that reason still relatively uncertain, consideration of possible opt out litigation appears to be an increasingly indispensible part of the analysis of potential litigation exposure and of the total cost of securities litigation. My discussion of the emergence of opt out issues can be found here.

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In a powerful affirmation of the rule of law, two justices of the U.K.’s High Court of Justice ruled in an April 10, 2008 opinion (here) that the British Serious Fraud Office (SFO) must reconsider its decision to discontinue its bribery investigation into the award of a weapons contract between Saudi Arabia and BAE Systems plc. My prior post regarding the BAE investigation can be found here.

The SFO announced its decision to discontinue the investigation in December 14, 2006. The investigation had been ongoing for some time and had even withstood a prior attempt in October 2005 to have the investigation stopped. However, in July 2006, apparently when the SFO was about to obtain access to certain Swiss bank accounts, the British government received “an explicit threat made with the intent of halting the investigation.”

In the proceedings before the court, the government refused to characterize the threat, but the opinion quotes news reports that what happened was that Prince Bandar bin Sultan bin Abdul Aziz of al-Saud “went to Number 10” and told the Prime Minister’s Chief of Staff to “get it stopped” or the military weapons contract ‘was going to be stopped and intelligence and diplomatic relations would be pulled.” (Prince Bandar, the Saudi ambassador to the United States from 1983 to 2005, is now and in 2006 was the Secretary-General of the Saudi National Security Council.)

Following the July 2006 threat, an internal governmental review process unfolded, including high level consultations with the British ambassador to Saudi Arabia and others, culminating in a previously confidential December 8, 2006 memorandum by then-Prime Minister Tony Blair to his Attorney General Peter Goldsmith that “developments” had “given rise to the real and immediate risk of the collapse of UK/Saudi security, intelligence and diplomatic cooperation.” This, the Prime Minister said, would “have seriously negative consequences for the UK public interest in terms of both national security and our highest priority foreign policy objectives in the Middle East.” The government was particularly concerned with the Saudis continued counter-terrorism support, without which, it was feared, British lives could be in danger.

According to news reports (here), in August 2006 (that is, one month after Prince Bandar’s visit to “Number 10”), BAE won a $8.7 billion order from the Saudi government for 72 Eurofighter Typhoon warplanes, purportedly the latest component of the Al Yamamah arms deal, which dates back to 1985 and is the largest British export contract ever.  

The legal challenge to the decision to terminate the investigation was presented by two public interest groups, Corner House Research and the Campaign Against Arms Trade. They challenged the SFO’s decision to accede to the threat as “contrary to the constitutional principle of the rule of law,” as well as on other grounds. By contrast, the government argued, as the court summarized, that “the law is powerless to resist the specific, and as it turns out, successful attempt by a foreign government to pervert the course of justice in the United Kingdom.” (The court said of this argument that “so bleak a picture of the impotence of the law invites at least dismay, if not outrage.”)

The April 10 opinion was written by Lord Justice Alan Moses. After a detailed review of the background to the SFO’s decision to terminate the investigation, the Court considered the claimants’ challenge, which Lord Justice Moses said did not question the government’s assessment of the national security risk. The threat that was the basis of the decision to terminate the investigation “was not simply directed at the company’s commercial, diplomatic and security interests, it was aimed at its legal system.”

The threat was made “with the specific intention of interfering with the course of the investigation.” The court noted that “had such a threat been made by one who was the subject of the criminal law of this country, he would risk being charged with an attempt to pervert the course of justice.” Surrender to such threats “merely encourages those with power, in a position of strategic and political importance, to repeat such threats.” The court concluded that “in yielding to the threat, the [SFO director] ceased to exercise the power to make the independent judgment conferred on him by Parliament.” As a result, the court concluded that the submission to the threat was “unlawful.”

The court’s opinion reviews a host of other considerations, including in particular the U.K’s obligations as a signatory Organization for Economic Cooperation and Development’s Convention on Combating Bribery of Foreign Public Officials in International Business Transactions (which specifies that investigations “shall not be influenced by considerations of national economic interest, the potential effect upon relations with another State or the identity of the natural or legal persons involved.”). But the court’s essential conclusion is that the decision to terminate the investigation was contrary to the principles of the rule of law. “It is difficult,” the court said,” to identify any integrity on the role of the courts to uphold the rule of law if the courts are to abdicate in response to a threat from a foreign power.”

