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

So the U.S. Supreme Court held in Morrison that the investors who purchased their shares of a non-U.S. company on a foreign exchange cannot pursue claims under the Exchange Act, but securityholders who purchased American Depositary Receipts (ADRs) in the U.S. can still seek damages under the Exchange Act, right? Not according to a September 29, 2010 decision by Southern District of New York Judge Richard Berman in the Société Générale subprime-related securities class action lawsuit.

The defendants did not even raise the argument, and it may comes as somewhat of a surprise to some observers, but Judge Berman held, applying the U.S. Supreme Court’s decision in Morrison (about which refer here), that not even domestic purchases of SocGen’s ADRs can assert claims under the Exchange Act. As a result, Judge Berman wound up dismissing the entire case, and not just the claims of investors who purchased their SocGen shares on foreign exchanges.

As discussed below, if the Exchange Act does not even apply to domestic transactions in ADRs, the question that immediately arises as to who is left that might be able to assert Exchange Act claims against non-U.S. companies. The answer in many cases may be – well, nobody.

Background and Decisions

Investors had sued the French bank and certain of its directors and officers in 2008 following the revelations of Jérôme Kerviel 4.9 billion euro trading losses and the bank’s disclosures of its own losses from subprime mortgage related investments.

After the Supreme Court issued its opinion in Morrison, the defendants in the SocGen case had moved to dismiss the claims of two the three named plaintiffs. Both of the two were U.S. residents who had purchased their securities outside the U.S. Judge Berman quickly disposed of these claims, ruling (in reliance on, among other post-Morrison cases, the Credit Suisse case and the Alstom decision, about which refer here and here respectively) that the Exchange Act does not reach claims of such so-called "f-squared claimants."

Judge Berman didn’t stop there, but went on to consider the applicability of the Exchange Act to the claims of the third named plaintiff, UFCW, which had purchased ADRs over the counter in the United States. Even though the defendants had not even themselves raised the question, Judge Berman decided sua sponte that Morrison precludes UFCW’s claims as well.

In reaching this conclusion, Judge Berman said:

…even though Defendants do not argue that UFCW’s claims should be dismissed under Morrison, the Court concludes that the Exchange Act is inapplicable to UFCW’s ADR transactions. That is, the Court finds that because "[t]rade in ADRs is considered ‘predominantly a foreign securities transaction,’ Section 10(b) is inapplicable. An ADR ‘represents one or more shares of a foreign stock or a fraction of a share." Accordingly, UFCW’s claims are also dismissed.

Discussion

Judge Berman’s decision seemingly does not depend on the fact that UFCW purchased its ADRs over the counter, rather than on an exchange. His logic instead depends on the fact that what UFCW purchased were ADRs, the acquisition of which, he held, represents a fundamentally foreign transaction. -- which appears to suggest that Judge Berman would apply the same analysis even to ADRs purchased on an exchange.

It is fair to say that Judge Berman’s ruling is unexpected Not even the defendants in the case saw it coming. I think it also raises several questions.

First, Judge Berman’s analysis seems to depend on his rather brief review of what an ADR is and the nature of the transaction involved in a domestic ADR purchase. This seems to me like an issue that would have benefitted from full briefing by all parties. Certainly before any other court chooses whether or not to follow Judge Berman, a comprehensive examination of the relation of the purpose and uses of ADRs would seem to be indicated.

Second, and perhaps more importantly, Judge Berman’s analysis of whether or not the Exchange Act applies to UFCW’s ADRs arguably would have benefitted from more detailed consideration of whether the UFCW’s ADR purchases are "domestic transactions in other securities" to which the Exchange Act applies under the second prong of the Morrison standard.

Third, Judge Berman’s conclusion seemingly put domestic ADR transactions in an odd category about which it may be asked – which jurisdiction’s laws apply to these transactions if not U.S. law?. Are ADR purchases transactions without a country? (Or to put it in a less contentious frame, what jurisdiction’s securities laws make more sense than those of the U.S. to apply to ADR transactions in the U.S.)?

To the extent it is (if ever) conclusively established that the Exchange Act does not even reach domestic ADR transactions, that holding would represent a significant blow to the U.S. securities class action plaintiffs’ bar, as it would eliminate in many instances all or virtually all of the claims that had seemed to be left after Morrison.

If domestic purchasers of ADRs cannot assert claims under the Exchange Act, there would be very few if any holders of securities of many foreign domiciled companies who could assert Exchange Act claims. One wonders whether Judge Berman’s holding could spell the end (or virtual elimination) of many of the current securities cases pending against foreign companies – not only cases such as Vivendi, where plaintiffs won a jury verdict on the issue of liability, but also in more recently filed cases such as those initiated against BP and Toyota.

Not only would that seem to dramatically narrow, if not eliminate, what claims seemed to remain against foreign domiciled companies in the wake of Morrison, but it could drastically limit opportunities for security holders of non-U.S. companies to file future lawsuits under the Exchange Act.

The Morrison decision itself was a surprise, now Judge Berman seems to have compounded that surprise by taking Morrison in a completely unexpected direction. Of course, where it will all lead remains to be seen. I think more will be heard on the issues Judge Berman has raised.

I have in any event added the SocGen decision to my running tally of subprime and credit crisis related lawsuit dismissal motion rulings, which can be accessed here.  Special thanks to a loyal reader for supplying a copy of the SocGen decision.

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In a September 27, 2010 order (here), Judge Laura Taylor Swain denied the dismissal motions in the subprime-related securities class action lawsuit pending against AIG, certain of its former directors and officers, its accountant and its offering underwriters. Andrew Longstreth’s September 27 Am Law Litigation Daily article about the decision can be found here.

AIG, of course, was rescued from collapse only by a massive government bailout. Following the bailout, the company’s share price plummeted and securities class action litigation ensued. As discussed in detail here, the plaintiffs allege that the defendants violated the securities laws through various disclosures and omissions related to the company’s securities lending program and its credit default swap portfolio.

Both the credit default swap portfolio and the securities lending program entailed exposures to subprime mortgages. In many instances, the CDSs were placed in connection with securities backed by subprime mortgages. In the securities lending business, the cash received in exchange for the loaned securities was invested in mortgage-backed securities. Additional collateral requirements for these transactions triggered by the subprime mortgage meltdown led to the government bailout. The plaintiffs contend that these exposures were not adequately disclosed. The defendants moved to dismiss.

In her September 27 opinion denying the dismissal motions, Judge Swain held that the plaintiffs’ allegations were "adequate to plead material misrepresentations and omissions on the part of AIG," particularly with respect to the company’s exposure through its CDS portfolio to subprime mortgages.

Judge Swain rejected the defendants’ contention that the allegedly misleading statements were forward-looking statements protected by the bespeaks caution doctrine, observing that "generic risk disclosures are inadequate to shield defendants from liability for failing to disclose known specific risks" and that "statements of opinion and predictions may be actionable if they are worded as guarantees or supported by specific statements of fact." Judge Swain cited in particular the defendants’ alleged failure to disclose a litany "of hard facts critical to appreciating the magnitude of the risks described."

With respect to scienter, Judge Swain, after reciting a list of adverse undisclosed facts and developments allegedly known to defendants, concluded that the plaintiffs had "satisfied their burden of alleging facts giving rise to a strong inference of fraudulent intent," adding that "no opposing inference is more compelling."

Finally, Judge Swain also denied the defendants’ motion to dismiss on loss causation grounds. The defendants had argued that AIG’s stock price decline was "attributable to the decline experienced in the stock market generally, and in the financial services sector specifically." Judge Swain found that "the sharp drop in AIG’s stock price in response to certain corrective disclosures, and the relationship between the risks allegedly concealed and the risks that subsequently materialized, are sufficient to overcome the argument at the pleading stages" – although she added that the defendants ultimately may be able to prove that "some or all" of plaintiffs’ losses are "attributable to forces other than AIG."

Finally, Judge Swain held that the plaintiffs had standing to assert Section 11 claims, and that the Section 11 claims were timely, because, Judge Swain concluded, the plaintiffs were not on "inquiry notice" of possible misrepresentations until the September 2008 bailout. Judge Swain also denied the motions to dismiss the Section 11 claims against the offering underwriter defendants and AIG’s outside auditor.

Discussion

The AIG lawsuit is one of the highest profile cases filed as part of the subprime litigation wave. Given the magnitude and causes of the company’s losses, its near collapse, and the massive size of the government bailout, it may come as no surprise that this particular case managed to get passed the initial pleading hurdles.

But now that the case is going forward, the question arises of where the case ultimately will lead given the U.S. taxpayer’s stake in the company. Even if the company’s D&O insurance program is not substantially eroded by defense fees alone, the remaining insurance is unlikely to represent a significant percentage of the claimed losses of the plaintiff class. The underwriter defendants and auditor might be expected (at least by plaintiffs) to contribute substantially toward the case resolution, but the banks’ financial health is not what it once was.

All factors considered, especially the political peril associated with a significant taxpayer funded contribution toward settlement, there are certain questions about the ultimate resolution of this case.

The dismissal denial in the AIG case, coming close on the heels of the dismissal motion denial in the Sallie Mae case, does serve as a reminder that there are subprime-related lawsuits that are going to survive the initial motions stage, particularly those involving higher profile companies.

In any event, I have added the AIG opinion to my running tally of subprime and credit crisis lawsuit dismissal motion rulings, which can be accessed here.

Where are the Criminal Prosecutions?: As I noted in a recent post (here), members of Congress are asking why there have been so few criminal prosecutions in the wake of the subprime meltdown. Wayne State Law School Professor Peter Henning has an interesting September 27, 2010 column on the Dealbook blog (here) discussing these issues and presenting his theories on the reasons why there haven’t been more criminal cases.

NYSE Corporate Governance Commission Report: In yesterday’s post, the link to the NYSE Corporate Governance Commission’s report was faulty. I have now corrected the link. Readers who wanted the report but were unable to access it due to the faulty link can refer here for a copy of the report. I apologize for the faulty link (now corrected) in yesterday’s post.

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NYSE Commission on Corporate Governance: On September 23, 2010, the NYSE Commission on Corporate Governance issued a report (here) following a two year review of governance issues and considerations. The Commission, chaired by Larry Sonsini of the Wilson Sonsini law firm, included more than two dozen members representing a broad range of constituencies, and its report presents an interesting and thoughtful review of the issues and statement of principles. The NYSE’s September 23, 2010 press release concerning the report can be found here.

The report’s centerpiece is its statement of ten principles of corporate governance, but in addition to distilling its analysis down to these ten principles, the report also helpfully reviews the history of events leading up to is report, including the recent history of corporate governance reform. In explaining its ten principles, the report states the Commission’s belief that "the respective roles of boards, management and shareholders needed greater understanding," and the principles primary focus is the respective roles of each of these three groups.

The board’s role, according to the report, is "to steer the corporation towards policies supporting long-term sustainable growth in shareholder value." While noting that other factors may affect long-term shareholder value, the report states (significantly in my view) that "shareholders have the right and responsibility to hold a board accountable for its performance in achieving long-term sustainable growth in shareholder value."

The report notes the critical role of management in establishing proper corporate governance, emphasizing that "successful governance depends heavily upon honest, competent, industrious managers." The report also noted that "constructive tension" between the board and management, if properly modulated, may be a characteristic of good corporate governance.

With respect to shareholders, the report takes a firm stand against short-termism. The report notes that investors have a responsibility to vote their shares in a "thoughtful manner." In a couple of different places, the report also expresses concern about the possibility of investors’ over-reliance on proxy advisory firms, noting that the decision to rely on advisory firms "does not relieve institutions from discharging their responsibility to vote constructively, thoughtfully and in alignment with the interests" of their clients.

The report is interesting, relatively brief and worth reading in its full length. Hat tip to the CorporateCounsel.net blog for the link to the report.

Norwegian Bank Files Individual Securities Suit Against Citibank: Citigroup may have settle the subprime-related enforcement action and even managed to get the court to accept the $75 million settlement (even if with certain provisos), but a separate subprime-related securities class action lawsuit on behalf of Citigroup investors remains pending. Despite the continuing existence of the class action, Norges Bank, which manages investments for the $450 billion Norwegian sovereign wealth fund, has now filed its own securities lawsuit, seeking separately to recover for the fund’s losses.

According to Victor Li’s September 24, 2010 Am Law Litigation Daily article (here), Norges filed a complaint in the Southern District of New York against Citigroup and 20 of its current and former directors and officers (including its current CEO, Vikram Pandit). The complaint alleges that because of the defendants’ misrepresentations about the company’s subprime exposure, Norges purchased Citi shares at inflated prices from January 2007 to January 2009. The bank claims it paid over $2 billion for the shares and claims to have lost over $835 million.

