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

On May 25, 2011, In the latest example of shareholders suing a company’s board following a negative “say on pay” vote, two union pension funds filed a shareholders’ derivative action claiming that Umpqua Holdings Corporation’s board violated its duties to investor by approving the2010 compensation plan despite the negative shareholder vote.. The lawsuit follows the April 19 annual meeting of the bank holding company, in which about 62% of shareholders voted “no” in the advisory shareholder vote on the company’s 2010 executive compensation plan. The claims asserted in the lawsuit rely directly on the negative note.

Background

As I discussed in a recent post (here), Section 951 of the Dodd-Frank Act expressly requires all but the smallest publicly traded companies to hold an advisory shareholder vote on executive compensation. This requirement has already started to have an impact on executive compensation practices, as many companies are adjusting certain compensation practices to avoid a negative vote. However, while the vast majority of companies have received shareholder support for their compensation practices, there are still some companieswhose shareholders have voted “no” on the shareholder resolution regarding executive compensation. (At last count, according to The CorporateCounsel.net,  there were over thirty companies whose “say on pay” resolutions had received a negative vote from a majority of their shareholders).

Umpqua’s “Say on Pay” Vote

As reflected in the company’s April 22, 2011 filing on Form 8-K, Umpqua is among those companies receiving a negative say on pay vote. The 8-K reflects that about 62% of shareholders voted against the company’s executive compensation shareholder resolution.

The 8-K explains that the negative vote followed a recommendation from Institutional Shareholder Services (ISS) that Umpqua’s shareholders vote against the resolution. The 8-K states that ISS found a “disconnect” between the company’s 2010 executive compensation and the company’s pay-for-performance standards. The 8-K states that the company takes the vote “seriously” and that it is committed to pay-for-performance principles. Nevertheless, the company takes exception to the ISS’s “formulaic” approach which, the company contends, inappropriately viewed 2010 compensation only by comparison to 2009 compensation, when the company’s executive compensation declined 29%. The company contended that the 2010 compensation plan is reasonable in light of prior compensation and in light of the company’s overall performance, particularly relative to its peers.

The Lawsuit

On May 25, 2011, two union pension funds filed a shareholder derivative lawsuit in the District of Oregon against the company, as nominal defendant; against the company’s individual board members; against four company executives; and against the company’s compensation consultant, PricewaterhouseCoopers. The complaint alleges that the Board’s “decisions to increase CEO and top executive pay in 2010, despite the Company’s severely impaired financial results, were disloyal, irrational, and unreasonable, and not the product of a valid exercise of business judgment.”

The complaint further asserts that the board’s approval of the 2010 pay hikes “violated its own pay-for-performance policy and, as intended, favored the interests of Umpqua’s CEO and top executives at the expense of the corporation and its shareholders.”

The complaint attempts to use the negative say on pay vote to try  to avert  the defendants’ reliance on the business judgment rule. The complaint states that the “adverse shareholder vote on the 2010 executive compensation is evidence which rebutted” the usual business judgment presumption. The complaint further states with reference to the negative shareholder vote that the company’s shareholders “concluded, in their independent business judgment, that the Umpqua Boar’s 2010 CEO and top executive pay hikes were not in the best interest of Umpqua and its shareholders.”

The complaint asserts a claim against the directors for breach of the duty of loyalty; against the compensation consultant for aiding and abetting breach of fiduciary duties and breach of contract; and against the four executive officers for unjust enrichment. The complaint seeks an award to Umpqua for damages; a declaration that the shareholder vote “rebutted the presumption of business judgment”; disgorgement of the allegedly excess compensation and implementation and administration of internal controls and systems to prevent excess executive compensation.

Discussion

At this point, it seems clear that plaintiffs’ bar intends to try to utilize a negative “say on pay” vote, in at least some instances, to try to bootstrap claims for allegedly excess executive compensation. At one level, this is hardly surprising, because the negative vote does create the possibility of the board appearing to be acting contrary to shareholders’ views. And executive pay unquestionably is a hot button issue right now.

But on the other hand, the vote required under the Dodd Frank is expressly and explicitly an “advisory” vote. Congress could have made the say on pay vote binding. The fact that Congress did not make it controlling but rather left the vote as advisory clearly allows for the possibility that the company and its board retained discretion and might elect to act contrary to the shareholder vote without acting improperly. Indeed, Section 951 (c) of the Dodd Frank Act expressly states that the say on pay requirement should not be interpreted to alter any existing fiduciary duties or to create any new fiduciary duties. Congress seemed to be going out of its way to try to avoid having the say on pay process to add compulsion or  to the legal exposures of directors and officers.

Indeed, given the express statutory provisions to make the vote advisory and to try to prevent against having the vote add to directors’ legal exposures, it seems clear that Congress was hoping that the vote, and the threat of the vote, would cause companies voluntarily to adjust their compensation practices, -- not out of fear of liability but out of a desire to maintain the affirmative support of shareholders. Indeed, that in fact seems to be happening, as many companies have adjusted their practices in order to try to avoid a negative shareholder vote.

Despite Dodd-Frank’s express provisions designed to eliminate the possibility that the say on pay vote should alter the legal responsibilities of directors and officers, the plaintiffs in this case are seeking to rely on the negative say on pay vote to argue that the defendants are not entitled to the usual protections of the business judgment rule. The plaintiffs do not explain why a purely advisory vote, which by its own enacting provisions is not intended to alter or create additional legal duties, should nevertheless deprive the board of the usual protections to which they are entitled.

The lawsuit has only just been filed and it remains to be seen how it will progress. But it will be interesting to see if the plaintiffs are successful in having the defendants’ rights to rely on the business judgment rule suppressed.  

The company itself seems to think that the best defense is a good offense, as the company’s spokesperson is quoted in a May 27, 2011 Portland Business Journal article as saying with respect to the plaintiffs’ firm that brought the suit, “our understanding of this firm is they create fees by dragging the names of reputable companies through the mud.”

Our Solar System’s Family Album: A wide variety of probes and vessels have been cruising the planets, taking some amazing pictures in the process. The truly stunning highlights are compiled in a May 27, 2011 post (here), on the InFocus blog on the Atlantic Monthly’s website.

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In a May 27, 2011 post on the FCPA Compliance and Ethics Blog (here), Tom Fox has some interesting observations about the ongoing FCPA gun sting trial. (Readers will recall that this prosecution involves numerous individuals from the armaments industry who were caught up in a government sting operation that included extensive wiretaps and an FBI agent posing as a representative of an African government.)

Among other things, Fox comments that this prosecution is a “game changer” because of the government’s use of “organized crime fighting techniques in very mundane white collar crime.”

Fox’s point is a serious one, particularly in view of the government’s use of wiretaps in several other recent high-profile prosecutions. The insider trading conviction of Raj Rajaratnam depended critically on extensive government wiretaps. The prosecution of the former big law associate who had passed along inside information gained from the law firms where he worked also relied on use of wiretaps.

The government’s use of these aggressive crime-fighting techniques underscores how seriously the government is taking its responsibility to enforce these laws. The government’s willingness to use these techniques also has important implications for anyone concerned about the potential exposures for companies and their executives. The most obvious lesson is that the government is vigilant and will actively pursue criminal activity. For that reason, corporate compliance efforts are critically important.

Another, perhaps more chilling implication is that presuming confidentiality for even the most private conversations and communications could be dangerous. There is probably a larger essay for another day here. Suffice it to say that the line between necessary vigilance and intrusive surveillance is a fine one, and the government’s involvement in monitoring its citizen’s activities is fraught with difficulties. Some might say it is only those involved in criminal activities that have any thing to fear.  I note that we only hear about the wiretaps that result in criminal prosecutions. One can only wonder about the extent of governmental intrusion into purely lawful communications.

Independent Director Liability Insurance: Do independent directors need a separate liability insurance policy? The IDL insurance product has been around for years, though relatively few companies buy it. The problem is that sometimes when things go wrong, things go catastrophically wrong. Though IDL continues to attract relatively few buyers, there are occasions when it could be critically important. A May 26, 2011 article from Corporate Secretary magazine (reprinted here) takes a closer look at the IDL product. (Full disclosure, I was interviewed for the article).

Take Two: Perhaps there are no panaceas, but there may be one thing Americans could do to solve many of their problems -- everything “from stuck zippers to the national debt” -- according to a recent report you might have missed.

The American Scene: A series of recent trips has reminded me that there are a multitude of beautiful places in this big country. Among other delightful places I have visited are several that are well worth the journey, including Davidson, North Carolina; Lake Tahoe, California; Denver, Colorado; and Lexington, Virginia.

My most recent sojourn, a Memorial Day weekend  trip to South Carolina for a wedding, introduced me to Greenville, which is yet another delightful surprise. The cluster of restored buildings and pedestrian bridges surrounding the waterfalls on the Reedy River and the blocks of shops and restaurants along the tree-lined Main Street make the town a pleasant and enjoyable place to explore. Greenville is only one of several U.S. cities that recently have made big investments in reorienting themselves toward their riverine setting, including Dubuque, Iowa and Jacksonville, Florida.

Travel has its stresses and headaches, but it also occasionally affords agreeable discoveries that reward the exertion. Truly, you could explore this country endlessly and never exhaust its aesthetic possibilities.    

Greenville, South Carolina  May 28, 2011

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According to FDIC’s Quarterly Banking Profile, released on May 24, 2011 (refer here), the pace of bank failures slowed during the first quarter. However, both the absolute and relative number of problem institutions continued to increase, albeit at a reduced pace compared to recent quarters. The FDIC’s May 24, 2011 press release about the Quarterly Banking Profile can be found here.

During the first quarter of 2011, 26 banking institutions failed, compared to 41 in the first quarter of 2010. The total of 26 bank failures in the first quarter is the smallest quarterly number of bank failures in seven quarters.  (My prior post on the declining pace of bank closures can be found here.) A total of 43 banks have failed year to date in 2011 as of May 25, 2011.

As of the end of the first quarter 2011, there were 888 “problem institutions,” compared to 884 at the end of 2010 and 775 at the end of the first quarter 2010. The increase in the number of problem institutions during the twelve month period ending March 31, 2011 is 113, or about 14.5%. (The FDIC identifies banks as problem institutions as those that are graded a 4 or a 5 on a 1-to-5 scale as a result of “financial, operational, or managerial weaknesses that threat their continued financial viability.” The FDIC does not release the names of the individual problem institutions.)

 The increase of only four additional problem institutions since year-end 2010 represents only a slight increase in the number of problem institutions. In its press release, the FDIC noted that this increase is “the smallest increase in three and a half years.” However, the 888 problem institutions as of March 31, 2011 represent the larges number of problem institutions since March 31, 1993, when there were 928.

The number of problem institutions as a percentage of all reporting institutions has continued to increase. This is not only due to the increase in the absolute number of problem institutions but also because of the declining number of reporting institutions. The decline in the number of reporting institutions is not only due to bank failures, but also due to mergers and acquisitions.

The 888 problem institutions as of March 31, 2011 represent about 11.7% of all 7574 reporting institutions. By way of comparison, the 775 problem institutions as the end of the first quarter 2010 represented only about 9.7% of all 7,934 reporting institutions as of that date. So both the absolute and relative numbers of problem institutions has increased substantially during the 12 months ending March 31, 2011.

Though the number of problem institutions has continued to increase, the aggregate assets those problem institutions represent has decreased. Thus the 775 problem institutions as of March 31, 2010 represented assets of $431 billion, whereas the 888 problem institutions as of March 31, 2011 represented assets of $387 billion.

With all of the remaining numbers of problem institutions, there are still a lot of challenges in the banking industry. There may yet be more bank failures yet to come, perhaps many more. However, the overall message of the Quarterly Banking Profile is guardedly upbeat. The press release quotes the FDIC Chairman Sheila Bair as saying that “the industry shows signs of improvement, “ and adding that “the process of repairing bank balance sheets is well along, but is not yet complete.”

As I have noted elsewhere, the numbers of bank failures overall may be slowing, but the lawsuits involving directors and officers of failed institutions may just be ramping up – slowly

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On May 25, 2011, the SEC adopted the final rules implementing the whistleblower provisions of the Dodd-Frank Act. The SEC declined to propose a rule that would have required whistleblowers to report first through internal corporate compliance programs. However, the SEC adopted changes that are intended to “incentivize whistleblowers to utilize their companies’ internal compliance and reporting systems when appropriate.”

The SEC’s May 25, 2011 press release about the final whistleblower rules can be found here. The SEC’s 305-page document describing the final rules can be found here. The SEC’s rules will be effective 60 days after they are submitted to Congress or published in the Federal Register.

Section 922 of the Dodd-Frank Act created certain new whistleblower incentives and protections. The section directs the SEC to pay awards to whistleblowers that provide the Commission with original information about a securities law violation that lead to the successful SEC enforcement action resulting in monetary sanctions over $1 million. The section also prohibits retaliation against whistleblowers.

The SEC released proposed rules to implement the whistleblower provisions in November 2010. The SEC received hundreds of comments on the proposed rules. The final rules document released yesterday describes many of the comments as well as the way that the SEC took the comments in to account in promulgating the final rules.

One of the most significant issues raise in the comments related to the impact of the whistleblower program on internal corporate compliance processes (refer here for a discussion of this issue). The gist of the concern is that the SEC whistleblower provisions would encourage the whistleblowers to bypass internal reporting mechanism (many of which have only recently been implemented pursuant to the requirements of Sarbanes Oxley). Though some commentators urged the Commission to require whistleblowers to report violations first internally, the SEC decided not to include this requirement. Rather, the SEC included in the final rules elements it hopes will encourage potential whistleblowers to use internal compliance processes.

Specifically, the rules make the whistleblower eligible for an award if the whistleblower reports the violation internally and the company informs the SEC about the violation. The SEC will also treat the informant as a whistleblower as of the date of an internal report of the employees provides the same information to the SEC within 120 days (this allows whistleblowers to save their “place in line” for a possible award). Finally, the informant’s voluntary participation in the company’s internal reporting program will be a factor the SEC will use to increase the amount of an award.

The SEC’s final rules also identify a number of categories of persons who will not be eligible for an award, including those with a preexisting legal or contractual duty to report their information; those who obtain their information either by privileged or illegal means; officers and directors who are informed by another person of the violations; compliance and audit personnel. (There are defined circumstances when compliance and audit personnel can be eligible.

The rules also clarify the whistleblowing procedures, and provide clarification of what constitutes a voluntary report; what constitutes original information; what constitutes a successful enforcement action and so on.

These rules will be effective shortly, most likely later in the summer. The ultimate practical effect of these new rules depends on how forthcoming prospective informants are; the quality of the information; and what the SEC does with the information.

