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

In a post last week, I discussed a recent article by three academics in which they considered whether companies involved in securities lawsuits  financially underperform after the cases are settled. The prior post provoked an unusual level of reader commentary. Among the comments posted was one from former plaintiffs’ securities class action attorney William Lerach.

Because I know readers enjoy a spirited discussion as much as I do, and because I believe this blog can and should encompass a wide variety of viewpoints, I communicated with Mr. Lerach to see if he would allow me to republish his comment in the form of a guest post on this site. Mr. Lerach agreed and so his comment is reproduced below. In order to appreciate the context for Mr. Lerach’s remarks, I strongly recommend reading the prior post on which he is commenting. Here are his comments:

After reading Kevin's description of this study concerning the post settlement performance of companies sued for securities fraud and his own evaluation of the paper I don't know whether to characterize them both as silly or stupid. They're probably a combination of both. Almost everything about the study and the associated commentary ignores the basic realities of the circumstances that surround the vast majority of securities fraud litigations. Most companies end up being sued for securities fraud––and then end up (with the help of directors’ and officers’ liability insurance) paying a settlement––because they have lied to the marketplace about the quality of the corporation's business or its products or finances. Frequently the revelation of the truth results and not only a sharp drop in the stock price but adverse financial revelations, a drop in revenues and cash flow, violation of bank or lending covenants and management shakeups. So are we surprised that companies with these characteristics suffer "greater risks of financial distress" after they later settle a lawsuit. Of course they face such risks because they were lying about the nature of their business earlier--to cover up flaws in products, performance or the business model itself. Often such companies face a" liar's discount" in the marketplace as a consequence of their prior bad conduct. It's not the lawsuit or the settlement of the lawsuit that injures the company-or impairs it ongoing performance of financial condition-it is the misconduct, the lying and the financial falsification of the executives that got the company sued in the first place that undermines the future performance and financial health of the company. We should not be surprised that companies that have committed securities fraud––whether it's stuffing the channel, lying about their products, or falsifying their financials, "perform worse than their peers". What is it about such companies and their managements that would cause us to believe that they would perform better than their peers? Kevin's conclusion that this flawed study suggests that suits are better directed at the individuals who perpetrated the misconduct i.e. the officers of the company-- and that this would somehow spare the corporate entity the financial distress of the settlement -ignores the reality of the indemnification obligation of the company which in virtually every case causes the company to fund the bulk of any settlement on behalf of the officers directors and then only to the extent it has not been paid for by directors and officers liability insurance, a contributor which would have no material adverse impact on the corporate entity. Underlying the study and Kevin's commentary on it is the notion somehow that suits brought on by half of shareholders merely transfer money from one group of shareholders to another and therefore really don't benefit anyone-- but harm the company. Not only does this ignore the reality that the bulk of the settlement monies in these cases comes from directors and officers insurance but it completely misses the point that the vast majority of settlement proceeds go to former shareholders of the company––those investors who purchased the shares of the company at an inflated price during the fraud period but who in most instances, out of anger , frustration, or even for tax considerations later sell the shares at a loss and have no further interest in the corporate entity. These are former shareholders not current shareholders with the equivalent of a tort claim against the company. I normally am not moved to comment on the academic work done concerning securities lawsuits but the simplistic nature of this study is so obvious that I could not resist pointing out these shortcomings. It may well be that there are many defects with securities fraud class action lawsuits but any financial underperformance of companies that follows their settling such lawsuits against them and their officers and directors is not one of them.

I would like to thank Mr. Lerach for taking the time to communicate his reaction to my prior post and for allowing me to reproduce his thoughts here. As I have already had my say on this topic, and because my business partners prefer that I attend to my day job from time to time, I will not respond here to Mr. Lerach’s comments. However, I expect some readers may have their own reactions to Mr. Lerach’s remarks, and I encourage everyone to consider adding their thoughts to this post using the blog’s comment feature. I have always hoped this site would serve as a platform for the exchange of ideas, and I encourage all readers to use post their thoughts for the benefit of other readers.

In a prior post (here), I reviewed the recent biography of Mr. Lerach, Circle of Greed. My interview with the book’s authors can be found here.

That's Reassuring:  I am still trying to work out whether I am silly or stupid. Or perhaps both. In the meantime, I take some consolation from the fact that Lexis Nexis has selected The D&O Diary as one of the Top 50 Insurance blogs, as reflected in the icon embedded in the right hand margin.

In addition, George Mason Law Professor J.W. Verret, writing in the Truth on the Market blog on Monday, included The D&O Diary as one of twelve blogs he lists as his "favorite corporate law blogs." UCLA Law Professor Stephen Bainbridge, commenting on Verret's list on  the ProfessorBainbridge.com blog, also included The D&O Diary on his (somewhat longer) list of corporate law blogs he reads regularly.  My thanks to both venerable Professors (and fellow bloggers). I should add that my blog list is very much like theirs and that my list also includes both of their blogs.

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In an August 27, 2010 opinion so massive that its table of contents alone is five pages long, Southern District of New York Judge Kevin Castel granted in part and denied in part the motions to dismiss in the consolidated securities and derivative litigation arising from Bank of America’s January 2009 acquisition of Merrill Lynch and related events. Though the opinion dismisses parts of the lawsuit, other substantial pieces, particularly those related to the controversial bonuses paid to Merrill employees at the end of 2008, will be going forward.

Background

In the whirlwind of events in mid-September 2008 that included the collapse of Lehman Brothers and the dramatic government bailout of AIG, BofA agreed to acquire Merrill Lynch. According to the allegations in the subsequent lawsuits, one of the important features of the merger negotiations related to 2008 bonuses scheduled to be paid to Merrill employees in January 2009. The complaint alleges that BofA agreed to a $5.8 billion bonus pool and agreed that the bonus payments could be accelerated so the payout occurred prior to year end 2008 and before the merger transaction closed on January 1, 2009.

The complaint alleges that these bonus arrangements were not disclosed to BofA shareholders in the proxy materials that were sent to shareholders on November 3, 2008. (The arrangements were described in a "Disclosure Schedule" that was not available to shareholders prior to the shareholder vote).

On October 7, 2008, after the merger was announced but prior to the proxy vote, BofA conducted a $9.9 billion secondary offering. In October and November 2008, while shareholder approval of the transaction was pending, Merrill suffered losses of over $15 billion and also took a $2 billion goodwill impairment charge. The Complaint alleges that BofA’s senior officials were aware of these losses as they occurred. The Complaint alleges that the losses were so significant that BofA management discussed terminating the transaction, prior to the December 5, 2008 shareholder vote on the merger, in which BofA shareholders approved the merger.

In discussions after the merger vote about Merrill’s deteriorating condition, BofA senior management considered whether BofA had the right to terminate the merger under the merger agreement’s "material adverse change" (MAC) clause. On December 17, 2008, BofA Chariman and CEO Kenneth Lewis called Treasury Secretary Henry Paulson to advise him that BofA was "strongly considering" invoking the MAC clause. At Paulson’s invitation, Lewis flew to Washington for a face-to-face meeting, at which Paulson and Federal Reserve Board Chair Ben Bernanke urged Lewis not to invoke the MAC clause.

In subsequent conversations, Lewis again advised the government officials that BofA intended to invoke the MAC clause. According to the complaint, BofA’s board voted on December 21, 2008 to invoke the MAC clause, but on the following day, the Board voted to approve the merger, apparently in part based on Lewis’s statement that he had received verbal assurances from Paulson that BofA would received a capital infusion and a guarantee against losses from risky assets if the merger concluded. Lewis allegedly told the Board that the company would not enter into a written agreement concerning the federal funds because he could not risk public disclosure of the government loans prior to the transaction’s scheduled January 1, 2010 closing. Instead, the government bailout package would be disclosed at the time of the company’s earnings release later in January.

On January 16, 2010, BofA disclosed the fourth quarter losses of both BofA and Merrill and also revealed the federal funding package, which included $20 billion in capital and protection against further losses on $118 billion in assets. In following days, news about Merrill’s bonus arrangement broke.

In response to this news, BofA’s share price declined, and shareholder litigation ensued. The plaintiffs alleged that the defendants misstated and concealed matters related to the Merrill bonuses, the losses that accrued in the Fourth Quarter of 2008 after the merger was announced, and the pressure to consummate the deal from government officials. After the securities and derivative lawsuits were consolidated, the defendants moved to dismiss.

The August 27 Order

Judge Castel’s massive August 27 memorandum opinion and order covers a lot of ground, much of which cannot be easily summarized. For simplicity’s sake, I have summarized here only his rulings pertaining to the major categories of factual allegations.

Merrill Lynch Bonus Payments: First, Judge Castel held that the plaintiffs had sufficiently alleged actionable misstatement with respect to the parties’ "undisclosed written agreement authorizing the payment of bonuses to Merrill," because the proxy "portrayed bonus payments to Merrill employees as a contingent event, when, in reality, the parties had reached agreement as to the timing and range of bonuses." Accordingly, the proxy materials "omitted information necessary to render the statements truthful" and the omission "was material."

Judge Castel also held that the plaintiffs had sufficiently alleged scienter in connection with the Merrill Lynch bonus allegations, at least other than with respect to two specific BofA officials (Price and Crotty) who were not sufficiently alleged to have been involved in the negotiations or disclosures.

Judge Castel found that "the Securities Complaint explicitly alleges awareness of the bonus arrangement on the part of Lewis and [Merrill CEO John] Thain, which was memorialized in the secret Disclosure Schedule." Both of these men, Judge Castle said, "were closely involved in the details of the bonus negotiations, the resolution of which was concealed from BofA shareholders." These allegations, Judge Castle said, "raise an inference of recklessness that is ‘at least as compelling as any opposing inference of nonfraudulent intent.’"

With respect to the BofA directors, Judge Castel concluded that the allegations of scienter were insufficient, but the allegations were sufficient to allege negligence, and therefore, while not stating a claim under Section 10(b), were sufficient to state a claim under Section 14(a). Judge Castel observed with respect to the BofA directors that if they "were aware that the Joint Proxy was materially deficient (as is alleged) or if they should have been aware of deficiencies but took not steps to remedy or inquire about them (as is also alleged), the negligence standard of Section 14(a) would be satisfied." The allegations against Price and Crotty were insufficient event to establish negligence.

Fourth Quarter Losses: Judge Castel also concluded that the plaintiffs had sufficiently alleged actionable misstatements with respect to the alleged failure to disclose the fourth quarter losses. However, while concluding that the complaints adequately allege that the magnitude of the losses was material, the Complaint does not "sufficiently allege how the failure the failure to disclose the losses was ‘highly unreasonable’ and "represented an extreme departure" from the standards of ordinary care."

Judge Castel added that the securities complaint fails "to adequately and plausibly explain why a defendant would be motivated to accurately disclose a ‘turbulent’ and ‘tumultuous’ economic forecast for the quarter yet recklessly or intentionally conceal the dire reality as the quarter unfolded." Accordingly he concluded that the securities complaint "fails to allege scienter as to defendants’ failure to disclose the fourth quarter losses."

However, while Judge Castel concluded that the securities complaint "does not satisfy the threshold for alleging fraud" it does "adequately set forth a theory grounded in negligence." Accordingly he denied the defendants’ motion to dismiss securities plaintiffs’ Section 14(a) claims, as well the derivative plaintiffs’ claims, based on the failure to disclosure the fourth quarter losses.

Undisclosed Federal Bailout Arrangements: Judge Castel found that the plaintiffs had sufficiently alleged an actionable misstatement or omission with respect to the bailout understanding that Lewis reached with Paulson. He found that "detailed, non-conclusory allegations plausibly allege that BofA received concrete assurances from officials …that BofA would receive a massive capital infusion in exchange for proceeding with the Merrill acquisition" but that this agreement was "intentionally not memorialized to avoid public disclosure." Judge Castel concluded that these allegations "adequately alleged the particulars of fraud."

However, Judge Castel found that the allegations about the nondisclosure of the federal agreement fail to satisfy the requirements for pleading scienter. He noted that "the scienter allegations are thin" and that the complaint only explicitly asserts scienter as to Lewis.

Judge Castel noted that the complaint alleges a consciousness on Lewis’s part of avoiding liability because he sought a letter from Bernanke providing immunity from civil claims. Judge Castle observed that the securities complaint does not allege that Lewis or any other defendant "stood to gain from non-disclosure" and to not allege "a quid pro quo type arrangement" or that failing to disclose the federal funding brought a benefit to any defendant.

Judge Castel noted further that "the decision not to disclose federal support originated in an instruction by Paulson." There is, Judge Castel noted, "no allegation that Lewis or any other defendant hatched a scheme to avoid public disclosure of the federal capital support." Rather than "self-interested motivations," Lewis "acted as ‘instructed’ by Paulson." Judge Castel added that "while Paulson’s instruction would not necessarily preclude a finding of scienter if other allegations established motive or recklessness, it anchors the defendants’ concealment to Paulson’s directions."

The defendants, Judge Castel noted, "were acting at the instruction of the Treasury Secretary during a moment of acute economic and political uncertainty. There are no allegations of personal gain derived from the federal funds, or a violation of a statute or regulation in a ‘highly unreasonable’ manner."

The October 2008 Offering: Judge Castel denied the defendants’ motion to dismiss the securities plaintiffs’ ’33 Act claims, except to the extent the allegations related to non-actionable puffery.

Other Holdings: Judge Castel dismissed both the securities plaintiffs’ and the derivative plaintiffs’ allegations relating to the defendants’ disclosures regarding the defendants’ failure to invoke the MAC and the alleged failure to disclose the defendants’ consideration of possible invoking the MAC. Judge Castel also dismissed the plaintiffs’ claims relating to statements about the adequacy of BofA’s due diligence. Judge Castel also rejected the plaintiffs’ claims relating to a number of post-merger statements.

Demand Excused: Judge Castel concluded that the demand was excused on the derivative plaintiffs’ Section 14(a) claims because the directors "faced a ‘substantial likelihood’ of personal liability on the Section 14(a) claim at the time the suit was commenced," which would have "prevented them from exercising their disinterested and impartial judgment to a demand request." However, Judge Castel concluded that demand was not excused as to the derivative plaintiffs’ breach of fiduciary duty claims against the BofA board for approving the merger.

Discussion

The BofA/Merrill Lynch merger was one of highest profile events during the peak of the global financial crisis in late 2008 and early 2009. The disclosures in early 2009 about Merrill’s losses and about the bonus payments were highly controversial. As a result, Judge Castle’s opinion in the consolidated shareholder litigation undoubtedly will provoke extensive scrutiny and commentary. There are indeed a number of parts of the opinion that are worthy of discussion, but the part this is the most interesting to me is his conclusion regarding the inadequacy of the scienter allegations in connection with the alleged failure to disclose the federal bailout that Lewis negotiated with Paulson.

