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

On July 27, 2009, NERA Economic Consulting became the latest to publish a mid-year analysis of the year to date securities litigation developments. The NERA report, written by Stephanie Plancich and Svetlana Starykh, is entitled "Recent Trends in Securities Class Actions Litigation: 2009 Mid-Year Update," and can be found here. The NERA Report joins the earlier mid-year report of Cornerstone Research (refer here). My own mid-year review can be found here.

The NERA report seemingly reports a higher number of securities class action filings than the earlier reports, although the seeming difference requires some explanation; on closer review, the apparent difference arguably becomes more apparent than real. In addition to an analysis of the first half lawsuit filings, the NERA report also includes a review of the first half securities lawsuit settlements as well.

For the first six months of 2009, NERA reports that there were 127 new securities class action filings. This tally is quite a bit higher than the 87 first half filings that Cornerstone reported in its recent study of first half filings. However the difference may be attributable to a difference in counting methodology. As explained in footnote 2 of the NERA report, "unless cases are consolidated, we report all filings potentially related to the same alleged fraud, if the complaints are filed in different Circuits or if different securities are alleged to be affected by the fraud." Since many of the complaints filed in the first half involve duplicated allegations with multiple complaints filed in different circuits, NERA’s reported number of filings is quite a bit higher than other published reports. NERA notes that "if cases are ultimately consolidated, the data are adjusted." Hence, my statement that the seeming difference in the number of filings may be more apparent than real.

The NERA report notes that the first half filings are on an annualized pace of more than 250 filings, which would be more than in 2008. Consistent with earlier reports, the NERA report does note that the number of filings declined in the second quarter. The NERA report also notes that the first half filings were largely driven by the credit crisis cases and new lawsuits relating to the Ponzi schemes. Over 40% of first half filings were credit crisis related and over 20% were related to the Ponzi scheme allegations. About 67% of first half filings named at least one financial company as a primary co-defendant.

In addition, the NERA report notes that accounting firms have been named as co-defendants in 17.3% of filings, which represents a significant increase from prior years. Cases against foreign domiciled defendants have also increased, with 19 cases or 15% of all cases naming a foreign company as a primary defendant, the highest percentage since the passage of the PSLRA.

In terms of drivers affecting the pace of securities class action lawsuit filings, the report confirms that the filing rate is correlated to overall market volatility, but the relationship is "not tight" and in fact volatility accounts for only about 28% of the variability in quarterly filing levels.

In looking at case resolutions, the report attempts to determine how long on average it takes for these cases to be resolved. Looking back at the cases filed in 2000, the report finds that on average, the time to resolution is 2.9 year, with an average time for dismissals of 1.7 years and settlements it was 3.5 years. Most of the more recent cases, particularly those related to the subprime meltdown and the credit crisis still remain only in their earliest stages, and so it is too early to tell how these cases ultimately will be resolved.

In analyzing case outcomes overtime, the report finds that a higher fraction of cases have been dismissed since the U.S. Supreme Court’s 2005 ruling in Dura Pharmaceuticals, consistent with the hypothesis that defendants are more likely to prevail in a motion to dismiss as a result of that decision.

With respect to settlements so far this year, the NERA report finds that the median securities class action settlement is $8 million, which is about the same as in 2008. Median values have remained very consistent for the past five years.

The average securities class action settlement during the first half of the year has been $43 million, about even with last year’s average and slightly below the average of $49.6 million for the period 2003 to 2009. The high average relative to the median is driven by large outlier settlements. If the settlements above $1 billion are removed, the average for the period 2003 to 2009 drops to $27.6 million, although the year to date average for 2009 settlements remains at $43 million. A substantial number of settlements this year have been over $100 though less than $1 billion.

Median investor losses for cases filed in 2009 ($600 million) are much higher than for cases settled in 2009 ($289 million). Since settlement amounts traditionally have been "strongly correlated" to investor losses, this would seem to suggest that the 2009 cases would be much higher than more recently settled cases. However, given that the companies affected by the credit crisis "may no longer have …substantial resources to make …large settlement payouts" the traditional relationship of settlement amount to investor losses may or may not hold.

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With the closure of a group of six interrelated Georgia banks this past Friday night, the state has now reclaimed the dubious distinction of as having the most failed banks of any state this year. With the addition of the most recent closures, there have now been 16 failed banks in Georgia this year, compared to 12 in Illinois, which had previously and for a brief period (refer here) led Georgia in the number of failed banks.

There were a total of seven bank closures on July 24, 2009, which brings the year to date total number of closures to 64. The pace of bank failures has definitely picked up in the last several weeks. There have been 27 bank closures just in the five-week period since June 19, which is more that the number of banks (25) that failed in all of 2008.

The six Georgia banks that filed Friday were all subsidiaries of Security Bank Corp., which had been Georgia’s fourth-largest lender. The six units were technically six separate banks, although according to the Atlanta Business Chronicle (here), "the banks essentially operated as the same institution."

The Atlanta Journal-Constitution described the rise and fall of the holding company (here) as "a stark symbol of the state’s banks woes." The bank made a "fatal push" into the Atlanta residential market in 2005 and 2006. The bank "tripled in size" between 2005 and 2009. The bank lost $243 million last year, and at the end of the first quarter of 2009 reported $277 in "severely delinquent loans that bank had given up hope of collecting on."

There have now been 22 different states that have had at least one bank failure this year. Beyond Georgia and Illinois, the other states with high numbers of bank failures include California (8) and Florida (3). Generally, the banks that have failed so far this year have been smaller banks; of the 64 banks that have failed so far this year, 55 have had assets under $1 billion. The FDIC’s complete list of all banks that have failed since October 2000 can be found here.

Relatively few of the bank failures involve publicly traded institutions. In its recent mid-year report on securities litigation (here), Cornerstone Research noted that of the 45 banks that had failed through June 30, 2009, only 21 involved publicly traded companies, and only one failed banks had been involved in securities class action lawsuits this year.

My earlier post analyzing the number of failed banks in Georgia can be found here.

Break in the Action: The D&O Diary will be on an intermittent publication schedule for the next few days. The "normal" publication schedule will resume the week of August 10.

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In a July 15, 2009 motion (here), the plaintiff in the subprime-related securities class action lawsuit involving RAIT Financial Trust moved for preliminary approval of a proposed settlement of the case. According to the company’s May 27, 2009 filing on Form 8-K (here), the parties entered a preliminary agreement on May 26 2009 to settle the case for a cash payment of $32 million, to be funded entirely by the company’s D&O insurers.

As reflected in greater detail here, the company was first sued in August 2007 in a securities class action lawsuit alleging that in the offering materials accompanying the company’s January 2007 IPO as well as subsequent statements, the defendants made misrepresentations and omissions about the company’s credit underwriting, exposure to investments in debt securities, loan loss reserves and other financial items.

In a December 22, 2008 ruling, Eastern District of Pennsylvania Judge Legrome Davis substantially denied the defendants’ motions to dismiss. Among other things, Judge Davis’s ruling was noteworthy for its acceptance of the "core business operations" theory in concluding that the plaintiffs had adequately pled scienter, as discussed at greater length here.

The RAIT settlement joins the recent Accredited Home Lenders settlement (refer here) as subprime-related securities lawsuits in which the cases settled after the motions to dismiss were denied. The $22 million settlement in the Accredited case together with the $32 million settlement in this case suggest that companies (or at least their D&O insurers) may face significant financial consequences for losing the dismissal motion in these cases. These settlements and the recent $30.5 million settlement in the Beazer Homes case also start to create an impression that overall, the subprime and credit crisis cases might prove to be very expensive to resolve.

I have in any event added the RAIT settlement to my register of the subprime and credit crisis-related lawsuit resolutions, which can be accessed here.

Very special thanks to a loyal reader for calling my attention to the RAIT settlement.

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As I have shown (here) and has been detailed by others (here), the number of securities class action lawsuits declined during the first half of 2009 compared both to last year and to historical norms. There is a lot that might be said about the decline and its causes. However, the mainstream media (refer, for example, here) has latched onto the message that the number of securities suits is declining because the plaintiffs are "running out of people to sue."

Let’s be honest -- fish gotta swim, birds gotta fly, and plaintiffs’ lawyers make their living filing lawsuits. The fish and the birds can be counted upon to continue their traditional activities, and so can the plaintiffs’ lawyers. The very idea that the plaintiffs have run out of targets is a flawed conclusion built on a faulty premise.

Before I get started on this topic, I think it would be useful to review why this question matters. Once before, the idea circulated that the securities class action plaintiffs’ lawyers were going out of business. This hypothesis turned out to be very wrong and it proved to be a very expensive mistake.

After the PSLRA was enacted at the end of 1995, some D&O insurers assumed the statute’s passage would mean that many fewer securities lawsuits would be filed, and so they slashed their insurance pricing. The marketplace followed. When securities litigation ramped back up, the D&O insurance industry suffered hundreds of millions of dollars in losses. The industry paid a lot of tuition to learn that what plaintiffs’ lawyers do is file lawsuits. Given how expensive the lesson was, it would seem unwise to start assuming now that anything has changed.

But with respect to the recent decline in securities lawsuits, let’s at least get the facts straight. The number of lawsuits did not decline during the entire first six months of the year. During the period January through April, the number of new securities lawsuit filings was more or less at normal levels. The drop took place in May and June. Now, looking at the ebb and flow of securities lawsuit filings during the last 14 years, there arguably is nothing noteworthy about a two-month decline. It could just be a blip. It may or may not continue; only time will tell. It does seem important (to me at least) that so far in July, there have already been at least twelve new securities lawsuits, more than were filed in either May or June.

The other thing about the first half of 2009 is that it was not as if the plaintiffs’ lawyers were idle -- they were just otherwise occupied. Among other things, they were busy filing lawsuits related to Madoff, the Stanford Financial Group and other Ponzi schemes. Indeed, my list of Madoff-related lawsuits (which can be accessed here) now runs to some 23 pages, with more than 40 new cases filed during May and June.

This other extensive litigation activity is highly relevant, because of the similarity to what happened back in the period mid-2005 to mid-2007. That was the period when there was a sustained "lull" in new securities class action lawsuit filings. During that period as well, the plaintiffs’ lawyers were also otherwise engaged. Then, they were busy filing options backdating-related shareholders’ derivative lawsuits, eventually filing 168 of them (as shown here).

That prior "lull" in new securities lawsuit filings motivated some observers to speculate that the move to lower securities litigation levels might represent a "permanent" change. Subsequent history has shown that in fact there was no permanent change, and indeed the securities lawsuit activity returned with a vengeance.

Of course, it is possible that plaintiffs’ lawyers have indeed run out of targets and that lower level of new securities class action filings will persist going forward. Only time will tell. Just based on what history has shown, though, both after the passage of the PSLRA and after the so-called "lull," I think it would be unwise to bet that hereafter the plaintiffs lawyers will file fewer securities lawsuits.

My own theory about why the number of lawsuits has dipped is that the plaintiffs’ lawyers have been busy, not just with the Madoff lawsuits, but also dealing with the extraordinary number of lawsuits they previously filed in connection with the subprime meltdown and credit crisis. Many of these lawsuits are uncommonly complicated and they have in many cases entered procedurally demanding stages.

The main reason I believe that the plaintiffs’ lawyers have just been jammed up is that I think there is evidence that they are dealing with a backlog of cases, a point that I have made before (here). Recent filings even further reinforce the conclusion that the plaintiffs’ lawyers are now starting to work off a backlog.