There are a number of interesting aspects to this case. The first is that the bank concluded that notwithstanding the existence of the shareholder class action lawsuit, its interests were better served by proceeding separately from the class. The other thing about the lawsuit is the sheer size of the claimed losses – its losses alone are far greater than the collective investor losses in most securities class action lawsuits.

The massive size of Norges’s claimed losses explains its desire to pursue litigation, but the initiation of a separate suit can only be explained either by Norges’s assumption that it will fare better separately than within the class, or perhaps that it will pay lower fees – or perhaps both.

The Norges lawsuit follows on the heals of the separate opt-out lawsuit filed against Merrill Lynch on behalf of the New York pension funds, about which I commented here. The phenomenon of large institutional investors electing to pursue their own claims was a characteristic of many of the lawsuits arising from the corporate scandals during the last decade. Though these kinds of cases had seemed to have died down for a while, the New York lawsuit against Merrill and the Norges suit suggest that the individual lawsuits may be back – and that large institutional investors may be considering them in preference to class actions.

The seeming rise of this phenomenon has been a matter of significant discussion and some concern, as the prospect of multiple individual lawsuits could overwhelm the putative procedural advantages and effectiveness of the class action process.

The magnitude of Norges Bank’s claimed losses may be sufficiently unusual to raise a question whether there may be other investors similarly motivate to pursue separate lawsuits – there simply are going to be few individual investors in few circumstance with losses of that magnitude. Of course, there is always the possibility of smaller investors with smaller losses getting into the act, which they might do if they too believe they will fare better separately rather than within the class.

The prospect for other investors to conclude that their interests are better served through an individual action is a prospect that could pose a host of challenges and represents a "worrisome trend," as I have previously discussed here.

My previous post discussing the Norwegian sovereign wealth fund can be found here.

More Credit Union Troubles: On September 24, 2010, the National Credit Union Administration announced a series of moves, including the seizure of three wholesale credit unions, as part of an overall effort to shore up the country’s credit union industry. The move also included the creation of a $30 billion guarantee to backstop the credit union industry in an effort to stave off further losses. The Wall Street Journal’s September 25, 2010 front page article about the NCUA’s actions can be found here.

Wholesale credit unions provide back office services to retail credit unions. Since March 2009, bad investments in mortgage-backed securities have resulting in the government takeover of five of the country’s 27 wholesale credit unions.

At least one of these wholesale credit union failures has resulted in a civil action by the NCUA against former directors and officers of the failed institution. As discussed here, on August 31, 2010, the NCUA initiated an action against former directors and officers of Western Corporate Federal Credit Union of San Dimas, California.

It is unclear from the NCUA’s latest announcement and actions whether the NCUA might pursue additional lawsuits against the directors and officers of other failed institutions. However, it is clear that the same kinds of difficulties that have beset the commercial banking sector are also troubling the credit union industry as well, and these troubles at a minimum additional may mean regulatory seizures and also present at least the possibility of further claims.

Finally, the NCUA’s moves are a reminder that two full years out from the most tumultuous moment of the credit crisis, the reverberations continue to vex the financial services industry.

Layoffs Mean More Job Bias and Disability Claims: According to Nathan Koppel’s September 24, 2010 Wall Street Journal article (here), layoffs arising from the economic downturn are resulting in a "rising number of claims" that companies "illegally fired workers on account of age, race, gender or medical condition." Among other things, the article cites EEOC statistics showing that for the six months ended April 30, 2010, more that 70,000 people had filed claims alleging job discrimination, which represents a 60% increase in bias claims compared to the same period a year earlier.

The article also notes that companies are also facing "a rising tide of disability claims," noting that more than 21,000 people filed disability claims last year, which represented a 10% increase over the prior year and a 20% increase over 2007. The article notes the difficulties financial troubled companies may face trying to accommodate disabled employees.

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In a September 24, 2010 order (here), Southern District of New York William Pauley denied the dismissal motions of Sallie Mae and its former CEO, Albert Lord, but granted the dismissal motion of CFO (and later CEO), Charles Andrews, in the credit crisis-related securities suit against Sallie Mae first filed in 2008. The decision is interesting in a number of respects, particularly concerning scienter issues.

Sallie Mae is one of the country’s largest providers of student loans. The complaint, which Judge Pauley described as "a behemoth" containing "labyrinthine allegations," alleges that in a series of statements in 2007, the defendants misled the market about Sallie Mae’s financial performance for the purpose of inflating its share price.

Among other things, the company was attempting during this same period to complete a planned merger with J.C. Flowers, an investment firm, in a transaction that ultimately was not consummated and that resulted in separate litigation (later settled) between the company and Flowers.

The complaint alleges that during the class period, the company lowered its borrowing criteria to increase its portfolio of lower quality but higher margin private loans; hid defaults by changing its forbearance policy; and inflated profits through inadequate loan loss reserves. The defendants moved to dismiss. My prior post about the lawsuit can be found here.

In his September 24 order, Judge Pauley denied the motion to dismiss as to Lord and the company, but he granted the motion to dismissal as to Andrews.

Judge Pauley first concluded that the plaintiffs had adequately alleged falsity. The defendants had argued that the plaintiffs had not alleged particularized facts sufficient to establish the falsity of the loan loss reserves. However, Judge Pauley observed, the plaintiffs primary challenge to the accuracy reserves, made in reliance on the testimony of confidential witnesses, was that Sallie Mae had not accurately reported its loan default rate (which in turn led to insufficient loan loss reserves). Judge Pauley held that "given the error in the default rate metric and its impact on Sallie Mae’s other financial reports, such allegations are sufficient to plead falsity."

In concluding that the plaintiffs had adequately alleged scienter with respect to Lord and Sallie Mae, Judge Pauley noted three reasons on which plaintiffs relied which, "considered together," are "sufficiently concrete to give rise to an inference" that Lord and Sallie Mae "possessed the intent to defraud shareholders." The three reasons were the Flowers transaction, Lord’s stock sales, and certain equity forward contracts.

Judge Pauley found that Lord had financial incentives to try to complete the Flowers transaction, because upon completion of the deal he would have received a $225 million cash payment and been free to exercise options at above market prices. In addition, Judge Pauley found that, in order to keep merger prospects alive, Lord also had an incentive to keep the company’s share price above the trigger in its equity forward contracts, because had the price gone below the trigger, the company would have been required to repurchase about $2.2 billion in shares, which "would have torpedoed the merger and Lord’s payout."

Judge Pauley also found that Lord made "unusual" stock sales in February, August and December 2007. The December sales, which took place two days after the Flowers transaction collapsed, and which represented a "liquidation of 97% of his Sallie Mae holdings," were "unusual for a corporate officer by any measure."

Lord had offered explanations for his stock sales – the August sales allegedly "were necessary to pay the exercise price of expiring options and associated taxes" and the December sale was "necessary to satisfy a margin call" – but with respect to Lord’s exculpatory explanations, Judge Pauley said "these facts remain in dispute."

By contrast, Judge Pauley found that the allegation of scienter as to Andrews were insufficient. Andrews not only had sold no shares but the defendants alleged he had acquired shares.

Lord’s incentives to complete the Flowers transaction clearly influence Pauley’s decision. The insider sales alone seem less determinative, as the timing of his sales seemed less than profit maximizing. For example, his December sale, the one he contends was triggered by a margin call, came two days after the Flowers deal collapse). This sale seems inconsistent with the theory that it represented the culmination of a fraudulent scheme.

In other words, it was the presence of the unusual and case specific circumstance of the Flowers deal that in large part explains this case’s survival of the dismissal motions.

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

Special thanks to a loyal reader for providing a copy of the Sallie Mae opinion.

Behemoth and Labyrinth: When Judge Pauley described the plaintiffs’ complaint as a "behemoth," he was invoking a literary reference with rather startling associations. According to Wikepedia, the word "behemoth" first appeared in the book of Job, which says the following about the beast:

15 Behold now the behemoth that I have made with you; he eats grass like cattle.
¹⁶ Behold now his strength is in his loins and his power is in the navel of his belly.
¹⁷ His tail hardens like a cedar; the sinews of his thighs are knit together.
¹⁸ His limbs are as strong as copper, his bones as a load of iron.
¹⁹ His is the first of God's ways; [only] his Maker can draw His sword [against him].
²⁰ For the mountains bear food for him, and all the beasts of the field play there.
²¹ Does he lie under the shadows, in the cover of the reeds and the swamp
²² Do the shadows cover him as his shadow? Do the willows of the brook surround him?
²³ Behold, he plunders the river, and [he] does not harden; he trusts that he will draw the Jordan into his mouth.
²⁴ With His eyes He will take him; with snares He will puncture his nostrils.

Judge Pauley also described the plaintiffs’ allegations as "labyrinthine," presuamably in reference to the Labyrinth from Greek mythology. According to Wikipedia (here), the Labyrinth’s elaborate structure was "designed and built by the legendary artificer Daedalus for King Minos of Crete at Knossos. Its function was to hold the Minotaur, a creature that was half man and half bull and was eventually killed by the Athenian hero Theseus. Daedalus had made the Labyrinth so cunningly that he himself could barely escape it after he built it. Theseus was aided by Ariadne, who provided him with a skein of thread, literally the "clew", or "clue", so he could find his way out again."

Geez, no wonder the complaint survived the dismissal motion.

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News reports about the September 22, 2010 Senate Banking Committee hearing regarding the SEC have focused on the provocative statements by SEC Inspector General H. David Katz. Among other things, Katz suggested that a Texas-based SEC official quashed the investigation of allegations regarding Stanford Financial Group, allowing the Stanford-related Ponzi scheme to continue. Katz also suggested that the SEC times its initiation of its enforcement action against Goldman Sachs to draw attention away from the Inspector General’s report critical of its Stanford-related failures. (Katz’s written testimony, which focuses primarily on the Stanford-related issues, can be found here.)

But along with the headline-grabbing commentary on the SEC’s processes, there was also other commentary and information at the Hearing suggesting the possibility of future regulatory and enforcement actions against corporate and banking figures in response to the global financial crisis.

First, at least according to press reports, the hearing seemed to reflect political expectations, in the wake of the financial crisis, for regulators to pursue actions against corporate officials. For example, the September 23, 2010 Wall Street Journal quotes Delaware Senator Edward Kaufman as having observed at the hearing that "we have seen very little in the way of senior officers or boardroom-level prosecutions of the people on Wall Street who brought this country to the brink of financial ruin. Why is that?"

Second, the same Journal article quotes the deputy inspector general of the FDIC as saying that the FDIC is investigating 227 banks.

There undoubtedly will be further fallout from the SEC Inspector General’s report about the SEC’s handling of the Stanford investigation. But amid those details, the larger picture should not be overlooked. That is, we remain in an atmosphere of recrimination that includes a political expectation that government officials should pursue action against corporate executives in connection with the financial crisis. In this atmosphere, because of the political pressures, it seems probable that government officials will feel obliged to bring claims and pursue actions.

And while these government actions might take any number of forms, one area where regulatory and enforcement action seems probably is in the banking arena. Just as during the S&L crisis, the FDIC pursued numerous claims in response to political pressure, the FDIC may well feel the same kind of pressure in the current circumstances, and may pursue claims as a result.

All of which is a reminder that larger forces may drive claims against corporate and banking officials, possibly for years to come.

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In a series of posts, I have been exploring the "nuts and bolts" of D&O insurance. In this post, the fifth in the series, I examine D&O insurance issues of particular concern to private companies. Both the potential liability exposures and the available insurance solutions for private companies and their directors and officers are quite a bit different than for public companies.

Why Should Private Companies Buy D&O Insurance?

Most public companies don’t need to be persuaded that their company needs D&O insurance. Public company executives generally understand that D&O insurance is an indispensible prerequisite for a company whose securities are publicly traded.

However, the view among at least some private company managers is different. These officials, particularly those at very closely held companies, feel they are unlikely to need the insurance because, they believe, they are unlikely to ever have a D&O lawsuit. In my experience, just about every company that has ever had a claim was quite sure, before the claim arrived, that they would never have a claim. Executives who have survived a claim know better; too many company officials find out the hard way that when they recognize they need the insurance after all, it is too late. The fact is, the right time to buy the insurance is when you think you don’t need it.

Many of those who resist the need for D&O insurance are affiliated with companies that have only a very small number of shareholders. These company executives look at the ownership structure and conclude their company could never have a D&O claim. This perspective overlooks the fact that the plaintiffs in D&O claim include a much broader array of claimants than just shareholders. D&O claims plaintiffs also include customers, vendors, competitors, suppliers, regulators, creditors and a host of others. In our litigious age, just about anybody is a prospective claimant.

And when a company has claim, expenses mount quickly. Even frivolous suits can be expensive to defend and resolve. At the same time, the cost of insurance to protect private companies against D&O claims is relatively low. Indeed, the incremental costs of private company D&O insurance, on top of the company’s employment practices liability insurance (and no entity should do business in this country without EPL insurance) is relatively slight.