As alleged in the complaint, this massive federal package was negotiated after the shareholder vote but before the deal closed. Its existence was apparently critical to the BofA board’s vote to go forward with the deal rather than to invoke the MAC clause. Moreover, it was understood that Paulson’s verbal agreement would have to be disclosed if it were reduced to writing – and accordingly, it was not reduced to writing so it wouldn’t have to be disclosed.

In concluding that these actions, which seem to have been taken precisely so that something everyone recognized as important would not have to be disclosed prior to the merger closing, do not give rise to a strong inference of scienter, Judge Castel relied on two considerations: (1) Paulson "instructed" Lewis not to disclose the federal package; and (2) Lewis had nothing to gain personally from withholding disclosure.

Though these factors undoubtedly are relevant, it strikes me that these points do not necessarily answer the question whether or not Lewis consciously misled BofA shareholders of acted with reckless indifference to the truth.

It could be argued that the allegations strongly suggest that Lewis did not want the BofA shareholders to know that the only way the BofA board was willing to go forward with the deal was the existence of massive federal support. A plausible inference is that he, like Paulson, feared the chaos that would have emerged if these facts were revealed before the deal closed. It is also plausible to infer that Lewis and others didn’t want to anger Paulson and risk losing the proffered federal support.

These might all have seemed like good and sufficient reasons to withhold the information, but whether or not the reasons might have seemed good and sufficient does not answer the question whether Lewis and others acted with awareness of or conscious disregard whether BofA shareholders would be misled.

The fact that Paulson "instructed" Lewis to withhold disclosure does not answer the question whether or not Lewis was aware BofA shareholders would be mislead; to the contrary, it might actually suggest a concern that BofA’s shareholders couldn’t be trusted with the truth. (Indeed, Paulson’s instruction arguably does nothing more than make him complicit in the alleged deception, which in Paulson’s case, encompassed not just BofA shareholders but also U.S. taxpayers.)

Why is Paulson’s "instruction" relevant at all to the question whether or not the securities laws were violated? Is Castel suggesting that there is some sort of immunity from securities liability if the actions were at the request of a government official? It seems to me that the supposed relevance of Paulson’s instruction is surprisingly unexamined in Castel’s opinion, and the entire discussion of the issue is disconnected from the question whether or not Lewis knew that the shareholders would be misled.

Judge Castel’s emphasis on Lewis’s lack of personal benefit, while not irrelevant, is also beside the point. Lewis’s lack of personal benefit certainly doesn’t answer the question whether Lewis and others were deliberately taking steps to avoid disclosing material information because they were afraid of what would happen if they did.

In the final analysis, I think Judge Castel’s ruling can perhaps only be understood by his observation that these events took place "during a moment of acute economic and political uncertainty." While this fact has nothing to do with whether or not Lewis was consciously withholding information from BofA shareholders, it does suggest Castel is simply unwilling to permit liability for actions taken at the direction of senior public officials at a time of national exigency. It is almost as if he is saying, with shrugging shoulders, "What else was BofA going to do?" I certainly understand this way of looking at these circumstances. The problem is that it doesn’t necessarily address the questions required by the securities laws.

Judge Castel does not actually say he is inferring either an official instruction or national emergency exception to the requirements of the securities laws. But by emphasizing those aspects of the situation, he seems to be suggesting that these exceptions exist and apply.

To be sure, Judge Castel did observe that the scienter allegations regarding the nondisclosure of the federal package, which he characterized as "thin," might have been sufficient if they were accompanied by adequate allegations of motive or recklessness. It could be argued that his ruling is simply a reflection of insufficient factual pleading, which may be the case. Nevertheless, his analysis raises many questions that in my view are insufficiently examined, whether or not the scienter allegations themselves were or were not sufficient.

Given the high profile nature of this case, I suspect there will be much discussion of Judge Castle’s opinion in the weeks and months ahead. Legal proceedings arising out of these circumstances do seem to attract controversy – as, with for example, Judge Rakoff’s high profile rejection of the SEC’s settlement of its enforcement action against BofA arising from these circumstances.

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

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As reflected in their agreement filed on August 26, 2010, the parties to the New York and Delaware derivative actions involving former AIG CEO Maurice Greenberg, as well as certain other former AIG directors and officers, have agreed to settle the case for a payment to AIG by its D&O insurers of $90 million. The agreement also provides that the insurers will pay $60 million to Greenberg and Howard Smith, AIG’s former Chief Financial Officer, for their legal fees.

The settlement is subject to the approval of Delaware Chancery Court Vice Chancellor Leo Strine. Jef Feeley and Hugh Son’s August 27, 2010 Bloomberg article about the settlement can be found here.

This derivative lawsuit settlement follows AIG’s $725 settlement of a related securities class action lawsuit, and also follows the $115 million settlement in 2008 of a separate shareholders derivative lawsuit involving directors and officers of AIG.

Background

In 2004, the first of many separate shareholders derivative lawsuits (later consolidated) were filed in New York and in Delaware, against AIG as nominal defendant, and against numerous former AIG directors and officers, including Greenberg and Smith. The investors alleged that AIG insiders to misstated AIG’s financial performance in order to deceive investors about AIG’s financial condition.

The centerpiece of the lawsuit was an allegedly fraudulent $500 million reinsurance transaction in which various AIG insiders staged an elaborate artificial transaction with Gen Re Corporation. The complaint also alleged AIG insiders allegedly used secret offshore subsidiaries to mask AIG losses, misstated accounts with no basis for their adjustments, failed to correct well-documented accounting problems in an AIG subsidiary, and hid AIG’s involvement in controversial insurance policies that involved betting on when elderly people would die. The complaint also related to alleged bid-rigging allegations and alleged sale of illegal financial products.

In a lengthy February 2009 opinion, Delaware Vice Chancellor Leo Strine denied the motions to dismiss of Greenberg, Smith and certain other senior former AIG officials, although he granted the motion as to certain other individuals. Strine observed, among other things, "The Complaint fairly supports the assertion that AIG’s Inner Circle led a — and I use this term with knowledge of its strength — criminal organization. The diversity, pervasiveness, and materiality of the alleged financial wrongdoing at AIG is extraordinary."

Following further procedural wrangling and developments, the parties participated in a series of mediations involving retired Judge Layn Phillips, which resulted among other things in this settlement agreement.

The Settlement

The August 26 agreement seems to resolve all of the litigation involving all of the parties. However, the agreement is also not self-sufficient, as it is "conditioned upon execution of and compliance with a written settlement agreement under which the D&O carriers" pay the agreed upon amounts. I have not been able to obtain a copy of the separate insurance agreement and indeed the wording of the August 26 agreement suggests that at least at the time the August 26 agreement was drafted, the implied insurance agreement had not yet been drafted or fully executed.

The August 26 agreement does recite that the applicable insurance consists of AIG’s 2004-2005 D&O insurance tower, which has aggregate limits of liability of $200 million. The agreement does not identify the insurers in the tower or their respective limits of liability. The agreement also recites that the parties to the August 26 agreement have claims pending against the insurance tower in excess of its $200 million limit.

The agreement also states that the insurers "dispute that the D&O Insurance Tower is available to pay the claims made under the policies," but that the parties "desire to resolve their disputes regarding the appropriate allocation of their respective rights to the D&O Insurance Tower."

The agreement also incorporates certain understandings as the plaintiffs’ attorneys’ fees. Among other things, the agreement provides that the Delaware plaintiffs’ attorneys shall seek and the other parties shall not oppose attorneys’ fees of no more than 22.5% of the Settlement Amount (i.e. no more than $20.25 million) and no more than $1 million in expenses. The New York plaintiffs’ attorneys will seek a fee of no more than $2.5 million. If the two sets of attorneys were to realize the full amount of these fee awards and expenses, the net recovery to AIG from the settlement would be $66.25 million.

Discussion

There are a number of interesting things about this settlement. First, the cash payments specified in the agreement are to be funded exclusively with the proceeds of the D&O Insurance Tower.

Indeed, the Bloomberg article linked above quotes Greenberg’s attorney as saying that all of litigation by or on behalf of AIG again Greenberg "was settled with Mr. Greenberg paying nothing and other parties paying money to Mr. Greenberg." (This statement is probably worthy of an entire blog post some day all on its own.). Victor Li’s August 27, 2010 Am Law Litigation Daily article (here) about the settlement quotes the Delaware litigation lead plaintiffs’ attorney as saying that as a result of the settlement, $90 million is going to AIG that otherwise would have gone to Greenberg and other defendants based on a 2009 settlement between AIG, Greenberg and Smith, under which AIG agreed to reimburse up to $150 million of their legal fees.

While others can debate who gave or got what in this settlement, the bottom line is that the money for this settlement is coming entirely from insurance.

Without details about the separate insurance settlement referenced in the August 26 agreement, it is hard to know for sure, but it seems as if the $150 million of insurance funds exhausts the remaining funds under the D&O Insurance Tower, either by actual payment of loss or by compromise. (There obviously is some linkage between the $150 million total of payments in the August 26 agreement and the November 2009 agreement between AIG and Greenberg, but the precise connection isn’t apparent from the face of the documents I have seen so far.)

In addition to the fact that the August 26 agreement recites that the parties claims on the D&O Insurance Tower exceed the Tower’s $200 million aggregate limits of liability, another reason I assume that the Tower is actually or effectively exhausted is the interpleader action the primary insurer in this Tower filed against Greenberg and AIG, in order to avoid or resolve an arbitration dispute about priority rights to the proceeds of the $15 million primary policy. By interpleading the $15 million limits of liability, the primary insurer was effectively disclaiming any rights to those funds, indicating that those amounts at least consumed by claims costs. The next layers up above the primary insurance undoubtedly were also substantially eroded if not consumed by claims costs as well.

My final observation about the $90 settlement on behalf of Greenberg with AIG is that this represents yet another jumbo settlement of a shareholders’ derivative suit. There was a time when a derivative lawsuit settlement involving substantial cash payments was very unusual, but in recent years substantial payment of cash in connection with the settlement of derivative lawsuits has become increasingly common.

In addition to the $115 million settlement of the prior AIG derivative suit, other large recent derivative lawsuit settlements include the $118 million Broadcom options backdating related derivative settlement, the $122 million Oracle settlement and the $225 million Comverse Technology options backdating related derivative lawsuit settlement. It is particularly noteworthy that all of these payments are outside the insolvency context.

One consequence of this outbreak of jumbo settlements in derivative lawsuits is that the possibility that Excess Side A insurance might be called upon to pay loss – even outside of the insolvency context -- seems to be increasing. Certainly these massive settlements provide increasing evidence for the value to insureds of these kinds of insurance structures, whether or not the recent AIG settlement did or did not actually involve contributions from Excess Side A insurers. The increasing numbers of derivative settlements involving large cash payments certainly underscores that the Excess Side A insurers are exposed to potential losses -- even outside of the insolvency context -- an exposure that actually seems to be increasing over time.

Special thanks to Jef Feeley for providing a copy of the August 26 agreement.

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Most securities lawsuits settle. The common assumption is that once the cases are settled, the litigation wraps up and everybody moves on. But does the litigation have a lingering effect on the defendant company? Is there a "hidden dark side" for companies that settle securities lawsuits?

That is the question asked in a March 18, 2010 paper entitled "Lying and Getting Caught: An Empirical Study of the Effect of Securities Class Action Settlements on Targeted Firms" (here) by Cincinnati Law Professor Lynn Bai, Duke Law Professor James Cox, and Vanderbilt Law Professor Randall S. Thomas. (Hat Tip to the Class Action Countermeasures blog, which has a post about this paper here.):

Through their research, the authors sought to discover whether getting hit with a securities a lawsuit and then subsequently entering into a settlement "weakens the defendant firm so that from the point of view of well-received financial metrics the firm is permanently worse off as a consequence of the settlement."

In order to examine this question, the authors examined 480 companies that were defendants in settled post-PSLRA securities class action lawsuits. The authors then examined whether there is any change in the defendants’ financial well-being and stock performance relative to their peer group over time.

The authors compared the defendants’ performance with that of comparable companies over several time periods. "Comparable" companies consisted of those with the same SIC Code and the same asset size but that had not been involved in a securities class action lawsuit during the relevant time periods.

The authors compared the defendant companies to the comparable companies using seven performance criteria, including asset turnover; return-on-assets: the ratio of Earnings Before Income and Tax payments to total assets; the current ratio; the Altman Z-Score (a bankruptcy prediction measure); the market to book ratio; and the one-year stock price return. The authors looked at changes in defendants’ performance according to these measures over time using multivariate regressions.

The authors’ research produced a number of results which even they characterized as "puzzling." On the one hand, companies that settled securities class action lawsuits experienced no decline in sales opportunities, but did "experience a reduced level of operating efficiency while the lawsuit was pending (but not after it was settled)."

More significantly however, the authors did also observe that "defendant firms experience liquidity problems post-settlement and worsening Altman-Z scores." The authors wrestle with how to interpret these latter findings. On the one hand, the deterioration of the Altman Z-scores could suggest that "settlements drive firms toward financial distress (i..e., settlements are causally related to the worsening situation)," but on the other hand these data could suggest that "the financial deterioration observed in earlier time periods continues downward." Or perhaps it could be some combination.

The authors concede that their analysis could support alternative conclusions, but they nevertheless offer their own interpretations as well. Among other things, they note that "while uncertainty persists about the precise connection between the settlements and financial distress, there is no uncertainty that firms that are involved in securities class action litigation experience statistically greater risks of financial distress than their cohort firms."

The authors also conclude that their findings "lend strong support for the view that such suits are better directed toward the officers, advisors and other individuals who bear responsibility for the fraudulent representation(s) that spawned the suit."

Discussion

The authors’ findings about the post-litigation performance of companies settling securities class action lawsuits are interesting. With full recognition that the question of the causation for that diminished performance is uncertain, the conclusion that companies experiencing securities suits perform worse than there peers is relevant information, both from an investment and a D&O insurance underwriting standpoint.

One implication of the authors’ analysis is particularly interesting to me, because one factor implicitly contributing to the negative post-litigation performance is the financial burden the litigation and the settlement imposed on the company. This implication (if indeed my interpretation is valid) seems at odds with other recent research, particularly that of Stanford Law Professor Michael Klausner, who in a recent article published with a colleague concluded that "on the whole D&O insurance pays substantial portions of settlements in a large majority of cases, and that both corporate and individual defendants are highly protected."

There seems to be a tension in the analysis between these two academic studies, since if it is the case that D&O insurance substantially protects corporate defendants in securities class action lawsuits, why should there be lingering negative financial effects on the defendants companies?

Perhaps the answer may be that the reason for the negative performance relative to the companies’ peers post-litigation may not be financially related, but may be operationally related, and the same below standard operational performance post-litigation in some cases may be related to the factors that led to the litigation in the first place.

An alternative explanation may be that while the D&O insurance funds a "substantial portion" of settlements, that still leaves a substantial portion unfunded, and the burden on the companies to fund the difference harms them financially. The authors even note that their analysis insurance in consistent with the conclusion that insurance "provided less than full coverage of the settlement amounts and that the defendants paid the discrepancy out of their current assets. The settlement payment exacerbated liquidity constraints, making the defendants more vulnerable to liquidity crunches and prone to bankruptcy."

