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

With the addition of four more bank closures this past Friday night, the YTD number of bank failures now stands at 29, which already exceeds 2008’s total of 25 and is the highest annual total since 1993, at the end of the last era of failed banks. All signs are that the number of bank failures will continue to grow in the months ahead, a prospect that is already affecting the D&O insurance marketplace, even for smaller community banks. 

The four banks that closed this past week were: American Southern Bank of Kennesaw, Georgia, which prior to its closure had assets of $112.3 million (for further details about its closing, refer here); Michigan Heritage Bank in Farmington Hills, Michigan, which previously had assets of $184.6 million (refer here); First Bank of Beverly Hills in Calabasas, California, which previously had assets of $1.5 billion (refer here); and First Bank of Idaho in Ketchum, Idaho, which has assets of $488.9 million (refer here). 

Although the assets of three of the banks were sold to other financial institutions, the FDIC was unable to find a buyer for First Bank of Beverly Hills, forcing the FDIC to assume the financial institutions assets. 

The closure of American Southern Bank adds to the growing list of failed banks in Georgia, which, as I noted at length here, leads the nation in number of bank failures. With the addition of American Southern, there have been ten bank failures in Georgia since January 1, 2008, including five already in 2009. California is a close second behind Georgia in number of failed banks, and the failure of First Bank of Beverly Hills brings the number of California bank closures since January 1, 2008 to nine. 

But the overall geographic distribution of the latest four banks to fail, and indeed of the banks closed so far in 2009, highlights the fact that the bank woes are not concentrated in any one geographic area. Rather, the banking troubles seem to be distributed around the country. Banks have failed in 16 different states already this year, sprinkled across the national map. The FDIC’s complete list of failed banks since October 1, 2000 can be found here. 

These latest four closures also highlight the fact that the banking woes are not limited just to the largest banks; to the contrary, the bank failures increasingly seem to involve the smaller community banks. Three of the four most recently closed banks had assets below $500 million, and many of the other banks closed this year also were similarly smaller banks.

One generally accepted definition of a community bank is a banking institution with assets below $1.0 billion (refer here). By this definition, 25 of the 29 banking institutions that have failed this year are community banks, as only four the failed banks had assets over $1 billion. Indeed, most of the failed banks are very small; only seven of the 29 banks that have failed in 2009 had assets over $500 million. 

For many years, and even throughout the recent financial turmoil, community banks have been viewed as relatively safe. Their lack of involvement both in commercial lending and in subprime loans seemingly spared them the most significant problems that have characterized the current crisis – until now. The growing problems in residential real estate and rising unemployment levels are raising problems even in the community banking sector, as the bank closures described above demonstrate. Based on the 2009 bank closures, the community banking sector may now have become the leading edge for problems in the banking sector. 

Unfortunately, all signs are that these difficulties will continue in the months ahead. In the FDIC’s most recent Quarterly Banking Profile (as of December 31, 2008), the FDIC counted 252 institutions with assets of $159 billion on its “Problem List,” up from 171 institutions with $116 billion in assets at the end of the third quarter of 2008. (The FDIC does not identify the problem banks by name.) With unemployment growing and the number of troubled loans increasing, the number of banks on the “Problem List” undoubtedly will have grown when the FDIC releases its Quarterly Banking Profile for the first quarter of 2009 in a few weeks. And the bank closures are likely to continue to accumulate. 

The D&O insurance marketplace for the community banking sector had been a placid, quiet area where many insurers were willing to offer broad terms at low prices. However, as a result of the recent deterioration in the sector, the D&O insurance marketplace has very recently begun to change. There are still a number of carriers active in this space, but a number of players have recently started to take more conservative positions, even nonrenewing insureds in certain geographic areas or with certain characteristics. 

More restrictive terms that had largely disappeared, such as the regulatory exclusion, are suddenly reappearing in coverage proposals for some accounts. And banks that have been declined by several carriers may find they can only place their coverage at significantly increased premiums. The D&O insurance marketplace for community banks is placid no more. 

Perhaps the most noteworthy thing about these changes is how quickly they have taken place. This heretofore quiet corner of the D&O marketplace has very quickly become characterized by rapid chance. Although I have been and remain skeptical of some of the predictions about when we may see a hard insurance market, the speed of the changes in community banking sector represents the type and velocity of change that can occur in a market turn. It is still premature to say definitively that we are headed into a hard market anytime soon, even just for community banks, but there is some evidence to suggest that a harder market could well lie ahead.

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Bank of America’s acquisition of Merrill Lynch went through, so we will (fortunately) never know what would have happened if the deal had collapsed. But as detailed in the April 23, 2009 letter (here) from New York AG Andrew Cuomo to Sen. Chris Dodd, Rep. Barney Frank and others, if it had been up to BofA, the deal would not have closed, and it was only as a result of a combination of threats and inducements from Henry Paulson and Ben Benanke that BofA and its Chariman, Kenneth Lewis, were convinced to complete the deal.

In his letter, Cuomo urged Congressional and regulatory officials to examine the pressure that Paulson and Bernanke applied to Lewis and to BofA. Cuomo wrote that the federal officials' actions "raise fundamental questions about the interactions of regulators and those they regulate, as well as important issues of corporate responsibility and shareholders' rights." 

The information in the April 23 letter and accompanying documents is fascinating, but the still-incomplete picture of the December meetings in which BofA was convinced to complete the deal raise a number of serious questions. The letter and the accompanying exhibits can be found here.

1. Why did Lewis contact Paulson and Bernanke to tell them that BofA wanted to invoke the "material adverse event" clause and kill the deal? Presumably, the merger agreement was a private transaction between two private parties. Right? Well, maybe not. Apparently, as a result of its role in having brokered the Merrill deal, the government retained something more than a gaming interest in the transaction.

But why did Lewis have to report to the feds? Doesn’t it seem like he was asking their permission? Why? Was there a prior strong-arm session, perhaps back in September, where the government previously offered threats and inducements to BofA to get them to accept the deal in the first place? Did BofA make a commitment to the feds, and vice versa, as part of the events that led to the original deal?

2. Did Lewis and the BofA board accede to the fed officials’ demands in order to preserve their positions? Cuomo’s letter certainly intends to communicate that Lewis was convinced to go through with the deal in order to be able to keep his job. Lewis undeniably testified when examined by NYAG’s office personnel that Paulson threatened BofA’s board and Lewis with a loss of their positions. (A transcript of Lewis’s testimony can be found here.)

BofA’s December 22, 2008 Board of Directors Meeting minutes (here) reflect that Lewis reported to the board that Paulson had threatened them (Lewis and the board) with the loss of their positions if the deal failed to go through. Cuomo’s letter also reports that Paulson told the NYAG’s officials that the job threat to Lewis "changed his mind about invoking the MAC clause and terminating the deal."

To be sure, the December 22 board minutes also very carefully recite that "the Board clarif[ied] that is [sic] was not persuaded or influenced by the statement by federal regulators that the Board and management would be removed if federal regulators if the Corporation were to exercise the MAC clause and failed to complete the acquisition by Merrill Lynch." And both the December 22 and December 30, 2008 board minutes (here) reflect concerns about the possible damage to the global economy if the deal failed to go through.

But there doesn’t seem to be any doubt that the threats were made, that Lewis reported the threats to the BofA board, that the board and Lewis discussed the threats, and Paulson at least seems to think the threats had the effect he intended.

3. Realistically, could BofA have turned down the fed officials’ demands? It is not as if just that the Secretary of the Treasury and the head of the Federal Reserve Board alone were strong-arming BofA. BofA’s December 30 board minutes reflect that Bernanke was communicating about the deal to the Office of the Comptroller of the Currency, the FDIC, and the "incoming economic team of the new administration." The existence of these communications were revealed to reassure BofA that it could count on promised additional TARP money, but the existence of the communications also carried an unsubtle implied threat for a high profile company in a highly regulated industry.

At a minimum, BofA had to wonder how regulators might respond, at a very precarious time for the company, if it walked away.

4. Who said what to whom about disclosure? The April 23, 2009 Wall Street Journal led with the story, supported by the transcript from Lewis’s testimony before NYAG officials, that Paulson directed Lewis to withhold disclosure of BofA’s concerns with the deal in order to ensure that it went through. Whether or not these directions took place will be the central issue in the investigative frenzy that is no doubt about to unfold.

The one thing that is clear is that the BofA board was concerned about disclosure. Among other things, the minutes of the BofA’s December 30 board meeting show that the reason the federal officials could not give BofA written assurance that additional TARP funds would be forthcoming if the deal closed is that "written assurances would require formal action by the Fed and the Treasury, which formal action would require public disclosure." The wording of this sentence makes it unclear whether it is BofA or the feds that were worried about disclosure, but it seems clear that the feds were aware of and involved in the disclosure question.

A December 22 email from Paulson to the BofA board (here) seems to suggest that Lewis and the board was concerned about preventing disclosure, but the email arguably is ambiguous. In the email Lewis told the board that Paulson "could not send a letter of any substance without public disclosure, which of course, we do not want." The problem with this sentence is the question of who the word "we" refers to? Is Lewis reporting that Paulson used the word "we" (referring, perhaps, Paulson and his fellow regulators, or perhaps, to Paulson and Lewis), or is does the statement attributed to Paulson stop at the comma, and is the clause after the comma a statement of Lewis’s own, with the word "we" referring to BofA’s board?

Cuomo's letter and Lewis's transcript both seem to suggest that disclosure was not just a concern on the part of the BofA board, but that it was also a concern of Paulson's, and that he actibvly sought to avoid disclosure related to the unreported Merrill losses. Disclosure was a concern, a topic of discussion and focus in discussions between Lewis and Paulson. Which leads to my next two questions.

5. Did Paulson or Bernanke provide Lewis with immunity assurances? We are talking about some very smart guys, and they were fully aware of the legal requirements of disclosure, even if they didn’t pause to analyze the legal particulars. Lewis had to have known that by going through with the deal even though the Company felt entitled to invoke the MAC clause, and that by withholding disclosure of Merrill’s huge and unexpected fourth quarter losses, he and even perhaps the BofA board were potentially undertaking a massive legal exposure – at a minimum, a civil lawsuit exposure, and possibly even much worse exposures.

Did Lewis raise these issues with Paulson and Bernanke? (I find it almost impossible to believe that he did not.) Did they provide any assurances to him? Was he given assurances of immunity or indemnity? Did they promise him a "get out of jail free" card? Without these assurances, how could he possibly have been persuaded to "take one for the team"? Doesn’t it seem wildly improbable that these issues were not discussed?

6. Are Paulson and Bernanke or others potentially exposed to aiding and abetting liability? This question is not facetious and in fact it is particularly important to me, because I have former colleagues from GenRe, people whom I knew and whom I respect, who are going to jail for their complicity in a deal that seems miniscule and trivial compared to this minuet. Certainly, if the federal regulators directed Lewis and BofA not to disclose material nonpublic information, their involvement in nondisclosure that is later found to constitute securities fraud could implicate them as well.

But could they be implicated even if they did not direct the nondisclosure but simply accommodated and facilitated it (for example, by not following through on required federal processes that would have compelled public disclosure)? That is certainly all the Gen Re officials did, and as a result they are going to be spending some serious time in the federal penitentiary.

Let me hasten to add that I am not suggesting that criminal prosecution is something that I think will happen here, or even that I think should happen here. But if these kinds of questions are later raised, the questions clearly should be followed all the way to their logical conclusion.

7. The strong-armed deal may have hurt BofA shareholders, but could it have been worse for them if the deal crumbled? There is no doubt that Paulson’s demand that BofA go through with the deal despite the BofA’s view that it was entitled to invoke the MAC clause had the effect of requiring the BofA shareholders to take a big hit for the sake of the global economy. But that does not necessarily mean it was contrary to the BofA’s shareholders’ interests for BofA to go through with the deal.

Given how massively disruptive Lehman Brothers’ collapse was to the global financial marketplace, it is almost inconceivable how disruptive it could have been if the Merrill deal had fallen through. Merrill would have been cast off, and the revelation of its staggering and unexpected fourth quarter losses would have triggered its immediate collapse – or maybe federal officials could have tried a huge AIG-style rescue of Merrill while somehow trying to reassure that global financial marketplace that there was no reason to panic.

My point is that if the Merrill deal had fallen through, the collateral damage from the ensuing firestorm could have substantially damaged BofA's near and longer term interests.. It is impossible to know now, but the fact is that it may well have been in the BofA shareholders overall best interests for the firestorm to have been averted. Of course, it does seem like the BofA shareholder ought to have had the right to decide for themselves, doesn’t it?

8. Is there a national interest exception to the disclosure requirements in the federal securities laws? Imagine for a second if BofA had come right out and disclosed that it felt entitled to invoke the MAC clause but that in order to support the global economy and in exchange for some additional TARP money, it was going through with the deal anyway. Now basic principles dictate that they should have disclosed all of this. But if they had, the chaos that would have followed might have been as bad or even worse than what happened if the deal failed to close – which might well have happened anyway in the wake of these kinds of disclosures.

It is easy for commentators to try to argue now what should have been done, as if this were just an amusing question in a parlor game. At the time, however, the principals had no way of knowing how close they were running to potentially catastrophic financial disruption. In view of the weakness in the financial markets and the economy, it was no time for any experiments.

But do their fears, even if well founded, earn them a pass for their silence? If they get a pass, on what basis? What is the legal justification and where is it found? On what standard is it based? And who gets to decide when interests are sufficiently important to override the securities laws – can any government official decide that national interests override disclosure requirements? And what precedent would be set for the future? And isn’t it a duty of public officials to ensure compliance with the law, rather than encouraging noncompliance?

9. Given the facts on the table at the time and the surrounding revelations about Merrill’s fourth quarter losses, how is it possible that the controversial Merrill bonuses were permitted? Obviously, there is a lot more to be told on this score, but if the federal regulators had the authority to tell BofA it had to complete the deal, and if they felt empowered simply to override federal disclosure requirements, surely these same people had the clout to shut down the bonuses? If they felt they had the ability to trample, or simply disregard, BofA shareholders’ rights, why would they hesitate to bar the payment millions in bonuses for billions of losses?

Given all that was going on, that the bonus payments happened seems even more incomprehensible to me – and I am sure I am not the only one.

10. How long will it be before this all gets sorted out? I suspect this will go on for years and years to come. Expect the most immediate steps to include a cycle of sessions in Congressional hearing rooms, replete with the revolting spectacle of speechifying politicians grandstanding at the expense of public dignity. The various judicial processes, some of which are already well underway, some of which will be launched in the months ahead, will grind on for years, with at least two or three round trips to the Supreme Court. My prior post about lawsuits already filed about these circumstances can be found here.

At some point, possibly in the near future, a coalition of crusaders, a lynch mob, or a gang of zealots will try to organize Lewis’s ouster, and who knows, maybe they may well succeed this time. Indeed, for those wondering why all of this is coming to light all of the sudden now, the timing was obviously due to the fact that the BofA shareholders' meeting is next week -- leaving just enough time for the voices of outrage to get fully tuned up for the meeting.

Whatever else you want to say about these circumstances, the spectacle to which we are all about to be subjected will not be pretty and is unlikely to be edifying.

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The recent Environmental Protection Agency (EPA) proposal to find that greenhouse gases "contribute to air pollution that may endanger public health or welfare" is just the latest in a series of actions and events suggesting that climate change related issues could affect a large number of companies, in a variety of ways, including most specifically with respect to at least some companies’ disclosure obligations. These trends could have important implications for potential liability exposures of directors and officers of public companies.

On April 17, 2009, the EPA released a proposed "endangerment finding" with respect to six greenhouse gases (including carbon dioxide). The EPA’s April 17 press release can be found here and a summary of the proposal can be found here. Under the EPA’s proposed finding (which can be found here), the EPA is proposing that the six gases "threaten the public health and welfare of current and future generations." The EPA also proposes to find that motor vehicle emission of these gases "contribute to concentrations of these key greenhouse gases and hence to the threat of climate change."

The proposed endangerment finding was promulgated in response to the 2007 U.S. Supreme Court decision in Massachusetts v. EPA (discussed at length here). The EPA’s proposed finding, which is now in its public comment period, does not itself include any specific regulatory action or requirements. However, if the proposed finding is adopted, regulatory and even legislative action seems probable, especially given the politics and inclinations of the current President and Congress. Indeed, the adoption of the proposed finding could motivate legislators to act preemptively, to try to avert regulatory provisions they might find unacceptable.

The potential scope of any future regulatory or legislative action can be gauged by the specific observations in the EPA’s proposed endangerment finding. That is, the proposed finding not only concludes that climate change "impacts human health in several ways" (such as increased threat of catastrophic weather activity or harm to water and other natural resources), but also that the effects of climate change will have a "disproportionate impact" on certain vulnerable segments of the populations, such as the very poor, the elderly and those already in poor health.

The EPA’s report also includes the suggestion that climate change has "serious natural security concerns" based on the instability that could follow in the wake of "increasing scarcity of resources."

With these kinds of concerns as a starting point, the potential for any ensuing regulatory or legislative activity to have a disruptive impact on many industries and companies seems high. Indeed, if the risk assessments in the EPA’s findings are anywhere near accurate, the climate change itself, independent of any governmental action, could have a disruptive impact on many industries and companies.

Many of the industries and companies likeliest to be affected already are under pressure to anticipate these changes and assess their possible future impact.

The most recent effort to mandate these kinds of assessments is the disclosure requirement adopted on March 17, 2009 by the National Association of Insurance Examiners (NAIC). The NAIC’s March 17 press release can be found here and further background regarding the NAIC’s disclosure initiative can be found here.

The NAIC’s new disclosure requirements specify that no later than May 1, 2010, all insurance companies with annual premiums over $500 million must complete a Insurer Climate Risk Disclosure Survey. The Survey is designed to require the insurers to disclose "the financial risks they face from climate change, as well as the actions the companies are taking to respond to those risks."

Under the NAIC’s mandate, insurers will be required to report on "how they are altering their risk-management and catastrophe-risk modeling in light of the challenges posed by climate change." Insurers must also report on "steps they are taking to engage and educate policymakers and policyholders on the risk of climate change," as well as "whether and how they are changing their investment strategies." As discussed below, the requirement for insurers to disclose how they are "engaging and educating" policymakers and policyholders could be the bridge that extends the NAIC’s initiative to many other industries.