The full opinion is lengthy but it is well worth the read. The details surrounding the government’s consideration of how to respond to the threat are fascinating, and the court’s analysis of the legal considerations involved is thought-provoking, particularly its consideration of how imminent a threat of loss of life must be before a court might consider yielding. The inherent tension in the court’s decision arises from the fact that this case tests the limits of what any government might be willing to risk in resisting corruption; the lesson the court rejected is that if the corrupt forces are rich and powerful enough, they have nothing to fear from the force of law.

It remains to be seen, however, whether the investigation will go forward in the end; the court did not rule that the investigation must proceed, only that the December 2006 decision to terminate the investigation was unlawful. According to an April 11, 2008 article in The Guardian (here), “the high court will reconvene in a fortnight to decide what remedy to award the two groups of anti-corruption campaigners who brought the judicial review of the Serious Fraud Office decision to end the inquiry.”

As I have noted in a number of prior posts, most recently here, many governments around the world (including the U.S. government) are increasingly committed to enforcing anti-corruption laws. BAE is also being investigated in the U.S. and in Switzerland, and is only one of several current high-profile corruption investigations. The April 10 opinion underscores the seriousness of the issues involved, as well as the stakes. Courts will continue to grapple with the challenges these cases present, but it is important for companies to understand that the risks involved with corrupt practices include the threat of civil litigation, as I discussed here. BEA is in fact already the target of a shareholders’ derivative lawsuit in the United States. The growing threat of this type of litigation suggests why corrupt activity may represent the “next corporate scandal.”

Press coverage of the April 10 decision can be found here and here. The FCPA Blog’s post on the decision can be found here.

Subprime Litigation Webcast: On Friday April 11, 2008, at 11:00 a.m., I will be a panelist on a webcast sponsored by Risk Metrics on the topic “Subprime Litigation and Liability.” The panel will be moderated by Adam Savett, author of the Securities Litigation Watch blog, and will include defense attorney Darryl Rains, of the Morrison and Foerester firm, and plaintiffs’ attorney Mark Lebovitch, of the firm Bernstein, Litowits, Berger & Grossman. Registration for the webcast (which is free) can be accessed here. Further information, including links to background papers by Risk Metrics, can be accessed on the Securities Litigation Watch, here.  

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In two recent federal district court decisions, two options backdating-related securities class action lawsuits – one involving Witness Systems and one involving Jabil Circuit – were dismissed.

First, in the Witness Systems case, on March 31, 2008, Judge Clarence Cooper of the United States District Court for the Northern District of Georgia granted the defendants’ motion to dismiss, with prejudice. A copy of the Order can be found here. Background regarding the case can be found here.

The complaint alleged that seven options grants in 2000 and 2001 were backdated and that four grants in 2004 were springloaded. Oddly, the plaintiff alleged that he company’s financial statements during the period April 23, 2004 to August 11, 206 were misleading because of the 2000-2001 backdating. The allegedly misleading statements allegedly began earlier and continued through the class period.

Judge Cooper found that

Plaintiff has failed to allege sufficient, particularized facts to support a “cogent and compelling” inference of scienter as to Witness or as to each Individual Defendant. Although the [amended complaint] is lengthy, the details contained therein are simply insufficient to support a strong inference of scienter. Specifically, the allegations are in the nature of a theory that Defendants must have known that the 2004 and 2005 financial statements were misstated due to backdating that occurred in 2000 and 2001. The [amended complaint] never explains when, or how, any or all Defendants learned about the circumstances pertaining to any backdated option grants. (Citations omitted.)

Judge Cooper went on to observe that “nothing is alleged that would demonstrate that these individuals had any knowledge that disclosures during the class period might require further adjustments based on options grants made in 2000 and 2001.”

Judge Cooper further found that the defendants’ stock sales did not support an inference of scienter. Judge Cooper specifically found that the defendants’ “pattern of regular dispostions was inconsistent with allegations of scienter, and the two defendants who sold significant share percentages only joined the company as a result of a merger after the alleged backdating. Judge Cooper also found that the plaintiffs had not adequately pled loss causation.

In the Jabil Circuit case, on April 9, 2008, Judge Steven Merryday of the United States District Court for the Middle District of Florida granted defendants’ motion to dismiss, but with leave to amend. Plaintiffs have until May 12, 2008 to file an amended complaint. A copy of the April 9 order can be found here. Background regarding the Jabil Circuit case can be found here.

