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

The Internet is buzzing over Bank of America’s June 29, 2011announcement (here) of its eye-popping $8.5 billion settlement to resolve “nearly all” of the repurchase claims involving legacy Countrywide-issued residential mortgage-backed securities (RMBS). The company’s press release and accompanying June 29, 2011 filing on form 8-K contain a lot of information about the underlying dispute and the settlement, but the deal has many moving parts and there is a lot to absorb here.

From a survey of the settlement documents, it appears that, among other things, the settlement resolves only the investors’ repurchase claims under the documents governing the securities but apparently does not resolve the investors’ separate claims under the federal securities laws, as discussed below.

The deal itself involves a settlement with the Bank of New York Mellon as trustee to 530 RMBS trusts having an original principal balance of $424 billion and unpaid principal balance of $221 billion. According to the Wall Street Journal’s account of the deal, the dispute had begun with a demand last October from a law firm representing 22 institutional investors. 

The investors had demanded that BofA repurchase mortgages that had been packaged into securities, basing their demand on allegations of   “breaches of representations and warranties contained in the Governing Agreements with respect to the Covered Trusts (including alleged failure to comply with underwriting guidelines (including limitations on underwriting exceptions), to comply with required loan-to-value and debt-to-income ratios, to ensure appropriate appraisals of mortgaged properties, and to verify appropriate owner-occupancy status),  and of the repurchase provisions contained in the Governing Agreements. ”Although the original demand was on behalf only of the 22 investors, the settlement is on behalf of virtually all investors in the trusts.

The settlement agreement can be found here. The plaintiffs’ firms press June 29, 2011 press release about the settlement can be found here. The basic framework of the settlement is straightforward – BofA will pay $8.5 billion to settle the claims. But there is more to it than that.

First, the settlement requires court approval. The settlement agreement explains that the Trustee will initiate an “Article 77 proceeding” in order to obtain the necessary approval. An article 77 proceeding is an action provided for under the New York Civil Practice Law and Rules, refer here. All costs associated with the Article 77 proceedings are to be borne by BofA. The 8-K specifically warns that given the number of trusts and investors and the complexity of the settlement “it is not possible to predict whether and to what extent challenges will be made to the settlement.”  The settlement is also conditioned on the receipt of tax rulings from the IRS and New York.

Second, on its face, the settlement involves a lot more than $8.5 billion. The 8-K says that” in addition to” the $8.5 billion settlement payment, BofA is “obligated to pay attorneys’ fees and costs to the Investor Group’s counsel as well as all fees and expenses incurred by the Trustee in connection with the settlement, including fees and expenses related to obtaining final court approval.” According to the exhibits to the settlement agreement, the plaintiffs’ firm is to receive $85 million in fees and costs.. As Susan Beck points out on the Am Law Litigation Daily, that may only represent one percent of the settlement, but it is still a respectable chunk of change.

Third, although the settlement is intended to be broad, there are a number of matters that the settlement does not resolve. For example, the settlement does not cover “a small number” of legacy transactions, including six transactions in which BNY Mellon did not act as Trustee.

Perhaps even more interestingly, the settlement does not resolve the investors’ claims under the securities laws. As the 8-K states, “because the settlement is with the Trustee on behalf of the Covered Trusts and releases rights under the governing agreements for the Covered Trusts, the settlement does not release investors’ securities law or fraud claims based upon disclosures made in connection with their decision to purchase, sell or hold securities issued by the trusts.”

Specifically, Paragraph 10 of the Settlement Agreement states that “release and waiver in Paragraph 9 does not include any direct claims held by Investors or their clients that do not seek to enforce any rights under the terms of the Governing Agreements but rather are based on disclosures made (or failed to be made) in connection with their decision to purchase, sell, or hold securities issued by any Covered Trust, including claims under the securities or anti-fraud laws of the United States or of any state; provided, however, that the question of the extent to which any payment made or benefit conferred pursuant to this Settlement Agreement may constitute an offset or credit against, or a reduction in the gross amount of, any such claim shall be determined in the action in which such claim is raised, and the Parties reserve all rights with respect to the position they may take on that question in those actions and acknowledge that all other Persons similarly reserve such rights.”

Fourth, beyond the $8.5 billion settlement, BofA will also record an additional 2Q11 charge of $5.5 billion additional representations and warranties exposure to non-government sponsored entities “and to a lesser extent GSE exposures.” Despite the sizeable amount of this charge, the 8-K specifies that the amount is not intended to include a variety of other costs, including “potential claims under securities laws.” The 8-K adds that the company is “not able to reasonably estimate the amount of any possible loss” concerning these other matters (including securities claims), noting that “such loss could be material.”

The settlement documents do not indicate whether any portion of the settlement will be funded by insurance. Given the nature of the settlement and of the underlying claims, the settlement would not appear to be a matter than would involve D&O insurance. At least one reader has raised the question whether or not the settlement might involve BofA’s E&O insurance. Much would depend on the nature of the coverage the bank has purchased. I welcome readers’ thoughts on the possibility of insurance coverage availability for this type of a settlement.

In any event, as massive as the settlement and the separate charge are, they do not and not intended to relate to the investor claims asserted under federal securities laws or state laws. As for those claims, I guess we will all just have to stay tuned…

Readers will of course recall that the parties to the securities class action lawsuit brought by shareholders of Countrywide against Countrywide and certain of its directors and officers previously announced a more than $600 million settlement (refer here). There are many other pending suits brought on behalf of investors who purchased Countrywide-issued mortgage backed securities. 

UPDATE: There is even more to this deal than I discussed above. If you have read this far, you will really want to take the time to read Susan Beck's excellent detailed analysis of the settlement in the Am Law LItigation Daily,here.

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Years from now, when the history of the Roberts Court is finally written, I hope that the historians will be able to explain why during the first dozen years of the 21^st century, the U.S. Supreme Court seemed so eager to take up securities cases. But whatever the reason, on June 27, 2011, on the final day of a term in which the Court heard three different securities cases, the Supreme Court granted a petition for writ of certiorari to hear yet another securities case next term.

The case is styled as Credit Suisse Securities (USA) LLC v. Simmonds and the question that the Supreme Court will address has to do with the interpretation and application of the statute of limitations in Section 16(b) of the ’34 Act, relating to so-called “short swing profits.” Here is the Question Presented in the case:

Whether the two-year time limit for bringing an action under Section 16(b) of the Securities Exchange Act of 1934, 15 U.S.C. § 78p(b), is subject to tolling, and, if so, whether tolling continues even after the receipt of actual notice of the facts giving rise to the claim.

The litigation arises out of the IPO laddering scandal from the dot com era. The plaintiff filed fifty-four related derivative complaints under Section 16(b) in connection with 54 IPOs in 1999 and 2000. The gist of the plaintiff’s allegation is that the supposed arrangement whereby the underwriters had arranged for post-IPO stock purchases of the issuers’ securities at progressively higher prices (“laddering”) constituted prohibited short-swing profits. The plaintiff seeks to compel the underwriter defendants to disgorge their profits.

The District Court granted the defendants’ motions to dismiss. As to thirty of the cases, the district court granted the dismissal motion as to thirty of the companies based upon the inadequacy of the derivative demand letters the plaintiff had sent to the issuer companies. The District Court dismissed the remaining twenty-four cases on the basis of Section 16(b)’s two year statute of limitations. The plaintiff appealed.

In a December 2, 2010 opinion (as amended on January 18, 2011) written  by Judge Milan Smith a three-judge panel the Ninth Circuit affirmed the district court’s ruling as to the demand letters, but reversed the district court as to the statute of limitations issue. The specific issue the Ninth Circuit addressed was whether the two-year statute of limitations is a strict statute of repose, or whether it is a “notice” or “discovery” statute that is tolled until the claimant has sufficient information to be put on notice.

The Ninth Circuit, following its own prior precedent, held that the two-year statute operates as a “notice” statute, and the running of the statute is tolled until there has been adequate disclosure of the trade. Because the statute begins to run only when the defendant files a Section 16(a) disclosure statement, and because the defendants did not file a Section 16(a) statement, the Ninth Circuit held that the claims are not time-barred.

In an unusual twist, Judge Smith, the author of the opinion for the three judge panel, added an additional opinion “specially concurring” in the result and expressing his view that the two-year statute of limitations is a statute of repose, and that were it not for the prior Ninth Circuit precedent on which the court relied in deciding this case, he would have voted that the Section 16(b) cases could not be brought more than two years after the short-swing trades took place.

The defendants affected by the Court’s ruling on the statute of limitation filed a petition for a writ of certiorari with the United States Supreme Court and on June 27, 2011, the Court granted the petition.

Discussion

There was a time when the Supreme Court rarely took up securities cases. That time is long passed. The Court is not only routinely taking up securities cases, but it is even taking up routine matters – this is the second securities-related statute of limitations case the Court has taken up recently. Just last year the Court dealt with statute of limitations issues in the Merck case.

The Court has only just accepted this case and it has not yet been briefed, much less argued. The Supreme Court does not explain why it takes up the cases it takes up. But I have to say that it doesn’t seem very likely that the Supreme Court took up this case to affirm the Ninth Circuit’s holding. I have no idea how five or more votes on this case will line up, but if I had to predict I would guess that the Court will say that two –year statute of limitations in Section 16(b) operates as a statute of repose.

It seems that Judge Smith’s unusual appended opinion specially concurring in the holding but in effect dissenting from the Ninth Circuit’s precedent operated like an entreaty to the Supreme Court to clean up the situation.

The one wild card is that Chief Justice Roberts may not participate in this case. The Court’s June 27 order specifies that Roberts did not participate in consideration of the cert petition. He may be conflicted out, perhaps as a result of his prior activities while in private practice. If Roberts does not participate, the conservative majority that lined up together this past term on the Janus Capital (refer here) and Wal-Mart Stores case (here) may not be able to put together the five votes to control the outcome. In which case, the outcome of the Supreme Court review may be too close to call.

But in any event, next October we will enter yet another Supreme Court term with at least one securities case on the Court’s docket. I know for sure at least one blog post I will be writing somewhere between next October and next June.

Special thanks to a loyal reader for alerting me to the cert petition grant.  

A Year After Morrison: Speaking of the Supreme Court and securities cases, the first anniversary of the Morrison v. National Australia Bank case has just passed, and in recognition of the event, Luke Green had an interesting retrospective post on his ISS Securities Litigation InSights blog (here). I have long thought that the Morrison case was one of the most interesting developments in this area, and as Green’s post makes clear, the case has had a multitude of interesting implications.

Summertime: “Love to me is like a summer day/silent because there’s just too much to say./Still and warm and peaceful,/even clouds that may drift by can’t disturb our summer sky.”

Pentwater, Michigan  June 26, 2011

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In the wake of the U.S. Supreme Court’s landmark June 20, 2011 decision in Wal-Mart Stores v. Dukes, numerous commentators have asserted that the case could have a significant impact on future class actions. For example, one law firm’s memo about the case stated that the decision “should limit the number of class actions that are certified.” Which inevitably leads to the question of what the impact of the Wal-Mart decision will be with respect to class certification in securities class action lawsuits.  This question seems all the more acute given the unanimous opinion the Court issued in the Erica P. John Fund, Inc. v. Halliburton case just days before it issued its opinion in the Wal-Mart case.

First, some background. The Wal-Mart case involves an employment discrimination lawsuit brought by three female Wal-Mart employees on behalf of all female Wal-Mart employees. The plaintiffs did not allege that Wal-Mart had an express discriminatory policy against the advancement of women. (Wal-Mart in fact had a nondiscrimination policy.) Rather, the claimed that local managers’ discretion over pay and promotions had an unlawful disparate impact on women, and that the company’s refusal to constrain its managers’ discretion amounted to disparate treatment.

In order to satisfy Fed. R. Civ. Proc. 23(a)(2)’s class certification prerequisite that “there are common questions of law or fact common to the class,” the plaintiffs argued that the discrimination to which they have been subjected is common to all female Wal-Mart employees. But the commonality of the 1.5 million class members’ claims derived from the local manager’s discretion. In effect, the plaintiffs were arging that the non-policy (allowing local manager discretion) was a policy.

In his majority opinion in the Wal-Mart case, Justice Scalia said (rejecting the statistical evidence and expert testimony on which plaintiffs sought to rely) that the plaintiffs “have not identified a common mode of exercising discretion that pervades the entire company.” He added that “other than the bare existence of delegated discretion, respondents have identified no ‘specific employment practice,’ much less one that ties all their 1.5 million claims together.” The majority concludes that because the plaintiffs “provide no convincing proof of a companywide discriminatory pay and promotion policy, we have concluded that they have not established the existence of any common question.”

In reaching this conclusion, the majority commented that Rule 23 “does not set forth a mere pleading standard”; rather a party seeking class certification “must affirmatively demonstrate his compliance with the Rule – that is, he must be prepared to prove that there are in fact sufficiently numerous parties, common questions of law or fact, etc.” The majority opinion goes on to state that the required “rigorous analysis” will “entail some overlap with the merits of the plaintiff’s underlying claim. That cannot be helped.”

So, it seems, courts determining whether or not to certify a class should not rely on plaintiff’s mere allegations alone, but must examine the merits in order to determine whether or not the plaintiff has met the certification requirements. The “rigorous analysis” requirement apparently applies whenever a claimant seeks to proceed in the form of a class action, regardless of the nature of the underlying claim – including even when the alleged injury is asserted under the securities laws.

So courts determining whether or not to certify a class in a securities lawsuit must examine the merits? As University of Illinois Law Professor Christine Hurt asked in the recent post on the Conglomerate blog (here), isn’t that basically what the Supreme Court just rejected a few days ago in the Erica P. John Fund, Inc. v. Halliburton Co. case?  As Professor Hurt put it, referring to the Halliburton case “we've already had this fight in securities law, and the plaintiffs won in a unanimous ruling.”

Just to review, in the Halliburton case, the Court held that a securities plaintiff relying on the “fraud-on-the-market” theory to establish reliance did not have to separately establish loss causation in order to obtain class certification.

As it happens, the majority opinion in Wal-Mart expressly discussed the Halliburton case, in footnote 6, which footnote accompanies the opinion text in which the majority discussed the need for courts to review the merits of the plaintiff’s underlying claim in determining whether or not to certify a class.

The footnote states, in pertinent part, that “perhaps the most common example of considering a merits question at Rule 23 stage arises in class-action suits for securities fraud.” The commonality requirement “would often be an insuperable barrier to class certification, since each of the individual investors would have to prove reliance on the alleged misrepresentation.” But the “problem dissipates” if the plaintiff relies on the fraud-on-the-market presumption, by which all traders in an efficient market are presumed to rely on the accuracy of the company’s statements. Citing Halliburton, the footnote states that “to invoke this presumption, the plaintiffs seeking 23(b)(3) certification must prove that their shares were traded in an efficient market,” adding after the citation that this is “an issue they will surely have to prove again at trial in order to make out their case on their merits.”

In light of this footnote, it seems in that in order to establish commonality and obtain class certification, a securities plaintiff must establish that their shares traded in an efficient market. Halliburton held that if a plaintiff has established the right to rely on the fraud on the market presumption, the plaintiff does not have to separately establish loss causation in order to obtain class certification. Footnote 6 in the Wal-Mart opinion seems to suggest that the entitlement to the fraud on the market presumption to establish reliance is sufficient to satisfy the commonality requirement, and no further merits determinations are required at that stage.

