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

Among the recurring sources of D&O insurance coverage disputes are issues relating to timely notice of claim. A 6-3 decision by the Texas Supreme Court on March 27, 2009 (here), written over a vigorous dissent (here), recapitulates many of the perennial notice issues and reaches a result that while unquestionably policyholder friendly also poses certain concerns.

Background

At the time of FlashNet Communications May 2000 merger with Prodigy Communications, FlashNet purchased a 3-year discovery period under its existing D&O insurance program, which extended coverage for claims first made during the period May 31, 2000 to May 31, 2003.

The notice provision in the policy had been amended. The original provision required as a "condition precedent to coverage" that the insured provide notice of claim "as soon as practicable…but in no event later than ninety (90) days after such claim is made." The amended provision required "as a condition precedent" to coverage that the insured provide "notice, in writing, as soon as practicable of any claim first made against [the insureds] during the Policy Period, or Discovery Period (if applicable) but in no event later than ninety (90) days after the expiration of the Policy Period, or Discovery Period."

On November 28, 2001, FlashNet was named as a defendant in a securities class action lawsuit that was one of the many IPO laddering cases. Prodigy was served with a copy of the complaint on June 20, 2002.

Prodigy first communicated with the insurer by letter dated June 6, 2003, in which Prodigy sought the insurer’s consent under the policy to settlement of the securities case. The insurer responded that the June 6 letter failed to comply with the policy’s notice requirements. In reply, Prodigy sent a formal notice of claim on June26, 2003, which Prodigy claimed was timely because it was sent within ninety days of the May 31, 2003 expiration of the 3-year discovery period. The carrier denied coverage and Prodigy initiated an action seeking a judicial declaration of coverage.

Proceedings Below

The trial court ruled that Prodigy had failed to comply with the condition precedent to coverage and that this failure "avoids coverage, with or without prejudice to [the insurer]." The court of appeals affirmed, holding among other things that notice given almost one year after the lawsuit was filed was not "as soon as practicable," and that the insurer was not required to proved that it was prejudiced.

The Majority’s Opinion

Chief Justice Wallace B. Jefferson’s opinion for the majority framed the question before the court as "whether, under a claims made policy, an insurer can deny coverage based on its insured’s alleged failure to comply with a policy provision requiring that notice of claim be given ‘as soon as practicable’ when (1) notice of claim was provided before the reporting deadline specified in the policy; and (2) the insurer was not prejudiced by the delay."

The majority did not consider it determinative that notice as "as soon as practicable" was identified in the policy as a "condition precedent" to coverage. Rather, the Chief Justice wrote, in order to determine whether or not a showing of prejudice is or is not also required in order for the insurer to assert late notice as a defense to coverage, the question is whether the "notice as soon as practicable" language was "an essential part of the bargained-for exchange in the claims made policy at issue."

After reviewing the role of the notice provisions within claims made policies generally, the Chief Justice concluded that the insured’s obligation to provide notice "as soon as practicable" was "not a material part of the bargained-for exchange," and further concluded that "in a claims-made policy, when an insured gives notice of a claim within the policy period or other specified reporting period, the insurer must show that the insured’s noncompliance with the policy’s ‘as soon as practicable’ notice provision prejudiced the insurer before it may deny coverage."

Therefore, because the insurer had admitted that it was not prejudiced by the delay in receiving notice, the majority held that the insurer could not deny coverage based on Prodigy’s failure to provide notice as soon as practicable.

The Dissenting Opinion

The dissenting opinion, written by Justice Phil Johnson and joined in by two other justices, asserted that "today the Court rewrites an unambiguous insurance contract and changes the agreement of the parties." Justice Johnson wrote that "the record does not show as a matter of law that the notice language was not essential to the parties’ agreement," adding that "the Court’s conclusion otherwise is in derogation of the parties’ intent as expressed by the policy language."

Justice Johnson added that "there is no basis in the record for concluding that Prodigy’s one-year delay in reporting the claim was any more or less important to [the insurer’s] insurance business than if Prodigy had delayed for a year reporting a claim made on the last day of the Discovery Period."

Discussion

If nothing else, the majority opinion in this case confirms the frequent observation that courts disfavor insurance coverage denials based on late notice defenses. The general reluctance of courts to recognize notice defenses is based on an apparent perception that a policy notice requirement can operate like a "gotcha" to cut insureds off from the policy coverage for which they paid and to which they would have been entitled if notice were timely – and if the carrier is not prejudiced by the late notice, well then, no harm, no foul, right?

But even allowing for these assumed biases, the majority’s opinion’s disregard of the policy’s explicit "condition precedent" language and its own determination that the "as soon as practicable" language was "not a material part of the bargained for exchange" are both discomfiting.

Some perspective seems in order here. Not only was Prodigy’s notice to the insurer delayed by nearly a year, but Prodigy’s first contact with the insurer was a request for settlement consent. At some level, these facts exemplify the very kinds of circumstances to which insurers will sometimes refer in attempting to explain why notice provisions are necessary.

It may well be objected that if the insurer was not prejudiced by the delay here, what difference did the one-year delay really make? The typical insurer answer to this question is that they don’t want to get caught up in sometimes complicated and potentially fraught debates about whether or not a delay prejudiced their interests. After all, what really constitutes prejudice? What has to shown to establish prejudice? Rather than having to debate these kinds of fact intensive and divisive issues, the insurers prefer certain bright line tests that specify the minimal requirements under certain circumstances.

On the other hand, the policy language itself may have preordained a policyholder friendly outcome here. The notice provision the court was interpreting had in fact been amended to make it more policyholder friendly, by substituting the more flexible "as soon as practicable language" for the policy’s base form requirement of notice within a specified number of days.

The question is whether the majority opinion’s ruling represents more of a policyholder friendly outcome than the insurers may have thought they were offering with the more flexible language – an outcome that may in the future constrain the insurers’ willingness to offer the flexible language and encourage them to insist on more rigid alternatives as reaction to this kind of outcome. A more rigid approach could in turn lead to more questions about the timeliness of notice and potentially to more coverage disputes.

All of that said, and knowing full well how devastating any coverage denial can be to policyholders, and how some clerical or administrative error potentially could produce notice problems that otherwise might leave policyholders in the lurch, there arguably is some fundamental fairness to the judicial system’s chronic suspicion of notice defenses. Viewed in that light, the outcome in the Prodigy case is at least understandable, even if the majority opinion itself could be unsettling in certain respects.

Special thanks to the several readers who provided me with copies of the Prodigy opinion.

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A rare jury trial has commenced in a long-running securities lawsuit that resonates with overtones of the current subprime mortgage meltdown. On March 30, 2009, Northern District of Illinois Ronald Guzman began empanelling a jury in the securities class action lawsuit styled as Lawrence E. Jaffee Pension Plan v. Household International, Inc., a case that has been pending since August 2002. Background regarding the case can be found here.

According to the plaintiffs’ consolidated amended complaint (here), the case was brought on behalf of all persons who acquired Household International securities between October 23, 1997 and October 11, 2002. The plaintiffs contend that during the class period, the defendants concealed that Household "was engaged in a massive predatory lending scheme."

According to the complaint, Household "engaged in widespread abuse of its customers through a variety of illegal sales practices and improper lending techniques." Household also reported "false statistics" that were intended to "give the appearance that the credit quality of Household’s borrowers was more favorable that it actually was." The plaintiffs allege that the "defendants’ scheme" allowed them "to artificially inflate the Company’s financial and operational results."

In the third quarter of 2002, the company took a $600 million charge and restated its financial statements for the preceding eight years, and in October 2002, the company announced that it had entered into a $484 regulatory settlement regarding its lending practices. On November 14, 2002, the company announced that it was to be acquired by HSBC Holdings. (In recent months, HSBC’s results have been significantly affected by losses in the subprime mortgage portfolio it acquired in the Household deal and its chairman has publicly admitted that "with the benefit of hindsight, this is an acquisition that we wish we had not undertaken.")

The defendants in the lawsuit include Household International and its mortgage finance subsidiary, Household FInancial Corporation, and Household’s former CEO and CFO, as well as one other former individual officer of the company, as well as the former company’s former directors. The company’s offering underwriters were also initially named as defendants, but they were later dismissed from the case (refer here). The plaintiffs also reached a prior settlement with the company’s former auditor, Arthur Anderson.

According to news reports (here), Judge Guzman has bifurcated the case into two parts, with a damages phase to follow the initial liability phase, which is expected to last four weeks, if the initial phase results in a finding of liability.

As most readers undoubtedly are aware, jury trials in securities class action lawsuits are extremely rare. According to data compiled by Adam Savett at the Securities Litigation Watch (here), only 20 cases have gone to trial since the PSLRA was enacted in 1995. Six of those 20 cases involved conduct that occurred after the PSLRA’s enactment.

Two recent high profile trials involved JDS Uniphase and Apollo Group. As noted here, on November 27, 2007, the jury in the JDS Uniphase trial returned a defense verdict. The Apollo Group trial initially resulted in a January 2008 plaintiffs’ verdict and an award of $277.5 million in damages, but as detailed here, on August 4, 2008, the judge granted the defendants’ motion for judgment as a matter of law, which set aside the jury verdict. A detailed discussion of the two cases can be found here.

With the adjustment for the post-trial motion in the Apollo Group case, the jury verdict scoreboard for the six post-PSLRA cases now stands at three each for the plaintiffs and defendants, as explained in my post regarding the Apollo Group post trial motion.

As for the question why this case is going to trial when so many others settle, there undoubtedly are many factors but one may be the "billion-dollar price tag" that news reports suggest that plaintiffs have put on the case.

A March 30, 2009 AmLaw Daily article discussing the case can be found here.

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Along with the flood of securities lawsuits, the current credit crisis has also generated a wave of litigation under ERISA, as I have detailed here. And just as many of the credit crisis-related securities cases have failed to survive preliminary judicial scrutiny (as noted recently here), at least some of the ERISA cases also may encounter judicial skepticism, if the recent decision in the Huntington Bancshares ERISA litigation is any indication.

On February 9, 2009, in an opinion that bespeaks a reluctance to sustain litigation based on the effects of the global financial crisis, Southern District of Ohio Judge Gregory Frost granted the defendants’ motion to dismiss in the Huntington ERISA case. A copy of the opinion can be found here.

Background

The lawsuit had been brought on behalf of participants in Huntington’s 401(k) plan. The plaintiffs alleged that the plan fiduciaries breached their fiduciary duties in connection with Huntington’s July 1, 2007 acquisition of Sky Financial. The plaintiffs alleged that Huntington’s risk of loss greatly increased by subjecting Huntington to $1.5 billion of subprime exposure through Sky’s relationship with Franklin Credit Management Corp.

The plaintiffs alleged that because of the merger with Sky Financial and its subprime exposure, Huntington stock became too risky to be considered a prudent plan investment. The plaintiffs alleged that the defendants failed to take any action to protect the plan assets from the "enormous and entirely foreseeable" risk that he increased subprime exposure would injure the plan and its participants’ retirement savings. The plaintiffs claim that defendants’ alleged breaches caused over $100 million in losses to the plan.

The February 9 Opinion

Judge Frost first agreed with the defendant’s contention that the plaintiffs’ allegation that Huntington violated ERISA when is acquired Sky "is simply an attempt to second guess Huntington’s business decisions and is not governed by ERISA."

Judge Frost also rejected plaintiffs’ claim that the defendants breached their fiduciary duty when they continued to invest in Huntington shares after the merger. Among other things, Judge Frost noted that large public pension funds had continued to invest in Huntington, and indeed had even increased their investment, after the merger.

He also noted that "although Huntington has experienced a significant drop in its stock price," its share price essentially "moved in tandem with the other regional banks in Huntington’s geographic footprint." Judge Frost also noted that the plaintiffs "do not point to any ‘red flags’ that should have placed Defendants on notice of a need to cease offering the Huntington stock."

Judge Frost also rejected plaintiffs’ allegation that defendants had failed to warn investors (including plan participants) of the risk, finding that in its SEC filings, Huntington "specifically disclosed its exposure to subprime, housing and construction markets and frequently disclosed the effect of increasing market turmoil."

Discussion

Judge Frost’s rejection of the plaintiffs’ ERISA claims was based on the specifics of plaintiffs’ allegations. However, his rejection was also clearly based in part on his perception of what the case represents. Among other things, he observed that:

it is clear that federal courts are currently experiencing a significant rise in "stock drop cases" due to the current status of the Stock Market and the economic climate in general, which of course includes the subprime lending crisis. However, ERISA was not intended to be a shield from the sometimes volatile stock market.

Judge Frost’s reference to "stock drop cases" shows not only how he perceived the Huntington case itself but also reflects a more general perception of the overall subprime litigation wave – that is, that the current influx of cases is the due to stock market volatility caused by the global economic downturn.

His general view the subprime cases represent an effort by investors to avoid the consequences of market volatility could, if widely shared, represent a substantial hurdle to the plaintiffs in many of these cases – both cases filed under ERISA as well as cases filed under the federal securities laws. Indeed, I have already noted (most recently here) numerous other credit crisis-related securities cases where courts clearly have shown skepticism that the plaintiffs’ losses were the result of anything other than the financial crisis itself.

To be sure, there have been subprime-related ERISA cases that have survived dismissal motions, just as there have also been subprime and credit crisis-related securities lawsuits that have survived motions to dismiss. For example, as I discussed here, the judge in the NovaStar ERISA case recently denied the defendants’ motion to dismiss, a decision that is particularly noteworthy because the motion to dismiss was granted in the NovaStar subprime-related securities lawsuit. (My discussion of the NovaStar securities lawsuit dismissal with prejudice can be found here.)

But while some of the ERISA cases may yet survive preliminary motions, many of the cases could also face the same kind of judicial skepticism reflected in Judge Frost’s opinion in the Huntington case. If so, a substantial number of the lawsuits being filed in the current wave of subprime and credit crisis-related litigation could fail to make it past the preliminary stages.

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

Special thanks to a loyal reader for providing me with a copy of the Huntington opinion.

An Unusual Madoff Victim Has Unusual Problems: As reflected in my register of Madoff-related litigation (which can be accessed here), the Madoff scandal has resulted in a wide range of suits and other legal proceedings. But the most unusual of the Madoff-related proceedings may be the motion for temporary restraining order and preliminary injunction filed on March 11, 2009 against Bernard Madoff in the Middle District of Florida by Gino Romano.

In his hand-written motion (a copy of which can be found here), Romano, an inmate in the federal prison system, alleges that Madoff enlisted him to recruit other inmates to invest with Madoff, by guaranteeing Romano "an annual return of 18.5%." Romano alleges that Madoff initiated this contact with Romano by sending him an "investment package" in January 2005.

Romano alleges that he "collected $1 million dollars from gang leaders" including members of "the Mexican Mafia, Chicago’s Gangster Disciples, the Black Panthers, the Aryan Brotherhood, and D.C. Blacks." Romano asserts that "now I’m in danger from these gangs because Madoff Ponzi scammed us."

The dangers Romano claims he now faces include not only irate gang members, but Madoff himself, whom Romano asserts has sent Romano threatening letters. Among other things, Madoff allegedly has communicated to Romano that "he is going to kill me and he has stolen Ponzi money to hire the best hitman money can buy."

As readers might well imagine, Romano finds all of this very distressing. He alleges that because of Madoff’s threats he has "suffered a mental breakdown, bed wetting, [and] panic attacks."

Call my cynical, but I have my doubts about many of Romano’s allegations. However, I am willing to allow the possibility that the part about "bed wetting" might well be true – although it seems unlikely that Madoff is responsible for that.

Special thanks to loyal reader Jon Jacobson for providing me with copies of numerous new Madoff-related pleadings, including Romano’s. I have added all of these new pleadings to my register of Madoff-related suits (here).

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On March 18, 2009, Judge John F. Walter of the Southern District of California granted the defendants' motion to dismiss, with leave to amend, in the subprim-related securities lawsuit involving certain former directors and officers of Downey Financial Corp. A copy of the order can be found here.

Background

Securities class action lawsuits were first filed against Downey and certain of its directors and officers in May 2008, following the company's announcement before the market opened on March 17, 2008 that the company had experienced a significant increase in its nonperforming assets and that it found itself forced to restructure its loans with many borrowers. As reflected in its subsequently filed First Amended Consolidated Complaint , the plaintiff alleged that

(a) defendants' portfolio of Option ARMs contained millions of dollars worth of impaired and risky securities, many of which were backed by subprime mortgage loans; (b) prior to the Class Period, Downey had seen Countrywide's growth and had started to get more aggressive in acquiring loans from brokers such that the loans were extremely risky; (c) defendants failed to properly account for highly leveraged loans such as mortgage securities; (d) Downey had very little real underwriting, which led to large numbers of bad loans that would cause huge numbers of defaults; and (e) Downey had not adequately reserved for Option ARM loans, the terms of which provided that during the initial term of the loan borrowers could pay only as much as they desired with any underpayment being added to the loan balance.

In the amended complaint, the plaintiff alleged certain specific misrepresentations as to each of the three defendants, as well as other misrepresentation not attributed to any one defendant.

On November 21, 2008, the FDIC took control of Downey and sold its assets to another institution (about which refer here).