The Jabil Circuit case may be of some interest because the company was one of the several companies whose option grants were reflected in the charts that accompanied the  original March 18, 2006 Wall Street Journal article entitled “The Perfect Payday” (here) that launched the options backdating scandal.

The crux of Judge Merryday’s decision is his conclusion that the plaintiffs’ allegations failed to establish that any grant was backdated. Judge Merryday said:

Although the complaint specifies the offending statement and identifies when and where the defendants issued the statement, the complaint includes deficient allegations concerning the falsity of the statement. The plaintiffs purport to allege repeated instances of backdating by stating the dates of “suspiciously timed” option grants and the individual defendants who received the grants. However, the plaintiffs never allege the any specific grant of stock to any specific individual defendant was backdated. The issuance of suspiciously timed options fails to convert the [company’s compensation policy] representation into a false and misleading statement.

Having found that the complaint did not adequately allege backdating, Judge Merryday was able to dispose of plaintiffs’ allegations that the company had not properly accounted for the option grant or made misrepresentations when company officials later denied that there had been backdating.

Judge Merryday also found that the plaintiffs’ scienter allegations were insufficient because the complaints’ allegations of “knowledge of non-public information fails to raise an inference of scienter with respect to any defendant.” The insider trading allegations were insufficient because the complaint failed to allege the percentage of total shares sold or to compare the share sales to sales before and after the class period. The defendants’ alleged receipt of option grants was also found insufficient.

Judge Merryday also found that the complaint’s allegations of GAAP, IRS and SEC violations were insufficient “because the complaint fails to adequately allege a basis for the claim of backdating.” Similarly, with respect to the issue of loss causation, Judge Merryday found that “having failed to adequately allege the falsity of the backdating-related statements, the plaintiffs fail to sufficiently plead loss causation as to those statements.” Judge Merryday also rejected plaintiffs’ claims of proxy misstatements based on the plaintiffs’ failure to adequately allege backdating.

I have added these two dismissals to my table of options backdating lawsuit settlements, dismissals and denials, which can be accessed here. These two dismissals may be noteworthy because they appear to be the first options backdating securities lawsuit dismissals outside of the Ninth Circuit. They are also the first dismissals granted in an options backdating securities lawsuit in several months. But while some of these options backdating securities suits have now been resolved, many more remain pending.

As reflected on my running tally of the options backdating lawsuit filings (which can be found here), there were a total of 36 options backdating-related securities class action lawsuits filed. And as reflected in my table of options backdating lawsuit case dispositions (linked above), of these 36 cases, eight have settled, six have had their motions to dismiss denied, and five have been dismissed (albeit some with leave to amend). That leave 17 cases on which no action has yet been taken, and with the six dismissal denials, 23 cases that remain pending – not to mention the cases on which amended pleadings or appeals may give new life.

These cases appear to have a very long way to run yet. But the high degree of skepticism shown in these two opinions is striking, and would not bode well for these cases were this general view to become widespread.

Special thanks to an alert reader who prefer anonymity for providing copies of the two opinions.

Another Subprime-Related D&O Loss Estimate: On April 9, 2008, Fitch’s Ratings released a report entitled “Subprime Mortgage Exposure for Property/Casualty Insurers.” A link to the repor can be found in this Business Insurance article (here), but registration is required for access to the report.

The report repeats prior estimates of industry-wide insured subprime-related losses in the range of $3 to $4 billion (although also noting that estimates have ranged as high as $9 billion). The report states that “Fitch believes that the majority of these losses will be borne by the larges writers of primary and excess D&O.”

The report also states that “Fitch believes that the near-term impact from the subprime issues will have a stabilizing or modestly positive effect on professional liability rates, especially within the financial services sector, but are unlikely to result in broad hardening.” The report warns though that “if the credit contagion spreads into sectors not directly tied to the subprime mortgage market or if the weakening economy leads to increased bankruptcies, current loss estimates will prove to be inadequate and there could be adverse reserve development that could have a larger impact on rates going forward.”

Fitch’s estimates and comments are largely in line with prior D&O loss estimate, about which I previously commented here.

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Regular readers know that I have been tracking subprime-related class-action lawsuits (here). In a recent post, I noted my interest in trying to develop a similar list of subprime-related derivative lawsuits. In response to my request, a number of readers supplied helpful information, and as a result I have been able to develop a list of subprime-related derivative lawsuits, which can be accessed here.