The sheer scale of the prospective awards (from 10 to 30 percent of awards in excess of $1 million) is clearly designed to encourage whistleblowing, as indeed is the SEC’s final rule. For its part, the SEC has a huge incentive in the post-Madoff era to heed whistleblower’s warnings and to pursue the reported information. Just looking at the way the incentives and motivations line up, the most probable outcome here seems to be that there will be significant numbers of whistleblower reports and that these reports will trigger significant numbers of investigations and enforcement actions. These enforcement actions could well be followed by follow-on civil litigation, which could increase the potential exposure that companies and their senior officials could face as a result of the implementation of these rules.

It certainly appears that a portion of the plaintiffs’ bar things there is an opportunity here supporting prospective whistleblowers and perhaps using their reported information as the basis for separate civil suits – refer for example to this advertisement for the “SEC Whistleblower Claims Center.” The quick emergence of an opportunistic plaintiffs’ bar eager to try to turn these new rules to their advantage is hardly surprising. Enterprising plaintiffs’ lawyers have been profiting from the whistleblower incentives in the False Claims Act for years (refer, for example, here)

However these incentives may appear now, they will all be augmented exponentially once a whistleblower or two has garnered a significant award. Given the magnitude of some of the recent SEC enforcement actions (as for example in connection with SEC enforcement action under the FCPA, refer here) the likelihood that we might see some large awards seems high. Refer here for further discussion of the particular concerns surrounding the prospects for whistleblowing activity in the FCPA context.

The bottom line is that for those of us who worry about the potential exposures of directors and officers of public companies, there is a whole new category of concerns.

Special thanks to a loyal reader for the link to the whistleblower advertisement.

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Yet another U.S.-traded Chinese-based company has been hit with an accounting fraud securities class action lawsuit. The latest lawsuit, involving Longtop Financial Technologies Limited, comes after a series of stunning announcements from the company earlier this week.

Longtop’s ADRs trade on the NYSE and until recently the company had a market cap in excess of $1 billion. Unlike many of U.S.-listed Chinese companies, it did not obtain its U.S. listing through a reverse merger, but instead it became public through a conventional IPO in 2007. Its financial statements were audited by the Chinese arm of Deloitte. Questions involving Longtop first arose when Citron Research published an April 26, 2011 online report critical of the company. Among other things, the report questioned the company’s “unconventional staffing model,” alleged prior undisclosed “misdeeds” involving management, and referenced “non-transparent” stock transactions involving the company’s chairman, among other things. Other critical research coverage followed.

Longtop’s problems took another turn for the worse when, in advance of the recent high profile IPO of Chinese social networking company, Renren Network, Longtop’s CFO, who sat on Renren’s board as chair of the audit committee, resigned to prevent the questions at Longtop from affecting Renren’s IPO.

The company defended itself from the charges (refer for example here). Nevertheless, NYSE halted trading in its shares last week pending news, a development that garnered an article in the May 18, 2011 Wall Street Journal (here).

Then on May 23, 2011, in a filing with the SEC on Form 8-K, the company announced that both its CFO and its outside auditor, Deloitte Touche Tomatsu (DTT) had resigned. In its accompanying press release (here), the company said that DTT stated that it in its May 22, 2011 letter of resignation that it was resigning as a result of, among other things,

(1) the recently identified falsity of the Company’s financial records in relation to cash at bank and loan balances (and possibly in sales revenue); (2) the deliberate interference by certain members of Longtop management in DTT’s audit process; and (3) the unlawful detention of DTT’s audit files.

DTT further stated that it was “no longer able to rely on management’s representation’s in relation to prior period financial reports, and that continued reliance should no longer be place on DTT’s audit reports on the previous financial statements.”

In the same press release, the company announced that it has been advised that by the SEC that the agency is conducting an inquiry; and that the company’s audit committee had retained U.S. counsel and authorized the retention of forensic accountants to investigate the matters in DTT’s resignation letter.

In their May 23, 2011 press release (here), plaintiffs’ counsel announced that they had filed a securities class action lawsuit against the company and certain of its directors and officers in the Central District of California. According to the press release, the complaint specifically references the resignation of DTT as Longtop’s auditor and the resignation of the company’s CFO.

With this latest lawsuit, there have now been a total of 22 securities class action lawsuits filed against Chinese and China-liked companies in 2011, out of a total of about 93 securities lawsuits that have filed so far this year --  meaning that the suits against Chinese companies represent about 23% of all securities lawsuits filed so far this year.

Signs are that the onslaught of accounting fraud lawsuits against Chinese companies will continue, as plaintiffs’ lawyers have also announced recently that they are “investigating” yet other Chinese companies (refer for example, here and here), which usually presages lawsuit filings.

The Latest in Securities Class Action Lawsuit Settlement Funding?: As I noted at the time in July 2010, there was just “one little problem” with the Ohio Attorney General’s announcement that the pending AIG securities class action lawsuit had been settled for $725 million -- specifically, “AIG doesn’t have the money to pay for the settlement. The plan, such as it is, is that AIG is going to fund the first $175 million following the settlement’s preliminary approval. Then, AIG is going to try to conduct a stock offering to raise the remaining $550 million.”

According to AIG's July 16, 2010 filing on Form 8-K, the settlement is conditioned on the company's "having consummated one or more common stock offerings raising new proceeds of at least $550 million prior to court approval." 

Although I was skeptical at the time that investors would be interested in making an equity investment in order to provide securities class action litigation funding, with yesterday’s sale of AIG shares, the company may in fact be in a position to fulfill the outstanding settlement condition. According to a May 24, 2011 Bloomberg article entitled “AIG Share Sale Aids Ohio Firefighters Burned By Stock Losses Before Rescue” (here), AIG intends to use $550 million from the share sale to pay for the settlement announced last July. Assuming that there were no glitches involving with the offering that would interfere, or that the fact that the share sale came in at the low end of the anticipated pricing range is not a barrier, it looks as if AIG will now be able to fund the remainder of the settlement.

Even though if the funding mechanism  worked here, I doubt that equity financing as a way to raise funds for securities class action lawsuit settlements is likely to catch on as a general matter.

Subprime Lawsuit Dismissal Motion Rulings: There have been a couple more dismissal motion rulings in subprime-related securities class action lawsuits.

First, in a May 10, 2011 ruling (here), Southern District of New York Judge John G. Koeltl granted in part and denied in part the defendants’ motion to dismiss the complaint in the J.P. Morgan Acquisition Corp. Mortgage Pass-Through Certificate securities class action lawsuit. He granted the motion to dismiss for lack of standing as to ten of the eleven offerings reference in the complaint in which the named plaintiffs had not purchased securities. However, he denied the motion to dismiss as to the remaining offering, finding that the plaintiffs had adequately alleged securities law violations in connection with that offering.

Second, in a May 23, 2011 ruling (here), Southern District of New York Judge John F. Keenan granted the defendants’ motion to dismiss, without prejudice, in the Manulife Financial subprime related securities class action lawsuit, finding that the plaintiffs’ complaint did not meet the heightened pleading standard under the PSLRA and ignored "the massive economic and political changes taking place during the Class Period" in attempting to plead that the defendants acted with scienter. David Bario’s May 24, 2011 Am Law Litigation Daily article about the Manulife decision can be found here.

I have added these decisions to my running tally of the subprime lawsuit dismissal motion rulings, which can be accessed here.

Flash from the Past: Call it nostalgia for an earlier time, or simply mild interest that these kinds of cases are still kicking around, but I was interested to note that Fossil Inc. announced in a May 20, 2011 filing on Form 8-K that it had settled the options backdating –related derivative lawsuit that had been filed against the company, as nominal defendant, and certain of its directors and officers. According to the accompanying settlement documents, in order to settle the case, the company’s D&O insurers had agreed to pay $8.666 million. It appears that insurance will be funding the entire amount of the settlement.

I guess there may be a number of  these cases still kicking around, but this settlement sure does seem like a vestige from another time in place. In any event, I have added the settlement to my running tally of options backdating-related case resolutions, which can be accessed here.

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The parties to two of the consolidated subprime-related securities lawsuits pending against Oppenheimer Funds have settled the case for a total of $100 million. This settlement has a number of interesting features, as discussed further below, including in particular aspects of the allocation of the total settlement amount between the two consolidated fund actions. The settlement also leaves the consolidated action filed against yet other Oppenheimer Funds pending.

In Spring and Summer 2009, a total of 32 class action lawsuits were filed against a number of the Oppenheimer Funds. These actions were brought by investors who had purchased shares of the Funds that were traceable to offering documents that allegedly contained misrepresentations and omissions. As a general matter, the investors alleged that the Funds had been marketed as representing investments that did not involve undue risk, but that beginning in 2006, the Funds had invested heavily in “risky” investments such as mortgage-backed securities, credit-default swaps and total-return swaps. When the financial crisis hit, these Funds later lost a substantial part of their net asset value.

As ultimately organized, the Oppenheimer Funds lawsuits were organized into three consolidated cases involving, respectively, the Oppenheimer Champion Income Fund; the Oppenheimer Core Bond Fund; and the consolidated “Rochester” cases (involving seven other Oppenheimer Funds).Background regarding the Core Bond Fund action can be found here. Background regarding the Oppenheimer Champion Income Fund can be found here. These two cases were consolidated  for discovery purposes. The Rochester cases proceeded independently. Background regarding the Rochester cases can be found here.

 The $100 million settlement involves only the Oppenheimer Champion Income Fund action and the Oppenheimer Core Bond Fund action. The consolidated Rochester Funds case is not part of this settlement, which apparently remains pending in the District of Colorado.

The $100 million settlement is described in various settlement documents filed with the District of Colorado on or about May 19, 2011. The stipulation of settlement in the Oppenheimer Champion Bond Fund case can be found here. The stipulation of settlement in the Oppenheimer Core Bond Fund case can be found here. The motions to court for preliminary approval of the settlements can be found here and here, respectively.

The parties’ settlement-related filings portray an interesting settlement process resulting in a settlement with a number of interesting features.

 First of all, the parties were able to reach this settlement while the motions to dismiss were fully briefed and pending, but before there had been any ruling on the motions.

Second, the settlement was the result of a protracted settlement mediation process that consumed a number of months. As a result of this process, the parties agreed to the $100 million settlement amount – but the parties were not done yet. They had to further agree on how the $100 million would be split, or allocated, between the Oppenheimer Champion Bond fund case, on the one hand, and the Oppenheimer Core Bond Fund case , on the other hand.

The parties entered a separate process for determining the allocation of the $100 million between the two cases. The parties entered a separate mediation process to determine the process, and for purposes of this separate process, the plaintiffs’ Lead Counsel brought in separate, independent counsel to represent each of the two respective Funds. Each side then presented mediation briefs to the mediator. On February 25, 2011, the mediator determined that the appropriate allocation between the two funds would be 47.5 percent for the Core Bond Fund Class and 52.5 percent for the Champion Income Class.

As a result of this allocation, the parties stipulated that the $100 million settlement amount is to be allocated between the two cases as follows: $52.5 million to the Champion Income Fund and $47.5 million to the Core Bond Fund class. Each of the two settlements is expressly condition on the approval of the settlement in the other case.

The settlement papers say relatively little with respect to the role that insurance may have played in the settlement. The settlement stipulations do specify that the parties to the settlement “understand and agree that any obligation of the Trustee Defendants [I.e., the individuals named as defendants in the suits who had served of trustees of the respective funds] hereunder will be satisfied by insurers or other Defendants and that no portion of the Settlement Amount is to be paid personally by the Trustee Defendants.”

There are a number of noteworthy aspects of this settlement. The first is that it was reached before the motions to dismiss had been ruling. Obviously there is no prohibition on settling cases before the dismissal motions rulings, as cases do settle prior to dismissal motion rulings from time to time. But it is relatively unusual, and the size of this settlement before the dismissal motion rulings is also noteworthy.

It is also noteworthy that these cases have been settled for a significant amount while the other Oppenheimer Fund cases involving the Rochester funds remain pending and unresolved. Those other cases remain on a different track, apparently, but the settlement does put those unresolved cases in an interesting light.

The subprime-related lawsuits against the Oppenheimer funds were only one among several sets of cases filed against mutual fund families or funds raising subprime related allegations. Another of these mutual fund cases, the Schwab Yield Plus case, settled previously for a total of $235 million (about which refer here). Many more of these mutual fund related cases also remain pending. This Oppenheimer Fund settlement put those other mutual fund cases in an interesting light, as well.

In any event, I have added the Oppenheimer Fund settlement to my running tally of subprime-related case resolutions, which can be accessed here. According to my data, the $100 million Oppenheimer Funds settlement represents the sixth largest subprime-related securities lawsuit settlement so far. (If the Rochester funds cases were to ultimately settle, the amount of any settlement of those cases would obviously increase Oppenheimer’s aggregate settlement amount.)

As I have noted before, many of the subprime-related cases remain pending and eventually they will be resolved. It is worth noting that as the various Oppenheimer cases went forward, they were consolidated in various ways, and it appears that other cases are being resolved on a consolidated basis as well. This consolidation processcould reduce the overall number of case resolutions while potentially increasing the total resolution amounts in connection with any one consolidated case.  

Nate Raymond’s May 22, 2011 Am Law Litigation Daily article about this settlement can be found here. The plaintiffs’ attorneys’ press release regarding the settlements can be found here. Special thanks to the readers who sent me information about this settlement.

SEC Investigations and D&O Insurance: There are three articles in this week’s National Underwriter that may be of interest to readers of this blog. The articles and their respective links are as follows: “A Newly Assertive SEC, Backed By Whistleblowers, Means Rise in Investigations – And Risks” (here); “As Investigation –Cost Coverage Evolve, Prices on Existing D&O Solutions Drop” (here); “Investigation Edge: Brokers Welcome New ‘Entity’ Product From Chartis” (here).

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One of the most distinctive trends in corporate and securities litigation in recent years has been the rise in litigation related mergers and acquisition activity. Cornerstone Research’s most recent year-end litigation filing study, released in conjunction with the Stanford Law School Securities Class Action Clearinghouse, documented that in M&A litigation in 2010 increased at a much greater rate than did M&A activity during the year. .

One of the factors behind this accelerated litigation growth is the fact that increasingly a merger announcement triggers multiple different lawsuits, often filed in multiple jurisdictions. This proliferation of multi-jurisdiction litigation raises a host of procedural challenges, as the nominal corporate defendant is forced to litigate on multiple fronts while at the same time attempting to press ahead with the underlying transaction.