For the relatively low cost, private company D&O insurance buyers obtain coverage that is quite broad. Private company D&O insurance policies are materially broader than D&O insurance for public companies. In particular, the entity coverage under a private company D&O policy is significantly broader than the entity coverage under public company D&O insurance policies. The entity coverage in public company D&O insurance policies is generally limited just to securities claims. However, private company D&O policies contain no such limitation, so the private company D&O insurance policy provides significant balance sheet protection for the insured entities.

Because the private company D&O insurance policies provide broad coverage at relatively low cost it should be a part of every private company’s risk management portfolio – not just private companies with a broad ownership base.

Combined or Separate Limits?

A recent D&O insurance innovation is the development of modular management liability policies. These permit various management liability coverages to be combined in a single policy. The typical modular policy consists of a declarations page (identifying the limits of liability and the policy period, and so on), a general terms and conditions section applicable to all of the separate coverage parts, and then separate coverage parts for each of the various management liability coverages (such as D&O, EPL, Fiduciary, Crime, etc).

These modular policies have become quite popular. They do have certain advantages. The first is that the policies simplify the management liability insurance acquisition process by reducing what would otherwise be a series of discrete transactions into a single insurance transaction. The modular structure also ensures that the various coverages are coordinated, which could be important in the event of a claim the straddles several coverages.

The modular structure does present questions with respect to the limits of liability. Many buyers, attracted by the convenience of multiple coverages combined in a single policy are also attracted by the possibility of combining the limits of liability for the various coverages into a single, combines aggregate limit, under which a claim payment under any of the various coverages would reduce the amount of insurance remaining for a separate claim under any of the coverages.

There is no doubt that combining the limits of liability into a single aggregate limit affords costs savings for the buyer. For some insurance buyers, particularly very small enterprises, the cost saving consideration justifies the decision to structure the insurance into a single aggregate limit.

For most other enterprises, however, the combination of all of the coverages into a single limit may be a poor choice. A combined limit presents the possibility that a prior claim might reduce the amount of insurance available for a later, more serious claim. The fact is that when things go wrong, multiple problems can arise at once.

My greatest concern is that a prior unrelated claim against the company might leave company executives with insufficient remaining insurance to protect them if a separate claim later arises against them as individuals. This concern is particularly applicable in the bankruptcy context, in which company indemnification is unavailable. The executives could be left without insurance or with insufficient insurance at the time when they need it most.

I am Old School on this issue. I have a bias in favor of separate limits for the separate coverages, because I believe that there should be a fund of insurance available to protect the individual executives, without a concern that entity claims might drain the insurance away. Of course, as noted above, cost considerations may nevertheless dictate that some small enterprises will purchase combined limits. But most insurance buyers should not allow relatively small premium differences to drive important insurance decisions, potentially leaving the company with insurance that might not afford sufficient protection with the hour of need arises.

Duty to Defend or Duty to Indemnify?

Public company D&O insurance is written on reimbursement basis, based on the insurer’s duty to indemnify the insured company for its defense expenses and claim resolution costs. Under this duty to indemnify type of coverage, the insureds select their defense counsel, subject to the insurer’s consent, and the insureds control the claim. The insurer reimburses the insureds for these costs.

Private Company D&O insurance is also often written on a duty to indemnify basis. In addition, however, private company D&O insurance is also sometimes written on a duty to defend basis, under which the insurer selects the defense counsel and controls the defense. Many private company D&O insurance carriers offer their prospective insureds the choice of whether or not the coverage will be written on a duty to indemnify or a duty to defend basis.

There are certain advantages to the duty to defend structure. The first is ease of administration. Under the duty to defend coverage, the carrier appoints defense counsel and takes care of managing the claim. The policyholder doesn’t have to deal with legal bills and so on. This can be particularly helpful for smaller and more routine claims. In addition, the counsel the carrier selects often are experienced with these kinds of claims, which can also contribute to smoother claims resolution.

Another advantage of duty to defend coverage is that, in general, if any part of the claim is covered, the insurer must defend the entire claim, even those parts of the claim that are not covered. This unified defense avoids what can be a recurring problem under a duty to indemnify policy when a claim encompasses both covered and uncovered matters; in that circumstance under a duty to indemnify policy, the defense costs must be allocated between the covered and uncovered matters and the insurer reimburses only the defense expenses associated with the covered matters (often only a percentage of total defense expenses). The process of determining the allocation can be contentious and disruptive at a time when the insured and the insurer ought to be trying to work together to resolve the claim.

But despite these advantages of the duty to defend coverage, there may be times when duty to defend coverage is not the best choice. In particular, many policyholders are not comfortable having the insurer’s counsel defending a claim. This may be particularly true with more serious and more sophisticated litigation, which some insureds feel are outside the capabilities of some insurer-selected defense counsel. Also, although the topic involves issues far beyond the scope of this blog post, a host of issues arise when the insurer is defending a claim subject to a reservation of rights to deny coverage for any settlements or judgments.

There are no absolute answers to the question whether the D&O coverage should be written on a duty to defend or a duty to indemnify basis. It is a question each insurance buyer must decide in consultation with their insurance adviser.

One innovation the D&O insurance industry has introduced in recent years is an optional duty to defend policy, which gives the policyholder the option of tendering the claim defense to the carrier at the outset of the claim. The advantage of this arrangement is that it allows the policyholder to let the carrier handle the smaller or more routine matters, while allowing the company to select its own counsel and manage its defense on more significant matters or matters of greater concern to the company.

Public Offering Exclusion

The critical distinction between private and public companies is that public companies have publicly traded securities and private companies do not. Private company D&O insurers do not intend to cover exposures arising from the issuance or subsequent trading of publicly traded securities, and so private company policies typically have a public offering exclusion.

One particular concern with this exclusion is that it should not be written so broadly that it would preclude coverage for claims arising from pre-IPO activities. If a company is preparing to go public, the company and its senior executives undertake a variety of activities that may create potential liability exposures. If the company ultimately goes public, the public company D&O insurance policy, put in place on the offering date, should pick up coverage for all claims arising from the offering related activities. However, if the company does not complete the offering and claims result, or if offering activity claims arise prior to the offering date, then private company policy is the one that will respond to the claims.

Because of the heightened claims exposure associated with pre-offering activities, it is critically important that the public offering exclusion is worded in a way to afford coverage for these kinds of claims. Unfortunately, this is an area where there is a significant and serious lack of uniformity in available wordings, and many of the wordings available are not well-designed to provide the full extent of coverage needed. For example, many carriers, in an attempt to address this concern, will include a so-called "roadshow carve back" from the securities offering exclusion. These wordings, while helpful, are not sufficient to address all of the potential pre-IPO exposures, because pre-offering problems might arise that have nothing to do with the roadshow.

The concerns arising in connection with coverage for pre-IPO activities is a good illustration of the unavoidable fact that even with respect just to private company D&O, it is critically important for insurance buyers to associate knowledgeable and experienced insurance advisors in the insurance acquisition process. Otherwise the insured could wind up with D&O insurance coverage that is not well suited to the company’s needs and exposures, and that does not reflect the best coverage available in the marketplace.

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

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When the U.S. Supreme Court issued its ruling earlier this year in the Merck case pertaining to the question of what triggers the running of the statute of limitations in securities cases, there was some speculation that the decision might encourage an influx of cases involving events from the distant past. There really have not been that many cases that seemed to have been filed in reliance on Merck -- at least not until now.

A case filed late last week, in which the class period cutoff date is over three years past, seems to represent a pretty clear example of a filing made in reliance on Merck, and may suggest both the kinds of filings that Merck may encourage and also the problems these cases may present.

Just to review, in its April 2010 decision in Merck, the U.S. Supreme Court held that the statute of limitations for cases under Section 10(b) is not triggered until the claimants have, or with reasonable diligence could have had, knowledge of the facts constituting the violation, including in particular facts constituting scienter.

According to their September 17, 2010 press release (here), plaintiffs’ lawyers’ have filed an action in the District of Idaho against PCS Eduventures!.com, its CEO and its former CFO. Though the complaint (a copy of which can be found here) was only just filed last week, the lawsuit purports to be filed on behalf of investors who purchased the companies’ shares between March 28, 2007 and August 5, 2007 – a period that ends more than three years before the complaint was filed.

The gist of the complaint is that on March 28, 2007, the company announced that it had entered a license agreement with its Mideast distributor, PCS Middle East, for a fixed license fee of $7.15 million. However, the complaint alleges that PCS Middle East did not have the ability to pay the fee without first entering a contract with the Saudi Arabian government. PCS did not have a contract with Saudi Arabia, and the complaint alleges that "PCS officers knew there was no contract."

The reason that the class period cuts off in August 2007 is that on August 15, 2007, after several months worth of disclosures about the Saudi arrangement or reflecting the revenue from the arrangement, the company issued an "update" clarifying that while the company had relied on their Mideast distributor’s assurances that a contract was "imminent," in fact, the company was "unable to confirm a timeframe or other specifics regarding any such contract" and the company’s managers "do not know when our Company will be called upon to participate in the initiative through our independent licensee."

The complaint anticipates the statute of limitations issue by alleging that "it was not until August 26, 2010, when the SEC instituted a civil action against PCS and others, did [sic] any reasonable investor could have reasonably suspected that Defendants’ misstatements about its purported $7.5 million sales contract were made with scienter."

The SEC’s August 30, 2010 press release regarding its enforcement action can be found here and the SEC’s amended enforcement complaint against PCS and its CEO and former CFO can be found here.

According to the SEC’s complaint, in March 2007, the company’s Mideast representative had been promising the Saudi contract for months, at a time when the company also faced the looming possibility of missing its EBIDTA requirements in one of its loan covenants. The SEC alleges that the company concocted the license fee arrangement with its Mideast distributor as a way to come up with revenue to satisfy the EBITDA requirement.

The company booked the fee as revenue in March 2007, even though the distributor could not pay the fee until there was a Saudi contract. The SEC alleges that the company’s officers "knew there was no contract with Saudi Arabia." The SEC also alleges that in the absence of the contract, the company lacked an appropriate basis to recognize the fee as revenue, a fact of which the SEC also alleges company management was aware.

Discussion

Because the investor complaint was filed more that three years after the August 2007 "update," the complaint would appear to be untimely, unless the plaintiffs succeed in persuading the court that the statute of limitations was not triggered until the SEC filed its complaint more than three years later, in August 2010.

The U.S. Supreme Court held in Merck that the statute of limitations is not triggered until the claimant has knowledge of the facts constituting the violation, including the facts constituting scienter. The plaintiffs expressly allege in their complaint that until the SEC initiated its enforcement action, they were unaware of the facts constituting scienter – that is, that the PCS officials knew all along there was no Saudi contract.

The defendants undoubtedly will argue that the plaintiffs could have with reasonable diligence uncovered the facts constituting the violation, and indeed the company’s mealy-mouthed August 2007 "update," which uses a lot of words to explain the simple facts that there was no Saudi contract and there never had been a Saudi contract, should have set off some alarm bells.

The defendants will argue in particular that the August 2007 update specifically noted that the company had only been told that the Saudi contract was "imminent" and had been "unable to confirm the timeframe or other specifics regarding any such contract" – meaning that even back in March, when the company booked the fee revenue, the company lacked specifics regarding the contract, which suggests that the company lacked the minimum necessary to recognize the fee as revenue, and that the company clearly was as aware in March as it was in August that it lacked sufficient specifics to support recognition of the revenue.

It will be interesting to see how this case unfolds. At a minimum, the lawsuit’s filing does demonstrate the troublesome potential of the Merck decisions to encourage the pursuit of litigation over long-distant events.

The problem is that this possibility creates significant uncertainty about when events in the past so long gone that companies can be sure that they are "out of the woods" about past problems. This is also a serious problem for D&O insurance underwriters trying to assess the risk associated with companies that have had problems in the past. If cases like this one go forward, underwriters will be compelled to extend their scrutiny of a particular company far into the past, with no sure way of knowing how far back is far enough. This uncertainty poses a challenge for companies and underwriters alike.

One final question has to do with the SEC’s action. I am not sure of theory on which the SEC will show that its action was timely, a question that presents its own separate set of issues and that will have to be worked out as the enforcement action goes forward. I welcome readers thoughts on the statute of limitations issues.

More Bank Failures: In case you missed it, the past Friday evening after the close of business, the FDIC took control of six more banks, bringing the 2010 year to date total number of bank failures to 125. The 2010 pace of bank closures continues to run well ahead of the pace in 2009, when the FDIC closed 140 banks. Bank closure number 125 in 2009 did not occur until December.

Among the six banks closed this past Friday night were three more Georgia banks. Since January 1, 2008, there have been 44 bank failures in Georgia, the highest total for any state during that period. However, the 14 bank failures in Georgia so far in 2010 represent only the third highest state total this year, behind Florida (23) and Illinois (15).

