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

D&O insurance policyholders typically do not have to provide "fresh warranties" when they renew their policy of the kind they provided when they originally purchased the coverage – that is, they do not have to represent to the insurer that at the time of the renewal they are not aware of any facts or circumstances that could give rise to a claim. However, when policyholders increase their limits of liability at the time of renewal, they often are required to provide "fresh warranties" as to the increased limits, whether in the form of an increased limits application or in a separate warranty letter.

An October 26, 2009 Tenth Circuit opinion (here) illustrates the potential pitfalls for policyholders required to provide fresh warranties for increased limits. In its recent opinion, the Tenth Circuit held that an increased limits warranty exclusion precluded coverage for the defense fees of insured persons that fell within the amount of the increased limits. The Tenth Circuit held that the allegations in a later SEC complaint showed that at the time the policyholders’ representatives signed the letter, individual insured persons had knowledge of accounting improprieties that might (and subsequently did) give rise to claims.

Background

Fisher Imaging carried $5 million of primary D&O insurance, as well as an excess D&O policy providing an additional $2.5 million of insurance. At the time of the company’s April 2002 D&O insurance renewal, the company sought to increase the excess policy’s limits of liability from $2.5 million to $5 million.

In order to obtain this additional $2.5 million of excess coverage, Fisher supplied the excess insurer with a warranty letter signed by the then-CFO and the CEO representing that "no person or entity for whom this insurance is intended has any knowledge of information of any act, error, omission, fact or circumstance which may give rise to a claim which may fall within the scope of the insurance." The warranty letter stated further that it was an "express warranty for all insureds." (This last sentence is capitalized in the original.)

In April 2003, Fisher was sued by its shareholders in two securities class action lawsuits, both of which were later dismissed. In addition, in June 2005, the SEC filed a civil enforcement action against five officers and directors of Fischer. The SEC amended its complaint in May 2008. The amended complaint alleges that from January 2000 through September 2002, the officials had engaged in a scheme to fraudulently inflate the company’s share price by improperly recognizing revenue, misstating financial reports and misleading the company’s outside auditors.

Defense expenses incurred in connection with these actions exhausted the primary $5 million as well as the first $2.5 million of the excess layer. (The primary insurer and the excess insurer advanced these amounts subject to a reservation of rights to challenge these payouts later) However, the excess insurer took the position that the allegations in the SEC’s complaint triggered the exclusionary language in the warranty letter and therefore that it had no obligation to advance defense fees that fell within the "top" $2.5 million layer.

The individual directors and officers who are defendants in the SEC enforcement action filed a separate action against the excess insurer seeking a judicial declaration of coverage for their fees within the top $2.5 million, or in the alternative for a declaration that the excess insurer had a duty to advance defense fees within the layer.

The parties cross moved for summary judgment. The district court held that the allegations in the SEC’s amended complaint triggered the warranty letter exclusion, because "when read together," the SEC complaint and the exclusion show that certain of the individual SEC enforcement action defendants "knew of the wrongful activities at Fischer that could give rise to a claim."

The court granted summary judgment in favor of the insurer and the plaintiffs appealed.

The Tenth Circuit’s Opinion

On appeal, the plaintiffs argued that in reaching its conclusion that the warranty letter exclusion had been triggered, the district court improperly considered matters developed in discovery in the underlying SEC action, and that therefore represented matter "extrinsic" to the question whether the SEC’s amended complaint triggered the exclusion. The Tenth Circuit rejected this argument, stating that "we … confident that the court confined its legal analysis to the allegations in the SEC’s amended complaint."

The plaintiffs next argued that the district court had improperly used an "objective" standard in determining that the exclusion had been triggered – that is, the plaintiffs argued, the district court based its decision on what the plaintiffs (or some of them) must have known, rather than what they subjectively knew. The Tenth Circuit found that the district court properly used the required subjective standard, rather than an improper objective standard. The Tenth Circuit noted:

While the district court did not use the term "subjective knowledge" when it recounted the allegations, its reliance on those allegations about each director’s or officer’s knowledge about and participation in Fischer’s irregular accounting practices establishes that the court properly applied a subjective knowledge standard.

The plaintiffs raised several additional arguments, each of which the Tenth Circuit rejected with a variation on its conclusion that "the district court correctly concluded that the SEC’s claims, when read together, compelled the conclusion that the SEC’s allegations were within the exclusion in the Warranty Letter."

Discussion

Upon initial review, I found a number of things about the Tenth Circuit’s opinion puzzling. The first is that the opinion refers throughout to a warranty "exclusion" – yet there is nothing in the warranty letter language quoted in the Tenth Circuit opinion that would or even could affirmatively precludes coverage. Without any expressly exclusionary language, the excess carrier would lack any contractual basis to disclaim coverage within the top $2.5 million layer, even if there were warranty letter misrepresentation.

In order to try to answer to this puzzle, I tracked down the parties’ appellate briefs on PACER. Upon review of the briefs, it turns out that there was additional, critically important language in the warranty letter that the Tenth Circuit opinion neglects to even quote (a rather astonishing oversight, given that but for this exclusionary language in the warranty letter, there would have and could have been no coverage dispute).

That is, as described in the excess insurers’ appellate brief (here, see page 5), the warranty letter contains additional language, following the warranty statement in which the applicants disclaim the existence of knowledge of any facts or circumstances that may give rise to a claim, providing that "it is agreed that if such knowledge or information exists, any claim arising therefrom…is excluded from the proposed coverage." (The original is in all capital letters.)

So, you wouldn’t know it from the text of the Tenth Circuit’s opinion, but there was critically important exclusionary language in the warranty letter, and that language was in fact the language that the Tenth Circuit was deciding whether or not to apply.

The other thing that puzzled me about the Tenth Circuit’s opinion (and for that matter, the district court’s opinion) is that it seems to make an awful lot out of what are unproven allegations. Merely because the SEC has alleged some things doesn’t mean they are true. Yet the Tenth Circuit repeatedly says the district court properly relied on what the courts themselves both acknowledge were just pleading allegations. Both courts concluded that the mere allegations were enough for the excess insurer to withhold payment of defense fees that fell within the top $2.5 million.

A review of the plaintiffs’ appellate brief (here) did little to help clarify this puzzle. The plaintiffs never quite seem to get around to arguing that just because the SEC has thrown up a bunch of allegations that doesn’t mean that any of individual actually had knowledge of the facts or circumstances that might give rise to a claim at the time the warranty letter was signed.

Indeed, in its brief the excess insurer notes how far away from this argument the plaintiffs stayed, observing that the plaintiffs "understandably have nothing to say about the detailed litany of wrongdoing alleged in the SEC’s Amended Complaint" adding later that the plaintiff "never address this litany of facts." Instead, the plaintiffs seem (to me at least) to get hung up on arcane arguments about whether the objective or subjective standard should apply. It seems to me that only facts are sufficient to satisfy either an objective or a subjective standard, but that mere unproven allegations cannot suffice to satisfy either standard, regardless of which one applies.

This puzzling aspect of the opinion is all the more bewildering (to me at least) given the Tenth Circuit’s conclusion that the "subjective" test is the proper standard to apply. That is, the exclusion could be triggered only if the insured persons had subjective knowledge of the triggering facts. How can a test of subjective knowledge be satisfied by mere allegations rather than upon the proof of actual knowledge? Particularly if, as the Tenth Circuit further held, extrinsic matter is irrelevant -- nothing outside the complaint can be relied upon to show that the allegations are true.

Claimants assert all sorts of bizarre things, but mere allegations alone should not be enough to trigger policy exclusions, particularly an exclusion that is triggered only by what insured persons subjectively knew. Readers who may be able to explain to why I should not be troubled by this aspect of the Tenth Circuit’s decision are strongly encouraged to clarify this for me and other readers using this blog’s comment function. I am particularly interested to know how mere allegations could possibly provide a sufficient basis to trigger an exclusion requiring subjective knowledge of the triggering facts.

One possible explanation does occur to me. It may well be that the plaintiffs did not make the argument that the SEC amended complaint represents mere allegations because they felt they simply couldn’t make an argument premised on the suggestion that they did not have knowledge of some or all of the facts described in the complaint.

Indeed, it probably should be noted in that regard that the company itself had in 2004 voluntarily entered a cease and desist order with the SEC (refer here).Among other things, the agreed order recited that the company, "acting through certain of its officers and personnel," had improperly recognized revenue, overstated inventory, improperly classified expenses, among other things. The plaintiffs may felt under these circumstances that there were limitations on how much they could argue that the SEC’s complaint against them represented "mere allegations."

However, the existence of the cease and desist order might (or then again, might not) explain why the plaintiffs’ may not have raised the argument that the SEC complaint represents mere alletgations; they don’t really explain why the Tenth Circuit concluded that mere pleading allegations were sufficient to trigger the exclusion.

It is worth noting that the circumstances involved in this coverage dispute may be a vestige of the time period in which these events took place. The excess insurer’s warranty letter used provisions that would be unlikely to be used today. Specifically, the excess insurer’s warranty letter was set up so that if any one insured had knowledge of the preclusive facts or circumstances, the top $2.5 million would be unavailable to any insured person, even those without knowledge.

A well-crafted increased limits application or increased limits warranty letter today would likely provide (or the policy to which it referred would provide) that no knowledge of any person would be imputed to any other person. This nonimputation language would operate to preserve coverage for those without knowledge of the preclusive facts, which is clearly a preferable arrangement from the standpoint of insured persons.

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In an October 28, 2009 opinion (here) in a case in which the Ninth Circuit found the plaintiffs’ allegations met the heightened pleading standards of Twombley and Tellabs, the appellate court reversed the district court’s dismissal of the plaintiffs’ complaint in the Matrixx Initiatives securities class action lawsuit. The decision is significant not only because the appellate court reversed the lower court’s prior dismissal of the case, but also because of what the Ninth Circuit’s opinion implies about the heightened pleading requirements.

The plaintiffs sued Matrixx and three of its officers in April 2004, alleging that the defendants were aware that numerous users of Matrixx’s intranasal cold remedy, Zicam, had developed anosmia (loss of the sense of smell), but that they had failed to disclose the risk and instead issued false and misleading statements regarding Zicam. The complaint alleges that the defendants were aware of these problems because of various calls to the company’s customer service line; because of certain academic research, the results of which were communicated to the company; and because of product liability lawsuits that had been filed against the company.

The district court granted the defendants’ motions to dismiss, finding that the complaint failed to adequately allege materiality, because the number of anosmia-related complaints of which Matrixx was aware was not "statistically significant." The district court also found that the complaint failed to allege scienter adequately because it "fails to allege any motive of state of mind with relation the alleged omissions."

The Ninth Circuit first held that the district court "erred in relying on the statistical significance standard" in concluding that the plaintiffs had not adequately alleged materiality, finding that a court "cannot determine as a matter of law whether such links [between Zicam and anosmia] were statistically insignificant because the statistical significance is a question of fact."

Instead the Ninth Circuit said that the appropriate "fact-based inquiry" is (citing Twombley and its progeny) whether the complaint states a claim that is "plausible on its face" – and, with respect to the issue of materiality, whether "the possible link between Zicam and anosmia was information that a reasonable investor would have found significant."

After reviewing the plaintiffs’ allegations, the Court found that the complaints allegations were sufficient to meet the PSLRA’s pleading requirements for materiality and, citing Twombley, to "nudge" the plaintiffs’ claims "across the line from conceivable to plausible."

The Ninth Circuit further held, with reference to Tellabs standard for pleading scienter, that the inference that the defendants "withheld information intentionally or with deliberate recklessness is at least as compelling as the inference that [the defendants] withheld the information innocently."

In reaching this conclusion, the Ninth Circuit noted that the company’s disclosures were "misleading because [they] spoke of the risk of product liability actions without revealing that lawsuits had already been filed." The Ninth Circuit observed that the inference that "high level executives such as [the individual defendants] would know that the company was being sued in a product liability action is sufficiently strong to survive a motion to dismiss."

The Ninth Circuit also referenced the various customer complaints and academic studies the results of which were communicated to the company’s director of research and development.

Based on its conclusions about materiality and scienter, the Ninth Circuit reversed the lower court’s dismissal and remanded the case for further proceedings.

The Ninth Circuit’s decision in the Matrixx case is interesting in a number of respects, not least of which is because the decision reversed the district court’s prior dismissal of the case, although it is certainly interesting in that respect as well.

Among other things, the decision is also interesting for its application of the Twombley "facial plausibility" standard to the question of the sufficiency of the plaintiffs’ allegations of materiality. In a prior post (here), I discussed the question whether the "facial plausibility" test of Twombley and its more recent companion case, Iqbal, would have much impact on securities cases, given the PSLRA’s heightened pleading standards. The Matrixx decision suggests that the Twombley standard could indeed impact securities cases, even with respect to elements of a securities claim for which heightened pleading standards are defined in the PSLRA, since the Ninth Circuit cited both the PSRLA’s materiality pleading requirements and Twobley in determining the sufficiency of the plaintiffs’ allegations.

The further significance of the Ninth Circuit’s citation to Twombley is the fact that the court also found that the Twombley standard had been satisfied here. Though many objections to Twombley and Iqbal have been raised, the fact is that the "facial plausibility" standard can be satisfied and cases will still be going forward, notwithstanding the pleading standard articulated Twombley and Iqbal.

Another interesting thing about the Ninth Circuit’s decision is the way in which the court found that the scienter pleading requirements to have been satisfied, particularly with respect to the individual defendants. The court seems to have put great weight on the individual defendants’ positions, and was less focused on the question whether or not there were allegations of knowledge or awareness as to each of the individual defendants.

Thus, for example, with respect to the existence of product liability litigation, the court was willing to draw an inference of scienter as to the individual defendants because "high-level executives… would know" the company had been sued. – without apparent consideration of the question whether the individual defendants did know about the litigation, or even what the company’s practices were for circulating information about new litigation to the company’s senior officials.

Similarly, the allegations of scienter based on the alleged awareness of the existence of customer complaints and academic studies was found sufficient as to all three individual defendants, though the allegations refer only to communications of these matters to the company’s director of research. The court’s decision does not refer to what the other two individual defendants are alleged to have known, or even what they would have known in light of the company’s processes for communicating this kind of information internally.

If nothing else, the Ninth Circuit’s finding that the scienter allegations were sufficient represents a suggestion that in at least some circumstances (and in at least some courts) allegations that individual defendants held a certain office or position may be sufficient to support a finding of scienter, even where no supporting allegations about what the defendants know or what information they were provided or had access to.

Readers may be interested to know that on June 16, 2009, the FDA warned consumers (here) to stop using three Zicam intranasal products because the products may cause a loss of smell. As reflected here, a second securities class action lawsuit was filed after the company’s share price plunged following this announcement.

Iqbal on the Hill: Meanwhile, the Iqbal debate arrived on Capitol Hill this week, as the House Committee on the Judiciary Subcommittee on the Constitution, Civil Rights and Civil Liberties held hearings on October 27, 2009. The hearing was entitled "Access to Justice Denied – Ashcroft v. Iqbal." The Committee’s page about the hearing, including links to the witnesses’ testimony can be found here. An October 29, 2009 AmLaw Daily article by Alison Frankel about the hearings can be found here.

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In a detailed October 27, 2009 opinion (here), Western District of Washington Judge Marsha J. Pechman substantially denied the defendants’ motions to dismiss the plaintiffs’ amended complaint in the Washington Mutual subprime securities class action lawsuit. Judge Pechman’s ruling is noteworthy in and of itself, but perhaps even more because Judge Pechman had previously granted the defendants motions’ to dismiss all of the plaintiffs’ ’34 Act claims and all but one of defendants’ ’33 Act claims.

As discussed here, in granting the prior motions to dismiss, Judge Pechman had been sharply critical of the clarity and organization of the plaintiffs’ initial consolidated amended complaint, which she characterized as "verbose and disorganized." and as embodying "puzzle pleading."

By contrast, in her October 27 ruling, Judge Pechman stated that the second amended complaint (hereafter, the "complaint") presents "cogent and concise allegations against Defendants." She also stated that the Plaintiffs have "largely succeeded in remedying the deficiencies of their initial complaint."

As described in the October 27 opinion, the complaint alleges that the defendants "(1) deliberately and secretly decreased the efficacy of WaMu’s risk management policies; (2) corrupted WaMu’s appraisal process; (3) abandoned appropriate underwriting standards; and (4) misrepresented both WaMus’ financial results and internal controls."