In other words, it may be that once the case is settled, everyone may move on to other things, but the company is left financially impaired in a way that undermines its future performance – which obviously harms the interests of the company’s shareholders. All of which does leave you wondering about the ultimate value of a process carried out in the name of shareholders but that leaves shareholders’ interests indelibly impaired. .

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In recent months, I have documented on this blog the rising tide of failed banks as well as the ensuing failed bank related litigation. An August 16, 2010 report by Paul Hinton of NERA Economic Consulting entitled "Failed Bank Litigation" (here) takes a comprehensive view of the economics and causes of recent bank failures, compares the recent bank failure wave to the S&L crisis, and analyses the implications for litigation against the directors and offices of the failed institutions. The report contains a wide variety of different kind of information that readers will find interesting and useful.

Bank Failures to Date

The report begins with an analysis of the causes of the bank failures to date. The report notes that the earliest failures in the current wave derived from "losses in residential real estate and their structured finance businesses," but more recently the bank failures have been "characterized by smaller institutions that are more specialized in financing local businesses, commercial mortgages and real-estate development."

The report specifically notes that banks that went on to fail were held worse performing loans in each loan category than banks overall. These banks were also "less well prepared to deal with expected losses," since their allowance for loan losses at the beginning of the credit crisis were "not correspondingly higher," but instead were "lower than for all other banks."

Possible Future Bank Failures

Looking ahead, though the economy has improved and banks overall are showing signs of recover, the number of problem banks continues to rise and loan performance has yet to turn around. Many community banks may be burdened as a result of their issuance of trust preferred securities, the holders of which have priority rights in the event of bank failure, which could deter prospective investors. A wider concern for community banks is "the risk posed by continuing financial distress in commercial real estate markets," an issue I explored at length in a prior report here.

The report notes that one group of banks particularly at risk are "community banks with high [construction and development, or C&D] loan concentrations and the smallest allowances for loan losses compared to their level of non-performing loans." Another high-risk group of institutions are banks that are "under-provisioned and that have relatively high levels of non-performing loans."

Comparison to the S&L Crisis

Though the number of failed banks so far in the current wave is lower than the number that failed during the S&L crisis, "the losses incurred in 2009 are larger than all but one year of losses during the S&L crisis (expressed in 2010 dollars)," because the average size of banking institutions and savings institutions has increased since the time of the S&L Crisis. The average per failed bank loss in the current crisis ($303 million) is more than three times larger in 2010 dollars than for banks in the S&L crisis and were attributable to banks that were about two and a half times as big.

The factors contributing to bank failures in the current failed bank wave appear similar to the factors the FDIC identified as having caused bank failures during the S&L crisis. That is, economic conditions were "secondary to poor management and other internal problems."

Many readers will find the reports analyses of the banking regulators’ S&L crisis-related litigation track record particularly interesting. Among other things, the report documents (in Figure 14) that the FDIC pursued D&O claims with respect to about one-quarter of failed institutions. The report also shows (in Figure 15) that the FDIC’s peak recoveries lagged peak bank failures by about three years, which may be suggestive of the likely recovery track for the current bank failures.

Of particular interest is the detail (in Figure 16) regarding the FDIC’s professional liability claims recoveries during the period 1990-1995 (when most, but not all, of the FDIC’s S&L Crisis-related recoveries took place.). The chart shows that overall, excluding recoveries related to Drexel Burnham and excluding further criminal restitutions, the FDIC recovered $3.2 billion, $1.3 billion of which was from D&O claims, $1.15 billion of which was from accounting claims, and $500 million of which was from attorney malpractice claims. Another $300 million was from fidelity bond claims.

Failed Bank Litigation

The report details the FDIC’s special litigation authority under FIREEA (about which refer here), while noting that the FDIC’s special standing may not entirely preclude the claims of private litigants. Though the FDIC has to date filed only one action against former directors and officers of failed banks, all signs are that the FDIC is readying itself to bring more claims, as the report details.

Among other things, the report notes that many of the failed and troubled banks in the current wave are publicly traded, by comparison to the S&L crisis, when almost none of the failed institutions are publicly traded. As a result, there is much more investor related litigation this time around than there was during the prior crisis.

The report notes that of the roughly 240 credit crisis-related securities class action lawsuits, there were 45 against depository institutions (after excluding auction-rate securities cases). Eleven were filed against failed banks. Of the 20 banks that failed prior to 2010 and that produced the largest losses. 13 were publicly traded, of which eight have been sued in securities class action lawsuits as of the end of 2009.

The report notes that the private litigants will compete with the FDIC for D&O insurance, and while the FDIC is generally first in line to recover assets, private litigants may be able to recover against insurance assets even when the FDIC is not (for example, where the D&O policy has a regulatory exclusion that would preclude coverage for the FDIC’s claim but not for the investors’ claims).

Though there is already extensive litigation and more seems likely to come, all claimants, including even the FDIC, will face a basic causation problem; as the report concludes, "distinguishing the effects of underwriting practices from the effects of a deteriorating economy will be one of the important elements of this litigation." These cases "will require careful case-by-case economic analysis."

Conclusion

Overall, this report is useful and informative. Readers will undoubtedly find the report’s distillation of important background information and analysis in a single source to be particularly helpful.

Many D&O insurance professionals in particular will find this report to be helpful, particularly those involved with either the placement of D&O insurance for banking institutions or those involved in claims arising under those policies. Underwriters and brokers will find the report’s analysis of the causes of bank failures and the likely causes of future failures informative. Those involved in claims and claims administration will find the aggregate date from the S&L crisis claims particularly useful.

Special thanks to the report’s author, Paul Hinton, for providing me with a copy of the report. I would also like to thank Paul for his numerous citations to this blog in his report.

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The question of insurance coverage for the attorneys’ fees of Allen Stanford and his co-defendants is at issue in a three-day bench trial before Southern District of Texas Judge Nancy Atlas that began on Tuesday, August 23, 2010 in Houston.

Stanford and several other individuals have been criminally charged with financial fraud in connection with the collapse of the Stanford Financial Group. The criminal trial is set to commence in January 2011. Stanford and several of the other individuals are also defendants in an SEC enforcement action as well as numerous other civil proceedings.

Stanford Financial had $100 million in D&O insurance. The primary policy contains a money laundering exclusion that the insurers contend precludes coverage under the policies. The money laundering exclusion specifies that it does not apply "until such time as it is determined that the alleged act or acts did in fact occur."

In a January 26, 2010 opinion, Southern District of Texas Judge David Hittner entered a preliminary injunction prohibiting the insurers from "withholding payment" of defense expenses from four individuals (including Allan Stanford), as discussed here.　

In a March 15, 2010 opinion (about which refer here), the Fifth Circuit reversed and remanded the case to the district court, concluding that the money laundering exclusion’s "in fact" wording required a judicial determination to establish whether or not the exclusion had been triggered, but also concluding that this determination can be made in a separate proceeding such as a coverage action.

Based upon the trial that began on Tuesday in Houston, the court will determine whether or not the money laundering exclusion has been triggered, and therefore whether the insurers have any obligations to pay the defendants’ attorneys fees or other amounts on the defendants’ behalf under the policies.

According to news reports, there were a number of interesting developments in the first day of trial.

First, the lawyer for Laura Pendergest-Holt, Stanford Financial’s former Chief Investment Officer, told the court that Pendergest-Holt had entered a settlement with the insurers. The details of the settlement were not disclosured.

Second, in response to a question from Judge Atlas as to where the policy’s unusual definition of "money laundering" had originated, the lawyer for the insurers told the court that the language had been in prior policies through several renewals, but the language originally "been brought to the contract negotiation …by Stanford’s insurance broker." The insurers’ lawyer said that the insurer did not plan to offer a witness on the origins of the language.

Judge Atlas commented: "All I can say, it’s turning out not to be such a bargain."

Third, the witnesses are unlikely to testify during the coverage trial, given the risks that would entail for the criminal case. Judge Atlas said she will not determine yet whether she will draw an adverse inference about the individuals’ guilt from the individuals’ decision not to testify during the coverage case.

Finally, the insurers revealed that to date the insurers had advanced over $15 million dollars to pay for attorneys’ fees on behalf of the individuals and other insured persons under the policy.

Think Your Commute is Bad?: According to an August 24, 2010 Wall Street Journal article, a 60-mile traffic jam near Beijing "could last until mid-September." Traffic has been backing up since earlier this month due to construction on the Beijing-Tibet highway. Traffic is now backed up "almost all the way to Inner Mongolia."

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In prior posts published as part of a continuing series, I have been exploring the basics of D&O insurance. In this third post in the series, I continue the discussion of the nuts and bolts of D&O insurance with a discussion of the policyholder’s policy obligations and requirements.

When most people think of insurance, they are usually thinking about the insurer’s obligation to pay claims. And rightly so, as the insurer’s claims payment obligation is the very essence of the insurance agreement. Unfortunately, from time to time the insurer does not pay claims, or does not pay them completely or in a timely fashion. On some occasions, the insurer’s failure to fulfill or complete its payment obligation is the result of good faith coverage disputes. But it also sometimes happens that the insurer’s delay or failure to pay is the result of the insurer’s contention that the policyholder has not taken or completed some action required under the policy.

The purpose of this post is to discuss the policyholder’s obligations under the D&O insurance policy. This topic is critical for many policyholders, because the insurer’s contention that the policyholders have not taken or completed required steps is at the center of many insurance disputes.

As a preliminary matter, it should be noted that not all of the policyholder’s policy obligations and requirements are claim related. First and foremost, the policyholder must pay the required policy premium. And there are also other D&O insurance policy obligations that impose requirements on the policyholder outside the claims context.

By way of illustration, the typical D&O insurance policy has "organizational change" provisions specifying how the policy will respond, for example, if the company is sold. These provisions also specify how the policy will respond if the insured company acquires another company with assets greater than a specified threshold amount. These after-acquired subsidiary provisions often require the policyholder to notify the insurer in writing of the "full particulars of the new Subsidiary," in order for the policy’s coverage to extend to the new subsidiary. Private company policies often have similar notice requirements if the company conducts a public securities offering. In both instances, the insurer may also require the payment of additional premium.

But while there are some policyholder requirements that are not claim related, many of the typical D&O policy’s other policyholder requirements are claim-related.

Notice of Claim: First, the policy requires the insured, as a condition of coverage, to provide notice of claim within a specified time or time frame (that is, either within a set number of days or "as soon as practicable"). In the absence of notice or if notice is tardy, the carrier may take the position that it is relieved of its obligation to pay – although some courts require the carrier to establish that the notice failure prejudiced the insurer’s rights in order to disclaim coverage.

Consent to Counsel: Second, most D&O policies require the policyholder to get the carrier’s consent for the lawyers that will be defending the claim. Some policies to have so-called "panel counsel," which is a list of authorized law firms, but most other policies allow the insured to select the lawyers, subject only to the carrier’s consent.

Though the carrier’s consent should be (and often is) a very straightforward matter, issues can and often do arise. The typical carrier objections are to the selected lawyer’s or selected law firms hourly rates. The carrier sometimes objects to the number of lawyers involved. Less frequently, the carrier raises concerns about the lawyer’s qualifications to handle the claim.

It may be impossible to completely eliminate these kinds of disputes, but there are certain steps policyholders can take to reduce the likelihood of disputes. The most important step is to notify the carrier as soon as practical of the names and hourly rates of the attorneys involved. (Often this can even be addressed before any claims have arise, which is a good practice that can avoid problems if claims do later arise.) It should be kept in mind that because defense expenses erode the policy limits, both the carrier and the policyholder have an interest in ensuring that the defense goes forward in the most cost effective way possible, in order to preserve limits for the payment of settlements and judgments.

Cooperation: Third, once the claim is underway, policyholders have another obligation, and that is the requirement to cooperate. The specifics of this cooperation duty usually are not provided, but it basically refers to the insured’s obligation to take steps to support, and to refrain from taking steps that interfere with, the defense of the claim.

Though the policy does not specify, many carriers will also contend that the cooperation clause requires the policyholder to keep the carrier informed about the claim, to provide copies of pleadings and other key documents, and to provide the carrier with information related to the defense (in particular, with defense expense information and fee statements).

Whether or not these kinds of steps truly are required by the cooperation clause, taking these steps is simply good practice and is more likely to result in smoother claim resolution. By the same token, failure to take these steps is the often the source of claims handling frictions and frequently contribute to issues with the carrier’s fulfillment of its payment obligations.

Consent to Settlement: Fourth, the typical D&O insurance policy requires the insurers consent to settlement. The failure to keep the insurer informed about settlement discussion is a frequent source of tension. The important thing for the policyholder to remember is that the insurer’s consent really is required. Where problems sometimes arise is in connection with excess insurers, when settlement amounts unexpectedly pierce upper layers of insurance. These kinds of recurring disputes underscore the fact that the consent of all of the affected insurers is required, and that keeping the insurer informed about the claim really means keeping all of the carriers involved and potentially involved informed about the claim.

I know many readers will be surprised that I have chosen to write about policyholders’ policy obligations, as it is the carrier’s claims payment obligation that is the heart of the insurance contract. Some readers may also be bothered by the fact that the insurance policy has so many policyholder requirements. But whether or not as a philosophical matter it is or is not appropriate for the insurance policy to incorporate so many policyholder requirements, the fact is that these requirements are found in most D&O policies, and so the best approach is to recognize and address these requirements.

Far too many claim disputes arise when carriers take the position that policyholders have failed to fulfill one or more of these requirements. My hope is that by highlighting these requirements, more of these process related disputes might be avoided.

Readers who would like to read the prior posts in this series about the nuts and bolts of D&O insurance should refer here:

Executive Protection: Indemnification and D&O Insurance – The Basics

Executive Protection: D&O Insurance – The Insuring Agreement

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In an August 19, 2010 order (here), Northern District of Georgia Judge Thomas Thrash granted the defendants’ motion to dismiss the subprime-related securities class action lawsuit that had been filed against SunTrust Inc and certain of its directors and officers. The opinion is noteworthy for the harshness of its tone, the comprehensiveness of the dismissal, and for the court’s willingness to consider the larger context of the overall global financial crisis.

As reflected in greater detail here, the plaintiffs first filed their action against SunTrust in March 2009. SunTrust is the parent holding company of it wholly-owned banking subsidiary, SunTrust Bank. As reflected in the lead plaintiffs’ amended complaint, the plaintiff alleges that in the second and third quarter of 2008, SunTrust tried to hide the extent of its increase in nonperforming loans by classifying some of these loans as "in-process" loans, which permitted the company to report better financial results.

These loans were later reclassified in the fourth quarter of 2008, which cause the company’s nonperforming loans to increase, which in turn, the plaintiff asserts, caused the company’s share price to drop eleven percent in a single day.

