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

It was possible to overlook it amongst the flurry of high profile opinions the Supreme Court released on the final day of the 2009 court term, but on June 28, 2010 the Court granted yet another petition for writ of certiorari in a case arising under the securities laws. Although the case arises out of the specific context of a mutual fund market timing case, it raises fundamental issues about who may be a "primary violator" under the securities laws. The Court seems poised to delve yet again into critical issues under the federal securities laws.

Background

Janus Capital Group (JCG) is the holding company for a family of mutual funds. Janus Capital Management (JCM) is the funds’ investment advisor. In November 2003, JCG investors filed a complaint in the District of Maryland alleging that the two firms were responsible for misleading statements in the certain funds’ prospectuses. The allegedly misleading statements represented that the funds’ managers did not permit, and took active measure to prevent, "market timing" of the funds. The investors claim they lost money when market timing practices JCG and JCM allegedly authorized were made public.

In 2004, JCM reached a settlement with the SEC in connection with the market timing allegations in which the firm paid a disgorgement of $50 million and an additional $50 million in civil penalties. Information regarding the settlement can be found here.

The district court dismissed the shareholders suit in May 2007. The shareholders appealed to the United States Court of Appeals for the Fourth Circuit. In a May 7, 2009 opinion (here), the Fourth Circuit reversed the district court, finding that the shareholders had adequately stated a claim under the securities laws. The defendants’ filed a petition for writ of certiorari, which the Supreme Court granted on June 28, 2010.

Issues Involved

As the Supreme Court itself recently affirmed in its Stoneridge case (about which refer here), there is no private action for aiding and abetting liability under the federal securities laws. Accordingly, the defendants can be liable if at all if they are "primary violators," that is, if they are directly responsible for the allegedly wrongful conduct. The Janus entities contend that as mere service entities for the actual funds, they cannot be held primarily liable.

The plaintiffs argue that JCM was not a "mere service provider" contending that the firm handles all of the funds’ operations, "including preparation, filing, and dissemination of the Fund prospectuses and prospectus statements" and that all of the funds’ officers were executives at the advisor. The investors contend that they had every reason to believe that the Fund prospectus statements were JCM’s work.

The Fourth Circuit ruled that "a service provider can be held primarily liable in a private securities fraud action for ‘helping’ or ‘participating’ in another company’s misstatements." The Fourth Circuit’s ruling is at odds with the decisions of other Circuit courts. Some courts hold that only someone that "makes" a statement and has it attributed to him can be held liable as a primary violator. Other courts, similarly to the Fourth Circuit, have held that someone that "substantially participates" in the activities that led to the creation of the allegedly misleading statement can be held liable as a primary violator, even if the statement is not attributed to him or her.

Discussion

Though this case nominally is just about whether or not a service provider can be held liable, fundamentally it is about who can be held liable as a primary violator. A bright line test would limit primary violator liability to those who speak or who have statements attributed to them. However, a broader "substantial participation" test would substantially widen the scope of persons who potentially could be held liable. The scope of liability could potentially extend to a wide range of persons who are involved in the preparation of public statements, including, for example, potentially even the issuers’ attorneys and accountants.

Indeed, at some level, this "substantial participation" test starts to sound a lot like the "aiding and abetting liability" that the Supreme Court had rejected in connection with private lawsuits in the Stoneridge case. That may, in fact, be why the Supreme Court took up the case – not just to reconcile an apparent split in the Circuits, but to align the principles of primary violator liability with those of the secondary violator jurisprudence. In a June 29, 2009 Am Law Litigation Daily article (here), Susan Beck furhter develops these issues relating to the tension between the Fourth Circuit's standard and the case law relating to secondary liabiltiy.

I have absolutely no way of knowing how this case ultimately will turn out, and indeed the case has yet to be fully briefed or argued. But if I were a betting man, I would bet that the principles on which the Fourth Circuit based its decision are unlikely to survive Supreme Court scrutiny. (I could also be wrong, which is why I don’t gamble.)

It is worth noting that the Court suddenly seems particularly keen to take up securities cases. As I recently noted here while discussing the Court’s cert grant in the Matrixx Intiaitves case, there was a time when the Court would go many terms without taking up any securities cases. For several years now, the Supreme Court has taken up one or two securities cases. The Court’s increased interest in securities cases make great blog fodder, but it also creates the potential for disruptive alterations of the settled litigation landscape.

The Court’s sudden heightened interest in securities cases must be particularly unnerving for plaintiffs’ lawyers as the Court, with its current lineup, has generally proven to be less than entirely plaintiff friendly. There is some considerable risk that the Janus case will provide yet another opportunity for the Court to deliver an opinion the plaintiffs’ bar finds unhelpful.

In any event, the Supreme Court will now have two potentially significant securities cases on its docket next term. I really do find it surprising, given this blog’s topical focus, how often I find myself writing about Supreme Court-related issues –especially lately. I never expected that. I do find it all very fascinating though

Special thanks to the several readers who sent me links and other materials about this case. Special thanks to the SCOTUS Wiki blog (here) for links to some of the key documents to which I linked above.

Surprising Stuff Under the Hood of the Financial Reform Act: In recent posts (most recently here) I noted the possibility that the Supreme Court’s decision in the Morrison v. National Australia Bank case could well trigger Congressional action, particularly with respect to the SEC’s authority over conduct in the U.S. even if the transaction occurred outside the U.S.

An alert reader who clearly has a lot of patience managed to sift through the thousands of pages of the Conference Committee version of the financial reform bill (the "Dodd-Frank Wall Street Reform and Consumer Protection Act," which can be found here), and he reports (and my review of the Bill confirms) that the Conference Bill actually addresses the extraterritorial question.

First, Section 929P(b) authorizes an action brought by the Commission, inter alia, based on "conduct within the United States in furtherance of the violation," in effect allowing the Commission to take enforcement action based on conduct in the U.S. even if the transaction took place outside the U.S. (if all the provision's conditions are met).

Second, Section 929Y, entitled "Study of Extraterritoral Private Rights of Action," directs the Commission to study whether private rights of action should be allowed on the same basis as authorized for the Commission in Section 929P(b). The provision directs the Commission to deliver the report to Congress within 18 months of the statute’s enactment.

In other words, if the Bill is enacted in its current form, the Commission will have the ability to bring cases involving foreign companies and even involving transactions outside the U.S., if the conduct meets the standards defined in the provision, and the Commission will study and report to Congress on whether private claimants should have the same right.

Very special thanks to the alert reader who found these provisions and pointed them out to me.

Bank Shot: Regular readers know I have been reporting frequently on the possibility of litigation arising in the wake of the wave of failed banks. The July 2010 issue of U.S. Banker has an article entitled "First the Failures, Then the Lawsuits" (here) which takes a very interesting look at this possibility.

The article reports that the FDIC "has begun laying the groundwork for potentially years of lawsuits against senior executives and directors it claims may have been responsible for their bank’s collapse." The article notes that the FDIC has sent "hundreds of demand letters," which the article describes as "the necessary first steps in assessing accountability."

Among other things, the article reflects a dispute over who the FDIC is targeting with the demand letters. On the one hand, the article quotes the executive director of the American Association of Bank Directors as saying that the "where there’s money to go after," the FDIC is pursuing the claim, "whether there is a good case or not." On the other hand, the article quotes an agency attorney as saying "How far we go depends on the facts and circumstances of each case…If … there’s nothing there, then we close out the investigation."

The article points out that while the FDIC has not filed any director or officer lawsuits during the current crisis, "but observers say that will likely change soon," particularly in light of the three-year statute of limitation. One attorney is quoted as saying we may start to see the suits in 2011 with more in 2012.

The article quotes an agency official as saying that the purpose of the demand letters "is simply to preserve insurance," adding that "we try to make enough of a preliminary investigation to make sure that when we send the letter we’re sending it to the right people and we have a basis for the claim."

Special thanks to a loyal reader for sending a link to the article.

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One of the recurring D&O insurance coverage issues is the question of excess D&O insurers’ obligations when the underlying insurers have paid less than their full policy limits as a result of a compromise between the underlying insurers and the policyholder.

In the latest of a growing line of recent cases examining these issues, Judge Wayne Anderson of the Northern District of Illinois, in a June 22, 2010 opinion applying Illinois law, held that the "plain language" of the excess D&O insurance policies at issue required the actual payments of full policy limits in covered claims before the insureds could access the excess insurance.

Background

During the relevant period, Bally Total Fitness Holding Corporation carried a total of $50 million in D&O insurance arranged in five layers of $10 million each, between a primary insurer and four excess insurers. Bally and certain of its directors and officers were named as defendants in a securities class action lawsuit (about which refer here) in connection with which Bally incurred $33 million in defense expenses, for which Bally sought coverage under from its D&O insurers.

The primary insurer initiated an action in the Northern District of Illinois seeking a judicial declaration of noncoverage. Bally joined the excess insurers to the action as third-party defendants. Ultimately the primary insurer and the first and second level excess insurers reached a compromise by which they agreed to contribute a total of $19.5 million toward Bally’s defense expenses. The first level excess insurer settled for $8 million, $2 million less than its full policy limit. The second level excess insurer settled for $1.5 million.

The third and fourth level excess insurers refused to settle or otherwise contribute toward Bally’s defense expense. These two excess insures argued that the conditions precedent to coverage in their excess insurance policies had not been triggered. In making this argument, the third level excess insurer relied on its policy’s language that its payment obligations are triggered "only after the insurers of the Underlying Policies shall have paid, in the applicable legal currency, the full amount of the Underlying Limit." The fourth level excess insurer relied on language in its policy specifying that its payment obligations apply "only after all Underlying Insurance has been exhausted by payment of the total underlying limit of insurance."

The Court’s June 22 Opinion

In his June 22 opinion, Judge Anderson granted the third and fourth level excess insurers’ motions for summary judgment, finding that the plain language of their policies requires that the underlying insurers each "make actual payments of $10 million each in covered claims before Insureds can access coverage provided by the Third and Fourth Layer Excess Policies."

The insureds had argued that the third and fourth level excess policies were "ambiguous" as to whether the underlying policies had to make actual payment of a full $10 million each to trigger the top level excess carriers’ coverage. The insureds argued that the third and fourth level excess carriers had contracted to pay claims in excess of specified levels "regardless of who makes payment for covered claims" below those levels.

Judge Anderson considered the case law on which the insureds relied, particularly the 1928 Second Circuit decision in Zeig v. Massachusetts Bonding & Ins. Co.. In examining this line of cases, Judge Anderson concluded that "if an excess insurance policy ambiguously defines exhaustion, as in Zeig, courts generally find that settlement with an underlying insurer exhausts the underlying policies." However, Judge Anderson went on, "in cases where the policy language clearly defines exhaustion, the courts tend to enforce the policy as written."

Judge Anderson went on to find that the third and fourth level excess policies clearly defined how the underlying insurance must be exhausted prior to the insureds accessing coverage. Accordingly, and because the underlying insurance had not been exhausted by the underlying insurers’ payment of covered loss, Judge Anderson granted summary judgment in the third and fourth excess insurers’ favor.

Discussion

As a result of rising settlement levels and escalating defense costs, excess D&O insurance has become increasingly important in D&O claims resolutions. As more and more claims get pushed into the excess layers, more and more questions are arising, including this recurring question of whether the excess carriers’ payment obligations are triggered when the policyholder has compromised with the underlying carriers.

Judge Anderson’s holding in the Bally Total Fitness case joins a line of several recent cases in which courts have similarly held that, given the excess policy language at issue, the excess carriers’ payment obligation were not triggered when the underlying carriers paid less than their full policy limits as a result of a compromise with the policyholder. These recent cases include the July 2007 Eastern District of Michigan decision in the Comerica case (about which refer here) and the March 2008 California intermediate appellate court decision in the Qualcomm case (about which refer here).

The outcome of these various coverage disputes is a direct reflection of the excess policy language involved, and in particular the language specifying what is required in order for excess insurers’ payment obligations to be triggered. These cases underscore the critical importance of the language describing the payment trigger in the excess policy.

In recent months, and in large part as a reaction to these cases, excess carriers increasingly have been willing to provide language that allows the excess carriers’ payment obligations to be triggered regardless whether the underlying amounts were paid by the underlying insurer or by the insured. (I note as an aside that this language was not generally available at the time that Bally Total Fitness purchased the D&O insurance at issue in this case.)

The potential importance of the excess insurance payment trigger language, and the availability of language alternatives in the current insurance marketplace, in turn underscores the importance for policyholders of involving a knowledgeable and experienced D&O insurance broker in their acquisition of D&O insurance. The presence of the most favorable excess trigger language, among many other critically important policy language issues, could make a significant difference in the availability of coverage in the event of a claim.

Speedy Justice: According to Judge Wayne Anderson’s official biography (here), the Judge is the co-holder of the record for the 100-yard dash at Harvard University, from which he graduated in 1967.

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In a June 28, 2010 decision (here), the Supreme Court issued its opinion in Free Enterprise Fund v. Public Company Accounting Oversight Board case. This case had been widely followed because the petitioners challenged the constitutionality of the Sarbanes-Oxley Act and of the Public Company Accounting Oversight Board (PCAOB).

The petitioners prevailed before the Supreme Court, and a majority of the Court held that restrictions on the removal of PCAOB board members were unconstitutional, but the Court declined to hold either that the Sarbanes Oxley Act itself or the PCAOB are unconstitutional. The net effect is that Sarbanes-Oxley remains fully operational, other than the provisions governing the removal of PCAOB members.

Background

This case arises out of a dispute involving a small Nevada accounting firm, Beckstead and Watts. In September 2005, the PCAOB disclosed that it was investigating the firm and that it had found "deficiencies" eight of sixteen of the firm’s audits. In response, the firm sued the PCAOB and the federal government, seeking an order blocking the PCAOB from taking any further action. The firm was joined in the action by the Free Enterprise Fund, which according to its website, is a nonprofit advocacy group "dedicated to fighting the so-called Sarbanes-Oxley law."

