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

THE TABLE OF CASES LINKED BELOW WAS LAST UPDATED ON September 28,  2010.

All signs are that the collapse of Bernard Madoff’s Ponzi scheme will produce a flood of litigation. By my count, there have already been at least seven federal securities class action lawsuits against Madoff, his firm, or the "feeder firms" that invested their clients’ funds with Madoff. There have also been a number of state court lawsuits as well.

It is already difficult to keep track of the lawsuits that have been filed. In all likelihood, there will be extensive additional litigation against other feeder funds and other third party defendants, which will make it even more difficult to keep track.

In order to monitor the Madoff-related litigation in a more orderly way, I have created a table of the lawsuits that have been filed to date.

The table can be found here.

I believe the table is complete, but I welcome any additional or clarifying information that readers may wish to bring to my attention.

I will update the table as new or different lawsuits emerge. Readers are strongly encouraged to let me know about any additional litigation I may have missed or to provide me with any information necessary to make the table more accurate.

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UPDATE: A regularly updated list of all Madoff investor litigation, including in particular Madoff "feeder fund" litigation, can be accessed here.

As further proof that the losses associated with the Madoff fraud scheme will trigger a wave of litigation, on December 23, 2008, plaintiffs’ lawyers initiated a lawsuit in the Southern District of New York on behalf of investors in the FM Low Volatility Fund, against Family Management Corporation ( the Fund’s general partner and manager) and certain of FMC’s directors and officers; three "fund of funds" in which FMC invested investor funds (Andover, Beacon and Maxam); and the Funds’ auditor.

The complaint, which can be found here, alleges violations of the federal securities laws and related stated and common law violations, and also asserts derivative breach of fiduciary duties on behalf of the Funds.

According to the plaintiffs’ lawyers’ December 24, 2008 press release (here), FMC

concentrated more than half of the Fund’s investment capital with at least three funds of funds ("FOFs") -- Andover, Beacon and Maxam -- that, in turn, all heavily invested in entities managed by Bernard Madoff ("Madoff") or Madoff-related entities. Investors who entrusted their savings to FMC suffered millions in damages as a result of Madoff’s fraudulent scheme.
 

The complaint further alleges that the defendants failed to perform requisite "due diligence" and "knew or should have known" about Madoff’s Ponzi scheme.

The plaintiffs’ also allege that FMC and its defendant directors and officers issued misleading offering documents that

falsely stated that FMC would not invest more than 35% of the Fund’s net asset value with any one investment vehicle, but, in reality, more than 60% of the Fund’s assets were funneled through three FOFs – Defendants Andover, Beacon and Maxam – and invested in Madoff-related entities. The Offering Memorandum also falsely stated that FMC would (i) endeavor to verify the integrity of each manager of a FOF in which the Fund was invested; (ii) attempt to monitor the performance of each manager; and (iii) request detailed information regarding the historical performance and investment strategy of each of the selected investments for the Fund. Plaintiffs allege that Defendants, with no or inadequate due diligence or oversight, abdicated their responsibilities and entrusted the Fund’s assets to Madoff-run investment vehicles.

Even More Madoff Investor Litigation: In earlier post (here), I noted the class action lawsuit that had been filed against Tremont Group Holdings, certain of its directors and officers, and its corporate parents, on behalf of investors in the American Masters Prime Fund, whose assets Tremont managed and that had suffered losses due to Tremont’s investment of those funds with Bernard Madoff and his firm.

On December 23, 2008, plaintiffs filed a similar but separate lawsuit against Tremont and related entities, but on behalf of the class of investors in the Rye Funds, who also claim that they lost their investment due to Tremont’s investment with Madoff and his firm. The Rye Funds complaint also includes as a defendant Tremont’s auditor, KPMG. A copy of the Rye Funds’ investors’ complaint can be found here. A copy of the plaintiffs’ lawyers December 23 press release can be found here.

In addition, according to a December 24, 2008 Bloomberg article (here), New York University has initiated a New York state court lawsuit against J. Ezra Merkin, Gabriel Capital, and Ariel Fund, in which it alleges that $24 million of endowment investments due to the defendants’ investment of the assets with Madoff and his firm. A copy of the NYU lawsuit complaint can be found here.

An earlier class action lawsuit that previously had been filed against Gabriel and related defendants can be found here.

Special thank to Adam Savett of the Securities Litigation Watch (here) for providing a copy of the Rye Funds Complaint.

Keeping Track: By my tally, the Family Management Corporation case is at least the seventh federal class action lawsuit filed in the wake of the revelation of the Madoff fraud. Of these, six of these seven are directed against so-called "feeder funds," the seventh directly against Madoff and his firm. In addition, there are several other state court lawsuits, including the one identified above and the earlier lawsuit filed against the Fairfield Greenwich fund firm (about which refer here).

If the early returns are any indication, there could be a flood of litigation yet to come. Of course it remains to be seen whether or to what extent any of these claims succeed. But in the meantime, indications are that these Madoff-related lawsuits will continue to mount.

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In the latest ruling on a motion to dismiss in a subprime-related securities lawsuit, on December 22, 2008, Judge Legrome Davis of the Eastern District of Pennsylvania granted in part and denied in part defendants’ motion to dismiss the suit that plaintiffs’ filed in August 2007 against RAIT Financial Trust and certain of its officers and trustees. The opinion can be found here.

Judge Davis’s ruling largely denied defendants’ motions, other than with respect to the plaintiffs’ ’33 Act claims concerning the company’s July 2007 secondary offering, which were dismissed due to the plaintiffs’ lack of standing. Otherwise, Judge Davis ruled in plaintiffs favor. The plaintiffs’ remaining ’33 Act claims and all of the plaintiffs’ ’34 Act claims will now go forward.

Background

RAIT is a real estate investment trust providing debt financing to home builders, mortgage lenders and other real estate companies. As more fully set forth here, plaintiffs’ complaint relates to the July 30, 2007 failure of American Home Mortgage to make a payment due under certain trust preferred securities, resulting in a net equity exposure to RAIT of at least $95 million. Shortly thereafter, the company disclosed that it had $373 million of similar exposures. The plaintiffs allege that the defendants failed to disclose its exposure to these types of investments and failed to reserve adequately for the risk of nonpayment or default.

The plaintiffs’ complaint asserts claims under both the ’33 Act and the ’34 Act. The defendants in the ’33 Act claims include the offering underwriters that facilitated RAIT’s January 2007 common stock offering and July 2007 preferred stock offering, as well as the company’s auditor, Grant Thornton. The defendants’ moved to dismiss.

The December 22 Opinion

First, the court dismissed the ’33 Act claims relating to the July 2007 preferred stock offering due to lack of standing, because none of the named plaintiffs purchased securities traceable to the offering.

However, the court denied the defendants’ motion to dismiss the ’33 Act claims raised in connection with the January 2007 offering. Judge Davis found that the plaintiffs had adequately alleged falsity and materiality, and rejected defendants’ contentions that the plaintiffs’ arguments represented nothing more than "fraud by hindsight." Judge Davis also rejected the defendants’ contentions that the alleged misrepresentations "bespoke caution" or were "mere puffery."

Judge Davis also found that his rulings that the plaintiffs had adequately pled falsity and materiality applied to the plaintiffs’ ’34 Act claims as well.The defendants nevertheless sought to have the ’34 Act claims dismissed, arguing that the plaintiffs had not adequately pled scienter.

Judge Davis found that "despite the demanding standard of recklessness imposed in pleading a strong inference of scienter," the plaintiffs nevertheless had adequately pled scienter. His ruling depended on the "core business operations" theory, with respect to which he stated:

Because the alleged misstatements involved RAIT’s core business operations and because the Officer Defendants had ample reason to know of the falsity of the statements, there is a strong inference of scienter in this case.

Judge Davis also found that though the core business operations allegations alone were sufficient, other allegations also supported the inference of scienter, including "the sheer size of the impairment eventually taken by RAIT," which he found adds to "the imputation" that defendants "must have had some awareness that problems were brewing." Judge Davis also found that "familial and business relationships involved" in a RAIT acquisition were "relevant in our consideration of scienter."

Discussion

Other than the ’33 Act claims relating to the July 2007 offering (which was dismissed for lack of standing), the plaintiffs largely prevailed on the dismissal motions. Judge Davis’s ruling is significant not only because it seems to run counter to the early trend other courts arguably have established (albeit with some notable exceptions) of general skepticism toward subprime-related allegations. Judge Davis’s ruling is noteworthy in that regard for its rejection of the defendants’ "fraud by hindsight" arguments.

Judge Davis’s opinion is perhaps most noteworthy in its acceptance of the "core business operations" theory in concluding that the plaintiffs had adequately pled scienter. Though earlier courts had rejected this theory as inconsistent with the PSLRA’s pleading requirements, more recently courts, for example, in the Ninth Circuit (refer here) and the Seventh Circuit (refer here), have taken it up. As noted in a recent commentary by the Katten Muchin law firm entitled "Reform Act Under Attack?" (here), the core operations theory "has made a comeback in 2008," which the authors contend is inconsistent with the PSLRA’s meaning and intent.

Were other courts similarly willing to take up the core operations doctrine, it could substantially impact the many pending dismissal motions in various subprime-related securities lawsuits.

In any event, I have added the RAIT opinion to my table of subprime and credit crisis-related securities lawsuit settlements, dismissals, and dismissal denials, which can be accessed here.

Special thanks to a loyal reader for alerting me to the RAIT opinion.

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In the latest of what undoubtedly will prove to be a surge of Madoff-related litigation, investors have filed two more lawsuits against investment firms that invested their clients’ money with Bernie Madoff, resulting in massive investor losses.

UPDATE: Please note that a regularly updated table of all Madoff investor litigation, including in particular Madoff "feeder fund" litigation, can be accessed here.

The Tremont Lawsuit

First, as reflected in their December 22, 2008 press release (here), plaintiffs’ lawyers have filed a securities class action lawsuit in the Southern District of New York on behalf of investors in the American Masters Broad Market Prime Fund, L.P., a Delaware limited partnership which is managed by Tremont Group Holdings, which is also the Fund’s General Partner. The defendants in the lawsuit include Tremont; Oppenheimer Acquisition Corporation, which acquired Tremont in 2001; Massachusetts Mutual Life Insurance Company, Oppenheimer’s parent; and Ernst & Young, the Fund’s auditor.

The complaint (which can be found here) alleges violations of the federal securities laws as well as state common law fraud, negligence and breach of fiduciary duty. The complaint also assets derivative breach of fiduciary duty claims on behalf of the Fund.

According to the plaintiffs’ lawyers’ press release, the complaint alleges that

defendant Tremont, general partner of the Fund, concentrated over half of its investment capital with entities that participated in the massive, fraudulent scheme perpetrated by Bernard Madoff ("Madoff"). Investors who entrusted their savings to Tremont have suffered millions in damages and are faced with financial ruin.
 

The complaint also alleges that the defendants "failed to perform the necessary due diligence that they were being compensated to perform as investment managers and fiduciaries" and that the defendants "either knew or should have known that the Fund’s assets were employed as part of a massive Ponzi scheme and took no steps in a good faith effort to prevent or remedy that situation, proximately causing billions of dollars of losses and possible complete collapse of the Fund." Oppenheimer and Mass Mutual are named defendants as controlling persons of the Fund.

The complaint alleges with respect to Ernst & Young that the firm was "reckless or grossly negligent" in connection with its performance of its auditing duties, and specifically that the firm failed to detect "a myriad of ‘red flags’ indicating a high risk to Tremont from concentrating its investment exposure in Madoff."

The complaint alleges that the defendants allowed Tremont to invest $3.3 billion, over half of its assets, with Madoff.

The Fairfield Lawsuit

In addition, investors have also initiated a lawsuit in New York County (New York) Supreme Court against the Fairfield Greenwich Group, the hedge fund firm that has as much as $7.5 billion invested with Madoff. A December 22, 2008 Bloomberg article describing the Fairfield lawsuit can be found here. A copy of the complaint can be found here.

The lawsuit, which is filed as a class action on behalf of in the Fairfield Sentry fund, names as defendants Fairfield itself; Fairfield’s founding partners, as well as two principals of a Bermuda affiliate of Fairfield. It alleges breach of fiduciary duty, negligence, and unjust enrichment.

According to the news reports, the complaint alleges that the fund’s managers "had an obligation to look into Madoff’s investment methods and that the team ignored the ‘red-flag warning’ that Madoff’s investment produced small, steady gains in a declining market." The article also quotes the plaintiffs’ attorney as saying that the case has been filed in state court rather than federal court so that discovery can go forward quickly.

The arrival of these new lawsuits, following closely in the wake of the prior Madoff-related litigation suggests that there could substantial associated litigation yet to come, particularly with respect to the so-called feeder funds that invested clients’ assets with Madoff. The press coverage certainly suggests that there will be extensive additional litigation, as reflected, for example, in the December 22, 2008 National Law Journal article entitled "Lawyers from Florida to New York Besieged by Madoff Investors" (here).

The Tremont lawsuit’s inclusion of Ernst & Young corroborates an article published in the December 22, 2008 New York Times entitled "In Madoff’s Wake, Scrutiny of Accounting Firms" (here), which suggests that investors suffering losses from their investments in Madoff feeder funds may attempt to target the firms’ auditors. As noted in the article, the lawsuit filed last week against Madoff feeder fund Ascot Partners (about which I wrote here) also named the fund’s auditor, BDO Seidman, as a defendant in that case.

Credit Crisis Litigation Issues: A November 17, 2008 paper entitled "Legal and Economic Issues is Litigation Arising from the 2007-2008 Credit Crisis" (here) written by Harvard Law Professor Allen Ferrell, and Jennifer Bethel and Gang Hu of the Babson Business School surveys the marketplace conditions behind the credit crisis litigation and reviews the legal issues that are likely to arise as the litigation goes forward.

The article focuses on three principles that the authors believe will be critical in the credit crisis related securities litigation (1) no fraud by hindsight; (2) truth on the market defenses; and (3) loss causation issues.

With respect to the truth on the market defense, for example, the authors contend that "the quality of disclosures in the mortgage backed securities registration statements (and virtually all mortgage backed securities were registered) actually improved between 2001 to 2006 (in part due to the promulgation of Regulation AB in 2004) and that it was quite clear from these registration statements that the quality of the underwriting in a number of instances had declined."

With respect to the "loss causation issue," the authors contend with respect to the banks that suffered massive writedowns during 2007 and 2008, that the banks"suffered substantial losses due to their ‘super senior’ positions in CDOs and various liquidity guarantees to asset backed commercial paper conduits, rather than directly on their mortgage-backed security holdings."

Hat tip to The Harvard Law School Corporate Governance Blog (here) for the link to the authors’ paper.

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The initiation of a criminal investigation against a company or its directors and officers can be a watershed moment in the life of any company. In addition to the question of how it will respond, the company must also determine how it will fund the associated legal expense. It is at this critical juncture that the company confronts issues surrounding the availability and limitation of D&O insurance in connection with criminal investigations.

These issues are explored in a December 2008 article by Patricia Bronte of the Jenner & Block firm entitled "D&O Coverage for Corporate Criminal Investigations" (here). As Bronte notes, the availability of coverage for a criminal investigation depends upon the particular language in the applicable policy, particularly the policy’s definition of the term "claim." The critical question will be whether or not the particular circumstances presented constitute a "claim."

The article opens with a review of case law from an earlier era, when D&O policies did not routinely define the term "claim." However, as the article discusses, the typical D&O policy now defines the term and includes within its definition a specific reference to a "criminal proceeding," which usually is further defined as having been "commenced by the return of an indictment."

One of the useful things Bronte’s article does is that by reviewing the early case law, she shows how the carriers came to insert the language limiting coverage for criminal proceedings to post-indictment matters. Prior cases where carriers were compelled to fund a wide range of expenses related to investigations and other pre-indictment matters clearly led to this change.

However, Bronte’s article also illustrates the difficulties, from the policyholder’s perspective, of this post-indictment limitation of coverage for criminal matters. That is, "a corporation’s best hope for a favorable outcome – and sometimes the best way to avoid disaster – is to persuade the prosecutor not to file any formal criminal charges at all."

As a consequence of this need to try to avert indictment, the corporation can incur considerable expense pre-indictment in respond to subpoenas, addressing a grand jury investigation, or otherwise attempting to answer the investigative threat. Costs incurred in connection with these efforts represent defense expenses, whether or the investigation ultimately results in an indictment.