The complaint’s ’34 Act claims assert claims for securities fraud against the seven officer defendants, although the complaint also alleges Section 20 control person liability against the outside director defendants as well as the officer defendants.

With respect to the plaintiffs’ ’33 Act claims, the complaint alleges different specific allegedly misleading statement as to each of the individual officer defendants. The defendants moved to dismiss these allegations on the grounds that the complaint does not sufficiently allege that the statements are false and misleading and failed to allege "particularized facts giving rise to a strong inference of scienter."

In reviewing the adequacy of the plaintiffs’ allegations, Judge Pechman reviewed each of the alleged misstatements with respect to each of the individual officer defendants, grouping the allegedly false statements in four categories "(1) risk management; (2) appraisals; (3) underwriting; and (4) internal controls."

Other than with respect to two statement of WaMu’s former CEO, Kerry Killinger, which Judge Pechman found to "lack sufficient clarity to state a claim," Judge Pechman found that the plaintiffs’ ’34 Act claims were sufficiently pleaded, and therefore (other than with respect to two of the CEO’s statements), the motion to dismiss the ’34 Act claims was denied. Judge Pechman also denied the motion to dismiss the Section 20 control person liability claims against the individual officer defendants and the outside director defendants.

In denying the motion to dismiss, Judge Pechman referred repeatedly to the allegations drawn from internal memoranda and on testimony from confidential witnesses. With respect to the plaintiffs’ scienter allegations, Judge Pechman found with respect to each of the statements (other than the two statements of the CEO that were dismissed) that the "defendants have not raised a competing inference of innocence that outweighs the strong inference of scienter."

In her prior ruling in the case, Judge Pechman had granted the defendants’ motions to dismiss the ’33 Act claims, finding that the plaintiffs at that time did not have standing to assert ’33 Act claims in connection with WaMu’s August 2006, September 2006 and December 2007 securities offerings. The most recent amended complaint purports to add several additional plaintiffs, in an effort to establish standing to assert ’33 Act claims as to the August 2006, September 2006 and December 2007 offerings.

Judge Pechman found none of the new plaintiffs had standing to assert claims as to the August 2006 offering of 5.50% Notes. Judge Pechman also found that the plaintiffs’ lacked standing to assert Section 12(a)(2) claims as to both 2006 offerings. She otherwise found that the plaintiffs had standing to assert ’33 Act claims as to the other offerings. She also found that the complaint’s allegations met the ’33 Act’s substantive pleading requirements.

In short, virtually all of the plaintiffs’ most recent amended complaint survived the renewed dismissal motions. This is a fairly dramatic turnaround from the outcome of the initial motions, in which the initial dismissal motions were substantially granted, other than with respect to the ’33 Act claims in connection with the August 2007 offering. The turnaround is all the more noteworthy given how critical Judge Pechman was of the plaintiffs’ initial complaint. It is a very long way from Judge Pechman’s assessment that the prior complaint was "verbose and disjointed" to her assessment that the most recent complaint is "cogent and concise."

But the difference in outcomes is not attributable solely to the improved organization of the amended complaint. It is also clear that the added allegations, particularly those drawing on confidential witness testimony, were instrumental in bringing about the different outcome.

This turn of events could be significant in connection with the many other pending subprime and credit crisis related securities class action lawsuits, particularly those in which initial motions to dismiss have been granted with leave to amend. If nothing else, Judge Pechman’s October 27 opinion shows that plaintiffs can successfully amend their complaints in order to remedy initial pleading deficiencies. This possibility underscores the fact that initial dismissals without prejudice are indeed provisional, and no one should assume that a case in which initial motions have been granted is done – the plaintiffs in those cases, like the plaintiffs in the WaMu case, may yet succeed in overcoming the initial pleading hurdles.

A couple of aspects of the way in which the WaMu plaintiffs overcame the initial pleading hurdles are instructive for other plaintiffs in subprime and credit crisis-related securities lawsuits. Clearly, Judge Pechman preferred the more organized presentation of the amended complaint to the "puzzle pleading" presented in the prior complaint. Clarity and brevity are indeed virtues, in pleading cases as in all other endeavors, which is a consideration other plaintiffs might well want to heed.

Another clear implication from Judge Pechman’s October 27 order is the value of allegations based on the testimony of well-placed confidential witnesses. This lesson was also apparent from the recent ruling on the renewed motion to dismiss in the Dynex Capital case (about which refer here). While not every plaintiff will be similarly able to present allegations based on the testimony of well-place confidential witnesses, that clearly is one way to overcome the steep pleading hurdles that plaintiffs face at the outset of these cases. And, as I noted in connection with the Dynex Capital ruling, even the rigorous requirements for pleading scienter under the Tellabs case can be overcome with the right kind and quantum of confidential witness testimony.

But perhaps the greatest significance of the ruling on the renewed motions to dismiss is that the motions were denied in a high profile case like the WaMu suit. As I have noted elsewhere on this blog, the defendants generally have seemed to be doing better on the motions to dismiss in the subprime and credit crisis cases. However, the WaMu ruling adds a significant counterweight to the plaintiffs’ side of the ledger, along with the dismissal denials in the Countrywide (refer here) and New Century Financial subprime suit (refer here). The WaMu ruling may be even more significant, given that the dismissal motion had previously been substantially granted.

One final note about the October 27 order in the WaMu case is that the motion was denied as to all defendants, including the offering underwriters and WaMu’s auditors, Deloitte. The fact that the gatekeepers have been kept in the case is significant if for no other reason that its suggestion that gatekeepers generally will continue to be a part of the subprime and credit crisis-related litigation, which could have important implications for how these cases are resolved, as well as what the aggregate costs of these cases might eventually be.

In any event, I have added the October 27 ruling in the WaMu case to my running tally of the dismissal motion rulings in the subprime cases, which can be accessed here.

Special thanks to a loyal reader for providing me with a copy of the October 27 opinion. I get my best material from readers and I am always grateful when readers take the time to send things along to me.

Andrew Longstreth’s October 28, 2009 article on AmLaw Daily about the WaMu decision can be found here.

Another Belated Securities Suit Filing: In several prior posts (most recently here), I have noted the recurring phenomenon during 2009 of new securities class action lawsuit filings in which the proposed class period cutoff is well in the past, in some cases nearly two years before the filing.

The securities class action lawsuit filed on October 28, 2009 against Pitney Bowes and certain of its offices pushes this belated filing phenomenon to its furthest edge of its theoretical possibilities. As reflected in the plaintiffs’ counsel’s October 28 press release (here) , the proposed class period in the case runs from July 30, 2007 to October 29, 2007. In other words, the plaintiffs filed their complaint on what appears to be the last day before the two-year statute of limitations would have expired. A copy of the complaint in the case can be found here.

The Pitney Bowes case is merely the latest (and arguably most extreme) example of this phenomenon. I have long speculated that this rash of seemingly belatedly filed lawsuits may be attributable to a backlog of case filings that built up over prior periods in which plaintiffs lawyers were concentrating on filing subprime and credit crisis related lawsuits as well as lawsuits related to the Madoff scandal. Now that the new filings in those other areas are dying down, the plaintiffs’ lawyers may be getting around to working off the backlog.

The Pitney Bowes case, as is the case with many of these other seemingly belated cases that have been filed during the latter half of 2009, was filed against a company outside the financial sector. This feature of the phenomenon seems to suggest that as the plaintiffs’ counsel work off what seems to be a backlog of cases, the mix of companies sued will shift back toward the more usual spread of kinds of companies, and away from the concentration in the financial sector that characterized filings during the period from mid-2007 through the first part of 2009.

The one thing about these belated filings is that it does create a challenge in trying to determine when a company is "out of the woods" with respect to any adverse developments the company might have had.

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Lawsuits seeking to recover large amounts of money are commonplace. But how about a claim that seeks to recover more money than exists in the entire world?

According to a September 24, 2009 order (here) by Southern District of New York Judge Denny Chin, the complaint of plaintiff Dalton Chiscolm, Jr. against the Bank of America seeks to recover "1,784 billion trillion dollars," to be deposited in his ATM account "the next day." Oh, and in addition, another $200,164.

Judge Chin states that in Chiscolm’s complaint (which Chin describes as "incomprehensible"), the plaintiff "seems to be complaining" that his checks apparently have been rejected because of incomplete routing numbers and when he placed a series of calls to the bank he "received inconsistent information from ‘a Spanish wom[a]n.’"

Judge Chin’s September 24 Order directs Chiscolm to show cause in writing by October 23, 2009 the basis on which his claim, which purported to be filed in reliance on federal question jurisdiction, is brought in federal court, or the complaint will be dismissed. As of October 25, 2009, PACER did not show that any statement had been filed.

The astonishing quantum of damages sought is more than just a random large number. As it turns out, 1,784 billion trillion – equal to 1.784 multiplied by 10 to the twenty-fourth power, or 1,784 followed by 21 zeroes – corresponds to a value in the International System of Units known as a "Yotta." According to Wikipedia (here), Yotta currently is the largest unit in the system of measurement. In other words, the plaintiff is literally seeking to recover the largest describable number of dollars.

An October 23, 2009 BBC News article (here) about Chiscolm’s lawsuit quotes Kevin Houston, a University of Leeds mathematics professor, as saying that "the guy wants more money than there is in the entire world."

Well, yeah, but the customer service really was terrible.

Judge Chin, who recently was nominated to the Second Circuit, of course is the judge that sentenced Bernard Madoff to 150 years of imprisonment, and so Chin knows a thing or two about large amounts of damages, but the amount of damages that Chiscolm has claimed even managed to get Judge Chin’s attention.

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The Supreme Court’s decision in the Iqbal case earlier this year has generated a great deal of controversy and comment and even a proposal to overturn the decision legislatively. Iqbal does seem to be having an impact on a number of cases. An interesting question, however, is whether the Iqbal case will have an impact on federal securities cases, given that the securities laws already have their own separate heightened pleading standards. But a recent Eighth Circuit decision, applying Iqbal to affirm a lower court dismissal, suggests that Iqbal could indeed have an impact in damages actions under the federal securities laws.

Background

First, some background. Fed. R .Civ. P. 8(a)(2) requires that a "claim for relief" must contain a "short plain statement of the claim showing that the pleader is entitled to relief." Historically, courts had come to use the shorthand phrase "notice pleading" to describe the requirements under this rule.

In the Supreme Court’s 2008 Twombley case (here), the Court said that in order to satisfy these pleading requirements, the complaint must contain sufficient factual matter, accepted as true, to "state a claim to relief that is plausible on its face."

In the 2009 Iqbal case, the claimant in a Bivens action had sought to argue that Twombley’s "facial plausibility" test should be limited to the pleadings made in the context of an antitrust dispute, as had been involved in Twombley. The Supreme Court held that the argument  that Twombley was limited to antitrust actions "is not supported by Twombley and is incompatible with the Federal Rules of Civil Procedure." Twombley, the Iqbal court said, "expounded the pleading standard for all civil actions."

The Iqbal decision that the "facial plausibility" pleading sufficiency test applies to all federal civil actions has been the subject of a great deal of heated discussion. It has been criticized in many quarters. For example, in a September 3, 2009 article entitled "Plausibility Pleading Revisited and Revised: A Comment on Ashcroft v. Iqbal" (here), Boston University Law School Professor Robert G. Bone argues that Iqbal "takes Twombley’s plausibility standard in a new and ultimately ill-advised direction." Seton Hall Law Professor Edward Hartnett, less critical of the decision, argues in his recent paper (here) that Twobley and Iqbal can and should be "tamed."

Twombley and Iqbal have thir supporters. Fellow bloggers Mark Herrmann and James Beck argue on their Drug and Device Law Blog (here) that:

There’s nothing radical about requiring a plaintiff to have sufficient facts to plead a prima facie case before the courts will entertain the lawsuit – and that goes for all forms of litigation. It’s simply a construction of the language of Rule 8 "short and plan statement" that emphasizes "statement" a little more and "short" a little less. It’s about time, we think, that courts adopt a construction of the Rules that favors reduced, rather than expanded, litigation.

Whether Twombley and Iqbal are generally viewed as good or bad developments largely seems to depend on where your starting point is. But regardless of whether they are good or bad, the cases are having an impact in the lower courts, as Beck and Herrmann underscored in their more recent Drug and Device Law Blog post (here) detailing developments, by way of illustration, in recent medical device cases applying Twombley and Iqbal.

These practical impacts have registered with the plaintiffs’ bar, and indeed a September 21, 2009 Law.com article (here) discussed how civil rights and consumer groups and trial lawyers have been meeting to discuss ways to undo Iqbal. According to the article, Iqbal has already had a very significant impact – it has "already produced 1,500 district court and 100 appellate court decisions."

These groups have already managed to get proposed legislation introduced in Congress seeking to have Iqbal overturned. On July 22, 2009, Senator Arlen Specter introduced Senate Bill 1504, "Notice Pleading Restoration Act of 2009," which basically provides that courts shall not dismiss a complaint except under the notice pleading standards applicable under Supreme Court precedent prior to Twombley.

Whether this legislative effort will go anywhere remains to be seen. Congress has rather a full plate these days, and a bid to adjust a narrow feature of civil pleading standards may not make the cut. On a related note, according to a Point of Law blog post (here), there will be a House hearing on October 27, 2009 on the topic of "Access to Justice Denied – Ashcroft v. Iqbal."

Impact on Securities Cases?

Whatever the impact of Iqbal may be in other contexts, it has seemed an uncertain question whether Iqbal will prove to have a substantial impact in damages actions under the federal securities laws, due to the fact that the securities laws already have their own particularized pleading standards. Indeed, under the PSLRA, there are very specific requirements regarding what must be pleaded with respect to misleading statements or omissions and with respect to the required state of mind. The Supreme Court’s 2008 decision in the Tellabs case even further underscored the degree of specificity required to satisfy the state of mind pleading requirements.

Given these very specific statutory requirements applicable to the federal securities laws, it could be argued that the more generalized pleading requirements expounded in Twombley and Iqbal might have relatively less impact in the context of a damages action under the federal securities laws. However, a recent decision from the Eighth Circuit suggests that Iqbal could have an impact in securities cases after all.

In an October 20, 2009 decision in McAdams v. McCord (here), the Eighth Circuit was reviewing an appeal of a district court’s dismissal of the securities class action lawsuit that have been filed against Moore Stephens Frost (MSF), the outside auditors of UCAP. The district court had held that the complaint "failed to plead with particularity the circumstances of MSF’s alleged fraud, as well as facts giving rise to a strong inference of scienter."

The Eighth Circuit held that it "need not decide whether the complaint adequately states with particularity facts giving rise to a strong inference that MSF acted with scienter," because, the court held applying Iqbal to the loss causation pleading requirement under the Dura Pharmaceuticals case, that "the complaint fails to sufficiently plead loss causation."

The court referenced what it called the complaint’s "threadbare, conclusory allegation" that as a "direct and proximate cause" of defendants’ fraud the plaintiffs had lost their investments. The court noted that this allegation failed to "specify" how MSF’s alleged statements "as compared to the complaint’s long list of alleged misrepresentations and omissions by the executives, proximately caused the investors’ losses." The court noted further that the complaint "does not state the value of UCAP’s stock when the investors made their investments, or its value right before, or right after, the need for restatement was announced."

The Court concluded that without these allegations "the complaint does not show that the investors’ losses were caused by MSF’s misstatements," which "defeats the plausibility of the investors’ claims that MSF’s audit opinions …caused their losses."

Discussion

The Eighth Circuit’s decision in the McAdams case, in which the Eighth Circuit held, applying Iqbal, that the claimants’ loss causation allegations lacked "plausibility," shows that Iqbal could indeed have an impact on securities cases.

It is particularly interesting that the Eighth Circuit affirmed the lower court’s dismissal on the grounds of insufficient loss causation plausibility, while observing that it did not even need to reach the question whether the plaintiffs had plead scienter with sufficient particularity under the PSLRA. The conclusion suggests that Iqbal’s generalized pleading requirements must be considered analytically prior to the PSLRA’s more particularized requirements. And whether or not the Iqbal standard is to be viewed as prior, its "facial plausibility test" apparently applies to the elements required to state a cause of action under the federal securities laws, even those elements for which the PSLRA does not itself specify particularized pleading requirements.

In any event, the basic holding of the McAdams case that the complaint’s loss causation allegations must meet the Iqbal "facial plausibility" standard in order survive an initial motion to dismiss could be a valuable tool for defendants’ to use at the initial pleading stage. (Of course, many plaintiffs will include allegations in the complaint of the kind that the plaintiffs in the McAdams case had omitted, so the extent to which the McAdams decision will affect other cases could be limited – with the inclusion of seemingly minimal additional information about their alleged investment loss, plaintiffs could likely defeat a motion raising similar arguments.)