 The March 18 Order

The defendants moved to dismiss the plaintiffs complaint. Judge Walker summarized the plaintiff's amended complaint (and perhaps tipped his hand about how he felt about plaintiff's allegations) when he observed that "in short, Plaintiff alleges that the decline in Downey's shareholder value resulted from alleged misrepresentations made to the investing public by Downey's current and former officers and/or directors, and not from the current economic climate."

Judge Walker granted the motion on each of the grounds urged by the defendants: he found as follows: first, that the plaintiff failed to plead that the individual defendants made a material misrepresentation or omission; second, that the plaintiff failed to plead scienter adequately; and third, that plaintiff had failed to plead loss causation adequately.

With respect to the individual defendants' own alleged misrepresentations, Judge Walter found that "there is not a single actionable misrepresentation or omission in the 161 pages of the [amended complaint] attributed to the Individual Defendants."The specific statements on which plaintiffs sought to rely were "far too vague to be actionable."

He also found that "the general allegations against Downey cannot be attributed to the Individual Defendants under the group pleading doctrine, because as this Court previously held, the group pleading doctrine did not survive the PSLRA."

With respect to the issue of scienter, Judge Walter found that the plaintiff's allegations "when considered collectively, do not give rise to a strong inference of scienter." In reaching this conclusion, Judge Walter specifically observed that the defendants' corporate positions alone do not give rise to scienter.

He similarly found that the plaintiff had not adequately pled scienter in connection with Downey's public filings; the resignation and termination of Downey officials; the plaintiffs' allegations of GAAP violations; and allegations based on confidential witness statements. In each instance, Judge Walter said the allegation were too vague and general and lacked the requisite specificity.

Judge Walter also found the absence of insider stock sales also negated the inference of scienter. He observed that two of the individual defendants had not sold any of their massive holdings of Downey stock. He found that “their substantial losses suffered "¦due to the failure to sell any stock during the class period negates any inference of scienter that may have been raised by other allegations."

Finally, with respect to loss causation, Judge Walter found that "the public disclosures referred to in the [amended complaint] do not contain disclosure of wrongdoing, and, at best, demonstrate only that the market learned of and reacted to Downey's 'poor financial health' rather than any alleged fraud."

Judge Walter gave the plaintiff leave to file an amended complaint by April 1, 2009.

Discussion

Judge Walter's opinion has a number of interesting features. First, in rejecting plaintiff's contention that the defendants had misrepresented Downey's exposure to "subprime" loans, he rejected plaintiff's contention that a subprime loan is any loan made to a borrower with a FICO score below 660. He accepted defendantss argument that the company had fully disclosed that the company itself defined a subprime loan as one made to a borrower with a FICO score below 620. Because the company had fully disclosed its own definition of "subprime" loans (which definition Judge Walter also found had some support in financial literature), the defendants could rely on the company's own definition of "subprime" in arguing that there had been no misrepresentations about the company's exposure to subprime loans. 

Second, Judge Walter's blanket statement that the "group pleading doctrine" did not survive the PSLRA is interesting, but it is a view that is not necessarily universally shared. Indeed, as I have noted elsewhere, the group pleading doctrine has recently undergone something of a revival in recent months.

In any event, the Downey Financial case can now be added to the lengthening list of subprime-related securities lawsuits in which motions to dismiss have been granted. It is also yet another example of a case, along with NovaStar Financial

I have added the Downey Financial decision to my register of subprime-related securities lawsuit settlements, dismissals and dismissal motion denials, which can be accessed here.

Special thanks to a loyal reader for providing a copy of the Downey Order.

More Bank Failures: On March 20, 2009, the FDIC took control of three more banks: TeamBank N.A. of Paolo Kansas (refer here); Colorado National Bank, Colorado Springs, Colorado (refer here); and First City Bank, of Stockbridge, Georgia (refer here). The addition of these three banks brings the 2009 year to day bank failure tally to 20 (compared to 25 during the entire year of 2008). The FirstCity Bank closure is the eighth in Georgia since October 2007. The FDIC’s complete list of failed banks can be found here.

The possibility of additional claims growing out of these continuing banks failures undoubtedly remains as a significant factor, but prospective claimants might do well to review Judge Walter's opinion in the Downey Financial case before pulling the trigger on filing a new securities lawsuit against the failed bank's former directors and officers.

Apologies: I apologize for any typing, layout, font, or other errors that may appear in the published version of this post. I had more technical difficulties getting this one online than just about anything I have ever attempted with this blog. Gremlins, I suppose.

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Private equity firms and the funds they organize frequently place individuals on their portfolio companies’ boards. However, all too frequently, it is not until a claim has arisen that the various entities consider how the potentially implicated indemnities and insurance will interact. Unanticipated interactions sometimes can produce unintended consequences, particularly from the perspective of the private equity firm.

A March 19, 2009 article by the Latham & Watkins firm on the Harvard Law School Corporate Governance Forum blog entitled "Indemnification of Director-representatives by PE Firms" (here) takes a closer look at these issues.

Among other things, the authors note that "the allocation of responsibility for indemnification and advancement obligations … are not considered until after litigation has been filed" and the same "holds true with respect to the amount of available insurance, especially at the portfolio company level."

The authors offer a number of excellent practical suggestions.

First, they suggest that the contractual arrangements between the private equity firm and the individuals serving on the portfolio company boards "provide clearly that the private equity firm’s indemnification and advancement obligations to its director-representatives are secondary to the indemnification and advancement obligations of the portfolio company." Otherwise, courts may consider the private equity firm and the portfolio company to be "co-equally liable," which could prove very costly for the private equity firm if it advances costs in the first instance and later seeks reimbursement from the portfolio company.

Second, the authors suggest that if the indemnification documents with the director-representative cannot be modified, the private equity firm "should seek an assignment of the director-representative’s rights to indemnification and advancement from the portfolio company prior to the fund paying out defense or settlement costs on their director-designees’ behalf."

Third, the authors point out that advancement rights are distinct from indemnification rights, and they suggest that the portfolio company’s advancement commitments "should be examined to be certain that advancement is contractually required and that any advancement obligations owed by the private equity firm or its fund are secondary to the obligations of the portfolio firm."

The authors’ final observations relate to insurance. They comment that typically "neither the director nor the private equity firm will look at the portfolio company’s D&O insurance policies until after the director needs to defend/or settle such claims."

The authors correctly note that the private equity firm should review the portfolio company’s policies to ensure that the policies are "adequate to protect their director-representatives." The authors also suggest a review of the provisions that will determine how the portfolio company’s policies and the private equity firm’s policies will interact in order to "prevent a battle of the insurance companies."

The authors cite the interaction between the portfolio company’s D&O insurance policy and the private equity firm’s policy as a potential concern. These insurance issues become particularly critical if the portfolio company goes bankrupt, in which case portfolio company indemnity issues drop out of the picture and the portfolio company's insurance can becomes critical.

Bankruptcy often has a way of demonstrating the insufficiency of the limits of insurance that the portfolio company purchased. Moreover, bankruptcy also has a way of demonstrating –after the fact – the need for auxiliary insurance structures (such as Side A/DIC insurance or independent director insurance) to protect individuals in the event of complex claims while the portfolio company is bankrupt.

The authors are correct that the the various potentially implicated insurance policies terms and prospective insurance interactions all too often go unexamined. However, looking at the terms alone is not enough. Limits selection and program structure should also be carefully considered. Private equity firms should take steps to ensure that the portfolio company’s insurance program will sufficiently protect the director-representatives in all contingencies, even bankruptcy—or, rather, especially in bankruptcy.

I disagree with the article’s authors on one point. The authors state that "private equity firms should also strongly consider having the same carrier write the primary policies at both the firm and at each of its portfolio companies." The authors suggest this approach avoids the "other guy’s" policy coverage dodge.

The authors are correct that this would avoid the "not my problem" dodge. But it could be a terrible insurance solution in every other respect, both for the private equity firm and for the portfolio companies. First, from the private equity firm's perspective, there are relatively few carriers willing to write those kinds of risks in the first place, and within that small group, the available terms and conditions vary dramatically. The private equity firm should focus first on placing the optimal insurance solution for its own risks and needs, without being forced to accept a suboptimal solution out of an artificial effort to try to match carriers with its portfolio companies.

By the same token, the portfolio companies are unlikely to have uniform exposures and interests. Given the incredible diversity of potential insurance alternatives available in the marketplace, it is very unlikely that the same carrier would provide the best insurance solution for each of the various portfolio companies. And by the same token, the portfolio companies should not have their range of potential D&O insurers restricted only to the relatively few carriers that also will write private equity firm D&O insurance.

In short, trying to cram all of the various insured entities under a single carrier’s umbrella could address one single issue but create a host of potentially more significant problems as a result. The preferred approach is exactly the one the authors otherwise recommend, which is to consider policy interaction issues in connection with the insurance placement process – a process that should in the first instance be addressed to providing the best solutions for each respective entity.

The authors’ interesting article highlights the need for private equity firms to enlist knowledgeable and experienced insurance professionals in connection with their insurance placement and in connection with their consideration of the issues discussed above. Insurance can sometime appear like a peripheral or relatively unimportant matter-- unless things go seriously wrong, in which case insurance can turn out to be the most important thing. At the point that things have gone seriously wrong it a very poor time to discover that critical insurance issues were insufficiently considered.

Break in the Action: The D&O Diary is taking its act overseas, and so the publication schedule will be disrupted for the next few days. Regular publication will resume the week of March 30.

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The current global financial crisis may result in "unprecedented levels of litigation" that "will either serve to identify ‘weak links’ in the chain of participants who originate, appraise, and service collateral and underwrite, manage, insure, rate and sell securities," or it will serve to "highlight where the market may have underappreciated certain risks or failed to appreciate certain circumstances," according to a paper featured in a March 17, 2009 post (here) on the Harvard Law School blog.

The paper, entitled "Legal and Economic Issues in Litigation Arising From the 2007-2008 Credit Crisis," was written by Babson College Professor Jennifer Bethel, Harvard Law Professor Allen Ferrell, and Babson Professor Gang Hu, can be found here.

The paper explores the "economic and legal causes and consequences of the 2007-2008 credit crisis." In particular, the paper examines "the risks that can arise from financial and technology innovations and losses that are uniquely related to correlated events in the setting of loan markets." The paper sets for a detailed and interesting overview of the economic and financial causes that contributed to the current credit crisis.

The paper also notes that "the credit crisis is not solely an economic phenomenon, but a legal one as well." The paper discusses a number of different types of lawsuits that have arisen, but focuses in particular on securities class action lawsuits against public companies, which the paper describes as "by far the most important litigation likely to arise out of the credit crisis."

The paper asserts that "plaintiffs that bring Rule 10b-5 class action lawsuits will face substantial challenges," and notes in particular that the securities plaintiffs will have to navigate around three basic legal principles: "(i) there can be no ‘fraud by hindsight’; (ii) there can be no actionable disclosure deficiency with respect to information the market already knew (the ‘truth on the market’ defense); and (iii) plaintiffs must establish loss causation for their claims."

First with respect to the "fraud by hindsight" concern, the paper notes that it will not be enough for plaintiffs to show that there have been economic losses; they will also have to show that the adverse developments were reasonably foreseeable at the time the supposedly disclosures were made. The authors note that

Whether a failure of certain market participants to provide detailed disclosures regarding the implications of an event – the first full national fall in housing prices since World War II in conjunction with a dramatic and increasingly global crisis – from which the actors themselves suffered huge losses is actionable will likely prove an important stumbling block, in our judgment, for a number of actions being brought.

The authors add that "the presence of disclosure failures and materiality thereof must be assessed in light of what was known at the time of the disclosures without the benefit of 20/20 hindsight, even if losses occur."

Second, with respect to the "truth on the market" defense, the authors question whether the target companies in fact had "special knowledge that was not known by the market at large." The authors suggest that this may have been a situation where the market was at least as informed, or at least no less informed, than the defendants on relevant issues.

Third, the authors suggest that "loss causation is likely to be a challenging litigation issue for plaintiffs, because market prices, especially of financial-sector securities, declined overall."

The few dismissal rulings that have accumulated so far provide at least some support for the authors’ theories. In at least two cases where dismissal motions have been granted with prejudice – the NovaStar Financial case (about which refer here) and the Impac Mortgage case (refer here) – the courts seemed particularly concerned that the defendant companies had been caught in an industry-wide or even economy-wide downturn. Even if the courts did not use the price phrase "fraud by hindsight," the concept was seemingly implied in the rulings.

At the same time, however, there have also been significant cases where courts have had no difficulty denying dismissal motions – for example, New Century Financial (refer here) and Countrywide (here) – in which the courts have expressed open outrage regarding the alleged misrepresentations and omissions. The authors’ analysis seems deficient to me to the extent it fails to recognize the possibility that at least some courts’ judgments potentially may be affected by this sense of outrage, particularly over the extent of damage done, to investors and to the economy. (A list of all of the subprime dismissals and dismissal motion denials can be accessed here.)

In addition, given the authors overall hypothesis that plaintiffs will face substantial hurdles in pursuing these cases, it seems a noteworthy and even odd omission that the authors detailed and exhaustive paper neglects to even mention the possibility that the U.S. Supreme Court’s decision in the Tellabs case could also represent a significant hurdle for the plaintiffs. In that regard, the Tellabs decision has generally proven instrumental in those cases where dismissal motions have been granted thus far.

Finally, with respect to the authors’ suggestion that loss causation issues may prove critical, I note that in a prior post (here) I discussed the challenge that plaintiffs may face where they have sued for supposed economic losses on securities that continue to provide scheduled interest payments on time and in full. These arguments may be particularly relevant in claims brought by mortgage-backed securities investors who have sued the securities issuers and the securities offering underwriters.

Defenseless: Laura Pendergast-Holt, the erstwhile Chief Investment Officer of Stanford Financial Group, has a few legal problems to sort out. First, she is a defendant in an SEC enforcement proceeding involving the Stanford Group. Second, she was arrested on February 26, 2009 and charged with obstructing a proceeding before an agency of the United States. Third, she has been named as one of the defendants in numerous civil lawsuits brought by irate Stanford group investors. (A complete list of Stanford-related litigation can be accessed here.)

Ms. Pendergast-Holt clearly needs the services of an attorney. Unfortunately, she is also party to one more lawsuit, one in which she is the plaintiff, and which suggests the challenges she may have in providing for her legal representation in the above matters.

On March 17, 2009, she filed a lawsuit in Texas (Dallas County) District Court against Stanford Group’s directors and officers’ liability insurer, alleging that the insurer has "failed and refused to provide a defense so that she can defend herself in the SEC action, the civil class action, and in the criminal matter." A copy of her Original Petition can be found here.

Ms .Pendergast-Holt seeks a judicial declaration of coverage. Arguing that she has no way of satisfying any self-insured retention, she also seeks a "declaration that any self-insured retention or deductible be waived, held inapplicable or enjoined." She also alleges breach of contract and bad faith. She seeks damages estimated to exceed $5 million, as well as punitive damages estimated to exceed $40 million.

The bases on which the insurer has declined coverage for Ms. Pendergast-Holt’s defense are not specified in her Original Petition. While the scandal surrounding Stanford Group is notorious, as yet there have been no verdicts and no guilty pleas, nor to my knowledge have there even been any admissions. Whatever the facts ultimately prove to be, nothing has as yet been determined. These considerations may prove relevant to the coverage dispute, for example, with respect to the potential applicability of policy exclusions. On the other hand, representations made in connection with Stanford’s policy application (particularly with respect to Stanford’s finances) may also figure into the insurer’s coverage position.

A March 18, 2009 AmLaw Daily post regarding the coverage lawsuit can be found here. Hat tip to the Courthouse News Service (here) for a copy of the Original Petition.

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Last fall, the New York Department of Insurance ignited a firestorm when it issued an opinion that a D&O insurance policy may not place the duty to defend on the insured. As I discussed in an earlier post (here), the opinion is contrary to both the uniform practice of the D&O insurance industry and the unambiguous preference of public company D&O insurance buyers.

On February 26, 2009, following his keynote address at the the Professional Liability Underwriting Society (PLUS) D&O Symposium, New York Insurance Superintendent Eric Dinallo acknowledged the industry’s reaction to his department’s opinion, and indicated that the department would reconsider the issue and address it through the issuance of a new regulation. He also invited the industry to help his department to shape the new regulation.

Based on the Superintendent’s invitation, PLUS is now working with the American Insurance Association (AIA). The AIA has drafted proposed revised regulatory language that is now being circulated among its members. PLUS has also invited its member companies to comment on the draft regulatory proposal. PLUS will compile the comments and share them with the AIA and the New York Department of Insurance.

One representative from each PLUS member company can obtain a copy of the draft proposed regulatory language by contacting PLUS’s Executive Director, Derek Hazletine, dhazeltine@plusweb.org.  

I am setting all of this information out in a separate blog post because the deadline for comment to be received is next Monday, March 23, 2009, so companies that want to participate will have to move quickly.

In his Feb. 26 presentation, Dinallo indicated that he intends to act quickly on the proposed regulations and that he hopes to have the regulations in place by late spring.

