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

The stock market, that omnipresent and all-purpose barometer of all human sentiment and endeavor, was back up today. So, everything’s fine, right? Congress will get back to work, pass the bailout bill (of course, we all knew we really needed it all along, it was just an election year test, you see) and then we can all go back to important things like driving our SUVs around and watching Desperate Housewives on our big screen TVs. Right?

 Perhaps.

There are still a few items of concern.

1. LIBOR:  The London Interbank Offered Rate, or LIBOR as it is more familiarly known, has gone stark raving mad. The rate measure climbed 431 basis points today, to an all time high of 6.88 percent. Bloomberg (here) quoted one commentator as saying that "any institution that hasn’t completed its 2008 funding needs by now is going to be in serious trouble. More banks are going to fail." Another trader is quoted as saying that "the money markets have completely broken down, with no trading taking place."

2. Hedge Funds: The Market Movers blog asks rhetorically about hedge funds (here), and in light of hedge funds’ recent dramatic underperformance, "what happens when investors decide to take their money out [on October 1], as they are generally allowed to do on the first day of any quarter?"

The answer, according to the Pensions & Investments blog (here), is that there could be a "bloodbath." The "body count could be as many as 2,000 hedge funds and 500 hedge fund of funds between now and the end of March."

As the Market Mover blog notes, the hedge fund shakeout could have enormous consequences as "thousands of hedge funds are all trying to unwind their positions at the same time." A "worst-case scenario" is that the funds that provided credit protection fail, "leaving their investors with nothing and counterparties with little."

3. Europe (and Beyond): You may have noticed that over the past weekend, Europe caught America’s bailout fever. Fortis, Bradford & Bingley and Dexis all required massive governmental bailouts. The Washington Post, in a September 30, 2008 article entitled "As Contagion Spreads, Moods Abruptly Shift" (here), noted that central bankers and national leaders around the globe are alarmed and on high alert. Economies throughout the world perceive themselves to be besieged.

Of all of the threats to the American people, there may be no greater threat right now than that the rest of the world feels so unwell that they decide to stop buying U.S. debt. The technical definition for the position we would then be in is, I believe, "screwed."

4. Headlines Change Daily, Dust Settles Slowly: Let’s recap. During the past three weeks, the government has assumed control of Fannie Mae and Freddie Mac. Lehman Brothers has gone bankrupt. Bank of America agreed to buy Merrill Lynch. The government bailed out AIG. Washington Mutual became the largest bank failure ever. Citigroup agreed to buy Wachovia in an FDIC-brokered rescue. Congress punted on an administration-sponsored bailout plan. Got that?

Any one of these events represents an enormous development with huge consequences. Taken collectively, these events are, I don’t know, choose your own metaphor, an earthquake, a tsunami, the comet hitting the planet. The consequences for the larger economy are colossal, gargantuan, choose your own adjective. It will take months, if not years, for the effects and consequences to fully emerge.

There are already countless examples of these forces at work, but to choose one that is likelier to be of greater interest to readers of this blog, on Monday, Fitch Ratings lowered its outlook on Hartford Financial Services Group from stable to negative due to concerns that credit market exposures are eating into the company’s capital. As discussed here, the company has significant exposures in its asset portfolio to Lehman Brothers, AIG and Washington Mutual. This is merely the most recent example. There will be many, many more.

Coda: In a democracy, the electorate gets the political leadership it deserves. Under current circumstances, then, I suppose it is no surprise that reelection is our national legislature’s sole priority. On Monday, they sure showed us. Ultimately, history will judge. In the meantime, perhaps Congress and the electorate will have had more leisure to assess where true interests lie. We can only hope that delay (or further inaction) will be without further consequences. We already have quite enough damn things to worry about, thank you very much.

And please read James B. Stewart's October 1. 2008 column in the Wall Street Journal, entitled "A Bailout May be Unpopular, But Doing Nothing is Worse" (here).

Note to file: Financial crises should not occur during election years.

Historic Perspective: One of the great curses for any blogger is to lack anything to write about. In recent days, opposite conditions have prevailed. So much has happened of such potential significance that it is simply overwhelming. The extraordinary events of the past few days have left many of us (even verbose, opinionated bloggers like me) at a loss for words.

In despair of finding the time to comment on all that has happened and of finding the words to give it expression, perhaps the best approach is to rely on the thoughts of those who have been down this road before.

With this observation in mind, a loyal reader sent me a link to the Mark DiIonno’s September 30, 2008 column in the Newark Star-Ledger (here), which among other things, quotes at length from FDR’s first inaugural address. DiIonno’s column motivated me to track down and read the entire address, which can be found here.

FDR delivered the address on March 4, 1933, a dark time indeed in the nation’s history. It was in this speech that FDR said that "the only thing we have to fear is fear itself."

I commend the entire address, but call the specific excerpts to readers’ attention:

Practices of the unscrupulous money changers stand indicted in the court of public opinion, rejected by the hearts and minds of men.

True they have tried, but their efforts have been cast in the pattern of an outworn tradition. Faced by failure of credit they have proposed only the lending of more money. Stripped of the lure of profit by which to induce our people to follow their false leadership, they have resorted to exhortations, pleading tearfully for restored confidence. They know only the rules of a generation of self-seekers. They have no vision, and when there is no vision the people perish.

The money changers have fled from their high seats in the temple of our civilization. We may now restore that temple to the ancient truths. The measure of the restoration lies in the extent to which we apply social values more noble than mere monetary profit.

Happiness lies not in the mere possession of money; it lies in the joy of achievement, in the thrill of creative effort. The joy and moral stimulation of work no longer must be forgotten in the mad chase of evanescent profits. These dark days will be worth all they cost us if they teach us that our true destiny is not to be ministered unto but to minister to ourselves and to our fellow men.

****

Restoration calls, however, not for changes in ethics alone. This Nation asks for action, and action now.

****

We require two safeguards against a return of the evils of the old order; there must be a strict supervision of all banking and credits and investments; there must be an end to speculation with other people's money, and there must be provision for an adequate but sound currency.

As an exercise, picture your preferred Presidential candidate attempting to say  anything remotely approaching the foregoing in either sentiment or eloquence. Now picture your preferred Presidential candidate's vice presidential nominee making the same attempt, if you can.

Elections matter.

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Allegations that the defendant companies and their senior managers failed to disclose the hazards associated with the company’s risky investments. Allegations that management failed to account for losses on high risk investments in a timely or complete manner. Allegations that company management minimized the deteriorating values of high risk investments in piecemeal damage control statements to the marketplace.

Sound familiar?

You may be surprised to learn that these allegations do not come from a lawsuit filed as part of the recent wave of subprime and credit crisis litigation. Instead these allegations appear in a case filed against American Express and certain of its directors and offices in July 2002. Background regarding the case can be found here.

On September 26, 2008, Judge William H. Pauley of the Southern District of New York, considering the case on remand from the Second Circuit, granted the defendants’ motion to dismiss in an opinion (here) that may have considerable significance for the more recently filed subprime and credit crisis securities lawsuits.

The plaintiffs had alleged that in the late 90s, the company began investing in "high-risk, high yield debt securities such as below-investment grade bonds and collateralized debt obligations." The complaint alleges that in early 2001, the company recognized $123 million in losses during the preceding fiscal year in losses on the High Yield Debt Portfolio, and that during the first calendar quarter of 2001, the defendants became aware that the portfolio was "deteriorating rapidly." In April 2001, the company announced an additional $185 million in portfolio losses.

During the second calendar quarter of 2001, the second amended complaint alleges, the defendants became aware that "even the investment grade CDOs" were "damaged due to defaults in the underlying bonds." In July 2001, the company announced a $826 million pre-tax charge to recognize additional write-downs to the High Yield Debt Portfolio.

The plaintiffs sought to pursue claims on behalf of persons who had purchased the company’s shares between July 18, 1999 and July 17, 2001. Their second amended complaint alleged three categories of fraud: (1) false and misleading statements that the company had adopted risk management policies; (2) failure to properly account for investment losses; and (3) mischaracterizations of developments relating to the High Yield Portfolio.

Judge Pauley granted the defendants’ motion to dismiss the second amended complain on the grounds that the plaintiffs had failed to establish a strong inference that the defendants had acted with scienter.

Judge Pauley found that the allegations that the defendants were motivated to commit fraud by the senior managers’ aggressive income targets and incentive compensation "were not entitled to any weight."

Judge Pauley also rejected plaintiffs’ contention that defendants were "reckless" in not knowing the risks of the high yield investments and that the public disclosures of the company about those investments misrepresented that risk. Those allegations, the court concluded, "do no more than state in conclusory fashion what Defendants should have known, they are not entitled to any weight."

The court also rejected the plaintiffs’ allegations based on confidential sources, holding that:

None of the confidential sources specifically states that any Individual Defendants had information or access to information indicating that Amex was not properly valuing the High Yield Debt, that is risk control policies were inadequate, that Amex was violating GAAP, or that contradicted the Company’s statements in 2001.

With respect to plaintiffs’ allegations that the defendants minimized the deteriorating asset valuations through piecemeal disclosures, Judge Pauley focused on the internal efforts the Company was making to evaluate its deteriorating assets and found that "the more compelling inference is that Defendants were not acting with intent to deceive, but rather attempting to quantify the extent of the problem before disclosing it to the market."

Judge Pauley also found that the allegations about defendants’ examination of the High Yield Debt Portfolio "suggest that the Defendants upheld their duty to monitor," which "precludes any inference of recklessness."

The SEC Actions blog has a detailed analysis of the opinion, here.

The allegations in the American Express case contain many parallels with many of the lawsuits in the current litigation wave. Indeed the nature of the investment assets involved, including in particularly the investment grade CDOs, and the causes of the valuation declines (including the deteriorating of the bonds underlying the CDOs) bear an uncanny resemblance to many of the allegations in the more recent subprime and credit crisis related litigation.

With the insertion of the words "subprime mortgages," the case arguably would be indistinguishable from many of the more recent cases. Many of the more recent cases allege, like the American Express lawsuit, that the defendant companies lacked internal controls, failed to account for declining investment valuations, and soft-pedaled the seriousness of the valuation declines through piecemeal write-downs.

Because of these similarities, the failure of the American Express lawsuit to survive a motion to dismiss is potentially significant with respect to the more recent lawsuits. Of course, every lawsuit has its own distinct allegations, and the differences in any given case could well be sufficient to produce a different outcome.

Nevertheless, Judge Pauley’s scienter analysis may be particularly important to many of the subprime and credit crisis-related securities lawsuits, in view of the fact that a very large percentage of the recent cases have been filed in the Southern District of New York, where the American Express case was also pending.

Special thanks to Neil McCarthy of LawyerLinks (here) for providing a copy of the American Express opinion.

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Congress, regulators and leading figures in the Bush administration worked overtime this weekend and have crafted a compromise bill that apparently will be put to a congressional vote this upcoming week. A copy of the current discussion draft (which House Speaker Nancy Pelosi says will be “frozen” in this form) that likely will be put to a vote this week can be found here.

At 110 pages, the current draft is significantly more voluminous than the initial three page draft Treasury Secretary Henry Paulson initially introduced last weekend.

As reflected in the bill’s summary (here), the “Emergency Economic Stabilization Act of 2008” not only provides up to $700 billion in funding to buy assets under the Troubled Asset Relief Program (TARP), it also authorizes the Treasury Department to modify troubled mortgage loans. The Act also requires companies selling assets to the government to provide warrants so that taxpayers benefit from the future growth of any company selling assets to the government. The Act also contains provisions relating to executive pay, as discussed below.

Finally, and by contrast to Paulson’s initial proposal, the Act provides for significant oversight and even for judicial review under certain circumstances.

The financial institutions able to take advantage of the Act include not only banks, but also any “savings association, credit union, security broker or dealer, or insurance company.” The assets that may be acquired include mortgage-backed assets created before March 14, 2008, a date apparently coinciding with the collapse of Bear Stearns. The Secretary, in consultation with other authorities, may also designate other assets to be included in the program.

The Act actually ranges far afield, particularly with respect to matters that historically have been viewed as internal or at most the province of state law. Section 111 of the Act specifies that when the government acquires a financial position in a participating institution, the Secretary of the Treasury “shall require that the financial institution meet appropriate standards for executive compensation and corporate governance.”

This section specifically provides that the standards for compensation and governance shall include “limits on compensation that include incentives for executive officers …to take unnecessary risks that threaten the value of the financial institution;” a “provision for the recovery by the financial institution of any bonus or incentive compensation … based on criteria that are later proven to be materially inaccurate;” and a prohibition on “golden parachutes.”

Congress apparently also wants to get into accounting practices and policy. In Section 132, the Act specifies that the SEC shall have the authority to suspend mark-to-market accounting under FASB 157. Section 133 of the Act requires the SEC to conduct a study of the effects and impacts of FASB 157.

In the days ahead, there undoubtedly will be further comment on the Act’s provisions (perhaps there will be further comment even on this blog). But more interesting than the Act’s provisions will be the Act’s practical effects. The purpose of the Act is to try to avoid financial catastrophe and to restore financial market functioning. The storm clouds that suddenly have appeared over a number of European banks, and the further questions involving U.S. financial institutions, serves as a reminder that the circumstances indeed are perilous.

In the days ahead as the Act is put to a vote, the question will be whether the ominous dynamic that has overtaken the financial markets finally relents. Unfortunately, as noted on the Real Time Economics blog (here), the economy may be in trouble regardless of the bailout.

Among other effects also to be watched include the impact on upcoming elections. The electorate is worried, uneasy, and will likely exhibit reactions across a wide spectrum. While the members of Congress may feel they had no choice with regard to the bailout bill, there may still be considerable voter backlash.

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Amidst all of the tumult over the Fed bailout and the Presidential debates, not to mention a host of other events large and small, news about WaMu’s collapse has already slipped from the front pages of the nation’s newspapers. Astonishingly, in one short weekend, events have superseded the largest bank failure in U.S. history.

The problem with treating this extraordinary development as just another item in the news cycle is that it could be possible, notwithstanding the magnitude of the event, to overlook its significance. Make no mistake, however; the consequences of Washington Mutual’s failure, and the specific way the J.P. Morgan buyout went down, are enormously significant, and the implications of these developments are laden with portent.

Takeover/Buyout/Bankruptcy

On September 25, 2008, the Office of Thrift Supervision announced (here) that it closed Washington Mutual and appointed the FDIC as the institution’s received. The FDIC announced that same day (here) that as a result of an auction process J.P. Morgan Chase had acquired Washington Mutual’s banking assets.

J.P. Morgan’s September 25, 2008 press release (here) provides further detail regarding this transaction. J.P. Morgan’s press release explains that in exchange for the payment of $1.9 billion, the company had acquired "all deposits, assets, and certain liabilities of Washington Mutual’s banking operations." The press release also states that the transaction excluded "senior unsecured debt, subordinated debt, and preferred stock" of WaMu’s banks as well as any assets or liabilities of the parent holding company or the parent holding company’s nonbank subsidiaries.

J.P. Morgan also announced that as a result of this acquisition, it "will be marking down the acquired loan portfolio by approximately $31 billion," which it said "represents our estimate of remaining credit losses related to the impaired loans."

The final step of this process followed on September 26, 2008, when the parent holding company filed a bankruptcy petition in U.S. Bankruptcy Court in Delaware, about which refer here.

As NYU economics professor Lawrence White noted in a September 26, 2008 Forbes column (here), for its $1.9 billion investment, J.P. Morgan acquires net assets with a nominal value of $240 billion and deposit liabilities of $188 billion, suggesting a nominal acquisition value of approximately $52 billion. Of course, the planned write-downs diminish –but do not eliminate --this nominal value. Nevertheless J.P Morgan’s $1.9 billion offer was the best bid that the FDIC received.

Clearly, asset valuation uncertainty explains this apparent disparity. J.P. Morgan’s announcement of an immediate $31 billion write-down underscores the magnitude of the valuation uncertainty. But both the extent of this disparity and the magnitude of the write-downs have major implications, as discussed below.