One question that may be of more interest to civil procedure buffs is whether it matters that in McAdams the court was considering a complaint to which (as the McAdams court itself noted) Rule 9(b) applied, rather than (or perhaps, in addition to) Rule 8. Rule 9(b) requires that fraud must be plead with "particularity." To my mind, it does not and should not matter whether the applicable pleading standard is under Rule 9 rather than under Rule 8, either way it would seem (as the McAdams court noted) that the Iqbal "facial plausibility" test should apply, although I would be interested to know if readers disagree.

One final thought about Iqbal itself. I tend to agree with the school of thought in favor the decision. I recognize the argument that the "facial plausibility" test does not appear in the Fed. R. Civ. P., but then neither does the phrase "notice pleading." And I find myself puzzled by the critics of Iqbal – are they suggesting that complaints that are not facially plausible should be allowed to go forward? In any event, under Rule 15 (a)(2), courts are admonished to allow pleading amendments "freely when justice so requires," so plaintiffs will typically have at least a second crack at trying to present a "facially plausible" complaint.

In any event, based on the McAdams decision at least, Iqbal appears to represent yet another factor raising the hurdle that plaintiffs’ initial pleads must overcome in order to survive a motion to dismiss in a securities class action lawsuit. Clearly, the accumulating number of substantive and procedural developments increasingly favors the defendants in these cases.

Very special thanks to Tom Gorman of the SEC Actions Blog for his recent post (here) discussing the McAdams case.

More About Loss Causation: An October 21, 2009 memo entitled "Loss Causation Challenges in Securities Cases" (here) by Michael Smith and William Hutchinson of the King & Spaulding law firm surveys recent case law regarding loss causation issues under the federal securities laws.

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It been a catastrophic week for Galleon Group and its founder, Raj Rajaratnam, with the firm reportedly about to wind itself up in the wake of the epic insider trading allegations raised against Rajaratnam. But the trading indictment is not the only recent stunning legal development involving Rajaratnam and his firm.

Among other things, on October 22, 2009, a group of survivors of alleged "terrorist" bombings sued Rajaratnam and his father claiming they knowingly provided financial support to the Tamil Tigers.

On a more positive note, Galleon was recently affirmed as lead plaintiff in a securities class action lawsuit pending in the Eastern District of Pennsylvania.

The terror victims filed their lawsuit on October 22, 2009 in the District of New Jersey. The seven-count complaint (copy here) was, according the plaintiffs’ lawyers press release (here), the result of "a year-long investigation." The complaint was filed under the Alien Tort Claims Act of 1789, which gives U.S. district court jurisdiction "of any civil action by an alien for tort only, committed in violation of the law of nations or a treaty of the United States."

The complaint alleges that Rajaratnam and the family foundation headed by his father provided millions of dollars in funds used for terrorist attacks by the group formerly known as the Liberation Tigers of Tamil Elam (LTTE). The complaint alleges that from 2004 to 2009 LTTE conducted hundreds of attacks and bombings, claiming over 4,000 victims. The complaint alleges that Rajaratnam and his family foundation provided millions in funding to a group that the Treasury Department has described as "a charitable organization that acts as a front to facilitate fundraising and procurement for the LTTE." The complaint alleges that Rajaratnam’s donations were given "with the intent of supporting specific LTTE attacks and operations."

The complaint alleges that the defendants aided and abetted terrorist acts "universally condemned as violations of the law of nations: aided and abetted, intentionally facilitated or recklessly disregarded "crimes against humanity in violation of international law," as well as, among other things, wrongful death, negligence and negligent or intentional infliction of emotion distress.

Things said about Rajaratnam and his firm in the September 30, 2009 ruling (here) by Eastern District of Pennsylvania Judge Juan R. Sanchez, in which Sanchez affirmed Galleon as lead plaintiff in the Herley Industries securities class action lawsuit, were decidedly more positive. The subsequent events (which the court obviously had no way of anticipating) do cast a very strange light on the opinion.

Even prior to events of the last week, Galleon’s selection as lead plaintiff in the case was notable. Investment advisors typically are regarded as lacking standing to pursue the claims of their clients’ funds, because they lack an "injury-in-fact" – that is, they suffered no direct injury. A long line of district court cases have declined to appoint investment advisers as lead plaintiffs for that very reason. In considering these issues, Judge Sanchez observed that Galleon, unlike the investment advisors in the other cases, was "closely connected" to the Galleon funds that held the company’s stock.

With respect to the connection between Galleon and the funds, Judge Sanchez noted that "the same people control both Galleon and the funds," adding that "Raj Rajaratnam serves as director of the two funds and as Galleon’s managing partner." There were, however, further standing issues involved because the funds had not assigned their claims to Galleon until after Galleon was initially appointed to serve as lead plaintiff.

Finding that Galleon now had standing in light of the assignment, and noting further that "Galleon has served as an adequate plaintiff for more than two years," and that it had a larger financial interest in the case than the competing pension fund, the court exercised its discretion to affirm Galleon as the lead plaintiff in the action.

In support of this conclusion, Judge Sanchez observed, among other things that "to appoint a new lead plaintiff at this late date would unduly disrupt the litigation process."

Certainly, no one wants the litigation process unduly disrupted, but I suspect that in light of events subsequent to Judge Sanchez’s September 30 order, the litigation process in the Herley Industries case is about to be duly disrupted.

Among other ironies is that in the court’s prior order initially appointing Galleon as lead plaintiff (here), the competing pension fund had argued that Galleon was an "unsuitable" lead plaintiff owing to the "unique defenses" to which Galleon was subject. Among other things, the competing pension fund had argued that Galleon was a hedge fund that had shorted Herley’s stock during the class period (and therefore allegedly profited from the fraud on the market), and further argued that the short sale activity violated the federal securities laws. Judge Sanchez found the securities law violation allegations to be speculative and selected Galleon as lead plaintiff in light of the PSLRA’s presumption in favor of the plaintiff that suffered the greatest financial.

The competitor pension fund presumably could be substituted in as lead plaintiff, but, as Judge Sanchez noted, the pension fund’s losses "pale by comparison" to Galleon’s.

As interesting as all of these things are, I suspect there will be more attention-grabbing legal developments about Galleon and Rajaratnam in the weeks and months ahead.

Special thanks to Adam Foulke of the Motley Rice firm for providing me with a copy of the plaintiffs' complaint in the Tamil Tiger case. Special thanks to a loyal reader for providing copies of the opinions in the Herley Industries case.

In Case You Missed It: OakBridge Insurance Services announed yesterday that Mickey Estey and Lance Sunder, both previously of NASDAQ Carptenter Moore,  have joined OakBridge and will be opening offices for the company in the metro regions of San Francisco, CA and Minneapolis, MN, respectively.

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On October 19, 2009, in a securities case from an earlier era involved allegedly misleading statements regarding asset-backed securities, Southern District of New York Judge Harold Baer substantially denied the defendants’ motions to dismiss the plaintiffs’ complaint as amended, following the long-running case’s trip through the Second Circuit on interlocutory appeal. A copy of the October 19 opinion can be found here.

Judge Baer’s decision in the Dynex Capital securities case is noteworthy not only because of the previous high profile appellate decision in the case, but also because Judge Baer found plaintiffs’ amended allegations sufficient to survive the renewed motion to dismiss, after prior pleadings had failed in whole or in part to withstand scrutiny.

Though the case is from a slightly earlier era (it was initially filed in 2005), it raises many allegations similar to those involved in the current round of subprime and credit crisis-related securities lawsuits, and therefore could be influential with respect to dismissal motions in the more recent cases.

Background

Dynex was in the business of packaging mortgage loans into securities. Between 1996 and 1999, Dynex originated or purchased 13,000 mobile home loans that served as collateral for bonds that a unit of the company issued. The underlying loans performed poorly and in 2003-04 the bonds were downgraded by the rating agencies. The bonds’ value dropped by as much as 85%.

The plaintiffs filed a securities class action lawsuit on behalf of investors who had purchased the bonds between February 7, 2000 and May 13, 2004. The plaintiffs allege that the defendants artificially inflated the bonds’ price by misrepresenting that the poor performance of the bond collateral was due to market conditions, concealing that the defendants’ "aggressive and reckless loan underwriting and origination practices generated a pool of collateral loans of poor credit quality and inherent defects."

In a February 2006 opinion (here), Judge Baer granted the defendants’ motion to dismiss the complaint as to the individual defendants for failure to adequately allege scienter, but he denied the motion as to the corporate defendants. In June 2006 he certified his opinion for interlocutory appeal on the question "whether scienter could be adequately alleged against a corporation without concomitant allegations that an employee or officer acted with the requisite scienter."

In 2008, the Second Circuit held (here) that corporate scienter may be sustained even "in the absence of successfully pleading scienter as to an expressly named officer." However, the Second Circuit held that the plaintiffs had not met the standard for corporate scienter, vacated Judge Baer’s prior ruling and remanded the case to allow the plaintiffs an opportunity to replead.

The plaintiff filed a second amended complaint (hereafter, the amended complaint) and the defendants’ renewed their motion to dismiss.

The October 19 Opinion

In their newly amended complaint, the plaintiffs added the statements of nine confidential witnesses and also identified and described for the first time four categories of reports that the plaintiffs alleged put the defendants on notice that their public statements were materially misleading.

Based on the confidential witnesses’ statements, which bolstered the plaintiffs’ allegations about how the defendants accessed and used the identified categories of reports, Judge Baer found that the plaintiffs had sufficiently alleged that several categories of the statements on which plaintiffs sought to rely were misleading and false. These categories included defendants’ statements regarding the adherence to underwriting standards; the defendants’ statements about the reasons for the deterioration in the collateral performance; and the defendants’ statements about the adequacy of the company’s loan loss reserves and internal controls.

More significantly in light of the case’s prior procedural history, Judge Baer found that the plaintiffs had adequately pled scienter. Judge Baer found that the plaintiffs’ allegations about the information available to defendants in the newly referenced documents represented strong circumstantial evidence of scienter. Judge Baer found that the amended complaint, by contrast to the plaintiffs’ prior complaint, "contains factual allegations about several forms of reports that collectively provided to Dynex’s senior management, including the Individual Defendants, information that contradicted their misleading statements."

The information in the documents was "available to and reviewed by the senior management responsible for the public statements at issue that either put them on notice of the falsity of these statements or clearly should have done so." Judge Baer found that the inference of scienter from these allegations was as least as compelling as the contrary inference that the defendants sought to draw.

Judge Baer found that when the amended complaint is viewed "holistically," a "cogent story of securities fraud is revealed":

The Defendants originated or purchased a large number of mobile home loans of generally low credit quality, a substantial number of which were "inherently defective," and packaged them into the Bonds failing to disclose that the stated underwriting guidelines were "systematically disregarded"; then, when adverse market conditions coincided with rising defaults and many loans were uncollectible as a consequence of inherent defects, Defendants publicly stated that market conditions were to blame in an attempt to forestall deeper drops in the value of the Bonds, many of which they held for their own account.

Accordingly, Judge Baer held that the amended complaint "alleges facts giving rise to a strong inference" that the statements he "found to be false and misleading were made with scienter."

Discussion

The Dynex Capital case arose in February 2005, two years before the current round of subprime and credit crisis litigation began, but the plaintiffs’ allegations are remarkably similar to many of the allegations raised in the more recent lawsuits. The fact that the amended complaint largely survived the most recent motions to dismiss is all the more significant given the plaintiffs’ early difficulties in the district and appellate courts in trying to get over the initial pleading hurdles.

The fact that the plaintiffs in the Dynex Capital case were ultimately able to overcome the initial pleading hurdles will obviously be of particular interest to the plaintiffs in the more recent cases. The plaintiffs were able to survive the renewed dismissal motion in this case because of the large number of well-placed confidential witnesses who were able to provide detailed descriptions of the company’s processes and of the key documents and their availability to senior management, as well as how the information in the documents allegedly contrasted with the defendants’ public statements.

Obviously not all plaintiffs in other cases will be able to muster the same number or caliber of confidential witnesses or success in being able to utilize confidential witnesses to show with such particularity what information was available to senior management and how the available information contrasted with public statements.

But the fact that the plaintiffs in this case were able to put those elements together, and were able to do so in a way sufficient to overcome the court’s original skepticism shows that plaintiffs in general can put together allegations to surmount even the heightened scienter pleading standards of the Tellabs case. The fact that these plaintiffs were able to do so after the initial pleading challenges also suggests that in other cases in which plaintiffs initial complaints failed to survive, the pleading defects still may be overcome with sufficiently particularized amended pleading, even on the critical issue of scienter.

In any event, because of the similarity of the allegations on this case to the allegations in many of the current cases, Judge Baer’s recent decision in the Dynex Capital case is likely to be important in the current cases similarly involving asset-backed securities allegedly misleading disclosures about underwriting standards, collateral quality, internal controls and adequacy of loan loss reserves.

Special thanks to Adam Savett of the Securities Litigation Watch blog for providing a copy of Judge Baer’s October 19 opinion.

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Because private equity firms often place representatives on the boards of their portfolio companies, questions can sometimes arise about the interplay between the private equity firms’ and the portfolio companies’ D&O insurance when claims are asserted against portfolio companies’ boards. All too often, these questions are considered only after claims have emerged. However, the better approach is for these issues to be considered at the outset, when the coverages are first put in place.

An October 19, 2009 article entitled "Getting Your Portfolio D&O Insurance Right (The First Time Around)" (here) by Paul Ferrillo of the Weil Gotschal law firm takes a look at the factors to be considered in connection with structuring both the portfolio companies’ and the private equity firm’s insurance in order to ensure that the policies are appropriately coordinated.

The first question the memo addresses is the issue of how much insurance the portfolio company should carry to ensure that the insurance is sufficient "to insulate the sponsor’s own D&O coverage and more importantly the fund from liability." There are, the memo notes, a host of factors to be considered, including how large the portfolio company is and whether or not the portfolio company under consideration is private or public, but the memo correctly points out that the most important consideration is that the portfolio company’s insurance "should be adequate to insure the portfolio company and its directors and officers against risks related to that company."

As the memo notes, the question of the sufficiency of the portfolio company’s policy limits "is not an area to get caught short" because otherwise the private equity firm’s insurance might be looked to in order to "make up the difference."

The memo notes that in addition to the adequacy of the portfolio company’s limits of liability, the adequacy of the terms and conditions in the portfolio company’s policy must also be considered, since neither all D&O policies nor all D&O carriers "are created equal."

The memo lists a number of particularly important policy features to consider, including: making sure the policy is non-cancelable and that the Side A coverage is non-rescindable; confirming that the Insured vs. Insured exclusion has a broad coverage carve back for claims brought by the bankruptcy trustee, receivers or other bankruptcy constituencies; that the policy has a priority of payments clause; and ensuring that the conduct exclusions are fully severable so that no one’s conduct is imputed to another insured person for purposes of precluding coverage. (I have more to say below about the memo’s comments concerning the conduct exclusions.)

The memo also discusses indemnification issues that can arise when private equity firm’s representatives sit on portfolio companies boards. In a prior post (here), I discussed the potentially conflicting indemnification issues that can arise when private equity firm representatives serve on portfolio company boards, and I reviewed recommendations on how these conflicts may be addressed. The law firm memo also notes that the potentially conflicting indemnification obligations could lead to confusion over the applicability of the private equity firm’s and the portfolio company’s insurance. In particular, the memo raises the concern that if these indemnification issues are not addressed in advance, the portfolio company’s carrier might try to claim that the private equity firm’s insurance should "share" in settlement and litigation expense incurred in connection with a claim against the portfolio company’s board.

In order to prevent an outcome that is not a "result that anyone intended," the memo suggests that the private equity firm’s D&O insurance policy should incorporate wording in its "other insurance clause" stating that with respect to a portfolio company claim against a private equity firm representative on the portfolio company’s board, the portfolio company’s D&O policy is primary and the portfolio company’s policy is excess. The portfolio company’s policy should contain "similar clarifying language."

The memo also suggests that the private equity firm and the portfolio company should enter "separate letter agreements" confirming that the portfolio company is the primary indemnitor for advancement, indemnification and D&O insurance purposes.

Overall, the memo provides a good overview of the issues and raises some important considerations. However, I respectfully disagree with the memo on two points.

