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

Oral argument in the Morrison v. National Australia Bank case, now before the U.S. Supreme Court on a petition for writ of certiorari, is scheduled to take place next week, on Monday March 29, 2010. The case presents questions about the extraterritorial application of the U.S. securities laws, questions of growing importance in light of increasing globalization of financial activity. My prior discussion of the Second Circuit’s ruling in the case can be found here.

While the NAB case represents the first time the U.S. Supreme Court will directly address these issues in the context of the U.S. securities laws, this is far from the first time the Court has been called on to address the extraterritorial application of U.S. law.

For example, the court has previously addressed the extraterritorial application of the U.S. antitrust laws. Most recently in the Court’s 2004 decision in Hoffman-LaRoche Ltd. v. Empagran S.A. (here), the Court held that it was unreasonable to apply U.S. antitrust laws to foreign conduct where the resulting foreign injury was independent of any domestic injury.

However, thought the Empagran case does address questions of extraterritorial application of U.S. laws, it may provide relatively little insight into how the Court might address the issues in the NAB case, since the Court in the Empagran case was interpreting an express statutory provision addressing the extraterritorial application of the U.S. antitrust laws, the Foreign Trade Antitrust Improvement Act of 1982. There is no equivalent statutory provision with respect to the securities laws – at least not yet. A brief overview of the extraterritorial application of the U.S. antitrust laws can be found here.

The question of extraterritorial application of U.S. laws comes up in a variety of contexts. Stetson Law Professor Ellen Podgor points out on her White Collar Crime Prof Law Blog (here) that a February 2010 petition for a writ of certiorari in the British American Tobacco case raises the question of the extraterritorial application of RICO. A copy of the cert petition can be found here.

In addition, according to a March 2010 paper by the Hughes Hubbard law firm (here), the question of extraterritoriality also comes up in the bankruptcy context. Just as there are practical advantages that would lead a foreign investor to pursue securities claim in U.S. courts under U.S. laws, there are reasons why a foreign domiciled debtor might decide to "enjoy the shelter of chapter 11 of the U.S. bankruptcy code," which the foreign debtor apparently can do if it has assets in the U.S. and a U.S. bankruptcy court accepts jurisdiction.

The fact is that in a complex global economy where cross-border business transactions are an integral part of financial activity, questions involving the extraterritorial application of law are inevitable.

Because of these fundamental considerations, the NAB case is both an important case and a closely watched case. The case has attracted fifteen amicus briefs, including briefs filed, among others, on behalf of the governments of Australia and of France. The United Kingdom and Northern Ireland also filed an amicus brief, here. The foreign governments urge that principles of comity and respect for the sovereign rights of nations to govern their internal affairs militate against the exercise of jurisdiction by U.S. court over the claims non-U.S. claimants against non- U.S. companies. All of the Supreme Court briefs in the NAB case can be found here.

Among the briefs is an amicus brief filed by the U.S. Solicitor General. The SG has urged that a transnational securities fraud violates the U.S. securities laws if "significant conduct material to its success" occurs in the United States and if the U.S.-based component of the fraud directly causes the claimant’s injury. (The SG’s brief also argues that the questions before the court are not jurisdictional at all, but rather simply the plaintiffs are entitled to relief under the relevant statutory scheme.)

I am going to go out on a limb here and make a prediction that the test that emerges from the Supreme Court is going to look a lot like that urged by the Solicitor General. That is, it will not be enough for claimant to allege merely that the U.S. conduct to be "a substantial component of the fraud," but rather the U.S. conduct must have directly caused the claimant’s injury. That is, the court will look at some sort of nexus to the injury test.

By way of illustration, in the NAB case itself, the alleged underlying financial fraud took place in Florida but the allegedly misleading disclosures were issued in Australia. Under the test urged by the SG, the misleading disclosures caused the claimant’s injury, not the underlying financial misconduct, and therefore the case should not go forward in U.S. courts.

Hiatus: The D&O Diary will be taking a break from its usual publication schedule for the next few days. Normal publication activities will resume the week of April 5, 2010.

Service Announcement: I just wanted to remind readers that I will be changing the service that I use for email notifications. The change will take place during the week of March 29, 2010.

The critical message here is that current email subscribers who wish to continue to receive email notifications will have to reconfirm their subscription.

If all goes according to plan, on March 29, readers will received an email message from me at The D&O Diary. The email message will require you to resubscribe in order to continue to receive email notifications from The D&O Diary. Please follow the links in the resubscription email in order to continue to receive email notifications.

Because of the break in the publication schedule, the first email notification from the new service will not arrive until the week of April 5.

• Email This
• Print
• Comments
• Trackbacks
• Share Link

On March 24, 2010, Cornerstone Research released its annual study of securities class action lawsuit settlements. The most recent study, which is entitled "Securities Class Action Settlements: 2009 Review and Analysis" and is written by Ellen M. Ryan and Laura E. Simmons, can be found here. Cornerstone’s March 24, 2010 press release concerning the study can be found here.

The study reflects a number of interesting observations about median and average securities class action lawsuit settlements that were approved during 2009. The study also includes a useful analysis of the factors that affect settlement size, and concludes with some commentary about likely future settlement trends.

First, the median 2009 settlement of $8.0 million is unchanged from 2008, although slightly up from the $7.4 median of all settlements during the years 1996 through 2008.

Second, the 2009 average settlement amount of $37.2 million is up from the 2009 average of $28.4 million. The 2009 average of $37.2 million is well below the $55.4 million average of all settlements during the period 1996 through 2009. However, if the largest four settlements during the period 1996 through 2008 are removed from the analysis, the average 2009 settlement of $37.2 million is slightly higher than the adjusted $34.4 million average for the 1996 to 2008 period.

(This analysis of average settlements excludes the settlements associated with the IPO Laddering cases, which given the number of cases resolved in that settlement has the effect of distorting the average settlement values.)

Third, the distribution of 2009 settlements also is comparable to prior years. Almost 60% of all settlements during the period 1996 through 2009 are below $10 million, and more than 80 percent settled for less than $25 million. Settlements in excess of $100 million remain relatively infrequent, occurring in approximately 7 percent of all cases.

Fourth, according to the study, the largest single most important factor is the amount of so-called plaintiffs’ style damages (that is, "damages" calculated using the methodology most often urged by securities class action plaintiffs). However, settlements as a percentage of plaintiffs’ style damages generally decrease as damages increase, and this observation is particularly valid for very large cases.

Fifth, the Cornerstone also assesses settlement values relative to what it calls Disclosure Dollar Loss, which compares the defendants company’s stock prices on the days before and the days after the corrective disclosure. The study reports that settlements as a percentage of the disclosure dollar loss generally decline as the loss increases.

The study also identified a number of other factors that affect overall settlement size:

1. GAAP Violations: Approximately 65% of 2009 settlements involved cases included alleged violations of GAAP. These cases "continued to be resolved for larger settlements that for cases not involving accounting allegations.

2. Auditor Defendants: Cases in which auditors are defendants settle for a relatively higher percentage of estimated plaintiffs’ style damages even when compared to the broader set of all cases in which improper accounting allegations were made. Since the cases filed in 2009 involve an increased number of auditor defendants even while the overall number of filings declined compared to the prior year, the presence of auditor defendants could become an increasingly significant factor in future settlements.

3. Financial Restatements: Approximately 45 percent of 2009 settlements involved financial restatements, which contrasts with reports of declining numbers of financial restatements. However, given the general lag between filing and settlement, the 2009 settlements generally involve cases filed during the 2004 to 2006 period, which was when the most significant numbers of restatements occurred.

4. ’33 Act Allegations: After controlling for the presence of underwriter defendants and controlling for other factors, the inclusion of ’33 Act claims does not result in a statistically significant increase in settlement amounts.

5. Institutional Investors Plaintiffs: Cases involving institutional investors as lead plaintiffs are associated with significantly higher settlements. The higher settlements are associated with cases involving public pension plans as lead plaintiffs as opposed to union funds or other institutional investors. These larger settlements may be due to the fact that the sophisticated investors get involved in the stronger cases and the larger cases. However, even when controlling for case size and other factors the presence of a public pension plan as lead plaintiff is still associated with a statistically significant increase in settlement size.

6. Companion Derivative Suits: Securities class action lawsuits associated with companion derivative cases are associated with statistically significant higher settlement amounts.

7. SEC Enforcement Actions: Cases that involve SEC actions are associated with significantly higher settlements, as well as higher settlements as a percentage of estimated "plaintiffs’ style" damages.

The study concludes with the observation that the economic environment during 2009 "did not have a distinguishable effect either on the number of settled cases or on the total value of securities case settlements approved during the year.’

The study also notes that as a general matter the securities class action lawsuits associated with credit crisis largely have not yet settled. Looking ahead, the study’s authors "anticipate that as these cases are resolved, settlements are likely to increase both in number and in value."

Discussion

As has been the case in prior years, Cornerstone’s analysis of the 2009 settlements is interesting and full of useful information. There are a number of important considerations to keep in mind in assessing the information in the study.

The first is that the Cornerstone analysis is limited exclusively to aggregate amounts paid in settlement of securities class action lawsuits. It does not reflect, or even provide any indication of, settlement amounts that were or were not paid for out of D&O insurance.

Second, the settlement values do not reflect costs incurred in connection with the defending the securities class action lawsuits, or any related proceedings (for example, derivative suits or SEC enforcement proceedings). In considering the Cornerstone data for purposes of assessing D&O limits adequacy, appropriate adjustment would have to made for associated defense expense. Given the incredible escalation of defense expenses in recent years, the adjustment required to accommodate likely defense expense is substantial.

Third, the data set upon which the Cornerstone analysis is based is limited exclusively to class action settlements. In recent years, however, there has been the increased incidence of claimants opting out of the class settlement and reaching their own separate settlements. This phenomenon potentially increases the aggregate dollar costs required to resolve all related securities litigation, which is an additional factor that needs to be taken into account in connection with the overall question of D&O limits adequacy.

• Email This
• Print
• Comments
• Trackbacks
• Share Link

In a March 23, 2010 Summary Order (here), the Second Circuit affirmed the March 2, 2009 ruling of Southern District of New York Judge Gerald Lynch, in which he held that the excess insurers’ prior knowledge exclusion precluded coverage under their policies for claims brought against former Refco directors and officers.

Background

As detailed in a prior post about Judge Lynch’s district court order (here), at the time that the Refco scandal emerged, Refco had $70 million of D&O insurance arranged in multiple layers. The primary and first level excess insurers advanced their entire combined $17.5 million limits of liability in payment of defense expenses. In a separate ruling not involved in this appeal, Judge Lynch ruled that the second level excess insurer also must advance its defense expense.

In his March 2, 2009 ruling (here), Judge Lynch granted summary judgment for the third and fourth level excess insurers, based on exclusions in those policies (not found in the underlying policies) precluding coverage for claims arising from any facts or circumstances of which "any insured" had knowledge at policy inception and that might reasonably be expected to give rise to the claim. (In a portion of his opinion not relevant to this appeal, Judge Lynch denied summary judgment as to the fifth level excess insurer.)

The critical question before Judge Lynch was whether the knowledge of the fraudulent scheme of Refco’s CEO Phillip Bennett could be imputed to the other directors and officers. These individual had sought to rely on so-called severability provisions in the primary policy, to which the excess policies were "follow form," and from which they sought to argue that the prior knowledge exclusion was not applicable to them. Their argument was that Bennett’s knowledge could not be imputed to them due to the non-imputation language in the primary policy’s severability provision.

Judge Lynch rejected their argument that the severability provision in the primary policy precluded the operation of the prior knowledge exclusion in the excess policy.

The Second Circuit’s March 23 Summary Order

In its March 23 Summary Order, the Second Circuit expressly adopted Judge Lynch’s "comprehensive and well-reasoned analysis." The Court quoted Judge Lynch’s language that "in the context of the [prior knowledge exclusion] the words ‘any insured’ unambiguously precludes coverage for innocent coinsureds."

The Second Circuit also expressly affirmed that because the exclusionary language in the excess policy "cannot be reconciled with the severability language provision of the underlying policy, the language in the excess policy controls." The Second Circuit also affirmed that the claims against the individuals come within the "arising out of" preamble of the exclusion.

Discussion

As I detailed in my prior discussion of Judge Lynch’s opinion, this case illustrates the complicated ways that the various components of a single D&O insurance program can operate in unanticipated ways to produce unexpected results. The case also demonstrates the extent to which supposed "follow form" excess coverage is not always truly "follow form."

The outcome also underscores the importance of application and exclusion severability issues not just at the primary levels but all the way up the insurance tower.

My other ruminations about this outcome are set forth at length in my prior post about Judge Lynch’s opinion.

The Second Circuit’s Summary Order states on its face that it has no precedential effect. However, the practical effect of the Summary Order is the validation of Judge Lynch’s analysis, to which future litigants undoubtedly will refer.

It is probably worth noting that while Judge Lynch was a district court judge in March 2009 when he wrote his coverage opinion in the Refco case, by the time the Second Circuit got around to reviewing the case, Judge Lynch had become a member of the Second Circuit bench, where his new Circuit Court colleagues found his prior work as a district court judge to be "comprehensive and well reasoned." Perhaps the preservation of domestic tranquility around the courthouse water-cooler requires no less.

Special thanks to Neil McCarthy of Lawyer Links for providing me with a copy of the Second Circuit’s Summary Order.

• Email This
• Print
• Comments
• Trackbacks
• Share Link

In the largest weekly collection of bank failure so far this year, the FDIC took control of seven banks this past Friday evening, bringing the 2010 year to date total of failed banks to 37. The YTD total already far exceeds the 2008 annual total of 25 failed banks and the pace of the 2010 closures is well ahead of last year’s pace, when a total of 140 banks closed by year end.

The closures this past Friday night included three more banks in Georgia, bringing the 2010 year to date total in that state to five, and the total since January 1, 2008 to 35, by far the highest number for any state during that period.

The only other state with as many as 2010 closures as Georgia is Florida, which also has five failed banks in 2010. Since January 1, 2008, Florida has had a total of 21 failed banks, which ranks the state fourth overall during that period, behind Georgia, Illinois (25), and California (24). During 2010, Illinois has three failed banks and California has two.

Two other states that have significant numbers of 2010 bank closures are Minnesota and Washington State. Minnesota has four 2010 YTD bank failures and eleven total since January 1, 2008, Washington has four failed banks this year and seven total since January 1, 2008.

Overall 17 states have had at least one bank failure in 2010. Although there is a perceptible concentration of bank failures in Georgia and Florida, the 2010 failed banks have been widely dispersed geographically.