The Coolest Time-Waster Website Ever: Check out the Global Genie. When you click on the "Shuffle" button, the site displays a Google Earth view of some random location somewhere on five continents (Antarctica and for some reason South America are not included). Each location is helpfully identified by an accompanying Google Map. The "Shuffle" button quickly becomes addictive.

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On September 14, 2010, in another ruling that the U.S. Supreme Court’s decision in Morrison v. National Australia Bank precludes claim by "f-squared" claimants – that is, U.S. residents who purchased shares of a Non-U.S. company on a foreign exchange – Southern District of New York Judge Victor Marrero dismissed the claims of investors who purchased their Alstom shares on the Euronext exchange from the long-running Alstom securities class action lawsuit. A copy of Judge Marrero’s opinion can be found here.

In reaching his conclusion, Judge Marrero rejected an argument that plaintiffs in Vivendi and other cases have raised to try to salvage claims of those who purchased their shares on foreign exchanges – that when non-U.S. companies have "listed" their shares on U.S. exchanges, investors who purchased their shares outside the U.S. can still assert securities claims under U.S. law in U.S. courts.

Background and Decision

Investors first sued Alstom and certain of its directors and officers in the U.S. in 2003. Discovery in the case in now complete and the parties face a November 12, 2010 deadline for filing summary judgment motions.

On July 29, 2010, two days after he issued his opinion precluding f-squared claimants’ claims in the Credit Suisse case (about which refer here), Judge Marrero directed the plaintiffs in the Alstom case to show cause why the "claims of plaintiffs who purchased their shares on foreign exchanges should not be dismissed."

The plaintiffs’ response, Judge Marrero noted, "went far beyond the limited direction of scope the court’s direction." In any event, Judge Marrero rejected both of the arguments on which the plaintiffs sought to rely.

First, Judge Marrero rejected the plaintiffs’ argument that because the Euronext purchases of Alstom shares had been "initiated" in the United States, they represented "domestic transactions" as required by Morrison. In rejecting this argument, Judge Marrero cited his own prior opinion in the Credit Suisse case.

Second, Judge Marrero also rejected the plaintiffs’ argument that because Alstom shares are "listed" on the NYSE, the claims of purchasers who acquired their shares anywhere in the world are cognizable under the U.S. securities laws. Judge Marrero described this argument as a "selective and overly-technical reading of Morrison that ignores the larger point of the decision."

With respect to the specific portions of Morrison on which the plaintiffs sought to rely in making this argument, Judge Marrero said these excerpts "read in total context" compel a result contrary to that urged by plaintiffs. The Morrison opinion, Judge Marrero said, taken as a whole, "reveals a focus on where the securities transaction actually occurs," adding that the Morrison court was "concerned with the territorial location where the purchase or sale was executed."

Judge Marrero added that the conclusion "that the transactions themselves must occur on a domestic exchange to trigger application of Section 10(b) reflects the most natural and elementary reading of Morrison."

Finally, Judge Marrero rejected the plaintiffs’ suggestion that he should retain "supplemental jurisdiction" over the claims of the foreign purchasers and apply French law to their claims, noting that the case has been pending for seven years exclusively under U.S. law and "plaintiffs have not given any indication that the French claims were unavailable when they began this action and the Court is not now persuaded they should be allowed to press the reset button here."

Discussion

The second argument the plaintiffs raised – that is, because Alstom’s shares are "listed" on a U.S. exchange, the U.S. securities laws extend to transactions in the company’s shares taking place outside the U.S. – has been raised by plaintiffs in a number of pending securities cases involving non-U.S. companies. For example, and as detailed at length in a guest post on this blog (refer here), the Vivendi plaintiffs are relying on this argument to try to preserve their claims against foreign purchasers in that lawsuit.

According to Andrew Longstreth’s September 16, 2010 article in the Am Law Litigation Daily (here), Judge Marrero’s order in the Alstom case "appears to be the first decision to address the various plaintiffs’ "controversial interpretation" of Morrison.

Judge Marrero’s rejection of the plaintiffs’ listing argument is categorical. However, his ruling binds no other judges, not even other Southern District judges. Whether his interpretation of Morrison prevails in other cases before other judges remains to be seen.

In that regard, it is worth noting that though there are now two high-profile decisions holding that Morrison precludes the claims of "f-squared" claimants, both of the opinions were written by Judge Marrero – indeed, he even quoted his first opinion in the second one.

But though the plaintiffs’ lawyers in many other pending cases involving claimants who purchased their shares outside the U.S. may continue to limit Morrison’s effects in order to preserve those claims, the arguments look increasingly challenging.

The stakes involved in many of these cases are enormous. Indeed, the Am Law Litigation Daily article linked above quotes defense counsel in the Alstom case as saying that Judge Marrero’s decision "cuts the potential damages by 95 percent."

Looking retrospectively, some of the largest U.S. securities lawsuit settlements involving foreign companies likely would have worked out substantially differently were all claims based on overseas purchases precluded. For example, as reported in NERA’s Mid-Year 2010 securities litigation study, in the $1.1 billion Royal Ahold settlement (the seventh largest settlement of all time), 97.6% of all trading volume during the class period took place on foreign exchanges.

The elimination of these claims from U.S. securities suits not only potentially narrows the putative aggregate class damages dramatically in cases involving non-U.S. companies, but it also could make future cases against some non-U.S. companies substantially less attractive to plaintiffs’ counsel than they might have been in the past.

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 A lawsuit brought by investors who had purchased securities in three ING Group bond offerings in 2007 and 2008 was largely dismissed in a ruling issued Tuesday, although some allegations regarding the company’s June 2008 offering disclosures did survive.These rulings appeared in a September 14, 2010 order written by Southern District of New York Judge Lewis Kaplan. A copy of his ruling can be found here.

As discussed at greater length here, the ING bond investors first filed their action in February 2009. The allegations related to three ING bond offerings, in June 2007, September 2007, and June 2008, respectively, in which the company raised a total of $4.5 billion. The defendants include the company and two affiliated entities and certain of its directors and officers, as well as the offering underwriters.

The allegations in the plaintiffs’ complaint, as amended, relate to disclosures in the offering documents concerning ING’s own investments in Alt-A and subprime residential backed mortgages, which the plaintiffs allege were "extremely risky," because material portions of the loan pools on which they were based were comprised of lowest quality mortgages. The defendants moved to dismiss.

In his September 14 order, Judge Kaplan addressed each of the three offerings separately, dismissing all of the allegations regarding the June 2007 and September 2007 offerings, and many of the allegations with respect to the June 2008 offering. However, Judge Kaplan denied the motion to dismiss with respect to one part of the allegations concerning the June 2008 offering.

First, Judge Kaplan dismissed the allegations regarding the June 2007 offering on the grounds that they were untimely. Essentially, Judge Kaplan held that information contained in the September 2007 offering documents contained "storm warnings" that were sufficient to put the June 2007 bond offering investors on "inquiry notice," and since the plaintiffs first complaint was not filed until February 2009, more than a year later, the claims were untimely.

With respect to this ruling, Judge Kaplan added that "the facts placing one on inquiry notice need not detail every aspect of the fraudulent scheme, but only enough in the totality of circumstances to establish a probability of the alleged claim," adding that here, "these disclosures did so."

Second, with respect to the September 2007 offering, Judge Kaplan noted that the plaintiffs’ allegations largely relied on industry-wide or market-wide troubles, some of which post-dated the offering. Judge Kaplan said, quoting Twombley, that "absent some factual allegations suggesting that ING assets had been impacted by the general market conditions as the time allegedly misleading statements were made, [the complaint] stops short of the line between possibility and plausibility" that the offering documents were "misleading in a way that required additional disclosures."

Third, Judge Kaplan also granted the defendants’ motions to dismiss with regard to the June 2008 offering in many respects, in particular dismissing the allegations that the offering documents failed to disclose certain loan and loan-backed asset impairments, holding that the impairments themselves were immaterial.

However, Judge Kaplan denied the motion to dismiss with respect to the plaintiffs’ allegations that the offering documents misleadingly described the company’s mortgage-backed assets as "near prime and of high quality" and that the company was "well insulated from the worst effects of the market turmoil." Judge Kaplan found that the complaint’s allegations "sufficiently allege a connection between the general market conditions and ING’s assets" to "plausibly suggest" that "ING’s assets in June 2008 were ‘extremely risky’ and that could impact the company’s performance."
 

The defendants had argued that the statements were immaterial, a question Judge Kaplan described as a "close call." He observed that the offering documents disclosed "in some detail" the risks the assets posed, but he found that these disclosures were sufficiently "undercut" by other statements, as a result of which he could not conclude as a matter of law that a reasonable investor would find the omitted disclosure immaterial.

Discussion

Judge Kaplan’s ruling in the ING case is the latest in a series of recent decisions where plaintiffs have suffered full or substantial setbacks in their claims pertaining to the defendant company’s exposures to subprime-mortgage loans and mortgage loan backed assets. Judge Kaplan’s methodical opinion demonstrates that while it is not impossible for plaintiffs to survive dismissal motion in these cases, it is difficult.

The ING case is interesting in part because of the defendant company itself. Later in 2008, after the offerings that were the basis of this lawsuit, the Dutch government made a capital infusion into ING to the tune of 10 billion euros (about $13 billion). Judge Kaplan’s opinion references the bailout, although he ultimately concluded that the later events had not been alleged to have any connection with the earlier offering document disclosures.

Judge Kaplan’s analysis seems to suggest that even though a company may have received a bailout – even a massive bailout – does not mean that claims of securities fraud will not be scrutinized, and a later bailout by itself may mean little with respect to the question whether earlier statements were misleading.

It does seem that the dismissal motion rulings in the subprime and credit crisis-related cases are continuing to run against the plaintiffs. To be sure, a portion of the ING case will be going forward, and I know the name of the game for the plaintiffs is just to live for another day. But all but a small part of this case got knocked out, as seems to have been the case in many recent rulings.

I have in any event added the ING decision to my running tally of subprime and credit crisis dismissal motion rulings, which can be accessed here. Because the dismissal motion was denied at least in part, I added it to the motions denied table.

Special thanks to a loyal reader for providing a copy of the ING ruling.

Don't Throw Stones: ING may have the oddest corporate headquarters of any company in the world. The building basically looks like a giant glass and steel baskeball shoe on stilts. It is hard enough to imagine any designer having the sheer audacity to present this thing to a client that presumably paid a lot of money for the design. It is even harder to imagine a room full of people saying,, "That's it! That is exatly the image we were looking for." Perhaps the next project for the team that selected the design was to develop a strategy for getting the bank into U.S. residentail mortgage investments.  

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In the latest ruling to address the pleading adequacy of a securities suit based on a financial institution’s loan loss reserve disclosures, a federal judge has found that the plaintiffs’ allegations in the SunTrust Trust Preferred Securities lawsuit were not sufficient to state a claim under the securities laws. Northern District of Georgia Judge William Duffey, Jr.’s September 10, 2010 decision (here) , which granted the defendants’ dismissal motions without prejudice, may be particularly noteworthy because it found that the plaintiffs’ allegations were not sufficient even to meet the ’33 Act’s pleading standard.

As discussed at greater length here, the complaint relates to SunTrust’s February 2008 offering of Trust Preferred Securities. The defendants include SunTrust and certain of its directors and officers, as well as the offering underwriters and SunTrust’s outside auditor.

The complaint alleges that the offering documents underestimated SunTrust’s allowance for loan and lease loss reserves (ALLL). The plaintiffs allege that the bank failed to disclose its mortgage-related exposures, and accurately account for losses in those assets and their impact on the bank’s liquidity and capital adequacy. The complaint alleges that as the housing market collapsed, SunTrust failed to increase its ALLL to account for the rise of non-performing loans from the fourth quarter of 2007 to through the end of 2008. The defendants moved to dismiss.

In his September 10 order, Judge Duffey noted that the plaintiff’s allegations depend on their assertion that after the offering, and after the housing market deteriorated further, SunTrust raised its ALLL. The plaintiff, Judge Duffey observed, “thus seeks to assert its Securities Act claims using a backward-looking assessment that interprets, in the context of later events, the statements that Plaintiff has identified” as misleading.

Moreover, whether SunTrust had adequate loan loss reserves “is not a matter of objective fact, but rather a statement of SunTrust’s opinion regarding what portion of its loan portfolio would be uncollectable.” Judge Duffey commented that “Plaintiff only asserts that Sun Trust’s opinion with respect to its loan reserves was ill-founded and proved so by a later course of events.”

Judge Duffey noted that the plaintiff does not allege that the defendants did not hold the opinion it expressed in the financial statements when they were issued, and that “absent an allegation that the Defendants did not believe the statements,” the plaintiff has not stated a claim for misstatements relating to the inadequacy of the loan reserves.