In an interesting post on The Harvard Law School Forum on Corporate Governance and Financial Regulation entitled “Improving Multi-Jurisdiction, Merger-Related Litigation” (here), Mark Lebovitch of the Bernstein Litowitz Berger & Grossman law firm takes a look at these problems and proposes a Delaware-court based procedural solution to try to address the issues.

The article first summarizes  the problems involved when mulit-jurisdiction M&A litigation arises. Lebovith states that “the current system is prone to manipulation and gamesmanship.” The defendants face duplicative costs; the shareholders interests may be subordinated as part of procedural jockeying between competing plaintiffs (and their lawyers); and plaintiffs’ lawyers may find themselves compelled to pay a “tax” to competing counsel in order to deliver a global settlement.

Lebovitch urges the adoption of “a system that centralizes deal-related litigation into a single forum.” Specially, he suggests “the adoption of an efficient, predictable and transparent rules-based system for appointing lead plaintiffs and lead counsel to settle organizational issues” in M&A litigation. He is not suggesting the approach embodied in the PSLRA, where the presumptive leadership goes to the claimant with the largest financial interest. Rather, he urges a process for the selection of lead plaintiff based on “anticipated ability to achieve the best results for the class.”

In the system Lebovitch proposes, the first plaintiff to file in the Delaware Court of Chancery would be required to publish a nationwide notice of class, which would trigger a 10-day period during which any other shareholder interested pursuing the claim would have the opportunity to submit a leadership motion detailed their theory of the case, case management plan and their counsel’s experience with similar claims. The materials would be reviewed in camera and the Court would select the lead plaintiff, with emphasis on “counsel’s track record and ability to represent the class, taking into account the nature of the action, the novelty of the issues raise, and the movant’s case-management plan.”

The contention is that with a clear, detailed and predictable leadership selection process, there would be less incentive for procedural jockeying between plaintiffs.

Lebovith correctly points out that though this approach would mitigate the problems with multijurisdictional litigation, the problems would not finally be solved. The proposed leadership selection process would ameliorate jockeying for position within Delaware but it would not eliminate the problems arising when plaintiffs in another jurisdiction attempt to press forward. The parties could still have to face a multi-front war, even if the process has been improved within Delaware.

One possible way to address these remaining issues was suggested by now-former Chancellor William Chandler in his March 28, 2011 opinion in the Allion Healthcare Shareholders Litigation. The Allion Healthcare case arose out of a proposed going-private transaction. After the transaction was announced, multiple lawsuits arose in Delaware and New York. Because the various plaintiffs refused to coordinate, the cases proceeded in both jurisdictions. After the transaction closed, the parties reached a settlement agreement, but the plaintiffs were unable to agree on allocation of fees, and the matter wound up before Chancellor Chandler.

Chandler noted at the outside the “increasingly problematic” challenges associated with multi-jurisdictional litigation, commenting that it forces defendants to “litigate the same case –often identical claims – in multiple courts.” In addition, judicial resources are “wasted” and there is a danger that different courts “would apply the law differently or otherwise reach different outcomes,” leaving “the law in a confused state and pose full fait and credit problems.”

Having posed the problem, Chandler then (in footnote 12 of the opinion) identified his own “personal preferred approach,” which is for “defense counsel to file motions in both (or however many) jurisdictions …explicitly asking the judges in each jurisdiction to confer with one another and agree upon where the case should go forward.”  Of course, as Chandler notes, “judges in different jurisdictions might not always find common ground on how to move the litigation forward. “ But this approach, Chandler contends is “one (if not the most) efficient and pragmatic method to deal with this increasing problem,” adding that “it is a method that has worked for me in every instance in which it was tried.”

The approach Chandler advocated in his Allion Healthcare opinion was endorsed by Theodore Mirvis of the Wachtell  Lipton law  firm on an April 12, 2011 post on the Harvard Law School Forum on Corporate Governance and Financial Regulation entitled “Delaware Court of Chancery Addresses Multi-Forum Deal Litigation” (here). Mirvis comments that Chandler’s opinion “indicates that Delaware Courts will apply their practical wisdom to combat the untenable burdens imposed by multi-forum deal litigation and remain receptive to new approaches to harmonize conflicting and duplicative merger litigation.”  

An additional comment about the Allion Healthcare opinion can be found on Peter Ladig’s April 25, 2011 post on the Delaware Business Litigation Report entitled “Multi-Jurisdictional Litigation a Rich Vein of Issues for Chancer Court” (here).

The two approaches are not mutually exclusive and they are not incompatible. Indeed, it would appear that the two approaches together would significantly advance the possibility of avoiding many of the ills associated with the multi-jurisdictional litigation. To be sure, as Chancellor Chandler noted in his Allion Healthcare opinion, the practical approach between courts might not always eliminate the possibility that identical cases could go forward in different jurisdictions. But the approach creates an opportunity to avoid the problem. And the procedural mechanism Lebovitch advocate would increase the likelihood that the proceeding in Delaware would go forward in an orderly way.

None of these procedural issues addresses the central underlying problem, which is that opportunistic plaintiffs’ lawyers have identified what seems like a sure-fire profit opportunity in creating litigation obstacles to announced transactions.  Lebovitch’s blog post explains the growth in this type of litigation as due to “the high-profile success achieved by certain members’ of the plaintiffs’ bar” which has “triggered a wave of new entrants to the field.” Moreover, “the dramatic decrease in securities class actions has further increased the number of firms willing to pursue M&A litigation.” As “more law firms enter this already crowded field” the consequence is that “the number of lawsuits stemming from each deal continues to increase.”

Reasonable minds may differ as to the value of the M&A litigation. But regardless of the theoretical value, the multiplication of costs and the imposition of increased procedural inefficiencies resulting from the escalating litigation activity represent an enormous burden on business. The concerns are all the more apparent when the increasing amounts of litigation is not the result of increased numbers of injustices crying out for redress but simply reflect increasing numbers of plaintiffs lawyers looking for a piece of the action.

Colonel Roosevelt: Colonel Roosevelt, the third and final volume of Edmund Morris’s epic biography of Theodore Roosevelt covers Roosevelt’s personal and professional life following the conclusion of his second term as President. Among other things, the book details Roosevelt’s ill-fated bid for the Presidency in 1912, in which his candidacy arguably succeeded in splitting the Republican vote sufficiently to ensure Woodrow Wilson’s election.

The political aspect of Roosevelt’s post-Presidency are interesting enough, but it is the personal side of the story that makes this fascinating and well-written book worth reading. Even though there are critical parts of Roosevelt’s persona that do not translate well into our culturally different era, what does come through in Morris’s account is what an extraordinary person Roosevelt was.

Roosevelt was a man of astonishing ambition. He was also a man of unusual personal courage, strength and perseverance. During the 1912 election, he was struck at close range by an assassin’s bullet (his folded speech and glasses case, stuffed in his breast pocket, probably saved his life). When he found that the shot had not killed him, he proceeded to deliver his planned speech, while bleeding from the gunshot wound, with the would-be assassin’s bullet lodged against his ribs.

Perhaps his most extraordinary feat of personal courage came during the scientific expedition in which he participated in 1913-14. Roosevelt was 55 years old at them. The 17-person expedition’s purpose was to map the Brazilian river ominously called Rio da Dúvida  -- the River of Doubt.

Almost from the start, the expedition was plagued with problems. Insects, disease, unsuitable supplies and equipment created innumerable difficulties. The expedition’s long and troubled journey turned dangerous as the expedition encountered a seemingly endless series of cascades. The torrents required repeated portages through hostile, forbidding jungle and nearly impassible terrain. When they were able to return to the water, their canoes were battered and damaged. In the midst of these difficulties disaster struck. A canoe carrying Roosevelt’s son, Kermit, and another member of the expedition capsized in a whirlpool. Before help could arrive, the other man had drowned.

A few days later, when one of the expedition’s pontoon boats capsized in a rapid, several people, including Roosevelt, rushed to rescue the men who fell in the water. The men were saved, but Roosevelt cut his leg on a rock. The wound soon became infected. The infection led to coronary stress. Roosevelt was in mortal danger:

The next morning, Roosevelt had reason to believe he was in the valley of the shadow of death. … Rock walls that could have been sliced by civil engineers blocked the sky. Kermit and Lyra lost yet another canoe, reducing the flotilla once more to two pontoons. A reconnaissance party came back with news of rapids continuing as far as the eye could see.

At this very moment, the expedition was stunned by the sound of gunfire. A disaffected member of the support team, overcome by privation and stress, had ambushed another member of the team and shot him dead. The murderer fled into the jungle.

After they had buried the murder victim, Roosevelt was overcome with fever and he became delirious. Fortunately, the fever subsided but at the same time his son became ill. Roosevelt wrote in his journal “The expedition is in a state of peril.” With damaged canoes, diminished supplies, two men dead, one man missing and two others deathly ill, the expedition stumbled ahead. As the cascades finally diminished, the expedition was able to advance, and within a matter of days, the expedition reached a military outpost that had been established a month before in anticipation of their eventual arrival.

When Roosevelt finally arrived back in New York, he arrived “haggard, malaria-yellow, limping on a cane, his belt hauled in six inches.” Even so, just five weeks later, Roosevelt was in Madrid for Kermit’s wedding, finding time to meet with the King and Queen of Spain. He made time to meet with Wilson on his return to Washington.

The tale of the expedition’s survival of their ordeal on the River of Doubt (now renamed Rio Roosevelt), with its drowning, murder, privation and disease, is remarkable enough by itself. But the fact that this tragic, nearly disastrous mission included (and almost led to the death of) a former President of the United States, makes this story nothing short of astonishing. In our time, we have had some ex-Presidents attempt and even accomplish some remarkable things. But for my money, nothing compares to Roosevelt’s participation in the descent of the River of Doubt.

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On May 18, 2011, the California Intermediate Court of Appeals held in the Luther v. Countrywide Financial Corporation case that state courts have concurrent jurisdiction with federal courts to hear liability lawsuits under the Securities Act of 1933, and that more recent legislative enactments did not eliminate the concurrent state court jurisdiction for the plaintiffs’ ’33 Act claims.

 I suspect that those of you who, like The D&O Diary, have been following the Luther case are going to say – wait a minute, didn’t the Ninth Circuit decide that very issue in that same case several years ago? Alas, it is not so simple, nor so straightforward.

For those of you who have not been following the Luther case, here’s the background. The claims are brought on behalf of purchasers of billions of dollars of mortgage pass-through certificates issued between June 2005 and June 2007. The securities were registered but not listed on any national exchange. The complaint alleges that the defendants violated Sections 11, 12 and 15 of the ’33 Act, essentially on the grounds that the risk of investing in the mortgage pass-through certificates was much greater than represented by the registration and prospectus supplements, which allegedly omitted and misstated the creditworthiness of the underlying borrowers.  The plaintiffs do not assert any state law claims. The Luther complaint names as defendants several Countrywide subsidiaries and affiliated individuals, multiple loan trusts, and Countrywide’s offering underwriters.

The plaintiffs originally filed their complaint in California Superior Court for Los Angeles County. The defendants, in reliance on the Class Action Fairness Act of 2005, removed the Luther case to federal court. The plaintiffs filed a motion to remand the case to state court. As discussed here, on February 28, 2008, Central District of California Judge Mariana R. Pfaelzer granted the plaintiffs’ motion to remand the case to state court, holding that the removal bar in Section 22(a) of the ’33 Act trumps CAFA’s general grant of diversity and removal jurisdiction. The defendants appealed.

In an opinion filed on July 16, 2008 (here), the Ninth Circuit affirmed the district court, specifically holding that Class Action Fairness Act, “which permits in general the removal to federal court of high-dollar class actions involving diverse parties, does not supersede Section 22(a)’s specific bar against removal of cases arising under the ’33 Act.”  

And with that it seemed, and I so concluded at the time, that what would happen next is that the Luther case would go forward in state court.

But that is not exactly what happened. As reflected in the May 18, 2011 opinion of the California Court of Appeal in the Luther case  when the case returned to state court, the defendants filed a demurrer on the ground that the California state court lacked jurisdiction under the ’33 Act as amended by the Securities Litigation Uniform Standards Act (SLUSA). The trial court agreed with the defendants and sustained their demurrer. The plaintiffs appealed.

Before getting to the Court of Appeals ruling, it is worth pausing to review the grounds on which the defendants had demurred. The defendants’ argument was based on the language of Section 22 of the ’33 Act, as amended by SLUSA, which provides in pertinent part:

The district courts of the United States and the United States courts of any Territory shall have jurisdiction of offenses and violations under this title and under the rules and regulations promulgated by the Commission in respect thereto, and, concurrent with State and Territorial courts, except as provided in section 16 with respect to covered class actions, of all suits in equity and actions at law brought to enforce any liability or duty created by this title.

The defendants’ argument is based on the phrase “except as provided in Section 16 with respect to covered class actions” which was added under SLUSA. The parties do not dispute that this case is a “covered class action” within the meaning of SLUSA (as it involves a suit in which damages are sought on behalf of more than 50 people). The question is whether the “except as provided” creates an exception to concurrent jurisdiction for all covered class action or only “as provided” in Section 16.

In the May 18 opinion, a three-judge panel of the Court of Appeals reversed the trial court’s ruling, concluding that SLUSA did not eliminate the concurrent state court jurisdiction in Section 22 of the ’33 Act. Specifically, Court of Appeals concluded that the “except as provided” language did not create an exception to concurrent provisions for all covered class action, but only according to the terms of Section 16. Based on its review of Section 16, the Court of Appeals concluded that “nothing” in Section 16 ”puts this case into the exception to the rule of concurrent jurisdiction,” adding that “the fact that the case is not precluded and can be maintained, but cannot be removed to federal court if filed in state court, tells us that the state court has jurisdiction to hear this action.” The Court of Appeal concluded that the concurrent state court jurisdiction survived the SLUSA amendments.

So, now we can all agree, there is concurrent state court jurisdiction for securities class action lawsuits under the ’33 Act, right? Well, maybe. Or maybe not.

For starters, other Circuit courts have not agreed with the Ninth Circuit’s conclusions regarding the impact of CAFA on the ’33 Act’s concurrent jurisdiction provision. As noted here, in a 2009 opinion in Katz v. Gerardi , the Seventh Circuit held here the provisions of the more recently enacted statutes, particularly CAFA, trump Section 22. The Seventh Circuit expressly rejected Luther v. Countrywide’s conclusion that the more specific securities statute prevailed. However, the Seventh Circuit’s  opinion, depended in part on the fact that the investment instruments involved are not "covered securities" (i.e., do not trade on a national exchange), and therefore did not come within one of CAFA’s removal exceptions. The Seventh Circuit held that the underlying mortgage securities-related class action lawsuit was properly removable to federal court.