The plaintiffs contended that in creating the PCAOB in the Sarbanes Oxley Act, Congress set up a private corporation that exercised governmental authority. The plaintiffs argued that this arrangement and in particular SOX’s statutory provision for the SEC’s appointment of the PCAOB’s five members, and more particularly specifying that the members can only be removed by the Commission for just cause, contravened the separation of powers in the U.S. Constitution by conferring wide-ranging executive power on Board members without subjecting them to Presidential control.

In a March 21, 2007 decision, Judge James Robertson of the District Court for the District of Columbia rejected the plaintiffs’ arguments, and on August 22, 2008, the D.C. Circuit Court affirmed the lower court’s dismissal. The Circuit Court later denied an en banc review, and the plaintiffs filed a petition for a writ of certiorari to the Supreme Court, which the Court granted.

An excellent summary of the background regarding the case and the parties’ arguments can be found on the SCOTUSWiki site, here. My prior post about the case can be found here.

The Supreme Court’s Opinion

In a 5-4 majority opinion written by Chief Justice John Roberts, the Court focused on the Sarbanes Oxley’s Act’s provisions for the removal of the PCAOB members. The removal provision provides that members can only be removed by the SEC Commissioners for good cause shown and then only pursuant to rigorous procedural requirements. The Court said the arrangement "not only protects Board members from removal except for good cause, but withdraws from the President any decision on whether that good cause exists."

The result of what the Court described as "a second level of tenure protection," in the form of the procedural requirements, is that the Commission "cannot remove a Board member at will" and the President therefore "cannot hold the Commission fully accountable." This arrangement, the majority found, is "contrary to Article II’s vesting of the executive power in the President." The majority opinion added:

By granting the Board executive power without the Executive’s oversight, this Act subverts the President’s ability to ensure that the laws are faithfully executed – as well as the public’s ability to pass judgment on his efforts. The Act’s restrictions are incompatible with the Constitution’s separation of powers.

However, having found a provision of Sarbanes Oxley Act to be unconstitutional, the majority drew back from finding either the entire Act or the PCAOB itself to be unconstitutional. The Court found that the "unconstitutional tenure provisions are severable from the remainder of the statute" and that even if board removal provisions violate the Constitution, the "existence of the Board does not." The Act itself "remains fully operative as a law with these tenure restrictions excised," since the "remaining provisions are "not incapable of functioning independently."

The majority opinion reversed the Court of Appeals opinion in part and remanded the case for further proceedings.

A dissenting opinion written by Justice Breyer asserted that the removal provisions violated no separation of power principles and contended that the majority’s ruling "threatens to disrupt severely the fair and efficient administration of the laws" because it is inconsistent with the structure of many administrative agencies.

Discussion

Though the majority found a portion of the Sarbanes Oxley Act to be unconstitutional, its holding was about as limited and as nondisruptive (at least as to the continued operation of the Act) as might be hoped for, given the finding of constitutionality. Certainly the finding that Act remains otherwise fully operational fell well short of the plaintiffs’ objective so trying to have the entire Act set aside.

Indeed the relief provided seems like pretty weak beer. The majority said only that "petitioners are not entitled to broad injunctive relief against the Board’s continued operations. But they are entitled to declaratory relief sufficient to ensure that the reporting requirements and auditing standards to which they are subject will be enforced only by a constitutional agency accountable to the Executive."

The Court’s refusal to declare the entire Act unconstitutional, despite finding one part to be unconstitutional, might have surprised and disappointed some advocates and Court watchers, who, as discussed here, had contended that the absence from the Act of a "savings clause" preserving the rest of the statute if one part was disallowed, should have required the entire Act to be found improper. The Court clearly strained to avoid this result, relying on prudential and precedential principles to steer clear of a disruptive result that arguably might otherwise have been required by absence of a statutory savings clause.

As the Conglomerate blog commented, the majority opinion "illustrated how to hold an agency to be unconstitutional without really doing anything important at all." CFO.com quotes one commentator as saying that the decision against the PCAOB "was about as gentle a finding as you could expect." The Volokh Conspiracy blog said "The Court drew a line in the sand to safeguard executive power and ensure greater accountability, but did so without picking much of a fight."

The net effect of the Court’s holding is that the SEC now may remove the PCAOB board members at will, rather than having to go through the removal procedures that had been defined in the Sarbanes Oxley Act. The SEC issued a statement after the opinion was published in which the SEC said that "the Act ‘remains fully operative as a law’ with the for-cause restrictions excised, leaving the members of the PCAOB subject to removal by the Commission without restriction. The opinion does not call into question any action taken by the PCAOB since its inception." 

Professor Stephen Bainbridge has an interesting commentary on his eponymous blog (here) commenting that he is "unpersuaded" by the majority opinion, agreeing with the dissent that there is nothing about the effective result of the Court’s ruling that actually validates the President’s actual right or authority to oversee the PCAOB.

In a nice piece of ironic timing, the Court released its opinion in the case on the first day of the Senate Judiciary Committee confirmation hearings for Supreme Court nominee Elena Kagan. The Court’s ruling represents a defeat for Kagan, who as Solicitor General had argued the case for the government. (A transcript of the oral argument in the case can be found here.)

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As I discussed in a recent post, on June 23, 2010, the Ninth Circuit issued an opinion reinstating the $277.5 million jury verdict in the Apollo Group securities class action lawsuit. In my post discussing the opinion, I included some observations about the Ninth Circuit’s ruling and the likely future course of the Apollo Group case, as well as about the current state of play on post-PSLRA jury trials in securities class action lawsuits in general.

Over the weekend, Tower Snow of the Howard Rice law firm sent me a note commenting on my observations. Because I think Tower makes a number of interesting points, I asked his permission to reproduce his observations on this blog. Tower very graciously gave me permission, and the text of his email is reproduced in indented text below.

Although I rarely disagree with what you post on the blog, I do disagree with the conclusions you draw re where the Apollo case is heading.

The Ninth Circuit reversed based on the concept that the market may have failed to appreciate the significance of earlier disclosures and that any earlier disclosures may not have been of sufficient intensity and credibility for the market to understand them. Thus, according to the Ninth Circuit, the jury could properly conclude that the disclosure at issue was "corrective."  These are alien concepts to economists and the efficient market theory.

There is a vast universe of economic studies and literature which incontrovertibly shows that the financial markets are incredibly efficient (and sophisticated) and absorb and properly evaluate new information entering the markets in a matter of minutes. There is no respected economic literature which supports the idea that markets sometimes "fail to appreciate the significance" of negative information or that markets may be misled by disclosures because they are not of sufficient "intensity or credibility" to be fully understood. To the contrary, all the studies conclude the opposite.

The courts can't rely on the efficient market theory for purposes of creating a rebuttable presumption of reliance for purposes of class certification and then ignore its underpinnings for purposes of evaluating loss causation. Either one embraces the theory or one does not. If one embraces it, then once it is established that the prior disclosures revealed the truth about the allegedly misstated or omitted information, there is nothing left for the jury to decide. The later disclosure, by definition, cannot be corrective, as the market already had absorbed the information. Here, the "corrective" disclosure came out seven days after the information had been previously released. Seven days is an eternity in the financial markets.

The district court denied the defendants' motion for summary judgment on this issue because it had not heard the evidence. When it did, the court properly concluded that the "corrective" disclosure was old news. It was, and it could not under well established economic doctrine have caused plaintiffs' losses. The district court got it right.　

This case has a good chance of eventually making its way to the Supreme Court. If it does so, the defendants will win. Loss causation is too important an issue, and the lower courts are all over the map in applying the efficient market doctrine in different contexts. Either the efficient market theory has to be embraced and applied consistently, as economists apply it, or it should be thrown out.

For what it is worth, I also come to a different conclusion re Post-PSLRA trial results. Although your win/loss numbers are correct, when one takes into account post plaintiff-verdict settlements and plaintiff verdicts in the context of the damages sought, plaintiffs have done very poorly. What the trials show is that juries view investing as a high risk game, they hold investors accountable for their actions and losses, and they are not inclined when seeing individual officers and directors-- absent very compelling evidence -- to easily conclude that  they engaged in fraud. Couple these dynamics with plaintiffs' fear of post-trial adverse rulings, the dangers of appeals, the time delays, and a host of other factors, and it becomes apparent that even a plaintiff "win" often turns into a loss. I personally doubt whether either the Apollo or Vivendi verdict will survive.　

I would like to express my thanks to Tower for taking the time to send a detailed commentary and for his willingness to allow me to reproduce it here. I welcome submissions from responsible persons who are interested in proposing guest posts for publication on this blog. I am in any event always interested in hearing what readers think.

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It was obvious from the first reading that the U.S. Supreme Court’s decision in Morrison v. National Australia Bank represents a sweeping victory for the defendants. As I noted in my initial post after the decision came down, the Court’s holding that plaintiffs can’t pursue fraud claims for securities purchased on foreign exchanges will have a significant impact both on pending cases and on future filings.

On further reflection, it seems the case could have even more significant implications.

First, with respect to pending cases, it is worth noting that Vivendi itself believes, as I suggested in my prior post, that National Australia Bank ruling has significant implications concerning the jury verdict entered against the company in January 2010. Indeed, Vivendi issued a June 25, 2010 press release (here), in which it said that the company is "very satisfied" with the decision, commenting further that the Court’s ruling is "totally in line with the position defended all along by the Group in the American and French Courts."

According to prior press reports (here), as many as two-thirds of Vivendi’s investors live in France, and undoubtedly many of them, as well as many of Vivendi’s other investors that reside outside the United States, likely bought their shares on securities exchanges outside the United States. Under the transactional test the Court enunciated in the National Australia Bank decision, investors who bought their share on non-U.S. exchanges cannot pursue a claim under U.S. securities laws. It seems likely that the class of persons entitled to claim injury in the Vivendi case necessarily will be dramatically narrowed.

There are many other pending cases that are likely to be similarly affected. In a June 25, 2010 AmLaw Litigation Daily article (here), Andrew Longstreth examines the likely impact of the National Australia Bank case on the securities class action litigation filed under U.S. securities law against BP and certain of its directors and officers. BP’s common shares trade on the London Stock Exchange, and though many investors likely bought American Depositary Receipts for BP on U.S. exchanges, many of its shareholders more likely bought their shares in the U.K. (The AmLaw article notes that 28% of BP’s equity is in ADRs, so those shares are unlikely to be affected by the Supreme Court’s recent decision.)

Other cases that are likely to be affected by the Supreme Court’s decision include the action brought against Porsche, which was sued in January 2010 by short sellers of Volkswagen stock who claimed Porsche secretly cornered the market in Volkswagen shares but denied that it intended to acquire Volkswagen. According to a June 25, 2010 Bloomberg article (here) discussing the impact of the National Australia Bank decision on the Porsche case, the plaintiffs claims in the case are likely reduced only to "causes of action based on low-volume American depositary shares."

A number of foreign-domiciled companies that have been the target of securities class action litigation under U.S. securities laws filed amicus briefs in the National Australia Bank case; the cases filed against many of these companies, including EADS and Alstom, seem likely to be substantially affect by the Court’s holding.

Other recently filed cases also seem likely to be affected, including the cases recently filed against Toyota,

Securities suits against foreign companies have in recent years been a significant part of overall securities lawsuit filings in recent years. For example, 24 (or 12.7%) of the 2009 securities lawsuit filings involved companies that are domiciled outside the United States. In 2008, there were 34 foreign domiciled companies sued in securities class action lawsuit, or about 15% of all filings that year.

Not all of these securities suits are necessarily going to be affected by the National Australia Bank case. For example, the lawsuit filed earlier this year against Nokia was at the very outset brought only on behalf of investors who bought their American Depositary Shares in the company on U.S. exchanges. Similarly the lawsuit filed late last year against Siemens was brought solely on behalf of purchasers of the company’s American Depositary Receipt shares.

The fact that cases against foreign companies with securities trading on U.S. exchanges may still be susceptible to securities class action litigation in U.S. court because their securities trade on U.S. exchanges could well discourage some overseas companies from having their shares trade here.

While there will still be circumstance even after National Australia Bank in which securities suits in U.S. courts against foreign-domiciled companies will still be filed and will still go forward, it seems probable that many other cases that might have been filed in the past will now simply go unfiled, at least in the U.S -- particularly in those cases where the foreign companies do not have significant numbers of ADRs or other securities trading on U.S. exchanges.

Given what a significant percentage of total U.S.-based securities class action filings these actions against foreign companies have become in recent years, the reduction in these filings could mean a material reduction in the overall level of securities class action filings (although please see my comments below about some other possibilities for U.S.-based litigation.)

The fact that investors who bought shares on foreign exchanges can no longer access U.S. courts clearly creates a problem these investors. As the filing levels described above demonstrate, these investors increasingly had come to rely on the U.S processes and remedies as a way to seek redress when they felt they had been misled, at least where the alleged fraud involved U.S-based conduct.

Indeed, numerous foreign institutional investors had filed amicus briefs in the National Australia Bank case (refer for example here), arguing that "both foreign and domestic investors alike rely on American Law to ensure that corporations doing business in America are not tainted by fraud."

Now that these investors can no longer "rely on American Law" in many instances, these investors will have to consider their alternatives. One possibility is that these investors will increasingly rely on remedies in their own country. Without access to U.S. courts, these and similarly situated investors may find action in their domestic courts more attractive.

For that matter, without access to U.S remedies and processes, investors in foreign countries may press for the implantation of legal reforms in their home countries to permit them better means of attempting to recoup losses based on alleged fraud.

Of course, resourceful plaintiffs’ lawyers in this country are now highly motivated to try to find ways around the National Australia Bank decision. Some possible ways it might be circumvented include filing individual lawsuits in state court under state law, and filing federal court class actions alleging state law violations. Claimants in these kinds of cases arguably may face the same hurdles of trying to show that the relevant law provides remedies regarding securities transactions on foreign exchanges, but the existence of U.S.-based fraudulent conduct potentially could provide a sufficient basis for relief under many legal theories, even if not under the federal securities laws.

Another possibility is that the foreign institutional investors and others may seek legislative change in the U.S. in order to establish a new statutory basis for relief in U.S. courts for investors who bought shares overseas, at least where there is U.S.-based conduct involved in the alleged fraud. As I pointed out in my prior post, legislative initiatives in the current Congress proposed to do that very thing.

