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

I am pleased to present below a guest post from Mary C. Gill, Robert R. Long and Todd F. Chatham of the Officers & Directors of Distressed Financial Institutions team at the Alston & Bird law firm, in which they discuss the critical issues surrounding the defense of former directors and officers of failed banks who find themselves the target of an FDIC lawsuit.

My thanks to Mary, Robert and Todd for their willingness to publish their article here. This article will also be published in the October edition of The Review of Banking and Financial Services. Mary will also be presenting on these same topics in a September 14, 2011 webinar entitled "Bank Executives Under Heightened Scrutiny by the FDIC," about which refer here. I welcome guest posts from responsible commentators on topics of relevance to this blog. Any readers who are interested in publishing a guest post on this site are encouraged to contact me directly. Here is Mary, Robert and Todd's guest post.   

In the three years since the crush of the financial crisis, the number of banks that have been closed is roughly half the number of financial institutions that failed after the savings and loan crisis of the late 1980’s. [1] Although the number of problem institutions declined in the second quarter of 2011, there remain 865 institutions on the FDIC’s “problem bank list,” which indicates that bank closings will likely continue at a steady pace in the near term. [2] Whether the number of failed banks ultimately reaches the level of closings experienced in the post-savings and loan crisis remains to be seen.

The wave of litigation that has begun slowly and will continue in the wake of the bank closings also parallels the post-savings and loan crisis in many respects. [3] Significant developments in the law during the last decade, however, may yield strikingly different results in the claims that flow from the current financial crisis.

When a federally insured bank is closed, the Federal Deposit Insurance Corporation (“FDIC”) is appointed as conservator or receiver. The FDIC investigates every closed bank to determine whether there may be claims that can be pursued in an effort to recoup losses to the bank. [4] The investigation of a closed bank by the FDIC typically takes eighteen months with the focus on an array of professionals who provided services to the bank including accountants, lawyers, appraisers, and insurance brokers.  

The most intense scrutiny of the FDIC investigation, however, is on the former directors or officers of the failed financial institution. As a result, for an officer or director of a distressed financial institution, the risk of claims brought by the FDIC would appear to be high.    The FDIC has three years from the closing of a bank to bring claims against the former officers and directors. [5] At this point, the FDIC has authorized suits to be brought against 266 former directors and officers of 30 failed banks, seeking damages of $6.8 billion.   To date, however, only eleven lawsuits have been filed by the FDIC against former bank officers and directors. With the approach of the three year mark from the early bank closings, the pace of lawsuits filed against former bank officers and directors will undoubtedly increase.

FDIC Claims Against Bank Officers and Directors

According to its policy statement, the FDIC will only bring suit when there is a reasonable chance of establishing liability and the likelihood of recovery exceeds the cost of pursuing a claim. [6]   The current post-bank crisis litigation presents significant challenges to the FDIC in proving its case in court against the former officers and directors.   Under the federal statute that governs these claims, the FDIC must demonstrate that the officer or director conduct was grossly negligent, unless the applicable state law allows liability to be imposed based upon a stricter standard. [7] Simply stated, the FDIC must prove that the officers and directors made decisions that were in reckless disregard of the best interests of the bank.   In each case, the FDIC also must prove that the actions of the officers and directors caused actual losses to the bank.    In addition, the FDIC must rebut any affirmative defenses raised by the officers and directors to these claims. 

The first professional liability action brought by the FDIC in the current financial crisis was filed on July 2, 2010, against officers of the mortgage subsidiary of IndyMac, one of the earliest and largest bank failures. Since then, the FDIC has filed suit against the former officers and directors of ten other banks in Arizona, California, Illinois, Georgia and Washington. [8] The FDIC has asserted claims against these former officers and directors for negligence, gross negligence and breach of fiduciary duty. [9] In most of these cases, the claims relate to loans that were made by the bank. The FDIC also generally claims that the business plan executed by the officers and directors of the bank involved undue risk, overly aggressive growth strategy or unwarranted concentration in real estate based lending, particularly acquisition, development and construction. 

The FDIC has espoused the policy of pursuing claims against outside bank directors only for conduct that rises to the level of gross negligence or worse. [10] And, indeed, not all of the directors of these banks have been caught in the net of litigation. In many cases, only the outside directors who served on the loan committee and bore some responsibility for approving the particular loans were joined as defendants. In one instance, the FDIC sued outside directors for failure to supervise an allegedly faulty loan approval process.   Notwithstanding its stated policy, however, the FDIC has asserted claims of negligence against these outside directors.