Insurers Must Disclose Climate Change Exposures: On March 17, 2009, the National Association of Insurance Commissioners adoped a "mandatory requirement that insurance companies disclose to regulators the financial risks they face from climate change, as well as the actions the companies are taking to respond to those risks." According to the NAIC's press release (here), all insurance companies with annual premiums of $500 million or more will be required to complete an annual Insurer Climate Risk Disclosure Survey with an initial deadline of May 1, 2010. 

In the Survey, insurers will be required to report on "how they are altering their risk-management and catastrophe risk moedline in light of the challenges posed by climate change" and they will also be required to report  on "steps they are taking to engage and education policymakers and policyholders on the risks of climate change" as well as "whether and how they are changing their investment strategies." 

These reporting requirements could have a singificant impact, not just on insurers disclosures, but on their conduct as well. The requirement to disclose what the carriers are doing to "engage and educate" policymakers seems to suggest that the NAIC expects carriers to become proactive on the legislative and regulatory front regarding climate change. The disclosure regarding investment strategies potentially could influence insurers'' investment decisions. The clear implication of the NAIC's rule is that the regulators expect the disclosure requirements will motivate the carriers to become proactive in these areas.

The web page for the NAIC's Climate Change and Global Warming Task Force, including a link to the draft language of the new disclosure requirements, can be found here.

The Hits Just Keep on Coming: Bernard Madoff may now be in jail following his recent guilty plea, but that does not seem to have slowed the flow of new Madoff-related lawsuits. As the new suits have come in, I have added the new suits to my running tally of the Madoff-related litigation, which can be accessed here.

The litigation register has now grown to be quite lengthy. Madoff’s fraudulent scheme may have cost investors billions, but he has stimulated a heaping stack of litigation.Special thanks to the many readers who have been sending me the new complaints as they have come in, especially Jon Jacobson of the Greenberg Traurig law firm. Readers may be interested to know that Jon is also reporting on the new cases on Twitter (here) as they come in.

Speaker’s Corner: Next week I will be in London speaking at the C5 D&O Liability Insurance Conference. The specific panel on which I will be speaking is entitled "Current Litigation Trends in Europe and the U.S.: Are Class Actions on the Horizon?" The conference, which will take place March 24 and 25, 2009 at the Grange City Hotel., will feature a diverse array of speakers on a wide variety of D&O insurance related topics. The entire program agenda can be found here.

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A liability insurance policy is not intended to provide policyholders a means to shift to the insurer their separate, voluntarily undertaken contractual obligations. Private company D&O insurance policies generally embody this principle in a separate exclusionary provision. However, the wording of the exclusionary clause can substantially affect the scope of coverage otherwise available under the policy. In particular, the expansive reading given certain exclusionary language in recent cases suggests that a more narrowly constructed exclusion would more appropriately address the concern that the provision was originally intended to address.

Background

Long standing case law establishes that liability insurance policies do not cover breach of contract claims, because a contractual duty is not a liability imposed by law but is rather a voluntarily undertaken obligation. By way of illustration, a debtor ought not to be able to borrow funds, neglect to repay the debt, and then shift the repayment obligation to an insurer.

While these case law principles are well-established, some years ago private company D&O insurers nevertheless began to insert express contract exclusions in their policies. In part the insertion of the contract exclusion was intended to address the recurring policyholder objection that the policy does not say that it will not cover contractual liability. The insurers also wanted policy language to try to address recurring problems presented by claims against insured companies that sound both in contract and in tort (e.g., a complaint that asserts both a breach of contract claim and a claim for tortious breach of contract).

In addressing these issues, some carriers have adopted broadly worded exclusionary language. For example, one leading carrier’s private company D&O insurance policy contract exclusion precludes coverage for claims "based upon, arising from, or in consequence of any actual or alleged liability of an Insured Organization under any written or oral contract or agreement provided that this exclusion… shall not apply to the extent that an Insured Organization would have been liable in the absence of the contract or agreement."

As an important aside, most public company D&O insurance policies typically have no contract exclusion, for the simple reason that the company (or "entity") coverage provided in most public company D&O insurance policies is limited exclusively to Securities Claims. Because contract claims are not within the scope of entity coverage provided in the typical public company policy, there is no need to exclude contract claims. The contract exclusion (in some form) is, however, a relatively standard part of most private company D&O insurance policies because the entity coverage afforded under the private company policy is more expansive and is not restricted merely to a single category of claims.

While most private company D&O insurance policies have some form of contract exclusion, not all policies have adopted the more expansive exclusionary language of the type illustrated in the example quoted above. The scope of language in the exclusion can substantially affect the extent of coverage available under the policy; in particular, courts have applied a broadly preclusive interpretation to the expansive exclusionary language of the type quoted above.

Recent Case Examples

Spirtas: In an April 2008 opinion (here), the Eighth Circuit affirmed an Eastern District of Missouri opinion granting summary judgment on behalf of a D&O insurer on the basis of the applicable policy’s contract exclusion.

The insured, Spirtas Company, had entered a contract to perform construction contract demolition work. The project manager later sued Spirtas claiming that it had not performed the demolition work properly and had failed to use funds the project manager had supplied Spirtas to pay subcontractors and suppliers. The complaint alleged breach of contract, breach of express or implied trust, conversion and unjust enrichment. Spirtas sought coverage for the claims under its D&O insurance policy.

The D&O insurer denied coverage in reliance on a policy exclusion that, in pertinent part, precluded coverage "based upon, arising from or in consequence of any actual or alleged liability of an Insured Organization under any written or oral contract or agreement." In the ensuing coverage litigation, the district court granted the insurer’s motion for summary judgment holding that the underlying cause of action, including the tort claims, arose from Spirtas’s obligations under the demolition contract.

The Eighth Circuit affirmed, holding that the contract exclusion "applies to claims sounding in tort as long as they flowed from or had their origins in the breach of contract." The Eighth Circuit made it clear that its conclusion was reinforced by the broad scope of the exclusion’s "arising from" language.

GE HFS: The difficulty with the breadth of scope given the "arising from" language in this context is that it potentially lacks a logical stopping point. A 2007 opinion in the GE HFS case in the District of Massachusetts illustrates the how broadly this expansive reading just might extend. (The magistrate’s report and recommendation, which was subsequently adopted by the district court, can be found here; this post refers to the magistrate’s report and recommendation.)

In the GE HFS case, a home health care company had a line of credit in which the company was obliged to provide the lender certain status reports, upon which the lender relied in advancing additional credit. After receiving reports and advancing funds, the lender claimed the company had overstated its assets, as a result of which it had overextended the credit. The company went bankrupt. The lender sued certain of the company’s directors and officers.

The lender’s complaint, by its own terms, sought damages from the individual defendants for "negligent misrepresentations…with respect to collateral available to satisfy loans." The complaint also sued certain of the individual defendants for breach of contract on a personal guaranty. (There was no contention that the claims based on the personal guarantees were covered under the policy.) According to the magistrate in the coverage action, the "crux" of the lender’s complaint is its allegation that the individual defendants in the underlying action "failed to exercise reasonable care and competence in the preparation and communication" to the lender, as a result of which the receivables collateral were overstated and the lender advanced more money than it would have if the reports had been accurate.

The coverage case involved one of the individual defendants, Ingoldsby, who asserted among other things that the underlying complaint did not allege that he had prepared or compiled the disputed reports, and therefore that the claim against him was in effect a claim for negligent supervision or mismanagement, rather than misrepresentation. Indeed, the magistrate assumed for purposes of its opinion that the claim against him was for "negligent supervision."

The D&O insurer nevertheless denied coverage for Ingoldsby’s defense expenses on the basis of the applicable policy’s contract exclusion. The exclusion precluded coverage for claims "alleging, arising out of, based upon or attributable to any actual or alleged contractual liability of the Company or any other Insured under any express contract or agreement."

The magistrate found that the "arising out of" language "must be read expansively," holding that because the "allegedly wrongful conduct" was "dependent upon and in furtherance of" the loan, the loan "provided more than context: the entire claim was based upon the performance under the contract." Because the "allegedly wrongful conduct was part and parcel of performance under the contract," the contract exclusion applied.

The court also rejected the Ingoldsby’s argument that "the exclusion is void as it excludes virtually all types of coverage." The magistrate found that "misrepresentations may occur in a business setting yet not be related to a contractual duty."

Discussion

The outcome in the GE HFS case may be entirely appropriate give the facts and the contractual language involved, but the practical consequences of the case should not be overlooked. The court denied coverage for an individual director and officer for a negligent supervision claim, because of the relation of the claim to the underlying contract and because of the breadth of the contract exclusion.

The troublesome thing about the breadth of the preclusionary effect applied in these cases is that some type of transaction is at the heart of many claims under a private company D&O insurance policy. The danger is that insured individuals could find themselves facing claims of a kind that might well have assumed would be covered (say, for example, a negligent supervision claim), because of the involvement in the claim of an underlying transaction and because of the expansiveness of the D&O insurance policy’s contract exclusion.

Which brings me to the ultimate point– that is, the real problem here may be the expansiveness of the preamble to the exclusion. Clearly, the use of the broad "based upon" and "arising out of" language was instrumental in the two cases discussed above.

The court in the GE HFS case more or less recognized this when it acknowledged that "the coverage provided by the policy at issue… may be more limited than other available D&O policies." The inverse of this statement is, of course, that coverage provided by other policies is less limited. While that does not necessarily mean that a differently worded policy would have covered the claims at issue in the GE HFS case, the differently worded policy would not be as "limited."

My own observation is that carriers whose policies have the broad preamble language in the contract exclusion of the type discussed above perceive that coverage under their policies is indeed limited, demonstrating that as a practical matter there may be no logical stopping point in interpreting the coverage restrictions created by an expansive exclusionary provision.

By significant contrast, certain carriers’ private company D&O insurance policies have contract exclusions that do not use the broad omnibus "based upon" or "arising out of" preamble language. Rather, these carriers’ policies use the more restricted "for" wording.

Given the extent of the preclusive effect that courts have found in interpreting policies with the broad omnibus wording, policy forms using the narrower "for" wording are, in this respect at least, clearly superior from the policyholder’s perspective, particularly if carriers whose policies have the broader wording choose (as some are now doing) to try to apply the exclusion to preclude a wide swath of otherwise covered claims, including not just contract claims against entities but tort claims against individuals.

Indeed, I would argue that the "for" wording is much closer to the original purposes for the inclusion of the contract exclusion in private company D&O insurance policies – that is, an exclusion with the "for" wording makes it clear that insurers do not intend to pick up the insured company’s contractual liability, without extending the potential preclusive effect, for example, to tort claims against individuals.

Many prospective insurance buyers would be surprised indeed to learn that their prospective insurer intended to take the position that their policy would not cover even defense expense for, say, a negligent supervision claim if the claim also involves an underlying business transaction. Indeed, I suspect that many D&O underwriters would be surprised to learn that the claims handling counterparts would take such a position.

The use of the "for" wording in the contract exclusion provides at least some assurance that these reasonable expectations will not later be defeated by a reading of the contract exclusion that is so broad that is arguable defeats coverage for claims that might reasonably be presumed to be covered.

One final note. I want to acknowledge that my thoughts on this topic were triggered by the excellent November 2008 PLUS Journal article by Joseph A. Bailey III of the Drinker Biddle law firm entitled "Trio of Recent Cases Affirms Broad Scope of Contract Exclusion" (here). I hasten to add that the views expressed in this post are exclusively my own.

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In a prior post (here), I discussed Judge William Alsup’s rejection of the proposed settlement of the options backdating-related derivative lawsuit involving Zoran Corporation, in which the parties had proposed to resolve the case without any cash payment to the company. A more recent case presents another example of a court’s similar unwillingness to approve an options backdating derivative lawsuit settlement in the absence of any cash payment to the company. The events ensuing after the settlement’s rejection represent a rather noteworthy and surprising outcome.

In a January 8, 2009 order (here), Judge Sam Sparks of the Western District of Texas rejected the proposed settlement of the Cirrus Logic options backdating-related derivative lawsuit. Judge Sparks first noted that "while the Settlement consists of no monetary benefit to Cirrus, it does include a provision by which Plaintiffs’ attorneys will be paid $2.85 million in fees by Cirrus’ insurer."

With respect to his obligation to determine that a proposed derivative settlement is "fair, reasonable and adequate," Judge Sparks said this "does not mean that the settlement must be fair to the attorneys (as the Stipulation of Settlement no doubt is) but that it must be fair in light of the corporation’s interests."

Judge Sparks went on to observe that the parties had "utterly failed to convince the court that it is fair."

Judge Sparks stated that the supposed "substantial benefits" were "for the most part, cosmetic." He found that the proposed governance reforms "appear far too meager." He added that "the Court simply is not convinced that the proposed reforms alone present any meaningful compensation to Cirrus for the extreme damages Plaintiffs claimed were suffered by the corporation as a result of the backdating." The proposed reforms "confer so little value" that that the settlement, Judge Sparks found, could only be approved "by showing that the suit brought by the Plaintiffs was virtually meritless."

The plaintiffs’ lawyers had argued that their proposed attorneys’ fees were "well within the range of attorneys’ fees paid in shareholder derivative backdating cases, especially given the substantial benefit to Cirrus brought through the prosecution of the Litigation." However, Judge Sparks said with respect to these proposed fees and their purported justification that

For obtaining a minimal (if not non-existent) benefit to Cirrus, Plaintiffs’ attorneys under the terms of the Stipulation of Settlement would earn $2.85 million in attorney’s fees for a suit that has been pending less than two years. Although the Court would prefer to give deference to all parties’ counsel’s views and opinions regarding whether the settlement is satisfactory given the risks of continued litigation, the Court simply cannot fathom (and was entirely unconvinced by Plaintiffs’ counsel at the hearing) how counsel feels they could have earned these fees. Viewed objectively, the attorneys are requesting top-dollar fees for their inability to be successful in this case. By approving this Stipulation of Settlement, the Court would be compensating Plaintiffs’ counsel handsomely and encouraging plaintiffs’ attorneys in the future to go on fishing expeditions against corporations. Sometimes when at [sic] attorney goes fishing he catches fish, and sometimes he does not – but when he does not he should not eat filet mignon afterwards.

Duly chastised by Judge Sparks’ vituperative rejection of their initial proposed settlement, the parties regrouped and on March 10, 2009, they submitted a revised proposed settlement stipulation (here).

The revised settlement not only includes significant alternations to the proposed governance reforms, but also provides that Cirrus’ D&O insurer will pay its "remaining Limit of Liability" of $2,850,000 directly to Cirrus, "in consideration of which Plaintiffs and Plaintiffs’ Counsel will waive and relinquish any claim for attorneys’ fees and expenses."

Although Judge Sparks’ January ruling rejecting the initial proposed Cirrus settlement makes no reference to Judge Alsup’s earlier rejection of the Zoran settlement, both decisions are very much in the same vein. (To be sure, Judge Alsup’s rhetoric, replete with words such as "collusive" is more heavily freighted than that of Judge Sparks, although the outcome in both cases was more or less the same.)

Certainly, both opinions underscore the fact that courts take their responsibilities to absent class members very seriously and in particular that courts will take a dim view of proposed settlements in which plaintiffs’ attorneys’ reap substantial fees but in which the purportedly harmed corporation receives no monetary benefit.

The surprising finale in the Cirrus Logic case, in which plaintiffs’ attorneys wound up waiving their fee in order to complete the settlement, highlights how critical it may be for plaintiffs’ attorneys to be able to demonstrate in the first instance that it is the corporation and not the attorneys that benefit the most from a proposed settlement.

I noted in my prior discussion of Judge Alsup’s rejection of the Zoran settlement that there may be an increasing sense in which the plaintiffs’ attorneys seem to be growing weary of the options backdating cases and indeed may just want them to go away. The plaintiffs’ attorneys’ willingness to resolve the Cirrus Logic case without any provision for the payment of their own fees would certainly seem to corroborate this point. Whether or not the plaintiffs’ attorneys want the options backdating cases in general to go away, the specific lawyers in the Cirrus Logic case pretty clearly were committed to bringing an end to that particular case. Given some of Judge Sparks’ comments, who could blame them?

I have in any event added the revised proposed Cirrus Logic settlement to my updated table of options backdating settlements and case resolutions, which can be accessed here.

Special thanks to a loyal reader for a copy of Judge Sparks’ January 8 opinion.

Curses, Foreclosed Again: It may be supposed that growing wave of residential mortgage foreclosures is sufficiently awful that there would be no need for further dramatization. However, that supposition fails to reckon with Hollywood’s capacity to sensationalize anything, even something as banal as a bank officer’s decision to foreclose on an overdue mortgage. 

"Drag Me to Hell," a new movie by Sam Raimi, the director of the "Spiderman," involves a young bank office (Alison Lohman) who, in order to show herself worthy of a promotion, decides to foreclose on a home owned by a frail eldely woman. In response, the old woman lays a curse on the bank officer, whose career and life suddenly becomes very dark and gruesome. The ensuing mayhem may somehow be metaphorical of the financial chaos in which we all find ourselves.

I have linked below to a trailer for the movie. After viewing the trailer it may be unnecessary to actually see the movie, which in at a time when everybody is trying to save a few bucks may be good thing. However, the movie itself may be too dark to satisfy any populist need for vengence on supposely cruel and insensitive banks.