In reviewing plaintiff’s allegations in his August 19 opinion, Judge Thrash noted that plaintiff "never explicitly alleges facts" that would support its claim of a half billion dollars of misclassified loans, a "figure," Judge Thrash notes, that "seems to be plucked out of thin air."

Judge Thrash said that the plaintiff’s "theory" about the misclassification "collapses" in the face of the defendants’ showing that the average daily nonperforming loan balance was greater at the end of each quarter during this period than at the beginning, which, Judge Thrash said, is "entirely consistent with the continuing deterioration of SunTrusts’s loan portfolio over the course of the financial crisis" and is "entirely inconsistent with the Plaintiffs’ theory of large scale misclassification of nonperforming loans at the end of each quarter."

Judge Thrash notes that in its opposition to the motions to dismiss, the plaintiff shifted its liability theory from the misclassification allegation to alleged understatement of reserved for nonperforming loans. Judge Thrash found plaintiff’s inadequate loan loss reserve allegations insufficient, noting that "the fact that SunTrust substantially increased its reserves for nonperforming loans in the fourth quarter of 2008 is not evidence of fraudulent accounting practices in earlier periods."

"Life," Judge Thrash noted, "is too short to say more about this."

Judge Thrash also found that the plaintiff’s scienter allegations were also insufficient. Specifically, Judge Thrash found that the plaintiff’s allegations of intentional wrongdoing, access to information, motive were insufficient to support an inference of scienter. He also found that "competing inferences totally overwhelm any inference of scienter." especially in light of the fact that there were no suspicious stock sales and the totally speculative nature of the supposed benefit the defendants theoretically might have gained from a putative merger.

Finally Judge Thrash concluded that the plaintiff had not established loss causation, noting among things that the eleven percent stock price drop on which the plaintiff sought to rely to plead loss causation "occurred during a financial crisis that hit the financial services industry hard." The company’s share prices had already lost two-thirds of its value prior to the supposedly corrective disclosure, and though it fell an additional 11% on the disclosure date, other banks also had significant share price declines that day, some of which were even greater as a matter of percentage than SunTrust’s.

Judge Thrash concluded that the complaint’s allegations "cannot support an inference that SunTrust’s misstatements – rather than general market conditions – proximately caused the Plaintiffs’ loss."

Although the Opinion does not explicitly state whether or not it is with prejudice, Judge Thrash did not expressly grant plaintiffs leave to amend and in fact entered judgment for the defendants.

Special thanks to a loyal reader for providing me with a copy of Judge Thrash’s opinion.

I have in any event added the SunTrust decision to my running tally of subprime and credit crisis-related dismissal motion rulings, which can be accessed here.

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The FDIC closed took control of eight more banks this past Friday night, bringing the 2010 total of failed banks to 118. The eight closures is the largest single day total since April 16, 2010. The pace of closures remains well ahead of last year’s closure rate – the FDIC did not reach its 118^th closure in 2009 until November. The FDIC is on pace for 180 bank closures this year, compared to 140 in 2009.

There have now been 283 bank failures since January 1, 2008. The state with the largest number of closures during that period is Georgia, with 41. However, during 2010, the state with the highest number of bank closures is Florida, with 22 bank failures this year and 38 since January 2008 (which ranks second overall). Two of the banks that closed this past Friday night were based in Florida.

One of the banks closed on Friday was in Illinois, which has the second highest number of bank closures in 2010 (15), and is the third highest since 2008 with 37. Four of the banks that closed this past Friday were based in California, which now has 10 bank closures in 2010, and 32 overall.

Those four states – Georgia, Florida, Illinois and California – account for 148 (52%) of the banks that have closed since January 1, 2008, and 58 (49%) of the 2010 bank closures.

Of the 118 bank closures in 2010, 97 (82%) had assets of less than $1 billion. 27 (23%) had assets under $100 million. Overall, since January 1, 2008, 225 (79.5%) of the failed banks have had assets under $1billion, with 56 (19.7%) under $100 million. There have already been more closures of banks with assets of under $100 million in 2010 (27) than in all of 2009 (24).

39 States and Puerto Rico have all had at least one bank closed in since January 1, 2008. The states that have not had any banks closed during that period are: Alaska, Delaware, Connecticut, Hawaii, Maine, Montana, New Hampshire, North Dakota, Rhode Island, Tennessee, and Vermont. So – small states, new states, northeastern and upper plains states, and, inexplicably, Tennessee.

Morgan Stanley Subprime Mortgage-Related Lawsuit Dismissed: On August 17, 2010, Southern District of New York Judge Laura Taylor Swain granted the defendants’ motion to dismiss a securities class action lawsuit filed on behalf of purchasers of mortgage pass-through certificates sold by 31 Morgan Stanley trusts. In her opinion, Judge Swain held that lead plaintiff, which had bought shares in only one of the trusts, lacked standing to assert claims in connection with the other thirty, and that the claims in connection with the trust certificates it had purchased were time barred.

Judge Swain’s dismissal as the 30 trusts in which the lead plaintiff had not bought shares was with prejudice; however, the dismissal as to the trust in which the plaintiff had purchased shares was without prejudice, as plaintiffs were given leave to replead as to those allegations.

Andrew Longstreth’s August 20, 2010 Am Law Litigation Daily article about the decision can be found here. I have added the ruling to my running tally of subprime and credit crisis-related lawsuit dismissal motion rulings, which can be found here.

All the World’s a Stage: Michael Maslanka, a Dallas-based labor lawyer wrote an interesting August 20, 2010 Texas Lawyer column entitled "What Can Lawyers Learn From ‘Othello’" (here), in which he examines the lessons for lawyers exemplified in the play’s two lead male characters, Othello and Iago.

For those readers unfamiliar with the play, Iago manipulates Othello into believing that his wife, Desdemona, has been false with him by having an affair with Cassio. In a jealous rage, Othello kills Desdemona, though it is a heart-breaking scene for the audience, not only because Desdemona has been falsely accused, but also because Othello clearly still loves her.

Maslanka’s analysis extracts some important lessons from the play. From Iago’s character, Maslanka draws lessons about the pitfalls of manipulation, and from Othello, he draws lessons about rationalization.

Though Maslanka’s analysis is perceptive, there is another character in the play whose role may have yet another and perhaps more important lesson. The character is Iago’s wife, Emilia, who is Desdemona’s attendant and friend. In a peculiarly modern twist, Amelia plays the role of whistleblower, by revealing – at hazard to her own life -- Iago’s falsity and proving Desdemona’s innocence.

Emilia’s role, though relatively small, is crucial, for without her brave willingness to protect Desdemona’s innocence and reveal Iago’s perfidy, Iago’s nefarious scheme might have gone undetected.

Emilia has a special role in Shakespearean literature for the speech she delivers at the end of Act IV, Scene iii, in which she recognizes the centrality of the struggle between men and women, a struggle for which she places the responsibility squarely on the men – "I do think it is their husbands’ fault." Her observations seem particularly apt in a play where both male leads murder their wives, both of whom are innocent, in the play’s final act.

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The subprime-related securities lawsuit pending against BankAtlantic Bancorp and certain of its directors and officers is headed to trial on October 6, 2010 in Miami, following the recent summary judgment rulings in the case. Southern District of Florida Judge Ursula Ungaro’s 62-page ruling, issued August 18, 2010, which granted in part and denied in part the parties’ cross-motions for summary judgment, contains a number of interesting features, discussed below.

BankAtlantic Bancorp is the publicly traded parent company of Bank Atlantic, a federally chartered bank. As reflected in greater detail here, plaintiffs first filed their securities class action lawsuit in October 2007. Judge Ungaro granted the defendants’ initial motion to dismiss the plaintiffs complaint, but allowed the plaintiffs leave to amend. However, in May 2009, Judge Ungaro denied the defendants’ renewed motions to dismiss after plaintiffs’ their amended complaint.

The plaintiffs’ amended complaint basically alleges that the defendants made misleading statements about the credit quality of certain land loans in the bank’s commercial real estate portfolio; failed to follow conservative lending practices as described in its underwriting policies, and therefore its loan portfolio was exposed to a higher level of risk than represented to investors, and misrepresented that BankAtlantic’s loan loss reserves were adequate.

Plaintiffs contend that when the truth about the banks loan portfolio was revealed between April and October 2007, the company’s stock price fell and investors were harmed.

In her August 18 order, Judge Ungaro addressed the plaintiffs’ motion for partial summary judgment with respect to the falsity of certain July 2007 statements by the company’s former Chairman and CEO, as well as the defendants’ motions for summary judgment as to all of plaintiffs’ claims.

Plaintiffs’ conceded that the defendants were entitled to summary judgment as to all claims for the period prior to October 18, 2006 and as to all claims arising from alleged misstatements about loan loss reserves, and accordingly Judge Ungaro granted defendants summary judgment as to those issues.

A significant portion of Judge Ungaro’s opinion is focused on defendants’ motion to exclude the testimony of the plaintiffs’ expert on the issues of market efficiency, materiality, loss causation and damages, which Judge Ungaro addressed because she considered the motion relevant to the summary judgment motion.

Judge Ungaro largely granted the defendants’motion to exclude the expert’s testimony on the issue of loss causation and materiality, ruling that the expert may testify on only narrow parts of these issues, although she ruled that the expert may testify as to the cause of certain specific aspects of the decline in the company’s share price. Judge Ungaro also excluded certain aspects of the expert’s testimony on damages, but ruled that the testimony will be permitted on other damages issues.

With respect to the defendants’ motions for summary judgment on the plaintiffs’ claims, Judge Ungaro held that the "the evidence raises genuine issues of material fact as to whether Defendants’ statements beginning in April of 2007, focusing solely on the credit and repayment problems with [builder land bank, or BLB] loans and omitting mention of the problems the non-BLB land loans were contemporaneously experiencing were misleading."

Judge Ungaro also concluded that the defendants were not entitled to summary judgment on the issue of scienter, concluding that the evidence raised genuine issues of fact as to whether the defendants knew their class period statements creased a "an obvious danger of misleading investors" as to "the true credit quality of the land loan portfolio"; as to "the accelerating deterioration of credit quality throughout the land loan portfolio"; and as to the "worsening credit and repayment problems with the BLB loans."

Finally, on the issue of loss causation, Judge Ungaro concluded that there were genuine issues of material fact regarding the April 26, 2007 and October 26, 2007 price declines, but not as to the October 29, 2007 price declines.

Judge Ungaro then turned to the plaintiffs’ motion for partial summary judgment on to certain statements by the company’s former Chairman and CEO in a July 25, 2007 analyst conference call. In response to a specific question in the call about the Bank’ BLB loans, the Chairman made a number of reassuring statements, including the statement that "the portfolio has always performed extremely well, continues to perform extremely well."

In reliance on prior email exchanges in which the Chairman and CEO participated, as well as the testimony of other bank officials, Judge Ungaro concluded that there were not genuine issues of material fact that the July 25, 2007 statements were false when made, and accordingly ruled that the plaintiffs are entitled to summary judgment on this issue.

Discussion

This decision is noteworthy if for no other reason it means that (absent intervening events) a trial in this case will commence in just a few short weeks. As most readers of this blog know, trials in securities class action cases are quite rare, and it would be a significant and noteworthy event if this case were to go to trial beginning on or about October 6.

The decision is also noteworthy for Judge Ungaro’s detailed explication of the issues on which the plaintiffs’ expert will be permitted to testify. Again, because so few of these cases actually go to trial, there is relatively little judicial authority on questions concerning the issues on which expert testimony will be admitted. The absence of this authority can present a challenge when parties attempt to rely in expert testimony, for example, in connection with settlement negotiations, which can be vexing without knowing whether the expert’s views are relevant in any way. However, because Judge Ungaro’s analysis of these issues is very case and fact specific, her analysis of the expert testimony questions, though interesting, may be of limited value in other cases.

But perhaps the most interesting thing about this ruling is Judge Ungaro’s grant of partial summary judgment for the plaintiffs on the issue of falsity. It is relatively rare for any case to get to the point where a decision on this kind of issue is even ripe, and in most cases courts are inclined to leave these kinds of issues to the jury. I actually can’t recall ever having seen a court granting summary judgment in the claimants’ favor on the issue of falsity.

The plaintiffs will still have to prove that these false statements were materially misleading, were made with scienter, and cause damages. However, it will be a singular development when the court instructs the jury that the court has already concluded that the statements are false.

And so, if this case does go to trial on October 6, it will be interesting to watch, for a number of reasons.

I have in any event noted Judge Ungaro’s August 18 order in my running tally of rulings in subprime and credit-crisis related cases, which can be found here.

Special thanks to a loyal reader for sending me a copy of Judge Ungaro’s ruling.

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Bankruptcy filings overall rose by 20 percent in the twelve-month period ending on June 30, 2010, according to information released on August 17, 2010 by the Administrative Office of the U.S. Courts. Though this filing surge was largely driven by non-business filings, business related filings also remained at elevated levels during the 12 months ended June 30.

According to the Administrative Office’s data, there were 59,608 business related bankruptcy filing in the 12 months ending on June 30 this year, compared to 55,021 in the 12 months ending on June 30, 2008, which represents an increase of 8.34%. The 59,608 for the twelve months ending on June 30, 2010 is the highest number of business-related filings for that 12 month period since the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 took effect.

The number of business filings for the 12 months ended June 30, 2010, though only slightly greater than the comparable period in 2009, is also over 76% greater than the number during the comparable period in 2008, and almost 150% greater than during the comparable period in 2007.

Though the number of business-related filings remained at elevated levels during the 12 month period ended June 30, the number of business-related filings declined during each of the three month periods within that 12 month period. Thus, during the first three months of the 12-month period, there were 15,303 business related filings; in the second three months, there were 15,156 business-related filings; in the third three month period, there were 14,697; and in the final three months, there were 14,452.

As reflected in an August 17, 2010 analysis of the bankruptcy filing data by the American Bankruptcy Institute, business filings decreased 4 percent for the six-month period ending June 30, 2010, to 29,059 from the first-half 2009 total of 30,333.

Despite this quarter by quarter decrease in business-related bankruptcy filings, the overall number of filings (including non-business related filings) actually increased during the three months ending June 30, 2010, to 422,061, which is the highest for any quarter during fiscal 2010 (which runs October 1, 2009 to September 30, 2010), and the highest for any April-June quarter since the 2005 third quarter filings.

Though the news about bankruptcy filings overall is discouraging, the news related to business related bankruptcy filings may be slightly encouraging as there appears to be some suggestion that the worst may be past. However, that positive note should not obscure the fact that, even if the number of filings may be declining on a quarter to quarter basis, the number of business filings still remain at elevated levels compared to periods preceding the current economic crisis.

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In a recent post, I discussed several recent decisions in which securities cases involving failed or troubled banking institutions survived dismissal motions. By contrast, however, in an August 16, 2010 ruling (here), Southern District of New York Judge Robert Patterson, Jr. granted the defendants’ motion to dismiss without prejudice in the securities class action lawsuit filed against Raymond James Financial and certain of its directors and officers alleging inadequate disclosures regarding the company’s banking subsidiary’s loan loss reserves.