In each of the pending lawsuits, the former officers and defendants have moved to dismiss the negligence claims on the grounds that FIRREA requires, at a minimum, a showing of gross negligence. [11] Thus, the threshold issue in these cases is whether claims of ordinary negligence will lie against the former officers and directors under the applicable state law.    Based upon well-established state law principles and decisions from the post-savings and loan litigation, courts should readily determine that the FDIC claims for negligence should be dismissed. In most states, directors are not subject to liability for negligence, either by statute or the application of the business judgment rule, which is generally viewed as protecting directors and officers from personal liability for ordinary negligence. Accordingly, in cases arising from the savings and loan crisis, courts rejected claims of negligence brought by the FDIC against bank officers and directors. For example, in a 1999 decision applying California law, the Ninth Circuit Court of Appeals held that directors are immune from claims of ordinary negligence brought by the FDIC when they have acted in good faith and on an informed basis. [12] Similarly, in the first court decision rendered in the recent wave of litigation, a federal court in California followed the same reasoning and held that the former directors of a credit union could not be held liable for negligence, which allegedly caused the failure of the financial institution. [13]

Although each case will be governed by the applicable state law governing the particular bank, the similarities in state law should lead to comparable results in most cases. Unless the state law governing the bank permits officers and directors to be held liable for ordinary negligence, the courts should dismiss the FDIC’s negligence claims.   The rulings in these initial cases will have a profound effect on the director and officer litigation that will continue in the years to come.

The Availability of Affirmative Defenses to FDIC Claims

The FDIC will also confront a variety of affirmative defenses raised by the former officers and directors in these cases. Many of these defenses were rejected by courts in the post-savings and loan crisis litigation.    The most common ground for striking affirmative defenses was the so-called “no duty” rule. A ruling by the United States Supreme Court near the end of the savings and loan litigation, however, has reopened the door to these defenses. As a result, there is a renewed viability to many of these affirmative defenses, which will level the playing field for officers and directors defending against FDIC claims.

The “no duty” rule was based upon “federal common law” and precluded former officers and directors from asserting certain defenses against the federally appointed receiver. The policy behind the “no duty” rule was “that any affirmative defense calling into question the pre-or post-bank closing action of the FDIC are [sic] insufficient as a matter of law because the FDIC owes no duty to the O&Ds of a failed bank either in its pre-failure regulation of a bank or in its post-failure liquidation of the same." FDIC v. Schreiner, 892 F. Supp. 848, 853 (W.D. Tex. 1985). Based upon this reasoning, the Resolution Trust Corporation (“RTC”), which served as receiver for many closed savings and loans, and the FDIC consistently relied on the “no duty” argument to block former officers and directors from asserting a variety of affirmative defenses to the receiver’s claims, including failure to mitigate damages, contributory or comparative negligence, estoppel and waiver. Prior to 1994, the RTC and the FDIC were generally successful in striking these defenses. As a result of the widespread acceptance by the courts of the “no duty” rule, bank officers and directors were handicapped in defending these lawsuits in the late 1980s and early 1990s.  

The litigation landscape was significantly altered near the end of the savings and loan litigation through a decision by the United States Supreme Court. As a result, former officers and directors of failed banks who face FDIC claims today may have an array of defenses that were not previously available. 

In the 1994 landmark decision, O’Melveny & Myers v. FDIC, 512 U.S. 79 (1994), the Supreme Court rejected the premise of “federal common law,” which afforded the FDIC unique protection from defenses. In doing so, the Supreme Court ruling swept away the basis for the “no duty” argument that had been applied by courts to reject an array of affirmative defenses raised by bank officers and directors to the FDIC claims.   In O’Melveny & Myers, the FDIC sued the former lawyers of a failed savings and loan institution. In their defense, the lawyers relied upon a defense that imputed the fraud of the former officers of the savings and loan to the institution itself and, as a result, to the FDIC, which as receiver stepped into the shoes of the institution.   The FDIC argued that public policy and federal common law barred the application of this defense against the FDIC.   Calling the FDIC’s premise “plainly wrong,” the Supreme Court unequivocally rejected the principle that there was a federal body of common law that afforded special defenses to the receiver. The Court held that neither federal policy, nor FIRREA itself, created a federal rule to protect the FDIC. Instead, “any defense good against the original party is good against the receiver.” [14]