One aspect of J.P. Morgan’s acquisition that was widely emphasized in the press reports was the FDIC’s success in completing this transaction without any losses to the deposit insurance fund. Indeed, there were reports that the FDIC’s chairman’s highest priority in the sequence of events was protecting the fund. Had the deposit insurance been called into play, the impact on the fund would have been enormous, and impact on depositors whose deposits exceeded the insurance limits also would have been significant. Nevertheless, the particular way in which the fund was protected, which left debtholders and bond investors exposed, presents its own set of issues.

Consequences and Implications

1. Valuation Issues: The massive discount on WaMu’s asset valuations implied in J.P. Morgan’s acquisition price has great significance for other institutions holding similar assets. While mortgage assets are not uniform, and the distinct characteristics are highly relevant to valuation issues, the obvious implication of the price and of J.P. Morgan’s announced $31 billion write-down is that similar assets on other institutions’ balance sheets may be overvalued.

Professor White, in the Forbes article cited above, states that these developments are "strong reinforcement for the view that lots of other institutions’ mortgages and mortgage-backed securities are also overvalued."

Indeed, the September 27, 2008 "Heard on the Street" column in the Wall Street Journal notes that "applying J.P. Morgan’s projections on other large banks implies higher losses for those with WaMu-like assets." The Journal column specifically suggests that these concerns may explain why Wachovia’s shares plunged on Friday and that rumors of Wachovia’s possible sale also immediately began circulating. Wachovia, it should be noted, like WaMu, has a significant concentration in Option ARM loans, which undoubtedly reinforce the concerns about possible future write-downs on Wachovia's loan portfolio.

Professor White notes with respect to these valuation concerns that "most of these assets are held outside the banking system," as they are held in "investment banking firms, finance companies, insurance companies, hedge funds, mutual funds, pension funds, etc." All of these institutions will face valuation pressures in the wake of the WaMu takeover.

In any event, along with the possibility that other institutions’ assets may be overvalued is the consequent possibility that investors in those institutions may later claim that they have been misled about the true financial condition of those institutions. (Indeed, WaMu itself previously had been hit with a securities lawsuit in which investors claim that they were misled about the company’s exposure to Option ARM loans, as noted here.) All of which may suggest the possibility of significant additional litigation, as discussed further below.

2. The Insurance Fund is Safe. Bond Investors? Not So Much: J.P. Morgan’s September 25 press release carefully isolated the liabilities it was not acquiring as part of the transaction. While the company cheerfully acquired WaMu’s bank deposit liabilities, other liabilities were left behind.

As detailed in a September 25, 2008 Seattle Times article (here), J.P. Morgan’s $1.9 billion payment will go into a fund for WaMu’s creditors. The only creditors likely to get anything out of the fund are the holders of WaMu’s $7 billion senior unsecured debt, who possible will get not more than 27 cents on the dollar. Holders of over $11 billion of WaMu subordinated debt and preferred stock will get nothing, as will other WaMu debtholders. The total amount of WaMu’s debt outstanding may be as much as $28 billion.

Among others that will be left out in the cold is the private equity fund TPG (formerly known as the Texas Pacific Group), which pumped $1.3 billion into WaMu as one of several investors that invested $7 billion into WaMu just five months ago. As the Wall Street Journal noted in its September 27, 2008 article entitled "WaMu Fall Crushes TPG" (here), these "losses illustrate the peril of investing in distressed banks and financial companies."

These losses are significant in two particular ways. First, WaMu’s collapse has thrown off significant losses for bond investors, many of whom are already reeling from earlier collapses of Bear Stearns, Lehman Brothers, Fannie Mae and Freddie Mac. As these losses continue to filter out into the investment community and the larger economy, the cumulative effect potentially could be staggering (especially in combination with equity investment losses, discussed below).

These losses may also have important implications for other troubled banks’ capital raising prospects. The FDIC may well have succeeded in protecting the insurance fund in this instance. However, the incentives for any investors to consider pumping additional capital into banking institutions have been undermined. Certainly, the likelihood of another TPG-like capital infusion for another troubled bank would seem increasingly improbable in light of these developments.

By its unwillingness to liquidate WaMu now, a move that might have salvaged something for bond investors, the FDIC potentially could have set up further problems down the road. If investors are unwilling to risk investments in floundering financial institutions, additional bank failures could follow. The losses to the insurance fund potentially could be even greater.

3. "I awoke last night to the sound of thunder/ How far off I sat and wondered": The reverberations from the WaMu collapse will ripple through the economy, with many effects near and far, for months to come. Some, like the ones described above, may be readily apparent. Others will be more remote and will take longer to emerge.

Take, for example, the recondite world of collateralized debt obligations, already the subject of much scrutiny due to CDO investment in subprime mortgages. According to a September 26, 2008 Bloomberg article (here), WaMu’s collapse could also have a "significant" impact on CDOs.
 

According to the Bloomberg article, 1,526 synthetic CDOs sold default protection on WaMu. The CDOs sold notes to investors that are repaid using proceeds of credit default swap premiums. As a credit default swap seller, the CDOs must pay the buyers face value in exchange for the underlying securities or the cash equivalent after a bankruptcy filing.

In other words, as a result of WaMu’s collapse, the CDOs are likely to sustain enormous losses. CDO investors and noteholders, whose investments were already hit by the Lehman Brothers bankruptcy, will see the value of their investments fall even further.

The realization and assessment of these and other more remote consequences of WaMu’s failure, as well as other tumultuous events in the financial marketplace, may take time to emerge. It will likely be a considerable time before all of these consequences have surfaced.

4. A Billion Here, A Billion There: In the last year, WaMu’s market capitalization declined over $80 billion. In isolation, this is significant. Taken collectively with other market losses, the aggregate impact is staggering. Collectively, the failures of WaMu, Lehman Brothers, Bear Stearns, Fannie Mae and Freddie Mac represent roughly a $230 billion loss in market capitalization from a year ago.

Nor is that all. If you add in the market capitalization loss in the last year at AIG, Merrill Lynch, Goldman Sachs, Bank of American and Citigroup, the aggregate market capitalization decline in the last year is nearly $700 billion (just about the size of the Treasury bailout, by coincidence).

These stocks were largely held by institutional investors. The aggregate losses on these investments significantly affect the value of these institutions’ holdings, with significant implications for these institutions’ beneficiaries, investors and other stakeholders.

5. Knock-on Effects: One consequence of these circumstances in our blame-centric culture is that as these losses surface and become more apparent, litigation seems virtually inevitable. I have already noted (here and here) how Lehman Brothers’ failure has been significant factor in recent litigation against other companies. Similar litigation consequences from WaMu’s collapse seem likely. The wide dispersion of the consequences from WaMu’s failure raises the significant possibility that the litigation effects will not be limited to the financial sector alone.

Commercial Irony: Although ironic now with the benefit of hindsight, Washington Mutual consciously built its identity on its willingness to lend to those unable to borrow from others. The thrift built this identity with a series of commercials that remain amusing, although for some reasons now perhaps different than at the time the commercials were first created. I have linked a particularly amusing example below, which I commend for its entertainment value. (Hat tip to the Wall Street Fighter blog, here, for the video link.) Note the ironic symbolism of the disfavored borrower popping a balloon at the start of the commercial.

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In my preceding post, I wrote about a possible new wave of credit crisis lawsuits, where the defendant companies are not themselves directly affected by credit crisis fallout, but instead suffer from exposure to other companies that have been directly affected. In a litigation example of these circumstances at work, plaintiffs’ lawyers today initiated another securities class action against a company suffering the effects of Lehman Brothers’ collapse.

In a September 22, 2008 press release (here), plaintiffs’ lawyers announced their filing in the Southern District of New York of a securities class action lawsuit against Constellation Energy Group and certain of its directors and officers. A copy of the complaint can be found here.

According to the press release, the complaint alleges that

In July 2008, the Company reported favorable financial results and reaffirmed EPS guidance of 5.75 per share for 2008. In August 2008, analysts questioned Constellation’s accounting and the implications of a credit downgrade. Then, on September 15, 2008, investors and the market became aware of Constellation’s exposure to Lehman Brothers Holdings Inc.’s (“Lehman”) bankruptcy, which affected the Company’s ability to engage in energy-related trades. With this news, Constellation’s shares plunged to $47.99, a 50% drop from the Company’s Class Period high of $97.34 per share.

The complaint specifically alleges that: 

(a) defendants were inflating Constellation’s results through manipulations relating to the characterization of depreciation expense which inflated the Company’s reported cash flows; (b) the Company’s financial results were inflated by overly optimistic assumptions which were reflected in mark-to-market accounting; (c) the Company’s exposure to credit problems of trading partners was much greater than represented – in fact, one of Constellation’s key trading partners, Lehman, was having severe financial problems; and (d) the Company was not on track to report 2008 EPS of $5.25+ per share.

This lawsuit raises a number of different allegations against the defendants, and the allegations relating to Lehman’s collapse are only part of this lawsuit. Nevertheless, this lawsuit demonstrates that the reverberations from the most recent phase of the credit crisis are spreading far beyond the high profile financial services companies whose names have dominated recent headlines. As Constellation’s circumstances show, the financial companies’ turmoil has also affected their “trading partners,” adding to their partners’ difficulties, and, at least in the case of Constellation, leading to litigation.

One of the questions I have long been asking about the subprime and credit crisis litigation wave is whether it will eventually spread beyond the financial sector. There may not yet be quite enough evidence to declare that the wave has done so. But the allegations against Constellation, and the fact that a company like Constellation has been sued, does suggest the way the litigation wave could well spread outside the financial sector, if it eventually does in any numerically significant way.

In my previous post, I described this potential new class of credit crisis litigation as representing the “second derivative” of the credit crisis litigation wave – that is, the companies targeted may not themselves have been directly affected by the credit crisis, but other companies to which they are exposed have been directly affected, as a result of which even the company seemingly remote from the direct credit crisis turbulence winds up experiencing and suffering from its effects.

It remains to be seen whether this new wave of credit crisis litigation becomes widespread. The one thing I know for sure is that the consequences from last week’s event are enormous and are continuing to ripple through the financial markets and the entire economy. Many companies are likely to be affected and some will be sued.

Some readers may recall that Constellation was also in the news last week in connection with the announcement that Constellation is to be acquired by Berkshire Hathaway affiliate company MidAmerican Energy. Indeed, MidAmerican has agreed to buy Constellation in a transaction valued at about $4.7 billion (refer here). Investors’ reaction to this transaction may be assessed from the per share acquisition price of $26.50, which is less than half the company’s market value just a week previously. At latest word (refer here), a competing bidder is weighing an alternative bid despite the fact that Buffett’s company has already injected $1 billion in cash into Constellation.

Ripple in Still Waters: In another illustration of the wide dispersion of the economic consequences from the large financial institutions’ failures, the September 23, 2008 Wall Street Journal reports in an article entitled “Fannie Mae, Freddie Mac Takeovers Cost U.S. Banks Billions” (here), that about a quarter of the nation’s banks lost a combined $10 to $15 billion due to the mortgage giants’ government takeover.

According to the Journal, the American Bankers Association reports that approximately 2300 banks hold Fannie and Freddie preferred shares, which are likely worthless. 85% of the affected institutions are community banks with assets less than $1 billion. The irony is that many of these banks themselves steered clear of subprime lending excesses, and at the same time considered Fannie and Freddie, as the Journal states, “rock solid investments.”

For most of the affected banks, the losses will be small and manageable. Nevertheless, the dispersion of the losses shows how widespread are the effects from recent events. The impact on companies that were not themselves directly involved in subprime lending illustrates the way these consequence are spreading the effects of the credit crisis to the larger economy.

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The economic crisis that began as the subprime meltdown has clearly entered a dark new phase. And just as the prior stages of the crisis generated waves of related litigation, this new phase already has produced its own distinctive round of lawsuits. Like the underlying economic circumstances, the new litigation phase also seems darker and more threatening.

As might have been predicted, shareholder lawsuits have already been filed against the directors and officers of some of the most prominent companies caught up in the recent events. For example, on September 15, 2008, Merrill Lynch shareholders filed a complaint (here) in New York state court against the company and certain of its directors and officers alleging that the company’s planned merger with Bank of America is the result of a "flawed process and unconscionable agreement" and that the defendants had breached their fiduciary duties.

Similarly, as reported on September 18, 2008 in CFO.com (here), shareholders have filed a Delaware Chancery Court lawsuit against certain current and former directors and officers of AIG. The lawsuit blames the defendants for the company’s "exposure to and grossly imprudent risk taking in the subprime lending market and derivative instruments." The lawsuit seeks the return to AIG of all compensation paid to AIG’s CEO and to its directors, among other things.

These lawsuits are perhaps the almost inevitable products of events reported in last week’s headlines. But along with these more predictable litigation consequences, there have also been additional developments and resulting litigation, and it is this further litigation that suggests that the credit crisis litigation wave my now have entered a new, more complex phase.

As widely reported last week, the Primary Fund money market fund of the Reserve Family of Funds "broke the buck" when its "net asset value" fell below one dollar a share. Reserve’s September 16, 2008 press release announcing that net asset value of the Primary Fund had fallen below one dollar can be found here. On September 18, 2008, plaintiffs’ counsel filed a securities class action lawsuit in the Southern District of New York (complaint here), on behalf of persons who purchased shares of the Primary Fund between September 28, 2007 and September 16, 2008, against the Fund’s underwriters, investment advisor, and officers and directors.

The complaint alleges that the Fund’s offering documents failed to disclose, among other things, "the lack of diversification of the Fund’s assets and exposure to, at a minimum, now largely worthless debt securities valued at $785 million of the now defunct Lehman Brothers Holdings, Inc."

The circumstances behind this lawsuit represent something of a second derivative of the subprime crisis. That is, the subprime meltdown led to problems with certain real estate assets and investments of Lehman Brothers, which ultimately led to Lehman’s collapse, which caused its debt securities to lose substantially all their value, which undermined the asset value of the Primary Fund and harmed its investors.

The reverberations of these second derivatives of the subprime meltdown are rippling through the economy, encompassing a broader array of participants, many of whom may have had little or no direct exposure to subprime-prime related investments per se. However, these companies had exposures to other companies that had exposures to mortgage backed assets.

The Primary Fund is far from the only market participant that has been harmed by its exposure to losses during this latest phase of the economic cycle. By way of illustration, on September 16, 2008, Conseco announced (here) that as of that date it held $108 million of securities of Lehman Brothers, AIG, and Washington Mutual, and that the company had during the third quarter realized losses of approximately $40 million on sales of securities of these issuers. Conseco’s shares fell over 40% the next trading day, although the share price has subsequently recovered somewhat.

Similarly, Japanese insurers have disclosed a combined $2.4 billion of potential losses from Lehman’s collapse (refer here).

On September 11, 2008, Progressive Corporation announced (here) August 2008 write-downs of $324 million (of which $278 million related to common and preferred stock investments in Fannie Mae and Freddie Mac), and also disclosed that the U.S. government’s take over of the companies produced an additional $171 million of September 2008 losses, bringing Progressive’s combined two month investment write-downs on its Fannie and Freddie holdings to nearly a half a billion dollars – a substantial amount even for a company with $20 billion in assets.

A multitude of other companies have announced or will be announced similar losses, and not just related to Lehman, but also in connection with Fannie Mae, Freddie Mac, AIG, and other companies whose securities have faced or that will face similar collapses. A September 18, 2008 CFO.com article entitled "Exposed and Disclosed: Filings Show Ties to Turmoil" (here) highlights recent filing in which companies have disclosed their exposure to investment declines as a result of adverse developments at these companies. A September 16, 2008 CFO.com article similarly identifying companies disclosing losses from the Lehman bankruptcy can be found here.