The list is accurate but it may not be complete. Readers aware of any other subprime-related derivative lawsuits are encouraged to let me know, so that I can address any omissions. I will update the list as new lawsuits come in or as new information becomes available.

The table of cases I have compiled lists the companies that have been named as nominal defendants in shareholders’ derivative lawsuits. Some of the companies listed actually have been sued in multiple derivative suits, and some companies have been sued in multiple jurisdictions. However, where the allegations relate to substantially similar allegations, each company has only been listed once, regardless of the number of actual derivative lawsuits pending. Where I have been able to supply relevant links (in most cases to the actual complaint), the link pertains to the first filed suit.

As the list reflects, a total of 20 companies have been sued as nominal defendants in subprime-related derivative lawsuits. The derivative suits against seven of these companies were first filed in 2008, the rest in 2007. Most (but not all) of the companies named in the derivative suits have also been named in subprime-related securities class action lawsuits. Most of the companies sued in the derivative lawsuits are in the lending and banking industries, but the list also includes insurance companies, home builders, and REITs, among other.

Special thanks to Adam Savett of the Securities Litigation Watch (here) for providing information and links to several of the lawsuits, and thanks to all readers who provided information and suggestions in response to my inquiry.

Another Auction Rate Securities Lawsuit: On April 8. 2008, plaintiffs’ lawyers filed another purported securities class action lawsuit on behalf of auction rate securities investors against the companies that allegedly sold them the securities, in this case Raymond James Financial. A copy of the plaintiffs’ lawyers’ April 8 press release can be found here, and a copy of the complaint can be found here.

This brings the total number of auction rate securities lawsuits to eleven. My prior post discussing the auction rate securities lawsuits can be found here. I have been tracking the auction rate securities lawsuits as part of my running tally of subprime-related class action lawsuits, about which more below.

Adjusting the Subprime-Related Class Action Litigation Tally: Also as a result of my efforts to build the list of subprime-related derivative lawsuits, I received additional information regarding three previously filed securities class action lawsuits. In the past, I had determined that these three lawsuits were not appropriately categorized as subprime-related. However, upon further inquiry and based on conversations with some readers, I have now added these three additional lawsuits to my running tally of subprime-related securities class action lawsuits. The three added lawsuits related to Municipal Mortgage & Equity (about which refer here), WSB Financial Corp. (refer here), and CBRE Realty Finance (refer here).

With the addition of these three lawsuits, and with the addition of the Raymond James auction rate securities lawsuit referenced above, my running tally of subprime-related lawsuits now stands at 68. One unfortunate consequence of my decision to add these three cases is that now my running tally may no longer agree with others’ tallies, such as the Stanford Law School Securities Class Action website (here). There is an inherent categorization problem in trying to track the subprime lawsuits. Reasonable minds will disagree about whether a case is or is not appropriately categorized as subprime related. There are almost always going to be some disagreements at the margins.

Many thanks to the readers who supplied the information and commentary about the three class action lawsuits.

Subprime ERISA Lawsuit Update: As most readers know, I have also been tracking subprime-related ERISA lawsuits (here). As a result of my research and inquiries regarding subprime derivative lawsuits, I identified three additional subprime-related ERISA lawsuits of which I previously had been unaware. These three additional ERISA lawsuits pertain to Huntington Bankshares (refer here), National City Corp. (refer here), and Impac Mortgage (refer here).

With the addition of these three suits to my list, the number of subprime-related ERISA lawsuits now stands at 14, five of which have been filed in 2008, and the remainder of which were filed in 2007.

Two Options Backdating Case Developments: Two courts recently issued rulings on motions to dismiss in options backdating-related lawsuits.

First, on March 31, 2008, in the Juniper Networks option backdating-related securities litigation (about which refer here), Judge James Ware of the United States District Court for the Northern District of California largely denied the defendants’ motion to dismiss, except that he granted the motion (with leave to amend) as to one individual defendants, and he granted the motion to dismiss all alleged misrepresentations that took place prior to July 14, 2001, as time barrred. A copy of the March 31 order in the Juniper Networks case can be found here.