 Thus, the FDIC’s previously successful argument that a federal “no duty” rule trumps otherwise available state law defenses is no longer available.   Moreover, because O’Melveny & Myers undermines the rationale upon which the prior pro-FDIC case law was based, these earlier decisions are no longer binding, nor should they be persuasive to courts in the current litigation environment.   In a number of decisions, courts have relied upon O’Melveny & Myers to reject the FDIC’s “no duty” argument and afford the director defendants state-law defenses that would have been denied them previously. [15] These decisions should pave the way for courts to allow the officer and director’s affirmative defenses to proceed on the merits, rather than stripping them of these arguments as a matter of federal policy. 

Conclusion

The wave of FDIC litigation against former officers and directors of banks will continue to build over the next few years. Not all officers and directors will face claims by the FDIC. For those who do, the burden of proof on the FDIC to establish liability is high.   Moreover, as a result of significant court decisions from the earlier savings and loan litigation, former bank officers and directors who face FDIC claims today have access to affirmative defenses that may bar or otherwise limit the receiver’s claims against them.   Bank directors and officers of distressed financial institutions may wish to seek counsel who can advise them and take steps now to prepare for potential FDIC claims.

__________________________________

[1]Between 1988 and 1992, there were 794 bank failures and 1,019 savings and loan failures. Recent Bank Failures and Regulatory Initiatives, Before The Committee on Banking and Financial Services, U.S. House Of Representatives (Testimony of Donna Tanoue, FDIC Chairman), February 8, 2000, available here.

[2] FDIC Quarterly Banking Profile, Second Quarter 2011, available here.

[3] The FDIC asserted professional liability claims against the former officers and directors of 24% of the banks that failed as a result of the savings and loan crisis from the late 1980s. Many of these claims were resolved, however, without litigation being filed by the FDIC.

[4] In an earlier article, the authors provided a full discussion of the FDIC investigation process, see Claims Against Bank Officers and Directors Arising from the Financial Crisis, The Review of Banking & Financial Services, Vol. 26 2010, available here.

[5] In some instances, the FDIC will seek to enter into tolling agreements with the former directors and officers in an effort to resolve the claims without filing a lawsuit and to afford the parties more time to do so.

[6} Fed. Deposit Ins. Corp., The FDIC and RTC Experience, Managing the Crisis, 266 (1998), available here.

[7] Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (“FIRREA”), 12 U.S.C. § 1821(k), refer here.

[8] FDIC v. Van Dellen, No. 2:10-cv-04915-DSF-SH (C.D. Ca.), July 2, 2010; FDIC v. Saphir, No. 1:10-cv-07009 (N.D. Ill.), Nov. 1, 2010; FDIC v. Appleton, No. 2:11-cv-00476-DDP-PLA (C.D. Ca.), Jan. 14, 2011; FDIC v. Skow, No. 1:11-cv-0111 (N.D. Ga.), Jan. 14, 2011; FDIC v. Stark, No. 3:11-cv-03060-JBM-BGC (C.D. Ill.), Mar. 1, 2011; FDIC v. Killinger, No. 2:11-cv-000459 (W.D. Wash.), Mar. 16, 2011; FDIC v. Spangler, No. 10-cv-4288 (N.D. Ill.), May 5, 2011; FDIC v. Perry, No. 11-cv-5561-ODW-MRWx (C.D. Cal.), July 6, 2011; FDIC v. Briscoe, No. 1:2011-cv-002303 (N.D. Ga.), July 14, 2011; FDIC v. Bryan, et al., No. 11-mi-99999-UNA (N.D. Ga.), August 22, 2011; FDIC v. Gary A. Dorris and Phillip A. Lamb, No. 11-cv-01652-GMS (D. Ariz.), August 23, 2011.

[9] In one of the cases, the spouses of the former officers were also sued for alleged fraudulent conveyance of assets.  FDIC v. Killinger, No. 2:11-cv-000459 (W.D. Wash.), Mar. 16, 2011.

[10] Managing the Crisis, supra, note 6, at 275.

[11] The difference between negligence and gross negligence is significant. Gross negligence requires a showing of reckless conduct in disregard of the best interests of the bank. Ordinary negligence may be established by showing a failure to act with ordinary care.

[12] FDIC v. Castetter, 184 F.3d 1040 (9^th Cir. 1999).

[13] National Credit Union Administration v. Siravo, No. 2:10-cv-01597-GW-MAN (C.D. Cal.), Mar. 3, 2010.