As Luke Green points out in his post on the Risk Metrics Securities Litigation blog (here), the National Australia Bank case does not carve out an exception for the SEC and the DoJ, and there may be considerable interest providing statutory means for these agencies to pursue remedies for U.S.-based fraudulent conduct even if in connection with transactions on foreign exchanges. (Green also has a number of other interesting thoughts and comments about the decision.)

UPDATE: An alert reader points out that in the Conference Committee of the financial reform bill (called "The Dodd-Frank Wall Street Reform and Consumer Protection Act", here ) there are provisions addressing these questions of extraterritoriality. First, Section 929P(b) authorizes an action brought by the Commission based on a statutorily defined conduct and effects test. Second, Section 929Y directs the Commission to study whether private rights of action should be allowed on the same basis as authorized for the Commission in 929P(b). The Commission is to report to Congress within 18 months of the statute's enactment.

The bottom line is that National Australia Bank is an important decision that will have a number of significant impacts, some immediately and some in the months and years to come. Some of the impacts are obvious and apparent now, and some will only become apparent over time.

The National Australia Bank case does underscore how significant it is when the U.S. Supreme Court decides to take up a securities case. Each occasion represents a context within very significant changes in the interpretation or application of the U.S. securities laws potentially could occur, as proved to be the case here. Full consideration of this possibility makes it all the more interesting and potentially significant that the Supreme Court recently agreed to hear the Matrixx Initiative securities suit. This development raises the possibility for even further landscape altering case law from the U.S. Supreme Court in its next term.

It’s Not Over Yet, Folks: While it is not too early to start looking ahead to the Supreme Court’s next term, it is also worth noting that this current term is not yet complete, as the Court has yet to issue decisions in four high profile cases. As noted on the WSJ.com Law Blog (here), these four decisions are likely to be issued on Monday, June 28, 2010.

Among the four cases yet to be decided is Free Enterprise Fund v. PCAOB, which will address the question whether it was appropriate for Congress to give authority to the SEC to name the members of the Public Company Accounting Oversight Board. The case raises basic questions about the separation of powers between the Executive and Legislative branches and potentially could address the question of the constitutionality of the Sarbanes Oxley Act.

Depending on how the Court rules, this case could potentially be very significant, particularly if the Court reaches the constitutionality question. As the WSJ.com Law Blog comments, "If the justices agree that the accounting board isn’t constitutional, it could force Congress to revisit Sarbanes-Oxley, or at least the portion of it that creates the accounting board. It could also call into question other independent agencies and how they appoint members of similar boards."

More World Cup Notes:

1. A tip of the hat to the Ghanians, who played with speed, skill and opportunism and did what they had to do to win an exhausting, exciting game.

2. A final salute to the Americans, too, who played all four of their games with heart and class and who are going home simply because there is a limit to how many times a team can come from behind. Landon Donovan's winning goal in extra time last Wednesday against Algeria is one of the great moments of this World Cup.

3. England's fans have to be beside themselves over Frank Lampard's disallowed goal late in the first half of their game against Germany. On the other hand, as unjust as the disallowance was, England pretty much got beat, by a clearly better team. .

4. The Mexicans have a legitimate gripe about Argentina's first goal on Sunday. Carlos Tevez was clearly offsides. However, poor officiating had nothing to do with the total defensive breakdown that allowed Gonzalo Higuain's goal for Argentina's second score, and the Argentiines' third goal was a magnificent strike from Tevez. The Germany/Argentina game next week should be terrific.

5. If, as seems likely at this point, FIFA spends the next four years trying to figure out how to improve  the offciating at the next World Cup, I hope they will also take a hard look at ways to better enforce the rules against embellishment. Too many players seem more inclined to flop than to play. It really is revolting.

6. The French don't have to worry about anybody disrespecting them, because there's really no need -- the French have done such a masterful job of it themselves. The Irish can be excused for any pleasure they might be taking from the French team's embarrassment.

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In a long-awaited ruling, the U.S. Supreme Court on June 24, 2010 issued an opinion affirming dismissal of the Morrison v. National Australia Bank case. Among other things, the Court’s opinion will limit securities claims by investors who bought their shares on foreign exchanges. This ruling could have a dramatic impact on many pending cases as well as on future filings.

Background

NAB is Australia’s largest bank. Its shares trade on securities exchanges in Australia, London, Tokyo and New Zealand. Its American Depositary Receipts trade on the New York Stock Exchange. NAB has a mortgage servicing subsidiary, HomeSide, based in Florida. In 2001, NAB disclosed that it was taking a significant write-down due to a recalculation of the amortized valuating of HomeSide’s mortgage servicing rights. Following this announcement, the price of NAB’s shares and ADRs declined, and investors filed a securities class action lawsuit in the Southern District of New York.

The claim was initially brought by four plaintiffs. One of the four purported to represent domestic purchasers of NAB’s securities. The three other plaintiffs bought their shares abroad and sought to represent a class of non-U.S. purchasers. Background regarding the case can be found here.　

On October 25, 2006, the District Court granted defendants’ motion to dismiss the complaint. The District Court held that it lacked subject matter jurisdiction over the foreign claimants claim. The court dismissed the domestic plaintiff’s action for failure to state a claim because the domestic plaintiff failed to allege that he suffered damages. The three foreign plaintiffs appealed. The domestic plaintiff’s claim was not before the Second Circuit, and so the appellate court was exclusively concerned with the jurisdictional issue.

As discussed at greater length here, on October 23, 2008, the Second Circuit ruled (here) that U.S. courts lack subject matter jurisdiction over the claims of foreign claimants in that case who bought their NAB shares on a foreign exchange and affirmed the district court’s dismissal of the case. The Second Circuit found that the U.S. based conduct was not sufficient to support jurisdiction under the Circuit’s long-standing two-part test measuring whether there were sufficient domestic actions or effect to support jurisdiction. The plaintiffs filed a petition for writ of certiorari.

The Supreme Court’s Opinion

In an opinion written by Justice Antonin Scalia, the Court affirmed the Second Circuit’s holding, but overturned decades of jurisprudence on the question of the extraterritorial reach of the U.S. securities laws, holding that the U.S. securities laws do not apply extraterritorially.

The opinion opens with a recitation of the "longstanding principle of American law" that "when a statute gives no clear indication of an extraterritorial application, it has none." The opinion notes that despite this presumption, the Second Circuit over the course of many years developed an extensive body of case law intended to "discern" when Congress would have wanted the statute to apply. The opinion notes that "the Second Circuit never put forward a textual or even extratextual basis for these tests."

The opinion completely rejected this entire body of case law and the two-part test on which the Second Circuit had relied in this case, noting that "the results of this judicial-speculation-made-law – diving what Congress would have wanted if it had thought the situation before the court –demonstrate the wisdom of the presumption against extraterritoriality. Rather than guess anew in each case, we apply the presumption in all cases, preserving a stable background against which Congress can legislate with predictable effects."

The majority opinion rejected the arguments of the claimants and of the Solicitor General (that would be Solicitor General Elena Kagan, the current Court nominee) that the securities laws contained statutory support for extraterritorial application, finding that "there is no clear indication in the Exchange Act that Section 10(b) applies extraterritorially, and we therefore conclude that it does not."

The opinion also specifically rejected the argument that the domestic conduct was sufficient to support jurisdiction, observing that "it is a rare case of prohibited extraterritorial application that lacks all contact with the territory of the United States."

What matters is not where alleged deceptive conduct occurred but where the securities were purchased:

The focus of the Exchange Act is not upon the place where the deception originated but upon purchases and sales of securities in the United States. Section 10(b) does not punish deceptive conduct, but only deceptive conduct "in connection with the purchase or sale of any security registered on a national securities exchange or any security not so registered."

Based on this analysis, the Court concluded that "only transactions in securities listed on domestic exchanges, and domestic transactions in other securities, to which Section 10(b) applies."

The Court also noted another reason for rejecting a standard that would allow jurisdiction for securities cases solely on the basis that the deceptive conduct took place in the U.S. That is, "some fear that [the U.S.] has become the Shangri-La of class-action litigation for lawyer representing those allegedly cheated in foreign securities markets."

Because this case "involves no securities listed on a domestic exchange, and all aspects of the purchases complained of by those petitioners who still have live claims occurred outside the United States" the Petitioners have "failed to state a claim on which relief can be granted" and the Court therefore affirmed the dismissal.

Justice Breyer wrote a separate opinion concurring in part in the opinion and concurring in the judgment, saying in effect it was sufficient for him that the securities involved in this case were not purchased in the U.S.

Justice Stevens wrote a separate concurring opinion, joining in the judgment, by rejecting the majority’s "transaction test." He would not have rejected the Second Circuit’s two-prong test, saying that the Second Circuit has "refined its test over several decades and dozens of cases, with the tacit approval of Congress and the Commission and with the general assent of its sister Circuits."

Justice Sotomayor did not take part in the case.

Discussion

The Supreme Court’s opinion in the NAB case seems to put an end to the so-called "f-cubed" cases – that is, claims brought in U.S. courts under U.S. securities laws by foreign domiciled claimants who bought their share in foreign companies on foreign exchanges. Indeed, the opinion seems to sound the death knell for any would-be claimants under the U.S. securities laws who bought their shares on foreign exchanges.

The opinion would seem to have very significant implications for the many pending cases in which the claims of claimants who bought shares on foreign exchanges are involved. Among other very high profile cases, the Vivendi case, which involved primarily foreign domiciled claimants and recently resulted in a plaintiff’s verdict, would seem to be subject to substantial reconsideration in light of this opinion. (UPDATE: At least one reader has raised the question whether the Court's holding will or even can be applied retroactively. to damages suffered before and purchases made before. I am not sure general prohibitions on retroactive application apply here, as this decision is about the basic reach of the securities laws, but I thought it was worth noting this question here.)

The Supreme Court’s transactional test would also seem to suggest that we have seen the end of filings in U.S. court against foreign companies, except those whose shares are traded on U.S. securities exchanges. (UPDATE: One reader has noted that the "except" clause in the prior sentence does raise the question about whether there might still be jurisdiction over "f-squared" cases, that is those that involve either foreign domiciled companies and foreign investors who bought their shares on U.S. exchanges, or foreign domiciled companies and U.S. investors who bought their shares on foreign exchanges. The first of these two categories seems to meet the test of the NAB case, the second category is a more interesting question. In any event these kinds of issues will have to be sorted out in lower courts in the wake of the NAB decision.)

My concern with that possibility is that it could lead foreign companies to decide not to list their shares on U.S. exchanges, or to delist their shares, as a way to avoid the burden and expense of U.S.-based litigation exposure.

It is entirely possible that this entire debate will now shift to Congress. Indeed, during the current Congressional term, there were specific proposals to incorporate a version of the two-prong test directly in the securities laws. While these proposals had been languishing, it is possible that the NAB opinion could give these proposals new life.

While Congress might now reconsider these proposals, one portion of the NAB opinion might weigh against these kinds of statutory revisions. The majority opinion specifically refers to the arguments of many foreign countries in amicus briefs that the extraterritorial application of U.S. securities laws would result in "interference with foreign securities regulation." These concerns and the requirements of comity, which are detailed in the majority opinion, could well weigh against the legislative reform.

But in any event, the Supreme Court’s opinion in the NAB case must now be applied in the lower courts. There are dozens of cases pending in the lower courts involving claimants who purchased their shares on foreign exchanges. These claimants will now be scrambling to try to establish some basis for their cases to be preserved notwithstanding the Supreme Court’s ruling in the NAB case. However, it seems probable that the foreign purchasers’ claims are likely to be dismissed. This will have significant implications for Vivendi and many other pending cases.

Andrew Longstreth's June 24, 2010 Am Law Litigation Daily artice about the decision can be found here.

Many thanks to the several loyal readers who send me copies of the Supreme Court's opinion.

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In a terse June 23, 2010 ruling (here), the Ninth Circuit reversed the district court’s post-trial ruling that set aside the $277.5 million jury verdict in the Apollo Group securities class action lawsuit, and remanded the case for "entry of judgment in accordance with the jury’s verdict."

Background

Apollo Group is the parent of the University of Phoenix (UOP), the largest for-profit provider of higher education in the United States. According to the plaintiff's amended complaint (here), in 2003, two former UOP employees filed a False Claims Act action against UOP alleging that UOP received U.S. Department of Education funding in violation of laws specifying the way company educational recruiters may be compensated.

The Department of Education initiated an investigation of the issues raised in the False Claims Act action, and on February 5, 2004, a Department of Education employee issued a "Program Review Report" that accused UOP of violating the Department of Education rules with respect to education employees' compensation. The plaintiff in the securities case alleges that the violations in the report could have resulted in the limitation or termination of Department of Education funding to UOP.

On September 7, 2004, Apollo agreed to pay the Department of Education $9.8 million to settle the program review. The settlement agreement (a copy of which can be found here) specified that Apollo's entry into the agreement did not constitute an admission of wrongdoing or liability. News of the allegations in the Department of Education report first became public on September 14, 2004. The price of Apollo's stock fell significantly on September 21, 2004, when a securities analyst issued a report expressing concern about the company's possible exposure to future regulatory issues. Plaintiff shareholders subsequently initiated a securities class action lawsuit in the District of Arizona.

On January 16, 2008, a civil jury entered a verdict in favor of the plaintiff class on all counts, awarding damages of $277.5 million. Under the verdict, Apollo is responsible for 60 percent of the plaintiffs' losses, former Apollo CEO Tony Nelson is responsible for 30 percent, and former CFO Kenda Gonzales is responsible for 10 percent. The jury verdict is discussed at greater length here.

As discussed in greater length here, on August 4, 2008, Judge James Teilborg of the United States District Court for the District of Arizona entered an order (here) granting the defendants’ motion for judgment as a matter of law, based on his finding that the trial testimony did not support the jury’s finding of loss causation. Judge Teilborg’s order vacated the judgment and entered judgment in defendants’ favor.

Judge Teilborg had held in connection with the parties’ pre-trial cross-motions for summary judgment that the issue whether the analyst reports constituted "corrective disclosure" sufficient to support a finding of loss causation was a question for the jury.