The losses on these investments are widespread and will affect a wide variety of market participants. The heroic (and astronomically expensive) bailout package that the Treasury department announced over the weekend (refer here) will not restore the value of these investments. In the weeks and months ahead, many other entities will be reporting losses or write-downs on these and other investments. In addition, in a completely different aspect of the current crisis, market participants who depended on Lehman for credit default protection will also be reporting the consequences of Lehman’s demise.

These announcements undoubtedly will trigger strong investor reactions for at least some of the disclosing companies, as was the case, for example, in connection with Conseco’s recent announcement. And in some instances, as was the case in connection with the Primary Fund, these announcements will also result in litigation.

Several months ago, I noted that the evolving litigation wave had long ago ceased to be just about the subprime meltdown. As lawsuits emerge from what I described above as the second derivative of the subprime meltdown, where companies lacking any direct exposure to subprime nevertheless experience losses because of exposure to other companies suffering credit crisis-related reversals, the ensuing litigation wave could threaten to become a generalized inundation deluging a substantial number of participants in the larger economy.

The ultimate wildcard is the impact that the current comprehesive Treasury bailout will have on litigation going forward. The analytic model for the current bailout plan is the formation of a government salvage operator along the lines of the Resolution Trust Corporation (RTC) during the Savings & Loan crisis. Those of us who were around then will recall that the RTC was an active litigant aggressively using litigation to try to recover taxpayer losses. Law.com has a September 22, 2008 article entitled "U.S. Could Emerge as Major Player in Suits Stemming From Financial Crisis" (here) that speculates on that the new government bailout agency could once again play an active litigation role.

How the current bailout package ultimately will shake out remains to be seen. But one of the important themes in the current dynamic is the urge to assign blame. Some congressional figures have already targeted executive compensation and compensation clawbacks as important considerations of the bailout effort. These kinds of considerations could well lead to an effort to target directors and officers as well as their professional advisors, as part of the overall bailout.

More Reserve Fund Litigation: Shareholders have raised an additional concern in connection with the recent events involving the Reserve Fund. In a separate September 19, 2008 lawsuit (complaint here), Fund investors have also alleged that the Fund tipped off "about a dozen institutional investors" to withdraw a total of $40 billion from the funds at one dollar a share immediately before the Fund’s announcement of the losses due to the Lehman investment’s drove the net asset value below one dollar.

In a September 19 order (here), Judge Paul Magnuson entered a temporary restraining order prohibiting the Fund from honoring withdraw requests of over $10,000, until an evidentiary hearing can be held. Among other things, Judge Magnuson’s order said that "plaintiffs would be irreparably harmed if Defendants were allowed to honor redemption requests of investors who were made privy to the bad news before the public was made aware." The court will hold further hearings on September 23, 2008.

Special thanks to a loyal reader for providing copies of the insider tipping complaint and the TRO.

Run the Numbers: I have added the AIG bailout lawsuit and the Merrill Lynch/BoA lawsuit to my list of subprime and credit crisis-related derivative lawsuits, which can be accessed here. With the addition of these two lawsuits, the current tally of subprime and credit-crisis related derivative lawsuits now stands at 23.

In addition, I have added the Reserve Fund lawsuit, together with a more conventional subprime-related lawsuit filed last week against the Canadian Imperial Bank of Commerce (about which refer here) to my list of subprime and credit crisis-related securities lawsuits, which can be accessed here. With the addition of these two new securities lawsuits, the current tally of subprime and credit crisis-related securities lawsuits now stands at 117, of which 77 have been filed in 2008.

Storm Surge: Plaintiffs’ securities attorneys were extraordinarily busy this past week. By my unofficial count, there were at least nine new securities class action lawsuits filed in the past week alone. And while some of this activity is directly attributable to the economic circumstances discussed above, a part of the activity is less directly connected.

Indeed the past week’s new lawsuits involve a broad variety of companies including clothing companies (refer here), wireless communications companies (refer here and here) and silicon wafer manufacturers (refer here).

We clearly are well past the securities lawsuit filing lull that prevailed from mid-2005 through mid-2007. The more troubling question now is whether we have entered a dangerous new phase of heightened litigation activity that includes but also extends well beyond lawsuits arising directly from financial difficulties attributable to turbulence in the credit markets.

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For many companies, one of the most challenging parts of the Directors and Officers (D&O) insurance procurement process is determining how much insurance to purchase. Against a backdrop of basic affordability, the company must consider complex issues such as limits adequacy – that is, how much insurance is enough?

Determining limits adequacy is even more challenging in light of today’s escalating claims severity. Recent developments underscore the fact that in addition to rising settlement levels, growing defense expense is an increasingly important part of the limits adequacy analysis.

In the September 2008 issue of InSights (here), I review recent D&O claims defense expense developments and consider their ramifications for purposes of both limits selection and insurance program structure. The article concludes with a brief review of claims management implications arising from these defense expense issues.

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From the earliest days of the options backdating scandal, one of the recurring questions has been the potential extent of outside director liability exposure (refer, for example, here). On September 17, 2008, In a development that may also have significant implications for more recent events, the SEC filed settled options backdating-related charges against three former outside directors of Mercury Interactive.

A copy of the SEC’s September 17 press release regarding the settled charges can be found here. A copy of the Complaint can be found here.

The SEC’s complaint alleges that the three outside directors “recklessly approved backdated stock option grants, and reviewed and signed public filings that contained materially false and misleading disclosures about the company’s stock option grants and company expenses.”

The complaint alleges that the three individuals approved 21 backdated stock option grants between 1997 and April 2002. The complaint alleges that the three were aware that options with an exercise price lower than the date on which the options were actually approved created a compensation expense. Nevertheless, the complaint alleges, they repeatedly executed stock option documents while “failing to observe, among other things, that the exercise price of stock options they were approving was less than the market price of the company’s stock at the time of approval.”

The three individuals are alleged to have routinely signed unanimous consents “despite being presented with numerous facts and circumstances indicating that management was backdating option grants.” In addition to signing options grants made with earlier “as of” dates, on a few occasions the three “signed multiple written consents presented to them by management for the same grant with different grant dates that had more favorable prices.”

Without admitting or denying the allegations, the three agreed to permanent injunctions and each will pay a $100,000 financial penalty to settle the charges.

In light of the current circumstances, in which scapegoat hunting is in high gear, the SEC enforcement division’s statements about outside director liability may be instructive. SEC enforcement division director Linda Thomsen is quoted as saying, among other things, that “today’s action serves as further notice that misconduct by outside directors, as well as company management, will not be tolerated.”

Another enforcement division official is quoted as saying that, even though they understood how options expensing worked, “time and again, directors approved in-the-money option grants that had been backdated” and that the directors “recklessly approved option grants despite numerous facts and circumstances indicating to them that the grant dates they were approving were improperly backdated.”

While options backdating enforcement actions may seem like yesterday’s news (or even the day before yesterday’s news), these developments have significance today. If nothing else, they demonstrate the SEC’s willingness to pursue enforcement actions against outside directors, at least in certain circumstances, particularly if apparently knowing and active violations are involved.

These developments also underscore the continuing liability exposures to which outside directors potentially may be subject, and the need to address these exposures as part of any well-designed directors’ and officers’ liability insurance program. The SEC’s willingness to pursue outside directors for options backdating-related violations also suggests that today’s even more dramatic circumstances potentially could involve significant outside director liability exposure. The SEC’s interest in the possibility must be presumed.

Some readers may want to know what happened to the Mercury Interactive managers that proposed the backdating options for the directors’ approval. The SEC previously filed civil fraud charges against the company and four former officers (refer here). The company agreed to pay a $28 million penalty. The case against the former officers remains pending. A securities class action lawsuit arising from the Mercury Interactive options backdating allegations settled for $117.5 million (about which refer here).

UPDATE: The Race to the Bottom blog has an interesting post (here) discussing the SEC enforcement proceeding against Mercury Interactive's outside directors. Professor Brown suggests that this case represents another instance where federal regulatory authorities may be creating federal standards of director conduct, in a gradual preemption of state law.

Despite Settlements, Auction Rate Lawsuit Proceeds: Following the recent high-profile auction rate securities settlements, one of the unanswered questions was what impact the settlements would have on the previously pending auction rate securities lawsuits. There are still no definitive answers. But, notwithstanding the settlements, at least one auction rate securities lawsuit is going forward.

As reported in the September 17, 2008 Wall Street Journal (here), Judge Gary Sharpe of the Northern District of New York has ruled that they auction rate securities lawsuits that Plug Power filed against UBS can go forward notwithstanding UBS’s recent $19 billion action rate securities buy-back settlement. A copy of the transcript of the September 17 hearing in the case can be found here. (Hat tip to the Wall Street Journal Law Blog, here, for the transcript link.)

According to Plug Power’s Amended Complaint (here), the company had alleged that, based on supposed assurances that the auction rate securities investments were safe and liquid, the company had bought $62.9 million in auction-rate securities backed by student loans. After the market for the securities seized up in February 2008, the company was (and remains) unable to liquidate its investments. The securities make up nearly half of the company’s investment portfolio.

Under the UBS auction rate settlements, institutional investors’ securities are expected to be bought back in 2010. The Journal quotes Plug Power’s attorney as saying that “we need the funds before 2010 and they’re not providing us a guarantee that they will be able to pay out.”

The disfavored position of institutional investors is one of the features of the auction rate securities settlements I noted at the time (refer here). Other institutional investors may be motivated similarly to Plug Power to proceed with litigation notwithstanding the buy back settlements. And the September 17 ruling in the Plug Power case suggests that at least some of the cases may go forward notwithstanding the settlements.

As noted in a September 18, 2008 post on the Securities Docket (here), plaintiffs’ attorney Daniel Girard of the Girard Gibbs law firm argues that private litigation still has a role to play in the auction rate securities debacle. He points out that many billions worth of these investments are not yet part of any settlement and that even with regard to the securities covered by the settlements, it will be a considerable time before the buybacks kick in (this in connection with investments that supposedly were liquid and just like cash.).

BAE Systems Lawsuit Dismissed: In prior posts discussing civil litigation arising out of corrupt practices investigations (for example, here) one of the cases to which I have frequently referred is the derivative lawsuit filed in the District of Columbia by shareholders of BAE Systems. (For background regarding the BAE Systems case, refer here and here).

In a September 11, 2008 opinion (here), Judge Rosemary Collyer dismissed the BAE Systems derivative lawsuit on the grounds that the plaintiff lacked standing to bring the lawsuit.

The court’s ruling, while narrow, is interesting. The court held that as a result of the “internal affairs doctrine,” the law of the United Kingdom (the country in which BAE Systems is incorporated) governs the case. Under U.K. law, beneficial owners of a company’s securities lack standing to sue derivatively.

The plaintiff in the derivative suit did not directly own BAE systems shares but rather owned American Depositary Receipts (ADRs) as a result of which its ownership is merely beneficial under U.K. law. Accordingly, the plaintiff lacks standing to sue derivatively under U.K. law, and the court granted the defendants’ motion to dismiss.

Even though the court’s holding is narrow, it is significant in at least one respect. That is, it underscores the numerous potential obstacles that any plaintiff will face in attempting to use U.S. courts to assert civil liability in connection wtih a foreign domiciled company’s allegedly corrupt activities. Notwithstanding these obstacles, however, I continue to believe that the threat of civil litigation arising from corrupt practices investigations remains significant.

As the Wall Street Journal noted in its September 12, 2008 article entitled “U.S., Other Nations Step Up Bribery Battle” (here), anticorruption enforcement activity is an increasingly important prosecutorial priority worldwide, in which cross-jurisdiction cooperation is an increasingly important factor. As prosecutorial activity affects an increasing number of companies, investor interest n recovering civil damages for alleged harm to companies from the allegedly corrupt practices will continue to grow.

Special thanks to a loyal reader for the link to the BAE Systems decision.

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One of the most closely followed recent case developments in the D&O insurance arena is the ruling in the CNL Hotels & Resorts case that a Section 11 settlement did not represent covered loss under a D&O insurance policy. As I noted in a recent post (here), on August 18, 2008, the CNL Hotels & Resorts holding was affirmed by the Eleventh Circuit. These developments have occasioned a great deal of discussion and commentary in the D&O insurance community.

Among the more noteworthy commentary on this topic is the analysis of the well-known and widely respected D&O insurance coverage attorney, Joe Monteleone of the Tressler, Soderstrom, Maloney & Preiss law firm. Joe’s commentary appeared in his firm’s August 2008 Specialty Lines Advisory (here, at page 2). As always, I found Joe’s analysis interesting, but I also found that I disagreed with him on a portion of his analysis.

Because I thought an exchange of views on these topics would be useful and perhaps even entertaining, I approached Joe to determine his willingness to engage in a colloquy on this topic to be reproduced on this site. Joe agreed, and our exchange follows below. First, I have quoted a portion of Joe’s article, which is followed by my comments on his article. Joe’s rebuttal appears after my comments.

Joe's Article (Extract):

In his commentary, Joe wrote the following with respect to the CNL Hotels & Resorts case (and cases with similar holdings): 

When you cover the entity for its Section 11 loss, you are in effect saying that your IPO was overpriced by perhaps tens of millions of dollars. While not saying that it is OK, what you are saying is we will let the insurer step in and pay that loss and the corporation can keep its ill-gotten gain. How is that any different than a company simply refusing to pay for goods it has ordered and then letting its insurer pay when it is sued for a breach of its contract to pay? Insurance may cover negligent and even reckless misconduct, but it should not cover crooked behavior.

  Kevin's Comments:

In his article, Joe makes a number of valid and interesting points, particularly with respect to the history of these issues. However, underlying Joe’s legal analysis is a series of value judgments. It seems to me that these value judgments misapprehend several critical considerations. I have set out these critical considerations below. In doing so, I also recognize that courts may have disfavored several of my arguments; readers will judge for themselves whether it is legitimate for me to reference these judicially disfavored points here

The first important consideration is that while companies that are the target of Section 11 claims may be alleged to have made all sorts of misrepresentations or omissions, these allegations are virtually never put to the test of proof. The mere fact that plaintiffs allege that offering documents contained supposed misrepresentations does not mean that the offering proceeds were in fact "ill-gotten." These kinds of claims, like all claims, are compromised because of the burdens and expense of litigation and because few are willing to accept the risk of an adverse verdict.

Nor does the fact that substantial sums are paid to compromise these claims, in and of itself, mean that the defendants company’s IPO was overpriced, much less that the company engaged in "crooked behavior." These settlements take place after the company has experienced a significant stock price drop. Compromising claims in the context of significant market capitalization losses can prove costly, but entry into even a costly settlement is far different than a determination of culpability or wrongdoing.

But I have even deeper concerns beyond just the fact that a settlement does not in and of itself betoken that a company’s IPO was "overpriced" or that the company is improperly keeping "ill-gotten gains." The fact is that the use of heavily freighted words such as "ill-gotten" and "crooked" are fundamentally misplaced in connection with alleged corporate liability in a Section 11 claim.

Under well-established legal principles, corporations are said to be "strictly liable" under Section 11 for material misrepresentations and omissions in offering documents. There is no element of fraud or scienter required in a Section 11 claim, and indeed plaintiffs pleading claims under Section 11 now routinely state (as a means of averting onerous pleading requirements) that they are not alleging or averring fraud in relation to these claims. The point is that in general not even the plaintiffs asserting the claims against these companies allege that the companies engaged in "crooked behavior."

In his article, Joe concedes that insurance properly can be paid for behavior that is merely negligent or even for behavior that is reckless. How then is it appropriate to withhold insurance benefits from companies who can be found liable without any fault at all?
 

I know that the district court in the CNL Hotels & Resorts case said that the absence of fraud allegations in Section 11 claims represents "distinction without a difference." But the absence of allegations of knowing or reckless misconduct does matter, deeply. The use of acutely pejorative words – that are completely unwarranted given the strict liability standard for corporate liability under Section 11 -- has the effect of demonizing the company and putting it the position of moral error. The danger is that it is easier to withhold insurance benefits from a "bad" company. The use of these morally freighted words not only inappropriately shapes the tone of the dialog but potentially enables an unjustified result.