[14] O’Melveny & Myers, 512 U.S. at 86.

[15] See, e.g., RTC v. Mass. Mut. Life Ins. Co., 93 F. Supp. 2d 300, 306 (W.D.N.Y. 2000) (permitting the defense to assert the affirmative defenses of contributory negligence and failure to mitigate damages against the FDIC/RTC); FDIC v. Ornstein, 73 F. Supp. 2d 277, 282 (E.D.N.Y. 1999) (concluding that O’Melveny & Myers completely undermined the “no duty” rule and freed defendants to assert state law affirmative defenses, such as failure to mitigate damages, against the FDIC); FDIC v. Gladstone, 44 F. Supp. 2d 81, 89 (D. Mass. 1999); FDIC v. Haines, 3 F. Supp. 2d 155 (D. Conn. 1997); RTC v. Liebert, 871 F. Supp. 370 (C.D. Cal. 1994).   A few courts have reached contrary results and held that O’Melveny & Myers should be limited to its facts. See, e.g., FDIC v. Healey, 991 F. Supp. 53 (D. Conn. 1998); see also Grant Thornton, LLP v. FDIC, 535 F. Supp. 2d 676 (S.D. W. Va. 2007); FDIC v. Raffa, 935 F. Supp. 119 (D. Conn. 1995). These decisions are based upon the rationale that it is inappropriate to second-guess the conduct of federal banking agencies. See generally, Healey, 991 F. Supp. at 58-63. This reasoning, however, directly contradicts O’Melveny & Myers, which rejects the notion of federal common law used as a shield for affirmative defenses that would otherwise be available. O’Melveny & Myers, 512 U.S. at 86.

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In an opinion that provides an interesting glimpse of a complex D&O insurance program, on August 24, 2011, Central District of California Judge R. Gary Klausner granted the motions to dismiss of the insurance company defendants in an action that had been brought by a subsidiary of IndyMac bank, which was trying to establish its rights to coverage under the failed bank’s D&O insurance policies. A copy of the August 24 opinion can be found here.

IndyMac failed on July 11, 2008. The bank’s closure represented the second largest bank failure during the current banking crisis, behind only the massive WaMu failure. (IndyMac has assets of about $32 billion at the time of its closure).

As I detailed in a prior post (here), the bank’s collapse triggered a wave of litigation.  The lawsuits include a securities class action lawsuit against certain former directors and officers of the bank; lawsuits brought by the  FDIC and by the SEC against the bank’s former President; and a separate FDIC lawsuit against four former officers of Indy Mac’s homebuilders division.  According to Judge Klausner’s August 24 opinion, there are a total of twelve separate lawsuits pending (referred to in the opinion as the “underlying actions”). Judge Klausner describes the litigation generally as alleging “various improprieties, mostly centering around mortgage backed securities.”

IndyMac MBS was a subsidiary of IndyMac Bank, and is now wholly owned by the IndyMac federal receivership. IndyMac MBS is a defendant in a number of the lawsuits that have been filed in the wake of the bank’s collapse. Earlier this year, IndyMac MBS filed an action seeking a judicial declaration of coverage on its behalf under the bank’s D&O insurance policies.

The insurance policies at issue represent a total of $160 million of insurance coverage spread across two policy years. (Judge Klausner’s opinion does not explain why two policy year’s policies are potentially implicated, rather than only one.) The coverage in the 2007-2008 policy year, providing coverage during the year from March 1, 2007 to March 1, 2008, consists of eight layers of insurance. Each layer has a $10 million limit of liability. The eight layers consist of a primary policy providing traditional ABC coverage, with three layers of excess insurance providing follow form ABC coverage, followed by four layers of Excess Side A insurance.

The coverage for the policy year March 1, 2008 to March 1, 2009 is arranged similarly, except that the lineup of insurer involved changed slightly in the 2008-2009 program. Judge Klausner’s opinion names all of the carriers involved and their respective roles in the two programs.

In its declaratory judgment action, IndyMac MBS sought to have the court determine that each of the underlying actions is covered under one or the other of the two insurance coverage towers. Moreover, because the two programs are each subject to a “priority of payments” provision giving the individual defendants in the underlying actions priority to coverage under the policies, IndyMac MBS sought to have the court make a determination of coverage for the individual defendants in the underlying actions, so as to allow the court to ascertain whether IndyMac MBS  may be eligible to receive coverage under the policies. The defendant insurance companies moved to dismiss.