Another industry under pressure to analyze and assess climate change impacts is the utilities industry. As discussed (here), in August 2008, New York Attorney General Andrew Cuomo reached the first of several regulatory settlements with utilities companies, in which the settling companies agreed "to disclose financial risks that climate change poses to investors."

Among other things, the settling utilities have undertaken to disclose risks associated with probable future climate change regulation; climate change related litigation; and the physical impacts of climate change. In his press release relating to the first of these settlements, Cuomo expressly stated that he expected these companies’ disclosure undertakings to "establish a standard."

The insurance and utilities industries may be the most likely industries but they are far from the only industries that potentially will be affected by climate change regulation and the physical impacts of climate change. Other obvious possibilities include auto manufacturing; oil and gas extraction, production and distribution; transportation and shipping; mining; agriculture; tourism; and forestry.

But the comprehensive nature of climate change suggests that the potential impacts will not be restricted just to these more obvious industries; the regulatory and the physical impacts of climate change are likely to extend to any business that is engaged in manufacturing; owns or operates vehicles; owns or operates buildings or other physical facilities; or has any other process or activity that has carbon outputs.

In other works, the impacts could well reach every company and enterprise. This assessment may seem overly dramatic, but at a minimum it seems likely that the kinds of disclosure requirements now facing insurance companies and the utilities industry could come to be expected of many other companies. As Cuomo said in connection with the settlement described above, he expects that the disclosure requirements will "establish a standard."

Whether these changes will actually take place remains to be seen. But whether or not they ultimately happen, the prudent course would seem to be to anticipate that they will. Which leads to the point referenced above, about the prospect that insurers could wind up driving change for many other companies.

That is, with insurers themselves obliged to start reporting next May among other things on what steps they are taking to engage and educate policymakers and policyholders on climate change, one possibility is that insurers could take the lead in communicating the message that prudent companies should assume that these changes are coming. Insures could wind up spurring their policyholders to undertake the same kind of risk assessment and disclosure that Cuomo is requiring in the regulatory settlements with the utilities.

Specifically, it seems possible that D&O insurers, in order to fulfill their own disclosure obligations under the NAIC’s mandate (and to look proactive while doing so) could undertake to "educate" their policyholders about the need to assess both the possible regulatory and physical impacts of climate change on their operations and financial condition, and to disclose those assessments to investors, as a way to manage a variety of climate change related risks.

In any event, whether or not insurers actually take that step, well-advised companies may independently conclude on their own that given the possible regulatory and physical impacts of climate change, risk assessment and disclosure is simply prudent.

One of the lurking dangers when a single issue predominates, as the global financial crisis recently has, is that all other concerns may seem trivial and unimportant by comparison. For many companies, especially those outside the insurance and utilities industries, climate change issues may now seem subordinate and remote to the point of irrelevance. But when we finally emerge from the current crisis, we may find that the climate change risks loom larger than ever and are more important than anyone now imagines.

This is not the first time I have raised these climate change related issues (refer for example here). I know there are those who think I am alarmist about this issue, and I suppose the skeptics could be right. However, even the most hardened cynic will have to acknowledge that, given the EPA’s recent pronouncement and given the current political environment in Washington, regulatory and even legislative activity seems likely, which is clearly a risk, trend or uncertainly that prudent companies will be assessing and disclosing.

And allow yourself for a moment to consider the possibility that the risk assessments in the EPA report could actually come to pass. At a minimum, if these things are possible, shouldn’t companies also be assessing the possible impact of climate change on their operations and financial condition?

Many companies today might conclude that there will be time enough tomorrow to deal with tomorrow’s problems. That was exactly the logic that led Detroit to keep grinding out SUVs and Hummers for the last twenty years, when more forward-looking competitors were already capturing market share by making hybrid vehicles. Just as Detroit’s past leaders are now criticized for their lack of vision, so too may other corporate leaders who now defer on these issues find themselves later under siege for failing to look ahead and anticipate the changes and problems just ahead.

Somehow, on Earth Day, these issues seemed particularly important for me. And for my kids.

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As reflected in the most recent dismissal motion rulings in the Countrywide subprime securities lawsuit, the proper use of a Rule 10b5-1 trading plan can provide a substantial defense to allegations of securities law violations. In her April 6, 2009 opinion (here), Central District of California Mariana Pfaelzer dismissed the insider trading allegations against certain individual defendants whose trading plans were in order. However, she refused to dismiss the insider trading allegations against Countrywide CEO Angelo Mozillo, whose plan was ‘unusually modified," demonstrating that merely having a plan is by itself not enough, if the plan is not structured properly or has been altered.

This difference in outcome underscores the need for certainty about what plan features and practices will afford the desired protection under the Rule. In a March 25, 2009 update (here), the SEC’s Division of Corporate Finance updated its Exchange Rules Compliance and Disclosure Interpretations (C&DI) to provide additional guidance on Rule 10b5-1.

As reflected in an April 17, 2009 DLA Piper memo (here) discussing the SEC’s recent updated guidance, the update "comes at a time of heightened and well-publicized scrutiny by the Enforcement Division of the SEC regarding trading activity in and around Rule 10b5-1 plans." According to the law firm memo, the updated C&DI includes "some important new guidance."

As discussed in the memo, the updated guidance clarifies that "the cancellation of one of more plan transactions" affects the availability of the affirmative defense under the Rule, because the cancellations represent an alteration of or deviation from the plan. Similarly, the facts and circumstances surrounding the creation of a new plan after the cancellation of a prior plan needs to be evaluated to determine the "good faith" intent of the person creating the plan.

The updated guidance also clarifies that the affirmative defense is not available if a person establishes a plan while in the possession of material nonpublic information, even if the plan is structured so that the transactions will not begin until after the information is made public.

The SEC’s issuance of updated guidance is instructive and helpful, because Rule 10b5-1 plans can be a very important tool for individuals to use to try to limit their liability when they trade in the personal shares in company stock. As discussed at greater length here, the Eighth Circuit’s October 16, 2008 opinion in the Centene Corporation securities litigation underscored the fact that these plans are still a good idea, notwithstanding some of the concerns that recently have been raised. In that case, the court held that there could be no inference of scienter from insider sales made pursuant to Rule 10b5-1 plans.

Melissa Klein Aguilar has an April 21, 2009 article in Compliance Week (here) discussing the SEC’s updated guidance. Hat tip to Bruce Carton at the Securities Docketfor the tweet that alerted me to Aguilar’s article.

New ERISA Litigation Study: A frequently recurring question is whether I know where to find good statistical information about ERISA litigation. Unfortunately, the publicly available resources in this area are limited.

However, as reflected on the Susan Mangiero’s Pension Risk Matters blog (here), on April 15, 2009, Pension Governance Incorporated and its partner Michael-Shaked Group debuted a new study of over 2,400 ERISA cases that were filed between January 1, 2005 and August 31, 2008. A copy of the study can be found here.

The study reports a number of interesting findings, including in particular the fact that "ERISA lawsuits are increasing in number and complexity in terms of combinations of allegations." The study also breaks down the ERISA cases in the study database by type of allegation; by Circuit; by disposition; and by distribution of outcomes. The study also analyzes top litigated ERISA Code sections.

This new study is a great resource, which I hope the authors will continue to update and publish. I also hope that in future updates, the authors might consider publishing aggregate settlement data, along the lines that NERA and Cornerstone publish with respect to securities class action cases.

And Finally: At least according to a story that is making the rounds on the Internet (here), Demitrius Soupolos of Stuttgart, Germany, and his former beauty queen wife, Traute, were unable to have children because, as he was advised by his doctor, Soupolos is sterile. So Soupolos paid $2,500 to his neighbor, Frank Maus, already the father of two children, to impregnate Traute.

About three times a week over the course of six months -- a total of 72 different times -- Maus "attempted to impregnate" Traute. When Traute did not become pregnant, Maus had his own medical exam.

Turns out that Maus, too, is sterile, which "shocked everyone but his wife, who was forced to confess that Maus was not the real father of their two children." Soupolos has now sued Maus to get his money back. Maus’s defense? He did not guarantee conception, only that he would give it "an honest effort." The news articles do not report on how things stand now between Maus and his wife.

All of which makes me wonder, shouldn’t somebody look into whether there is something in the water supply that is causing the men in the neighborhood to become sterile? And do you suppose Soupolos will ask Maus’s wife for the name of the father of her children?

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The collapse of the market for auction rate securities (ARS)  has generated a flood of litigation, mostly brought by angry ARS investors against the broker dealers who sold them the securities or against the mutual funds that allegedly failed to disclose that their assets were invested in these kinds of securities. More recently (refer for example here), companies that invested in ARS and carried the securities on their balance sheet have been sued by their own shareholders in connection with the companies’ ARS disclosures.

A recently filed lawsuit presents yet another variant of ARS litigation – in this most recent case, the directors and officers of a student loan originator that issued ARS have been sued by the company’s own shareholders for failing to disclose the company’s dependence upon and susceptibility to the weaknesses of the ARS marketplace.

Until it filed for voluntary Chapter 7 bankruptcy on February 9, 2009, MRU Holdings was an originator and holder of federal and private student loans which it marketed through its consumer brand My Rich Uncle. MRU collected its loans into student loan pools that were packaged and sold by broker-dealers (including Merrill Lynch) to investors. The interests in the pool were issued as auction rate securities. This securitization process freed up capital to make new loans and also generated fee income and other revenues. During its fiscal year ended on June 30, 2007, 58% of the company’s income came from securitizations, more twice the income the Company earned on interest from student loans.

On April 15, 2009, plaintiffs’ counsel filed a complaint in the Southern District of New York against four of MRU’s former directors and officers on behalf of persons who purchased MRU’s shares between July 9, 2007 and September 19, 2008. A copy of the complaint can be found here. The company itself, which is in bankruptcy, was not named as a defendant.

The complaint alleges that the company failed to disclose that the ARS market was illiquid and depended on the illusion of liquidity created by the broker-dealers’ undisclosed interventions to prop up the marketplace and prevent failures of the auction process. The complaint alleges that this illusion "allowed the Company to pay a lower interest rate" in the notes issued in connection with the company’s 2007 securitization, and that the spread allowed the company to realize a $16.3 million gain.

The complaint also alleges that the Company failed to disclose that once the "true nature of the ARS market became known," the Company’s future securitizations would not be as favorable and that "without the favorable terms available in the ARS market as a result of the manipulation by broker-dealers, the Company would not have sufficient capital to originate loans, making the Company’s business model untenable."

The complaint alleges that the Company failed to disclose the impact that the February 2008 collapse of the market for ARS would have on its ability to depend on securitizations to sell loans and free up capital. The complaint further alleges that on July 3, 2008, the Company announced the pricing of a $140 million private student loan securitization; however, on July 7, 2008, the Company further announced that the bonds to be issued in the pending securitization would be sold at a discount, and that rather than generating income, "the securitization would result in a significant write-down of assets."

Thereafter, the company’s share price declined, and Moody’s subsequently downgraded the company’s ARSs. On September 5, 2008, the Company announced that it would "pause" its student loan program. On September 19, 2008, the Company announced that its September 15, 2008 audit report contained a going concern opinion. The company later filed for bankruptcy.

As noted above, this new complaint against the former MRU directors and offices differs from prior ARS lawsuits, both in terms of who the plaintiffs are and in terms of the allegations raised. In the vast bulk of the ARS lawsuits filed under the securities laws, the plaintiffs are ARS investors who are suing broker-dealers who sold them the securities and whom the investors allege made misrepresentation in connection with the ARS. Similarly, mutual fund investors have sued the funds for failing to disclosure the funds’ investments in ARS. More recently, shareholders of companies that were ARS investors and that suffered balance sheet write-downs (and ensuing share price declines) have sued the companies because of the companies’ investment in ARS.

By contrast to those other case, the plaintiffs are neither ARS investors nor shareholders of companies that invested in ARS instruments. Rather, the plaintiffs in the MRU case are shareholders of a company that put loans into pools out of which the securities were issued.

And again by contrast to the other cases, the misrepresentation alleged in the MRU case are not about the nature of the ARS investments (as in the broker dealer cases}, or even about a balance sheet exposure to ARS investments (as in the prior public company cases), but rather about the company’s alleged dependence on the availability of the artificially favorable ARS marketplace as a way to generate income and as a way to free up capital.

While the MRU case may represent a new variant on the ARS theme, more cases of the now familiar forms of ARS litigation have continued to accrue.

For example, on April 16, 2009, Ashland Inc. filed a lawsuit in the Eastern District of Kentucky against Oppenheimer & Co. (copy of complaint here), in which Ashland alleged that Oppenheimer convinced Ashland to hold and to continue to invest in ARS "at a time when Oppenheimer knew the market for those ARS was collapsing."

The Ashland complaint alleges that after August 2007 disturbances in the marketplace for ARS based on municipal government bonds, that Oppenheimer steered Ashland toward ARS based on student loan obligations ("SLARS"). The complaint alleges that after the market for SLARS collapsed in 2008, Ashland was left "with approximately $194 million of illiquid Oppenheimer-brokered SLARS."

In a separate complaint also filed on April 16, 2009, Braintree Laboratories and related entities sued Citigroup Global Markets in the District of Massachusetts (complaint here). Braintree alleges that between June 2008 and August 2008, Citigroup sold Braintree approximately $33.3 million of ARS, which Citigroup allegedly had referred to not as ARS but as "seven day rolls" and as "government backed ‘money market’ investments."

Braintree alleges that despite its admissions in its various regulatory settlements, Citigroup has refused Braintree’s demand for rescission of the transactions. Among other things, Braintree alleges that in connection with the sale of the ARS to Braintree, "Citigroup acted with criminal and flagrant indifference to the rights, interests and property of the Braintree Entities and the public" and that the sales "resulted from ongoing fraudulent practices."

The Braintree complaint also alleges that the ARS sales to Braintree "fell close in proximity to Citigroup erasing recordings of conversations involving employees at its auction rate desk." The complaint alleges that "when engaging in these acts of spoliation of evidence and obstruction of justice, Citigroup acted willfully and with scienter."

If nothing else, the one thing that is absolutely clear about the breakdown of the auction rate securities marketplace is that it has proven to be an absolute litigation generating machine.

The Ashland and Braintree cases also demonstrates, as I have argued elsewhere (refer here), that neither the dismissal of the UBS auction rate securities lawsuit nor the ARS regulatory settlements marked the end of ARS litigation. As I noted more recently (here), the ARS litigation has continued to come in – and as the Braintree lawsuit demonstrates, interesting new allegations (such as the spoliation charge) continue to emerge.

The MRU lawsuit also shows that the auction rate securities litigation wave has continued to evolve as it has continued to grow. Further lawsuit variants seem likely as the wave continues to progress.

I have in any event added the MRU lawsuit to my table of credit crisis related class action securities litigation, which can be accessed here.

Special thanks to Adam Savett of the Securities Litigation Watch blog (here) for providing a copy of the MRU complaint.

A Tribute to Susan Boyle: If you have not yet seen the video of Susan Boyle, an unemployed 47 year-old, singing a song from Les Miserables on the April 11, 2009 episode of Britain’s Got Talent, then you must drop everything and watch the video right now. Due to YouTube restrictions, I can’t embed the actual video in this post, but the video can be seen here.Take the time to watch the entire video; it is worth the seven minutes it takes to watch it. (Hat tip to the Drug and Device Law Blog, here, for the link.)

The video is even more moving if you follow the lyrics of the song she is singing, which are as follows (thanks to the Conglomerate blog, here, for the lyrics):

I dreamed a dream in time gone by,
When hope was high and life, worth living.
I dreamed that love would never die,
I dreamed that God would be forgiving.

Then I was young and unafraid,
And dreams were made and used and wasted.
There was no ransom to be paid,
No song unsung, no wine, untasted.
 

But the tigers come at night,
With their voices soft as thunder,
As they tear your hope apart,
And they turn your dream to shame.
 

And still I dream he'll come to me,
That we will live [our lives] together,
But there are dreams that cannot be,
And there are storms we cannot weather!
 

I had a dream my life would be
So different from this hell I'm living,
So different now from what it seemed...
Now life has killed the dream I dreamed...
 

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In an interesting decision that raises a host of important issues, a federal district court applying Arkansas law held that due to renewal application misrepresentations, a hospital’s D&O insurance policy is void ab initio, and therefore that the hospital must refund amounts the insurer previously paid as defense costs. The April 17, 2009 opinion, written by Eastern District of Arkansas Judge Susan Webber Wright can be found here.

Background

The insurance dispute involves three key events: the May 22, 2003 adoption by Baptist Health, a nonprofit corporation that operates hospitals in Arkansas, of an Economic Conflict of Interest policy (ECOI policy), commonly known as "economic credentialing"; Baptist Health’s December 16, 2003 renewal of its D&O insurance; and the February 2004 filing of the first of three lawsuits filed against Baptist Health relating to its adoption of and enforcement of the ECOI policy.

The ECOI policy provided that no physician that directly or indirectly owns or acquires an interest in a competing hospital will be eligible to apply for an initial or renewed appointment or clinical privileges for the professional staff at any Baptist Health hospital. The physicians were required to disclose their financial interests, and physicians failing to meet the eligibility requirements were not entitled to any hearing or appellate review.

Judge Wright’s opinion has a detailed review of the events and deliberates that led up to Baptist Health’s adoption of the ECOI policy, because the events and deliberations preceding the adoption were relevant to the subsequent insurance dispute.

As summarized on pages 31 and 32 of the opinion, Judge Webber found, among other things that Baptist Health knew at the time it adopted the ECOI policy that legal challenges had been raised in connection with at least four other hospitals’ attempts to adopt similar policies ; that questions had been raised whether the ECOI policy violated federal kickback laws; that at an FTC hearing prior to Baptist Health’s adoption of the ECOI policy, and in the presence of Baptist Health’s CEO, the head of one of Baptist Hospital’s competitors had raised questions about the legality of ECOI policies.