As discussed in greater detail here, plaintiffs first filed their action against Raymond James Financial in June 2009. The plaintiffs’ allegations center on the loan portfolio and loan loss reserves at the company’s banking subsidiary, Raymond James Bank. Judge Patterson stated in his August 16 opinion that, despite the length of the complaint (which "extreme length," Judge Patterson noted, provides "an independent ground for dismissal"), the plaintiff’s allegations "boil down to one proposition: that the Defendants purposefully underfunded their loan loss reserves and then made material misrepresentations about het adequacy of those loan loss reserves during the class period."

With one small exception, Judge Patterson concluded that the misrepresentations and omissions on which plaintiff seeks to rely are not actionable. For example, he concluded that the alleged misrepresentations about the bank’s loan loss reserves "are, without exception, general statements of optimism" which "in and of itself renders these statements inactionable."

Similarly, Judge Patterson concluded that the statements about the quality of the bank’s loan portfolio "were, similarly, very general and not sufficiently detailed to have misled investors" and "for the most part" represent "classic puffery."

The one exception to his conclusion that the statements on which the plaintiff sought to rely are not actionable were two paragraphs in the Amended Complaint relating to the quality of the loan portfolio. These statements included representations that the bank "independently underwrote" all loans, including loans "sourced from agent or syndicate banks." The Amended Complaint reference the testimony of a confidential witness who avers that many loans that were later charged off were not independently underwritten.

However, Judge Patterson also concluded that the plaintiff had not sufficiently alleged scienter. He concluded with respect to the plaintiffs’ scienter allegations that:

None of the allegations of scienter are sufficiently specific that they allow the Court to determine whether the Defendants knew (or even likely knew) that their statements were false when made. For the most part, the scienter allegations are of the sort that could be made about nearly any company operating in the United States, namely that the executives were motivated to create profit, that the executives received a near-constant stream of information about economic trends, and that the executives made mistakes in some of their forward-looking projections.

These allegations, Judge Patterson concluded, were insufficient to give rise to a strong inference that the defendants acted with the requisite state of mind.

Accordingly, Judge Patterson granted the defendants’ motions to dismiss, but he did so without prejudice.

I have added Judge Patterson’s opinion to my running tally of subprime and credit crisis-related dismissal motion rulings, which can be accessed here.

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Among the very, very latest trends in securities class action lawsuit filings are suits against for-profit educational companies. Just since the middle of last week, at least five companies in this sector have been tagged with new lawsuits, four of which were securities class actions.

These lawsuits have been accumulating in the wake of an August 3, 2010 Government Accountability Office report (here) which alleged that several companies in the for-profit education industry encouraged fraud and engaged in deceptive advertising. The report was prepared in connection with the August 4, 2010 hearing before the Senate Committee on Health, Education, Labor and Pensions.

The GAO report said that undercover tests revealed that at least four schools encouraged fraudulent practices and all 15 tested made deceptive or questionable statements to the GAO’s undercover applicants. The fraud involved encouraging falsified financial aid applications. A summary of the report can be found here. A statement of the report’s highlights can be found here.

Though no specific companies are named in the report (or perhaps because no specific companies are named in the report), the share prices of many of the publicly traded for-profit education companies fell after the news about the GAO report circulated. And, perhaps inevitably, the lawsuits started coming in.

As far as I am aware, at least four for-profit education companies have been named in securities class action lawsuits just since the end of last week. These companies include the following:

Education Management Corp., against which the first suit was filed on August 11, 2010. A copy of the complaint filed in the Western District of Pennsylvania can be found here.

American Public Education, against which the first suit was filed on August 12, 2010. A copy of the complaint filed in the Northern District of West Virginia can be found here.

Lincoln Educational Services, against which the first suit apparently was filed on August 13, 2010. A copy of the complaint can be found here.

Apollo Group, Inc., against which the first suit apparently was filed on or about August 16, 2010. A copy of complaint can be found here.

In addition to these securities class action lawsuits, a separate class action lawsuit against Alta Colleges, Inc. (parent of Westwood College) and related entities and persons was filed on August 11, 2010 in the District of Colorado alleging violations of the Colorado Consumer Protection Act. A copy of the Alta/Westwood complaint can be found here.

With five suits in already, it seems safe to predict that other publicly-traded for-profit education companies could also get hit with one of these suits. This seems to be one of those classic contagion events that produces an epidemic of similar lawsuits that comes up every now and then. Last year it was ETFs (refer here); this year it seems to be for-profit educational companies.

The name Apollo Group may be familiar to many readers, as the company was the target of a prior securities class action lawsuit that has achieved a certain amount of notoriety because it is one of the few securities cases that has actually gone to trial. The trial resulted in a plaintiffs’ verdict, although the presiding judge later set the verdict aside in a response to a post-trial motion. More recently, the Ninth Circuit reversed the trial court’s ruling and remanded the case to the district court for further proceedings, a development that has sparked significant interest and discussion.

Unfortunately for Apollo Group, all of the long-running drama in the prior case was no shield against another case being filed.

It remains to be seen how these cases will fare. But this industry-specific litigation outbreak is a reminder of the many odd and circumstance-specific events that can drive securities class action lawsuit filings. Many things determine filing levels, many of which cannot be captured or predicted in historical filing data. As a result, it can be misleading to try to generalize from short term trends about future filing levels. Simply put, the numbers vary over time, because, for example, contagion events and industry epidemics happen.

New Securities Suit Based on FCPA-Related Allegations: Regular readers know that I have frequently commented that one result of increased Foreign Corrupt Practices Act enforcement has been the growth in the number of follow-on private civil lawsuits based on the underlying corruption allegations.

The latest example of this phenomenon is the lawsuit filed against SciClone Pharmaceuticals and certain of its directors and officers. According to the plaintiffs’ lawyers’ August 16, 2010 press release (here), the complaint they filed in the Northern District of California alleges that:

defendants were engaged in illegal and improper sales and marketing activities in China and abroad regarding its products. This ultimately caused the Company to become the focus of a joint investigation by the Securities and Exchange Commission ("SEC") and the Department of Justice ("DOJ") for possible violations of the Foreign Corrupt Practices Act ("FCPA"). It was only at the end of the Class Period, however, that investors ultimately learned the truth about the Company's operations after it was reported that the SEC and DOJ were investigating the Company for violations of the FCPA. At that time, shares of the Company declined almost 40% in the single trading day.

This case presents further support for the proposition that increased anticorruption enforcement activity represents a growing area of liability exposure for company executives.

Thought for the Day: "Time flies like an arrow. Fruit flies like a banana." (Often attributed to Groucho Marx, but although it seems as if he would have said it, he apparently did not.)

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Though we are in the midst of the dog days of summer (at least in the northern hemisphere), the federal courts, at least, have been busy. In the last several days alone, several courts have issued dismissal motion rulings in lawsuits arising out of the subprime meltdown and the credit crisis.

As noted below, several of these decisions involve failed or troubled banks, and therefore may be of particular interest in relation to the many banks have failed in recent months or that are continuing to struggle now. Though investor plaintiffs in other cases involving failed or troubled banks have sometimes struggled to survive the initial pleading stages, in the cases discussed below, the plaintiffs managed to survive the dismissal motions, at least in part.

PFF Bancorp: In an August 9, 2010 opinion (here), Central District of California Judge Andrew Guilford denied the defendants’ motions to dismiss in the securities class action lawsuit against two former directors and officers of PFF Bancorp, the corporate parent for PFF Bank & Trust, which failed on November 21, 2008.

As reflected here, in January 2009, shareholders of the holding company filed a securities lawsuit alleging that the company’s President and CEO and its CFO contending that they concealed the Bank’s unsafe lending practices and made misleading statements about the bank’s loan loss reserves and capital levels.

In his August 9 order, Judge Guilford found that while the plaintiffs’ allegations that defendants made misleading statements about the banks’ "cautious" and "conservative" lending practices were insufficient to state a claim, the plaintiffs’ allegations that defendants had falsely characterized the bank’s loan loss reserves as "adequate" were sufficient to state a claim.

Judge Guilford also found that plaintiffs had adequately alleged scienter, finding that plaintiffs’ allegations "permit the inference that Defendants knew PFF’s loan practices were risky and that PFF had inadequate loan loss reserves, yet told investors that the loan loss reserves were adequate."

Interestingly, Judge Guilford found plaintiffs’ scienter allegations to be adequate despite the defendants’ contention that they had actually purchased PFF shares at the supposedly inflated prices. Judge Guilford declined, at the motion to dismiss state, to take judicial notice of the SEC forms on which defendants sought to rely in order to establish their share purchases.

Popular, Inc. (Securities Claim): In an August 2, 2010 order (here), District of Puerto Rico Judge Gustavo Gelpí granted in part and denied in part the defendants motion to dismiss the securities class action lawsuit that had been filed against Popular, Inc., certain of its directors and officers, its auditor and its offering underwriters.

The plaintiffs’ complaint focused on the company’s accounting for a deferred tax asset. In the three years preceding the beginning of the class period (which went from January 24, 2009 to February 2009), the company had recorded tax loss carry forwards that totaled over $1 billion, largely as a result of the company’s U.S. subprime and other lending operations. The benefit of these deferred tax assets could only be realized if the company experienced sufficient U.S.-based gains within 20 years.

To offset the possibility the company might not fully realize the value of the deferred tax assets, accounting rules required reporting companies to take a valuation allowance, but the company recorded no material valuation allowance of this asset until late 2008. The company ultimately recorded an allowance for the full value of the asset. Following the announcement of this action, the company’s share price fell substantially.

The plaintiffs allege that the increasing, multiyear U.S.-based operating losses prevented it from anticipating sufficient taxable income to realize the full value of the deferred tax asset prior to the expiration of the 20-year period, yet failed to take a valuation reserve because doing so would have lowered the bank’s risk-based capital ratio below regulatory requirements. The financial picture the company’s treatment of the asset portrayed allowed the company to raise over $300 million in a May 2008 offering.

The Court found that the plaintiffs allegations adequately alleged material misrepresentations, given that "Popular’s three-year cumulative loss position, combined with the Company’s significant downsizing of its U.S. mainland operations and the worsening market conditions, constituted strong evidence that at the beginning of the class period it was more likely than not that the Company would not be able to realize the benefit of its [deferred tax asset] in full."

The Court also concluded that the complaint adequately alleged scienter, concluding that the defendants’ decision "not to take an earlier valuation allowance was ‘highly unreasonable’ and an ‘extreme departure from the standards of ordinary care’ to the extend that the danger was either know to the defendants or so obvious that they must have been aware of it."

The Court also concluded that the ’33 Act allegations against the officer defendants were also sufficient. However, because the Court found that the amended complaint in which the plaintiffs added as defendants the outside directors, the company’s auditor and its offering underwriters had been filed more than a year after there were sufficient "storm warnings" to put the plaintiffs on inquiry notice, the ’33 Act claims against those defendants were untimely and were therefore dismissed.

Popular, Inc. (Derivative Suit): In an August 11, 2010 opinion (here), applying Puerto Rico law, in the shareholders’ derivative lawsuit filed against Popular, Inc, as nominal defendant, certain of its directors and officers, and its outside auditor, Judge Jay Garcia-Gregory denied in part and granted in part the defendants’ motions to dismiss. The allegations in the derivative suit largely mirror those alleged in the securities class action lawsuit.

The officer and director defendants had moved to dismiss on the ground that the plaintiff had not presented a demand to the company’s board to pursue the lawsuit. The plaintiff argued that demand was futile, and the Court agreed. The Court found that the plaintiffs’ allegations and of the requirements of SFAS 109 "provide ‘reason to doubt’ the legality of declining to record a valuation allowance until 2009" and therefore "demand is excused" because the presumption that the board took a valid business judgment had been rebutted by the alleged lack of "legal fidelity."

The Court did, however, dismiss the plaintiff’s gross mismanagement claim as duplicative of the breach of fiduciary duty claim. The Court also found that the plaintiff had not adequately alleged corporate waste. Finally, the Court found that the plaintiff’s claim against the company’s auditor should also be dismissed, on the grounds that the plaintiff had not made a demand on the company’s board to pursue the claim and had not established demand futility.

Discussion

Plaintiffs have had some difficult surviving initial dismissal motions in many of the securities class action lawsuits that have been filed against the directors and officers of banks that have failed during the current failed bank wave. For example, the securities class action lawsuit arising out the failure of Downey Financial Corp. (whose operating bank failed the same day as PFF Bank & Trust) was dismissed with prejudice.

Similarly, the motion to dismiss in the Fremont General case was also ultimately dismissed with prejudice. Similarly, the motion to dismiss was granted in the BankUnited securities case, albeit without prejudice.

More recently, however, the motion to dismiss was denied in the securities class action lawsuit arising out of the failure of Corus Bankshares. With the above decisions, it seems as if the plaintiffs in these cases have managed to overcome the initial pleading hurdle at least in several cases now.

To be sure, the reasoning the Popular case is based on circumstances that may be unique to that case. The allegations in the PFF Bancorp case, however, arguably are more typical. But while the PFF Bancorp case survived the dismissal motions, it remains to be seen whether the case will survive additional proceedings in the case, if defendants are able to establish that the purchased company shares at the allegedly inflated prices.

Ultimately, the fundamental question about the failed banks is whether the FDIC will lower the litigation boom on directors and officers of the failed banks. So far, the FDIC’s litigation activity has been limited to a single lawsuit it filed against officers of a subsidiary of IndyMac (about which refer here). Whether and to what extent the FDIC will pursue other claims will be revealed in the weeks and months ahead.

In any event, I have added these decisions to my running tally of subprime and credit crisis-related dismissal motion rulings, which can be accessed here.

Very special thanks to the loyal readers who provided me with copies of these decisions.

Another Banking Institution Dismissal Motion Ruling: Though the financial institution involved has neither failed nor is seriously troubled, it should be noted here at least briefly that in an August 10, 2010 order (here), Southern District of Ohio Judge Sandra Beckwith denied in part and granted in part the defendants’ motion to dismiss in the securities class action lawsuit that had been filed against Fifth Third Bancorp and certain of its directors by former shareholders of First Charter, which Fifth Third acquired in a deal announced in August 2007.

As discussed here, the former First Charter shareholders alleged that in connection with the merger, Fifth Third and certain of its directors and officers had materially misrepresented Fifth Third’s exposure to poorly performing residential real estate markets, and had not fully represented how seriously its mortgage portfolio was deteriorating.

Judge Beckwith’s detailed and painstaking August 10 opinion denied the motion to dismiss as to the claims of certain classes of First Charter shareholders, but granted the motion to dismiss as to all other claims and claimants.

Another Credit-Crisis Related Securities Suit Dismissal Motion Ruling: In an August 13, 2010 order (here), District of Maryland Judge Catherine Blake denied in part and granted in part defendants’ motions to dismiss the securities class action lawsuit that had been filed against Constellation Energy.