Many of the recent filings have proposed class periods that are well in the past, sometimes years in the past. For example, the securities lawsuit filed on July 14, 2009 against Ambassador Group (refer here) has a proposed class period cutoff date of October 23, 2007. The securities lawsuit filed on July 17, 2009 against Bare Escentuals (refer here) has proposed class period cutoff date of November 26, 2007. The securities lawsuit filed on July 22, 2009 against Accuray (refer here) proposes a class period cutoff of August 19, 2008. Other recent filings though not quite as superannuated involve class period cutoff dates that well over six months past (refer, for example, here).

If you notice from the cases I have listed above and in my prior post, these cases not only involve a time gap, but they also are all outside the financial sector. It seems as if the plaintiffs lawyers have been so preoccupied with the race to the courthouse in lawsuits against the financial sector, they are just now getting around to filing the cases against the other kinds of companies.

The way I look at it, the plaintiffs’ lawyers have not had a shortage of targets, they have just had a shortage of time. But evidence suggests that they are getting caught up and they are now getting around to working off the backlog that has been accumulating. The one thing I know for certain is that they will continue to file lawsuits. Consider how reliable the birds and fishes are, and I think you will see what I mean.

One line of analysis that does give me pause is the suggestion that the lawsuit filings declined because of diminished stock market volatility. According to this theory, there is a correlation between overall market volatility and the level of securities lawsuit activity. This theory may have something to it; it is certainly the case that an individual lawsuit is directly related to the target company’s experience of volatility in its own share price. If this market volatility theory is true and if the lower volatility persists, then we could be in for a period of lower numbers of security lawsuits. We had a lull before, we could certainly have one again.

Because of the possibility that persistent lower market volatility might mean reduced lawsuit filings for awhile, I am not making any absolute predictions. I am just saying that I wouldn’t make any bets based on the assumption that the plaintiffs lawyers have run out of people to sue.

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By the SEC’s own account, an enforcement action the SEC initiated on July 22, 2009 represents the first occasion on which it has used the Sarbanes-Oxley Act’s "clawback" provision to recover compensation from an individual not otherwise alleged to have violated the securities laws. While this type of action apparently was contemplated by the statute, it has never been pursued before and it raises some interesting questions.

As reflected in the SEC’s July 22, 2009 press release (here), the SEC enforcement action charges Maynard L. Jenkins, the former CEO of CSK Auto, with violation of Section 304 of the Sarbanes Oxley Act, the statute’s compensation clawback provision. The action seeks to compel Jenkins to reimburse CSK Auto for the more than $4 million he received in bonuses and stock sale profits "while CSK was committing accounting fraud." A copy of the SEC's complaint can be found here. (Hat tip to the Courthouse News Service for the complaint.)

In May 2009, the SEC brought a settled enforcement action against CSK for filing false financial statements for fiscal years 2002 though 2004. The SEC has also brought a separate civil enforcement action against four CSK officials, but Jenkins is not among the officials that the SEC is pursuing.

Section 304 does provide that if a company restates its financials, then the company’s CEO and CFO "shall reimburse" the company any bonus compensation received during the 12 months following the restated period, as well as any stock sale profits earned during those twelve months.

There is no requirement in Section 304 that the CEO or the CFO from whom the reimbursement is sought have any involvement in the events that necessitated the restatement. Indeed, the statute doesn’t require any showing of wrongdoing or fault at all.

Professor Larry Ribstein criticizes the SEC’s use of the statute this way in a post on his Ideoblog (here), for "punishing business executives even when they are not accused of making a mistake." Jenkins undoubtedly will attempt to challenge the SEC’s attempt to use the statue this way. This provision has never been challenged on this basis before, so it will be interesting to see whether it withstands the legal challenge.

The SEC’s use of the statute in this way will undoubtedly add yet another item to the long list of criticisms of Section 304. As noted here, the statute previously has been criticized, among other reasons, because it lacks a private right of action; because it can only be used against the CEO and CFO, but not other corporate officials; and because it is only available in the event of a restatement, but not for other accounting discrepancies. Now it will be criticized as well because it can, if the SEC’s position withstands judicial scrutiny, effect a forfeiture without a requirement of fault, involvement or knowledge of the circumstances requiring the restatement.

To be sure, the logic of the statute is that since the financials were restated, the compensation was never earned in the first place. But litigation has its costs, and the burden an executive hit with a suit like this must endure goes beyond just the compensation he or she might be required to return. Among other things, defending against an SEC enforcement action can be extremely costly.

An executive facing an action like this might well seek to have his or her defense expenses paid by the company’s D&O insurer. But there could be problems with that as well. There would likely be no coverage under the typical D&O policy for any returned compensation, among other reasons because of the standard exclusion for claims for any "profit or advantage" to which the executive was "not legally entitled."

Many of these exclusions are written with a broad preamble (that is, precluding coverage for any loss "based upon, arising out of, or in any way relating to"), which some carriers might attempt to rely upon to preclude coverage not just for the returned compensation but for costs incurred in defending against the claim, even before a liability finding. While this interpretation of the policy would be highly suspect, the possibility of this interpretation highlights the need to try to revise the exclusion to require an actual judicial determination of the absence of "legal entitlement" to the profit or advantage before the exclusion’s preclusive effect is triggered. This revision may help to ensure that if an executive is hit with one of these suits that there is at least insurance coverage available for the executive to mount a defense.

An interesting July 22, 2009 Bloomberg article discussing the case can be found here. The article quotes a number of commentators with a variety of perspectives on the SEC’s action.

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As reflected in a recently released and detailed analysis of audit firms’ current litigation and prior lawsuit settlements, the audit firs’ litigation challenges are a serious and growing problem. The July 2009 presentation by Mark Cheffers, the CEO of Audit Analytics, is entitled "Accounting Professional Liability: Scorecards and Commentary" and can be found here. According to a July 22, 2009 Compliance Week article (here), Cheffers presented the slides at a recent litigation conference cosponsored by the American Bar Association and the American Law Institute.

The presentation materials reflect very detailed information about the major accounting firms’ litigation. Among other things, the presentation aggregates the top 50 accounting malpractice settlements since 1999. The data show that Ernst & Young has paid the largest amount in malpractice settlements during that period, totaling $1.92 billion. KPMG follows with settlements totaling $1.42 billion, followed by PricewaterhouseCoopers at $1.27 billion and Delotte & Touche at $1.25 billion.

As detailed in the presentation, the audit firms now face huge potential exposure from the growing numbers of lawsuits that have been filed against them in connection with the credit crisis and the Madoff scandal. Cheffers’ presentation lists the current litigation scorecard of cases that have been filed against the audit firms. According to the Compliance Week article, Cheffers said at the conference that these lawsuits filed so far are "likely just the beginning."

The presentation also shows the prevalence of going concern audit opinions, both in terms of percentage of all audit opinions and in absolute numerical terms. The presentation shows that in 2008 going concern opinions, both in percentage terms and in absolute numbers were at their highest level in the past decade

There may well be other places where this kind of information about audit firm liability exposure has previously been compiled, but this is the first time I have seen the information presented this comprehensively. The information presented in the slides is fascinating and one can only hope that Cheffers will continue to update the information and continue to make it publicly available.

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 The 2009 securities lawsuit filings have been characterized by an overall decline in filing activity, particularly in the second quarter, as well as the continued prevalence of lawsuits against financial sector issuer-defendants, according to a July 20, 2009 study by the Stanford Law School Securities Class Action Clearinghouse in cooperation with Cornerstone Research. The study, which is entitled "Securities Class Action Filings: 2009 Mid-Year Assessment" can be found here. A July 20 press release describing the study can be found here. My own prior study of the first half securities lawsuit filings can be found here.

According to the Cornerstone study, there were 87 securities class action lawsuits filed in the first half of 2009, which represents a 22.3 percent decline from the 112 securities suits that were filed in both the first half and the second half of 2008. The first half filings project to an annual filing rate of 174 securities class action, which would represent a 22.3 percent decrease from 2008 and an 11.7 percent decrease from the annual average for the 12 years ending in December 2008.

The drop in new filings was particularly pronounced in the second quarter of 2009, as only 35 of the 87 new filings occurred during the second quarter. The Cornerstone Report notes that over the same period, there was "a similarly dramatic decline" in the stock market volatility measured by the Chicago Board Options Exchange Volatility Index. The report also suggests that the "decline in market volatility raises the possibility of a return to the subdued levels of filing activity observed from the third quarter of 2005 to the second quarter of 2007."

Filings against companies in the financial sector predominated in the first half of 2009, as financial companies were named as defendants in 66.7 % of the first half filings. Slightly less than 50% of the first half filings were related to the credit crisis, as 42 of the 87 first half filings contained allegations related to the credit crisis.

The 2009 mid-year report contains a couple of new metrics. The first measures the number of unique issuers whose exchange-traded securities were involved in class action lawsuits. The metric shows that the number of lawsuits against unique exchange traded issuers has declined even more rapidly than the overall number of new lawsuits. The decrease is "driven by a large number of filings related to non-exchange trade securities and private companies" in the first half of 2009. These suits relate to Ponzi scheme allegations as well as other filings "related to mortgage-backed securities, preferred stock and open-ended mutual funds."

The other new metric in the mid-year report measures the number of filings against defendant corporations headquartered outside the United States. The metric shows that the number of suits against non-U.S. companies has been gradually increasing over the years, from only 6.8 percent of all filings during the period 1997 through 2003 to 13.8 percent in 2008. This upward trend continued in the first half of 2009, with 20.7 of all filings against non-U.S. companies, largely due to cases against foreign domiciled companies in the financial sector. Interestingly, this increase in litigation activity has coincided with a decrease in the share of foreign companies listed on the major U.S. exchanges.

In terms of the potential damages involved in the first half filings, the report’s detailed analysis shows that the 2009 filings are characterized by a decrease in losses associated with announcements at the ends of class periods and an increase in overall market capitalization losses for the entire class periods.

The report notes that since the end of 2008, there has been an "unprecedented" concentration of new Ponzi-scheme related filings. The Madoff scandal has resulted in five filings in the second half of 2008 and 15 in the first half of 2009, and there were four additional Ponzi scheme-related filings unrelated to Madoff in the first half of 2009.

The report concludes with an observation of the heightened number of bank failures during 2009, adding the observation that only 21 of the 45 banks that had failed through June 30, 2009 were publicly traded, and only one of the bank failures has resulted in a securities class action lawsuit.

The report’s new metric related to number of lawsuits against unique exchange-traded issuers is particularly useful for observers of public company litigation trends. Though the numerous lawsuits against private firms and mutual fund companies are interesting and important, those developments are less likely to affect the overall market for public company directors and officers liability insurance. In that respect, the Cornerstone report’s observation that the decline in lawsuits against unique publicly traded companies is even more pronounced than the overall decline in lawsuit filings is a particularly significant observation. The addition of this new metric is a particularly useful and welcome addition to Cornerstone’s reporting on litigation activity.

The report’s suggestion that the decline in lawsuits is linked to a decline in market volatility is also particularly interesting, as is the observation that lower volatility may mean a return to the low filing activity of the period mid-2005 through mid-2007. My own view, expressed in my prior post (here), is that the decline in lawsuit filing activity during the second quarter arose because plaintiffs’ lawyers found themselves in a logjam, due to the onslaught of Madoff-related litigation and the fact that many of the previously filed credit crisis cases had reached critical procedural stages.

The filings so far in July have in fact been characterized by the number of lawsuits outside the financial sector, many with class period ending dates considerably before the filing dates, which does suggest that plaintiffs’ lawyers are to a certain extent working off a backlog. Of course, the pace and nature of the second half filing activity overall remains to be seen.