In addition, by the time Baptist Hospital adopted the ECOI policy, hospital administrators had compiled a list of physicians whom they anticipated would be affected by the policy (all of whom subsequently were plaintiffs in lawsuits against Baptist Health). When asked at a deposition in the subsequent underlying litigation if Baptist Health had adopted the policy "knowing that it could result in a lawsuit," the CEO answered "Yes, sir." (However in the separate coverage litigation with the D&O insurer, the same CEO submitted an affidavit in which he swore that at no time prior to the filing of the first of the underlying lawsuits did he believe that it was likely that the adoption of the ECOI would result in litigation.)

In December 2003 – that is, after the ECOI policy was adopted but before the first of the three underlying lawsuits had been filed – Baptist Health renewed its D&O policy. Its expiring coverage, in force during the period December 12, 2002 to December 12, 2003, had been with one of the larger, more well-established insurance carriers. However, during the policy period of Baptist Health’s D&O policy, the individual that had underwritten the Baptist Health account for the incumbent carrier left that job to join a new, start-up insurance company. For reasons Judge Wright discusses at greater length in her April 17 opinion, Baptist Health moved its coverage from the incumbent carrier to the new, start-up carrier at the time of its December 12, 2003 renewal.

In connection with the renewal process, Baptist Health completed two  applications, first completing one on the incumbent carrier’s renewal application form, and then later on the start-up carrier’s application form. Each of these two application forms asked "prior knowledge" questions (discussed below). Although there were slight differences in the questions each form asked, the difference proved to be unimportant for the outcome of the subsequent coverage dispute.

The prior knowledge question in both forms asked whether any entity or individual proposed for coverage is aware of any fact, circumstance, situation or event that could result in a claim. Both renewal application forms also stated that if any such fact, circumstance, situation or event exists, any claim arising thereform is excluded from coverage. In response to this question in each of the application forms, the hospital responded "None," indicating that it was not aware of any such fact or circumstance.

In February 2004, a group of physicians filed the first of three lawsuits against Baptist Health alleging that the ECOI policy violated anti-kickback and Medicaid statutes. Baptist Health submitted this claim and the two subsequent lawsuits to its new D&O insurer as claims under its D&O policy. After the third lawsuit was filed, the D&O carrier became aware of some of the circumstances that had preceded the hospital’s adoption of the ECOI policy.

The D&O insurer subsequently filed an action seeking a judicial declaration that the hospital was required but failed to disclose in the application forms the information that its adoption of the ECOI policy may lead to claims, and as a result there is no coverage under the policy for the three subsequent lawsuits about the ECOI policy. Baptist Health counterclaimed, seeking a judicial declaration of coverage. The parties filed cross-motions for summary judgment.

The April 17 Opinion

In her April 17 opinion, Judge Wright granted the insurance carrier’s motion for summary judgment and denied the hospital’s summary judgment motion.

The essence of her ruling, on pages 30-32 of the opinion, is her conclusion that Baptist Health was "specifically aware" of a wide variety of circumstances that suggested the possibility of a claim when it answered the prior knowledge questions on the application. She found that, given Baptist Health’s awareness of the likelihood of litigation, the conclusion that Baptist Health’s answers to the prior knowledge questions in the renewal applications "were misrepresentations" seems "inescapable."

Among other things, Judge Wright noted that Baptist Hospital was aware of that other hospitals’ adoption of similar policies had led to litigation. She specifically found that "a reasonable person would foresee that adoption" of the policy "in these circumstances may give rise to or result in a claim." She also noted that Baptist Health’s CEO acknowledged in a deposition in the underlying action that the ECOI policy "was adopted knowing that a claim would result."

Judge Wright reviewed Baptist Health’s responses to other questions in the applications that called for relevant information but that Baptist Health had failed to supply. She found Baptist Health’s attempts to explain its answers to these questions to be "reflective of an apparent tendency on the part of Baptist Health to contort language to its own purposes" and "disingenuous." She said of Baptist Health’s defense of its responses to one application question "reflects a parsing of language that might properly be characterized as a misrepresentation."

Judge Wright held under Arkansas law that because the application misrepresentations were material to the underwriting of D&O insurance policy, the policy "is void ab initio and rescinded as if it were never in effect." She also found that even if some of the hospital’s answers were not misrepresentations, the prior knowledge exclusion in the renewal applications "operates to bar coverage."

Finally, Judge Wright held that Baptist Health’s retention of the defense expenses the insurer had paid would represent "unjust enrichment," and therefore the insurer is entitled to recover those amounts from the hospital. She did hold that the insurer had to return to Baptist Health the amount of the premium the hospital had paid.

Discussion

I have four different reactions to this decision, each one based on different perspectives I have acquired over the years as a participant in different parts of the insurance underwriting and claims handling process.

The first reaction I have is based on my many years of representing insurance companies in coverage litigation similar in many ways to this case, as well as my years as an insurance company manager. From this insurer-oriented perspective, this decision represents a complete sweep for the carrier of a kind that rarely occurs. Judge Wright’s ruling that Baptist Health had to return the amount of previously paid defense fees put an extra olive in a sweet martini that insurance company lawyers rarely get to enjoy. As one who knows how these things go, I tip my hat to the counsel that successfully represented the insurance carrier in this case.

But these considerations lead to the second of my reactions to this decision, which is more from the perspective of a neutral observer. That it, it seems pretty obvious that by the time Judge Wright ruled on the summary judgment motions, she had developed a less than flattering view of Baptist Health.

For instance, I think the opinion suggests pretty strongly that she didn’t think much of the ECOI policy itself, which her opinion describes in negative tones. I also think Judge Wright was genuinely offended that Baptist Health’s CEO submitted an affidavit in support of the summary judgment motion, claiming that Baptist Health was not aware that its adoption of the ECOI policy would result in litigation, even though the same individual had testified in a deposition in the underlying litigation that Baptist Health had adopted the ECOI policy knowing that litigation would result.

When a federal judge refers to a litigant as "disingenuous" and accuses it of "contorting" and "misrepresenting" insurance policy language, that litigant is going down.

My third reaction to this case is based on the perspective from my current role counseling and advocating for policyholders. Here, I am not as concerned with Baptist Health itself and the merits of its particular case, but rather what these facts suggest. Looked at from this perspective, there are a couple of things that trouble me.

First, the insurance dispute arises out of a policy renewal, not the initial placement of a policy. Why then was Baptist Health being asked to answer the "prior knowledge" question in the first place? Yes, both the incumbent and the new carrier asked the question. But to me, the insertion of a "knowledge" question in a application at the time of renewal is inconsistent with the theoretical justifications insurers routinely provide for claims made coverage.

That is, in exchange for the improved loss exposure determinations offered with respect to claims made policies, insurers undertake to provide coverage for any claims made during the policy period, regardless of when the underlying circumstances may have occurred.

Insurance carriers rightfully should not be expected to cover claims that are known or anticipated when coverage initially incepts. But implicit in the "claims made bargain" is that policyholders should be entitled to expect continuity of coverage as the claims made policy renews, so that the policyholder is not susceptible to losing coverage due to the mere caprice of the date on which a claimant chooses to file a claim. The inclusion of the knowledge question into the application at the time of renewal of a claims made policy represents the insertion of a jagged edge that could – and here, did – result in stripping the policyholder of coverage that would have been available under an expiring policy if the claim had been filed before the prior policy expired.

I do not mean to find fault with anyone who was involved in this policy renewal. The insurance marketplace in late 2003 was different than it is today, and I do not mean to judge former circumstances by today’s standards. But even allowing for all of that, I find the inclusion of the knowledge question in a claims made policy application at the time of renewal surprising, troubling, and arguably inconsistent with the very nature of claims made coverage.

The other thing I find troublesome from the policyholder’s perspective about this decision is that Baptist Health’s answer to the knowledge question (which comes with and supposedly is enforced by its own prior knowledge exclusion) resulted not just in an exclusion of coverage, but in a policy rescission rendering the policy void ab initio. For most of the last decade the D&O insurance industry collectively has struggled to develop insurance policy provisions to narrow the coverage forfeiture consequences of application misrepresentations. As part of this dialog, insurers try to characterize the prior knowledge exclusion in a policy application as a stepped-down threat from the possibility of policy rescission, since the remedy it triggers results only in the exclusion of coverage and not in the entire policy being voided.

Yet here, Baptist Health’s answer to the knowledge question (as well as its answers to other questions, to be sure) resulted not just in noncoverage of a claim, but the rescission of the entire policy (which clearly is yet another reason why the inclusion of the knowledge question in a renewal application is highly objectionable).

The fourth and final set of reaction I have to this decision really represents a combination of all points of view. That is, I can’t help but observe that this case involves a couple of very significant missed opportunities.

The first of the missed opportunities was the chance Baptist Health had to lock in coverage for the subsequently filed claims, under the incumbent carrier’s policy that expired on December 12, 2003. That is, if you accept Judge Wright’s findings of fact as true, Baptist Health knew prior to the time this policy expired that it was probably going to get sued; it knew who was probably going to file the lawsuit(s); and it even knew what legal theories were likely going to be asserted.

In short, Baptist Health had at its disposal, prior to the expiration of the incumbent carrier’s policy, all of the constituent elements required to have provided notice of circumstance that might give rise to a claim. Had this notice been provided to the incumbent carrier, then any subsequently filed claim would have related back to the incumbent carrier’s policy.

Again, I am not trying to find fault with anyone that was involved in insurance issues for Baptist Health, particularly since I know I now have the benefit of hindsight and the convenience of the factual recitations in a carefully groomed judicial record. This perspective and these facts may not have been available to the persons directly involved in the insurance transaction. However, if Baptist Health had provided notice of potential claim under the incumbent carrier’s expiring policy, then it could have avoided the problems that later arose with the new carrier under the subsequent policy. (As an aside, I note that this notice of potential claim opportunity may represent the best response to the concerns I noted above about claims made issues).

The final missed opportunity that may have been involved here is the chance the parties had to negotiate a compromise of the insurance coverage dispute. Footnote 1 to the opinion reports that a settlement conference in the case took place before a Magistrate Judge, but that the conference "proved unsuccessful." There are innumerable reasons why any case might not settle. But parties that are motivated to settle can usually find a way to get it done.

Here, Baptist Health had ample reasons to try to seek a compromise, whether it realized it or not. The hospital CEO’s deposition testimony in the underlying case that when Baptist Health adopted the ECOI policy it anticipated getting sued arguably should have motivated the hospital to seek a compromise of this claim (and that is without even considering the deeply troubling conflict between the CEO’s deposition testimony on this point and the contrary affidavit he supplied in connection with Baptist Health’s summary judgment motion in the coverage case.)

There are even reasons why an insurer in this situation might arguably want to consider a compromise. I know many readers would find this observation surprising, especially given how sweeping the insurer’s litigation victory subsequently proved to be. Long experience has taught me that even very strong cases can turn out far differently than expected, and this uncertainty alone ought to counsel any litigant to remain open to possible compromise, regardless of how strong their case may seem.

In addition, as I have previously discussed at length (here), the thing about rescission as a policy defense is that it is such a powerful weapon, its effects can not always be predicted in advance. I have direct, relevant personal experience from which to say that even a complete victory in a highly meritorious rescission case can produce unanticipated collateral damage for an insurer. Based on what I have seen and know, any carrier involved in a rescission case, no matter how meritorious, would be well advised to consider opportunities to resolve the case without taking it all the way to the end.

One final note about this decision is that it is worth reading for the interesting glimpse it affords into the operations of a fledgling insurance company in its earliest stages. I will not characterize here what the opinion reflects, except to say that most industry participants will find the "inside baseball" description of  the start-up operation interesting.

Special thanks to Karen Ventrell of the Troutman Sanders law firm, who together with her colleague Whitney Lindahl represented the insurer in this case, and who provided me with a copy of the decision. I hasten to add that the views expressed in this post are exclusively my own, and nothing I said here about the insurance transaction should in any way reflect on the outstanding job the insurer's lawyers did in this case.

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Although a wide variety of surprising details have come to light as the Madoff scandal has been exposed, there has as yet been no reported connection between the scandal and Britney Spears—that is, until now. A handwritten complaint filed in the Eastern District of Michigan on March 16, 2009 raises a number of, well, colorful allegations involving Spears and an assortment of other unexpected persons.

The complaint (here) purports to be filed on behalf of none other than Bernard L. Madoff himself, whom the complaint further characterizes as "d/b/a Jonathan Lee Riches," who in turn is described as "a/ka Gino Romano, Inc." The named defendants include Spears, her ex-husband Kevin Federline and the Securities and Exchange Commission.

Among other things, the complaint alleges that Spears is in possession of "1.6 billion of Ponzi money from victims of ours." Riches claims that he and Spears met on eHarmony.com in 1996 and that Spears "stole" his American Express Black card to "purchase her circus tour outfits." (You were wondering where she got those, weren’t you?)

The complaint links Spears in some rather unexpected ways to two of the most prominent names in the current financial crisis. First, the complaint alleges that Spears has a "secret affair" with Angelo Mozillo. Next, the complaint alleges that Spears has been visiting Madoff’s New York Penthouse for "secret affairs with Madoff" in return for Saks Fifth Avenue gift certificates.

Riche’s real objection to Spears seems to be that allegedly she has tattooed his name to her, um, back, which she allegedly displays during concerts. Riches seeks $20 million from Spears and a restraining order against Spears’s younger sister, Jamie Lynn, who allegedly has "threatened Plaintiffs with various unknown teenagers who are pregnant."

Riches (a/k/a Gino Romano) is a prisoner in the federal prison system. According to Wikipedia (here), he has filed over 1,000 federal lawsuits since 2006, against, among others, George W. Bush, Steve Jobs and Martha Stewart. Readers may recall a prior post (here), in which I described an earlier lawsuit Riches had filed against Madoff.

Indeed, this lawsuit is not even the first complaint Riches has filed against Spears. According to news reports (here), Riches previously alleged that Spears held him at gunpoint and forced him to commit an array of crimes. He also alleged that Spears forced him to pay for abortions, breast implants, cocaine and alcohol.

I certainly don’t want to seem like I take threats involving unknown pregnant teenagers lightly. But even though the allegations do have a certain entertainment value, somebody needs to take away this guy’s pencil.

I have in any event added this Riches complaint, along with a variety of other recently filed Madoff-related actions, to my register of Madoff-related lawsuits, which can be accessed here. I have to say that I never anticipated that I would be referring to Britney Spears on this blog, for any reason whatsoever. Just goes to show, you never know.

Special thanks to a loyal reader for providing me with a copy of the Riches complaint. Thanks also to the alert reader who previously steered me to the Wikipedia item about Riches.

Repeat After Me: Correlation is Not Causation: And speaking of unexpected connections, we feel compelled to report on the February 18, 2009 article "Regulators and Redskins" (here), which discloses the unexpected connection between federal government activity and the performance of the Washington Redskins.

The authors report "a significantly positive, non-spurious, and robust correlation between the Redskins’ winning percentage and the amount of federal government bureaucratic activity as measured by the number of pages in the Federal Register."

The authors’ explanation for this "surprising result" is that "a winning football team makes for a commonly shared source of joyous optimism to lubricate [the bureaucrats’] negotiations." The authors note however that they do not find the same correlation when examining Congressional activity "which we attribute to legislator loyalty to their home state’s team(s)."

Hat tip to the Ideoblog (here) for the link to this truly groundbreaking academic study.

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One of the recurring issues in securities litigation is the way the erstwhile class counsel and their clients, the prospective class representatives, come together. In what one federal judge described as a "blatant, shocking conflict of interest," it appears, from testimony at a recent lead plaintiff selection hearing, that the leading plaintiffs’ firms are providing investment portfolio "monitoring services" for which the firms are paid only if their public pension fund clients pursue litigation recommended by the law firm. In a post-hearing brief in the case, the  firm involved defended its practices as appropriate.

These issues arose at an April 1, 2009 hearing before Southern District of New York Judge Jed Rakoff, involving two cases, the Credit Based Asset Servicing case (about which refer here) and the Merril Lynch Mortgage Pass Through Certificate case (refer here). Both cases involve alleged misrepresentations in connection with the initial public sale of certain mortgage-backed securities.

At the April 1 hearing, Judge Rakoff consolidated the two cases. The primary purpose of the April 1 hearing was to determine which of the two proposed plaintiffs was the "most adequate" to represent the class in the consolidated case.

As reflected in the hearing transcript (here), Judge Rakoff first heard testimony from an administrator for Iron Workers Local No. 25 Pension. In response to questions from the Judge, the administrator testified that they way he learned about the allegations in the case was that "they were brought to me by counsel."

The administrator explained that the lead plaintiffs’ firm representing the pension fund in the case has a long-standing investment portfolio monitoring contract with the fund. Under this contract, the law firm monitors the fund’s investments and advises the firm when circumstances arise that would warrant a lawsuit. The plaintiffs’ firm is only paid if they bring a lawsuit and recover.

Among other things, Judge Rakoff called this arrangement "about as obvious an instance of conflict of interest as I’ve ever encountered in my life," noting that the plaintiffs’ counsel,

under the guise of monitoring the [pension fund’s] investment to determine whether or not there are any violations of the law …have made an arrangement whereby they will only get paid if there are lawsuits brought that they can recover on, and that they will be plaintiffs’ counsel in that lawsuit.

Judge Rakoff observed that "if that isn’t a gross conflict of interest in violation of the most elementary fiduciary duties, I don’t see what is." He added that the arrangement inherently compromises the objectivity of the monitoring they’ve been asked to undertake. Indeed, to be frank, I’m shocked that any law firm would enter into such an arrangement."

Counsel for the Iron Workers gamely defended the arrangement, among other things asserting that "this portfolio monitoring is not something unique to this firm," an argument that did not impress Judge Rakoff. In response to plaintiffs’ counsel’s suggestion that his law firm analyzes and evaluates the merits of the case before recommending that the fund become involved in litigation, Judge Rakoff said that arrangement "makes crystal clear that the Iron Workers are being led by counsel rather than the other way around," a circumstance the PSLRA had tried to eliminate.

Judge Rakoff then heard testimony from the Special Assistant to the Mississippi Attorney General, on behalf of the other proposed lead plaintiff, the Mississippi Public Employees Retirement System. The representative’s testimony established that Mississippi also had monitoring arrangements with plaintiffs’ law firms, but with twelve separate firms rather than just one. The representative also testified that the possibility of bringing this particular action had been brought to the state’s attention by a separate firm that performs bankruptcy related services for the state.