This overall geographic spread has characterized the current wave of bank failures since its beginning. Indeed, since January 1, 2008, 36 different states have each had at least one failed bank. There has, however, been some concentration in certain states, particularly Georgia, Illinois, California and Florida.

The pace of bank closures so far in 2010 is well ahead of the pace during 2009. At this same point a year ago, there had only been 20 failed banks, compare to 37 so far this year. The 37^th bank closure last year did not take place until June 5, 2009.

The pace of bank failures definitely has quickened in recent months. During the 27 month period since January 1, 2008, here have been 202 bank closures. However, of those 202, 132 (or roughly two-thirds) have failed just in the nine months since July 1, 2009.

Although there has been no single month that has come close to the July 2009 total of 24 failed banks, the 15 so far this month is tied with the third highest monthly total since the early 90’s.

The 2010 bank closures continue to be concentrated among the smaller banks. 29 of the 37 bank failures so far this year have involved institutions with assets under $1 billion. (Of course, there are many more institutions with assets under $1 billion, so in that sense this distribution may not be surprising.)

The pace of bank failures has remained at elevated levels over the past nine months. Given that in its last Quarterly Banking Profile, the FDIC identified 702 banks as "problem institutions" as of December 31, 2009, the heightened pace of bank failures seems likely to continue for some time to come.

But while the number of failed banks continues to grow, there has not yet been an equivalent wave of failed bank litigation. Indeed, at least one lawsuit brought by a failed bank’s investors has been withdrawn.

As I noted in an earlier post (here), in December 2009, nearly 60 investors in New Frontier Bank had brought suit against certain former directors and officers of the failed bank. However, the Greeley (Colo.) Tribune reported on March 17, 2010 (here), that the investors are withdrawing their lawsuit out of concerns about insurance coverage and out of recognition of the FDIC’s priority rights as receiver to the bank’s claims. Based on the article, I am no entirely sure what the investors’ insurance coverage concerns are, but I have previously written about the FDIC’s priority rights here.

The New Frontier Bank’s investors’ expectation is that the FDIC will pursue claims against the former directors and officers of that bank. Indeed, the expectation in general has been that the FDIC will pursue these kinds of claims with respect to many of the banks that have failed during the current round of bank closures. Certainly during the S&L crisis, the FDIC pursued claims against former directors and officers of roughly a quarter of the banks that failed (as detailed here). There no reason to assume that the FDIC will not be similarly litigious this time around. But at least so far lawsuits brought by the FDIC as receiver against the directors and officers of failed banks have yet to materialize in significant number.

Travel Hell: On Saturday March 13, 2010, I was scheduled to catch a flight from Cleveland to Newark at 5:55 pm, where I was to catch an 8:45 pm flight to London. At around 3 pm on Saturday, I received an email from Continental Airlines advising me that my flight to Newark was delayed due to weather and that it would not arrive in Newark until 8:30 pm.

Because of concern that I would miss my connection in Newark, I called Continental. They advised me that the 2:00 pm flight from Cleveland to Newark was also delayed and had not yet left Cleveland, and perhaps I could catch that flight and still make my connection.

I sprinted to the airport and managed to get a seat on the delayed 2:00 pm flight. However, as the afternoon turned into evening, all of the Newark bound flights were pushed back further and further. (There were huge storms in the New York area that night.) Eventually, the delayed flights were scheduled to leave Cleveland after the scheduled departure time of the London flight. I threw in the towel and booked myself on the first flight to Newark in the morning, and then I went home.

The 8:45 am flight from Newark to London, meanwhile, left Newark right on time. I suspect it was the only flight that entire weekend that was on schedule.

The next morning, I was up at 4:00 am (which felt like 3:00, due to the daylight savings time change), and I went to the Cleveland airport to start all over again. My 6:25 am flight to Newark was also delayed somewhat, but I made it to Newark by about 8:30 am, in plenty of time for the 10:00 am connection to London.

However, the airplane that was to be used for the London flight had been delayed coming out of Lima, Peru the prior evening, and it did not actually arrive in London until about 11:30 am.

After the plane from Peru arrived, there was a long delay, and finally about 12:45 pm, there was an announcement that while en route from Lima, the plane had been hit by lightening, and it was being taken out of service. A new plane would have to be brought to the gate.

We finally started to board the new plane at around 2:00 pm. The plane was entirely full and the boarding process took a long time. Finally, after everyone had boarded, the captain came on the P.A. and announced that the crew had timed out, and there would have to be a delay while the crew rested. So – everyone off the plane. The new departure time announced was 12:45 am.

After several lonely lifetimes haunting the concourse at Newark, we finally boarded the plane at 2:00 am. After everyone had boarded, the captain came on the P.A. and announced that the plane had a flat tire, and so we would have to get a new plane. So—everyone off the plane.

After everyone was off the plane, it was discovered that everyone’s boarding passes had expired. So everyone had to get new boarding passes.

After everyone had their new boarding passes, we boarded yet another new plane at around 4 am. Astonishingly, at about 4:45 am, the plane finally departed.

About three hours later, while the plane was approximately over the middle of the Atlantic Ocean, a flight attendant came on the P.A. and said, "If there is a doctor on the plane, could you please ring your flight attendant call button." About ten minutes later, the flight attendant came back on the P.A. again and said, "If there is anyone on the plane who is qualified to read vital signs, could you please ring your flight attendant call button."

For the rest of the flight, the flight attendants rushed back and forth with worried faces. When we finally reached the gate at Heathrow, a crew of EMTs boarded the plane and they removed a very grave looking older man from the plane.

After I took a taxi into London, I finally arrived at my hotel around 5 pm local time on Monday – about 46 hours after I first left my house on Saturday. I had missed all of my Monday meetings.

I left my hotel to return home at about 5 am on Wednesday morning, about 36 hours after I had finally arrived. In other words, I spent ten hours less in London than I had spent trying to get there.

On the other hand, though it was pretty bad for me, it was worse for the guy they carried off the plane on stretcher.

Service Announcement: Readers may have experienced a variety of different problems with the email notifications for this blog. There have been duplicate notifications, late notifications, missing notifications -- and the problems have been getting worse.

As a result of these problems, I will be switching to a different service provider for delivery of email notifications. I am still not 100% sure when the switchover will take place, but probably some time in the next few days.

When the change does occur, every current email subscriber will receive an email requiring them to confirm their subscription. This is important – if you wish to continue to receive email notifications, you will need to reconfirm in order to reactive your subscription, so that you will receive email notifications from the new service provider.

I apologize for any inconvenience this change may cause, but in light of the recurring problems with my existing email notification service, I had to take corrective action. Please let me know if you have any difficulties with the change.

• Email This
• Print
• Comments
• Trackbacks
• Share Link

In recent decisions in separate subprime-related securities class action lawsuits reflecting a common unwillingness to engage in "backward looking assessments," two different Southern District of New York judges granted defendants’ motions to dismiss. In each of the cases, the judge’s recognition of the extent of the financial crisis played into their rulings, and in the absence of specific allegations showing how internal information or knowledge differed from the defendant companies’ public statements, both judges were unwilling to allow the cases to go forward.

The State Street Case　

In a February 22, 2010 opinion (here), Southern District of New York Judge Richard Holwell granted with prejudice the motion of defendants to dismiss the subprime-related securities class action lawsuit that had been filed against State Street Corporation, its management arm, and two executives and eight trustees of the management arm and one of the funds it managed, the Yield Plus Fund.

According to the complaint, the Fund’s value declined 34% during the class period of July 1, 2005 and June 30, 2008. This decline was alleged to have reflected the write-downs of the value of the Fund’s mortgage-related holdings. The Fund was liquidated on May 30, 2008.

The plaintiffs claimed that the Fund’s offering documents reflected three categories of misrepresentations: (1) a misleading description of the Fund’s investment strategy; (2) misrepresentations of the extent of Fund’s exposure to mortgage-related securities; and (3) inflated valuations of the Fun’s mortgage-related holdings. Based on these alleged misrepresentations, the plaintiffs sought to recover damages under the liability provisions of the Securities Act of 1933.

With respect to the plaintiffs’ allegations that the defendants’ misrepresented the Fund’s investment strategy, by misrepresenting its goal to invest in "high-quality debt securities," Judge Holwell found the plaintiffs had insufficiently pled falsity. He noted that though the phrase "high quality" is "somewhat vague when read in isolation," it "surely cannot be understood as a guarantee that investors would not suffer losses."

Judge Holwell also observed that the plaintiffs cannot allege that it was false for defendants to describe the Fund’s investments as high quality "without averring facts showing that the investments’ actual quality …was in fact otherwise." Judge Holwell went on to observe that:

Of course, from our vantage point on the other side of the financial crisis, it is conventional wisdom that highly rated, investment grade securities were exposed to risks that the rating agencies did not perceive….And not surprisingly, the Fund sustained most it is calamitous losses on securities with high investment ratings. …In hindsight then, it could be alleged that investments were viewed by defendants – and the marketplace – to be "high quality"…in fact stood on shaky foundations. But the accuracy of the offering documents must be assessed in light of information available at the time they were published…A backward-looking assessment of the infirmities of mortgage-related securities, therefore cannot help plaintiffs’ case.

 

As to the plaintiffs’ allegation that the offering documents misrepresented the Fund’s exposure to mortgage-related securities, Judge Holwell concluded that the plaintiffs had not alleged sufficient to plead that the Fund’s investment categorizations were materially misleading.

Finally, Judge Holwell held that plaintiffs’ allegations that the Fund overstated the value of its mortgage-related holdings "fail" because the Complaint "does not aver a single concrete fact to suggest that defendants deviated from the prescribed valuation methods." Judge Holwell noted that other financial entities, including even other mutual funds, have been accused of carrying mortgage-related securities on their books at inflated values, but in light of these other accusations, "the Complaint’s failure to identify information about how State Street overvalued its holdings is telling."

The CIBC Case　

In a March 17, 2010 opinion (here), Southern District of New York Judge William H. Pauley III granted the motions to dismiss the subprime related securities class action lawsuit filed against defendants Canadian Imperial Bank of Commerce (CIBC) and four of its officers and directors.

CIBC is a Canadian bank whose shares are traded on the New York and Toronto stock exchanges. The plaintiffs allege that the defendants misled investors about CIBC’s exposures to mortgage-backed securities.

In granting the motions to dismiss, Judge Pauley noted that not only had none of the defendants benefited from the alleged fraud, but in fact both CIBC and three of the four individuals bought CIBC shares during the class period. Judge Pauley noted that "it is nonsensical to impute dishonest motives to the Individual Defendants when each of them suffered significant losses in their stock holdings and executive compensation."

Judge Pauley also noted that the complaint "makes no reference to internal CIBC documents or confidential sources discrediting Defendants’ assertion that they were only adapting to a ‘rapidly changing economic environment’ during a ‘once-in-a-century credit tsunami’." He added that the plaintiffs "should, but do not, provide specific instances in which Defendants received information that was contrary to their public declarations."

Judge Pauley also noted a "compelling" alternative explanation for CIBC’s statements:

The Complaint describes an unprecedented paralysis of the credit market and a global recession. Major financial institutions like Bear Stearns, Merrill Lynch, and Lehman Brothers imploded as a consequence of the financial dislocation. Looking back, a full turn of the wheel would have been appropriate. That CIBC chose an incremental measured response, while erroneous in hindsight, is as plausible an explanation for the losses as an inference of fraud. …CIBC, like so may other institutions, could not have been expected to anticipate the crisis with the accuracy Plaintiff enjoys in hindsight.

Judge Pauley also found that the complaint "is bereft of factual allegations from which a reader could infer Defendants intentionally or recklessly failed to take write-downs on U.S. mortgage backed securities."

Judge Pauley’s dismissal order is not expressly without prejudice; however, he does close his opinion with the observation that "any request for leave to file an amended consolidated class action complaint should conform to this Court’s Individual Practices."

CIBC was represented by Jay Kasner and Scott Musoff of Skadden Arps. Andrew Longstreth's March 18, 2010 AmLaw Litigation Daily article about the CIBC decision can be found here. Special thanks to the several readers who sent me copies of the CIBC ruling.

Discussion

These two opinions, both out of the Southern District of New York, where so many of the subprime and credit crisis-related securities class action lawsuits were filed, share a number of similar and significant features.

First and foremost, in both instances, the judges were reluctant to subject the defendant company’s pre-credit crisis disclosures to hindsight judgment. The courts were simply unwilling judge as fraudulent the defendants’ failure to anticipate the crisis that arose later.

Nor were the courts receptive to the arguments in both cases that the defendants knew their companies were vulnerable or knew that things were already going wrong. That is, without more specific details about what the defendants supposedly knew and how that differed from public statements, the courts were unwilling to let the cases go forward.

These two judges’ unwillingness, in light of the magnitude of the financial calamity, to engage in "backward-looking assessments," is a judicial predisposition that plaintiffs in many of these cases will have to struggle to overcome. Absent internal documents or confidential witness testimony showing internal company knowledge or information different from public statements, many other subprime and credit crisis cases may face the same fate as did the complaints in these two cases.

These ruling underscore how critical confidential witness testimony is. Indeed, as I noted here, in cases in which renewed motions to dismiss were denied after initial motions to dismiss had been granted, the critical additional detail that convinced the courts to allow the amended complaints to go forward was the addition of allegations supported by confidential witness testimony. In the absence of that corroborative support, courts seemingly are much more likely to follow their predisposition to avoid backward looking assessments.

In any event, I have added these two rulings to my register of subprime and credit crisis related dismissal motion rulings, which can be found here. The interim scoreboard continues to show that motions to dismiss in these cases are continuing to be granted in disproportionate numbers, at least so far than is the case for the universe of all securities class action cases. My recent status update of the subprime and credit crisis related litigation can be found here.

And Finally: "Outside of a dog, a book is man’s best friend. Inside a dog it’s too dark to read." Groucho Marx

• Email This
• Print
• Comments
• Trackbacks
• Share Link

Within the space of just a few days, two federal appellate courts – the Fifth and Sixth Circuits – issued separate opinions consider D&O insurers’ obligations to advance defense expenses. The Fifth Circuit entered its March 15, 2010 decision in the high-profile Stanford Financial insurance coverage dispute. The Sixth Circuit’s March 11, 2010 opinion was entered in an insurance coverage dispute involving Abercrombie & Fitch and a rather unusual set of circumstances surrounding the company’s D&O insurance policies. The Sixth Circuit’s opinion was also accompanied by a rather spirited dissent. Both decisions are interesting and provide illuminating perspective on D&O policy interpretation.