Moreover, even if a Section 11 claimant should allege fraud or dishonesty, the typical D&O policy’s fraud exclusion ensures that insurers do not have to pay benefits for "crooked behavior." But here’s the thing about the fraud exclusion – at least as worded in most current policies, it is only triggered after an adjudication of fraud. The fraud exclusion is no barrier to the payment of insurance benefits to fund settlements of claims alleging fraud.

Indeed, insurance companies regularly fund Section 10(b) claim settlements, notwithstanding allegations of fraudulent misconduct. Surely Joe is not suggesting that insurers cannot properly fund Section 10(b) settlements? And if Section 10(b) settlements properly can be funded because there has been no adjudication of fraud, why can insurers withhold payment of insurance benefits from Section 11 benefits in the absence of an adjudication of fraud, merely because of unproven allegations of "ill-gotten gains" or even "crooked behavior"?

An August 25, 2008 New York Law Journal article by Joshua Sohn of the DLA Piper law firm entitled "Liable Until Proven Innocent" (here) decries the leniency of Section 11 and Section 12(a)(2) pleading requirements. Among other things, Sohn quotes the Supreme Court’s recent Twombley opinion to assert that lenient Section 11 and 12(a)(2) pleading standards will continue to "push cost-conscious defendants to settle even anemic cases."

The lenient pleading standards make IPO companies that experience sharp stock price drops likely targets for Section 11 claims. The leniency of the Section 11 liability standards also means that the lawsuits are likely to survive preliminary motions, leaving defendant companies few options other than settling. Because of this heightened susceptibility to dangerous litigation, companies about to conduct an IPO are particularly sensitive to the need for D&O insurance.

An IPO company is generally regarded as an attractive insurance prospect, and many insurers compete actively to write the insurance for IPO companies. The confounding thing is that insurers that actively competed for the business and voluntarily undertook to insure an IPO company would later contend that the most likely and most dangerous claim the company would face is uninsurable. Whether or not this coverage position makes the insurance agreement illusory, it certainly raises serious concerns about the utility of the insurance agreement.

It will be argued that public policy prohibits insurance for corporate Section 11 liability because the relief sought is restitutionary in nature. As a general matter, the determination of private contractual matters based on public policy grounds raises certain fundamental question about the sources and uses of law. One particular concern is that the supposed requirements of public policy lack a definite point of reference and could become simply a matter of perspective. The notion than insurance for Section 11 claims is against public policy is neither inherent nor absolute, and indeed is an issue on which pertinent parties take a point of view different than followed in recent case law.

The SEC’s perspective is particularly relevant to this public policy question. On the one hand, the SEC takes the position (here) that corporate indemnification for ’33 Act liabilities is "against public policy" and unenforceable. On the other hand, the SEC emphatically does not specify that insurance for ’33 Act liabilities is against public policy. To the contrary, the SEC expressly designates (here) as among the expenses that properly may be charged to the costs of a securities offering the premium charged for insurance "which insures or indemnifies directors or officers against any liability they may incur in connection with the registration, offering or sale of such securities."

The SEC’s public policy analysis distinguishes between the indemnification of Section 11 liability and the provision of insurance for Section 11 liabilities. The SEC’s statements suggest that in its view public policy does not prohibit the enforcement of policies insuring against Section 11 liability, by contrast to its indemnification.

If nothing else, the SEC’s views ought to suggest that what public policy dictates as far the insurability of Section 11 claims is neither self-evident nor universally held. All of which should raise serious concerns about using judicially declared principles of supposed public policy to determine private contractual rights.

It was a nearly universal reaction among both D&O underwriters and brokers that this line of case law produced a result that, while perhaps perfectly logical to an insurance lawyer, ran absolutely contrary to marketplace understanding and commercial expectations. It is worth considering that both underwriters (the ones who sell insurance) and brokers (the ones who procure insurance on behalf of insurance buyers) universally agree that D&O policies should cover these kinds of settlements.

In response to these concerns, the entire D&O insurance industry has taken steps, as quickly and as vigorously as any insurance-related industry has ever done anything, to try to insert policy language calculated to prevent lawyers from making arguments that while perhaps logical to the lawyers defy the expectations and understandings of the commercial marketplace. The marketplace understands that the compromise of disputed Section 11 claims in no way means that a company has engaged in "crooked behavior" and in fact represents the very contingency for which policyholders buy insurance.

Joe's Counterpoints:

Kevin’s repeated admonishments for my use of the term "crooked behavior" call to mind Judge Posner’s words in the Level 3 decision, a case that perhaps more than any other establishes the public policy rationale relied upon by the CNL Resorts courts.

Taking a cue from Judge Posner, I should have refrained from use of the pejorative term "crooked", and I regret any possible inadvertently implied mischaracterization of the motive of the corporate issuer in CNL Resorts or other cases.

Nonetheless, I will now "politely" set forth a number of rebuttal points.

First, I believe the fact that the underlying CNL Resorts litigation, like many other similar litigations, concluded with a settlement and, hence, no evidentiary proof of ill-gotten gain, misses the point of these insurance coverage cases. Regardless of the culpability of the conduct, there could be no liability of the issuer unless the offering was in fact overpriced. To have an insurer pay the amount of the overpricing, rather than have the issuer disgorge it uninsured, results in an unentitled windfall to the issuer.

That being said, I share Kevin’s observation of the irony that in these cases of what is in essence strict liability there can be no insurance recovery, but yet insurers routinely pay to cover liabilities resulting from reckless conduct in other securities cases. Ironic, yes, but it is supportive of the point that culpability of conduct is not the issue.

Also, I would agree that in most of these cases that are disposed via settlement, the insurer cannot apply one or both of its "conduct exclusions", which with increasing frequency in today’s insurance market are written with requirements of a final adjudication in the underlying proceeding. That may hold true for both the dishonesty exclusion and that for personal profit. The latter would arguably apply to preclude coverage for these settlements, but for an adjudication requirement, and in addition to the uninsurability reasoning of the courts in applying the law and public policy.

By no means do these decisions render the insurance agreement illusory, because none of them have applied the uninsurability argument to the individual directors and officers defendants. Thus, in most cases, an allocation should result, but certainly not a complete absence of coverage for all defendants. Although the court in the SR International decision enunciated a public policy argument of having the insurers stand behind the way they market their policies, that was in the context of a dispute over coverage for an underwriter defendant. There is little argument that an underwriter does not receive the proceeds of the offering, and thus its settlement payment cannot be fairly characterized as a disgorgement of ill-gotten gain. Nevertheless, the public policy arguments in that decision give a degree of validity and support to those D&O insurers who have voluntarily attempted to underwrite around the issue by endorsement, notwithstanding what may be the law now in some jurisdictions.

I do not want to belabor the seeming contrast between the SEC’s views on indemnification vs. insurance, but I believe the SEC may well not be inclined to enforce an indemnification prohibition in a settlement context where arguably no Section 11 "liability" has been established.

Finally, I must raise a bit of skepticism at Kevin’s conclusion that insurance underwriters and brokers are in universal accord as to providing "full" coverage for a Section 11 settlement, and that the debate remains only an arcane one among the wonks in the insurance coverage bar. I cannot speak for any particular insurer on this, but it appears at least some were vigorously contesting this issue before the Eleventh Circuit until its decision last month in CNL Resorts. Yes, the endorsements and new policy language purporting to clarify and grant the coverage are frequently seen in today’s market (and, in full disclosure, I have even crafted some of the endorsements and policy language at the request of clients), but I remain reluctant to concede the approach is universal.

Afterword: Consistent with the rules of engagement that I established for this colloquy, Joe gets the last word, so I will offer no surrebuttal. I would like to thank Joe for his willingness to engage on this topic and to offer his views. I would also like to invite readers to chime in on the debate using the blog’s comment feature. (Please note that you can add a comment without providing identifying information, so it possible to add comments anonymously.)

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In a statement issued on Tuesday evening (here), the Federal Reserve announced that it had authorized a loan of up to $85 billion to American International Group. This move is described in detail in a September 17, 2008 Wall Street Journal article entitled "U.S. to Take Over AIG in a $85 Billion Bailout" (here). Bloomberg’s article describing the development can be found here.

The Outlines of the Loan Facility

The loan facility, which the statement says has been extended pursuant to Section 13(3) of the Federal Reserve Act, has been "designed to protect the interests of the U.S. government and taxpayers." According to the Real Time Economics blog (here), the only other time this specific Fed power has been exercised since the Depression era was in connection with the Bear Stearns bailout.

The Fed statement says that it exercised its authority because of adverse economic effects that would follow from a "disorderly failure" of AIG. The loan facility is designed to permit AIG to "meet obligations" in order to "facilitate a process under which AIG will sell certain of its businesses in an orderly manner."

The facility has a 24-month term. The interest rate is set at three month LIBOR plus 850 basis points. Three month LIBOR is a variable rate that resets weekly. The current weekly rate (here) is 2.81%, so the current interest rate on this loan facility is 11.31% -- pretty hefty. Just keep in mind that annual (simple) interest of 11.31% on $1 billion is $113.1 million. On $10 billion it is $1.131 billion. And on $85 billion it is $9.61 billion.

The loan is collateralized by all of the assets of AIG and of its non-regulated subsidiaries. (The good news here is that the assets of the regulated subsidiaries – the insurance companies – are off limits.) The loan is to be repaid from asset sale proceeds.

According to the Fed statement, the government "will receive a 79.9% equity interest" in AIG, with the right to veto dividends to common and preferred shareholders.

The size of the facility presumably was set to accommodate all likely requirements, so AIG may or may not draw down all of it. But AIG will most likely draw down a very large part of it. AIG will have to repay its borrowings (plus interest). In referring to the means of repayment, the press release refers to the orderly sale of "businesses," so one can assume that the non-core subsidiaries are on the blocks for an "orderly" sale.

Questions about the Loan Facility

The problem for AIG is that sale of its non-core subsidiaries alone may not be sufficient to pay back even half of $85 billion. The Deal Journal blog estimates (here) that sales of AIG’s non-core subsidiaries and minority interests might raise "as much as $42 billion" – and that, I might add, is before taxes. (I think Uncle Sam will insist on the payment of all applicable taxes.) Which raises the question whether the sale of "businesses" specifically contemplates the sale of some or all of AIG’s core insurance operations?

Left unanswered in the Fed press release is the question of what this development means for AIG’s continuing business operations. The primary goal of the Fed facility is the orderly sale (as opposed to the "disorderly failure," as the Fed statement put it) of AIG’s businesses. What does this imply about the future of AIG’s operating companies? And what will be left of AIG after the "orderly sale"?

Presumably, the answers to many of these questions will become apparent in the days ahead. In the meantime, there are some things that everyone will want to know. I have posed some of these questions below. Please note that many of these questions may simply be a reflection of the limited amount of information currently available. Many of these questions may appear simple-minded once the information is known. But based on what we know so far, here are the other things we still need to know:

1. Who will run the company? Is current senior management to remain in place, or will AIG get its third CEO this year? (For the record, the government did embed new management at Fannie Mae and Freddie Mac as part of the recent takeover.). How about the Board of Directors, will they also be replaced?

UPDATE: The New York Times reports (here) that AIG CEO Robert Willumstad will be replaced by Edward M. Liddy, the former chairman of Allstate Corporation.

2. What exactly does government ownership of 79.9% of the company equity mean? Is this just a shorthand way of saying that the government is entitled roughly 80% of any later liquidation? Or is there more to it than that?

For example, does the government want the value of its ownership interest to grow? What will the government ultimately do with its ownership interest? Will the government sell its interest, and if so, when, to whom, for what price, and under what circumstance? Why is the government now the majority owner of a major insurance company? Does the government want its insurance company to compete and succeed in a competitive marketplace against investor owned insurance companies?

3. The government wants to get repaid, so it wants the "orderly sale" of the businesses to produce sales values sufficient to effect repayment. That implies that the operating companies should continue operating. But among the insurance companies, for example, there are many practical questions that only active and engaged management can decide – risk appetite, level of pricing aggressiveness, extent of reinsurance, limit exposures, prohibited classes, and so on. All of these decisions must now take place under potentially unusual conditions, in effect under the supervision of a government appointed caretaker/liquidator?

4. What impact will these developments have on credit ratings, both at the parent company level and at the insurance subsidiary level? The fact the company’s primary mission now seems to be a slow-motion liquidation is clearly a relevant factor, as are the unusual operating conditions. In addition, I would expect that all of AIG’s other debt is subordinate to the Fed loan, which also seems relevant to financial strength ratings.

5. What happens if $85 billion is not enough? This is not as absurd of a question as it might seem at first glance. Keep in mind that AIG just raised $20 billion in the second quarter and that clearly was not enough. What does the current lending facility imply about the future – for AIG, for taxpayers, for the economy?

6. What about the credit rating for the U.S. government? How far can this go? The U.S. government just assumed responsibility for $5 trillion in Fannie Mae and Freddie Mac debt. When do we start to get concerned about the government’s balance sheet? When do we start to get concerned about the ability of the U.S. to meet of all of its obligations?

Policyholders’ Interests

Finally, I must address the interests of policyholders. On Tuesday, AIG released a statement (here) that its insurance subsidiaries "remain adequately capitalized and fully capable of meeting their obligations to policyholders." Along those lines, it is important to keep in mind that AIG’s current predicament is not the result of insurance losses, so the separately capitalized insurance companies’ ability to meet its obligations essentially remains unchanged.

Moreover, the collateral securing the Fed’s lending facility does not include the insurance companies’ assets, so even if the parent company heads south in a big way despite the $85 billion loan, the insurance companies’ existing surplus should remain to address policyholder claims, subject of course to the effects of claims payment.

In the days ahead it will be very important to understand how the current operating circumstances will affect the insurance companies and their operations, and in particular whether there are any other implications for policyholder surplus and the insurance companies’ claims paying ability.

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Since the earliest days of the subprime litigation wave, one of the recurring questions has been whether the wave would spread beyond the financial sector. The question remains, but allegations in a new securities lawsuit suggest that circumstances arising from the subprime crisis are affecting a diverse variety of companies, and by extension the claims asserted against them.

According to their press release (here), on September 16, 2008, plaintiffs’ counsel filed a securities class action lawsuit in the United States District Court for the Southern District of California against NextWave Wireless and certain of its directors and officers. NextWave is a mobile broadband and multimedia technology company that develops, produces and markets mobile multimedia and wireless broadband products. A copy of the complaint can be found here.

According to the press release, the complaint alleges that:

Defendants issued materially false and misleading statements regarding the Company’s business and financial results. As a result of defendants’ false statements, NextWave stock traded at artificially inflated prices during the Class Period, reaching as high as $10.10 per share in June 2007.

On August 7, 2008, after the market closed, Nextwave issued its second quarter 2008 financial results, announcing it only had $71.1 million in cash and similar instruments available as of June 30, 2008 and, unless it raised money, its cash would run out at the beginning of October 2008. As a result, the Company was seeking financing that would give the Company enough money to operate through June 2009. On this news, NextWave’s stock fell $1.90 per share to close at $0.95 per share, a one-day decline of 67%.

According to the complaint, the true facts, which were known by the defendants but concealed from the investing public during the Class Period, were as follows: (a) NextWave did not have adequate sources of liquidity to continue operations as it executed its growth strategy and continued making aggressive worldwide acquisitions; (b) defendants had no reasonable basis to make favorable statements that the Company’s WiMAX semiconductor products would be available for commercial sale in the first half of 2008; (c) NextWave’s growth and acquisition strategy was not financially successful and did not provide the basis for continued growth or financial success because it was straining NextWave’s fragile liquidity position and NextWave did not have the financial resources to continue to operate its world-wide operations through the end of 2008; (d) NextWave failed to timely disclose that it had invested all of its marketable securities in extremely high-risk and illiquid auction rate securities; and (e) NextWave’s ability to continue as a going concern was seriously in question by reason of the facts alleged in subparagraphs (a)-(d) above.