Similarly, an October 2008 decision in the Second Circuit in the New Jersey Carpenters’ Fund v. Harborview Mortgage case had refused to remand to state court a ’33 Act case, as is more fully discussed on the 10b-5 Daily blog (here). The Harborview decision was primarily based on the fact that the underlying securities lawsuit did not involve "covered securities" for which SLUSA created an explicit removal exception; because the exception did not apply, the case could appropriately be removed to federal court notwithstanding the nonremoval provision in Section 22.

The Seventh Circuit’s  opinion, like the Second Circuit opinion in Harborview, depended in part on the fact that the investment instruments involved are not "covered securities" (i.e., do not trade on a national exchange), and therefore did not come within one of CAFA’s removal exceptions. Of course that was also the case with the securities in Luther – so where does that leave us?

I suppose where that leave us is that if you are a plaintiff hoping to pursue a ’33 Act claim in state court, your best bet is to file the lawsuit in California stat court. That is, in fact, exactly what the plaintiffs involved in a mortgage securities class action lawsuit filed against Morgan Stanley did. As discussed here, even though the plaintiff is a Mississippi pension fund and the defendant is a New York investment bank, the plaintiff filed lawsuit in Orange County, California, superior court. Clearly, at least one plaintiff concluded that, if there is a tactical advantage to being in state court, then California state court is the place to be.

To be sure, it is not as if pursuing a state court claim has proven to be all that rewarding for the Luther plaintiffs, at least not so far. The Luther plaintiffs filed their lawsuit years ago, they have been through not one but two appeals already, and they have only just now finally established their right to proceed in state court. Or, perhaps not. Who knows, maybe the next stop for this case is in California Supreme Court, And perhaps from there to the U.S. Supreme Court. The parties could be fighting for years before the jurisdictional question is finally decided.

There does seem to be something wrong with a system where what “concurrent jurisdiction” between state and federal courts winds up meaning concurrent jurisdiction in some states but not others. With everything that Congress has to worry about these days, this issue may not make it to the top of the list, but this really does seem like something that Congress ought to clean up. Regardless of where you come down on this issue, there seems to be a lot for both sides to argue about when it comes to concurrent jurisdiction, which is hardly a desirable state of affairs.

Nate Raymond's May 19, 2011 Am Law Litigation Daily artilcle about the California appellate decision in the Luther case can be found here.

Special thanks to the several readers who sent me copies of the California appellate opinion.

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One of the ways in which the current wave of bank failures is different from the failures during the S&L crisis is that this time around, by comparison to that prior period, a number of the bank closures have been accompanied by shareholder lawsuits brought  against the former directors and officers of the failed institutions. Some of these shareholder suits have survived dismissal motions, as was the case, for example, with the lawsuit involving Corus Bankshares, the recent settlement of which is discussed below.

But there have also been a number of these failed bank shareholder suits that have not survived the preliminary motions, as was the case with the shareholder suit involving UCBH Holdings, as also described below. To be sure, the court’s grant of the UCBH defendants’ motion to dismiss is without prejudice. But in view of the nature of the factual allegations involved, the dismissal motion ruling is noteworthy. In particular the court’s consideration of the FDIC’s regulatory actions regarding the bank are particularly interesting.

UCBH was the holding company of United Commercial Bank of San Francisco. The FDIC took control of United Commercial Bank on November 6, 2009 (refer here). Shareholders filed a securities class action lawsuit in the Northern District of California against eight officer defendants and six director defendants, as discussed at greater length here. Their complaint originally named UCBH  as well, but following UCBH’s November 25, 2009 bankruptcy filing, the claims against UCBH itself were stayed.

The plaintiffs allege that during the class period  the defendants issued false and misleading statements concerning UCBH’s allowances and provisions for loan loss and falsely represented that the company’s financial reporting controls were effective. The complaint further alleges that on May 8, 2009, the company’s auditor, KPMG, met with the FDIC and state banking authorities to discuss the deterioration in asset quality and overall deterioration of UCBH’s financial condition.

On May 13, 2009, KPMG alerted UCBH’s audit committee that illegal acts may have occurred relating to the overvaluation of impaired and real estate owned loans. The audit committee investigated. On September 8, 2009, the company announced that as a result of the investigation UCBH was required to restate its financial statements and that UCBH had reached a consent agreement with FDIC relating to a cease and desist order concerning alleged improprieties. UCBH’s  stock value fell and the bank ultimately was closed.

The defendants moved to dismiss the plaintiffs’ complaint. In a May 17, 2011 order (here), Northern District of California Judge Jeffrey S. White granted the defendants’ motion to dismiss without prejudice, on the grounds, inter alia, that the plaintiffs had not adequately alleged scienter.

In concluding that the plaintiffs allegations were insufficient to create a strong inference scienter, Judge While found that the plaintiffs allegations based on UCBH’s statements about the efforts of “senior management” to monitor and evaluate the bank’s loan portfolio did “not contain sufficiently particularized allegations to give rise to a strong inference of scienter.” Similarly, Judge Whit found that the plaintiffs’ allegations that the senior officers were motivated to conceal UCBH’s financial condition in order to obtain TARP funds also failed to allege that the these defendants had information about the bank’s financial condition that was withheld or falsely reported.

The more interesting part of Judge White’s scienter analysis concerned the plaintiffs’ efforts to rely on the FDIC’s actions and findings. In particular the plaintiffs sought to rely on the findings in the FDIC’s “material loss review” (MLR) that “senior executives” engaged in deliberate misconduct to conceal the Bank’s deteriorating financial condition by delaying risk downgrades and minimizing the bank’s loan loss allowance. Judge White observed that these allegations do not support a strong inference of fraud “as to any one Defendant,” since the MLR does not name “any particular individual as responsible for the alleged misconduct.”

The plaintiffs also sought to rely on the FDIC’s report of examination in April 2009 and KPMG’s May 2009 report to the company’s audit committee to establish scienter, but Judge White found that the allegations do not establish when the defendants became aware of the alleged misconduct and which defendants became aware.

Finally Judge White rejected plaintiffs attempt to rely on the “core operations inference” to satisfy the scienter pleading requirement, essentially arguing that the matters alleged to be misrepresented were so essential  to the bank’s core operations as to establish that the defendants had access to the disputed information. Judge White rejected this suggestion, concluding that the plaintiffs had not sufficiently alleged that the loan loss allowances and provisions were part of the bank’s “core operations.”

Judge White’s ruling in the defendants’ favor on the dismissal was without prejudice, and the plaintiffs were given leave to replead. It may be that the plaintiffs will overcome the pleading deficiencies in their amended complaint – indeed, in many respects Judge White’s opinion provides a roadmap for repeading.

Nevertheless it is striking that the dismissal motion was denied in a case where the company’s own auditor reported that illegal acts may have occurred and where company’s own audit committee investigation preceded a restatement and an entry into a cease and desist order, and where the FDIC itself concluded that the “senior executives” engaged in deliberate misconduct to conceal the bank’s deteriorating financial condition. Judge White’s analysis represents  a very demanding application of the PSLRA’s specificity requirement. In particular, his unwillingness to accept the FDIC’s conclusions of misconduct involving “senior executives” as sufficient allegations against any one individual defendant is a very exacting application of the standard -- although certainly justified, from the defendants’ perspective.

It of course remains to be seen whether the plaintiffs will be able to cure the deficiencies on repleading.. But it is noteworthy that the UCBH is only one of several shareholder suits filed against directors and officers of failed banks that have faced difficulties overcoming the initial pleading hurdles. Motions to dismiss have been granted in a number of these cases, including for example the cases relating to Downey Financial (refer here), Fremont General (here) and Bank United (here -- without prejudice).  But as noted below, a number of survived the dismissal motions as well.

I have in any event added the UCBH ruling to my running tally of credit crisis dismissal motion rulings, which can be accessed here.

Corus Bankshares: Among the failed bank securities class action lawsuit is the one filed against the former directors and officers of Corus Bankshares, the parent company of Corus Bank, which closed on September 11, 2009 (about which refer here). As discussed here, in April 2010, Northern District of Illinois Judge Elaine Bucklo denied the defendants’ motion to dismiss (The opinion that stands in interesting contrast to Judge White’s opinion in the UCBH case.)

On May 17, 2011, the parties to the Corus Bankshares case filed a stipulation of settlement (here) indicating that the case has been settled for $10 million, all which is to be paid for by company’s D&O insurance. I have added the Corus settlement to my list of credit crisis securities lawsuit settlements, which can be accessed here.

As a result of its relatively modest size, the Corus settlement may not seem particularly noteworthy, which may be a fair assessment. What strikes me about the Corus settlements is that it represents something that still seems to be surprisingly rare, which is a settlement of credit crisis-related securities class action lawsuit.

Even though there were well over 230 credit crisis-related securities class action lawsuits filed, there still have only been 20 settlements of the credit crisis securities suits. To be sure, a fair number of these cases were dismissed, but a substantial number (like the Corus case) were not dismissed. Even though many of these cases are now several years old only a very small number have settled so far – indeed the Corus settlement is only the third such settlement this year.

It seems to me that there is a substantial backlog of these as-yet unresolved cases, many of which are moving – apparently very slowly -- toward settlement. Eventually these cases will settle in substantial numbers. Though many of the settlements will, like the Corus settlement, be relatively modest, some will not be so modest and in the aggregate the total settlements will likely represent a very large figure. Even though a large chunk of these settlements may not be insured, a big chunk will be insured. The collective cost to D&O insurers could represent an impressive total. Reasonable minds may question whether or not insurers are now fully reserved for this eventuality.

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Largely (although not exclusively) driven by last summer’s enactment of the Dodd-Frank Act, we have entered a watershed period of corporate governance reform. Processes already now afoot have wrought a transformation in the relations between corporate boards and corporate shareholders. Even further changes lie ahead. In this post, I take a look at where we are now, what lies ahead, and what it all means.

Many of the observations in this post were influenced by the commentary during a panel discussion in which I participated on May 11, 2011, entitled “Dodd-Frank and the Rising Tide of Shareholder Empowerment”,” at the Menlo Park offices of the Orrick law firm. The views expressed in this post are my own.

Changes Already Underway

Though many of the rulemakings required by the Dodd Frank Act have fallen behind schedule, a number of the implementing rules already are in place and are already driving changes. In addition, other processes not directly connected to Dodd-Frank are also underway and changing board processes, practices and structure. Here are four specific governance reform processes currently underway:

1. Say on Pay: As a result of Section 951 of the Dodd Frank Act and the requirements of SEC rules that went into effect January 25, 2011, all but the smallest public companies have had to put their executive compensation practices to an advisory shareholder vote during the current proxy season. The practice of an advisory vote on executive compensation has been in place in many European counties for some time. Many U.S. companies and their advisors resisted the adoption of the requirement here, and others questioned the value of a mere advisory vote.

In ways that I think may have caught some observers by surprise, it appears that – even though the shareholder “say on pay” vote is purely advisory – the implementation of the requirement for a “say on pay” vote is having a significant impact on executive compensation practices. As reflected in a May 2, 2011 Wall Street Journal article entitled “Firms Feel ‘Say on Pay’ Effect” (here) , many companies, scrambling to win shareholder approval in the say on pay vote, have been pressured to alter pay practices. As the article says, “despite some early skepticism, the prospect of such votes has sparked boardroom debate over executive-pay practices that were long-rubber stamped:”

The last minute changes that some corporations have put through to avoid negative votes have included some extraordinary steps. Just before the shareholder vote at Disney, for example, the company dropped certain provisions in its contract with its CEO Robert Iger, as well as other executives removing a provision that would have grossed up any compensation awards to these officials in the event of an ownership change.

The net effect of this process, and board’s desire to avoid a negative vote, is that certain compensation practices may fall by the wayside and all companies will face greater pressure to better align executive compensation and company performance.

A May 3, 2011 memo from the Davis Polk law firm (here) provides a detailed status update on the current round of “say on pay” votes.

2. Proxy Access: On August 25, 2010, the SEC adopted rules, in changes that were to be effective November 15, 2010, to require all but the smallest public companies to include in the proxy materials that board candidates nominated by shareholders who meet certain qualifying criteria. In order to qualify to nominate a candidate, a shareholder or shareholder group must individually or collectively own at three percent of the voting power of company’s shares and must have held those shares for at least three years.  

However, on September 29, 2010, the Business Roundtable and the U.S. Chamber of Commerce filed a lawsuit challenging the proxy access rules that the SEC had adopted. The petitioners contend that the new rules are “arbitrary and capricious,” violate the Administrative Procedures Act, and infringe on the First and Fifth Amendments. In response to this legal challenge, the SEC on October 4, 2010 issued a stay of the effectiveness of the rules while the legal challenge is pending. A ruling in the legal challenge is expected later this year.

While the implementation of the proxy access rules are in abeyance and the outcome of the legal challenge is uncertain, the likelihood is that in the future shareholder will enjoy greater shareholder access by requiring a company to include in its proxy materials shareholder nominees to the board of directors. As two attorneys from the Saul Ewing firm wrote in an October 29, 2010 article in the Legal Intelligencer entitled “Be Prepared: Shareholder Activism is Here to Stay” (here), “whether under the rules now being considered by the court or some revision thereof, the Dodd-Frank Act, and its focus on shareholder protection and access, ensures shareholder activism is here to stay.” 

3. Board Declassification: One of the long-standing objectives of corporate governance reformers has been the elimination of classified or staggered boards, whereby directors were elected for three years terms ensuring that in any given year only a third of the directors are up for vote. The Dodd-Frank Act does not have anything to say directly on this issue. Nevertheless reformers, led by the Florida State Board of Administration, have succeeded in obtaining the voluntary agreement of a number of companies to the declassification of their boards, pursuant to which the companies will put their entire board to an annual vote.

As one recent commentator noted, “the overwhelming trend in corporate governance is toward the declassification of boards.” An April 26, 2011 press release from the Florida Board about its efforts can be found here. A May 10, 2011 commentary by Nell Minow on her Risky Business blog about the board declassification efforts can be found here.

4. Majority Voting: Another longstanding goal of corporate governance reformers has been the implantation of majority voting. In many U.S. public companies, director election requires only a plurality vote, so that a director candidate in an uncontested election who receives only one vote will be elected. In a majority vote model, a director in an uncontested election who fails to receive a majority of votes must offer their resignation.

As discussed in an April 19, 2011 Westlaw Business article entitled “Corporate Governance: Assertive Activist Investors” (here), the 2011 proxy season is the “culmination of a major drive to install majority voting standards,” and shareholders at a number of companies have voted in favor of shareholder proposals calling for majority voting standards.