The Fifth Circuit’s Stanford Financial Decision

The March 15 Opinion

The Fifth Circuit’s March 15, 2010 opinion (here) arises out of the expedited appeal of Stanford Financial’s D&O insurers to the January 26, 2010 opinion of Southern District of Texas Judge David Hittner entering a preliminary injunction prohibiting the insurers from "withholding payment" of defense expenses from four individuals (including Allan Stanford) who face SEC and criminal actions in connection with the Stanford Financial scandal. My prior discussion of Judge Hittner’s ruling can be found here. 

Stanford Financial had $100 million D&O insurance. The primary policy contained a fraud exclusion which does not apply absent a "final adjudication" that the prohibited conduct had occurred. The policy also contains a "money laundering" exclusion, which the insurers contend precludes coverage. The money laundering exclusion specifies that it does not apply "until such time as it is determined that the alleged act or acts did in fact occur."

In its March 15 opinion, the Fifth Circuit considered whose determination of the facts this exclusionary provision requires. The court emphasized that the provision does not specify that the insurer was to make this determination. The court commented that "while there is nothing remarkable about an insurer reserving the right to make a unilateral coverage decision, it is equally unremarkable to require an insurer to be explicit when doing so, rather than leaving the reader to ponder the word ‘it’."

The Fifth Circuit also considered the wording contrast between the fraud exclusion, which requires a "final adjudication," and the money laundering exclusions "in fact" wording, and observed that the difference between the two exclusions’ wordings boils down to the judicial proceeding in which the determination is to be made. The "final adjudication" provision, the Fifth Circuit reasoned, requires the determination to be made in the underlying proceeding, but the money laundering exclusion’s "in fact" determination wording requires a judicial determination but allows that determination to be made in a separate proceeding such as a coverage action.

The Fifth Circuit also held, in contrast to Judge Hittner’s ruling at the district court level, that the evidence relevant to this determination is not limited to the "eight corners" of the insurance policy and the underlying complaint; rather, the policy’s terms expressly contemplate the consideration of "extrinsic evidence" in the determination of policy coverage.

The Fifth Circuit remanded the case to the district court, with the added proviso that a judge not involved in the underlying criminal proceedings should consider the insurance coverage issues. The remanded case will be the "collateral vehicle" in which coverage is to be determined.

In the interim, until the determination, the insurers are obligated to advance defense costs until the merits are resolved. To that extent, the Fifth Circuit affirmed the district court’s preliminary injunction enjoining the insurers from withholding payment of defense expenses until the judicial determination.

However, the determination cannot be "final" until the underlying proceeding is resolved, because "a determination of the facts on remand unfavorable to the executives would have to be reconsidered should the executives be cleared of all charges."

Discussion

The money laundering exclusion in the Stanford Financial D&O insurance policy is an unusual provision not found in many D&O insurance policies, and the wording arguably also reflects an unusual and awkward formulation. As the Fifth Circuit said of its own work and of the policy, its construction "is a sensible construction of an awkwardly drafted instrument."

But the Fifth Circuit’s analysis represents more than just a detailed exposition of an awkwardly worded and atypical clause. Most D&O policies have conduct exclusions requiring "determinations" as a prerequisite to the exclusions’ application to a particular set of circumstances. The Fifth Circuit’s orderly analysis of the determination processes implied by various policy formulations will undoubtedly inform future judicial consideration of the "determination" language found in the more typical D&O policy exclusions.

In particular, the Fifth Circuit’s analysis implying a requirement of a judicial determination in the first instance, and precluding unilateral insurer determinations unless expressly provided for, will illuminate coverage analysis whenever these types of conduct exclusions are at issue.

And in the underlying cases, the individual defendants will have their defense expenses advanced, for now, on an interim basis, until there is a determination in the collateral coverage case, and subject to the outcome of the underlying proceedings. Depending on how all of these circumstances unfold, the coverage dispute could go on for a considerable time. For now at least the individuals will be able to fund their defenses.

The Sixth Circuit’s Abercrombie Opinion

The March 11 Decision

In its March 11, 2010 opinion in the Abercrombie & Fitch coverage action, the Sixth Circuit affirmed the district court’s determination that Abercrombie’s D&O insurer must advance defense expense incurred in connection with the underlying claim. The Sixth Circuit’s opinion can be found here.

The coverage dispute arose out of an unusual sequence of events. Abercrombie had been insured by a $10 million D&O insurance policy that expired on September 1, 2005 (hereafter, the predecessor policy). On September 2, 2005, Abercrombie and certain of its directors and officers were sued in a securities class action lawsuit. Subsequently derivative suits were also filed and an SEC investigation ensued. On September 30, 2005, Abercrombie exercised its right under the predecessor policy to purchase one-year extended reporting period coverage.

Abercrombie also purchased a successor D&O insurance policy with a different insurer with a policy period incepting on September 1, 2005. The successor policy was amended to specify that the successor policy is expressly excess to the predecessor policy for any claims made regarding acts occurring prior to September 1, 2005. The parties to the coverage dispute agree that if the successor policy lacked this excess provision, the predecessor and successor policies would both be primary and would pay loss for the claim (including defense expense) on a pro rata basis.

The predecessor insurer contended that in this deal shifting the burden to provide primary coverage exclusively to the predecessor insurer, Abercrombie violated the policy’s cooperation clause, which specifies that "in the event of a claim," the policyholder "will do nothing that will prejudice [the insurer’s] position or its potential or actual rights of recovery."

The Sixth Circuit rejected the predecessor insurer’s argument, holding that the "purpose" of the cooperation clause, including its "no prejudice" provision, was to "enumerate the parties’ respective rights and obligations when a claim was made against an insured," but it "does not address the parties’ rights and obligations when a policy has elapsed, a claim has been made against a (formerly) insured, and the insured is deciding whether to elect – and how to structure – extended insurance coverage."

The Sixth Circuit added that "there is nothing about" the cooperation clause that "prevents Abercrombie from making fiscally driven business decisions, even if such a decision is unanticipated by an existing or past insurer." The Sixth Circuit also adopted the district court’s statement that it is an "unreasonable interpretation" of the cooperation clause "to find that it requires Abercrombie to structure its insurance needs based not on its own needs and its own best interests, but rather to minimize the insurers’ potential exposure."

Judge Kethledge’s Dissent

Circuit Judge Raymond Kethledge dissented. He emphaszied that the successor policy incepted on September 1 and as originally written was primary, and in fact, Abercrombie first reported the September 2 claim to the successor insurer. Then on September 29, Abercrombie elected discovery coverage, which Judge Kethledge noted "seemed a strange thing to do," since the $820,000 extended reporting period coverage was seemingly duplicative of the coverage in place under the successor policy.

Abercrombie was, Judge Kethledge wrote, "behind the scenes" negotiating with the successor insurer, for the successor insurance to be excess to the predecessor insurer’s coverage. It was not until November 22, 2005 that the successor policy was endorsed to make the successor policy expressly excess.

The effect of these changes, Judge Kethledge noted, was "retroactively to foist" on the predecessor insurer "the entire burden of coverage for the claim up to the $10 million policy limit." The reason Abercrombie did that, and was willing to pay the $820,000 premium for the extended reporting period coverage, was that in exchange the successor insurer waived its $2 million retention for the securities claims and promised not to increase Abercrombie’s premium for the following renewal.

Judge Kethledge viewed these events as having "prejudiced" the predecessor insurer in violation of the "no prejudice" provision in the cooperation clause, because it extinguished the predecessor insurer’s right to collect half of the claims costs from the successor insurer. Judge Rutledge noted that the "very purpose" of Abercrombie’s post claim action was to "increase [the predecessor’s] liability by $5 million and to extinguish its contribution claim for that amount." Judge Rutledge found the no prejudice clause’s requirement that the policyholder "do nothing" to prejudice that predecessor to be unambiguous and to clearly govern these circumstances.

Discussion

What makes this situation so awkward is that Abercrombie’s negotiations with the successor insurer took place after the claim arrived. The opinion is not sufficiently clear on this point, but it seems as if at the time of the September 1, 2005 renewal the successor insurer competed to move onto the account and then got smacked by a claim airmailed in the second day it was on the policy.

It isn’t clear who initiated the negotiations, but the successor insurer was bargaining to reduce its exposure to the walk in claim. Reading between the lines, the predecessor insurer’s gripe is not with Abercrombie but with the successor insurer, for (as Judge Kethledge put it) "foisting" the claim on the predecessor insurer.

The deal Abercrombie and the successor insurer struck clearly benefited both of them – the successor insurer reduced its claim expense (for a claim that was clearly made during its policy period), and Abercrombie was able to obtain valuable concessions.

I can certainly see why the predecessor insurer objected under these circumstances. The question is whether as a matter of contractual rights and duties (as opposed to more basic notions of fair play) the detrimental impact of the successor insurer’s deal with Abercrombie represents the kind of "prejudice" that violates the provisions of the cooperation clause.

On the one hand, as a result of the deal, the predecessor insurer was obligated to do nothing more than it was otherwise obligated to do under the extended reporting period coverage, which all agree that Abercrombie was entitled to purchase, even if it did so after the claim came in.

On the other hand, the predecessor insurer’s rights and obligations under its policy also include the right to proceed against alternative sources of recovery. Abercrombie’s entry into the deal with the successor insurer compromised the predecessor insurer’s rights and it did so after the claim had come in. You can certainly see the predecessor insurer’s argument that this violated the requirement that the policy "do nothing" after a claim to prejudice the predecessor insurer’s right of recovery.

The majority found that there is nothing in the policy to prevent Abercrombie from structuring its insurance according to its own interests. There is certainly nothing here to suggest that Abercrombie did anything to prejudice the underlying claim. Moreover, there is nothing about the "no prejudice" provision that requires a policyholder to subordinate its interests to those of the insurer, and that consideration seems particularly relevant after a policy’s expiration.

In the end we may all nod sympathetically in response to the plight of the predecessor insurer here. Our sympathetic nods, however, reflect the sentiment expressed in the words of Judge Keithridge’s dissent: "What is legal is sometimes different than what is right."

And Finally: "Cigarettes are very like weasels – perfectly harmless unless you put one in your mouth and try to set fire to it." Boothby Graffoe.

• Email This
• Print
• Comments (4)
• Trackbacks
• Share Link

Data security and privacy could be the "stealth issue of 2010," according to a recent report. Despite the intense focus on financial and related issues during the current economic crisis, a variety of legislative and regulatory initiatives suggest that data privacy and security issues necessarily will become a top corporate priority. These developments have important risk management consequences, among which are the increasing importance of privacy breach and network security liability insurance within a company’s overall insurance program.

Recent Regulatory and Legislative Action

A March 12, 2010 Law Technology News article entitled "The Evolving Landscape of Data Privacy" (here), takes a comprehensive look at the various recent regulatory and legislative developments raising the importance of data security and privacy issues.

As the article emphasizes, several new federal and state privacy regimes go into effect this year. In particular, the FTC’s long-delayed Red Flag rules will become effective on June 1, 2010. These rules will require "financial institutions" and "creditors" (as those terms are defined in the rules) to implement a written identity theft protection program designed to detect the warning signs of identify theft, to prevent the crime, and to anticipated the damage it inflicts. The FTC’s guide to the new rules can be found here.

In addition, the Massachusetts Office of Consumer Affairs and Business Regulation has promulgated its "Standards for the Protection of Personal Information of Residents of the Commonwealth" (here), which applies to persons who "own, license, store or maintain personal information about a resident of the Commonwealth of Massachusetts."

The regulation requires all affected persons to "develop, implement, maintain and monitor a comprehensive, written information security program applicable to any records containing such personal information." The regulations include the requirement that the affected persons must "adopt comprehensive security programs that include technical administrative and physical safeguards for both electronic and paper records."

The state level action in Massachusetts suggests the possibility of similar actions in other states, which raises the specter of a confusing patchwork of different regulatory requirements, a situation that cries out for uniform regulation at the federal level. In that context it is hardly surprising that there are Congressional initiatives in this area as well.

On December 8, 2009, the House passed the Data Accountability and Trust Act (H.R. 2221), about which refer here. The legislation would, among other things, require all businesses to implement safeguards to protect reasonably foreseeable data vulnerabilities and to notify customers if their personal information is breached. Similar initiatives are receiving Senate consideration. Though the Senate has a great deal of other things on its plate right now, it is possible this legislation could still get through, perhaps as part of another larger bill (for example, a financial reform bill).

Practical Steps, Including Insurance Solutions

It seems probable that these kinds of regulatory and legislative initiatives will continue to emerge in the months and years ahead. In light of these concerns, the article cited above suggests that companies adopt compliance strategies, including: reviewing how their firms safeguard non-public customer and employee data; adopting risk-based safeguards and controls that encompass industry best practices and make use of available technology; and reviewing their firms’ data privacy policies and notices.

In addition to these practical steps, every company’s data privacy and security risk management should also include the acquisition of a privacy breach and network security liability insurance policy. These policies have been available for some time, but in recent years, both their availability and their scope of coverage have improved significantly. There are now a variety of commercially attractive insurance products available in this area.

Because this insurance product is relatively new, there still is some skepticism over the need for this type of insurance protection. Some of this resistance is simply due to the lack of familiarity with the numerous and growing sources of exposure in this area. As time goes by and the extent of corporate vulnerabilities becomes increasingly apparent, this reluctance will eventually fade, a process that will undoubtedly be accelerated by the increasing amount and extent of the growing regulatory requirements.

Another source of skepticism about his product arises from the view that the consumer actions that have been filed so far have not fared particularly well. Some of the consumer cases have indeed been unsuccessful (refer for example here), in part because consumers have a difficult time showing proximately caused damages. In light of consumer concerns when data breaches occur, however, it seems likely that consumers affected by data breaches will continue to bring these kinds of actions, which at a minimum means a continuing defense costs exposure.

Companies that suffer data breaches will continue to have both notification and remediation requirements, which even in relatively modest breaches can entail an enormous expense. A recent study relating to data security breaches in the United States (link unavailable) shows that the average 2009 per-incident costs were $6.75 million. The costs included an average cost of $204 per customer with a potentially compromised data record.

In addition, companies sustaining data breaches are subject to the costs of regulatory investigations, as well as penalties and fines. While not all of these costs will be insured in every instance, remediation costs and legal expense will be covered in many instances. Many policies offer fines and penalties coverage on a sub-limited basis under certain circumstances.

Finally, because of the likelihood that plaintiffs’ lawyers will continue to press these issues when data breaches occur, there is a continuing danger that plaintiffs lawyers will succeed in imposing liability on persons they contend are responsible for the data breach. The policies cover negligence or failure to protect or safeguard confidential data, even for acts of rogue employees or vendor employees. Some policies will apply in instances of employee negligence such as lost or stolen laptops.