The answer to Professor Hurt’s question seems to be that the Court in Halliburton did not say that the merits were not to be considered at the class certification stage in a securities suit; rather, at least as interpreted in footnote 6 in the Wal-Mart decision, the merits determination at the class certification stage is limited to the requirement that securities plaintiffs establish entitlement to rely on the fraud on the market theory, as that is sufficient to establish commonality.

So my answer to Professor Hurt’s question is that Wal-Mart is (or at least can be read to be) consistent with Halliburton. My further view is that Wal-Mart didn’t change much at least when it comes to class certification in securities cases. To be sure, there undoubtedly will be defense attorneys who will attempt to use the Wal-Mart decision in opposition to class certification motions in securities cases. We must await another day to see if these likely efforts produce an impact. For now, my own view is that the impact of Wal-Mart is likely to be limited in the securities class action litigation class certification context.

I am interested in readers’ thoughts on whether Wal-Mart changes anything at the class certification stage for securities plaintiffs.

The one final observation about Wal-Mart relates to the final clause in footnote 6. The clause states that even if a securities plaintiff has established at the class certification stage their entitlement to rely on the fraud on the market presumption, that is “an issue they will surely have to prove again at trial on order to make out their case on the merits.”

In other words, establishing an efficient market at the class certification stage is not ultimately determinative of the issue. This obviously leaves open the door for a contrary determination at trial, with the attendant possibility that the basis for the certification of the class could be eliminated as well. That would seem like a pretty daunting prospect for many securities plaintiffs, at least where there is a real possibility of a trial determination that that the defendant company’s shares did not trade in an efficient market. Something I would think securities class action plaintiffs’ attorneys would have to think pretty hard about before pushing a case to trial.

Special thanks to a loyal reader with whom I exchanged emails about footnote 6.

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As the worst days of the financial crisis (if not their ill effects) receded into the past, the accompanying credit crisis-related litigation wave appeared to lose its momentum. By late 2010, new credit crisis-related lawsuit filings seemingly had dwindled away. But now at the midpoint of 2011, two new credit crisis related lawsuit have arisen. These new lawsuits raise a number of interesting issues, as discussed below.

The Latest Filings

Deutsche Bank: According to their June 21, 2011 press release (here), plaintiffs’ lawyers have filed a securities class action lawsuit in the Southern District of New York against Deutsche Bank and four of its directors and officers. The complaint, which can be found here, purports to be filed on behalf Deutsche Bank common shareholders who purchased their shares between January 3, 2007 and January 16, 2009.

The complaint, which alleges that the defendants “concealed the Company’s failure to write down impaired securities containing mortgage-related debt,” asserts that the defendants concealed that:

(a) defendants failed to record adequate provisions for losses on the deterioration in mortgage assets and collateralized debt obligations on Deutsche Bank’s books caused by the high amount of non-collectible mortgages included in the Company’s portfolio; (b) Deutsche Bank’s MortgageIT subsidiary was issuing and had issued billions of dollars of mortgage loans which did not comply with stated lending practices, leading to thousands of defaults; (c) Deutsche Bank’s internal controls were inadequate to ensure that losses on residential mortgage-related assets were accounted for properly; and (d) Deutsche Bank had transferred billions of dollars in defaulting, or soon-to-default, mortgages to unwitting investors and government programs due to its disregard of adverse findings by outside consultants.

Carlyle Capital Corp.: On June 21, 2011, a plaintiff filed a securities class action complaint in the U.S. District for the District of Columbia against certain individual officers and directors of the now defunct Carlyle Capital Corp. (CCC), its investment manager and related entities. The complaint, which can be found here, purports to be filed on behalf of all those who purchased CCC shares between June 19, 2007 and through March 17, 2008.

The complaint alleges that CCC was organized under the laws of Guernsey to profit from the spread between the its portfolio of residential mortgage-backed securities (RMBS)and the cost of financing those assets through short term repurchase agreements and other forms of financing. Its principal place of business was in Washington, D.C. The complaint alleges that the entity was a “house of cards” because it was committed to acquiring “volatile, risk-securities that could only be purchased using massive borrowing with the securities purchased serving as collateral.” The company’s RMBS portfolio deteriorated during 2007, even prior to the company’s July 2007 IPO on Euronext. The complaint alleges that the deterioration and the liquidly issues associated with the companies repo agreement financing were not disclosed to investors.

The complaint alleges that following the offering, the defendants continued to misrepresent the company’s financial condition, particularly with respect to its RMBS portfolio. Despite the deteriorating market for RMBS, CCG continued to acquire additional RMBS. The complaint alleges that as the marketplace nearly reached a “meltdown” in August 2007, the company did not recognize its portfolio losses. In early 2008, a cascade of margin calls forced the company’s managers to put the company into liquidation under the authority of the Royal Court of Guernsey.

Discussion

These two cases have more in common than just the fact that they both related (each in their own way) to the global financial crisis. First, they both involve entities organized under the laws of non-U.S. jurisdictions. Second, the complaints were first filed well after the end of the purported class period. In each of these two cases, these case attributes may present some interesting challenges for the plaintiffs.

Deutsche Bank is of course a domiciled in Germany. However, the company’s Global Registered Shares are listed on the NYSE. Its shares also trade on the Frankfurt Stock Exchange. The complaint purports to represent all investors that purchased the company’s common shares during the class period. The complaint does not explicitly restrict its class to those investors that purchased their shares on the NYSE, but the question undoubtedly will arise under Morrison v. National Australia Bank whether the relief available under the U.S. securities laws will extend to those who purchased their shares outside the U.S.

Though CCC had its principle place of business in Washington, D.C., CCC was organized under laws of Guernsey and its shared traded on the Euronext Exchange. Euronext is based in Amsterdam and has affiliates in Belgium, France, Netherlands, Portugal and the U.K. The defendants undoubtedly will seek to argue, in reliance on Morrison v. National Australia Bank, that because the transactions in which the purported class of investors purchased their shares took place outside the U.S., their alleged injuries are not cognizable under the U.S. securities laws.

The plaintiff in the CCC case, no doubt anticipating this argument, alleges in his complaint that since April 2007 Euronext has been owned by the NYSE; that most of the alleged misconduct too place in the U.S.; that a substantial majority of the CCC shares were owned by U.S. residents, and that U.S. investors “with typical brokerage accounts” access Euronext shares the same as they would NYSE or NASDAQ shares. These considerations notwithstanding, the question under Morrison is where the “transaction “ took place, and in light of the post-Morrison case law, the CCC plaintiff may face significant challenges overcoming the defendants’ Morrison-based motion to dismiss. The defendants undoubtedly will argue that Morrison expressly rejected the very kind of “conduct and effects” arguments on which the plaintiff apparently intends to rely.

The belated nature of both of these cases also presents some rather interesting issues. The Deutsche Bank case was filed about two and a half years after then end of the purported class period. The CCC complaint is even more belated, having first been filed more than three years after the class period cut off.

The timing of the Deutsche Bank complaint may have to do with the timing of the U.S. Department of Justice’s recently announced suit against the bank related to the its  alleged misrepresentations about its mortgage loans. The recently filed class action complaint, specifically references the DOJ action and the May 4, 2011 Wall Street Journal article about the DOJ complaint. The securities class action complaint appears to have followed in the wake of and in reaction to the filing of the DOJ complaint. But while the timing of the filing of the class action complaint may be understood as related to the timing of the DOJ complaint, the plaintiffs should anticipate that the defendants’ dismissal motion will include a motion to dismiss the case on statute of limitations grounds.

The CCC plaintiff’s complaint expressly anticipates the likelihood of a statute of limitations dismissal motion. The complaint contains numerous paragraphs raising the delays that the Liquidation authority faced in trying to investigate the causes of CCC’s collapse. The complaint alleges that the defendants and other related Carlyle parties “undertook deliberate and affirmative steps to conceal… facts sufficient to apprise Plaintiff and the Class of the existence of potential claims against the Defendants.” The complaint cites purported statements of the Liquidator that the defendants “repeatedly obstructed their efforts” to obtain CCG’s books and records.

On July 7, 2010 the Liquidators commenced a civil action against the defendants in multiple jurisdictions, asserting that the defendants breached their fiduciary duties to CCC. The plaintiff alleges that the defendants’ “fraud was effectively and indefinitely concealed from the public at least until July 7, 2010.”

It remains to be seen whether the CCC plaintiff’s fraudulent concealment argument will prove sufficient to overcome statute of limitations concerns. But the belated nature of these cases and the presence of the statute of limitations concerns underscore why the credit crisis-related litigation wave has largely petered out, and why we are unlikely to see very many more credit crisis-related lawsuits. Even if these cases manage to overcome the statute of limitations hurdle, any other potential case that has not yet been filed will facing even more daunting timeliness problems.

It is interesting to note how both of these cases embody filing trends that seemed to have completely played out some time ago, or at least to have dwindled out. As I noted at the outset, both of these cases are credit crisis-related, a litigation trend that seemed to have mostly played out a year ago. But these cases are “flashes from the past” in other ways as well. They are both “belated” cases, in that they were filed more than a year after their purported class period cutoff. There were a host of “belated” cases in late 2009 and early 2010 (about which refer here), but the belated cases flings seemed to have gone away some time ago.

And both cases involved companies organized under the laws of non-U.S. jurisdictions, and whose shares trade in whole or in part on exchanges located outside the U.S. In the wake of the U.S. Supreme Court’s June 2010 Morrison v. National Australia Bank case, there was widespread speculation that filing of securities class action lawsuits in the U.S. against non-U.S. companies would become a thing of the past. Of course, lawsuits against foreign companies whose shares trade on the U.S. exchanges have continued, and that may explain the Deutsche Bank suit. The CCC case seems to be another matter.

It really is interesting that, notwithstanding Morrison, how many of the 2011 securities class action lawsuit filings involve non-U.S. companies. About 33 of the approximately 109 (roughly 30%) securities class action lawsuits filed so far during 2011 involve non-U.S. companies, compared to 15.9 percent during all of 2010. To be sure, a large part of the 2011 filings involve U.S.-listed Chinese companies. But regardless of the reason, the fact is that contrary to expectations, one year after the Morrison decision, the securities class action lawsuit filings against non-U.S. companies as a percentage of all filings has actually increased.

In any event because of the issues that these two recent cases present, they will interesting to follow. It will also be interesting to see if there are any more credit crisis related lawsuit filings ahead. I have in any event added these two cases to my running list of credit crisis-related lawsuit filings, which can be accessed here.

Final Notes:  Although the credit crisis related litigation wave largely played out early in 2010, a trickle of credit crisis-related cases has continued to come in. In fact the two cases above actually bring the number of credit crisis-related cases so far in 2011 to at least four (categorization issues of course always come into these kinds of analyses, but by my categorization there have been at least four, others may categorize and therefore count differently). The prior two 2011 credit crisis-related cases are the Bank of America foreclosure documentation case (refer here) and the United Western Bancorp case (refer here).

And finally, these two cases are not the only “belated” cases filed so far in 2011. By my count, there have been at least five “belated” cases far this year, counting these two. The other three belated cases are Frontpoint Partners (here), Oilsands Quest (here) and Elan Corp. (here)

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I am still out in the field and on assignment in Palo Alto at the Stanford Law School Directors’ College. The keynote speaker on the first full day of the event was Myron Steele, the Chief Justice of the Delaware Supreme Court. Later in the morning, SEC Enforcement Director Robert Khuzami presented what the conference organizers called a “short shot.” Both speakers’ presentations were thoughtful and interesting.

Chief Justice Steele’s presentation addressed his concern about “the significant intrusion of the federal government into corporate governance.” The problem with the changes that both SOX and Dodd-Frank are bringing about is that the new federal statutory standards were enacted without proper appreciation of the possible “unintended consequences” and without a proper “cost/benefit analysis.”

Steele suggests that the Congress adopted the changes even though they were “missing an analytic basis” for the change. Steele described this approach as “faith-based corporate governance,” because the changes were imposed on “faith that changing the corporate governance will result in better corporate governance.” Rather than basing the changes on empirical proof that a certain practice would produce better governance, the changes were “dictated by the politics of the hour.”

Steele’s position is that “the federal government shouldn’t have a role in corporate governance of state-chartered system.” A state-based approach is preferable, according to Steele, because it allows different companies to choose and it allows experimentation, because what works for some may not work for others.

As examples of the alternatives available at the state level, Steele contrasted the approach of two other states, North Dakota and Nevada, with that of Delaware. The critical distinction, Steele asserted is the legal system that is available in Delaware, which provides “predictability, clarity and consistency.” The Delaware legal system provides reassurance to directors that if they act in the best interests of the corporation, then they won’t have to worry about “some bizarre result.”

Steele said that if he had to describe the Delaware judiciary in two words, they would be “prudence” and “reasonableness” – that is, that the courts would be “prudent” in their review and  the courts would apply a “reasonableness” test in their application of the laws. He said that the test of every judicial doctrine in Delaware comes down to that single word – reasonableness.

In answer to a question from the audience, Steele referred to the conduct of the Airgas board taken during the course of the recent attempt of Air Products for a hostile takeover of the company. After Airgas had first rejected Air Products buy out offer, Air Products had managed to bring about the election of a short slate of new directors to the Airgas Board. The reconstituted Airgas board then took up the question whether the date for the next director election should be accelerated, which theoretically could have allowed Air Products to control a majority of the Airgas board and then to have the Airgas poison pill provision set aside. However, the newly constituted board, included the short slate of Air Products designees, declined the election date change and also continued to reject the Air Products offer.

Steele said that the Airgas board’s performance “renewed his faith and confidence in the boards of publicly traded companies” because the newly elected board members did not come onto the Airgas board as “shills” for the would-be acquirer. Rather, when they took their seat on the Airgas board, they took their duties to Airgas seriously.

Khuzami on the SEC Whistleblower Rules: Robert Khuzami’s presentation essentially amounted to a defense of the approach the SEC took in the recently released Dodd-Frank whistleblower rules. Khuzami began by noting that under Dodd-Frank, the payment of the whistleblower bounties is not discretionary, as the statutory provision “requires” the SEC to pay a reward when a whistleblower’s information results in a fine or penalty meeting the statutory requirements.

Khuzami noted that the Commission received a large volume of comments about the SEC’s proposed rules and that many commentators were concerned that the rules will create incentives such that whistleblowers will report “out” rather than “up,” which could create prevent companies from remediating problems themselves. Although the Commission staff met frequently and discussed these concerns at length, in the end the decision was made not to include a requirement that whistleblowers would have to report their information internally first in order to qualify for the bounty, because such an absolute requirement would be inconsistent with Dodd-Frank itself, as the statute has no requirement that whistleblowers report internally first. The Commission was concerned that requiring internal reporting first might “chill” whistleblowers from coming forward, particularly where the person to whom the whistleblower might have to report the information is involved in the misconduct.

However, the Commission recognizes great value in internal compliance, and therefore adopted an approach that, rather than requiring internal reporting, provides incentives for internally reporting. First the final rules give a whistleblower a “120-day grace period,” within which the whistleblower might first report to the company and have the measurement date for determining whether or not the whistleblower was first to report to the SEC related back to the date of the internal report. Also, if the whistleblower reports to the company and the company accumulates information and then self-reports to the SEC, the whistleblower will get the benefit of the entire package of information reported in order to determine whether or not the other bounty requirements had been met.