The most interesting part about these allegations to me is the reference to the company’s investment in auction rate securities. The complaint itself further alleges with respect to these "extremely high-risk and illiquid auction rate securities" that NextWave "had misrepresented these investments as marketable securities on its balance sheet included in its financial statements disseminated in its Form 10-K and 10-Q and press release."

There have of course been many prior lawsuits against investment banks and broker-dealers in which it is alleged that the financial institutions misrepresented the risks of auction rate securities. But this new lawsuit against NextWave represents the first instance of which I am aware in which an auction rate investor has been sued for failing to disclose its exposure to auction rate securities investments. Obviously, there are a lot of other allegations in the lawsuit, but the auction rate investments allegations are an important part of the complaint and, if nothing else, are noteworthy.

The allegations about the company’s alleged balance sheet misclassification of its auction rate investments is of particular concern. Many companies (and other entities) hold auction rate securities investments, and all of these entities have been struggling both with valuation issues and with balance sheet classification issues. These classification and disclosure issues affect not just auction rate related investments but subprime and other mortgage-backed investments as well. At least theoretically, plaintiffs’ lawyers could allege similar investment disclosure and asset classification issues in connection with these companies.

Perhaps I am getting ahead of myself, but I also wonder whether similar "failure to disclose investment exposure" allegations might be alleged against companies that will be reporting significant write-downs in their holdings of securities of, for example, Fannie Mae, Freddie Mac, Lehman Brothers, and AIG. Admittedly, this may be a far-fetched possibility at this point. But some companies’ write-downs of their investments in those assets could be material, which in turn could affect the reporting companies’ own stock market valuations. If the impact is significant, angry investors might consider their litigation alternatives.

Another Credit Crisis Lawsuit: There was also a more conventional credit crisis lawsuit filed today. According to the plaintiffs’ counsel’s September 16, 2008 press release (here), plaintiffs have filed a securities class action lawsuit against BankUnited Financial Corp. and certain of its directors and officers. A copy of the complaint can be found here.

According to the press release, the complaint alleges that

Defendants made false and misleading statements about BankUnited. Specifically, defendants misrepresented: (a) the losses the Company was likely to suffer due to BankUnited’s poor underwriting standards, which losses would occur once interest rates reset on the billions of dollars of pay-option arms (adjustable rate mortgages where borrowers had the ability to choose their payment amount during the initial period of the loan); (b) BankUnited’s sketchy appraisal process, which permitted borrowers to obtain mortgages in excess of their ability to pay and in excess of the value of the underlying property; and (c) BankUnited’s policies with regard to "piggy-back" loans, which are essentially second mortgages made at the time a home is purchased to fund a down payment.

The BankUnited lawsuit is the latest to raise allegations involving Option ARM mortgages, which I have discussed in prior posts, most recently here.

Run the Numbers: Many readers know that I have been tracking subprime and credit crisis-related securities lawsuits. My running tally can be accessed here. As time has gone by, definitional issues have become increasingly challenging. The NextWave lawsuit may present the most significant definitional challenge to date, because the auction rate investment allegations arguably are a peripheral part of the complaint.

I could go either way on this one, but after some thought, I have decided to include the NextWave lawsuit in my count, simply due to the fact that the company’s financial problems apparently were due in part to its investments in auction rate securities. Reasonable minds could differ on whether or not to include the lawsuit.

But with the addition of the NextWave and BankUnited lawsuits, the current tally of subprime and credit crisis-related lawsuits now stands at 114, of which 74 have been filed in 2008.

Dear Bob, you might not remember me, but I used to work at AIG: If you have not yet seen it, you must read the September 16, 2008 letter (here) that Maurice "Hank" Greenberg, AIG’s former Chairman and CEO and current Chairman and CEO of C.V. Starr, to now-former AIG Chairman and CEO Robert Willumstad.

I can’t imagine why Greenberg thinks Willumstad might have been concerned that Greenberg would "overshadow" him. Willumstad undoubtedly was reassured that, although Greenberg did feel compelled to note "you and the Board have presided over the virtual destruction of shareholder value built up over 35 years," it was not Greenberg’s "intention to point fingers or be critical."

Hat tip to the Wall Street Journal for the link.

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Because of trees felled last night as Ike’s remnants swept through Ohio, I was unable to make it to the office today. I spent more or less the entire day on the telephone talking about AIG, looking out at my yard strewn with fallen tree limbs, branches, twigs and leaves – a visually suitable tableau give the winds that ripped through Wall Street over the last 48 hours.

With respect to AIG, can I just say that today’s mainstream media coverage regarding AIG was absolutely terrible? For most of the day, various news reports seemed to suggest that New York insurance regulators had authorized AIG’s insurance subsidiaries to loan the parent company $20 billion. However, when the transcript of New York Governor David Paterson’s Monday afternoon press conference (here) was later made available on the Governor’s website, it became clear that what the regulators had authorized was quite a bit different than depicted in the media.

As the transcript explains (if you read the whole thing), the regulators have authorized an "asset swap." The idea is that the insurance subsidiaries are swapping the more liquid assets they hold for less liquid assets of equal or greater value held by the parent company, so that the parent company can post the liquid assets as collateral. The transaction is further explained in a CFO.com article here.

The governor himself noted that this swap transaction alone is not sufficient to see AIG through this current crisis, as the working number for AIG’s current requirements is $40 billion. Much about the asset swap transaction "depends" – that is, it depends on the company’s ability to raise the additional funds it requires, it depends on the actual assets that are transferred, it depends on what further capital requirements AIG may have in this rapidly changing environment.

The critical question of the sufficiency of policyholder protection in light of the asset swap will depend on the quality of the assets exchanged. One can hope that given what is at stake that there is a great deal of transparency concerning the assets the insurance subsidiaries receive. Given the regulators’ involvement, one can also hope that policyholders’ interests will not be subordinated to the interests of AIG’s shareholders or bondholders.

In the final analysis, AIG’s ultimate circumstances may finally depend on what the credit rating agencies do. CNN is reporting tonight (here) that Fitch’s has already downgraded AIG’s financial ratings, which potentially could trigger significant additional collateral requirements on the AIG’s credit default swap contracts, perhaps as much as $13.3 billion. The specifics regarding the Fitch downgrades can be found here. Following suit, S&P has also downgraded AIG's counterparty and financial strength ratings (refer here), with the lowered ratings remaining on credit watch "with negative implications." Apparently the downgrades fully considered the potential benefits to AIG as a result of the asset swap transaction.

Perhaps of equally significant (if not greater) concern to readers of this blog is the action this evening by A.M. Best’s to downgrade AIG’s property/casualty insurance financial strength rating to A (Excellent) from A+ (Superior), about which refer here.

UPDATE: A September 16, 2008 Financial Times article entitled "Downgrades Deepen AIG Woes" can be found here. Moody's has apparently downgraded AIG as well (refer here).

There will be further material developments ahead. The ultimate outcome remains to be seen. The company itself did not publicly comment as these events unfolded today, but some reports suggest that there will be a company statement prior to the opening of the markets tomorrow.

About Lehman: At the same time as AIG’s struggles, the details of Lehman’s demise have started to emerge, starting with the company’s Monday morning bankruptcy petition, which can be found here. The Dealbreaker blog has distilled some of the more interesting tidbits from the petition, here.

A more scholarly look at the Lehman petition can be found on the Bankruptcy Litigation Blog (here), which notes that the petition bears the indicia of having been prepared in haste. The blog also notes that as a result of recent bankruptcy law revisions, Lehman’s petition may face some rather complicated challenges. (Hat tip to Francis Pileggi of the Delaware Corporate and Commercial Litigation Blog, here, for the link to the Bankruptcy Litigation Blog.)

Roger Parloff also discusses on the Legal Pad blog (here) the challenges that Lehman’s petition presents. As statements Parloff quotes on his blog make clear, Lehman may not be able to enjoy one of the primary benefits usually available to company’s filing a bankruptcy petition, the automatic stay. Bankruptcy laws relating exclusively to investment banks provide that Lehman’s transaction counterparties can now, even after the petition filing, seek to terminate their contracts with Lehman, which could further exacerbate the current distress.

And on another note, CFO.com has an interesting article (here) asking the question whether Lehman’s creditors can try to recoup the $5.7 billion in bonuses that Lehman paid its employees in December 2007.

The damage from Lehman’s collapse will be widespread, as investors holding its shares and even its debt securities will likely see little or nothing on their investment. This asset wipeout comes on the heels of the Fannie Mae and Freddie Mac takeout, and at the same time as the precipitous decline in AIG’s shares. All of this means that in a few short days a significant chunk of asset valuation has disappeared (and that is not even counting the overall decline in market values today). These investment losses are going to hit a lot of other companies, not to mention pensions, mutual funds, hedge funds, other insurance companies, endowment funds and so on. These losses will have to be reckoned in the weeks and months to come.

The extent of the consequences from these events may be difficult to foresee even now,  though the events have been widely reported. Who could have foreseen that when Ike came roaring ashore early Saturday morning in Galveston that on Monday morning trees would be down all over Northeast Ohio?

For Those Who Can’t Wait: If you are (like me) one of those people who need to know what it all means, you will want to refer to Professor Davidoff’s overview on the Dealbook blog (here). An analysis that takes a darker, more cynical view of these events can be found on The Big Picture blog (here).

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According to various news sources (here), Kansas Bankers Surety (KBS, about which refer here), a unit of Berkshire Hathaway, is exiting the business of privately insuring bank deposits beyond the $100,000 limit of the Federal Deposit Insurance Corporation. The September 10, 2008 Wall Street Journal reported (here) that the company is notifying about 1,500 banks in more than 30 states that it will no longer offer bank deposit guaranty bonds.

The part of this story that interests me (and, I am guessing, most other people, too) is the Journal’s statement that, according to sources, the order to stop insuring bank deposits came directly from Warren Buffett himself, although a spokesman for the company declined to comment on the report.

The Journal article also shed a little bit of light on what might have precipitated the decision. The article reports that KBS insured some deposits of Columbian Bank & Trust Company of Topeka, Kansas which failed on August 19, 2008 (about which refer here), which at the time of its failure had 610 accounts representing approximately $46 million potentially exceeding government insurance limits.

It is unclear from news reports what KBS’s exposure is in connection with the Columbian Bank failure. However, Columbian Bank is one of eleven banks to have failed already this year, and concerns about further failures loom. As the Journal article stated, the decision for KBS to withdraw from bank deposit guaranty bonds is "an indicator of how many in the industry are worried about future bank failures."

The prospect of future losses could have been a precipitating factor in KBS’s pullback. But I am guessing that Buffett himself needed little persuading to exit this business. He has a long-standing and very public antipathy for the banking business. As he wrote in one of his annual letters to Berkshire’s shareholders (here):

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 failing that 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. In their lending, many bankers played follow-the-leader with lemming-like zeal; now they are experiencing a lemming-like fate.

Some readers may wonder about these comments in light of Berkshire’s substantial investment in Wells Fargo. Specifically, as of December 31, 2007, Berkshire owned 303,407,068 Wells Fargo shares, representing 9.2% of the shares outstanding, at today’s price worth more than $10 billion. Buffett commented on his willingness to invest in Wells Fargo at the time he made his first significant investment in the company, notwithstanding his general antipathy for banks, citing the quality of Wells Fargo's management and its culture.

However, at the same time Buffett lauded Wells Fargo’s virtues, he also acknowledged its vulnerabilities:

Of course, ownership of a bank - or about any other business - is far from riskless. California banks face the specific risk of a major earthquake, which might wreak enough havoc on borrowers to in turn destroy the banks lending to them. A second risk is systemic - the possibility of a business contraction or financial panic so severe that it would endanger almost every highly-leveraged institution, no matter how intelligently run. Finally, the market's major fear of the moment is that West Coast real estate values will tumble because of overbuilding and deliver huge losses to banks that have financed the expansion. Because it is a leading real estate lender, Wells Fargo is thought to be particularly vulnerable.

Readers may be interested to know when Buffett wrote these statements. Both Buffett’s remarks about the lemming-like qualities of banking managers and the potential problems of systemic risk and overbuilding on the West Coast appeared in Buffett’s 1990 letter to Berkshire shareholders. Reading his 1990 remarks some eighteen years later does suggest that history seems destined to repeat, at least when it comes to banking. From the 1990 shareholders’ letter is also clear that part of the reason Buffett was willing to invest in Wells Fargo then was that, due to terrible banking results at the time, bank stocks were beaten down and Wells Fargo was a relative bargain.

There have been numerous reports that we are now facting the worst set of conditions for the banking industry since that prior period. Although Buffett was then able to make a favorable investment in Wells Fargo, he undoubtedly recalls what happened to others in the banking industry in the late 80’s and early 90’s. The current conditions are similar to those from which Buffett profited in the past. He undoubtedly has aspirations of repeating that performance this time around, but at the same time he has no interest in footing the bill for depositors’ losses in excess of FDIC insurance.

If Buffett thinks this movie looks like a remake of old familiar classic, his actions suggest that he is pretty sure he know what is going to happen in the next scene.

From the Archives: Buffett is not the only one who memory runs back to the earlier era of failed banks. Many of us oldsters in the D&O business earned our spurs during the S&L crisis and era of failed banks in the early 80s and 90s. If we are indeed headed into another period of significant bank failures, many of the themes from that earlier time may again be relevant, including some venerable D&O insurance coverage issues, as I noted on a recent post, here.

Back to the Future: Comparisons back to the earlier era of failed banks seems to be the order of the day. According to a September 11, 2008 press release (here) from Navigant Consulting, the subprime-related litigation filed in federal court in the last 18 months already exceeds the amount of litigation filed in the S&L crisis.

The press release states "the number of subprime-related cases filed in federal courts through the second quarter of 2008 has topped the 559 savings-and-loan (S&L) lawsuits of the early 1990s, until now viewed by many as the high-water mark in terms of litigation fallout from a major financial crisis."

The release specifically cites the "rising tide of bank failures" as one potential source from which future litigation could emerge.

The Navigant data is interesting, but it would be even more helpful if the company had specified how it collected its data and what it was "counting" as subprime litigation. I know from my own efforts to track the subprime securities litigation that deciding what to count and what to exclude is an extremely challenging task. It would enhance the Navigant reports if the company were to provide a little more specificity about exactly what the company’s "count" actually represents.

Special thanks to the several readers who sent me links about the Navigant report.

The Hits Just Keep on Coming: In my prior post (here) commenting on the government takeover of and litigation involving Fannie Mae, I noted that the company’s huge loss of market capitalization would translate to significant losses throughout the marketplace and that in the weeks and months ahead we would find out where those losses landed. Along those lines, Progressive Corp. today announced (here) a monthly loss for August 2008 of over $135 million, based on large part on the write-down of the company’s holdings in Fannie Mae and Freddie Mac securities.

The company reported that during August, its holdings of Fannie and Freddie preferred stock declined $271.4 million and its holdings of the two companies’ common stock declined $6.8 million. The company also reported that following the government’s recent takeover, its holdings in Fannie and Freddie preferred stock declined an additional $171.3 million, which loss will be reported in the company’s September monthly results.

For those keeping score at home, that means that the value of Progressive’s holdings in Fannie and Freddie’s preferred securities declined a total $442.7 million in August and September. Even for a company the size of Progressive (the company had YE 2007 assets of nearly $19 billion), that is significant.

Progressive is far from the only company that will be reporting these kinds of results in the weeks and months ahead. Indeed, and to bring this blog post full circle, I note in that regard that a September 11, 2008 CFO.com article entitled "Fannie-Freddie Bailout  Losses Hit Banks" (here)  reports that a number of banks have issued warnings about the hits they must take to their balance sheet because of Fannie and Freddie's collapse.

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In what is, according to news reports (here), the largest settlement to date in a shareholders’ derivative lawsuit in Delaware Chancery Court, four former AIG executives and former AIG managing general agent C.V. Starr today reached a $115 million settlement in the 2002 AIG derivative lawsuit.