Judge Duffey added that while he would allow the plaintiff to attempt to replead its loan loss reserve allegations, it will have to meet the heightened pleading standards required if the amended complaint alleges that the defendants knowingly or recklessly cause material misstatements to be published. He added that in the current complaint the plaintiff “appears to be attempting to have it both ways, that is, disavowing a claim for fraud to avoid the need to meet the heightened pleading standard, at the same time suggesting that SunTrust’s stated opinion was false because SunTrust knew or should have known that it was undercapitalized.”

Judge Duffey also found that the allegations in the complaint “fails to provide minimal factual content” to meet the requirements of Twombly and Iqbal, noting that the complaint “offers, at most, conclusory assertions, including that SunTrust’s ALLL and loan loss provisions were understated, as evidenced by the fact that SunTrust subsequently raised these figures after the economic downturn.” This “hindsight assessment” does not support an inference that “SunTrust’s financial assessments were false or misleading at the time they were made.” (emphasis in original).

Judge Duffey also granted the underwriter defendants’ and auditor’s motions to dismiss.

Discussion

Prior decisions granting dismissal motion rulings in loan loss reserve cases have depended on the insufficiency of the complaint’s allegations relating to ’34 Act claims, particularly with respect to scienter. Refer, for example, to my recent post (here) discussing the dismissal of the loan loss reserve disclosure case involving Raymond James Financial.

The SunTrust Trust Preferred Securities case may be noteworthy because the loan loss reserve allegations were found to be insufficient event to satisfy the requirements for a ’33 Act claim, which do not have a scienter requirement. From Judge Duffey’s opinion, and his statement that the plaintiff may have been “trying to have it both ways,” the plaintiffs may have walked too fine of a line in trying avoid having their claims sound in fraud.

Judge Duffey’s firm rejection of what he interpreted as the plaintiff’s hindsight allegations is also interesting. The plaintiffs in many loan loss reserve cases will be fighting similar judicial impressions, especially to the extent that they plaintiffs cannot marshal facts suggesting that the defendants knew the loan loss reserves were insufficient.

Judge Duffey’s rejection of hindsight allegations may also be significant simply because of where his court is located. Georgia has been the leading state for bank failures since January 1, 2008, and many investors have filed actions alleging they were misled regarding the defendant bank’s financial conditions. To the extent Judge Duffey’s rejection of hindsight analysis reflects a larger sense of skepticism about alleged misrepresentations in the context of the subprime meltdown and global financial crisis, many of these investor actions could face an uphill battle.

In that regard, it is worth noting that Judge Duffey’s opinion follows the highly skeptical August 19, 2010 opinion of Judge Tom Thrash in the separate SunTrust subprime securities lawsuit, filed on behalf of SunTrust’s common shareholders. As discussed in a prior post, the opinion was particularly noteworthy for the harshness of the tone Judge Thrash used in dismissing the case. Though Judge Duffey’s opinion lacks the harsh tone, it seems to evince a similar level of skepticism.

Finally, it worth noting that the SunTrust Trust Preferred Securities case is one of numerous lawsuits filed amidst the subprime and credit crisis litigation wave that related to financial institutions’ trust preferred securities offerings, as discussed here. As noted in my prior post, many banks conducted these kinds of offerings in the years leading up to the financial crisis, and investors in these offerings have been active in seeking judicial relief following the meltdown.

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

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Even though substantial parts of the case have been knocked out, at least one part of the auction rate securities case filed against Raymond James Financial and related entities has survived a renewed dismissal motion, making it the first of the auction rate securities cases to survive the preliminary motions – even if it only did so in limited part.

The ruling came in a September 2, 2010 order (here) from Southern District of New York Judge Lewis Kaplan. A September 8, 2010 Bloomberg article by Thom Weidlich about the ruling can be found here.

As detailed here, the plaintiffs sued Raymond James and two of its operating subsidiaries alleging that the defendants engaged in a scheme to defraud auction rate securities investors by knowingly misrepresenting the securities as highly liquid investments. The plaintiffs purport to represent investors who purchased the securities between April 8, 2003 and February 13, 2008.

As discussed at length in a prior post, in September 2009, Judge Kaplan granted the defendants’ motions to dismiss the plaintiffs’ initial complaint, holding that that the plaintiffs had failed specifically to attribute the allegedly actionable statements to any defendant and to plead with particularity any defendants’ scienter. The dismissal was without prejudice, and the plaintiffs subsequently filed an amended complaint. The defendants renewed their dismissal motions.

In his September 2 order, Judge Kaplan granted the defendants’ renewed motions as to all of the plaintiffs’ renewed claims, with one exception. That is, he found that the plaintiffs had adequately alleged both scienter and misrepresentation with respect to part of the Section 10(b) claims against one of Raymond James’ operating units, Raymond James & Associates (RJA). The claims against Raymond James itself and the other operating unit defendant, as well as the other claims against RJA, were otherwise all dismissed.

In attempting to allege that RJA had acted with scienter, the plaintiffs had argued that the unit was motivated, following turmoil in the auction rate securities market in 2007, to try to unload its own inventory of the securities, and that in fact it had provided its broker with financial incentives to sell those securities. Judge Kaplan found that these allegations were insufficient to establish scienter prior to November 2007, but "the period November 2007 through February 2008 stands differently."

Judge Kaplan said, with respect to that later period, that "given the deterioration of the ARS market that began in August 2007 and RJA’s wish to reduce its own position from November 2007 forward, it is quite reasonable to infer that RJA then had a motive to conceal the ARS liquidity risk from customers to whom it hoped to sell ARS from its own portfolio." Judge Kaplan held that the plaintiffs had adequately alleged scienter as to RJA for the period November 2007 through the end of the class period in February 2008.

Judge Kaplan also found that actionable misrepresentations had been made to one of the plaintiffs by an RJA broker. The amended complaint alleged that the broker had told the plaintiff that ARS were safe, liquid investments. However, the amended complaint further alleges that the broker did not tell the plaintiff that the appearance of a liquid market for the securities was only maintained by "extensive and sustained" interventions in the market place by various broker dealers.

Judge Kaplan said that "a trier of fact would be entitled to find that it would have been important to a reasonable investor, in deciding whether to buy or sell ARS, that the ARS – supposedly liquid investments – were liquid only because auction brokers routinely intervened in the auctions to ensure their success. Accordingly, RJA was under a duty to disclose this information."

Judge Kaplan rejected the plaintiffs’ allegations that the specific alleged misrepresentations made by individual brokers to the named plaintiffs were part of a larger scheme to defraud. As Judge Kaplan noted, other than with respect to the two brokers who interacted with the named plaintiffs, the amended complaint "does not allege any specific statement made to any investor."

In the absence of scheme allegations, the claims on behalf of an investor class may prove challenging, as the only supposed misrepresentations that survived the motion to dismiss were made only to one of the named plaintiffs and not to the class the plaintiffs are purporting to represent. Accordingly, the plaintiffs may yet face significant challenges even on the claims that survived, particularly at the class certification stage.

Nevertheless, even if narrow, Judge Kaplan’s ruling is noteworthy, as it represents the first occasion in an auction rate securities case in which a court has held that a plaintiff has adequately alleged misrepresentation and scienter.

The case against Raymond James may be somewhat distinct from the cases that had been pending against other large investment banks. In many of those cases, the defendant firms had separately entered regulatory settlements for the benefit of many of their auction rate securities investors. These regulatory settlements had served as the basis for dismissal of the auction rate securities cases pending against these banks, including for example the cases pending against UBS (refer here) and Northern Trust (refer here).

Raymond James, by contrast to these other firms, had not entered a regulatory settlement involving its investors. Indeed, the firm has been the target of certain high profile criticism (refer here) as a "holdout" for its resistance to entry into a regulatory settlement. Without a regulatory settlement, Raymond James was not able to move for dismissal on the same "absence of recoverable damages" theory as did the defendants in the Northern Trust and UBS cases.

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

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In a series of posts, I have been exploring the "nuts and bolts" of D&O insurance. In this post, the fourth in the series, I examine issues surrounding the application for D&O insurance and the surrounding application process. Although this might seem like a pretty straightforward topic, there are actually quite a few issues involving the D&O insurance application.

The Policy Definition of "Application"

As with most insurance, D&O insurers usually require insurance applicants to complete an insurance application as part of the insurance acquisition process. The D&O insurance application is of course a physical document – but it is not just a physical document. The term "application" is usually defined to comprise several categories of materials beyond just the physical document.

The term "application" is often defined broadly to include all prior applications the applicant previously submitted; all materials submitted with the application; and, in the case of public companies, all documents filed with the SEC or equivalent regulatory bodies. These policy definitions of the term "application" are sometimes unnecessarily overbroad and need to be narrowed to avoid sweeping in an entire universe of information that has no reasonable relationship to the actual application process. For example, many carriers will agree to revise the category of publicly filed documents to be included within the "application" to be narrowed to documents filed within the preceding twelve months.

The Application Form Itself

With respect to the physical application document itself, there is a further question of which application form an insured appropriately may be asked to complete and submit. Specifically, there is an important difference between the questions that appropriately may be asked when new coverage is being placed (or increased limits are being procured), compared to what appropriately may be asked when existing coverage is being renewed.

When new coverage or increased limits are being put in place, the insurer appropriately can ask the so-called "warranty question" – that is, whether the applicant is aware of any fact, situation or circumstances that might reasonably be expected to give rise to a claim. (The actual wording of the representation required varies among insurers and applications.) Any matters disclosed pursuant to the warranty statement will be excluded from coverage.

Because the policyholder is entitled to expect complete continuity of coverage in successive policy years, the warranty question emphatically is not appropriate in connection with the renewal of existing coverage.

Unfortunately, process participants sometimes use applications including the warranty question even in connection with renewals of existing coverage. The problem with providing an answer to the warranty question on renewal is that it potentially can provide the carrier with a basis on which to try to disclaim coverage, when the question should not even have been asked or answered in the first place. (In a previous post, here, I discussed a case in which a carrier successfully relied on this defense to disclaim coverage, in a situation where it fairly may be asked whether the policyholder should have answered the warranty question in the first place.)

Application Misrepresentations and the Consequences

This whole question of the carrier seeking to rely on application responses to disclaim coverage leads to the larger question of policy rescission – that is, the question of when the carrier may, on the basis of alleged material misrepresentations in the policy application, seek to have the policy declared void ab initio – that is, as if it had never been put in place. There are several components of this question, each one raising important considerations in connection with the wording of key policy terms and conditions.

The first issue of course is what the application consists of, as noted above. The second question is whose alleged misrepresentations may be relied on by the carrier and against whom may they be used.

The Representations Clause

Many policies will specify in a representations clause whose knowledge of the mispreresented facts will result in a vitiation of coverage. For example, the policy might specify that if certain top company executives are aware that application statements were untrue, then coverage will not apply to those executives or to the company. Because the operation of the representaitons clause could void coverage for the company, it is critical that the group of persons who knowledge will void coverage for the company be restricted and as narrow as possible, preferably just the CEO, CFO and General Counsel.

Nonimputation and Severability

Two related issues pertain to questions of imputation and severability. The question is basically whether one individual’s knowledge will be imputed to the company or to other individuals. As noted in the preceding paragraph, certain officials’ knowledge will be imputed to the company. But ideally, the policy terms will be structured so that no individual’s knowledge is imputed to another individual – or to put it another way, that each individual’s knowledge is severable from that of other individuals. (Please see the note below discussing the difference between this type of severability – that is, application severability – from a different type of severability that may arise under the D&O policy—that is, exclusion severability).

The inclusion within the policy of a provision of so-called "full severability" (that is, the specification that no individual’s knowledge will be imputed to another individual for purposes of determining the effect of an application misrepresentation) is critical in order to ensure that coverage for innocent insureds remains unimpaired.

Policy Rescission and Claim Exclusions

The final question that should be asked about policy provisions pertaining to application misrepresentations is the issue of what the consequences of an application misrepresentation will be. As noted above, absent policy provisions providing otherwise, the carrier may seek to rely on application misrepresentations as a basis on which to rescind the policy. From the policyholder’s perspective, policy rescission is highly undesirable on many levels, not least of which is that the voiding of the policy means not only that coverage will be unavailable for the specific matter at hand, but also for any and all future matters that might arise.

In light of this latter consideration, many carriers will agree to amend their policies so that in the event of an alleged application misrepresentation, policy coverage is unavailable only for persons aware of the misrepresentation and only with respect to claims pertaining to the allegedly misrepresented matter. This formulation allows for the possibility that coverage might be available for future matters that might arise, even if it is not available for certain persons in connection with the immediate matter at hand.

Non-rescindable Policies

In addition, in many instances, carriers are willing to incorporate provisions specifying that the policy is nonrescindable. In some cases, the policy may provide that it is nonrescindable only as to Side A coverage (that is, the coverage protecting the individuals in the event that corporate indemnification is unavailable due to insolvency or legal prohibition). In other cases, the policy may be fully nonrescindable.