The representative explained by using plaintiffs’ firms for monitoring , rather that paying for independent monitoring services, the state was able to save costs. The state representative described the use of plaintiffs’ firms for monitoring services as a "commonplace practice," in response to which Judge Rakoff observed

Yes, well, I’m learning that, and to be frank, that doesn’t make me less shocked, that makes me more shocked, because what you’re telling me is that persons, entities with a fiduciary duty, which includes a fiduciary duty to monitor the investments they’re making with their members’ money, have concluded that to save a few bucks they will employ as monitoring entities firms that can only profit of their advice goes one way and not the other.

Judge Rakoff did find certain distinguishing characteristics in Mississippi’s case, in that one of its twelve monitoring firms had not brought the case to the state (although it turns out that the bankruptcy firm that did bring the case to the state does have a contingency fee interest in the case); and that even if one of the twelve firms were to bring a case forward, the case would be independently evaluated by other firms and the state’s own representatives. Finally, the state representative testified that in this case the state had reached out to the lead plaintiffs’ firm, rather than the other way around.

Ultimately Judge Rakoff did not rule at the April 1 hearing on the question of which of the two proposed plaintiffs would be the lead plaintiff in the case. Rather, he asked for further briefing, noting a concern that at the hearing he might have been "overreacting because of hearing about this arrangement for the first time."

Even though Judge Rakoff ultimately did not rule at the April 1 hearing, his shocked response to the practices that were described multiple times at the hearing as "commonplace" does seem to suggest that there may be concerns with the monitoring arrangements. Certainly, the language the Judge used to characterize the arrangements is impressive, to say the least.

Pursuant to Judge Rakoff’s briefing schedule, and in response to his comments, on April 8, 2009, the Iron Workers filed a legal brief (here), that among other things defends the monitoring arrangements on the grounds that the monitoring agreement does not itself authorize the firm to initiate litigation on the fund’s behalf without the fund’s authorization, and that the fund is under no obligation if it decides to pursue litigation to use that particular law firm.

In addition, the Iron Workers’ brief cites multiple cases in which various courts found that the existence of similar monitoring arrangements were not a barrier to the proposed plaintiffs’ service as a class representative.

Finally, the brief also includes an opinion from the distinguished legal scholar Geoffrey Hazard that the portfolio monitoring services were not "professionally improper" and that there is no conflict of interest in these circumstances because the pension fund is not obligated to bring suit even if the firm recommends it. Hazard also stated that the mere fact that the plaintiffs’ firm was "working for a contingent fee" does not present an "inappropriate bias."

The Mississippi Public Empoyees' Retirement System's brief regarding the alleged conflict and the lead plaintiff issue can be found here. Merrill's brief can be found here.

UPDATE: In an  April 23, 2009 order (here), Judge Rakoff appointed the Mississippi Public Retirement System as the lead plaintiff in the cases. In the April 23 order, Judge Rakoff also stated that  the lead plaintiff determination "involved the Court's resolution of several difficult issues, which will be elaborated in a written opinion." Judge Rakoff said that he would issue the detailed opinion after he completed an ongoing criminal trial that he has been conducting.

Special thanks to a loyal reader for providing a copy of the hearing transcript.

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In prior posts (most recently here), I discussed the fact that while litigation against the financial sector has predominated recent securities lawsuit filings, plaintiffs’ attorneys also have targeted other sectors, including in particularly the life sciences sector. An April 2009 memorandum by David Kotler of the Dechert law firm entitled "Dechert Survey of Securities Fraud Class Actions Brought Against Life Sciences Companies" (here) takes a closer look at the 2008 life sciences securities lawsuits and analyzes the allegations on which the claims are based.

The memo notes that the 23 securities lawsuits filed against life sciences companies in 2008 is about the same number as the 25 life sciences securities lawsuits filed in 2007. However, the report also notes that the 2008 life sciences securities lawsuit filings represented only 10% of all securities lawsuit filings during the year, compared to 14% in 2007. The report attributes this slight drop to the fact that securities lawsuits in the financial sector "skyrocketed" in 2008.

The memo reports that, similarly to prior years, half of the life sciences companies sued in 2008 were very small, with market capitalizations below $250 million. However, by contrast to 2007, when nearly half of the life sciences companies sued had market capitalizations greater than $10 billion, on 2008 "only 13% of total actions were brought against the largest companies."

With respect to the allegations raised in the new lawsuits, the memo notes that in 2008, the majority of claims "pertained to accounting improprieties and/or misstated or misleading financial results and forecasts, by comparison to the 2007 filings, where industry-specific issues such as product safety, efficacy or marketing predominated.

The memo does note that about 25% of the 2008 filings contained allegations of alleged misrepresentations or nondisclosure regarding the commercialization or marketing of the product, and about 25% alleged that the defendants had made false and misleading statements about the safety of their product.

The memo also notes that one trend observed in 2007 had continued in 2008; that is, the plaintiffs’ lawyers are continuing to include key research personnel as defendants, on the apparent theory that these individuals "had a high level position within the company and access to internal information," and therefore "they knew and failed to disclose the allged adverse non-public information." The memo reports that key research personnel were named as defendants in five of the 23 life sciences securities lawsuits filed in 2008.

With respect to the likelihood of future litigation in the sector, the memo notes that life sciences companies "are particularly vulnerable to securities lawsuits because of their inherently volatile stock prices, often driven by a drug or device product life cycle that is fraught with potential for adverse and unpredictable events." That vulnerability "may increase in coming months and years when the boom of securities class actions in the financial sector busts." The memo speculates that "once plaintiffs’ targets in the financial sector dry up, other sectors, including life sciences, may see an increase in lawsuits aimed their way."

In discussing the 2007 version of Dechert’s life sciences securities litigation report, I had raised (here) the question whether or not the numerous lawsuits against life sciences companies actually were successful, and in particular, I asked whether or not the cases were dismissed more frequently than other securities lawsuits. The 2008 Dechert memo addresses these questions by taking a look at how the 2007 life sciences securities lawsuits have fared so far.

The 2008 memo reports that of the 25 life sciences securities lawsuits filed in 2007, eleven have been dismissed and two have settled. The memo states that the two settlements are "within the standard range" for securities lawsuit settlements generally, and that the dismissal rate "mirrors that of securities class actions in general."

The dismissals largely have been based on the plaintiffs’ failure to fulfill the requirements for pleading scienter. The memo comments that "though plaintiffs may be given multiple opportunities to amend their complaints, they will not be able to survive a motion to dismiss with general, conclusory or generic allegations of knowing misconduct."

The Dechert memo’s tally of 23 life sciences securities lawsuits in 2008 squares with my own count. I note that in preparing my count of the life sciences lawsuits, I had used a rather narrow definition of the category, limiting the "life sciences" companies to those either in SIC Code series 283 (Drugs) or SIC Code series 384 (Surgical, Medical and Dental Instruments and Supplies).

The memo, which concludes with practical risk minimization suggestions, is quite good and merits reading at length and in full.

Special thanks to the author of the Dechert memo, David Kotler, for providing me with a copy of the memo.

The Rise and Fall of Bill Lerach: The Professional Liability Underwriting Society (PLUS) has posted its acclaimed video, "The Rise and Fall of Bill Lerach," on the members’ section of its website. PLUS members can access the video here. The video alone might justify cost of membership. A trailer of the video can be found on the Securities Docket site, here.

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A growing chorus of voices is calling for public companies to make the separation of the Chairman and CEO functions the default governance structure. This movement, which may have the support of the new SEC Chair, appears likely to lead to some type of "adapt or explain" approach. Increasing evidence that the companies where the CEOs also act as board Chair are likelier to have "certain troubling governance characteristics" will likely encourage shareholder interest in the initiative as well.

The idea of separating the two roles is hardly new, but it has gained significant support from a wide variety of sources recently. First, on March 30, 2009, the Chairmen’s Forum of the Millstein Center for Corporate Governance at Yale School of Management issued a report entitled "Chairing the Board: The Case for Independent Leadership in Corporate North American" (here) calling on all North American companies to "voluntarily adopt independent chairmanship as the default model of board leadership," and if they chose to take a different course "to explain to their corporate shareholders why doing so represents a superior approach to optimizing long-term shareholder value."

(The Chairman’s Forum is a group of more than 50 current and former board chairs, directors and CEOs convened at the Millstein Center.)

The Millstein Center’s March 30, 2009 press release (here) reports that while in the U.k. only 5% of the FTSE 350 companies combine the chairman and CEO roles, over 60% of the S&P 500 companies have boards that are chaired by their CEOs. The press release quotes one commentator as saying that the independent chair model "has been adopted successfully by many companies in many regions of the globe as a means to further ensure and empower board independence."

The press release also quote the former chairman of Northwest Airlines as saying that combining both roles puts both functions in one person who "is obviously conflicted in the essential duty of providing oversight and monitoring the CEO and management team."

A March 30, 2009 Wall Street Journal article discussing the Chairmen’s Forum’s report can be found here.

Recent remarks from, Mary Schapiro, the SEC’s new Chair, in her April 6, 2009 speech to the Council of Institutional Investors (here), seem to suggest the possibility of an SEC move to a disclosure based approach toward separating the two roles. Among other things, she said that "we’ll also be considering whether boards should disclose to shareholders their reasons for choosing their particular leadership structure—whether that structure includes an independent chair, a non-independent, or a combined CEO/Chair."

As Professor Jay Brown has suggested on his Race to the Bottom blog (here), Schapiro’s remarks may suggest a SEC attempt to influence corporate governance through disclosure. Professor Brown has been a vocal advocate in favor of separating the two roles (as shown here).

The logic of targeting this particular issue as an important corporate governance objective was reinforced by the research recently released by The Corporate Library. As described in their March 25, 2009 press release (here), companies whose CEOs also serve as board Chair are "more likely to have certain troubling corporate governance characteristics than companies where the roles are separated."

The troubling characteristics, which are "associated with board entrenchment or lessened oversight of management," include relatively long CEO tenures; fewer board meetings per year; classified board structure; and "the presence of executive committees, which are typically given the power to act on behalf of the entire board, potentially allowing for a concentration of power."

The Corporate Library’s findings raise the possibility that having a single person as the Chair and CEO could be a risk factor for D&O insurance underwriters to assess. Along those lines, it is worth considering, as noted by the Chairmen’s Forum report, that "the overwhelming majority of financial institutions had combined roles before the current crisis erupted" – including, among others, Bear Stearns, Lehman Brothers, Citigroup, Washington Mutual and Wachovia.

On the other hand, there may be limits to how much can be expected or discerned from this single governance trait. As the Chairmen’s Forum’s report also notes, "splitting the role of chairman and CEO does not guarantee the application of independent oversight," adding that "it is no secret that certain companies, featured in some of the most famous corporate debacles, had separate CEOs and chairmen." Splitting the roles must be accompanied by other steps "in order for the independent chairman to fulfill the important leadership role."

In other words, while the continued combination of the two roles in a single person may (particularly in the current climate) represent something of a risk factor, the separation of the two functions alone is no guarantee of the absence of risk.

In any event, it seems likely that pressure for change will continue for all companies, and that companies that do not change will find themselves increasingly called upon to explain.

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Deteriorating economic conditions threaten a massive wave of corporate defaults.  Corporate borrowers’ inability to fulfill debt obligations could not only prompt a bankruptcy filing surge, but could also result in a flood of lawsuits and claims as creditors and shareholders seek to recoup their losses.  These claims could present a host of challenging D&O coverage issues. 

In the latest issue of InSights (here), I take a look at the conditions that could contribute to an increase in corporate bankruptcies, the likelihood that more bankruptcies could translate to increased litigation, and the D&O insurance issues that bankruptcy litigation could present.

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Antitrust regulation and securities enforcement each involve entirely separate areas of the law. However, an increasingly frequent follow-on effect of a regulatory investigation for allegedly anticompetitive conduct is an ensuing class action lawsuit under the securities laws. A lawsuit recently filed in the Southern District of New York, which also has some unique characteristics all of its own, is the latest example of this kind of follow-on securities litigation. These cases may present important D&O insurance considerations, as well.

According to their April 9, 2009 press release (here), plaintiffs’ counsel have filed a securities class action lawsuit against Mechel OAO and certain of its directors and officers. Mechel is a Russian mining and metals company whose American Depositary Receipts trade on the NYSE. The securities complaint (which can be found here) follows in the wake of declines in the company’s share price after allegations of "anticompetitive and monopolistic practices."

The sequence of events surrounding the allegations involves a remarkably compressed time frame. According to the complaint, on July 24, 2008, then-Russian Prime Minister Vladimir Putin "called for antitrust authorities to investigate Mechel’s raw material pricing policies," amid allegations that Mechel charged Russian customers twice what it charged non-Russian customers. On July 28, 2008, Putin also stated that Mechel had used offshore traders to minimize tax payments, which he characterized as "tax evasion."

According to the complaint, on August 14, 2008, barely three weeks after Putin’s initial statement, Mechel was found guilty of breaking competition laws; discriminating against Russian consumers; and maintaining a monopoly in the coal market. Mechel was ordered to take several remedial steps, including cutting prices and signing long term deals with local clients. The company was also ordered to pay a $32 million fine.

The securities complaint filed on April 8 alleged that the defendants failed to disclose:

(i) that the Company had engaged in anticompetitive conduct by employing a discriminatory pricing policy for raw material sales between domestic and foreign steel firms; (ii) that the Company had engaged in monopolistic conduct by fixing and maintaining coking coal prices at artificially high levels and unreasonably refusing contracts; (iii) that as the Company’s anticompetitive and monopolistic practices were discovered, the Company would incur a significant level of fines, and would be forced to enter into long term coking coal supply contracts below market prices; (iv) that a portion of the Company’s revenue was derived from anticompetitive and monopolistic conduct, and when such behavior was discovered, the Company’s revenue would significantly decline in future periods; (v) that the Company had used a sophisticated sales and distribution scheme involving wholly owned offshore trading companies to evade paying taxes on a portion of its revenue; (vi) that the Company lacked adequate internal and financial controls; (vii) that the Company’s financial statements were not prepared in accordance with United States Generally Accepted Accounting Principles ("U.S. GAAP"); and (viii) that, as a result of the foregoing, the Company’s financial statements were materially false and misleading at all relevant times.

The Mechel complaint has a number of distinctive and noteworthy features, but in addition it shares one characteristic in common with several other recently filed securities lawsuits – that is, the alleged securities law violations are based on an alleged disclosure failures relating to supposed anticompetitive behavior.

For example, in August 2008, investors filed a securities class action lawsuit in the Eastern District of Michigan against Reddy Ice Holdings and certain of its director and officers. Background regarding the case can be found here. The complaint alleges that the company engaged in a price-fixing conspiracy that permitted the company to report revenues that were "derived from illegal activities in violation of the U.S. antitrust laws."

Similarly, in December 2008, investors filed a securities class action lawsuit in the District of Delaware against container shipping company Horizon Lines and certain of its directors and officers. Background regarding the case can be found here. The securities lawsuit followed in the wake of guilty pleas entered by three Horizon employees to fixing shipping fees in the Puerto Rico shipping Lane. The securities complaint alleges, among other things, that as a result of the price fixing, Horizon’s revenues had been inflated and its earnings reports and revenue guidance had been misleading.

These lawsuits alleging violations of the securities laws based on allegations of anticompetitive conduct should be distinguished from cases in which plaintiffs seek to allege antitrust violations as a way to circumvent the procedural requirements of the PSLRA. The U.S. Supreme Court rejected this kind of "end run" in the IPO Laddering Antitrust Case (Credit Suisse v. Billing), which is discussed at greater length here. The Supreme Court said in that case that it could not allow the antitrust case to proceed, as "to permit an antitrust lawsuit risks circumventing [the statutory requirements of the PSLRA] by permitting plaintiffs to dress what is essentially a securities complaint in antitrust clothing."

By contrast, the Mechel case and the other cases above are seeking to accomplish the reverse; that is, they are seeking to dress allegations of anticompetitive behavior (and the economic consequences of the regulatory enforcement action) in the clothing of a securities class action lawsuit. The plaintiffs will of course have to satisfy the PSLRA’s pleading requirements in order to be allowed to proceed. But the point that should not be overlooked is that there has been a string of cases in recent months where plaintiffs have filed follow-on securities lawsuits in the wake of allegations of anticompetitive behavior.

Given the predominance of the subprime and credit-crisis securities litigation since early 2007, it is easy for less conspicuous trends like this to be overlooked. The likelihood is that there could be more of this kind of litigation ahead as a result of the current economic turmoil, because of the danger that desperate companies might do desperate things, like calling a competitor to try to work things out.

The possibility of securities litigation based on allegations of anticompetitive behavior does raise an important D&O insurance consideration. Although it is relatively uncommon in public company D&O insurance policies, some private company D&O insurance policies contain an antitrust exclusion. For example, one private company D&O insurance carrier’s form excludes coverage for loss "based upon, arising from, or in any way related to any actual or alleged violation of any law, rule or regulation relating to anti-trust, restraint of trade, unfair business practice or interference with another’s business, contractual or economic relationships or interests."

These kinds of exclusions are objectionable on a number of different grounds, but the cases described above demonstrate one very specific reason to avoid policies containing this language. Were this language to make its way into a public company D&O policy, the insurer might, especially given the breadth of the preamble language ("based upon, arising from, or in any way relating to"), attempt to rely on this provision to try to preclude coverage for the kind of claim described above. The typical public company D&O policy does not contain this exclusion, but its mere existence even just in some private company forms is reason enough to be on guard.

While the Mechel case shares some attributes with the two other cases discussed above, it is in most ways a strikingly unique case. Among other things, the complaint’s references to Vladimir Putin’s statements represent an element of a kind not found in many complaints – with one other significant exception, as described below.

Mechel itself is not the first Russian company to become involved in a U.S. securities lawsuit. For example, investors in Yukos Oil tried to bring a U.S. securities lawsuit against the company (refer here), but with little success. The Yukos investors also separately attempted to sue the Russian Federation, several Russian oil companies, and a number of Russian officials (including the current Russian Prime Minister Dmitry Medvedev). Putin himself was not named as a defendant in the case but the complaint did quote certain statements attributed to him. As described here, this separate case ultimately was dismissed on jurisdictional grounds.