Disputes over these kinds of legal costs are among the perennial battles in the D&O claims arena. Invariably, policyholders will argue that these expenses were indispensible to their post-indictment defenses, or even that they helped avert an indictment. Further complicating these discussions is the fact that these expenses associated with the pre-indictment criminal investigation often are being incurred at the same time that the company is also incurring legal expense in connection with an SEC investigation and also separate civil litigation. These various proceedings may be covered in whole or in part under the policy.

Because all of these various legal matters are going forward simultaneously and usually pertain to a single set of circumstances, sorting out which legal expenses relate to which proceeding (and therefore which expenses are covered under the policy) can become a vexing problem and source of tension between the policyholder and the carrier.

Exacerbating these problems is the fact that among all these proceedings, the criminal matter usually looms the largest and therefore may consume the larges amount of legal effort and expense. This is particularly true if, as is often the case, the individuals involved each retain separate counsel. The potentially massive expense associated with the criminal investigation underscores why these issues can be so critical.

In light of these considerations, the article offers some practical suggestions. Bronte notes:

Brokers and risk managers should press for "claim" definitions and coverage limits that adequately protect the corporate entity from the expense of criminal investigations, which almost inevitably involve multiple teams of lawyers defending the corporation and its employees.

In that regard, many D&O insurers now include within the definition of the term "claim" not only a reference to post-indictment (or post-information) criminal proceedings, but also a separate explicit reference to "investigations" (including criminal investigations), usually delimited in some way around the requirement for the naming of an insured person as a target of a possible indictment. The precise wording of the definitional provisions relating to "investigations" potentially could be critical.

In addition, at least one major carrier now has a form that removes any reference to an indictment requirement, and instead refers simply to "criminal proceedings." The removal of the indictment requirement, together with the reference to "proceedings," at least potentially opens the door to coverage for grand jury investigations, subpoenas, and other matters. While this alternative wording is not universally or even widely available, it does present an alternative for consideration.

The article also notes, in connection with efforts to secure coverage for criminal proceedings that "policyholders do not advance their position if they or their brokers characterize the criminal investigation as merely a ‘potential claim.’" An alternative possibility is to refer to the matters involved as a claim, or, in the alternative, a potential claim.

The article correctly points out that "the high cost of defending against accusations of criminal wrongdoing is one of the reasons that corporations purchase D&O insurance." Nevertheless, the extent of coverage for criminal proceedings remains one of the perennially disputed claims issues. The further development of D&O policy wordings that better address policyholder expectations is a continuing challenge for the D&O insurance industry and one on which there are fruitful areas for further discussion.

More About NERA’s Year-End Securities Litigation Study: In a prior post (here), I linked to NERA Economic Consulting’s year-end report on 2008 securities litigation activity. (The report itself can be found here). In a December 19, 2008 post (here), the Securities Docket has an interesting interview with the report’s authors, my good friends Stephanie Plancich and Svetlana Starykh. Among other things, the interview quotes the authors as saying, with respect to their projections for litigation activity in 2009:

While our paper does not forecast trends into the next year, our best guess is that filing activity will remain high into 2009. As mentioned above, there have been a number of new filings in late December — traditionally a slow time for litigation activity — indicating that the rate of filings has yet to decrease.

And while the first credit crisis cases were concentrated in the financial industry, there has been an emerging trend of credit crisis- and recession-related filings emerge outside of the financial sector.

Ghost of Christmas Preset, 2008 Version: With apologies to Charles Dickens, I excerpt below an imagined version of his holiday classic, updated for current circumstances. We can only hope that the Ghost of Christmases Yet-to-Come bears happier tidings. 

And taking Scrooge by the arm, the Spirit lifted him high above the financial landscape. Below him, Scrooge could see a parade of spectacles he scarcely could have imagined: the largest bank failure ever; the largest bankruptcy ever; the largest government bailout; the collapse of the housing market and the near-collapse of the entire financial system. 

"Spirit!" said Scrooge. "Show me no more! Conduct me home. Why do you delight to torture me?"

"One Shadow More!" exclaimed the Ghost.

And below, in the mist, Scrooge could see an avuncular man. Oddly and incongruously, the man wore a baseball cap. 

"Who is that man, Spirit?" Scrooge asked.

"Those who used to think of themselves as his friends called him ‘Bernie’" the Spirit said.

"No more!" cried Scrooge. "No more, I don’t wish to see it. Show me no more!"

Break in the Action: I think we could all use a break. I will discontinue my regular publishing schedule for the next few days. Regular publication will resume after the New Year.

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Securities lawsuit filings reached a six-year high in 2008, according to a year-end report released today by NERA Economic Consulting. The report, entitled "2008 Trends in Securities Class Actions" (here), was written by NERA economists Stephanie Plancich and Svetlana Starykh, and reports that through December 14, 2008, there were 255 securities class action filings, up from only 131 filings in 2006 and 195 filings in 2007. NERA's December 18, 2008 press release regarding the report can be found here.

If the "atypical" cases (e.g., IPO laddering) are excluded from the comparison, the 2008 filings are "on pace to reach a 10-year high." The filings are also on pace for a 37% increase over 2007 and the highest annual increase since 2002 (the year of the corporate scandals).

The report attributes the "surge" in filings to the credit crisis. Of the 255 YTD filings, 110 were credit crisis related, and almost 50% of cases involved defendants in the financial sector, as compared to only 16% of cases in the 2005-06 period. (My table of the credit crisis-related securities lawsuit filings can be accessed  here.)

But while the financial sector saw increased litigation activity, "other sectors also saw continued filing activity." For example, though lawsuits against companies in the health technology sector declined as a percentage of all filings, the absolute number of filings against companies in the health technology sector increased, as there were 29 filings against health technology companies in 2008, compared to only 19 in 2006.

The 2008 filings have been concentrated in the second and ninth circuits. The second circuit filings were increased by the large number of filings in the Southern District of New York, particularly financial companies domiciled there.

Though the pattern of increased filing activity in 2008 is clear, "there have been no clear increasing or decreasing trends in the patter of resolutions." The report notes that median settlements have "remained relatively stable." The 2008 median settlement of $7.5 million is slightly below the 2007 median of $9.4 million, but above the 2006 median of $7.0 milllion.

Average settlements, which can be substantially affected by large settlements, were up in 2008 relative to 2007. The average settlement in 2008 was $38 million, up from $31 million in 2007, but well below the post-Sarbanes Oxley average from 2003 to 2008 of $45 million. (The annual average settlement has ranged from $21 million to $82 million during this six-year period.)

The report does observe that over time there has been an increase in the dollar value of claimed investor losses, from about $120 million ten years ago, to around $340 million during 2008. However, the ratio of median settlement to median investor losses has "stayed relatively steady in the 2-3% range over the past few years."

Looking forward, the report notes that there could be "two opposing factors" that could determine whether or not average or median settlements will increase in the future. On the one hand, investor losses associated with the credit crisis lawsuits in 2008 are very large, which could be "an indicator of big settlements to come." On the other hand, the credit crisis has "dramatically shrunk the size of many defendants’ pockets." Lower financial wherewithal might operate as a downward force on settlement values.

The report concludes that "only time will tell if the huge investor losses for credit crisis filings may put upward press on median settlements in the future, or if the financial distress faced by defendant companies may pull median settlement values down."

My own observations on the 2008 securities litigation activity will be detailed in my year-end analysis, which will be forthcoming after the first of the new year. UPDATE: My year end analysis can be found here. For now, I note a few things.

First, this has been an extraordinarily difficult year in which to just try and count the cases. For example, many litigation targets have been sued multiple times by different claimants, whether they are shareholders who acquired their shares over different time periods, or they are security holders with different classes of equity interests. Whether a new filing should or should not be "counted" has been difficult. Further complicating this has been the large number of state court filings, which are difficult just to find. I emphasize this point simply because there is going to be a significant variation in the various commentators’ year-end reports about how many filings there were this year. My own count is lower than NERA’s.

Second, while the 2008 filings were significantly increased by filings against companies in the financial sector, as the year has progressed and the impact of the credit crisis has become more widespread, the credit crisis-related filings have spread outside the financial sector (refer for example here).

Third, you may see comments elsewhere that the 2008 filings were inflated by one-time sector events, like the auction rate securities lawsuits. While this is true, the recent surge of litigation activity involving the Madoff victims demonstrates that in many ways the pace of securities litigation activity is simply a reflection of a series of supposed one-time events. The mere fact that there is an identifiable event arguably may be irrelevant to analyses of current or future filing trends.

Fourth, the NERA report makes no projections about what is likely to happen to the pace of filing activity in 2009. My own view is that the current active filing pace is likely to continue well into 2009 and perhaps beyond. Among other things, filing activity has been elevated over the last several weeks, which is unusual for December, historically a slow month. The continued spread of credit crisis filings outside the financial sector is likely to continue in 2009. Moreover, the impacts of the financial downturn will begin to emerge as company’s report their 2008 results and as the year progresses, which could contribute to litigation activity.

As I said, my own report will be forthcoming. I am very interested in hearing readers’ thoughts and reactions in the interim.

Special thanks to Ben Seggerson of NERA for providing me with a copy of the NERA report.

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If today’s filings are any indication, a huge wave of Madoff victim lawsuits could be coming. Madoff investors were quick to sue Madoff and his firm, with the first complaint filed last Friday (as noted here). But with Madoff’s firm in liquidation and the money likely long gone, investors who lost money as a result of Madoff’s scheme are casting around for other targets from whom to try to recover their losses. Early returns suggest that investment firms and Madoff "feeder funds" could find themselves facing substantial Madoff victim litigation.

UPDATE: Please note that a regularly updated table of Madoff investor litigation, including "feeder fund" litigation can be accessed  here.

First, as reflected in their December 16, 2008 press release (here), plaintiffs’ lawyers have filed a securities lawsuit in the Southern District of New York against investment partnership Ascot Partners L.P., its founder and general partner (Merkin), and its auditor, BDO Seidman. The class members are persons who purchased limited partnership interests in Ascot.

According to the press release, the complaint alleges that Ascot and Merkin

caused and permitted $1.8 billion -- virtually the entire investment capital of Ascot -- to be handed over to Madoff to be "invested" for the benefit of plaintiff and the other limited partners of Ascot. Plaintiff's investment in Ascot has been wiped out, as a direct result of: (a) defendant Merkin's abdication of his responsibilities and duties as General Partner and Manager of Ascot and its investment funds and; (b) the failure of Ascot's auditor Seidman, in light of "red flags" indicating a high risk to Ascot from concentrating its investment exposure in Madoff as sole third-party investment manager for all of the Partnership's assets, to perform its audits and provide its annual audit reports in conformance with generally accepted auditing standards.

The press release states that the complaint alleges ’34 Act violations as well as related statutory and common law breaches. A copy of the complaint can be found here.

UPDATE: On December 16, 2008, investors also filed a separate lawsuit against a different fund affiliated with Merkin, Gabriel Partners. A copy of the December 17, 2008 press release can be found here.  A copy of the complaint can be found here.  A WSJ.com Law Blog post about the Ascot and Gabriel lawsuits can be found here.

Second, and also on December 16, another plaintiffs’ firm initiated a separate securities lawsuit in the Central District of California. The lawsuit is filed against Madoff and his firm, but also names as defendants Brighton Company, a California limited partnership and a so-called "feeder fund," and its principal ( Stanley Chais). The firm’s press release (here) states that Brighton was "one of the many feeder funds that directed investor capital" to Madoff and his firm. The press release says that Chais "managed several investment groups [including Brighton], the monies for which were given to Madoff" and his firm.

The complaint (here) alleges that the plaintiff invested money through CMG Ltd., a California limited partnership. The complaint alleges that CMG provided all of its investment capital to Chais as general partner for Brighton, which in turn invested all of CMG’s money with Madoff. The complaint alleges that "all defendants contributed to the false, misleading, unlawful, unfair and fraudulent acts and practices associated with the Ponzi scheme."

The purported class consists of two groups; all persons who invested capital with Chais and Brighton, and all persons who invested with Madoff and his firm. The complaint alleges violations of the ’34 Act.

The press release also states that "the firm is investigating the actions of other feeder firms on behalf of investors." The December 17, 2008 Wall Street Journal has an article (here) discussing Stanley Chais and his investment funds'  (and charitable organizations') relation to Madoff
 

Given the magnitude and widespread dispersion of the Madoff losses, and given the fact that there appears to be little money left with Madoff and his fund, it seems highly likely that there will be other (perhaps many other) investment funds, "feeder funds," hedge funds, funds of funds, and other entitles, targeted by Madoff victims. The attention in the press (for example, here) to alleged failures of investment firms to catch supposed red flags or to conduct due diligence will only increase the likelihood of this kind of litigation. The inclusion of the auditor in the Ascot lawsuit suggests that some of these claims could range pretty far afield.

A December 16, 2008 Business Week article discussing the likelihood of Madoff investor claims against hedge funds and others, also discussing the Ascot lawsuit, can be found here.

The Wall Street Journal is helpfully collecting a list of Madoff’s victims here. It is a long list but it is also clearly incomplete; for example, Fairfield Greenwich Advisors may have been hit with $7.5 billion in losses, but those amounts in reality represent the losses of Fairfield’s own investors. The list would be substantially longer if all of these and other fund investors and customers were listed individually. The fund investors are the ones, like the plaintiffs in the cases described above, that will likely target the investment funds.A December 17, 2008 Wall Street Journal article entitled "Fairfiled Group Forced to Confront its Madoff Ties" (here) conveys some pretty strong suggestions along those lines.

In any event, going forward, the number one question D&O insurance underwriters will be asking financial institution applicants will be whether the applicant invested funds with Madoff.

Meanwhile, the Credit Crisis Litigation Wave Churns On: It seems as if the plaintiffs’ lawyers have kicked it into high gear as the year end approaches. There has been a flood of new securities lawsuit filings so far in December. By my informal count, there have already been at least 20 new securities lawsuit filings so far this month (if you count the two cases described above), an unusually high number for December, which historically is a quiet month for securities filings.

And though the filings have included a diversity of cases (as I discussed here), the filings have also included a number of new subprime and credit crisis related lawsuits, including at least four new cases that have been filed or become public this week.

For example, as reflected in their press release (here) on December 16, 2008, plaintiffs’ lawyers initiated a securities class action lawsuit in the Southern District of New York against investors in the C-Bass Trust Certificates backed by residential mortgage loans and issued by Credit-Based Asset Servicing and Securitization LLC. The defendants include C-Bass, the issuing trusts, and the offering underwriters. The complaint, which can be found here, asserts claims under the ’33 Act.

In addition, on December 4, 2008, plaintiffs’ initiated a securities class action on behalf of investors who purchased AIG shares in shelf offerings conducted during the period 2003 to 2007. The complaint (here) asserts claims against AIG, certain of its directors and officers, and its offering underwriters under the ’33 Act.

And on December 8, 2008, defendants removed to federal court a lawsuit that previously had been filed in New York County (New York) Supreme Court against Residential Asset Securitization Trust (which issued certain residential mortgage pass-through certificate), its offering underwriter, and two rating agencies. A copy of the removal petition, to which the original complaint is attached, can be found here.

Finally, plaintiff shareholders have initiated a securities class action lawsuit (here) against private equity firm American Capital Ltd. in the District Court of Maryland, alleging among other things that the firm failed to disclose its exposure to disruptions in the credit market.

I have added these new lawsuits to my running tally of subprime and credit-crisis related litigation, which can be accessed here. With the addition of these new lawsuits, the running tally of subprime and credit-crisis securities lawsuits now stands at 138, of which 98 have been filed during 2008.

Special thanks to Adam Savett of the Securities Litigation Watch blog (here) for providing information and links about these new lawsuits.

And Finally: Before writing this post, I had no prior acquaintance with the phrases "Madoff victims" and "feeder funds." I guess I better get used to them.

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A December 15, 2008 opinion (here) in a Delaware bankruptcy court adversary proceeding provides a rare judicial interpretation of an "inadequate consideration" exclusion in a D&O insurance policy. I have reproduced with permission below a summary of the case prepared by the Wiley Rein law firm, followed by my own brief commentary. The firm’s case summary, which appears in the indented text below, can also be found here.