Some of the insurance products also provide protection in the event of cyber extortion, for example in connection with the threat of a disclosure of a security breach or a denial of service attack. Some policies also provide first party coverage in the event of electronic business interruption or reimbursement coverage for the cost to replace or reconstruct digital assets.

Insurance for privacy liability and network security is still a developing product area, but with the passage of time, more and more companies are recognizing that their insurance programs are incomplete without this kind of protection. The evolution of this product very similar to where we were several years ago when Employment Practices Liability insurance came along. At first, takeup of the product was slow. But over time the product improved and the need for the insurance became more self-evident, and now pretty much every company has EPL insurance. Within a very short time, the same will also be true of privacy liability and network security insurance.

The fact is that, particularly in the current regulatory and legislative environment, every company is susceptible to these kinds of problems and so every kind of company should consider this insurance as an important part of a complete corporate insurance program.

• Email This
• Print
• Comments (1)
• Trackbacks
• Share Link

In their terrific new book "Circle of Greed: The Spectacular Rise and Fall of the Lawyer Who Brought Corporate America to Its Knees," Patrick Dillon and Carl M. Cannon detail the fascinating story of Bill Lerach, who rose to the pinnacle of his profession only to be brought down by criminal wrongdoing. My review of the book appears here.

While I was reading it, I began to wonder about the Pulitzer-prize winning journalists who had written the book and what they thought about their subject and their project. I approached them and asked them if they would be willing to answer some questions. To my surprise, they said yes.

I have set out below my written Q&A exchange with the authors. The text in italics following the Qs represents my questions, and the text following the As represents their answers.

Q: Why did you write a book about Bill Lerach?

A: He’s a great story, and we’re journalists – it was a natural. Bill Lerach’s life and career is a classic parable. We couldn’t resist.

Q: Lerach cooperated with your work on this book. What effect do you think this had? What would you say to any reader who thinks his cooperation meant that you soft- pedaled what you wrote?

A: We’d tell them to read the book. We hardly soft-pedal Bill Lerach’s crimes or his rough edges. Bill is on record as telling other journalists that he thought we were tough, but fair. We’ll accept that description. And Bill cooperated without ever so much as asking to see a single word of this manuscript before it was published in its final form. To us, that willingness to let the chips fall as they might demonstrated a gutsy pragmatism and a confidence in his own story that we couldn’t help but admire.

Q: You obviously drew on many difference sources in gathering your material for the book. Did you run into any particular problems in trying to gather information?

A: Much of the material was in the public record. We found other troves in our own files in our attics and basements as we both had written about Learch earlier in our careers. Most of the lawyers and other key actors were generous with their time. Our big regret is that Lerach’s law partner Melvyn Weiss would not consent to an interview.

Q: Your book is rich in anecdote and detail. What do you think was the most interesting thing you found in gathering information?

A: Well, Kevin, you’ve read it so you know. Fascinating scenes crop up throughout this narrative—because they did in Bill Lerach’s life. He seemed at times to be a real-life (if very smart) version of Forrest Gump. We hope these tales delight readers as much as they did the authors when we came across them: The preposterous art theft that led to the criminal case against Milberg Weiss; the epic trials pitting Lerach against the Methodist Church and, later, against the entire "Chicago school" of business. Bill doing legal battle with the great Sam Witwer; sweet talking iconic leftist Jerry Voorhis, the congressman defeated by Richard Nixon; Bill funneling money to Bill Clinton and then asking him for a veto; wringing a dramatic apology from John McCain; tangling with New York plaintiff’s lawyer Sean Coffey; cross-examining Roy Disney; jousting with Kirk Kerkorian; readying for holy war against Dick Cheney and Halliburton, suing every Silicon Valley entrepreneur you ever heard of; prevailing in Enron. Writing this book sometimes felt like being on a treasure hunt.

Q. Your book reports on Lerach’s question whether his criminal prosecution was in retaliation for his pursuit of claims against Halliburton. What do you make of that idea?

A: Readers of the book will see that this simply isn’t true. The criminal investigation of Milberg Weiss and its top partners predates the Halliburton mess, and it was managed by a dedicated civil servant in the Los Angeles U.S. attorney’s office named Richard Robinson who is not only a career prosecutor, but a Democrat. We think Bill makes some of these assertions for dramatic effect. Having said that, what’s that old phrase, "You’re not paranoid if they’re really out to get you." That may apply here. How many individuals in this country found their business practices targeted by the Republican Party’s 1994 "Contract with America"? How many had an act of Congress aimed specifically at them? (The Private Securities Reform Litigation Act of 1995 was dubbed the "Get Lerach Act.".) Bill Lerach didn’t imagine that. Bill also believes that the U.S. Supreme Court went through some strange gyrations to make third-party actors virtually immune from class action securities lawsuits—even when their fraud is massive and manifest. In this contention, Lerach appears to the authors to be on solid footing.

Q: While writing this book, you obviously had to become immersed in the world of securities class action litigation. Based on what you have seen, what do you think about this kind of litigation and the way it goes forward in our system? 

A: Kevin, as someone who is interested in the other side of this issue—the other side from Bill Lerach, that is—you know the havoc that the old "strike suits" wreaked on entrepreneurs, corporate officers, and the companies that insured them. This was especially true before enactment of the PSLRA, when class action securities cases were filed on no more evidence than a simple dip in a company’s stock price. Even in cases with no merit at all, the cost of settling them was less than the cost of defending them. So a consensus emerged that these lawsuits had become a kind of legalized extortion racket and were an anathema to justice and good business practices. Bill Lerach and Mel Weiss and their imitators came to be seen as glorified shakedown artists. We had covered these issues before writing this book (Carl Cannon covered Washington for the San Jose Mercury News, and Pat Dillon edited Forbes ASAP in Silicon Valley) and we knew this back story. It forms the narrative tension in Circle of Greed.

However, as we delved deeply into the rationale for such lawsuits, we couldn’t help but notice some other facets of your question. Here’s one: Although Lerach would allege fraud based on little more evidence than a falling stock price and a few upbeat press releases, he would in the course of his litigation routinely uncover instances of insider trading—the dumping of stock by top company officers immediately before bad news was about to be announced. The authors couldn’t help but be disillusioned by the frequency of this practice. A second point we would make: Once Congress decided that class action securities lawsuits were not the best way to enforce shareholders’ interests (not to mention honest business dealings), it became incumbent on the Securities and Exchange Commission to be ever-more vigilant against fraud. Perhaps this was too big a job for the SEC, but this did not happen. The upshot, as Lerach himself had warned many times, was a tsunami of fraud on Wall Street in the past decade that did great harm to investors and working people alike and which we believe made the current recession much worse for almost all Americans.

Q: In your book’s Epilogue, you write that "Bill Lerach was no monster, but he had indeed gone after fraud by using fraud." Do you think that this is just an instance of someone getting corrupted by the system, or was it something innate, something particular to Lerach himself, that drove his willingness to cross the line?

A: You mentioned that line in your very thoughtful review of our book, but let’s parse that sentence for a moment: He used fraud to go after fraud. That means there was fraud to begin with, and Bill Lerach would say that this reality—not his legal strategy—was the larger underlying problem. This contention may be self-serving, but it’s worth taking seriously. There was indeed something rotten on Wall Street—and in Silicon Valley—and instead of addressing the way corporate capitalism had been turned into an insiders’ game, Congress, the White House, and the Supreme Court spent their energy reining in the law firms that were rooting out corporate corruption and malfeasance.

As for Lerach’s personal motivation in being willing to cross the line into illegality, that seems to entail a complicated set of incentives and impulses. Let’s start with his fierce competitive streak. Like most super-successful trial lawyers, Bill Lerach loves to win and hates to lose. In the law, as in life, that attitude can lead to ethical shortcuts. Also, altruism was certainly a factor as well—a fierce brand of altruism animated by Bill’s populist political views: Lerach was convinced, and remains so, that he was doing good with these lawsuits. Finally, of course, greed was a factor in this epic morality play, just as it was for those on the receiving end of Lerach’s wrath—hence our title.

Q: Have you been surprised by the responses your book as received?

A: We’ve been pleased so far, although it’s instructive to see how critics and commentators tend to concentrate on passages in the book that bolster their pre-existing views.

Q: What do you think the lessons learned or conclusions are from the story you have told in this book?

A: We’d mention two: First, politics in this country really is broken. It’s an overly partisan hothouse environment where monetary contributions crowd out the art of compromise, and where the merits of any given issue give way to a desire to reward your allies and punish your rivals. Second, in the heat of his three-decade war of attrition with corporate officers and directors Bill Lerach ultimately began to resemble his adversaries—the ones he detested the most. There’s a lesson here for all of us in this, and it’s the line that precedes the one you mentioned about monsters. It’s from Friedrich Nietzsche, who put it this way: "Whoever fights with monsters should see to it that he does not become one himself."

The D&O Diary would like to express its deep gratitude to the authors’ willingness to answer our questions. We hasten to add that everyone who has read this far really should definitely read the book.

Speakers’ Corner: On Tuesday, March 16, 2010, I will be speaking at the C5 D&O Liability Insurance Forum in London. I will be speaking on a panel with my good friend John McCarrick of the Edwards Angell law firm on the topic "What are the Risks to European D&O Insurers from Class and Derivative Actions in the U.S." Information regarding the event can be found here.

• Email This
• Print
• Comments (1)
• Trackbacks
• Share Link

In a March 12, 2010 order (here) in a Madoff-related derivative suit, the New York (Nassau County) Supreme Court, applying New York law, substantially denied defendants’ motion to dismiss, holding among other things that demand was excused. As far as I am aware, this is the first Madoff-related derivative suit to survive a motion to dismiss. It is also the first Madoff-related lawsuit dismissal motion denial by a New York court of which I am aware.

The derivative suit was filed on April 1, 2009 by non-managing member of Andover LLC, on behalf of Andover LLC, as nominal defendant. Among the defendants are Andover’s investment manager (Andover Management), general partner, and investment consultant (Ivy Asset Management) and Andover’s auditor. The complaint, which can be found here, alleged that Andover should recover damages for the defendants’ negligence, gross negligence, breach of fiduciary duty, and for aiding and abetting breach of fiduciary duty.

The complaint alleges that the defendants committed these wrongs by permitting Andover to invest "approximately a quarter of its assets under the personal control of [Bernard Madoff] through his investment firm." The complaint alleges that as of December 31, 2007, Andover had assets of $57.7 million. The complaint further alleges that Andover’s auditors were negligent in conducting annual audits by failing to plan and perform appropriate audits and appropriate tests that would have identified Madoff’s fraud.

The plaintiff alleged that serving a demand on Andover’s management to prosecute these claims would have been futile because Andover and its principles were involved in wrongdoing constituting the basis of the claims. The plaintiff also asserted that it would have been futile to demand that Andover pursue claims against Ivy because Ivy’s agreement with Andover required Andover to indemnify Ivy. The plaintiff alleged it would have been futile to demand that Andover suit the auditor because Andover’s misconduct was "inextricably interconnected" with that of management.

The defendants moved to dismiss, arguing the plaintiff’s lack of capacity to sue; that the plaintiff’s claims are barred by New York’s Martin Act; that his derivative claims were barred by failure to make a demand on the managing member of the limited liability company and by the business judgment rule, and numerous other grounds. The auditor moved on lack of capacity and lack of proximate causation since the investment has been made before the current auditor was retained and the loss therefore could not have been avoided.

In its March 12, 2010 order, the court substantially denied the defendants’ motions in all material respects.

First, the court ruled that the plaintiff’s failure to make a demand was excused. The court reasoned that Andover Management and general partner had an interest in not being sued and an interest in protecting its principals, Ivy and its auditor from being sued, as claims against those persons "would tend to establish that Andover Management negligently breached its own fiduciary duty."

Second, the court ruled that the plaintiff’s claims were not barred by the Martin Act because the plaintiff’s claims do "not arise from alleged securities fraud and is not simply a securities fraud claim."

Third, the court also denied the defendants’ motion to dismiss plaintiffs’ gross negligence claim against Andover Management because "it may be inferred" that Andover Management "failed to exercise even slight care in failing to detect" Madoff’s fraud. It may also" be inferred" that Andover Management "showed complete disregard for Andover associates’ right and the safety of its investment."

In addition to its several other holdings, the court also denied the auditor’s motion to dismiss as well, observing that "the court must assume that an audit … conducted pursuant to generally accepted accounting procedure would have uncovered Madoff’s fraud" and that "a proper audit would have provided Andover with an opportunity to liquidate its investment."

The Andover case is not the first Madoff lawsuit to survive a motion to dismiss (see, for example, my recent post here about a dismissal motion denial in a Madoff-related case). However, it is as far as I am aware, the first dismissal motion denial in a Madoff-related derivative case and it is as far as I am aware the first dismissal motion denial in a court in New York, many of the Madoff-related cases are pending.

If the March 12 order is in any way indicative of the likely course of Madoff investors’ claims against feeder funds and investment gatekeepers, the investors’ litigation outlook appears favorable, at least at the dismissal motion stage. Indeed, the March 12 order fairly bristles with incredulity that the various defendants failed to take steps that, the court assumes, would have detected Madoff’s fraud.

But while a similar judicial predisposition might allow other claimants, like the plaintiff in this case, to survive a dismissal motion, it remains to be seen whether the claimants ultimately will be able to recover their losses or any substantial part thereof.

Of course, to even have any hope of any recovery, the aggrieved investors’ claims must first survive a motion to dismiss. The March 12 order in this case should be of keen interest to other Madoff claimants.

Special thanks to Daniel Tepper, one of the plaintiff’s counsel in the Andover case, for providing a copy of the March 12 order.

• Email This
• Print
• Comments (1)
• Trackbacks
• Share Link

According to the March 11, 2010 bankruptcy examiner’s report, the collapse of Lehman Brothers was a result of the deteriorating economic climate, exacerbated by Lehman’s executives, whose conduct ranged from "serious but non-culpable errors of business judgment to actionable balance sheet manipulation."

The Report was prepared pursuant to a January 2009 bankruptcy court order directing the trustee to appoint an examiner to investigate the events leading up to Lehman’s collapse. The examiner appointed was Anton Valukas of the Jenner & Block law firm.

The full report is nine volumes long, consisting of 2,200 pages, and can be found here. The executive summary (which alone is 239 pages long) can be found here. According to news reports, Valukas spent $38 million conducting his examination. He and his team interviewed more than 100 people and scrutinized more than 10 million documents, plus 20 million pages of e-mails from Lehman.