Second, and also on March 31, 2008, in the Microtune options-backdating related derivative litigation, Judge Richard Schiff of the United States District Court for the Eastern District of Texas granted the defendants’ motion to dismiss, albeit with leave to amend as to certain individuals on certain claims. A copy of the Microtune opinion can be found here. Judge Schell first concluded the Congress had not created a private right of action under Section 304 of the Sarbanes-Oxley Act, and dismissed that claim. Judge Schell also granted the dismissal with prejudice of claims of allegedly misleading proxy statements as to the individual defendants who were not on the board at the time of the proxy. The proxy allegations were dismissed without prejudice as to the remaining individual defendants. Similarly, the plaintiffs’ claims based on Section 10(b) were also all dismissed, but with prejudice as to some defendants and without prejudice as to others. The court declined to exercise jurisdiction over the plaintiffs’ state law claims.

I have added these two decisions to my table of options backdating related case dispositions, which can be accessed here. Readers are encouraged to let me know about case dispositions of which they become aware so that I can add them to the list.

Special thanks to Nick Even of the Haynes and Boone firm for the link to the Microtune decision.

New Century Updated: In an earlier post (here), I noted that the court had granted (with leave to amend) the defendants’ motion to dismiss in the first-filed subprime related securities class action lawsuit, involving New Century Financial Corporation. On March 24, 2008, the plaintiffs filed their amended complaint (here), which names as defendants not only certain former directors and officers of the company, but also the company’s former auditor, KPMG, and the company’s offering underwriters.

Readers will recall that in connection with the New Century bankruptcy proceeding, the bankruptcy examiner recently released a detailed report (about which refer here) in which, among other things, the examiner reviewed the question of the auditors’ and the company's directors and officers' potential responsibility for certain accounting practices and statements at the company. In light of the bank examiner’s report, the plaintiffs sought (and the defendants’ agreed not to oppose) leave to file a second amended complaint, which the court granted. The plaintiffs’ must file their second amended complaint by April 30, 2008. The court also set a briefing schedule for the anticipated motion to dismiss, to be argued September 8, 2008. A copy of the court’s order granting leave and setting the scheduling can be found here.

A German Securities Trial?: The Securities Litigation Watch has an interesting post (here) about the apparent mass securities lawsuits trial that has commenced in Germany involving Deutsche Telecom. An April 7, 2008 Business Week article discussing the trial can be found here.

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Add E*Trade and SunTrust Bank to the growing list of companies that have been sued in purported class action lawsuits on behalf of auction rate securities investors against companies that sold them the instruments. The plaintiffs’ attorney’s April 2, 2008 press release regarding the E*Trade auction rate securities lawsuit can be found here, and the complaint can be found here. The plaintiffs’ attorneys’ April 2, 2008 press release regarding the SunTrust lawsuit can be found here and the SunTrust complaint can be found here. With the addition of these two new suits, there have now been a total of ten companies sued in these auction rate securities class action lawsuits.

The auction rate lawsuits are interesting. Clearly the plaintiffs’ lawyers think they are worth pursing. And if the intensity of the auction rate securities investors’ anger is an accurate gauge, then the plaintiffs’ lawyers filing of these lawsuits ultimately could be justified. As a result of prior posts on this blog (here and here) about auction rate securities, I have received numerous emails and inquiries from upset auction rate securities investors. Notwithstanding the investor anger, it is probably worth noting that so far as I can tell the leading plaintiffs’ securities firms are not (at least not yet) active in this space. Most of the auction rate securities class action lawsuits thus far have been filed by two plaintiffs’ firms (refer here and here).

The allegations in these auction rate securities class action lawsuits are largely identical. Essentially the plaintiffs contend that the defendants failed to disclose material facts about the instruments. In particular, the defendants are alleged to have failed to disclose that the auction rate securities were not cash alternatives, but rather that there were only liquid at the time of auction. More to the point, the complaints allege that the defendants failed to disclose that the auction rate securities would become illiquid as soon as the broker-dealers stopped maintaining the auction market.

In each of these class action lawsuits, the complaint names as defendants a specific financial institution and its broker-dealer affiliate. No individual defendants are named. While each complaint contains substantially identical generalized allegations of misrepresentations or omissions, the complaints contain virtually no allegations about specific statements the particular defendants companies are alleged to have made.

And even though the complaints purport to allege breaches of Section 10(b) of the ’34 Act, the complaints’ only basis for alleging scienter are generalized allegations of knowing falsity; there are no allegations of insider trading, and no particularized factual allegations supporting the general allegations of knowing falsity. The complaints similarly depend on the failure of the auction rate market itself as satisfying the loss causation requirement, rather than referring to any alleged curative disclosures or anything else in particular about the specific securities in which the class members invested.