Mechel is merely the latest of many foreign domiciled companies to become involved in securities litigation in the U.S. Just in 2009 alone, as many as 14 of the roughly 65 securities class action lawsuits filed so far this year (about 21%) have been filed against companies domiciled outside the U.S. Similarly in 2008, 34 of the 226 securities class action lawsuits (about 15%) were filed against foreign companies. Clearly the non-U.S. companies are sued at a greater rate than are domestic companies. Some of the foreign companies may simply make attractive targets, but the number of suits may also suggest that the foreign companies are not always ready for the scrutiny that comes with a U.S. listing.

An April 9, 2009 Bloomberg article by Thom Wiedlich about the Mechel case can be found here.

Optional Federal Insurance Regulation?: A recurring topic in recent years has been the possibility of the introduction of federal insurance regulation. Although this idea has a long history, it could received greater attention in the current environment.

The idea was recently revived in proposed legislation introduced on April 2, 2009. The National Insurance Protection Act (H.R. 1880) would allow insurers and insurance producers to elect federal regulation. An April 8, 2009 memorandum from the Locke, Lord, Bissell & Brooke firm entitled "Once More into the Fray: National Insurance Consumer Protection Act Revives Optional Federal Charter Discussion" (here) describes and analyses the bill in detail.

Among other things, the memo notes that the recent financial turmoil has "increased momentum for change to regulation of the financial services industry and the insurance industry is no exception." However, the memo also notes that it is unclear how the proposed legislation would fit within the Treasury Department’s overall plan for regulatory reform, and until the Treasury details its plan, the proposed legislation "may not gain much legislative traction."

Special thanks to Peter Schwarz of the Securities Mosaic for providing a copy of the memo.

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On April 9, 2009, the subprime securities lawsuit pending against Radian Group joined the growing list of subprime-related cases in which the dismissal motions have been granted. Eastern District of Pennsylvania Judge Mary McLaughlin entered the order dismissing the case, without leave to amend. A copy of the opinion can be found here.

As reflected in an earlier post about the lawsuit (here), Radian provides credit protection products (such as mortgage guarantee insurance). The lawsuit related to an affiliate company in which Radian was a minority owner, Credit Based Servicing & Asset Securitization (C-Bass), an investor in the credit risk of subprime residential mortgages. Radian was a joint venturer in the affiliate with MGIC, with which Radian also had an agreement to merge.

The plaintiffs alleged that the defendants (the company and several of its directors and officers) made false and misleading statements about C-Bass’s profitability and liquidity position and thus, the value of Radian’s investment in C-Bass. The statements allegedly inflated Radian’s share price, which led to losses to shareholders when Radian announced an impairment of its investment on July 30, 2007. The turbulence surrounding the C-Bass affiliate may also have undermined the pending merger with MGIC. Further background about the case can be found here.

Judge McLaughlin granted the motion to dismiss based on the plaintiffs failure to adequately plead scienter. She found that the plaintiffs’ allegations "do not establish either motive and opportunity or conscious misbehavior or recklessness on the part of the defendants" and that the plaintiffs therefore have not "raised a strong inference of scienter." She also found that the inference of scienter the plaintiffs sought to draw "is neither cogent not at least as compelling as the plausible opposing inferences suggested by the defendants."

The plaintiffs had alleged that the defendants had delayed announcing the material impairment to the C-Bass investment in order to allow the completion of the MGIC merger, and also to allow the defendants to sell shares in their personal holdings of Radian.

Judge McLaughlin found the motivation to complete the merger is not "distinctively unique" as it is like "the motives that have been found to be generally possessed by most corporate directors." She also found that the plaintiffs failed to allege any concrete and personal benefit the completion of the merger might provide the individual defendants.

Judge McLaughlin found further that the allegations of insider trading inadequate to establish motive and opportunity. One of the three individual defendants more than tripled his investment during the class period, which a second sold only 2.7% of his holdings, and the related Form 4s showed they were sales of restricted stock, and in part motivated to pay taxes. The third individual defendant sold a much larger percentage of his holdings but the public record showed that he was not planned to be a part of the merged company and was divesting his ownership.

In support of their allegation that the defendants had been reckless, the plaintiffs had argued that as a result of their positions with Radian, the defendants were aware of the risky nature of C-Bass’s business and the deteriorating conditions of the subprime industry. Judge McLaughlin found first that the plaintiffs’ allegations did not establish that C-Bass was in fact impaired before the company took the impairment charge. Judge McLaughlin also found that the plaintiffs’ allegations "did not establish with sufficient particularity that the defendants knew or should have known that their statements presented an obvious danger of misleading the investing public."

The plaintiffs had also argued that the defendants had to be aware of the problems at C-Bass because of their positions of responsibility within the company and the relation of the C-Bass investment to the "core operations" of the company. Judge McLaughlin said that while some courts have found that knowledge of core activities can be imputed to company officials under some circumstances, they had done so only when there were particularized allegations showing that the defendants had ample reason to know of the falsity of the allegedly misleading statements.

Judge McLaughlin said that the plaintiffs had failed to explain why C-Bass’s activities were part of Radian’s core activities. She also found that the plaintiffs had failed to show why defendants must have known that their statements presented a danger of misleading investors. In this connection, Judge McLaughlin reviewed the plaintiffs’ extensive allegations about the deteriorating conditions in the subprime marketplace, which the plaintiffs alleged the defendants must have known.

With respect to these allegations, Judge McLaughlin observed that "these facts were known to the plaintiffs and by the market at large, and the [amended complaint] itself establishes that Radian publicly disclosed its knowledge of these facts and their potential to effect on Radian’s investment in C-Bass."

Judge McLaughlin also found that the plaintiffs’ attempt to establish scienter in reliance on confidential witnesses, the defendants’ sox certifications and the company’s alleged violation of GAAP were equally unavailing,

Judge McLaughlin’s opinion joins the growing list of subprime and credit crisis-related securities class action lawsuits in which courts have granted preliminary motions to dismiss. It is also is yet another case that seems to reflect a general judicial unwillingness to conclude that merely because companies were caught in the downdraft accompanying the subprime meltdown that the company had engaged in fraud. (Refer here for similar observation regarding the recent dismissal motion grant in the subprime case involving Downey Financial.)

I have in any event added the Radian opinion to the table in which I have been tallying the subprime case resolutions. The list can be accessed here.

Special thanks to a loyal reader for forwarding me a copy of the Radian decision.

Dismissal Denied Again in Countrywide Case: Perhaps by contrast, and in one of the prominent cases in which a dismissal motion has been denied, on April 6, 2009, Judge Mariana Pfaelzer largely denied the defendants’ renewed motions to dismiss. A copy of Judge Pfaelzer’s opinion can be found here.

In a prior opinion (available here), Judge Pfaelzer had substantially denied the defendants motions to dismiss, although she did granted the motion in certain respect with leave for the plaintiffs to amend. The plaintiffs filed an amended complaint and the defendants renewed their motions to dismiss.

In her April 6 opinion Judge Pfaelzer largely incorporated her reasoning from her prior opinion. However there were a couple of respects in which the April 6 ruling is noteworthy. First, she found that the plaintiffs’ revised allegations against defendant KPMG, whose dismissal motion previously had been granted, would now "suffice" and therefore KPMG’s renewed dismissal motion was denied.

However she also found that insider allegations as to certain insider defendants, whose sales were made pursuant to written Rule 10b5-1 trading plans, were insufficient and accordingly the insider trading were dismissed. However she refused to dismiss most of the insider trading allegations against former Countrywide CEO Angelo Mozillo, even though he too purported to have traded pursuant to a Rule 10b5-1 plan, because of "unusual" modifications he had made to his plan.

Allison Frankel’s April 8, 2009 American Lawyer article about Judge Pfaelzer’s latest opinion can be found here. I urge everyone to read it, if for no other reason that along the way Frankel refers to The D&O Diary’s author (that would be me) as "our favorite subprime litigation savant." I am humbled by the accolade.

Special thanks to several loyal readers who supplied me with a copy of the April 6 opinion.

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Litigation over executive compensation is nothing new. The long-running clash over Richard Grasso’s $187 million NYSE pay package is only one of many titanic legal battles compensation issues produced in the past. But executive compensation litigation recently seems to have entered a new phase, fueled by moral outrage.

Drawing on popular anger evidenced most recently in the outrage surrounding the AIG bonuses, these most recent compensation-related cases could represent an even more pronounced litigation threat than prior lawsuits over pay. The same forces driving the litigation have also produced a variety of other corporate and social responses, some of which may or may not fully serve the purposes of overall social utility.

Among other recently filed lawsuits involving executive compensation is the derivative complaint filed on April 1, 2009 in California (Los Angeles County) Superior Court against the current AIG CEO Edward Liddy and several other AIG directors and officers. The complaint (copy here) among other things alleges that "there was no rational business purpose or justification for these lucrative additional payments, particularly given AIG’s deteriorating financial condition and dismal financial performance," and described Liddy’s explanation of the bonus payments as "outrageous on its face" and "absurd." The complaint seeks to recover damages for corporate waste, breach of fiduciary duty, abuse of control and unjust enrichment.

The bonuses paid to Merrill Lynch employees at year end just prior to the consummation of the company’s merger with Bank of America also features prominently in the shareholders’ litigation filed against Bank of America earlier this year, following the revelation of Merrill’s massive and previously unreported losses.

The $68 million exit package awarded Citigroup CEO Charles Prince following his November 2007 departure from the company is the subject of one of the claims in a Delaware shareholders’ derivative suit against Citigroup’s board. The claim, which alleges waste, is particularly noteworthy, because in a February 24, 2009 decision (here) in which the Delaware Chancery Court otherwise dismissed the plaintiffs’ claims against the Citigroup board for failure to monitor the company, the court found that the claim related to Prince’s compensation had been adequately pled. Unlike plaintiffs other claims, the claim for waste survived the motion to dismiss. An April 2009 memo entitled "Executive Compensation Under Fire" (here) from the Greenberg Traurig law firm described the denial of the motion to dismiss in the Citigroup case on the waste issue as "an unusual move from the traditionally pro-business courts."

As noted on the CorporateCounsel.net blog (here), the Delaware Court’s ruling in the Citigroup case regarding the compensation claims could be the most significant part of the decision and could suggest a possible judicial receptivity to waste claims related to executive compensation. The Greenberg Traurig memo cited above comments that as a result of this decision, "don't be surprised if more companies face similar challenges to executive compensation in the future," adding that these challenges might include not only a derivative suit like the one involving Citigroup, but also shareholder demands on the board; books and records requests; and even proxy contests.

An April 6, 2009 Law.com article entitled "Executive Bonuses Triggering Lawsuits Nationwide" (here) observes that litigation triggered by executive compensation controversies not only include claims of excess compensation but also lawsuits ranging "from corporate officers who allege their companies reneged on bonuses to officers who believe they were fired for protesting them." The article, which cites several examples of each of these kinds of claims, also notes that "attorneys are bracing for more litigation and legislation involving executive bonuses and compensation matters."

In addition, another recurring theme currently surrounding executive compensation is the possibility of a clawback remedy, to recover compensation already paid, which is a topic I previously discussed here.

One positive consequence of the current furor over executive compensation is that at least some companies have become more solicitous of shareholders’ views on pay. Indeed, as discussed in an April 6, 2009 Wall Street Journal article entitled "Companies Seek Shareholder Input on Pay Practices" (here) reports that biotech firm Amgen invites its shareholders to complete a 10-question online survey to determine the shareholders’ views on whether the company’s compensation plan is based on performance and whether performance goals are clearly disclosed and understandable. The article identified other companies that are taking similar steps to consult or enlist shareholders.

That said, the actions taken based on current popular outrage over executive compensation issues also have an ugly side. The stones thrown through the home windows of former RBS chairman Fred Goodwin and the French workers’ recent seizures of local managers, among other recent examples, suggest the possibility that the current populist backlash could slip into far more dangerous manifestations, which is one of the dangers when politicians play to the galleries on these kinds of issues.

Popular anger over bonuses paid to money-losing managers is understandable. Indeed Goldman Sachs Chairman and CEO Lloyd Blankfein has said (here) that he recognizes why the public is angry and called for a reform of the way financial institution executives are compensated, particularly at companies receiving government bailout funds.

All the same, we should take care as a society that our proclivity for blamecasting and scapegoating does not unleash darker forces. Social disorder has arisen in past economic crises, and there is nothing that says that it can’t happen again.

An April 7, 2009 Wall Street Journal op-ed column considers (here) how generalized populist outrage can quickly transform into nationalist or ethnic rage.

My apologies to The Economist  for using the cover art from this week's issue of the magazine to lead this post. I figure that on the cover of last week's issue of the magazine, they shamelessly imitated the iconic Saul Steinberg Map of New York cover art from the March 29, 1976 issue of The New Yorker Magazine. In its original form, Steinberg's map reflected a view of the world as seen from New York's Ninth Avenue. On the cover of last week's issue, The Economist adapted Steinberg's map as a contemporary map of Beijing, adding an apology for the adaptation. I extend to The Econmist the same apology here for my adaptation of the magazine's cover art here.

Subprime Securities Litigation: Early Trends: Even though the subprime and credit crisis-related litigation wave recently entered its third year (as I noted here), and though there have been a few settlements as well as a few rulings on motions to dismiss (refer here), by and large, the cases remain only in their earliest stages.

Nevertheless some trends have begun to emerge, as detailed in the March 23, 2009 memorandum from the Gibson Dunn law firm entitled "Suprime-Related Securities Litigation: Early Trends" (here). The memo does a particularly good job categorizing the various kinds of allegations that plaintiffs have alleged as well as the defenses that defendants have asserted. As for what may lie ahead, the memo states that "there is unlikely to be any slowdown in the near future of new filings of securities cases related to the credit crisis."

The National Map of Bank Distress: The FDIC did not close any banks this past Friday night, so the number of year-to-date bank failures remains at 21, and the total number of bank failure since January 1, 2008 remains at 46.

Those readers who are tracking these banking-related developments closely may want to refer to this nifty interactive graphic (here) from TheStreet.com, on which they have plotted the bank closures since January 1, 2008 on a map of the United States. Cool.

Some Things in the Insurance Industry Never Change: In his enjoyable book about the rebuilding of London following the Great Fire of 1666 entitled London Rising, author Leo Hollis discusses the innovation Nicholas Barbon introduced when he launched "the first fire insurance company in the world." Hollis writes that

His scheme was brilliantly simple: it offered a defence against the risks of living in the city while also making him a healthy profit. For a premium of 2.5 per cent of the yearly rent for brick buildings and 5 per cent for wooden-frame structures he offered insurance against fire for terms of seven, eleven, twenty-one and thirty-one years. By the 1680s, he would have over four thousand subscribers.

However, insurance industry behavior pattern apparently were established even in the industry’s earliest days; Hollis notes that "the problem with innovation is that it is often copied and Barbon’s ideas were swiftly replicated." The City Corporation offered its own competing scheme and offered terms for life. Barbon "had to work hard to sell his services before the opposition stole his market," while the Corporation soon found "that it was offering too much to get customers."

So it may be said, with respect to the insurance industry’s apparently inexhaustible capacity for self-destructive competition, ‘twas ever thus.

And Finally: On behalf of everyone who has watched as much college basketball on TV over the last few weeks as I have, I would like to make a motion – that is, that every single person associated in any way with the production or distribution of the Taco Bell "nacho drag" commercial should be taken out and summarily shot, without benefit of clergy. All those in favor say "Aye."

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Following close on the heels of the Massachusetts regulator’s action filed last week against Madoff feeder-fund Fairfield Greenwich and related individuals, on April 6, 2009, New York Attorney General Andrew Cuomo initiated a civil action in New York (New York County) Supreme Court against J. Ezra Merkin and Madoff feeder fund Gabriel Capital Corporation. The AG’s April 6 press release, which links to the complaint and accompanying exhibits, can be found here.

The complaint alleges that over the course of many years beginning in the 90s and going through December 2008, Merkin earned $470 million in management and incentive fees, representing to investors and to nonprofits on whose boards he sat that he was managing their money when in fact he was simply handing much of the money over to be managed by Bernard Madoff, whom Merkin "failed to adequately oversee, audit or investigate."

The complaint alleges that through his "misrepresentations, concealment, self-dealing, reckless conduct and gross negligence," Merkin "abused the trust of investors" and "breached the fiduciary duties" he owed to the nonprofits on whose boards he sat. As a result, the complaint alleges, investors lost approximately $2.4 billion.

Merkin not only misrepresented his role as a money manager, but also, according to the complaint, concealed Madoff’s critical role in (supposedly) managing the funds. The complaint also alleges that not only was Madoff perhaps uniquely aware of many of the "red flags" about Madoff (including his uncanny returns, his suspicious clearing of trades every quarter end, and the suspicious identity of his auditor), but he also received numerous warnings about Madoff from "his closest and most trusted advisors." The complaint alleges that Merkin disregarded these warnings because his "financial incentive to keep funds with Madoff blinded him."

The complaint alleges that the Ascot funds, one of the groups of funds Merkin founded and supposedly managed, turned virtually all of its investor funds over to Madoff to handle. Of the $1.7 billion in the Ascot funds as of May 2008, $215 million, or about 12 percent, belonged to 35 nonprofit groups, of which more than half ($115 billion) belong to organizations on whose board Merkin sat as a director. The complaint alleges that "Merkin embedded himself in charitable boards and used those positions to solicit new investments."

The complaint charges Merkin with violations of the Martin Act for fraudulent conduct in connection with the sale of securities; with other statutory violations for "persistent fraud in the conduct of business"; and with violations of New York’s Not-for-Profit Corporation Law and breaches of fiduciary duty in connection with Merkin’s service on the boards of certain nonprofit entities. The complaint seeks payment of damages and disgorgement of fees, restitution and other equitable relief.

The NYAG’s complaint obviously presents a host of factual and legal issues. Among other things, it also raises some potentially complex and even vexing insurance complications as well.

Merkin will obviously seek to resort to his firm’s D&O and/or E&O coverage in connection with his defense against the AG’s claims. However, his firm’s insurance coverage may already be under significant pressure as a result of the extensive civil litigation already pending against him and his firm.