Khuzami emphasized that the Commission did not want to undermine internal compliance efforts and processes, so there are certain types of whistleblowers who are disqualified from the bounty, including attorneys and internal compliance offices, as well as those who obtained those who obtained their information in violation of the law.

Khuzami said that the Commission and its staff are going to remain attentive and if what they see requires further changes. As for the Commission’s ability to handle the whistleblower reports, he expressed confidence that the Commission could handle the reports, although he added that he does not expect a “huge flood” of reports.

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I am on the ground in Palo Alto this week at the annual Stanford Law School Directors’ College, where the opening speaker on Sunday night was SEC Commissioner Troy Paredes, whose presentation was in the form of a dialog with Stanford Law Professor and former SEC Commissioner Joseph Grundfest. The format lent itself to give and take and produced some interesting comments from both Paredes and Grundfest.

Much of the discussion was devoted to issues surrounding the Dodd-Frank whistleblower provisions. Paredes explained that he had voted against the adoption of the recently release SEC whistleblower rules (about which refer here) because of his “central concern” about “what the rules would do for internal compliance processes.” Because of the rules’ incentives, “when faced with a choice,” the whistleblower’s “rational financial interest will lead him to bypass the internal process.” (Parades’s comments in this respect echo the formal statement he made at the time he voted against the adoption of the rules. His statement can be found here.)

But Paredes added, now that we have the rules, rather than “throwing our hands up,” we should do what we can to “increase the chances that the whistleblower will report the information to the company,” which can best be accomplished by establishing a culture where “individuals feel it will be meaningful if you report problems to the company.” Of course, businesses can do the most by “reducing the chances that there will be something to blow the whistle about.”

Parades acknowledge that the likely influx of whistleblower reports to the agency will put pressure on the agency to “make sure that we have the people, processes and technology” so that when the information comes in, we “put it to good use.” He expressed his concern that if the agency falls short, it could “erode” the agency’s “legitimacy” and its “credibility.”

The challenge of course is that the SEC must accomplish this in the context of all of its other responsibilities, and at a time when the government generally is facing budget pressure, and while the agency is accommodating other increased responsibilities under the Dodd Frank Act.

In response to a question from the audience about what reforms he would have preferred in order to address the problems that came to light in the wake of the financial crisis, Paredes said that “to the extent the cause of the crisis was inadequate capital and liquidity….that’s where the change should have taken place.”

Grundfest had his own comments on the reform that followed the financial crisis. He said that many of the reforms presume that the problems arose because the regulators” lacked authority,” which Grundfest said is “false.” The problem is not one of authority but of “competence.” The real problem is that in many instances the regulators didn’t know what to do with the information available to them. The SEC’s specific problem is that it has “too many lawyers” and what the agency needs is a different “skill mix” to be able to process the information it receives.

In commenting on the government’s general competence issues, Grundfest added that the problem is that the U.S. government is “the world’s largest insurance company with the world’s largest military,” and the U.S.’s government insurance systems “have nothing to do with the way a rational insurance company would run its business.”

More notes about the conference will follow tomorrow. I must say that, Stanford University is a truly beautiful, impressive place.

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As discussed in a prior post (here), the U.K Bribery Act of 2010 is now set to take effect on July 1, 2011. In a guest post below, Anjali Das, a partner in the Chicago office of the Wilson Elser law firm, takes a look at the Act’s key provisions and requirements and then reviews the Act’s D&O insurance implications. 

My thanks to Anjali for her willingness to publish her article as a guest post here.  I welcome guest posts from responsible commentators on topics relevant to this blog. Any readers who are interested in publishing a guest post on this site are encouraged to contact me directly,

Anajli’s guest post follows:

            As if companies and their directors and officers did not have enough to contend with in the wake of the global financial crisis and the U.S. government's increasingly zealous prosecution of violations of the Foreign Corrupt Practices Act ("FCPA"), they will soon have to comply with the U.K. Bribery Act of 2010 ("Bribery Act") effective July 1, 2011, which far surpasses the FCPA in terms of potential liability exposure for bribery in the broadest sense of the word. In light of the potential long-arm reach of the Bribery Act, Directors and Officers ("D&O") liability carriers should familiarize themselves with the potential increased exposure to their insureds under the Bribery Act.

            This article discusses the following the issues related to the Bribery Act:

• Four key bribery offenses under the Act: 

• Imputation of bribery offenses by associated persons to the company;

• Six guiding principles for implementing effective anti-bribery policies and procedures;

• Potential coverage issues under D&O policies for investigations and proceedings under the Act

PART I: Overview of the Bribery Act

            On March 30, 2011, the U.K. Ministry of Justice ("MOJ") issued long-anticipated Guidance on the Bribery Act which provides an overview of the four key offenses under the statute and six guiding principles to prevent bribery in violation of the Act.

 Four Key Offenses Under the Act

            As discussed below, the key offenses under the Bribery Act include: (i) active bribery or offering bribes (Section 1), (ii) passive bribery or accepting bribes (Section 2), (iii) bribery of a foreign public official (Section 6), and (iv) a company's failure to prevent bribery (Section 7).  

            Sections 1, 2 and 6 apply with respect to acts of bribery that take place in the U.K. or if the person committing the offense has a "close connection" to the U.K such as a British citizen, resident of the U.K., or entity incorporated under the laws of any part of the U.K. A company may also be liable under Sections 1, 2 or 6 if the offense was committed by or with the consent of a company's senior officer. Section 7 applies to companies that are incorporated or formed in the U.K. or "carry on business" in the U.K., regardless of whether the bribery occurred in the U.K. or elsewhere. 

            Active and Passive Bribery: Section 1 of the Bribery Act prohibits "active bribery" and makes it an offense for a person to offer, promise, or give "financial or other advantage" to another person with the intent to induce "improper performance" of a relevant function or activity. Section 2 of the Bribery Act is the flip side of Section 1 and prohibits "passive bribery".   Section 2 makes it an offense for a person to accept or receive a financial or other advantage intended to induce or reward improper performance by the recipient or some other person. According to the MOJ's Guidance, improper performance means "performance which amounts to a breach of an expectation that a person will act in good faith, impartially, or in accordance with a position of trust." 

            In the introduction to the MOJ's Guidance, Kenneth Clarke, U.K. Secretary State for Justice, seeks to assuage businesses that the parameters of the Act are not intended to prohibit reasonable client development activities: "Rest assured, -- no one wants to stop firms getting to know their clients by taking them to events like Wimbledon or the Grand Prix." Moreover, the Guidance itself suggests that "an invitation to attend a Six Nations match at Twickenham as part of a public relations exercise designed to cement good relations or enhance knowledge in the organisation's field is extremely unlikely to engage section 1. . . ." However, more lavish hospitality intended as a quid pro quo to induce favorable treatment in a pending business deal (i.e., to get new business, keep business, or get some other business advantage) could be subject to greater scrutiny under the Act. The test is what a "reasonable person" in the U.K. would expect under the circumstances, and whether the prosecution can demonstrate evidence of intent to induce improper performance as defined by the Act.

            Bribery of Foreign Officials: Section 6 of the Bribery Act, which resembles the anti-bribery provisions in the FCPA, prohibits the bribery of a foreign public official. As explained in the MOJ's Guidance, an offense is committed when a person offers, promises or gives a foreign public official a financial or other advantage with the intent of: (i) influencing the official in the performance of his or her official duties, and (ii) obtaining or retaining business or other advantage in the conduct of business by offering the bribe. A foreign official includes any person who performs public functions in any branch of national, local, or municipal government in any country or territory outside the U.K.   An example in the MOJ's Guidance of a permissible transaction with foreign officials is a U.K. mining company's offer to pay for reasonable travel and accommodation to enable the foreign officials to inspect the standard and safety of the company's distant mining operations. In contrast, an offer to pay the foreign officials' "five-star holiday" in an unrelated destination is questionable. 

            Failure to Prevent Bribery :Section 7 of the Bribery Act creates a new offense for corporate liability for failing to prevent bribery in the first instance. Under this section of the Act, a company will be liable if a person associated with it bribes another person with the intention of obtaining or retaining business or other advantage. Liability under this section applies to "relevant commercial organizations" which include: (1) entities incorporated or formed in the U.K., regardless of whether the entity conducts business in the U.K., and (2) entities that "carry on business" in the U.K., regardless of the place of incorporation or formation. The Act itself does not define the term "carry on business," and the MOJ's Guidance merely states that this interpretation is subject to a "common sense approach". While the MOJ notes that the courts are the final arbiter of this determination, the Government itself does not expect that companies merely listed on the London Stock Exchange without a "demonstrable business presence" in the U.K. are subject to liability under Section 7 of the Act. 

 Imputation of Acts by Associated Persons

            Corporate liability under Section 7 of the Act may be established through bribery conducted by "associated persons" which broadly encompasses any person or entity that "performs services" for the company. An associated person may include the company's employees, agents, subsidiaries, or any other party that performs services for or on behalf of the company regardless of the "capacity" in which such services are performed. Significantly, this may include the company's suppliers (that do more than merely sell goods) and direct contractors (as opposed to sub-contractors). As a result, there is an increased burden on companies to examine their supply chain and external business relationships with third parties for potential risk of bribery and imputation of corporate liability under the Act.

 Ministry of Justice's Six Guiding Principles

            The MOJ has identified six "guiding principles" to assist companies in adopting effective policies, and procedures to prevent bribery. If a company can demonstrate that it has adequate anti-bribery procedures in place, this could be a complete defense to violation of Section 7 of the Bribery Act. These guiding principles include:

(1) Proportionality: The company's anti-bribery policies and procedures should be "proportionate" to the size of the company and the perceived risks it faces. The procedures should be designed to mitigate identified risks and prevent deliberate unethical conduct on the part of associated persons.

(2) Top Level Commitment: The message of zero tolerance for bribery should be adopted, implemented, and/or communicated by individuals at the highest levels of the organization such as the board of directors.

(3) Risk Assessment: The company should periodically assess and document its perceived exposure to internal and external risks of bribery, including an analysis of bribery risk in the markets in which it conducts business (for country risk, sector risk, transaction risk, and business opportunity risk) and risk presented by various business partners/associates.

(4) Due Diligence: The company should conduct appropriate due diligence either internally or by external consultants prior to hiring and engaging other persons, third party intermediaries, agents, or business partners/associates to represent the company in its business dealings.

(5) Commmunication: The company's anti-bribery policies and procedures should be communicated internally to staff and employees and externally to all business partners/associates that perform services for the company. Such communications may be made orally, in writing, and/or through training sessions.

(6)    Monitoring and Review: The company should periodically evaluate its anti-bribery policies and procedures for effectiveness in light of changing business or political environments that may increase the company's bribery risk in certain markets. These periodic reviews may be conducted through special internal systems such as internal financial control mechanisms, staff surveys, formal reviews by top-level management, and/or external verification of the effectiveness of the company's anti-bribery procedures. 

            It is important to recognize that the MOJ's guidelines for anti-bribery policies and procedures are not "prescriptive," and there is no "one- size-fits-all" approach that applies to all companies. 

PART II:     Potential Coverage Issues Under D&O Policies 

            These days, D&O policies routinely afford "worldwide" coverage, including coverage for foreign (non U.S.) proceedings against a company's foreign subsidiaries and directors and officers of these subsidiaries.   Therefore, U.S. companies that do business in the U.K., have subsidiaries, directors and officers, employees or agents in the U.K. may be subject to violations of the Bribery Act. As such, D&O insurers would be well-advised to consider the potential coverage implications under their policies for claims and investigations under the Bribery Act.

            Potential coverage issues that might arise under D&O policies for Bribery Act violations, investigations and proceedings include, but are not necessarily limited to:

·        Coverage for investigations

·        Covered claims against a D&O versus uncovered claims against the company

·        Allocation of defense costs

·        Insured subsidiaries and their directors and officers

·        Coverage for collateral litigation arising from Bribery Act violations

·        Dishonesty and Personal Profit Exclusions

·        Coverage for fines and penalties

 Coverage for Investigations

            Initially, it is important to consider whether a government investigation for potential violations of the Bribery Act gives rise to an insurer's obligation to pay or advance the insured's legal fees and expenses under a D&O policy. Like FCPA investigations, investigation costs for Bribery Act violations could be substantial – potentially exceeding millions of dollars. Consider for example the ongoing FCPA investigation of Avon Products, Inc. where the company reportedly spent $96 million in 2010 and $35 million in 2009 for legal fees related to its FCPA investigation. 

            Coverage for investigations under D&O policies has evolved dramatically in recent years. In some instances, the D&O policy definition of a Claim has expanded to encompass investigations of directors and officers by various government or regulatory authorities. Some D&O policies only afford coverage for formal investigations if a director or officer is served with a "subpoena" or identified as a "target" of an investigation by a governmental investigative authority. More recently, some insurers have expanded coverage to include informal investigations of directors and officers which do not require the issuance of a subpoena.  Such informal investigations may include a voluntary request for production of documents, interviews, or testimony.  This year, for the first time, a new generation of D&O coverage affords entity coverage for investigations "of the company" itself.  However, entity coverage for investigations under these newest policies may be limited to claims for violations of securities laws and/or expressly exclude FCPA and Bribery Act claims. Thus, it is critical to analyze the specific policy wording to determine the scope of coverage for investigations. 

            Undoubtedly, there are numerous cases finding both in favor of and against coverage for investigations under D&O policies. This is a fact-sensitive analysis dictated in part by the precise policy wording and the circumstances surrounding the investigation.  

            For instance, a number of courts have held that subpoenas and/or Civil Investigative Orders issued by the SEC, DOJ, or other government authorities are covered claims under a D&O policy – particularly where the definition of a claim expressly includes an "investigative order". In MBIA, Inc. v. Federal Ins. Co., 2009 U.S. Dist. LEXIS 124335 (S.D.N.Y. 2009), the court held that subpoenas issued by the SEC and New York Attorney General ("NYAG") in connection with their investigations of MBIA constituted a Securities Claim which was defined as "a formal or informal administrative or regulatory proceeding or inquiry commenced by the filing of a notice of charges, formal or informal investigative order or similar document". The court rejected the insurer's argument that a subpoena was not an investigative "order". At a minimum, the subpoenas were "similar documents" that triggered coverage under the policies. 

            In Ace American Ins. Co. v. Ascend One Corp., 570 F.Supp.2d 789 (D. Maryland 2008), the court held that an administrative subpoena issued by the Maryland Attorney General and a Civil Investigative Demand issued by the Texas Attorney General constituted a Claim which was defined by the policy as "a civil, administrative or regulatory investigation against any Insured commenced by the filing of a notice of charges, investigative order, or similar document". The court also rejected the Insured's argument that the subpoena and Investigative Demand failed to allege a Wrongful Act. The court observed that the Maryland and Texas Attorney General's Office were investigating violations of their respective state Consumer Protection Acts in connection with the company's business activities. 

            In National Stock Exchange v. Federal Ins. Co., 2007 U.S. Dist. LEXIS 23876 (N.D. Ill. 2007), the court held that an SEC investigation commenced by a formal order of investigation was a Claim under the policy. In that case, the definition of a Claim included "a formal administrative or regulatory proceeding commenced by the filing of a notice of charges, formal investigative order or similar document". It was undisputed that the SEC issued an order directing a private investigation and designating officers to take testimony. The court rejected the insurer's argument that the SEC investigation was not a Claim "against an Insured Person for a Wrongful Act". The court observed that the scope of the SEC's investigation included the company and its directors and officers for possible violations of securities laws. 