The lawsuit was filed by the Teachers’ Retirement System of Louisiana in 2002 against AIG, as nominal defendant; certain former AIG directors and officers (many of whom were later dropped from the case); and Starr.

According to news reports (here), the plaintiff alleged that half of the $2 billion AIG paid C.V. Starr between 2000 and 2005 "represented sham commissions for work that, in some cases, was done by AIG employees." The lawsuit also questioned "why some executives were allowed to serve simultaneously as officers of C.V. Starr, a closely held insurance agency, while profiting from business between the two companies." The complaint also alleged that Starr gave the individual defendants bonuses on fees from AIG. In effect the complaint alleged that the commissions were a mechanism for the defendants to "line their pockets."

The case was scheduled to go to trial on September 15, 2008. The four settling individual defendants include former AIG Chairman and CEO Maurice Greenberg; former AIG CFO Howard Smith; former Vice Chairman of Investments Edward Matthews; and former director and Vice Chairman of Insurance Thomas Tizzio.

The vast bulk of the settlement -- $85.5 million – is to be paid by AIG’s D&O insurance carriers. A list of the carriers on AIG’s D&O program can be found here.

The more interesting question is where the remaining $29.5 million will come from. Some of the news reports give the impression that the individuals are funding the settlement. However, it appears that the individuals themselves are funding only a small portion of the remaining $29.5 million.

Greenberg’s counsel’s statements to the press (for example, here) are quite emphatic that Greenberg himself will not be contributing anything the settlement. One news report (here) does suggest that Tizzio "is expected to pay between $1 million and $5 million," Smith and Matthews "would pay very small amounts, if anything."

It appears that the bulk of the $29.5 million will be paid by C.V. Starr. According to Greenberg’s counsel, Starr "expects to contribute between $20 million and $30 million."

The details about who will be paying what seem surprisingly imprecise. In particular, the wide potential variance in Tizzio’s contributions seem odd to me, as even a wealthy individual generally would require a more precise determination of how many millions of his dollars are going to be required. Which makes me wonder whether perhaps Tizzio has an individual source of insurance that may be contributing on his behalf.

There are a variety of other odd features to this settlement, at least as it is described in the news reports, the most striking of which is that Tizzio apparently will be making a material settlement contribution but apparently Greenberg will not. To be sure, C.V. Starr, of which Greenberg is still Chairman and CEO, will be making a more than $20 million contribution, raising the question whether the amount of Starr’s contribution and the fact that Greenberg himself is not contributing to the settlement are linked.

And even with respect to C.V. Starr’s contribution, certain questions arise. For example, given the fact that some or all of the individual defendants apparently were also officers of C.V. Starr, is Starr’s D&O carrier funding some or all of Starr’s contribution to the settlement?

It should also be noted with respect to Starr’s payment to AIG that Starr is in fact AIG’s largest shareholder. As of July 15, 2008, Starr owned 10.5% of AIG’s outstanding shares, which represents Starr’s largest asset. Maybe that is just context, but it is an interesting context nonetheless.

I also have questions concerning the $85.5 million contribution from AIG’s D&O carriers. Beyond sheer curiosity about how much of AIG’s D&O insurance tower was depleted by defense expense, I also wonder whether the insurer’s settlement contribution to this derivative settlement drew upon the insurance program’s Side A coverage, which provides protection for nonindemnifiable loss. You would not expect the $85.5 million payment to AIG to be indemnifiable in the absence of insurance, so all else equal the amount would seem to represent a Side A loss. The same would also seem to be true with respect to the individuals’ own separate contribution to the settlement.

My question about which D&O policy coverage funded the settlement may require some context. Given the size of this derivative settlement, as well as other recent large derivative settlements (including, for example, the $50 million Hollinger derivative settlement), there seems to be a growing threat of very large derivative settlements, which is a relatively new development.

Many companies, particularly large financial services companies, often have D&O insurance programs built exclusively or predominantly of Side A-only protection. These kinds of programs have become increasingly common in recent years, but in general losses have really not yet caught up to this coverage to a significant degree.

The options backdating derivative cases presented the possibility of significant potential losses for these types of coverages, but it is my understanding that the Side A-only losses from these cases really have not yet significantly materialized. There has been speculation that the subprime litigation wave might also produce significant Side A losses, but those cases are only in their earliest stages yet, so the losses have yet to fully develop.

The possibility of derivative settlements of the magnitude of the recent AIG settlement may represent the most significant threat to these Side A programs and coverages, at least outside of the bankruptcy context. Which is why I am curious to know which policy coverage funded the AIG D&O insurers’ portion of the AIG settlement.

Finally, I am curious about how likely coverage issues were dealt with in connection with this settlement. I expect that the insurers would have raised the personal profit exclusion typically found in most D&O policies as at least a potential defense to coverage. I am guessing that the existence of this issue complicated the settlement process (or at least the insurers’ contribution to the settlement). The absence of a judicial determination that the individuals had improperly profited undoubtedly ameliorated this potential impediment. The individuals' desire to avoid any determination that might preclude coverage may have helped precipitate settlement on the eve of trial.

As always, I am interested if any readers can shed any light on the details. I am particularly interested details involved with the individuals’ contributions; around the extent of insurance funding for C.V. Starr’s contribution; and concerning AIG’s insurers’ contributions. Anonymity will be scrupulously protected.

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According to news reports (here), on September 8, 2008, Judge Jeremy Fogel of the Northern District of California preliminarily approved the settlement of the Apple options backdating derivative litigation.

As reflected in the parties’ Stipulation of Agreement of Settlement (here), the plaintiffs in the consolidated Apple derivative action agreed to dismiss the action subject to the defendants agreement to pay $14 million to the company; the defendants’ agreement to pay the plaintiffs’ counsel’s various attorneys’ fees and costs totaling $8.85 million; and the company’s agreement to adopt certain corporate governance reforms. According to the Stipulation, the various derivative lawsuits "were a material factor in obtaining the $14 million payment from Apple’s liability insurers." The total cash value of the various payments is $22.85 million.

UPDATE: An alert reader has raised an important question about my statement that the total cash value of this settlement is $22.85 million. The reader said the following in an e-mail to me: "You describe the settlement as involving a cash payment of $22.85 million based on the $14 million D&O settlement paid to Apple and the $8.85 million fee award expense payment made by Apple to the plaintiffs. However, as a practical matter aren't you 'double counting' since, presumably, the plaintiff fee awared was paid by Apple from the D&O proceedsit received from its carriers?"

Assuming this reader's analysis is correct, this is a very important distinction. The Stipulation of settlement is consistent with the reader's hypothesis, but not definitive. The Stipulation is clear that the $14 million payment is coming from Apple's D&O carriers. It also says that the $8.85 million is to be paid by Apple. It is not clear whether or not the D&O insurers will be reimbursing Apple for the $8.85 million or if the $14 million is the only payment that the D&O insurers will be making in connection with the settlement. It would be helpful if any reader with more specific knowledge of the insurance arrangements pertaining to this settlement would let me know.

This reader's question also suggests another component that is relevant to these insurance issues but that is not addressed in the Stipulation, and that is the question of defense expense. In a case like this where there are regulatory proceedings and special litigation committee activities as well as civil litigation, there frequently are disputes about which defense fees are covered and which are not. In a case like this one, the aggregate amount of all fees could well exceed $10 million. To the extent the insurer's $14 mllion payment is the total amount of insurance remitted to Apple, leaving the company to absorb both the $8.85 million of plaintiffs' attorneys' fees and expenses as well as all of the related defense expense, the $14 million payment could even be less than the amounts for which the company itself is reponsible.

The settling defendants include the Company; its Chairman, Steven Jobs; and certain other present and former directors and officers of the company. Judge Fogel set a final settlement hearing for October 31, 2008.

I have already received inquiries from persons questioning the size of the Apple options backdating derivative lawsuit settlement. The questioners are concerned that the settlement amount is seemingly small, especially in light of who the company is and the nature of the allegations.

There is no doubt that the Apple options backdating allegations have been very high profile. In addition, parallel SEC enforcement proceedings did result in the payment of some significant fines. On August 14, 2008 former Apple general counsel Nancy Heinen agreed to pay $2.2 million to settle options backdating charges (about which refer here), and last year former Apple CFO Fred D. Anderson agreed to pay $3.5 million to settle SEC claims against him (about which refer here).

The consolidated amended complaint also contains some apparently serious allegations. As discussed here, the amended complaint raised certain options springloading allegations, including the allegation that three Apple executives received a windfall when they were granted options to buy over 2 million shares the day before the announcement of a significant technology investment and other developments sent Apple’s shares up 48 percent. The amended complaint also alleges that Jobs himself received backdated options that were later cancelled in exchange for restricted stock.

Despite these allegations and notwithstanding the SEC settlements, the plaintiffs’ case faced certain potentially significant challenges. First, in a December 19, 2007 opinion (here), Judge Fogel had dismissed the plaintiffs’ initial pleadings, with leave to amend. In issuing this ruling, Judge Fogel did not even reach the demand futility issue, deferring that to a later date.

The plaintiffs filed their consolidated amended complaint on December 18, 2006 (refer here), seeking to overcome the deficiencies in the original pleadings. However, just days later, on December 29, 2006, Apple announced the completion of the special investigative committee’s investigation of the company’s stock option practices.

A joint statement by the committee’s co-chairs, former Vice President Al Gore and audit committee chair Jerome York, stated that Apple’s board "has complete confidence in the senior management team." The company’s 10-Q issued the same day (here) stated that the committee "found no misconduct by current management." (The 10-Q did go on to say that the investigation had "raised serious concerns about the actions of two former officials"—presumably Heinen and Anderson).

It is no surprise to me that faced with an apparently skeptical court and an unhelpful (if also somewhat controversial at the time) investigative committee report, the plaintiffs’ found it expedient to settle. The questions I have received have not reflected concerns about the fact that the plaintiffs settled; the concerns have had more to do with the amount of the settlement.

If you disregard for a moment that a high-profile company like Apple is involved, there is nothing particularly unusual about the size of this options backdating derivative settlement, at least in the context of other options backdating derivative settlements. Setting to one side the UnitedHealth Group derivative settlement (about which refer here), the options backdating derivative lawsuit settlements to date have been relatively modest, and the total value of the Apple derivative settlement is well within range of the other settlements.

As reflected in my running table of the options backdating lawsuit case resolutions (which can be accessed here), the total value of very few of the options backdating derivative settlements has exceeded seven figures. Indeed, the Apple settlement is actually one of the larger options backdating derivative settlements. The total cash value of only three derivative settlements exceeds the Apple settlement: UnitedHealth Group; Cablevision ($34.4 million, about which refer here); and Electronics for Imaging ($24 million, refer here).

By and large the options backdating derivative settlements (in the cases that have not been dismissed outright) have been relatively modest, consisting in many cases only of a payment of plaintiffs’ attorneys’ fees and the agreement to adopt certain governance reforms. Although there were a truly impressive number of options backdating derivative lawsuits filed (168 by my count, as reflected here), very few of them seem to be resulting in significant payouts.

As the options backdating scandal recedes in the rear view mirror, it definitely has started to seem like less and less of a big deal, particularly in the context of the current daily diet of government bailouts, floundering investment banks, and multibillion dollar securities buybacks – with one big exception, as noted below.

And Speaking of UnitedHealth: The UnitedHealth Group cases have definitely been the most notable big-dollar exception in the options backdating scandal. The company was back in the news again today with the announcement (here) from the options backdating securities lawsuit lead plaintiff, Calpers, that the company’s former CEO William McGuire had agreed to pay $30 million and its former general counsel David Lubben had agreed to pay an additional $500,000 in settlement of the options backdating securities claims pending against them. McGuire’s own press release about the settlement can be found here.

Taken together with the $895 million previously announced settlement (refer here) in the UnitedHealth Group options backdating securities lawsuit, the aggregate value of the options backdating securities settlements in the case now totals $925.5 million, certainly a large number by any measure. This settlement total is also in addition to the UnitedHealth options backdating derivative settlement, which had a total value of over $600 million.

Although the various press releases are not specific in this respect, the implication is that McGuire’s $30 million settlement payment will come out of his own personal assets, rather than insurance or corporate indemnity. If that is the case, this settlement would represent one of the larger individual payments of its kind.

Fifth Circuit Affirms Options Backdating Securities Lawsuit Dismissal: In a September 8, 2008 per curiam opinion (here), the Fifth Circuit affirmed the dismissal of an options backdating related securities lawsuits. (The district court’s October 4, 2007 dismissal can be found here. Background regarding the case can be found here.)

The Fifth Circuit affirmed the district court’s dismissal on loss causation grounds. The holding is interesting because the company’s stock actually did drop on the date of the alleged corrective disclosure.

The Fifth Circuit held that the press release in question was not sufficient to satisfy the requirements to establish loss causation because "although the stock price dropped dramatically on the day of the 1 August 2006 press release, no new facts concerning Cyberonics’ stock-option accounting were disclosed in that release which demonstrated that the ‘truth became known’ about Cyberonics’ challenged financial statements." Therefore the Fifth Circuit concluded, "a causal connection between the material misrepresentations and the loss was not adequately pled."

Special thanks to Neil McCarthy of Lawyer Links for alerting me to the Fifth Circuit’s opinion.

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Each fall for the last two years, I have taken a look at the current trends and hot topics in the world of D&O. There are of course certain perennial topics that are always critical, but this overview is intended  to focus on the issues the most significant current interest for D&O insurance professionals and their clients. Here is my list of the current issues to watch:

1. Limits Adequacy: The question of limits adequacy has long been one of the more challenging parts of the D&O acquisition process. Against a backdrop of basic affordability, the company must try to determine how much insurance is "enough"?

Several recent developments have surrounded these issues with even greater urgency. The most dramatic of these developments arises from the claims surrounding the collapse of auto parts supplier Collins & Aikman. The company carried $50 million D&O insurance limits, but the cumulative expense of the various civil, regulatory and criminal proceedings arising from the company’s demise have entirely exhausted the $50 million insurance program, leaving individual defendants to face ongoing criminal prosecutions and civil litigation without insurance available to fund their defense. (Refer here and here for further discussion of the Collins & Aikman case.)

There have been several other recent examples where astronomical defense expense has exhausted or substantially depleted entire D&O insurance programs.

The escalating cost of defense is only one of several factors raising limits adequacy concerns. The steady rise in average and median claims severity, as well as the growing threat of separate opt-out litigation following the settlement of class litigation (about which refer here), also underscore the growing complexity of limits adequacy issues.

In light of these developments, particularly the catastrophic potential for defense expense to deplete policy limits, it may be time to rethink traditional notions of limits adequacy, because past assumptions may no longer be sufficient.

2. Insurance Structure: For several years now, conversations in connection with the D&O insurance transaction have included the discussion of additional Side A insurance to provide additional protection for individuals’ liability and defense expense that is not indemnifiable due to insolvency or legal prohibition. In recent months, interest in Side A protection and other auxiliary D&O insurance structures has recently taken on increased urgency, as a result of two developments.

The first derives from the preceding topic; that is, concerns about limits adequacy inevitably lead to questions about structure, because even substantially increased limits may not be sufficient to address all concerns, given the potential for defense expense to consume available limits.

One way for corporate officials to ensure they are not left without insurance to protect them is through the creation of an auxiliary insurance structure dedicated solely to their protection. There are a number of different auxiliary D&O insurance products available to address these concerns. Most of these structures have been available in various forms for some time now. What has changed is the level of interest in these insurance structures.

A separate legal development is also driving interest in auxiliary insurance structures. In March 2008, a Delaware Chancery Court opinion in the Schoon v. Troy Corporation case held that a Delaware corporation may retroactively eliminate former directors’ advancement rights. (Refer here for my prior discussion of the case). The possibility that former directors could lose their rights to indemnification or advancement after the end of their board service may come as unwelcome news to many directors.

The typical D&O insurance policy provides coverage for former directors and officers. Under most circumstances, a former director from whom corporate advancement and insurance has been withheld would still be able to seek defense expense protection and indemnification under the company’s D&O insurance policy.