Moreover, his firm’s insurance coverage would only cover him as excess insurance in connection with the allegations against him in his capacity as a director of the referenced nonprofit entities. Insofar as he is named as a defendant in those capacities, his firm’s policy would cover him, if at all, after both the nonprofit’s available insurance and indemnification obligations were exhausted.

In other words, as a result of the allegations against him in his capacity as a director of those nonprofits, he would as a theoretical matter be in a position to attempt to resort to those organization’s insurance policies as well as to seek indemnification from those organizations.

The potential implications that these nonprofits insurance policies (and even indemnification obligations) would be called upon to respond to the claims against Merkin would raise a host of complex issues, including, for example, allocation issues (owing to the fact that Merkin is named as a defendant in multiple capacities). But as a strictly theoretical matter – and without expressing any opinion as to the merits of the effort or the justice it would or would not represent – Merkin certainly might well seek to access the various nonprofits’ insurance policies, at least to the extent he is named as a defendant in his capacities as a director of the nonprofits. However, even to the extent the policies afforded coverage in connection with this claim it would only be for Merkin as an individual and to the extent of his insured capacity under each particular policy, and it would not in any event extend to his funds.

One additional complicating factor, at least as a preliminary matter, is that the various nonprofit organizations are not referenced by name in the complaint. This initial hurdle is likely surmountable through discovery, and seemingly would quickly be overcome. (According to an April 7, 2009 Wall Street Journa article about the AG's law suit, which can be found here, the institutions on whose Boards Merkin sat and which had funds invested with Merkin included New York University, New York Law School, Yeshiva University and Bard College.) Whether or not the potentially affected policies would in fact respond to these claims would of course have to be determined according to the applicable allegations and the applicable policy language.

Ironically, as least some of these nonprofit institsutions have separtely initiated their own actions against Merkin and his funds -- for example, New York Law School (refer here for the complaint) and New York University (refer here) have each filed suit against Merkin . These separate actions against Merkin would likely trigger the insured vs. insured exclusion found in most D&O insurance policies and therefore would not themselves implicate coverage. The irony is that these same institutions, who are pursuing substantially the same claims against Merkin as is the NYAG,  could  see their insurance policies accessed and potentially depleted by the NYAG's complaints, assuming for the sake of discussion that the policies are in fact implicated as discussed here.

A detailed and particularly compelling portrait of the long relationship between Madoff and Merking is set out in New York Magazine’s February 22, 2009 article entitled "The Monster Mensch" (here). The article describes Merkin as "an intellectual showman" and a "marvel of erudition" who commanded respect as a civil and philanthropic leader and as Chariman of GMAC, the finance arm of General Motors. He was, according to a friend quoted in the article, the "wisest man on Wall Street." Which may explain a lot, unintentionally and in retrospect, about Wall Street.

I have in any event added the NYAG’s complaint to my roster of Madoff-related lawsuits, which can be accessed here. (The list also includes a separate action filed against Merkin, Gabriel and the funds' auditor on April 6 by publisher and real estate magnate Mortimer Zuckerman, who claims in his complaint that he lost $40 through his investments with Merkin.)I note that this list gets considerably longer every day, as new complaints continue to arrive. Special thanks to the many readers who continue to provide me with copies of the new lawsuits, particularly to Jon Jacobson of the Greenberg Traurig firm.

And Finally: Although arguably it has nothing to do with Merkin himself or any of the foregoing, I nevertheless feel compelled to alert readers to the interesting and somewhat peculiar meaning that the work "merkin" has in the English language.

According to Wikipedia (here), a "merkin" is "a pubic wig, originally worn by prostitutes, after shaving the genitalia to eliminate lice or disguise the marks of syphilis." The Wikipedia entry helpfully provides a picture of "a mock merkin."

Now you know.

Special thanks to the loyal reader who pointed out this fact – which, upon further reflection, may not be quite so unrelated after all.

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The possibility that a conflict of interest could arise when an attorney or law firm simultaneously representes a corporation and one or more of its officers or directors is a a frequently recurring issue. The issue  was raised recently, for example, in the civil complaint that former Stanford Financial Group CFO Laura Pendergest-Holt filed against the firm’s former outside counsel, in connection with his conduct of the defense in connection with the SEC’s investigation of the firm. (A copy of Pendergest-Holt’s complaint can be found here.)

An April 1, 2009 opinion (here) by Central District of California Judge Cormac Carney in the Broadcom Corporation options backdating criminal case presents a far more dramatic example of the pitfalls that can arise from dual representations.

The opinion involves the Irell & Manella law firm’s "separate, but inextricably interrelated representations" of Broadcom and its CFO, William Ruehle. The law firm represented the company in its internal investigation of the backdating allegations. It also represented the company and Ruehle in the defense of the backdating related civil litigation.

In June 2006, two lawyers from the firm interviewed Ruehle, without disclosing possible conflicts or disclosing they might later reveal his statements to third parties (such as the government). Subsequently, the law firm, at the company’s direction, disclosed Ruehle’s statements to the company’s auditors, the SEC and the DoJ.

Ruehle sought to suppress the government’s reliance on his statements in connection with the criminal prosecution, because the statements represented privileged communications. Judge Carney agreed, but his April 1 opinion went far beyond this conclusion.

Judge Carney found that Irell "committed at least three clear violations of its duty of loyalty" – it failed to advise Ruehle of and obtain his written consent to the conflict; it interrogated him for the benefit of another client (Broadcom); and it disclosed privileged communications to a third party without consent.

Judge Carney said that he found Irell’s "ethical breaches" to be "very troubling," not only because they resulted in the suppression of relevant evidence, but also because they "compromised the rights of Mr. Ruehle, the integrity of the legal profession, and the fair administration of justice." Because of these concerns, Judge Cormac concluded that he "must refer Irell to the State Bar for discipline."

Judge Carney’s blistering opinion is noteworthy in and of itself, both because of the prominence of the firm involved and because of the heat of the rhetoric he employed. His opinion is also a cautionary example both to lawyers involved in corporate representations and to corporate officers whose interests may be being represented by the company’s own counsel in connection with serious investigations that may potentially involve criminal implications.

The opinion may also be relevant for insurance professionals who often are called upon to address questions surrounding the possible need for separate counsel for individual defendants. Judge Carney’s opinion in the Broadcom case underscores how serious these issues may be, and the consequences that can sometimes arise if separate counsel issues are not appropriately addressed.

Insurance professionals of course cannot become involved in the kinds of ethical questions presented in Judge Carney’s opinion, but an awareness of the kinds of issues that can arise is an important perspective to bring to the table when questions involving separate representation do arise.

It is sometimes the case that it is the firm’s outside law firm that is resisting the suggestion that the firm may not be able to maintain the multiple representations it has purported to assume. These kinds of discussions can be particularly vexing, as law firm can often dominate the dialog and the insured company or insured individuals may not see where their interests may diverge from the position the law firm is advocating. While these conversations can sometimes be extremely delicate, they can involve critical issues. Insurance professionals aware of the kinds of issues involved in the Broadcom case can at least raise appropriate questions to try to ensure that issues are discussed.

Special thanks to a loyal reader for proving a copy of Judge Carney’s opinion.

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The consolidated  IPO Laddering Cases, that superannuated vestige of a long-gone era that has continued to grind on despite numerous procedural setbacks, apparently has been settled (again), at least according to the parties’ April 1, 2009 settlement stipulation (here). Hat tip to the WSJ.com Law Blog for the link to the stipulation.

According to the settlement stipulation, the aggregate gross amount of the settlement is $586 million, out of which will come both plaintiffs’ attorneys’ fees and extensive notice and administrative expenses. The amount of the plaintiffs’ attorneys’ fees are not specified in the agreement. News reports (here) suggest that the plaintiffs intend to seek fees of as much as $195.3 million, plus $56 million in expenses, from the settlement.

The stipulation provides for two different $10 million advances from the gross settlement fund for the payment of notice and administration expenses, and provides a mechanism should further expenses become necessary. Clearly, the parties anticipate that notice of and administration for the settlement will be massive, expensive undertakings.

The publicly available version of the stipulation does not answer the question I was most interested to know, which is who, between the underwriter defendants and the issuer defendants and their insurers, will be paying how much of the proposed settlement? Unfortunately, Exhibits E and F to the stipulation, which reflect the defendants’ respective settlement contributions, were filed under seal. The prying curiosity of nosy bystanders like me sadly will go unfulfilled.

My curiosity about the relative settlement contributions is driven largely by the convoluted history of the prior attempts to settle this case (or should I say these cases?). Readers will recall (as discussed at length here), that prior settlement attempts were derailed on December 6, 2006 when the Second Circuit held that the district court had erred in certifying a class against the offering underwriter defendants. Among other things, that decision vitiated the pending settlement in which the issuer defendants had agreed to pay the investor plaintiffs $1 billion, with the issuers’ contribution to be reduced to the extent of investor recoveries from the underwriter defendants. The decision also set aside J.P. Morgan’s proposed agreement to pay $425 million to settle its liability.

Following that setback, the case ground on. On March 26, 2008, Southern District of New York Judge Schira Schindlin denied the defendants’ renewed motions to dismiss, as discussed here. Though this case probably could have kept squadrons of attorneys employed from now until doomsday, there comes a time for all things to end.

So much as has changed since these cases first flooded in during 2001, particularly in recent months. Not only has Lehman Brothers gone bankrupt, but other high profile underwriter defendants have been merged out of existence. 41 of the issuer defendants have gone bankrupt. Indeed, Mel Weiss, who was at the outset at the vanguard on behalf of the investor plaintiffs, has pled guilty to criminal charges. And so this massive case, initially involving 55 underwriter defendants and 310 issuer defendants, may have finally come to an end.

Press reports (here) quote one of the plaintiffs’ attorneys as saying "When these cases were filed in 2001, no one would have believed that in 2009 Bear Stearns would be out of business, Lehman in bankruptcy, and names like Salomon and Merrill Lynch erased from the financial landscape…Under the circumstances, this settlement is the best available real-world alternative."

It should be noted that the agreement is subject to court approval as well as a host of contingencies, and could still be terminated by any one of a number of parties or contingencies.

The mammoth size of the proposed settlement is impressive. A quick look at historical settlement data suggests that this settlement would represent the 12th largest securities class action settlment of all time. Inevitably this latest settlement attempt will draw comparisons to the prior $1 billion minimum attempt to settle the case.

In addition, curious readers will want to take a look at the schedules to Exhibit C to the stipulation, which show a number of interesting things. First, the schedules show, as required by the PSLRA, the gross recovery per damaged subject security – in most cases, only a penny or two per share.

Second, the schedule also shows the plaintiffs’ preliminary estimate of the potential damages for class members, indexed by issuer defendant. These estimates reflect some truly staggering numbers. Even if they are purely theoretical, they are nonetheless impressive. Some of them, with respect to just a single issuer, exceed the entire amount of the settlement itself. For example, the estimate for Priceline.com is $1.166 billion. The estimate for Global Crossing is $780 million. Foundry Networks, $720 million; Commerce One, $641 million.

The schedule omits to provide an aggregate number for all of the issuer defendants, but I suspect that the figure would rival the kind of numbers that only someone like the late Carl Sagan and Timothy Geithner would be comfortable saying in public (and even then, in Geithner’s case, only recently). In any event, those are some big numbers.

One likely byproduct of this settlement will be the forthcoming mailings to the settlement class members. I can only imagine how many individual pieces of mail we are talking about, and how much the postage alone will cost. No wonder the notice and administrative expenses are expected to be so high. The class mailings by themselves could remedy the U.S. Postal Service’s chronic operating deficits.

In all seriousness, this settlement stipulation obviously was a maddeningly difficult thing to nail down. The attorneys who finally got this monster worked out in a global settlement (or at least an attempted global settlement) are to be congratulated on tackling what had to have been an extraordinarily difficult challenge. Even if history should ultimately little note nor long remember what happened here today, their efforts are worthy of respect.

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The global financial crisis has produced challenges across the entire economy, but the financial sector, where all the problems arguably began, has been particularly hard hit. While the most investment firms and other banking institutions may have experienced the most dramatic consequences, insurance companies have also been swept up in the whirlwind.

The extent of the recession’s impact on insurance companies and the resulting consequences for the insurance marketplace are the subjects of an April 2009 paper from insurance industry data firm Advisen entitled "The Impact of the Economic Crisis on the P&C Insurance Industry" (here, $ required). Advisen’s April 2, 2009 press release describing the report can be found here.

According to the paper, the various economic forces at play will likely shrink insurers’ policyholder surplus, thus diminishing the supply of insurance. These circumstances ordinarily would produce a so-called "hard" market, characterized by rising prices for insurance. However, the reduction in economic activity as a result of the current recession could also reduce the demand for insurance, which in turn could complicate the insurance cycle’s transition and "make for a very turbulent 2009" for the insurance industry.

The major cause for the reduction in the demand for insurance, which according to the paper could delay the transition to a hard market, is "shrinking exposure units." An exposure unit is the basis for calculating premium – for example, the size of an employer’s workforce will determine the employer’s workers comp and EPL insurance premiums.

Many of the exposure units that are critical for determining pricing for a variety of insurance lines – such as sales, real estate square footage, number and mileage of vehicles, payroll, and property values – are all likely to shrink in the months ahead, as a result of the recession. The shrinking exposure base will produce a fall-off in insurers’ top-line revenue.

In addition, insurance demand will also likely be further eroded as businesses close or fail. Even companies that survive may seek to increase self-insured retentions or limits, as a way to cut costs.

The reduction in demand will also likely be accompanied by a reduction in supply, in the form of policyholder surplus, both as a result of increased claims losses and as a result of diminished investment income and investment losses.

The likely increased claims losses could arise from a variety of sources. The paper states that job losses frequently are accompanies by an increase in the frequency and severity of workers’ comp claims. Reductions in force also could trigger EPL claims. And as has been well documented on this blog (refer here), the current economic crisis has also produced a wave of shareholder claims. As the Advisen report notes, these claims are particularly complex which will make them costly to defend and could also make them costly to resolve. D&O claims arising from bankruptcies and E&O claims arising from the various Ponzi scheme scandals could exacerbate the claims losses that insurers experience.

On the investment side, insurers’ investment results have taken a massive hit. Many insurers have had to take huge write-downs, both in their fixed income assets and with respect to more exotic investments. A few insurers have been particularly hard hit with valuation issues concerning "toxic" assets.

In more typical cycle transitions, insurance pricing swings result from changes on the supply side (i.e., policyholder surplus). But the depth of the current economic crisis could also uncharacteristically affect the demand for insurance. One proxy for insurance demand is GDP. When policyholder surplus declines relative to GDP, a hard market usually follows. In the current circumstances, GDP is under pressure, but the decline in policyholder surplus is relatively greater.

These circumstances, together with the likely difficulty insurers will face trying to raise fresh capital, suggest that the insurance marketplace will eventually harden, and higher premiums eventually will result. The Advisen paper projects that the hard market could "begin to set in" as early as mid-2009, and in any event no later than 2010.

However, the hard market will "likely take off slowly" due to lack of consumer and business confidence. When it comes, though, the hard market "could extend longer than previous hard markets owing to the lack of new capital entering the market."

The Advisen report is accompanied by extensive supporting data and analysis, and I think the author makes an excellent point about the pressure that the recession will put on the demand side of the insurance equation

As for the report’s predictions of the arrival and timing of a forthcoming hard market, I guess time will tell. In my view, a hard market is characterized by more than just rising prices; among other things, it also means a shortage of capacity as well as a constriction of terms and conditions. If there really were going to be a hard market as early as mid-2009 (which at this point is only a couple of months away), you would expect some sign of these things in the marketplace, but so far there is very little evidence of any of these things. Which at a minimum suggests to me that if there is going to be a hard market, its arrival could be more delayed than the report suggests.

That said, the report does make a compelling case for the likelihood that there actually will be a hard market this time. It may not be a question of whether, but only of when. Overall, the report is interesting and provides useful analysis of the current insurance marketplace and its likely future direction. The report is well worth reading at length and in full and I commend it to everyone.

Rescission Denied: Policy rescission is a controversial topic. But because the debate often involves high profile cases where the insurer has successfully rescinded a policy, it is sometimes overlooked how difficult it is for insurers to rescind coverage. A recent decision illustrates the difficulties carriers face when they seek to rescind a policy.

In a March 25, 2009 opinion (here), New York (New York Country) Supreme Court Justice Charles Ramos granted summary judgment for JP Morgan Chase in an insurance dispute involving several high profile claims. An excess insurer in J.P. Morgan’s bankers professional liability insurance program had sought to rescind its policy based on alleged misrepresentations in the company’s 2001-02 insurance renewal.

The excess insurer claimed that the company had made misrepresentations about its exposure to Enron, both in a Notice of Potential Claim submitted under the prior insurance program and in a Press Release.

As reflected in the April 2009 memo from the Proskauer Rose law firm entitled "Court Grants Summary Judgment Dismissing Insurer’s Rescission Claim" (here), Judge Ramos found that the Notice and the Press Release were not part of the renewal materials, and the insurer had not asked the company to warrant either document in connection with the renewal.

Judge Ramos also found that there was no issue of triable fact either that the insurer’s underwriters relied on the documents or that the company officials who prepared the documents were aware of any misrepresentations in the documents.

Judge Ramos also found that the insurer had waived rescission because it did not raise the defense until 2006, several years later, and had retained the premium.

While much more might be said about this decision, if nothing else, Judge Ramos’s opinion demonstrates the many hurdles carriers face in attempting to rescind a policy. Any carrier considering policy rescission might well want to review the opinion.

A prior post in which I discuss the difficulties carriers face in attempting to rescind coverage can be found here. Among other things, I note that "policy rescission wreaks havoc on all concerned."

Special thanks to John Gross and Michelle Migdon of the Proskauer Rose firm for providing a copy of the opinion.

More About the Bailout: Much has been written and said about the gargantuan federal bailout. A March 19, 2009 Rolling Stone article entitled "The Big Takeover" (here) presents a particularly irreverent and occasionally profane perspective on the subject.

Although the overall tone of the article borders on feverish, and the article definitely tends toward the conspiracy view of the world, it also contains some funny lines as well as some interesting observations. I particularly liked the author’s take on AIG: "AIG is what happens when short, bald managers of otherwise boring financial bureaucracies start seeing Brad Pitt in the mirror."