The examiner’s report states that as conditions worsened during 2008 and in order to "buy itself time," Lehman "painted a misleading picture of its financial condition." For example, the report states, that while reporting a significant loss at the end of the second quarter 2008, Lehman "sought to cushion the bad news by trumpeting that it had significantly reduced its net leverage ratio," while failing to disclose that it had been using an "accounting device" – known as Repo 105 – that had "no substance" and whose sole purpose was to allow Lehman to "manage its balance sheet."

The report states that Lehman neither disclosed its use of nor "the significance of the use of the magnitude of its use of" Repo 105, to the Government, to rating agencies, to investors or even to its own Board. Its auditors were aware of but did not question the transaction. The Repo 105 balance sheet manipulation is summarized on the WSJ.com Deal Journal blog, here.

The examiner concluded that the business decisions that brought Lehman to a crisis "may have been in error but were largely within the business judgment rule." However, the "decision not to disclose the effects of these judgments does give rise to colorable claims against the senior officers who oversaw and certified misleading financial statements," including CEO Richard Fuld and the company’s CFOs, Christopher O’Meara, Erin Callan and Ian Lowitt.

The examiner also found that there is a "colorable claim that the "sole function" of the Repo 105 transactions was "balance sheet manipulation" that "created a misleading picture of Lehman’s true financial health."

The examiner also concluded that there are "colorable claims" against the company’s auditor, Ernst & Young, on the grounds that it "did not meet professional standards" for its "failure to question and challenge improper or inadequate as disclosures."

The examiner’s report explains that the report uses the phrase a "colorable claim" to mean one for which "there is sufficient credible evidence to support a finding by a trier of fact," without presuming the finder of fact’s ultimate conclusion.

The examiner also reviewed the actions of Lehman’s lenders, JP Morgan and Citigroup. The report concludes that "The demands for collateral by Lehman’s lenders had direct impact on Lehman’s liquidity pool," adding that "Lehman’s available liquidity is central to the question of why Lehman failed." Citigroup, which handled currency trades for Lehman, received a new guarantee from Lehman when Lehman was already insolvent and didn’t give enough value in return, the report said. The report concludes that "a colorable claim exists to avoid the Amended Guaranty as constructively fraudulent."

The examiner also reviewed the acquisition of Lehman’s North American brokerage, concluding that "a limited amount of assets" belonging to Lehman were "improperly transferred to Barclays."

The examiner recites at the outset of the report that under the relevant bankruptcy code provisions one purpose of a bankruptcy examination is to determine the existence of "a cause of action for the estate." Given the bankruptcy examiner’s conclusion that there are colorable claims against Fuld and the other former Lehman’s officials, as well as against its outside auditor, it seems reasonable to anticipate that the next step with be the bankruptcy trustee’s initiation of claims against these individuals and the auditor.

By way of comparison, after the New Century Financial bankruptcy examiner issued a report issued a report critical of company officials and the company’s auditor (about which refer here), the bankruptcy trustee filed a lawsuit (refer here) seeking to hold New Century’s auditors liable. In addition, the claimants in the New Century securities class action lawsuit relied heavily on the Examiner's findings in their amended complaint, which later suvived a motion to dismiss. I noted at the time of the dimissal that the bankruptcy examiner's findings may have strongly influenced the court in its dismissal motion ruling.

General Growth Properties Settles Credit Crisis-Related Securities Suit: According to a February 23, 2010 filing in the Northern District of Illinois, the parties to the credit crisis-related securities suit arising out of the collapse of General Growth Properties has been settled for $15.5 million, subject to court approval. The parties’ stipulation of settlement can be found here.

The General Growth Properties suit was one of the cases first filed in late 2008 as the subprime meltdown morphed into a full blown credit crisis, as I discussed in a post at the time, here.

The lead complaint, which can be found here, was filed in January 2009. The plaintiffs alleged that General Growth’s survival depended on its ability to refinance in November 2008 approximately $1.5 billion of its $27 billion of outstanding debt. Ultimately the company was unable to refinance its debt and it filed for bankruptcy in April 2009. The plaintiffs essentially alleged that the eleven individual defendants misrepresented the company’s ability to refinance its debt.

The complaint also alleged that the company’s senior executives had improperly loaned money to certain executives so that the executives did not have to sell their company shares in a margin call. The companies also allege that the company’s officials improperly sought to have the company’s shares included in the SEC’s short selling ban, so that the officials could sell their share at inflated prices.

In a September 29, 2009 opinion (here), Northern District of Illinois Milton Shadur granted in part and denied in part the defendants’ motion to dismiss. According to the settlement stipulation, in January 2010, the parties submitted the case to mediation, from which the settlement ultimately resulted.

The General Growth suit is one of only a handful of cases filed in the wake of the subprime meltdown and the ensuing credit crisis that has reached the settlement stage, and one of only a smaller handful of cases that have been settled following a dismissal motion ruling. We undoubtedly will see more settlements ahead as more cases work their way through the system.

I have in any event added the General Growth Properties settlement to my list of subprime and credit crisis-related case resolutions, which can be accessed here. My recent status update on the subprime and credit crisis related securities litigation can be found here.

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

Hello Polly: Many readers undoubtedly saw the article in yesterday’s Wall Street Journal (here) reporting that the Bank of America has apologized after its local contractor entered the home of a mortgage borrower, while she was away, and cutoff her utilities, padlocked the door and "confiscated her pet parrot, Luke." The homeowner, separated from her parrot for a week, filed a lawsuit against the bank for emotional distress.

This momentous story was deemed by the Journal’s editors to be worthy of a front page photograph of the homeowner, now fortunately reunited with her beloved parrot.

We mention this because, as was pointed out to us by a loyal reader, the Journal’s front page above- the- fold color photograph was headlined with the phrase "Hello, I Wish to Register a Complaint." We suspect that the Journal’s editors ran the picture on the front page for the sole reason that it gave them an excuse to use that headline.

If the topic is parrots, the only possible reference is to the immortal Monty Python dead parrot sketch, which believe it or not has its own Wikipedia page, here. The skit begins with John Cleese entering a pet shop and stating (as reflected in this script of the sketch) "Hello, I wish to register a complaint." Cleese’s problem in the sketch is not that his parrot has been confiscated; rather, his problem is that the parrot he had just purchased is dead. Deceased. It is no more. It has ceased to exist. It has joined the choir celestial. This is an ex-parrot

We are delighted to have this pretext to be able to embed a video of the sketch below. Because we think everyone should know a dead parrot when they see one.

• Email This
• Print
• Comments (2)
• Trackbacks
• Share Link

For those of us who spend a lot of time looking at securities class action lawsuits, the cases often have a familiar pattern. Unfortunately, the familiarity may dull sensitivity to the allegations or even to the process itself. So it was interesting to read a layman’s reaction to a recently filed lawsuit, if for no other reason than it provided a look at the lawsuit and the process with a fresh set of eyes.

The lawsuit in question was filed in the Northern District of California on March 9, 2010 against Medivation and certain of its directors and offices. As is so often is the case in these kinds of lawsuits, Medivation is a life sciences company whose developmental stage product failed to meet certain clinical trial goals. Specifically, and as reflected in the plaintiffs’ lawyers March 9 press release (here), its product did not meet primary and secondary goals in a Phase 3 clinical trial for patients with mild to moderate Alzheimer’s disease. When the company announced this news, its stock price declined and the lawsuit followed. A copy of the complaint can be found here.

This lawsuit will work its way through the system. The lawyers involved, all of whom undoubtedly are (or when they are retained to defend will be) well versed in these things, and will raise familiar arguments that may or may not succeed. All very familiar to those of us who spend all of our time immersed in these kinds of things.

An interesting perspective about this lawsuit appeared on the Blogging Stocks site (here). The author, Gary E. Sattler, has a number of reactions to the plaintiffs’ complaint, summarizing his comments with the observation that "even when given my usually cynical nature, and my usual dislike for big pharmaceutical interests, I still take issue with this potential class action lawsuit."

After summarizing the plaintiffs’ allegations, the author notes that

The plaintiff class has to cross a significant threshold of proof in order to prevail in this case. Based on my reading of the original complaint, plaintiffs fail to establish intent, fail to reveal purposeful omission of fact, and fail to establish that the actions of the defendants were the true overt cause of any artificial inflation of Medivation's stock value. Furthermore, the plaintiff's complaint seems to disregard that Medivation has had broad yet cautious support from within the Alzheimer's treatment community. Was it all wishful thinking? Perhaps it was, but that support came from many well-educated minds experienced in the field.

Sattler goes on to note that "to me, this potential class action smacks of sour grapes." He then reiterates his support for the company and for the company’s Alzheimer’s product.

Sattler seems to be reasonably objective (he states that he has no investment interest in the company). Of course, his rough and ready assessments have no direct relationship to how the lawsuit and its allegations might fare in court. But I have often found that the court of public opinion is an accurate sounding board. True, it might be argued that because of Sattler’s preexisting interest in the company and in its product he might be biased in its favor. But just the same it is interesting to look at the allegations through his eyes and see his reaction to the allegations.

When the U.S. Supreme Court first issued its opinion in Tellabs, I thought it would make little fundamental difference, because I thought that in the end and regardless of the formal standard, courts would give the green light to cases that raised a stink and would cut short the rest. Regardless of whether I am right about the Tellabs standard, I think trial courts fundamentally assess cases on a smell test, which is basically what Sattler has done in his post, albeit without specific reference to legal standards. Viewed in that light, his rough and ready assessment is interesting. And perhaps significant, at least with respect to the case’s prospects.

More About the FCPA: Regular readers know that I have a certain fixation about the Foreign Corrupt Practices Act. (Indeed, one reader has gone so far as to accuse me of being "obsessive" about it.) I continue to believe that the FCPA will be an increasingly important corporate exposure in the years ahead, if for no other reason than the relentless globalization of commerce.

For those who remain skeptical on the topic, I suggest a quick review of the March 10, 2010 post by Bruce Carton on his Securities Docket blog (here). In his post, Carton painstakingly compiles all of the recent comments by regulators corroborating that the FCPA is a top priority. He also reviews the significance of the recent Africa Sting enforcement action, as well as the implications of the Bribery Bill which may soon become law in the U.K. As Bruce’s emphasizes, there are a number of very significant implications to the Bribery Bill.

As Carton puts it, top FCPA lawyers agree that the anti-bribery activity has reached "a fever pitch." Whether or not I am obsessive, it is indisputably clear that FCPA related enforcement activity will be a significant area of corporate exposure in the months and years ahead.

A Picture is Worth a Thousand Words: Want to know what the financial crisis is all about? Check out this graphic depicting the escalating mortgage default rate during the current crisis. No interpretation required. As for myself, I am considering investing in gold. And stocking my basement with water, canned goods, matches, stout rope and a knife. You never know.

This Too Shall Pass: You are probably familiar with the OK Go video performed on an array of treadmills. If not, you should get out more. I’ve seen it and I have serious social issues. (See prior item). However, and in any event, everyone should watch the new video from OK Go for its new song, "This Too Shall Pass." Rube Goldberg would be impressed. Smashing pianos, crashing trash cans, smashing TV sets (showing the treadmill video, no less), the whole enchilada.

Though I have embedded the Rube Goldberg version below, there is an alternative spoof marching band version here that is also funny in a completely different way. (Don’t you love the Internet?) Please also see the Author's Note below.

Authors’ Note: This blog post was written in its entirety on a laptop computer while the author was sitting in Cladgagh Irish Pub in Lyndhurst, Ohio and watching Real Madrid play Lyon in a UEFA Champions League game on the television. (In an excellent game, the teams played to a 1-1 tie.)  I hope you enjoy reading this post as much as I enjoyed writing it. Gradus ad Parnassum.

• Email This
• Print
• Comments
• Trackbacks
• Share Link

It has now been over three years since the first subprime-related securities class action lawsuit was filed in February 2007, yet many of the cases filed in the ensuing litigation wave are still only in their earliest stages. While the vast majority of these cases are still unfolding, there have been some important recent developments, suggesting that the evolving litigation wave has passed some significant milestones. With that possibility in mind, it seems appropriate to check in for a status report on the subprime and credit crisis-related litigation wave.

In the latest issue of InSights (here), I take a look at the developments to date as the subprime and credit crisis-related cases have worked their way through the system, including trends in motion to dismiss rulings and settlements, as well as with respect to issues such as gatekeeper liability and defense expense costs.

• Email This
• Print
• Comments
• Trackbacks
• Share Link

Both the number of restatements and the number of companies reporting restatements are declining according to a new study. The number of restatements has been declining for three years now, and the number has declined materially since the figures peaked in 2006, both because of better controls and changing standards.

The study, by Audit Analytics, is not yet available online, but it has been widely reviewed, including in a March 4, 2010 CFO.com article (here) and a March 1, 2010 article by Matt Kelly of Compliance Week (here).

As reflected in this article, the study shows that there were just 630 companies reporting 674 accounting restatements in 2009. There were 24% fewer restatements in 2009 compared to the prior year, when there were 923. The 2009 figures represent the lowest number of restatements since 2001 (when accounting scandals dominated the headlines).

The number of restatements has actually declined for three years in a row since they reached their peak in 2006, when 1,564 companies filed 1,796 restatements. In other works, the number of restatements in 2009 was 62 percent less than the number in 2006.

In addition to the declining number of restatements, accounting errors requiring a restatement are now being caught sooner. The average restatement in 2009 covers a period of 476 days, compared to 716 days in 2006.

Restatements also reduced earnings by smaller amounts. 2009 restatements on average reduced earnings by $4.6 million, compared to $7.2 million in 2008 and $23.5 million in 2006.

The CFO.com article reports that the study’s authors attribute the decline to two factors: improved internal controls as a result of Section 404 of the Sarbanes Oxley Act, and a 2008 recommendation by the SEC’s Advisory Committee on Improvements to Financial Reporting that the SEC “relax its requirements on what types of errors should trigger restatements.”

One circumstance supporting the suggestion that SOX may be contributing to the reduced number of restatements is the fact that the majority of U.S.-based companies issuing 2009 restatements (374 out of 522) were “nonaccelerated filers,” meaning that Section 404’s requirements do not yet apply to them. Of course, there are, in fact, more nonaccelerated filers than accelerated filers in the first place, so the raw numbers alone may not tell the whole story. In addition, the smaller nonaccelerated filers simply may be more likely to have problems due to their small staffs and fewer tools.

On his Compliance Week blog, Kelly points out that the number of restatements by accelerated filers grew between 2002 and 2005, the year they had to comply with Section 404, but they have declined since that time. Kelly concludes that, despite all of the criticism of the provision, Section 404 may be working.