ABA TIPS Panel: The Financial Collapse -- What Caused It and How Will It Continue To Impact Corporations and Their Boards?: The American Bar Association Tort Trial & Insurance Practice Section (TIPS) Task Force on Corporate Governance will hold this meeting at the ABA Building in Chicago on July 30, 2009 as part of the ABA Annual Meeting, to discuss the 2008 financial collapse and how corporations can manage risk throughout the remainder of the ongoing crisis.

I will be participating in this free session, which will be chaired by my good friend Kim Hogrefe from Chubb. The panel will also include Fiona Phillip of Howrey LLP and Dr. Faten Sabry of NERA Economic Consulting. The event will be followed by a reception. More information about the event, including event registration can be found here.

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In the latest subprime-related securities lawsuit to be settled, on July 15, 2009, the parties to the Accredited Home Lenders Holding Company securities fraud lawsuit filed a motion for preliminary approval of their proposed $22 million settlement of the case. A copy of the parties’ stipulation of settlement can be found here. Background regarding the case can be found here.

The Accredited Home Lenders case was one of the earliest subprime-related securities lawsuits to be filed – the first filed complaint in the case was filed in March 2007. And as reflected here, it was also one of the early subprime-related cases to survive a motion to dismiss.

In her January 4, 2008 order denying the motion to dismiss, Central District of California Judge Marilyn Huff found that the plaintiffs’ complaint adequately pled that the alleged misrepresentations were false and misleading. In making this finding Judge Huff relied on the "group pleading doctrine" which she found properly applied to the officer defendants because they had "direct involvement with the company’s day to day affairs and financial statements." She also found that the complaint adequately pled scienter, based on confidential witness information that the defendants directed "deviations" from company policy.

Accredited itself filed for bankruptcy protection in May 2009. According to the settlement stipulation, the settlement is conditioned upon receiving bankruptcy court approval for the company’s participation in the settlement.

According to the stipulation, the settlement was the result of "extensive settlement discussions" in April 2009, following mediation.

The $22 million settlement apparently is to be entirely funded by a transfer of funds from the company’s directors’ and officers’ liability insurers, who are identified in the definitions section of the stipulation. The stipulation recites that settlement is also conditional on bankruptcy court approval of the use of the insurance proceeds to fund the settlement.

The Accredited settlement joins the recent $30.5 million settlement announced in the subprime-related securities lawsuit involving Beazer Homes (about which refer here). Because the Accredited case was one of the first subprime lawsuits to be filed and because it had already progressed past the motion to dismiss, it may or may not immediately prefigure coming events in other subprime cases, as so many of the cases are still just in their earliest stages. Nevertheless, as settlements like those in the Beazer and Accredited cases accumulate, a better sense of the range of possible settlements may begin to emerge.

I have in any event added the Accredited settlement to my register of subprime and credit crisis-related lawsuits settlements and case resolutions, which can be accessed here.

ABA TIPS Panel: "The Financial Collapse -- What Caused It and How Will It Continue To Impact Corporations and Their Boards?": The American Bar Association Tort Trial & Insurance Practice Section (TIPS) Task Force on Corporate Governance will hold this meeting at the ABA Building in Chicago on July 30, 2009 as part of the ABA Annual Meeting, to discuss the 2008 financial collapse and how corporations can manage risk throughout the remainder of the ongoing crisis.

I will be participating in this free session, which will be chaired by my good friend Kim Hogrefe from Chubb. The panel will also include Fiona Phillip of Howrey LLP and Dr. Faten Sabry of NERA Economic Consulting. The event will be followed by a reception. More information about the event, including event registration can be found here.

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As a result of legislative reforms and a changing enforcement environment, the number of disclosure related securities cases in Japan has increased in recent years and is likely to continue to grow in the years ahead, according to a July 15, 2009 report from NERA Economic Consulting. The report, which was written by Makoto Ikeya and Satoru Kishitani, is entitled "Trends in Securities Litigation in Japan: 1998-2008" and be found here.

The report examines 249 criminal and civil actions alleging violation of the Japanese securities from 1998 through 2008. Because very few Japanese cases settle, the report analyzes cases that have resulted in a judgment following trial.

The 249 cases studied encompass a wide variety of kinds of matters. The vast majority of the 249 cases (79%) represent broker-dealer cases (reflecting, for example, suitability allegations as well as a variety of other issues). The list also contains other kinds of cases included "market manipulation" and "insider trading" cases. But a large and growing number of the cases involve allegations of "misstatement" – indeed, by 2008, the misstatement cases represented half of all of the cases.

The growth in the number of misstatement cases in recent years is attributable to changes in the liability provisions in the Japanese securities laws. One set of revisions lessened the plaintiff’s burden for proving damages. In addition, for fiscal years beginning April 1, 2008, misstatements in internal control reports are subject to civil liability. The introduction of new accounting standards, more rigorous audits and disclosure of quarterly reports has added disclosure responsibilities, "increasing the risk that companies may make misstatements and face suits." Finally, Japan’s Securities and Exchange Surveillance Commission has been strengthened and expanded.

The report’s data show that cases related to misstatements have increased significantly since 2005, although the numbers in part reflect that certain high profile scandals have attracted multiple suits in the absence of any provision in Japan for class action litigation. For example, there have been eleven cases filed against Seibu Railway and four against Livedoor.

The report also notes that cases alleging that auditors alleged failed to detect misstatements have been on the rise since 2006, with ten such cases from 2006 through 2008, compared to only two from 1998 through 2005.

The report also notes that the type and number of plaintiffs involved is changing. Institutional investors have been more involved in recent years; for example, pension funds and trust banks are the main plaintiffs in the cases against Livedoor and Seibu Railway. Plaintiffs attorneys have also started forming large groups of plaintiffs to file for damages; the Livedoor case involved 3.310 individual investors and similarly large plaintiff groups have formed in other cases.

The increased number of misstatement cases has also affected the damages trends. The 9.5 billion yen award in the Live Door case raised the average award in 2008 to 450 million yen. However, of the 25 civil cases alleging misstatements between 1996 and 2008, a high number resulted in no damages award, although eight of those sixteen involved audit firm defendants and four involved Seibu Railway litigation.

Excluding litigation against the audit firms, 44% of the civil misstatement cases resulted in damage awards that were more than half of the amount sought and the average judgment was 1.5 billion yen.

The report concludes by noting that given the changes in disclosure requirements and the current litigation environment, securities litigation in Japan is expected to gradually increase going forward. However, in light of the "fundamental differences" between the U.S. and Japan (for example, "the absence of class actions, fewer attorneys, and other social factors") it is "unlikely that the number of securities litigation cases in Japan will be comparable to the U.S."

An interesting January 2009 legal memorandum by the Anderson Mori & Tomotsune law firm on the topic of civil liability under Japanese law for false statements in securities filings can be found here.

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In what may be the largest ever outside director securities lawsuit case settlement, on July 13, 2009, Southern District of California Judge Roger R. Benitez preliminarily approved the six settling outside directors’ $55.95 million settlement of the claims pending against them in the Peregrine Systems securities class action lawsuit. The July 13 order can be found here. As discussed further below, the directors’ settlement is the latest of a multiple settlements in the case, as a result of all of which former Peregrine outside directors have now agreed to pay a total of $61.55 million in settlements.

Background

As reflected in greater length here, in May 2002 plaintiffs filed securities class action lawsuits against Peregrine and other defendants, including certain directors and officers of Peregrine. Peregrine itself filed for bankruptcy in September 2002 and was dropped from the lawsuit. On April 5, 2004, following an initial round of motions, the plaintiffs filed their first amended consolidated complaint.

The complaint alleges that Peregrine materially overstated its revenues and earnings during the class period due to the company’s failure to recognize revenue properly. Peregrine ultimately issued restatements of its financial statements for fiscal years 2000 and 2001. The restatement reduced previously reported revenue of $1.34 billion by $509 million, of which, according to the SEC’s separate civil enforcement complaint against Peregrine (here), "at least $259 million was reversed because the underlying transactions lacked substance." Several Peregrine officers, including the company’s CEO and CFO, entered guilty pleas in connection with the criminal investigations of Peregrine.

In July 29 2006, the parties to the class action lawsuit announced a partial settlement in the amount of $56.3 million on behalf of certain settling defendants. As part of the July 2006 settlement, and as reflected further here, Arthur Anderson agreed to pay $30 million; former officer Douglas Powanda agreed to pay $4.675 million; former director William D. Savoy agreed to pay $5.1 million; and former director Thomas Watrous agreed to pay $500,000. The July 2006 settlement also included certain amounts received in bankruptcy from the company. In November 2006, Judge Benitez approved the July 2006 settlement. The case proceeded against the non-settling defendants.

On February 9, 2009, the plaintiffs filed a motion (here) for approval additional settlements with the remaining individual defendants, six former outside directors (John J, Moores, Charles E. Noell III, Norris vandenBerg, Richard A. Horshey II, Christopher Cole, and Rodney Dammeyer), and four former officers (Stephen P Garner, Mattew C. Gless, Frederic B. Luddy, and Richard T. Nelson).

One of the settling directors, John Moores, was Peregrine’s chairman from 1990 to July 2000 and from May 2002 through March 2003. For a time, Moores owned the San Diego Padres major league baseball team. According to Wikipedia, here, during his years on Peregrine’s Board, Moores sold over $600 million worth of Peregrine stock.

Accompanying the February 9 motion were two settlement stipulations, one each with respect to the two groups of defendants. The settlement stipulation with respect to the outside director defendants, a copy of which can be found here, is dated December 2008 and reflects the six outside director defendants’ agreement to pay a total of $55.95 million toward settlement.

The settlement stipulation with respect to the four officer defendants can be found here and provides that defendant Luddy will pay $100,000 and defendant Nelson will pay $25,000. The stipulation provides further that defendants Gardner and Gless "shall note be required to pay any cash in light of their current financial condition and, as to Gardner, the fact that the forfeitures obtained from him in the criminal case … may be distributed" to claimants.

In Judge Benitez’s July 13 order, he preliminarily approved these two proposed settlement, subject to a final determination at a hearing scheduled for October 16, 2009.

I should emphasize that the foregoing description as well as the analysis below is based solely on the information available in the public record. If I have mischaracterized anything or misunderstood any of the events discussed above, I encourage readers to let me know so that I can correct any errors.

UPDATE: Andrew Longstreth's July 16, 2009 American Lawyer article about this settlement (here)  includes a statement from counsel for one of the outside directrros that insurers did contribute toward the outside directors' settlement and the outside directors are pursuing payments from excess insurers. Counsel for the outside directrors also disputes that this is the largest ever settlement on behalf of outside directors, which could be true -- but this is still a very large settlement.

The Outside Directors’ Settlement

The outside directors’ settlement stipulation does not disclose the source of funds for the outside directors’ payments in the settlement. Given Peregrine’s bankruptcy, the payments obviously will not be funded by indemnification from the company. And in light of the extensive, years-long litigation, as well as the 2006 settlement, it seems probable that any potentially available D&O insurance was long ago exhausted; the stipulation itself does not indicate whether any portion of the outside directors’ settlement is to be funded by insurance.

There are however, certain indications in the stipulation suggesting that at least part of the outside directors’ settlement will be funded out of one or more of the directors’ personal assets. For example, of the directors’ total $55.75 million settlement contribution, $27.5 million is to be paid in the form of a note signed and payable by John J. Moores and Rebecca Ann Mores as individuals and as trustees of the John and Rebecca Ann Moores Family Trust. The stipulation also provides that the security for the note will be provided either by a letter of credit or by a security interest in JMI Holdings LLC’s economic interest in a San Diego hotel. These and other terms strongly suggest that at least a portion of the settlement will be funded out of one or more directors’ personal assets.