As discussed here, Constellation Energy was one of the many nonfinancial companies that suffered credit crisis related financial reverses in late 2008 and early 2009 and attracted securities litigation arising out the companies’ financial woes.

In September 2008, Constellation shareholders and subordinated debenture holders filed a securities class action lawsuit against the company, certain of its directors and officers and offering underwriters. Their complaint asserts claims under Section 11, 12(a)(2) and 15 of the ’33 Act and under Section 10(b) of the ’34 Act.

Essentially, the plaintiffs alleged that the defendants had misrepresented the additional collateral the company would have to post in connection with its merchant energy business in the event of a company credit downgrade. (As the company itself later disclosed, the collateral requirements for a one-notch credit downgrade were less than had been disclosed; the collateral requirements for a two or three notch downgrade were significantly greater than disclosed.)

The plaintiffs also alleged that the defendants had not sufficiently disclosed the company’s exposure to Lehman Brothers. The plaintiffs also alleged that the defendants’ misrepresented the company’s future earnings, business outlook, risk management and internal controls.

In fall 2008, after the company suffered a several notch ratings downgrade and after Lehman collapsed, the company’s share price fell and investors’ sued. The company ultimately sold a substantial portion of its assets.

In her August 13 order, Judge Blake found that the plaintiffs’ ’33 Act allegations regarding the company’s downgrade collateral obligations were sufficient to state a claim. Interestingly, Judge Blake reached her conclusion even though the company’s debenture prices dropped only slightly immediately after the disclosure of the company’s revised collateral obligation and in fact rose thereafter for several weeks. These facts "ultimately may counsel against materiality" but are "not dispositive at this stage of the litigation.

Judge Blake found that the plaintiffs’ remaining ’33 Act allegations were insufficient to state a claim.

As for plaintiffs ’34 Act allegations, Judge Blake found that the plaintiffs had not adequately alleged scienter in connection with the downgrade collateral obligations. She noted that "without additional factual allegations that the defendants were somehow aware that the downgrade collateral requirements were miscalculated …neither Constellation nor its officers can be presumed to have known of a faulty computer calculation."

Judge Blake also found that the plaintiffs’ remaining ’34 Act allegations were inadequate.

I have also added the Fifth Third and Constellation Energy rulings to my running tally of credit crisis lawsuit dismissal motion rulings, which again can be accessed here.

Special thanks to a loyal reader for providing a copy of the Constellation Energy decision.

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The September 2008 collapse of Lehman Brothers resulted in the largest bankruptcy filing in U.S. history, as well as an explosion of litigation and regulatory actions and investigations. In the pending bankruptcy proceedings a recent motion by the debtor’s counsel details the massive legal costs accumulating in the various legal proceedings and also raises some interesting D&O insurance implications.

Special thanks to Wayne State University Law Professor Peter Henning, who provided me with copies of the bankruptcy-related documents and who previously these issues on the Dealbook blog, here.

On July 27, 2010, counsel for the debtor filed a motion in the Lehman Brothers bankruptcy proceeding under Bankruptcy Code Section 362 for relief from the automatic stay in order to allow certain of Lehman’s excess D&O insurers to advance defense expenses.

According to the motion papers, for the policy period May 16, 2007 to May 16, 2008, Lehman carried an aggregate of $250 million in D&O insurance, consisting of a $20 million primary policy and sixteen layers of excess insurance. A copy of the Lehman primary policy, which is included in the bankruptcy pleadings, can be found here.

In March and November 2009, respectively, the bankruptcy court previously entered orders granting relief from the stay to allow defense fees to be paid first from the $20 million primary policy and then from the $15 million first excess policy.

However, the motion papers note, submitted defense fee statements already exceed the limits of liability of the first excess policy (i.e., the aggregate fees already exceed $35 million). The motion seeks relief from the stay to allow the second excess insurer, whose policy provides limits of $10 million in excess of $35 million, to advance defense expenses.

The motion goes on to state that the second excess policy’s $10 million excess of $35 million limits are likely to be exhausted "by August of this year." (That is, fees apparently already have or are about to top $45 million.) Accordingly the motion asks for relief from the stay for third excess policy, which provides limits of liability of $10 million excess of $45 million.

The third excess policy may also soon be exhausted. The motion suggests that the third excess policy may be exhausted by October. So the motion also asks for relief from the stay for the fourth excess policy, which provides limits of $15 million in excess of $55 million.

In answer to the obvious question of how so much defense expense could be accumulating so rapidly, the motion provides a brief recitation of the various proceedings in which the company’s former directors and officers are involved. First, there are the various securities class action lawsuit which have been brought by Lehman security holders. Then there are the various securities lawsuits which have been brought against former directors and officers in connection with the plaintiffs’ purchases of mortgage-backed securities. There are also additional actions or arbitrations which have been brought against certain individuals in connection with Lehman-issued securities, auction rate-securities and other alleged conduct.

In addition, the U.S. Department of Justice as well as the SEC and the New Jersey Bureau of Securities have "commenced formal grand jury and regulator investigations concerning the circumstances surrounding the collapse of the Lehman enterprise and have issued various requests and subpoenas," according to the motion papers.

All of these various proceedings undoubtedly took on a heightened sense of urgency after the March 11, 2010 release of the report of the bankruptcy examiner, Anthon Valukas, in which he referred, among many other things, to what he regarded as "actionable balance sheet manipulation."

In light of all of these various proceedings and given the fact that each of the individuals undoubtedly has their own counsel, it may be unsurprising that defense fees are accumulating so rapidly. Indeed, as Professor Henning notes in his Dealbook post, the fees seem to have been accumulating more rapidly in recent months, to the point that the fees now seem to be running at about $5 million a month. At that rate, even the fourth excess policy is likely to be exhausted before year’s end.

Given the size of Lehman’s insurance tower, there may be no immediate reason for the individual defendants to be alarmed. Even were the fourth excess policy to be soon exhausted, that would still leave $180 million in insurance available to cover the defense expenses.

But even if there may be no immediate cause for alarm for the individuals, the events so far and that likely lie ahead do present some noteworthy issues.

First, the sheer volume of defense expense so far dramatically underscores the enormous potential for a catastrophic claim to produce astonishing levels of defense expenses. To be sure, the Lehman collapse, as the largest bankruptcy in U.S. history, may represent an extreme case. But it is not as if the Lehman situation is the only case where enormous defense expenses have rapidly accumulated. To cite just two examples, in prior posts I have detailed the huge defense expenses that accumulated in the Broadcom options backdating lawsuit (refer here) and in connection with the Collins & Aikman bankruptcy (refer here).

In that regard, it should noted that not only has the pace of defense fee accumulation in the Lehman case accelerated in recent months, but the fees seem likely to accumulate even more quickly if the SEC were to file an enforcement action or the DoJ were to file criminal charges. As astonishing as are the fees that have accumulated already, it seems possible (arguably, probable) that even more astonishing fees could lie ahead. Professor Henning’s blog post, linked above, discusses these possibilities in greater detail.

While it is still only the catastrophic claims circumstances that produce these kinds of enormous fees, these cases do raise some very serious questions about traditional notions of limits adequacy. The fact is that the most important purpose of D&O insurance is to ensure that the individual directors and officers are protected in the event that the corporate entity is unable to indemnify them. These catastrophic claims scenarios demonstrate how challenging it may be to ensure that the D&O insurance can provide sufficient protection at the point where it is most needed.

One answer to this challenge may be the one that Lehman itself apparently followed, which is to buy very significant amounts of D&O insurance. Of course, not every company can afford to purchase anywhere near the amount of insurance that Lehman did. (To put the Lehman insurance program into perspective, the primary policy alone – which was written over a $10 million corporate reimbursement retention – cost Lehman more than $2 million. Clearly Lehman was willing to invest very substantial sums for its executives’ protection.)

For that matter, it remains to be seen if even the huge amount of insurance that Lehman put in place will be sufficient to protect the individuals from all of the defense expenses that may lie ahead. If the SEC were to file an enforcement action and the DoJ were to pursue criminal charges, it is not impossible that the accumulating defense expenses could test even the remaining limits

(And that is without even allowing for the possibility, raised by Professor Henning in his blog post, that one or more of the excess insurers might seek to disclaim coverage – "You know how insurance companies can be," he comments.)

There are no easy solutions to these kinds of concerns, although one consideration that should be taken into account is D&O insurance program structure. That is, in addition to considering the question of how much insurance is enough, the question of what structure of insurance should be put into place should also be considered. Among other things, one particular question is whether specific parts of the program should be designated solely for the protection of specific individuals (for example, outside directors) as one way to ensure that no matter what happens there is always a specific pot of money available for the protection of those individuals.

In any event, the consequences following the Lehman collapse are continuing to unfold and undoubtedly have much further to run. The astonishing accumulation of defense expense seems likely to continue if not accelerate. Whether or to what extent any of the D&O insurance might be available to pay settlements or judgments remains to be seen.

This last point, about possible funds for settlements or judgments, does underscore an issue that could well become critically important later on. That is, the D&O insurance tower that is responding to these various proceedings is the one that was in place for the period May 2007 to May 2008. However, Lehman filed for bankruptcy in September 2008. There is in fact, according to footnote 6 of the debtor’s memorandum in support of the motion for relief from the stay, a separate $250 million insurance tower that was in place for the period May 16, 2008 to May 16, 2009.

The 2007-2008 tower presumably is the one that is responding to these various proceedings because the first of the shareholder lawsuits apparently was filed in February 2008, during the policy period of the earlier tower, and later filed proceedings apparently have been treated as interrelated with the first filed claim, and therefore relate back to the date the first claim was made.

Given the huge amount of money at stake and in light of the fact that the 2007-2008 tower is being substantially eroded, it seems probable that someone will find it worthwhile to try to establish that one or more of the various claims triggered the 2008-2009 tower. (Indeed, it may well be that this type of effort is already well underway in one or more disputes or proceedings.) Before all is said and done in connection with the fallout from the Lehman collapse, there could be many twists and turns.

With as many as 17 different D&O insurers involved in this claim, there undoubtedly are quite a number of professionals in the D&O insurance industry involved in this matter. With a situation like this, there could be some pretty good scuttlebutt. I encourage anyone involved in this matter who is willing to share to post a comment using this blog’s comment function (anonymously if necessary). I am certain there is a lot more going on in this claim than can be discerned from the bare face of the pleadings.

Finally, for those practitioners who would appreciate insight into how the D&O insurance policy operates in the bankruptcy context, the debtor’s motion makes some pretty interesting reading. The motion not only shows how the the policy proceeds are administered and monitored in light of bankruptcy procedures, but it also illustrates how various key policy provisions (for example, the priority of payments clause) are intended to operate.

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In the latest development in the long-running lawsuit that is among the very few securities cases to actually have gone to trial, the Ninth Circuit – in its second crack at the case – affirmed the district court’s dismissal. The Ninth Circuit’s August 9, 2010 opinion (here) in the Thane International securities class action lawsuit affirmed the district court’s entry of judgment for the defendants on the issue of loss causation.

Background

Reliant Interactive Media Corp. was acquired by Thane International in September 2001. Reliant shareholders received Thane shares in the merger. Thane’s shares had not been publicly traded, but the merger prospectus stated that Thane’s shares had been "approved for quotation and trading on the NASDAQ National Market" upon completion of the merger.

However, when the merger was consummated, Thane’s shares commenced trading not on the NASDAQ National Market System by on the NASDAQ Over-the-Counter Bulletin Board. For nineteen days, the shares traded above the merger price. However, when the company then reported disappointing earnings, the share price fell, and it continued to decline until Thane ultimately bought back the shares at a fraction of the merger price.

In September 2002, a class of former Reliant shareholders sue Thane and four of its directors and officers under Sections 12(a)(2) and 15 of the ’33 Act, alleging that the pre-merger prospectus had been misleading because it implied that Thane Shares would list on the NASDAQ National Market System.

Following a three-day bench trial, the district court concluded that Thane did not violate Section 12(a)(2), finding that the prospectus was not misleading, and that in any event the misrepresentations were not material because Thane’s share price did not depreciate below the merger price after the market became aware of the market on which the company’s shares were trading.

As discussed here, in a prior appeal, the Ninth Circuit reversed the district court’s trial ruling, holding that the statements in the prospectus, even if literally true, contained misleading statements regarding where Thane shares would be listed and trade, and that the information was material, because a reasonable investor would have wanted to know where the shares would trade. However, the Ninth Circuit recognized that the defendants could still prevail by establishing the affirmative defense of lack of causation.

On remand, the district court held that the defendants had carried their burden of establishing lack of loss causation, holding that there could be no loss as long as Thane’s share price remained above the merger price, and there could be no loss causation since the stock price didn’t fall below the merger price after "impounding" the information about the nonlisting on the National Market System. The plaintiffs’ appealed.

The August 9 Opinion

In its latest opinion, the Ninth Circuit quickly rejected the plaintiffs’ argument that the appellate court’s prior ruling that the prospectus misrepresentation "foreclosed" the defendants’ reliance on the loss causation defense. The Ninth Circuit found that materiality and loss causation are separate issues, and the question whether investors would find information important (materiality) is different than the question whether a particular misstatement actually resulted in a loss (loss causation). Even if the "two inquiries are related" that "does not mean they are the same."

The Ninth Circuit also rejected the plaintiffs’ argument that, due to the inefficiency of the market in which Thane’s shares traded, the share price could not be used in a loss causation assessment. The Court said the absence of efficiency "does not mean that prices are unreliable." The Court rejected the theory urged by the plaintiffs that it is inappropriate to rely on stock prices in an inefficient market to determine loss causation.

Finally, the Ninth Circuit held that the district court did not err when it found that Thane’s share price had "impounded" (absorbed) the failure to list on the National Market System before it fell below the merger price.

Discussion

The decision is likely to be of greatest interest to the parties involved, although it also has some value for its analysis of the relation between materiality the loss causation issue. The Court’s analysis of the role in the loss causation analysis of prices for shares that trade on an inefficient market is also interesting.

However, the thing that makes this decision most noteworthy is that it involves one of the very rare securities class action lawsuits that actually went to trial. Yes, the trial was a three-day bench trial, and yes the case’s lengthy post-trial procedural history essentially reduces the fact that there was a trial to just one event in the long history of the case.

Nevertheless, the process of tracking securities cases that have gone to trial has taken on an importance of its own, so for purposes of maintaining the running scorecard of securities cases that have gone to trial, this Ninth Circuit’s decision upholding the lower court’s dismissal is noteworthy.

According to data compiled by Adam Savett, the Director of Securities Class Actions at Claims Compensation Bureau, there have been nine securities class action lawsuits that have gone to trial post-PSLRA involving post-PSLRA conduct, including the Thane International case. Taking the Ninth Circuit’s recent ruling in the Thane case into account (as well as other recent developments, including the Ninth Circuit’s recent action in the Apollo Group case), the scoreboard in those nine post-PSLRA cases currently stands at five for the plaintiffs and four for the defendants.