Changes Just Ahead

1. Compensation Ratios: In one of legislation’s lesser noted provisions, Section 953(b) of the Dodd Frank Act directs the SEC to amend its executive compensation disclosure provisions to require reporting companies to disclose the ratio between total annual compensation of their CEO and the median annual compensation of their employees. Rules implanting these provisions are required to be adopted before the end of 2011.

As University of Denver Law Professor Jay Brown notes on his Race to the Bottom Blog (here), these disclosure requirements potentially could be “powerful.” As Professor Brown notes, the compensation ratio disclosure would shift the executive compensation dialog away from a comparison between executive compensation at different companies toward a comparison within the company itself. The provision rather obviously reflects an intuition that there is a disparity between the compensation paid to executives and the compensation to other company employees.

These provisions are controversial and there already is a move underway to repeal this provision.  But if the provisions become effective and reporting companies are required to disclose the compensation ratio as specified in the Dodd-Frank Act, it seems likely that what will follow is a protracted discussion around issues of compensation fairness and compensation equity, particularly as popular  notions about the appropriate ratios develop over time. Companies whose ratios suggest greater compensation disparity are likely to face added pressure on executive compensation issues.

2. Compensation Clawbacks: Another of Dodd-Frank’s executive compensation requirements is set out in Section 954, which requires to SEC to direct the national exchanges to impose new listing standards directing  public companies to implement compensation clawback provisions. Under Section 954, companies making accounting restatements of prior financials must recover from any current or former officer all incentive-based compensation paid during the preceding three-year period above what would have been paid without the misstated financials. According to a May 12, 2011 CFO.com article about the provisions (here), the SEC plans to propose and adopt rules implanting these requirements between August of this year and year-end.

The Dodd-Frank clawback provisions go far beyond the clawback requirements instituted in the Sarbanes Oxley Act. The SOX provisions were limited just to the CEO and CFO, where as the Dodd-Frank provisions are applicable current and former executive officer. SOX clawed back only the year prior to the restatement, whereas the Dodd Frank provisions reach back three years, and are applicable without regard to fault or wrongdoing.

The clawback provisions also have proven controversial. The CFO.com article cited above notes that these provisions have a “potentially far-reaching impact” that may “result in serious reconsideration of how incentive compensation plans are designed.” It is also possible, as another set of commentators has noted, that companies who in future find that they must restate prior financials may face litigation (or rather their officers and directors may face litigation) on questions whether a compensation clawback is required, against whom it should be enforced, and for what types or amounts of incentive compensation.

What it All Means

Though rule-making delays and litigation have delayed the implantation of some of the Dodd-Frank Act’s  requirements, many of the changes Dodd-Frank required are already here and others are just around the corner. These changes, and the other corporate governance reforms being pursued by shareholder advocates  have a number of significant implications, beyond just the most obvious practical effects.

1. Heightened Scrutiny: Not all companies are going to give in on executive compensation issues or on board process issues like board declassification and majority voting. (Indeed, there are certainly a number of serious commentators who question the value or even the wisdom of many of these reforms). But while different companies may respond to these developments in different ways, companies that resist these governance developments may face heightened levels of scrutiny, both from shareholders and from the media.

A very recent example of this kind of scrutiny involves the Internet media company, LinkedIn, which has recently filed to conduct an initial public offering of its securities. In two interesting but highly critical commentaries on the DealBook blog (refer here and here),University of Connecticut Law Professor Steven Davidoff takes LinkedIn to task for adopting “a governance structure that not only disenfranchises its future shareholders, but contains elements that have been heavily criticized by corporate governance advocates.” Among other things, Davidoff criticizes Linked In for its dual share class structure that ensures that the company founders will retain voting control of the company; for adopting a staggered board; and for instituting onerous by law provisions.

In referencing Davidoff’s critique of LinkedIn here, I am expressing no opinions in whether or not his criticisms are valid or whether LinkedIn fairly may be criticized. Rather I cite his analysis to show the kind of scrutiny all companies are likely to face if they pursue practices or implement policies that fly in the face of the current trends in corporate governance reform. This level of scrutiny is only likely to increase as other reforms, such as the compensation ratio disclosure requirements, go into effect.

2. Increased Litigation Risk: Companies that resist shareholder driven reform initiatives may not only face scrutiny, but they (or their directors and officers) may also face an increased likelihood of litigation. In a recent post (here), I noted the apparent trend in which companies who experience a negative “say on pay” vote may find themselves facing shareholder litigation relating to the companies’ compensation practices. As noted above, there are others of these current reforms – for example, the clawback provisions – that could also encourage shareholder litigation.

3. Changing Judicial Attitudes: A very strong principal traditionally informing judicial scrutiny of board processes and decision making has been a broad judicial deference to the boards themselves. With the shift towards greater shareholder empowerment, courts may also be less inclined than perhaps they were in the past to defer to boards.

This notion that evolving  corporate governance norms may affect judicial consideration of board process and functioning was highlighted in the Chancellor Chandler’s August 9, 2005 opinion in the Walt Disney Shareholder Litigation, where Chandler observed that “in this era of Enron and WorldCom debacles, and the resulting legislative focus on corporate governance, it is perhaps worth pointing out that the actions (and the failures to act) of the Disney board that gave rise to this lawsuit took place ten years ago, and that applying 21st century notions of best practices in analyzing whether those decisions were actionable would be misplaced.”

The Chancellor’s unmistakable implication is that heightened 21st century standards will be applied to 21st century board actions – in other words, as corporate governance standards change, boards will be held to standards of conduct reflecting the changed governance norms and expectations. And in an era of growing shareholder empowerment, that reality may translate into increased judicial expectation for boards to address shareholder initiatives.

Conclusion

There is of course within all of this extensive room for serious debate about whether or not these changes ultimately will advance or impede corporate performance and what impact all of this will have on the relatively competitiveness of U.S companies in a global marketplace. But whatever may be said along those lines, it seems clear that the changes brought about in the current round of corporate governance reforms are here to stay and will require corporate officials to adapt to the new environment.

Meanwhile, In Another Universe: Things that are commonplace now (the Internet, arthroscopic surgery, the E-Z pass toll collection system, open-on-the-bottom condiment containers, etc.) were virtually inconceivable just a short time ago. Rivka Galchen’s article entitled “Dream Machine” in the May 2, 2011 issue of the New Yorker provides a fascinating glimpse of even more fantastic changes the future may bring, in the form of "quantum computing" -- that is, computing based on the principles of quantum mechanics.

The promise of quantum computing is the vast improvement in computational power it could provide. As an example of a problem not otherwise resolvable through conventional computing but that could be solved through quantum computing is “prime factorization.” That is, it is easy to multiply two large prime numbers but very difficult to take a large number that is the product of two primes and to deduce the original prime factors. To factor a number of two hundred digits would take a conventional computer longer than the history of the universe but would only take a prime computer an afternoon.  

The explanation of how a quantum computer would accomplish this involves a scientific theory known as the Many Worlds Interpretation. It entails the “counterintuitive reasoning” that “every time there is more than one possible outcome, all of them occur.” So if a radioactive atom might decay and it might not, it both does and doesn’t.  From this, the many implied small branchings “ripple out until everything that is possible in fact is.”

According to Oxford physicist David Deutsch, the Many Worlds theory explains how quantum computers might work. According to Deutsch, a quantum computer would be “the first technology that allows useful tasks to be performed in collaboration between parallel universes.” The quantum computer’s processing power “would come from a kind of outsourcing of work, in which calculations literally take place in other universes.”

The Many Worlds theory to which Deutch refers to explain quantum computing’s theoretical operation seems (to me at least) to have more to do with the imaginative world of literature than it does to science. Perhaps my feeling in this respect is due in part to the unmistakable parallels between the Many Worlds theory and a short story written by the Argentine writer, Jorge Luis Borges.

Borges’s story, The Garden of Forking Paths, involves Dr. Yu Tsun, who is a descendant of a scholar (Ts'ui Pên ) who wrote an indecipherable novel about labyrinths. In this story, Dr. Yu meets a British sinologist who has uncovered the mystery of Ts'ui Pên’s novel. The British sinologist described his interpretation of the novel as follows:  

In all fictional works, each time a man is confronted with several alternatives, he chooses one and eliminates the others; in the fiction of Ts'ui Pên, he chooses-- simultaneously--all of them. He creates, in this way, diverse futures, diverse times which themselves also proliferate and fork. Here, then, is the explanation of the novel's contradictions. Fang, let us say, has a secret; a stranger calls at his door; Fang resolves to kill him. Naturally, there are several possible outcomes: Fang can kill the intruder, the intruder can kill Fang, they both can escape, they both can die, and so forth. In the work of Ts'ui Pên, all possible outcomes occur; each one is the point of departure for other forkings. Sometimes, the paths of this labyrinth converge: for example, you arrive at this house, but in one of the possible pasts you are my enemy, in another, my friend.

And so, I will leave you with this thought: In at least one universe, the quantum computer will become a working reality. The question that remains to be seen is which universe. Or to put it another way -- the possibility that there might be another universe in which the airline does not lose my luggage does not do me much good in the universe in which my luggage has been lost.

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The FDIC’s pursuit of litigation against directors and officers of banks that have failed as part of the current round of bank failures has been moving forward, albeit at a deliberate pace. The agency’s litigation efforts advanced a couple of steps in recent days, as the agency filed an additional lawsuit and publicly announced that even more are coming.

The FDIC filed its latest lawsuit on May 5, 2011 in the Northern District of Illinois. The lawsuit was filed against certain former directors and offices of Wheatland Bank of Napierville, Illinois, of which the FDIC took control on April 23, 2010 (about which refer here). The actual lawsuit in which the FDIC filed its complaint had begun as a shareholders’ derivative lawsuit in Cook County (Illinois) Circuit Court. The FDIC had removed the lawsuit to federal court (refer here) and on May 5, 2011, the federal court granted the FDIC’s motion to intervene as a party plaintiff and to filed its amended complaint.

In its complaint (a copy of which can be found here), the FDIC seeks to recover at least $22 million that the bank allegedly sustained in connection with commercial real estate loans (CRE). The complaint asserts claims for gross negligence, negligence, breach of the fiduciary duty of care, breach of the fiduciary duty of loyalty, and failure to supervise. The 6 individual defendants include four directors (two of whom who were also officers of the bank and two of whom were nonofficer directors who served on the loan committee), as well as the bank’s chief lending officer and its chief financial officer.  

The complaint alleges that:

Defendants recklessly implemented an unsustainable business model pursuing rapid asset growth concentrated in high-risk CRE loans without having adequate loan underwriting and credit administration practices to manage the risk. To make matters worse, the Bank routinely violated whatever loan policies it had in place and approved loans that had little chance of repayment. The Bank also made loans to favored shareholders and borrowers on terms that were preferential and abusive and then, after default, failed to pursue the borrowers and guarantors on these loans. Regulatory warnings about the Bank’s reckless lending practices were repeatedly ignored by Defendants. The out-of-control lending continued until the Bank was closed after only three years of operation.

With the filing of the Wheatland Bank complaint, the FDIC has now filed a total of seven lawsuits against former directors and officers of banks that have failed as part of the current round of bank failures. My running list of the FDIC’s lawsuits can be accessed here.

Interestingly, three of the seven have been filed against banks that had operated in Illinois. At one level, this not a surprise as Illinois has been of the leading states in terms of the number of failed banks. But there have been more in Georgia (which has only one lawsuit), and the over 360 bank failures since January 1, 2008 have involved banks in many different states. It isn’t clear if there is a reason why the litigation seems to be advancing in Illinois, as opposed to anywhere else.

While the FDIC has now filed a total of seven lawsuits against the former directors and officers of failed banks, it seems clear that there are more to come. On May 11, 2011, the FDIC updated its professional liability lawsuit page on its website to reflect that the FDIC has authorized suits against 208 individuals for D&O liability with damage claims of at least $3.86 billion. (The latest update increased the number to 208 from last month’s figure of 187.) Since the seven lawsuits the agency has filed includes only 52 individual lawsuits, there clear implication is that there are many more lawsuits yet to come against the remaining 156 defendants.

The FDIC’s website also discloses that the FDIC also has authorized 13 fidelity bond, attorney malpractice, and appraiser malpractice lawsuits. In addition, 135 residential malpractice and mortgage fraud lawsuits are pending, consisting of lawsuits filed and inherited.

The number of directors and officers against whom the FDIC has authorized litigation has increased every month since the FDIC first began publishing the data in September 2010. The aggregate figure has increased much more quickly than the total number of individuals against whom lawsuits have actually been filed. The clear implication is that the FDIC is being very deliberate in preparing its claims. The suggestion is that the lawsuits will continue to come in slowly – and that the process of filing the lawsuits may go on for quite a while yet.

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In a May 11, 2011 opinion (here), a three-judge panel of the Second Circuit affirmed the dismissal of rating agency defendants in litigation filed under the Securities Act of 1933 and involving mortgage-related securities issues by Lehman Brothers and IndyMac and the Residential Asset Securitization Trust (RUST). The Second Circuit affirmed the District Court’s rulings that the credit rating agencies could not be held liable under Section 11 of the ’33 Act as “underwriters” – even if they helped structure the securities at issue.

The plaintiffs were purchasers of mortgage backed securities. The plaintiffs generally alleged that the originators of the loans that backed the securities failed to comply with the general loan underwriting guidelines described in the offering documents. The plaintiffs allege that the rating agencies determined the composition of the loans in the mortgage pool that the instruments securitized. The plaintiffs also allege that the credit enhancements supporting the loans were insufficient to support the investment ratings the rating agencies gave the securities.

The plaintiffs premised their securities liability claims against the rating agencies based on their argument that the rating agencies were "underwriters" within the meaning of Section 11 of the ’33 Act. The plaintiffs based their theory that the rating agencies were "underwriters" on the argument that the "underwriter" liability extends to those "who engaged in steps necessary for the distribution." Plaintiffs argued that because the rating agencies structured the certificates at issue to achieve the desired ratings, that had performed a necessary predicated for the securities’ distribution in the market, and therefore they should be liable as underwriters.

In separate rulings on February 1 and February 17, 2010, Southern District of New York Lewis Kaplan granted the rating agency defendants’ motions to dismiss in the Lehman Brothers Mortgage Backed Securities lawsuit, as discussed here and here. Judge Kaplan relied on his ruling s in the Lehman Brothers case to granting the rating agency defendants’ dismissal motions in the IndyMac and RUST cases.  The plaintiffs’ appealed. Because the separate cases raised similar issues, the appeals were consolidated before the Second Circuit.