To those who say we had a crisis in 2008 notwithstanding Section 404, Kelly points out that the most recent crisis “has largely been a crisis of flawed assumptions and reckless risk management coming home to roost – not accounting fraud.” Kelly concludes that whatever financial reform Congress might conjure up in response to the current crisis, it is not time to “start rewriting Sarbanes-Oxley wholesale,” as “the law is working just fine.”

The suggestion that the declining number of restatements is due to SOX reforms brings to mind the long-standing question whether the changes in the number of securities class action filings are also attributable to improved company behavior as a result of SOX.

However, though the number of restatements has declined steadily, the number of lawsuits has fluctuated from year to year. Indeed, the most recent year with the highest numbers of restatements, 2006, when there were almost three times as many restatements as in 2009, there were fewer class action lawsuit filings (116) than in any year since 1996, and certainly significantly fewer filings than in 2009, when there were (depending on whose count you are using) at least 178 filings.

So there may well be fewer restatements as a result of Sarbanes Oxley, but that alone does not explain what has been happening with fluctuating securities class action lawsuit filings. Changed corporate behavior as a result of Sarbanes Oxley, even if it has occurred, is not a sufficient explanation for lawsuit filing levels. There may simply be too many other areas of corporate activity, beyond those addressed in Sarbanes Oxley, that continue to attract the unwanted attention of the plaintiff’ class action securities lawsuits.

The bottom line seems to be that as good as the news is that the number of restatements is declining, that does not necessarily mean as a general matter that companies are necessarily less likely to be sued.

• Email This
• Print
• Comments
• Trackbacks
• Share Link

An astonishing amount of litigation followed in the wake of the Madoff scandal revelations, as I have detailed here. But thought the litigation filings have surged, the question remains whether the plaintiffs’ desperate attempts to recover their losses from third parties have any chance of success.

This question was underscored by the March 4, 2010 ruling by a Luxembourg court that individual investors who lost money in Madoff’s scheme lack standing to sue UBS AG and its auditor Ernst & Young for losses in the bank’s LuxAlpha funds. According to news reports, the court said that the investor plaintiffs had failed to show they had suffered individual damage separate and apart from the funds themselves. They also failed to show any individual damage suffered by the alleged behavior of UBS or Ernst & Young.

But though the Luxembourg dismissal received widespread coverage, there was a largely overlooked earlier Madoff-related case ruling out of Florida, in which the investor plaintiffs’ claims largely survived the defendants’ motions to dismiss. (The Florida case is mentioned in a March 5, 2010 Wall Street Journal article, here, which otherwise is devoted to the Luxembourg court ruling.)

The Florida case arose on May 7, 2009, when seventeen plaintiffs filed a 62-page complaint in Palm Beach County Circuit Court against Madoff feeder funds Tremont Group Holdings and Tremont Partners, as well as three associated Rye Select funds. The complaint also names KPMG, which had serves as the Rye funds’ auditor, as a defendant.

The plaintiffs’ complaint alleges that the Tremont and Rye Select Fund defendants failed to perform their professional duties, but rather simply turned invested funds over to Madoff. The plaintiffs allege that the defendants "did not analyze Madoff, investigate his companies, conduct significant due diligence, or ensure that there were rudimentary safeguards." The plaintiffs further allege that the defendants took tens of millions of dollars in management and other fees from the funds.

The complaint alleges that the defendants violated Florida securities laws, committed common law fraud, negligent misrepresentation, professional malpractice and negligence. The complaint also alleges that defendants breached their contractual and fiduciary duties. The defendants moved to dismiss.

In a February 5, 2010 order (here), Circuit Court Judge David E. French granted in part and denied in part the defendants’ motions to dismiss.

With respect to the Tremont and Rye funds defendants, Judge French granted the motions to dismiss, without prejudice, as to plaintiffs’ claims of breach of fiduciary duty (Count VI), breach of statutory fiduciary duty (Count VII), breach of contract (Count XI), and adding and abetting breach of fiduciary duty (Count XII), all essentially on the grounds that the plaintiffs had failed to allege individualized injury, apart from the injuries to the funds themselves.

However, Judge French denied the Tremont and Rye funds defendants’ dismissal motions as to plaintiffs’ claims for violation of state securities laws (Count I), Negligence Per Se (Count II), Fraud in the Inducement (Count III), Negligent Misrepresentation (Count IV), and Deceptive and Unfair Practices (Count VIII), as these are claims where the investor plaintiffs suffered their own individual injuries.

Judge French also granted without prejudice KPMG’s dismissal motions as to plaintiffs’ claims for Negligent Misrepresentation (Count V), Professional Malpractice (Count X) and Aiding and Abetting Breach of Fiduciary Duty (Count XIII), but denied KPMG’s dismissal motion as to plaintiffs’ allegations against KPMG for deceptive or unfair practices (Count IX).

While the defendants’ dismissal motions were granted in part, substantial portions of the plaintiffs’ complaint survived and the case will now go forward, showing that at least some Madoff victims may be able to allege claims sufficient to survive initial dismissal motions.

The February 5 ruling seems significant because as far as I am aware it represents the first instance in which a private plaintiff against a Madoff feeder fund has survived a motion to dismiss.

To be sure, on February 8, 2010, New York Supreme Court Judge Richard B. Lowe III did enter an order (here), denying the defendants’ motions to dismiss in the New York Attorney General’s civil fraud lawsuit pending against Ezra Merkin and his Madoff-related feeder funds. But the Florida ruling is the only ruling of which I am aware in which a private plaintiff lawsuit against a Madoff feeder fund has survived a dismissal motion and will be going forward.

Obviously, the massive amount of Madoff-related litigation will continue to grind through the courts for years to come. The Florida decision shows that plaintiffs may be able to survive dismissal motions in at least some of these cases. Of course, whether the plaintiffs will ever recover even a very small part of their losses remains to be seen.

Special thanks to a loyal reader for calling my attention to the Florida decision and providing me with a copy of the opinion.

Class Act on the Danube: Here at The D&O Diary, we scour the globe looking of interest for our readers. By way of example, we refer readers to the article that appeared in the March 8, 2010 issue of the Budapest Business Journal (here), in which it is reported that "a revision to the standing civil code will shortly introduce class action lawsuits to the Hungarian legal system and already has a number of nongovernmental interest groups revving up to start the proceedings."

The prospects for class litigation outside the U.S. apparently continue to spread. Everyone here will remain vigilant.

If You Are Even Thinking about Starting a Blog: As we have pointed out before, a blog is a harsh mistress, as we know all too well. However, there may be those at this very moment who may be thinking about starting a blog. For all the aspiring bloggers, we recommend an essay by Mark Herrmann (now an ex-blogger since relinquishing his role as co-author of the essential Drug and Device Law Blog) in the Winter 2010 issue of the ABA Section of Litigation Journal entitled "Memoirs of a Blogger" (here, hat tip to the WSJ.com Law Blog).

Although much of the article is focused on the question whether a law blog is a good idea for a big firm attorney, there are many more universal truths as well. Among other indispensible pointers with which we concur, Herrmann states: "If you’re thinking of launching a legal blog, have your eyes open. Once you launch a blog, you will face the relentless, mind-numbing, never-ending task of finding worthwhile material to publish. That burden begins on the day of your first post, and ends only the day you call it quits."

Amen, brother.

And along those lines, everyone here at The D&O Diary is always grateful when readers send along blog ideas and suggestions. We get our best material from readers, so please let us know if you see anything interesting out there.

• Email This
• Print
• Comments
• Trackbacks
• Share Link

The SEC first acquired the right to impose civil penalties against corporations in the Securities Enforcement Remedies and Penny Stock Reform Act of 1990. Since the Remedies Act was enacted, the SEC has struggled with the question of when it is appropriate to obtain money penalties from corporate issuers.

In January 2006, in order to put some clarity around the issue of corporate penalties, the SEC issued its Statement of the Securities and Exchange Commission Concerning Financial Penalties (here). More recently, the sharp questions of a prominent federal judge have put a harsh spotlight on the SEC’s practices regarding corporate money penalties. In light of these questions, it is hardly surprising that the SEC might feel compelled to reexamine its practices for the imposition of penalties on corporations.

In a recent speech, current SEC Commissioner Luis Aguilar has proposed revising the guidelines in order to put the "appropriate focus" on the issue of deterrence. However, for reasons discussed below, I question whether Commissioner Aguilar’s position is necessarily the best approach to accomplish the desired goals.

Background

In the 2006 Statement, and after reviewing the legislative history of the Remedies Act, the SEC articulated a standard whereby the question of the appropriateness of a corporate penalty turns on two considerations: "the presence or absence of a direct benefit to the corporation as a result of the violation," and "the degree to which the penalty will recompense or further harm the insured shareholders." The Commission also identified seven additional factors that are also "properly considered," including "the need to deter the particular type of offense."

In a February 6, 2010 speech (here), SEC Commission Luis Aguilar characterized the 2006 Statement as a "misguided approach." The "serious flaw" in the Statement’s approach, he said, is that "the conduct itself becomes of secondary importance." Aguilar contends that the Commission "fails to appropriately focus on deterrence." He called the Commission to promptly revisit the 2006 guidelines go that penalties are refocused on their "purpose," which is to "deter and punish misconduct."

A March 6, 2010 Wall Street Journal article further discussing Aguilar’s views can be found here.

Discussion

In the current environment, Aguilar’s desire to focus the Commission’s enforcement efforts on the deterrence of future misconduct is both appropriate and commendable. However, that does not necessarily mean that the imposition of penalties on corporations is the appropriate means to that goal or even that the 2006 Statement needs to be revisited.

First, upon review of the 2006 Statement, it is clear that in devising the current guidelines, the Commission took significant pains to consider and to try to implement the considerations expressed in the legislative history of the Remedies Act, particularly the relevant Committee Report. Whatever Aguilar’s views may be, the current guidelines track the sentiments expressed in the Committee Report.

The second problem with Aguilar’s view is that, at least as expressed in his recent speech, it appears that his proposed approach simply disregards the fundamental problem with corporate penalties, which is that in many instances the penalties inappropriately harm the company’s current shareholders.

In that respect, the timing of Aguilar’s speech advocating the use of corporate penalties for deterrence purposes is more than a little odd, coming as it does so closely on the heels of Southern District of New York Judge Jed Rakoff’s highly publicized questions of the proposed settlement of the SEC’s enforcement action against the Bank of America.

Readers will recall that in his blistering September 14, 2009 opinion (here), Judge Rakoff rejected the SEC’s proposed $33 million settlement, on among other grounds that the proposed settlement "does not comport with the most elementary notions of justice and morality" because it "proposes that shareholders who were the victims of the Bank’s alleged misconduct now pay the penalty for the misconduct."

In response to the SEC’s argument that the proposed settlement "sends a strong signal" and "allows shareholders to better assess the quality and performance of management," Judge Rakoff said that

the notion that Bank of America shareholders, having been lied to blatantly in connection with the multi-billion dollar purchase of a huge, nearly bankrupt company, need to lose another $33 million of their money in order to "better assess the quality and performance of management" is absurd.

Judge Rakoff did subsequently approve a $150 settlement of the SEC enforcement action, but essentially as an act of judicial restraint and only while the Court was "shaking its head." Rakoff called the settlement "half-baked justice at best."

Judge Rakoff’s strong words seemingly challenge the very idea of corporate penalties, both because of the burden they impose on corporate shareholders and because the disconnect between penalties and the possibility of deterrence. In the immediate aftermath of the questions surrounding the BofA settlement, Aguilar’s advocacy of corporate penalties as a way to achieve deterrence seems both off-key and tone deaf.

We can all agree, as Aguilar proposes, that misconduct should be punished and deterred. However, it does not follow that the imposition of corporate cash penalties is the best or even a potentially well-calibrated means to try to achieve those goals. Indeed, as Judge Rakoff’s comments suggest, the problem with corporate penalties is that both the punishment and the putative deterrence are misdirected. Indeed, the notion that penalties paid out of the assets of one corporation will deter future misconduct by another corporation seems both abstract and unpersuasive.

Viewed in this light, the principles articulated in the Committee Report accompanying the Remedies Act, as implemented in the 2006 Statement, arguably represent an appropriate balancing of the considerations that should be taken into account in connection with the imposition of corporate penalties – including in particular the question whether the proposed corporate penalty "will recompense or further harm the injured shareholders."

My further concern about Aguilar’s initiative to try to ramp up corporate penalties is that his proposal arises at a time when the SEC is desperate to reestablish its regulatory credentials. One danger is that in its eagerness to look tough that SEC might try to extract enormous penalties from corporate treasuries while accomplishing little except the addition of unnecessary and unwarranted costs on beleaguered companies and their long-suffering shareholders (which is in fact the very thing that troubled Judge Rakoff).

The bottom line for me is that in the wake of the pointed questions that Judge Rakoff raised in the BofA enforcement action, this is a very odd time for any SEC Commissioner to be advocating increased corporate penalties as a likely or even promising way for the SEC to best accomplish its goals.

Just Visiting this Planet: In her latest email epistle, our globetrotting eldest daughter, now working in Quito for a nonprofit organization, passed along the following observation about a recent therapy session for refugee women she attended:

I was oddly reminded of the time at the neighborhood barbeque in Hokkaido with the inebriated  Japanese grandpas who wanted to sing Billy Joel. Totally unrelated to Spanish-speaking refugee women discussing how being a refugee increased their stress and messed up their female biorhythms. I think I drew the connection in my mind because of the "where on earth have I ended up" feeling I had both times.

• Email This
• Print
• Comments (1)
• Trackbacks
• Share Link

Time-honored legal principles typically shield corporate officers and shareholders from direct personal liability for legal violations of the corporation itself, consistent with the notion that the corporation itself has a distinct and separate legal identity. However, as I noted in a prior post (here), courts have evolved a concept called "the responsible corporate officer doctrine," pursuant to which individuals can be held liable for corporate misconduct without involvement in or even awareness of the wrongdoing. Recent indications suggest that regulatory authorities may be planning a more aggressive use of this doctrine, a development that may have disturbing implications.

The responsible corporate officer doctrine was first articulated by the U.S. Supreme Court in the 1943 case of United States v. Dotterweich, in which corporate officers in positions of authority were held personally (and in that case, criminally liable) for violating strict liability statutes protecting the public welfare.

The Supreme Court approved the application of liability under the Food, Drug and Cosmetic Act (FDCA) in the 1975 case of United States v. Park holding that the FDCAs "requirements of foresight and vigilance" are "no more stringent than the public has a right to expect of those who voluntarily assume positions of authority in business enterprises whose services and products affect the health and wellbeing of the public that supports them." The Supreme Court approved the imposition of liability in that case, though the defendant had no involvement in or personal knowledge of the violation.