Completing the Application and Polling the Board

As noted above, there are times when it is undeniably appropriate for the carrier to ask the warranty question. The issue for the applicant company is how to answer the question in a way that will need lead to problems down the road. The applicant obviously wants to make sure that all known circumstances are disclosed, so that coverage is not later impaired if it later turns out that there were known circumstances that were not disclosed.

In order to address this issue, the applicant company should poll its senior executives and board members, in a process that communicates the importance of the inquiry. The polling process and responses to the survey should also later serve to substantiate the fact that the applicant company took reasonable steps to determine whether or not any person was aware of any fact, circumstance or situation.

Two Different Kinds of Severability

As noted above, in an appropriately structured policy, no person’s knowledge will be imputed to any other person for purposes of determining the scope and effect of any alleged misrepresentations. This non-imputation is sometimes referred to as "full severability." This type of application severability is separate and distinct from another type of severability that operates in many D&O policies.

That is, many D&O policies contain provision, typically at the end of the exclusions section, in which it is provided that for purposes of determining the operation of the policy exclusions, no individual’s conduct will be imputed to any other individual. This "exclusion severability" is analytically separate and distinct from "application severability" but the similarity of the names can sometimes be confusing. Both types of severability are critically important but they are dealt with in separate parts of the policy and they must be addressed separately.

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

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Every fall since I first started writing this blog, I have assembled a list of the current hot topics in the world of directors’ and officers’ liability. This year’s list is set out below. As should be obvious, there is a lot going on right now in the world of D&O, with further changes just over the horizon. The year ahead could be very interesting and eventful. Here is what to watch now in the world of D&O:

1. What Impact Will Dodd-Frank Have on D&O Liability?: The massive Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, which Congress enacted this past July, represents the most significant reform of financial regulation in decades. It will affect virtually every aspect of our financial system. However, exactly what the impact will be and how that might affect the liability of directors and officers remains to be seen.

Among the few things that are clear at this point is that some of the proposed reforms were not incorporated into the final version of the Act. Thus, for example, the law did not, as was proposed, legislatively overturn the U.S. Supreme Court’s decision in Stoneridge and enact a private right of action for aiding and abetting. The Act also did not incorporate a proposed legislative provision that would have extended the extraterritorial jurisdiction of the U.S. securities laws in cases brought by private litigants. (The Act did include a provision regarding the SECs extraterritorial jurisdiction, however).

One reason that the Act’s ultimate implications remain unclear is that much of the work still remains to be done. The Act calls for more than 240 rulemaking efforts and nearly 70 studies by 11 different regulatory authorities. Most of the details of the key provisions, and the ways those provisions will be implemented, remain to be spelled out by the various regulators in the months ahead.

But though much of the picture has yet to be fleshed out, there are certain provisions that clearly will impact directors and officers, even if the ultimate effect is uncertain. First, the Act provides rules regarding executive compensation and corporate governance generally applicable to U.S. public companies, including requirements on shareholder "say on pay;" broker discretionary voting; compensation committee independence; executive compensation disclosures; executive compensation "clawbacks;" disclosure regarding employee and director hedging; disclosures regarding Chairman and CEO structures; and shareholder proxy access.

These provisions do not expressly create new causes of action against directors and officers, but they do create a host of new obligations that undoubtedly will drive shareholder expectations. The probability of claims arising from these new requirements seems high, particularly with respect to the new disclosure requirements.

Among the specific parts of the Act that also seem particularly likely to lead to future claims are the new whistleblower provisions. The whistleblower provisions include the creation of a new whistleblower bounty pursuant to which individuals who bring violations of securities and commodities laws to the attention of the Securities and Exchange Commission or the Commodities Futures Trading Commission will receive between 10 percent and 30 percent of any recovery in excess of $1 million.

Many commentators have predicted that these incentives could lead to a dramatic increase in complaints of accounting misconduct, corrupt practices, and other violations. (The specific possibilities for increased reporting related to the Foreign Corrupt Practice Act are discussed below.) The likely increased enforcement activity also seems likely to generate a related upsurge in follow-on civil litigation, as the underlying violations are disclosed.

There are many ways that the impact of Dodd-Frank Act can be anticipated or at least conjectured, but the Act’s overall impact and significance wil only become apparent over the long haul. At 2,319 pages, the Act’s scope is so sweeping that many of its specific implications inevitably will reveal themselves only with the passage of time. Be prepared for years of commentaries about the Act that begin "Though the provision was little-noticed at the time that the Dodd-Frank Act was enacted, …" In the meantime, the laws of unintended consequences will be hard at work.

2. What Happens Next with the Subprime and Credit Crisis-Related Litigation Wave?: For several years beginning in 2007, corporate and securities litigation was largely driven by lawsuits arising out of the subprime meltdown and the global credit crisis. Beginning in the second half of 2009, the litigation wave began to lose steam, and the related lawsuits dwindled as we headed into 2010.

But while the pace of new lawsuit filings has dwindled, new filings have not entirely gone away. Even now, well into 2010, the credit crisis-related lawsuits continue to arrive (although as time goes by, it become harder and harder to maintain absolute definitional certainty around what makes a particular case "credit crisis-related."). By my count, there have been as many as 19 new subprime and credit crisis related lawsuits filed during 2010, out of approximately 104 new securities class action suits so far this year (as of September 3, 2010).

In the meantime, the vast amount of litigation that accumulated over the last four years continues to work its way through the system. There have been over 220 subprime and credit-crisis related securities class action lawsuits filed overall since the first was filed back in 2007. About two-thirds of the cases remain pending and many have yet to reach the motion to dismiss stage, though the dismissal motion rulings are starting to accumulate.

And while a number of courts have seemed skeptical about the fraud allegations in light of the magnitude of the global financial crisis, there have also been a number of decisions were the court have found the plaintiffs’ allegations sufficient. My running tally of the various subprime and credit crisis-related lawsuit dismissal motion rulings can be found here.

With the increasing number of dismissal motion rulings, the cases that survive are likely to head towards settlement. Just in the last few months, there have been several very high profile subprime-related lawsuit settlements, including the $624 million settlement in the Countrywide case, the roughly $124 million settlement in the New Century Financial case, and the $235 million total settlement in the Schwab Yield Plus case. (All settlement figures reflect aggregate settlement amounts) By my calculation, though there have been only 15 subprime and credit crisis related lawsuit settlements so far, those few settlements alone total over $1.8 billion.

The one thing that seems clear is that when all is said and done on the subprime and credit crisis-related litigation wave, the total costs will be staggering. The defense costs alone associated with this litigation will be enormous. (By way of illustration, the defense expenses associated just with the Lehman bankruptcy are running at about $ 5 million a month, and those costs are likely to accelerate in the event the SEC files an enforcement action or the DoJ files criminal charges.) Though not all of these costs will be insured, many of them will be.

In the aggregate the subprime meltdown and credit crisis represents an enormous event for the D&O insurance industry. Just how big of an event it is will continue to unfold in the weeks, months and years ahead.

3. Will the Wave of Bank Failures Lead to a New Wave of Failed Bank Litigation?: Since January 1, 2008 and through September 3, 2010, 283 banks have failed in the United States, and the total number of failed banks continues to grow. Indeed, in its most recent Quarterly Banking Profile, the FDIC reported that one out of ten banks in the United States is a "problem institution" (meaning rated a "4" or "5" on a scale of one-to-five on lineup of financial and operational criteria).

During the S&L crisis, the banking regulators pursued claims against the directors and officers of the failed institutions in connection with about a quarter of the bank failures. These efforts proved worthwhile for the FDIC, since its S&L crisis D&O claims led to recoveries of about $1.3 billion, out of total professional liability claims recoveries of about $3.25 billion. Given that history, it seems probable that the FDIC will pursue D&O litigation as part of the current bank wave.

Though the FDIC, as part of the current bank failure wave, has to date filed only one lawsuit against former directors and officers of a failed banks, there is every reason to expect that there will be more claims to come, perhaps many more. The FDIC has sent claims notice letters to the directors and officers of many failed banks, and otherwise taken steps to preserve its right to pursue claims and also to assert its priorities over other claimants.

During the S&L crisis, the lag between the peak of the failed banks and the timing of the FDIC’s peak recoveries was about three years. Since the current wave of bank failures did not really start to take off until late 2008 and did not really gain serious momentum until 2009, and in light of the lag in the FDIC’s recovery during the S&L crisis, it would seem that the FDIC’s failed bank lawsuit will begin to accumulate in earnest some time during 2011.

In the meantime, other claimants are also asserting claims against the failed banks’ former directors and officers . Unlike during the S&L crisis, when most of the failed institutions were privately held, many of the banks that have failed during the current wave were publicly traded. According to a recent NERA report, about 45 of the subprime and credit crisis related securities class action lawsuits have involved depositary institutions. Of the 20 failed banks that produced the largest losses prior to 2010, 13 involved publicly traded securities, of which eight had been named in securities class actions as of the end of 2009.

Even in privately held banks’ investors are pursuing claims, although they are crafting their claims very carefully to avoid running afoul of the FDIC’s priority rights to the claims of the failed institutions.

In some respects these investor lawsuit could be competing with the FDIC for the proceeds of the D&O insurance policies insuring the directors and officers of the failed institutions. However, while the FDIC generally has priority, the investors may be able to access the policies proceeds when the FDIC may not, if, for example, the relevant policies have exclusions precluding coverage for claims by regulatory bodies.

For now, the extent to which the FDIC will pursue litigation against former directors and officers of the failed institutions is uncertain, although the likelihood is that there will be extensive litigation ahead. In the meantime, numerous investors are pressing ahead with their own claims. In all likelihood, an extensive amount of litigation related to failed and troubled banks seems likely to accumulate as we head into next year.

4. Will the Mix of Litigation Involving Directors and Officers Continue to Shift Away from Securities Class Action Lawsuits?: One of the more interesting litigation phenomena of the last several years, at least as relates to the exposure of directors and officers, as been the material shift of litigation away from securities class action lawsuits and towards other types of lawsuits.

This shift was first discernable in the litigation that arose from the options backdating scandal, beginning in 2006. Though there were over 30 options backdating related securities class action lawsuit file, there were more than 160 options backdating related shareholders derivative lawsuits filed.

According to the mid-year 2010 corporate and securities litigation study by the insurance information firm Advisen, this shifting mix of litigation away from securities class action lawsuits has continued and securities class action lawsuits have represented a progressively smaller proportion of overall corporate and securities litigation for several years now. Thus, whereas prior to 2006, securities class action litigation represented over half of all corporate and securities litigation, through the middle of 2010 securities class action litigation represented less than 20% of all corporate and securities lawsuits.

What is making up the remainder of the corporate and securities lawsuits are a broad mix of kinds of claims including individual securities lawsuits, shareholder derivative lawsuits, and breach of fiduciary duty lawsuits.

This shifting mix has a number of important considerations. The first is that the dialog about litigation levels tends to focus on securities class action lawsuit filing patterns. Though class action lawsuit filings levels have always ebbed and flowed over time, it seems that every time the filing levels decline or climb (as they inevitably do), some commentator will make some sweeping generalizations about permanent changes in the filing levels.

The fact is, the dialog about shifting class action filing levels may be beside the point. The real story may be that the kinds of cases that are getting filed have changed.

In any event, the growing importance of lawsuits other than securities class action lawsuits does alter the issues that should be considered in the context of directors’ and officers’ liability exposures. The changing mix of litigation could have important implications for D&O insurance terms and conditions and limits of liability.

At a minimum, the changing litigation mix provides an important context within which to consider information relating to securities class action filing levels. Even if fewer class action lawsuits are being filed (at least lately, anyway), that does not mean the overall threat of litigation has declined. To the contrary, the Advisen report shows that the threat of corporate and securities litigation generally continues to increase. That is, the litigation threat is not declining, it is simply changing.

5. What Will Be the Impact of the Supreme Court’s Most Recent Securities Law Decisions?: Every year it seems, at least recently, the U.S. Supreme Court has issued important decisions affecting securities litigation. The Court’s most recent term, which was completed in June, proved to be no exception. The Court issued two cases of particular significance that potentially could have significant impact on future securities lawsuit cases and filings.

First, on June 24, 2010, the Supreme Court issued its long awaited ruling in the Morrison v. National Australia Bank case. The case was much anticipated because it was expected to provide much-needed guidance on the questions of the extraterritorial jurisdiction of the U.S. securities laws.

The Court threw everybody a bit of a curve ball, when it discarded many decades of jurisprudence analyzing when there was sufficient "conduct" in the U.S to support the application of the U.S. securities laws to a foreign company. The Court said that rather than a "conduct" based test, the securities laws required a "transaction" test, and effectively held that the U.S. securities laws do not apply to transactions that take place outside the U.S.