The six outside directors’ settlement, taken together with the $5.6 million in settlement amounts to which the two directors agreed as part of the July 2006 settlement, brings the total amount paid in settlement of claims against former Peregrine directors to $61.55 million, which exceeds any prior securities lawsuit solely on behalf of outside directors of which I am aware.

Discussion

When I spoke as a panelist at the 2009 Stanford Law School Directors’ College last month, the number one concern of the directors attending the D&O insurance session was the possibility that their personal assets might be exposed in the event of a lawsuit against them arising out of their service as directors. Although relatively rare, there is in fact some danger that directors might have to pay settlement of claims against them out of their own assets, as the Peregrine settlement strongly suggests.

As I noted in a prior post (here) concerning the now infamous Just for Feet case, the possibility that directors might have to contribute personally toward settlement is materially increased in the bankruptcy context, when the defunct company is unable to fulfill its indemnification obligations. In the event of complex and serious claims following bankruptcy, there is danger that the available D&O insurance could be exhausted before all claims are resolved, potentially leaving directors exposed to additional claims without insurance, which is what happened in the Just for Feet case.

The threat of possible exposure of personal assets of outside directors raises the question whether there are insurance solutions that can be used to try to insure against these possibilities.

Many companies in recent years have secured so-called Side A/DIC coverage, which in effect provides catastrophic claim protection for company officials, particularly in the event of corporate bankruptcy. However, the typical Side A/DIC policy insures all company officials, including officers, raising the risk that even the Side A/DIC policy could be exhausted by defense expense or settlement payments on behalf of the officers, potentially leaving directors exposed without adequate insurance.

As discussed at greater length here, the best way for an individual director or a group of directors to ensure that a pool of insurance will be available to protect them regardless of what happens is to secure a policy solely for the protection of those individual(s). One possible solution is a separate Side A policy just for nonofficer directors. An alternative solution is an individual director liability policy (IDL) designed to provide insurance protection exclusively to a named individual or group of individuals.

The nightmare scenario suggested in the Peregrine Systems settlement, where outside directors may have been required to contribute massive amounts out of personal assets to extricate themselves from litigation arising from their service as directors, together with the availability of alternative insurance products that could address their exposure, are the reasons why I contend that outside board members should retain and consult an independent insurance advisor in connection with the company’s D&O insurance acquisition.

As I noted recently (here), in my experience outside directors are keenly interested in learning more about the protection afforded by these alternative products. A separate consideration of competing and sometime conflicting interests can sometimes result in the selection of different D&O insurance structures.

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Given the massive amount of litigation arising out of the Madoff scandal as well as the enormous sums of money involved it is perhaps inevitable that the scandal would also generate its own category of insurance coverage litigation. As the two cases described below demonstrate, the Madoff-related coverage litigation has now arrived. There undoubtedly will be much more to come in the weeks and months ahead.

The first of the two recently filed coverage complaints was filed on July 14, 2009 in Hennepin County (Minn.) District Court by Upsher-Smith Laboratories, a pharmaceutical company. A copy of the complaint can be found here. Since 1995, Upsher-Smith had invested all of its funds in its profit sharing plan with Bernard L. Madoff Securities LLC. As of December 2008, the company had invested $12 million in plan assets with Madoff. The company had also invested millions of its own with Madoff.

As a result of the plan losses, the U.S. Department of Labor launched an investigation, and by letter dated June 30, 2009, the DOL has demanded that the company "restore losses" to the plan, or the DOL may file a lawsuit.

Upsher-Smith filed a claim with its "Employee Benefits Plan Administrative Liability" insurer in connection with the plan losses and the DOL’s actions. The company has also filed an action with its crime insurer in connection with its own separate losses. Both carriers have denied coverage. In its July 14, 2009 complaint, Upsher-Smith seeks a judicial declaration of coverage under both policies, and also alleges breach of contract against both insurers.

The second of the two complaints was filed on July 15, 2009 in the Southern District of New York by Ann & Hope, Inc., which operates retail stores, as well as by an affiliated entity and affiliated persons. The complaint, which can be found here, was filed against the company’s crime insurers. The complaint alleges that on August 14, 2008, Madoff’s firm "caused $5 million to be transferred" from the affiliated company to Madoff’s account with JP Morgan. As a result of Madoff’s fraud, the funds have been lost. The company submitted a claim to its crime insurer, which has denied the claim. The complaint seeks a judicial declaration of coverage and also alleges breach of contract.

Merely because these complaints have been filed does not, of course, mean that they are meritorious. In that regard, I note that both complaints neglect to mention the specific grounds on which the respective carriers have denied coverage, an omission that may be telling. The stilted wording on the Ann & Hope complaint alleging that Madoff "caused the funds to be transferred" may suggest the kind of coverage problems that the companies seeking coverage under their crime policies for Madoff losses will have to solve.

There may well have been other Madoff-related insurance coverage litigation before these two cases, although I have been keeping track of all Madoff-related litigation fairly attentively and I have not seen any other coverage lawsuits before. The one thing I know for sure is that these lawsuits won’t be the last.

Madoff may be in prison for the next 150 years, but while he does his time outside the prison walls, the litigation his crimes have engendered will grind on for many years. I predict that the litigation will live on long after his obituary appears.

I have in any event added the two insurance coverage cases to my register of Madoff-related litigation, which can be accessed here. In recognition of the distinction that these two new coverage cases represent, I have created a new table on my litigation chart (Table V) for Madoff-related coverage litigation. I hope readers will help me to maintain the table by supplying me with copies of complaints of which they may become aware.

Special thanks to loyal reader Bill Sweeney for providing me with copies of the two coverage complaints.

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In a July 1, 2009 opinion (here), Northern District of California Judge Susan Illston denied in part and granted in part the defendants’ motion to dismiss the plaintiffs’ consolidated complaint in the subprime-related securities class action lawsuit pending against the The PMI Group and certain of its directors and officers. Among other things, Judge Illston specifically found that insider trades pursuant to a Rule 10b5-1 trading plan cannot serve as the basis of a finding of scienter. Background regarding the case can be found here.

Judge Illston denied the defendants’ motion in part, finding that the plaintiffs’ consolidated complaint had sufficiently alleged material misrepresentations with respect to the adequacy of PMI’s risk management practices and its reporting of its loss reserves. She also found that the complaint adequately alleged loss causation. However, she nevertheless granted the defendants’ motion to dismiss with leave to amend on the grounds that the consolidated complaint did not adequately allege scienter.

With respect to scienter, Judge Illston found that the complaint "falls short of showing that the defendants were aware that the statements were false or misleading when made."

Judge Illston specifically found that the confidential witness testimony on which the plaintiffs sought to rely was insufficient. Judge Illston noted with respect to the internal reports that one confidential witness referenced that "the complaint does not describe these reports in any detail, and thus there is no information in the complaint as to whether the reports should have alerted the defendants" as to the falsity of the disclosures.

With respect to the other confidential witnesses’ testimony, she said that the complaint does not disclose how the witnesses would have had "personal knowledge" of the items they reference or that that the individual defendants were aware of this information.

Judge Illston also rejected as insufficient the plaintiffs’ attempt to satisfy the scienter requirements by arguing that the individual defendants are company officers who may be presumed to have knowledge of the company’s "core operations." She found that the "plaintiffs have not shown that this case fits within the unusual circumstances" to which the "core operations" theory might apply, noting that in addition to alleging the defendants’ corporate positions, the complaint must detail the defendants’ actual exposure to information. She noted that the plaintiffs can attempt to amend their complaint if they can to show that the defendants "actually had information showing the problems."

In addition, Judge Illston rejected as insufficient the plaintiffs’ attempt to rely on the existence of a bonus plan and of insider trading to establish scienter. She noted that "the simple fact that PMI had a bonus compensation plan, without more does not support scienter."

She rejected the alleged insider trading allegations as insufficient both because the complaint does not contain any allegations regarding the defendants’ prior trading histories and because she found that three of the defendants had actually increased their holdings during the class period, "which is inconsistent with the intent to defraud."

Finally, Judge Illston noted on the issue of scienter that 98% of on individual defendant’s sales were pursuant to Rule 10b5-1 trading plans, with respect to which she further noted that "sales according to pre-determined plans may rebut an inference of scienter." (Refer here for discussion of another recent case where trades pursuant to a Rule 10b5-1 plan were also found sufficient to rebut the inference of scienter.)

Because she concluded that plaintiffs had not adequately alleged scienter she granted defendants’ motion to dismiss with leave to amend. The plaintiffs have until July 24, 2009 to file their amended complaint.

I have in any event added Judge Illston’s opinion to my running register of subprime and credit crisis-related securities lawsuit dismissal motion rulings, which can be accessed here.

Special thanks to Adam Savett of the Securities Litigation Watch for providing a copy of Judge Illston’s opinion.

Bloomberg Podcast on Directors’ Accountability Now Available: On June 24, 2009, I participated in a Bloomberg-sponsored roundtable discussion on the topic of "Corporate Directors’ Accountability During and After the Economic Crisis." Also participating on the panel were Professor Charles Elson, Director of the John L. Weinberg Center for Corporate Governance at the University of Delaware, Michael Barry of Grant & Eisenhofer, and Michael Forman of Dorsey & Whitney. The hour-long panel discussion can now be accessed or downloaded from Bloomberg’s website, here.

The Latest Stanford Financial Group Lawsuit: According to a July 13, 2009 Bloomberg article (here), Stanford Group investors have filed a class actoin lawsuit in the Southern District of Texas against The Commonwealth of Antigua and Barbuda, alleging that the Caribbean nation helped the financier engineer a massive fraud. The complaint (here) , purports to be filed on behalf of all individuals and investors who were customers of Stanford International Bank as of February 16, 2009, alleges violations of and seeks to recover damages under RICO.

I have added this latest lawsuit to my running register of all Stanford Group-related litigation, which can be accessed here.

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From time to time on this blog I try to draw generalizations from a variety of disparate claims as a way to identify emerging themes. However, a single recently filed securities class action manages to embody in a single complaint several themes I have previously tried to describe.

The case in question is the action filed on July 10, 2009 in the Southern District of New York on behalf of those who purchased common shares of Tronox, Inc. between November 28, 2005 and January 12, 2009. The complaint names as defendants certain former directors and officers of Tronox, as well as Kerr-McGee Corporation, Andarko Petroleum Corporation and certain Kerr-McGee executives.

According to the plaintiffs’ lawyers’ July 10, 2009 press release (here), the complaint alleges that:

Tronox was spun-off from Kerr-McGee in a two-step transaction. In November 2005, Kerr-McGee sold 17.5 million shares of Tronox Class A shares in an initial public offering for $14.00 per share (the "IPO") generating proceeds for Kerr-McGee of $225 million. After the IPO, Kerr-McGee continued to hold 56.7% of Tronox’s outstanding common stock. In March 2006, Kerr-McGee distributed the balance of the shares that it owned as Class B shares to its shareholders as a dividend (the "Spin-Off").

The Complaint alleges that, throughout the Class Period, Defendants failed to disclose material adverse facts about the Company’s true financial condition, business and prospects. Specifically, the Complaint alleges that Defendants failed to disclose the true scope and extent of Tronox’s environmental and tort liabilities. When the market learned of the true facts about the Company, the price of Tronox stock declined precipitously.