Case Summary

A federal bankruptcy court, applying New York law, has dismissed an adversary proceeding brought by a bankrupt home mortgage company against its directors and officers liability insurers, holding that coverage for a pre-petition lawsuit against the mortgage company was barred by application of an "inadequate consideration" exclusion. Delta Fin. Corp. v. Westchester Surplus Lines Ins. Co., Case No. 07-11880 (CSS) (Jointly Administered) (Bankr. D. Del. Dec. 15, 2008).  The court also held that the coverage dispute was a non-core proceeding.  Wiley Rein LLP represented one of the insurers in this case.

The underlying lawsuit arose from the mortgage company’s 2001 restructuring transaction.  In connection with that transaction, the mortgage company allegedly first convinced its unsecured and senior secured note holders to surrender their notes to a newly-formed holding company for which the note holders were granted certain interests in the holding company.  Next, the holding company returned the senior notes to the mortgage company, and, in exchange, the mortgage company transferred excess "cash flow certificates" to the holding company.  The mortgage company and the holding company intended that value of the exchanged senior notes and cash flow certificates would each be approximately $153 million.

In 2003, the former note holders filed suit against the mortgage company and its directors and officers alleging that, at the time of the restructuring transaction, the cash flow certificates had an actual fair market value of only $43 million.  The plaintiffs ultimately asserted eight causes of action against the defendants concerning various aspects of the restructuring transaction.  The mortgage company tendered the suit to its directors and officers liability insurers, and the primary insurer denied coverage based in part on the inadequate consideration exclusion.  In 2007, the mortgage company filed for Chapter 11 and brought an adversary proceeding against the insurers seeking damages and a declaratory judgment that the insurers were obligated to advance defense costs and provide indemnification for the underlying lawsuit.

In considering the insurers’ motions to dismiss, the bankruptcy court focused on the primary policy’s inadequate consideration exclusion, which provided that "[t]he insurer shall not be liable for Loss on account of any Claim made against any Insured: . . . based upon, arising out of, or attributable to the actual or proposed payment by the Company of allegedly inadequate or excessive consideration in connection with the Company’s purchase of securities issued by any company."  Noting that New York courts rely on a "but for" causation test to interpret insurance exclusions with "arising from" lead-in language, the bankruptcy court conducted a three-part analysis to determine whether the pre-petition lawsuit was excluded by the inadequate consideration exclusion. 

First, the bankruptcy court noted that each of the plaintiffs’ eight causes of action sought damages related to the harm caused by the alleged difference between the senior notes, worth $153 million, and the cash flow certificates, worth $110 million less. 

Second, the bankruptcy court determined that this harm would not have existed "but for" the restructuring transaction, and, thus, the restructuring transaction was the "operative act." 

Finally, the bankruptcy court concluded that the operative act was explicitly encompassed by the inadequate consideration exclusion because the restructuring transaction involved an "actual payment" by the mortgage company of "inadequate consideration"—the cash flow certificates—in connection with the mortgage company’s purchase of "securities issued by any company"—in this case, its own senior notes.  Accordingly, the bankruptcy court determined that the exclusion barred coverage for the underlying complaint in its entirety.  As a result of that determination, the court did not reach the insurers’ other argument that the amount at issue in the underlying case did not constitute "Loss" as defined by the policies.

After concluding that all of the mortgage company’s claims in the adversary proceeding were barred by the inadequate consideration exclusion, the bankruptcy court rejected the mortgage company’s waiver and estoppel arguments, which were based on the passage of 18 months before the primary insurer denied coverage.  The bankruptcy court noted that, under New York law, an insurer could not waive a defense to coverage, and the mortgage company had failed to allege sufficient facts demonstrating its reliance on the failure to issue a coverage position.  Finally, relying on the reasoning in In re Stone & Webster, Inc., 367 B.R. 523 (Bankr. D. Del. 2007), the bankruptcy court agreed with the insurers that the adversary proceeding was a non-core proceeding.

Commentary

In recent years, it has become increasingly common for D&O carriers to issue policies containing "inadequate consideration" exclusions, or as they are sometimes known, "bump up" exclusions. Carriers designed these exclusions to address disputes that sometimes arise in connection with merger objection lawsuits.

These kinds of lawsuits routinely emerge after the announcement of a merger or acquisition. Invariably, plaintiffs’ attorneys file a lawsuit claiming that the acquired company’s shareholders were receiving inadequate consideration for their shares in the acquired company. These lawsuits sometimes end with the defendant acquirer agreeing to pay some additional consideration. The acquirers then sometimes try to pass these increased acquisition costs to the D&O insurers. The carriers object to paying amounts that they contended was merely a transaction cost and did not "loss" as a result of a wrongful act.

In order to try to avoid disputes over these increased consideration, or "bump up," amounts, some carriers have attempted to insert exclusions for "inadequate consideration" claims into their policies. These kinds of provisions are not always included in D&O policies, nor is the wording in the various exclusions used in the marketplace uniform. In addition, there is very little case law interpreting these kinds of provisions.

The Delta Financial decision highlights a number of noteworthy aspects of the particular exclusion language used in the applicable policy that may be important in connection with the wording of these kinds of exclusions.

First, it is important to note that the allegations of inadequate consideration were made in connection with the company’s acquisition of its own securities, rather than those of another company. The court’s ruling certainly underscores the significance of the exclusion’s use of the word "any" in the phrase "the securities issued by any company," as opposed to, for example, the possible alternative use of the word "another." Had the exclusion used the word "another" rather than "any," the outcome could well have been different.

Although it was not relevant in the context of this particular dispute, the exclusion’s reference only to "securities" also highlights the possible outcome determinative impact in other situations if the exclusion were also to refer to "assets of" in addition to the "securities issued by" any company. The exclusion’s reference only to securities, as opposed to both securities as well as assets, is narrower, as a result of which the exclusion would, in this respect at least, have a narrower preclusive effect.

Many readers undoubtedly noted that this case arose out of the bankruptcy of a residential mortgage origination and servicing company that funded its lending operations by selling interests in securitized pools of mortgages, a business pattern that is not unfamiliar these days (nor indeed is the bankruptcy itself unfamiliar these days). The procedural context, and perhaps even the substantive dispute, may presage a host of disputes that may lie ahead in connection with the subprime and credit crisis-related litigation wave.

In any event, the outcome of the coverage dispute underscores a point that I have made many times in the past on this blog—that is, the critical importance of policy wording.

Very special thanks to Dan Standish of the Wiley Rein firm for providing a copy of the Delta Financial opinion and for allowing me to reproduce his firm’s case summary.

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In the latest preliminary ruling in a subprime or credit crisis-related securities lawsuit, Southern District of Florida Judge Ursula Ungaro in a December 11, 2008 opinion (here) granted the defendants’ motion to dismiss the plaintiffs’ complaint, with leave to amend.

Background

BankAtlantic Bancorp is a bank holding company that offers consumer and banking lending services, through its wholly-owned subsidiary. The plaintiffs complaint alleged securities law violations against the holding company and five present and former directors and officers of the holding company or of the subsidiary. The plaintiff purports to represent persons who purchased the holding company’s stock during the period November 9, 2005 though October 25, 2007. Background regarding the case can be found here.

As summarized in the December 11 opinion, the complaint alleges that the company "sought to capitalize on the Florida real estate boom through expansion of its commercial real estate loan portfolio." To fuel the growth, the company "cut corners" including "ignoring the Company’s internal lending guidelines." The company also allegedly "failed to adequately reserve for loan losses" in its commercial real estate loan portfolio, "resulting in material misstatements in the Company’s financials." After the Florida real estate market "entered a free fall in 2007," borrowers "began defaulting" and the company was "forced to reveal the true extent of the Company’s exposure in its real estate portfolio."

The Opinion

In her December 11 opinion, Judge Ungaro held that the complaint "adequately alleges misrepresentations and omissions in a manner sufficient to withstand a motion to dismiss," and that the complaint "is legally sufficient in so far as it pleads loss causation." However, she found that the complaint did not adequately allege scienter.

As a preliminary matter, Judge Ungaro addressed the complaint’s reliance on confidential witness statements. She found that "there is no specific information as to the confidential witnesses’ positions in the Company, their employment duties, the foundation or basis for their knowledge, or whether they were even employed with the company during the relevant time period." Accordingly, she concluded that she is "unable to give any significant weight to the allegations made by those confidential witnesses.

She then considered the scienter allegations against the individual defendants. With respect to the allegations against the Vice Chairman, the current CEO and the Chairman, she found that the "factual allegations do not give rise to a strong inference of scienter." She said that even assuming the confidential witness statements could be given weight, the allegations are insufficient; "the confidential witness’s vague and conclusory assertion that it was ‘common knowledge’ that the Company had risky loans on its books is not the type of particularized allegations required under the PSLRA."

She also noted that the defendants’ "knowledge of the company’s lending or accounting practice by virtue of their high-level positions…does not create a strong inference of scienter." She also found that the fact that these individuals received "Exception Reports" establishes "nothing about what these Defendants knew or should have known about the Company’s lending practices."

Judge Ungaro also rejected the contention that the defendants’ $7.8 million in insider stock sales established scienter, because the complaint "does not allege that the amount or percentage of shares sold …were unusual," nor does the complaint alleged "that the sales were inconsistent with their prior trading history."

With respect to the scienter allegations against the company’s former and its current CFO, Judge Ungaro concluded that the complaint "does not contain factual allegations that would support a finding that [the defendants’] statements were made with scienter." The complaint "lacks particularized allegations" that these two officials "played a role in approving loans or in setting loan loss reserves," and the complaint does not allege that they were "presented with information that would have shown the falsity of the Company’s financial statements or that they were confronted with concerns regarding the Company’s lending practices or loan loss reserves."

Finally, with respect to the company (but without reference to more generalized theories regarding "collective scienter"), Judge Ungaro held that the plaintiff "has not adequately pled scienter as to any of the Individual Defendants; therefore, Plaintiff has failed to adequately pled [sic] scienter as to BankAtlantic."

The court’s grant of the defendants’ dismissal motion is without prejudice and the plaintiffs have 20 days in which to file an amended complaint.

Discussion

The BankAtlantic case joins a growing list of subprime and credit crisis related securities cases that failed to survive preliminary motions. To be sure, the dismissal motions in the Countrywide subprime securities case (refer here) and the New Century Bankcorp subprime securities case (refer here) were both recently denied in strongly worded opinions. But as reflected in my running tally of subprime and credit crisis-related securities lawsuit settlements, dismissal and motion denials (which can be accessed here), a greater number of dismissal motions have been granted than denied.

It should be noted that at this point only a handful of dismissal motions have been resolved one way or the other. And many of the dismissals that have granted have been without prejudice. The plaintiffs in these cases may yet successfully amend their complaints and survive a subsequent motion to dismiss. Nevertheless, the early returns seem to suggest that many of these cases are facing judicial resistance.

On a related note, I have observed elsewhere (refer here) that the growing wave of bank failures could lead to an increased number a new wave of "dead bank" litigation. To the extent these cases do emerge, the Bank Atlantic opinion may suggest that the cases could face significant pleading hurdles.

In any event, I have added the BankAtlantic opinion to my running tally of subprime and credit crisis-related lawsuit settlements, dismissals and dismissal denials, which can be accessed here.

Court Rejects KLA-Tencor’s Special Litigation Committee’s Motion to Dismiss Backdating Case: In a December 11, 2008 opinion (here) that is extensively redacted due to its reliance on evidence submitted under seal, Judge James Ware of the Northern District of California denied the motion of KLA-Tencor’s Special Litigation Committee (SLC) to dismiss the options backdating derivative lawsuit pending against the company, as nominal defendant, and certain of its directors and officers.

The plaintiffs had filed a complaint alleging that the defendants "permitted senior KLA insiders to unlawfully manipulate the grant dates associated with KLA stock options, resulting in hundreds of millions of dollars of losses to KLA." (Background regarding the options backdating allegations at KLA-Tencor can be found here.) In response to the filing of the complaint, the company’s board formed the SLC and appointed two directors to serve as its members. The SLC prepared a report and filed a motion to dismiss the derivative action, concluding that the derivative action "is no longer in the interests of KLA or its shareholders."

Judge Ware considered the motion under Delaware law. Because of the redactions in his opinion, his reasoning is not always entirely evident. Basically, he was concerned that one of the SLC members "was on the Board and on the Audit Committee at a time when continued backdating may have been occurring at KLA." This raises the "possibility" that the one SLC member was "tasked with investigation corporate malfeasance that he had previously, if unintentionally, approved," which in turn raised questions about his independence.

Because of the independence concerns, the Court was also "concerned by the overall size of the SLC, as it consisted of only two members." On these grounds, the court found that the SLC had not carried its burden, noting that

Although no single factor is dispositive in the Court’s determination, evaluation of the totality of the circumstances, including the size of the SLC, questions surrounding its independence, and the depth and focus of its inquiry leads to this conclusion.

Accordingly, the court denied the SLC’s dismissal motion, denied certain individual defendants’ proposed (unspecified) settlements, and scheduled the case to go forward.

Without having statistical evidence to support the observation, I note that it is relatively unusual for a court to reject an SLC’s recommendation to drop a derivative case. On the other hand it is also unusual for an SLC to have only two members, and these two unusual features wound up being related. A December 17, 2008 Law.com article discussing these aspects of Judge Ware's opinion can be found here.

In any event, I have added the KLA-Tencor decision to my table of options backdating related lawsuit settlements, dismissal and dismissal denial, which can be accessed here. KLA-Tencor’s $65 million settlement of the options backdating securities class action lawsuit that had been filed against the company is discussed here.

Are European Investor Groups Turning to U.S. Court for Subprime Claims?: A December 16, 2008 post (here) on PomTalk, the blog of the securities plaintiffs’ firm Pomerantz Haudek Block Grossman & Gross, noting that "pension funds around the globe have lost hundreds of billions of dollars" in the credit crisis, as a result of which "increasingly, they are turning to U.S. courts to seek recovery of losses."

The article notes that "in recent years, European funds have begun to play a more prominent role" in U.S. class actions, and that according to a U.K. pension fund group, "23% of British pension funds have now actively participated in a U.S. securities class action."

The article suggests that European funds "will be particularly affected by three categories of suits": suits against financial services companies; suits involving structured financial instruments; and suits involving agency obligations and preferreds (this latter category is a reference to the securities of government sponsored entities). The article concludes by noting that "European funds are certain to remain a fixture in U.S. securities class action."

Readers of this blog may be interested to read the article’s observations in connection with litigation against financial services companies:

A major question in suits against banks is whether they have the ability to satisfy a large judgment or enter into a reasonable settlement. Many banks have already gone under or are hanging by a thread. But even failed banks generally have D&O insurance, and there may be other viable defendants like underwriters.

Ah, yes. Round up the usual suspects. Be sure to frisk them for insurance, as well as the presence of any professional advisors.

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We interrupt our regularly scheduled stream of dispatches from the credit crisis front to provide a quick update on the now seemingly remote options backdating scandal. Even though the whole world has moved on and though options backdating pales by comparison to what followed, many options backdating cases continue to grind on. At least a couple of these cases recently settled, and there appear to be many more yet to come.

First, on December 11, 2008, Amkor Technologies announced (here) that it had reached an agreement to settle the option backdating-related securities class action lawsuit that had been filed against the company and certain of its current and former directors and officers in connection with the company’s historical stock option practices. Background regarding the lawsuit can be found here.

According to the company’s press release, the plaintiffs have agreed to dismiss the case in exchange for a payment of $11.25 million. The company said that its directors and officers liability insurance carrier has agreed to pay $9 million of the settlement amount and the company will pay the balance.

Second, and also on December 11, 2008, the parties to the options backdating-related shareholders’ derivative suit filed against Foundry Networks, as nominal defendant, and certain of its directors and officers, filed a notice of a proposed settlement (here). According to the parties’ filing, the company will receive cash payments of $2.117 million, of which $1.637 represents payments from the individual defendants and $400,000 represents payments from the company’s insurer. Certain shares granted to certain individuals have been repriced and the company also agreed to certain governance changes. The company also agreed to pay plaintiffs’ attorney’s fees and expenses of $1.2 million.