The Second Circuit affirmed Judge Kaplan’s ruling that the rating agencies cannot be held liable as “underwriters” under the ’33 Act. The Second Circuit said that:

The plain language of the statute limits liability to persons who participate in the purchase, offer, or sale of securities for distribution. While such participants may be indirect as well as direct, the statute does not reach further to identify as underwriters persons who provide services that facilitate a securities offering but who do not themselves participate in the statutorily specified distribution-related activities.

The Second Circuit also affirmed the lower court rulings that the Rating Agencies were not subject to “control person” liability under Section 15. Finally, the appellate court concluded that the district court did not abuse its discretion in denying plaintiffs’ leave to amend their pleadings.

The Second Circuit’s ruling not only is fatal for the claims of the plaintiffs in these cases with respect to the rating agencies, but also in the many other cases where other plaintiffs had raised similar claims. To be sure, these claims had not been faring particularly well in the district courts, as most other district courts were following Judge Kaplan’s district court ruling in the Lehman Brothers case. But now with the Second Circuit’s opinion these claims seem to have received what may be their final blow.

It is worth noting, however, that investors have filed lawsuits relating to subprime investments against the rating agencies on other theories. For example, in one case, discussed here, CalPERS had sued the rating agencies in connection with the agencies’ ratings on certain investment vehicles, asserting claims of negligence and negligent interference with prospective economic advantage. In the Cheyne Financial case (discussed here), the plaintiff investors had asserted a variety of common law claims against the rating agencies, including common law fraud and misrepresentation. These claims based on other theories will not be affected by the Second Circuit’s ruling.

What remains to be seen is whether the subprime mortgage-backed securities investors will prevail against the rating agencies on any theory.

Nate Raymond’s May 11, 2011 Am Law Litigation Daily article about the Second Circuit’s decision can be found here.

Is It Really Time to Head Out?: I know things have been challenging for securities class action plaintiffs’ lawyers. A string of Supreme Court decisions has made it lot tougher for them to pursue their claims and the cumulative impact of various legislative reforms have made it more difficult for the plaintiffs’ claims to survive the preliminary motions. But has it gotten so bad that it is time to pull up stakes to try to pursue shareholder claims in another country? Apparently so, at least judging from the actions of Michael Spencer, a securities class action plaintiffs’ attorney for the Milberg firm in New York.

According to a May 10, 2011 article in The (Toronto) Globe and Mail entitled “Top U.S. Class Action Lawyer Coming to Canada” (here), Spencer, who was lead plaintiffs’ counsel in the Vivendi securities trial, has been completing all of the requirements for being admitted to the Ontario bar, with the goal of practicing law there. He apparently intends to set up his Canadian practice with the Toronto law firm of Kim Orr Barristers. P.C.

The article explains that Spencer’s move is due to the years of tightening down on securities class actions in the U.S. (particularly in light of the U.S. Supreme Court’s decision in Morrison v. National Australia Bank). By contrast, court’s applying Ontario’s securities laws have recently certified a global class (in the Imax case, for example). The article quotes Spencer as saying “Simply put, Canada presents a great opportunity.”

I have recognized that the cumulative impact of the Supreme Court’s recent decisions had made life tougher for the plaintiffs’ bar. But I had not thought that things had reached a point that litigation prospects looked more promising outside the United States. The fact that we have reached the point that litigation prospects look brighter in Canada than in the United States represents a watershed development of some kind. I wonder how the Canadians feel about that…

I note for the record the Spencer has been a guest blogger on this site; his guest post can be found here.

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One of the most noteworthy stories over the past several months has been the flurry of accounting fraud allegations involving Chinese companies that obtained listings on U.S. securities exchanges through a reverse merger with a publicly traded domestic shell company. The emergence of these  allegations has certainly been one of the securities class action litigation stories so far this year (as discussed most recently here). One of the recurring questions I have been asked about these developments  is whether the SEC is going to step in and take action at some point. Signs are that the SEC is now getting into the action.

As discussed in a May 9, 2011 CFO.com article entitled “SEC Cracking Down on Foreign Shell Cos.” (here), the SEC has “become increasingly proactive” with respect to reverse merger companies—and not just with respect to the Chines companies that obtained their U.S. listings through reverse mergers.

The SEC heightened interest in this topic was specifically detailed in an April 27, 2011 letter that SEC Chairman Mary Schapiro sent to the House Committee on Oversight and Government Reform. In her letter, Schapiro stated that “the SEC has moved aggressively to protect investors from the risks that may be posed by certain foreign-based companies listed on U.S. exchanges.” She added that “while the majority of foreign-based issuers are engaged in legitimate business operations, others may take advantage of the remoteness of their operations to engage in fraud.”

Schapiro’s letter notes that last summer the SEC launched a “proactive risk based inquiry” into U.S. auditing firms that have a significant client base of companies whose principal operations are located outside the U.S. She notes that since the SEC launched this inquiry, 24 China-based companies have filed reports on Form 8-K disclosing auditor resignations, accounting problems or both. Many of these disclosures have noted the accountants’ concerns with cash and accounts receivable and the accountants’ inability to confirm these amounts.

Schapiro’s letter also notes that in the last several weeks the SEC has suspended trading in the securities of three China-based companies, HELI Electronics Corp., China Changjiang Mining & New Energy Co.; and RINO International Corp. The SEC has also revoked the securities registration of eight Chinese companies that obtained U.S. listings through reverse mergers. Schapiro’s letter also details enforcement actions the agency has pursued against auditors and individuals associated with the management of Chinese-based companies.

In addition to these actions by the SEC, the trading exchanges have also halted trading in more than a dozen Chinese reverse merger companies, which apparently has been a source of some frustration to investors, according to a May 10, 2011 Wall Street Journal article (here).

According to Schapiro’s letter (citing data from the PCAOB), there were a total of 159 Chinese-based companies that engaged in reverse merger transactions between January 1, 2007 and March 31, 2011. If Schapiro’s remarks in her April 27 letter are any indication, these companies’ disclosures are likely to be the source of heightened scrutiny. Indeed, SEC officials cited in the CFO.com article make it clear that all reverse merger companies, not just those linked to China, may face this same level of scrutiny.

The number of accounting-related concerns disclosed alone suggests the need for this heightened scrutiny. Schapiro’s letter and the SEC’s recent actions suggest that the SEC is gearing up for even greater enforcement and regulatory action.

In the meantime, private litigants are pressing ahead. In the last several days, investors have filed securities class action lawsuits against two more Chinese companies in U.S. courts. The first was filed on May 6, 2011 in the Central District of California against Sino Clean Energy Inc. and certain of its directors and officers. A copy of the plaintiffs’ counsel’s May 6 press release can be found here. The second was filed on May 8, 2011 in the Southern District of New York against Fushi Copperweld and certain of its directors and officers. A copy of the complaint can be found here. Both allege accounting and financial reporting misrepresentations.

With the filings of these latest two lawsuits, there have now been a total of 21 securities class action lawsuits filed against Chinese and China-linked companies so far this year. That is out of a total of about 85 new securities class action lawsuits YTD in 2011. That is, the Chinese-related suits represent almost one quarter of all new securities class action lawsuits this year.

The SEC may be becoming increasingly proactive with respect to non-U.S. reverse merger companies, and it may even have taken some very specific concrete actions in recent weeks. But at least so far it seems that the SEC is lagging not leading the effort. That said it does appear that the SEC is focused on the issue and further action seems likelier in the future.

Long-Running Alstom Securities Class Action Suit Settles: On May 9, 2011, the parties to the long-running Alstom securities class action lawsuit pending in the Southern District of New York filed their agreement to settle the case. As noted at greater length here, the plaintiffs first filed their action in 2003. Readers of this blog may recall that in September 2010, Judge Victor Marrero entered a significant ruling in the case, in which he granted the defendants’ motion, in reliance on the Morrison v. National Australia Bank case, to dismiss from the action the claims of the Alstom shareholders who had bought their shares in the France-based company outside the United States.

According to the parties’ settlement agreement (which can be found here), the parties have agreed to settle the case for $6.95 million dollars. The agreement itself does not specify whether or not this amount is to be funded by Alstom’s insurers; however, the agreement does specify that the funds are to be paid into escrow by the company or its insurers, and the released parties include the company’s insurers.

It seems fair to say that the size of the settlement reflects the drastic reduction in the size of the class as a result of Judge Marrero’s Morrison-related ruling. The settlement seems to indicate the extent to which Morrison may operate to reduce the magnitude of securities class action lawsuits filed against non-U.S. companies, even those whose shares or ADRs trade on U.S. exchanges. At least where only a small portion of the company’s shares trade in the U.S., the size of the lawsuit class will be substantially narrowed and the potential damages and settlement exposure may be substantially reduced.

Twelve Steps to Good Corporate Governance: In light of the changes wrought by the Dodd-Frank Act and other developments, the corporate governance landscape has been transformed. Many companies are struggling to come to grips with the requirements of the new environment. In recognition of the changing governance environment, the Latham & Watkins law firm has published an interesting memo entitled “12 Steps to Truly Good Corporate Governance” (here). This memo is readable and worth reading. It contains a number of valuable insights and useful suggestions for companies to come to grips with the demands and requirements of the new era of shareholder empowerment.

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A number of different organizations  generate annual publicity for themselves by designating a word (or words) of the year. We are not yet half way through 2011 but I am already prepared to propose my own candidate for this year’s word of the year – the word is “whistleblower.” From the provisions of the Dodd-Frank Act and the predecessor provisions of the Sarbanes Oxley Act to the litigation activities of activist investors, whistleblowers’ actions and protections are a growing source of attention and concern – and litigation.

Since the Dodd Frank Act’s  passage last summer, the whistleblower provisions of the Dodd-Frank Act have received a great deal of scrutiny. The SEC proposed rules to implement the provisions last November (refer here).  The proposed rules have not yet been enacted by the SEC. However, according to a May 5, 2011 Reuters article (here), the vote on the final rules implementing the whistleblower provisions could come as early as May 25, 2011.

Among the issues surrounding the final rules is the question of whether or not they mandate  that would-be whistleblowers must first report wrongdoing internally before reporting violations to the SEC, in order to be eligible for the so-called whistleblower bounty.  According to the Reuters article, the SEC has “no plan to make internal reporting a mandatory first step for whistleblowers.” However other alternatives are under consideration, including the possibility of allowing company employees to reap full benefits of the bounty provisions if a combination of the employee’s tip and information from a company’s internal probe lead to the imposition of fines or penalties for securities law violations.

While the final rules on the whistleblower bounty provisions are pending, there have also been developments related to the other significant components of the Dodd-Frank whistleblower provisions -- the provisions’ anti-retaliation protections. A May 4, 2011 order in a case pending in the Southern District of New York took a detailed look at who may invoke the anti-retaliation provisions and what is required to invoke the protection. The order can be found here. UPDATE: Please note that  in a subsequent September 1, 2011order, here, Judge Sands dismissed the plaitiffs' claims with prejudice, having concluded that the plaintiff has insufficiently pled his claims of retaliation and of securities fraud.

This case was brought by an employee of Trading Screen. The employee believed the company’s CEO was diverting opportunities and assets from Trading Screen to a company solely controlled by the CEO. The employee reported the CEO’s actions to the company’s President, who in turn reported the information to the company’s Board. The Board hired outside counsel (the Latham & Watkins firm) which investigated and concluded that the activity was taking place as the employee reported. However, when the Board sought the CEO’s voluntary resignation from the company, the CEO  was able to wrest control of the Board. The CEO later fired the employee who had reported the violation.

The employee filed suit against TradingScreen, the CEO and a variety of related entities asserting a number of claims, including a separate cause of action for retaliatory discharge under the Dodd Frank whistleblower provisions (about which generally refer here). Among other things the relief available under the provisions includes reinstatement, double back pay, and costs and fees.

In moving to dismiss with respect to these allegations the defendants contended that the plaintiff is not covered by the Dodd Frank anti-retaliation provisions because he did not personally report the alleged violation to the SEC and because he does not otherwise come within the four other categories of activity that would bring his conduct within the provision.

The four other categories of disclosures protected under the Dodd Frank anti-retaliation provisions are disclosures: under the Sarbanes Oxley Act; under the Securities Act of 1934; under federal statutory provisions relating to investigative officers; or disclosures under any other law, rule or regulation of the Commission. In his May 4, 2011 order, Southern District of New York Judge Leonard Sand found that because TradingScreen is a private company, the employee’s disclosures did not come within the Sarbanes Oxley Act or the Securities Act, and that plaintiffs’ allegations were otherwise insufficient to bring his actions within the other two categories of disclosures.

The employee himself had not disclosed the alleged violation to the SEC. But the employee contended that he nevertheless came within the statute because he had made the disclosure to the SEC “jointly” with the outside law firm that investigated his allegations of misconduct. Judge Sand allowed that if the disclosures had been made to the SEC by the law firm, they were made “jointly” by the employee with the law firm, because law firm’s investigation of his report had led to the disclosure. However, Judge Sand also found that the plaintiff had not sufficiently alleged that the law firm had in fact disclosed the information to the SEC, but he granted the plaintiff leave to amend his complaint in order to try to establish that the law firm had in fact disclosed the information to the SEC. However, it should also be noted that in his September 1, 2011 order, Judge Sands dismissed the plaintiffs' claims with prejudice, concluding in particular that "Plainitff's Second Amended Complaint fails to allege a claim under the Securities Whistleblower Incentives and Protection provisions of teh Dodd-Frank Act." 

Much of the focus of discussion about the Dodd Frank whistleblower provisions has been on the whistleblower bounty. However, given the breadth of the anti-retaliation provisions, those provisions could also prove to be critically important. 

On May 3, 2011, the Ninth Circuit issued an opinion (here) in a separate alleged whistleblower retaliation case, this one under the whistleblower protections in the Sarbanes Oxley Act.  The case involved two individuals who had been part of the IT Sarbanes Oxley audit group at Boeing. The two had become concerned that Boeing was putting pressure on the audit team to rate Boeing’s internal controls “effective.” After raising concerns internally, the two had communicated with a reporter at the Seattle Post-Intelligencer, who wrote articles about the company’s audit process. After an investigation, the company concluded that the two had violated the company’s policy against releasing internal information to the press without authorization, and the company terminated the employment of the two individuals.

The two individuals filed an action against the company alleging retaliation for actions protected by Sarbanes Oxley. The district court had granted the company’s motion for summary judgment and the two individuals appealed.