Hat tip to the NPR Planet Money blog (here) for the link to the trailer.

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On March 9, 2009, in a short but strongly worded opinion, Judge Andrew Guilford of the Central District of California dismissed with prejudice the third amended complaint in the subprime-related securities class action lawsuit filed against Impac Mortgage Holdings. A copy of the opinion can be found here.

Background

As discussed here, on October 6, 2008, Judge Guilford had dismissed plaintiffs’ second amended complaint with leave to amend. Plaintiffs filed their third amended complaint on October 27, 2008, and the defendants renewed their motion to dismiss.

The third amended complaint essentially alleged that contrary to the company’s public statements and to the company’s own underwriting guidelines, the company’s Alt-A loans were being sold to less creditworthy borrowers, so that the Alt-A loan portfolio was as risky as a portfolio of subprime mortgages. The plaintiffs further alleged that at the same time, the company misrepresented its true financial condition by its failure to write down the value of its loan portfolio. Further background regarding the lawsuit can be found here.

The March 9 Opinion

In his March 9 opinion, Judge Guilford noted that the in opposing dismissal the plaintiffs had quoted from the court’s opinion in the New Century case denying the motion to dismiss (about which refer here), contending that this case, like the New Century case, is about a "staggering race-to-the-bottom of loan quality and underwriting standards as part of an effort to originate more loans for sale through secondary markets."

Judge Guildford said that he "disagrees" with this characterization, noting that in his view, "this case is about a company involved in a volatile industry at the onset of a long, destructive economic downturn."

The specific basis on which Judge Guilford granted the motion to dismiss is his finding that the third amended complaint "fails to plead a strong inference of scienter." He found that the former employees’ statements on which the plaintiffs relied were just "vague accusations and conjecture." The third amended complaint’s reference to follow due diligence or loan guidelines were just generalizations lacking connection to specific actions or events.

The plaintiff had also relied on the "core operations inference" to try to satisfy the scienter requirement. While noting that there may be rare instance in which an event is so prominent that it would be "absurd" to suggest that key officers lacked knowledge of it, this, Judge Guilford found, was "not one of those exceedingly rare cases."

Discussion

Judge Guilford’s opinion joins a growing list of subprime and credit crisis-related securities lawsuits in which dismissal motions have been granted. (To access my running scorecard of subprime and credit crisis-related securities lawsuit settlements, and dismissal motion denials, refer here.) To be sure, there have also been a number of cases, including some higher profile cases – particularly the Countrywide case (about which refer here) and the New Century case (refer here) – where dismissal motions have been denied.

However, Judge Guilford’s express rejection of the Impac plaintiffs’ attempt to compare their case to the New Century case, and to use that as a way to avert dismissal, may suggest the constraints that plaintiffs in other cases may face in trying to rely on the Countrywide and New Century dismissal motion denials.

It should be noted that relatively few of the dismissal motion denials thus far have been with prejudice. Indeed, of the dismissals granted, only the Impac dismissal and the dismissal in the NovaStar Financial case (about which refer here) have been with prejudice. However, in both of those cases, the courts seemed particularly concerned with the fact that defendant companies had been caught in an industry-wide or even economy wide downturn, and as a result were openly skeptical of plaintiffs’ claims of fraud.

It is still too early to generalize about how these cases are faring or will fare overall, as most of them are only in their earliest stages. But at a minimum it appears that some courts, fully aware of the global financial turmoil, are viewing at least certain of these cases with skepticism. By the same token, there have been courts that have found the plaintiffs’ initial pleadings to be sufficient to survive a motion to dismiss.

Judge Guilford’s refusal to consider the core business operations inference stands in contrast to the opinion denying the motion to dismiss in the RAIT Financial subprime-related securities case, where the court held that the allegations regarding the defendant company’s core business operations were adequate to satisfy the scienter requirement. As I noted in my discussion of that ruling (here), earlier courts had rejected this theory as inconsistent with the PSLRA’s pleading requirements, but 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.

In any event, I have added the Impac dismissal to my list of subprime and credit crisis securities lawsuit resolutions, which can be accessed here.

The "Ultimate Solution" to Corporate Financial Misconduct?: In a March 10, 2009 press release (here), Fuwei Films, a China-based plastic films manufacturer whose shares trade on Nasdaq, reported that it had "become aware" of an "initial verdict" by the Jinan Intermediate People’s Court, in the city of Jinan, in the Shandong province. The verdict related to an action brought against three major shareholders of the company, for misappropriation of state-owned assets worth tens of millions of renminbi, during the reorganization of Shandong Neoluck Plastics. The three shareholders were identified as Mr. Jun Yin, Mr. Tongju Zhou, and Mr. Duo Wang.

According to the press release, the verdict found the three individuals guilty of the charges. The court "sentenced Mr. Yin to death, with a stay of execution of two years." The other two defendants received life imprisonment. The court will transfer to the Chinese government all of the personal property of the three defendants, including their holdings in two entities that owned approximately 65% of Fuwei’s common shares.

The press release stated that "none of these individuals is currently involved in Fuwei’s day-to-day operations."

Prospective investors will be happy to know that with this bit of unpleasantry put to rest, the company will now "be able to focus exclusively on executing Fuwei’s strategy to emerge from the current economic crisis." In light of the court-ordered ownership change, it is probably good that the company added that "we believe the Chinese government will support our long-term growth."

Special thanks to a loyal reader for the link to the Fuwei press release.

Options Backdating Update: The Securities Litigation Watch has updated (here) its helpful scorecard of the options backdating-related securities lawsuits. As reflected in the scorecard itself (here), of the 39 options backdating related securities lawsuits, 26 have now been resolved – nine have been dismissed and 17 have settled.

According to the Securities Litigation Watch, the average settlement for these cases is $83.1 million. However, if the largest settlement (United Health) is removed, the average is $32.37 million, which is roughly line with the overall average class action settlement level noted by Cornerstone in its recently released study of securities lawsuit settlements.

My own detailed running tally of the options backdating lawsuits settlements and dismissal motion grants and denials can be accessed here.

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Last year, investors filed numerous lawsuits against the investment banks and broker dealers who sold the investors auction rate securities. However, in a recent lawsuit, the targeted company was not an auction rate securities seller; rather, it was an auction rate securities buyer, which is alleged to have misrepresented to its own shareholders its exposure to auction rate securities in which it had invested.

According to their March 11, 2009 press release (here), the plaintiffs’ attorneys have initiated a securities class action lawsuit in the Southern District of New York against Perrigo Company, a Michigan-based pharmaceutical manufacturer and distributor, and certain of its directors and officers. The complaint (which can be found here) alleges that Perrigo had invested in $18 million in auction rate securities and that until September 15, 2008, the company had a reasonable expectation of redeeming its auction rate securities.

However, the complaint alleges that on September 15, Lehman Brothers, which had underwritten and sold Perrigo’s auction rate securities, went bankrupt. The complaint alleges that

On November 6, 2008, the beginning of the Class Period, defendants reported the "fair value" of Perrigo’s ARS as $14,500,000, but concealed the impact of Lehman’s bankruptcy on Perrigo’s ARS. Then just three months later, on February 3, 2009, defendants disclosed, for the first time, that Lehman had underwritten and sold the ARS to Perrigo. They also announced that the Company was writing off the entire value of its ARS, wiping out over a third of Perrigo’s earnings in the quarter. As a result of this disclosure, the stock price plunged 18% that day, causing massive losses to investors.

Although the allegations brought against Perrigo as an auction rate securities investor may seem unusual, the Perrigo complaint is actually not the first to assert securities fraud in connection with a company’s disclosures concerning its investment in auction rate securities. Indeed, as noted here, shareholders raised allegations against NextWave Wireless in connection with that company’s auction rate securities investment.

Nor is Perrigo the first company to be exposed to securities litigation as a consequence of Lehman’s bankruptcy. As I noted in prior posts, Constellation Energy (about which refer here), Reserve Fund (here), JA Solar (here), and Farmer Mac (here) have all found themselves hit with securities lawsuits in part due to the impact on them from the Lehman Brothers bankruptcy.

All of these cases represent what I previously called (here) the new wave of subprime and credit crisis-related securities litigation, in which the thrust of the allegations is not that the target companies themselves are exposed to subprime-related risks, but rather that the companies were exposed to other companies or assets that were themselves exposed to the subprime or credit risk.

The fact that this lawsuit is filed against Perrigo, a pharmaceutical company, underscores a point I have previously noted about the new wave of subprime and credit crisis related litigation, which is the potential for this new wave to bring the credit crisis litigation wave, which up until now has been largely restricted to the financial sector, to companies throughout the larger economy.

In any event, despite the much ballyhooed auction rate securities settlements, lawsuits related to the frozen auction rate investments continue to flow in. Indeed, on March 10, 2009 Careerbuilder LLC filed an action (here) in Illinois (Cook County) Circuit Court against Bank of America, alleging that even though BofA has reached at least two prior regulatory settlements regarding the auction rate securities, Careerbuilder remains stuck with the $32 million in auction rate securities that BofA sold them.

Yet Another Form of Credit Drawn in the Litigation Wave: As I have previously noted (most recently here), the current litigation wave long ago ceased to be just about subprime debt and has expanded to encompass a wide variety of different kinds of lending. The most recent example of this spread to other kinds of lending is the lawsuit filed on March 11, 2008 against Corus Bankshares.

According to their press release (here), plaintiffs’ counsel filed the suit against Corus and certain of its Chief Executive Officer in the Northern District of Illinois. The complaint (which can be found here) alleges that the company’s disclosures were misleading because they failed to disclose

(i) that Corus was failing to recognize losses on its condominium loans in accordance with generally accepted accounting principles ("GAAP"); (ii) that Corus and/or its affiliates was purchasing condominiums in developments Corus had financed in an attempt to: (a) inflate the appraised values of condominiums to delay having to recognize losses on financing for such condominiums; (b) inflate developers’ sales figures to increase the likelihood of successful future sales; and (c) create the illusion of successful sales histories in order to inflate appraisal values for the condominiums to ensure inflated future prices for the condominiums; and (iii) that Corus was involved in detailed and in-depth negotiations with the Federal Reserve Bank of Chicago and the Office of the Comptroller of Currency regarding its deteriorating pool of condominium loans.

The complaint alleges that when on the company released its financial results on January 29, 2009 and disclosed that "Corus is suffering from the extraordinary effects of what may ultimately be the worst economic downturn since the Great Depression," the company’s shares fell nearly 47% to close at $.59 per share on February 2, 2009.

So add condominium loans to the kinds of lending that has become involved in the subprime and credit crisis related litigation. I have added the Perrigo and Corus lawsuits to my running tally of the subprime and credit crisis related securities class action lawsuits, which can be accessed here. A spreadsheet with the 2009 subprime and credit crisis-related securities class action lawsuits can be found here.

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On March 11, 2009, Cornerstone Research released its report of 2008 securities lawsuit settlements entitled "Securities Class Action Settlements: 2008 Review and Analysis" (here). Cornerstone previously released its review of 2008 securities class action filings, which can be found here. Among other things, the newly released Cornerstone Report concludes that "the value of cases settled in 2008 was lower than the historically unprecedented high totals reported from 2005 through 2007." Cornerstone's March 11, 2007 press release regarding the report can be found here.

Although the Cornerstone Report is more or less consistent with prior analyses of the 2008 settlements (for example, the previously released study by NERA Economic Consulting, which can be found here), it also differs in some specific details. The differences are in part explainable due to the methodology used to assign settlements to a particular year. In the Cornerstone Report, the designated settlement year corresponds to the year in which the hearing to approve the settlement was held, rather than the year in which the settlement was first announced.

The Report finds that the median value of 2008 settlements was $8 million, which is lower than 2007’s all-time high median of $9 million but is higher than the median of $7.4 million for all cases settled during the period 1996 through 2007. Median settlements as a percentage of estimated damages were generally higher for cases settled in 2008 compared to settlements during the period 2002-2008. Just over half of the 2008 settlements were for less than $10 million, although the number of "very small settlements" is declining, while the number of settlements in the $20-$25 million range is increasing.

The average settlement in 2008 "fell dramatically" from $62.7 million in 2007 to $31.2 million, which is partly due to the fact that there were no settlements approved in 2008 that exceeded $1 billion (by contrast to 2007, during which the massive Tyco settlement was announced). If the top four all-time settlements are excluded from the analysis, 2008’s average settlement of $31.2 million is "in line with" the average settlement during the period 1996 through 2007 of $34.6 million. (All settlement amounts are adjusted for inflation and are expressed in 2008 dollars.)

The Report found that the average time from filing to settlement has increased steadily. Whereas historically cases settled approximately three years after filing, during 2007 and 2008, the average time from filing to settlement increased to three and a half years.

The Report also identified a number of factors that appeared significant with respect to settlement values:

1. GAAP Violations: The Report found that GAAP violations, which were alleged in 70% of 2008 settled cases, "continued to be resolved with a larger settlement amount and a higher percentage of estimated damages relative to cases not involving accounting allegations."

2. Restatements: Allegations involving restatements were involved in 35% of 2008 settlements. However, cases with restatements "are no longer associated with a statistically significant increase in settlement amounts," consistent with PCAOB research concluding that restatement announcements "are viewed by the market as less significant events." However, cases in which an accountant was named as defendants continued to settle for the "highest percentage of estimated damages among cases with accounting allegations."

3. ’33 Act Claims: Controlling for the presence of underwriter defendants, the presence of Section 11 or Section 12(a)(2) claims is "not associated with a statistically significant increase in settlement amounts." The Report does note that suits with ’33 Act allegations reached "historically high levels" in 2007 and 2008, and that as these cases settle over the next few years, the importance of ’33 Act claims in determining settlement amounts "may increase."

4. Institutional Investor Plaintiffs: When institutional investors are lead plaintiffs, settlements are "significantly higher." However these higher settlements are "associated with public pension plans, as opposed to union funds or other types of institutional investors."

5. Accompanying Derivative Claims: The number of settlements of securities class actions that were accompanied by derivative actions decreased in 2008 compared to prior years. But with respect to the securities suits that were accompanied by derivative actions, the settlement amounts were "significantly higher." In general, cases with accompanying derivative actions tend to be larger (in terms of estimated damages) and also typically involve accounting allegations and public pension plaintiffs, and include accompanying SEC actions. Controlling for these other factors, the Report concludes that cases involving derivative actions "are associated with statistically significant higher settlement amounts."

6. SEC Actions: Cases with associated SEC actions are involve "significantly higher settlements" as well as higher settlements as a percentage of estimated damages.

7. Non-Cash Components: 9% of 2008 settlements involved non-cash components. Settlements involving non-cash components are statistically higher in value, even controlling for estimated damages and the nature of the allegations.

The Report concludes with several remarks about the recent wave of subprime and credit crisis related securities litigation. First the report notes that the three settlements of these cases so far include the $475 million Merrill Lynch class action settlement. The Report notes that the Merrill case reached settlement in 18 months, which is relatively quick compared to other cases. Otherwise, however, the Report notes that, with only three of these cases settled so far, "it is still too early to anticipated what impact, if any" settlements of the credit crisis cases will have on overall settlement trends.

(My running table of subprime and credit crisis related securities lawsuit settlements and dismissals can be accessed here. My commentary on the Merrill Lynch settlement can be found here.)

The Report concludes with an observation regarding the damages represented in the 2008 securities lawsuit filings. That is, the "disclosure dollar losses" (a defined term in the Report representing one measure of investor losses) associated with the 2008 filings "reached historic highs in 2008." Because disclosure dollar loss is a "significant predictor of settlement size," the size of settlements "may increase in the future."

The Report reflects a number of different findings of significant interest to D&O insurers. In particular, the Reports finding regarding the increase in settlements in the $20 to $25 million could have significant implications for excess insurers that are active in this space. Moreover, the Report’s detailed analysis of factors affecting settlement values could be important considerations in setting case reserves.

However, D&O insurers will also want to take a couple of additional considerations into account in assessing the implications of this report. First, the Cornerstone report reflects only settlement amounts. D&O insurers’ losses in connection with any given claim also include defense expense, which is not reflected in the Cornerstone study. Indeed, D&O insurers can incur significant amounts of defense expense even if a case is dismissed and there is no settlement.

In addition, the Cornerstone study reflects only class action settlements. It does not take into account any amounts that defendants or their insurers were obligated to pay as part of settlements to plaintiffs that opted out of the settlement class. As I have noted previously, opt outs are an increasingly important factor in the resolution of securities lawsuits. As a result, class action settlement data along may insufficiently express the overall dollar exposure of securities class action defendants and their insurers.

The Cornerstone contains extensive additional analysis and warrants reading at length and in full. Once again, the Report’s authors, Laura Symons and Ellen Ryan, have done an outstanding job analyzing the latest settlements and explaining their findings.

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The current financial crisis involves a potent witches’ brew of bankruptcies, mortgage bailouts, failed banks, blame assignment, and liquidity issues. Because every one of these ingredients contributes in some important way to the total mix of current woe, this post briefly references each one of these issues and concludes with a video that manages to find humor despite the current dismal circumstances.

Bankruptcies Double: Though it is early yet, one of 2009’s stories of the year has to be the surge in corporate bankruptcies. According to recently published data (here), bankruptcies this year by publicly traded companies are running at more than twice their 2008 pace. Bankruptcies of companies with assets over $1 million are fueling the surge.