I have added these two settlements to my running table of options backdating-related lawsuit settlements, dismissals and motion denials, which can be accessed here. The Amkor settlement is, by my count, the sixteenth options backdating-related securities lawsuit settlement, and approximately six of the cases were also dismissed. Given that there were according to my count (refer here) 39 options backdating-related securities lawsuits filed in total, there still may be as many as 17 of these cases yet to be resolved.

The individuals’ cash contribution toward the Foundry Networks settlement, if not indemnified, would represent an unexpected element, as it remains an unusual settlement element for directors and officers to make cash settlement contributions out of their own assets.

OK, enough about that. We now resume our regularly scheduled programming, which is already in progress.

California Countrywide Subprime-Related Derivative Case Dismissed: In a December 11, 2008 order (here), Judge Mariana Pfaelzer dismissed the Countrywide subprime-related derivative case pending in the Central District of California.

Judge Pfaelzer previously had denied the defendants’ motion to dismiss the derivative case, in a strongly worded May 2008 opinion (about which refer here). However, in July 2008, Bank of America acquired Countrywide in a stock for stock merger. As a result, and as discussed here, in October 2008, the Delaware federal court dismissed the parallel Countrywide subprime-related derivative case pending in that court, because of the plaintiffs’ lack of standing to pursue the claim owing to the plaintiffs’ inability to show "continuous ownership" due to the BoA transaction.

The plaintiffs in the California Countrywide subprime-related derivative case argued that, notwithstanding the merger, they could still satisfy the "continuous ownership" rule and therefore still had standing based on a merger-related exception to the rule recognized in the Ninth Circuit. After detailed consideration of Erie Doctrine issues, Judge Pfalzer declined to exercise equitable powers associated with the merger-related exception, and granted the defendants’ motions to dismiss the derivative claims due to the plaintiffs’ lack of standing.

Judge Pfaelzer’s ruling on the derivative claims was without effect on the plaintiffs’ merger related class claims, which she previously had stayed in favor of parallel proceedings pending in Delaware Chancery Court. In addition, the Countrywide subprime-related securities class action lawsuit remains pending before Judge Pfaelzer, as a result of her recent dismiss motion denial in that case, discussed here.

In any event, I have added the dismissal of the California Countrywide Derivative lawsuit to my list of subprime lawsuit settlements, dismissals and motions denials, which can be accessed here.

Special thanks to Michael Delhegan of the Tressler Soderstrom firm for providing a copy of Judge Pfalzer’s December 11, 2008 opinion.

Standalone Insurance for Independent Directors: In prior posts (most recently here), I have noted the considerations that may militate in favor of standalone insurance protection for independent directors. In a December 12, 2008 memorandum entitled "Independent Directors Require Additional Protection in Financial Crisis Litigation" (here), the Baker & McKenzie firm suggests that "there is an increasing interest by independent directors in coverage that protects only a company’s independent or outside directors, not its officers."

The memo reviews the origins of IDL insurance and examines why "it may be a useful tool for both attracting high quality independent directors, and as a means of protecting and retaining the best talent." Among other reasons suggesting the need for IDL protection is the increasing susceptibility of traditional D&O insurance limits to erosion or depletion through defense expense or indemnity protection for other persons insured under the D&O policy, a phenomenon on which I previously commented here.

More About the NY Insurance Commissioner’s Recent Opinion: In a recent post (here), I commented on the recent opinion of the New York Insurance Commissioner’s office requiring D&O insurance policies to incorporate a duty to defend. The opinion and its implications are reviewed at greater length in a December 2008 Client Advisory from the Edwards, Angell, Palmer & Dodge law firm entitled "The New York Insurance Department Will No Longer Approve D&O Policies Lacking ‘Duty-to-Defend’Coverage Feature" (here).

This memo contains a detailed analysis of the opinion and raises a number of important considerations about what the opinion does and does not mean. The memo also notes difficulties that carriers may face as the attempt to adapt to the opinion, and also suggests alternative responses available to the carriers, including seeking legislative relief.

Special thanks to John McCarrick of the Edwards Angell firm for sending along a copy of the memo.

And Finally: By far the best thing I have seen written on the Madoff scandal is the column that Wayne State Law Prof. Peter Henning wrote as a guest column on the DealBook blog, here.

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From this week’s news, it almost appears as if there had been some kind of an unannounced competition for most outrageously fraudulent or corrupt scheme. First, there was Marc Dreier’s incredibly brazen plot to peddle bogus notes to hedge funds using assumed identities. Then there was Illinois Governor Rod Blagojevich’s apparent attempt to flog Barrack Obama’s vacant Senate seat for personal enrichment. And finally there was New York financier Bernard Madoff’s massive Ponzi scheme, which may have taken investors for as much as $50 billion.  

The scale of the corruption and deception involved in these schemes is almost incomprehensible. It could be said of the three perpetrators of each of these scandals, as Time Magazine said (here) of Blagojevich, he is “either delusional, stupid or some combination of both.” But as astonishing as these developments may all be, they really don’t represent anything new.

Buried underneath the week’s headlines were the latest developments in an older but equally unsavory tale, which may serve as a reminder that there is, regrettably, nothing new about massive schemes of deception and corruption.

According to a December 12, 2008 Bloomberg article entitled “Siemens Agrees to Pay Fine to Settle Bribery Charges” (here), Siemens AG has agreed to plead guilty to Foreign Corrupt Practices Act violations and pay $800 million to settle U.S. charges that it paid $1.36 billion in bribes to government officials in at least a dozen countries.

The FCPA Blog (here) has an extensive review of the charges against Siemens, as well as links to the supporting documents, including the criminal information filed against Siemens and the DoJ’s sentencing memorandum. As the FCPA Blog puts it, the criminal charging documents detail “years of systematic and intentional violations of the internal controls and books and records provisions. It's a story of fraud, deceit and concealment -- filled with phony contracts, fake invoices, slush funds, and a boardroom feigning ignorance. “

A hearing on the deal under which Siemens would pay a $450 million fine and forfeit $350 million in profits will take place on December 15. If accepted, the penalty would be by far the largest FCPA penalty ever, far eclipsing the prior record payment of $44 million in the Baker Hughes case (about which refer here).

The Siemens case is a reminder that, as startling as this past week’s revelations have been, there is nothing new about fraudulent schemes or deceptive behavior. In the timeless words of the Book of Ecclesiastes (here), “What has been will be again, what has been done will be done again; there is nothing new under the sun.”

Next Up: The Litigation: One inevitable byproduct of the developments like those of the past week is litigation, and so it comes as no surprise that a lawsuit against Bernard Madoff and his firm has already emerged.

On December 12, 2008, an investor initiated a purported securities class action lawsuit in the Eastern District of New York against Madoff and his firm (BMIS), on behalf of “all persons and entities who purchased securities sold by or through” Madoff and his firm, “from the early formation of BMIS in the 1960s until December 12, 2008.” Refer here for news coverage of the lawsuit.

The complaint (reproduced below) alleges that its claims arise “from one of the most damaging Ponzi schemes in the history of Wall Street and the United States,” and that the defendants “swindled investors out of monies estimated to exceed $50 billion.” The complaint alleges breaches of the federal securities laws, civil RICO violations, and related state and common law violations.

Meanwhile, other plaintiffs’ firms have announced (for example, here) that they are investigating the alleged “massive fraud.” UPDATE: Please refer here to access my regularly updated list of all Madoff investor litigation, including in particular "feeder fund" lawsuits.

The filing of this lawsuit may not be surprising, and there may be further litigation yet to come. As detailed in the lead story in the December 13, 2008 Wall Street Journal (here), the victims of Madoff’s scheme include a host of institutional investors, hedge funds, and funds of funds. It may well be that these entities’ investors, eager to recoup losses as well as to assign blame, will also file lawsuits in a daisy-chain of litigation based on the Madoff firm’s collapse.

Hat tip to the Dealbook blog (here) for the text of the Madoff class action complaint, which can be viewed here:

Class Action Lawsuit Against Madoff

Another Friday Night Special: December 12, 2008 was a Friday, and that can only mean one thing – after the close of business, the FDIC announced another round of bank closures.

First, the FDIC announced (here) that state banking regulators had closed, and the FDIC had been appointed receiver of, Haven Trust Bank of Duluth, Georgia. Next, the FDIC announced (here) that state regulators had closed, and the FDIC had been appointed receiver of, Sanderson State Bank of Sanderson, Texas.

These two closures represent, respectively, the twenty-fourth and twenty-fifth bank failures so far this year. The FDIC’s complete list of failed banks during the period October 2000 to the present can be found here. Haven Trust is the fifth Georgia bank to close this year, which represents the highest total for any one state. The Sanderson bank’s closure is the second in Texas this year.

As I have noted before (here), the pace of bank closures has accelerated as the year has progressed. Of the 25 bank closures in 2008, 21 have taken place since July 1, eight of them just since November 1. The trend certainly suggests that there will be further bank closures in the weeks and months to come. And, pertinent to the preceding discussion, there likely will also be further bank-related litigation (refer here).

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As the year end approaches, various commentators will be issuing their retrospectives on the year’s securities litigation activity. The lead story undoubtedly will be that the wave of subprime and credit crisis-related lawsuits continued to flood in during the year. With some 94 new subprime and credit crisis related securities lawsuits so far in 2008 (by my count, which can be accessed here), the litigation wave undoubtedly is an important part of the story. But it is not the whole story. The danger is that the wave of credit crisis-related litigation has become so predominant that other important developments may be overlooked.

This past week illustrates my point. There were seven new securities class action lawsuits filed during the week of December 8, which is noteworthy in and of itself, as December historically is a slow month for securities class action lawsuit filings.

Among this past week’s seven new securities lawsuits was one new credit-crisis related filing. On December 11, 2008, plaintiffs’ lawyers filed a class action lawsuit against GS Mortgage and certain of its directors and officers, on behalf of purchasers of mortgage pass-through certificates and asset-backed securities the company issued. (GS Mortgage is an affiliate of Goldman Sachs, which is also named as a defendant.)

According to the plaintiffs’ press release (here), the GS Mortgage complaint alleges a variety of misrepresentations in the instruments’ offering documents, including with respect to the underwriting standards and appraisals used in the origination of the underlying mortgages.

But while the seven lawsuits filed last week did include this one subprime-related lawsuit, the other six lawsuits appear completely unrelated to the subprime or credit crisis-related events.

The remaining six companies named include a Canadian mining company, Crystallex International, allegedly facing regulatory issues in Venezuela (about which refer here); two medical device companies, Medtronix and Atricure (refer here and here); a media conglomerate, CBS Corporation, that announced non-cash impairment charges to intangible assets and goodwill (refer here); a laser and technology manufacturer, GSI Corp., that restated its financials due to revenue recognition issues (refer here), and a Chinese agricultural company, China Organic Agriculture, facing allegations regarding its development of organic products (refer here).

These six lawsuits represent a diverse mix of companies and allegations. The point here is that none of these six lawsuits is related to the subprime meltdown or credit crisis. Similarly, during the past year, while there have been a host of credit crisis-related lawsuits filed, there have also been many other lawsuits that are totally unrelated to the credit crisis.

Given the nature and magnitude of the financial developments this year, it is hardly surprising that there has been significant litigation activity involving the financial sector. What may be even more noteworthy is that notwithstanding the predominance of the financial events, there have been a significant number of lawsuits having nothing to do with the credit crisis or the financial sector.

I will detail these observations in my own forthcoming year-end analysis of securities litigation activity. In the interim, particularly as the various year-end reports emerge, it is important to keep in mind that 2008 securities litigation activity was not just about the credit crisis alone, nor was it confined just to the financial sector.

Does This Sounds Familiar?: Our age is not the first to have to contend with the consequences from cultural excess fueled by speculation, debt and deficit spending enabled by “financial wizardry.” A similar pattern also appeared in the events leading up to the French Revolution. In his book, Revolutionary France, 1770-1880 (here), historian François Furet details the country’s astonishing accumulation of indebtedness, and the consequences that followed.

In particular, Furet explores the way the French monarchy, led by Finance Minister Jacques Necker, financed its participation in the American war of independence by increasing state-guaranteed life annuities, fueling a speculative bubble and enabling borrowing backed by inflated values. Furet writes:

In total, between 1776 and 1781, 530 million in loans of all kinds fed the Treasury and financed a war that was all the more popular because it was painless. Money continued to flow in, and the resale of annuities enriched Parisian speculation. Even if the state was seriously compromising its future, Necker retained his popularity. In 1781, to counter-attack court intrigues … he published the Compte rendu, a statement of accounts which concealed the expenditure of the extraordinary budget and revealed an apparent surplus revenue of ten million livres.

As Furet observed, “after three years of war and no new taxes, that was truly  financial wizardry!” The problem is that, contrary to Necker’s assurances, “the real deficit lay in the region of eighty million.”

Similar deficit financing by Necker’s successors furthered the French government’s financial challenges. A successor minister, Charles Alexandre de Calonne, “found, out of 600 million livres in annual revenue, 176 million committed in advance, 250 million absorbed by debt service, and 390 million in accounts in arrears to be settled.” What was Calonne’s response? “He borrowed money on all sides, even more and at a higher rate than his predecessors.”

Among other things, this massive indebtedness enabled the illusion of prosperity; “one would need to reconstruct the entire circuit of money borrowed by Calonne to understand how these years were without doubt the most dazzling in court civilization.” But, as Furst notes, “sinking borrowed money into the parasitic round of court life proved eventually to be the downfall of this aristocratic sleight of hand.” This “artifice” unleashed “one of the most gigantic crashes in history.”

As we face the consequence of the collapse of our own era of debt-fueled prosperity, with its accompanying speculation, asset-valuation bubbles and financial wizardry, there is something sobering in realizing that once again the response consists of “borrowing money on all sides.” The ever-cumulating deficits have reached the point where figures of billions and trillions have lost all meaning. I am sure I am not the only one with the uneasy  feeling that we may be sinking borrowed money into parasitic hands and that we could be “seriously compromising our future.”

PLUS D&O Symposium: The Professional Liability Underwriting Society (PLUS) will be holding its annual D&O Symposium on February 25 and 26, 2009, at the Marriott Marquis in New York City. I will be co-Chairing the event again this year, along with my good friends, Tony Galban of Chubb and Chris Duca of Navigators Pro. There will be a terrific line up of speakers, including the keynote speakers Madeline Albright and New York Insurance Commissioner Eric Dinallo .

The panels will include all of the familiar favorites, such as the securities litigation update panel, to be chaired again by Boris Feldman of the Wilson Sonsini firm, and View from the Top panel, featuring the heads of the leading D&O underwriting facilities. Other panels will also address issues surrounding the governmental bailouts and increased business failures. An added bonus is that the fascinating video The Rise and Fall of Bill Lerach will be shown during the conference. (View a trailer of the video here).

Further information about the 2009 PLUS D&O Symposium, including registration information, can be found here. This event sells out every year, so early registration is advised.

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As I have previously noted (here), one of the significant procedural developments in the subprime securities litigation wave has been the plaintiffs’ apparent interest in pursuing ’33 Act subprime-related lawsuits in state court. Section 22(a) of the ’33 Act expressly provides that the federal court’s jurisdiction for ’33 Act lawsuits is "concurrent with State and Territorial courts," which presents an immediate forum selection issue for any prospective ’33 Act plaintiff.

A recent ’33 Act lawsuit filing suggests that the forum selection issue involves not only electing between federal and state courts, but also deciding in which state to file, if a state court forum is to be preferred. The case also suggests that the forum selection may also entail forum shopping.

The Lawsuit

On December 2, 2008, the Public Employees’ Retirement System of Mississippi filed a ’33 Act class action complaint in Orange County (California) Superior Court against Morgan Stanley and several Morgan Stanley affiliates, several individuals associated with the Morgan Stanley affiliates and fourteen issuing trusts that sold certain mortgage pass-through certificates. The complaint also names as defendants McGraw Hill Companies, the corporate parent of S&P, and Moody’s. A copy of the complaint can be found here.

The complaint alleges that the offering documents associated with the securities "misstated and omitted material information regarding the quality of the loans underlying the Certificates," and failed to disclose" that the loan originators had "systematically ignored their stated and pre-established underwriting and appraisal standards." The complaint also alleges that Morgan Stanley entities "overpaid for underlying mortgages without regard to the quality of the loans for the sole purpose of increasing its position in the mortgage lending and securitization industry."

The complaint further alleges that the rating agency defendants "directly participated in structuring the securitization transaction" and that the rating agencies’ ratings "did not represent the true risk of the Certificates."