            In contrast, other cases have held that government investigations are not a claim under a D&O policy. In Office Depot, Inc. v. National Union Fire Ins. Co., 734 F. Supp. 2d 1304 (S.D. Fla. 2010), the court held that the D&O insurer was not liable to pay legal fees and costs incurred by the company in connection with: (1) the SEC's investigation, or (2) the company's internal investigation by its Audit Committee. First, the court opined that the SEC investigation was not a covered Securities Claim against the Company since the definition expressly excluded "an administrative or regulatory proceeding against, or investigation" of the company. Second, the court concluded that the SEC investigation was not a Claim against an Insured Person (D&O). The definition of a Claim included "a civil, criminal, administrative or regulatory, proceeding" or "investigation . . . commenced by service of a subpoena" or identifying an Insured Person in writing as the target of an investigation. Here, however, the SEC investigation was directed to the company – not to an Insured Person. The SEC's formal order of investigation did not identify any specific D&Os or any specific wrongdoing by any of the D&Os. Third, the court found that the insurer was not liable for the company's internal investigation because they were not a covered "loss" "arising from" a Claim or Securities Claim. Instead, the internal investigation, which preceded subsequent shareholder suits, was triggered by a whistleblower complaint regarding various accounting irregularities. Fourth, the court observed that the internal investigation costs did not "result solely from investigation or defense" of a covered Claim as contemplated by the policy definition of Defense Costs. The court held that the insurer was not liable for the legal fees and costs incurred by the company in response to: (i) the SEC informal inquiry, (ii) SEC formal investigation prior to the issuance of a subpoena or Wells notice on an Insured Person, or (iii) internal investigation by the Audit Committee. 

            In Diamond Glass Companies, Inc. v. Twin City Fire Ins. Co., 2008 U.S. Dist. LEXIS 86752 (S.D.N.Y. 2008) , the court held that expenses incurred by the insured in responding to a federal grand jury investigation were not covered under the insured's D&O policy. In that case, the court opined that the investigation was not a "criminal proceeding . . . commenced by the return of an indictment, filing of a notice of charges, or similar document" as defined by the policy. The court observed that there was no claim against an individual insured, because the policy expressly stated that the individual must receive "written notice from an investigating authority specifically identifying such Insured Person as a target against whom formal charges may be commenced". 

            Of course, if prosecutors ultimately sue any directors or officers for violations of the Bribery Act, such a legal proceeding might be covered if the D&O policy broadly defines a Claim to include any civil, criminal, administrative or regulatory proceeding. On the other hand, if the company alone is the subject of a legal proceeding for violation of Section 7 of the Bribery Act, this may not constitute a covered Claim. Under many D&O policies entity coverage is limited to a Securities Claim against the company such as a lawsuit by shareholders in connection with the purchase or sale of the company's securities. Such a narrow definition of Securities Claim may not apply to a company sued for violations of the Bribery Act to the extent the bribery does not involve a violation of securities laws, does not arise out of the purchase or sale of a company's securities, or is not brought by a company's shareholders. 

Identifying the Insured

            It is also critical to determine whether an "insured" is the subject of an investigation. As noted herein, many D&O policies offer worldwide coverage for a company, its subsidiaries, and their directors and officers. However, a subsidiary is a defined term that may be limited to entities in which the company owns a specified percentage of the subsidiary's stock. Consider, for example, a company that has an overseas U.K. affiliate in which it owns 40% of the voting stock. That affiliate and its directors and officers are the subject of an investigation or proceeding for violations of the Bribery Act. However, if the D&O policy only affords coverage to subsidiaries in which the company owns 50% or more of the voting stock, then the affiliate and its directors and officers are not insureds. 

            However, if both a covered subsidiary and one of its officers are sued for violations of the Bribery Act, this could give rise to a covered claim against the subsidiary's officer and an uncovered claim against the company (assuming the policy does not afford entity coverage for investigations). In that event, the insurer may need to seek an allocation of covered defense costs (for the officer) versus uncovered defense costs (for the company). Some D&O policies contain express allocation language which state that the parties will make a reasonable effort to arrive at a fair allocation for covered versus uncovered defense costs and, in the event of a dispute, the insurer will advance those amounts which it determines are covered until the coverage dispute is ultimately resolved by negotiation, arbitration, litigation, mediation, or otherwise. 

Collateral Litigation

            It is possible that Bribery Act violations may spur collateral litigation against a company and/or its directors and officers by shareholders, employees, customers, competitors, or other third parties. By comparison, FCPA violations have prompted a number of shareholder suits in the U.S. which may give rise to a covered Securities Claim.  In addition, in the case of multinational corporations, Bribery Act investigations by U.K. authorities might provoke similar investigations or legal proceedings by foreign governments or U.S. authorities under the FCPA or other anti-bribery laws. Many D&O policies are claims made and reported policies. In other words, a claim is covered if it first made during the policy period and timely reported to the insurer. When there is a chain of bribery-related investigations or legal proceedings, potential coverage issues include the date the initial bribery claim was first made (and reported), and whether subsequent bribery claims are deemed to be related to the initial claim such that they are all covered under a single policy period.  

D&O Policy Exclusions 

            Common exclusions in D&O policies include the fraud, dishonesty, and personal profit exclusions. These exclusions might be implicated if an insured is found to have engaged in intentional misconduct or unlawfully profited from his wrongdoing.   Oftentimes, however, such exclusions are subject to a final adverse adjudication establishing that the insured engaged in such wrongdoing. In addition, such exclusions may be "severable" such that the wrongful acts of one insured cannot be imputed to another for purposes of triggering an exclusion.

            Companies and individuals may be subject to imprisonment and/or fines for violations of the Bribery Act. As a general rule, most D&O policies do not afford coverage for fines or penalties. However, some D&O policies now afford very limited coverage for fines imposed under the FCPA. Thus, it is possible that similar coverage for limited fines or penalties might be offered for Bribery Act violations in the future.

Conclusion 

            Without a doubt, governments are demonstrating increasing intolerance of bribery in the corporate world by individuals and companies alike. To date, the Bribery Act far surpasses other anti-bribery laws, including the FCPA, in identifying the breadth of unacceptable business practices in both the private and public sectors that are subject to prosecution. U.K. enforcement authorities have emphasized the strong public policy rationale for adopting the Act's stringent measures which are designed to encourage "free and fair competition," and have outright rejected the notion of greasing the wheels of commerce by so-called facilitation payments which are considered commonplace in some parts of the world. If the rigorous enforcement and prosecution of FCPA violations in the U.S. has caused companies pause for concern, the Bribery Act might possibly signal just cause for companies to scrutinize and re-think their transnational business activities to avoid future claims, prosecution, and legal expenses for potential violations of the Act.

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Even though the story has been brewing for months, the mainstream media and the SEC suddenly seem to have decided that the alleged accounting frauds involving certain U.S.-traded Chinese companies are the central story of the moment. You can hardly pick up the business papers or turn on the television these days without encountering some coverage of this  issue. One  problem with this sudden torrent of coverage is that there are now so many items and events that it is easy to fall behind. To make sure that everyone is on top of the latest, here is a round up of the most recent news and developments about this continuing story.

Time to Hit Pause on the Litigation Onslaught?: Plaintiffs’ lawyers seem to be engaged in an old-fashioned race to the courthouse in connection with each new Chinese company swept up in this story. But when it comes to trying to litigate against companies based in China, there arguably are some practical reasons to move with greater deliberation, at least given problems that are likely to arise. Here, I have in mind not only the distances involved and language barriers, but even more basic issues – like service of process, for instance.

According to a June 15, 2011 ThompsonReuters News & Insight article entitled “Plaintiffs Hit First Roadblock in China Fraud Case,” (here) the plaintiffs in the Duoyuan Printing Inc. securities class action lawsuit (about which refer here) have not been able to effect service of process on five of the company's current and former directors and officers named as defendants in the suit.  The plaintiffs lack the personal addresses for the individuals, who reside in China. As the story notes, “serving individuals in China is an arduous and costly process and requires a central Chinese authority to forward any requests to local Chinese courts.”

From the article’s account of a recent hearing in the case, it appears that there may be procedural alternatives available that could help address this issue in that case. But even if plaintiffs in this and other cases can overcome the service of process hurdle, there are other issues. As the article notes, “plaintiffs face numerous obstacles, such as difficulty in pursuing evidence-gathering in China and limitations on their ability to collect judgments or legal awards.”

This latter point, about the ability to collect any awards, seems particularly salient. As this wave of accounting scandals has unfolded, I have frequently wondered whether the plaintiffs’ lawyers who are now rushing into court will see any reward for their labors. Earlier securities class action lawsuits filed against Chinese companies have hardly resulted in any sort of massive bonanza. For example, earlier this week, NYSE-traded and China-based agricultural company Agria Corporation announced (here) that it had settled the securities class action lawsuit that had been filed against the company, in exchange for a payment by the company’s D&O insurers of $3.75 million. While $3.75 million is a respectable sum, it does raise the question whether, if that amount is representative of the settlement range for these kinds of suits, these cases will wind up being worth it for the plaintiffs’ lawyers, given the practical, logistical and legal barriers these cases entail.

Of course, the plaintiffs’ lawyers intend to engage in a for-profit enterprise, so they clearly must think these cases will prove worth pursuing. We shall see. From what I have seen of the D&O limits that many of these companies carry, it could all turn out otherwise.

The Role of the Auditors: In a June 13, 2011 post on the New York Times Dealbook blog, Wayne State University Law Professor Peter Henning wrote an interesting column entitled “The Importance of Being Audited,” (here), in which he examines the critical role the auditors have played in raising questions about many of these companies. A problem that can arise when the auditors raise questions or even resign is that the companies involved may delay reporting these auditor actions. As Henning details in his column, these delays have in some cases been substantial.  

But while the auditors have served a key role identifying many of the companies that have accounting concerns, some auditors have also found themselves targeted for alleged complicity in the misstatements. As detailed in a June 9, 2011 Reuters article entitled “Auditors Face Suits Over U.S.-Listed Chinese Blowups” (here), recent securities lawsuits involving Chinese companies have in some instances also included the companies’ auditors as defendants. Among the recent cases cited in the article are those involving Puda Coal and China Integrated Energy. Other case mentioned in which the auditors have been sued include those involving China MediaExpress and Orient Paper.

In addition, the recent lawsuit filed in Ontario involving Sino-Forest also named the company’s auditor as a defendant. In a June 9, 2011 New York Times article entitled “Troubled Audit Opinions” (here), Floyd Norris examined the role of Sino-Forest’s auditor, the Toronto office of Ernst & Young, in the accounting questions surrounding the company. On the one hand, the audit firm issued a clean audit opinion. On the other hand, serious questions have been raised in the media about Sino-Forest (see below). Which, for Norris, raises question not just about the audit, but raises questions about what investors realistically can expect from an audit, the purpose of which is not necessarily to detect fraud.

As the questions swirl about the veracity of the Chinese companies financial statements, fundamental questions about the reliability of the financial statements are inevitable. Which in turn will lead to questions about the auditors’ role in the process, and to questions whether the auditors were complicit in the financial misstatements.

Securities Analysts or Short-sellers?: Many of the accounting concerns involving Chinese companies have come to light through on-line postings by supposed securities analysts. But as I noted in an earlier post (here), some Chinese companies have gone on the offensive, charging that the supposed analysis is really just an attack job by financially motivated short-sellers seeking to undercut the companies’ share prices.

The most recent company to raise this assertion is Sino-Forest, which has attacked Muddy Waters Research, the financial analyst responsible for the first report questioning the company’s financial statements. The June 9 Floyd Norris column I referenced in the preceding section specifically discussed the role of Muddy Waters Research in the controversy surrounding Sino Forest. Similarly, a June 9, 2011 Wall Street Journal article entitled “’Backdoor’ China Plays Under Fire” (here) described the questions surrounding China Media Express, the questions about which also first arose following the publication by Muddy Waters of a report raising concerns about the company’s financial statements.

On June 9, 2011 the New York Times DealBook blog  ran an article entitled “Muddy Waters Research Is a Thorn to Some Chinese Companies”(here), describing Muddy Waters Research’s founder, Carson C. Block, who is “delivering a controversial message to investors enamored with Chinese companies: buyer beware.” The article cites critics of these kinds of firms, whom the critics allege, are “rumor-mongering” because they hope to profit by shorting the stocks of the companies they are attacking.

And the SEC Gets Into the Act: As I noted in an earlier post (here) , the SEC seems to have found itself once again in a reactive mode, this time on the question of whether or not it is adequately protecting investors with respect to the potential dangers of reverse merger companies. With the onslaught of media coverage , the SEC is stepping forward, trying to assert itself into the dialog and to establish that it is on patrol and looking for problems.

For starters, on June 9, 2011, the SEC released an Investor Bulletin (refer here) cautioning investors about companies that entered the U.S. markets through a “reverse merger” with a U.S. listed shell company. Among other things, the SEC cautioned in its press release regarding the Bulletin, that “investors should be especially careful when considering investing in the stock of reverse merger companies.” The Bulletin also details enforcement actions the agency has taken just since March 2011 against six companies that obtained their U.S. listing through a reverse merger. These companies had either failed to maintain current financial statements or questions had arisen about the accuracy or completeness of the company’s financial statements.

In addition, on June 13, 2011, the SEC announced (here) that it had instituted proceedings to determine whether stop orders should be issued suspending the effectiveness of registration statements filed by two companies – China Intelligent Lighting and Electronics Inc. (CIL) and China Century Dragon Media Inc. (CDM). The purpose of a stop order is to prevent a company or its selling shareholders from selling their privately-held shares to the public under a registration statement that is materially misleading or deficient. The agency said that it initiated these proceedings after the companies’ independent auditor resigned and withdrew its audit opinions on the financial statements included in the companies’ registration statements.

A Final Comment: I started this news roundup by saying that one problem with the torrent of information is that it is getting hard to keep up. Another problem is that the coverage is getting overheated. There are over 500 U.S.-listed Chinese companies and the questions that have been raised so far have involved only a small number of these companies. The concerns are now being generalized to all of the Chinese companies.

This very large group of companies is unfairly being swept with the same broad brush. That is not only unfortunate from an investment perspective, but also from a D&O insurance perspective. This has turned into the classic contagion event, where every company in the entire category is being treated as if it were plague-infested.

The media may now have switched to an “all China, all the time” mode on this topic, but that does not mean that this story relates to all U.S.-listed Chinese companies. A discerning underwriter that understands the difference could profit from these circumstances.

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In an unpublished per curiam opinion dated May 24, 2011, the United States Court of Appeals for the Eleventh Circuit affirmed the district court’s dismissal of the credit crisis-related securities class action lawsuit pending against certain former officers of the bankrupt mortgage REIT, HomeBanc. A copy of the Eleventh Circuit’s opinion can be found here.

Background

HomeBanc was an Atlanta-based real estate investment trust in the business of investing in and originating residential mortgage loans. In their consolidated amended complaint, the plaintiffs alleged that prior to the company’s August 9, 2007 bankruptcy the defendants projected an "overly rosy picture" of the company’s finances, and misrepresented the company’s underwriting practices, loan loss reserve model, and other aspects of the company’s lending and mortgage investment operations. The plaintiffs alleged that the company "loosened its underwriting standards and policies in response to slowing loan originations and shifted from its stated focus on conservative risk management to attempting to profit by selling poor quality loans." The defendants moved to dismiss.