In its post-trial motion, Apollo argued that the evidence at trial was insufficient to support a finding that the analyst reports represented "corrective disclosure," because they did not contain any new fraud-revealing information. Judge Teilborg found that "the evidence at trial undercut all bases on which [the plaintiff] claimed the (analyst) reports were corrective."

Accordingly, the court concluded that although the plaintiff "demonstrated that Apollo misled the markets in various ways concerning the DoE program review," the plaintiff "failed to prove that Apollo’s actions caused investors to suffer harm." The court therefore concluded that "Apollo is entitled to judgment as a matter of law."

The Ninth Circuit’s Opinion

In its June 23, 2010 opinion, a three-judge panel of the Ninth Circuit held that the district court "erred in granting Apollo judgment as a matter of law." The opinion states that "the jury could have reasonably found that the (analyst) reports following various newspaper articles were ‘corrective disclosures’ providing additional or more authoritative fraud-related information that deflated the stock price."

The Ninth Circuit further held that Apollo is not entitled to a new trial and that there is no basis for remittitur (reduction of the verdict). The Ninth Circuit reversed and remanded the case with "instructions that the district court enter judgment in accordance with the jury’s verdict."

Discussion

Given the procedural development of this case so far, there may be no reason to assume that the June 23 ruling by the three-judge panel represents the case’s final stage. The defendants undoubtedly will seek rehearing and/or rehearing en banc, and given the stakes involved, the defendants may well seek Supreme Court review. However, the likelihood of the defendants obtaining rehearing or rehearing en banc, much less convincing the Supreme Court to take up the case, seems like a remote possibility. The defendants may continue to agitate, but they may be running out of options.

With the reinstatement of the plaintiffs’ verdict in this case, and the entry of the jury verdict in the plaintiffs’ favor in the Vivendi case, the securities class action jury trial scoreboard is looking more favorable to plaintiffs.

According to data included in the 2009 NERA year-end securities litigation study (about which refer here), and adjusted for the Ninth Circuit’s opinion in Apollo Group and for the verdict in Vivendi, the securities lawsuit jury verdict scoreboard shows as follow: since the enactment of the PSLRA, there have been 23 securities class action lawsuit that have gone to trial, of which 16 have gone all the way to verdict. Of those 16 cases, nine have resulted in a verdict for the plaintiffs in whole or in part, and six have gone in favor of the defendants.

Data from Adam Savett of the Claims Compensation Bureau (here) show that there have now been nine cases filed post-PSLRA involving conduct occurring after the enactment of the PSLRA that have resulted in jury verdicts or bench decisions at trial. Of these nine, five have gone for the plaintiffs and four have gone for defendants.

Plaintiffs have to be heartened by the Ninth Circuit’s decision in the Apollo Group case. But notwithstanding this development, and for many reasons, trials in securities lawsuits still are likely to remain extremely rare.

A June 23, 2010 Bloomberg article by Thom Weidlich and Emily Heller about the Ninth Circuit’s opinion can be found here.

Special thanks to a loyal reader for providing a copy of the Ninth Circuit’s opinion.

Self-Restraint:  I considered captoning this post "Apollo -- "Oh No!" but thought better of it.

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While many courts are showing a greater willingness to grant motions to dismiss in subprime-related securities class action lawsuits, some cases are surviving dismissal motions and others are settling for hundreds of millions of dollars, as a result of which the "watchword is uncertainty until a more consistent and predictable pattern emerges," according to a recent study.

In a June 2010 report entitled "Subprime Class Actions Revisited," Jonathan Eisenberg of the Skadden law firm examines 14 new subprime-related securities lawsuit rulings issued during the first five months of 2010. This report updates Eisenberg’s prior analysis of 16 dismissal motion rulings entered in 2009.

Eisenberg’s overall conclusions are that "courts are showing more evidence of subprime fatigue and a greater willingness to grant motions to dismiss even in cases that do not require proof of scienter," but while "recent trends have been more favorable for defendants, the results are by no means one-sided, and the final chapters of the subprime class action story have yet to be written."

Eisenberg notes that, by contrast to his earlier study, "more than half of the recent dismissals occurred in non-scienter Securities Act claims." Eisenberg also notes that courts continue to dismiss many of the Section 10(b) claims asserted in the subprime securities class action, "principally, but not exclusively, on the ground that the allegations of scienter are inadequate." Court has also found a number of the allegedly fraudulent statements immaterial as a matter of law.

With respect to the cases that have survived dismissal motions, the basis "overwhelmingly" are allegations related to "declining underwriting standards." In light of the numbers of cases that have survived the dismissal motions, as well as the significant dollar figures involved in some of the settlements, "while the story in the aggregate is positive for defendants, much risk remains in these cases." Overall, Eisenberg finds that he has "not found a single factor that explains the outcomes across all cases."

My running tally, listing (with links) dismissal motions rulings and settlements in all subprime and credit crisis-related lawsuits, can be accessed here. All of the decisions referenced in Eisenberg’s article are listed with links in my tally.

One interesting aspect of Eisenberg’s paper is with respect to his discussion of the difficulties plaintiffs face in trying to allege that defendants were "slow to recognize the enormity of the subprime crisis." He recites data from Bloomberg’s tally of subprime-related write downs showing that "less than three-tenths of one percent of the more than $1.75 trillion of global write-downs between 2007 and 2009 occurred prior to the third quarter of 2007." The rest occurred incrementally from the third quarter from the 2009.

Eisenberg suggests these data show that Judges "are and should be skeptical of the types of claims that could be made against virtually any financial institution that was late to recognize the damages ultimately inflicted by the subprim tsunami."

Special thanks to Jon Eisenberg for providing a copy of his article.

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As opening speaker on June 21, 2010 at the Stanford Law School Directors’ college, Southern District of New York Judge Jed Rakoff shared his views about Bank of America’s settlement of the SEC enforcement action, including some thoughts about why he approved the revised $150 million settlement of the case after he rejected the prior $33 proposed settlement. He also commented on what he hopes the significance of the sequence of events may be.

In August 2009, the SEC filed an enforcement action against Bank of America related to the events surrounding the company’s acquisition of Merrill Lynch. At the outset, the case related solely to omissions pertaining to the payment of bonuses at Merrill Lynch prior to the merger, although as later amended the action extended to omissions in the proxy materials relating to Merrill’s deteriorating financial condition after the merger was announced but prior to the shareholder vote.

In a harshly worded September 14, 2009 opinion (here), Judge Rakoff had rejected the parties initial $33 proposed settlement, finding that it did not meet the requisite standard for judicial approval, as it was "neither fair, nor reasonable, nor adequate." He challenged the very premise of the deal, which he said "proposes that shareholders who were the victims of the Bank’s alleged misconduct must now pay the penalty for the misconduct."

On February 4, 2010, the SEC announced a revised settlement of its amended enforcement action. Though the revised settlement substantially increased the cash value of the settlement, many observers at the time questioned whether the revised settlement addressed Rakoff’s numerous concerns with the initial pact. Yet Rakoff approved it, although "reluctantly."

In his speech at the Stanford Directors College, Judge Rakoff provided some explanation of the reasons he approved the revised deal. Among other things, he noted that the revised settlement included "specific prophylactic measures" regarding disclosures that had not been included in the initial proposal.

In addition, though the settlement funds would still ultimately come from Bank of America’s then-current shareholders, the funds under the revised settlement would go to Bank of America’s pre-merger shareholders, rather than to the SEC, as had been the arrangement under the initial settlement. Because about half of the post-merger shareholders had prior to the merger been Merrill Lynch shareholders, but only the pre-merger Bank of America shareholders would receive the settlement funds, the practical effect of the settlement was a "renegotiation" of the price of the merger deal.

Rakoff also mentioned that the day before the settlement was proposed, New York Attorney General Andrew Cuomo ("Hereinafter to be referred to as ‘The Candidate,’" Rakoff added) filed a state court action against Bank of America and two of its officers charging them with fraud (about which refer here). He said that "under the circumstances, he had no alternative but to examine" the material the AG had relied upon, as a result of which he concluded that the SEC’s "view of the facts was not unreasonable."

Rakoff added that he "really would have preferred that the case go to trial, as that would have provided an opportunity for a jury to determine what the facts were," but his role was not to determine his own preferences but rather to determine whether the proposed settlement was "fair, reasonable and adequate."

In commenting on what the significance of these events may be, Judge Rakoff noted that in the past SEC consent judgments have largely been free from "scrutiny" because of the generally "high regard" the judiciary has for the SEC and the "deference" the SEC is given as a result.

Judge Rakoff said he "harbors the hope" that the questions he raised about the Bank of America settlement may "encourage some of my colleagues in being more proactive in assessing other SEC consent judgments" as well as consent judgments in other cases. These kinds of efforts may or may not contribute to greater "efficiency" but they "will lead to greater justice."

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In the opening keynote address on June 20, 2010 at the Stanford Directors’ College at Stanford Law School in Palo Alto, California, SEC Chair Mary Schapiro discussed the SEC’s "singular" mandate to address the needs of investors, noting the increasing challenges involved in "making sure the markets are fair and efficient."

Schapiro opened her speech discussing the ways that ways the agency is adopting its regulatory approach in light of rapidly changing technology. In particular, she addressed the events involved in and the consequences of the May 6, 2010 "flash crash" and the steps the agency is taking to "minimize chances it can ever happen again." Among other things, she steps the agency is taking to propose and implement "circuit breaker" rules to protect both the markets and investors from "clearly erroneous trades."

Schapiro also discussed the ways that technology has transformed trading activities, including for example the growth in ultra high speed trading activity. These developments and the increasing presence of dark pools trading, among other things, have led the agency to launch a series of initiatives, including new rules that would give the agency much faster and more complete access to information about trading activity.

Schapiro said that she appreciates the benefits and advantages that the various technological changes offer, particular those that "make markets more efficient, reduce costs, and increase liquidity." But, she added, "when these changes have the potential to destabilize markets without significantly contributing to key market functions, we believe they deserve a second look."

Schapiro then talked about the steps the agency has been taking as part of its mandate to protect the interests of "all investors, large and small." In later remarks during the Q&A, Schapiro underscored the importance to her and the agency of this aspect of the agency’s mission, noting that the SEC has to help investors, noting that "there is not another agency that works for the interests of investors."

Among other steps the agency is taking to try to advance its goals of helping investors is to reevaluate all existing corporate filing forms and disclosure requirements in order to consider what will be most meaningful to investors and what will "elicit better disclosure." She noted that these efforts may be slowed somewhat by the current financial reforms process and the likelihood of increased agency mandates will emerge from Congress, but the process to improve investor information will continue.

The final topic Schapiro addressed are the current reform initiatives, both within the agency and in Congress, with respect to corporate governance. She emphasized the SEC’s role is not to define what constitutes good governance, but rather to ensure that its requirements encourage "accountability and meaningful communication" about how the company is governed.

For example, the SEC’s role is not to mandate a particular board structure, but to ensure that investors know why a particular board structure was selected. She also emphasized that investors should have meaningful information about director candidates’ qualifications.

Among other specific governance issues Schapiro discussed were proxy disclosures and shareholder voting process issues. She enumerated a number of voting related issues that require further discussion, including, for example, the question whether proxy advisory firms should be subject to increasing SEC oversight and how to encourage retail investors voting participation.

Schapiro concluded by noting that while there agency faces many challenges, the "higher goal is a financial marketplace where investors invest capital in dynamic companies in a growing economy."

UPDATE: The text of Schapiro's speech has now been posted online, here.

Speakers' Corner: I am here at Stanford Law School for the conference as an interested member of the audience as well as member of the Directors’ College faculty. Tomorrow morning, I will be participating on a panel entitled "Personal Liability Risks, Indemnification and D&O Insurance." Joining me on the panel will be my good friends Priya Cherian Huskins of Woodruff Sawyer and Chris Warrior of Beazley. Though I have official responsibilities, I hope to be able to add post blog updates during the conference.

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There was a time when it was relatively rare for the Supreme Court to take up securities cases. Until recently, the Court basically went several years between cases filed under the securities laws. Those days are clearly over, as the Court has granted cert petitions in several securities cases in recent years, including the Merck and National Australia Bank cases this term.

The Court has now granted cert in a securities suit for next term as well. On June 14, 2010, the Supreme Court granted the petition for a writ of certiorari in the Matrixx Initiative case.

The question presented is whether plaintiffs must allege that adverse event information is "statistically significant" in order to establish that the defendants’ alleged failure to disclose the information was material. Though the issues involved appear narrow, the case potentially could address broader issues of securities claim pleading sufficiency.

Background

Matrixx Initiatives manufactured an internasal cold remedy called Zicam. In April 2004, plaintiff shareholders filed a securities class action lawsuit against Matrixx and three of its directors and officers, alleging that the defendants were aware that numerous Zicam users experienced loss of the sense of smell. The complaint alleges that the defendants were aware of these problems because of calls to the company’s customer service line; because of academic research, which was communicated to the company; and because of product liability lawsuits that had been filed against the company.

The district court granted the defendants’ motion to dismiss, finding that the complaint failed to adequately allege that the alleged omissions were material, because the complaint did not allege that the number of customer complaints was "statistically significant."

As discussed at greater length here, on October 28, 2009, the Ninth Circuit reversed the district court, holding that the district court "erred in relying on the statistical significance standard" in concluding that the complaint did not meet the materiality requirement. The Ninth Circuit said that a court "cannot determine as a matter of law whether such links [between Zicam and loss of smell] was statistically significant, because statistical significance is a matter of fact."

The Ninth Circuit said (citing Twombly and its progeny) that the appropriate test is whether the claim is "plausible on its face." The Ninth Circuit found that the complaint’s allegations of materiality were sufficient to "nudge" the plaintiffs’ claims from "conceivable to plausible."

On June 14, 2010, the U.S. Supreme Court granted the defendants’ petition for writ of certiorari, on the question whether the plaintiff can state a securities claim "based on a pharmaceutical company’s nondisclosure of adverse event reports even though the reports are not alleged to be statistically significant."