The complaint itself (which can be found here) alleges that the alleged misrepresentations and omissions

(i) deceived the investing public regarding the true nature and extent of the Company’s environmental and tort liabilities, Tronox’s business, operations, management, and the intrinsic value of Tronox’s stock; (ii) enabled Kerr-McGee to sell $225 million of Tronox stock to the unsuspecting public at artificially inflated prices; (iii) enabled Kerr-McGee to successfully rid itself of hundreds of millions of dollars of liabilities, thereby clearing the way for Kerr-McGee to sell itself to Andarko; and (iv) cause Plaintiff and other members of the Class to purchase Tronox common stock at artificial prices.

There are a number of interesting things to me about this complaint, all of which sound themes that will be familiar to readers of this blog.

First, this case represents yet another example of the way in which the spreading wave of corporate bankruptcies is extending the litigation consequences of the financial crisis beyond just the financial sector. (My prior post on this topic can be found here.) Tronox, the bankrupt company at the cent of this case, is engaged in the business of producing and marketing titanium dioxide, a white pigment used in a variety of products. Tronox, which definitely is not a financial services company, was not named as a defendant in the case owing to its bankrupt status.

Second, the complaint is based on alleged misrepresentations and omissions regarding Tronox’s environmental and tort liabilities. Among other things, the complaint alleges that the defendants ignored known information in setting Tronox’s reserves for environmental liabilities, and in particular that the reserves did not include any allowance for special sites (supposedly known as "secret sites") Kerr-McGee had identified as part of an investigation. The complaint also alleges that the defendants knew that independent third parties had reviewed the company’ s non-public information regarding its environmental liabilities and concluded that the company’s liabilities could be substantially larger.

These allegations may be noteworthy in and of themselves, but they are also noteworthy because they represent specific examples of what I have previously identified (most recently here) as the growing disclosure risks public companies face regarding their environmental liabilities. Although more recently I have emphasized the growing risks surrounding climate change related issues, as this case demonstrates, the disclosure risks also include the risks associated with more conventional environmental liability exposures.

Third, the roster of defendants involved in this case demonstrates a potential problem that can arise under D&O insurance policies in certain situations. Under the typical D&O insurance policy, coverage for the corporate entity is provided solely for "securities claim," which is a policy term that is typically defined in one of two ways. The first way is with respect to the securities involved, and the second way is with respect to the specific legal violations alleged.

In the first of these formulations, the policy includes within its definition of the term "securities claim" for which entity coverage is provided any claim based upon the purchase or sale of the securities of the Insured Entity itself. The alternative formulation pertains to claims alleging violation of any federal, state, local, or foreign securities law. (It should be noted that some current policies incorporate both formulations within the definition of the term "securities claim.")

The interesting thing about the Tronox lawsuit in connection with these alternative definitions of the term "securities claim" is that the Tronox complaint alleges violations of the securities laws against Kerr-McGee and Andarko, but not in connection with the purchase or sale of those companies’ own securities, but rather in connection with the securities of Tronox. Thus, to the extent these companies’ D&O insurance policies contain only the first of the two alternative formulations for the term "securities claim," their respective insurers might take the position that the Tronox complaint is not a "securities claim" with the meaning of their policies.

I should emphasize here that I have no familiarity with the specific terms or conditions of the D&O insurance policies of any party involved in this case and I am expressing no opinions one way or the other about the availability of coverage under any policies that may be applicable.

As I noted above, many policies available in the D&O insurance marketplace today actually incorporate both alternative formulations with the definition of the term "securities claim." But the Tronox complaint provides an example of how problems might arise in connection with D&O insurance policies containing more restrictive definitions of the term.

As for my first two observations noted above, I suspect that there will be many other securities lawsuits yet to come arising out of bankruptcies outside the financial sector. And I suspect strongly that in the months and years ahead we will see an increasing number of securities lawsuits raising allegations based on supposed misrepresentations or omissions relating to environmental liabilities and exposures, including but not limited to climate change issues.

And Speaking of Climate Change-Related Disclosure Issues: Just the other day I added a post (here) in which I raised the possibility that companies may soon find themselves facing the need to incorporate climate change-related disclosures in their periodic filings. A recent news article suggests that these changes may be even closer than I anticipated.

According to a July 13, 2009 New York Times article entitled "SEC Turnaround Sparks Sudden Look at Climate Disclosure" (here) federal regulators are preparing to launch a "very serious look" at requiring corporations "to assess and reveal the effects of climate change on their financial health."

According to the article, the SEC is following up on the landmark disclosure requirements enacted by the National Association of Insurance Commissioners this spring (and about which refer here). SEC representatives have also met with CERES, which submitted a petition in 2007 asking the SEC to clarify and strengthen requirements for climate change disclosure (and about which refer here).

Although the article hints strongly that formal disclosure requirements might be ahead, the article also acknowledges that nothing specific is actually underway now, and that a variety of practical and policy concerns would complicate any initiative that is launched.

Nevertheless, the message is that the SEC’s new leadership is more receptive to these possibilities and interested in pursing them further.

Hat tip to the Securities Docket for the link to the New York Times article.

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Claims arising out of corporate bankruptcy represent a significant stress test for directors’ and officers’ liability insurance coverage. Among other frequently recurring issues are questions whether post-bankruptcy claims against the bankrupt company’s directors and officers run afoul of the Insured vs. Insured (I v. I) exclusion found in most D&O insurance policies.

In a July 10, 2009 opinion (here) that highlights many of these perennial bankruptcy-related D&O insurance coverage issues, the Ninth Circuit held that a D&O policy’s Insured vs. Insured exclusion bars coverage for claims that were brought against former directors and officers of a bankrupt company by the post-bankruptcy debtor in possession and later assigned to a creditors’ trust. The decision may have important implications for the prospective wording of coverage “carve backs” from the  I v. I exclusion.

Background

Visitalk, which had filed a Chapter 11 bankruptcy petition, and while acting as “debtor and debtor in possession,” sued four of its recently discharged directors and officers for breaches of their fiduciary duties. Visitalk’s D&O insurers refused coverage for the claim, in reliance on the I v. I exclusion.

Visitalk’s primary D&O insurance policy’s I v. I exclusion provided as follows:

V. EXCLUSIONS

The Insurer shall not be liable to make any payment for Loss in connection with any Claim made against the Directors and Officers . . .:

(D) brought or maintained by or on behalf of an Insured in any capacity or by any

security holder of the company except:

(1) a Claim, including, but not limited to, a security holder class or derivative action that is instigated and continued totally independent of, and totally without the solicitation of, or assistance of, or active participation of, or intervention of an Insured;

(2) an Employment Practice Claim3 by a former Director or a present or former Officer;

(3) a claim for contribution or indemnity if the Claim directly results from another Claim that is otherwise covered under this Policy; or

(4) a claim by any employee(s) of the Company described in IV.(D)(2) of the Policy.

Visitalk filed a Chapter 11 reorganization plan that assigned its claims against the directors and officers to a trust created by the creditors. The trustee for the creditors trust (Biltmore) and the four director and officer defendants agreed to settle Visitalk’s claims for about $175 million. The four directors and officers assigned to the creditors’ trust their rights against the D&O insurers. (The record does not disclose whether or not the settlement with Biltmore also included a provision typical of these kinds of arrangements, which is a covenant by the settling claimant not to execute any judgment entered pursuant to the settlement on the assets of the settling defendants.)

Biltmore, as trustee for the creditors’ trust, then sued the D&O insurers in reliance on the individuals’ assignment to Biltmore of their rights under the D&O policies. The District Court dismissed Biltmore’s complaint on narrow grounds relating to the relation between Visitalk’s primary D&O insurer and the primary insurer’s successor in interest. The Ninth Circuit did not reach the successor in interest issue but nevertheless affirmed the District Court’s dismissal of the case on the grounds that the I v. I exclusion applies.

The Ninth Circuit’s Opinion

The Ninth Circuit’s July 10, 2009 opinion (here) written by Judge Andrew J. Kleinfeld opens with a review of the reasons for the inclusion of an insured vs. insured exclusion in D&O insurance policies, noting that “because risks such as collusion and moral hazard are much greater for claims by one insured against another insured … than for claims by strangers, liability policies typically exclude them from coverage.”

The Court then noted that because none of the exceptions to the policy’s I v. I exclusion apply, the only question was whether the underlying suit was “brought or maintained on behalf of an Insured in any capacity.”

The Court found that the underlying claim had been “instigated and continued” by Visitalk as Chapter 11 “debtor and debtor in possession.” Though coverage was now being sought by the trustee of the creditor’s trust, it was doing so merely as an assignee. The court noted that “an assignee of a claim against an insurance company can have no stronger claim than the assignor who assigned the claim.”

The question then is whether Visitalk’s status as debtor in possession at the time it initiated the claim triggered the I v I exclusion.

Biltmore argued that Visitalk, the chapter 11 debtor in possession that brought the underlying suit, is not the same entity as Visitalk, the insured corporation. However, the Ninth Circuit concluded after a review of authorities that “for purposes of the insured versus insured exclusion, the prefiling company and the company as debtor in possession in chapter 11 are the same entity.”

The Ninth Circuit acknowledged that “it is certainly true that interests differ once a debtor goes into bankruptcy.” Among other things, due to the bankruptcy “ownership of the cause of action fell into the bankruptcy estate” and Visitalk as debtor in possession of the bankrupt estate was “empowered to act as fiduciary for its creditors and shareholders.”

Biltmore argued that because Visitalk as debtor in possession was acting as representative for the estate’s creditors in bringing the suit, the I v. I exclusion does not apply. The Ninth Circuit reasoned that while suit might be brought for the benefit of creditors, it was not brought “on behalf of” the creditors. The Ninth Circuit said that the suit is “for the benefit of the creditors, but on behalf of the pre-bankruptcy corporation.”

The Court said that the question was not whether the creditors might benefit from any recovery. The court said that the insurance “cannot be turned into an available pot for the corporation’s creditors by enforcing the insurance obligations while disregarding the parties’ agreement to limit those obligations to exclude insured versus insured claims.”

The Ninth Circuit concluded its analysis of the I v. I exclusion issues by noting that a contrary holding would

create a perverse incentive for the principals of a failing business to bet the dwindling treasury on a lawsuit against themselves and a coverage action against their insurers, bailing the company out with the money from the D & O policy if they win and giving themselves covenants not to execute if they lose. That is among the kinds of moral hazard that the insured versus insured exclusion is intended to avoid.

Discussion

As I have previously noted (here), the insured vs. insured exclusion is heavily litigated and continues to be at the heart of many D&O coverage disputes, particularly in the bankruptcy context, as this case demonstrates. In response to these many continuing disputes, the exclusion itself has continued to evolve, and the I v. I exclusion in the typical D&O policy in today’s marketplace is quite a bit different than the exclusion at issue in the Visitalk case.

Among other things, the I v. I exclusion in most D&O policies today contain additional exceptions to the exclusion, or coverage “carve banks” as they are usually called. Among other provisions now more or less standard is a carve back to the I v. I exclusion specifically relating to the bankruptcy context. A typical carve back of this type would specify that the I v. I exclusion would not apply “in any bankruptcy proceeding by or against an Organization” to “any claim brought by an examiner, trustee, receiver, liquidator or rehabilitator (or any assignee thereof) of such Organization.”

It would have been interesting to see how the Ninth Circuit would have addressed the issues in the Visitalk case if the policy as issue had contained these now fairly standard provisions. However, even if Visitalk’s policy had contained a carve back of this kind, it likely would not have altered the outcome, because the underlying action in the Visitalk claim had not been brought by any of the creditors’ representatives referenced in the carve back, but rather had been brought by Visitalk as debtor in possession.