As discussed here (scroll down), on April 13, 2010, Northern District of Georgia Judge Timothy Batten granted the defendants’ motion to dismiss. Judge Batten agreed with the defendants’ position that "the bulk of the statements upon which Plaintiff relies fail to satisfy the ...standards for materiality." Among other things he found that the complaint "makes conclusory allegations of falsity without establishing contrary true facts." He also said that the complaint is "rife with forward-looking statements made by HomeBanc that were accompanied by meaningful risk disclosures."

Judge Batten also concluded that the plaintiff "has failed to allege sufficient facts to demonstrate a cogent and compelling inference of scienter," noting that "the complaint cites differences of opinion, conjecture and innuendo in an attempt to make the Defendants’ behavior look suspicious, but it conspicuously omits any facts that would require one to rule out an innocent explanation for the alleged behavior." Judge Batten also held that the plaintiff had not sufficiently pled loss causation. The plaintiffs appealed.

The May 24 Decision

In their May 24 per curiam opinion, a three judge panel of the Eleventh Circuit affirmed the district court. The panel agreed with the district court that the plaintiffs’ amended complaint’s scienter allegations were not sufficient to meet the pleading requirements of the PSLRA. The panel stated that

Although the Complaint alleges that the appellees expressed mistaken confidence in HomeBanc’s financial well-being and furthermore engaged in business practices that contributed to HomeBanc’s demise, the facts alleged do not give rise to a strong inference that appellees knew that their statements were fraudulent or were reckless in light of actual knowledge.

Rather the stronger inference is that appellees simply failed to predict the eventual collapse of the housing and subprime market, and, as a result, were ill-prepared to respond when the markets crashed. Indeed, as the district court explained “[t]he Complaint cites differences of opinion, conjecture and innuendo in an attempt to make [appellees’] behavior look suspicious, but it conspicuously omits any facts that would require one to rule out an innocent explanation for the alleged behavior.” Moreover, the public disclosures identified in the Complaint are replete with myriad warnings and other cautionary statements, which significantly undermines any inference that appellees intended to mislead HomeBanc’s investors.

Discussion

The Eleventh Circuit’s opinion in the HomeBanc case is the latest in a series of decisions in which the appellate courts have affirmed the district court’s dismissals of subprime or credit crisis-related securities class action lawsuits. Earlier example include the NovaStar Financial case (about which refer here), the Centerline Holdings case (refer here) and the Impac Mortgage Holdings case (refer here). At this point, it seems clear the appellate courts are reluctant to setting aside the dismissal motion rulings of the district courts in these cases.

However, there has been at least one exception to the pattern of appellate rulings; as discussed here, in connection with the Nomura Subprime Securities Suit, the First Circuit affirmed in part and reversed in part the lower court’s dismissal of the case. With the Eleventh Circuit’s affirmance in the HomeBanc case, the Nomura decision remains the only appellate ruling remains the only appellate ruling in which the lower court’s dismissal was not affirmed, even if the ruling reversed the lower court in that case only in part.

The Eleventh Circuit’s designation of its HomeBanc decision as “not for publication” compels me to return to one of my recurring gripes. In this day of universal Internet availability of all appellate rulings, isn’t the notion that any opinion is “not for publication” rather illusory, not to say anachronistic? Not only that, but the Eleventh Circuit cannot bar participants from referencing the case, as Federal Rule of Appellate Procedure 32.1 expressly provides that courts may not "prohibit or restrict" the citation to appellate opinions by designating them as, for example, "not for publication." So why bother designating an opinion as not for publication?

I have also always worried about what the “not for publication” designation implies. It sort of sounds like, well, here’s our ruling, but we really don’t want anybody to see it. Or maybe, here it is, we really don’t think of much of it, this opinion really doesn’t represent our best work. What are the parties to think of the fact that the appellate panel doesn’t think an opinion is worthy of publication—that their dispute wasn’t sufficient to command the effort required to produce a published opinion?  I think the very idea that an appellate court would designate an opinion as not for publication is a poor practice and sends the wrong messages.

I have in any event updated my running tally of subprime and credit crisis-related securities lawsuit case resolutions to reflect the Eleventh Circuit’s opinion in the HomeBanc case. My tally can be accessed here.

Special thanks to a loyal reader for alerting me to the Eleventh Circuit’s opinion.

More Litigation Following a “Say on Pay” No Vote: Yet another shareholder lawsuit has been filed following a “no” vote from shareholders on executive compensation. As reported here, at the company’s May 10, 2011 shareholder meeting, holders of a majority of shares of Hercules Offshore Corporation voted against the advisory executive compensation resolution. And then, according to press reports, on June 13, 2011, plaintiffs purporting to act of behalf of the company filed a shareholders’ derivative suit in Texas state court against the company’s board alleging breach of fiduciary duty.

As I have previously noted (here and here), one of the follow on effects of the advisory say on pay vote required by the Dodd-Frank Act has been the outbreak of investor litigation following a ‘no” vote of shareholders on the executive compensation resolution. Though the number of companies whose executive compensation resolutions have been voted down by shareholder is still relatively small, a relatively high number of companies receiving negative votes have been hit with the follow on shareholder suits.

Speakers’ Corner: Next week I will be attending the Stanford Law School Directors’ College in Palo Alto California. I will also be speaking on the topic of “Indemnification and D&O Insurance” on a panel with my friends Priya Cherian Huskins of Woodruff-Sawyer and Anthony Tatulli of Chartis. If it works out as planned, I hope to be publishing blog posts about the conference while I am there. Information about the conference can be found here.

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In a June 13, 2011 opinion written by Justice Clarence Thomas, the United States Supreme Court held, by a 5-4 margin, in the Janus Capital Group, Inc. v. First Derivative Traders case,  that a mutual fund management company cannot be held liable for the alleged misstatements in the prospectuses of the mutual funds that the management company administered. Justices Ginsberg, Sotomayor and Kagan joined in Justice Stephen Breyer’s dissent. A copy of the June 13 opinion can be found here.

Background

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

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

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

The June 13 Opinion

The fundamental question before the court is whether or not the management company could be said to have made the statements in the funds’ prospectuses. The Court held that because the management company did not make the statement, it could not be held liable, reversing the Fourth Circuit.

Justice Thomas, writing for the majority, said that “one ‘makes’ a statement by stating it” and that for purposes of Rule 10b-5, “the maker of the statement is the person or entity with ultimate authority over the statement, including its content and whether and how to communicate it.”

With this analysis as the starting point, and following the Court’s prior decisions in the Central Bank and Stoneridge cases (about which refer here), the majority adopted the rule that “the maker of the statement is the entity with authority over the content of the statement and whether or how to communicate it. Without such authority, it is not ‘necessary or inevitable’ that the falsehood will be contained in the statement.”  

The majority opinion went on to state that even if the management company may have been “significantly involved” in preparing the prospectus, this “assistance” was still subject to the ultimate control of the funds and their trustees. The majority analogized the management company’s role to that of a speechwriter; the ultimate speaker is the one that makes the speech. Because the management company did not make the alleged misstatements, they could not be held liable under Rule 10b-5.

In his dissent, Justice Breyer contended that that the majority “has incorrectly interpreted the Rule’s word ‘make.’” He argued that “both language and case law indicate that, depending on the circumstances, a management company, a board of trustees, individual company officers, or others, separately or together, might ‘make’ statements contained in a firm’s prospectus, even if a board of directors has ultimate content-related responsibilities.” Breyer further argued that Central Bank and Stoneridge were not controlling, as they concerned only secondary liability, whereas this case concerned primary liability.

Discussion

Despite the narrow 5-4 split, this decision comes as no surprise (at least to me). The argument that a legally separate entity that assists with but does not actually make the statement would be very hard to distinguish from the kind of “aiding and abetting” liability the Court rejected in the Stoneridge case. Indeed, as I noted at the time, that may well be why the Supreme Court took this case, to clarify that the “substantial participation” test that the Fourth Circuit had enunciated was inconsistent not only with the holdings of the other Circuit courts but also with the Supreme Court’s precedents in Stoneridge and Central Bank.

The case does break the short streak the plaintiffs had been enjoying before the Court. Earlier in the term, the Court had ruled favorably to plaintiffs in the Matrixx Initiatives case (refer here) and more recently in the Halliburton case (refer here). 

But while this case is favorable to the defendants, I don’t think it will result in any huge transformation in other cases going forward. The Fourth Circuit’s holding in this case was out of step with the holdings in the other circuits. While the outcome at the Supreme Court level might eliminate a pleading advantage the plaintiffs might have enjoyed in the Fourth Circuit, the result of this decision will really not change things elsewhere. Had the plaintiffs prevailed before the Supreme Court, the outcome would have had a significant impact on future cases. However, because the defendants instead prevailed, the impact of this decision will be limited and largely confined to the Fourth Circuit.

One final note for those readers who might have read the guest post of Brian Lehman published last Friday on this blog, in which Lehman attempted to predict the outcome of the Janus case, the case did not turn out as he had prognosticated. He had suggested that the Court might defer to the SEC’s interpretation, which the majority expressly declined to do in footnote 8, because the Court did not find the word “make” to be ambiguous.

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In an interesting and provocative June 7, 2011 post on the DealBook blog (here), University of Connecticut Law Professor Steven Davidoff voiced his frustration that public company directors are not held liable more often for problems at their companies. Directors, he says, “have about the same chance of being held liable for the poor management of a public firm as they have of being struck by lightning.”

Davidoff goes on to note that the Delaware courts set “an extraordinarily high standard for finding directors liable for a company’s mismanagement” adding that “a Delaware court is not going to find them liable no matter how stupid their decisions are,” but will only find them liable “if they intentionally acted wrongfully or were so oblivious that it was essentially the same thing.” The bottom line for Davidoff is that while the “upside” for board member is “huge,” their downside is “very limited.” 

I have some thoughts and comments about Davidoff’s column. My purpose is not to dispute his thesis or even necessarily to disagree with him, but rather to try to sharpen the focus of the discussion. My fundamental concern is that I think that there are already many more lawsuits against boards than there are companies engaged in corporate misconduct.

My fear, given the civil litigation resources our society already has deployed, is that more dramatic sanctions against corporate board members could result only in unintended collateral damage rather than greater traction in the fight against corporate misconduct. To me, a demand that all directors must face greater financial consequences in civil litigation is akin to a proposal that we must use more powerful rat poison in the kitchen – it is just as likely that we will wind up killing off the family pets and Grandma as it is that we will eliminate any greater number of rats. To be specific, if we are going to employ more potent means of controlling corporate misconduct, let us take great care to understand what our goals are and make certain the means are well calculated to achieve the intended goal.

Let me just say at the outset that I have nothing but respect for Professor Davidoff. His posts on the Dealbook blog are among the best out there. By raising the questions as I do below, I am merely hoping to consider his assumptions, not to disrespect his work in any way. I also should probably declare my biases at the outset, as well. I have spent most of my career worrying about the interests of corporate directors and officers. There is no doubt that I come at these issues from the perspective of the corporate officials, and with their interests in mind. However, I believe that even if it may the product of a bias, this perspective still affords an important take on these issues.

Davidoff seems very sure that directors are not being held liable often enough. However, it is not clear why he thinks directors should be held liable more often. Upon reflection, I can think of three possible reasons why it might be argued that directors ought to face civil liability more frequently: recompense; retribution; and deterrence. I examine each of these three reasons below and consider whether or not they substantiate the need for directors to face civil liability more frequently.

Recompense: Davidoff addresses the issue of recompense, at least inferentially. After identifying the two Delaware court cases in which directors have been held liable, and reviewing the amounts paid in those two cases, he aggregates the amounts paid and comments, with obvious derision, these payments amount to “no more than $8.35 million in personal payments by directors over the 26 years.”

While the cited figure may indeed represent the total amount that directors have themselves paid during that period in Delaware cases, it is hardly an accurate picture of the total amount of recompense paid to investors or to companies during that period. There have of course been many other cases settled during that period in which the settlement amounts were funded by D&O insurance or other sources.

Davidoff briefly acknowledges the role that D&O insurance plays, by stating that “even if there is a liability or a settlement, it is almost always covered by insurance of directors and officers.” But if the goal is recompense, what difference should it make whether that the funds were provided by insurance? The directors may not have paid these other settlements out of their own assets, but the settlements have provided extensive additional recompense to companies or to investors. Moreover, as I have noted on this blog (most recently here), the frequency of very large cash payments in Delaware cases and other derivative suits has become increasingly common in recent years.

In addition, though Davidoff briefly refers in his column to cases involving potential liability under the federal securities laws, he omits to mention that there have been billions of dollars of recoveries in these cases in recent years. Yes, as Davidoff notes, settlements in those cases rarely include amounts paid personally by directors, but if the goal is recompense (rather than retribution), the source of funds should be irrelevant.  

The omission of any reference to these many other settlements suggests that the real objection may not be that the cases do not produce enough recompense, but that these case resolutions do not produce enough pain for directors, because the funds did not come out of the directors’ pockets. But if the absence of pain is the problem, then the issue seems to be retribution, not recompense.

Retribution: Perhaps I am reading too much into Davidoff’s words, but I do not think I am being unfair in suggesting that behind Davidoff’s words is a belief that directors should face a greater threat of punishment, and specifically that their personal assets ought to be on the line.

In considering whether or not directors should face a greater threat of punishment, I think it is critical to note that in his column Davidoff only refers to civil litigation (specifically, Delaware state court litigation and federal securities litigation). His column does not address, discuss or mention criminal or enforcement actions.

There unquestionably are occasions when retribution against corporate officials may be appropriate. But the proper vehicles for retributive justice are criminal actions and enforcement proceedings, which are the appropriate means for enforcing societal values and imposing punishments.

There is and should be an entirely different discussion whether or not the criminal and enforcement authorities have sufficiently exercised their prosecutorial responsibilities in connection with corporate misconduct. But Davidoff’s column was restricted just to civil litigation. Civil litigation may well serve the goals of recompense (as discussed above) and deterrence (as discussed below), but I would contend that it is not the purpose of civil litigation to serve the goal of retribution, which is the goal of criminal and enforcement procedures.

Deterrence: Which brings us to the question of deterrence. I understand the argument that if directors faced a greater likelihood of being personally liable financially, there would be greater deterrence of corporate misconduct. But before examining this question, I want to make a few points about deterrence as it currently operates.

The problem with most analyses of the deterrent effect of corporate and securities litigation is that it usually assumes that the only effective deterrence is through financial consequences, and it overlooks other possibilities. My own experience is that the threat of civil litigation (as well as the possibility of criminal and enforcement proceedings) provides a powerful deterrent effect, separate and apart from the threat of financial liability.

My experience is that most corporate directors have a deep and abiding aversion to becoming associated with any type of corporate scandal. The prospect of seeing their name in the media paired with the word “fraud” or even “mismanagement” is a truly detestable possibility and one they are deeply committed to trying to avoid. These individuals value their reputations. They are keenly interested in avoiding the types of situations that would draw them into scandal and tarnish their personal or professional standing.

The individual directors are also highly motivated to avoid the burden, disruption and expense of civil litigation. And with regard to expense, I think it is critically important to note that Davidoff’s analysis of how often directors have been required to pay settlements or judgments themselves omits to consider how often directors are compelled to fund their defenses out of their own pockets.

Defending these kinds of suits can be hideously expensive, and if indemnification is unavailable and insurance is inadequate, directors can (and sometimes do) find themselves forced to draw on their own assets to mount their defense. Directors are well aware of these possibilities and they are highly motivated to avoid them.