The responsible corporate officer doctrine has been absorbed into environmental law as well, and, as discussed here, and has served as the basis of imposing liability in environmental enforcement actions.

According to a March 5, 2010 memo from the Skadden law firm entitled "FDA Announces New Push to Prosecute Corporate Officers and Executives for No-Intent Crimes" (here), the FDA, under fire for lack of active oversight of its office of criminal investigations, has advised Congress that it intends to "increase the appropriate use of misdemeanor prosecutions…to hold corporate officials accountable." The law firm memo suggests that this FDA statement to Congress is consistent with the "recent uptick" in prosecutions relying on the responsible corporate officer doctrine against pharmaceutical and medical device executives.

The responsible corporate doctrine unquestionably is a well-established tool for the imposition of liability on corporate officials in the context of public "health and wellbeing." But though well-recognized, it nevertheless has disturbing implications. The FDA’s apparent intention to use the responsible corporate officer doctrine more aggressively arguably is part of a larger and even more disturbing trend to try to hold corporate officers liable without regard to personal culpability.

First, the idea that liability can be imposed on an individual for corporate misconduct, in apparent disregard of the corporate form and without culpable involvement or even a requirement of a culpable state of mind, seems inconsistent with the most basic concepts surrounding the corporate form. The doctrine arguably imposes liability for nothing more than a person’s status. The word "responsible" in the doctrine’s name does not mean that the individual is responsible for the misconduct, but on that that the individual is responsible for the corporation.

Second, the application of the doctrine can have serious ramifications. The Skadden memo points out that in one recent FDCA prosecution, the individuals against whom liability was imposed on the basis of responsible corporate officer doctrine were required to pay criminal fines of $34.5 million (The imposition of liability is currently on appeal.) The imposition of criminal penalties of this extraordinary magnitude without any fault or even culpable state of mind seems fundamentally inconsistent with the fault-based framework of our criminal justice system.

But the most troubling thing about the responsible corporate office doctrine is that the apparently expanded willingness of regulators to use the doctrine to impose liability on corporate officials is entirely consistent with developments elsewhere that also suggest a willingness of government regulators to try to impose liability without regard to involvement of awareness of the alleged wrongdoing.

In that regard, there have been at least two instances recently where the SEC has pursued enforcement actions against corporate officials without regard to their lack of knowledge of the alleged legal wrongdoing. Though these regulatory enforcement actions did not expressly rely on or even refer to the responsible corporate officer doctrine, the enforcement actions implicitly reflect a similar presumption, which is that in certain instances corporate officials can be held liable solely on the basis of their position without respect to the presence or absence of personal culpability.

First, as noted here, the SEC has initiated an enforcement action against the former CEO of CSK Auto, in which the SEC seeks to "clawback" compensation the CEO earned at a time with respect to which the company subsequently had to restate its financial statements. The SEC is pursuing this claim even though the former CEO is not only not charged with fraud, but is not even alleged to have had any involvement in or even awareness of the circumstances requiring the later restatement.

Similarly , the SEC more recently filed an enforcement action seeking impose control person liability on two officer of Nature’s Sunshine Products, in which the SEC sought to hold the individuals liable for the company’s Foreign Corrupt Practices Violation, though the individuals were not alleged to have had any involvement in or awareness of the wrongful conduct. The Nature’s Sunshine Products case is discussed here.

Though these recent SEC enforcement actions did not expressly rely on the responsible corporate officer doctrine, the SEC’s actions in these cases reflect a willingness – similar to that of the FDA and other regulatory authorities -- to impose liability on corporate officials without regard to fault or culpability. These regulatory actions raise a very disturbing specter of strict liability for executives.

Even if there are circumstances where, as the U.S. Supreme Court has long recognized, that public health and welfare may justify the imposition of liability without culpability under certain circumstance, the enormous burden this possibility would impose on the civil rights and liberties of the affected individuals would seem to argue that these principles be used to impose liability on individuals only in the rarest and most extreme purposes.

But rather than restrict its use of these principles out of an appropriate respect for basic notions of fairness and individual liberty, regulators are moving in the exact opposite direction and apparently seeking new opportunities to use these principles to expand their regulatory reach.

The regulators may well feel this approach may be justified in order to accomplish regulatory goals and ensure that somebody pays the price for wrongdoing. The problem is that scapegoating individuals for misconduct in which they were not involved and of which they were not even aware is fundamentally unfair. In my view, this approach is inconsistent with some of the most basic assumptions of a well-ordered society governed by law.

If there are circumstances where public health and welfare might sometimes require the imposition of responsibility on a strict liability basis, the use of those circumstances should be infrequent and unusual. Regulators should be looking for ways to avoid relying on these powers rather than looking to expand their use. The imposition of penalties without regard to fault or culpability is a fundamentally unfair practice that should be discouraged at every possible opportunity.

• Email This
• Print
• Comments (4)
• Trackbacks
• Share Link

During his long and provocative legal career, former class action securities litigator and convicted felon Bill Lerach was a self-selected lightening rod for controversy. He taunted his foes, stalked his enemies, challenged convention, and in the process transformed himself into a larger than life figure.

And so when his legal career collapsed among revelations that he and his colleagues had paid improper kickbacks, the post-mortems almost inevitably reflected much of the same mythmaking hyperbole that Lerach himself generated. Lerach became a stock figure in a morality tale, in which the angry, defiant mortal is struck down for his pride.

The reality is that Lerach’s tale is so much more interesting that this stock narrative frame. And is certainly a tale worth telling, as demonstrated in the marvelous new book entitled "Circle of Greed: The Spectacular Rise and Fall of the Lawyer Who Brought Corporate America to Its Knees," written by two Pulitzer-prize winning journalists, Patrick Dillon and Carl Cannon. (Full disclosure: Carl is an old family friend, but I feel comfortable in saying I would have liked the book every bit as much if Carl and I had never met.)

The authors explain in their Prologue that initially, Dillon had intended to co-author a book with Lerach, but that project got waylaid when it became clear that Lerach’s legal difficulties were serious. Though the project moved into an unanticipated direction as a result of these events, Lerach continued to cooperate with the authors, right up to making himself available for interviews from prison.

The authors ask themselves why Lerach cooperated with them, and they confess they are not entirely sure. I was initially concerned the book might shade in Lerach’s favor or even fall into myth-making trap. Make no mistake, however, the authors fully and damningly document all of Lerach’s most outrageous flaws and faults.

The authors open their book at the point where Lerach’s many shortcomings have finally caught up to him, at the court hearing in October 2007 when Lerach pled guilty to one count of obstruction of justice. Then, to discern how the career of one of the most influential lawyers of our time could have come to this, the authors then trace his career from its very beginning, including his childhood in Pittsburgh and his early legal career with the Reed Smith firm. A case in which Lerach was involved for Mellon Bank took both took Lerach to San Diego and also introduced him to Mel Weiss, his law partner whose fame, fortune and fate would follow its own parallel trajectory.

Lerach’s skill and his excesses emerged in his first successful case in San Diego, in which he represented a group of retirees against the Methodist Church. Lerach’s legal performance was by all accounts brilliant, and produced a great result for his clients. But, the authors note, "along with the good came the other things: the hubris, the taunting, the acrimony with the opposing side, the hyperpartisanship borne of the Manichean world view."

Following after this victory, Lerach sooned carved out a career for himself as the high-profile scourge of Corporate America, and at the same time becoming the poster child for class action excesses. This list of companies Lerach ultimately sued reads like a membership list for the U.S. economy. Lerach became feared and reviled. And he also became enormously rich.

Despite (or perhaps because of) his enormous success, the weaknesses Lerach had shown in the Methodist Church case clearly could at times consume him. This is perhaps nowhere as evident as in his mad, ill-fated bid to avenge himself on Daniel Fischel, who had testified as a witness for the defense in the Nucor case. Lerach blamed Fischel for his stinging defeat in that case. When Lerach later filed a suit against Charles Keating in connection with the Lincoln Federal scandal, Lerach named Fischel and his firm as defendants. Though the claim was later compromised (in a "disposition," not a "settlement") Fischel never forgot the many outrageous things Lerach said along the way (many of which cannot be reproduced in this family-oriented blog).

In the end, Fischel was the one to get revenge. His subsequent slander suit against Lerach and his firm resulted in a $45 million verdict in his favor, and while the unresolved punitive damages phase was pending, the law firm agreed to pay $50 million to resolve the whole thing, agreeing even to have the settlement funded, in cash, that same day. There is something about this whole sequence of events that encapsulates so much about Lerach -- the excess, the outrageousness, and the way in which his own conduct caused him so much damage.

The book’s authors are not lawyers, but I think they deserve high marks for the way they deal with the legal topics. They also deserve credit for their appreciation of the atmosphere that Lerach’s excesses generated and how it influenced other participants in the process.

For example, the authors perceptively note that many of Lerach’s targets felt compelled to capitulate rather than confront a mad man – yet, the authors note, many of the companies who were unwilling to give in managed to walk away paying nothing. The lesson that the authors drew was that "if you really had done nothing wrong, it made sense to fight these class action securities cases in court. If more firms had done this successfully, there likely would have been fewer plaintiffs’ lawsuits."

The authors, unlike many other journalists that traverse this ground, also demonstrate an appreciation for the complex role that D&O insurance plays in the process, and indeed, that the actions and activities of class action attorneys have on the D&O insurance marketplace.

But what the authors do best, and what makes this book worth reading, is the way they weave the story of the criminal investigation through the massive corporate scandals, which were unfolding at the same time. The authors also methodically show how so much of Lerach’s crusading activities depending on his firm’s corrupt system for procuring plaintiffs on whose behalf to bring the suit, as well as on the testimony of a corrupt expert witness.

Many of the details of the criminal investigation may be familiar to many readers. The almost unbelievable way that a lover’s quarrel in Cleveland triggered a sequence of events that ultimate brought down Bill Lerach and Mel Weiss has been told elsewhere. The authors retell these tales particularly well. But what makes their version so compelling is the way the authors overlay events that were going on at the same time, particularly Lerach’s representation of the Enron litigants and his dispute with Weiss over the WorldCom case.

Frankly, Lerach’s contributions also help make the story compelling. His involvement provides a narrative tone and personal focus that bring the events to life. Lerach does not come off sympathetically, but he does come off as a real person – corrupt, deeply flawed, but real. As the authors say toward the end of their book, "Bill Lerach was no monster, but he had indeed gone after fraud by using fraud."

.

• Email This
• Print
• Comments (1)
• Trackbacks
• Share Link

The much-anticipated annual letter to Berkshire Hathaway shareholders of its Chairman Warren Buffett has long been valued for its business insights and occasionally humorous tone. The 2009 version, which was released on Saturday February 27, 2010, and which can be accessed here, is no exception, though the expanding size of Berkshire’s business portfolio has reduced Buffett’s discussion of many company operations to just a few sentences and left relatively little space for his usual commentary.

Buffett does manage to work in some choice observations about the responsibilities of financial institutions’ senior officials for their companies’ collapses, and also about boards’ responsibilities in the M&A context.

For many readers, the 2009 version may be noteworthy for the things it does not discuss. For example, the 79-year old Buffett has nothing to say about leadership succession planning at the company (although the February 27, 2010 Wall Street Journal does fill the gap somewhat with an interesting article, here, about possible Buffett successor David Sokol, the Chairman of MidAmerican Energy)

Buffett also has nothing to say about recent events of keen interest to Berkshire’s shareholders, including the company’s addition to the S&P 500 and its loss of its triple-A financial rating (owing to the company’s deployment of cash for its largest-ever acquisition of Burlington Northern Santa Fe).

But despite the omissions, there is still much of interest in this year’s letter. Full disclosure: I hold BRK.B shares, although not nearly as many as I wish I did. (Actually, I do own more shares than I used to, due to the January 2010 50-for-1 split of the B shares.)

Buffett on Boards of Directors

For readers of this blog, the most interesting comments in this year’s letter are Buffett’s remarks about senior management of the financial institutions at the center of the global financial crisis. Buffett prefaces his comments by stating that he would never "delegate risk control," going on to contend that "in my view a board of directors of a huge financial institution is derelict if it does not insist that its CEO bear full responsibility for risk control."

Buffett not only suggests that corporate leaders should have full responsibility, but that there should be liability consequences for failure. Buffett says that if the CEO "fails" at risk control, "with the government thereupon required to step in with funds or guarantees," the "financial consequences for him and his board should be severe." Buffett notes that it has "not been shareholders who have botched the operations of some of our country’s largest financial institutions," yet they have had to "bear the burden" caused by the management errors. Despite shareholder losses, "the CEOs and directors of the failed companies … have largely been unscathed."

Buffett proposes that "the behavior of the CEOs and the directors needs to be changed," and they way to do that he suggests is to ensure that if "institutions and the country are harmed by their recklessness," then "they should pay a heavy price – one not reimbursable by the companies they’ve damaged or by insurance." Senior managers have long enjoyed "oversized financial carrots," now their employment arrangements should now include "meaningful sticks."

Buffett’s grumpy ruminations about board behavior don’t stop there; later in his letter, he returns to the boardroom context to discuss board functioning in the M&A context. He notes, based on his "more than fifty years of board membership," that directors often are "instructed" by "high-priced investment bankers (are there any other kind?)" on the value of a proposed acquisition target. But "never" has he heard investment bankers "or management!" discuss the "true value of what is being given" for the acquisition when company stock is being used to finance the acquisition.

Buffett proposes, as the only way to get "a rational and balanced discussion," that directors hire a "second advisor to make the case against the proposed acquisition," with the advisor’s fee "contingent on the deal not going through." He concludes with an observation about the way deal advisors typically function by the aphorism "Don’t ask the barber whether you need a haircut."

Buffett on Berkshire’s Investments

Overall, Buffett’s letter is upbeat, as might be expected in a year in which his company’s net worth rose $21.8 billion and income rose 61 percent to $8.06 billion. (This after the company reported in 2008 its worst results ever, due to the effects of the global financial crisis.)

Buffett is particularly chipper in talking about the performance of the company’s investments. He notes that the company has "put a lot of money to work during the chaos of the last two years," adding that its been an ideal period for investors" because "a climate of fear is their best friend."

The tale of Berkshire’s recent cash deployment is truly remarkable. The company entered 2008 with $44.3 billion in cash and cash equivalents, and during 2008 and 2009 the company retained an additional $17 billion in earnings. Nevertheless, by the end of 2009, the company’s cash pile was "down" to $30.6 billion (with $8 billion of that earmarked for the Burlington Northern acquisition) – implying a net cash outflow of $47.6 billion, or as much as $55.6 billion if the Burlington Northern obligation is taken into account.

