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.