Discussion

When the U.S. Supreme Court grants cert, there is always the question "why"? On the theory that the Court wouldn’t take the case if it thought the Ninth Circuit got it right, one view might be that the Court took the case simply to overturn the Ninth Circuit. However, as we say in connection with the Supreme Court’s consideration of the Merck case (about which refer here), this assumption is not always borne out by the Court’s actions.

Perhaps the more neutral explanation is that as a result of the Ninth Circuit’s opinion, there is now a split in the circuits on the issue of the need to plead "statistical significance." Several other circuits (on which the district court relied in dismissing the Matrixx case) have held that plaintiff alleged that adverse events were "statistically significant," which the Ninth Circuit rejected that view and instead adapted a view that statistical significance cannot be resolved at the pleading stage and instead the court must consider facial plausibility.

Even if resolution of this narrow issue is all the Supreme Court accomplishes by taking up the Matrixx case, its review will still be significant. As the Morrison & Foerster law firm pointed out in its memo discussing the Supreme Court’s cert petition grant, companies regularly receive many customer complaints. These companies need to know when they have sufficient information about a product’s potential adverse effects that it must disclose that information.

Companies and defense attorneys would like a bright-line answer to this question, whereas, the MoFo memo suggests, plaintiffs "will push for an amorphous case-by-case determination."

There is a possibility that the Supreme Court’s consideration of this case could involve more than just this narrow issue, as important as it might be. Among other things, the 10b-5 Daily suggests that the Court could extend itself to a broader review of the issues of pleading materiality generally. Given what the Ninth Circuit said about what determinations are appropriate at the pleading stage, and what must be left to the trier of fact, this possibility seems substantial.

I also think it is critical to the Ninth Circuit’s rejection of the use of the "statistically significant" standard that its analysis was made in reliance on what it saw as required by the Twombly line of cases. Given the Ninth Circuit’s conclusion that its holding was required by Twombly, it seems unlikely that the Supreme Court could address the Ninth Circuit’s analysis without discussing what is required by Twombly and the larger issues of pleading sufficiency at the motion to dismiss stage.

There is the further possibility that the Supreme Court could range further and address other aspects of the Ninth Circuit’s decision, including even perhaps the Ninth Circuit’s conclusion that the plaintiff had adequately alleged scienter.

The Ninth Circuit’s conclusion that the scienter allegations were sufficient was based on plaintiffs allegations that the "high level executives …would know the company was being sued in a product liability action," and also based on the fact that the various academic research results and customer complaints were communicated to the company’s director of research – though there were no allegations that the other two individual defendants were aware of this information.

The Ninth Circuit put a great deal of emphasis on what the defendants’ "would have known" as higher level executives, without necessarily considering whether the plaintiffs had alleged that the defendants did know the supposedly omitted information.

This aspect of the case raises the question whether scienter may be sufficiently alleged based on an individual officers’ officer or position, even without supporting allegations about whether the defendants knew or what information they were provided access to.

Of course, there is no way of knowing whether the Supreme Court will reach these issues, or whether it will narrowly address the immediate questions presented. That is always one of the great uncertainties (and interesting possibilities) when the Court grants cert, you never know where the case might go. The broader possibilities here, while present, may also be conjectural best.

In any event, the next Supreme Court term will involve yet another consideration at the highest judicial level of questions involving securities lawsuit pleading questions. Perhaps this will be one of the first cases to be considered by Justice Kagan (assuming for the sake of argument that she does indeed join Justice Sotomayor and the other seven justices on the Supreme Court bench next term.

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

Why Do They Call Them Wells Notices?:  If like me you have always wondered why a Wells Notice is called a Wells Notice, you will want to take a look at the recent post from the Compliance Building blog. Turns out there was, as we all suspected, someone named Wells – in fact, John W. Wells, an attorney who, in 1972 was appointed to chair a committee that made a number of recommendations, including the process now referred to as a Wells notice. Now we know.

My personal thanks to Doug Cornelius, the blog’s author, for answering a question I have always kind of wondered about.

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The SEC has made it clear that it intends to use Section 304 of the Sarbanes-Oxley Act to "clawback" compensation from CEOs and CFOs of companies that restate their financial statements, even if the individuals are not alleged to have engaged in any wrongdoing. A recent district court opinion confirms that the statute gives the SEC the authority to proceed on that basis. These actions raise complex D&O insurance coverage concerns that arguably suggest certain necessary policy adjustments.

Section 304 provides that if a company restates its financials, the company’s CEO and CFO, who certified the financial statements under Sox Section 302, "shall reimburse" the company for any bonus compensation received during the 12 months following the restated period, as well as any stock sale profits earned during those twelve months.

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

The SEC’s first use of this statutory provision to clawback compensation from a corporate official against whom no wrongdoing is alleged was the enforcement action filed in July 2009 against Maynard Jenkins, the former CEO of CSK Auto. I first wrote about this enforcement action in a prior post, here.

CSK Auto had restated its financial statements for the fiscal years 2002 to 2004. The SEC filed separate enforcement actions against the company and four company officials for securities law violations in connection with the restatements. However, Jenkins is not among the company officials alleged to have violated the securities laws.

The SEC’s action, filed in reliance on Section 304, seeks to compel Jenkins to reimburse CSK Auto for more than $4 million he received in bonuses and stock sale profits "while CSK was committing accounting fraud." Jackson not only is not alleged to have had any role in or awareness of the alleged scheme, but the SEC has actually alleged in its separate enforcement action against the other CSK officials that the others concealed their scheme from Jenkins.

Jenkins moved to dismiss the SEC’s clawback action on numerous grounds, arguing that he cannot properly be forced to disgorge compensation in the absence of any personal wrongdoing.

In a June 9, 2009 order (here), District of Arizona Judge G. Murray Snow held that the SEC’s complaint against Jenkins alleges facts sufficient to state a claim under Section 304, stating further that "the text and structure of Section 304 require only the misconduct of the issuer, but do not necessarily require the specific misconduct of the issuer’s CEO or CFO."

Judge Snow elaborated by saying that "the misconduct of the issuer is the misconduct that triggers the reimbursement obligation of the CEO and the CFO." Before reimbursement can be required "the issuer’s misconduct must be sufficiently serious to result on material noncompliance with a financial reporting requirement."

The SEC has already made it clear that it intends to use Section 304 to try to clawback compensation from other CEOs and CFOs who are not alleged to have done anything wrong. For example, just a few days ago, the SEC settled a Section 304 filed against Walden O’Dell, the former CEO of Diebold, even though, as noted in the SEC’s June 2, 2010 litigation release, the SEC’s complaint does not allege that O’Dell engaged in the alleged fraud at Diebold.

Judge Snow’s opinion in the Jenkins case confirms that the SEC may properly pursue Section 304 clawbacks even against corporate officials who are not alleged to have engaged in personal wrongdoing (although he did leave open the question whether the statute could be used in ways that would be unconstitutionally punitive).

Though statutorily authorized, the statute’s use to effect a forfeiture without culpability or fault raises troubling questions, including even basic questions of fairness. On the other hand, it might also fairly be asked whether the CEO or CFO ought to be able to retain benefits accumulated at a time when the investing public was being misled, by financial statements that the CEO and CFO certified, about the company’s financial condition.

Beyond these issues, these kinds of actions may also raise complex D&O insurance coverage questions.

A Section 304 claim potentially would raise at least two possible coverage concerns – first, whether the claim involves an allegation of a "wrongful act" as required to trigger coverage; and second, whether coverage for the claim is precluded by the "profit or advantage" exclusion.

D&O insurance typically is only triggered by a claim made against an insured person for an actual or alleged wrongful act. Under a Section 304 claim in which no personal wrongdoing is alleged, the question would arise whether a wrongful act has been sufficiently alleged to trigger coverage under the policy.

I think it could fairly be argues that a Section 304 claim does involve a wrongful act even if no personal wrongdoing is alleged against the individual defendant. As Judge Snow’s opinion in the Jackson case emphasized, a prerequisite to a Section 304 claim is misconduct by the issuer (which is an "insured" under the typical public company D&O insurance policy’s "entity coverage" provision).

Given the statutory prerequisite of issuer wrongdoing, a Section 304 claim necessarily involves a claim for a wrongful act, even if the wrongful act alleged is not that of the targeted individual. The typical D&O policy emphatically does not say that the claim must be made against an insured person for that insured person’s own wrongful act – to the contrary, the typical policy requires only that the claim be made for "an actual or alleged wrongful act," without specifying whose act it must be.

Nevertheless, I can still imagine a carrier bent upon denying coverage urging that this policy provision requires a wrongful act by the insured person against whom the claim has been made, which may indicate the need for certain policy revisions, as detailed below.

Even if the wrongful act concern can be overcome, there is still the policy exclusion to be dealt with. The typical D&O policy excludes coverage for any loss based on a claim for any "profit or advantage" to which the insured is not legally entitled. A carrier might attempt to rely on this provision not only to deny coverage for the amount of any reimbursed compensation, but also to try to deny coverage for the costs of defending the claim.

One way to try to circumvent this concern about Section 304 defense costs is to amend the exclusionary provision to required a judicial determination in the underlying claim that the insured was not legally entitled to the "profit or advantage," which would at least allow defense costs to be advanced up until there has been such a judicial determination. The limitation of this approach is that once there has been a judicial determination, the carrier might seek to be reimbursed for the advanced defense costs.

The point here is that the question of D&O insurance coverage for the costs of defending a Section 304 clawback claim could be problematic. One approach to try to address these concerns would be to amend the policy to provide that the "profit or advantage" exclusion will not be applied to the costs of defending a Section 304 act, and to further amend the policy to provide that the carrier will not take the position that a Section 304 action does not allege a wrongful act.

At least one insurer has taken an alternative approach to address the Section 304 defense cost issue in its revised policy form. Under this approach, the costs of defending a Section 304 claim are expressly included in the policy’s definition of Loss.

It is not my intention here to debate the merits of these alternative approaches (which indeed may not be mutually exclusive) or of any other alternative approaches that might exist. My purpose here is simply to point out that this issue has reached the point where the question of Section 304 defense expenses ought to be addressed in the D&O policy form.

Just as a few years ago, the D&O insurance industry quickly adapted express policy language designed to address concerns arising from SOX whistleblower claims, it may now be time for the industry to adapt express policy provisions addressing Section 304 defense costs. Policyholders should not have to wait until the claim has been filed to find out what the carrier’s position will be on Section 304 defense expenses.

2010 World Cup: Some Early Notes:

1. Vuvuzela: Did the site selection committee know about those damned vuvuzela horns when they chose South Africa as the 2010 World Cup venue? What an awful, idiotic noise. (There are reports that the event organizing committee is considering a ban.)

2. Remember, The Beautiful Game is Fast, Too: England was up on the U.S. by a goal before I even had a chance to turn the T.V. on.

3. U.S. Goal Inspires Headline Writers Everywhere: Here’s my entry – "English Green’s Gift Gaffe Gives Yanks a Goal."

4. Most Underappreciated: Tim Howard ought to be one of the most celebrated athletes in the U.S. He certainly is one of the most talented.

5. Go Figure: The official nickname of the Australian team is the "Socceroos." Discuss.

6. Self-Destruction (and Team Takeout, Too): Substitute Algerian striker Abdelkader Ghezzal entered his team's game against Slovenia in the 58th minute (which was a scoreless tie at the time). Approximately five seconds later he was given a yellow card for an aggressive tackle. Then in 74th minute, he earned his second yellow (and an automatic red card, requiring his ejection from the game) for a flagrant hand ball . Within minutes, his shorthanded team conceded Slovenia's winning goal.

7. Divided By a Common Language: The "pitch" is the playing field. A "side" is a team. A "strike" is a shot. To "win a cap" is to be selected to play for your country’s team. "Nil" means zero. "Draw" means tie. And "nil-nil draw" (usually preceded by the word "dreaded") means a scoreless tie. The phrase "argy bargy" is not susceptible to translation. 

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In two different subprime securities suits, courts recently entered ruling with respect to dismissal motions going in opposite directions. In one case, the Second Circuit, in the second appellate ruling so far in connection with the subprime-related litigation wave, affirmed the lower court’s dismissal. In the other case, the district denied defendants’ motions to dismiss. Each may be significant in their own way.

The Centerline Holding Case

In a brief, five-page summary opinion issued on June 9, 2010 (here), the Second Circuit affirmed the lower court’s dismissal of the subprime-related securities class action lawsuit that had been filed against Centerline Holding Company and certain of its directors and officers.

As discussed here, on January Southern District of New York Judge Schira Scheindlin had dismissed the case without prejudice, finding that the plaintiffs had not sufficiently alleged that the defendants had had acted with scienter. In a August 4, 2009 order, Judge Scheindlin granted the defendants’ renewed motions to dismiss.

On appeal, the plaintiffs argued that they had sufficiently alleged the defendants had made material misrepresentations and omissions about the company’s plan to change its business model form one focused on the generation of distributable tax-exempt income to that of an asset manager focused on growth.

The Second Circuit affirmed the Judge Scheindlin’s dismissal, noting that "the effort in Plaintiffs’ amended complaint to characterize the Defendants’ class period statements as speaking to the company’s future plans – and this as misleading in light of Defendants’ undisclosed plans for Centerline – fails when the statements are reviewed in their entirety." These statements, the court found, "were not rendered misleading by the Defendants’ omissions."

Because the Defendants had not duty to disclose their plans, Plaintiffs’ had not adequately alleged conscious misbehavior or recklessness and "otherwise failed sufficiently to allege scienter."

The CIT Group Case

In a June 10, 2010 opinion (here), Judge Barbara Jones denied the defendants’ motion to dismiss in the subprime-related securities suit that had been filed against CIT Group and certain of its directors and officers.

As detailed here, the plaintiffs alleged that CIT's public financial statements failed to account for tens of millions of dollars in loans to Silver State Helicopter, which were highly unlikely to be repaid and should have been written off. The plaintiffs also alleged that the company had misrepresented the performance of its subprime home lending and student loan portfolios.

Citing at length the recent dismissal motion denial in the Ambac case, Judge Jones concluded that the plaintiffs had adequately pled misrepresentation with respect the company’s deteriorating lending standards, which allegedly conflicted with the company’s public statements. She also concluded that the plaintiffs had adequately alleged actionable misstatements with respect to performance of CIT’s student loan portfolio.