The solution to this coverage problem would seem to be simply to include the debtor-in-possession in the list of bankruptcy-related claimants for whose claims coverage is carved back as an exception to the exclusion. Indeed, parts of the Ninth Circuit’s opinion in the Visitalk case suggest that this would be appropriate, particularly the Court’s comments about how a debtor’s status changes upon becoming a debtor in possession, and how an action by a debtor in possession as representative of the estate is for the benefit of creditors.

However, throughout the Ninth Circuit’s opinion is a pervasive concern with the possibility of collusive litigation. The Court clearly was concerned that if there were coverage, a debtor in possession action might represent a collusive attempt by a debtor company to use the cover of a bankruptcy filing and the ruse of a supposed claim as a way to access insurance proceeds to pay off the company’s debts.

Without minimizing the collusive possibilities to which the Ninth Circuit refers, I believe there is also a legitimate concern that without policy recognition in some way for debtor in possession claims, individuals could be left without insurance for claims of a kind for which D&O policies are intended to provide coverage.A debtor in possession claim is not inevitably collusive, and in that regard I note that the individuals named as defendants in the underlying suit in the Visitalk claim were former directors and officers, targeted post-bankruptcy on behalf of the bankrupt estate.

There are, in fact, D&O insurance policies available in the current marketplace that attempt to address the problem of debtor in possession claims. For example, one policy’s list of the bankruptcy-related claimants for whose claims coverage is carved back include “a Claim by the Entity as Debtor-in-Possession after such Examiner, Trustee, Receiver has been appointed.” The prerequisite for the availability of coverage under this carve back for the appointment of an examiner or trustee does represent some check against the collusive possibilities about which the Ninth Circuit was concerned.

Whether or not this particular formulation is sufficient to preclude the possibility of collusive claims, it strikes me as a step in the right direction toward protecting against the possibility that individuals could otherwise be left without coverage for claims of a kind for which these policies were intended to provide protection.

To be sure, the individual defendants in the Visitalk claim were not left to defend themselves without coverage; they entered into the settlement and assignment of rights with the trustee to the creditors’ trust. The parties’ entry into this settlement arrangement clearly troubled the Ninth Circuit, and the Court’s concerns about these kinds of settlement and assignment of rights deals clearly affected the court’s analysis. However, it should be noted that there is nothing about the debtor in possession claim context that uniquely encourages this kind of settlement, and litigants in many other contexts enter similar arrangements. Indeed, if the individuals were clearly covered and thus able to defend themselves, they would have far less incentive to enter these kinds of arrangements.

While I don’t mean to trivialize concerns about the possibility of collusive claims, for me the most important message from the Ninth Circuit’s decision in the Visitalk case is not necessarily the threat of collusive claims but rather then need to address in the policy the possibility of debtor in possession claims against individual directors and officers. The clear implication seems to be that the now fairly typical bankruptcy-related coverage carve back to the I v I exclusion should be modified to preserve coverage for debtor in possession claims.

One final observation about this particular coverage problem is that whether or not the primary D&O insurer will agree to provide a coverage carve back in the I v I exclusion for debtor in possession claims, an insured company may be able to purchase an excess Side A policy providing “difference in condition” protection and that either does not contain an I v. I exclusion or has one that is very narrowly circumscribed.

Because of the issues raised in the Ninth Circuit’s opinion, particularly the court’s concerns about the possibility of collusive claims, I would like to hear readers’ views about these issues, and I encourage everyone to post their thoughts for others using this blog’s “Comment” feature.

Very special thanks to Mike Early of the Chicago Underwriting Group for providing me with a copy of the Visitalk opinion. I hasten to add that the views expressed in the blog post are exclusively my own.

2009 Failed Banks – The Slideshow: This past Friday night, the Bank of Wyoming of Thermopolis, Wyoming, became the fifty-third bank to fail this year (refer here for more details). Regular readers know that the FDIC maintains a detailed list of failed banks (here). But who needs a list when you can see a slideshow, including pictures of all of the banks that failed this year? Check out Clusterstock’s failed bank slideshow, which is complete prior to the closure of the Bank of Wyoming, and can be accessed here.

Mid-Year Review: Securities Litigation and Enforcement: On July 9, 2009, I participated in a Securities Docket webinar entitled “Mid-Year Review: Securities Litigation and Enforcement” that included as panelists Lyle Roberts of the 10b5-Daily blog, Francine McKenna of the Re: The Auditors blog, Tom Gorman of the SEC Actions blog, as well as Bruce Carton of Securities Docket. Carton has posted a brief summary of the topics discussed in the webinar in a July 10, 2009 Compliance Week column entitled “Bloggers Offer 2009 Mid-Year Review” (here).

The webinar itself is available to be viewed online and can be accessed below:

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 On June 26, 2009, when the U.S. House of Representatives passed the American Clean Energy and Security Act of 2009, it set the stage for changes that could have a direct effect on corporate financial results. The Act has now moved to the Senate, where it could face significant hurdles. But strong White House support for the initiative and pressures from looming regulatory changes suggest that some form of climate related requirements will ultimately be enacted, with significant implications for companies’ carbon-related risk disclosures.

As reflected in a July 8, 2009 CFO.com article entitled "Clearing the Air on Carbon Disclosures" (here), the cap and trade system currently under Congressional consideration "contains the makings of a new asset class for affected companies" in the form of carbon emissions allowances. The likely corporate trading in these allowances could have a material effect on reported financial results – the CFO.com article cites analyses suggesting that carbon costs "could depress earnings before interest, taxes, depreciation and amortization by 5.5% for the S&P 500."

These potential financial impacts will, as the article comments, "likely cause investors to demand more information about carbon-related risk."

According to a June 2009 report from PricewaterhouseCoopers Transaction Services Division entitled "Capitalizing on a Climate of Change" (here), as the financial impacts of climate change issues rise, "investors, stakeholders and regulators will demand greater transparency and comparability of companies’ financial information."

As reflected in M&A examples cited in the PwC report, this process is already well underway. The report refers to Porsche’s recent bid to acquire a majority stake in Volkswagen, which, the report claims, was motivated in part by Porsche’s desire to "offset its fleet’s high emissions with the more efficient and low emissions VW line."

The PwC report suggests that "climate change considerations will likely be a key consideration in M&A activity" and that in more and more deals, "the potential impacts of climate change on earnings, cash flow, and target valuation, as well as any opportunities for cost reduction through synergies, will have to be thoroughly evaluated."

The likelihood that these kinds of considerations will become increasingly critical does not depend alone on whether or not Congress ultimately enacts a climate change bill; regulatory developments at the EPA and elsewhere could drive climate change related mandates, as disclosed at greater length in a prior post, here. Indeed, the likelihood that regulators will act if Congress does not is one of the strongest motivations for Congress to find a way to put something together rather than to cede field to regulators.

According to the PwC report, in light of these considerations, "companies should begin planning today for the elevated status this issue now commands." Climate change issues are likely to become increasingly material, and companies that fail to adapt could risk "penalties, less profitability and damaged reputations." as well as "missed opportunities for growth."

The disclosure-centered nature of many of these potential risks creates a context within which litigation could well arise. To cite one example from the PwC report, investors may become increasingly attentive to M&A-related climate change exposures, the presence or absence of which could significantly affect deal valuations. Whenever there is an opportunity for investors to later contend they were misled or not fully informed, there is a danger of possible litigation.

The current predominance of issues relating to the global financial crisis may make these climate change related issues seem relatively remote and unimportant. But the possibility of claims based on carbon-related disclosures is only a matter of when, not if.

For that reason, in my view, the constituencies that will be scrutinizing carbon-related disclosures includes not only investors and regulators, but will also include D&O underwriters. As best practices in this area develop, D&O underwriters will necessarily develop their own sense of what disclosure practices suffice. Just as there are risks for companies that fail to adapt to the climate change related issues, there will be risks for D&O underwriters as well.

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In prior posts, I have frequently noted the rising tide of Foreign Corrupt Practices Act (FCPA) enforcement activity as well as the increasing level of FCPA follow-on civil litigation. If the trends noted in a recent law firm memo are any indication, we are likely to continue to see both heightened enforcement activity and ensuing civil litigation for some time to come.

In a July 7, 2009 memo entitled "2009 Mid-Year FCPA Update" (here), the Gibson Dunn law firm takes a comprehensive look at FCPA enforcement trends. The memo notes that during the first six months of 2009, the regulatory authorities have "continued the recent explosion of FCPA enforcement activity, and the number of ongoing investigations suggest that this trend will not soon subside."

In substantiating the observation that there is a "continuing explosion of FCPA prosecutions," the memo notes that "in just the first six months of 2009, more FCPA prosecutions were brought than in any other full year prior to 2007" and that "the nineteen enforcement actions initiated to date in 2009 exceeds the enforcement activity undertaken during the first half of any prior year."

The memo also observes that the heightened enforcement activity trend is likely to continue for the foreseeable future. The memo cites key regulators as having "confirmed" that "at least 120 companies are the subject of ongoing investigations."

The memo also addresses a theme frequently raised on this blog, which is the threat of civil litigation following in the wake of FCPA enforcement action. As the memo notes, even though the FCPA does not provide a private right of action, "enterprising plaintiffs’ lawyers have not been deterred from shoehorning alleged FCPA violations into a variety of civil actions," including securities fraud actions, shareholder derivative suits, contract claims and tort claims. At the same time, the memo notes, some corporate enforcement action defendants "have brought suit against the individuals responsible for these violations."

Among other things, the memo discusses the continuous threat of FCPA-related securities litigation, mentioning specifically the UTStarcom securities litigation (background here) in which the plaintiff shareholders allege that the company knowingly violated the FCPA by bribing officials in China, Mongolia, and India in order to secure contracts.

The growing significance of FCPA-related securities litigation was underscored in the January 2009 NERA Economic Consulting report discussing, among other things, the growing size and number of FCPA securities class action lawsuit settlements. As discussed here, the NERA report notes that a total of $84.4 million was paid in securities class action settlements between 2002 and 2008.

In addition to FCPA-related securities lawsuits, plaintiffs have also filed FCPA-related shareholders derivative lawsuits. The Gibson Dunn memo specifically mentions the April 2009 settlement in which FARO Technologies agreed to implement certain corporate governance changes and to pay $400,000 in plaintiffs’ attorneys’ fees to settle a derivative suit alleging that the directors and officers breached their fiduciary duties by failed to properly oversee the company’s internal activities. The FARO Technologies derivative settlement follows FARO’s earlier settlement of an FCPA-related securities lawsuit in which its D&O insurers paid $6.785 million to settle the suit.

During the first half of this year, plaintiffs also filed a shareholders derivative lawsuit against Halliburton and KBR as nominal defendants and against the companies’ current and former directors and officers to recover as civil damages amounts the companies paid in connection with their recent high profile FCPA settlements, as discussed here.

The Gibson Dunn memo emphasizes that the follow-on lawsuits are not always successful, and the memo specifically cites as examples of unsuccessful cases the shareholders’ derivative suits involving Baker Hughes and Chevron Corporation, where motions to dismiss were granted earlier this year.

The memo also describes civil litigation that companies themselves are pursuing to try to recoup amounts the companies paid to settle FCPA enforcement actions. Among other cases the memo specifically mentions is an action brought by Willbros International against several former officials and consultants. Willbros pled guilty to violating the FCPA in 2008 and now alleges that the defendants were responsible for the unlawful conduct.

The Gibson Dunn memo concludes that "the number of recent enforcement actions and ongoing investigations suggests that the FCPA enforcement environment that we have observed over the past several years is here to stay." As the FCPA enforcement activity continues to grow, an increasing number of companies will find themselves involved in FCPA-related civil litigation.