The first has to do with what the memo describes as important with respect to the conduct exclusions in the portfolio company’s policy. The memo states that the "fraud and personal profit exclusions should contain ‘in fact’ and/or ‘final adjudication" language.

I disagree with the memo’s suggestion that "in fact" and "final adjudication" wordings may be viewed as somehow equally acceptable, as they most definitely are not.

The "after adjudication" wording requires a judicial determination that the precluded conduct has occurred. The superiority of an adjudication requirement is in fact well-established (see for example my discussion here), as an "in fact" wording potentially could permit a carrier to try to deny coverage even though there has been no determination that the precluded conduct actually took place. Contrary to the suggestion in the memo, the "in fact" wording should be avoided. Indeed, in the current competitive insurance marketplace, there will rarely be a circumstance where any insured should have to accept "in fact" wording in the conduct exclusions.

The second point with which I respectfully disagree is the memo’s repeated suggestion that insurance brokers cannot be relied upon to guide firms with respect to the issues raised in the memo. I agree with the memo’s statement that the task of coordinating private equity firm’s insurance with that of their portfolio companies "is not a task for many ‘generalist’ brokers." However, I disagree with the memo’s later suggestions that brokers may not be a reliable source on the issue of carrier’s claims reputations, or that getting the portfolio company’s insurance right is "not a job to leave" to the insurance broker.

Generalist brokers may not be adequately equipped to address these issues, but there are specialized brokers who have the requisite experience and expertise to deal with these concerns. Of course many companies will also find it reassuring to have their outside counsel involved in the insurance transaction, but experienced insurance professionals with the requisite specialized expertise are eminently qualified to put together insurance programs that coordinate appropriately between private equity firms and their portfolio companies.

UPDATE: After this post's publication, I spoke with Paul Ferrillo, the author of the law firm memo referenced above. To be clear, Paul's comments on insurance brokers were only directed to the "generalist" broker without specific cross-training in Private Equity/Portfolio company D&O issues. Paul notes that he has a great many friends on the brokerage side who add tremendous value to complex D&O insurance transactions involving Private Equity firms and their portfolio companies. His practice pointer here was only that this area is a complex one involving both insurance and legal questions, which all must be melded into a wholistic solution for the client.

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One of the questions insurance professionals have been asking with interest and anxiety since the financial crisis began is whether the economic recession will lead to a "hard market" for insurance (characterized by rising prices and tightening terms and conditions).

Earlier this year, Advisen, the insurance information firm, created a stir by predicting that a hard market for insurance would "begin to set in" as early as mid-2009, and in any event no later than 2010. The earlier Advisen report did, however, note that the current recession could reduce the demand for insurance, which in turn could complicate the insurance cycle’s transition. My post about the prior Advisen report can be found here.

In an updated October20, 2009 study entitled "Planning for 2010: The Recession Will Keep Insurance Premiums Under Pressure" (here), Advisen now reports that "while rates are firming in a few isolated segments of the market," overall, due to falling demand resulting from the recession, insurance buyers "will continue to enjoy favorable pricing in 2010," and "materially higher rate levels most likely will have to wait until 2011."

The insurance cycle is basically a result of the shifting relationship between the demand for and supply of insurance. Prices fall when supply increases faster than demand. In order to track these shifting relationships, the Advisen report uses Gross Domestic Product (GDP) "as a proxy for demand," on the assumption that demand for insurance moves in relation to overall economic activity.

The study notes that historically, when the ratio of the supply of insurance (the insurers’ policyholder surplus) to GDP crosses the 3.2 percent mark, either up or down, "the market changes directions within the next 12 months or so." Part of the reason Advisen had earlier this year made its prediction of an approaching hard market is that the ratio fell to about 3.2 percent at the end of 2008 and continued to fall in the first quarter of 2009. However, the ratio crept back up to 3.27 percent at the end of the first half of 2009. Now, "the market remains unsettled with conflicting forces pushing and pulling on both sides of the tipping point."

The reason for this uneasy equipoise is that the recession is affecting both the supply and the demand sides of the equation. On the supply side, declining investment portfolio values has significantly reduced the insurers’ policyholder surplus. On the other hand, reduced economic activity has resulted in lower demand due to reduced numbers of "exposure units" (such as payroll levels, sales, vehicle units, etc.)

Other factors that have complicated the insurance cycle transition are: lower levels of catastrophe losses during 2009 compared to prior years; heightened competition from wounded market participants; the entry of new insurance capacity; and the insurers’ release of redundant loss reserves from prior years. Some of these factors could disappear (for example, catastrophe claims could emerge with little advance warning), or are less likely to be a factor going forward – in particular, loss reserve redundancies "now have been almost fully harvested," which eliminates insurers’ "cushion against adverse developments" and "could contribute to upward pressure on rates in 2010 and beyond."

Even if the recession may have ended as a matter of technical economic analysis, its effects are still being widely felt and the impacts from recovery "will be uneven, leading to further complexity and uncertainty" with respect to capacity and pricing. While these factors will continue to complicate the insurance cycle transition and "delayed the hard market," the shifting elements of the supply and demand equation "favor a modest increase in insurance demand by the end of 2010" – though "materially higher rate levels most likely will have to wait until 2011."

In the meantime, other than in certain areas, commercial insurance rates "on average continue to drift downward, though at a much reduced rate compared to a year ago." With respect to D&O insurance, financial sector premiums have "increased sharply" and financially stressed or highly leveraged companies "are likely to see higher premiums and some may have trouble finding adequate coverage." However other companies can expect to see premiums continue to fall into 2010, though "at a much slower pace."

Even at the time of Advisen’s earlier report, I had commented that "if there is going to be a hard market, its arrival could be more delayed than the report suggests." The more recent report seems consistent with my prior view that a hard insurance market could prove to be a long time coming. At this point, I don’t think I have any better sense of when it might arrive. I do agree that the uneven and gradual nature of the economic recovery could further delay the cycle transition. Unanticipated events (such as significant natural catastrophes) could intervene to accelerate the change, but absent those kinds of developments, the prospects for a market change anytime soon seem remote.

In any event, at 11 am EDT on October 22, 2009, Advisen will be hosting a free one-hour webinar on the State of the Insurance Market and the 2010. Registration for the webinar can be found here.

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The worst of the global financial crisis may be past, and we may even be well on the road to economic recovery, but there still may be considerable pain yet to come, particularly in connection with commercial mortgages. Increased vacancies, declining property values and shortages of refinancing capital could mean increasing numbers of commercial mortgage defaults ahead.

These problems could spell trouble for banks holding commercial mortgage loans, as well as for those who invested in securities backed by commercial mortgages (CMBS). These problems likely will lead to commercial mortgage-related litigation, in what may be the final surge in the credit crisis-related litigation wave.

Background

The business pages recently have been full of tales of commercial mortgage defaults. For example, an October 6, 2009, Bloomberg article (here) reported that hotel foreclosures in California tripled in the first half of this year. An October 13, 2009 Wall Street Journal article (here) reports that declining hotel room demand in Hawaii "means a number of Hawaii’s resorts no longer generate enough revenue to pay the mortgage" and overall Hawaii’s distressed debt tied to hotels totals nearly $1.6 billion.

Similarly an October 15, 2009 Wall Street Journal article (here) detailed the danger of default on the massive mortgage debt of the Peter Cooper Village and Stuyvesant Town properties, which the article noted could "signal[] the beginning of what is expected to be a wave of commercial property failures." The lead article on the front page of the October 16, 2009 Cleveland Plain Dealer asks the question "Will Bad Commercial Loans Leave Cleveland Area Banks Targets" (here).

An August 31, 2009 Wall Street Journal article entitled "Commercial Real Estate Lurks as Next Potential Mortgage Crisis" (here) explores the sources of the problems in the commercial mortgage sector. Many of the mortgage-related problems "are simply the result of bad underwriting." The Wall Street "CMBS machine" lent owners money "on the assumption that occupancy and rents of their office buildings, hotels, stores or other commercial property would keep rising," but now "a growing number of properties aren’t generating enough cash to make principal and interest payments."

Another source of difficulty is that property owners are unable to refinance as mortgages come due. The August 31 Journal article reports that by the end of 2012, $153 billion in loans that make up CMBS are coming due, and as much as $100 billion will face difficulty in refinancing.

Declining property values are contributing to the problem. According to Bloomberg (here), commercial property prices have fallen 39 percent since their 2007 peak. As the Journal article notes, the property values have "fallen so far that borrowers won’t be able to extend existing mortgages or replace them with new debt."

All of this spells serious trouble for already struggling banks. Banks hold $1.8 trillion in commercial mortgages and construction loans, and as the Journal notes, "delinquencies on this debt already have played a role in the increase in bank failures this year."

Indeed, banks’ exposure to commercial mortgage losses is a serious concern for banking regulators, particularly since banks have been "slow to take losses on their commercial real estate loans," according to an October 7, 2009 Wall Street Journal article (here). According to one analysis quoted in the article, banks with heavy exposure to real estate loans have set aside just 38 cents in reserves during the second quarter for every $1 of bad loans. As the Journal article notes, "the recession combined with inadequate loan loss provisions when times were good have left banks dangerously vulnerable to the deteriorating commercial real estate market."

A significant amount of commercial mortgage debt is also held by the pools backing the CMBS. According to an October 2009 memorandum from the Robbins, Kaplan, Miller & Ciresi law firm entitled "Caught in the Credit Crunch: An Investigation into Commercial Mortgage Backed Securities" (here), there was nearly $650 billion in CMBS issuance during the period 2005 to 2007, at the same time as there was a "dramatic decrease in the underwriting standards for commercial mortgages." The recent problems in the commercial real estate sector have "resulted in more loan defaults and potentially significant losses for CMBS investors."

Potential Litigation

The commercial mortgage woes have already led to a certain amount of litigation. By far the most significant number of lawsuits growing out of commercial mortgage problems involves the handful of cases where companies and their directors and officers have been sued by the company’s own shareholders for alleged misrepresentations or omissions about the company’s ability to support its mortgage debt or commercial property acquisition debt obligations. Examples of the companies involved in these kinds of lawsuits include General Growth Properties (about which refer here); Station Casinos (refer here); Perini Corporation (refer here); and MGM Mirage (refer here).

There may well be more of this type of shareholder or investor driven "commercial mortgage disclosure" litigation ahead, as commercial mortgage defaults continue to emerge in the months ahead.

There also seems to be every prospect for litigation to emerge in the wake of bank failures caused by commercial mortgage defaults. There certainly has already been considerable litigation following in the wake of bank failures driven by residential mortgage losses. Example of this kind of residential mortgage-related failed bank litigation include the lawsuits filed by the shareholders of Corus Bank (refer here) and Pacific Capital Bancorp (refer here). At this point, it seems prudent to expect that as rising commercial mortgage defaults lead to further bank failures that there would be similar failed bank litigation pertaining to the banks’ commercial mortgage losses.

The more interesting question may be whether there will be investor litigation relating to the CMBS. The Robins Kaplan memo linked above notes that "while there hasn’t yet been much specific CMBS litigation yet," as the CMBS mature over the next few years, litigation could arise similar to the many lawsuits that have emerged involving residential mortgage backed securities (RMBS).

The law firm memo does go on to note that there could be some practical considerations that could forestall, or at least complicate, prospective CMBS-related litigation. For example, the memo notes, CMBS offering documents "generally have substantially more property specific information" than for example typically was found in RMBS offering documents, which "may eliminate" omission-based claims of the type that have been asserted in RMBS-related litigation.

In addition, as time passes, CMBS investors’ ability to bring ’33 Act claims based on alleged misrepresentations or omissions in the offering documents may face statute of limitations constraints. Indeed, given that the CMBS marketplace ground to a halt in after the financial crisis in September 2008, we may already be past the point where CMBS investors will even have the option to pursue ’33 Act claims alleging misrepresentations or omission in the offering documents, due to the operation of the applicable one-year statute of limitations.

Nevertheless, and despite these litigation impediments, as growing defaults mean mounting losses for CMBS investors, the aggrieved investors likely will seek alternative theories on which to pursue claims, including, for example, common law fraud or misrepresentation. A long-running CMBS lawsuit now being pursued against the Cadwalader law firm and related to a 1997 CMBS offering (about which refer here) dramatically underscores how far into the future the litigation threat may extend. Moreover, if the commercial mortgage-related losses prove to be anywhere near the current theoretical potential, investors will have substantial incentives to pursue claims, even if it means relying on a wider array of legal theories in order to assert their claims.

All of which suggests that there may yet be a further surge of credit crisis-related lawsuits before the credit crisis litigation wave has finally played itself out.

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This past Friday night, San Joaquin Bank of Bakersfield, California became the 99^th bank the FDIC closed this year (refer here) The growing wave of bank failures has been a troubling story all year, and one that unquestionably will get worse before it gets better. But now that the 100^th bank failure of the year is approaching, the mainstream media have noticed and have taken up the story.

The approaching bank failure century mark certainly is noteworthy, but not all of the reporting is appropriately balanced. Some of the media reports have gotten a little overexcited about the whole thing.

Among the recent news reports observing the approaching 100^th bank failure of the year are the October 11, 2009 New York Times article entitled "Failures of Small Banks Grow, Straining FDIC" (here) and Time Magazine’s article, in its October 26^th issue, entitle "Spotlight: Bank Failures" (here). The Cleveland Plain Dealer’s lead article on Sunday October 18, 2009 was devoted to the topic, as well as to the threat that local banks face from souring commercial real estate loans.

The growing number of failed banks is unquestionably an important story and one that rightly deserves the media attention it is getting. But apparently not content with the presently available facts, some media sources have felt compelled to try and sensationalize the story.

Both the Time Magazine and New York Times article linked above repeat the alarmist (and as I detailed here, arguably suspect) forecast that as many as 1,000 banks – approximately one eighth of all the banks in the country – will fail by the end of next year. The Time Magazine article goes even further by reciting without question or comment an unsubstantiated projection that "soured commercial real estate loans may generate a fresh $600 billion of losses by 2013."

Not only is this projection out of proportion to other published commercial real estate loan loss projections – the highest number generally circulating is $100 billion – but it is self-evidently questionable. The total amount of commercial real estate and construction loans held by banks is $1.8 trillion (a figure recited, among other places, in the Times article linked above). How likely is it that one third of all of these loans will become total losses by the end of 2013? To put this question into context, the current commercial loan default rate that has everyone so alarmed is 3.8%.

In the current economy, we have more than enough real challenges to deal with without the media conjuring up projections to try to make things seem even scarier than they already are.

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It is always useful to look at aggregate securities lawsuit filing data to try to determine what trends and themes can be discerned, but occasionally it is also useful to look at a single new filing whether it might suggest anything. To choose one example, a closer look at a new securities class action lawsuit filed on October 14, 2009 in the Eastern District of Pennsylvania against Advanta Corporation and certain of its directors and officers seems to reflect a variety of different securities litigation tendencies and motifs.

Advanta at one time was the country’s largest issuer of Visa and MasterCard credit cards, through its subsidiary, Advanta Bank Corp. As reflected in the plaintiffs’ lawyers’ October 14, 2009 press release (here), the lawsuit alleges that the defendants failed "to disclose the impact of the economic environment and the deteriorating credit trends on its business and that the Company failed to adequately and timely record losses for its impaired loans and customer delinquencies, causing its financial results to be materially false."

Specifially, the complaint (which can be found here) alleges that:

(a) Advanta’s assets contained tens of millions of dollars worth of impaired credit card receivables for which the Company had not accrued losses; (b) prior to and during the Class Period, Advanta had been extremely aggressive in granting credit to customers without verifying the customers’ ability to pay, to such a degree that by the summer of 2009, Advanta customers’ default rate would be almost six times worse than industry average; (c) Advanta’s manipulation of its cash rewards program angered customers and caused the Company to lose good, creditworthy customers; (d) Advanta’s credit receivables were unduly risky due to the Company’s practice of issuing credit cards to small business owners without, in many instances, verifying income; (e) defendants failed to properly account for Advanta’s continuing delinquent customers and the credit trends in the Company’s portfolio, resulting ultimately in large charges to reflect impairments; and (f) the Company was not on track to be profitable in 2008.

The complaint alleges that the company’s share price plunged after its October 2007 disclosure that it was experiencing a higher rate of delinquencies. The complaint alleges that thereafter the news only got worse, and in May 2009 the company announced in May 2009 the cancellation of "millions of cards held by small businesses." On June 30, 2009, the FDIC entered a cease and desist order (here) against Advanta Bank following allegations of unsafe and unsound banking practices.