The Morrison case clearly rules out so-called "f-cubed" cases, which involve claims asserted against foreign-domiciled companies by foreign domiciled claimants who bought their shares on foreign exchanges.

Since the Morrison case came down, plaintiffs in other cases have tried to argue that Morrison does not preclude so-called "f-squared cases" – that is, cases in which U.S. investors bought a foreign company’s shares on a foreign exchange. So far, courts have not proven receptive to that argument but the issue is far from resolved.

In the meantime, the Morrison case seems likely to affect the many U.S. securities cases that have been filed in recent years against foreign domiciled companies. At a minimum, the cases in which the complaints have sought to assert claims on behalf of "f-cubed" claimants seem likely to be narrowed to exclude those claims. (I know many plaintiffs’ lawyers may contest the extent of this statement, and in recognition of their arguments I duly acknowledge their objections here.)

The larger impact of Morrison may be there will be fewer, or at least narrower, U.S. securities lawsuits filed against foreign domiciled companies. The many claimants who may now be unable to pursue claims in the U.S. may seek to resort to the courts and laws of their home countries, and perhaps, to the extent the home country laws fail to provide adequate relief, seek legislative change to allow greater investor protections.

The other significant decision this past term was the Court’s April 2010 ruling in the Merck case, in which the U.S. Supreme Court addressed the question of what is sufficient to trigger the running of the statute of limitations for securities claimants. The Supreme Court held that the running of the statute of limitations is not triggered until the plaintiffs have, or with reasonable diligence could have had, knowledge of facts constituting the violation, including facts constituting scienter.

The practical effect of the Court’s decision in Merck is that it could postpone the running of the statute of limitations, potentially lengthening the time within which plaintiffs might file their claim. This effect seems particularly significant in light of the relatively recent phenomenon that has developed in which plaintiffs have been filing securities lawsuits well after the proposed class period cutoff date.

Although so far there have been relatively few new filings that have reflected potential longer limitations periods, the possibility for an increase in belated filings remains. The challenge this presents for D&O insurance underwriters and companies alike is that it is harder to be sure when a company that has had adverse developments in the past may be "out of the woods" as far as possible securities lawsuits.

6. What Will Be the Impact of Securities Cases the Supreme Court Will be Considering in the Upcoming Term?: For whatever reason, the U.S. Supreme Court in recent years has seemed  particularly interested in taking up securities cases, and the Court’s docket for the upcoming October 2010 term is no exception. With Justice Kagan newly added to the Court’s lineup, the Court will be considering at least two potentially significant securities cases.

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

Even if the Court confines itself just to the narrow question of statistical significance, the Court’s consideration of this issue has the potential to be important, since companies are regularly receiving customer complaints and must decide when the level of complaints are significant.

The larger possibility for this case is that the Court might take the occasion as an opportunity for a more comprehensive consideration of the issue of materiality. Were the Supreme Court to take up this larger question, the Court’s ruling potentially could have significant ramifications for many future securities class action lawsuits.

Second, the Court also granted certiorari in the Janus Capital Group case, which involved the question of who may be a "primary violator" under the securities laws. The defendants in the case are the holding company and the management company for a family of mutual funds. Investors claim they were misled by statements that the funds did not engage in market timing; the funds later entered a settlement for market timing.

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

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

At some level, this "substantial participation" test starts to sound a lot like the "aiding and abetting liability" that the Supreme Court had rejected in connection with private lawsuits in the Stoneridge case. That may, in fact, be why the Supreme Court took up the case – not just to reconcile an apparent split in the Circuits, but to align the principles of primary violator liability with those of the secondary violator jurisprudence. In any event, and at a minimum, the case will draw greater clarity around what constitutes a primary violation of the securities laws.

7. What Will Happen to the Level of Business Bankruptcy Filings?: According to the latest report from the Administrative Office of the U.S. Courts, business bankruptcy filings rose 8.34% for the 12-month period ending June 30, 2010. Not only did the filing levels rise relative to the prior period, but they remain well above levels in recent years – for example, the filing rate during the twelve month period ending June 30, 2010 is 76% greater than the comparable period ending June 30, 2008, and 150% greater than the comparable period ending June 30, 2007.

The level of business bankruptcy filings directly affects the overall level of D&O claims activity, because so many bankruptcies involve claims against the former directors and officers of the failed entity. These claims are asserted by investors, creditors, the bankruptcy trustee and others. As long as the business bankruptcy filing rate remains at relatively elevated levels, D&O claims activity levels will also remain at higher levels.

The one positive note from the recent bankruptcy filing statistics is that the rate of business related filings may be slowing, albeit while remaining at relatively elevated levels. Thus, during the period ending June 30, the number of business-related filings declined during each of the three months periods during the twelve month stretch. During the first three months of the twelve 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.

We can all hope that the continuing economic recovery will lead to fewer business-related bankruptcy filings in the months ahead. However, as long as the filing levels remain elevated compared to historical norms, D&O claims activity will also be elevated.

These issues are important because the interaction between the D&O insurance policy and the processes of the bankruptcy court are intricate and fraught with complexities. The ongoing heightened risk of business bankruptcy has important implications for D&O claims exposure as well as for issues surrounding the D&O insurance placement process.

8. What Will be the Next Sector to Get "Hot"?: One of the well-established patterns of securities class action lawsuit filings is that periodically some industrial sector will get "hot" and suddenly numerous companies in that sector will find themselves the targets of securities class action lawsuits.

Companies in the for-profit education sector saw that during August this year, when, following a government report suggesting the possibility of education loan fraud, nearly a half dozen companies in the sector were hit with securities suits within the space of just a few days. In just about the same way, late last year, a host of exchange traded funds were hit with securities class action lawsuits over a very short time period.

The recent industry-specific litigation outbreak in the for-profit education sector 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.

9. Will Heightened FCPA Enforcement Activity Lead to Increased Follow-On Civil Litigation?: One of the relatively well-established trends in recent years has been that increasing Foreign Corrupt Practices Act enforcement activity has led to increasing levels of follow on civil litigation, in which the claimants assert that mismanagement and poor internal controls allowed the corrupt activity to occur. In addition shareholders also claim to have been misled about controls, as was alleged, for example, most recently in the securities class action lawsuit filed in August against SciClone Pharmaceuticals and certain of its directors and officers.

For at least a couple of reasons, the heightened level of anticorruption enforcement activity seems likely to accelerate in the months ahead.

First, as noted above, the recently enacted Dodd-Frank Act contains a whistleblower bounty provision that seems likely to produce heightened whistleblower activity in connection with FCPA violations. Under these whistleblower provisions, whistleblowers can receive rewards of up to 30 percent of recoveries over $1 million. These kinds of rewards could produce some enormous bounties in the FCPA enforcement context, where recent enforcement penalties have been in the range of tens and hundreds of millions of dollars.

Indeed, the top ten FCPA settlements collectively total $2.8 billion, but the top six, all of which took place just in the last 20 months, represent 95% of the total. Four of the top six settlements were reached just in 2010. Because of the massive scale of the settlements that the SEC has been achieving in this area, the potential rewards for whistleblowers are enormous.

Second, the UK Bribery Act received Royal Assent on April 8, 2010. On July 20, 2010, the U.K. Ministry of Justice released its timetable for the implementation of the Bribery Act, setting April 2011 as the effective date. The Act is widely viewed as in several important respects more "far-reaching" than the FCPA, and is likely to have significant impacts on business that either are based in the U.K. or have significant parts of their operations in the U.K.

Though the U.K. provisions may be somewhat delayed and though the impact of the new Dodd-Frank Act whistleblower provisions may be as yet undeveloped, there is no question that this is an area where many things are happening. Anti-corruption enforcement represents a significant and growing area of liability exposure for corporate officials, especially in light of the government’s apparent willingness to resort to sting tactics and other prosecutorial techniques as part of the heightened enforcement.

These developments also have significance for purposes of the structure and implementation of insurance calculated to protect corporate officials. The fines and penalties associated with these kinds of enforcement actions typically would not be covered under a D&O policy, but the defense fees, at least for the individuals might well be. However, the Dodd-Frank Act whistleblower provisions, for example, may raise concerns under the typical D&O policy’s insured vs. insured exclusion.

Finally, the increased levels of anticorruption enforcement may also represent a growing area of civil litigation exposure, as these kinds of enforcement actions frequently lead to follow-on civil lawsuits. Altogether, exposures arising from anticorruption laws represent an important and growing area of potential liability of corporate officials.

10. What Does All of This Mean for the D&O Insurance Marketplace?: The astonishing pace of legislative and judicial changes just over the last few months alone underscores how rapidly the liability exposures in the directors and officers arena can be transformed. Given the absolute whirlwind of recent changes, D&O insurers might be excused for taking a conservative approach to risk. Indeed, those outside the industry often assume that is what the carriers would be doing now.

But despite everything, the D&O insurance industry remains competitive, and all signs are that it will remain that way for the foreseeable future. Most insurance buyers, particularly those outside the financial sector and those with reasonably solid financials, can expect to obtain insurance with broad terms and conditions at relatively attractive prices. Though pricing is not declining at the pace we saw in recent years, pricing remains stable at relatively lower levels.

The iron laws of supply and demand are impervious to more trivial forces like legislative or judicial change. On the supply side, the insurance industry is operating with ample capacity, largely due to the absence of large-scale catastrophes. As a result, the D&O insurance marketplace is characterized by a large number of competitors all of whom are continuing to seek to write business. On the demand side, the number of businesses has been cut down by bankruptcies. Shrinking labor forces and diminished budgets have also reduced insurance demand.

In the absence of some large external event that substantially erodes insurance capacity, the likelihood is that insurance buyers (or at least those buyers outside the financial sector with relatively stable financials) will continue to enjoy a relatively favorable marketplace.

Nevertheless, the liability landscape for directors and officers is changing rapidly, and well-advised insurance buyers will want to make sure that their D&O insurance program is properly positioned to respond to these changing exposures.

Discount for Readers of The D&O Diary: On November 30 and December 1, 2010, I will be co-chairing the American Conference Institute’s 16th Annual Summit on D&O Liability. This conference is a great event every year, and once again the conference will feature an impressive array of the D&O insurance industry’s thought leaders. Background information about the conference, including the event brochure and registration information, can be found here.

The D&O Diary is a conference media partner for this event, and as a result the conference organizers are offering a $200 discount to readers of The D&O Diary. In order to obtain this discount, just use the code "D&O Diary" on the registration form. Hope to see everyone at the conference.

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If the number of out of office messages sent back when I sent out new blog post email notifications during August are any indication, many readers have been away for some or all of the past few weeks. I hope you saved the little paper umbrella from the fruity drink that you and your spouse shared on the terrace of the outdoor café and that you are still finding sand in your tennis shoes.

Sadly, the summer eventually ends and everyone eventually has to go back to school.

Now that you are back at your desk, you will want to get caught up, especially because while you were away, the blogosphere continued to gyrate, and The D&O Diary continued to publish new posts. Here’s just some of what you missed:

The Nuts and Bolts of D&O: I have now published three installments in my ongoing series about the nuts and bolts of D&O insurance, the latest of which relates to the policyholder’s obligations under the D&O policy. The prior posts in the series related to the relationship of indemnification and insurance, and to the insuring agreement in the Policy. Additional installments will be forthcoming in the weeks ahead.

Guest Posts: I have been delighted to be able to publish a number of interesting guest posts over the past several weeks.

First, I published, in the form of two separate posts (here and here), an interesting exchange between Milberg partner Michael Spencer and Minnesota Law Professor Richard Painter, on the question of the impact of the Morrison v. National Australia Bank case.

Second, I published a post from Jones Day partner John Iole on the topic of conflicts in the insurance transaction.

And finally, I published a post (here) written by former plaintiffs’ securities attorney Bill Lerach, who had some spirited comments about my prior post discussing an article by three academics about whether corporate defendants that settle securities suits suffering continuing financial detriments. I published the academics’ response to Mr. Lerach over this past weekend.

Failed Banks: The number of banks that have been closed as a result of the current failed bank wave continues to grow.  Indeed, according to the FDIC’s most recently quarterly report, one out of ten banks in the U.S. is a “problem institution.” The FDIC has filed its first lawsuit, as part of the current failed bank wave, against former directors and officers of a failed bank. Meanwhile, investor litigation involving failed banks continues to move forward. For example, in the PFF Bancorp and Banco Popular cases the dismissal motions were denied, although in the Raymond James loan loss reserve case the dismissal motion was granted. In the meantime, at least one investor lawsuit involving a troubled bank appears headed to trial. NERA has published a comprehensive report on failed bank litigation.

Subprime Cases: There have been a number of significant dismissal motion rulings in subprime-related securities cases, including the partial dismissal in the BofA/Merrill merger case and the dismissal in the SunTrust case. In addition, the New Century Financial case settled for about $125 million. My updated list of subprime and credit crisis-related lawsuit dismissal motion ruling can be found here.