According to the data, there have been 46 bankruptcy filings (under Chapter 11 or Chapter 7) by public companies in 2009, with total combined assets of $74 million. As this point last year, there were only 21 bankruptcies totaling $11 billion.

Some context is required for these numbers, however. This year’s bankruptcy pace is still below that of 2002, a "record-breaking" year in which there were 60 bankruptcies by early March.

The financial market turmoil is producing numerous casualties. Indeed, Blackstone Chairman Stephen Schwarzman was quoted today (here) as saying that "between 40 and 45 percent of the world’s wealth has been destroyed in little less than a year and a half." Give the staggering scale of market losses, even optimists will recognize that further bankruptcies undoubtedly lie ahead.

My recent post discussing D&O insurance issues arising from bankruptcy can be found here.

A Successful Mortgage Bailout: As depressing as the current circumstances are, a sucessful bailout from an earlier era may provide reason to hope that it may be possible to manage our way out of the current mortgage crisis.

A March 6, 2009 post in the Harvard Business Review Editors’ Blog entitled "The Mortgage Bailout That Worked (here) describes a "remarkably similar catastrophe" that "happened during the real estate boom of the 1920s." In that earlier time, an investment frenzy developed over "guaranteed mortgage certificates" that were issues, in denominations as small as $100, for shares in residential mortgages and groups of mortgages. The certificates were issued by guaranty companies and backed by the state of New York.

Investor demand for the certificates soon outstripped the supply of mortgages, in turn fueling a demand for even more mortgages, whether or not the mortgages were compliant with regulatory requirements. The frenzy to supply investors with more certificates also encouraged the guaranty companies to assume borrowers’ loan fees and offer bonuses to brokers for mortgages. Ultimately, to protect their own investments, the guaranty companies swapped good mortgages out of customers’ certificates and transferred them to their own certificates. (Sound familiar?)

Eventually, the scheme collapsed and the state of New York stepped in and "amazingly, managed to clean up the bulk of the mess in just four years of hard, hard work." The state formed a Commission, which eventually had over 1,000 employees, to "take over the guaranty companies and sort out the certificates." What they did was to "preserve the value of the certificates by preserving the value of the underlying real-estate assets."

The process the Commission followed, which was designed to work out the mortgage or dispose of the property in some productive way, could be a useful model for today. The lesson for the current circumstances from the prior effort, according to the HBR post, seems to be to "hire a sufficiently large group of people to track down and preserve the value of the assets underlying all of our current toxic real-estate securities" in a similar manner. It certainly worked in the earlier era; the Commission "recouped 84% of the value of the certificates" and brought "order out of chaos."

Are Bank Failures a Necessary Recovery Prerequisite?: Some readers may have noted that this past Friday night, the FDIC took control of yet another bank, Freedom Bank of Georgia (as noted here). Prior to its closure, the bank, which was located in Commerce, Georgia, had assets of $173 million. This latest bank closure brings the year to date total of failed banks to 17, and the number of banks that have failed just since July 1, 2008 to 39. The FDIC’s complete list of banks that have failed since October 2000 can be found here.

While bank failures are one among the more disturbing parts of the current economic turmoil, they may also be a necessary part of the recovery as well. A March 7, 2009 Washington Post article entitled "Every Bank Failure is Also a Beginning" (here) states that the increase in bank closures is "a sign of the nation’s economic distress," but it is also a "first step toward revival." According to the article, "in wiping away problem loans and brining in new investors, the government is creating the necessary conditions for new lending."

The Post article explains the FDIC’s bank closure process, including its efforts to transfer the bank’s existing banking relationships to a healthier institution. The process is not without its pitfalls, but it is, according to the article, essential to ensuring that a community has banking resources available despite the closed bank’s failure.

The Post article focuses on the events surrounding the closure of the Community Bank of Loganville, Ga., which failed in November 2008 (refer here). Last Friday’s bank closure involved yet another bank from Georgia, the seventh bank in Georgia to fail since October 2007. Many of the failed banks were located in or around Alphretta, Georgia, which earlier this year the Wall Street Journal referred to (here) as "Bank-Failure Central."

Among other things, commentators cited in the Journal article ascribed the rash of bank failures in Georgia to "overabundant home building, years of risky lending and one of the most relaxed environments in the U.S. for starting new banks." The Journal article also states that the failures "reflect an unusually dense concentration of go-go optimism run amok."

Credit Agency Focus: When assigning blame for the current crisis, many commentators often cite the credit rating agencies. Indeed, Time Magazine’s list of the 25 people to blame for the current financial debacle included Kathleen Corbet, who ran S&P for most of the last decade. Whether or not the credit rating agencies are blameworthy is one question; whether they can be held liable for it is yet another, as this blog has previously noted (here).

A recent memorandum by the Jenner & Block firm entitled "Credit Rating Agencies in the Spotlight: A New Casualty of the Mortgage Meltdown" (here) admirably summarizes the legal issues that investor litigation against the credit rating agencies might present. One noteworthy observation in the memo is the possibility federal preemption of state regulatory action under the Credit Rating Agency Reform Act of 2006. In addition to discussing other defenses that may be available to the credit rating agencies, the article also helpfully cites a lists a number of cases currently pending against the firms.

A recent post in which I discussed the partial denial of the motion to dismiss in the securities lawsuit that Moody’s shareholders filed against the company, and the ruling’s possible implications for the rating agencies’ potential liability for their ratings activities, can be found here.

Liquidity Issues Affect Everything: A company’s inability to access cash when needed can raise a host of complications, including even with respect to pending securities class action lawsuit settlements. As reflected in its March 10, 2009 press release (here), due to liquidity constraints, Korean semiconductor company Pixelplus is unable to fund its agreed $1 million cash contribution to the settlement of the securities class action lawsuit that had been filed against the company.

According to the press release, the court has approved an addendum to the parties’ settlement stipulation with respect to the company’s agreed settlement contribution. The press release states that the company could not make its contribution "due to the economic turmoil in Asia arising from the global financial crisis and the world-wide recession, which continues to have a severe negative impact on the financial position and business operations of the company."

In lieu of the company’s contribution, its insurance carrier is paying about $331,000 (at current exchange rates). The company will make up the difference "if and when such funds become available."

There may be implications here for the growing wave of subprime and credit crisis-related litigation. A cause of action is not worth much if the target company can’t even fund an eventual settlement. There may be more than a few target companies that might eventually prove unable to fund their portion of any eventual settlements.

Citi of the Future: Citigroup’s shares were up today on relatively positive news. However, according to an article in today’s Wall Street Journal (here), "barely a week after the third rescue of Citigroup," U.S officials are weighing "what fresh steps they might need to take if its problems mount." The bank’s continuing problems have, among other things, fueled rampant speculation that the government eventually will be forced to nationalize Citigroup.

The prospect of a nationalized Citigroup might have been unimaginable even a short time ago, but now some at least some folks apparently have no trouble imaging what a government-owned Citibank might be like, as reflected in the following video. (Sensitive readers should be forewarned that this video makes rather promiscuous use of the F-bomb and may otherwise be offensive. On the other hand, it is also very funny.)

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Early in my career when I was doing legal work for London insurers, we communicated with our U.K. clients using telex, a technology that is to communications what smacking clothes on a rock is to cleaning fabric. It seemed a huge leap when we progressed to faxes, even though the pages rolled off of cylindrical drums, producing curling documents covered with indistinct, easily smudged characters.

In our current Internet age with emails and text messages, these obsolete technologies now seem quaint, perhaps (in retrospect only) charming in an old-fashioned way. But as relatively advantageous as the latest tools are, even newer communications and information-sharing tools continue to emerge. At a minimum, these new alternatives already offer important supplements to the existing standard media, and potentially even offer entirely new ways of communicating and exchanging information.

What is Web 2.0?

Most of us have become very comfortable using the Internet tools to retrieve information – for example, using a Google search to locate information or find useful sites. The newly emerging tools, sometimes referred to collectively as the Web 2.0, offer more than just the opportunity to retrieve information – they offer the ability to interact and communicate with the network in general, and with a customized, personal network in particular.

I review and comment on some of these new tools below. As a preliminary matter, I think it is important to draw a theoretical distinction between these other tools and email. When using email, you are limited to communicating with persons whose email addresses you already have in advance, which is fine if you only need or want to communicate with a specific, pre-identified group of persons. These new tools, all of which are essentially free, allow you to communicate more broadly, even to persons you may not know, or at least may not know how to locate. This feature of these tools allows you to reach new audiences and to develop new relationships, as well as to be able gather information a diverse variety of new sources.

The Web 2.0 Tools

Twitter: A cross between blogging and instant messaging, Twitter offers users a way to communicate broadly, using no more than 140 characters. I confess that at first, I just didn’t get Twitter. After signing up and staring at my Twitter home page while nothing happened, Twitter seemed pretty pointless.

However, at the suggestion of Kevin O’Keefe of LexBlog, I began using a Twitter application called TweetDeck. Tweet Deck allows you to monitor a series of columns of "tweets" across your desk top, with a column of constantly updated tweets from the sites you have signed up to follow on the left side of the screen. Additional columns are arranged from left to right across your page relating to additional search topics you are following (for example, "lawsuits" or "securities" or "Madoff"). After using TweetDeck, I now appreciate the Twitter’s potential.

With TweetDeck (or one of several similar applications, such as Twhirl or Twitterific), you can tap into the steady stream of Twitter dialog that is constantly rippling across the Internet.

Twitter simultaneously facilitates several different types of activities. First, it accelerates real time news and information gathering. Most of the major news organizations are on Twitter. For example, I am a Twitter subscriber to a huge number of news sources, such as The New York Times, the Washington Post, the Wall Street Journal, Business Week, the Financial Times, American Lawyer, NPR Money, Reuters, Yahoo News and dozens of other groups. A list of some of the many news organizations on Twitter can be found here. These news outlest are frequently tweeting on subjects that may or may not eventually make their way into published articles. Other tweets have links to articles that have just been posted on their web pages. In addition, many governmental organizations, such as the SEC, Congress and the White House, also are on Twitter. A list of federal government Twitter sites can be found here.

Second, there is an entire parallel universe of bloggers, commentators, observers and other Net-based hunter gatherers who are constantly twittering their insights and comments, many of which might not make their way into full-blown blog posts or articles. This commentariat also reliably "retweets" an incredible variety of articles, links and other tidbits. (The "retweets" are readily identifiable by the prefix "RT" preceding the name of the source site.) It takes time to build up a good list of Twitter sites and sources worth following, but one good starting point is the list of "Twitter Feeds for Securities Counsel" that Bruce Carton of the Securities Docket has developed (here).

Third, Twitter provides a medium for information exchange. Because a Twitter message is essentially broadcast to all of your followers and also available to the wider web through Twitter tools like TweetDeck, you can launch an announcement or post a question and reach an enormous network. For example, I recently spotted a tweet from a journalist looking for information about Canadian securities class actions. We did not know each other, yet his question reached me and I was able to reply to him via Twitter to point him toward a recent post on my blog about Canadian class actions. (Replies can be discerned by the "@" prefix preceding the name of a Twitter site).

Fourth, and perhaps most significantly, Twitter allows you to quickly search for and retrieve tweets on a particular topic, many of which contain links to news articles and other resources. A Twitter search produces a harvest of tweets on the search topic. For example, after the Stanford Financial Group scandal broke, I used the search function to quickly retrieve the tweets about Stanford, many of which had links to sites and sources I would not otherwise have found. I also opened a new TweetDeck category through which to monitor the ongoing Twitter traffic about the Stanford Group.

For insurance professionals, Twitter offers a potential new source of underwriting and claims information. For example, a D&O underwriter could search for tweets about a particular company by doing a search on the company’s name, and the underwriter could then monitor ongoing Twitter traffic relating to the company using a separate Tweet Deck column. For all insurance professionals, the ability to broadcast questions or information offers another way to obtain information. The news site tweets allow anyone to monitor a steady stream of headlines and other information on a real time basis. Twitter also offers a means of announcing company events or publications.

Finally, the ability to develop a group of "followers" and to communicate with them and others using the reply and "retweet" functions provides a way to network and expand professional contacts. The March 7, 2009 Wall Street Journal has an excellent article (here) about how to develop Twitter followers and how to use Twitter to expand your personal network. I have further comments below about using all of these Web 2.0 tools to develop contacts and to network.

The New York Times also had a recent article (here) on the advantages and opportunities of using Twitter. A recent Law.com  article describing the different ways professionals might use Twitter can be found here.

One final note about Twitter. The 140 character limit can be a challenge. Using Twitter can sometimes feel like writing haiku. One way to make the most of the limited number of characters is to reduce a lengthy web address link by translating it into a short web address using a site like TinyURL.com. TweetDeck also has a function to shorten lengthy web address. A list of other useful Twitter pointers can be found here. A useful list of Twitter related tools and applications can be found here.

LinkedIn: LinkedIn is a networking site for professionals that has over 30 million users. As a minimum it is a place to post your resume and contact information, which if nothing else makes it easier for others to find you.

But LinkedIn is all about building connections. By asking others to join your network of connections, you add their names to the group of connections listed on your LinkedIn page. Each new connection allows you the opportunity to browse your new connection’s own network list, as a way to find others to add to your network. I have found this process interesting and it has allowed me to build my network out in unexpected ways. For example some of my connections are industry colleagues, some are contacts in my immediate locality, some are people whom I have just gotten to know who want to build out their own networks.

In addition, there are numerous LinkedIn affinity groups, where persons with similar interests can identify each other and exchange news and information. There are, for example, a host of insurance-related groups. For example, the Professional Liability Underwriting Society (PLUS) has a LinkedIn group (here). So does RIMS (here). There are numerous other insurance groups, and innumerable groups related to other topics as well.

In many ways, LinkedIn it still realizing its full potential, at least for the insurance community. Many of the insurance-related groups, for example, are characterized by a relatively low level of activity. However, I think there is enormous potential in these groups – frankly, one of my motivations in writing this blog post it a desire to spark others’ interest in vitalizing these groups, particularly the PLUS group. I can easily imagine these group sites functioning as community bulletin boards where important information is regularly updated and read by people from throughout the community

But even if LinkedIn may not yet have fully realized its full potential overall, I have personally had several experiences where my LinkedIn presence enabled me to form new and valuable relationships. Among other things, I was recently retained by a private equity firm to consult with them on an information-related project. The private equity firm found me through my LinkedIn site. I have further comments on these kinds of network and contact building possibilities below.

Facebook: For a long time I was skeptical that Facebook offered anything of value to me. I considered it a place where college kids wasted time and posted career-limiting pictures of themselves doing embarrassing or incriminating things. However, a friend who was for many years a Wall Street media analyst and who now teaches at a local university convinced me that I needed to get on Facebook. Among other things, she told me that that over 20 million of Facebook’s 150 million users are over the age of 30, and that the over 30 crowd is by far Facebook’s fastest growing demographic.

Facebook provides another way to establish an Internet presence and to develop or expand a network of contacts. What I have found in a relatively brief foray is that Facebook facilitates a way to reconnect with a lifetime’s worth of acquaintances. The reconnection potential is not only personally rewarding, it is also valuable from a business networking perspective. For example, in recent days I have reconnected with a childhood friend who now, it turns out, is the CFO of a publicly traded company right here in my home state. Another college classmate I found through Facebook is general counsel of a financial services firm; I had not seen him in years, but now we are scheduled to have lunch in a few days.

Facebook also has an astonishing variety of groups and affinity sites. I have already signed onto my undergraduate college alumni site and even a group page for my college fraternity. Some of these groups are larger and more dynamic than the groups on LinkedIn, but the most active groups are more social than many of the LinkedIn groups.

In any event, as with Twitter and LinkedIn, Facebook offers a way to expand your network and develop your business contacts. Some might be concerned that getting active on Facebook might risk mixing social and business contacts in an undesirable way. However, Facebook allows you to create separate friends’ lists, with different privacy settings. That way you can control who sees which of your various Facebook posts.

Are These Tools "Worth It"?

No doubt about it, these tools all have the potential to become time sinkholes. Fooling around with any one of these sites, not to mention all of them at the same time, could easily become a time-consuming exercise in pushing electrons around the Web. Moreover, much of the activity, particularly on Twitter, is not worth the electrons consumed. Some people – perhaps many people – may conclude that these media are just not for them, and they might well be right.

These new tools definitely have their critics. Just this week, Time Magazine ran a story (here) critical of Twitter and the shallowness of many of the messages, and the New York Times ran a story (here) noting privacy concerns associated with Facebook. Certainly, these new communications tools, like any other tool, can be used a variety of ways, some of which that are not beneficent.

My own view is that these tools, used properly, all have valuable potential to provide a way for anyone to expand their network of business contacts and business opportunities. At the same time, the inner paranoid within me that is always present just below the surface is also afraid that if I do not understand and take advantage of these tools, I will be losing a critical step to my competitors, or at least to someone other than me, who will figure out a way to take advantage of these tools, as a result of which I risk falling behind.

My own experience as a blogger also convinces me that the opportunities these tools afford are real. Over the almost three years that I have been blogging, I have had the experience numerous times of meeting someone virtually through my blog, and then having that virtual contact turn into a real relationship, which in turn has led to real opportunities and real projects.