Even though the FCPA enforcement fines and penalties generally would not be covered under a D&O insurance policy, the policy could be called upon to respond to the costs of defending against an FCPA enforcement action, and any follow-on civil litigation could also trigger the company’s D&O coverage, subject to all of the policy’s terms and conditions.

On a final note, the SEC Actions blog had an interesting recent post (here) emphasizing the high priority that FCPA enforcement actions are being given, both here and abroad. I would be remiss if I did not also note that The FCPA Blog (here) is a continuing source of excellent information on FCPA related developments that I follow regularly.

Pay to Play?: According to a July 7, 2009 article in the Deseret (Salt Lake City) News (here), U.S. Senator Bob Bennett (R. Utah) has asked the SEC to investigate whether plaintiffs’ law firms are making campaign contributions to public officials that oversee government pension funds in the hope of later being able to represent the funds in securities class action litigation.

According to the article, Bennett wrote that "state officials with control over pension fund decisions…receive very substantial campaign contributions from out-of-state law firms with no apparent interest in the election – other than the possibility of being chosen as the pension fund’s lawyer in a class action."

Bennett noted that these practices are of particular concern at a time when pension funds "are reeling from the decline the financial markets."

You Can’t Make This Stuff Up: As part of the eternal vigilance required in order to maintain this blog, I am constantly scouring the media for important developments. Sometimes I run across items that are noteworthy, even if they are not particularly important. Just to make sure that my readers are not deprived of these vital items, I share the following:

"Drunk Badger Disrupts Traffic in Germany" (here)

"France Faces EU Lawsuit for Failing to Protect Endangered Hamster" (here)

"Iowa State Fair Rethinks Jackson Butter Sculpture" (here)

Non, Je Ne Regrette Rien: With apologies to Edith Piaf and with a hat tip to Francine McKenna on whose blog, Re: The Auditors (here) I first saw this video, here is a musical tribute to a funny and odd assortment of Internet regrets.

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Though Rule 10b5-1 trading plan abuses have figured in recent high profile cases (refer here), predetermined trading plans remain a good idea. A July 1, 2009 dismissal of a securities class action lawsuit pending in the Southern District of New York underscores the potential protective benefit that a trading plan can provide.

Gildan Activewear is a Canadian sportswear company based in Montreal. Its shares trade on both the NYSE and the Toronto Stock Exchange. Following the company’s April 2008 press release in which it announced a reduction in its earning guidance, its share price declined and litigation ensured. Background regarding the case can be found here.

On November 17, 2008, the lead plaintiff filed a Consolidated Amended Class Action Complaint (here), and on December 19, 2008, the defendants moved to dismiss.

In a July 1, 2009 opinion (here), Southern District of New York Judge Harold Baer, Jr., granted the defendants’ motion to dismiss, apparently with prejudice. Judge Baer granted the motion among other reasons on the grounds that plaintiff’s scienter allegations were insufficient to meet the PSLRA’s pleading requirements.

In attempting to establish scienter, the lead plaintiff had sought to rely on alleged insider trading by Gildan’s CEO, Glenn J. Chamandy, and by its CFO, Laurence G. Sellyn. Judge Baer noted that Chamandy’s sales, which comprised “over 99% of the total insider trading” alleged, were made pursuant to a non-discretionary Rule 10b5-1 trading plan, which, Judge Baer said, “undermines any allegation that the timing or amounts of the trades was [sic] unusual or suspicious.”

Judge Baer noted several other shortcomings regarding the plaintiff’s insider trading allegations. Among other things, he noted that though the plaintiff alleges that the defendants’ sales produced gross proceeds of $96 million, it fails to “allege any facts relating to the amount of profit” the defendants garnered by their sales. Judge Baer also found that the relatively low percentage of the sales compared to the defendants’ overall holdings, as well as the timing of the sales, in addition to the fact that the other officers and directors did not sell their shares, also militated against a finding of scienter.

Although Judge Baer’s discussion of Chamandy’s Rule 10b5-1 plan is relatively brief, it appears that the critical components of the plan were that Charmandy entered the plan in advance of his trades, the plan was non-discretionary, and the sales were pursuant to the plan. Judge Baer’s holding is yet another reminder that a well-constructed Rule 10b5-1 trading plan can provide substantial protection.

Judge Baer’s opinion cites the Eighth Circuit’s 2008 opinion in Elam v. Niedorff, which also found sales pursuant to a Rule 10b5-1 plan sufficient to rebut scienter allegations, and which is discussed in an earlier post, here.

Special thanks to Adam Savett of the Securities Litigation Watch for providing a copy of Judge Baer’s opinion.

Best Boards in America?: When Eric Jackson at TheStreet.com set out to identify the best boards in America as part of his July 7, 2009 article (here), he found that it was easier to list companies with poor governance practice than the best. Part of the problem is that there is no universally accepted definition of good governance. In addition, past attempts to identify exemplary boards look dubious in retrospect, as the performance of many companies cited later slumped.

Jackson quotes University of Delaware Professor Charles Elson to the effect that board governance alone is no guarantee of success, but “good governance give you protection when things to wrong. It the long run, that will play out.”

In creating his best boards list, Jackson ultimately relied on two factors Elson identified: equity ownership of directors and independence of directors. Jackson added his at third criterion, which is that directors must actually have enough time to serve.

Based on these criteria, Jackson identified three companies as having the best boards: Berkshire Hathaway, Johnson & Johnson, and Amazon.com. Of the three, Jackson judged Amazon.com as the best, saying it has “done things right on the important governance factors of equity ownership, independence and time,” as a result of which Jackson says Amazon is “far less likely to suffer a Lehman-like shock that could destabilize or kill the company.”

Securities Docket Mid-Year Litigation Update Webcast: On July 9, 2009, at 2:00 P.M. EDT, I will be participating in a Securities Docket webcast entitled “2009 Mid-Year Review: Securities Litigation and Enforcement.” The webcast will be moderated by Bruce Carton of Securities Docket and the panelists will also include Francine McKenna of the Re: The Auditors blog; Lyle Roberts of The 10b-5 Daily blog; and Tom Gorman of the SEC Actions blog. Further information and registration instructions can be found here.

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This past Thursday night, the FDIC closed seven additional banks, including six in Illinois alone. These latest closures bring the number of year to day bank failures to 52, already double the 26 bank closures during all of 2008. The FDIC has closed twelve banks in just the last two weeks. The FDIC’s complete list of all bank failures since October 2000 can be found here.

The 2009 bank failures have been spread across 18 different states, but certain states have experienced a high bank closure concentration. Up until now, Georgia had the dubious distinction of leading the way, having been dubbed the “bank failure capital of the world” earlier this year (refer here).

But with the latest closures, the state with the highest number of bank failures this year is now Illinois, where twelve banks have now failed, compared to nine so far this year in Georgia. California has had six and Florida just three.

There are a number of reasons for the surge of Illinois bank failures, as discussed at length in a July 2, 2009 American Banker article entitled “The Next Georgia? Failures Spike in Illinois” (here). It is probably worth noting that this American Banker appeared before the six bank closures were announced after the close of business on Thursday evening.

Among other things, the number of Illinois bank closures may simply be the “law of numbers.” According to the American Banker article, Illinois, which was one of the last states to allow branch banking, has more banks than any other state, with 652 institutions headquartered there, compared to Georgia, which has only half as many.

The real estate downturn is also part of the explanation, as it is in other states,

But another reason for the particular problems in Illinois is challenge many of these banks are having with their investment portfolios. According to the American Banker article, because these banks had fewer lending opportunities in the slow-growing Midwest, some banks bought heavily into mortgage-backed securities.

According to a July 3, 2009 Bloomberg article (here), the six Illinois banks closed on July 2 were all controlled by a single family and all followed a similar business model, and all suffered losses on collateralized debt obligations (CDOs), as well as on soured loans.

The National Bank of Commerce, an Illinois bank that closed earlier this year, was forced to close after writing down its investments in the securities of Fannie Mae and Freddie Mac, which left the bank in a negative capital position.

The likelihood is that these problems will continue. Data in the American Banker article suggest that Illinois and Georgia led the country in the number of undercapitalized banks at the end of the first quarter, with 17 each. Of the 371 banks nationally judged undercapitalized or in danger of becoming so, 42 are in Illinois compared with 55 each in Georgia and Florida and 20 in California.

But with respect to banks having problems with their investments, Illinois leads the way. At least 17 Illinois banks took hits on their investments during the fourth quarter of 2008 and 11 did so in the first quarter of 2009. No other state came close. Florida, which had the next highest number of banks reporting securities write downs, had seven in the fourth quarter and three in the first quarter. 

The latest bank closures once again involved smaller institutions, continuing the trend of the involvement of community banks in the current bank failure wave. All of the seven banks closed on July 2 had assets under $500 million. Of the 52 bank failures this year, 46 have involved institutions with assets under $1 billion. Only twelve banks had assets over $500 million.

In a recent post (here), I noted that with the latest bank failure surge, D&O claims have started to emerge. And as a result, the D&O marketplace has begun to react, as I discuss at greater length here.

Over the last few weeks, I have written frequently about failed banks, perhaps too frequently for some readers’ tastes, but the fact is that something remarkable is happening in the banking sector. In the last 18 months, 78 banks have failed, 64 in just the twelve months since July 1, 2008. The twelve banks that have closed in just the last two weeks alone suggest that his is a problem that is going to get worse, perhaps a lot worse, before it starts getting better.

Anything Called “Hot Money” Can’t Be Good: In case you missed it over the weekend, the New York Times had a front page article on July 4, 2009 entitled “For Banks, Wads of Cash and Loads of Trouble” (here) that describes the complicated role that brokered deposits have played for many banking institutions. The article suggests that many struggling banks are particularly dependent on these deposits, which also may have played a role in many of the recent bank failures.

These deposits are made by out-of-state brokers who deliver billions of dollars in bulk deposits. These funds are often referred to as “hot money” because they arrive in search of the highest interest rates, and leave when better rates are available elsewhere. According to the Times article, hot money comes at a cost. In order to lure the money, “banks typically had to offer unusually high rates” which in turn “often led them to make ever riskier loans, leaving them vulnerable when the economy collapsed.”

The article focuses on banks in Georgia that sought to capture the brokered deposits, but the Georgia banks were hardly alone. Indeed, the article notes the banks that have failed since January 1, 2008 “had an average load of brokered deposits four times the national norm.” In addition, a third of the failed banks had both an unusually high level of brokered deposits and an extremely high growth rate “often a disastrous recipe for banks.”

The article shows that the 371 banking institutions on an independent bank rating firm’s “Watch List” as of March 31, 2009 “held brokered deposits that were twice the norm.”

 Securities Docket Mid-Year Litigation Update Webcast: On July 9, 2009, at 2:00 P.M. EDT, I will be participating in a Securities Docket webcast entitled “2009 Mid-Year Review: Securities Litigation and Enforcement.” The webcast will be moderated by Bruce Carton of Securities Docket and the panelists will also include Francine McKenna of the Re: The Auditors blog; Lyle Roberts of The 10b-5 Daily blog; and Tom Gorman of the SEC Actions blog. Further information and registration instructions can be found here.

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A recent German legislative action creates some interesting requirements for and limitations upon insurance for German corporate director liability. These legislative changes are designed to try to ensure greater director exposure to personal liability, as a deterrent to corporate misconduct. However, the legislative changes are susceptible to circumventions that may limit their intended effects.