Where has the cash gone? Well, in addition to the massive Burlington Northern deal and other items, the company invested an absolutely astonishing $22.1 billion in non-traded securities of just five companies: Dow Chemical, General Electric, Goldman Sachs, Swiss Re and Wrigley. Under the heading "that’s why he’s Buffett and you're not," it should be noted that these investments (which cost $22.1 billion) have a carrying value of $26 billion and also deliver an aggregate $2.1 billion annually in dividends and interest (or roughly 10% of cost annually, meaning the investments will pay for themselves in about 7.2 years).

Moreover, these massive purchases are far from the only investment successes on Buffett’s scorecard. Berkshire’s $232 million investment in 2008 in Chinese battery maker BYD Company is now worth $1.9 billion. Buffett also accumulated corporate and municipal bonds in 2009, which he called "ridiculously cheap." But, he wrote "I should have done far more. Big opportunities come infrequently. When it's raining gold, reach for a bucket, not a thimble."

Not all of Buffett’s financial moves have been funded out of cash; the company also sold some investments, including in particular its holdings in Conoco Phillips, Proctor & Gamble and Moody’s. Each of these investment sales is interesting in its own way.

In his 2008 letter, Buffett cited his mid-2008 purchase of ConocoPhillips as one the "dumb things" he had done during the year, referring specifically to the purchase as a "major mistake of commission" because he bought the shares at their peak. Berkshire’s P&G holdings were the result of P&G’s acquisition of Gillette, which had been a major Berkshire holding for many years prior to that. Buffett seemingly was less interested in holding the shares of the more diversified company.

The sale of the Moody’s shares is perhaps the most interesting move, as the company’s Moody’s position had been a prominent part of its portfolio for many years. Moody’s share price has plunged during the last couple of years as a result of controversies surrounding the company’s ratings of subprime-related investments. Buffett has plenty to say in his 2008 letter about the excesses that cause the subprime meltdown, but even then he omitted any mention of Moody’s. Perhaps his sale of the company’s shares, even if accomplished without comment or observation, is the most eloquent statement he could make. (As an aside, in April 2009, Moody’s downgraded Berkshire from its highest investment rating.)

Buffett on Berkshire’s Balance Sheet

Though Buffett says nothing about the company’s loss of its triple-A financial rating, he has a great deal to say (perhaps defensively?) about the company’s financial strength. He emphasizes that "we will always arrange our affairs so that any requirements for cash we may conceivably have will be dwarfed by our own liquidity."

He goes on to comment, somewhat triumphantly, that "when the financial system went into cardiac arrest in September 2008, Berkshire was a supplier of liquidity to the system, not a supplicant." adding that "at the very peak of the crisis we poured $15.5 billion into a business world that could otherwise look only to the federal government for help."

Buffett on Berkshire Shareholders

As I have previously noted (here) about Buffett’s essays to Berkshire shareholders, one of the not so subtle goals of his missives is to try to ensure that the company has the right kind of shareholder – that is, investors willing to take a long-term view and patient enough to await long-term results. Due to the Burlington Northern acquisition (and the split of the company’s B shares), Berkshire now has many new shareholders, and in his 2009 letter, Buffett is trying to school these new owners on what he hopes for from them

Buffett is very explicit that he wants to "build a compatible shareholder population." On that topic, Buffett sounds some themes that will be familiar to regular readers of Buffett’s letters. He warns his new shareholders that "investors who buy and sell on media analyst commentary are not for us." Rather, Buffett wants "partners who join us at Berkshire because they wish to make a long-term investment in a business they themselves understand."

Buffett on Berkshire’s Businesses

Much of the balance of Buffett’s letter is given over to a review of the operating companies’ performances. With a few exceptions (such as his lengthy exegesis of the systemic challenges facing mobile-home manufacturer Clayton Homes), most of his company-specific reviews are quite brief. Indeed, many Berkshire businesses are not even motioned in the letter. As Berkshire has enveloped more and more companies, the kind of meaningful review Buffett claims to want to provide investors has been increasingly more challenging.

Readers of this blog undoubtedly will be interested in Buffett’s review of Berkshire’s massive insurance businesses, which continue to perform magnificently, collectively producing over $1.5 billion in 2009 calendar year underwriting profit despite prevailing soft market pricing conditions. This continued underwriting profitability, even if not shared equally by all of Berkshire’s insurance competitors, virtually ensures that the soft market conditions will continue until either pricing collapses to the point where profit is simply no longer possible or some external event intervenes to overwhelm industry profitability.

Discussion

Some may find Buffett’s harsh words about CEOs and corporate boards alarming. His suggestion that company officials should be held liable for the harm they have caused, without benefit of indemnity or insurance, will strike fear into the hearts of company officials everywhere. It is particularly noteworthy that his prescription for individual liability is not limited just to CEOs but expressly extends also to members of the company boards.

However, a careful reading of suggests that these remarks may represent less of a threat to corporate officialdom that might appear at first blush. For example, it is clear that his remarks refer to officials at companies whose woes have required a government bailout. His suggestion of direct personal liability without benefit of indemnity or insurance is made with reference to misconduct that causes harm both to "institutions and the country." So, before anybody hits the panic button, Buffett is not necessarily suggesting that indemnification and insurance are never appropriate for corporate officials, but perhaps only when the officials’ misconduct has necessitated a government bailout.

But just the same, Buffett’s comments that corporate officials (including, apparently members of boards of directors) should not have recourse to insurance undoubtedly will make some board members uneasy – not to mention how uncomfortable it makes those of us who make our living in the D&O insurance industry.

Buffett’s plan for building a shareholder base built on owners who buy into Berkshire’s long term philosophy is commendable. However, as Berkshire has grown, this aspiration may be less realistic. Buffett may want partners invested "in a business they themselves understand" but the reality is that Berkshire may have grown beyond the point where the typical investor can fully appreciate and understand its business.

The fact is that much of this year’s letter seems a mile wide and an inch deep – indeed, at one point, he simply lists the names of companies, without any further gloss or detail.

Buffett’s description of the results of Berkshire’s insurance businesses is a good illustration of the challenge facing Berkshire’s new shareholders. Buffett is lavish in his praise of Ajit Jain and his thirty person operation. Indeed, Buffett adds the humorous aside that if he, Berkshire Vice Chair Charlie Munger and Ajit were in a sinking boat, "and you can save one of us, swim to Ajit."

But as for what Ajit’s 30 person team does to produce hundreds of millions of dollars of profit, shareholders are left with cryptic comments like this statement: "During 2009, he negotiated a life insurance contract that could produce $50 billion in premium for us over the next 50 or so years." Seems kind of important, but as for what kind of risks or uncertainties it involves, Buffett has little to say, because he has already moved on to the next topic.

The next topic, in fact, is another Berkshire insurance business, Gen Re, which prior to the Burlington Northern acquisition was Buffett’s largest ever acquisition and Berkshire’s largest operating division. Buffett spares only 125 words for Gen Re, 48 of which are actually about Gen Re’s European subsidiary Cologne Re.

Buffett also has relatively little to say about Berkshire’s derivatives exposures, other than to defend these complex transactions that cause Berkshire’s reported results to swing by billions from quarter to quarter. I hope that those of us who can recall that Buffett himself called derivative contracts "weapons of financial mass destruction" can be forgiven for feeling less than entirely comfortable with Buffett’s hasty sketch of Berkshire’s derivatives exposure.

Buffett says that "Charlie and I avoid businesses whose futures we can’t evaluate." Some of Buffett’s shareholders may wonder how in the world they are supposed to evaluate the future of a company that is entering massive, complex multi-decade financial commitments but whose leadership will be in place for only a few more years. Despite all of Buffett’s earnest attempts to educate Berkshire’s owners, current and prospective investors may simply have to take it on faith – which certainly does shine a harsh spotlight on that unanswered leadership succession issue.

But for all of that, the annual letter is not a disappointment. It continues to be worth waiting for. Buffett did manage to work in the zingers about corporate responsibility. And he even slipped in some of his signature humor. My personal favorite in this year’s letter is his remark, made as a demonstration of Prussian mathematician Jacobi’s inversion principles, that if you "sing a country song in reverse … you will quickly recover your car, house and wife." He ends his letter, with its extensive discussion of the Burlington Northern acquisition, with a postscript suggesting that visitors attending the May shareholders meeting should "come by rail."

• Email This
• Print
• Comments (1)
• Trackbacks
• Share Link

In a ruling that may have potential significance for the many claims that have been filed against the rating agencies in the subprime litigation wave, on February 17, 2010, Southern District of New York Judge Lewis Kaplan dismissed all but one of the claims that had been filed against the individual defendants in the Lehman Brothers Mortgage-Backed Securities Litigation. A copy of Judge Kaplan’s February 17 order can be found here.

Background

Plaintiffs had purchased the mortgage back securities that Lehman Brothers issued in August 2005 and August 2006. The plaintiffs allege that the originators of the loans that backed the securities failed to comply with the general loan underwriting guidelines described in the offering documents. The plaintiffs allege that the offering documents had failed to disclose that the rating agencies, which were paid for providing their ratings, had conflicts of interest and had been involved in helping to structure the securities. The plaintiffs also allege that the offering documents failed to disclose that the credit enhancements supporting the loans were insufficient to support the investment ratings the rating agencies gave the securities.

The individual defendants in the case are the officers and directors of the Structured Asset Securities Corporation, which issued the registration statements and acted as depositor in the securitization process. The individual defendants moved to dismiss.

As noted in prior posts, Judge Kaplan has previously dismissed plaintiffs’ claims against the rating agencies themselves (refer here), rejecting plaintiffs’ arguments that the rating agencies were "underwriters" under the ’33 Act. Judge Kaplan also previously dismissed the separate ERISA class action claims (refer here, scroll down). In his February 17 decision, Judge Kaplan separately ruled on the individual defendants’ motion to dismiss.

The February 17 Decision

Judge Kaplan held that the plaintiffs’ allegations that the offering documents failed to disclose the rating agencies’ conflict of interest were insufficient to state a claim, for two reasons.

First, Judge Kaplan held that the Securities Act does not require disclosures of "that which is publicly known," and "the risk that the rating agencies operated under a conflict of interest because they were paid by the issuers had been known publicly for years."

Judge Kaplan then went on to hold that "the rating agencies’ role in structuring the certificates is not material as a matter of law." His conclusion is based on the following analysis:

If the fee arrangement undermined an investor’s confidence in the rating agencies’ independence, a disclosure that a rating agency was involved in structuring the Certificates prior to rating them would have added nothing important to the "total mix" of information. If, on the other hand, an investor trusted the ratings agencies to give an honest opinion notwithstanding the fact that they were paid by the issuer, the fact that they were involved in structuring the Certificates, assuming that they were, likewise would have been unimportant. In consequence, these claims are insufficient.

With respect to the plaintiffs’ allegations that the offering documents contained misrepresentations about the amount and form of credit enhancement, Judge Kaplan held that the statement about the credit enhancement was a "statement of opinion," which could be actionable only if the complaint alleged that the rating agencies did not actually hold that opinion.

Judge Kaplan found that "at best" the complaint’s allegations "support an inference that some employees believed the rating agencies could have used methods that better would have informed their opinions," which he held to be insufficient to state a claim.

But Judge Kaplan did hold that the complaint’s allegations that the loan originators "systematically failed to follow the underwriting guidelines" were "sufficient at this stage to support a reasonable inference that the offering documents’ description of the underwriting guidelines was materially misleading."

Accordingly, Judge Kaplan granted the individual defendants’ motion to dismiss all of the claims against them except plaintiffs’ Section 11 claims about the loan originators’ supposed departures from underwriting standards.

Discussion

Even though Judge Kaplan’s February 17 opinion was issued in connection with claims asserted against the individual defendants and not in connection with claims asserted against the rating agencies themselves, the opinion nevertheless potentially could be of great significance in other subprime mortgage-related cases in which claims have been raised against the rating agencies.

In particular, Judge Kaplan’s holding that the offering documents’ omissions about the rating agencies’ alleged conflicts of interest and role in structuring the securities were not legally actionable may be of particular significance.

In many of the other cases in which claims have been asserted against the rating agencies, the claimants have, like the plaintiffs in the Lehman case, alleged that the rating agencies had undisclosed conflicts of interest and were involved in structuring the investments at issue. The rating agencies will undoubtedly find Judge Kaplan’s holding that the alleged omission of this information is not legally actionable to be helpful.

Judge Kaplan did not reach the question whether or not the rating agencies’ ratings are protected by the First Amendment, which is another defense on which the rating agencies will attempt to rely. But if the alleged omissions about the rating agencies are not actionable in the first place, there may never be a need to reach the First Amendment issues.

Judge Kaplan conclusion that the disclosures concerning the securities’ credit enhancements represented opinion rather than statements of fact is also instructive, even without getting into the First Amendment issues. As his February 17 decision states, statements of opinion are actionable only if the allegations show that the opinions were not actually as disclosed. Again, Judge Kaplan’s rulings are instructive and potentially significant as they suggest ways in which the claims against the rating agencies may be considered without even getting into the First Amendment issues.

Finally, Judge Kaplan’s holding that the rating agencies’ alleged conflicts of interest and involvement in the securitization transaction are immaterial does raise interesting questions about claimants’ ability to overcome the rating agencies’ First Amendment defenses. The plaintiffs have argued that the rating agencies were not entitled to rely on the First Amendment defense in the context of these kinds of structured investments because of the conflicts of interest and involvement in the transaction. Perhaps Judge Kaplan’s rulings are unrelated to these issues, but it does seem incongruous that considerations that are immaterial would be sufficient to overcome a constitutional defense.

Of course, it is entirely possible that other courts may not be persuaded by Judge Kaplan’s analysis. It is not intuitively obvious that, because it was public knowledge that rating agencies had conflicts, the rating agencies’ involvement in the transactions is legally immaterial. Indeed, the jump between the public knowledge of the conflict of interest and the immateriality of the rating agencies’ involvement in the transactions is frankly unsatisfying. Other courts might well be unwilling to make that analytic jump.

I have in any event added Judge Kaplan’s February 17 opinion to my table of subprime-related lawsuit motion to dismiss rulings, which can be accessed here. Because a portion of the claims against the individual defendants survived the dismissal motion, I have listed the ruling in the table of dismissal motion denials.

Special thanks to a loyal reader for sending a copy of Judge Kaplan's February 17 opinion.

• Email This
• Print
• Comments (1)
• Trackbacks
• Share Link