The article’s overall take on the bailout is summarized in this paragraph:

In essence, Paulson and his cronies turned the federal government into one gigantic, half-opaque holding company, one whose balance sheet includes the world's most appallingly large and risky hedge fund, a controlling stake in a dying insurance giant, huge investments in a group of teetering megabanks, and shares here and there in various auto-finance companies, student loans, and other failing businesses. Like AIG, this new federal holding company is a firm that has no mechanism for auditing itself and is run by leaders who have very little grasp of the daily operations of its disparate subsidiary operations.

The report concludes with the observation about the bailout that "it’s AIG’s rip-roaringly shitty business model writ almost inconceivably massive." (I should probably emphasize that the view in the article quoted above are those of the article’s author, and do not necessarily represent the view or sentiments of this blog’s author.)

Special thanks to a loyal reader for providing a copy of the Rolling Stone article.

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On April 1, 2009, PricewaterhouseCoopers issued this year’s version of its annual study of securities class action litigation (here). The PwC report differs in certain particulars from previously released studies of the 2008 securities lawsuit filings, but the overall findings are directionally consistent with the prior reports. The PwC report also adds some interesting observations of its own.

My own analysis of the 2008 securities lawsuit filings can be found here. Cornerstone’s previously released study of 2008 filings can be found here and Cornerstone’s study of the 2008 securities lawsuit settlements can be found here. NERA’s 2008 study can be found here and Advisen’s can be found here.

The PwC study found, consistently with the prior reports, that as a result of the financial crisis, the number of securities class action lawsuits rose for the second year in a row in 2008. The PwC report tallied 210 securities lawsuits in 2008, a number that is notably below the numbers reported by other studies. The 2008 total represents a 29 percent increase over 2007. The report found that the filings were steady throughout the year, with a slight uptick in the fourth quarter.

The report found that the majority of the 2008 filings were related to the financial crisis. Indeed, the report noted that "for the first time since the PSLRA, in 2008 the plaintiffs’ bar filed more federal securities lawsuits against the financial services industry group (banking, brokerage, financial services and insurance) than any other industry." By the same token, for the first time since the PSLRA’s passage, high tech companies were not the most frequently targeted.

The number of filings against companies in the pharmaceutical industry remained consistent with 2007, with 21 lawsuits in the sector in both years. My own analysis of the 2008 securities filings in the life sciences sector can be found here.

Filings against companies in the Fortune 500 were up in 2008, with 37 filings during the year, or 18% of all cases filed. The average annual percentage of filings against Fortune 500 companies since the PSLRA’s enactment is 13%. The majority (65%) of the Fortune 500 companies sued in 2008 were in the financial sector.

The report notes that the profile of financial companies sued in 2008 changed from those named as defendants in 2008. The focus changed from loan originators in 2007 to entities involved in loan securitization in 2008. (I might add parenthetically that the loan securitizers remain a target in 2009.) In 2008, the auction rate securities lawsuits were a significant part (38%) of the suits filed against entities involved in loan securitization.

According to the PwC report, securities lawsuits in the United States against foreign issuers "reached an all-time high in 2008, with 36 cases representing 17 percent of the total federal securities class actions filed." These filings against foreign issuers represent the highest percentage of the total cases in any year since the enactment of the PSLRA. 15 (or 42%) of the 36 cases filed against foreign issuers involved companies in the financial services industry, and 32 out of the 36 of the suits against foreign issuers were filed in the Second Circuit. The countries whose companies were sued most frequently were Canada, China and Switzerland.

The report notes that the number and aggregate dollar value of securities lawsuit settlements declined in 2008. However, if the $3.2 billion Tyco settlement is excluded from the 2007 numbers, the remaining total value of the 2007 settlements ($3.3 billion) is 9 percent less than the total value of the 2008 settlements ($3.6 billion).

The average 2008 settlement of $41 million represented a substantial increase from 2007’s average of $28.3 million, but the 2008 average was still well below the 2005 average of $67.6 million. The median 2008 settlement of $8 million was unchanged from 2007.

The report has an interesting statistic showing that the 2008 average for settlements greater than $1 million but less than $50 million was $11.2 million, which not only represents an increase over the equivalent 2007 average of $9.6 million, but also represents the highest such average since the PSLRA’s enactment.

The report also has extensive additional interesting analysis regarding the prevalence and type of accounting allegations, and their impact on settlement; the nature of SEC enforcement activity; and the increase in foreign regulatory activity.

The report concludes by noting that there are three areas in which "companies will want to remain especially vigilant," which are "institutional plaintiff activity (particularly activity relating to public and union pension funds), internal controls accounting-related allegations, and FCPA enforcement." The report ends with the observation that "securities litigation activity in 2009 is likely to reflect [the] new era of accountability and oversight, particularly if the regulatory environment is overhauled, as most think inevitable."

An interesting interview discussing the PwC report can be found here.

Special thanks to a loyal reader for providing me with a link to the PwC report.

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Georgia’s banks have issues. The state has led the nation in the number of bank failures since January 1, 2008, a fact that earlier this year (even before the most recent round of closures) led the Wall Street Journal (here) to describe the Atlanta area as "the bank failure capital of the world." Signs indicate there may be more Georgia bank failures yet to come.

After the FDIC moved in this past Friday night (refer here), Atlanta’s Omni National Bank became the ninth Georgia bank closure since the beginning of last year. (A tenth Georgia bank closed in September 2007.) Though banks in 19 different states have failed since the beginning of 2008, no state has had more bank failures than Georgia. Not even California, which has had eight banks fail during that period, or Florida, which has had four.

The Georgia bank failures represent a significant part of the total number of bank failures in recent months. Since the beginning of 2008, there have been a total of 46 bank failures. So the nine failures in Georgia during that period represent about one-fifth of the total. The pace of Georgia bank failures has continued in 2009, with four out of the 21 closures so far this year.

The nine Georgia bank failures since the beginning of 2008 had a total of $4.7 billion in assets. The failures’ estimated cost to the FDIC insurance fund is about $1.4 billion.

A January 2, 2009 Wall Street Journal article entitled "Bank Failure Central? Try Alphretta, Georgia" (here) noted that the Atlanta region has been "haunted by overabundant home building, years of risky lending, and one of the most relaxed regulatory environments in the U.S. for starting new banks."

Nor have these problems entirely played themselves out yet. The Journal article quotes industry sources as saying that "as many as 20 of the 122 banks still headquartered in or near Atlanta could go under before the credit crisis and recession are over."

A March 31, 2009 Street.com article entitled "Georgia Banks Face More Pain" (here) similarly projects that "there’s a lot more trouble ahead" for Georgia’s banks. The article’s accompanying analysis shows that over 30 of Georgia’s 331 banks and thrifts are "in a weakened condition."

The Street.com article identifies four banks (beyond those that have already failed this year) as "undercapitalized" as of December 31, 2008. The article also identifies thirty-three more that had "nonperforming asset ratios above 10%." On the other hand, the article also identifies 83 of Georgia’s 331 banks and thrifts as "good" or above.

These institutional failures have their costs, and even the closure of a smaller bank can leave problems behind. A March 28, 2009 New York Times article entitled "A Small Town Loses Its Pillar: Its Only Bank" (here) describes the difficulties experienced in Gibson, Georgia – a town far from Atlanta too small even for a hospital, a jail or a Wal-Mart – when it lost its only bank, FirstCity. (Refer here for background regarding FirstCity’s closure.)

The Times article recounts how the bank’s decline began with the 2001 sale of the former Bank of Gibson. After the sale, the bank rushed to "cash in on the expanding real estate market." By the time it failed, the bank was so weak that the FDIC couldn’t find another institution to buy its deposits. The article quotes the bank’s founder’s grandson as saying about the owners who acquired the bank in 2001 that "maybe they weren’t as smart as they thought they were."

The FDIC’s complete list of all bank failures since 2001 can be found here. Hat tip to Adam Savett of the Securities Litigation Watch for link to the Times article.

A Tweet Deal: I find myself becoming ever more deeply immersed in the world of Twitter. Among other things, I am more frequently adding links and comments on the same general topics as this blog, but between blog posts. An increasingly large number of people are now following me on Twitter as well. I invite all readers to join me on Twitter by subscribing here or clicking on the Twitter button in the right hand margin above.

And while on the Web 2.0 theme, I also invite readers to connect with me on LinkedIn by clicking on the relevant button in the right hand margin. A number of readers have joined my network recently and have also joined the industry groups of which I am also a part on LinkedIn. I welcome the connection with readers.

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Earlier this week, I suggested (here) that the UBS auction rate securities lawsuit dismissal did not spell the end of the auction rate securities litigation. Two of the categories of likely future litigation involving auction rate securities I mentioned were lawsuits involving institutional investors (who are not covered, at least immediately, by many of the regulatory settlements) and lawsuits involving auction rate securities buyers that are targeted by their own investors.

As if to prove my point about the likelihood for continuing auction rate securities litigation, two significant auction rate securities lawsuits have arrived just since I added my post earlier this week.

First, in a lawsuit against an auction rate securities buyer, on March 31, 2009, PIMCO mutual fund investors filed a securities class action lawsuit in the Central District of New York against the funds’ investment manager and the funds’ sub-advisor, certain of the managers’ directors and officers (including bond investing guru Bill Gross). A copy of the complaint can be found here.

The complaint alleges that the funds concealed from the investors that

(a) The Funds lacked effective controls and hedges to minimize the risk of loss and risk of liquidity from auction rate securities ("ARS") which affected a large part of their portfolios; (b) The Funds lacked effective internal controls to ensure that the Funds would remain in compliance with restrictions and limitations related to their investment portfolios and strategies; (c) The extent of the Funds' liquidity risk due to the illiquid nature of a large portion of the Funds' portfolios, including ARS, was omitted; and (d) The extent of the Funds' risk exposure to ARS was misstated.

The PIMCO mutual fund lawsuit joins recent lawsuits filed against Perrigo Company (about which refer here) and NextWave Wireless (refer here), as examples of cases in which auction rate securities buyers are targeted by their own investors for their exposure to the instruments. These lawsuits differ from the more standard auction rate securities lawsuits, in which the auction rate securities buyers were the plaintiffs and the defendants were the broker-dealers or others that had sold the instruments.

PIMCO’s woes with its funds’ investments in auction rate securities have been well-documented in the press in recent days, as the funds’ managers have struggled to manage problems stemming from the investments. A recent Wall Street Journal article discussing the funds’ woes can be found here.

The second of the two new auction rate securities lawsuits involves an institutional investor buyer, brining an action against the broker-dealers that sold the company the instruments. On April 1, 2009, Texas Instruments filed an Original Petition in Texas (Dallas County) District Court against Citigroup Capital Markets, BNY Capital Markets and Morgan Stanley, in connection with the company’s purchase of $524 million of auction rate securities backed by student loans. A copy of the Petition can be found here.

The Petition alleges that despite the defendants’ "assurances of liquidity and low risk," the company is now stuck with auction rate securities that it "cannot liquidate." The Petition alleges that the defendants "downplayed any risk of failed auctions" and "misrepresented the market demand" for the securities by omitting to disclose "the extent to which the entire ARS market depended on continued bidding and purchasing by the Defendants and other broker-dealers."

Beyond these more general allegations, the complaint contains some very case specific allegations relating to the defendants’ alleged failure to disclose that as 2007 progressed securities issuers (including issuers of securities that Texas Instruments held) were waiving the maximum interest rate limitations in connection with auctions of their securities. The company alleges that had it been advised of these waivers, it would have been alerted to the weakening demand for the instruments. The company alleges these omissions and affirmative reassurances induced it to continue to buy and hold the securities.

The Petition alleges violations of the Texas securities laws and seeks rescission of the securities purchase transactions as well as prejudgment interest.

Interestingly, the Petition does not mention the various regulatory settlements that Citigroup and others have reached with respect to the auction rate securities, presumably because the settlements do not provide relief (at least not immediately) to an institutional investor like Texas Instruments.

In any event, it is evident that the auction rate securities litigation is far from over.

Hat tip to the Courthouse News Service for the link to the Petition. Special thanks to Adam Savett of the Securities Litigation Watch for a link to the PIMCO lawsuit.

Dismissal Motion Ruling in Options Backdating-Related Securities Lawsuits: The options backdating cases continue to grind through the courts. On March 27, 2009, District of Arizona Judge Robert Broomfield issued a 138-page ruling (here) on the pending dismissal motion in the options backdating-related securities lawsuit against Apollo Group and several of its directors and officers. (Background regarding the case can be found here).

Judge Bloomfield’s ruling is very painstaking and detailed. He parsed the allegations against each of the defendants extremely finely. The outcome is rather complex, and it would require a spreadsheet to explain with respect to each of the plaintiffs' substantive claims which defendants have been dismissed with prejudice, which have been dismissed without prejudice, and which have had their dismissal motions denied. The most critical aspect of his ruling is that the Court denied the motion to dismiss the plaintiffs’ claims under Section 10(b) against the Company and its most senior officers.

Apollo Group was also involved in a separate, rather notorious securities class action lawsuit that resulted in a January 2008 plaintiffs’ jury verdict that was overturned by the trial judge in August 2008 on a post trial motion. Refer here for background on this separate case.

I have in any event added the Apollo Group decision to my table of settlements, dismissals, and dismissal motion denials, which can be accessed here.

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In a development that may foreshadow further "gatekeeper" claims as part of the current credit crisis litigation wave, on April 1, 2009, the trustee for the New Century Financial Corp. liquidation initiated lawsuits in California and New York against KPMG and its international parent, seeking to recover $1 billion in damages for negligence and for aiding and abetting breaches of fiduciary duty.

The California complaint, filed in the Los Angeles County Superior Court (copy here) against KPMG LLP, alleges that the firm "did not act like a watchdog" but rather "acted like a cheerleader for management."

The complaint alleges that KPMG "performed grossly negligent audits and reviews" and "failed to detect material errors" with respect to New Century’s residual interest on loans it securitized and on its loan repurchase liability. The complaint also faulted KPMG for its approval of faulty loan loss reserves, alleging that an audit partner silenced the concerns of a more junior audit team member who questioned the reserve calculation.

The complaint also alleges that KPMG "aided and abetted New Century’s directors’ and officers’ breaches of their fiduciary duties." The complaint alleges that KPMG knew that management was improperly reserving for risks the company faced and that management had failed to implement an effective system of internal controls.

The aiding and abetting allegations includes the charge that KPMG aided and abetted company officials "in maintaining material weaknesses and significant deficiencies in New Century’s system of internal controls over financial reporting." The complaint alleges that KPMG is "jointly responsible with the directors and officers for damages resulting from these breaches."

The complaint seeks compensatory damages of $1 billion, as well as punitive damages.

The complaint filed in the Southern District of New York (copy here) substantially repeats many of the same allegations as the California complaint, but addresses the alleged liability of KPMG’s international parent. The complaint alleges that the parent represented that it would "ensure that member firms’ work would meet professional standards and regulatory requirements."

The complaint alleges that KPMG International did not fulfill these responsibilities, and as a result New Century was harmed. The complaint seeks unspecified compensatory as well as punitive damages from KPMG International.

The trustee’s filings in these complaints certainly suggest the possibility that auditors and other "gatekeepers" could be targeted in the wake of the subprime meltdown. Leading accounting indusrty commentator Francine McKenna (also the author of the indispensible "re:The Auditors" blog) is quoted in the April 1, 2009 Wall Street Journal as saying that the case "may embolden others to look more closely at the possibiltiy of bringing [accounting] firms to some level of culpability for the things that happened" that led to the credit crisis.

But in assessing that possibility it may be important to note the particular key circumstances that preceded the trustee’s claims against KPMG.Specifically, the new lawsuits follow more than a year after the February 29, 2008 581-page report of Michael Missal, the KPMG bankruptcy examiner, in which the examiner concluded that KPMG had "contributed" to certain of New Century’s "accounting and reporting deficiencies by enabling them to persist in, and in some instances, precipitating the Company’s departure from, applicable accounting standards." A detailed review of the examiner’s report, including a link to the report itself, can be found here.

The examiner’s exhaustive review, which among other things specifically suggested the possibility of negligence claims against KPMG, was effectively a road map for the April 1 lawsuits. While the lawsuits might well have been filed even without the examiner’s report, few other prospective claimants considering "gatekeeper" litigation will have such a detailed script from which to compose their complaint.

On the other hand, many of the complaints already filed in numerous lawsuits as part of the current subprime and credit crisis-related litigation wave have already targeted a variety of gatekeepers, including offering underwriters, credit rating agencies, and, in some cases, even the outside auditors.

Indeed, the securities lawsuit filed against New Century’s former directors and officers also specifically named KPMG as a defendant. In his December 3, 2008 order denying the defendants’ motion to dismiss the securities lawsuit, Central District of California Judge Dean Pregerson specifically denied KPMG’s separate motion to dismiss, finding that the complaint in that case adequately alleged that KPMG was aware of accounting and internal control deficiencies but nevertheless issued its audit opinion in connection with the company’s 2005 financial statements. A detailed discussion of Judge Pregerson’s decision, including a link to the opinion, can be found here.

The outcome of KPMG’s dismissal motion in the New Century securities lawsuit, as well as the trustee’s filing of the April 1 lawsuit, among other things suggests that the U.S. Supreme Court’s decision in the Stoneridge case may not deter prospective litigants from pursuing claims against auditors and other gatekeepers.

One of the more interesting aspects of the trustee’s complaint against KPMG is his claim seeking to hold the accounting firm "jointly responsible" with New Century’s former directors and officers for the officials’ breaches of their fiduciary duties. While the trustee’s claims at this point represent nothing more than allegations and it remains to be seen whether his claims on this theory will result in any recovery, the possibility that auditors may be alleged to be "jointly liable" for directors’ and officers’ fiduciary breaches raises a host of concerns and questions, not the least of which relate to co-defendant (or third-party defendant) proceedings, such as cross-claims for contribution.

All of which leads to a point I have been asserting for some time, which is that we are still only in the earliest stages of the credit crisis related litigation wave. Not only are the cases against the defendant companies continuing to pour in, but the likelihood of further gatekeeper litigation like that filed against KPMG suggests that the litigation will continue for many, many years to come.

The "re: The Auditors" blog has an interesting and detailed analysis of the KPMG complaints, here.