Judge Jones also concluded that the plaintiffs had adequately alleged scienter. She found that the plaintiffs had adequately alleged that the defendants "knew about CIT’s lowered lending standards and in some cases affirmatively approve them – while publicly touting the company’s ‘conservative’ and ‘disciplined’ approach." She further noted, in connection with the conclusion that the plaintiffs had adequately alleged scienter, that the complaints adequately alleged that the defendants "learned of the deterioration of CIT’s home loan and student loan portfolios, which making public statements indicating that CIT was outperforming the market and would suffer only minimal losses."

Finally Judge Jones found that the ’33 Act plaintiffs’ claims met the pleading requirements to state a claim under Section 11.

Discussion

The Second Circuit’s affirmance of the Centerline Holding dismissal represents the second appellate court decision issued in connection with the subprime litigation wave. The first appellate decisions was the Eight Circuit’s September 1, 2009 opinion in the NovaStar Financial case, about which refer here. In NovaStar, the Eighth Circuit also affirmed the lower court’s dismissal.

Though coming later than the NovaStar ruling, the Centerline case could perhaps be more noteworthy, simply because such a large percentage of the subprime related cases have been filed in the Southern District of New York (which is located in the Second Circuit).

However, because the Second Circuit’s opinion was issued in the form of a summary order, its impact may be limited. By their own terms, summary orders, though they may be cited, "do not have precedential value" according applicable rules of the Second Circuit. Moreover the analysis in the Second Circuit’s opinion is quite limited.

Whatever the opinions impact may be on other cases, its greatest significance may have to do with simple scorekeeping – as in, two subprime related securities class action lawsuit appeals, two dismissal affirmances.

At the same time however, as the CIT case demonstrates, there are still cases in which the motions to dismiss are being denied. Among the more interesting things to me about the CIT ruling is the court’s reliance on the prior dismissal motion ruling in the Ambac case. I had speculated at the time of that the breadth of the language in the Ambac decision could make the court’s ruling influential. As the CIT decision confirms, the Ambac decision has proven to be influential.

I have in any event added these rulings to my running tally of the subprime-related securities class action lawsuit dismissal motion rulings. The tally can be accessed here.

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

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The unexpected resignation of an outside director may indicate that a company is about to experience tough times, according to a recent academic study. The research shows that a company experiencing a surprise director departure is likelier to face a number of different future adverse events.

Among other things, a company with a surprise outside director departure has a "significantly higher likelihood of being named in a federal class action securities fraud lawsuit." The study’s authors call this risk of future adverse events following a director’s departure the "dark side of outside directors."

These findings are set forth in a March 2010 paper entitled "The Dark Side of Outside Directors: Do They Quit When They Are Needed Most?" (here) by Rüdiger Fahlenbrach of the Ecole Polytechnique Fédérale de Lausanne, Angie Low of the Nanyang Technological University and René M. Stultz of Ohio State University. Hat tip to the Harvard Law School Forum on Corporate Governance and Financial Reform for the link to the paper. I note here that the author’s paper is copyrighted – a notation that the authors require from anyone quoting their paper.

The Authors’ Analysis

The authors note that among the remedial measures imposed following the era of corporate scandals last decade were requirements for increased numbers of independent directors on corporate boards. Though these measures had salutary purposes, the addition of increased numbers of independent directors also has "costs" as well as benefits.

Among these "costs" is what the authors refer to as "a dark side" of increased outside director involvement arising because of outside directors’ "incentives." That is, outside directors have "incentives to leave when they anticipate that the firm on whose board they sit will perform poorly and/or disclose adverse information."
 

The directors have incentives to quit "to protect their reputation or to avoid increases in the workload when the firm on which board they sit is likely to experience a tough time." As the authors put it, outside directors are "more likely to quit when they expect the firm to perform poorly or to disclose bad news, so they can at least partly and possibly totally escape the reputation loss."

Because outside directors have these incentives, an unexpected director resignation from a company’s board may indicate that the company may be poised for future adverse events.

The authors tested this hypothesis by examining "surprise director departures." The authors tracked resignations by directors whose ages were below the average director retirement age and then plotted the resignations against future events at the companies from whose boards the directors had resigned.

The authors found that following "surprise director departures" the firms involved experienced "significantly worse stock and accounting performance," and "are significantly more likely to suffer from an extreme negative return event, are significantly more likely to restate earnings, and have a significantly higher likelihood of being named in a federal class action securities lawsuit."
 

These results, the authors concluded, are "consistent with the directors leaving in anticipation of adverse events to protect their reputation or to avoid an increased workload."

Discussion

The authors’ analysis of the "dark side" of increased outside director involvement is interesting, because it suggests that the outside directors readiness to head for the exits when the going gets tough undermines the very reasons for which increased outside director involvement was required in the first place. As the authors put it, their analysis suggests that "outside directors are more likely to resign precisely when experienced outside directors are needed the most."

The authors’ findings about the increased risk of securities litigation following a director’s resignation are particularly interesting. Back when I was part of a D&O underwriting facility, my colleagues and I were constantly involved in trying to identify factors that were positively correlated with the risk of securities litigation. The authors’ analysis suggests that a surprise outside director departure is such a factor.

Specifically, the authors found that a surprise outside director departure (that is, one that is not explained by the director having reached the average age for director retirement) is "highly statistically and economically significant" in terms of litigation risk. The authors specifically found that the surprise departure of an outside director increases the probability of a securities class action lawsuit filing by 31% to 35%, with the likelihood increasing as firm size increases; if a company’s stock and accounting performance were poor in the prior year’ and if the firm raised relatively more external financing in the prior year.

The authors’ work raises important questions about the role of outside directors. However, for D&O underwriters, the authors’ analysis about the correlation between surprise director resignations and securities litigation risk may be the most interesting finding. At a minimum, the authors’ analysis suggests a potentially important new underwriting criterion.

Questioning Rating Agencies’ First Amendment Defenses: In a recent post, I discussed the latest decision questioning the applicability of rating agencies’ first amendment defenses. Left unanalyzed in these cases is the larger question of why rating agencies’ ratings opinions are thought to be entitled to first amendment protection in the first place.

In a June 9, 2010 Am Law Litigation Daily article (here), Susan Beck questions both the rating agencies’ entitlement to rely on the First Amendment and the limitations of the judicial decisions to date where courts have found the First Amendment defense inapplicable because the ratings were given only to a small group of sophisticated investors. Beck asks, with respect to the latter point, "Why should big, sophisticated investors like CalPERS have more redress under the law than small (and large) investors who buy securities in public offerings?"

Beck also suggests that "the premise of First Amendment protection for credit ratings is shaky." After reviewing and questioning the case authority on which the rating agencies rely in asserting their First Amendment defenses, Beck concludes "I'm hoping that the next judge to address the First Amendment question reads the case law differently and concludes that a credit rating, by itself, is not a matter of public concern that deserves Constitutional protection. That's not only fair, it's right."

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The FDIC in its status as receiver of a failed bank may not avoid rescission of a fidelity bond procured by material misrepresentation, notwithstanding the FDIC’s statutory receiver rights, according to a June 7, 2010 Second Circuit decision. This decision represents an important interpretation of the FDIC’s statutory rights as receiver, and could prove to be an important precedent in future insurance-related litigation arising out to the current round of failed banks. The Second Circuit’s June 7 opinion can be found here.

Background

In 1999, Connecticut Bank of Commerce (CBC) entered an agreement to acquire MTB Bank. The transaction closed March 30, 2000. Prior to the deal’s closing, two things happened of relevance to the subsequent insurance dispute.

First, MTB discovered that its agents had advanced $950,000 based on fraudulent invoices in connection a business deal involving Harmony Designs. MTB noticed its fidelity bond carrier regarding the Harmony Designs matter, although MTB ultimately reduced its loss below the amount of the deductible.

Second, in March 2000, before the CBC deal closed, MTB’s president and other officers were indicted in an alleged conspiracy involving the imposition of Argentinean minerals. MTB also noticed its fidelity bond insurer regarding the indictments.

After the CBC deal closed, CBC was added to MTB’s fidelity bond. As the bond’s June 30, 2000 expiration approached, CBC sought to renew it. The insurer declined to renew unless CBC came to London to provide additional information in connection with the renewal. The insurer also refused to extend the bond period 30 days.

CBC declined to visit London as the fidelity bond insurer had requested. Instead, CBC obtained replacement fidelity bond coverage from a different insurer. In order to secure this replacement coverage, CBC completed and submitted a policy application that required CBC, among other things, to disclose losses sustained during the preceding three years; whether there were additional circumstances relevant to the application; and whether insurance had been declined or canceled during the past three years. Post-binding, CBC completed the replacement insurer’s separate application form, which also asked questions related to past losses and whether CBC had had insurance declined or canceled.

CBC answered "None" or "No" to these application questions. CBC did not disclose or identify the Harmony Designs loss, the indictments, or the predecessor insurer’s actions in connection with the fidelity bond insurance renewal application.

CBC went into receivership in June 2002. In 2006, the FDIC as receiver sued CBC’s fidelity bond insurer alleging breach of contract for dishonoring claims under the bond for CBC’s losses related to a loan scheme used to fund MTB’s acquisition.

The district court granted the fidelity bond insurer’s motion for summary judgment on the ground that it properly rescinded the bond based on CBC’s application misrepresentations and omissions. The FDIC appealed.

The June 7, 2010 Opinion

In a June 7, 2010 opinion by Southern District of New York Judge John Keenan (sitting by designation on the Second Circuit), the Second Circuit affirmed the district court’s entry of summary judgment on behalf of the fidelity bond insurer.

In seeking to overturn the district court’s opinion, the FDIC had sought to rely on its rights under 12 U.S.C. Section 1823(e), which protects the FDIC from defenses not apparent on the face of an asset it acquires as a receiver of a failed bank. The FDIC argued that this provision bars the fidelity bond insurer’s misrepresentation defense.

The Second Circuit held (contrary to a prior holding in the Sixth Circuit) that a fidelity bond is in fact an "asset" to which this provision applies. However, the Second Circuit rejected the FDIC’s argument that this provision bars the fidelity bond insurer’s policy defenses.

The Second Circuit said that the provision is intended to "bar ‘secret’ defenses which would diminish the FDIC’s interests in a failed bank’s assets," but that "defenses raised by the bond itself may prevent recovery by the FDIC."

The Second Circuit found that "as the grounds for rescission were plainly stated on the face of the bond, there is nothing secret about [the fidelity bond insurer’s] misrepresentation defense." To recognize the FDIC’s position, the Second Circuit said, would be to "strike the rescission clause from the bond."

In the final portion of its opinion, the Second Circuit went on to hold that each of the three alleged misrepresentations separately provided sufficient ground to support rescission. The Second Circuit found that the omission of the information about the Harmony Designs loss, about the indictments, and about the prior insurer’s refusal to renew or extend each separately representing sufficient grounds for rescission.

The Second Circuit’s holdings about the sufficiency of the fidelity bond insurer’s basis for rescission are quite broad. Among other things, the Second Circuit said that "information about previous losses is presumptively material," and "the determination of risk is one properly left to the insurer, not the insured, and the insurer cannot make an accurate risk assessment without full disclosure from the applicant."

Discussion

It seems probable that in connection with the current wave of bank failures that the FDIC as receiver to the failed banks will attempt to recover under the failed banks’ insurance policies. The Second Circuit’s holding in the CBC case underscores the fact that notwithstanding the FDIC’s receivership status, and the statutory rights that status may entail, the FDIC’s ability to enforce the failed bank’s insurance coverage is subject to the defenses the insurer may have that appear in the relevant policies.

To that extent, at least, the Second Circuit’s opinion could be relevant to may arise in the wake of the FDIC’s attempt as receiver to recover under the failed banks’ insurance policies.

The CBC opinion is relevant for another reason that arguably is completely independent of the FDIC’s involvement in this dispute. That is, the opinion starkly demonstrates the critical importance of the policy application process and the extent of the insurer’s rights, under certain circumstances, to seek rescission. The Second Circuit’s view of the applicant’s obligation to provide responsive information is broad and encompassing.

The Second Circuit’s rescission holding seems to reflect a perception that CBC knew that if it disclosed the prior losses it would be unable to secure replacement fidelity bond coverage. To that extent, the rescission holding may reflect the somewhat distinct circumstances of the case. However, the Second Circuit’s rhetoric is broad and is not delimited to the referenced circumstances. The breadth of the ruling rescission ruling could well prove helpful to insurers in other rescission cases, even those lacking the distinctive characteristics of this case.

Financial Reform Impact on the Insurance Industry: In a prior post (here), I noted that the Senate’s version of the financial reform bill includes a number of specific reforms that particularly impact the insurance industry.

In a June 7, 2010 memo entitled "The Impact on the Insurance Industry of the Financial Regulatory Reform Bills: A Legislative Update" (here), the Simpson Thacher law firm examines and compares the various insurance industry reforms proposed in the House and Senate versions of the reform legislation.

The memo details the numerous insurance industry measures that are substantially similar in the two bills, suggesting that the provisions are likely to survive the current conference process. Among other things, the provisions intended to streamline the regulation of reinsurance and nonadmitted insurance are "substantially identical in both bills, and are therefore likely be enacted into law, as are a number of other measures.

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Just as the financial crisis itself has gone through various phases, the resulting litigation has also changed and evolved. A June 4, 2010 report entitled "Credit Crisis Litigation Revisited: Litigating the Alphabet Soup of Structured Products" by my friend Faten Sabry, and her colleagues Anmol Sinha, Jesse Mark and Sungi Lee, all of NERA Economic Consulting, takes a detailed look at the credit crisis-related litigation wave, with a particular emphasis on the way that it has developed over time.

The focus of the NERA report is credit crisis-related "securities cases," which includes not only state and federal securities class action lawsuits, but also "ERISA claims, shareholder derivative actions, individual state and federal cases, [and] international cases." Thus, the universe of cases that NERA is tracking is considerably broader than the ones I have included in my running tally of subprime and credit crisis-related litigation, which can be accessed here.