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I am pleased to present below an article submitted by John Iole, a partner in the Insurance Recovery Practice of the Jones Day law firm. John notes with respect to his guest post that “the views expressed in this post are those of the author and not necessarily those of the firm or any of its clients.”

I welcome proposed guest post submissions from responsible persons on topics relevant to this blog or its readership. Please contact me if you think you might be interested in submitting a guest post.

I note that John’s post addresses conflicts of interest that may arise in connection with the D&O insurance policy. In addition to the conflicts John discusses in his post, an additional conflict that can arise under the D&O policy is a conflict between the interests of the non-officer directors and other persons insured under the policy. I discussed these conflicts involving non-officer directors in a prior post, here.

Here is John’s post.

D&O insurance rightfully attracts the scrutiny of highly-placed personnel at purchasing companies. Likewise, the placing brokers are specialists with broad and deep experience in this line of cover. Nevertheless, a recurring issue that is infrequently addressed is the balance of interests that must be struck each year at the time of D&O renewal. This issue can arise again at the point of a claim.[1]

            Several characteristics combine to create divergent interests among the parties involved in D&O coverage. First, standard D&O insurance is sold on an aggregate limits basis, meaning that the program limits in any given policy period are available for any and all claims made against the policy. With exceptions that are essentially immaterial, any claim made against a D&O policy will, to the extent it is paid, result in an erosion of the limits available to pay all other claims that are made during (or allocated to) that same policy period. This means that a claim that is paid today necessarily reduces the insurance limits available to pay another claim tomorrow.[2]

            The second -- and for present purposes the most significant -- characteristic of D&O insurance is the fact that there are multiple insured persons who stand to receive the benefit of the insurance limits available. Each insured person has a separate interest in maximizing the limits available to pay a claim that might be asserted against that individual (or entity). Because insurance is protection purchased today against the financial consequences of events that might take place tomorrow, each insured person has an interest in guarding against erosion of limits – this holds true even when no claim has been asserted or is expected. Of course, if claims are known to be likely (known risks, not known losses, which would be excluded), then each insured person has an even greater interest in making sure that expenditures are kept to a minimum in order to protect the availability of funds. In addition, some individuals might have a particularly acute sensitivity to the potential for claims. For example, a member of the audit or compensation committee might expect a higher incidence of claims than non-member insureds. Although many insurance contexts represent the situation in which payment of claims results in a consumption of limits, the multiple insured persons that exist in the D&O context creates a potential for conflict.

            A third complicating consideration is the interest of the entity in the case of a company that has cover under Side-B (reimbursement of the entity for claims paid on behalf of directors and officers) or Side-C (which provides coverage to the entity itself, generally for securities claims). Take the case of a claim asserted against a director or officer that falls within the Side-B cover, and the entity not only is permitted to indemnify the individual, but also is required as a matter of corporate by-laws and/or indemnification agreement to do so. In such a case, the entity will pay the individual’s legal expenses as they become due, and these can be significant. In addition, the entity will stand ready to pay any judgment (or settlement) that results on the merits of the claim. In turn, the entity can expect to be reimbursed by the D&O insurance proceeds for the amount outlaid on behalf of the individual.[3] The individual’s interests are protected by the entity’s funds, and the individual has no direct concern as to whether the entity is reimbursed. Thus, a Side-B claim presents a conflict situation that is similar to the straightforward competition for limits (or preservation of limits) that exists between any two directors or officers. In a Side-B context, however, the competition is between the individuals (as a whole) and the entity.

            The conflict is essentially the same when a Side-C claim is asserted, in that the entity’s consumption of limits in the defense or resolution of a covered claim likewise reduces the limits available for other purposes (such as payment of Side-A claims). One significant difference in Side-C claims is that, unlike Side-B claims, a Side-C claim does not present any retirement of individual liability, but only pays for the elimination of corporate liability. In the case of a Side-B claim, the entity is reimbursed only after the individual claims already have been paid, whereas Side C claims potentially put the entity at the front of the claims line.

            Additional conflicts arise when a D&O program is laden with coverage “enhancements” that branch out from the core purpose of D&O cover. These enhancements sometimes are offered as a way to add value to an expensive line of insurance. In this respect, it can be an alluring prospect to equip the D&O program with optional coverages with the idea that the entity is saving premium dollars that otherwise would be spent on separate policies. For example, some D&O programs include special coverages (or combined limits) for employment-related claims or fiduciary claims. This type of cover might take the place of separate Employment Practices Liability or Fiduciary coverage.[4] Similarly, some D&O programs provide Employed Lawyers coverage for in-house counsel when acting as a lawyer (as opposed to coverage for counsel acting as an officer of the company).[5] As with securities claims against Side-C cover, these coverage grants can result in claims that compete for limits with “standard” D&O claims. Moreover, these coverages can extend the scope of insured persons to a broad swath of employees.

            These conflicts are not necessarily insurmountable problems, but should be adequately recognized and harmonized within the overall D&O program. There are many ways to deal with these issues, both at the point of policy placement, and also at the point of a claim. For example, a potential solution to invoke at the time of placement is to purchase substantial limits so that the risk of complete exhaustion is minimized, but of course this will bring extra cost. Another time-of-placement solution is to purchase Side-A only coverage (either excess, or excess difference in conditions) that sits above the Side A/B/C cover and comes into play if the A/B/C cover is exhausted (but of course this does not eliminate the potential for conflicts among insured persons). Another option is to purchase stand-alone individual Side-A-only cover for particular directors and officers.

            So long as the policy language provides sufficient flexibility, different solutions can be used at the point of a claim in order to reduce competition for limits. If it appears that the program limits could be compromised by pending and expected claims, the potentially competing demands can be harmonized by an automatic or discretionary deferral of payments to the entity through an order of payments clause.[6] A problem with an automatic order of payments clause (e.g., a clause stating that side A claims shall be paid before side-B or side-C claims), however, is that it can only operate with respect to known and ripe claims.  If the policy also combines a discretionary feature that allows the designated person to direct when and how payments will be made, then a deferral can be invoked to preserve limits for pending claims that are not yet ripe for payment, or for potential unasserted claims.[7] Because of the delicate interests that must be balanced in such a situation, the designated decision-maker will play a critical role.

            Given the inherent conflicts facing the directors and officers (both inter se and as between the entity), an additional consideration confronts each lawyer or other professional involved in policy placement and negotiation -- namely, the interests that he or she is protecting, and the extent to which he or she is charged with representing conflicting interests. It is basic black-letter legal ethics law that a lawyer representing a corporation represents “the organization acting through its duly authorized constituents.”[8]

            In the context of D&O insurance, however, the representation analysis is complicated by the fact that the entity is providing coverage for the benefit of the individuals, and potentially also for its own benefit. In that setting, there are multiple potential clients – or at least acutely interested parties – who do not share identical interests. Furthermore, because the actual or potential conflicts of interest might not be fully appreciated by each of the affected persons, and the role of counsel might not be clearly understood, some statement of role clarification ordinarily will be prudent.[9] Nevertheless, a potential adversity of interests does not necessarily require separate legal representation. In the case of divergent interests among clients, the basic ethics rules still permit a multiple representation, so long as the lawyer reasonably believes that each client can be competently represented and each provides informed consent.[10] Although conflicts of interest at the time of placement have not generated reported disputes or case decisions, similar conflicts that arise at the point of a claim can produce major difficulties if the rules are not carefully observed.[11] 

            Therefore, when embarking on a representation involving D&O insurance that might affect multiple constituencies, the most prudent course to follow is to clearly define and limit (if necessary) the scope of the representation, and to obtain informed consent of each affected client if representation of more than one party is undertaken.[12] Another option is to make clear that some constituencies are being represented as clients and others are not being represented. In cases of particular risks or sensitivities, there is always the option to retain separate counsel to represent one or more constituents who are adverse to the others. Depending on the interests and jurisdiction involved, this potentially could be accomplished through separate lawyers from the same organization, or might require separate outside counsel.[13] In the end, there is no certain decision that is foolproof, but a consideration of these items, along with thoughtful guidance when appropriate, hopefully will yield the most prudent decisions that properly accommodate the different interests involved.

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The amount of damages awarded in 2009 Japanese securities cases exceeded "the aggregate amount of securities litigation damages determined by court decisions in Japan for the entire previous decade," according to a new study of Japanese securities litigation from NERA Economic Consulting. The report, dated August 2, 2010 and entitled "Trends in Japanese Securities Litigation: 2009 Update," and which can be found here, updates the NERA report released last year that surveyed Japanese securities litigation from 1998-2008.

According to the report, there were 39 total cases filed in 2009, of which 14 related to misstatements, the same number of misstatement cases as in 2008. The balance of the filings largely involve broker-dealer cases, of which there were 23 in 2009, 12 of which related to unlisted stock trading.

The most significant trend noted in the report has to do with damages awards. The total value of all 2009 securities lawsuit judgments was about 47.2 billion yen (just under $550 million), which is four times the 2008 total and the highest annual level ever. The average damage aware per judgment amount was also a record high of 1.9 billion yen, or about $22 million.

Both the 2009 filings and damage awards reflected matters involving two notable companies, Livedoor and Seibu Railway. Thus, of the 14 new disclosure cases filed in 2009, five each related to Seibu Railway and Livedoor. New cases "involving other companies and/or allegations were limited." Similarly, much of the damages awarded "were related to the Livedoor and Seibu Railway cases." The report specifically notes awards that approximately 25 billion yen in damages is attributable to just two awards involving those two companies in 2009.

The report acknowledges that as the Seibu Railway and Livedoor cases are resolved, there is like to be a decrease in the number of judgments and damages related to misstatements, but the report suggests that any such downturn will be "short-term."

The report attributes the historical trends of increased number of disclosure related lawsuits and increased damages to changes that were introduced in Japanese law in 2004. Among other things, these changes the plaintiffs’ burden for proving damages was decreased and the powers of the Japanese Securities and Exchange Surveillance Commission were increased. Increased disclosure burdens on companies and heightened institutional investor expectations "may lead to an increase in the number of misstatement cases in the [the] future."

Though the reasons for the phenomenon in Japan may have uniquely Japanese attributes, Japan is only one of several countries that has seen an increase in the number and severity of securities related lawsuits in recent years, largely as a result of relatively recent legal reforms. Prior NERA reports have detailed these trends in Australia (about which refer here) and Canada (about which refer here).

These trends, which are also emerging in other counties as well, seem likely to continue, both because of the evolving impact of legal reforms as well as because of increased expectations of institutional and other investors. Other factors, including the increasing availability of litigation funding, which has proved to be a significant factor in the growth of securities litigation in Australia and elsewhere, could also contribute to these developments.

Another factor that at least potentially could encourage these trends is legal developments in the United States, particularly the U.S. Supreme Court’s June 2010 decision in Morrison v. National Australia Bank (about which refer here and here). As a result of this decision aggrieved investors who purchased securities on non-U.S. exchanges will be unable to pursue remedies under the U.S. securities laws in U.S. courts. As a result, some foreign-domiciled investors who might have attempted to pursue claims in the U.S. may now seek to pursue claims in their own country – and even, to the extent they find the remedies or procedures in their own country to be unsatisfactory, to seek legislative.

In any event, as the authors of the recent study suggest, the developments in Japan seem to represent longer term trends, which seems to be true in other countries as well. Even though there are still many more securities lawsuits in the U.S. than elsewhere, the number and significance of the lawsuits outside the U.S. appear to be increasing.

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In a prior post, I published the first in what I intend to be an occasional series of articles on the nuts and bolts of Directors’ and Officers’ Liability Insurance. I continue the series here with the second post in the series. In this post, I take a look at the most basic component of the D&O insurance policy – the insuring agreement. This basic policy clause contains the most critical terms, the definitions of which often determine whether or not a claim will be covered under the policy.

The Insuring Clause

Though the precise formulations may (and often do) vary from policy to policy, all D&O insurance policies more or less provide coverage for Loss arising from Claims first made during the policy period alleging Wrongful Acts against Insured Persons.

Each one of these nouns or noun clauses in the insuring agreement – Loss, Claims, Wrongful Acts, Insured Persons – are defined terms in the policy, and the specifics of the definitions of each of these terms may be among the most coverage-determinative provisions in a D&O insurance policy.

I briefly discuss below each of these terms and the claims issues that can arise in connection with each of the terms. I should emphasize at the outset that the precise contours of these terms have been the subject of extensive litigation over the years. Within the constraints of this blog format, I could not hope to summarize this litigation or all of the issues that have arisen. Moreover, it is important to note that the specific terms and definitions in any particular policy will determine the claims outcome in specific claims circumstances.

Here are the key insuring clause terms, addressed in a slightly different order than they typically appear in the D&O policy.

"Claims Made"

Many liability insurance policies are what are known as "occurrence" policies – that is, the policies provide coverage for accidents or mishaps that occur during the policy period, regardless of when the lawsuit is actually filed. However, D&O insurance policies are not "occurrence" policies, they are "claims made" policies. That is, D&O insurance policies provide coverage for claims made during the policy period, regardless of when the underlying conduct may have occurred.

(Actually, that last statement is not always literally true, as many D&O policies have "past acts" dates which specify the date after which the allegedly wrongful conduct must have occurred. In connection with policies that have past acts dates, claims based on conduct that occurred prior to the date would not be covered, even if the claim is made during the policy period.)

"Claim"

Obviously, in order to determine whether a claim was made during the policy period, one critical question is going to be, what is a "Claim"? Answering that question may be relatively straightforward in the context of civil litigation, as the service of the complaint is relatively easily recognizable as a claim.

The typical D&O policy’s definition of the term "Claim" extends much more broadly beyond civil litigation. Most policies’ definitions of the term encompass any type of demand for monetary or non-monetary relief, whether or not in the form of a complaint. A letter demand for redress of grievances, for example, though less formal than a civil complaint, typically constitutes a claim under a D&O policy.

In addition, the term "Claim" typically extends well beyond civil litigation to many other types of proceedings. For example, many policies extend the definition to include criminal proceedings, usually with a narrowing provision requiring the service of an indictment or an equivalent document. Many policies also extend to regulatory or administrative proceedings, although these clauses often include a requirement that these proceedings be "formal."

The term "Claim" also increasingly is defined to extend to arbitration and mediation and other types of alternative dispute resolution proceedings.

One of the perennial claims battlefields is the question whether investigative proceedings constitute a "Claim" within the meaning of a D&O policy. The question usually depends critically on the precise wording of the policy definition and the specifics of the investigation involved. Among other frequently recurring questions is whether grand jury subpoenas, informal document requests or other informal inquiries represent claims.

"Loss"

The term "Loss" specifies the things for which the policy will pay. The term usually encompasses specified indemnity amounts (settlements and judgments) as well as attorneys’ fees and other defense costs. (And, it should be noted, the policy’s payment of defense fees reduces the amount of insurance remaining under the policy, as payment of defense expenses erodes the limit of liability under the policy). The policy definition also typically excludes payment of certain items, including fines, penalties and matters deemed uninsurable under applicable law.