Hat tip to the Wall Street Journal (here) for copies of the KPMG complaints.

Honoring Those Who Serve: A recent MSNBC segment reported on what my good friends, David Bell of AWAC and John McCarrick of the Edwards and Angell law firm, have been doing to honor those who have made the ultimate sacrifice in service to our country. As reflected in the video below, a group they helped to organize, Grateful Nation Montana, is taking steps to ensure that the children of U.S. soldiers killed in the battle will be able to pursue a college education.

Please watch this video. It is guaranteed to bring tears to your eyes, but it will also make you appreciate the efforts of a couple of industry leaders, who have done something substantial and worthy to help make a difference.

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In an April 1, 2009 administrative complaint (here), Massachusetts Secretary of the Commonwealth William Francis Galvin accused Madoff feeder fund Fairfield Greenwich Advisors and its Bermuda affiliate of "complete disregard of its fiduciary duties to its investors" and of "flagrant recurring misrepresentations" that "rise to the level of fraud."

If you have not yet seen the complaint, you should take a look, because it contains some rather striking allegations, the most provocative of which are based on the transcript of a telephone conversation in which Bernard Madoff coaches senior Fairfield officials on how to respond to inquiries from the SEC.

At one time Fairfield has a much as $14 billion of assets under management, of which nearly $7 billion was invested with Madoff through its flagship funds. The firm earned hundreds of millions of dollars in fees from investors in connection with the Madoff related investments. (Detailed background regarding the Fairfield group can be found here.) UPDATE: Fairfield's principals were on track for payouts totalling over $117 million in 2008, before the scandal surfaced, as reflected in documents filed with complaint, according to the Dealbook blog (here).

The complaint alleges that Fairfield’s managers were "blinded by the fees they were earning" and "did not engage in meaningful due diligence" but instead "turned a blind eye to any fact that would have burst their lucrative bubble."

The complaint alleges that in contrast to the due diligence efforts Fairfield claimed in its marketing materials, the firm "neglected to do any meaningful check into whether Madoff was actually making trades he said he was making." The complaint further alleges that "the concept of due diligence was merely part of Fairfield’s marketing pitch, not an activity it meaningfully engaged in with respect to Madoff."

The centerpiece of the complaint is a transcript of a December 2005 telephone conversation between Madoff and several senior Fairfield officials. Fairfield apparently recorded the conversation then apparently unbeknownst to Madoff and produced the recording in connection with the Massachusetts investigation. The transcript of the call can be found here.

The SEC was about to interview the Fairfield officials in connection with the SEC’s investigation of allegations against Madoff by Harry Markopolos. The transcript shows that Madoff opened the call by stating "obviously, first of all, this conversation never took place, okay?"

Madoff then gave the Fairfield officials precise instructions on what to say in response to the SEC’s questions, noting at one point that "the secrecy as to information is the key issue for everybody," even going so far as to say to the Fairfield officials that "the less you know about how we execute… the better you are."

The complaint alleges with respect to this phone conversation that Madoff was "manipulating the flow of information to the SEC" and that as a result of its cooperation, Fairfield helped Madoff "evade SEC detection."

The complaint also alleges that Fairfield’s reliance on the outside audit firm’s audit of Madoff’s investment company was "absurd," and that Fairfield made "patently false representations" about the audit and the auditor even though Fairfield "did not know one thing about this one-person auditing firm."

The complaint also alleges that as 2008 progressed, client redemptions and larger problems in the financial marketplace began to trouble the Fairfield officials. They began to debate internally about "gaps" in their knowledge about Madoff. Their internal communications reflect liquidity concerns as well as concerns about Madoff’s counterparty exposures.

The complaint alleges that the officials did not follow up on these concerns. Instead, in response to Madoff’s anger about increasing fund redemption in the late fall 2008, they tried to support him by marketing against redemptions as well as by placing their own cash in new Madoff funds formed at the eleventh hour.

The complaint seeks a cease and desist order and restitution to all investors who invested in Madoff through Fairfield, as well as disgorgement of related fees and an administrative fine.

In response to the complaint, Fairfield issued an April 1, 2009 statement (here) in which it characterized the complaint as "false and misleading" and asserted that it "conducted vigorous and robust monitoring [of Madoff] on an ongoing basis." The complaint, according to the statement, is based on "nothing more than 20-20 hindsight that supposes that anyone familiar with Madoff’s operation should have determined that it was a Ponzi scheme." But, the statement notes, not one person detected the fraud.

Among the Fairfield officials mentioned by name in the complaint is Andres Piedrahita (a Fairfield partner and son-in-law of Fairfield founding partner Walter Noel), whom the complaint alleges in 2007 alone earned in excess of $45 million. The March 31, 2009 Wall Street Journal ran a fascinating front-page article about Piedrahita entitled "The Charming Mr. Piedrahita Finds Himself Caught in the Madoff Storm" (here), reporting among other things that Piedrahita had once told a friend that his "real job" was "to live better than any of my clients."

Piedrahita, trading on his "outstanding public relations skills," played a key role in "expanding the reach of the Madoff fraud by wooing wealthy Latin Americans and Europeans." Piedrahita is now under investigation with both Spanish and U.S. authorities, and is a defendant in numerous class action lawsuits, along with Fairfield and other Fairfield officials.

Meanwhile, the April 2009 issue of Vanity Fair has a lengthy article (here) about Fairfield founder Walter Noel and his family. The article features a particularly striking photgraph of Noel's five daughters, one of whom is the wife of Piedrahita. An October 2002 Vanity Fair article focused just on the five daughters can be found here. After awhile, trolling through the backstory on these sidelights to the Madoff scandal begins to create the same sensation as reading an overwritten novel.

A comprehensive list of the Madoff-related lawsuits, including the numerous lawsuit filed against Fairfield and related entities and individuals, can be accessed here. I have added the new Massachusetts complaint to the list.

Hat tip to the Wall Street Journal for the Fairfield Statement.

Other Stories We’re Following: According to news reports (here), a man in Newark, Ohio has been charged with drunk driving on a bar stool. The man apparently had built a motorized bar stool using a dismantled lawn mower. He managed to crash the stool, apparently as a result of the 15 beers he reportedly consumed prior to the accident. Readers interested in seeing this amazing (albeit unexpectedly dangerous) vehicle will want to refer here.

Meanwhile, on March 27, 2009, the Macomb (Ga.) Daily reported (here) that "a woman who sued a city of Warren police dog that she says bit her on the buttocks was ordered by a judge to pay $500 for frivolously naming the dog as a defendant." Frivolous? Has the judge ever been bitten on the butt by a police dog? Incidentally, the dog’s name is "Liberty" which is clearly what the dog took with the plaintiff’s behind

And in world news, Barrack Obama has apparently given Queen Elizabeth II an iPod as a gift in connection with his visit to Buckingham Palace today, as reported here. Alas, it is too late now, but had I been consulted in advance, I would have suggested loading the device with the music of this year’s inductees into the Rock and Roll Hall of Fame, in particular the songs of Run-D.M.C.

The Rock Hall induction, by the way, is this Saturday, April 4, 2009, in Cleveland, Ohio. (Cleveland Rocks, baby.)

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Largely driven by litigation in the financial sector arising from the ongoing credit crisis, the heightened pace of securities filings continued during the first quarter of 2009.

There were a total of 57 separate, new securities class action lawsuits filed during the first quarter. The 57 new securities lawsuits represents an annualized pace of 228 filings, which would be basically unchanged from the 226 lawsuits filed in 2008. (My analysis of the 2008 filings can be found here.)

However, the 57 first quarter filings do represent a decline from the 67 new lawsuits that were filed in the fourth quarter of 2008, when the Madoff-related filings that came in at year end and increased the quarterly numbers.

The filings during the first quarter 2009 were driven by the filing of new subprime and credit crisis-related securities lawsuits. Of the 57 first quarter suits, 35 (61% of the total) were subprime and credit crisis-related. A spreadsheet of the 2009 subprime and credit-crisis related securities lawsuit filings can be found here. A table of all of the subprime and credit crisis securities cases filed during the period 2007 to 2009 can be found here.

The first quarter lawsuit filings targeted entities in 26 different Standard Industrial Classification (SIC) code categories. But consistent with the predominance of the subprime and credit crisis cases, most of cases were filed with SIC codes in the financial sector. A total of 30 of the 57 cases (52%) involved companies in the 6000 SIC Code (Finance, Insurance and Real Estate) series. Indeed, 21 of the 57 cases (37%) were filed against companies in just three SIC Codes: SIC Code 6021 (National Commercial Banks), 9 filings; SIC Code 6029 (Commercial Banks not elsewhere classified), 6 filings; and SIC Code 6189 (Asset Backed Securities), 6 filings.

Not only were the first quarter cases largely concentrated in the financial sector, but many of the cases involved very specific kinds of financial transactions. At least 12 of the 57 cases were based upon the offerings of subordinated, preferred or other specialized classes of the issuer-defendants’ securities. (Some entities, for example, Deutsche Bank, were hit with multiple distinct suits relating to different securities offerings, as discussed further below.)

In addition at least five of the new filings involved actions against the issuers of mortgage pass-through certificates.

The various Ponzi scheme frauds were also a material factor in the first quarter filings. For example, the Madoff and Stanford Financial frauds accounted for a least six distinct cases among the first quarter filings. (There obviously were multiple additional duplicate filings involving these frauds, a source of one of the many counting problems associated with the first quarter filings.)

A significant number of the first quarter filings did not involve publicly traded companies. For example, the first quarter securities lawsuit filings targeted mutual funds, private investment firms or investment partnerships, and other private entities. At least eight of the 57 first quarter filings involved entities that lacked an SIC code designation.

Thirteen of the 57 new filings (or about 23%) involved foreign-domiciled companies, representing six different countries. However, many of these cases involved separate suits filed against the same companies. For example, while there were five separate lawsuits filed against U.K.-based companies, only two different companies, RBS and Barclays, were actually involved in those five separate cases.

The 57 cases were filed in 25 different courts, but 29 of them (about 51%) were filed in the Southern District of New York. Only one other court, the Northern District of California (5 filings) had more than two.

Even though the 57 first quarter filings represent a heightened level of litigation activity, the impact of those cases on D&O insurers will be more muted than might otherwise be expected, due to the nature and distribution of the filings.

First, the litigation activity was predominantly concentrated in the financial sector, which means that carriers that have not been active in this sector have largely avoided significant claims activity so far in 2009. The carriers that were active in the sector are not as fortunate, but that represents only a subset of the overall D&O insurance marketplace.

Second, the incidence of multiple distinct lawsuits against the same company, which was a significant part of the first quarter lawsuit activity, means that the maximum potential aggregate insurance exposure from the new lawsuits is likely substantially less than if 57 separate lawsuits had been filed against 57 complete separate companies.

Third, a certain percentage of the cases, particularly the Ponzi scheme cases, are likelier to produce E&O losses rather than D&O losses, so the impact on the D&O insurers from these cases could be more limited than might otherwise be the case for the more typical securities class action lawsuits.

All of that said, the pace of litigation activity certainly shows no signs of abating. There are still reasons to believe that the current litigation wave will spread more generally beyond the financial sector. The likelihood of litigation from corporate insolvencies also threatens continued heightened litigation activity as the year progresses.

Counting: A final word about counting the filings. I suspect that other observers have or will likely reach differing counts than I have for the first quarter filings. Part of the difference is a result of the perennial counting problems – for example, whether or not to count merger objection lawsuits or lawsuits where the main allegation is that the defendant failed to register securities (neither of which categories I count).

But beyond these recurring issues, the kinds of cases that were filed in the first quarter made counting particularly uncertain. The cases themselves made it very challenging to determine whether or not a new complaint represent a duplicate lawsuit or a new lawsuit.

For example, how many different lawsuits can there be regarding Deutsche Bank preferred securities? Is a lawsuit involving a different class of preferred securities a duplicate or distinct?

The multiple Madoff-related lawsuits post a particularly difficult categorization challenge, as the protean mix of defendant feeder funds targeted in the lawsuits present a dizzying array of combinations.

Just to cite one specific counting challenge, I refer to the complaints that have been filed in connection with Wells Fargo’s Mortgage Pass-Through Certificate offerings. One lawsuit represent certificate investors was filed in January 2009 (refer here). A second complaint was filed in March 2009 also brought on behalf of Mortgage Pass-Through Certificate investors (refer here). The March complaint related largely (but not exclusively, as far as I can tell) to different specific offerings of Mortgage Pass-Through Certificates. Reasonable minds (particularly reasonable minds with an abundance of time to undertake an intense textual comparison between the two complaints) might reach a different conclusion, but upon consideration of the different offerings involved, I counted these as two distinct filings rather than as duplicate filings.

These are not easy issues and different people could and probably will reach far different conclusions. I have at least tried to be internally consistent with my own counting. In any event, don’t be surprised if other securities lawsuit counts published elsewhere vary from my own. Even if the precise numbers differ at the margins but the general findings should be generally consistent.

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A federal judge has ruled that securities class action plaintiffs who availed themselves of UBS’s auction rate securities regulatory settlement cannot separately maintain claims for damages against UBS. But while this ruling would seem to represent at least the beginning of the end for many similarly placed plaintiffs, we may still be a long way from the end of the auction rate securities litigation, despite the regulatory settlements.

Background

UBS was one of the 21 different companies named as defendants in the wave of auction rate securities lawsuits filed during 2008. The names of all of the auction rate securities lawsuit targets can be accessed here. Background regarding the case against UBS can be found here.

Essentially the plaintiffs alleged that UBS had failed to disclosure the liquidity risks associated with the auction rate securities, and also failed to disclose that UBS and other broker dealers regularly intervened in the market for the securities to maintain trading --and allegedly to manipulate the market as well. When the broker-dealers simultaneously stopped supporting the market on February 13, 2008, the market for the securities collapsed and investors were left with securities for which there was no active market.

On August 8, 2008, UBS announced a nearly $20 billion settlement with regulators regarding the auction rate securities (about which refer here). In the settlement, UBS agreed to buy the securities back from retail investors at par value, or to make up the difference to retail investors who had already sold for less than par.

The plaintiffs in the UBS auction rate securities settlement took advantage of the regulatory settlement and redeemed their securities as par. The defendants moved to dismiss the lawsuit on that basis.

Judge McKenna’s Ruling

In a March 30, 2009 opinion (here), Southern District of New York Judge Lawrence McKenna granted the defendants’ dismissal motion, with leave to amend. Judge McKenna found that

Given that Plaintiffs have availed themselves of the relief provided in the Regulatory Agreement, Plaintiffs cannot now allege out-of-pocket damages. When Plaintiffs elected to have UBS buyback their ARS at par value, they received a full refund of the purchase price. Therefore, Plaintiffs have already been returned to the position they were in before they purchased the ARS and before any fraud ensued….Plaintiffs’ out-of-pocket damages are necessarily zero because after choosing to rescind the ARS purchases, Plaintiffs have effectively paid nothing for their ARS.

Plaintiffs argued that they were entitled damages despite the regulatory settlement because "UBS’s fraudulent acts prevented Plaintiffs from receiving a sufficiently high rate of interest or dividends to compensate them for the risk of illiquidity associated with their ARS investments." Essentially, they were arguing that if they had been appropriately informed about the securities’ liquidity risk, they would demanded and would have been paid higher interest rates or otherwise have enjoyed a higher investment return.

Judge McKenna rejected this argument because plaintiffs in securities actions must choose among prospective remedies, between rescission and out-of-pocket damages. Having elected rescission, the plaintiffs "may not now seek additional interest or dividends as benefits of ARS purchases they have already elected to disavow."

Finally, Judge McKenna found that the class plaintiffs lack constitutional standing to asset claims on behalf of "class members who purchased UBS-underwritten ARS from brokerage firms other than UBS and investors who transferred to another brokerage firm ARS they purchased from UBS before October 2007."

Discussion

Judge McKenna’s ruling might seem to suggest that the regulatory settlements represent the end of the auction rate securities lawsuits. However, conclusions along those lines could well prove to be premature.

First, Judge McKenna granted the motion with leave to amend. Although there is ample reason to doubt that these plaintiffs can circumvent Judge McKenna’s concerns in an amended pleading, the case itself is not over yet.

Second, other courts may decline to follow Judge McKenna’s conclusions. Indeed, in a March 31, 2009 AmericanLawyer.com article (here) Alison Frankel quotes the plaintiffs’ attorney from the UBS case as saying "we’re not convinced other courts will rule the same way."

Third, there are still the claims of those erstwhile class members who were frozen out of the UBS regulatory settlement, such as those who bought the auction rate securities from a non-UBS broker or who transferred their account away from UBS. As the plaintiffs’ lawyer from the UBS case also is quoted as saying in the American Lawyer article, "the key to the auction rate securities litigation is plaintiffs whose securities were not bought back by the banks."

This category of investors who were shut out of the regulatory settlements also includes the investors who bought their securities from banks or broker dealers who have not yet entered regulatory settlements.

Fourth, in all the regulatory settlements, institutional investors’ interests were treated differently. For example, in the UBS settlement, institutional investors cannot hope to have their investment redeemed until at least 2010. These investors’ liquidity issues continue to give rise to new litigation; for example, I described in recent post (here) the lawsuit that KV Pharmaceuticals filed in late February against Citigroup, in which the company alleged that the illiquidity of its auction rate securities investments was, among other things, forcing the company to lay off workers.

And finally, there is the separate category of litigation that has arisen against auction rate securities investors, rather than against the auction rate securities sellers. These cases involved companies whose balance sheet exposure to auction rate securities has harmed their financial condition, and who face litigation from their own shareholders who claim the companies failed to disclose their exposure. The most recent of these cases, involving Perrigo Company, is discussed here.

In short, while Judge McKenna’s opinion unquestionably represents a significant milestone, it by no means represents the finish line for auction rate securities litigation. Unfortunately, these cases likely will be around for some time to come.

All of that said, Judge McKenna’s opinion does hold out the hope that a large portion of these cases can eventually be cleared out, and the problem at least reduced over time, perhaps to more manageable levels.

I have in any event added the UBS dismissal to my roster of settlements, dismissals and dismissal motion denials in connection with the subprime and credit crisis related lawsuits. The roster can be accessed here.

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