Coming Attractions: Now that everyone is caught up, tomorrow morning I will be publishing my annual survey of the D&O marketplace, “What to Watch Now in the World of D&O.” Watch this site.

Speakers’ Corner: On September 29, 2010, I will be speaking at C5’s 5^th European Forum on D&O Liability Insurance in Cologne, Germany. I will be participating on a panel with Maurice Pesso of the White & Williams law firm on the topic “Why European Directors of U.S. Companies Should Worry About Their Exposure to U.S. Class Action Claims” – a topic that has changed pretty dramatically in the last few months. Information about the conference can be found here. I will look forward to seeing and greeting my European readers at this upcoming conference.

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A recent article by three academics raising the question whether corporate securities lawsuit defendants underperform financially after their case settles has generated significant commentary on this site. In this post, the professors respond to the commentary.

The article in question is 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.

The article describes the professors’ research in which they 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."

My initial post about the article provoked an unusual amount of reader commentary, including a comment about the academic’s research and analysis posted by former plaintiffs’ securities attorney, Bill Lerach. With Mr. Lerach’s consent, I republished his comment as a separate guest post, here.

The professors have prepared and submitted a response to the various comments about their paper.  Here is the professors’ response:

The comments seem to have concentrated on the possible alternative causation of the underperformance of defendant companies involved in securities class actions, i.e., these companies had financial problems prior to the lawsuit and it was likely that these pre-existing problems prompted the companies’ management to lie, and thus, it should not be surprising to see that these companies underperform their peers after settlement. We do not deny that this could be an alternative explanation to the underperformance that we have seen in the data, and indeed we have explicitly talked about this alternative explanation at a number of places in our paper. However, our study has also revealed empirical evidence that is inconsistent with this intuitive explanation, and we thought we should report such evidence in the paper so that people can think about them and perhaps follow up with more research.

First, we are not seeing deterioration (post-lawsuit and post-settlement compared to pre-class period) in the defendant firms’ sales numbers. This holds true both in terms of defendant firms’ absolute sales numbers and relative performance to their peers. We know that sales reflect the bottom line of the financial health of a company and the robust sales shown in the data are inconsistent with the story that these firms are deteriorating on their own independent of the lawsuit.

Second, we are seeing deterioration in liquidity in post-settlement period but not in the post-lawsuit-but-pre-settlement period. If the liquidity constraint is caused primarily by other factors such as banks’ withdrawal of credit as a result of revelation of fraud (as Bill Lerach suggested), why are we seeing significant constraints only in the post-settlement period?

Thirdly, although the average Altman Z-scores for defendant firms were lower in post-lawsuit and post-settlement periods compared to the pre-class period, the inferiority was more prominent in the post-settlement periods. The significantly lower Altman z-score in post-settlement periods seems consistent with the heightened liquidity constraint we observe in the post-settlement period. Again, we do not rule out the possibility that defendant firms are deteriorating on their own, but we want to point out that the data can also be consistently explained by an alternative hypothesis, i.e., lawsuit and settlement had an independently negative effect on the financial health of the defendant firms.

The comments are legitimate and we appreciate the interest that people have shown in this topic.  We have certainly thought about the causation issue in our research, but we could not explain completely what we were seeing in the data by the hypothesis that defendant firms were destined to underperform even if they were not dragged into a lawsuit. We have dutifully reported what we saw in the data.

I would like to thank the professors for taking the time to prepare a thoughtful response and for their willingness to have the comments posted on this site. My thanks to all of the readers who have engaged in this dialog. Further comments are still very much welcome.

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Many observers have been waiting to see whether and to what extent the FDIC will pursue claims against former directors and officers of banks that have failed during the current bank failure wave. So far, the FDIC has filed just a single suit, against former officers of a subsidiary of IndyMac.

However, on August 31, 2010, federal regulators filed a complaint in the Central District of California against 16 officer and directors of a failed financial institution – but the agency filing the lawsuit was not the FDIC and the failed institution was not a bank. Rather, the agency filing suit was the National Credit Union Administration, and the failed institution was a credit union, Western Corporate Federal Credit Union (or WesCorp) of San Dimas, California.

A copy of the NCUA’s complaint can be found here. A copy of the NCUA’s August 31, 2010 press release can be found here.

Prior to its closure, WesCorp had operated as a wholesale or corporate credit union, providing back office services to other credit unions. As reflected in the agency’s press release at the time, on March 20, 2009, the NCUA placed WesCorp in conservatorship. At the time, WesCorp had $23 billion in assets and 1,100 retail credit union members.

As reported in the Agency’s August 31 press release, the former directors and officers were originally sued in November 2009 in Los Angeles County Superior Court in action brought by seven WesCorp member credit unions. The NCUA intervened in that suit and sought leave to substitute the NCUA as the proper party plaintiff. The court granted the NCUA’s motion and to file an amended complaint by August 31. The NCUA’s complaint supersedes the initial complaint filed by the member credit unions.

The NCUA’s complaint alleges beginning in 2002, after Robert Siravo became the institution’s CEO, WesCorp embarked "an aggressive campaign" to grow, which was successful due to the institution’s reliance on borrowed funds to make investments in mortgage backed securities. While WesCorp grew, so did its borrowings, which eventually equaled over 30% of the institution’s assets. As the firm grew, so too did its exposure to exotic mortgage backed assets, particularly securities backed by Option ARM mortgages.

In 2009, WesCorp was forced to record $6.9 billion in losses, rendering the institution insolvent. About two-thirds of the losses were from Option ARM securities WesCorp purchased in 2006 and 2007.

In addition to allegations against all defendants alleging negligence and breach of fiduciary duty, the NCUA complaint also allege that Siravo and the former head of Human Resources manipulated their retirement accounts to make them more lucrative, resulting in over $4.4 million in overpayments, including an extra $2.3 million to Siravo.

One of the defendants in the case is William Cheney, who was a member of WesCorp’s board from May 2002 to February 2006. Cheney is currently the President of the National Credit Union Association, which is the credit union industry’s national trade association.

At the time that the NCUA took control of WesCorp, the institution was the largest of the corporate credit union. The credit union industry, along with the rest of the financial sector, had been suffering some turbulence over the last several years. The NCUA has closed 14 retail credit unions in 2010, and closed 12 retail credit unions in 2009. There were 7,554 federally insured credit unions as of December 31, 2009.

The Wall Street Journal’s September 2, 2010 article about the NCUA’s lawsuit can be found here.

Be Excellent to Each Other: San Dimas is not only the pre-conservatorship home of WesCorp. It is also the home of San Dimas High School, which is of course where Bill and Ted went to school in the most excellent 1989 movie, Bill and Ted’s Excellent Adventure. (I wonder if Bill and Ted went on to work at WesCorp after their high school graduation. Perhaps in the investment division.) I am sure that when Bill and Ted learned that WesCorp had been put into conservatorship, they said something like "Bogus. Heinous. Most non-triumphant."

In honor of San Dimas High School and the school’s two most famous alums, here’s a video tribute to Bill and Ted, showing their history report at a San Dimas high school assembly:　

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One of the most interesting aspects of the complicated sequence of events surrounding the Bank of America/Merrill Lynch merger is the suggestion that Treasury Secretary Henry Paulson instructed BofA’s CEO Ken Lewis not to disclose to BofA shareholders that the government, in order to keep BofA from backing out of the deal, was backstopping BofA to the tune of billions of dollars of additional TARP funds and asset guarantees.

As I recently pointed out in my discussion of the opinion, Southern District of New York Judge Kevin Castel, in his August 27, 2010 dismissal motion ruling in the BofA/Merrill securities suit, found that the plaintiffs had not sufficiently alleged scienter in connection with BofA’s alleged failure to disclose this federal backstop.

In support of this conclusion, Castel said the defendants 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."

Castel doesn’t say that BofA didn’t have a duty to disclose the existence of the federal backstop. But if BofA had a duty to disclose the information, what difference does it make under the federal securities laws that Paulson told Lewis not to disclose it? As CNN Money journalist Colin Barr noted on September 1, 2010 in his Street Sweep blog post entitled "Judge Embraces ‘Paulson Made Me’ Defense" (here), Castel’s ruling has "left some observers scratching their heads."

Is Castel suggesting that there is some kind of governmental instruction or national emergency exception to the disclosure requirements under the federal securities laws? On what basis? Whose instruction is sufficient? What level of exigency is sufficient and who decides?

I was glad to see Barr’s post focusing on this aspect of Judge Castel’s ruling. I think these issues are both interesting and important, but for whatever reason, this part of Castel’s opinion has largely gone without public comment.

I did explore these issues in my prior post about Judge Castel’s opinion. Because I think these issues are worthy of attention and further consideration, and at risk of appearing a little too self-referential, I am reproducing here my prior comments about this aspect of Judge Castel’s ruling, in order to try to highlight these issues and to try to encourage further discussion of these questions. Here are my thoughts on this issue:

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 reason 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.

Back to School: Add one more company to the list of for-profit education companies that have recently been sued in securities class action lawsuits. As I discussed in a recent post, within the space of just a few days in August, plaintiffs’ lawyers filed a cluster of lawsuits against for-profit education companies. On August 31, 2010, plaintiffs’ lawyers added one more company to the list when they sued Corinthian Colleges and certain of its directors and offices, based on allegations similar to those raise against the other for-profit education companies. A copy of the plaintiffs’ lawyers’ press release can be found here.

Old School: I wonder if this for-profit education company’s schools cover their chairs with Soft Corinthian Leather. For those who miss the reference, and in respectful memory of Ricardo Montalban, here is the original Chrysler Cordoba advertisement to which I was referring :

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According to the FDIC’s Second Quarter 2010 Quarterly Banking Profile, which the agency released on August 31, 2010, aggregate indicators of banking institutions’ financial health are improving, but at the same time the number of "problem institutions" also continues to increase. The FDIC’s August 31, 2010 press release about the Quarterly Banking Profile can be found here.

The positive news is that the industry’s 2Q10 earnings of $21.6 billion are the highest since the third quarter of 2008. Almost two-thirds of the banks reported higher year-over-year quarterly net income. However, 20 percent of institutions did report quarterly net losses (compared to 29 percent 2Q09).

The quarterly report also reflects that provisions for loan losses, while "still high by historic standards," represented the smallest total since the first quarter of 2008. Fewer borrowers are falling behind on their loan payments. With respect to just about every type of loan, troubled loans declined for the first time in more than four years. The only exception was commercial real estate loans, which continued to show increased weakness.

Despite this relatively good news, the number of problem institutions increased in the second quarter, to 829, up about 7% from the 775 problem institutions at the end of 1Q10, up 18% from the 702 problem institutions at the end of 2009, and up almost 100% from the 416 at June 30, 2009. (The FDIC defines a "problem institution" as those it rates as "4" or a "5" on its one-to-five scale of rating banks’ financial and operating criteria. The FDIC does not disclose the names of the problem institutions.)

The number of problem institutions is the highest since March 31, 1993, when there were 928.

To put the latest number of problem institutions into perspective, at the end of the second quarter, there were a total of 7,830 insured institutions. So the 829 problem banks represent about 10.6% of all insured institutions.

Or to put it a different way, one out of every ten banks in the United States is a problem institution. (And that’s after the 283 banks that have failed since January 1, 2008 have been taken out of the equation).

Though the number of problem institutions increased in the quarter, the assets associated with these banks did decrease. The 829 problem institutions at the end of the second quarter represented assets of about $403 billion, down slightly from the $431 billion that represented by the 775 problem institutions at the end of 1Q10.

To put the assets associated with the problem institutions into perspective, the collective assets of all insured institutions totals $13.2 trillion. The $403 billion in assets associated with the problem institutions represents about 3.1% of the industry’s total assets.

One other sign that the banking industry as a whole may not yet be in the clear, notwithstanding the relatively positive industry news overall, is that during the second quarter and for the first time in the 38 years for which data is available, there were no new insured institutions.

Since January 1, 2008, 283 banks have failed, 118 in 2010 alone. But even with the growing numbers of failures (each one of which presumably reduces the number of problem institutions by a count of one), the number of problem institutions continues to grow. The likelihood seems to be that the number of failed banks will continue to grow for some time to come.

Eric Dash’s August 31, 2010 New York Times article about the report can be found here.

Ain't Too Proud to Beg: The D&O Diary has been selected as a nominee candidate for the LexisNexis Top 25 Business Law Blogs of 2010. The ultimate list of the Top 25 blogs will be chosen based on comment submited by members of either of two LexisNexis business law communities, the Corporate & Securities Law Community and the UCC, Commercial Contracts and Business Law Community. If you are a registered member of either of these communities, I would appreciate your comment in support. Members of the Corporate & Securities Law Community can submit comments here, and members of the UCC, Commercial Contracts and Business Law Community can submit comments here. The deadline for comments is October 8, 2010.

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