Among the recurring issues in relation to the definition of "Loss" are questions of coverage under the policy for amounts paid as disgorgement or restitution. These amounts generally are not regarded as "Loss," since they typically represent a defendant’s restoration of funds that were never his or hers in the first place. The battleground on these questions, though, is usually over whether or not a specific payment or kind of payment actually represents restitution or disgorgement.

Another recurring D&O insurance question arises in connection with lawsuits filed in the M&A context, particularly where the claim is that the transaction price is unfair to shareholders. These claims often are settled with an adjustment of the sales price. The question is whether the additional consideration paid is covered under the policy. These kinds of claims, often referred to as "bump up" claims, frequently recur and often depend on the specific circumstances presented and the policy wording involved. (Many policies today actually have specific "bump up" exclusions.)

"Wrongful Act"

The term "Wrongful Act" is usually defined as an actual or alleged act, error or omission, misleading statement or breach of duty. D&O policies are liability policies, so in order for coverage to attach, the insured person must have done something (or be alleged to have done something) for which they are liable to third parties. Although that might seem pretty straightforward, it can often become tricky in a variety of contexts.

One frequently recurring set of circumstances where the question whether or not a wrongful act has been alleged is in connection with the investigative proceedings. As noted above, the question whether or not subpoenas or informal document requests are claims often comes up. However, even if the specific investigative proceedings are claims under the definition of a specific policy, there may still be questions of coverage (again, depending on the specific circumstances and policy language involved) because the subpoena or informal document request does not allege a wrongful act. Or, if they allege a wrongful act, whether or not it is alleged against an insured person.

"Insured Person"

Many D&O policies provide coverage for both natural persons and for corporate entities. Whether or not a person or entity is or is not an insured person under the policy will often depend both on the person’s status and on the capacity in which they were acting.

For individuals, the status entitling them as insured persons under the policy is usually their service as a duly elected or appointed officer or director of the company. Whether or not a person is duly elected or appointed will often depend on the insured company’s own organizing documents or corporate charter. Questions can sometimes arise about whether or not middle or lower level personnel are insured; these questions are usually best addressed at the time the policy is formed, by endorsing the policy to specify that persons holding specific offices – or even specify particular named persons—are insured persons under the policy.

A frequent concern is whether individuals have coverage after they have completed their board service or officer duties. Most D&O policies include current, past and future director and officers within the definition of insured persons, so a former director or officer should continue to have protection for acts undertaken during their service, at least as long as the company continues to have D&O insurance in place.

Beyond the questions whether an individual’s status entitles him or her to be an insured person under the policy are questions concerning the capacity in which an individual was acting at the time of the alleged wrongful conduct. The individuals are insured only for actions in an insured capacity – that is, in connection with their service as a director or officer of the company.

These questions can be difficult when the individual has multiple connections with the insured company – as an investor, for example, or as a representative of a private equity or venture capital firm, or where the individual’s actions were in connection with a joint venture or other related but separate entity. The capacity in which the person was acting at the time may be a critical issue.

As for entities insured under the D&O policy, the typical policy provides coverage both for the insured entity (usually the first named insured) and its subsidiaries. Questions can arise whether or not an entity is a subsidiary (depending on the corporate parent’s ownership percentage). Questions can also arise about organizations formed or acquired after the policy’s inception. Most policies have very specific policy provisions addressing these subsequent formations or acquisitions.

More complex organizational structures can pose particular challenges. Organizational vehicles such as joint ventures or limited partnerships can pose particularly troublesome concerns if not addressed in the policy. Full exploration of these entity organizational issues are well beyond the scope of this blog post, but the critical issue is that these organizational questions should be addressed during the insurance acquisition process.

Future Posts in This Series: Based on the response I received to my initial post in the series, I intend to continue to write and publish posts on the nuts and bolts of D&O insurance in the weeks ahead. I am interested to hear from readers on topics they are particularly interested in seeing this series address. I can’t promise that I will address every issue – that are so many issues that I might possibly address, some of which are well beyond the "nuts and bolts" scope of this project.

However, with a better understanding of the issues in which readers are interested I can at least try to shape future posts to the issues that appear to be of greatest interest or concern. As always, I welcome readers’ thoughts and comments on the posts I publish as part of this series, as well as any other issues relating to this blog or its content.

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Earlier this week, I hosted a guest post from the counsel for the plaintiffs in the Vivendi securities class action lawsuit, in which plaintiffs’ counsel summarized their position on the impact that the U.S. Supreme Court’s decision in Morrison v. National Australia Bank had on their case.

In response to their post, University of Minnesota Law Professor Richard Painter prepared the following commentary and submitted it to me for publication here. By way of background, Professor Painter’s opening reference is to George Conway of the Wachtell Lipton firm, who, as reported in the prior post on this topic, briefed and argued the Morrison case for National Australia Bank, and who has been quoted as characterizing the position of the Vivendi plaintiffs on this issue as “Completely nuts, N-U-T-S.” 

Here are Professor Painter’s comments:

Actually, Conway has to be right. The argument that Section 10(b) applies to foreign transactions in securities merely because those securities are listed in the United States is absurd.

First, a reading of the entire Morrison opinion leads to the conclusion that the Court did not extend the reach of Section 10(b) to foreign transactions in securities listed on an American exchange. The Court’s unequivocal holding is that Section 10(b) does not apply “extraterritorially.” The Court repeatedly emphasizes that the “focus” of American securities laws is on “domestic transactions” and on “purchases and sales of securities in the United States.”

An extremely large hole would be driven through that holding if the mere listing of a stock or an ADR on an American exchange were enough to justify application of U.S. law to a foreign purchase of the stock on a foreign exchange, as there are hundreds if not thousands of foreign issuers that list their home-country shares or ADRs on a U.S. exchange.

Second, the Court was well aware that NAB had ADRs listed in New York. In order for a foreign issuer to sponsor and list ADRs on a U.S. exchange, it must register the underlying, deposited shares with the SEC and, at least for the NYSE, actually list the underlying shares (though not for trading). NAB’s registration statement in the United States, for example, pertained to “ordinary shares” (At page 58 of the Supplemental Joint Appendix in Morrison v. NAB, the 20-F cover says NAB’s ordinary shares were “registered on the NYSE.” This cover looks exactly like the 20-F cover for Vivendi that the plaintiffs there are relying on.)

The Court nonetheless held that Section 10(b) did not apply to NAB’s ordinary shares traded in Australia. This holding is inconsistent with a theory that the Court would apply Section 10(b) to any security listed on a U.S. exchange even if the transaction in that security is outside the United States.

Many companies have ADRs trading in the United States. It cannot possibly be the case that the Court intended Section 10(b) to apply not only to the ADR itself but also to a foreign purchase of the underlying stock on a foreign exchange simply because the underlying shares are registered in the United States to enable the company to issue the ADR.

Indeed, if the Vivendi plaintiff’s counsel were correct, Section 10(b) after Morrison would have a broader extraterritorial reach than ever before. Think of the many foreign-cubed claims dismissed under the Second Circuit’s conduct test before the Supreme Court ruled: many – if not most – of the defendant issuers in those cases had sponsored ADRs that traded on American exchanges, just like NAB, and just like Vivendi. On plaintiffs’ reading of Morrison, those cases were wrongly dismissed. Section 10(b) – which the Supreme Court said did not have any extraterritorial application “at all” – according to Vivendi plaintiffs’ counsel would apply more extraterritorially than ever before.

This is the exact opposite of what the Court clearly intended. And it would mean that the Court got the result wrong in Morrison itself.

There are other points to make against the plaintiffs’ contention, such as the significance of Section 30 of the Exchange Act, whose territorial limitations would be rendered meaningless if plaintiffs’ reading of Morrison were correct. The bottom line is: it is quite clear that plaintiffs who transacted in securities outside the United States have no cause of action under Section 10(b) merely because these securities or related ADRs are listed on a U.S. securities exchange.

Nice try plaintiffs, but if you want a different rule, ask the SEC to recommend one in its study of extraterritorial private rights of action that Congress mandated in Dodd-Frank. Don’t waste your time with a meritless interpretation of Morrison.

I encourage reader to respond to Professor Painter’s commentary or to the Vivendi plaintiffs’ prior column using this blog’s comment function.

I welcome guest blog posts from responsible commentators on topics of interests to readers of this blog. Please contact me (using the Contact function in the right hand column) if you are interested in submitting a guest column.

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The New Century Financial securities class action lawsuit – which was the first of the subprime-related securities class action lawsuits when it was filed in February 2007 – has been settled for $124,827,088, subject to court approval. The plaintiffs’ July 30, 2010 unopposed motion for settlement approval can be found here.

The settlement actually consists of three separate settlement stipulations and three corresponding settlement funds. Of the total settlement amount, $65,077, 088 will be paid on behalf of the thirteen former New Century directors and officers; $44,650,000 will be paid on behalf of KPMG, New Century’s auditor; and $15 million will be paid on behalf of the offering underwriter defendants.

The $65 million to be paid in the class action settlement on behalf of the individual directors and officers is actually part of a larger settlement on the individuals’ behalf. As reflected in the separate director and officer settlement stipulation filed in connection the motion for settlement approval, a total of $91,102,331.51 will be paid in cash by eleven directors’ and officers’ liability insurers (which are listed on page 11 of the stipulation) in order to settle in whole or in part not only the claims against them in the securities class action lawsuits but also the claims pending against some or all of the individuals in proceedings before the SEC, in separate litigation brought against them by other plaintiffs, as well as bankruptcy trustee claims.

As reflected at greater length here, plaintiff investors first filed their action against the defendants in February 2007. New Century filed for bankruptcy in April 2007. In March 2008, the New Century bankruptcy examiner filed a report (refer here) finding, among other things, that the company had "engaged in a number of significant improper and imprudent practices related to its loan originations" that "created a ticking time bomb that detonated in 2007." On December 3, 2008, Central District of California Judge Dean Pregerson denied the defendants’ motions to dismiss (refer here).

The New Century Financial case was one of the higher profile subprime-related securities class action lawsuits and one of the most prominent in which the motion to dismiss was denied. However, as reflected in my running tally of subprime related case resolutions and settlements (which can be accessed here), it is only the fourth largest subprime securities suit settlement so far, behind the Countrywide settlement ($624 million), the Merrill Lynch settlement ($475 million) and the Merrill Lynch bondholders settlement ($150 million).

Unlike those larger settlements, however, in the New Century Financial case there was no viable entity remaining to fund a larger settlement. The size of the insurers’ contribution and the number of insurers involved in the D&O settlement stipulation suggests that the remaining D&O insurance was exhausted to fund the D&O portion of the settlement. These figures also suggest that there were certain constraints on the possible size of the settlement. KPMG’s very sizeable contribution of $44.75 million toward the settlement represents a significantly greater contribution that it paid in the much larger Countrywide settlement ($24 million).

I suspect that this was an enormously difficult settlement to pull off. Given the number of parties, the number of proceedings, the number of insurers, and the amount of money at stake, trying to settle this case undoubtedly was challenging, particularly since continuing defense expenses eroded the amount of insurance remaining as the settlement negotiations went forward. I tip my hat to the lawyers involved in bringing this settlement together.

The SEC’s separate July 30, 2010 announcement of its settlement of its enforcement action pending against three former New Century directors and officers can be found here. The stipulation of settlement in the class action lawsuit specifies that the portion of the $91 million in insurance funds is to be paid in part on behalf of the three individuals in the SEC proceeding; however, the stipulation specifies that these amounts "shall not be applied towards penalties owed pursuant to" the SEC settlement.

Another Subprime Securities Suit Settlement: In addition to the New Century Financial case, the subprime-related securities class action lawsuit involving The PMI Group also recently settled. The company announced in its August 3, 2010 filing on Form 1-Q (here) that on July 13, 2010 the parties agreed to a proposed settlement of $31.25 million, subject to court approval. The settlement is to be funded entirely by The PMI Group's insurers. Background regarding the case can be found here. Like the New Century Financial case, the PMI Group subprime-related securities class action lawsuit had also survived a motion to dismiss, as discussed here.

A Different Sort of Insurance Cover: Being an astronaut is a dangerous occupation, and those that climb into space launch vehicles understandably would want life insurance in case the worst were to happen. However, life insurers have proven reluctant to insure astronauts.

As reflected in this fascinating post on the UK Insurance blog (here), the interesting way the crews for the Apollo 11 through 16 dealt with this issue was for each crew member to sign specially issued, stamped and marked envelopes, with the idea that were the worst to happen, the value of the "insurance covers" would "sky-rocket" allowing the astronauts’ families to secure financial benefits without formal insurance.

Fortunately, none of the missions that used this makeshift form of insurance suffered any fatalities (though Apollo 1 did meet an unfortunate fate and later Space Shuttle Challenger and Columbia missions did suffer terrible disasters). The Apollo missions "insurance covers" were never used and now trade among collectors.

Special thanks to loyal reader Chris Areheart for sending along this interesting item.

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In a series of recent posts (most recently here), I have been taking a look at the practical impact that the U.S. Supreme Court’s June 24, 2010 decision in Morrison v. National Australia Bank will have on securities litigation in the United States involving non-U.S. companies. Among the cases seemingly most impacted by the decision is the Vivendi securities class action lawsuit pending in the Southern District of New York. Not only is the defendant company domiciled outside the United States, but about three quarters of its shareholders reside in France and most presumably purchased their shares on non-U.S. exchanges.

The question of whether these shareholders may assert a claim in a U.S. court under U.S. law is particularly acute due to the verdict that the jury returned on behalf of the plaintiffs in the case in January 2010.

As Andrew Longstreth reported on July 27, 2010 in the Am Law Litigation Daily (here), the parties to the Vivendi case recently presented their arguments to the court on the impact of Morrison. Among other things, the article characterized the plaintiffs’ argument that the foreign plaintiffs may proceed in the case as "highly creative" and the article also quoted George T. Conway III of the Wachtell Lipton law firm – who briefed and argued the Morrison case for the defendants – as describing the plaintiffs arguments as "Completely nuts, N-U-T-S."

After I linked to the Am Law Litigation Daily article, counsel for the plaintiffs in the Vivendi case reached out to me to express their concerns that their position has been misunderstood and is not receiving a fair hearing in the press and the blogosphere. In response, I offered to host a guest blog post on this site, in which the plaintiffs counsel could present their position as they wished. What follows is the guest post submitted to me by Michael Spencer of the Milberg law firm.

I encourage readers who have comments in response to Michael Spencer’s guest post to add their comments to this post using the site’s Comment feature.

I would like to thank Michael Spencer for his willingness to submit this post and have it published on this site. I welcome the opportunity to publish guest posts from responsible observers on this site. Those who may be interested in publishing a guest post on this site should feel free to contact me using the Contact function in the upper right hand column of this site.

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