The defendants undoubtedly will argue that these generalized allegations are insufficient to meet the threshold pleading requirements, in reliance in particular on Tellabs and Dura Pharmaceuticals. But while the defendants may seek to have the actions dismissed, the plaintiffs’ lawyers clearly intend to keep filing these actions.

The lawsuits potentially may also raise some interesting D & O liability insurance coverage issues. Because the complaints do not name any individuals as defendants, the sole potential coverage under the typical D & O policy that these claims might trigger is the so-called “entity coverage” found in most policies. In most public company D & O policies, the entity coverage is strictly limited to “securities claims.” While the auction rate securities lawsuits purport to raise claims under the securities laws, these allegations may or may not trigger the potentially applicable entity coverage, depending on how the term “securities claim” is defined in the applicable policy.

There are two general variants of the “securities claim” definition. One variant defines the term “securities claim” by reference to the securities laws themselves, including within the definition claims that assert breaches of federal or state securities laws or their equivalent. The other definitional variation defines “securities claim” by reference to the claimants and securities allegation with respect to which would be recognized as a securities claim. For example, this latter category might limit a “securities claim” to claims brought by holders of the company’s securities, or alternatively, might limit a securities claim to alleged breaches in connection with trading of the company’s own securities.

Clearly this definitional distinction could make a difference in connection with these recently filed auction rate securities lawsuits, as these claims might assert a “securities claim” and trigger the entity coverage in policies that use the former variants, but may or may not trigger the entity coverage in the policies that have the latter variant.

It is probably also worth noting that a number of the companies (for example, E*Trade) that have been sued in these auction rate securities class actions have also separately been sued in securities class action lawsuits by the companies’ own shareholders. These companies’ available insurance coverage may be under significant pressure already.

With the accumulation of these lawsuits, whose numbers are likely to continue to grow, it may well be time for these lawsuits to be broken out into their own separate statistical category, much as the IPO laddering cases were when the were filed in 2001. The auction rate securities lawsuits clearly represent a litigation category distinct from the more typical securities class action brought by public company shareholders.

But with the addition of the two latest lawsuits, the total number of subprime related lawsuits, as reflected on my running subprime lawsuit tally (which may be accessed here), now stands at 64, of which 26 have been filed in 2008. As noted above ten of these 64 lawsuits represent lawsuits brought by auction rate securities investors. Two of the 64 were brought by asset-backed securities investors against the investment banks who created the instruments. Two of the 64 were brought by mutual fund investors against the fund companies and fund managers. The remaining lawsuits were brought by public company shareholders.

Subprime Derivative Lawsuits: In addition to securities lawsuits, some shareholders have also filed subprime-related shareholders’ derivative lawsuits against company management alleging breach of fiduciary duty and other legal breaches. The latest of these subprime-related derivative lawsuits was filed on April 1, 2008 in the United States District Court for the District of Maryland against Municipal Mortgage & Equity (“Muni Mae”) , as nominal defendant, and certain of its directors and officers (complaint here). Muni Mae has previously been sued in a subprime-related securities lawsuit (refer here).

The derivative suit against Muni Mae joins other subprime-related derivative lawsuits that previously have been filed against, among others, Countrywide, American International Group, Regions Financial, and Bear Stearns. I have not been separately tracking the subprime-related derivative lawsuits, basically because I failed to anticipate that shareholders would file as many subprime-related derivative actions as they have. In response to readers’ inquiries, I will now endeavor to track the subprime-related derivative suits.

Unfortunately, because I am coming at this task belatedly, I may fail to account for derivative lawsuits that were filed previously and of which I am unaware. I would be grateful if readers would let me know of any pending subprime-related derivative lawsuits of which they are aware, so that I can add them to my tally and the list will be as complete as possible.

Subprime Litigation Overview: The field of subprime-related litigation has continued to grow and expand, to the point where it is difficult to get an organized sense of the range of issues and litigants involved. An April 1, 2008 memorandum from the Gibson Dunn law firm entitled “Subprime-Related Securities Litigation: Where Do We Go From Here?” (here) provides a top-level overview of current exposures facing companies involved in subprime-related businesses. The paper identifies early trends and key defenses, takes a brief look at likely D & O insurance issues, and describes the factors that are likely to affect the likely future direction of this litigation.