As reflected in a July 1, 2009 memo by Anthony Menzires and Dr. Gunbritt Kammerer-Galahn of the Taylor Wessing law firm entitled “D&O Insurance in Germany – The New Legislation Arrives” (here), on June 18, 2009, the Bundestag enacted the new Act on the Adequacy of Managerial Salaries.

Among other things, this new Act will impose a new requirement that German Stock Corporations (Aktiengesetz) purchasing D&O insurance for their executives must impose a personal deductible to be borne by the directors in an amount equivalent to at least 10% of the relevant loss, up to an annual cap. Comments accompanying the Act specify that the annual cap must be set at not less than one and one half the annual fixed remuneration of the director.

These requirements are applicable to all stock corporations, whether listed or publicly owned.

The requirements will to into effect immediately following the Act’s ratification by the Bundesrat on July 10, 2009, with immediate effect on all D&O insurance policies formed after that date and with a further requirement that all existing policies must be amended to bring them into compliance by July 1, 2010.

According to the law firm’s memo, these new statutory requirements codify long-standing German governance guidelines that had encouraged companies to structure their D&O insurance with a deductible to be borne personally by the directors as a way to “motivate them to avoid claims arising.” The memo observes that many German corporations “circumvented” these voluntary requirements.

The elevation of these provisions into statutory mandates represents an apparent legislative attempt to try to use the threat of personal liability to deter corporate misconduct. The German legislature’s action raises a couple of questions: Will the statutory requirement be effective? And will other countries follow?

As for whether the requirement will be effective in deterring corporate misconduct, there are certain aspects of the statutory requirement that are worth considering. The first is that that under the German two-tier system of board governance, the requirements apply only to D&O insurance for the management board (Vorstand) and not to the non-executive supervisory board (Aufsichtsrat). At a minimum, then, the deterrent effect, if any, is limited solely to the management board and would not reach the supervisory board.

The other aspect of the statute that may affect its effectiveness is the fact that the Act does not prohibit the acquisition of separate insurance for the individual director’s deductible exposure, which presents a rather obvious new product opportunity for German D&O insurers. And while the premium cost would have to be borne personally by the director, there is, as the memo notes, nothing to prevent each director from “seeking a commensurate uplift in their remuneration to cover the outlay.” Furthermore, there apparently is no existing requirement that would compel the corporation to disclose this type of compensation arrangement.

Whether other countries might follow the German legislation and enact similar statutory requirements may depend on whether the German requirement proves to be effective in deterring corporate misconduct. While the results from the statutory requirement remain to be seen, the apparent ease with which the personal exposure could be insured may well limit the deterrent effects.

The obvious logical step, then, might be to suggest that other countries considering the German requirement add further specifications that the director cannot acquire separate personal insurance to protect against the required liability exposure. My own view is that there are several critical considerations that should be taken into account before these kinds of prohibitions are imposed.

The first is that directors ought to be able to defend themselves, and so there should be no prohibition for the insurance providing defense expense protection. The second is that fundamental fairness requires that the barriers should apply only if an adjudication has determined that the director actually violated liability standards, and accordingly the statutory prohibition should only apply to judgments.

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While the number of securities class action filings through the year’s first half still project to an annualized filing rate consistent with historical averages, there was a noticeable slackening in the number of new securities lawsuits filed as the second quarter of 2009 progressed. New filings in the second quarter were well below the number of filings in the first quarter as well as in last year’s second quarter. There were few new filings in May and even fewer in June.

Overall, the filings continue to be largely concentrated in the financial sector. In addition, as discussed below, a significant number of the securities lawsuit filings in the first half of 2009 did not involve publicly traded companies, but instead involved other types of entities, such as private investment partnerships and mutual funds.

Based on my review of the securities filings through June 30, 2009, there were 94 securities class action lawsuits filed in the first half of 2009. (Please see my comments below on the topic of “counting” the lawsuits during the year’s first half.) The 94 first half filings represent an annualized filing rate of 188, which is slightly below but within range of the average number of filings of 197.7 during the 13-year period between 1996 and 2008. The annualized rate of 2009 filings is also below the average filing level of 204.7 for the most recent seven year period of 2002 through 2008.

The filing level during the second quarter of 2009 was below both the first quarter of this year and last year’s second quarter. There were only 35 new securities lawsuit filed during the second quarter of 2009, compared to 59 during the first quarter of this year and 56 in the second quarter of 2008.

The lower filing level during the second quarter of 2009 reflects the low number of new securities class action lawsuit filings during the months of May and June. There were just eleven new securities lawsuit filings in May and only six in June. The June filings represent the lowest monthly number of new filings since December 1996, when there were just five new securities class action filings.

But though there were fewer new securities class action filings during the second quarter of 2009, the total number of filings for the twelve-month period ending June 30 remains within historical annual averages. There were 205 new filings during the twelve month period ending on June 30, 2009, which, though below the 219 new filings during the twelve month period ending on June 30, 2008, is consistent with the average annual number of filings noted above.  

In addition to the filing activity levels, the first half filings were characterized by the relatively unusual types of claimants involved. For example, as many as ten of the first half lawsuits were filed on behalf of holders of preferred or subordinated securities. As I noted at greater length here, these are relatively unusual claimants.

The securities class action litigation targets during the first half were also unusual. An uncharacteristically high number of the first half lawsuit defendants were entities other than public companies, including private investment partnerships, mutual funds, and other nonpublic entities. As many as sixteen of the new first half lawsuit filings involved primary defendant entities that lacked Standard Industrial Classification code (SIC) designations. As many as eight of the new filings in the first half involved mutual funds (many of them in the Oppenheimer mutual fund family).

One characteristic that the first half filings did have in common with the filings in immediately preceding periods is that the new filings continue to be concentrated in the financial sector. Though the first half filings represented 38 different SIC Code classes, fully 51 of the first half filings against entities with SIC Codes involved companies in the 6000 SIC Code series (Finance, Insurance and Real Estate). In addition, virtually all of the 16 actions involving entities that lacked SIC codes also involved enterprises in the financial sector, so that more than two-thirds of the new first half filings involved financial services entities of one kind or another.

The concentration of the filings in the financial sector is largely a result of the continuing subprime and credit crisis litigation wave. By my count, 51 of the first half filings involved subprime and credit crisis related allegations. My complete list of all subprime and credit crisis securities lawsuit filings can be accessed here.

Another factor contributing to the concentration of securities lawsuit filings in the financial sector is the number of new securities class action lawsuits that were filed in the first half related to the Madoff scandal. By my count there were 11 new Madoff-related securities lawsuit in the first half, although there were many more duplicate Madoff-related lawsuits filed during that same period as well. My complete list of the Madoff related lawsuit filings can be accessed here.

The first half securities lawsuit filings were filed in 26 different courts, but fully 45 of them, or nearly half, were filed in the Southern District of New York.

Eighteen of the first half lawsuit filings involved foreign domiciled companies, representing ten different countries. The country with the largest number of first half filings was the United Kingdom. However, a number of these lawsuits against foreign-domiciled companies involve multiple separate lawsuits against a single target. For example, the six lawsuits filed against U.K. companies actually involve just two different companies, Royal Bank of Scotland and Barclays.

Of the actions against U.S.-domiciled companies, the first half lawsuits involved companies from 22 different states, with the largest number in New York (28) and California (12).

Why the Apparent Slowdown?: There may be any number of possible reasons for the relative slowdown in the number of filings during the second quarter. My own theory is that the plaintiffs’ lawyers may have found themselves in a logjam, due to two factors. One factor is the onslaught of Madoff-related litigation (which is not fully reflected in the above numbers but has nevertheless been massive) Another factor is the sheer quantity of previously filed subprime and credit crisis-related litigation, which in many instances has reached critical procedural stages.

If I am correct about the reasons for the second quarter slowdown, then the downturn could proved to be temporary and filing levels could ramp back up as plaintiffs’ lawyers circle back and attempt to work off the backlog. (Indeed, I have previously noticed signs that plaintiffs lawyers could already have been working off backlogs from earlier periods, as noted here). My view is that we will soon see filing activity return to historical norms. Of course, only time will tell.

Some Comments on “Counting”: The various litigation statistical services will also be issuing their counts for the first half of 2009 and their counts almost certainly will vary from mine. Because the Stanford Law School Securities Class Action Clearinghouse publishes all of the actions that it includes in its running tally, it is easiest for me to compare my count with theirs, and so I already know that my count differs from theirs, as I have both omitted lawsuits Stanford Clearinghouse has counted and I have counted lawsuits that the Stanford Clearinghouse omitted.

I have set forth these differences below not because I think I am right and alternative version wrong, but simply so readers might be able to understand the differences. Reasonable minds might well reach different conclusion as to whether the items mentioned below should or should not be recognized in any count.

Thus, I have omitted at least a couple of cases from the Stanford Clearinghouse list that to me appear to represent double counting of lawsuits that were counted elsewhere in the Clearinghouse’s list. (Refer for example here and here for examples of cases previously counted in the Stanford Clearinghouse tally.) Also, because I only count class actions seeking damages for disclosure violations under the federal securities laws, I have omitted merger objection lawsuits (refer for example here).

By the same token, I have included federal securities class action lawsuits that were filed in state court (refer for example here), which the Stanford Clearinghouse did not. I have also included a number of other actions that do not appear on the Stanford Clearinghouse list, including lawsuits involving Metaldyne (here); Royal Bank of Scotland Series Q preferred shares (here), Deutsche Bank Alt-A Securities (here); Merrill Lynch Mortgage Pass-Through Certificates (here); FM Multi-Strategy Investment Fund (here); Citigroup 8.125% Non-Cumulative Preferred Stock, Series AA (here); Agape World (here); Wells Fargo Mortgage Pass-Through Certificates Series 2006 et seq. (here); Citigroup 8.50% Non-Cumulative Preferred Stock (here); and Thornburgh Mortgage Pass-Through Certificates (here).

During the first half of 2009 the seemingly simple process of counting new lawsuit filings was extraordinarily complicated. As the filings have continued to emerge involving different classes of securities, it is increasingly challenging to determine whether or not each additional complaint represents a duplicate lawsuit or a separate action. In addition, the flood of Madoff-related litigation has involved an enormous number of similar or overlapping lawsuits.

If you would like a particularly challenging example of the difficulties involved in “counting,” refer to this June 30, 2009 press release in which plaintiffs’ counsel describe the class complaint they filed in the Eastern District of California on behalf of holders of derivative interests in bonds issued by the California Infrastructure and Economic Development Bank. To greatly oversimplify the action, the lawsuit alleges that the bond documents misrepresented certain bond attributes, for which the plaintiffs seek to recover damages under the federal securities laws. It is an investor class action lawsuit seeking to recover damages under the federal securities laws, and for that reason I included it in my count. On the other hand, it involves public financing authority rather than a public company; others might not count it. Read the press release and I think you will see what I mean. This is not simple.

Whether or not to count any of these complaints as a new action or as a duplicate lawsuit, or at all, is enormously challenging and reasonable minds almost certainly would reach differing results. The various published versions of the number of lawsuits filed during the first half of 2009 almost certainly will vary, perhaps substantially.

Securities Docket Mid-Year Litigation Update Webcast: On July 9, 2009, at 2:00 P.M. EDT, I will be participating in a Securities Docket webcast entitled “2009 Mid-Year Review: Securities Litigation and Enforcement.” The webcast will be moderated by Bruce Carton of Securities Docket and the panelists will also include Francine McKenna of the Re: The Auditors blog; Lyle Roberts of The 10b-5 Daily blog; and Tom Gorman of the SEC Actions blog. Further information and registration instructions can be found here.

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