The Report’s overall conclusion is that "there are conflicting signals about the future of this litigation." On the one hand, new credit crisis-related lawsuit filings have declined and almost half of the preliminary motion decisions to date have been dismissals. On the other hand, "types of allegations, products and defendants have continued to shift, and recent regulatory activity," such as the recent enforcement action against Goldman Sachs, "add to the uncertainty surrounding the direction and focus of the litigation."

According to NERA’s tally, there have been a total of 424 of the broad category of credit crisis cases filed since the beginning of 2007, 225 of which are securities class action lawsuits. The most active quarter both for credit crisis cases generally and for securities class action lawsuits specifically was the second quarter of 2008, when there were 48 new cases overall and 38 new securities class action lawsuits. Both overall credit crisis lawsuit filings and securities class action lawsuit filings declined every quarter during 2009.

The NERA report observes that there has "been a noticeable shift in the type of defendants as the credit crisis has progressed." Among other things, the incidence of cases involving corporate directors and officers has changed over time. The percentage of credit crisis filings that name directors and officers as defendants decreased between 2007 and 2009. In 2007 70% of the cases included director and officer defendants. The percentage of cases with director and officer defendants declined to 61% in 2008 and 52% in 2009. Early 2010 filings show a slightly increased percentage, with 67% of cases including director and officer defendants.

The types of companies involved in the cases have also shifted over time. For example, in 2007, mortgage lenders, home builders and REITs were named as defendants in 47% of filings, but by 2008, the kinds of companies were involved in only 20% of filings. Only 5% of the 2009 filings involved these kinds of companies, and so far none of the 2010 has involved these companies. With this shift away from residential mortgage defendants, the plaintiffs have changed, too, as the claimants have "shifted toward non-primary mortgage market participants."

While the percentage of filings against mortgage lenders, home builders, and REITs has declined over time, the percentage of cases naming securities issuers and underwriters has increased, from only 24% and 23% of filings in 2007 and 2008, to 37% of filings in 2009, and 60% so far in 2010.

The types of financial products involved in the credit crisis lawsuits have also shifted over time. Because the 2007 lawsuits largely involved lenders, mortgage originators and homebuilders, many of the 2007 suits involve mortgage loans – about 40% of the 2007 cases involved allegations relating to mortgage loans. By contrast only about 7% of 2010 cases involve mortgage loans, but "products such as ABS/MBS, CDOs and CDSs now make up the majority of the recent securities credit crisis lawsuits."

Slightly more than a third of the cases overall have either had dismissal motion rulings or been settled. I was a little puzzled by NERA statistics on case dismissals, as their data show that 61% of cases have been dismissed, with or without prejudice, which is considerably higher than my own figures reflect. (Refer here to access my own tallies of subprime and credit lawsuit dismissal motion rulings.)

However, NERA’s dismissal figures also include a number of voluntary dismissals. Removing those from the equation reduces the percentage of dismissal grants to 46%. In addition, NERA puts settled cases in a separate category and are counted neither as a dismissal motion denials or grants. Many of the case settlements followed dismissal motion denials, and so NERA’s figures on dismissal motion denials do not reflect those cases. All of these considerations should be taken into account when referring to the NERA data for purposes of determining how parties are faring in disputed dismissal motions.

Aggregate settlements to date in these cases total over $2.1 billion, with roughly $1.7 billion in settlements associated with securities class action lawsuit settlements. (My detailed list of subprime and credit crisis-related lawsuit settlements can be accessed here.)

Though the settlement numbers so far are impressive, there are clearly many more settlements yet to come, and the aggregate settlement figures are likely to grow. As the NERA report comments in closing, "settlements and judgments will be the next chapter in this story."

The NERA report contains a great deal of interesting and useful information and it is worth reading at length and in full. Very special thanks to Dr. Sabry for providing me with a copy of the report.

NERA also recently released a separate report entitled "Subprime and Synthetic CDOs: Structure, Risk and Valuation" which intended to provide a "plain English" explanation of many of the complex financial instruments that were involved with the financial crisis. This June 3, 2010 report can be accessed here.

My own recent status update on the subprime and credit crisis related litigation can be found here.

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The rating agencies have been among the targets in many of the lawsuits filed as part of the subprime-related litigation wave. By and large, the rating agencies have been successful in knocking out these cases in the early stages, particularly the lawsuits seeking to hold them liable as "underwriters" under the federal securities laws.

At the same time, there is a small but growing number of cases in which the rating agencies’ preliminary motions have been unsuccessful, and there is a definite sense in which these decisions are building on each other, particularly with respect to the issues surrounding the First Amendment defenses on which the rating agencies are seeking to rely.

The latest example of a case where the rating agencies’ preliminary motion on First Amendment grounds have been unsuccessful is the negligence suit that Calpers filed in California state court against the three principal rating agencies.

Background

In July 2009, Calpers sued the three main rating agencies in California state court. Calpers alleged that it had invested about $1.3 billion in instruments issued by three structured investment vehicles (SIV). The investments carried the rating agencies highest ratings, which ratings Calpers alleged were "wildly inaccurate." Calpers claims to have lost over $1 billion on the investments.

Calpers alleged that it would not have invested in the securities if the securities had not carried the highest investment ratings. Calpers alleged that the rating agencies "did not have a reasonable basis" for giving the SIVs the highest investment ratings.

The ratings were flawed, Calpers alleged, because they failed to account for "foreseeable scenarios" and failed to account for the SIVs’ critical risk – that is, that the were highly concentrated in certain types of residential mortgages and residential mortgage backed securities. Calpers also alleged that the rating agencies used "inadequate mathematical and statistical models" and "employed increasingly lax standards" while giving the SIVs the highest ratings, in order to be able to continue to secure business providing ratings for structured financial products.

The rating agencies demurred to Calpers’ complaint, asserting that the allegations were legally insufficient. In early May 2010, California (San Francisco County) Superior Court Judge Richard Kramer announced from the bench that he would be overruling the rating agency defendants’ demurrer to Calpers’ negligence claims, but that he was sustaining the demurrers with leave to amend as to Calpers’ allegations of negligent interference with prospective economic advantage. Judge Kramer indicated at the hearing that the reasons for his reasons would appear in a forthcoming opinion.

The May 24 Opinion

In an opinion dated May 24, 2010 and filed on June 1, 2010 (and which can be found here), Judge Kramer set out the reasons for his rulings on the rating agency defendants’ demurrers.

The most noteworthy aspect of Judge Kramer’s opinion is his statement of the bases on which he rejected the defendants’ argument that they could not be held liable for their ratings opinions because the opinions are protected under the First Amendment. Judge Kaplan said (citing and relying on Judge Shira Sheindlin’s opinion in the Cheyne Financial case, about which refer here):

The court rejects Defendants’ arguments that the First Amendment to the United States Constitution preempts Plaintiff’s claims. The right to free speech allows us to give our opinions to things of public concern. The issuance of these SIV ratings is not, however, an issue of public concern. Rather, it is an economic activity designed for a limited target for the purpose of making money. That is not something that should be afforded First Amenment protection and the Defendants are not akin to members of the financial press.

Judge Kaplan also rejected the rating agency defendants’ arguments that the plaintiff’s claims are precluded by New York’s Martin Act or by the Credit Rating Agency Defense Act. However, he did find that plaintiff’s claim of negligent interference with prospective economic advantage was legally insufficient, although he allowed plaintiff leave to attempt to replead the claim.

Discussion

There have only been a handful of preliminary motion rulings so far that have been unfavorable to the rating agencies. But Judge Kaplan’s opinion in the Calpers case demonstrates that each of these rulings, even though seemingly limited, creates an opportunity for later plaintiffs to try to exploit the rulings in other cases.

For example, Judge Kaplan expressly relied on Judge Sheindlin’s September 2009 opinion in the Cheyne Financial case. Judge Sheindlin’s rejection of the rating agencies’ First Amendment defense in that case was by its own terms narrow; she said only that credit rating that is not directed to the public at large, but that is "provided instead to a select group of investors," is not entitled to First Amendment protection.

Though Judge Kaplan expressly quoted this narrowing language, his opinion arguable is not as narrow. To be sure, he emphasized that the SIV itself was designed for a "limited target. But he also said that the rating agencies are not the equivalent of the "financial press," and he indicated that the opinions were not entitled to protection where the opinions are not of "public concern." This analysis may or may not be sufficient to bar the First Amendment defense in a public-at-large kind of claim, but it nonetheless does seen to constrain the availability of the defense in a wide variety of circumstances – and a wider variety of circumstances than would the standard in Judge Sheindlin’s case.

Whether plaintiffs in other cases will be able to build further on Judge Kaplan’s opinion remains to be seen. It particularly remains to be seen whether Judge Kaplan’s analysis will prove useful in a public-at-large case, as opposed to a "select group of investors" kind of case.

Nevertheless the plaintiffs in these cases have shown themselves capable of building on openings in the defense. However, even the plaintiffs that have already survived preliminary motions are all still a very long way from any actual recovery. But surviving the motions to live for another day is the name of the game for plaintiffs in these kinds of cases. The small but growing number of rulings favorable to the plaintiffs seem to offer some reason to suspect that a number of these cases against the rating agencies may yet go forward.

Special thank to Henry Turner of the Turner Law Offices for providing me with a copy of Judge Kaplan’s opinion in the Calpers case.

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At least one prominent commentator has suggested that the reason for the accumulation during late 2009 of a significant number of belated securities suits, where the filing date came well after the proposed class period cut-off date, is that plaintiffs lawyers are "trying to fill the litigation pipeline by bringing older lawsuits that weren’t attractive enough to file" as subprime- related cases mounted during earlier periods.

The further suggestion was that "these lawsuits are more likely to be dismissed and can be characterized as lower quality claims."

Whether or not the belated cases in general are or are not likelier to be dismissed, and even whether or not the cases are "lower quality claims," at least one of the first of the belatedly filed cases recently survived a motion to dismiss, suggesting that at least some of the belated cases could represent serious claims exposures

Background

As discussed at greater length here, Ambassadors Group was first sued in a securities class action lawsuit in July 2009. The complaint, filed in the Eastern District of Washington, purported to be filed on behalf of persons who bought company stock during the period February 8, 2007 to October 23, 2007. In other words, the initial filing date came some 21 months after the proposed class period cut-off date.

Ambassadors is in the business of providing student travel trips, primarily to middle school students. The plaintiffs alleged that the defendants had omitted to disclose that in December 2006, the mailing list company from which Ambassadors purchased its middle school names list ended its relationship for undisclosed reasons. Ambassadors purchased a replacement middle school names list from a different company.

On October 22, 2007, when the company released poor financial results, among the reasons given was the unexpected underperformance of the replacement mailing list. The company’s share price declined 44% on the poor financial news.

The plaintiffs alleged that the defendants’ statements during the class period were materially misleading because the company knew as early as summer 2007 that response rates were poor and had known in late 2006 that it had lost access to a key mailing list. The defendants moved to dismiss.

The June 2, 2010 Ruling

In a June 2, 2010 order (here), Judge Justin Quackenbush denied defendants’ motions to dismiss as to the July 24, 2007 statement of the company’s Executive Vice President that the company’s was launching its 2008 marketing campaigns, which were "similar in timing and delivery as previous years."

Plaintiffs had argued that this statement was "simply untrue" because the 2008 marketing campaign was note similarly in delivery to previous years, owing to loss and subsequent replacement of the mailing list, which represented 90% of the company’s marketing leads and 45% of the company’s business.

The court concluded that the plaintiffs’ complaint "pleads sufficient facts, that when taking as true, create a genuine issue of material fact regarding whether the 2008 campaign was not, in fact, similar to delivery in previous years."

However, Judge Quackenbush found that the defendants’ remaining statements on which the plaintiffs sought to rely were "general and vague" and constituted puffery and therefore could not serve as a basis of liability.

In finding that the plaintiffs had sufficiently alleged scienter, Judge Quackenbush found, in reliance on the "core functions" doctrine, that the company’s mailing campaign was "so integral to the operations of [the company that knowledge thereof cannot be denied by senior executives." The company’s CEO and Executive Vice President were also alleged to have sold over $4 million of their personal holdings in company stock between May and August 2007. The court noted that the insider trading was the subject of an SEC investigation.

Judge Quackenbush went on to observe that:

Ambassadors is a small company. There is no reasonable argument that the Defendants were not aware of the mailing list issue. The core operations inference in this case is a strong one, as the Middle School names list accounted for 45% of the marketing leads for Ambassadors. The inference is strengthened by the allegations of the confidential witnesses, the SEC investigation, and the stock sales.

The Company’s CEO and CFO each separately moved to dismiss the claims against them on the grounds that they themselves were not alleged to have made the allegedly misleading statements. After reviewing case law relating to the "group pleading" doctrine, Judge Quackenbush rejected the two individual defendants’ separate dismissal motions, observing that:

Corporate officers, however, may not stand idly by as investors and analysts, upon whose recommendations other investors rely, are mislead [sic]. Corporate exeutiveship often carries with it substantial financial remuneration, but with such remuneration comes duties and obligations to the company and its stockholders that must not be ignored, as the economic catastrophes befalling the company in the past two years have harshly illustrated. Affirmative steps are required to prevent fraud or to even merely clarify when a statements veers into a dangerous grey area. [The CFO] may not cloak himself in his silence and avoid liability for the misleading statements of his co-defendants made to public stock analysts during a conference call at which he was present.

Discussion

A single ruling arguably represents little from which to try to make any generalizations about the belated cases as a group. Moreover, there may be those who might want to argue that this case is going forward on the basis of a single seemingly neutral statement about the initiation of the marketing campaign.

Some observers might also note that Judge Quackenbush’s ruling is heavily dependent both on the "core functions" doctrine and the "group pleading" doctrine, the applicability of both of which under the PSLRA have been the subject of considerable debate.

Nevertheless, the case did survive the initial dismissal motion. The time lag between the class period ending date and the initial filing date was irrelevant to the court’s decision. The dismissal motion ruling suggests that at least some of the belated failings will survive dismissal motion rulings and that the mere fact that a case was belatedly filed may not necessarily mean that the case will be unable to overcome initial pleading thresholds.