In his August 24 order, Judge Klausner granted the insurance companies’ motions to dismiss, holding that IndyMac MBS’s request for declaratory relief is “too remote to constitute a case or controversy” because any insurance coverage that may ultimately be owed “can only be determined after the underlying actions involving the Individual Defendants have been concluded.” Accordingly, IndyMac MBS “does not yet have an adequate injury that would make this case justiciable.”

In addition, Judge Klausner found with respect to the excess layers of insurance had not even been triggered because the underlying insurance has not yet been exhausted, and whether the excess layers “will ever be triggered in the underlying action is too speculative to give rise to a valid request for standing in the current case.” Indeed, even under the primary policy, IndyMac’s alleged injury is “too speculative” as IndyMac MBS has not yet met the $2.5 million deductible.

Finally, Judge Klausner separately granted the Excess Side A insurers’ motion to dismiss. Because the insurance coverage under the Excess Side A policies is only available, if at all, for the benefit of the individual defendants, IndyMac “lacks standing to request declaratory relief” because it “cannot adequately allege that it has a legal interest” in the Excess Side A policies, given that the Excess Side A policies “provide coverage only for the Individual Insured Defendants.”

Discussion

There is nothing surprising about the outcome of this ruling. It clearly is too early for the court or anyone else to try to sort out who is going to be entitled to what under the various policies. Nevertheless, it certainly is understandable that IndyMac MBS would want to know how much insurance it is going to have as it faces the various lawsuits in which it is involved.

This is a classic situation of too many claims, too many defendants and possibly not enough insurance. Even though IndyMac carried annual limits of liability of $80 million (and I note as an aside, there is nothing that says that both of the two $80 million towers of insurance will actually be available; it is entirely possible that all claims will relate back to the date of the initial filing of the first claim, in which case only a single $80 million tower would actually be available to pay the various insured persons’ losses), that may prove to be an insufficient amount to pay the defense fees and to pay settlements and judgments in order to resolve all of the various underlying actions.

The larger concern for IndyMac MBS is that owing to the priority of payments provision in the traditional ABC policies, and owing to the limitation of coverage in the Excess Side A policies to the individuals only, it is entirely possible that payment of the individual insureds’ defense expenses and settlement amounts will entirely exhaust all insurance. The Excess Side A insurance of course is not available at all for IndyMac MBS. IndyMac’s declaratory judgment action seems like an attempt to try to do something before all of the insurance is gone.

Of course, I am assuming for the sake of argument that there actually is coverage available under these policies for the benefit of the individual insured persons. Whether or to what extent there are policy terms and conditions that preclude coverage in whole or in part for the individual insureds is another question. That is of course one of the questions that IndyMac MBS wanted answered in the declaratory judgment action, because knowing the answer to the question of how much insurance is available to the individuals is a necessary predicate to knowing the answer to how much insurance might be available to IndyMac MBS.

The structure of IndyMac’s insurance was somewhat unusual, as it is not common for companies to carry equal amounts of traditional ABC insurance and of Excess Side A insurance, or to carry $40 million of Excess Side A, as IndyMac did here. However, from the perspective of the individuals, the unusually large amount of Excess Side A insurance that the bank carried is turning out to be a good thing from there perspective, as it is looking like they are going to need it, and it is only going to be available to them and for their benefit, without having to share with other entities.

Anyway, while I don’t think the outcome of this decision is particularly surprising, it is still an interesting situation. The circumstances provide insight into the ways that the various parts of a D&O insurance program operate, particularly the priority of payments provision and the Excess Side A insurance structure.

One final observation has to do with the fact that a lot of insureds, like IndyMac MBS, become frustrated when they are unable to find out with clarity at the outset of a claim how much insurance is going to be available. The problem is, as this case demonstrates, until the underlying litigation has played itself out, it is not possible to know how all of the various rights and interests under the policy are going to be addressed. When this type of frustration arises in the course of a claim, the insured persons often translate their frustration into anger at the carriers involved. But as this case also shows, even taking as active a step as suing the carriers to try to force a determination of coverage cannot eliminate the unavoidable constraint that requires the underlying claim to be resolved (or at least sufficiently advanced) before coverage can finally be determined.

I do wonder sometimes whether it is a sad commentary that I find all of this interesting.

Special thanks to a dedicated reader for sending me a copy of the IndyMac order.