A Canadian Backdating Lawsuit: Though the backdating scandal now seems like ancient history, it seems that the lawsuits are still continuing to come in, although the most recent instance involves a Canadian company sued in a Canadian court.

According to news reports (here), a shareholder of Savanna Energy Services Corp. has filed an action in Alberta’s Court of Queen’s Bench against eleven current or former directors and officers of the company, alleging that the defendants manipulated the company’s stock options in order to profit personally. The lawsuit seeks damages equal to the defendants’ ill-gotten gains and a ban on issuing options to the company’s executives. The plaintiffs’ complaint relies on an affidavit from Eric Lie, the University of Iowa professor whose research initially triggered the options backdating scandal. Lie’s affidavit reports “a high statistical probability” that individuals at Savanna backdated options between 2004 and 2007.

Because Savanna is a Canadian company whose shares trade only on the Toronto Stock Exchange and because it has been sued in Canadian court under Canadian law, I have not tried to shoehorn the case into my running tally of options backdating lawsuits (which may be accessed here). The Savanna lawsuit may represent its own unique category of one.

Delaware Corporate Law Update: Francis Pileggi has posted on his Delaware Corporate and Commerical Litigation Blog (here) an interesting series of posts (here, here and here) reporting on the proceedings at Tulane University's Corporate Law Institute, which took place this past week. The posts include a number of interesting commentaries from members of the Delaware judiciary. Francis's post (here) about Delaware law regarding the sale of companies is particularly noteworthy and interesting, particularly Vice Chancellor Strine's remarks about the duties of boards of companies in the process of the sale of a company.

Death by Blogging?: Readers who may not appreciate how stressful it can be to maintain a blog may want to review the April 6, 2008 New York Times article entitled “In Web World of 24/7 Stress, Writers Blog Till They Drop” (here), which surveys the toll that blogging is taking on some authors.

While no one here at The D & O Diary seems to be in any immediate danger, maintaining the blog is unquestionably stressful. The authors described in the Times article are (or rather, were) at least getting paid for their troubles, whereas The D & O Diary lacks even that consolation. Our blogging efforts defy Samuel Johnson’s sage words that “No man but a blockhead ever wrote except for money” -- words that we frequently contemplate to our distress. Yet on we blog, as if by compulsion. A blog is indeed a harsh mistress.

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On April 1, 2008, the Wilmer Hale law firm released a report entitled “West Coast Securities Litigation & Enforcement” (here), in which the law firm reports, among other things, that “investors sued 44 public companies in the West in 2007, a striking 56 percent increase over 2006, reversing what some had hoped was a permanent post-Enron decline in securities class actions.” A copy of the law firm’s April 1 press release about the report can be found here.

The report attributes the “surge” in filings against West Coast companies to the “subprime crisis” which “precipitated lawsuits.” The report also attributes the apparent “upswing in filings” to the “increased capacity of the dozen-plus law firms that bring most of these class actions.”

The report notes that while there were more lawsuits filed, there were also more lawsuits dismissed (29) than settled (18) in the Ninth Circuit during 2007, from which the report happily concludes that “last year’s spike in filings was the product of opportunistic lawyers filing in a falling stock market, and not an indication that corporate malfeasance is on the rise.”

The report also considers 2007 settlement developments and concludes that “it has become cheaper to settle in the Ninth Circuit,” based on the fact that in 2007, the median West Coast settlement was $6 million, the “lowest point since 2004” and 40% below the national median of $9.6. The report concludes because of the lower settlement figures that “the recent wave of California cases appears weaker than those filed in New York and elsewhere and –as in the past – negotiated settlements reflect the financial condition of the defendant issuer or the magnitude of the market loss.” The report also notes that “favorable dismissal rates may have – indeed, should have – encouraged plaintiffs’ lawyers to scale back their expectations.”

The report also has a number of interesting observations about the backlog of pending options backdating cases. The Ninth Circuit courts have been “far less receptive to those cases than have courts in the other regions.” In addition, West Coast issuers “have successfully defended a large number of [options backdating-related] derivative actions; by year end, courts had dismissed 14 such cases and allowed only two to proceed.” The report notes that West Coast courts have thrown out a number of options backdating-related securities lawsuits, while courts in other jurisdictions have permitted these cases to go forward.

The report concludes with a number of observations about the activities of the SEC’s West Coast enforcement offices, which offices apparently remain active.