It is interesting to note that in his discussion of the responsibility of corporate officers to prevent fraud, Judge Quackenbush invoked both concerns about executive compensation and about the possible role of corporate officials in the financial crisis, suggesting a judicial context within which the activities of corporate officers may be viewed, even in the absence of allegations that the officers whose conduct is at issue received disproportionate compensation or contributed to the financial crisis.

The suggestion is that the popular outrage growing out the financial crisis may inform judicial decision-making, even in cases that seemingly do not directly involve the financial crisis.

One final observation is that, whatever the reason for the increase in belated securities class action lawsuit filings, and whether or not they represent "poorer quality claims," the plaintiffs’ lawyers continue to file them, as I noted in my recent discussion of recent securities lawsuit filing trends, here.

Special thanks to a loyal reader for sending me a copy of the Ambassadors Group decision.

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In two separate decisions, two courts issued opinions in cases that each related in different ways to Credit-Based Asset Servicing and Securitization, LLC, also known as C-Bass. As discussed below, Judge Rakoff has issued an opinion substantiating his prior dismissal motion rulings in the C-Bass subprime-related class action securities litigation, and in a separate opinion, Judge Mary McLauglin has dismissed with prejudice the subprime-related ERISA class action involving Radian Group and its investment in C-Bass.

The C-Bass Subprime-Related Securities Suit

As previously noted here, in a two-page March 31, 2010 order (here), Southern District of New York Judge Jed Rakoff issued an order denying in part and granting in part the defendants’ motions to dismiss in the C-Bass subprime-related securities suit. Judge Rakoff did not issue an opinion detailing his reasons for his rulings at the time. However, on June 1, 2010, Judge Rakoff issued his opinion substantiating his rulings. The opinion can be found here.

The most noteworthy aspect of Judge Rakoff’s decision is that he granted the rating agency defendants’ motion to dismiss, following Judge Kaplan’s ruling in the Lehman Brothers subprime-related securities suit that the rating agencies cannot be held liable under the ’33 Act as “underwriters.” Andrew Longstreth's June 1, 2010 Am Law Litigation Daily article discussing this aspect of Judge Rakoff's opinion can be found here.

Judge Rakoff said that similar reasoning requires him to dismiss three defendants (including C-Bass itself) who were merely “sponsors” of the offerings referenced in the plaintiffs’ complaint, as these defendants merely originated the mortgages underlying the securitizations, and therefore did not qualify as statutory underwriters. Judge Rakoff dismissed without prejudice the plaintiffs’ complaints against Merrill Lynch, holding that the specific allegations in the plaintiffs’ complaint were not sufficient to state a Section 11 claim against Merrill as an underwriter.

As to the defendants who actually were offering underwriters in connection with the offerings in dispute, Judge Rakoff said that the plaintiffs’ allegations that the mortgage originators had, contrary to representations in the offering documents about the originators compliance with underwriting guidelines, were sufficient to state a claim under the ’33 Act.

However, Judge Rakoff also granted the motion to dismiss plaintiffs’ claims as to 65 of the 84 securities offerings, in which the named plaintiffs had not purchased securities, on the basis of lack of standing.

One particularly interesting part of Judge Rakoff’s opinion is his ruling rejecting the defendants’ motion to dismiss on statute of limitations grounds. The defendants had argued that the plaintiffs were on inquiry notice prior to December 5, 2007 (that is, more than a year before the first complaint was filed) of their claims, and therefore the plaintiffs’ claims were time-barred.

In making this argument, the defendants had argued, as paraphrased by Judge Rakoff, that prior to December 2007, “questions about the bona fides of mortgage-backed securities were the subject of news reports, government investigations, public hearings, and civil complaints.” The plaintiffs argued that virtually none of these references referred to the defendants or to the securities at issue. Judge Rakoff said that at most, plausible inferences might be drawn for either side, making the issue inappropriate for resolution at the dismissal motion stage.

In reaching this ruling, Judge Rakoff expressly referenced the Supreme Court’s recent statute of limitations-related opinion in the Merck case (about which refer here). Judge Rakoff noted that Merck had addressed statutes of limitations issues under the ’34 Act, adding that the Second Circuit had not yet had occasion to determine how Merck might change statute of limitations issues under the ’33 Act.

However, with respect to Merck, Judge Rakoff noted that the Supreme Court had “rejected arguments of the defendants quite similar to the arguments made by the defendants here,” summarizing the Supreme Court’s ruling in Merck as holding that “a plaintiff would not be barred by the statute of limitations unless a reasonably diligent plaintiff similarly situated would have actually discovered facts showing the violations alleged in the plaintiffs’ complaint.”

Judge Rakoff’s ruling, though not dependent on the Merck case, is at least consistent with the general view that Merck itself could have a beneficial impact for plaintiffs in other securities class action lawsuits.

The Radian Group Suprime-Related ERISA Class Action

In a May 26, 2010 order (here), Eastern District of Pennsylvania Judge Mary McLaughlin granted with prejudice the defendants’ motion to dismiss in the Radian Group subprime-related ERISA class action.

The plaintiffs had alleged, on behalf of participants in the Radian Group benefits plan, that the defendants had misled the plan participants about the risks associated with investments in the plan in Radian stock due to Radian’s investment in C-Bass. The plaintiffs claimed that the plan participants were harmed with the value of the plan investments in Radian stock fell in value after Radian announced that its investment in C-Bass was materially impaired.

Judge McLaughlin had previously granted defendants’ motion to dismiss, without prejudice, and the plaintiffs amended their complaint. In her May 26 opinion, Judge McLaughlin granted the motions with prejudice, finding that the plaintiff has “once again failed to plead a breach of fiduciary duty.”

Judge McLaughlin specifically held that the plaintiff’s new allegations “do not demonstrate the inapplicability of the presumption of prudence, nor do they rebut the presumption.” She also found that the plaintiff had failed to state a claim for breach of the duty of disclosure.

I have added both of these rulings to my running tally of subprime-related litigation dismissal motion rulings, which can be accessed here.

Fifth Circuit Makes a Hash of the Climate Change Case: As I noted in a prior post, the October 2009 Fifth Circuit opinion in the Comer v. Murphy Oil Co. case, overturning the district court's dismissal of the plaintiffs' climate change related claims, raised the possibiltiy that other climate change cases might follow. However, the Fifth Circuit granted the defendants' petition for rehearing en banc, in the process vacating the October 2008 opinion of the initial Fifth Circuit panel.

That's when things started to get messy. One by one, different Fifth Circuit judges recused themselves, evenutally reaching the point where there weren't enough judges left to take up the en banc rehearing.

As discussed in Alison Frankel's June 1, 2010 Am Law Litigation Dailiy article here, the lack of a quorum for en banc review has left the case in a procedural netherword that she aptly describes as "weird."  It seems that the Fifth Circuit has dismissed the appeal, effectively reinstating the ruling of the district court. In its order dismissing the appeal, the Fifth Circuit expressly declined to reinstate the opinion of the three-judge panel. The Fifth Circuit said that there is no rule permitting them to reinstate a vacated opinion.

(You are excused if you feel a bit confused right now.)

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My weekend reading over the Memorial Day holiday included a hefty selection from the stack of law firm memos that accumulated in my inbox in recent weeks. Many of the most recent memos related to the Senate’s passage of its version of the financial reform legislation, but the memos also reflected a variety of other developments, including recent significant case developments and the passage of the UK bribery bill. I have set out below some of the more noteworthy recent law firm memos that have crossed my desk.

The Senate Financial Reform Bill

The Senate’s passage of the Restoring American Financial Stability Act of 2010 has triggered a flood of law firm memos. Though many of the memos have attempted to provide an overall description of the sweeping legislation, some have concentrated on focused on a narrow part of the bill. Several law firms have released memos focused just on the bill’s proposed corporate governance.

A May 24, 2010 memo from Sullivan & Cromwell provides an overview of the bill’s corporate governance reforms, including the bill’s provisions relating to majority voting for directors, "say on pay," executive compensation clawbacks, compensation committee independence and disclosures, and limitations on broker non-votes. The Sullivan & Cromwell memo points out that a number of the provisions in the bill – whistleblower protections, amendments relating to whistleblowers, private placement provisions and broker voting—would apply to non-U.S. issuers.

A May 28, 2010 memo from the Bingham McCutchen law firm also discusses the bill’s corporate governance reforms. Of particular interest, the Bingham memo contains an extensive discussion of the proposed "say on pay" reforms, with particular emphasis on concerns about "the amount of power the change would place in the hanks of proxy advisory firms," which provide compensation guidelines in connection with the proxy advice.

The Morgan Lewis firm also issued a May 27, 2010 memo about the Senate bill, here. The Morgan Lewis firm memo has an interested in discussion about the provision in the Senate bill that would require the securities exchanges to include the adoption of a compensation clawback policy as a listing requirement (by which incentive based compensation would be clawed-back from company officials in the event of a financial restatement of the financial statement of prior periods to which the compensation relations). The memo details the way that this provision the existing clawback requirements promulgated by SOX.

A May 27, 2010 memorandum from the Sidley Austin firm also provides an overview of the corporate governance reforms in the bill, and notes that that the bill contains additional compensation limitations for bank holding companies, and a separate provision requiring public companies to file a special SEC report of they using certain specified mineral products that may have originated in the Democratic Republic of Congo.

The Senate bill contains provisions designed to encourage corporate employees to blow the whistle on securities fraud. A May 21, 2010 Morgan Lewis memo (here) points out that these new provisions "give whistleblowers significant enhanced incentives to make a report" as part of the SEC’s new whistleblower program, and also provides extensive additional retaliation protections. The provisions would allow whistleblowers to receive rewards of between 10% and 30% of the monetary recovery. The provisions would also allow the whistleblower claiming retaliation to bypass existing administrative procedure requirements and proceed directly in federal court. The provisions also proposed a much longer statute of limitations and would create a double-back-pay remedy for retaliation claims, which created an incentive to bring retaliation claims.

Finally, a May 25, 2010 memo from the Faegre & Benson firm reports that the Senate’s financial reform bill "may give plaintiffs little to celebrate," noting that Congress "largely has chosen not to empower private parties" to enforce the rules. Indeed, the House bill’s provisions that would create the new consumer protection agency specifies that "nothing" in the provision establishing the new consumer protection "shall be construed to create a private right of action."

The Faegre & Benson memo does note that both the House and the Senate versions of the bill have "carved out a role for private litigants" to "help safeguard the integrity of the rating process" by allowing investors to sue credit rating agencies for securities fraud. The two versions disagree on the standard of liability to be required. Though the two versions must now be reconciled, some allowance private civil litigation against the rating agencies seems likely.

Securities Law Case Developments

A number of law firms have written memoranda discussing the Second Circuit’s April 27, 2010 opinion in the Pacific Investment Management Co. v. Meyer Brown case. Though the case outcome, in which the Second Circuit affirmed the dismissal of the securities fraud lawsuit against Refco’s lawyer, may have been unsurprising given the Supreme Court’s decision in Stoneridge, the law firm memos make the point that we may not have heard the last of the case.

As detailed in Arnold & Porter’s May 2010 memo about the case (here), the Second Circuit rejected the "creator theory" that both the plaintiffs and the SEC (in an amicus brief) had urged the court to adopt and instead held that "a secondary actor can only be held liabile for false statements in a private damages action for securities fraud only if the statements are attributed to the defendant at the time the statements are disseminated."

The Arnold & Porter memo points out that the decision, adopting the attribution test and rejecting the creator theory, has "two crucial limitations"; that is that it relates only to private civil actions under Rule 10b-5 and "does not speak" to government enforcement actions; and the Second Circuit refrained from addressing the question whether attribution is required for claims against corporate insiders.

The memo also notes that "perhaps most significant" is the fact that the decision was accompanies by Judge Barrington Parker’s concurring opinion, essentially calling for en banc review and even inviting the Supreme Court to weigh in on the matter. In other words, the memo notes, the Second Circuit’s recent opinion may not be the "final word on the subject."

Chadbourne & Parke also has a May 6, 2010 memo on the case, here. The Paul Hastings firm’s May 2010 memo on the case can be found here.

Finally, a May 26, 2010 memo from the Pillsbury Winthrop law firm discusses the Second Circuit’s May 18, 2010 decision in Slayton v. American Express , in which the Second Circuit held that even though forward-looking statements in the defendant’s SEC filing was not accompanied by meaningful cautionary disclosure, the plaintiffs failed to show that the statements were made with actual knowledge that they were misleading.

The Pillsbury firm memo identifies two "key takeaways" from the case: first, that "meaningful cautionary language must be specifically tailored to the statement at issue," as "boilerplate disclosure can be turned against a registrant because of its inherent lack of specificity." The Second Circuit’s holdings confirm the importance of "regularly reviewing the cautionary statements and risk factor disclosures contained in their public filings to ensure that the disclosure continue to be current and meaningful."

Second, the Second Circuit considered it to be a close call whether the plaintiffs had carried the burden of proving actual knowledge of falsity, "executive officers should remain vigilant and thoughtful when evaluating whether they have a reasonable basis for a particular forward-looking statement."

The U.K.’s Bribery Act 2010

The Morgan Lewis firm has a May 2010 memo entitled "The New UK Regime on Bribery" (here) describing the "far reaching implications" of the U.K.’s Bribery Act 2010. Among other things, the memo notes that the new law expands the scope of behavior that is targeted; no longer limited just to bribes paid to foreign officials, the new law applies to all bribes including purely commercial bribes, and applies to both the person paying and the person accepting the bribe.

Even more significant, the Act’s new Section 7 creates a new strict liability offense for organizations if a person associated with the organization bribes another person with the intent of benefiting the organization. However, organizations have a defense if they can show that they have in place "adequate procedures" to prevent bribery. In essence, the new Act is mandating compliance programs, to create controls against improper payments.

The Act has what the memo describes as a "wide territorial scope," applying of an act or omission forming part of the violation occurs in the U.K, or if in is carried out by a person with a "close connection" to the U.K.

A May 24, 2010 memo from the Weil Gotshal firm says that the new Act "provides the UK with one of the toughest regimes for regulating corruption in the world.

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