Directors who are concerned that events following their departure from the board could conspire to leave them unprotected (for example, if limits were exhausted or substantially depleted , as discussed above), yet another auxiliary insurance product is now available. A retired director insurance policy is dedicated solely to the protection of the named individual and cannot be terminated or discontinued by the action of others.

The point is that directors and officers rightly are more concerned about the availability of insurance protection when they need it most. As a result, interest in the wider variety of auxiliary insurance structures has increased.

3. Excess Insurance: For reasons that should be clear from the first point above, excess D&O insurance is an increasingly important part of the D&O claims resolution process. Perhaps because of excess D&O insurance’s increasing involvement, there have been a series of D&O insurance coverage disputes involving excess D&O insurance. These disputes have highlighted the importance of two particularly important issues concerning excess D&O insurance.

The first of these issues involves the excess policy’s language describing the circumstances under which the excess policy’s payment obligations are triggered. This language can become critically important if the policyholder reaches a compromise with an underlying insurer as a result of which the underlying insurer pays less than its full policy limits, leaving an insurance "gap" to be funded by the policyholder.

In two recent decisions, one involving Comerica (refer here) and one involving Qualcomm (refer here), courts interpreting policy language providing that the excess insurer’s obligations are triggered only if the underlying insurance is exhausted by the underlying insurer’s payment of loss held that the excess insurer’s obligations were not triggered even if the policyholder funded an insurance "gap."

These case developments have increased the awareness of the importance of excess insurance exhaustion language and coverage triggers. Alternatives now available in the marketplace allow payments by policyholders funding "gaps" as sufficient to trigger excess insurance payment obligations.

The second of the excess insurance issues involves coverage issues that so-called "follow form" excess insurers. The particularly troublesome issues arise when excess insurers raise policy defenses that the underlying insurers did not assert. Each policy of course represents a separate contract, but policyholders obviously expect each layer of a single insurance program to respond similarly to the same set of claims circumstances.

These issues have drawn even greater scrutiny in recent cases in which "follow form" excess insurers contend that their policy contains exclusions not found in the underlying policies, or that the excess insurer has policy application defenses different from the underlying insurers.

Although excess insurance frequently is described as "follow form," the increasing frequency of coverage defenses raised only by excess insurance suggest that, regardless of how the policy is characterized, the operation of excess insurance can be something substantially different than "follow form." The factors described above regarding escalating defense expense and increasing average and median claims severity ensure that these excess insurance issues are likely to be increasingly important.

4. Subprime Claims and The Cost of D&O Insurance: Largely as a result of the litigation activity surrounding the subprime meltdown, D&O claims activity has in recent months returned to historical levels after a period of reduced activity. Because much of the subprime litigation has been high profile, there is a frequent assumption that the cost of D&O insurance must be increasing.

As I noted in a recent post (here), so far, except with respect to certain marketplace segments such as the financial sector, D&O insurers generally have not restricted capacity, reduced coverage or raised prices. These buyer-friendly conditions are largely the result of the relatively positive results insurers have enjoyed in recent years. The insurance marketplace remains competitive.

The subprime litigation wave is continuing to spread. The risk for insurers is that in a competitive environment, pricing can fall below risk-related requirements, leading to an eventual correction. To the extent the current litigation wave produces significant insurance payouts, the current competitive conditions could change quickly, particularly if the litigation wave spreads beyond the financial sector. However, at this point, these possibilities continue to appear remote and the marketplace remains competitive.

Afterword: There are other developments that I think are important and worth watching, such as the growing potential for possible climate change disclosure issues (about which refer here) and the emergence of civil litigation arising from corrupt practices enforcement proceedings (about which refer here). These and other developing concerns still fall more in the category of emerging issues rather than current trends. The one thing that is clear is that the world of D&O continues to be characterized by constant change.

I have set out above what I consider to be the critical current issues but I am certain that others may have a different view of what the hot topics are in the current environment. I would like to encourage readers to use the comment function to add their own views about the current hot D&O insurance topics. Please note that comments can be added anonymously.

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When news of the federal government’s seizure of mortgage giants Fannie Mae and Freddie Mac became public, it became apparent that the government’s move was bad news for the holders of the companies’ common and preferred stock. 

The Wall Street Journal's front page September 8, 2008 article (here) commented that the government rescue is "likely to leave a trail of billions of dollars in losses for stock holders, including some major banks" because, among other things, the new government overseers "will eliminate dividends on billions of dollars of common and preferred stock," moves that are expected to further drive down the companies’ share prices. In addition, if the government exercised certain warrant rights, the common shares "will be drastically diluted."

In light of these developments and considerations, Fannie Mae’s share price declined sharply on Monday September 8, 2008. The company’s share price, which had closed at $7.04 on Friday, September 5, 2008, closed on Monday at $0.73, a drop of approximately 90%. Even though Fannie’s shares had been beaten down prior to September 5, the share price decline on September 8 alone represents approximately a $7 billion market capitalization loss.

In addition, news reports about the government takeover (for example, here) suggested that Treasury officials brought in to review the companies' accounting in connection with the government takeover found that the companies had been "playing games" with their accounting to meet reserve requirements.

Plaintiffs' lawyers lost little time reacting to these events. After the close of markets on Monday afternoon, plaintiffs’ attorneys issued a press release (here) announcing that on September 8, 2008 they had filed a securities class action lawsuit in the Southern District of New York on behalf of persons who purchased the publicly traded securities of Fannie Mae during the period November 16, 2007 through September 5, 2008. A copy of the complaint can be found here.

Interestingly, even though over 98% of Fannie Mae shares are held by institutions, the named plaintiff in this initial complaint is an individual. The publicly available copy of the complaint does not include the number of shares the named plaintiffs holds, nor is a copy of the named plaintiff’s certification attached to the publicly available complaint. The Complaint names as defendants four current and former directors and officers of Fannie Mae. Doubtlessly due to the fact that the company itself is now in a government conservatorship, the company itself was not named as a defendant. The company’s market capitalization decline during the purported class period is over $40 billion.

According to the press release, the Complaint alleges:

On July 7, 2008, a financial analyst at Lehman Brothers published a report suggesting that Fannie Mae might need to raise as much as $46 billion in capital, causing the Company’s stock price to plummet 16% in a single trading day. Following that disclosure, former St. Louis Federal Reserve Board President, William Poole, suggested that Fannie Mae was nearly insolvent and The New York Times disclosed that the federal government was making plans to place the Company into a conservatorship. On July 13, 2008, the Treasury Department announced that it was making a temporary line of credit available to Fannie Mae and would purchase an equity stake if necessary to provide more capital. From July 7 through July 14, 2008, Fannie Mae’s stock price declined over 48%. Finally, on Sunday, September 7, 2008, in the biggest government bail out in U.S. history, federal regulators seized control of Fannie Mae.

The press release also states that according to the complaint, during the class period, the defendants concealed from the investing public that:

(a) the decline in the U.S. housing market rendered Fannie Mae undercapitalized; (b) Fannie Mae’s December 2007 capital raise did not meet its capital needs; (c) Fannie Mae’s May 2008 capital raise did not meet its capital needs; (d) although Fannie Mae had more capital than its regulator required, it did not have "surplus capital" as defendants claimed; and (e) Fannie Mae’s publicly disclosed financial results misrepresented the financial condition of the Company.

Although it does not seem to be relevant to the allegations in this lawsuit, it appears that the Housing and Economic Recovery Act of 2008 provided Fannie's and Freddie's directors some limited lawsuit protection. As reported in a September 8, 2008 post (here) on the Blog of the Legal Times, the statute provides that "the members of the board of directors of a regulated entity shall not be liable to the shareholders or creditors of the regulated entity for acquiescing or consenting in good faith to the appoinment of the Agency as conservator or receiver for that regulated entity." Given the allegations in the lawsuit, this provision is unlikely to provide much protection for the defendants in that lawsuit.

The government takeover of Fannie and Freddie is among the most significant events so far in the wake of the subprime meltdown, and certainly the most dramatic development since the collapse of Bear Stearns. Just as was the case following the Bear Stearns takeover, the overall market reacted very positively to the news of the government rescue of Fannie and Freddie. In light of the growing significance of these events for the U.S. economy, one can certainly hope that the worst is now behind us.

There are reasons to be concerned that there may yet be further consequences from the government’s takeover of Fannie and Freddie. The Journal article notes that commercial banks and thrifts hold "high concentrations" of Fannie and Freddie preferred shares. The article also reports that approximately 16 of the institutions that the Office of Thrift Supervision regulates had "a concentration in common or preferred shares of Fannie Mae and Freddie Mac that surpassed 10% of their Tier I capital." While the regulator hopes to develop "capital restoration plans" there could be further fallout in the banking and thrift industries.

The sudden and dramatic loss of these entities’ share prices has undoubtedly hit other institutional investors as well. We will be hearing in the weeks and months ahead where these losses landed.

And as if all of that were not enough, Bloomberg also reported on September 8, 2008 (here) that the government rescue represents a credit event that may force investors to settle credit default swap contracts protecting more than $1.4 trillion of Fannie Mae and Freddie Mac bonds, which may represent the largest settlement of its type. Losses could actually be slight if the bonds themselves trade at or close to par. But the mere fact of this development and its size demonstrates the breadth and complexity of the consequences from the government's bailout. There undoubtedly will be other consequences, some of which may be significant and many of which may be as yet unforeseen.

Readers interested in a particularly good analysis of the government takeover will want to review Professor Davidoff's September 8, 2008 post on his Dealbook blog (here). Among other things, Professor Davidoff's post correctly forecast the arrival of the securities lawsuit. His post also contains a comprehensive list of completed, pending and contemplated government bailouts in connection with the current credit crisis.

Special thanks to a loyal reader for links to the Fannie Mae lawsuit press release and to the Bloomberg article regarding the credit default swaps.  

Run the Numbers: The new Fannie Mae lawsuit is actually not the first lawsuit to arise out of Fannie Mae's recent woes. Last month, investors who purchased Fannie Mae shares in the company's May 9, 2008 secondary offering filed a lawsuit in New York state court seeking damages under Section 12(a)(2) of the Securities Act of 1933. As I noted in my recent post (here) discussing this prior lawsuit, neither Fannie Mae nor any of its directors or officers were named as defendants in the state court suit; only the investment banks that underwrote the May 9 offering were named as defendants.

In any event, I have added the new Fannie Mae lawsuit to my running tally of the subprime and credit-crisis related shareholder litigation, which can be accessed here. With the addition of the Fannie Mae lawsuit, the current tally of subprime and credit crisis-related securities lawsuits now stands at 110, of which 70 have been filed in 2008.

Speaking of Subprime Litigation: The September 8, 2008 Financial Times had an interesting article (here) describing recent litigation brought by investors who lost significant money in connection with the collapse of structured investment vehicles (SIV). An August 26, 2008 Bloomberg article also discussing the litigation can be found here.

The articles describe in particular detail a lawsuit filed on August 25, 2008 by the Abu Dhabi Commercial Bank on behalf of itself and all others that between October 2004 and October 2007 invested in the SIV launched by Cheyne Finance plc. The SIV, which issued notes backed by subprime mortgages, collapsed last year. The lawsuit names as defendants Morgan Stanley, Bank of New York Mellon Corp., two units of the Moody's rating agency, and Standard & Poor's. The defendants are alleged to have mislead investors about the quality of assets the Cheyne vehicle bought and held.

The lawsuit specifically alleges fraud, negligent misrepresentation and unjust enrichment. The lawsuit alleges that the investment banks, motivated by fees based on the asset values in the SIV, misrepresented asset values. The investment banks are also alleged to have assisted in the selection of assets that went into the ill-fated SIV. Among other things, the SIV's assets included mortgages originated by New Century Bancorp.

The complaint alleges that the rating agencies, which allegedly received three times the fees for rating the SIVs than they received for corporate ratings, were paid only if they provided an investment grade rating and only if the deal closed with that rating.

The  Financial Times article also describes a prior lawsuit brought on behalf of investors by Oddo Asset Management in connection with two SIV-lites, Mainsail and Golden Key. The Oddo suit claims that Barclays in conjunction with the two SIV-lites' managers used the vehicles to buy impaired securities from the bank at inflated prices, using the vehicles "as dumping grounds for toxic assets that Barclays needed to quickly jettison." The Oddo lawsuit apparently also names the rating agencies as defendants in its lawsuit, alleging that the rating agencies "collaborated with their investment banking clients."

The Seeking Alpha blog has a very detailed and interesting article (here) describing in detail the purpose and function of SIVs and explaining the risks involved as well. It is clear that these vehicles carried a lot of risk and apparently a lot went wrong with them too.  The SIVs named in these lawsuits are far from the only vehicles that had problems. There may be many more of these kinds of lawsuits to come.

Call me pessimistic, but it seems to me that the subprime litigation wave has got a lot further to run yet.   

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We are now well into the second year of the current subprime litigation wave, but the rulings on preliminary dismissal motions are still just trickling in. In the latest of the early returns, involving one of the earliest subprime securities lawsuits, Judge James T. Giles of the Eastern District of Pennsylvania in an opinion dated August 29, 2008 denied defendants’ motion to dismiss the securities lawsuit pending against home builder Toll Brothers and nine of its directors and officers.

A copy of the August 29 opinion can be found here. Background regarding the case can be found here.

According to the Amended Complaint (here), between December 9, 2004 and November 8, 2005, the defendants made several misrepresentations relating to the company’s "ability to open new active selling communities at the rate necessary to support its financial projections, traffic in its existing communities, demand for Toll Brothers homes, and the ability to continue its historically strong earnings growth." The Amended Complaint further alleges that despite "adverse developments" the company raised its earning projections, which allegedly inflated the company’s share price, facilitating the defendants’ sale of 14 million of company shares for proceeds of over $617 million.

The Amended Complaint also alleges that "within days" of the completion of the insider sales, defendants "shocked investors" in a series of disclosures between August and November 2005 revealing that traffic and sales were declining, as a result of which the company’s share price declined 43% from its class period high.

Judge Giles’s August 29 opinion is relatively brief and largely represents a statement of his conclusions rather than an explanation of his reasoning. Thus, he simply states that plaintiffs have adequately alleged material misrepresentations and omissions, and have adequately alleged that defendants’ forward-looking misrepresentations were "knowingly unreasonable" at the time made. He also states that plaintiffs have adequately alleged that the company’s forward-looking statements were not accompanied by sufficient cautionary language and were mixed with representations of current condition.

The Judge’s rulings with respect to the issues of scienter and loss causation are slightly more detailed and are also more interesting.

With respect to the issue of scienter, Judge Giles noted that "Plaintiffs have alleged that Defendants’ stock sales were unusual in scope and timing, and the court finds these insider allegations are pled with the particularity required by the PSLRA." As a purported "plausible opposing inference," the defendants contended that the purpose of their stock sales "was diversification of their investments." The court concluded that "a reasonable person would find that the inference of scienter is at least as strong as the opposing inference."

With respect to the issue of loss causation, the plaintiffs alleged that the defendants made four statements between August and November 2005 that revealed the truth about the company. The defendants contended that plaintiffs "inappropriately grouped" the alleged "revelations" together in an attempt to establish loss causation.

Judge Giles rejected the defendants’ argument, and found that the plaintiffs made two allegations with respect to loss causation that the court found to be sufficient: first, the plaintiffs alleged that each of the four revelations and subsequent stock price drops were actionable; and second the plaintiffs allege that "through these four revelations" defendants "gradually revealed the truth regarding their prior misrepresentations."

Because the bases of Judge Giles’s rulings are not detailed, his opinion is unlikely to be influential in other subprime-related securities cases, particularly since the magnitude and timing of the alleged insider trading clearly seems to have been an important factor. Judge Giles’s willingness to accept the plaintiffs’ allegations that the truth was "gradually" revealed as sufficient to satisfy loss causation pleading requirements could be more significant, as plaintiffs in cases in which there was no abrupt stock price drop often attempt to make similar "gradual revelation" arguments.