In short, I believe that even conceding all of the points in Davidoff’s column about the infrequency of personal civil liability for directors, the threat of civil litigation still provides a powerful deterrent to corporate boards.

There are of course boards or individual directors to whom these deterrents are not sufficient. However, there is nothing that says that imposing greater financial liability in civil litigation would deter these undeterrable boards and individuals. Very significant personal liability was imposed on the boards of Enron, WorldCom and Tyco, but I would argue that perhaps other than with respect to the specific individuals involved these individuals’ settlement contributions otherwise had absolutely no measurable deterrent effect.

I can anticipate the argument that three cases alone is not enough, that personal liability must be imposed more generally in more civil cases in order to generate enough deterrent effect. But if personal liability in three cases was not enough, how many will be enough? How do we know? Doesn’t this all seem rather speculative?

My fear is that in the highly charged current environment, the generalized notion that individuals ought to be compelled to pay more out of their personal assets could wind up imposing costs and burdens in ways that far exceed the intended purposes – indeed, without any substantiation that it would even potentially produce the intended benefit. And likely imposing enormous costs on many of the wrong people.

Let me put it another way. The suggestion that individuals ought to be held personally liable is a far more comfortable notion if you are sure that the liability will never be imposed on you personally. It is an easy assertion to make against a group from which you have not only dissociated yourself, but that you have comprehensively demonized. However, you would take a far different perspective if the question involved your own personal assets. Particularly in our litigious society where sensational and even outrageous allegations can be made with impunity and where the high costs of litigation often can compel settlements simply as a way to avoid financial ruin. In these circumstances, the insistence on personal director liability looks to many directors like nothing more than a legally sanctioned predicate for future hostage crises.

I know that in taking this position, I may well be flying in the face of conventional wisdom. My purpose here is to provoke discussion and to make sure that before we move on to what actions we should take, we make sure that we identify our goals and ensure that the actions are well matched to the intended goals. Stronger rat poison undoubtedly will produce many effects, but there is nothing that it ensures that it will result in fewer rats.

My own view is that there are already far too many civil lawsuits against corporate boards, most of them involving circumstances where nothing improper has occurred. The law has evolved in response to the excess of litigation, and that is the reason for the barriers to liability that Davidoff bemoans. A welcome and interesting discussion would be one that addresses the question of how we can develop a more concentrated system of civil litigation, in which meritorious cases are resolved and fewer of the other kind are filed.

More About Delaware: This must have been the week to raise doubts about Delaware’s courts. In her June 9, 2011 “Summary Judgment” column on the Am Law Litigation Daily (here), which included her remarks on the nomination of Delaware Vice Chancellor Leo Strine to take the position of Chancellor of the Court, she commented, among other things, that Delaware is “soft on Corporate America” adding that corporate directors “have little to fear in terms of being held accountable when they do a lousy job and harm a lot of people in the process.” She concluded by calling on Strine to reconsider the words of the courts critics, adding that the Court “can and should send a much stronger message.”

In Case You Missed It: I hope readers had a chance to read the interesting guest post I published late last Friday afternoon (here), in which Bernstein Liebhardt attorney Brian Lehman presents his prediction of the outcome the Janus Capital case now pending before the U.S. Supreme Court. Lehman’s interesting prognosis is worth a look, particularly given that the Court is likely to release its decision in the Janus Capital case any day now.

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As the current Supreme Court term gets ready to draw to a close, many court observers are awaiting the Court’s decision in the Janus Capital case (background here). With the opinion due to be released any day now, I am pleased to be able to publish here a guest post from Brian Lehman, who is an associate at the Bernstein Liebhard law firm, in which Brian presents his prediction of how the Court will decide the Janus Capital case. Because the release of the Court’s decision may be imminent, I am presenting this guest post in the form of a special Friday afternoon edition.

I would like to add by way of introduction that I am always happy to accept proposed guest blog posts from responsible commentators. Please let me know if you think you would like to publish a guest post on this site.

Here is Brian’s guest post:

Predicting how the Supreme Court will decide a particular case can be a fool’s errand, but that’s also what makes it fun. So, as the securities litigation bar awaits the Court’s decision in Janus Capital v. First Derivative Traders, I offer a doozy: In Janus, Justice Thomas will defer to the position taken by the Securities and Exchange Commission (SEC) in its amicus brief and author a majority opinion holding that a person or company “makes” a false statement under Rule 10b-5 when “writing or speaking it, providing false or misleading information for another to put into it [e.g., a prospectus] or allowing it to be attributed to him.” Only Justice Scalia will dissent. And the decision will be heralded as the third opinion this term favoring securities class action plaintiffs (Matrixx and Halliburton are the other two).

By way of background, Janus Capital Group, Inc. is a publicly traded asset management firm that sponsors a family of mutual funds. The investment advisor to the funds is Janus Capital Management LLC. Investors sued the firm and the advisor on the ground that they knowingly or recklessly made false statements about how the funds would be operated. 

According to the complaint, the funds’ prospectuses created the misleading impression that the firm and advisor would implement measures to curb market timing in the fund when in fact, “secret arrangements with several hedge funds” allowed market timing transactions. The lead plaintiff seeks to represent a class of investors who purchased shares of the firm’s stock at inflated prices starting in 2000 and ending in 2003, when the market timing agreements were publicly revealed and the stock’s price dropped significantly. 

Rule 10b-5 states that it is unlawful for “any person, directly or indirectly” to “make any untrue statement of a material fact . . . in connection with the purchase or sale of any security.” In the lower courts, the advisor argued, among other things, that it did not make any of the false statements because they were not attributed to the advisor in the prospectus.

 In Janus, there are two questions that must be answered. First, what does it mean to “make” a statement? Second, once that standard has been established, is it plausible that the advisor made the statements based on the factual allegations in the complaint? 

My prediction only addresses the first question, and here is my reasoning. As Tom Goldstein at SCOTUSblog wrote last Thursday: “For the December sitting, only the Janus securities fraud case is outstanding. Justice Thomas is almost certainly the author, because he is the only Justice who does not yet have an opinion from that sitting.” Goldstein has explained before: “By tradition, the Court attempts to evenly distribute majority opinions, both within individual ‘sittings’ and across the entire Term.” (A “stat pack” that shows the distribution of decisions is available here.)

The length of time that it has taken for the Court to issue its decision indicates that there will be a dissent. The other cases argued in December had opinions issued in 109 days on average. Janus is now at 186 days and counting.

Many lawyers might think if Justice Thomas is writing the opinion and there is a dissent, then the defendants are going to win – perhaps a classic 5-4 split with Justice Kennedy in the majority? But yesterday, Justice Thomas issued a decision signaling that something else could be afoot.

The issue in Talk America, Inc. v. Michigan Bell Telephone Company was whether a regulation passed by the Federal Communications Commission (FCC) required local exchange carriers to make their existing entrance facilities available to competitors at cost-based rates in certain circumstances. In holding that the regulation did require this, Justice Thomas wrote: “As we reaffirmed earlier this Term, we defer to an agency’s interpretation of its regulations, even in a legal brief, unless the interpretation is plainly erroneous or inconsistent with the regulations or there is any other reason to suspect that the interpretation does not reflect the agency’s fair and considered judgment on the matter in question” (quotations marks and alterations omitted).

Justice Thomas quoted and relied upon Chase Bank USA, N. A. v. McCoy, which was issued on January 24, 2011, and Auer v. Robbins, a Supreme Court decision from 1997 and the reason why deferring to an agency’s interpretation is called “Auer deference.”

Rule 10b-5 is, of course, a regulation passed by an agency – the SEC. And the SEC set forth its position on how to interpret Rule 10b-5 in its amicus brief: “The Commission has construed the term ‘make’ as providing for primary liability when a person ‘creates’ a misrepresentation either by writing or speaking it, providing false or misleading information for another to put into it, or allowing it to be attributed to him. Under Auer v. Robbins, 519 U.S. 452, 461 (1997), the Commission’s construction of its own rule is entitled to controlling weight.”

If the Justices are going to be consistent, they will either need to defer to the SEC’s interpretation of Rule 10b-5 or explain why Auer deference doesn’t apply to the SEC’s interpretation of its own rule while distinguishing Talk America and Chase Bank from Janus. Deferring to the SEC seems far more likely.

If that’s correct, then we can expect Justice Thomas to issue an opinion in Janus that will be joined by all of the Justices but one: Justice Scalia. Yesterday, Justice Scalia stated that he agreed with the result in Talk America on the ground that “the FCC's interpretation is the fairest reading of the orders in question,” but then stated “[i]t is comforting to know that I would reach the Court’s result even without Auer.  For while I have in the past uncritically accepted that rule, I have become increasingly doubtful of its validity.” After outlining some of his concerns, Justice Scalia concluded: “We have not been asked to reconsider Auer in the present case. When we are, I will be receptive to doing so.” In contrast, the other Justices joined Justice Thomas’s opinion.

Janus looks to be the case where Justice Scalia will provide his reasons why Auer should be reconsidered. At oral argument in Janus, Justice Scalia argued against the SEC’s interpretation: “If someone writes a speech for me, one can say he drafted the speech, but I make the speech.” Counsel for the respondent (the plaintiff’s lawyer) answered, “Justice Scalia, we address the definition of ‘make’ under the SEC's interpretation, which is entitled to deference, as being to create or to compose or to accept as one’s own.”

Justice Scalia didn’t have an immediate response to counsel’s argument that the Court should defer to the agency, but instead answered: “That – that’s not what – it depends on the context of ‘make.’ If you’re talking about making heaven and earth, yes, that means to create, but if you're talking about making a representation, that means presenting the representation to someone, not – not drafting it for someone else to make.”

Reporters who closely follow the Supreme Court know that “Scalia doesn’t come into oral argument all secretive and sphinxlike, feigning indecision on the nuances of the case before him. He comes in like a medieval knight, girded for battle. He knows what the law is. He knows what the opinion should say.” Justice Scalia wasn’t playing devil’s advocate when he argued over what “makes” means; Justice Scalia just doesn’t agree with the SEC’s interpretation. But Justice Scalia also didn’t have an answer to the argument that the Auer deference should apply, and it is fairly uncharacteristic of Scalia not to have a response.

There is one last thing to note. At the end of January, Scalia joined the unanimous opinion in Chase Bank authored by Justice Sotomayor that held: “Under Auer v. Robbins, 519 U. S. 452 (1997), we defer to an agency’s interpretation of its own regulation, advanced in a legal brief, unless that interpretation is 'plainly erroneous or inconsistent with the regulation.’” If Scalia is now changing his mind about Auer deference, it must be because something happened in the last four months. 

To review: Janus has taken an extraordinary amount of time to be issued, which indicates a dissent. But interpreting the word “make” is not particularly difficult regardless of whether one is in the majority or dissenting. The briefs and decisions by the lower courts have fully covered this ground.

Nor is it difficult to determine whether the allegations in the complaint give rise to a plausible claim after the word “make” is interpreted. For example, in Matrixx, the Justices unanimously determined that the allegations gave rise to a plausible claim in an opinion that was issued in a mere 71 days. 

The Justices must be disagreeing about something else. Given the amount of time that has elapsed, the issue is probably significant and perhaps something that was not fully briefed or considered by the parties. 

A disagreement over Auer deference fits perfectly. Although the press hasn’t covered it, few, if any, issues decided this term can compare to the Court’s repeated holding that courts should defer to an agency’s interpretation of its own regulation. Anyone who thinks otherwise should consider this fact: the Dodd-Frank Act alone requires 243 rulemakings by eleven agencies. 

A year ago, I had either not heard of Auer or I had forgotten about it. Within a few years, every lawyer who works for a corporation will know this case. If an environmental regulation is ambiguous, defer to the agency. If an agricultural regulation is ambiguous, defer to the agency. If an energy regulation is ambiguous, defer to the agency. Defer, defer, defer. Here is the federal government’s A-Z Index of U.S. Government Departments and Agencies –  there are a lot of them.

But, despite the importance of Auer, the argument over whether the Court should defer to the SEC has not been well-developed. The Petitioners’ merits brief on behalf of the defendants does not mention Auer; the Respondent’s merits brief mentions it three times but does not dwell on it; and the Petitioners’ reply brief responds to the case with a single footnote on page 10 of its brief. 

Moreover, the Justices were not focused on this issue at oral argument. The word “deference” was only mentioned one time at oral argument – when Justice Scalia disagreed with counsel on how to interpret the word “make.” When Curtis Gannon argued on behalf of the government, he was immediately asked by Justice Sotomayor to distill his brief into “three sentences.” He responded by arguing the merits, rather than arguing that the Court should defer to the SEC’s interpretation.

When I put all of the pieces of the puzzle together here is what I get: Justice Thomas will write the majority opinion and defer to the SEC’s interpretation of Rule 10b-5; everyone but Justice Scalia will join. 

Justice Scalia disagrees with the SEC’s interpretation of the word “make” and has begun to question why courts should defer to agencies when interpreting their regulations. 

But the issue is not well-developed, so it is taking more time than usual for Justice Scalia to make his arguments. Justice Scalia has also realized how significant this issue is and, if Justice Scalia stays true to form, he is putting together quite the dissent.

-- Brian Lehman is an associate with the New York law firm of Bernstein Liebhard LLP. He concentrates his practice on complex and class action litigation. He may be contacted at lehman@bernlieb.com.

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One of the most distinct securities litigation filing trends during the last twelve months has been the filing of securities class action law suits against U.S.-listed companies based or operating in China. With a phenomenon this well-established, it is only natural that the trend should begin to evolve, which seems to be what has happened in connection with a couple of new filings during this past week.

Yahoo: First, according to their June 6, 2011 press release (here), plaintiffs’ attorneys have filed a securities class action lawsuit in the Northern District of California against Yahoo , its CEO Carol Bartz, and director and co-founder Jerry Yang. Yahoo is of course a well-established U.S.-based company. But the lawsuit relates to Yahoo’s investment in its Chinese-based strategic partner, Alibaba Group Holdings Limited, which is China’s largest e-commerce company. (Yahoo owns about 40% of Alibaba Group.)

The lawsuit arises out of the well-publicized dispute between Yahoo and Alibaba over the March 31, 2011 restructuring of a unit of Alibaba (Alipay) that resulted in Alibaba’s CEO’s ownership of 100% of Alipay. The complaint alleges that Alibaba and Yahoo received only about $45 million for Alipay, which allegedly is worth more than $5 billion. The complaint further alleges that Yahoo failed to disclose this information to investors until May 10, 2011. When Yahoo released the information in a periodic SEC filing, its share price declined. The complaint alleges that the delay in releasing the information misled investors.

The fact that the defendant in this case is a mainstream U.S. company makes this new lawsuit different from the many cases that have been filed recently against Chinese companies. But the case has certain features in common with those other suits, other than the obvious China connection. For example, both the alleged lack of transparency surrounding a critical corporate transaction and the allegations of self-dealing involving senior Chinese management are the kinds of allegations that have appeared in many of the prior suits against Chinese-linked companies. Alison Frankel’s June 8, 2011 article on Thompson Reuters News & Insight has further comments on the Chinese litigation connection of the new Yahoo lawsuit.

Sino-Forest Corporation:  The second of the two recent lawsuits involves Sino-Forest Corporation. Sino-Forest’s name has been in the news recently after the publication of analyst reports that the company has significantly overstated its forestry assets and revenues. The company’s share price declined sharply and the company announced that is has formed a special committee to investigate the allegation.