The complaint asserts claims under Sections 11, 12 and 15 of the ’33 Act and seeks relief on behalf of the class of investors who purchased securities pursuant to or traceable to the March 16, 2006 Registration Statement and accompanying prospectus.

Jurisdiction and Venue

The plaintiff is a Mississippi public employee pension fund. Morgan Stanley has its headquarters in midtown Manhattan. The complaint does not allege that any of the other defendants are domiciled in California. Apparently none of the parties are from California. So what exactly is this case doing in California?

As to why it is in state court rather than federal court, the state court has concurrent jurisdiction as I noted at the outset. But the mere availability of a state court forum does not explain why a state court was chosen in preference to a federal court. In my earlier posts (here), I have speculated that the plaintiffs are hoping to make an end run around the PSLRA’s procedural requirements, although no one has ever confirmed that.

But even if the preference of state court over federal court can be explained, why a state court in California?

The complaint itself purports to allege a variety of California connections: a "substantial portion of the wrongs complained of" are alleged to have occurred in Orange County. The defendants are alleged to have "availed themselves of the benefits of conducting business" in Orange County. Moreover, the complaint alleges that "a great percentage of the underlying mortgages pooled in the Certificates…were securitized by properties located in California."

All of these supposed connections to California are superficially plausible. But the fact is that all the parties are from outside California. The transaction that is at the heart of the lawsuit took place outside California. The supposedly misleading documents were created outside California.

I have my own theory why the case has been filed in California. That is, the plaintiffs really want the case to be in state rather than federal court. They anticipate that the defendants will seek to remove the case to federal court. The case law on which the plaintiffs would seek to rely in trying to have the case remanded back to state court is more favorable in California and less favorable in New York.

Specifically, as discussed here, in New York, in the HarborView mortgage case (about which refer here), the plaintiffs’ motion to remand the subprime-related securities case to state court was denied. However, in the Luther v Countrywide case, a subprime-related Section 11 lawsuit originally filed in California state court but removed by the defendants to federal court, the motion to remand the case to state court was granted, and the remand was specifically affirmed by the Ninth Circuit. For a detailed discussion of the Luther case including the Ninth Circuit’s opinion, refer here.

So did the plaintiffs choose a California state court because of the Ninth Circuit’s opinion in the Luther v. Countrywide case -- that is, because the chances of being able to proceed in state court in California was perceived to be greater than the chances of being able to proceed in state court in New York? If I am right, the plaintiffs selected the forum in order to increase the likelihood of a state court venue. Call it forum shopping to the second power.

Anyone who questions my theory should know that the complaint in the Morgan Stanley case explicitly references the Luther case, complete with case citation to the Ninth Circuit opinion. .

Of course, it may also be fairly observed that Orange County is ground zero for the mortgage meltdown, and as result the plaintiffs may expect a more sympathetic court and jury in that forum . This possible explanation is not inconsistent with my theory. Call it fourm shopping to the third power.

In any event, as I have previously noted, it appears likely that in connection with the subprime litigation wave, a significant amount of high stakes class action securities litigation will be going forward in state court. The plaintiffs’ lawyers ’33 Act forum selection preference is now well-established. Now we must wait and see what it all portends.

Rating Agency Defendants

The Morgan Stanley case is not the first subprime securities lawsuit naming the rating agencies as co-defendants. Indeed, the HarborView case referenced above also named rating agencies as defendants. However, in the HarborView case, the complaint alleged that the rating agency defendants were liable under Section 11 as "appraisers" as defined in Section 11(a)(4) of the ’33 Act. (Refer here for a detailed discussion of the allegations in the HarborView complaint.)

The Morgan Stanley complaint takes a different approach. Because it alleges that the rating agencies were directly involved in the creation of the securitized assets, the Morgan Stanley complaint alleges that the rating agencies are liable under Section 11(a)(5) as "underwriters" of the mortgage pass-through certificates. (The text of Section 11 can be found here.)

It will be interesting to see in any event whether these various liability lawsuits against the rating agencies succeed under any theory. As I have previously noted here, the rating agencies may have constitutional defenses protecting their rating activities. It remains to be seen whether the rating agencies involvement in the securitization process transformed them into "underwriters" sufficiently to subject them to Section 11 underwriter liability.

Run the Numbers

In any event, I have added the Morgan Stanley Pass-Through Certificates lawsuit to my running tally of subprime related securities litigation, which can be accessed here. With the addition of the new Morgan Stanley case, the current tally of subprime and credit crisis-related securities lawsuits now stands at 133, of which 93 have been filed in 2008.

Special thanks to Adam Savett of the Securities Litigation Watch (here) for a copy of Morgan Stanley mortgage pass-through certificates lawsuit complaint.

Subprime Loans, Predatory Lending?: One of the recurring allegations on behalf of subprime borrowers is that the subprime loans in which the borrowers became ensnared represented "predatory lending." A November 20, 2008 article by three NERA Economic Consulting economists – Denise Neumann Martin, Faten Sabry and Stephanie Plancich – reviews "the definition of predatory lending and describe the recent litigation history. The authors then examine alleged discriminatory lending in detail, reviewing key economic theory and evidence, as well as relevant statistical techniques."

The paper also reviews predatory lending allegations and takes a look at recent predatory lending lawsuit filings. The article categorizes the lawsuits according to the specific allegations, and also examines predatory lending lawsuit settlements.

The report contends that proper statistical analysis is required to establish whether or not discriminatory or other improper lending activity has taken place. The report states that:

A proper assessment of alleged predatory lending, then, must control for characteristics including but not limited to the credit history, employment status, income level, and education of the borrower, as well as the borrower’s preference for risk (or discount rate). The competitiveness of the market in which the loan was arranged and other relevant macroeconomic factors may also need to be considered. Such analysis is essential to distinguish behavior that is predatory from that which is explainable by these other factors and would not be evidence of discrimination.

The paper, entitled "The Use of Economic Analysis in Predatory Lending Cases: Application to Subprime Loans," can be found here.

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In a deeply troublesome decision, the New York Department of Insurance has issued an October 16, 2008 opinion (here) stating that "a D&O policy may not include a provision that places the duty to defend upon the insured, rather than the insurer." A December 5, 2008 memo (here) written by Carrie Cope, a partner in the Tressler, Soderstrom Maloney & Preiss law firm, diplomatically but accurately summarizes just how far off base the opinion is.

By way of background, public company D&O insurance as it is uniformly distributed and purchased throughout the entire U.S. marketplace today is written on a duty to indemnify rather than a duty to defend basis. Under this arrangement, the insured persons, rather than the insurer, select their defense counsel, subject to the insurer’s consent, and the insured persons control their defense. The insurer reimburses reasonable defense expense.

Not only is this arrangement the uniform marketplace standard for public company D&O insurance, but it is the clear and unambiguous preference of public company D&O insurance buyers, who want to be able to use their own counsel in matters affecting their personal liability.

This arrangement has also has been approved by state court insurance regulators throughout the country. As Cope’s memo succinctly points out, the New York Insurance Department’s opinion is directly contrary to this well established regulatory record.

Cope also notes that the opinion "fails to address the needs and desires of the Insureds that it seeks to protect." She correctly points out that public company D&O insurance policies are purchased by sophisticated parties represented by risk managers and other specialized insurance professionals who seek to procure the best insurance available for their clients. The terms and conditions are highly negotiated. While virtually every word in the policy is subject to intense scrutiny, no one is trying to insert a duty to defend into their public company D&O insurance policy.

The D&O insurance industry’s uniform adoption of a duty to indemnify approach rather than a duty to defend approach is not the result of some insidious insurance company conspiracy. It is instead exactly what sophisticated and well-advised insurance buyers want.

Cope also correctly points out the opinion’s flawed logic. The opinion seeks to criticize the specific insurance policy addressed in the opinion because it transfers to the insured the burdens of litigation "such as managing, controlling or otherwise overseeing the litigation." As Cope notes, the opinion "fails to recognize that the ability to oversee the litigation is exactly what the typical insured purchasing a public company D&O policy wants." (Emphasis added).

The opinion also criticizes the policy because it does not pay the compensation costs of in-house counsel. Cope correctly notes that even if the policy were a duty to defend policy, it would not cover these costs.

Cope concludes her memo by noting that the opinion, "if not further modified, may well have a chilling effect upon the D&O insurance industry in New York and unduly cause applicants to seek means to obtain coverage they need and want outside the State of New York."

Cope is correct. This opinion is not in anyone’s interests, and in particular it absolutely is not in the interests of any person to be insured under a public company D&O insurance policy. Cope’s memo should be a rallying cry for all industry participants to have this erroneous opinion modified or set aside as soon as possible.

Special thanks to the several readers who sent me copies of Cope’s memo.

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All litigants face the challenge of managing lawsuit expenses and exposures. The Reserve Primary Fund investor litigation defendants have crafted a novel approach to addressing these challenges – they apparently intend to finance their defense as well as any indemnity out of funds due to investors -- that is, the funds of the very people on whose behalf the claims are being asserted.

Background

In September, the Reserve Primary Fund ("the fund") gained notoriety when the money market fund "broke the buck," as massive redemptions and the fund’s exposure to Lehman Brothers’ securities drove the fund’s per share net asset value below one dollar. Due to the magnitude of the redemption requests, the fund’s trustees voted to liquidate the fund and distribute the assets to investors.On December 8, 2008, the Wall Street Journal ran a front page article (here) detailing the events behind the fund's woes.

Meanwhile, investors initiated a number of securities lawsuits against the fund, its directors and officers, its investment advisor and related parties. (Refer here for background regarding the lawsuits.) The lawsuits allege, among other things, that the defendants’ selective or inaccurate disclosure regarding the fund’s troubled assets enabled certain institutional investors to avoid losses to the detriment of other investors. The lawsuits also alleged that the fund failed to disclose its vulnerability due to its alleged overexposure to Lehman. The lawsuits also allege that the Lehman Brothers investments were inappropriate for a money market fund, and that the fund deviated from its stated investment approach.

The Liquidation Plan

On December 3, 2008, the fund’s trustees issued a "Plan of Liquidation and Distribution of Assets" (here). Among other things, the Liquidation Plan provides a plan for distribution of fund assets through "interim payments." The interim payments are to include distribution amounts "up to the amount of a special reserve, which would include amounts that would be required to satisfy disputed claims."

As the Liquidation Plan explains, this special reserve will be used to finance "costs and expenses of the Fund, its officers and Trustees"; "pending and threatened claims against the Fund"; and claims, "including but not limited to claims of indemnification that could be made against plan assets." Were the fund to distribute its assets without the special reserve, investors could expect about 98.5 cents per share. However, the special reserve, the amount of which has yet to be determined, will reduce this per share distribution.

As a December 5, 2008 New York Times article entitled "Embattled, Fund Shifts Costs to Investors" (here), put it, investors might hope to get 98.5 cents on the dollar, but "if they continue to wage legal battles against the fund managers, the company will use investors’ own money to defend itself against allegations or mismanagement and deception." Moreover, the Liquidation Plan makes it clear that the special reserve is not just for litigation expense, but also to "satisfy disputed claims." The December 8 Journal article cited above states that the fund has told investors "the fund will use some if its assets to fight suits investors have filed, which could reduce the money available to return to them."

Insurance and Indemnification

Readers who like me wonder whether there isn’t D&O liability insurance available to pay these amounts will be interested to learn that there is insurance, just not very much. According to the Liquidation Plan, the fund has a directors’ and officers’ liability insurance policy with a $10 million aggregate limit of liability.

Not only does the fund only have a $10 million D&O policy, but it is a "joint" policy, insuring not just the fund and its directors, officers and trustees, but also its investment advisor, its corporate parent, and other affiliated parties and person, many of whom are co-defendants with the fund and its directors and officers in the mass of investor lawsuits that have been filed.

In other words, though the fund has D&O insurance, its limits are, well, limited, and are also subject to erosion or depletion due to competing interests of multiple parties in the policy proceeds. It should be emphasized that under most D&O policies, defense expense reduces the amount of insurance remaining under the policy, meaning that there could be little or no insurance available to satisfy investors’ claims if the various cases are actively litigated.

The rights of the fund’s individual officers, directors and trustees to indemnification are not eliminated merely because of the allegations raised in the lawsuits (indeed, the outbreak of litigation is precisely the circumstances that trigger the operation of indemnification rights). Angered investors who may want to contend that the individual’s supposed misconduct should forfeit their rights to indemnification can try to argue based on Section 17(h) of the Investment Company Act that the fund cannot indemnify the individuals for "willful malfeasance, bad faith, gross negligence, or reckless disregard."

The problem for any investor inclined to make that argument is that the only way to establish that the statutory indemnification prohibitions have been triggered is to litigate the issue – which, as the Times article notes, is "the very act that could reduce the return to investors." In order to establish that the disqualifying conduct occurred, investors would have to pursue their case all the way to verdict, and arguably through appeal as well, a process that would be as uncertain as it would be costly and protracted.

Discussion

So basically the message seems to be, you want to litigate, investors? Fine, knock yourselves out. It’s your money. As the Times article puts it, the choice offered investors under the Liquidation Plan "struck some legal experts as brazen."

The fund’s insurance limits are also worthy of comment. The fund had assets of approximately $64 billion. In that light, some may find the fund’s $10 million D&O insurance limits, well, surprising, particularly given that the limits insure not just the fund and its directors, officers and trustees, but also the fund’s investment advisor and other affiliated parties and person. Reasonable minds might well question the fund’s limits selection.

These circumstances also highlight the risks associated with widely shared limits. The number and diversity of entities and person who will be depending on the limits, along with the apparent seriousness and extent of the litigation involved, raises the probability that the litigation expense will quickly erode if not altogether deplete the available limits. The risk of limits erosion associated with these kinds of shared limits further underscores the fact that reasonable minds might well question the fund’s insurance limits selection.

In any event, the circumstances, particularly the Liquidation Plan, present investors with some difficult decisions. It will be interesting to see their next move, and whether they try to challenge the Liquidation Plan.

Special thanks to Kelly Rehyer for the link to the Times article.

And Speaking of Threats to Litigating Investors: As I noted in a prior post (here), investors have sued the Bank of America, challenging the loan modifications to which the bank agreed in connection with mortgages issued by Countrywide. The litigation has apparently caught the attention of FDIC chairman Sheila Bair.

As reported in a December 4, 2008 Los Angeles Times article (here), Bair told a consumer group gathering that "there is an obligation to modify mortgages," and that "investors should take a hard look at what they are advocating." She also said that "the harder investors push, the more there’s going to be a backlash here." She suggested that Congress may step in and change the legal obligations of mortgage services toward investors.

Interestingly, Bair did not state that the investors’ opposition to the mortgage makeovers is illegitimate or unmeritorious, only that their assertion of their interests represents an obstruction to policy goals she advocates. It certainly can be inconvenient when concerned parties insist on asserting their rights, but the threat of a Congressional backlash could strike some as heavy-handed.

Call it a hunch, but Bair’s remarks seem likelier to embolden rather than to discourage investors, as her remarks suggest that she recognizes the potential significance of their claims. In any event, whether or not Congress has the power or political will to set aside the agreements on which the investors are relying, if Congress were to take such a step it would do little to restore investor confidence in mortgage marketplace mechanisms, which would seem to be an indispensible part to restoring stability to the mortgage lending industry.

And Speaking of the FDIC: In yet another Friday-night special, on December 5, 2008, First Georgia Community Bank of Jackson, Georgia became the twenty third U.S. bank failure this year, after state regulators closed the bank and the FDIC was named receiver. The closure is Georgia’s fourth bank failure this year.

The FDIC’s December 5, 2008 press release can be found here. The FDIC’s updated list of bank failures can be found here. My prior post about the significance of the accumulating bank failures can be found here, and my prior post about the prospects for a new wave of "dead bank" litigation can be found here.

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In a recent post (here), I described the "new wave" of credit crisis lawsuits, in which the companies involved were damaged by their exposures to other companies experiencing credit crisis losses. The latest of these new wave lawsuits to be filed involves the Federal Agricultural Mortgage Corporation, or "Farmer Mac" as it is more familiarly known.