Though the complaint references these more recent events, the putative class period proposed in the complaint runs from October 31, 2006 through November 27, 2007.

This complaint is of course a reflection of the specific circumstance alleged with respect to this one company and its banking subsidiary. Nevertheless, the complaint also reflects a number of different securities litigation themes and trends, some of which are well-established and some of which may only just be emerging.

First, this case is yet another example of the kinds of litigation that may emerge in connection with the growing numbers of troubled banks. As I have noted in numerous posts (most recently here), though the level of litigation involving failed and troubled banks is still well below what might be expected given the number of distressed institutions, a number of lawsuits have begun to emerge and there may yet be more in the future.

Second, while I have noted elsewhere that as 2009 has progressed the wave of subprime and credit crisis related litigation definitely seems to have slowed (or even just merged into larger litigation developments to the point that it may no longer be its own separately identifiable category of litigation), this case suggests that it is far too early to declare that the litigation wave has ended. Obviously, there may yet be other cases that raise similar credit related lawsuits in the months ahead.

This case also demonstrates with respect to the subprime and credit crisis-related litigation wave that the lawsuits encompass a wide variety of kinds and categories of credit, including, as shown here, credit card debt. As noted here with respect to the litigation involving American Express, there have been prior credit crisis securities lawsuits filed with respect to issues concerning credit card debt.

Third, the 23-month gap between the end of the proposed class period and the filing of this lawsuit is yet another example of the significant number of filings in the second and third quarter of 2009 that involve class period cutoff dates in the distant past. As noted in prior posts (most recently here), this phenomenon might suggest that while the plaintiffs’ lawyer were previously preoccupied filing numerous credit crisis and Madoff related lawsuits, they developed a backlog of cases that they have now started to work off.

Indeed, just in the past several days there have been several other cases with long past class period cutoff dates, including the lawsuit recent filed involving RHI Entertainment (filed on October 8, 2009, class period cutoff of June 19, 2008); Men’s Wearhouse (filed on October 8. 2009, class period cutoff date of January 9, 2008); and EnergySolutions (filed October 9, 2009, class period cutoff date of October 14, 2008).

Apparently, as the Advanta case suggests, the backlog may even include other credit crisis cases, which is yet another reason that, as noted above, there may be still other credit crisis cases yet to come.

In any event, I have added this case to my list of subprime and credit crisis-related securities lawsuits, which can be found here. If this case is any indication, there could be others credit crisis securities cases yet to come.

Courtroom Drama: While we all remain interested in the developments in the ongoing trial in the Vivendi securities class action lawsuit, there is certainly nothing new about courtroom drama, and some of the most compelling courtroom tales have an ancient and venerable pedigree.

A particularly engaging tale of courtroom drama is told in The Life and Times of Constantine the Great, a biography of the Roman emperor by D.G. Kousoulas. During Constantine’s reign, Athanasius, the bishop of Alexandria and one of the protagonists in the long-running Arian controversy, was accused by his foes of murder. An inquest of bishops and imperial officials was convened.

At the inquest, the accusers presented their case against Athanasius, and even produced a blackened hand, allegedly that of the victim, Arsenius. Kousoulas describes the scene:

After the accusers had enjoyed a moment of triumph as they passed the blackened hand around, Athanasius asked in a quiet voice if any of those present knew Arsenius personally. A number of bishops claimed to have known the murdered bishop well. Would they recognize him if they saw him, Athanasius asked. Certainly, they replied, "if he were alive." At that point Athanasius signaled to a man who was standing near the doorway, his face covered with his cloak. The man, his face still covered, moved to the front. "Lift your cloak," Athanasius said. The man removed the cloak and [as a contemporary account noted] "lo and behold it was Arsenius himself." Athanasius moved closer and drew first one and then the other sleeve. Aresenius had both of his hands. "Has God given a man more than two hands?" Athanasius asked with a sarcastic smile.

***

For a moment there was stunned silence. Then one of the accusers declared loudly that all this was sorcery and devil’s work. The man was not Arsenius although he had his face, he was not even human but an illusion produced by Athanasius with his knowledge of black magic. Athanasius asked the bishops to come and touch the man he was accused of having murdered. The meeting turned into a brawl, and Dionysius, the imperial officer attending the meeting on orders from Constantine, had to hurry Athanasius out to save his life.

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Lawsuits alleging violations of the securities laws showed a strong comeback in the third quarter of 2009, according to an Advisen report released on October 14, 2009 (here). The report, the latest in a quarterly series from Advisen, reports that securities lawsuit filings were up "solidly" in the third quarter after a relative decline in the second quarter. Advisen’s report is directionally consistent with my own prior analysis of third quarter securities class action lawsuit filings, which can be found here.

One absolutely critical thing to understand about the Advisen report is that it uses its own unique terminology. As reflected on page 2 of the report, the report uses the term "securities suit" to describe a broad range of lawsuits beyond just securities class action lawsuits. As used in the report, the term "securities suits" includes, beyond the class actions, regulatory and enforcement actions; collective actions outside the United States; lawsuits alleging common law torts, contract law violations and breaches of fiduciary duty; derivative actions; and any other "securities-related suit" that impacts management liability insurance policies other than ERISA liability suits.

In addition, the report uses the phrase "securities fraud suits" to describe regulatory and enforcement actions brought by the SEC and other regulatory and enforcement agencies. Importantly this category of "securities fraud suits" also includes "cases brought by private parties alleging violations of securities laws that are not styled as class actions."

The report notes with respect to the broader category of "securities suits," as that term is used in the report, that there were 169 "securities suits" in the third quarter, which represents an 11 percent increase over the second quarter of 2009.

The report also notes that there were 55 new securities class action lawsuits in the third quarter of 2009, up from 38 cases in the second quarter, but down from 59 in the third quarter of 2008. The securities class action filing rate through the first three quarters of 2009 annualizes to 220 new lawsuits, which is "below the 230 filed in 2008 but well within its historical range."

The class action securities cases were, however, only the second largest subcategory among the larger group of "securities cases" (as that term is used in the report) filed in the third quarter. The largest subcategory among "securities cases" in the third quarter was "securities fraud cases" (which, again, is the term that the report uses to describe securities-related regulatory and enforcement actions, as well as private securities suits that are not filed as class actions), of which there were 70, up from 50 in 2Q09.

Overall, the securities class action lawsuits continue to represent an increasingly smaller proportion of all "securities suit" filings. The report notes that the proportion of securities class action lawsuit filings as a percentage of all "securities suits" has "been on a long downward trend." Whereas in the past, securities class action lawsuits have represented a majority of all "securities suits," in the third quarter, securities class action lawsuits represented just 33 percent of all "securities suits."

The report also notes that though filings against financial firms "remained strong" in the third quarter, new filings were more "widely dispersed" among other sectors than in the first half of the year. The report also notes that new Madoff and credit crisis-related suits "dropped substantially" in the third quarter compared to the first half of the year.

The report also notes the "long-term trend of growing numbers of suits against non-U.S. companies." Specifically, the report notes "the number of large securities suit filings against non-U.S. companies" are on a "long-term growth path."

With respect to potential insurance, the report notes that there is a growing number of "securities suits" that potentially trigger insurance coverage other than D&O insurance. The report notes that this trend "started in 2008 and continued in 2009," largely due to the filing of credit crisis and Madoff-related lawsuits. These cases may even be excluded by D&O policies but covered by E&O or fiduciary liability policies.

The Advisen report introduces a couple of nifty new features this quarter. First, the report includes a "Sector Impact Metric," which is designed to show the degree to which "securities suits" hit various industrial sectors over the past decade. The other new feature is the "Market Cap Impact Metric," which measures the market capitalization loss experienced by companies with securities class action lawsuits.

Speaker’s Corner: On Friday, October 16, 2009 at 11 am EDT, Advisen will be hosting a webinar to discuss the third quarter, in which I will be participating along with Arthur J. Gallagher’s Phil Norton, Zurich’s Paul Schiavone, and Advisen’s David Bradford. The session will be moderated by Advisen’s Jim Blinn. In addition to reviewing trends of securities litigation during the third quarter, the panel will discuss appropriate D&O limits.Registration for the webinar can be found here.

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As noted in a prior post (here), trial in the Vivendi securities class action lawsuit began last week in the Southern District of New York. Thanks to the AmLaw Litigation Daily (here), the transcript of the opening arguments in the case are available here. The opening statements make for some interesting reading in and of themselves, and there are already a number of critical observations that may be made about this case.

Background

This case involves the financial impact on the company from the $46 billion December 2000 merger between Vivendi, Seagram’s entertainment businesses, and Canal Plus. The plaintiffs contend that as a result of this and other debt-financed transactions, Vivendi experienced growing liquidity problems throughout 2001 that culminated in a liquidity crisis in mid-2002, as a result of which, the plaintiffs contend, Vivendi’s CEO Jean-Marie Messier and CFO Guillaume Hannezo were sacked.

The defendants in the case include the company, Messier and Hannezo. The plaintiffs contend that the between October 2000 and July 2002, the individual defendants misled investors by causing the company to issue a series of public statements "falsely stating that Vivendi did not face an immediate and severe cash shortage that threatened the Company's viability going forward absent an asset fire sale. It was only after Vivendi's Board dislodged Mr. Messier that the Company's new management disclosed the severity of the crisis and that the Company would have to secure immediately both bridge and long-term financing or default on its largest credit obligations."

Additional background regarding the case and the plaintiffs’ allegations can be found here.

A prior SEC enforcement proceeding against the company and the two former officers resulted, according to the SEC’s December 23, 2002 press release (here), in "Vivendi's consent to pay a $50 million civil money penalty. The settlements also include Messier's agreement to relinquish his claims to a €21 million severance package that he negotiated just before he resigned his positions at Vivendi, and payment of disgorgement and civil penalties by Messier and Hannezo that total over $1 million."

The Opening Statements

The lawyers making the opening statements on October 6, 2009 were: for the plaintiff class, Arthur Abbey of the Abbey, Spanier Rodd & Abrams firm; for Vivendi, Paul Saunders of Cravath, Swaine & Moore; for Messier, Micheal Malone of King & Spaulding; and for Hannezo, Martin Perschetz of Schulte, Roth & Zabel. The available transcript covers only the statements on the first day of trial, and does not include Perschutz’s opening argument, which took place the morning of the trial’s second day, so I have not discussed his opening argument below.

In his opening statement, Abbey tried to reduce the case to three points:

Number one, we are going to show you that Vivendi had growing problems during 2001 and the first half of 2002...and the problems that they had were with a thing called liquidity. Number two, they didn't tell the truth about those problems....And the third thing that we will prove is that in the middle of 2002, the truth about Vivendi's liquidity condition finally came out, and when that happened, unfortunately for my clients, the stock price fell and the investors that we represent suffered great losses. In a nutshell, that is why we are here today--a growing problem, failing to tell the truth, and then, like every lie, it finally comes out.

The overall theme of the plaintiffs’ case is that the defendants portrayed the company one way publicly, but another way internally:

Publicly, and I can’t stress this enough, defendants portrayed Vivendi as strong, healthy, and growing. They continuously downplayed the risks, the warnings, and they told the investing public how successful Vivendi was and would be in the future. But inside the company, behind the closed doors at Vivendi, the defendants were acknowledging a far different truth.

Among other things, Abbey referred to a "book of warnings" Hannezo supposedly compiled for the new CEO after Messier’s departure from Vivendi, which Abbey characterized as a collection of documents showing various forewarnings and admonitions Hannezo had send Messier and others about the company’s growing liquidity risks. Abbey read to the jury one note that Hannezo wrote to Messier at the end of 2001 following a meeting Hannezo had had with the rating agencies, in which Hannezo said "he felt like he was sitting in the death seat of a car that was accelerating in a sharp turn, and he didn't want it to all end in shame." Abbey emphasized that while Hannezo had been communicating these warnings internally, they were not communicated to investors.

Abbey also argued in his opening that the company was under pressure to meet EBIDTA goals, and he further argued that the company was only able to report that it had met these goals by using, accounting adjustments (Abbey cited internal Vivendi documents referring to "accounting magic"), particularly "purchase accounting." Abbey told the jury that Vivendi never told investors the significant impact purchase accounting had on Vivendi’s reported results. He argued further that while use of accounting adjustments allowed the company to continue to report that it had met EBIDTA goals, the noncash adjustments did not help the company with its liquidity problems.

In support of the plaintiffs’ contentions, Abbey also referred to documents the company had filed in its severance dispute with Messier, in which the company supposedly said that Messier had driven the company "to the brink" yet had failed to disclose the problems to the company’s board.

Saunders, on behalf of Vivendi, argued that, contrary to the plaintiffs’ allegations about the company’s supposed liquidity problems, the company always had enough cash and credit to pay its bills, and in fact did pay all of its bills. He also argued that, contrary to the plaintiffs’ arguments that the defendants had misled investors, the company never had to restate its financials, even after new management came in. Saunders also emphasized that within days of his arrival, the new CEO completed a financing of over $1 billion, which, Saunders argued, demonstrated that even at the peak of the supposed crisis the company had sufficient resources (including credit) to pay its bills.

Saunders also argued that far from representing anything sinister, the company’s use of "purchase accounting" was only entirely appropriate, it was in fact required as a result of the three-way merger.

Saunders conceded that the company did have difficulties during the class period, but largely as a result of the September 11 tragedy and the following decline in economic activity (particularly at the company’s theme park properties). In that regard, he compared Vivendi’s stock price decline to the stock graphs of companies that the plaintiffs’ own expert had said were comparable, and that the stock graphs were virtually indistinguishable.

Finally, Saunders explained the two individuals’ departures from the company as a result of disagreements over the strategic steps the company should take in response to the business challenges it was facing, including a dispute between the board and Messier over whether Vivendi should sell its heirloom French water utility business.

Malone, arguing on behalf of Messier, contended that the plaintiffs’ case depended entirely on discrete "snippets" take out of context from a wide variety of documents, but that when the statements were put back in context, they show only the ordinary activities of business people struggling to deal with day to day business challenges. Malone emphasized the case is not about whether or not the company had problems or even about whether or not there were errors of judgment, but only about whether or not there had been an intentional effort to mislead investors.

Malone also emphasized that when Messier exercised stock options at the end of 2001, he invested all of the proceeds in Vivendi shares, and even took out a bank loan to buy additional shares. Messier also invested his entire April 2002 bonus in Vivendi shares, and indeed, within days of leaving Vivendi, Messier invested even more in Vivendi shares. Malone argued that Messier never sold a share, and that when Vivendi’s share price collapsed, no individual lost more than Messier.

Observations

Though the transcript only represents the arguments of counsel and not the actual presentation of evidence, a number of themes clearly emerge.

First, this case will be complex and will require the jury to grapple with a host of daunting technical terms and concepts. Just in his opening, Abbey referred to EBIDTA; purchase accounting; debt service; noncash earnings; nonoperational accounting entries; free cash flow; liquidity; and dividends. Saunders referred to negative cash flow; generally accepted accounting principles; and market capitalization. Malone referred to options exercises; hedging and hedging transactions; and tax advantages.

It is not that juries are incapable of figuring out these kinds of things. The problem is that these kinds of things put an enormous burden on the lawyers, the witnesses and the court to keep things clear; to avoid letting the trial get bogged down in technical minutiae; and making sure the jury it neither confused nor bored to death.

Second, much has been made (for example, here) of the fact that this Vivendi case is so unusual because it is the first "f-cubed" case to go to trial – that is, it involves claims against a foreign-domiciled company by foreign claimants who bought their shares on foreign exchanges. Whatever else might be said about whether or not f-cubed cases ought to be heard in U.S courts, it is clear just from the attorneys’ opening statements that there are serious challenges involved in attempting to put on one of these cases in a U.S. court. All of the lawyers wrestled with problems, for example, involving currency conversions and language translations. Abbey in particular seemed to experience embarrassment and discomfort using French names and phrases. The lawyers also warned that much of the testimony and many of the documents are in French for which the jury would be given English translations.

In addition, the opening statements also showed the complications that will arise from differing accounting systems, different account practices and standards, and different accounting conventions.

Third, all of the lawyers’ opening statements underscore the problems any plaintiff would face when large unrelated but material events – such as the 9/11 tragedy and the dot-com crash – happened at the same time as the supposed events of which the plaintiffs were complaining. Abbey tried to anticipate these issues and explain the plaintiffs’ theory of how these events should be understood in the context of the plaintiffs’ case. The defense counsel, for their part, showed that the defendants will argue that the challenges the company faced can only be understood within the context of these external events, which are, the defense counsel contend, among the root causes of the company problems involved in the case.