In any event, Judge Giles’s ruling joins the small collection of subprime-related securities lawsuit dismissal motion determinations, a list of which may be accessed here. Although among the small group of rulings dismissal motions have been both granted and denied, the motion denial in the Toll Brothers case comes after the two most recent rulings in the Standard Pacific (refer here) and NovaStar (refer here) cases, in which the dismissal motions were granted.

There are many more cases in which the dismissal motions are yet to be heard, but Judge Giles's opinion in the Toll Brothers case is a reminder that even with the substantial arguments that defendants can make in reliance on Tellabs and Dura Pharmaceuticals, some cases will nevertheless survive motions to dismiss. At least based on the Toll Brothers ruling, the presence of significant insider sales may be a significant factor in producing that result.

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A recurring D&O insurance coverage concern involves the question whether the standard pollution exclusion typically found in most D&O policies could preclude coverage for a securities lawsuit alleging pollution-related misrepresentations or omissions. An August 15, 2008 opinion (here) by a New Jersey intermediate appellate court addressed this issue squarely.

The New Jersey Superior Court Appellate Division per curiam opinion affirmed a trial court determination, in a coverage case arising out of a securities class action lawsuit alleging misrepresentation of contingent asbestos liabilities, that the "alleged pollution at issue was too attenuated from the damages arising from the alleged misrepresentations to trigger the pollution exclusion."

Background

The underlying case arose out of a series of complex corporate recapitalization, reorganization and merger transactions, as result of which Sealed Air Corporation acquired certain assets and liabilities previously held by W.R. Grace. In post-transaction statements, Sealed Air made representations concerning its contingent liability for asbestos-related claims retained by a spun-off subsidiary.

As a result of asbestos liability lawsuits against the spun-off subsidiary, the subsidiary sought bankruptcy protection. The bankruptcy court later determined that the corporate reorganization transaction represented a fraudulent conveyance. After the fraudulent conveyance ruling became public, Sealed Air’s stock price plunged.

Sealed Air shareholders initiated a securities class action lawsuit against the company and its directors and officers. Background regarding the securities lawsuit can be found here. The company sought coverage for its litigation costs from its D&O insurer. The D&O insurer denied coverage in reliance upon the pollution exclusion in its policy. The pollution exclusion precludes coverage, in pertinent part, for loss "based on, arising out of, or in any way involving: (a) the actual or threatened discharge, release, escape, seepage, migration or disposal of Pollutants."

Sealed Air filed a declaratory judgment action against the insurer. Following a trial in the coverage action, the trial court entered judgment in the company’s favor, requiring the insurer to advance the company’s securities litigation defense expense. The insurer appealed.

The Appellate Ruling

On appeal, the insurer argued that the exclusion should be "given a literal reading," contending that "the language and effect of the Policy’s pollution exclusion is clear and unambiguous." Sealed Air, for its part, argued that "the alleged loss to shareholders arises out of the allegedly misleading financial statements, not from air-borne pollutants." The company contended that because "the alleged damages arise from securities misrepresentation and not traditional environmental pollution," the policy provides coverage.

The New Jersey Superior Court Appellate Division found that "the language of the policy at issue precludes [the insurer] from disclaiming based on the pollution exclusion." The court said that "it is clear to us that the gravamen of the securities holders’ complaint has its root in securities fraud and misrepresentation, not pollution." The Court found that the pollution on which the insurer sought to rely "is too attenuated from the damages sought and the legal grounds supporting such alleged damages."

The appellate court specifically addressed the insurer’s argument that the broad preamble to the exclusion, precluding coverage for loss "based on, arising out of, or in any way involving" excluded pollution. The appellate court concluded that the damages sought in the securities lawsuit were neither "based on" nor "arising out of" excluded pollution. In concluding that the "in any way involving" wording similarly did not trigger the exclusion, the appellate court noted:

Read together with the surrounding words, "based on" and "arising out of," in the context of the pollution exclusion clause, "in any way involving" requires a more direct causal relationship between the pollution and the harm. [The insurer’s] interpretation of the pollution exclusion is too broad, unfair and contrary to the reasonable expectations of the insured.

The appellate court concluded that the "plain and ordinary language of the policy, as well as the reasonable expectations of the insured," prevent the insurer from precluding coverage.

Discussion

As a preliminary matter, it should be noted that the appellate court’s opinion is designated as "Not for Publication." Under Rule 1:36-3 of the New Jersey Rules of Court (here), "no unpublished opinions shall constitute precedent or be binding on any court." In addition, under the Rule, an unpublished opinion cannot be cited "unless the court and all other parties are served with a copy of the opinion and of all other relevant unpublished opinions known to counsel including those adverse to the position of the client."

While the appellate court’s opinion is therefore of no precedential authority and of only restricted persuasive potential, there are nonetheless lessons that can be derived from the case.

First, it should be noted that Sealed Air was able to establish its entitlement to coverage under the Policy for its defense expense incurred in defending against the securities litigation only after enduring a trial and subsequent appeal (and any other proceedings that the insurer may yet pursue in its attempt to deny coverage). It clearly is in the interest of any policyholders for their policy to clarify that the policy is intended to provide coverage for securities claims, even if the underlying misrepresentations alleged relate in some way to pollution.

In the current marketplace, many carriers will agree to provide a coverage carve back from the pollution exclusion specifying that the exclusion does not in any event apply to securities claims or to shareholders’ derivative actions.

In addition, in the current marketplace, many carriers will also agree to modify the exclusion’s preamble so that rather than the broad preamble wording found in Sealed Air’s policy, the preamble specifies that the exclusion applies only if the claim is "for" excluded pollution. This wording provides some measure of protection against carrier attempts to rely on remote connections between the actual claim against the insured persons and underlying facts involving pollution as a basis to deny coverage.

It should also be noted that certain of the so-called Side A/DIC policies available in the marketplace do not contain pollution exclusions. Depending on the coverage provided under these policies, the policies could potentially "drop down" and provide a measure of protection for individual defendants if the first line D&O insurer denies coverage for a claim based on the pollution exclusion.

One final note pertains to the underlying securities claim. I have previously commented (most recently here), about the possibility that growing social and political pressures relating to climate change issues could lead to climate change-related claims against directors and officers of publicly traded companies, particularly in connection with climate change-related disclosures. My views in this regard have met with some interest, but also with some skepticism.

The underlying securities lawsuit involved here demonstrates how shareholders might allege that a company did not fully disclose, for example, its contingent liabilities arising out of climate change-related issues. The Sealed Air case suggests (to me at least) how short the leap might be to these kinds of allegations. But the risk, however measured, underscores the need for the policy-wording issues identified above to be addressed.

An August 28, 2008 memorandum from the Wiley Rein law firm discussing the outcome of the Sealed Air coverage appellate decision can be found here.

Securities Docket: Bruce Carton of the Unusual Activity blog (here) has launched a new securities litigation news website called the Securities Docket (here). The Docket bills itself as a "globlal securities litigation and enforcement report." The first iteration is certainly visually attractive and full of a wide variety of interesting items. The Docket looks like it will be an interesting resource that we intend to monitor closely. Congrats to Bruce on getting the Docket launched.

WSJ RIP: Joe Nocera of the New York TImes has a post on his Talks Business blog (here) in which he mourns the death of the Wall Street Journal -- not the death of the newspaper itself, just its death as the repository of important business news. I have felt the same things that Nocera expresses for a while. The pre-Rupert Murdoch WSJ filled a valuable role that no one other paper (or other news source) plays. Now instead of a unique and indispensible source of business news, it is just one more source for stories about politics that have already been reported in any number of our media sources. I agree with Nocera --  I miss the old Journal a lot.

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In prior posts (here and here), I discussed two recent decisions in which courts held that D&O insurance coverage was precluded for settlements the insureds entered without first obtaining the insurers’ consent as required under the applicable policies. An August 19, 2008 Second Circuit opinion (here) addressed the related question of what happens when the insured seeks but the insurer withholds settlement consent.

Based on the somewhat strained circumstances involved, the Second Circuit affirmed a jury verdict holding two excess carriers liable under their policies to fund their portion of a settlement, even though the insured had requested settlement consent on a Sunday evening at 10:00 PM and givn the carriers only eleven hours to respond.

Background

The underlying claim arose out of the Globalstar Telecommunications securities litigation (about which refer here). After the corporate defendants sought bankruptcy protection, the case went forward solely as to Globalstar’s former CEO, Bernard Schwartz. There were various pretrial mediation and settlement conferences, but the case did not settle and proceeded to trial.

The first four layers of Globalstar’s D&O insurance program consisted of a primary $10 million layer and three successive excess layers of $5 million each. Prior to trial, the plaintiffs’ latest settlement demand was $15 million. The primary insurer’s last pretrial settlement offer was $5 million. The plaintiffs reportedly warned that once trial began, their demand would rise to $20 to $25 million.

After two weeks of trial and on the day before he was scheduled to testify, Schwartz agreed to a $20 million settlement. Schwartz’s defense counsel sought the insurers’ consent to enter into the settlement. The request for consent was sent via email on a Sunday night at 10:00 pm. According to the Second Circuit’s later opinion, Schwartz’s defense counsel "offered to discuss the reasonableness of that figure later than night or between 8:45 am and 9:00 am on Monday." Over the next few days, all four insurers refused to consent. The court entered judgment approving the settlement. Schwartz later funded the $20 million settlement with a personal check.

The Coverage Litigation 

Schwartz then sued the four insurers. Schwartz sued the primary carrier for bad faith refusal to settle and for breach of contract. Schwartz sued the three excess carriers for breach of contract. (The third layer excess carrier was involved because at the time Schwartz agreed to settle the case, defense fees had eroded the first $3 million of the primary policy, so the $20 million settlement implicated the third layer excess policy.) The second and third layer excess insurers also cross claimed against the primary insurer alleging bad faith, on the theory that as excess insurers they were equitably subrogated to Schwartz’s bad faith claims against the primary insurer.

Before the coverage lawsuit went to trial, both the primary insurer and the first level excess insurer settled with Schwartz by paying their full policy limits. The coverage trial went forward on Schwarz’s claims against the second and third level excess insurers, and on these two excess insurers’ cross claims against the primary insurer.

Following trial, the jury found in favor of Schwartz and awarded damages of $5 million against the second level excess insurer, and $4 million against the third level excess insurer (the full amount that Schwartz had sought).

On the excess insurers’ cross claims against the primary insurer, the jury awarded the second level excess insurer damages of $2 million and the third level excess insurer damages of $3 million. However, the jury also specifically found that the primary insurer had not acted in "gross disregard" of Schwartz’s rights. In a post-trial ruling, the district court dismissed the excess insurers’ cross claims, holding that New York law applied to the cross claims and that under New York law there could be no recovery for bad faith in the absence of a finding of "gross disregard."

The Second Circuit Opinion 

On appeal, the excess insurers argued "Schwartz’s failure to satisfy the condition precedent of consent to settlement absolved them of their contractual duties." The excess insurers contended that Schwartz’s settlement request "gave them mere hours (over a Sunday night and Monday morning) to decide whether to settle." The Second Circuit characterized these arguments as contending that the 11-hour period represented "the interval in which the Excess Insurers had to assess – for the first time – the risks, opportunities and settlement demands at play."

The Second Circuit, in an opinion by Chief Judge Dennis Jacobs, said that "the insurers’ opportunity to consider settlement extended over a prolonged course of consultation, monitoring and negotiation, so that the settlement was in the nature of anticlimax rather than surprise." The Second Circuit found the jury appropriately considered this evidence and concluded that the excess insurers "had an adequate opportunity to consider and evaluate the settlement opportunities; that $20 million was a reasonable sum; and that [the excess insurers] unreasonably withheld consent." The Second Circuit held that there was sufficient evidence to support the jury’s verdict in Schwartz’s favor.

The Second Circuit also rejected the excess insurers’ argument that the trial court inappropriately applied New York law to the excess insurers’ equitably subrogated bad faith claims against the primary insurer.(Under New York law, but not under California law, a finding of "gross disregard" is required to support the imposition of bad faith liability.) Among other things, the excess insurers argued that it was not appropriate to apply California law to Schwartz’s breach of contract claims but New York law to their equitably subrogated bad faith claims.

The Second Circuit found that applicable choice of law principles allowed different jurisdictions’ laws to apply to different aspects of the same dispute. The Second Circuit also rejected the excess insurers’ argument that application of different law to their cross-claims inappropriately deprived them of the same right of recovery as the person to whom they were equitably subrogated.

Discussion 

The most critical fact in these strained circumstances may be that in the absence of the insurers’ consent Schwartz accepted personal liability for the settlement and funded it out of his own assets. That step substantially undercut the insurers’ ability to argue that the settlement amount was unreasonable, and by extension that their withholding of consent was reasonable.

These circumstances nevertheless present some very troublesome aspects. One particularly questionable part is the settlement consent request that was presented in an email at 10 pm on a Sunday evening with an 11-hour response time. However one might characterize this communication, it was hardly calculated to provide the insurers with what most people would consider a reasonable opportunity to consider the request and respond.

In seemingly overlooking the unorthodox nature of these communications, the Second Circuit placed great weight on the excess insurers’ prior attendance at mediation and settlement conferences, and at trial. During these proceedings there were opportunities to settle the case for $15 million. To be sure, the plaintiffs had indicated that the settlement demand would rise once trial started. The second and third level excess insurers had demanded that the primary and first level excess insurers settle the case for the $15 million amount. Had the case settled for that amount, the second level insurer would only have paid a portion of its limits and the third level excess insurer’s limit would not have been implicated at all.

Under these circumstances it seems that what this case really was about was the question of who ought bear the costs of the $20 million settlement. In that regard, it is significant to note that the jury specifically awarded substantial damages in favor of the second and third level excess insurers against the primary insurer, notwithstanding the jury’s finding that the primary insurer had not acted in "gross disregard" of Schwartz’s interests.

The amount of the cross claim awards seems to be explained by the fact that at the time of the settlment, the first $3 milion of the primary policy had been eroded by defense expense. The sum of the $7 million remaining on the primary policy, the $5 million under the first level excess policy, and the first $3 million of the second level excess policy collectively represented the $15 million amount at which the case could have been settled before trial. The jury shifted to the primary insurer responsibiltiy for the incremental $5 million difference between the $15 million for which the case could have been settled before trial and the $20 million for which it actually settled, by awarding damages of $2 million to the second level excess insurer and $3 million to the third level excess insurer.

However, the trial court negated these cross claim damage award in its post-trial choice of law decision, which the Second Circuit affirmed. I am insufficiently steeped in "decapage" and other rarified choice of law principles to have any informed opinion about the merits of the Second Circuit’s analysis of the law to be applied to excess insurers’ cross claims. The excess insurers undoubtedly are frustrated that they were found liable to Schwarz (to whom they were equitably subrogated) under California law, but that the primary insurer was not liable to them (despite the jury verdict in their favor on the cross claims) because New York law rather than California law applied to their cross claims.

The net effect is that the excess insurers are left holding the responsibility for amounts that the jury assigned to the primary carrier. The primary insurer of course would that in the absence of a finding of "gross disregard" it would be inappropriate for it to have to bear liability for these amounts.

In the end, the outcome of this case may be best understood as the result of the strained circumstances. It should probably be emphasized that demanding insurer consent on a Sunday evening with an 11-hour deadline does not, shall we say, represent an advisable approach. Of course there may be sufficiently pressing circumstances (including, it should be noted, during the constraints of trial) where rushed communications may be unavoidable. But in general, complete, timely and business-like communications are to be preferred, and are likelier to avoid disputes with the carrier.

Special thanks to a loyal reader for providing a link to the Second Circuit opinion.

When Introducing Her, McCain Did Say Something Like "And Now For Something Completely Different": Prior to this past Friday, the only person I had every heard of with the last name of "Palin" was Michael Palin, of Monty Python fame.

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