In addition, my blogging experience reinforces for me the potential to use these web-based tools to develop or enhance both a personal brand and a corporate brand. I am based in suburban Cleveland, yet Ithrough my blog I have developed an International audience and a professional profile, because I have been able to exploit the communications potential of the Web. (A more detailed view on my blogging experience can be found in a prior post, here).

The interesting thing to me about Twitter, LinkedIn and Facebook is that they each offer a similar potential to leverage the Web, but in ways that are not only distinct from blogging, but that are also unique to each separate tool. I have already found that the networks I have formed from each of these tools largely do not overlap. Facebook in particular has allowed me to expand my network in directions far different from the other tools.

Every insurance professional knows that we are in a relationship business. Business opportunities come from having contacts. These tools allow a new means to develop the contacts that can raise your profile, enhance your personal brand and expand your opportunities. Moreover, these resources are available from anyone’s desktop and for free.

I am very interested in readers’ thoughts and experiences about these tools. I encourage readers to use this blog’s comment feature to share their own experiences with Web 2.0, whether positive or negative.

I also welcome all readers to join me on LinkedIn by clicking on the LinkedIn button in the right hand margin. I hope readers will consider joining the PLUS group on LinkedIn. I also invite readers to follow me on Twitter, which they can do by clicking here or on the button in the right hand margin above.

Finally, readers who would like a more detailed, multi-media introduction to Web 2.0 should be sure to watch a replay of the February 17, 2009 Securities Docket webcast entitled "Web 2.0: Leveraging New Media to Maximize Your Securities and Compliance Practice," which can be found here. The webcast has additional useful information about the Web 2.0 media discussed above, and in addition has a detailed discussion of how to use RSS feed reader technology gather useful news articles and other information on subject you want to monitor.

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General Motors’ March 4, 2009 filing on Form 10-K (here), among other things, reflected the doubts of the company’s auditor, Deloitte & Touche, of the company's ability to continue as a "going concern."

The auditors, quoted in the company’s filing, said that "the corporation’s recurring losses from operations, stockholders’ deficit, and inability to generate sufficient cash flow to meet its obligations and sustain its operations raise substantial doubt about its ability to continue as a going concern."

The company itself said in the filing that its future depends successfully executing its restructuring plan. The company said that "if we fail to do so, we will not be able to continue as a going concern and could potentially be forced to seek relief through a filing under the U.S. Bankruptcy Code."

General Motors may be the most prominent company to have been dealt a going concern opinion, but it is far from alone. Indiana-based insurer Conseco recently said (here) its auditors have doubts about its ability to continue as a going concern. Similarly, senior adult-residence developer Sunrise Senior Living also recently announced (here) that it has received a going concern opinion. Other companies that have recently announced that have received or anticipate receiving a going concern opinion include Allied Capital, Lear and UTStarcom.

The likelihood is that the number of going concern opinions will escalate in 2009. In a recent interview (here), the CEO of Grant Thornton predicted that the number of going concern opinions could hit an "all-time high" this year. Separately, he also said (here) that "we’ll see an unprecedented number of going concern footnote disclosures and clarifications from the auditors." Industries that are likely to be hard hit include automotive, residential construction, manufacturing, financial services and retail.

The problem with going concern opinions is that they can become self-fulfilling prophecies. A March 5, 2009 CFO.com article entitled "The Growing Concern over Going Concern" (here), stated that "the revised status can further hinder a company on the brink of filing for Chapter 11 from avoiding bankruptcy court," because the qualification spooks "investors, suppliers and lenders."

In other words, the increase in going concern opinions could amplify the already escalating number of bankruptcies. (According to one report, here, the number of bankruptcies in February 2009 was up 29% over a year ago.)

Among other things, this likelihood of increased bankruptcies also means the potential for an increase in claims against the directors and officers of the failing companies.

A bankruptcy filing is particularly likely to be followed by claims against the bankrupt company’s directors and officers. In its recent report analyzing the 2008 securities lawsuits (about which refer here), the information database firm Advisen noted that the rising number of bankruptcies "almost certainly will be accompanied by an increase in securities lawsuits."

The Advisen Report reports that since 1995, roughly 35 percent of large public companies (defined as having more than $250 million in assets, measured in 2008 dollars) that filed for bankruptcy were also named in securities class action lawsuits. During 2007 and 2008, that percentage increased to 77 percent.

Unfortunately, an increase in bankruptcy related claims could also mean an increase in D&O coverage disputes as well. As I noted in recent post (here), D&O claims in the context of bankruptcy raise a number of recurring and potentially significant coverage issues.

In addition, a significant increase in the number of corporate bankruptcies could have a magnified impact on the D&O insurers’ loss results. In recent years, many carriers substantially supplemented their revenue by writing extensive amounts of so-called "Side A" excess insurance, which effectively operates as catastrophe insurance to provide individuals with an added layer of protection in the event of insolvency (among other things).

Up until now, the carriers’ experience on the Side A product has been overwhelmingly positive. However, a dramatic surge in corporate bankruptcy filings and the associated litigation could quickly wipe out years of earnings on this product line.

In any event, among other critical issues the directors and officers of a company facing the facing bankruptcy is the amount, structure and coverage of the company’s D&O insurance. At perhaps no other time in a company’s life cycle is it more important to the company’s directors and officers for the company to have a D&O program designed to provide them the fullest extent of insurance protection.

Accordingly, it is particularly important for senior officials of financially troubled companies to ensure that the company’s D&O insurance has been reviewed by a knowledgeable insurance professional who understands the coverage challenges bankruptcy can present.

More About GM: One of The D&O Diary’s favorite blogs, Francine McKenna’s Re: The Auditors blog, recently underwent a radical facelift. The revised site, now in beta (here), has a visually attractive new face. But even more importantly, the new design makes it even easier to access McKenna’s trenchant observations about problems in the accounting industry, and the Big 4 accounting firms in particular.

Among other things, McKenna has an interesting and detailed explication (here) of her view that aGM bankrupcy may be the least bad alternative for all concerned.

A March 5, 2009 Business Week article (here) points out that GM’s plan to try to get back to annual sales of 16 million vehicles may represent nothing so much as a failure of the company’s management to accept the reality that those kinds of sales figures in prior years represented a bubble of the same kind that ultimately overwhelmed the residential real estate market. Both were fueled by cheap credit.

In Memoriam: The professional liability insurance community has lost a good friend. Last Friday, Michael J. Stringer, of the Duane Morris firm, passed away. He was only 42. Michael was a well known and respected member of the select group of attorneys who specialize in representing carrier interests in D&O coverage matters. He will be missed.

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On March 4, 2008, twenty-one Stanford Financial Group investors filed an action in the Southern District of Texas against the SEC, the U.S. Marshal’s Service and the Stanford Group receiver claiming that the defendants violated the investors’ rights under the U.S. Constitution by freezing their Stanford Group accounts though the investors have been accused of no wrongdoing.

The investors’ complaint (which can be found here) opens with a quotation from Thomas Jefferson ("The true foundation of republican government is the equal right of every citizen in his person and property and in their management") and alleges that "acting in secret on President’s Day," the defendants "seized private property and suppressed free speech and assembly." The complaint alleges that the defendants "have not come forward with any evidence that the owners of the seized accounts did anything wrong, yet the Defendants continue to exercise control over Plaintiffs’ property in a reckless and negligent manner."

The complaint alleges that the SEC obtained a judicial order authorizing the freezing of the Stanford entities’ assets and appointing Ralph Janvey as receiver, and that the next day the U.S. Marshals surrounded and seized Stanford’s offices. As a result of these actions, the complaint alleges, the defendants took control of 35,000 bank accounts, including those of the plaintiffs. As a result of these actions, the plaintiffs cannot access their accounts. 

The group of twenty-one plaintiffs includes a gallery of victims whose woes surely tug the heartstrings. Plaintiff Tory DeArmond "lost her husband to cancer five days after the Presidents’ Day order froze the couple’s account." Plaintiff Alva Kerr suffers "the constraints of multiple sclerosis." Plaintiff Catherine Coulter "runs the Greyhound Pets of America Houston organization that places retired greyhounds for adoption."

Interspersed with these paragons are a number of financial advisor plaintiffs, some of whom were employed by the Stanford Group, and one of whom contends that he "wants to contact his clients immediately to tell them about the freeze and to advise them to take actions" but was told "that if he communicated with his clients, he could be put in jail."

The complaint seeks relief for "Violations of the First Amendment" (an apparent reference to the prohibitions barring the financial advisors from contacting their clients); "Violations of the Fourth Amendment" (for unreasonable seizures); Conversion; Negligence; and Gross Negligence. The complaint seeks actual damages; prejudgment interest; attorney’s fees; punitive damages; and post-trial damages. Oddly, the complaint does not specifically seek to have the freeze order lifted.

Meanwhile, and coincidentally also on March 4, the Stanford Group receiver, Ralph Janvey, apparently has petitioned the court to release the frozen Stanford investor accounts containing less than $250,000, so long as they aren’t linked to an $8 billion fraud investigation, according to a March 4, 2009 Bloomberg article, here. The accounts could be released as soon as March 9.

However, since the twenty-one plaintiffs seek compensatory not injunctive relief, the receiver’s actions to lift the freeze order would at least on a theoretical level neither supersede the plaintiffs’ claims nor provide the relief the plaintiffs seek.

The perennial law student within me feels compelled to point out that lurking somewhere within the investors’ complaint is what is referred to as a Bivens action. The name refers to the 1971 Supreme Court case of Bivens v. Six Unknown Named Agents of the Federal Bureau of Narcotics. The Bivens case held that a plaintiff can recover money damages from officers of the U.S. government for their actions violating the plaintiff’s fourth amendment rights. However, one difficulty these plaintiffs will face is that Bivens actions can only be asserted against federal officials, not federal agencies. Against federal agencies, the equivalent relief is limited to that available under the Federal Tort Claims Act, which among other things, prohibits relief for many intentional torts.

These legal observations are supplemented by the helpful comments of an esteemed legal professor (to whom I happened to married), who points out that the Administrative Procedure Act allows actions for injunctive relief against the U.S. and that the U.S. Supreme Court has long allowed plaintiffs to sue federal officials personally for injunctive relief. Which highlights the question as to why the investors’ complaint fails to seek injunctive relief.

I have in any event added this complaint to my list of Stanford Group lawsuits, which can be accessed here.

A March 4, 2009 Bloomberg article about the investors’ lawsuit can be found here.

You, You’re Nothing But a Hedge Fund: Apparently the insult du jour is to say that an enterprise is "just a hedge fund." First, on March 3, 2009, Ben Bernanke, in congressional testimony in which he declared how "angry" the AIG bailout made him, said that the AIG Financial Products division "was a hedge fund basically that was attached to a large and stable insurance company."

If a company can be disparaged by calling it a hedge fund, then how about a whole country? Michael Lewis (author of Liar’s Poker and other books) in an article in the April 2009 issue of Vanity Fair entitled "Wall Street on the Tundra" (here) quotes an unnamed IMF official as having said in October 2008, "Iceland is no longer a country. It is a hedge fund."

Lewis’s article tells the fascinating tale of how Iceland turned itself into a global financial powerhouse, and describes the astonishing wreckage left behind when the powerhouse turned out to be a house of cards. There are so many gems in this article it is hard to choose just one, but here is a sample. In explaining how the country adopted an entirely new way of economic life, one commentator noted that it was "just a bunch of young kids" who "came in, dressed in black, and started doing business."

His Name Was Maurice, He Called Himself Hank, But Everyone Knew Him for Chutzpah: Over the years, The D&O Diary has studiously avoided saying anything critical about Hank Greenberg. Frankly, The D&O Diary is scared of Hank Greenberg. However, all of a sudden, others seem to have decided that it is open season on Hank Greenberg.

First, a March 4, 2009 column in the Financial Times entitled "Too Much Time in the Spaceship, Hank" (here) chides Greenberg for his "chutzpah," compares him to "Ozymandias" and derides him because AIG’s failings "stem from its having been designed to be run by Mr. Greenberg. As soon as its domineering chief executive was shown the door, it was difficult for anyone to get a grip on what was going on."

The column hastens to add that "this implies, however, that things would be all right if Mr. Greenberg were still at the helm of AIG, and there is no proof of it." To the contrary, the column notes, the activities that brought AIG down started on Greenberg’s watch. The column concludes that "from this distance, amid this noise, it is hard to know what occurred, but no version of events fully exonerates Mr. Greenberg."

There is much more of this in the same vein in Ann Wolner’s March 4, 2009 Bloomberg column (here), in which she too emphasizes that the AIG Financial Products Division started while Greenberg still ran the company, and that it was on his watch that "that AIG began marketing credit default swaps linked to subprime mortgages."

She also notes that "it is rarely convenient for him to mention his status as an unindicted co-conspirator in a $500 million deal involving General Reinsurance Corp. that got the indicted co-conspirators convicted and imprisoned," and that "the company has so far paid $1.8 billion in fines and penalties to resolve civil claims by government regulators looking into the Greenberg era at AIG." She concludes that "it would be refreshing if Greenberg would stop for a moment pointing his finger at others and admit that he, too, was part of the problem."

I wish to stress that the views expressed in the two columns quoted above are solely those of their authors and should not necessarily be interpreted as expressing the views or opinions of The D&O Diary.

March Madness is Just Around the Corner: Many readers will be interested to learn about the Washington Post’s new site entitled "Beer Madness" (here). Be sure to roll your cursor across the beer bottles on the bottom of the page.

If You Knew Sushi Like I Knew Sushi: Here is a truly odd but interesting video, taken in a  restaurant in Tomakomai, on the Japanese island of Hokkaido. Watch, and leave your world behind for a few moments. (The fun is basically over once the camera goes into the kitchen.) Special thanks to a loyal reader for the video link.

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On March 2, 2009, in an opinion with important implications for the availability of coverage when a company official has inculpatory knowledge at the time of policy formation, Judge Gerald Lynch of the Southern District of New York granted the motions for summary judgment of two of Refco’s excess D&O insurers, but denied the summary judgment motion of a third excess insurer. The reasons both for the grants and the denial are instructive, particularly with respect to the interplay between varying excess forms and the language of the primary policy. A copy of the March 2 opinion can be found here.

Background

As reflected in prior posts regarding this case (here and here), this coverage dispute relates to the D&O insurance Refco procured in connection with its ill-fated August 2005 IPO. Refco’s $70 million insurance program was arranged in multiple layers, with a primary carrier and several excess carriers.

The $70 million program was arranged as follows: A primary $10 million layer; a first level excess layer of $7.5 million excess of the primary $10 million; a second excess layer of $10 million excess of the underlying $17.5 million; a third excess layer of $12.5 million excess of the underlying $27.5 million; a fourth excess layer of $10 million excess of the underlying $40 million; and a fifth excess layer of $20 million excess of $50 million. UPDATE: According to the remarks posted by an anonymous commentator, the fifth level excess policy is a Side A/DIC policy.

In October 2005, two months after Refco’s IPO, it was revealed that at the time of the IPO, Refco had an undisclosed $430 million receivable due from an entity controlled by Refco’s CEO, Phillip Bennett. Following this revelation, the company collapsed. Bennett, among others, has pled guilty to an array of criminal offenses.

Following Refco’s collapse, the company’s directors and officers were the target of extensive litigation. The primary and first level excess carriers advanced their entire combined limits of $17.5 million in payment of defense expense, subject to repayment if it is determined that there is no coverage. The four remaining excess carriers initiated litigation seeking a judicial determination of no coverage under their policies. In a June 18, 2008 opinion (here), Judge Lynch denied the second level excess carrier’s motion for summary judgment and in a subsequent opinion (here) determined that the second level excess carrier had an obligation to advance the payment of defense expense while the coverage issues were pending.

The March 2 Opinion

Judge Lynch’s March 2 Opinion relates to the motions for summary judgment of the third, fourth and fifth level excess carriers. Judge Lynch granted the motions of the third and fourth level excess carriers but denied the motion of the fifth level excess carrier.

The difference in outcome turned significantly on important differences between and among the excess policies each of the three carriers had issued to Refco. The third and fourth level excess policies were so-called "follow form" policies, meaning they followed the terms and conditions of the primary policy, except to the extent that their excess policies expressly adopted additional or different terms and conditions. The fifth level excess policy was not a follow form policy, a distinction that proved to be outcome determinative, at least for purposes of the summary judgment motions.

Each of the three policies had their own exclusionary provisions (not found in the primary policy) precluding coverage for claims arising from any facts or circumstances of which any insured had knowledge at policy inception and that might reasonably be expected to give rise to a claim. (The relevant exclusions were described in the third and fourth level excess policies as "prior knowledge exclusions" and as an "inverted representation endorsement" in the fifth level excess policy.)

Although he took some time getting there, in the end Judge Lynch had little trouble concluding that Bennett’s knowledge of the undisclosed receivable at the time of policy formation triggered these knowledge exclusions. The critical question was whether or not Bennett’s knowledge and the operation of the exclusions precluded coverage for all of the other insureds in light of the applicable policy terms and conditions.

The availability of coverage for the other insureds in turn depended on the operation of the applicable "severability language." This language determines whether or not the knowledge of one insured can be imputed to another.