The parallel to the challenges facing the plaintiffs in the current round of subprime and credit crisis-related cases is unmistakable. The plaintiffs in these more recent cases will face the same challenge of attempting to explain how company-specific rather than marketplace-wide developments led to the defendant companies’ problems.

The final observation from a reading of the transcript is that the trial of a complex matter like a class action securities case is an elaborate, time-consuming, pain-staking exercise that could quickly become mind-numbingly tedious. Just judging from the opening statements, the jury could be in for a very long slog. One can only imagine how the jurors’ hearts sank when they heard Messier’s counsel tell them in his opening statement that "this trial will go on for months."

Nor will the verdict of this jury bring an end to this matter. Not only will there likely be further proceedings in this case, but as a result of the court’s class certification ruling in this case excluding Austrian and German investors from the plaintiff class, this case may only be the first of the trials in this matter. As reported in an October 7, 2009 article in the Telegraph (here), the defendants could face a "second trial" brought on behalf of European investors excluded from the plaintiff class in the Southern District of New York. (Hat tip to the 10b-5 Daily, here, for the Telegraph article link).

In my earlier post about the Vivendi trial, I noted how rare trials are in securities class action lawsuits. In an October 8, 2009 post (here) on his Enforcement Action blog, Bruce Carton (also the author of the Securities Docket blog), interviewed Adam Savett of the Securities Litigation Watch blog. In the brief interview, hosted on the Enforcement Docket site, Savett reviews statistical data regarding the prior securities cases that have gone to trial, and discusses why trials in these cases are so rare. He also discusses the significance of the presence of the f-cubed claimants.

They’re a Page Right Out of Hist-oh-Ree: Even allowing for the fact that The Flintstones show was set in the Stone Age, the program advertisement linked below still seems deeply primitive. Clearly, prehistoric peoples had a longer attention span, as the commercial seems almost movie-length compared to its more modern counterparts.

And even allowing for the time lapse since those long ago days, the advertisement’s politically incorrect premise and tobacco-related message seem vestiges of a culture completely unrelated to our own.

Finally, the way that Fred and Barney are sneaking around together and hiding from their wives, you do start to wonder whether the final line in the show’s theme song lyrics implied more than might originally have been suggested.

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Stanford Financial Group’s D&O insurer may advance the individual directors’ and officers’ defense expenses without violating the court’s receivership order, according to an October 9, 2009 ruling by Northern District of Texas Judge David Godbey. A copy of Judge Godbey’s ruling can be found here.

As detailed in a prior post (here), the insurer had been prepared to begin advancing defense expenses of Stanford Group’s former CFO, Laura Pendergest-Holt, subject to a reservation of its rights to later deny coverage under the policy if circumstances should warrant. However, before the insurer began advancing these amounts, the Stanford group receiver had notified the receiver that if the insurer advanced Pendergest-Holt’s defense expenses, the receiver would seek to have the insurer held in contempt of court for violating the court’s receivership and asset freeze orders.

The receiver asserted that the proceeds of the D&O insurance policies are "receivership assets" within the meaning of Judge Godbey’s prior receivership and asset freeze orders. The receiver also argued that his right to the proceeds "supersedes" the rights of insureds under the policy.

Pendergest-Holt filed a motion in the SEC enforcement proceeding (here) seeking a judicial clarification that the receivership order does not apply to the D&O policy proceeds, and alternatively seeking authorization for the disbursement of the proceeds for payment of her defense expense.

The insurer itself had also inquired of the court whether it could advance the defense expenses without "running afoul" of the receivership order. However, the insurer, which has separately filed an action seeking a judicial declaration that the Stanford receivership is not entitled to payment of claims as a result of the operation of policy exclusions, did not request the court in the SEC enforcement proceeding to decide whether or to what extent any insured is entitled to coverage—it sought only to determine whether the receivership order barred it from advancing the individuals’ defense fees.

In his October 9 ruling, Judge Godbey concluded that he did not need to determine whether or not the proceeds were receivership assets, because he concluded that he would exercise "equitable discretion" to permit the payment of defense costs "even if the proceeds were part of the receivership estate."

In deciding to exercise his discretion to allow the proceeds to be advanced for defense expenses, he noted that "there is no argument that the insurance proceeds are potentially tainted by fraud" and therefore "the Court has not duty to preserve them as such." As for the possibility that the insurance premiums might have been paid with "stolen money," he noted that while this might be "unjust and regrettable," that fact "would not entitle victims to proceeds of policies intended to pay defense costs."

With respect to the receiver’s argument that allowing policy proceeds to fund the individuals’ defense expense would "decrease the coverage dollars eventually available for distribution," Judge Godbey found that "the possibility that the D&O proceeds might one day be paid into the receivership does not justify denying the directors’ and officers’ claims." The judge noted that the receiver "has not yet tendered any claims against the Stanford entities to [the insurer] for a defense," noting further that even if it had, "it is not at all clear" that the insurer would ever pay a claim into the receivership, owing to the insurer’s policy defenses.

Finally, Judge Godbey found that the "interests of fairness" justify allowing the individuals to access the insurance proceeds. The receivership’s potential claims are "speculative" while the individuals "expected that D&O proceeds would afford a defense" and the "potential harm to them if denied is not speculative but real and immediate: they might be unable to defense themselves."

Judge Godbey emphasized that in his ruling that his prior orders the insurer from disbursing policy proceeds to fund the individuals’ defense, he was not holding that any defendant "is entitled to have its defense costs paid by D&O proceeds." Moreover, Judge Godbey emphasized that his October 9 ruling does not authorize the insurer "to pay any claims other than defense costs."

Though Judge Godbey ruled only on Pendergest-Holt’s motion, his ruling expressly "extends to any covered officer or director whose claim is approved" by the insurer. Judge Godbey’s ruling seemingly applies to R. Allen Stanford himself, at least to the extent that the ruling represents a determination that the court’s prior receivership orders are no bar to the insurer advancing defense costs.

Whether the insurer will in fact advance Allen Stanford’s defense expenses may be yet to be determined, notwithstanding the October 9 ruling that the receivership order is no bar. An October 9, 2009 Bloomberg article (here) presumes that as a result of Judge Godbey’s ruling, Stanford is now entitled to have his attorneys’ fees advanced. Indeed, absent a judicial "determination" that Stanford in fact engaged in excluded misconduct, the basis on which the insurer might withhold advancement of Stanford’s defense expenses is not immediately apparent, notwithstanding the seriousness of the allegations against him.

The problem for everyone involved is the sheer number of persons who will seek to have their defense fees paid by the insurance and the extent of the collective defense expense. According to the Bloomberg article, as many as 60 Stanford officials are seeking to use the D&O insurance proceeds to pay their legal bills. Moreover, many of these individuals are involved in numerous civil and criminal proceedings.

The total amount of D&O insurance available is not entirely clear from the published reports. The Bloomberg article variously reports that the total insurance limits are "as much as $50 million" and "as much as $90 million" – kind of a big swing on a rather important detail. But the potential for defense expenses in catastrophic claims to substantial erode or even exhaust insurance programs of a similar magnitude has already been demonstrated in other claims (refer for example here).

Given the seriousness of the allegations and the multiplicity of proceeding involved, the various individuals’ collective defense expenses could quickly erode the available limits, particularly if, as seems possible, Stanford himself accesses the policy proceeds for his defense expenses.

It is worth noting that Judge Godbey exercised his discretion to allow the proceeds to be advanced toward the defense expenses, notwithstanding the Stanford entities’ potential claims, even though this policy reportedly lacked a "priority of payments" provision, which would have given the individual defendants priority to the policy proceeds over the entity, as a matter of policy language. As discussed in an October 4, 2009 Business Insurance article (here), this type of provision is now standard in most D&O insurance policies, and might have helped sort out this dispute, although in the end the outcome apparently would have been no different.

Special thanks to William Schreiner of the Zuckerman Spaeder law firm for providing me with a copy of Judge Godbey’s October 9 ruling.

No D&O Policy Coverage Where Claim Made Only Against the Company: In an October 8, 2009 opinion (here), the First Circuit held that a D&O insurance policy does not cover the settlement of a disability discrimination claim that did not name any individual directors and officers as defendants.

The Medical Mutual Insurance Company of Maine had been sued in an administrative proceeding by a former company executive who claimed that the company had discriminated against him due to his stroke-related disability. The administrative proceeding resulted in a "right to sue" letter, pursuant to which the former executive initiated a federal court discrimination lawsuit. Both the administrative complaint and the federal complaint named only the company itself as a defendant.

The company settled the lawsuit and sought coverage under the D&O insurance policy for $325,000 of the settlement amount. The D&O insurer denied coverage under its policy, arguing that because there had been no claim made against an individual director or officer, there was no coverage for the settlement under the policy’s "corporate reimbursement" coverage. (The opinion explains in footnote 3 that while the policy also separately provided "entity coverage" for "securities claims," the discrimination complaint was not a securities claim and accordingly the policy’s separate entity coverage provisions were not implicated.)

In an October 8 opinion written by Judge Bruce Selya, the First Circuit held that the company’s argument that the policy’s coverage extended to claims in which directors and officers were not named as defendants "would if accepted transmogrify D&O policies into comprehensive corporate liability policies," and that "such a transmogrification is contrary to both the letter and the spirit of the D&O policy at issue."

The company had argued that the Policy’s claims made requirement had been satisfied because the underlying discrimination complaint consisted "largely of allegations of misconduct on the part of the directors and officers." The First Circuit held that "no matter what conduct the complaint describes, it is not a claim ‘made against’ any of the directors and officers."

The court went on to note that the policy’s separate requirements of both allegations of wrongful acts and for claims against insured persons "are complementary requirements and allegations of wrongful acts, without more, do not satisfy both."

The First Circuit’s opinion is arguably unremarkable, as D&O policies clearly and separately require both allegations of wrongful acts and claims to be made against insured persons.

The only puzzling thing to me about this case is why there was a D&O insurance dispute at all. The more natural place for the company to have looked for coverage for a claim like this is an Employment Practices Liability (EPL) insurance policy. EPL policies are designed to provide coverage for employment-related discrimination claims and generally provide coverage for claims against the insured organization.

Because I was curious, I ran down the parties’ appellate briefs on PACER. As it turns out, and as might have been predicted, the insured company did indeed also submit this claim to its EPL insurer.

As reflected in the D&O insurer’s appellate brief (here, at pages 4-6), not only did the EPL insurer provide the company with a defense for the underlying claim but it also paid $225,000 toward a total settlement amount of $500,000. The remaining $325,000 portion of the settlement amount for which the company sought coverage under the D&O policy represented the amount the company paid in resolution of the former executive’s unpaid contractual severance and benefits, for which the EPL carrier denied coverage under its policy.

So – that explains why this company was trying to stick what is rather obviously an EPL claim into the D&O policy, because there was a portion of the underlying EPL claim settlement for which the EPL policy did not provide coverage.

In any event, congratulations to my friend and former colleague Leslie Ahari, who represented the insurer in this action.

An October 12, 2009 Law.com article discussing the opinion can be found here. Special thanks to alert reader Marty Fox for providing me with a link to the Law.com article.

The Transmogrifier: For reasons unrelated to the merits or even the issues involved, the First Circuit’s opinion is one of my new favorites -- it is the first judicial opinion of which I am aware using the words "transmogrify" and "transmogrification." (Judge Selya, the opinion’s author, has a well-established reputation for using flamboyant and occasionally obscure language in his opinions.)

The word "transmogrify" in its various formulations was forever immortalized in the Calvin and Hobbes comic strip, in which Calvin turned an empty cardboard box into a "transmogrifier," capable of changing a person into "whatever you’d like to be."

There is a truly wonderful website here dedicated exclusively to the Calvin and Hobbes transmogrifier comic strips. And the excuse to be able to link here to the Transmogrifier site is more than enough justification for discussing the First Circuit opinion above.

Please click through to the site and enjoy the comic strips. They will make you smile. You too could consider turning yourself into a "500-story gastropod, a slug the size of the Chrysler Building." However, do keep in mind, as Calvin reminded Hobbes, that "transmogrification is a new technology."

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In the latest of the subprime and credit crisis cases to be dismissed, on September 30, 2009, District of Massachusetts Judge Richard G. Stearns dismissed the securities class action lawsuit that had been filed by purchasers of mortgage pass-through certificates against Nomura Asset Acceptance Corporation, certain of its directors and officers, the eight mortgage trusts that had issued the certificates, and the offering underwriters who had supported the 2005 and 2006 public offerings of the certificates. A copy of Judge Stearns’s opinion can be found here.

As discussed in my prior post about this case (here), the plaintiffs initially filed their complaint against Nomura in Massachusetts state court, but the defendants removed the case to federal court. After plaintiffs had amended their complaint, the defendants moved to dismiss. More detailed background regarding the case can be found here.

In their amended complaint (here), the plaintiffs alleged that in connection with each of the eight separate certificate offerings, the defendants had misled investors with respect to the loan underwriting by the originators of the mortgages in the trusts; with respect to the originators’ appraisal practices; with respect to level of delinquencies for the mortgages in the trusts; and with respect to the certificates’ investment ratings.

The court first addressed the standing of the plaintiffs to assert claims against the eight trusts, which, Judge Stearns noted, "are separate legal entities" that "each issued its own securities backed by different pools of mortgages." Judge Stearns found that because the named plaintiffs had only bought certificates from three of the eight defendant trusts, "the named plaintiffs are incompetent to allege an injury caused by purchase of Certificates that they themselves never purchased."

Judge Stearns held, based on the "overwhelming weight of authority," that the named plaintiffs lacked constitutional standing to assert claims against the five trusts from which they had not purchased certificates. Judge Stearns also held that the named plaintiffs lacked standing to assert claims against the offering underwriter defendants that had supported offerings only with respect to the five trusts from which the plaintiffs had not purchased securities. Judge Stearns dismissed the claims against the five trusts and the associated offering underwriter defendants.

Judge Stearns also granted the remaining defendants motions to dismiss the plaintiffs Section 12(a)(2) claims. He held that in order to state a claim under Section 12(a)(2), the plaintiffs must allege that they purchased securities from the defendants. However, the plaintiffs alleged only that they "acquired" the securities "pursuant and/or traceable to" the offerings. In granting the motion to dismiss the Section 12(a)(2) claims, Judge Stearns noted that "if plaintiffs did in fact purchase the Certificates directly from the defendants, they should have said so. An evasive circumlocution does not suffice as a substitute."

Finally, Judge Stearns granted the motion of the remaining defendants to dismiss the remaining claims under Sections 11 and 15 of the ’33 Act. He found with respect to the plaintiffs’ allegations concerning the mortgage originators’ underwriting standards that the offering documents contain a "fusillade of cautionary statements" that "abound with warnings about the potential perils." Judge Stearns noted that plaintiffs’ contention that they were not "on notice" of those perils "begs credulity."

With respect to the alleged misrepresentations regarding loan delinquency, Judge Stearns, noting that the allegedly delinquent loans represent 0.1 percent of the mortgages in the pool, stated that "there is no plausible question regarding materiality."

Finally, with respect to the allegations concerning the certificates’ ratings, Judge Stearns noted that while questions regarding the process by which mortgage-backed securities received ratings have arisen in recent months, none of those questions pertain specifically to the ratings of these certificates. Moreover, none of the later developments "support the inference that the ratings were compromised as of the dates" on which the offering documents became effective.

Because Judge Stearns found that the plaintiffs "have failed to allege a sufficient factual basis to support their claims for Securities Act violations," he granted the defendants’ motions to dismiss with prejudice.

The Nomura action is only one of many securities lawsuits that investors have brought against the securitizers that aggregated mortgages into pools that issued mortgage-backed securities. In many of these cases, as in the Nomura case, the plaintiffs have lumped together many different issuing trusts and many different offerings. In some of these cases, the plaintiffs will face the same "standing" hurdles that confounded the plaintiffs in the Nomura case.

And more to the point, the offering documents provided in connection with many of these mortgage-backed securities offerings, like the documents relating to the offerings at issue in the Nomura case, also contained a "fusillade of cautionary statements" that abound with warnings" about the perils.

During most of 2008 and into early 2009, Plaintiffs aggressively filed these types of Securities Act cases against the securitizers, perhaps on the theory that a Securities Act case (for which there are no scienter pleading requirements) might more easily survive a dismissal motion. However, Judge Stearns opinion in the Nomura suit suggests that these cases could face rigorous scrutiny and may also face substantial difficulty getting over the initial pleading hurdles.