Freddie Mac is a government sponsored entity that was established to support a secondary market for agricultural real estate and rural housing mortgage loans. According to their December 5, 2008 press release (here), plaintiffs’ lawyers have initiated a securities lawsuit against Farmer Mac and certain of its directors and officers in federal court in the District of Columbia. According to the press release,

a) defendants were inflating Farmer Mac's results through manipulations relating to the characterization of impairment costs and/or depreciation expenses which inflated the Company's reported cash flows, gross margins and Core and GAAP-earnings; (b) the Company's financial results were inflated by defendants' use of overly optimistic assumptions of asset valuations and investments, which were also reflected in defendants' misuse of mark-to-market accounting; (c) the Company's exposure to investment losses and credit problems of trading partners such as Lehman Bros. and Fannie Mae was much greater than represented; and (d) the Company was not on track to meet or exceed guidance sponsored or endorsed by defendants.

Investors only first learned the truth about Farmer Mac on September 12, 2008, when its shares closed at $16.56, from an open of $23.78, losing over 30% of their value in one day after the Company filed documents with the SEC saying it would incur significant charges due to its exposure to Fannie Mae securities. Further, shares of the Company continued to trade down thereafter to close to $2.00 per share following announcements concerning the resignation of its Chairman of the Board and losses related to debt issued by Lehman Brothers.

The involvement of the allegations relating to the company’s Fannie Mae and Lehman Brothers investments is the reason I have characterized this case as a new wave credit crisis lawsuit. That is, it was its exposure to these other companies that caused Farmer Mac’s problems, at least in part.

However, because of the allegations relating to Farmer Mac’s own asset valuations, including its alleged misuse of mark-to-market accounting, the lawsuit also has characteristics of the more conventional subprime and credit-crisis related type of litigation that has accumulated over the last two years.

In any event, I have added the Farmer Mac lawsuit to my running tally of subprime and credit crisis-related securities lawsuits, which can be accessed here. With the addition of the Farmer Mac lawsuit, the current tally of subprime and credit crisis-related securities lawsuits now stands at 132, of which 92 have been filed in 2008.

And Speaking of Credit Crisis Litigation: One of the more noteworthy events during the current credit crisis was the collapse of Bear Stearns in March 2008 (which already seems like a long time ago, doesn't it?) and its acquisition by JP Morgan Chase.

Following JP Morgan’s March 16, 2008 agreement to acquire Bear Stearns, shareholders of Bear Stearns filed a New York (New York County) Supreme Court lawsuit against both Bear Stearns and JP Morgan, alleging that the $10 per share consideration JP Morgan paid for Bear Stearns was inadequate. The plaintiffs sought damages from Bear Stearns’ directors for claimed violations of their fiduciary duties and from JP Morgan for its allegedly tortious conduct in effecting the merger.

In a December 4, 2008 opinion (here), Judge Herman Cahn granted the defendants’ motion for summary judgment. The court rejected the plaintiffs’ challenges to the deal, holding that the business judgment rule applied, and that under the rule, the court could not second guess the board:

In response to a sudden and rapidly-escalating liquidity crisis, Bear Stearns’ directors acted expeditiously to consider the company’s limited options. They attempted to salvage some $1.5 billion in shareholder value and averted a bankruptcy that may have returned nothing to the Bear Stearns’ shareholders, while wreaking havoc on the financial markets. The Court should not, and will not, second guess their decision.

In a December 5, 2008 post on the Harvard Law School Corporate Governance Blog (here), the attorneys that represented JP Morgan in the Bear Stearns case discuss the decision in greater detail, noting that "as the credit crisis continues and evolves, boards will continue to face serious challenges. The Bear Stearns opinion confirms, however, that the directors that act diligently and in good faith should not have exposure for their actions."

The suggestion that the Bear Stearns opinion represents a precedent in support of the protection of directors arguably has already been borne out in a North Carolina court.. As Francis Pileggi discusses on his Delaware Corporate and Commercial Litigation Blog (here), the North Carolina court considering shareholders’ challenges to the merger of Wachovia and Wells Fargo has dismissed the action, with reference to  the New York court’s decision in the Bear Stearns case. The Wachovia and Wells Fargo merger was arranged in similarly unusual circumstances in light of the economic turmoil that in very short order saw some of the countries largest financial institutions "go under" or need "bailouts."

A December 6, 2008 Charlotte Observer article describing the ruling in the Wachovia case can be found here.

Fake ID: In a recent post (here), I analyzed the problems associated with credential inflation and reviewed famous examples of identity misrepresentation. However, a recent episode involving prominent attorney Marc S. Dreier, the name partner of Drier LLP, may represent a whole new level of identity misrepresentation.

As reported on December 5, 2008 on the City Room blog (here), earlier last week Toronto police arrested Drier for "fraudulent impersonation." A December 8. 2008 Law.com article (here) reports that at a meeting in the offices of the Ontario Teachers’ Pension Plan with representatives of Fortress Investment Group and involving a multimillion dollar deal between the two organizations, Drier "pretended to be Michael Padfield, senior legal counsel for investments at Ontario Teachers." The Wall Street Journal reports (here) that Dreier passed out Padfield's business card and signed documents as Padfield. When Padfield himself arrived at the meeting, police were called.

As if that were not enough, three attorneys from the Wilson Sonsini firm have been retained "to examine firm operations and finances, including escrow accounts." Whether or not these concerns are related to Drier’s arrest is not specified. However, the Above the Law blog reports here that as much as $38 million is missing from the Dreier firm’s client escrow account.

The Journal also reports that federal prosecutors are looking into concerns raised by Solow Realty, a former client of the firm, "that Mr. Dreier allegedly was selling to hedge funds fraudulent documents falsely purporting to be debt instruments of Solow without Solow's authority."

The firm’s holiday party, planned to take place last Thursday night at the Waldorf Astoria, was cancelled. I guess it is hard to party when your name partner is (or was) in jail and your client escrow account is missing tens of millions of dollars.

I doubt even John Grisham could have made this one up.

UPDATE: The Marc Dreier story just keeps getting weirder and weirder. In a totaly bizarre development, on December 8, 2008, the SEC filed a complaint against Dreier in which it accused him of "fraud in connection with an elaborate scheme that raised at least $113 million from the sale of bogus promissory notes." Read the SEC's press release here. The press release that Dreier has already admitted his involvement with the phony note sale. The WSJ.com Law Blog reports (here), that the DoJ has also filed a criminal complaint against Dreier and that he was arrested upon his return to the U.S. on Sunday. The firm's lender has also sued the law firm because the firm is in default on its line of credit.

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Following closely on the heels of the denial of the motion to dismiss in the Countrywide case earlier this week (about which refer here), on December 3, 2008, Judge Dean Pregerson of the Central District of California issued an opinion (here) denying the defendants’ motions to dismiss in the New Century Financial Corporation securities class action lawsuit.

Background

New Century was at one time the largest subprime mortgage lender. However, on April 2, 2007, the company filed for Chapter 11 bankruptcy protection. In a development with significance for the securities lawsuit, in March 2008, the New Century bankruptcy examiner filed a report (refer here) finding, among other things, that the company had "engaged in a number of significant improper and imprudent practices related to its loan originations" that "created a ticking time bomb that detonated in 2007."

The lead plaintiff in the New Century securities lawsuit is the New York State Teachers’ Retirement System. The plaintiff filed a consolidated class action complaint on September 14, 2007, and the defendants moved to dismiss. On January 31, 2008, as discussed here, Judge Pregerson granted the motions dismiss without prejudice, but the dismissal focused entirely on the organization and complexity complaint and the court’s difficulty in evaluating the basis of the plaintiff’s claims. Thereafter, the plaintiff’s filed a second consolidated amended complaint (refer here, referred to below as the amended complaint) and the defendants again moved to dismiss.

The amended complaint names as defendants certain officers and directors of New Century; its former auditor, KPMG; and the investment banks that underwrote certain New Century securities offerings. The complaint alleges that the defendants

misrepresented New Century’s ability to repurchase defaulted loans; overvalued its residual interests in securitizations; falsely certified the adequacy of its internal controls, loan origination standards, and the quality of its loans; and failed to identify these problems in public statements, registration documents, audits, or elsewhere.

Further background regarding the case can be found here.

Judge Pregerson’s Opinion

In his December 3 opinion, Judge Pregerson first considered whether the amended complaint remedied the organization and clarity issues for which he had previously granted the defendants’ motions to dismiss. While noting that the amended complaint is "truly massive" and commenting that he "questions whether the Complaint provides a manageable road map for litigation," he nevertheless concluded that the amended complaint was "responsive to the concerns" and that he was "now able to evaluate whether the allegations sufficiently state a claim." He also recognized that the PSLRA’s "stringent pleading requirements appear to invite both parties to throw everything and the kitchen sink into their respective pleading."

In turning to the merits, Judge Pregerson examined whether the plaintiffs could rely on the "group pleading doctrine," under which "group published documents" (e.g, press releases) for which there is not identified author can be considered the collective work of those with direct involvement in the company’s day-to-day affairs.

After reviewing the relevant case law, and noting that the Ninth Circuit had not expressly rejected the doctrine, Judge Pregerson joined the "majority of other courts in the Circuit" and held that "group pleading" is not longer viable under the PSLRA. He dismissed the plaintiff’s allegations that were made in reliance on the group pleading doctrine. However, he also noted that because the amended complaint alleges attributed misrepresentations that do not rest on the doctrine as to each of the officer defendants, his holding regarding group pleading "does not preclude any of the Officer Defendants from liability."

Judge Pregerson then addressed the 10b-5 allegations in the amended complaint. He concluded that the amended complaint adequately alleged falsity as to loan quality and underwriting and as to financial reporting and internal controls. Interestingly, in concluded that the allegations concerning loan quality and underwriting standards adequately alleged that the statements were false and misleading when made, Judge Pregerson expressly noted that other district courts in the Ninth Circuit had "found similar statements regarding loan quality and underwriting to provide a basis for actionable securities law violations," citing the Countrywide and Accredited Home Lenders decisions. (Refer here regarding the Accredited Home Lenders decision.)

On the issue of scienter, Judge Pregerson found that the amended complaint

sufficiently alleged facts giving rise to a strong inference that the Officer Defendants were at least deliberately reckless in making misrepresentations as to loan quality, internal controls and various financial statements.

Judge Pregerson noted that "the confidential witness statements describe a staggering race-to-the-bottom of loan quality and underwriting standards," noting that "the witnesses catalog an explosive increase in risky loan product." The allegations

are sufficient to infer a deliberately reckless set of statements telling the public one thing when New Century was doing something quite different – the loans were poor, not great quality; the underwriting was all but absent, not strict; and the internal controls were slack rather than searching.

Judge Pregerson also found that the insider trading allegations supported his finding of the adequacy of the scienter allegations, as did the allegations regarding the defendants’ bonus and other compensation. In that regard, it is interesting to note that Judge Pregerson specifically observed with respect to the defendants’ trading plans that "the timing of the 10b5-1 plans, several years after they became available, at least raises the question precisely why there was a delay in creating these plans, and why they were formed during the Class Period."

Judge Pregerson also denied KPMG’s motion to dismiss. The firm had issued an audit opinion on the company’s 2005 financial statements. He found that the amended complaint adequately alleged that KPMG was aware of accounting and internal control deficiencies but nevertheless issued its audit opinion. He found that the allegations against KPMG adequately alleged scienter and loss causation.

Finally, Judge Pregerson concluded that the amended complaint adequately pled claims under Section 11 in connection with New Century’s securities offerings, including as to the Underwriter Defendants.

Discussion

Judge Pregerson’s opinion is another subprime-related securities lawsuit pleading-stage victory in favor of plaintiffs. The New Century opinion, together with the recent decision in the Countrywide case,  undermine the suggestion (refer here) that plaintiffs may not be faring well in the subprime related litigation. These cases establish that in at least some instances, plaintiffs can satisfy the pleading requirements, notwithstanding the fact that the current financial crisis has affected virtually every company and every segment of the economy.

Moreover, both the New Century and the Countrywide opinions are sweeping and strongly worded. The potential for these cases to take on a collective power may be seen in Judge Pregerson’s own reference, in connection with the loan quality and underwriting standards allegations, to the conclusions in prior rulings in other cases. A developing body of judicial decisions potentially could take on a collective and persuasive weight that could affect other cases.

Judge Pregerson’s ruling with respect to KPMG is also noteworthy. His decision may have been influenced by the strongly worded findings in the New Century bankruptcy examiner’s report. But in any event, his willingness to permit the allegations as to KPMG to go forward may suggest the possibility that auditors could be targeted in at least some other subprime and credit crisis related cases.

One interesting note in the opinion is Judge Pregerson’s reference to the defendants’ trading pursuant to Rule 10b5-1 plans. As in the Countrywide case, Judge Pregerson found that the defendants’ use of the trading plans raised suspicions. Rule 10b5-1 was intended to provide a way for insiders to trade without liability concerns, yet, ironically perhaps, the defendants’ implementation of trading plans was in and of itself found in these cases to be grounds for suspicion. As I have noted elsewhere (here), Rule 10b5-1 plans can still be a good idea if properly implemented, but they clearly can be dangerous is not used properly.

A final observation about Judge Pregerson’s comments on the trading plans. There is an odd note in his consideration of the defendants’ plans. He referred, with suspicion, to the timing of the defendants’ adoption of plans "several years after they became available." This is a curious statement, as if he is suggesting that the very fact that the defendants decided to adopt a plan later is itself suspicious. These seems to me to be the very kind of circumstances in which there a host of alternative innocent inferences, including even the possibility that the defendant just didn’t get around to doing it for awhile. The suggestion that a belated adoption is suspicious would potentially bar anyone who has not already adopted a plan from doing so now, which obviously would undermine the Rule’s purposes of attempting to allow corporate officials to trade in company shares without liability concerns.

In any event, I have added the New Century decision to my table of subprime and credit crisis-related lawsuit dismissals and denials, which can be accessed here.

D&O Indemnification and Insurance: As the credit crisis litigation wave gains momentum, issues surrounding indemnification and insurance for directors and officers are becoming increasingly important. A December 3, 2008 memo by the Gibson, Dunn & Crutcher law firm entitled "Director and Officer Indemnification and Insurance in Turbulent Times" (here) takes a look at recent case law developments regarding indemnification and review the key issues concerning D&O insurance.

The memo provides a good summary overview of these issues. I note parenthetically that readers who may be interested in more detail regarding the specific items in the memo can refer back to this blog, where I have discussed at greater length each of the items discussed in the memo.

One particularly noteworthy observation in the memo is the statement with respect to D&O insurance that:

Due to the complexity of policy language and the issues involved, expert advice from qualified insurance and legal professionals can be important in obtaining a thorough understanding of the coverage available under a company’s D&O insurance program. A growing number of boards of directors are seeking comprehensive analyses of their companies’ D&O insurance programs, undertaken with the assistance of experts, in connection with the purchase or renewal of D&O insurance coverage.

As suggested in the memo, I have also noted that more boards are now seeking outside reviews of their insurance, and that an increasing number of boards (and, in particular, independent directors) are interested in a review of their insurance independent from the company’s broker or regular outside counsel, whom boards apparently are concerned have their first loyalties to company management. I have in recent months taken on a number of assignments along these lines, and I am available to discuss these services for others who may be interested.

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In an earlier post (here), I suggested that the credit crisis litigation wave had reached an inflection point, and in subsequent posts, I identified additional "new wave" credit crisis lawsuits.

The exact contours of this "new wave" is admittedly amorphous, but the basic concept is that it involves, first, companies that were not themselves undermined by the credit crunch but rather as result of their exposure to companies that were. The most prominent examples are companies that suffered losses due to their exposure to Lehman Brothers. One specific example is Constellation Energy, which, as noted here, is the target of a securities lawsuit alleging among other things that the company insufficiently disclosed its exposure to Lehman Brothers securities.

That there will be other lawsuits in the "exposed to others’ misfortunes" category is demonstrated by the lawsuit initiated on December 3, 2008 in the Southern District of New York against Chinese solar cell manufacturer JA Solar Holdings and certain of its directors and officers. According to the plaintiffs’ counsel’s December 3 press release (here), the Complaint alleges that the defendants failed to disclose that:

JA Solar purchased from a subsidiary of Lehman Brothers Inc. ("Lehman Brothers") a three month, $100 million note (the "Lehman note") on or about July 9, 2008. At the time of this purchase, Lehman Brothers, which guaranteed the Lehman note, was under severe financial distress. According to the complaint, defendants failed to disclose: (i) that JA Solar had made a material, highly speculative investment in a subsidiary of Lehman Brothers, an entity that was then undergoing a credit crisis and under significant financial distress; (ii) that the value of JA Solar’s investment in the Lehman note had diminished considerably; and (iii) that, as a result of the foregoing, defendants’ positive statements concerning JA Solar’s financial performance, outlook and earnings guidance were materially false and misleading and without reasonable basis.