Because the third and fourth level excess insurers’ policies are "follow form," the severability language on which the insureds relied to argue that Bennett’s knowledge was not imputable to them was from the primary policy. By contrast, because the top level excess policy was not a follow form policy, but instead had its own severability language, the insureds relied on the top level policy’s language in arguing for coverage under that policy.

After a lengthy discussion whether or not the primary policy’s application severability provision applied to the excess insurer’s exclusions, the court concluded that in the end the question didn’t matter. (See the following section for the distinction between application severability and exclusion severability.) Judge Lynch concluded that, under the policies’ terms, the addition of the knowledge exclusions to the third and fourth level excess policies "superseded" any contrary language in the primary policy, including the primary policy’s severability provisions.

Since the knowledge exclusions the third and fourth level excess policies precluded coverage where any insured has knowledge of the existence of facts giving rise to the claim, Judge Lynch concluded that Bennett’s knowledge of the receivables scheme precluded coverage for all of the insureds under the third and fourth level excess policies.

By contrast, however, Judge Lynch concluded that "a number of facts unique to [the top level excess insurer] preclude granting summary judgment to the insurer." The critical distinction is that the top level excess policy had its own severability provision, which, because it was in the same policy, was not superseded by the presence of the knowledge exclusion.

In addition, the top level excess insurer’s severability language lacked a critical sentence that the primary policy’s severability language included. The severability provision in the primary policy contained, but the top level insurer’s severability provision lacked, the following final sentence: "If any particulars or statement in the Application is untrue, the Policy will be void as to any Insured who know of such untruth." Because the top level excess insurer’s policy had no such provision, which specifically linked the severability language to the application, Judge Lynch concluded that the top level insurer "had not met its burden of showing" that its severability provision applied only to the application and not also to exclusions.

The Distinction Between Application and Exclusion Severabiltiy

A critical point to try to understand what is going on in this opinion is the distinction between application severability (that is, whether or not one person’s knowledge of application misrepresentations will be imputed to other persons) and exclusion severability (that is, whether or not one person’s knowledge or actions can be imputed to another for purposes of an exclusion).

Many practitioners will likely share my puzzlement that the decision almost entirely involves the question of the arguably more general operation of application severability provisions, even though the insurers were not relying on application misrepresentations to deny coverage, but rather upon the operation of the knowledge exclusion.

The explanation is that the excess policies apparently had no exclusion severability language of their own. Since the top level excess policy was not follow form and the excess policy has no exclusion severability language, the insureds relied on the arguably generalized operation of the application severability language to contend that Bennett’s knowledge could not be imputed to them for purposes of the exclusion.

The primary policy did, in fact, have its own exclusion severability language. However, Judge Lynch concluded (in a footnote) that because of the way the primary policy’s exclusion severability provision was worded, it applied only to the exclusions in the primary policy, and not to the distinct exclusion in the excess policy. Judge Lynch found that because the primary policy’s exclusion severability language applied only to the "above exclusions," it applied only to those found (that is, literally appearing "above") in the primary policy.

Discussion

If nothing else, this case provides an object lesson of the complicated way that the various components of a single D&O insurance program can operate to produce disparate results.

The so-called "follow form" policies wound up following neither the application severability nor the exclusion severability language of the primary policy, not because the excess policies expressly disclaimed those provisions, but simply because of the way the various policies interacted with each other. This opinion certainly highlights the truly limited extent to which "follow form" excess may actually follow form.

The extension of the excess policies’ knowledge exclusions to persons without knowledge is likely to trouble at least some observers. For most of the last decade, the D&O insurance industry has struggled to try to ensure that "innocent insureds" do not lose their insurance protection due to the misconduct or misrepresentations of others . The efforts to avoid these problems have concentrated on developing application and exclusion severability language limiting the consequences from the bad actors’ misconduct to the bad actors themselves.

This opinion illustrates an issue that may not have been a part of these industry efforts to create policy mechanisms to protect innocent insureds --  that is,  the importance of clarity of the purpose and design of application and exclusion severability provisions not just at the primary level, but all the way up the tower.

Another factor in this opinion not touched on above was the uncertainty whether or not the knowledge exclusions were even part of the excess policies. In addressing this issue, Judge Lynch reviewed the communications surrounding the placement of the insurance coverage. In my view, there was nothing unusual about these communications, which reflect nothing so much as the short time frame within which these kinds of insurance programs often are put together. But while the communications themselves are not out of the ordinary, the questions that subsequently have arisen do highlight the pitfalls of the policy procurement process.

Among other things, the process (at least to the extent reflected in Judge Lynch’s opinion) seems to suggest that in connection with the placement of the excess policies, the company’s representatives accepted the knowledge exclusion in lieu of an increased limits application. The practitioners’ pointer from this case is that severability is an equally important issue with respect to the exclusion as it would be to the increased limits application. This case suggests that in order to determine whether or not the severability issue is appropriately addressed entails consideration not only of the specific exclusionary language but also consideration of the interaction of all of the pieces in the tower.

The other specific practitioners’ pointer is that the exclusion severability language in a primary policy can be (and in this case, was) worded so as to restrict exclusion severability solely to the primary policy, without effect on any exclusions that may be added in any excess policies and regardless whether or not the excess policies otherwise are follow form policies. This observation suggests the need to specifically consider the question of exclusion severability in the context of any exclusions added to excess policies.

I wish to emphasize that nothing in these observations should be taken in any way as a criticism of anyone involved in the Refco coverage placement. This case demonstrates how complicated the interaction of the various program components can be, and that the interaction of the components can even, as this case demonstrates, produce results that might not be anticipated at the time of policy placement.

One final thought has to do with the fact that the court granted summary judgment for the third and fourth level excess insurers but not for the top level insurer. There has not at this point been any determination that there is coverage under the top level insurer’s policy. But if there were, I wonder whether the court’s entry of summary judgment on behalf of the third and fourth level excess insurer would create a gap in coverage that would relieve the fifth level excess insurer from its payment obligations – or rather, because the coverage underlying the fifth level of coverage will not be exhausted by payment of loss, could the fifth level excess carrier’s policy even be triggered? Obviously, the specific trigger language in the fifth level excess policy could be critical on this issue, but I suspect that before all is said and done the argument that there is a coverage gap will come up.

A March 3, 2009 memo from the Wiley Rein law firm discussing the Refco opinion can be found here. The Wiley Rein memo discusses a number of other important aspects of this opinion that I have not addressed above. Special thanks to the several loyal readers who sent me a copy of the opinion.

The Marc Dreier Scandal: The subsequent and much larger Madoff and Stanford Financial scandals have driven the Marc Drier scandal into the background, but the Dreier scandal is in some ways even more astonishing than those larger cases. A truly fascinating account of Marc Drier’s manic passage from hyper-aggressive lawyer to identity-misrepresenting fraud is set out in a March 3, 2009 American Lawyer article entitled "Anatomy of a Crack-Up: The Marc Dreier Case" (here). Alison Frankel’s comprehensive retelling of Drier’s disturbing tale makes for compelling reading.

We Don’t Need No Stinking TARP Money: According to a March 3, 2009 CFO.com article (here), a number of regional banks have concluded they are better off without TARP money. The article cites, for example, TCF Financial Corp, a Minnesota-based bank holding company with $16.7 billion in assets which claims that it only took the money ($361.2 million) under government pressure.

The article quotes the company’s CEO as saying that "the rules have definitely changed," and that whereas at the outset the message had been that only healthy banks would be granted the funds, subsequent Treasury actions and congressional mandates have created a "public perception" that banks that took TARP money "did so out of weakness." The CEO says that this perception puts the bank at a "competitive disadvantage."

The government recovery program is in trouble if bankers become convinced there is a stigma associated with accepting government aid. Part of the problem for the banks undoubtedly is the grandstanding politicians who insist on attempting to aggrandize themselves by flaying anyone receiving government aid. Even if some (but definitely not all) bankers made a hash of it in recent years, do we really want Congress trying to tell banks what to do?

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On February 23, 2009, Advisen released its Report of 2008 securities litigation entitled "Securities Litigation in 2008: Implications for the D&O Market in 2009 and Beyond" (here, $ required). The Advisen Report’s numerical securities litigation analysis is directionally consistent with prior reports of the 2008 lawsuits, although the Report also contributes its own unique observations to the dialog. The Report also provides a number of specific comments about the lawsuits themselves as well as about likely future trends, including in particular reflections on the implications for D&O insurers.

Advisen’s February 26, 2009 press release describing the Report can be found here.

Largely as a result of the way it counted the lawsuits, the Advisen report concludes that securities class action lawsuits as such did not substantially increase in 2008 compared to 2007, although both years’ activity did increase compared to 2006. Pertinent to these conclusions, the Advisen Report provides a lengthy explanation of its "counting" methodology, which is helpful in understanding how Advisen’s numbers differ from those reflected in prior reports. The Advisen Report correctly notes that the phrase "securities class actions" is "increasingly inadequate for categorizing and explaining securities suits."

The Advisen Report is consistent with previous released studies in its conclusion that during 2008 securities litigation was concentrated in the financial sector. The Report notes that "fully half of securities lawsuits filed in 2008 named financial firms and their directors and officers as defendants." Specifically, the Report finds that banking, finance and insurance companies accounted for half of the securities lawsuits in 2008.

The Report stresses that the nature of many of the suits filed in 2008 differs from what may have been standard form in prior years. Many of the suits were not filed against public companies for their financial disclosures, but rather were filed against companies that structured or sold securities, and were being sued for representations about the securities themselves. The auction rate securities lawsuits are one illustration of this new category.

In addition, Advisen reports that during 2008, many of the suits were filed not as securities class action lawsuits as such, but rather in the form of lawsuits for breach of fiduciary duty, breach of contract, or common law torts. Many of these lawsuits were filed in state court.

The Report notes that as the economy continues to deteriorate, "at some point in 2009, the idea of ‘subprime and credit crisis’ as a category of suits will fade away as the credit crisis simply becomes ‘the economy’." Among other things, the Report speculates that the spreading economic woe could cause the growing litigation wave to spread outside the financial sector.

The deteriorating economic conditions could also lead to increased bankruptcies, a development the Advisen Report notes "almost certainly will be accompanied by an increase in securities lawsuits." The Report notes that since 1995, roughly 35 percent of large public companies (defined as having more than $250 million in assets, measured in 2008 dollars) that filed for bankruptcy were also named in securities class action lawsuits. However, in 2007 and 2008, the percentage increased to 77 percent.

The Report also notes a number of factors contributing toward escalating costs of defense, including the complexity of the cases being filed, the novelty of many of the legal theories, and the coincidence of multiple, simultaneous proceedings.

The Report reviews the implications of these developments and trends for D&O carriers. The Report also contains interesting comments from several D&O mavens, including John McCarrick, Rick Bortnick and Joe Monteleone. The Report is interesting, well-written and well-documented, and well worth reading in its entirety.

My own overview of the 2008 securities lawsuit filings can be found here.

Remember Options Backdating?: The cases from the last wave of corporate scandals still remain, although fewer and fewer or them all the time. On February 27, 2009, the parties to the Sunrise Senior Living securities lawsuit, one of the remaining options backdating related securities class actions, agreed to settle the case for $13.5 million. A copy of the stipulation of settlement can be found here.

I have added the Sunrise settlement to my running table of the options backdating related lawsuit settlements, dismissal and dismissal motion denials. The table can be accessed here.

Special thanks to Adam Savett of the Securities Litigation Watch for providing me with a copy of the Sunrise settlement stipulation.

Now I Have Seen Everything: According to a March 2, 2009 story on Bloomberg (here), former AIG Chairman and CEO Maurice "Hank" Greenberg has sued AIG alleging that "material misrepresentations and omissions" caused him to acquire AIG shares in his deferred compensation profit participation plan at an inflated value, and later to lose nearly his entire investment after AIG's losses became known.

A March 2, 2009 Reuters story about the lawsuit (here) says that Greenberg acquired the shares on January 30, 2008, when AIG shares traded at $54.37. The company’s shares closed today at 42 cents. Greenberg seeks the difference between what he paid for the shares and what he said the shares were worth, as well as reimbursement of more than $70 million of taxes.

The defendants in the lawsuit include, in addition to the company, Greenberg’s successor as CEO, Martin Sullivan, as well Joseph Cassano, who headed AIG’s Financial Product (AIGFP) division. Both men worked for Greenberg prior to Greenberg’s departure.

I wonder if his lawsuit would be barred from coverage under AIG’s D&O insurance program (assuming for the sake of argument that it is not otherwise exhausted by prior claims)? As a former officer and director of the company, he still qualifies as an "insured" and so his lawsuit potentially at least could trigger the "insured vs. insured" exclusion typically found in most D&O policies. On the other hand, he left the company in March 2005, and so his claim might come within a coverage carve back in the exclusion, depending on how the applicable provision is worded.

If one were to assume that insurance would not be available, then defense expenses (both for the company and for the individuals, who would be indemnified by the company) would come from AIG itself, which owes the U.S. government approximately a gazillion dollars. The same would go for any uninsured settlements or judgments. I leave to others to comment on whether or not taxpayers ought to have to incur the costs associated with this lawsuit.

Perhaps pertinent to the question whether or not taxpayers should have to bear the cost of Greenberg's lawsuit, in comments published today (here), the current AIG CEO, Edward Liddy, said that Greenberg is partially responsible for AIG’s current woes. Among other things, Liddy said "The formation of the AIGFP unit, which has literally brought us to our knees, that happened on his watch. The compensation systems that have gone astray, happened on his watch. I don’t think it’s as clean and simple as sometimes Hank would like to portray."

And Finally: This week’s Time Magazine has several interesting article about the current economic crisis, including an article highly critical of former SEC Chairman Christopher Cox, entitled "The Inside Story on the Breakdown at the SEC" (here).

In addition, this week’s issue also has a fascinating story entitled "One Bad Bond" (here), which explains how losses have compounded exponentially in connection with a CDO-cubed created in March 2007 and called Jupiter High-Grade CDO V. This poster-child of financial engineering excess was originally rated AAA, but now nearly 59% of the instrument’s investments are worthless. Among Jupiter’s investments is an interest in the Mantoloking CDO, a toxic investment vehicle about which I blogged a year ago, here.

The article is worth tracking down in its original print version, because the print version is more detailed and is accompanied by graphics that are not available online but that do a particular good job in showing how the complexity of these instruments compounded the losses as the underlying mortgages have faltered.

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Even though I was not even away a full week for the recent PLUS D&O Symposium, there was a flood of noteworthy developments while I was gone. Here is a roundup of last week’s news and notes.

Subprime-Related Derivative Lawsuit Largely Dismissed: In a detailed and painstaking February 24, 2009 opinion (here), Chancellor William Chandler dismissed the bulk of the consolidated subprime-related derivative suit pending against Citigroup, as nominal defendant, and certain of the company’s directors and officers, in Delaware Chancery Court. A very thorough review of the opinion can be found on the Delaware Corporate and Commercial Litigation Blog, here.

Chancellor Chandler dismissed all but one of plaintiffs’ claims for failure to adequately plead demand futility. He did, however, allow plaintiffs’ claims of waste concerning the compensation and benefits package for Citigroup’s CEO to continue.

The most interesting part of Chancellor Chandler’s opinion relates to the plaintiffs’ allegations that the defendants failed to monitor the company’s business risk with respect to Citigroup’s exposure to the subprime mortgage market. Chandler characterized this claim as an assertion that "the director defendants should be personally liable to the Company because they failed to fully recognize the risk posed by subprime securities."

Chandler noted that Delaware case and statutory law places "an extremely high burden on a plaintiff to state a claim for personal director liability for failure to see the extent of a company’s business risk." Chandler concluded that in light of this burden, plaintiffs’ conclusory allegations (and thus their failure to plead particularized facts) were insufficient to excuse demand.

Among other things, Chandler noted that the "oversight duties under Delaware law are not designed to subject directors, even expert directors, to personal liability for failure to predict the future and to properly evaluate business risk."

Chandler did take pains to distinguish the recent Chancery Court decision in which the "failure to monitor" claim against the directors and officers of AIG survived a motion to dismiss. (The February 10, 2009 opinion in the AIG case can be found here.) In that case, unlike the Citigroup action, the defendants "allegedly failed to exercise reasonable oversight over pervasive fraudulent and criminal conduct." The Citigroup case, by contrast, involved only alleged failure to recognize the extent of the company’s business risk.

Both because of the high-profile nature of the Citigroup case as well as Chancellor Chandler’s detailed review of the applicable provisions of Delaware law, his opinion could prove to be particularly influential in other pending subprime and credit crisis-related derivative suits. The basis on which he distinguished the AIG case could also prove to be an important distinguishing characteristic in the determination of which derivative suits will survive and which may be dismissed.

I have in any event added the Citigroup opinion to my table of subprime and credit crisis-related lawsuit settlements, dismissal and dismissal denials. The table can be accessed here. A list of the subprime and credit crisis-related derivative suits themselves can be found here.