In its May 3 order, the Ninth Circuit concluded that the individuals were not protected under Sarbanes Oxley because it provides protections only for disclosures to a federal regulatory agency; a member or committee of Congress; or a supervisor or other individual authorized to investigation such misconduct. “Members of the media,” the court found, “are not included,” noting that Congress had limited the activity protected under the provisions to “employees who raise certain concerns of fraud or securities violations with those authorized or  required to act on the information.”

The court concluded that the provision “does not protect employees of public companies who disclose information regarding fraud or certain securities violations to members of the media.” The court concluded that Boeing was within its rights to terminate the employees for violating company policy. The Ninth Circuit affirmed the district court.

The Ninth Circuit’s opinion and to a lesser extent Judge Sand’s opinion in the case discussed above serve as a reminder that those who comply with the statutory requirements will be able to bring themselves within the statutory protection.  The statutory provisions do not protect whistleblowing in and of itself, but only certain kinds of whistleblowing under certain kinds of circumstances and conditions. Along with cases exploring the protections available under these statutory provisions, we can expect further cases examining the question of when supposed whistleblowers are entitled to the protection of the statutory provisions.

One final note during on the general whistleblowing theme is the lawsuit that was unsealed this past week in which taxpayers allege that certain loans extended by the Federal Reserve Bank of New York in the fall of 2008 as part of the bailout of AIG had defrauded taxpayers. The lawsuit, which first filed in the Southern District of California in 2010, and which was ordered unsealed last month, asserts claims under the False Claims Act. The taxpayers’ amended complaint can be found here.

The taxpayers’ complaint relates to two emergency loans the government extended to AIG that totaled over $40 billion and that were used to settle trades involving blocks of mortgage-backed securities that AIG had guaranteed. The lawsuit, which names as defendants not only AIG but also the transaction counterparties (which included Goldman Sachs, Deutsche Bank, Bank of America and Societe Generale), alleges that the Fed’s loans were improper because they were made without first obtaining a pledge of appropriate collateral as required by applicable law. The plaintiffs seek to recover for the U.S. government the losses sustained by the government as a result of the fraud and false claims alleged in the complaint.

Though the taxpayers’ action may be different in kind and character than the other cases discussed above, the cases collectively serve to underscore the prevalence of whistleblowing activity. Courts undoubtedly will continue to sort out the prerequisites necessary to invoke the statutory whistleblower protections. But even while there may be many issues yet to be sorted out, whistleblowing itself already is a significant phenomenon, as witness by a host of current devopments, including the Wikileaks disclosures. With the protections and bounties under Dodd-Frank, its importance seem likely to increase. The likelihood for increased litigation involving whistleblower-related activity seems high.

Speakers' Corner: On May 11, 2011, I will be moderating a session in Menlo Park, California entitled "Dodd-Frank and the Rise of Shareholder Empowerment." The session is sponsored by the Orrick law firm, The Directors Network and Deloitte, and will take at place at the Orrick law firm's Menlo Park offices. The program, which is free and which will run from 8:45 am to 11:45 am, will provide insights and practical advice regarding fundamental changes in the corporate governance environment and the emerging role of shareholders in the U.S. corporation.

The session includes an all-star cast of panelists, including; Consuelo Hitchcock, Principal, Regulatory and Public Policy at Deloitte; Marc Gross, of the Pomerantz, Haudek, Grossman & Gross law firm; Anne Sheehan, Director of Corporate Governance at CalSTRS; George Paulin, the President of George Cook & Co.; and Jonathan Ocker and Bob Varian of the Orrick law firm.

Further information about the program, including registration information, can be found here.

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Since late last year, reports have been circulating that the U.S. government is investigating whether drug companies paid bribes overseas to increase sales and to obtain regulatory approvals. Some firms have now announced that they have reached settlements with enforcement authorities. And now the first civil lawsuit relating to these investigations has been filed, as discussed below.

According to press reports and company filings, a number of companies have disclosed last year that they were being investigated for possible FCPA investigations involving a broad range of possible violations including bribing government-employed doctors; paying sales agent commissions that are passed along to doctors, paying hospital committees to approve drug purchases and paying regulators to win drug approvals. Additional press coverage regarding the breadth of this industry probe can be found here.

The first enforcement action and  settlement related to this investigation emerged last month, when governmental regulators announced that Johnson & Johnson had agreed to pay more than $70 million dollars to settle FCPA-related allegations. The SEC’s April 8, 2011 litigation release can be found here, the U.S. Department of Justice’s April 8, 2011 press release can be found here and the U.K. Serious Fraud Office’s press release can be found here.

As reflected in the enforcement authorities’ various press releases, Johnson & Johnson’s subsidiaries, employees and agents were alleged to have paid bribes to public doctors and administrators in Greece, Poland and Romania and kickbacks to Iraq to win business there. Johnson & Johnson’s payments to settle the various probes included $48.6 million to the SEC in disgorgement and prejudgment interest, a $21.4 million criminal penalty to the Justice Department and a £4.8 million ($7.8 million) to the U.K. Serious Frauds Office. A detailed overview of the allegations and the settlements can be found on the FCPA Professor’s Blog (here). According to the FCPA Blog (here), the Johnson & Johnson settlement is the tenth largest FCPA settlement ever.

Moreover, it appears that other settlements arising out of the probe may soon follow. Last week, Eli Lilly. disclosed that it is in “advanced discussions” to settle bribery related allegations. According to news reports, the activities under investigation involve alleged improper payments in Poland and possibly include activities in other countries as well.

The ongoing investigation is affecting ordinary business operations in companies caught up in the probe. For example, SciClone Pharmaceuticals announced earlier this week that its compensation committee would defer decisions on executive compensation until its board receives a report of a foreign bribery probe. The internal investigation is said to be parallel to that of the U.S. enforcement authorities.

And now it appears that the ongoing drug company bribery probe has also produced its first civil lawsuit. On May 2, 2011 investors filed a shareholders’ derivative suit in the District of New Jersey against Johnson & Johnson, as nominal defendant, and eleven board members, relating to the company’s settlement of the bribery charges. The complaint, which can be found here, alleges that the individual defendants breached their duty of loyalty by “failing to cause J&J to implement an internal controls system for detecting and preventing bribes to public doctors and administrators in Greece, Poland, and Romania, and kickbacks to Iraq to win business there.”

The complaint asserts claims for breach of fiduciary duty, mismanagement, abuse of control, corporate waste, unjust enrichment and violations of the federal securities laws.” The complaint seeks to hold the individuals liable to the company for damages, which the complaint alleges, referring to the fines, disgorgement and interest that the company has agreed to pay, exceed $70 million.

The FCPA itself does not provide for a private right of action. But as I have observed in previous posts (refer for example here) , one of the frequent accompaniments of an FCPA enforcement action is a follow on civil action, of the type filed against the Johnson & Johnson officials. And while the fines, disgorgements and penalties paid in connection with the FCPA settlement would not typically be covered un der a D&O policy, the defense costs incurred in connection with the follow on civil action would be covered, and settlements and judgments entered in the civil action would at least potentially be covered, subject to all of the applicable policies terms and conditions.

With the signs suggesting that there may be further enforcement actions and settlements in connection with the ongoing pharmaceutical industry bribery probe, there is an accompanying concern that as the overall investigation moves forward, there may also be a parallel wave of follow on civil litigation. This possibility is not only an added concern for the affected companies themselves and their senior executives, but is also a concern for the D&O insurance carriers.

There are a number of interesting features of the Johnson & Johnson settlement that may be significant in connection with the continuing investigations against the other drug companies. The first is that in connection with the Johnson & Johnson enforcement action, the governmental authorities took the position that the FCPA was relevant with respect to payments made to doctors in the counties specified. The position of the SEC and the other enforcement authorities is that because the health system in the counties involved is a government operation, the doctors involved are “foreign officials” within the meaning o f the FCPA, which , as discussed on the FCPA Professor blog here and here, is noteworthy issue of considerable interest and concern.

The other interesting about the Johnson & Johnson settlement relates to the comments in the DoJ’s press release with respect to Johnson & Johnson’s cooperation. The DoJ noted not only the company’s “timely voluntary disclosure” but also noted the company’s “significant assistance in the industry-wide investigation.” The press release also states that the company received a reduction in its criminal fine” as a result of its cooperation in the ongoing investigation of other companies and individuals.” The clear implication is not just that the probe is ongoing but that other companies and individuals are under investigation. The upshot may well be, as suggested above, that there will be further enforcement actions and possibly further settlements ahead.

The DoJ’s press release also underscored the extent to which the investigation of corrupt activities is a global, cross-border undertaking. In its press release, the DoJ noted not only the investigative collaboration with other U.S enforcement agencies and with the U.K. serious fraud office, but also recognized the helpful assistance of investigative bodies in Greece and Poland. These circumstances highlight both the collaborative international scale of the investigations but also how seriously the matters are being taken by a wide variety of governments and governmental authorities.

Finally in light of the magnitude of the Johnson & Johnson settlement (and the fact that the settlement made the Top 10 List) it is probably worth reflecting that the company reached this settlement while, at least according to the DoJ, receiving a reduction in its penalties not only because of the cooperation noted above, but also because of the company’s “pre-existing compliance and ethics programs, extensive remediation, and improvement of its compliance systems.” That the company should still face fines and penalties of the magnitude to which it agreed notwithstanding the credits the company received for these efforts is a striking development.

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You may have seen May 2, 2011 Wall Street Journal article entitled “Overhaul Grows and Slow” (here), which described the backlog developing as regulators struggle to meet the rule-making deadlines mandated by the Dodd-Frank Act. The article itself was interesting enough, but if you really want to appreciate the daunting task regulators face, you may want to take a look at the law firm memo on which the article was based.

The May 1, 2011 memo from the Davis Polk law firm, entitled “Dodd-Frank Rulemaking Report” (here) provides a much more detailed look at the regulators' massive burden.

As the memo details, Dodd-Frank (which was massive enough itself) mandated 387 different rulemakings from 20 different regulatory agencies. (Some of the mandates require multiple agencies to issue rules on a given topic or item; if the joint rules are not double-counted, the number drops from 387 to 243.)  Congress not only required the rulemakings, but it specified the rulemaking schedule for many of the mandates as well. Of the 387 required rulemakings, 275 have specified rulemaking deadlines or annual requirements.

The bad news for regulators is that with most of the regulatory deadlines yet to come, they have already fallen behind. For example, not a single one of the agencies involved met any of the 26 deadlines that fell in April 2011. Cumulatively, the agencies collectively have now missed more than 30 deadlines.

The worse news for regulators is that most of the deadlines are yet to come. As the chart on page 8 of the law firm memo shows, only 40 of the 387 deadlines will have occurred through the end of the 2^nd quarter 2011. The real problems will arise during the 3^rd quarter of 2011 (which will coincide with the first anniversary of Dodd-Frank’s passage). In the third quarter alone the agencies will face 108 different rulemaking deadlines, about 28% of the total. There is no relief after that, either, as 37 more deadlines fall in the fourth quarter.

The agency that will face the biggest challenge is the SEC. Of the 387 rulemaking mandates, 95 (or about one quarter of the total) are directed to the SEC. Of those 95 SEC mandated rulemakings, 75 have deadline requirements, and 45 have deadlines that fall in the third quarter of 2011. As of today, the SEC has completed new regulations only six required items, proposed 28 additional rules and missed deadlines on 11. In the second half of 2011, the SEC will have to complete a total of 52 more rulemaking -- and that doesn’t even take into account the deadlines on which the SEC has already fallen behind.

The authors of the law firm memo are not optimistic that the regulatory agencies will much greater success meeting these upcoming deadlines than they did with the deadlines that have occurred so far. As graphics in the memo depict very vividly, the commentary period that follows a proposed rulemaking produces a “mountain” of comments. Working their way through that mountain required regulators to read many comments in a short timeframe. Missed deadlines seem likely.

The rulemakings that have been delayed already include some of those relating to the Dodd-Frank Act’s most closely watched provisions. For example, the rules relating to the Act’s new whistleblower provisions, which had been due April 21, now reportedly will not be available until late July. The SEC also delayed the release of its proposed regulations on resource extraction and conflict minerals disclosure, which had been required earlier in April.

The problem is not just the sheer magnitude of the task; it is also the political pressure that interested groups are applying to the process. The Journal article cites Stanford Law Professor (and former SEC Commissioner) Joseph Grundfest as saying that “the problem is not just the number of the rules, It’s the complexity of them, and it’s the political power of the various constituencies that are affected by these rules.”

Whatever the reason for the delay, it seems like the day by which we will finally be able to assess the overall impact of the Dodd-Frank Act may now be even further off into the future.

Legal  History: The Davis in the Davis Polk law firm’s name refers to John W. Davis, who was the Democratic party candidate for President in 1924. Davis  lost the election to Calvin Coolidge.  The firm can boast of a former President among its alumni, as Grover Cleveland was a member of a predecessor firm during the period between his two separate Presidential terms.

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The wave of new securities class action lawsuits involving accounting scandals at U.S-listed Chinese firms is already a well-established phenomenon. But in the latest twist on the tale, Deer Consumer Products, one of the U.S.-listed Chinese companies most recently sued based on allegations of accounting fraud, has gone on the warpath and is publicly alleging that the lawsuit against the firm is part of an elaborate scheme by “illegal” short sellers to manipulate the company’s share price. And according to press reports, a different  Chinese firm that also  has been hit with a lawsuit also have raised the question whether short sellers might be behind the accounting fraud allegations.

The latest story involving Deer Consumer Products began on April 30, 2011, when plaintiffs’ lawyers announced in a press release that they had filed a securities class action lawsuit in the Central District of California against the company and certain of its directors and officers. Among other the plaintiffs’ attorney’s press release states that:

Deer misrepresented its financial performance, business prospects, and financial condition to investors, citing inconsistent Chinese regulatory filings. The Complaint also alleges that Deer improperly recognized revenue in violation of Generally Accepted Accounting Principles (“GAAP”). On March 9, 14, and 17, 2011, analyst Alfred Little issued a series of reports disclosing defendants’ alleged fraud, which caused the stock price to drop, damaging investors.

On May 2, 2011, Deer Consumer Products issued its own  press release (here) in which the company asserted that it has “evidence of continuing illegal short selling” in its stock, and also  asserted that its “common stock has been manipulated in collusion among ‘naked’ short sellers.” The press release goes on to assert that the class action lawsuit itself is “part of the attempted manipulation.”

Now, it is nothing new for companies to assert that the bad news circulating about them is based on rumors from profit-motivated short sellers. But the Deer Consumer Products takes this common gripe quite a bit further. The company asserts that the supposed analyst, Alfred Little, whose reports are the source of the rumors and are relied on in the complaint is “a fictitious character” whose phony identity is “a disguise used by one or more illegal short sellers in the short sale scheme.” The purported reports of Alfred Little were “published in collusion with short sellers” to “intentionally create fear in the general public to drive down DEER’s share price.”