Ultimately, at the end of the Class Period, JA Solar wrote off its $100 million investment in the Lehman note. After JA Solar fully disclosed and recorded an impairment in the value of its investment in the Lehman note, on November 12, 2008, JA Solar’s stock closed at $2.38 per share, a price that represented a decline of more than 87% from the high during the three month Class Period.

A copy of the JA Solar complaint can be found here.

Constellation Energy and JA Solar are far from the only companies experiencing losses as a result of the onslaught of bankruptcies and bailouts. Many companies have experienced huge losses as a result of the collapse of Lehman Brothers, Fannie Mae and Freddie Mac, AIG, Washington Mutual, and the other recent massive failures. There undoubtedly will be further lawsuits like the ones filed Constellation Energy and JA Solar.

Another category of "new wave" credit crisis litigation relates to companies that made wrong way bets on commodities and currencies, as I noted in a prior post (here). These companies have experienced significant losses as commodities prices and currency exchange rates suddenly and unexpectedly reversed direction this fall. Some of these companies have also been hit with securities lawsuits, as I noted in my prior post, and as also illustrated in the lawsuit recently filed against Aracruz Cellulose (about which refer here).

As discussed in a December 3, 2008 Wall Street Journal article entitled "Rapid Price Decline in Commodities Turns Some Offsets into Big Losses" (here), a number of companies "have taken hedging-related losses in the third quarter as a result of the rapid decline in commodities costs." But, the article emphasizes, "it isn’t over, either." Companies hedge their costs a few quarters in advance, so hedges taken more recently "are going to hurt profits for many in the fourth quarter and beyond." The article specifically mentions Campbell Soup, Kraft Foods, Pilgrim’s Pride, and Southwest Airlines.

The reference to Pilgrim’s Pride is particularly noteworthy as part of this discussion, because as I previously noted (here), the company has already been hit with a securities lawsuit based among other things on the company’s wrong way bet on corn prices. As the Journal notes, there will be other companies reporting losses after the end of the fourth quarter and even beyond on wrong way commodities and currency bets. Some of these companies likely will also face securities lawsuits.

The final category (or at least final until a new category emerges) involves auction rate securities. I refer here not to the mass of litigation filed earlier this year by auction rate investors against the broker-dealers that sold them the auction rate securities. Rather, I am referring to the cases where investors have sued companies because of losses the companies suffered as a result of the companies’ investment in auction rate securities.

An example of this auction rate case is the one involving NextWave Wireless (about which refer here) in which it is alleged, among other things, that the company "failed to timely disclose that it had invested all of its marketable securities in extremely illiquid auction rate securities."

There are a host of other companies facing distress due to their exposure to illiquid auction rate securities. For example, a December 3, 2008 Wall Street Journal article entitled "LandAmerica’s Collapse Leaves Investors Looking for Cash" (here) describes the failure of title insurance company LandAmerica Financial Group, which came about because one of the company’s subsidiaries had put funds held for real-estate investors in auction rate securities. Land America filed for bankruptcy last week.

There undoubtedly will be other companies facing liquidity crises as a result of their exposure to auction rate securities, and some of these companies, like NextWave Wireless, will face securities litigation as a result.

One final point about the evolution of the credit crisis litigation wave is that many of the companies involved in these various "new wave" categories identified above are outside the financial services sector. To the extent these new wave lawsuits continue to accumulate, this evolutionary process could be the means by which the credit crisis litigation wave spreads outside the financial sector to the larger economy.

Premonition of War Foretold: As we wonder how we got into the mess, one of the things that is becoming obvious is that the sober voices were silenced and mocked, and the dialog was dominated by the voices of those who had spent far too much time at the punch bowl.

The following video compiles of series of clips from the period 2006 through 2007, showing both how many foolish things were said, and also showing the prescience of Peter Schiff of Euro Pacific Capital. I don't know what is more amazing about this video, that Schiff's predictions were so uncanny or that the others, who mocked and even laughed at him, so badly misperceived what was happening, especially with respect to housing prices. I guarantee you will shake your head in disbelief at some of the things that are said in this video. Schiff in the meantime sounds like a man who had access to a crystal ball.

Hat tip to Joe Nocera of the New York Times in his Executive Suite blog (here) for the link to the video.

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Has the "due diligence" standard articulated in the WorldCom securities litigation produced an increase in the Section 11 litigation? That is the question addressed in David J. Michaels’s November 29, 2008 paper entitled "An Empirical Study of Securities Litigation After World Com" (here).

In this post, I review the analysis based upon which Michaels contends that, due to the WorldCom due diligence decision, Section 11 filings have increased as a percentage of all securities lawsuits, followed by my own discussion of the data on which Michaels relies.

The Author’s Analysis

Outside directors historically have had little Section 11 liability exposure, owing to their ability to rely on Section 11’s due diligence defense. Michaels notes that courts generally have found outside directors’ due diligence obligations to be minimal. However, Michaels contends, the Southern District of New York’s Section 11 due diligence decision in In re WorldCom Securities Litigation, 2005 WL 638268 (S.D.N.Y. 2005) (refer here) "significantly changed the landscape for outside directors" by holding them to a "stringent standard of liability."

A more detailed review of the impact of the WorldCom litigation on the due diligence defense can be found here.

Michaels hypothesized that because the WorldCom decision represents a change in the due diligence standard, making it easier for plaintiffs to pursue Section 11 claims (particularly against outside directors), securities cases under Section 11 would increase. In order to test this hypothesis, Michaels examined the ratio of securities filings asserting Section 11 claims to Section 10b-5 filings during the period 2002 through 2007, using data from the Stanford Law School Class Action Clearinghouse website. Because the court issued the WorldCom opinion in March 2005, the period selected included both years preceding and following the decision.

Michaels reported the following ratios of Section 11 filings to Section 10b-5 filings for the years 2002 through 2007:

2002 13%

2003 11%

2004 6%

2005 10%

2006 13%

2007 23%

Michaels concludes that these data suggest an "abnormal rise in Section 11 filings." Michaels concedes that "it is difficult [to] prove a causal relationship between WorldCom and the rise in Section 11 filings," he nevertheless asserts that it "is reasonable to attribute causation of the rise in Section 11 filings to WorldCom." In support of this conclusion, Michaels states:

Consider the following series of events. Prior to WorldCom, Section 11 filings were relatively constant; WorldCom comes along and greatly alters 35 years of precedent by making it easier for plaintiffs to survive a motion for summary judgment; Section 11 filings increase.

Michaels ends his paper by arguing that the upward trend in Section 11 cases will continue, but also that WorldCom’s holding applying a stringent standard to outside directors’ "due diligence" defenses is contrary to the ’33 Act’s purposes. He proposes a safe harbor for outside directors that "would exclude from liability outside directors who follow certain procedures designed to inform them of all material information surrounding a given offering."

Discussion

Michaels may be correct that the WorldCom decision will result in an increase in Section 11 filings. Reasonable minds may differ on whether the data support his conclusion that there already has been a demonstrable increase in Section 11 filings. Those same reasonable minds might hesitate before jumping to any conclusions about the causes of any increase that arguably may have taken place. A more conservative view is that it is at best premature to reach any conclusions in that regard.

First, the data on which Michaels relies represents only a brief time period. Since the WorldCom opinion was issued in 2005, that data from calendar year 2005 represent only a partial year. Michaels’s analysis places an enormous weight on data from just two years, 2006 and 2007. Michaels does not explain why he believes a data set that small is sufficient to support his conclusions.

Second, Michaels does not consider whether or not there were external factors that may have affected securities filings during the period after the WorldCom decision. In fact, it has been well documented (refer, for example, here) that there was a filing "lull" during the period from mid-2005 through mid-2007, in which there were an historically low number of securities filings overall. Michaels does not even mention this fact, nor does he consider whether the filing levels during that period may suggest that other factors may have been at work during this period.

Third, although Michaels is convinced that there was an "abnormal rise" in the Section 11 filings after WorldCom, the only thing I can conclude from looking at the data is that something was going on during 2007, as the 2005 and 2006 data are consistent with the prior years’ data. Michaels is essentially arguing the filing activity in a single year supports his hypothesis. Again, Michaels does not consider whether or not there may have been some anomalous factor behind the 2007 data.

My own prior review of the 2007 filing data (refer here) concluded that a significant number of the overall 2007 filings involved companies that conducted IPOs during the 12 months prior to getting sued. Many of these IPO cases involved foreign domiciled companies. Perhaps it may be concluded that the 2007 uptick in Section 11 litigation was due to a wave of IPOs involving foreign companies that were not ready to go public. At a minimum, there are certainly other plausible explanations for the 2007 uptick in Section 11 litigation other than the WorldCom decision alone.

Not only does Michaels fail to consider other possible explanations for the anomalies in the data, but the basis on which he nevertheless argues that WorldCom decision alone explains the supposed increase is also suspect.

In effect, he urges us to conclude that because the supposed increase in Section 11 filings came after the WorldCom decision, the decision must have been the cause of the supposed increase. This analysis arguably represents an example of the logical fallacy post hoc ergo propter hoc (after this, therefore because of this). Essentially, Michaels is trying to substitute chronological sequence for causation. However, the mere order of events does not rule out other factors that might explain the data, as the preceding paragraph shows.

From my perspective, given the anomalousness of the 2007 data, it is premature to reach any conclusions without the opportunity to consider subsequent years’ data, to see, for example, whether the 2007 uptick represented a trend or (as I strongly suspect) is merely a statistical outlier. I can say from my own informal review of the 2008 year to date filing data, a much smaller percentage of 2008 cases involve IPOs (14 out of 195 year to date in 2008, compared to 29 out of 172 in 2007), which suggests that the number of Section 11 filings will prove to have been down substantially in 2008 compared to 2007.

The decline in 2008 IPO-related lawsuits is hardly surprising given the downturn in the number of IPOs in recent months. Given the low level of IPO activity during 2008, and indeed the low level of securities offerings of any kind, it seems probable that Section 11 litigation could well taper off in the months ahead. All of which suggests to me the inadvisability of trying to make a few months of filing data support sweeping conclusions.

It may well be, as Michaels argues, that WorldCom’s articulation of the Section 11 due diligence standard arguably is inconsistent with the ’33 Act’s goals, particularly to the extent it may result in the imposition of greater Section 11 liability on outside directors. I simply disagree with Michaels’s conclusion that WorldCom decision has demonstrably caused an increase in Section 11 filings. Michaels’s hypothesis may or may not eventually prove to be correct, but it will be a significantly longer period of time than he has allowed before we can reach any conclusions.

Special thanks to Werner Kranenburg of the With Vigour and Zeal blog for the link to Michaels’s article.

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In order to remedy the faulty link in the email distribution notice for today's post about the Countrywide subprime-related securities class action lawsuit, I have republished the post, which can be found here.

I apologize for any inconvenience that the faulty link in the prior email may have caused.

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On December 1, 2008, in a massive, detailed 112-page opinion (in three parts, here, here and here), Central District of California District Judge Mariana R. Pfaelzer substantially denied the defendants’ motions to dismiss the Countrywide subprime-related securities class action lawsuit.

Background regarding the case can be found here. The consolidated amended complaint can be found here.

Judge Pfaelzer’s ruling did dismiss with prejudice the plaintiffs’ claims against Grant Thornton, and also dismissed with prejudice allegations concerning certain alleged 2003 accounting misstatements as well as other specific alleged misstatements. Judge Pfaelzer also dismissed with leave to amend certain allegations as to certain defendants, but otherwise, and in substantial part, the motions were denied.

In certain respects, Judge Pfaelzer’s opinion may come as little surprise, as she wrote the lengthy May 2008 opinion denying the motion to dismiss in the separate California-based Countrywide subprime-related derivative lawsuit (about which refer here). Indeed, in her December 1 opinion in the securities lawsuit, Judge Pfaelzer even quotes her prior opinion in the derivative lawsuit.

If Judge Pfaelzer did not tip her hand about her views of the securities case in her prior opinion in the derivative case, she certainly did in the opening overview section of the December 1 opinion, in which she stated that the amended complaint’s allegations.

present the extraordinary case where a company’s essential operations were so at odds with the company’s public statements that many statements that would not be actionable in the vast majority of cases are rendered cognizable to the securities laws.

As an illustration, she notes that "descriptions such as ‘high quality’ are generally not actionable"; however, in this case, the amended complaint "adequately alleges that Countrywide’s practices so departed from its public statements that even ‘high quality’ became materially false and misleading" and "to apply the puffery rule to such allegations would deny that ‘high quality’ has any meaning."

Judge Pfaelzer’s view of the case may also be seen from her response to defendants’ arguments that allegations of falsity after the third quarter of 2007 should be barred because by that time the company was "forced to admit the poor quality of the mortgage loans." Judge Pfaelzer states that this argument "borders on the frivolous" because the 3Q07 disclosures "failed to correct all misrepresentations" but instead "the truth only gradually leaked."

That is not to say that Judge Pfaelzer is complimentary of the plaintiff’s pleading; to the contrary, she states that she "would have appreciated a complaint that is more concise, less redundant and better organized." She also noted that she "has little patience for excess – and 416 pages is excessive."

Having set the stage, Judge Pfaelzer then proceeded to undertake a painstaking review of each of the defendants’ dismissal grounds, substantially rejecting most of them.

Among her other noteworthy observations, and one that may reverberate in other subprime cases, is one she makes in connection with the defendants’ arguments based on market forces. Defendants in this case, as in many of the subprime cases, sought to argue that the company’s woes were largely due to marketwide forces. As Judge Pfaelzer put it, "for the past year, almost all defendants have recited…that an ‘unprecedented’ external ‘liquidity crisis’ caused all (or most) of Countrywide’s decline."

Judge Pfaelzer noted that Countrywide’s shares declined only as the company’s deteriorating underwriting standards came to light, though "Countrywide held itself out for a long while as situated differently than from other subprime lenders" and "concurrently with corrective disclosures" made "continued misrepresentations and omissions" into early 2008.

It is true, Judge Pfaelzer notes, that "the domestic market shifts will raise complicated questions on damages." But, she also notes by the same token, the amended complaint raises the "inference" that the company’s deteriorating lending standards "were causally linked to at least some of the macroeconomic shifts of the past year." In any event, she concludes that at this stage the issue is whether the alleged violations caused a loss, not how much of the loss the violations proximately caused.

With respect to the amended complaints Rule 10b-5 allegations, Judge Pfaelzer’s opinion concludes that the plaintiffs "have created a cogent and compelling inference of a company obsessed with loan production and market share with little regard for the attendant risks, despite the company’s repeated assurances to the market."

In concluding that the amended complaint adequately alleges scienter, Judge Pfaelzer relies in large part on the allegations of insider trading as well as allegations concerning the individual defendants’ respective positions of responsibility combined with their access to detailed underwriting information. Her analysis of the scienter issues relies heavily on her prior analysis of scienter in her May 2008 opinion in the Countrywide subprime-related derivative suit, and indeed, she repeatedly cites and even quotes her prior opinion.

In connection with the insider trading allegations, Judge Pfaelzer placed particular emphasis on the coincidence of the insiders’ sales with the company’s initiation of a share repurchase program financed with outside capital. The inference is that the company was raising funds to buy shares to keep the share price up so that the insiders could sell profitably.

She also specifically noted (as she did in her prior opinion in the derivative case) that former CEO Angelo Mozillo was increasing his sales, and even modifying his Rule 10b5-1 trading plan to facilitate further sales, as the company increased its share repurchases. She repeated her conclusion from the derivative suit that these actions defeat the very purpose of Rule 10b5-1 plans.

Based on the stock sales and the individuals’ positions within the company she concluded that there were no plausible innocent inferences (except to the extent that some of the chronologically earlier allegations involve periods prior to which certain individuals could have learned particularized information).