Inevitably, a securities class action lawsuit filed. In certain respects, this new lawsuit filing is similar to many of the prior suits involving Chinese companies, based as it is on allegations of accounting and reporting misrepresentations. What makes this suit different is that it has been filed in Canada, by a Canadian law firm, as reflected in the law firm’s June 8, 2011 press release ( here). Sino-Forest’s shares are listed on the Toronto stock exchange and the lawsuit has been filed in the Ontario Superior Court of Justice.

Sino-Forest, meanwhile, has struck back at the analyst, whom the company claims is a short-seller spreading misinformation about the company in order to profit by driving down the company’s share price. Sino-Forest has threatened litigation. Indeed, several of the Chinese companies that have suffered share price declines (and securities class action lawsuits) following negative analysts’ reports have taken a similar approach. A June 6, 2011 Bloomberg article (here) reports that several of these companies have even initiated litigation against the analysts.

So with the filing of these two new lawsuits, it appears that the securities litigation filing trend involving China-linked companies is developing. These latest filings involve, in the case of the Yahoo lawsuit, a company’s whose connection to China is indirect and unrelated to the basic public identity of the company. In the case of the Sino-Forest filing, the trend has expanded to reach beyond just the Chinese companies whose shares are traded in the U.S.

There undoubtedly will be even further variations as this latest securities litigation filing trend continues to develop. Up until this point, I have been keeping a pretty careful tally of the filings against the Chinese and China-linked companies. Not counting the two lawsuits described above, there have been 24 lawsuits filed in 2011 against Chinese and China-linked companies, out of about 102 new lawsuit total so far this year. But as the types of lawsuits become increasingly diverse, it clearly is going to be increasingly challenging to maintain definitional clarity about exactly what I am counting. I suppose I will have to start deploying Roger Maris type asterisks in presenting my tallies.

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In a decision that largely turned on detailed confidential witness statements, on June 7, 2011, Northern District of Alabama Judge Inge Prytz Johnson denied the motions to dismiss in the Regions Financial Corporation subprime-related securities lawsuit. This ruling is the latest of a series of decisions involving the company. The June7 ruling can be found here.

Background

As detailed here, this case arose following the company’s January 20, 2009 announcement that it was taking a goodwill impairment of nearly $6 billion related to the company’s November 2006 purchase of AmSouth Bancorporation. As the plaintiffs later alleged, even though Regions acquired AmSouth, with a year former AmSouth executives were running the combined company. The AmSouth loan portfolio was heavily weighted toward Florida real estate.

The plaintiffs allege that the company and its senior officials were well aware of the deteriorating conditions in the Florida real estate market, but they failed to recognize the non-performing loans in the company’s portfolio. As a result, the defendants “repeatedly, yet falsely, claimed that the $6 billion in goodwill associated with the AmSouth acquisition was unimpaired. “

But by January 2009, “the collapsing real estate market proved more devastating than even defendants’ fraud could conceal,” and on January 20, 2009, “defendants were forced to finally announce a huge increase in loan loss reserves , and a colossal $6 billion writedown of goodwill.” The company’s share price declined and litigation ensured. The defendants moved to dismiss.

The June 7 Opinion

Judge Johnson’s June 7 Opinion denying the defendants’ motions to dismiss relied heavily on the statements of confidential witnesses cited in the amended complaint. Her opinion recites this testimony at length. Among other things, one confidential witness reports that senor bank officials changed the status of nonaccrual loans at month or quarter end, but that following the month or quarter end, the numbers would be switched back, the delay done with the purpose of “making the numbers.” Another confidential witness stated  that the company did not properly classify nonperforming loans as nonaccruing assets in a timely manner.

The plaintiffs also relied on confidential witness statements to establish that “defendants were kept aware of this process through both the reporting structure and periodic reports.” The confidential witness cited specific detailed reports senior managers were regularly given.

Another confidential witness statedthat the Federal Reserve has opened an investigation into the company’s classification of loans as “non-accrual,” and that the Company’s Audit Committee is now in the process of conducting its own investigation, and has hired an outside law firm to investigate.

In denying the denying the defendants’ motions to dismiss, Judge Johnson differentiated the plaintiffs’ allegations from those involved in a separate case relating to Regions’ alleged delay in recognizing the impairment of the AmSouth transaction goodwill, in which Southern District of New York Judge Lewis Kaplan had granted the motion of the defendants in that case to dismiss the complaint.

By contrast to the allegations in that case, Judge Johnson said, the plaintiffs in this case have “pled many facts showing that the defendants had information that did not support defendants’ opinions.” Among other things, she cited the statements of the confidential witnesses “showing how defendants improperly handled and classified loans, defendants were aware of the collapsing commercial real estate in Florida yet continued to push for more growth there, and continued to ignore [internal] reports signaling a negative risk-adjusted bottom line.

Judge Johnson concluded that the plaintiffs has sufficiently alleged that the company’s loan loss reserves were false and misleading, citing the testimony of several confidential witnesses that “defendants mishandled loans in order to manipulate their financial reporting numbers.” Because the loan loss reserves impacted the company’s reported income (which was the measure by which the company tested its goodwill), Judge Johnson concluded that the plaintiffs had adequately alleged that the company’s goodwill was “overstate, false and misleading.”

Judge Johnson also relied on the confidential witnesses’ statements in concluding that the plaintiffs had adequately alleged scienter. Taking the fact that the defendants had compensation tied to company performance as one possible motive to be considered, Judge Johnson also noted that the defendants “had access to reports showing the true state of affairs regarding Regions’ loans and the deteriorating markets, particularly in Florida.”

Judge Johnson also found that the defendants’ “significant and sudden increase in loan loss reserves along with its $6 million goodwill write-down, considered collectively with all allegations, supports a strong inference of scienter.”  Judge Johnson added that “coupled with allegations of defendants’ knowledge of the scheme to manipulate classifications of loans, it was apparent to defendants that the financials were inaccurate long before their adjustment in January 2009.”

Discussion

Securities plaintiffs have been uniformly successful in attempting to rely on confidential witness statements  in order to try to meet the PSLRA’s pleading requirements This case is a notable example where use of confidential witness statements was successful. The success depended on a number of factors. The witnesses’ statements was detailed and specific. More importantly, Judge Johnson found that the witnesses’ statements  showed that the defendants were aware of the information about which the witnesses testified, in particular about alleged differences between the information cited by the witnesses and what the company was saying publicly.

At the same time it seems that the witnesses’ statements  reinforced Judge Johnsons’ predispositions. She clearly found the magnitude of the $6 billion write-down and the January 2009 increase in loan loss reserves to be disturbing, and even suspicious. These factors came together to support her conclusions.

The confidential witness statements were  clearly important and  help explain the difference in outcome between her ruling and that of Judge Kaplan in the separate ’33 Act claim that had been brought on behalf of class of investors who had purchased Regions trust preferred securities in a separate securities offering. As noted above, in that case, Judge Kaplan had granted the motion to dismiss. The difference seems to be the allegations based on the statements  of the confidential witnesses.

There have been a number of other credit crisis-related lawsuits in which the presence of statements from confidential witnesses seemed to have made a difference in enabling plaintiffs’ claims to survive the initial pleading hurdles. Among these cases are: the Sallie Mae case (refer here); and  the Wells Fargo Mortgage-Backed Securities case (refer here). Indeed, in the Credit Suisse case, which later settled for $70 million dollars, the court found that the information in confidential witness statements cited in the amended complaint was sufficient to permit the plaintiffs’ amended complaint to survive the renewed dismissal motions, after the motion to dismiss the initial complaint had been granted, as discussed here.

As I noted in a prior post, here, here have been a number of cases filed against this company in the wake of the AmSouth merger and in light of the problems Regions encountered during the financial crisis. A number of these cases are proceeding, including, as discussed in a prior post, the state court derivative complaint.

These cases are part of the huge number of cases that continue to work their way through the system following the financial crisis. I have in any event added the June 7 ruling to my running tally of credit crisis-related dismissal motion rulings, which can be accessed here.

Special thanks to a loyal reader for sending along a copy of the June 7 order.

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As many observers had expected, the U.S. Supreme Court has reversed the Fifth Circuit’s opinion in the Halliburton case. In a brief June 6, 2011 opinion from Chief Justice John Roberts, writing for a unanimous court, the Court held that securities class action lawsuit plaintiffs do not need to prove loss causation in order to obtain class certification. A copy of the opinion can be found here.

Background

As detailed here, in 2002, shareholders had filed a securities class action lawsuit against Halliburton and certain of its directors and officers, alleging that the company has misrepresented certain aspects of its financial condition, including the company’s exposure to potential liability from asbestos litigation and the company’s expected revenue from certain construction contracts. The plaintiffs alleged that Halliburton’s share price declined following a corrective disclosure.

The plaintiffs purported to represent a class of Halliburton investors and filed a motion for class certification. The district court found that the case could proceed as a class action, except for the fact that the plaintiffs had not satisfied the Fifth Circuit requirement that securities fraud plaintiffs proved “loss causation” in order to obtain class certification .The district court concluded that the plaintiff “had failed to establish loss causation with respect to the any of its claims” and therefore denied the motion for class certification.

The Fifth Circuit affirmed the denial of the motion for class certification, holding that in order to obtain class certification a securities plaintiff is required “to prove loss causation, i.e.., that the corrected truth of the corrected falsehoods actually caused the stock price to fall and resulted in losses.” Owing to the conflict among the circuit courts on the question whether loss causation must be proved at the class certification stage, the U.S. Supreme Court granted the plaintiff’s petition for writ of certiorari.

The June 6 Opinion

Chief Justice Roberts’s June 6 opinion reversed the Fifth Circuit, and expressly rejected the Fifth Circuit’s interpretation of the Supreme Court’s prior opinion in Basic v. Levinon and Basic's holding that to establish reliance using the fraud on the market presumption. The Fifth Circuit had held that in order to invoke the rebuttable presumption of reliance under the fraud on the market theory, the plaintiff had to prove that the decline in Halliburton's stock price had occurred because of the corrective disclosure and that the decline could not be explained by other factors.

In his opinion for the Court, Chief Justice Roberts said that this “requirement” is “not justified by Basic or its logic,” adding

To begin, we have never before mentioned loss causation as a precondition for invoking Basic’s rebuttable presumption of reliance. The term “loss causation” does not even appear in our Basic opinion. And for good reason: Loss causation addresses a matter different from whether an investor relied on a misrepresentation, presumptively or otherwise, when buying or selling a stock.

Roberts went on to draw a distinction between “transaction causation” (that is, whether the plaintiff relied on the alleged misrepresentation in deciding whether or not to engage in the transaction) and “loss causation” which “by contrast” required a plaintiff to show “that a misrepresentation that affected the integrity of the market price also cause a subsequent economic loss.”

Roberts said to require proof of loss causation in order to invoke the rebuttable presumption of reliance under the fraud-on-the market theory

contravenes Basic’s fundamental premise – that an investor presumptively relies on a misrepresentation so long as it was reflected in the market price at the time of his transaction. The fact that a subsequent loss may have been caused by factors other than the revelation of a misrepresentation has nothing to do with whether an investor relied on the misrepresentation in the first place, either directly or presumptively through the fraud-on-the market theory. Loss causation has no logical connection to the facts necessary to establish the efficient market predicate to the fraud-on-the-market theory.

Discussion

In many ways this decision is not a surprise. Indeed, as Justice Roberts notes in his opinion, Halliburton’s counsel was forced to concede that the Fifth Circuit had erred in trying to require loss causation at the class certification stage. (Defense counsel tried to salvage things by trying to argue that in using the phrase “loss causation” the Fifth Circuit had really meant “price impact” – but Justice Roberts was having none of that. The Fifth Circuit had said “loss causation” and that was what Justice Roberts interpreted them to have meant.)

On the other hand, while the outcome itself may come as little surprise, it is nonetheless less than expected that this particular court would come out so clearly in a ruling that favors the plaintiffs. This Court has not exactly been plaintiff-friendly over the years.  To be sure, except in the Fifth Circuit, this ruling really does not change anything, as the courts in the other circuits had not been requiring proof of loss causation at the class certification stage. Nevertheless, if this case had come out the other way and the Supreme Court had found that proof of loss causation is required at the class certification stage,  that would have represented a significant hurdle for plaintiffs at a critical preliminary stage. So, from the plaintiffs’ perspective, the outcome at the Supreme Court is more of a potential serious problem avoided than a significant new advantage gained.

The brevity of the Court’s opinion may disappoint some observers. There has been some hope that the U.S. Supreme Court would provide further elaboration on what elements plaintiffs must prove in order to trigger the presumption of reliance at the class certification stage, and perhaps provide further guidance on the plaintiffs’ burdens of production and persuasion. There may be some takeaways on these topics from the comments in the opinion about Basic and the fraud on the market presumption. But a detailed analysis of these issues will have to await another day.

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If a verdict form contains the jury’s specific finding that the insured engaged in “fraudulent, malicious, oppressive, wanton, willful, or reckless conduct,” you might think that would trigger the exclusion for fraudulent misconduct in the applicable D&O insurance policy. But apparently not, at least according to a May 12, 2011 Southern District of West Virginia ruling (here) in a case involving the Charleston Area Medical Center (CAMC). The case makes for some interesting reading and interesting analysis.

Background       

In September 2004, CAMC determined that Dr. R.E. Hamrick’s plan to self-fund his medical professional liability was inadequate and not actuarially sound. Based on this determination and the fact that Dr. Hamrick’s insurance coverage had lapsed, CMAC revoked his clinical privileges. Dr. Hamrick went to court seeking injunctive relief and three days later succeed in having his clinical privileges restored. He then pursued a damages claim against CAMC. Dr. Hamrick’s amended complaint contained a claim for defamation and a claim for invasion of privacy/false light. Dr. Hamrick also sought punitive damages.

In February 2008, Dr. Hamrick’s damages claim went to the jury. In Section 1 of the jury Verdict form, entitled “Liability,” the jury indicated that they found in favor of Dr. Hamrick. In Section 2 of the Verdict form, entitled “Damages,” the jury awarded Dr. Hamrick $5 million in compensatory damages. In Section 3, labeled “Punitive Damages,” the jury found that CAMC had engaged in “fraudulent, malicious, oppressive, wanton, willful, or reckless conduct with respect to Dr. Hamrick,” and awarded $20 million in punitive damages. In Section 4 of the form, labeled “Other,” the jury found that CAMC had acted in “bad faith, vexatiously, wantonly or for oppressive reasons with respect to Dr. Hamrick.”

In July 2008, the court granted CAMC’s motion for remittitur, and reduced the damages award to $2 million in compensatory and $8 million in punitive damages. The case ultimately settled for $11.5 million, representing the remittitur award of $10 million, post-judgment interest of $476,917 and attorneys’ fees of $1.023,083.

The Insurance Coverage Dispute

CAMC was insured, inter alia, by a  D&O insurance policy with a primary limit of liability of $10 million., including a punitive damages limit of $5 million (the punitive damages limits is part of not in addition to the primary $10 million limit.) The policy contains an exclusion stating that the insurer will “not pay Loss for Claims brought about or contributed to in fact (1) by any dishonest or fraudulent act or omission or any willful violation of any statute, rule or law by any Insured.”