I have in any event added the opinion in the Nomura case to my register of subprime and credit crisis-related lawsuit dismissal motion rulings, which can be accessed here.

Special thanks to a loyal reader for providing a copy of Judge Stearns’s opinion.

Full Disclosure: On October 5, 2009, the Federal Trade Commission announced (here) that it had approved final revisions to the guidance it gives advertisers on how to keep their endorsements and testimonials in compliance with FTC requirements. The FTC’s formal Notice of Adoption of the guidelines can be found here.

These new guidelines have received a great deal of attention for the requirements they purport to impose on bloggers. For example, the Wall Street Journal seemed to think that the FTC’s requirements regarding bloggers is front page news (refer here). The guidelines do seek to impose certain requirements on bloggers. For example, in its press release, the FTC stated that "bloggers who made an endorsement must disclose material connections they share with the seller of a product or service."

Everyone here at The D&O Diary wants to reassure our readers that we have accepted no promotional considerations of any kind in connection with matters discussed on this blog. Of course, it is probably fair to note that no one has ever offered us any promotional considerations, darn it. But readers can be assured that if we ever did have the opportunity to accept any promotional consideration, we would fully disclose the consideration in compliance with FTC requirements.

Our "promotional consideration intake operators" are standing by …

Speakers’ Corner: On October 16, 2009, at 11 am EDT, I will be participating in a one hour webinar sponsored by Advisen, about securities litigation during the third quarter of 2009. Joining me on the panel will be Arthur J. Gallagher’s Phil Norton, Zurich’s Paul Schiavone, and Advisen’s David Bradford. The session will be moderated by Advisen’s Jim Blinn.

This webinar will review securities cases filed and settled during the third quarter, include shareholder derivative suits, securities fraud suits, and other categories of securities-related litigation. The registration materials for the webinar can be found here.

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In several prior posts (most recently here), I have noted that defendants seem to be faring particularly well at the dismissal motion stage in the subprime and credit crisis-related lawsuits. However, in recent dismissal motion rulings in two subprime-related cases, one in a securities class action lawsuit and one in an ERISA class action lawsuit, the plaintiffs substantially prevailed, though in each cases portions of the plaintiffs’ complaint were also dismissed. If nothing else, these rulings demonstrate that in at least some of the cases, plaintiffs are to some extent managing to overcome the initial pleading hurdles.

General Growth Properties: In a September 17, 2009 order (here), Northern District of Illinois Judge Milton Shadur denied in part and granted in part the defendants’ motion to dismiss the complaint that General Growth Properties shareholders had filed against the company and eleven of its directors and officers. My prior post about the General Growth action can be found here and detailed background about the case can be found here.

The plaintiffs’ amended complaint contained three separate counts. The first count alleged that in a series of statements during 2008, the defendants misrepresented the company’s ability to refinance debt that was to mature in November 2008. The complaint’s first count further alleged that the company’s COO and CFO had received loans from the CEO’s family trust in violation of company’s ethics policies. Count II of the complaint alleged that the defendants allegedly "rigged the system" by obtaining a short-selling ban from the SEC prior to disposing of extensive share holdings. Count II alleged control person liability.

Judge Shadur granted the motions to dismiss Counts II and III, but denied in substantial part the dismissal motion with respect to Count I.

The defendants had moved to dismiss the allegations in Count I on the grounds that the allegedly misleading statements on which plaintiffs sought to rely all came with the "safe harbor" for forward-looking statements.

Judge Shadur agreed with the defendants that, except as to one of the alleged misrepresentations, all of the statements on which plaintiffs’’ sought to rely were accompanied by "meaningful cautionary language," as required to come within the safe harbor. As Judge Shadur noted, "General Growth’s cautionary statements were in fact entirely anticipatory of Plaintiffs’ claims."

However, even if they were accompanied by meaningful cautionary language, the statements only qualify for safe harbor protection if they were also "forward looking." In a very detailed and painstaking analysis, Judge Shadur went through each of the alleged misrepresentations on which plaintiffs sought to rely and found that while some of the statements were indeed forward-looking and therefore are within the safe harbor, many others were not forward looking and there for outside of the safe harbor.

Judge Shadur found further that the plaintiffs had adequately pled scienter. The defendants had argued that the plaintiffs impermissibly attempted to rely on "group pleading." Judge Shadur noted that, in general, it is insufficient to attempt to infer scienter from individual defendants’ corporate positions and generalized responsibility for corporate actions. However, he found further that the group pleading doctrine "does not render each individual defendant’s position within a company irrelevant."

In this case, Judge Shadur found that "the insider Defendants either had to know about General Growth’s ability or inability to refinance its looming debt, or if they did not, such lack of knowledge would amount to reckless disregard." As a result, Judge Shadur concluded that the defendants’ argument regarding group pleading "is without merit."

Judge Shadur also rejected defendants’ argument that their insider sales could not support scienter, because their sales were "the result of margin calls over which they had no control." However, he noted that the defendants’ arguments in that regard "fail to acknowledge" plaintiffs’ contentions that the defendants "attempted to inflate the stock price in an attempt to avoid margin calls."

Judge Shadur did dismiss Count II of the plaintiffs’ complaint relating to defendants’ alleged scheme to ban short selling of the company’s stock. He noted that "without an explanation as to who played what role in the alleged scheme," Count II fails to meet the pleading requirements. Judge Shadur also rejected the plaintiffs’ control person liability allegations, finding that "without alleging facts other than defendants’ status to support their conclusion, a count for control person liability is improperly pleaded and must be dismissed."

Thus, though Judge Shadur did dismiss significant parts of the plaintiffs’ complaint, a substantial portion of the plaintiffs’ claims remain and those allegations will go forward.

First Horizon: On September 30, 2009, Western District of Tennessee Judge S. Thomas Anderson denied in part and granted in part the defendants’ motion to dismiss the plaintiffs’ ERISA class action complaint that had been filed against First Horizon National Corporation (the holding company for First Tennessee Bank) and its plan fiduciaries.

As reflected in the plaintiffs’ complaint (here), the plaintiffs allege that the company required plan participants to invest in the company’s stock in order to received matching contributions. As of the end of 2005, more than half of the plan’s assets were invested in company stock.

The plaintiffs contend that after January 1, 2006, the investment in company stock was "imprudent" because the bank was lowering its underwriting standards, becoming more heavily involved with subprime and Alt-A loans, and increasing its use of off-balance sheet transactions. The plaintiffs contend that the company’s share price declined when the company announced on April 28, 2008 that it needed to raise $600 million of additional capital.

Judge Anderson granted the motion to dismiss with respect to plaintiffs’ allegations that defendants’ breached their fiduciary duty by requiring participants to invest in the company stock fund in order to receive matching contributions from the company in the form of company stock. Judge Anderson held that because these requirements are part of the Plan itself, the plaintiffs allegations failed to state a claim for breach of fiduciary duty.

However, Judge Anderson denied the defendants’ motion to dismiss plaintiffs’ claims that the defendants breached their duty by failing to take steps to remove the stock from the plan. Judge Anderson noted that the plan gave the defendants discretion to invest plan assets. Thought the plan required the fiduciaries to invest in company stock, " a plan does not impose on a fiduciary an unquestioning duty to follow the terms of the plan when doing so would be imprudent," holding further that under ERISA a plan fiduciary may only follow plan terms to the extent that those terms are consistent with ERISA.

Judge Anderson did dismiss plaintiffs’ claims that the defendants had breached ERISA by failing to provide employees with complete and accurate information about First Horizon’s financial condition, finding that the plaintiffs "have pointed to no provision in ERISA requiring a fiduciary to disclose the specific kinds of risks and factors" the plaintiffs claim the defendants omitted to disclose.

Similarly to the outcome in the General Growth Properties securities case, a material portion of the First Horizon ERISA complaint survived the motion dismiss, even though significant parts of the complaint were also dismissed. In both cases, the claims that survived the dismissal motion will go forward.

I have in any event added both decisions to my register of subprime-related dismissal motion rulings, which can be accessed here.

Court Grants Renewed Dismissal in Fremont General Case: While the plaintiffs in the above cases managed to overcome the initial pleading hurdles at least in part, the plaintiffs in the Fremont General securities lawsuit have now twice failed to survive a dismissal motion, although the court has given them yet another opportunity to amend their complaint to try to cure the pleading defects.

As noted here, Central District of California Judge Florence-Marie Cooper had previously granted the defendants’ initial motion to dismiss, with leave to amend. The plaintiffs subsequently amended their complaint, and the defendants renewed their dismissal motion.

In a September 25, 2009 order (here), Judge Cooper granted the defendants’ renewed motion to dismiss, but with further leave to amend.

As an initial matter, Judge Cooper found that "despite an effort to add allegations that would address the problems identified in the Court’s October 28, 2008 order, the [amended complaint] still suffers from inadequate organization and insufficient specificity to adequately plead falsity and the requisite level of scienter." She noted further that plaintiffs’ "puzzle pleading" makes it "extremely difficult to identify or follow Plaintiffs’ reasoning and to determine – with specificity — which allegations are intended to establish the falsity and scienter requirements."

She concluded that

Lead Plaintiff’s factual allegations are neither sufficient, nor sufficiently particularized, to satisfy the pleading standard for the falsity requirements, nor they [sic] do they articulate facts sufficient to give rise to the requisite strong inference that one or more of the Defendants made the challenged statements with the requisite level of scienter.

Finally, Judge Cooper commented that the plaintiff’s allegations that "Fremont’s underwriting was woefully inadequate and that some or all of Defendants utterly failed to implement policies and procedures sufficient to halt the company’s downward spiral," even if take as true, are "less likely to support an inference of fraud than they are to support an inference of profoundly misguided corporate mismanagement."

Judge Cooper gave the plaintiff thirty days to amend the complaint, but directed further that certain specific statements, which she said were "so broad or vague as to not be actionable" should be "omitted from the amended pleading."

I have also added Judge Cooper’s September 25 order to my register of dismissal motion rulings.

Special thanks to Adam Savett of the Securities Litigation Watch blog (here) for copies of the General Growth and Fremont General decisions.

Special thanks to Stephen Pincus of the Stember Feinstein Doyle & Payne law firm for providing a copy of the First Horizon decision. Pincus represents the plaintiffs in the First Horizon case.

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In a rare case in which a securities suit is actually going to trial, on Monday a jury was empanelled in the Vivendi securities class action lawsuit pending in the Southern District of New York. An October 5, 2009 New York Times article summarizing the background of the case can be found here. A more detailed description of the case can be found here.

The Vivendi trial is unusual in another respect – it involves the claims of so-called "f-cubed" claimants, as detailed in an October 5, 2009 AmLaw Litigation Daily article by Andrew Longstreth (here). That is, the case involves claims by foreign shareholders of a foreign domiciled company who bought their shares on foreign exchanges.

However, because of March 22, 2007 class certification rulings by Southern District of New York Judge Richard Holwell, the class on whose behalf the claims are asserted does not include all potential f-cubed claimants. That is, though the class includes claimants from France, England and the Netherlands, it does not include investors from Austria and Germany.

As the AmLaw Litigation Daily article notes, plaintiffs’ lawyers, who are keenly interested in bringing claims in U.S. courts on behalf of foreign investors, will be watching this case closely.

As noted in a prior post (here), the question of the extraterritorial application of the U.S. securities laws is a current hot topic that could well wind up before the U.S. Supreme Court this term. In addition, as noted here, subject matter jurisdiction over the claims of f-cubed claimants is one of the issues addressed in financial reform legislation recently introduced in Congress.

The Vivendi case is actually the second securities class action lawsuit to go to trial this year. As detailed here, on May 7, 2009, a jury in the Northern District of Illinois entered a mixed verdict in the plaintiffs’ favor in the Household International securities suit.

As reported on the Securities Litigation Watch blog (here), only 21 cases (prior to Vivendi) have gone trial since the 1995 enactment of the PSLRA. Only seven of the 21 cases (including the Household International case) that have gone to a verdict involved conduct that occurred after the PSLRA was enacted. Accounting for post trial motions and appeals (and post-appeal trials), with respect to the seven cases, the current scoreboard standings show three wins for the plaintiffs and four for the defendants.

Credit Suisse Subprime Suit DIsmissed on Jurisdictional Grounds: In a topically related development that also took place in the Southern District of New York yesterday, on October 5, 2009, Judge Victor Marrero released his opinion (here) explaining his prior September 28, 2009 dismissal, on the grounds of lack of subject matter jurisdiction,  of the subpime securities class action lawsuit that had been filed against Credit Suisse and certain of its directors and officers.

As described in greater detail here, the plaintiffs had alleged that the defendants misrepresented the company's financial condition by failing to disclose schemes to overstate assets, underestimate risk, hide subprime exposure, and ignore weaknesses in risk management and internal controls. The risk management and internal control allegations referred to the criminal prosecution of two former U.S.-based Credit Suisse employees, Julian Tzolov and Eric Butler, in connection with their sale of securities to customers of the bank, about which refer here.

In considering the sufficiency of the court's subject matter jurisdiction over the case, Judge Marrero divided the question between the claims of foreign-domiciled claimants who bought their shares in the foreign-domiciled claimants on a foreign exchange (the "f-cubed" claimants) and the claims of claimants who had bought ADRs on the NYSE. Approximately 4.1% of investors had bought their investment through ADRs on the NYSE.

Judge Marrero concluded that the court did not have jurisdiction over the f-cubed claimants,  observing that the plaintiffs "have not adequately alleged or otherwise demonstrated that hte fraudulent schemes...were concocted or masterminded in the United States." He found further that the allegedly misleading statements had originated abroad, and the wrongful acts alleged in the United States (even the alleged criminal misconduct of the two former Credit Suisse employees) fail to satisfy the conduct test for the exercise of jurisdiction over the claims of foreign claimants.

Judge Marrero also held that the court lacked subject matter jurisdiction over the claims of investors who bought ADRs on the NYSE, holding that he could not conclude that the plaintiffs "have demonstrated the required effects on United States investors." This latter result appears largely to be due to "lack of information" and "lack of briefing" on the plaintiffs' part. (Among other things, the amended complaint neglects to specify the domicile of the proposed lead plaintiffs who had bought ADRs on the NYSE.)

Judge Marrero allowed the plaintiffs 20 days to file a motion in which to attempt to show why allowing the plaintiffs to amend their complaint would not be futile.

The contrast between the events yesterday in the Southern District of New York courthouse involving these two cases could not be more stark. On the one hand, a jury is being empanelled with respect to the claims of the f-cubed claimants in the Vivendi case, which appears likely to head to a verdict. Yet in the same courthouse, Judge Marrero issued an opinion in whch he concluded that the court lacked subject matter over the claims of the f-cubed claimants. To be sure, this stark difference between the way the two cases have fared in the courthouse may simply be a reflection of underlying differences between the cases. Nevertheless, the contrast is stark.

Special thanks to a loyal reader for providing a copy of the October 5 opinion.

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One consequence of the current economic crisis that has long seemed inevitable is some form of legislative overhaul of the financial regulatory system. This possibility may have taken one step toward realization with the October 1 release of a package of legislative proposals by Pennsylvania Democratic Congressman Paul E. Kanjorski, the Chairman of the House Financial Services Subcommittee on Capital Markets, Insurnace and Government Sponsored Enterprises.

In his October 1, 2009 press release (here), Kanjorski released "discussion drafts" of three pieces of proposed legislation that, in the words of the press release, are "aimed at tracking key parts of reforming the regulatory structure of the U.S. financial services industry. The three bills include the Investor Protection Act (here), the Private Fund Investment Advisors Registration Act (here), and the Federal Insurance Office Act (here).

Most of the media coverage of these initiatives has focused on the second of these three proposals, the Private Fund Investment Advisors Act, as reflected for example in an October 2, 2009 New York Times article (here) about Kanjorski’s proposals. This proposed Act would for the first time require many financial providers, such as hedge funds and private equity funds, to register with the SEC. The proposed provisions specify recordkeeping and disclosure requirements and provide regulators with the authority to, as the press release states, "examine the records of these previously secretive investment advisors."

The Federal Insurance Office Act, as its name suggests, would create a national office of insurance. It does not appear that the proposed legislation would supplant state regulator of insurance or even provide for the so-called dual option that has been discussed for some time and which would allow insurers to choose whether to be regulated at the state or federal level, as banks do now.

The creation of a Federal Insurance Office would be intended to remedy a perceived "lack of expertise within the federal government" regarding the insurance industry. The new Insurance Office would "provide national policymakers with access to information" in order to allow them to respond to crises and to ensure a "well functioning financial system."