The law firm’s report is interesting, but many of the report's statistical observations consist of numerators yearning for denominators to give their existence meaning.

First, while the number of lawsuits against companies based in the Ninth Circuit may well have increased 56% percent between 2006 and 2007, lawsuits overall increased 43% (going from 116 lawsuits in 2006 to 166 in 2007, according to Cornerstone, here). The report’s feature stat would be significantly less compelling had the report more accurately stated that increase in the number of lawsuits on the West Coast in 2007 was 13% greater than the increase nationwide.

Second, the methodology used to conclude that California companies were 63% likelier to be sued than companies elsewhere in not revealed. For example, is report saying that the ratio of California companies sued to the total number of companies in California is 63% higher than the same ratio for all other states? Or is the report just making some comparison about the raw numbers of 2007 lawsuits against companies inside and outside California? It would have been helpful for the report to specify its methodology, because this particular conclusion is, well, challenging, given that 52 of the 166 securities lawsuits in 2007 were filed in the Southern District of New York, far more than any other federal district. (Refer here for my full analysis of the 2007 lawsuit filings.)

Third, the report seems to imply that the West Coast companies are being sued because they are located on the West Coast.. The report is written by the law firm's West Coast office and is clearly intended for West Coast companies, and the statistical analysis is clearly intended to convey meaning for those companies as West Coast companies.

But if plaintiffs’ lawyers really were targeting West Coast companies as West Coast companies in 2007, you would expect the lawsuits against the West Coast firms to have continued in 2008. Actually, the exact opposite has happened. While West Coast companies arguably were sued frequently in 2007, they have been sued infrequently in 2008. Through the first quarter of 2008, only six companies located in the Ninth Circuit have been sued in securities lawsuits, even though the number of filings overall in the first quarter  (52) was up compared the number of filings in 2006 and 2007, as I detailed in yesterday’s post.

The increased number of lawsuits against West Coast companies in 2007 can only have meaning for those companies as West Coast companies if the reduced number of lawsuits against West Coast companies so far in 2008 also has meaning for the companies as West Coast companies. The strong suggestion is that something other than geography alone explains both ends of this equation.

(As an aside, the potential role of geography in predicting securities lawsuit frequency was a recurring statistical question in my former life as a D & O underwriter. Brokers in the Midwest contended that Midwestern companies were less likely to be sued, and therefore all Midwestern companies should receive a D & O insurance premium discount. We could never prove that geography alone was an accurate predictor of securities litigation frequency; rather, what we found was that geography coincided with some other factor – usually industry – that was the true frequency predictor. An esteemed former colleague who taught me everything I know on this topic referred to this phenomenon as “multicollinearity “.)

The report also strains when it attempts to use the 2007 dismissals and settlements to analyze the 2007 filings.

Obviously, the cases that were dismissed or settled in 2007 were mostly filed before 2007. The fact that cases filed before 2007 were dismissed in 2007 really doesn’t tell you whether or not the cases filed in 2007 are meritorious or if “corporate malfeasance” is or is not “on the rise.” It is likely that the cases dismissed or settled in 2007 were actually filed over the course of several calendar years, so the raw numbers of dismissals, settlements and filings in a single calendar year may have little or no meaningful interrelationship, and further data (such as, for example, the total number and filing dates of pending cases) is required to make any useful comparisons or even to try to conclude, for example,  that West Coast courts have become "less receptive."  

The fact that median settlements in 2007 in the Ninth Circuit were lower than prior years’ median settlements tells you only that the median was lower. It does not tell you whether or not the 2007 settlements were “cheaper” than settlements in prior years in the Ninth Circuit or than 2007 settlements elsewhere, as these kinds of comparisons require not only the dollar figure at which the cases settled, but also the amount of investor loss that was at stake for each case category compared. Without further information, there is no way to know whether or not the lower 2007 median is simply due to smaller cases being settled in 2007 than in prior years in the Ninth Circuit, or in 2007 elsewhere. There is certainly nothing about the lower 2007 median alone that analytically supports the view that 2007 cases filed in California are “weaker than those filed in New York and elsewhere.”

The report’s commentary about the options backdating cases is interesting, and the most useful addition I can make to the report’s analysis about option backdating case dispositions is to refer readers to my running list of options backdating settlements, dismissals and denials, which can be accessed here.

And finally, because I can’t seem to write a concluding paragraph for this post without discretion making me hit the delete button, that’s a wrap.

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