The D&O insurer filed a coverage action seeking a judicial declaration that at least some portion of the settlement falls under the dishonest/fraudulent acts exclusion and therefore is not covered, maintaining further that the jury’s findings necessitate an allocation between covered and non-covered conduct. CAMC filed a counterclaim, and the parties filed cross motions for summary judgment.

The May 12 Opinion

In his May 12, 2011 opinion (here), Southern District of West Virginia Chief Judge Joseph R. Goodwin held that the insurer had not carried its burden under West Virginia law to prove the facts necessary to support an exclusion to coverage.

In attempting to carry its burden, the insurer had sought to rely on the jury’s determinations in Sections 3 and 4 of the verdict form. Judge Goodwin found that these portions of the verdict form “quite clearly related to damages and attorney’s fees, as the jury assessed liability only in Section 1 of the jury form,” adding that the insurer’s arguments that “the jury’s findings in Section 3 and 4 related to something other than damages and attorney’s fees is somewhat hard to fathom.”

Judge Goodwin noted that the standards in Sections 3 and 4 “are not elements of any of the causes of action on which the jury’s liability finding in Section 1 could have been predicated, nor are those standards relevant to compensatory damages.” As a result “the only reason for the jury to have made such findings would have been in relation to punitive damages and attorney’s fees.”

Judge Goodwin went on to state that the insurer

has lost sight of the simple fact that the claims presented to the Hamrick jury were for defamation and invasion of privacy, not fraud. Because Dr. Hamrick never pressed a cause of action that was predicated on fraudulent or dishonest conduct, the jury could not possibly have found for him on such a claim. Moreover, [the insurer] cannot identify any particular dishonest or fraudulent act or omission on the part of CAMC.

Instead, [the insurer’s] entire position boils down to the argument that the last two sections of the jury verdict form somehow transformed the claim into one involving dishonest or fraudulent conduct. …CAMC was alleged to have wronged Dr. Hamrick by communicating to others his lack of insurance coverage, the actuarial deficiencies of his self-insurance program, and his revoked clinical privileges. There is no fraudulent or dishonest conduct in those acts or omissions, however, and the mere fact that the jury made predicate findings with regard to punitive damages and attorney’s fees does not alter the nature of the conduct giving rise to the claim.

Judge Goodwin further stated that “there were only two claims in this case – for defamation and invasion of privacy – and no colorable argument that the conduct giving rise to them fit within the Dishonest/Fraudulent Act Exclusion,” adding that the insurer’s “argument for denying coverage stems not from the nature of the claims or the conduct giving rise to them, but from specific findings made by the jury as part of the damages award.”

Judge Goodwin entered summary judgment against the insurer and in favor of CAMC.

Discussion

This coverage dispute is different than the usual clash over the fraudulent misconduct exclusion. Disputes about the fraudulent misconduct exclusion are usually over the fact that there are all kinds of allegations but unless there has been a finding that the precluded conduct actually occurred, then the exclusion doesn’t apply. Here the usual debate has been completely turned on its head. The assertion is that regardless of the jury’s specific finding of precluded misconduct, the exclusion doesn’t apply because the precluded misconduct was never alleged.

Judge Goodwin emphasizes that the specific legal theories on which Hamrick proceeded did not allege or depend upon precluded acts or omissions. Perhaps Judge Goodwin reads the phrase precluding coverage for “Loss for Claims brought about or contributed to in fact” by the excluded conduct to mean (1) that it is not sufficient if the Loss is brought about or contributed to by the precluded act or omission; (2)  the exclusion applies only if the Loss arises from Claims brought about or contributed to precluded act or omission. Because the Claims on which Hamrick relied and which he asserted did not depend on or even allege precluded conduct, then the exclusion would not apply, regardless of whether or not Loss was brought about or contributed to by precluded conduct.

The arguable problem with this analysis is that it  exalts mere pleading over proof – regardless of what Hamrick’s pleadings might have alleged , the fact is that the  jury specifically found that CAMC had engaged in “fraudulent, malicious, oppressive, wanton, willful or reckless conduct” with respect to Dr. Hamrick. (Moreover, Judge Goodwin doesn’t seem to have considered the jury finding’s use of the disjunctive “or” to be inconsistent with a finding of “fraudulent “conduct. He seems to accept that the jury finding represents a finding of “fraudulent” conduct.)

Judge Goodwin emphasizes that the jury made its fraudulent misconduct determination in the portion of the verdict form that relates to damages rather than the portion of the form relating to liability. It may well be that this distinction is as determinative as he believes it to be. But he never explains why that is so, particularly with reference to the operative policy language. In the absence of this explanation, we are left to wonder why he finds that distinction determinative of the issue.

All of this analysis disregards what seems to be the real problem here –there doesn’t seem to have been any fraudulent misconduct pleaded or proven.  As Judge Goodwin states, the insurer “cannot identify any particular dishonest or fraudulent omission on the part of CAMC.” In other words, Judge Goodwin seems to to be saying, the fraudulent misconduct exclusion doesn’t apply because there wasn’t any fraudulent misconduct – notwithstanding the jury’s specific finding in the jury verdict form that there was fraudulent misconduct. Judge Goodwin eludes this problem with this statement: “The mere fact that the jury made predicate findings with regard to punitive damages and attorney’s fees does not alter the nature of the conduct giving rise to the claim.” Well,  what could “predicate findings” be based upon other than conduct?

Judge Goodwin doesn’t say anything about it expressly , but there really does seem to be something wrong with a result in which punitive damages have been awarded based on a jury finding for which there appears to be  no basis in the record. And that’s not all. For a few days loss of clinical privileges, Hamrick was awarded millions of dollars of damages for reputational harm. Even without the punitive damages, Hamrick seem immensely better off than he would have been if his privileges had not been briefly interrupted.  

I will leave it to others to assess what the result in the underlying case might imply about the process involved.  But given the apparent proclivity of West Virginia juries, Dr. Hamrick’s plan to self-insure really does not look like a great idea.

Special thanks to a loyal reader for sending along the opinion.

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According to news reports, on June 1, 2011, Alpha Natural Resources completed its $7.1 billion acquisition of Massey Energy Company. The deal went forward despite last minute efforts by groups of Massey shareholders proceeding in West Virginia and Delaware courts to try to enjoin the transaction on the grounds that the merger did not properly value the pending derivative claims against the company’s board, resulting in Alpha being able to acquire Massey without taking into account the fair economic value of the derivative claims.

The courts in both West Virginia and Delaware rejected the preliminary injunction motions. Delaware Vice Chancellor Leo E. Strine Jr.’s  81-page May 31, 2011 opinion (here) refusing to enjoin the merger makes for some extraordinarily interesting reading, as Susan Beck notes in her June 1, 2011 Am Law Litigation Daily article about the decision (here).

All of these events relate back to the April 5, 2010 disaster in Massey’s Upper Big Branch Mine in Montcoal, West Virginia, in which 29 miners were killed. In the wake of the disaster, the company’s share price declined, and the company struggled to deal with the fallout and scrutiny from the tragedy. These events set up a lengthy process that resulted in Alpha’s agreement to acquire Massey. During this process, Massey forced out its long-standing CEO, Don Blankenship.

Another thing that happened in the wake of the disaster (“inevitably,” Vice Chancellor Strine noted) is that Massey shareholders filed derivative suits seeking to ensure that to the extent Massey was harmed by the obligation to pay fines, judgments to the deceased miners’ families and lost cash flow from the damaged mine, the companies directors and officers should be held responsible for failing to make sure that Massey complied with mine safety regulations.

In addition to damages, the derivative plaintiffs sought a preliminary injunction against the merger, arguing among other things that the merger was an attempt by the board to evade its responsibilities for the harm to the company by means of a sale to Alpha.

In his May 31 opinion, Vice Chancellor Strine denied the plaintiffs’ motion for a preliminary injunction, holding that it is “highly doubtful” that the shareholders would be able to show that Massey’s board had sought to sell the company “solely, or even in a material way” to escape liability for the shareholder claims. He also said that to delay the deal would “threaten more harm to Massey shareholders than its potential benefits to them,” reasoning that Massey’s shareholders ought to be able to vote for against the merger on their own.

There are a host of interesting things about Vice Chancellor Strine’s highly readable 81-page opinion. Among them, in no particular order, are the following.

First, Vice Chancellor notes that it is “undisputed” “regrettable” “concerning” and “might even be characterized as a breach of the duty of care” that in connection with its consideration of the proposed Alpha merger the Massey board “failed to address the value” of the derivative claims, as the duties of a board in negotiating the sale of company are to consider and get full consideration for “all of the corporation’s material assets.” However, he added, that “does not much help the plaintiffs obtain an injunction,” as the record “does not support the inference that the Derivative Claims are material in comparison to the overall value of Massey as an entity.”

Second, as part of reaching the preceding conclusion, Vice Chancellor Strine noted that “the record does not persuade me that the Merger would, after trial, likely prove to be economically unfair to the Massey shareholders,” citing a number of considerations. In particular, with respect to the question whether or not the failure to separately negotiate value for the derivative claims harmed Massey shareholders, Strine noted numerous difficulties the claims face,  including the difficulty of showing that the defendants “acted with a wrongful state of mind, particularly given the exculpatory provision in Massey’s charter”; the possibility that “insurance proceeds may not be available to pay any judgment”; the questionable ability of even the wealthy board members to satisfy any judgment; and the fact that most of the individual defendants are independent directors whose “motivation to tolerate unsafe practices for the sake of profits would be tempered.” The value of the derivative claims might represent at most an opportunity for the company to recoup some of the costs for the disaster – and for that reason “it is unlikely that Alpha viewed these Claims as an asset at all, but merely as having some potential to reduce the gravity of the Disaster Fall-Out Alpha was inheriting.”

Third, though the Massey board itself might have been unclear on what the merger’s completion would mean for the derivative claims, Stine himself is very clear that the claims survive the merger (given his determination that the merger was not motivated primarily to avert the derivative suit liability). But with the merger’s completion, Alpha, as Massey’s successor in interest, controls the claims, putting the derivative plaintiffs in the position of having to prove demand excusal, and thus “receive leave to proceed in a double derivative action on behalf of Alpha” – an outcome Strine says “is not one an objective mind ought to consider probable” given that Alpha’s board has no exposure to the claims but “myriad of rational business reasons why Alpha may later decide that prosecuting these Claims does or does not make sense for Alpha.”

Nevertheless, Strine also notes that it is not a foregone conclusion that Alpha would not itself decide to pursue claims against the former fiduciaries of Massey. The fact is, as Strine notes, “Alpha will have to make a difficult business calculation about the extent to which it goes after Massey’s former management,” and its board will have to answer to Alpha’s own shareholders on their decision whether or not to pursue such claims. As Strine notes, “it is not clear why Alpha would not seek to offset the costs to itself of those violations by suing previous management if by doing so it had a realistic chance of obtaining some meaningful recovery.” That does not necessarily mean that Alpha will be able to effect a recovery commensurate with this costs (See the “second” item above and the “seventh” item below).

Fourth, Strine has some choice words to say about the Cravath law firm, which is not only acting as the board’s counsel in the derivative lawsuit, but also counseled the board on how it ought to consider the derivative suit in connection with the proposed merger. Strine characterized the law firm as being an “awkward source for advice” on this issue, and given the Cravath firm’s recommendation that the board not consider the existence of the derivative claims at all, “one cannot conclude that the Massey Board was presented with a reasoned analysis of the 'value' of the Derivative Claims." Strine also faulted Cravath for insufficiently explaining to the board what a survival of derivative claims means in the context of a merger. (Susan Beck’s Am Law Litigation Daily article linked above has more on this particular topic.)

Fifth, using language that is both noteworthy and striking, Strine went out of his way to excoriate former Massey CEO Don Blankenship, quoting descriptions of him as “autocratic” and describing him as having an “adversarial relationship” with the UAW and a “combative approach” to the federal mining regulator. He noted that Massey’s managers and employees understood that “if you wished to stay or get ahead at Massey under Blankenship, then the priority of profits over safety is one not to be questioned.” He also noted that in 2009, after President Obama’s election and a change in leadership at the mining regulator, and after Massey had sustained a number of losses in legal proceedings, Blankenship’s attitude toward regulators “deteriorated very sharply.”

Sixth, Strine makes it clear that he believes the real victims here are the deceased coal miners and their families – and in that regard, Strine is not prepared to let the shareholders off the hook. As he points out in a biting 1,071-word footnote (number 185), Massey’s shareholders not only had an annual opportunity to elect directors, but they “continued to invest in a company they say was well known to treat its workers and the environment poorly.” Indeed, “to the extent Massey kept costs lower and exposed miners to excess dangers, Massey’s stockholders enjoyed the short-term benefits in the form of higher profits.” The very practices of which the plaintiff shareholders now complain might rationally have been expected to act as a “goad” to shareholders to “give more weight to legal compliance and risk management in making investment decisions.” In the end, Strine notes, the “most sympathetic victims here were not shareholders, they were Massey’s workers and the families” and other constituencies who suffered while the company prospered and shareholders benefitted.

Seventh, readers of this blog will be interested in some parenthetical comments Strine has to make about D&O insurance. In noting the difficulties Alpha would have in collecting on any judgment entered in the derivative case, he notes that even if the derivative claims were to settle for the full amount of the D&O insurance, the total amount of coverage available is $95 million – not a “trifle,” but also not material in the context a merger valued over $ 7 billion. Also, Strine notes, showing that he has a keen appreciation for the D&O insurance market’s dark reality, “anyone who has dealt with coverage questions and insurance carriers would also tell you that a scenario in which the D&O insurers in the ‘tower’ would easily pay out anywhere near the full amount of the policy in a quick and low-cost way to Alpha is more the stuff of dreams than of real life.”

Eighth , it may not be entirely relevant to Vice Chancellor Strine’s decision or to the fact that the Alpha acquisition went forward as planned, but it is probably worth noting that among Massey’s former independent directors is another individual whose name has been in the news for entirely different reasons this week – that is, among the independent Massey directors named as defendants in the derivative litigation is Ohio State University President E. Gordon Gee. According to Wikipedia, Gee served on Massey’s board from 2000 until 2009 (that is, he resigned before the Big Branch Mines disaster, but during many of the prior safety and environmental problems the company faced.)

Now that the merger has been completed, the ball shifts to Alpha’s board to consider whether or not to pursue direct claims against the former Massey directors and officers. While Alpha might as Strine notes have substantial business reasons for wanting to close the book on the past and moving forward, the fact is that Alpha also inherited the wrongful death and regulatory claims that were pending against Massey. As much as Alpha might want to move on for business reasons, that may not be an available option.

To the extent Alpha must pay settlements, fines, and judgments, it will have to consider whether or not to pursue claims against the former Massey fiduciaries to try to recoup these costs. And in making that determination, the Alpha board will also have to consider its fiduciary duties to its own shareholders (some of whom now are former Massey shareholders.) I don’t know where any of this ultimately will lead, but the insurers in that $95 million insurance tower (whoever they may be, I have no idea) may find it prudent to wait a while before deciding whether or not to take down their reserves on this particular claim.

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

Yeah, I Really Hate it When the Guy in Front of Me Reclines His Seat Back, Too: On a May 29, 2011 United Airlines flight from Washington Dulles Airport to Ghana, one of the passengers decided to lower his seat back – which set in process a sequence of events that started with a scuffle on the plane and ended with Air Force F-16 fighter jets being scrambled. Because no one could make this up, you really have to read the Washington Post story (here) for yourself.

Just something to think about next time before reclining your seat back, O.K.?

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