Though it has received less attention, the third piece of proposed legislation, the Investor Protection Act, also contains some potentially significant provisions, including some proposed revisions to the federal securities laws.

The Investor Protection Act contains a number of proposed legislative changed designed to strengthen the SEC and boost investor protection. Among other things, the Act would, according to the press release, double the SEC’s funding over five years and provide "dozens of new enforcement powers and regulatory authorities."

The Investor Protection Act also introduces a number of proposed innovations, including a proposed whistleblower "bounty" that is intended to "create incentives to identify wrongdoing in our securities market." These provisions allow for bounties of up to 30 percent of monetary sanctions imposed on wrongdoers to be paid to whistleblowers, and also provide protection for whistleblowers from retaliation. The proposed Act also includes a number of provisions designed to facilitate collaboration between the SEC and foreign securities regulators. Broc Romanek outlines a number of the other provisions of the proposed Act on his CorporateCounsel.net blog (here).

Among the changes proposed in the Investor Protection Act are the jurisdiction provisions proposed in Section 215 of the Act, relating to "Extraterritorial Jurisdiction."

It has long been noted that federal securities laws are silent about their extraterritorial reach. The courts have long struggled with jurisdictional issues in securities cases involving foreign-domiciled companies – as, for example, was extensively reviewed by the second circuit in its 2008 decision to Morrison v. National Australia Bank (about which refer here) and by the 11^th Circuit in its recent decision in the CP Ships case (refer here).

Section 215 of the proposed Act would in effect legislatively mandate a jurisdictional standard for extraterritoriality. The jurisdictional reach proposed in the statute is very broad. By way of contrast, the defendants and amici in the Morrison case had urged the court to adopt a "bright line" test that would have held that mere conduct in the U.S. alone should not be enough for U.S. courts to exercise subject matter jurisdiction when the conduct had no effects in the U.S.

In its opinion in the Morrison case, the Second Circuit had rejected this proposed bright line test, holding that subject matter jurisdiction exists "if activities in this country were more than merely preparatory to a fraud and culpable acts or omissions occurring here directly caused the losses abroad."

Section 215 would amend the ’33 Act, the ’34 Act and the Investment Advisors Act of 1940 to specify that U.S. courts could properly exercise jurisdiction in any action involving "conduct with the United States that constitutes significant steps in furtherance of violation, even if the securities transaction occurs outside the United States and involves only foreign investors," as well "conduct outside the United States that has a foreseeable substantial effect in the United States." Under the first of these two prongs, U.S. based conduct alone would be sufficient jurisdictional basis, even with respect to foreign purchasers of who purchased their shares of foreign-domiciled companies on foreign exchanges (so-called "f-cubed claimants").

This proposal may represent a legislative effort to head off the Supreme Court, which is currently considering whether to grant certiorari in the Morrison case. Of course, it remains to be seen whether or not this jurisdictional provision will survive the legislative process, or even whether regulator reform legislation in any form remotely resembling the proposal Congressman Kanjorski has put forward.

According to the Times, the House Financial Services Committee has scheduled an October 6, 2009 hearing to discuss this issue of hedge fund regulation, among other issues. Though there is a glut of items on the current Congressional agenda, reform of financial regulation in some form seems likely in the current political and economic environment. What will emerge of course will only be revealed in the fullness of time, but Congressman Kanjorski’s opening salvo suggest that the process could be interesting and that the final outcome could included significant innovations and alterations on a wide variety of topics.

Special thanks to a loyal reader for sending along links to Congressman Kanjorski’s press release.

PLUS Chapter Event: On Wednesday, October 7, 2009, I will be moderating a panel at a Professional Liability Underwriting Society Midwest Chapter event at the Hyatt Hotel in Cincinnati, Ohio. The title of the panel is "Bankruptcy and Barriers to Coverage." The panel, which will go from 3 pm to 5 pm, followed by a reception, will include several of the leading D&O coverage experts. Registration information is available here.

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On September 30, 2009, in a decision that will be widely discussed both because of the high profile figures involved as well as because of the outcome, Southern District of New York Judge Loretta A. Preska ruled (here) that the statute of limitations bars the action brought by the Milberg law firm’s professional liability insurers to rescind the policies they had issued to the firm.

Background

During the period January 31, 2001 through January 31, 2004, the Milberg firm was insured under two professional liability insurance policies issued through the London insurance markets (the "Lead Policies") as well as under an Excess Policy.

In January 2002, Milberg and certain of its partners learned that they were the subject of a criminal investigation. The firm was served with investigative subpoenas. The law firm advised the insurers of the subpoenas and the investigation. The Lead Insurers provided defense expense funding in connection with the criminal investigation pursuant to an interim funding agreement.

The firm and several of its partners were indicted in May 2006. The firm provided a copy of the indictment to the insurers. During 2007 and 2008, four individual partners – Melvyn Weiss, David Bershad, William Lerach, and Steven Schulman – pleaded guilty to criminal charges for paying kickbacks to name plaintiffs in securities class action litigation. (Refer below for links regarding the guilty pleas.) On June 16, 2008, the prosecutor dropped the charges against the law firm itself under a non-prosecution agreement that required the firm to pay $75 million.

On August 26, 2009, the Lead Insurers filed an action seeking to rescind their policies, based on their allegation that they had been induced to provide the insurance by material misrepresentations in the policy application. The Excess Insurer intervened. The defendants moved to dismiss the action on the grounds that it is barred by the applicable statute of limitations.

The September 30, 2009 Decision

In granting the defendants’ motion to dismiss, Judge Preska rejected all of the Lead Insurers’ arguments that their action was not barred by the statute of limitations.

The Lead Insurers first argument was that the defendants should be "equitably estopped" from asserting the statute as a defense, because of the firm’s "emphatic denials" while the investigation was pending that the allegations had any basis. Judge Preska rejected this theory because the defendants failed to show or allege that they had reasonably relied on these denials of criminal guilt. Among other things, Judge Preska commented that:

This case … involves a contractual relationship between an insurer and an insured, both of who are sophisticated parties dealing at arm’s length. The London Insurers were not lulled into believing Milberg’s claims of innocence the same way a patient may be lulled into believing a doctor’s prognosis. And Plaintiffs do not contend that their contractual relationship with Milberg involved a fiduciary relationship such as that in a partnership, in which reliance on a party’s representations might be more justifiable. Therefore, the London insurers have failed to demonstrate that Defendants should be estopped from invoking the statute of limitations.

The court also rejected the Lead Insurers’ suggestion that the statute did not apply because the policy was void at its inception, holding that, notwithstanding the plaintiffs’ arguments, New York’s six year statute of limitations for fraud applied.

In that same vein, she rejected the plaintiffs’ argument that the running of the statute had been tolled because the insurers were providing a defense under a reservation of rights. Judge Preska noted that the plaintiffs "offer no authority holding that an insurer’s defense of its insured is inconsistent with investigating the validity of its contractual duty to defend." She went on to note that none of the cases on which the plaintiffs attempt to rely in support of their tolling argument "remotely suggest that an insurer’s duty to defend give it a special exception for the statute of limitations governing its own rescission claim."

Judge Preska further observed that "rather than awaiting the results of the government prosecution of Milberg, the London Insurers should have conducted their own inquiry into whether Milberg might have committed fraud in obtaining the London policies." The Court found that there was no record that the Lead Plaintiffs took any steps to determine whether the policies "were still valid."

Finally, Judge Preska rejected the Lead Insurers argument that their rescission claim was saved by the two-year discovery rule (that is, they argued that their action was brought within two years of the discovery of the fraud.) She found that because under New York law knowledge of a government investigation "clearly triggers a duty to inquire as to potential fraud," and because the Lead Insurers were aware of the government subpoenas soon after they were issued in 2002, they were put on notice of the alleged much longer than two years before they filed their action.

Judge Preska went commented further that "the most striking example of Plaintiffs’ willful ignorance of their potential rescission claim is their failure to have made any inquiry after Milberg was indicted." A "prudent insurer," she commented, "should have known in July 2006 that it may have a claim against Defendants for rescission." Yet, she noted, even then they undertook no inquiry, so that even if the two-year discover period runs from the time of the indictment, the rescission action "would still be time barred because Plaintiffs did not commence this action until August 2008."

Discussion

If nothing else, Judge Preska’s opinion serves as a vivid illustration of a point I have made many times, which is that courts are hostile to rescission claims. Let it be said, courts don’t like them, even apparently when asserted against convicted criminals.

Because the decision is particularly dependent on New York case law with which I am insufficiently familiar, I am in no position to assess this decision on its legal merits. I will stipulate that this decision could well be completely unremarkable given the governing principles.

But even allowing for these legal principles, I have to say I find this outcome somewhat, well, uncomfortable. I know statutes of limitations exist to encourage diligence and to eliminate stale claims, and therefore must be enforced. There is no doubt that a great deal of time elapsed while these events transpired. And I am well aware the insurers must act promptly in order to assert rescission.

What I am unsure about is exactly what it is that the court thinks the insurers should have done. I can only imagine what might have happened if the insurers had tried to launch their own investigation while the criminal investigation and prosecutions were pending. The criminal defendants undoubtedly would have raised holy hell if the insurers had, say, tried to interview witness or obtain copies of documents. The defendants and their lawyers almost certainly would have accused the insurers of quadruple bad faith for even trying to take those actions. I imagine that the defense attorneys would have argued that the insurers were interfering with or even prejudicing the criminal defense.

I can envision compelling arguments that under these circumstances it was entirely appropriate that the carriers showed forbearance until after the guilty pleas had been entered before taking action – had they acted earlier, they might well have been accused of acting precipitously or worse.

Finally, I am not sure I am entirely comfortable with what this decision implies about what a carrier should do in similar circumstances in the future – perhaps New York law may require insurers who wish to protect their interests to do so, but would it really be a good thing for insurers to interject their own investigation at a time when one of their insureds is accused of criminal misconduct? That strikes me highly undesirable for all concerned.

This is a very high profile case and it obviously will attract a lot of attention and perhaps significant debate as well—indeed, I can well imagine some readers taking vociferous objection to observations here. I am very curious to know readers’ reactions, either to Judge Preska’s opinion or to my observations. I strongly encourage readers to post their thoughts using this blog’s "comments" function.

An October 1, 2009 Business Insurance article discussing the opinion can be found here.

Special thanks to a loyal reader for supplying me with a copy of the court’s September 30 opinion.

Memory Lane: For those interested readers, my original post about the Milberg indictment and its possible effect on securities class action lawsuit filings can be found here. My post about Bill Lerach’s guilty plea can be found here. My post about Mel Weiss’s indictment and Steve Schulman’s guilty plea can be found here. My post about David Bershad’s guilty plea agreement can be found here.

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After a brief lull during the second quarter, securities class action lawsuit filings during the third quarter were closer to historical norms, although the filings levels did drop again during September.

By my count, there were 49 new securities class action lawsuits during the third quarter. For reasons discussed below, my count could vary significantly from third quarter tallies that others may publish. But the 49 third quarter filings brings the year to date total through September 30, 2009 to which brings the year to date total of new securities class action lawsuit filings to 143.

The annualized equivalent of the filings for the first nine months of 2009 projects to a twelve-month filing rate of 191, which is slightly below but still well within range of the average of 197.7 annual filings during the 13-year period between 1996 and 2008.

After a decline in filings during April and May at the end of the second quarter, when there were monthly filing totals of 11 and six respectively, there were 20 new securities lawsuit filings in June. But the number dropped to 17 in July and only 12 in September. Clearly, the filing activity levels have fluctuated month to month so far during 2009.

There may be any number of reasons for this fluctuation, but I continue to believe that the fluctuations are largely due to the fact that the plaintiffs’ lawyers are jammed up with the mass of lawsuits they filed over the last three years. As I have detailed at length elsewhere (here), many of the third quarter filings have proposed class period cutoffs well in the past, in some cases more than a year in the past. These filings may suggest that the plaintiffs’ lawyers have been so preoccupied with the other cases and with the Madoff lawsuits that they developed a backlog, which they are now getting around to working off.

The filings during the third quarter were not nearly so concentrated in the financial sector as during the first half of the year. In the first six months of 2009, about two thirds of the target defendant companies were in the financial sector. However, in the third quarter, only 12 of the 49 new securities lawsuit involved companies with Standard Industrial Classification Codes in the 6000 series (Finance, Insurance and Real Estate). There were also nine new securities class actions involving firms without SIC codes, most of which were financially related companies.

Even if all nine of those companies lacking SIC Codes are counted as financial, that still makes only 21 out of the 48 third court suits in the financial sector. Thus less than half of the third quarter filings were against companies in the financial sector, as compared to over two-thirds in the first half of the year.

One contributing factor in the relative decline in the number of new securities suits against financial companies may be the declining number of new lawsuits relating to the subprime meltdown and credit crisis. Thus, while there have been nearly 200 securities lawsuits filed since February 2007 related to the subprime and credit crisis litigation wave, including as many as 58 total in 2009, only about seven of subprime and credit crisis related cases were filed in the third quarter (depending on how you count).

As I noted in my recent interim update of the subprime and credit crisis related litigation (here), this apparent decline in the cases related to these phenomena may be due to the changing financial circumstances. What started several years ago with the subprime meltdown has evolved into a global financial crisis, affecting all companies across the entire economy. As a result of these developments, it has become increasingly difficult to define precisely what constitutes a subprime and credit crisis-related lawsuit. It may not be so much that the subprime and credit crisis litigation wave has crested as it is that the wave has merged into a larger tidal movement and is no longer its own separately identifiable phenomenon.

The high incidence of lawsuits involving companies without SIC Codes is a reflection of the number of new cases involving unusual lawsuit targets. There were, for example, several filings during the third quarter involving ETF Funds (refer here, here and here, for example). There were also new lawsuits filed involving closed end investment funds (refer here) and mortgage trusts (refer here and here). These actions are a continuation of the filing activity we have seen for several quarters, as a wide variety of complex financial firms and investment vehicles have been and continue to be drawn into securities litigation.

But though the third quarter filings, as was the case with the filings in the first half of the year, involved a number of these unusual targets, many of the companies named in third quarter lawsuits are more representative both of the larger economy and of more traditional securities litigation targets. Overall the companies named as defendants represented over 30 different SIC Code categories. For example, six of the third quarter filings involved life sciences companies in the 2830 SIC Code category and three involved filings against medical device companies in the 3840 SIC Code category.

By contrast to the first six months of the year, relatively few of the third quarter filings involved foreign domiciled companies. Thus, while 18 of the first half lawsuits involved foreign companies, only two of the third quarter lawsuits involved foreign companies. Many of the foreign targets in the first half of the year were financial companies, so the relative decline in filings against foreign companies may simply be a reflection of overall reduction in lawsuits against financial firms.

The new securities lawsuit filings in the third quarter were not nearly so heavily concentrated in the Southern District of New York as in the first half of the year. Thus, while in the six months of 2009, 45 out of 94 (or nearly half) of the new securities lawsuits were filed in the Southern District, only 12 of the 48 third quarter filings (or only 25%) were initiated in the S.D.N.Y. Again, this relative decline may be a reflection of the reduced number of lawsuits involving financial companies.

About Counting: As has been the case in recent quarters, the process of "counting" new securities lawsuits continued to be quite challenging during the third quarter. As has been the case in the past, I have not counted breach of fiduciary duty/merger objection lawsuits. In addition, I have also excluded from my count the "failure to register securities" lawsuits when these suits have been filed in state court (refer for example here), or even if filed in federal court assert only state law claims (refer for example here). In addition, the recurring phenomenon of lawsuit involving nontraditional financial vehicles makes it extremely challenging, given the outward similarity of many of these vehicles and their names, to tell whether or new complaint represents a new or a duplicate lawsuit.

These kinds of sorting issues inevitably result in some line drawing and some marginal categorization issues. Reasonable minds clearly could differ on many of these sorting concerns.

The bottom line is that my lawsuit count for the third quarter and for the first nine months almost certainly will differ from similar tallies that other may publish – indeed, for the same reason, the various other tallies will also likely disagree with each other as well. Certainly, anyone trying to come up with their own count that were to include, for example, merger objection suits or failure to register claims, would reach a substantially different number than the one I came up with.

I emphasize these counting issues, as I have in the past, as a way to try to explain the differences that may appear in the various published accounts. No one should be surprised by the differences, although consumers of the counting data have every right to know what has been included and excluded from any given count in order to understand how and why the count differs from other published versions.

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