Finally, with respect to the loss causation issue, Judge Pfaelzer concluded that the amended complaint did not fail to establish loss causation merely because the corrective disclosures and the resulting stock declines were piecemeal. Citing the Ninth Circuit’s decision from earlier this year in the Gilead case (about which refer here), Judge Pfaelzer concluded that "loss causation is not precluded by a series of disclosures; serial disclosures just make it more difficult for plaintiffs as a practical matter."

In its overall effect, Judge Pfaelzer’s December 1 opinion is a substantial rebuttal to the suggestion I raised in an earlier post (here) that plaintiffs may not be faring well in the subprime cases. At a minimum, the opinion establishes that certain cases will survive preliminary motions and that the overall economic decline is, in and of itself, not a barrier to the assertion of securities violations, at least in certain cases.

The December 1 opinion may also be of in connection with attempts to hold companies’ auditors responsible for subprime problems. Though Judge Pfaelzer did allow the plaintiffs leave to amend their allegations against KPMG, her analysis in this opinion suggests that plaintiffs could well have difficulty presenting allegations that withstand scrutiny. Her analysis of the allegations against KPMG could have significance in connection with attempts in other subprime cases to hold auditors responsible. (Her dismissal of Grant Thornton is less relevant, as the dismissal largely relates to the firm’s early and limited involvement in the events described in the complaint.)

In any event, I have added Judge Pfaelzer’s opinion to my table of subprime case dispositions, which can be found here.

One final note, as I discussed here, in October 2008, the Delaware federal court dismissed the Delaware-based Countrywide subprime-related derivative lawsuit, due to the plaintiff’s lack of standing to pursue the case following Bank of America’s acquisition of Countrywide. It appears that the Delaware court’s decision had no impact of any kind on Judge Pfaelzer’s consideration of the motions to dismiss in the Countrywide securities suit.

Special thanks to a loyal reader for alerting me to the December 1 opinion.

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The subprime scapegoating process has resulted in a round up of the usual suspects, including directors and officers of publicly traded companies. But among other targets many aggrieved parties seem particularly keen to blame in the subprime debacle are the rating agencies.

In prior posts (most recently here), I have noted the securities claims that some investors are trying to assert against the rating agencies, notwithstanding the substantial legal barriers (about which refer here) that may exist to the rating agencies’ liability.

The urge to try to hold the rating agencies responsible has reached a creative new level in the action filed on November 17, 2008 by the National Community Reinvestment Coalition, a national coalition of over 600 community-based housing advocacy organizations, against Fitch’s and Moody’s. The complaint was filed with the Department of Housing and Urban Development’s (HUD) fair housing and equal opportunity unit.

The complaint, which can be found here, purports to be brought under the Fair Housing Act of 1968 and alleges that the defendants "facilitated, encouraged and profited from subprime loans that were designed to fail, due to unfair payment terms and borrower income levels that could not sustain home ownership based on those payment terms."

The complaint further alleges that the defendants "unlawful actions caused a disproportionate adverse impact on African Americans and Latinos." The defendants are alleged to have "facilitated…predatory real-estate transactions" through their "unwarranted ratings, which fueled and sustained subprime lending."

The defendants are also alleged to have "facilitated discriminatory conduct" because their "inflated ratings…allowed discriminatory securitized subprime loans to be originated, brokered and serviced." The defendants’ alleged role was "central" because "investors purchased securities based on their ratings," as a result of which the defendants "profited significantly." Further, the defendants "knew or should have known that the predatory practices permeated the subprime securitization market."

The complaint seeks a declaratory judgment that the rating agencies violated the FHAA, a permanent injunction requiring the agencies to "take all affirmative steps necessary to remedy the effect of the illegal, discriminatory conduct"; and to award NCRC compensatory damages "for the frustration of mission and diversion of resources" the defendants’ conduct allegedly caused.

In its November 18, 2008 press release announcing the complaint (here), NCRC states that if HUD "does not adequately address the issues in the complaint," then the NCRC "will consider civil litigation."

According to a November 29, 2008 Washington Post article describing the complaint (here), the complaint did not name S&P as a third defendant, because the NCRC is "in discussions" with S&P. However, the article also quotes an NCRC source as saying that if discussions with S&P are "unsatisfactory," the NCRC could institute a separate proceeding against S&P.

The NCRC complaint belongs in a category with the nuisance lawsuit the City of Cleveland filed against the major investment banks (about which refer here). Both actions involve novel legal theories, and both attempt to scapegoat downstream deep pockets for the consequences of upstream transactions. Both depend entirely on simplistic causation analyses that disregard the multitude of causes that contributed to the subprime mess.

These blame casting exercises may gratify claimants or even provide catharsis, but these exercises in creative lawyering (and I do not mean that as a compliment) will do little, other than contributing friction costs, to affect the current deplorable conditions in the housing market. To be sure, there are no easy solutions in these circumstances, but simplistic litigation definitely does not help.

Where Were the Auditors?:  A December 1, 2008 CFO.com article entitled "Subprime Suspects" (here) takes a look at the likelihood that litigants will seek to blame auditors for the financial meltdown. The article notes that while claimants undoubtedly will pursue the auditors, "it’s far from clear what burden they will bear – or even what they did wrong."

One school of thought claims the auditors "are at fault for overlooking inflated asset valuations during the mortgage bubble." The other camp says that the "auditors were doing fine until they forced banks to take overly severe write-downs on assets, based on fears that they would face punishment from regulators."

The article suggests that the audit firms "may yet prove bulletproof" because of the difficulty even proving misconduct at their financial institution clients. The firms, however, are likely to face further litigation and are in any event facing their own challenges as a result of the disruptions in the financial and economic marketplace.

Investors Sue Over Mortgage Loan Workouts: In an earlier post (here), I noted the objections investors have raised to the various mortgage modification proposals designed to provide relief to distressed homeowners. I specifically noted concerns investors had raised about the Bank of America’s regulatory settlement in which the bank proposed to restructure over 400,000 mortgages the Countrywide Financial Corporation had originated prior to being acquired by BoA.

As discussed in a December 1, 2008 Business Week article (here), mortgage investors have now initiated a purported class action lawsuit alleging that the proposed modification of the Countrywide mortgages is illegal. The article quotes the lawsuit plaintiff as saying "while these loan adjustments may help to keep struggling borrowers in their homes," the alterations "run the risk of permanently damaging the secondary market for housing finance."

The investor 's lawsuit in New York (New York County) Supreme Court seeks a judicial declaration that under the terms governing the mortgage trust holding the securitized mortgages, "Countrywide is required to purchase any loans on which it agrees to reduce the payments." A copy of the state court complaint can be found here.

Special thanks to David Grais of the Grais & Ellsworth firm (which represents the plaintiff in the declaratory judgment action) for providing a copy of the state court complaint.

The investors clearly are committed to having their concerns about the mortgage modifications heard. The political pressure to provide mortgage relief is substantial. However, there does seem to be reason to be concerned whether future investors will be interested in investing in this class of assets if the investment agreements can be unilaterally altered.

Lehman Excavation: The November 30, 2008 issue of New York Magazine has a cover article entitled "Burning Down His House" (here) about the fall of Lehman Brothers and the role of Lehman CEO Richard Fuld in the firm’s collapse. The article raises the question whether Fuld is a dupe or a victim; the article says:

He held on to 10 million shares of Lehman stock until the end and lost almost $1 billion – "He drank the Kool Aid," said one executive. And consensus grows that the Lehman fall was one of Treasury Secretary Henry Paulson’s and Fed chairman Ben Bernanke’s biggest mistakes.

Professor Ribstein, on his Ideoblog (here), citing the article’s statement that Lehman was "in a financial condition that was even worse than critics suspected," interprets the article as suggesting that Fuld may be the "next loser in the corporate crime lottery."

Hat tip to the Securities Docket blog (here) for the link to the New York Magazine article.

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In a November 26, 2008 opinion (here), the Ninth Circuit affirmed the lower court’s dismissal of a lawsuit asserting securities law violations against InVision and certain of its directors and officers based on FCPA-related disclosures. The case is noteworthy not only for its involvement of FCPA-related allegations, but also for the appellate court’s consideration of "collective scienter" issues, as well as of the significance of Sarbanes-Oxley certification issues.

Background

On March 15, 2004, InVision announced it would be acquired by GE in a cash-for-stock transaction. That same day, the company filed its annual filing on Form 10-K to which the merger agreement was attached. On July 30, 2004, InVision announced that an internal investigation had revealed possible violations of the Foreign Corrupt Practices Act (FCPA). The company voluntarily reported the activities to the SEC and the DOJ. The company later entered negotiated arrangements with the DOJ and the SEC (refer here). GE later consummated the pending merger.

Shortly after InVision announced the FCPA concerns, shareholders initiated a securities class action lawsuit against the company and certain of its directors and officers. (Refer here for further background regarding the case). The plaintiffs based their claims on three alleged misstatements in the merger agreements, which InVision had attached to its 10-K.

The plaintiffs alleged that the merger agreement misleadingly stated that the company was "in compliance … with all applicable law"; in compliance with the "books and records" provision of the FCPA; and that that neither the company nor any of its officers, directors or employees had knowledge that the company had violated the FCPA’s antibribery provisions.

The district court dismissed the complaint and the plaintiffs appealed.

The Ninth Circuit’s Decision

The appellate court essentially assumed that the plaintiff had satisfied the requirement to plead falsity with respect to the three alleged misrepresentations stating that "even if [the plaintiff, Glazer] properly pled falsity, the district court’s dismissal would still be appropriate if Glazer failed to plead scienter adequately with respect to the three statements."

In order to satisfy the scienter requirement, the plaintiff urged the Ninth Circuit to adopt the "collective scienter" theory, following the Second Circuit’s recent decision in the Dynex Capital case (refer here) and the Seventh Circuit’s recent decision in the Tellabs case (refer here). Under this theory, as articulated by the Seventh Circuit, "it is possible to draw a strong inference of corporate scienter without being able to name the individuals who concocted and disseminated the fraud."

After reviewing the case law concerning corporate securities liability, including its own prior decision in the Nordstrom v. Chubb case (a decision that will be familiar to many of this blog’s readers), the Ninth Circuit ultimately concluded that this case did not require the court to decide whether or not to adopt the theory of collective scienter.

The court concluded that because of "the limited nature and unique context of the alleged misstatements" involved in the case, the "collective scienter" issue was not before the court. In reaching this conclusion, the court noted that

Glazer rests its securities fraud claim on three statements, all of which appear in a sixty-page legal document. If the doctrine of collective scienter excuses Glazer from pleading individual scienter with respect to these legal warranties, then it is difficult to imagine what statements would not qualify for an exception to individualized scienter pleadings. In fact, because the merger agreement warranted that the company was in compliance "with all laws," then under the collective scienter theory urged by Glazer, so long as any employee at InVision had knowledge of the violation of any law, scienter could be imputed to the company as a whole. This result would be plainly inconsistent with the pleading requirements of the PSLRA.

 

Accordingly, the Ninth Circuit held that in order to succeed on his claim, the plaintiff had to establish that individual defendants acted with scienter in making the statements in the merger agreement. The court said that "we see no way that [the defendant] could show that the corporation, but not any individual [director or officer] had the requisite intent to defraud." Only the company’s CEO and CFO had signed the merger agreement, and the plaintiff alleged scienter only with respect to the CEO, Magistri.

The court found with respect to Magistri, however, that Glazer had not pled any facts to demonstrate that "Magistri was personally aware of the illegal payments or that he was actively involved in the details of the details of InVision’s Asian sales."

The Ninth Circuit also refused to infer scienter from the CEO’s and the CFO’s signature of the Sarbanes-Oxley certifications, holding that the mere signature, without more, is insufficient to raise a strong inference of scienter.The Ninth Circuit followed prior decisions of the Eleventh and Fifth Circuits, concluding that there was no evidence that the SOX certification requirements were intended to alter the PSLRA’s pleading requirements. The Court said that "the Sarbanes-Oxley certification is only probative of scienter if the person signing the certification was severely reckless in certifying the accuracy of the financial statements.

Discussion

The Ninth Circuit’s decision is noteworthy for its discussion of the "collective scienter" issue, although in the end it is of limited significance on this point given the court’s conclusion that it did not need to reach that issue. The decision is also noteworthy for its discussion of the Sarbanes-Oxley certification issue, but in that respect it also merely followed existing precedent.

But perhaps the greatest significance about the Ninth Circuit’s opinion may be what it suggests about securities cases based on FCPA-related disclosures. The Ninth Circuit’s refusal to allow the claim to proceed in the absence of allegations that senior officials were aware of the improper conduct could present a significant hurdle for FCPA-related securities claims, at least in the circuits that have not adopted the "collective scienter" theory.

As the Ninth Circuit noted in the InVision case, "the surreptitious nature of the transactions creates an equally strong inference that the payments would have deliberately kept secret – even within the company." Obviously, payments of this kind invariably are of a surreptitious nature and of a kind that would be kept secret, even within the company. The implication is that in order for a securities claim alleging FCPA-related disclosures to survive the initial pleadings stage, the claimants may have to plead that the company officials who prepared the company’s public disclosures were aware of the improper activities.

In prior posts (most recently here), I have noted the increasing prevalence of follow-on civil litigation accompanying FCPA investigations, including the increasing frequency of follow-on securities litigation alleging misrepresentations in the FCPA-related disclosures. The Ninth Circuit’s decision in the InVision case suggests that, at least in jurisdictions that have not recognized the collective scienter theory, the ability of these follow-on securities lawsuits to get past the pleading stage may depend on the existence of allegations that senior company officials were aware of the improper payments. Given the invariably "surreptitious nature" of these payments, claimants may find this a challenging requirement to satisfy.

The SEC Actions blog has a thorough analysis of the Ninth Circuit’s discussion of the pleading issues in the InVision case, here. The FCPA Blog also has a good discussion of the case, here.

Special thanks to Neil McCarthy of Lawyerlinks.com for providing me with a copy of the Ninth Circuit’s opinion.

Another New Wave Securities Lawsuit: In a recent post (here), I noted that there have been several recent securities class action lawsuits in which the companies involved have been hit with significant losses due to wrong way bets on commodities or currencies.

The latest example of this type of securities litigation involves a case filed on November 26, 2008 in the Southern District of Florida against Brazilian forest products manufacturer Aracruz Cellulose S.A. and certain of its directors and officers on behalf of investors who purchased the company’s American Depositary Receipts on the NYSE., as well as purchasers of the company’s common stock, which trades on the Sao Paulo Bovespa.

According to the plaintiffs’ lawyer November 26 press release (here), the complaint alleges that

During the Class Period, Aracruz entered into undisclosed currency derivative contracts to purportedly hedge against the Company's U.S. dollar exposure. The Company characterized the use of these contracts as protection against foreign interest rate volatility and assured investors that this type of trading did not represent "a risk from an economic and financial standpoint." However, these contracts violated Company policy in that they were far larger than necessary to hedge normal business operations. As a result of Aracruz's clandestine and speculative currency wagers, credit rating agencies downgraded Aracruz, the Company's CFO resigned, and Aracruz's stock suffered a severe decline, plummeting to the lowest levels in 14 years.

As I noted in my prior post, many companies were also exposed to sudden and unexpected losses by dramatic changes in the commodities and currencies markets earlier this year. For example, the November 29, 2008 Wall Street Journal reported (here) on several airlines that have recently reported the negative impact from fuel cost hedges that generated huge losses. These kinds of developments and other unexpected fallout from the crisis roiling global financial markets are likely to affect a wide variety of companies, some of which may be subject to securities litigation.

It is interesting to note that the plaintiffs’ lawyers in the Aracruz case appear to have made a conscious decision to include within the class the Brazilian company’s common shareholders. Within this group are likely to be a number of shareholders domiciled outside the U.S. that bought their shares against the foreign company on a foreign exchange. The presence of these so-called "foreign-cubed" litigants could pose subject matter jurisdiction issues, at least as to those claimants.

My recent post discussing the Second Circuit’s recent "foreign-cubed" litigant ruling in the National Australia Bank case can be found here. The November 24, 2008 Southern District of New York decision granting the motion to dismiss the securities class action lawsuit that had been filed against Vodafone for lack of subject matter jurisdiction, in reliance upon the National Australia Bank decision, can be found here. (Note: Special thanks to the reader who pointed out that I had incorrectly referred to the Vodafone case as the Vivendi case. My apologies for any confusion.)

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