The press release goes on to assert that all of the allegations in the supposed Alfred Little reports are false and that the company intends to seek sanctions against the law firm that filed the lawsuit.

Deer is not the first U.S.-listed Chinese company to charge that the allegations of accounting fraud originated with short sellers. U.S. shareholders in another U.S- listed Chinese company that has also been hit with a securities class action lawsuit, China Agritech, are also alleging that stories circulating about the company and that are behind the lawsuit are the result of the actions of short sellers. (Background on the China Agritech lawsuit can be found here).

A very interesting April 26, 2011 Bloomberg article entitled “Wall Street Scion Lost in China Agritech as Shorts Cry ‘Scam’”(here) contains the allegations of one U.S. investor in China Agritech that “someone blatantly lied to short the stock.” The U.S. investor, Jesse Glickenhaus, troubled by an analyst’s report that the company was a scam with no real operations, went to China himself and toured company facilities with company executives, to verify the existence of claimed business operations and facilities.

Or at least Glickenhaus thinks he toured company facilities. In yet another twist to the story, after Glickenhaus published his account of his Chinese factories tours on his own investment company’s website, other short sellers  asserted that Glickenhaus  had been duped, and that rather than touring the company’s factory, Gliockenhaus had been taken to a state-owned plant at a different address than the one listed in China Agritech’s filings.

With all of these levels of confusion and disinformation, it is hard to tell who is scamming whom and what version of the truth actually corresponds to reality. Are the Chinese companies scamming investors by misrepresenting their true financial condition? Or are investors being misled by short sellers who have an incentive to cast doubt on the companies and drive down the share price?

You do start to wonder why any investors would invest in U.S.-listed Chinese companies. The Bloomberg article about Glickenhaus provides some of the answers. Glickenhaus is the 29-year old grandson of his investment firm’s founder, who invested in China Agritech without even knowing that the company had obtained its U.S. listing through a reverse merger. He seemed particularly persuaded by the fact that the Carlyle Group had previously invested in the company.

Even if he was not duped during his recent China visit about China Agritech’s operations, Glickenhaus seems like a remarkably uncritical investor. He remains committed to the company and to his investment even though the company has fired two auditors in four months and still has not filed its 2010 financial data. Carlyle’s representative on the company’s board has also resigned.  Glickenhaus does concede that “in the future, if I find a company in China, I’ll probably stick to those that have had a major, well-known auditor for several years.” 

Whether the accounting fraud allegations have substance or are the product of short-sellers’ profit-motivated imaginations, it is clear that the existence of the allegations is continuing to drive securities class action litigation against U.S.-listed Chinese companies. In addition to the new lawsuit against Deer, plaintiffs’ lawyers have in the last week and a half also filed lawsuits against these other U.S.-listed Chinese companies: Gulf Resources (refer here); ZST Digital Networks (refer here); and SkyPeople Fruit Juice (refer here). Interestingly, the same law firm that filed the Deer lawsuit filed these three others as well.

Another U.S.-listed company with its fish farming operations in China but its headquarters in Washington State, HQ Sustainable Maritime Operations, was also hit with a securities lawsuit last week (refer here).

With the arrival of these latest lawsuits, a total of 19 new securities class action lawsuits have been filed against Chinese companies so far in 2011. That is out of a total of about 79 lawsuits  this year, meaning that the China-related lawsuits represent about one-quarter of all2011 YTD  class action securities lawsuits. That is on top of the ten lawsuits that were fled against Chinese companies in 2010.

Signs are that there are more lawsuits yet to come, as well. Plaintiffs’ firms have issued press releases that they are investigating other China-linked companies, including Longtop Financial (refer here) and Sino-Clean Energy (refer here). Interestingly, the press release announcing the Sino-Clean investigation was issued by the same law firm that filed the Deer lawsuit described above, and the press release also references an analyst report by Alfred Little (the same analyst whom Deer claims is fictitious).

In addition to the securities class action lawsuit describe above, investors have also filed at least one shareholder derivative recently involving a Chinese company. On April 27, 2011, plaintiffs filed a derivative lawsuit in the District of Wyoming against Duoyuan Printing, as nominal defendant, and certain of its directors and officers, alleging that the individuals breached their fiduciary duties b, among other things, issuing false and misleading statements regarding the company’s financial results. A copy of the complaint can be found here. The company itself is a Wyoming corporation with its principal place of business in China.

An April 4, 2011 speech by SEC Commissioner Luis Aguilar (here) reported that there were 150 reverse merger transactions between 2007 and the present in which Chinese companies merged with U.S.-domiciled shells to obtain a listing on a U.S. exchange. I am sure not all of these 150 companies have accounting problems (or will otherwise be targeted by short sellers). But I am guessing that before all is said and done, a lot more of them may wind up as defendants in class action lawsuits filed in U.S. courts.

In any event, it does seem like the SEC is finally getting around to doing  something about all of this. On April 29, 2011, the SEC announced (here) that it had halted a Ponzi scheme involving China Voice Holding Company in which company officials were using proceeds from later offerings to pay off those who invested in earlier offerings.

It's All There in Black and White: The illustration at the outset of this post of course depicts the characters from the classic Spy v. Spy comic that first appeared in Mad Magazine. For those so culturally deprived as to be unfamiliar with the comic, the basic premise was that the two spies were identical, except that one was dressed in while and one was dressed in black, and they were endlessly trying to take each other out. The comic incorporated all of the requisite cartoon elements – bombs, blond bombshells, missiles, anvils, rocket ships, trapdoors, dynamite, electrified door knobs and so on. Here’s a short video clip capturing a classic moment from the comic:

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In a few days I will celebrate the fifth anniversary of the day I published my first post on this blog.  I had no idea what was going to follow after that first post, but having come so far after so long, it seemed appropriate on this occasion to reflect on the enterprise. It has been an interesting, unexpected, and ultimately rewarding experience.

In May 2006, I was still in the early stages of my current job. The phone had not yet started to ring, so to fill my time I started fooling around with the Blogger application on Google. I launched The D&O Diary with little planning and no expectation that it would amount to anything. That first step pretty much characterizes the approach I have taken all along since that first post – I just keep putting one foot in front of the other and I wait to see where the path will take me.

The timing of my blog launch was fortunate, as it turned out. Shortly after I got the blog set up and organized, the whole options backdating scandal broke. And after that in quick succession came the mortgage meltdown, the credit crisis, Madoff, the wave of bank failures, a host of Supreme Court decisions, Dodd-Frank, and a multitude of other scandals and events large and small.  Many of these developments involve truly terrible news, but they all provided great grist for the blogging mill. Even now, a bunch of Chinese companies are enmeshed in a terrible accounting scandal, which is bad news for them, but quite helpful to me (at least in my blogging capacity).

I have been fortunate in another way, which is that I have acquired a loyal and supportive readership that keeps me supplied (usually with accompanying requests for anonymity) with a steady stream of case decisions, pleadings, news article, books, academic articles, questions, comments and queries. I get my best material from readers, and I could never have kept this project alive without the regular contributions from readers.

I have been even more fortunate to be able to publish guest posts from and interviews with leading attorneys (both plaintiff and defense), academics, and journalists. These individuals’ willingness to publish their articles or comments has added both depth and breadth – not to mention variety – to this site.

And so with all of these fortunate things  going for me, here I am, five years into this crazy experiment, with over 2,000 email subscribers, another 1200 RSS subscribers, and countless other readers who access the blog through one of several aggregation services that pick up my content. The site itself has had over 2.5 million page views. It is fair to say that I didn’t anticipate any of this. The blog’s reach never ceases to amaze me.

From time to time, I get notes from readers with kind words about the blog, which I very much appreciate. (I also get notes with, shall we say, constructive criticism as well). But truthfully, no one gets more out of the blog than I do. It is not just that writing the blog is a regular source of amusement and an avenue of creative expression for me. It is rather that the blog has done so much for me personally and professionally.

First, on the most practical level, maintaining the blog has ensured that I am always up to speed on the latest developments in my field. The blog’s constant content requirements mean that I am aware of and have usually written and thought about  just about everything of importance out there.

Second, and more importantly, the blog has allowed me to form innumerable connections around the world. I have email pen pals on almost every continent (no readers in Antarctica that I know of – yet). I have regular communications with a large number of lawyers, academics, journalists, financial analysts and regulators. I have also formed fast friendships with many of my fellow bloggers, all of whom have been supportive and helpful over the years. These friendships and communications have not only enriched the blog, but they have expanded my own horizons and enhanced my awareness of and appreciation for important trends and developments.

Third, I have the recurring delight of hearing from completely unexpected sources that they have read my blog. Once I was stopped while walking through Times Square by a total stranger who wanted to tell me that he reads my blog every day. Several different times I have had people come up to me in airports to say they recognized me from my blog. (That’s why the picture is up there in the upper right hand corner.) I have even had guys at my golf club comment to me about posts on my blog. And I have to say that is about the last thing I ever expected, that I would get recognition at my country club for, of all things, having a blog.

But the most important thing for me about my blog is that I enjoy doing it. For me, the blog itself is like having my own personal  Fourth Plinth  (pictured above) – that is, I can put anything up there I want. A blog post can take just about any form – it can be a case note, a news report, an editorial, an interview, a book review, a statistical analysis, or anything else that I choose. My imagination is the only limitation.

The ability to imbed pictures, videos and hyperlinks to other sources affords a richness and depth that simply is not possible with the traditional written document. And the ability to publish content immediately means that I can quickly reach out to a vast audience of friends, peers, colleagues and casual readers. I get a big charge every single time I post an item.

All of this comes at a price, however. The actual content posted on the site is the culmination of a lengthy process that can take hours and hours and hours. The hardest step in the process is the first one, which is deciding what to write about. Blog topics are not self-revealing. Occasionally, somebody has sent me something that obviously needs to go up right away. But the rest of the time, blog topics have to be hunted down in the endless ocean of information and conversation that surrounds us all. The search for blogworthy topics is never-ending – the worst part about adding a new post is that at the moment of publication the pressure to find another topic starts all over again.

And the actual blog content is only a small part of the operation. The fact is that I am for all practical purposes in the publishing business. I am not only responsible for content, but I am the copy editor, the fact checker, the proofreader, the typesetter and the art editor. I am the research department, the customer service department, and the subscription department. I am the managing editor, the business manager, and the chief operating officer. With all of these duties, the process of maintaining the blog takes an insane amount of time.

Another problem is that the blog has required me to dwell among the demons of technology. No one would ever believe (except perhaps another blogger) how many weird technological challenges I have had to confront. To cite just one example, one day out of the blue, for no apparent reason and without any warning, our firm’s IT manager changed the IP address of the server on which I housed all of the self-hosted documents to which I had linked on my site. That meant that every single one of the hundreds and hundreds of links on my site to self-hosted documents (pleadings, case decisions, etc.) was broken. I was on suicide watch for several weeks. I eventually repaired the links in the most recent posts but the links in many older posts simply don’t work, and at this point, alas, probably never will again.

Sometimes the blog can feel like a full-time job, but the fact is that my job is my job. And my job is often demanding, stressful and time-consuming. Finding the time, energy and intellectual residue to work on the blog after a long day dealing with my real job can be very difficult at times.

The point I am trying to make is that maintaining a blog is a lot harder than it looks. A blog is a harsh mistress – and she can be a needy and temperamental bitch too.

Just the same, I can’t imagine stopping the blog. When I have my teeth into something I really want to write about, I am fully engaged. I get a great deal of satisfaction out of creating a blog post on a topic that has captured my imagination or sparked my creative energy. And when I hear someone refer to the blog, even to challenge something I have written, I get a huge charge. And so I intend to keep right on blogging, damn the torpedoes.

Even though this project is five years old, there are still a lot of things I want to try to do with the blog. I would like to attract more guest posts, particularly from attorneys, academics and even regulators .I would like to publish a lot more interviews, with practitioners and observers who have an interesting perspective toa dd.   I would like to introduce more international topics, particularly with respect to Asia. I would like to do more book reviews and I would like to include more posts with observations on other topics, like movies, wine and travel.  And wouldn’t it be cool if there was a way to imbed sound on the site? How about smell – maybe a scratch and sniff version. Hmmm…

The one thing I know for sure is that I will have to continue to try new things, because the blogging environment is changing all the time. One way the environment has already changed during the years I have been blogging is the rise of the social networking sites, particularly Twitter and Facebook. These outlets have for many readers occupied the space and time that other media (including blogs) used to inhabit. I also think they have resulted in shortened attention spans. By contrast to these newer media, blogs (especially one like mine) can look slow, bloated and out-of-date. At the same time, I sometimes worry that the constant chatter can be deafening. Or at least numbing. I worry that in that kind of environment, I become one more ditto head in the chattering class choir.

As I said at the outset, one of the great advantages I have had from almost the very beginning is that I have gotten a lot of support from my readers. As I look forward to this blog’s next phase whatever it might be, I could really use some advice. I want to stay (or perhaps, become) relevant. I want to provide content that is useful, interesting and entertaining for my readers.

So as I wind up this retrospective essay, I want to ask everyone to let me know what they would suggest for me to develop this site and make it better. I welcome everyone’s thoughts on possible topics, books I should review, persons I should interview, possible alternative approaches, analyses or formats, anything and everything that could add the content on this site. And in particular, I would really like to encourage anyone who has ever given a thought to submitting a guest post for publication on this site to put their post together and sent it to me any time.

There are many rewarding things about having this blog, and without a doubt one of the best is the sense of community I feel with my readers. When I hit that “publish” button, I know that readers around the world are going to open their emails and click through to the blog and read what I have written. The idea that I have my own little corner of the Internet that thousands of people willingly visit every day is absolutely amazing to me.

Thanks to every one for stopping by during the last five years. I look forward to having you visit again – frequently – in the future.

Finally, I would be remiss is I did not thank my colleagues at OakBridge and at RT Specialty for all of the support they have given me and this project over the years. This thing would never have gotten off the ground without their help and I would never have been able to keep it going without their backing. Thanks for everything, guys.

Prepare Ye, The Harmonic Convergence Approacheth!: : The Cleveland Indians are in first place in the Central Division with the best record in all of baseball. The have won six straight games and thirteen in a row at home. They won their last three games in their final at bats. No one, and I mean absolutely no one, saw any of this coming. (Hello? Hello? Is this thing on? [Tap, tap] Testing, testing, one, two, three...)

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