One final observation about the Delaware Corporate and Commercial Litigation Blog, which I referenced above. If you have any inclination or desire to follow the important legal trends affecting the potential legal liabilities and responsibilities of corporate directors and officers, you will find the Delaware litigation blog absolutely indispensible. I would rank the blog among the few truly must-read resources in this area on the Internet. The blog’s post on the Citigroup case is just one example why.

More Stanford Financial Developments and Litigation: In addition to the initiation of criminal charges against former Stanford Financial Group investment officer Laura Pendergast-Holt for obstructing the SEC’s investigation (about which refer here), last week’s developments regarding the Stanford scandal included the SEC’s filing late Friday night of an amended enforcement complaint in the matter.

According to the SEC’s amended complaint (which can be found here), R. Allen Stanford and his firm’s CFO, James M. Davis, operated a massive Ponzi scheme and misappropriated at least $1.6 billion of investor money in bogus personal loans to Stanford. An unspecified additional amount was also put into speculative investments, which by the end of 2008 made up the bulk of the Stanford Financial Group’s investments, though the company marketed its portfolio as a "well-diversified portfolio of highly marketable securities."

The amended complaint also alleged that Stanford and Davis fabricated portfolio’s investment performance, deciding each month on the return to be reported and "reverse engineering" the financial statements to reflect investment income that was never earned.

A February 28, 2009 New York Times article describing the criminal charges and the amended SEC complaint can be found here.

In addition to these criminal and regulatory developments, the Stanford Group was also hit with an additional civil lawsuit, this time involving a case filed in a Canadian Court. According to a February 27, 2009 article in the Financial Post (here), on February 25, 2009, Calgary-based furniture manufacturer has initiated a class action lawsuit in the Alberta Court of Queen’s Bench against Allen Stanford, Stanford International Bank, Stanford Group Company, Stanford Capital Management LLC, James M. Davis and Laura Pendergast-Holt.

The company alleges that it invested $1 million in certificates of deposit issued by the bank. The complaint, which seeks class action status, seeks damages for misrepresentation, unjust enrichment, conversion, fraudulent conveyance and breach of trust. The complaint also asserts fraud in connection with other Stanford investments.

I have added the new Canadian lawsuit to my running tally of the Stanford related litigation, which can be accessed here.

More Madoff Litigation, Too: During the past week, additional litigation related to the Madoff scandal also continued to flow in. I have added multiple new cases to my running tally of the Madoff-related litigation, which can be accessed here. Special thanks to the several readers who have alerted me to new Madoff cases, particularly to loyal reader Jon Jacobson.

One of the more interesting new cases is the one filed on February 24, 2009 in the District of New Jersey. Though this case raises allegations similar to those asserted in prior cases, the complaint asserts claims neither against Madoff and firm nor against the Madoff feeder funds. Rather, the sole defendant in the case is Peter Madoff, Bernard Madoff’s brother.

According to the complaint in the case (which can be found here), Peter Madoff and his brother "have worked side by side" for "nearly 40 years," and their offices "were only a few feet from each other." The complaint alleges, among other things, that Peter Madoff was responsible for "regularly verifying and accurately reporting the financial condition" of the Madoff firm, as well as establishing and monitoring internal controls and detecting and reporting any legal violations. The complaint asserts claims under Sections 10(b) and 20 of the ’34 Act, for breach of fiduciary duty, aiding and abetting, negligence, and negligent misrepresentation.

Hat tip to the Courthouse News Service for the Peter Madoff complaint.

Auction Rate Securities Litigation Continues to Amass: As I have previously noted (here), the various massive auction rate securities settlements do not seem to have stemmed the tide of auction rate securities litigation, and cases involving institutional and entity investors, who are not part of the regulatory settlements, continue to file new lawsuits.

The latest example of this phenomenon is the complaint filed on February 25, 2009 in the Eastern District of Missouri by KV Pharmaceutical Company against Citigroup Global Markets. A copy of the complaint can be found here.

The complaint alleges that between May 2005 and February 2008, Citigroup counseled KV into investing $72 million in auction rate securities that are now illiquid. Among other things, the complaint alleges that the securities can now be sold, if at all, at substantial discounts to par value. The complaint alleges that "holding $72 million of illiquid ARS exacerbates KV’s current cash crisis, which is requiring KV to seek borrowed capital and engage in overall cost-cutting by, among other things, eliminating approximately 700 jobs."

Clearly the auction rate securities market’s continued failure to function is causing enormous stress for the persons and entities unfortunate enough to have been stuck holding these instruments when the music stopped last February.

Hat tip to the Courthouse News Service for the KV Pharmaceutical complaint.

More Failed Banks: Add two more banks to the growing list of 2009 bank failures. On Friday, February 27, 2009, the FDIC took control of the Heritage Community, Glenwood, Illinois (about which refer here), and of the Security Savings Bank of Henderson, Nevada (refer here). Prior to its closure, the Heritage Community Bank had assets of $232.9 million, and Security Savings Bank had assets of $238.3 million.

The closure of these two banks brings the total number of  banks closed during February 2009 to ten, and the 2009 year to date total to 16 (compared to 25 during all of 2008). The FDIC's complete list of failed banks can be found here.

As I recently noted (here), a significant number of the 2009 bank failures, including the two most recent examples, involve smaller community banks. These troubling developments raise serious concerns both for the banking community and for the larger economy. The rash of bank closures also raises the likelihood that there will be increased litigation involving the failed banks and their former directors and officers.

Did the Milberg Kickback Scheme Hurt Class Members?: Those readers who were fortunate enough to have attended the PLUS D&O Symposium among other things heard interesting comments from St. John’s University law professor Michael Perino about the fascinating video, "The Rise and Fall of Bill Lerach" (to see the video trailer for which, refer here). Perino mentioned in his discussion the research he had completed about the impact on shareholder class members from the kickback payments the Milberg firm made to the paid plaintiffs.

In light of Professor Perino’s remarks, I thought readers might appreciate having a link to the Professor’s research paper, which can be found here. As reflected in the paper’s abstract, Perino concluded that not only were the firm’s fee requests and awards overall higher in the cases identified in the indictment, but that these findings are consistent with the hypothesis that class members were harmed.

An interesting commentary on the paper can be found on Professor Ribstein’s Ideoblog, here.

Insurance Persons of the Year: The LexisNexis Insurance Law Center is receiving nominations for the "Insurance Law Persons of the Year." The Center will be making four awards: the Policyholder Attorney of the Year; the Insurer Attorney of the Year; the Insurance Regulator of the Year; and the Insurance Jurist of the Year. In each case, the award will go to the person in each area that had the most impact in insurance law during 2008.

The deadline for nominations is March 6, 2009. Nominations can be sent to Karen Yotis the following address: karen.yotis@lexisnexis.com.

My New All-Time Favorite Headline: The table I have assembled regarding the Stanford Financial Group litigation, which I mentioned above, has proven to be a popular addition to this blog. I am grateful that a number of other blogs and sites have linked to the post in which the table can be accessed.

But as nice as it is for other blogs to recognize my post, nothing can top the article posted on February 24, 2009 on the American Lawyer website (here), entitled "D&O Diary Launches Stanford Financial Litigation Tally; Kevin LaCroix is Our Hero." That one even impressed my wife (I think), which is really saying something.

My thanks to AmLaw reporter Alison Frankel for this nice but undeserved accolade.

And Finally: Just a reminder to all my readers that I continue to report additional items between blog posts on Twitter. Among other things, I am increasingly active in retweeting interesting items from other Twitterers. Readers interested in monitoring my "tweets" are encouraged to click on the Twitter button in the right-hand column above to follow my Twitter posts.

In addition, I remain interested in connecting with readers on LinkedIn. I have recently become much more active in various LinkedIn groups and I would like to draw other readers into the dialog. I encourage readers interested in connecting with me on LinkedIn to click on the button in the right hand column above and join my network.

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On February 28, 2009, Berkshire Hathaway released (here) the annual letter of its Chairman Warren Buffett, to the company’s shareholders. Like prior editions, this year’s letter contains homey and often humorous aphorisms and thought-provoking observations both about Berkshire and about the business economy as a whole. But, consistent with the fact that 2008 was Berkshire’s worst year ever, this year’s letter is much denser than prior years’ and -- along with Buffett’s usual tone of self-deprecation – reflects some occasional and uncharacteristic notes of defensiveness. There is at least one rather noteworthy omission from the letter as well. (Full disclosure: I own BRK.B shares, although not nearly as many as I wish I did.)

The Letter's Major Themes

The Global Economy: The letter opens with a sober appraisal of the "debilitating spiral" into which the global economy slipped during 2008. Buffett observes that these dire circumstances produced unprecedented governmental action, steps that were "essential" if the "financial system was to avoid total breakdown." But these "massive actions," while necessary, will "almost certainly bring on unwelcome aftereffects," including an "onslaught of inflation."

Buffett also expressed his concern that "the economy will be in shambles throughout 2009, and, for that matter, probably well beyond." However, in contrast to this gloomy shorter term view, Buffett’s long view is optimistic. He notes that "our country has faced far worse travails in the past," but that "without fail we’ve overcome them." Buffett asserts that "America’s best days lie ahead."

Berkshire’s Investment Performance: But even if the longer term view is bright, the immediate picture isn’t pretty. Berkshire’s 2008 results were its worst ever. On the other hand, the company’s results were considerably better than those of the S&P 500 companies. For example, Berkshire’s book value per share declined by 9.6% in 2008, while the S&P stock index fell 37% last year, including dividends.

The overall value of Berkshire’s investment portfolio fell 13.89%, form $90,343 per share to $77,793 per share. Nineteen of top 20 stakes in Berkshire’s U.S. stock portfolio declined last year.

Contributing to this investment decline were some "dumb things" Buffett did in managing Berkshire’s investments, including a "major mistake of commission" involving a major acquisition of ConocoPhillips stock when oil prices were near their peak. Buffett comments in the letter that "the terrible timing of my purchase has cost Berkshire several billion dollars." Buffett also noted his poor timing in spending $244 million to invest in two Irish banks that have since declined 89% in value.

Berkshire’s Derivatives Portfolio: Nearly a quarter of the shareholders’ letter is given over to Buffett’s defense of Berkshire’s derivatives portfolio. Greater detail regarding the portfolio was not only requested by regulators, but it was perhaps obligatory in any event, in part because of Buffett’s own long standing criticism of derivatives as "financial weapons of mass destruction," but also because of what the derivative investments did to Berkshire’s reported 2008 financial results.

The company’s share price has declined over 40% in the past year largely due to concerns about the company’s exposures to derivatives. The company’s fourth quarter net income fell 96 percent to $117 million from $2.95 billion in the prior year’s final quarter. The decline is primarily the result of mark to market losses on long-term derivative investments in Berkshire’s portfolio.

But while detailed disclosure of Berkshire’s derivative portfolio may have been mandatory, Buffett seems rather grumpy about it. Indeed, at virtually the same time Buffett lays out the company’s derivative investments, he mutters some rather disparaging remarks about the futility of increased "transparency" requirements for "describing and measuring the risk of a huge and complex portfolio of derivatives."

In case some readers might conclude that Berkshire itself has a huge and complex portfolio of derivatives (and, in my view, that is the only conclusion that anyone acquainted with the facts, even as presented by Buffett, reasonably could reach), Buffett strains to try to differentiate Berkshire’s portfolio. Not only were Berkshire’s derivative contracts "mispriced at inception," but also, by contrast to many similar arrangements, Berkshire "always holds the money." Moreover, only "a small percentage of our contracts call for posting of collateral," and even under last year’s chaotic conditions," Berkshire had to post less than 1% of its securities portfolio."

So, I guess the message is, don’t be alarmed by those massive, multi-billion dollar "mark to market" write-downs -- everything is fine. My own view is that Buffett was much more persuasive before when he was decrying derivaties as "financial weapons of mass destruction." 

The Subprime Debacle: Buffett’s letter also contains a separate homily about the experience of Berkshire’s mobile home subsidiary, Clayton Homes, whose recent performance is, in Buffett’s retelling, a sort of morality tale against which to compare the events that up to the subprime meltdown.

Though they are people of "modest incomes and far-from-great credit scores," Clayton’s mobile home buyers have much lower default and foreclosure rates that those of many similar residential borrowers because "they took a mortgage with the intention of paying it off, whatever the course of home prices." The mobile home buyers didn’t "count on making loan payments by refinancing" and they weren’t seduced by "teaser rates."

Buffett observes that foreclosures don’t happen because housing prices decline, but because borrowers "can’t pay the monthly payment they agreed to pay." The home purchased "ought to fit the income of the purchaser." And, Buffett adds, homeowners who have "made a meaningful down payment – derived from savings and not from other borrowing – seldom walk away from a primary residence."

Buffett concludes with the observation that "putting people into homes, though a desirable goal, shouldn’t be our country’s primary objective." However, keeping them in their homes "should be the ambition."

Tax- Exempt Bond Insurance: Buffett also takes considerable pains to describe Berkshire’s move into tax-exempt bond insurance, and how the financial troubles of the traditional monoline bond insurers allowed Berkshire an opportunity to reap outsized premiums for "second-to-pay" insurance (triggered if the primary monoline carrier defaults).

Though unabashedly gleeful in describing this opportunity and how it came about, Buffett also gravely notes that it is "far from a sure thing that this insurance ultimately will be profitable for us." He notes that while municipal debt historically has enjoyed an essentially default free record, the future could be far different, and indeed, the very presence of Berkshire insurance could itself trigger a higher rate of defaults. Buffett also notes that defaults could be correlated. In short, insuring tax exempts "has the look today of a dangerous business."

Some Interesting Sub-topics

In addition to the major themes, there are also of narrower message salted throughout the letter. Some of these, although barely mentioned, are among the letter’s more interesting details.

For example, I was interested to note that as a result of Berkshire’s unsuccessful bid to acquire Constellation Energy, Berkshire not only received a break-up fee of $175 million but also reaped an investment gain on the Constellation shares it did acquire of $ 917 million. I supposed Berkshire could hardly be described under these circumstances as a "disappointed bidder." (The details of the transaction are briefly summarized here.)

Buffett also tucks into the letter a brief commentary of how the swing of the risk-tolerance pendulum had resulted in the "U.S. Treasury bond bubble of late 2008," which could be regarded as "almost equally extraordinary" as the "Internet bubble of the late 1990s and the housing bubble of the early 2000s." Buffett predicts that clinging to cash equivalents or government bonds will almost certainly be "a terrible policy of continued too long," if for no other reason that inflation alone will "erode purchasing power."

There are also a couple of separate notes in the letter about Berkshire’s apparent growing commitment to green energy. In his description of Berkshire’s utilities businesses, Buffett describes the utilities businesses’ growing wind power output. And in his description of the upcoming Berkshire shareholders’ meeting, he notes that among the exhibits at the meeting will be a "new plug-in car developed by BYD, an amazing Chinese company in which we own a 10% interest."

Commentary

While this year’s letter rewards careful reading just as much as prior years’ letters, and though this year’s letter arguably contains even more that customary detail, there are nonetheless some critical omissions.

First and foremost, the letter is silent about the criminal fraud convictions during the past year of the former CEO and former CFO of the Berkshire’s largest subsidiary, General Re, for misconduct committed while General Re was a part of the Berkshire group. For details regarding the convictions, refer here and here. (Full disclosure: for several years, I was employed by a General Re subsidiary.)

At one level, this omission may be understandable given questions some have asked about Buffett’s own possible involvement in the events at the heart of the prosecution. But given these criminal convictions, the letter’s happy talk about General RE’s 2008 annual results – including Buffett’s euphemistic reference to the fact that the subsidiary’s successor CEO also "stepped down" during the past year, without any reference to the reasons for the successor CEO’s other than purely voluntary departure – rings hollow, or at least lacking in context.

There is an ironic contrast between this rather obvious omission and the withering tone Buffett employs later in his letter to describe the June 15, 2003 OFHEO letter and report that "were delivered nine days after the CEO and CFO of Freddie had resigned in disgrace and the COO had been fired." Some might call it hypocritical on the one hand for Buffett to disparage OFHEO’s letter for its failure to mention the Freddie Mac officials’ departures while at the same time himself omitting even to acknowledge the criminal convictions of the two most senior officials of his company’s largest subsidiary.

In addition, while Buffett was characteristically direct in acknowledging the mistaken timing of his ConocoPhillips investment, I think it is worth noting that the ConocoPhillips and Irish Bank investments were far from the only recent Berkshire investments that may have been ill-timed.

Looking at Berkshire’s largest stock holdings, it appears that many of Berkshire’s most recent investments are faring poorly. In particular, the recent investments in Swiss Re (down 85% the past year), on which Buffett recently doubled down, raises certain questions.

For that matter, some of Buffett’s longer term investments have also declined beyond market wide averages, including in particular American Express (down 71% in the past year) and Moody’s (down 53% in the past year).

Of course, times are tough throughout the financial arena, and not even Berkshire is immune from the current overwhelming financial downdraft. Among many interesting points Buffett makes in his letter is his observation that 75% of the time during Berkshire’s 44-year history, the S&P 500 has recorded an annual gain, adding that he guesses "a roughly similar percentage of years will be positive in the next 44."

We can all, even those who may not own Berkshire shares, hope that Buffett is right about the prospects for future positive results.

A Final Note: My review of Alice Schroeder’s recent biography of Buffett, "The Snowball," can be found here.

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