Las Vegas Sands Credit Crisis-Related Securities Suit Survives Dismissal Motion: Like a lot of companies during the economic turmoil in late 2008, the Las Vegas Sands Corp. experienced serious liquidity problems that put it in breach of various covenants it has with its lenders. These disruptions affected the company’s ability to proceed with expansion plans in Las Vegas and Macao. As these events unfolded the company’s share price lost much of its value.

As I discussed in an earlier post, somewhat belatedly, in May 2010, a plaintiff shareholder filed a securities class action lawsuit in the District of Nevada, alleging that the company and certain of its directors and officers had made misleading statements about the company, its development plans, its liquidity and its financial condition. The defendants moved to dismiss.

In an August 24, 2011 order (here), District of Nevada Judge Kent Dawson denied the defendants’ motion to dismiss. He concluded that the plaintiffs “have adequately pled facts asserting that investors were misled by statements that liquidity was not an issue and that development was steadily progressing.” He also concluded that the plaintiffs have “adequately pled that Defendants knew that the statements they were making were false.”  He also found that the allegations in the complaint “show a series of public statements on material issues that were inconsistent with what was known internally.” He did conclude that certain forward-looking statements were not actionable, because they came within the safe harbor for forward looking statements.

I have added the Las Vegas Sands case to my running tally of credit crisis-related dismissal motion rulings, which can be accessed here.

Here’s A Real Shocker: Merger Objection Lawsuits Are Worthless: If the hurricane blew away your Saturday newspapers, you may not have seen the August 27, 2011 article in the Wall Street Journal entitled “Why Merger Lawsuits Don’t Pay” (here). According to the article, “legal experts” warn prospective claimants with respect to merger objection lawsuits that “the chances that you will succeed in stopping a deal or receiving a payday are minimal.”

The article reports data from Advisen that in 2010, there were 353 merger objection lawsuits, which represents a 58% increase from 2009. There have already been 352 merger objection lawsuits so far this year. The number of these lawsuits keeps increasing even though these suits “rarely result in a tangible award,” and the best outcomes are usually limited to “a delay in the merger or slightly improved disclosures about the deal’s terms.”

The answer to the question about why these cases are filed if they produce so little is that they make money for the lawyers. As the article puts it, “in many cases the biggest beneficiaries are the law firms,” which collect fees “from roughly $400,000 for typical cases to several million for bigger cases.” The article quotes a statement from Delaware Chancellor J. Travis Laster that the specific merger objection case before him was “a bunch of movement for nothing.”

Yes, it’s a great country, isn’t it?

Video Tribute: As a parting salute to Irene as she heads north and back out to sea, here's a video tribute -- The Scorpions "Rock You Like A Hurricane." (sorry about the commercial at the beginning, it is short).

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In a development that undoubtedly will attract comment and controversy, fourteen former Lehman Brothers executives – including former Lehman Chairman and CEO Dick Fuld (pictured) --have reached an agreement to settle the consolidated securities class action litigation that has been filed against them for $90 million. In a separate development, seventeen former Lehman executives have agreed to settle the separate lawsuit brought against them by the New Jersey Treasury Department Investment Division for $8.25 million.

The entire amount of both settlements is to be funded by D&O insurance. The settlements are subject to the consent of the bankruptcy court to lift the stay in bankruptcy to allow the D&O insurers to fund the settlement, as well as to the approval of the respective courts in which the respective settled actions are pending. The executives’ motion for relief from the bankruptcy stay in connection with the equity and debtholders’ action can be found here. The executives’ motion for relief from the bankruptcy stay in connection with the New Jersey action can be found here.

Peter Lattman’s August 25, 2011 article on August 25, 2011 article on The New York Times Dealbook blog  describing the motions and the settlements can be found here. Nate Raymond’s August 25, 2011 article on The Am Law Litigation Daily about the settlements can be found here.

Securities lawsuits had been filed against Lehman and certain of its directors and officers both before and after its dramatic collapse in September 2008. The cases ultimately were consolidated. On July 27, 2011, Judge Lewis Kaplan largely denied the motions to dismiss in the consolidated securities class action lawsuit, as discussed here.

At the time the first of these actions was filed against Lehman in early 2008, Lehman carried an aggregate of $250 million in D&O insurance, consisting of a $20 million primary policy and sixteen layers of excess insurance. A copy of the Lehman primary policy, which is included in the bankruptcy pleadings, can be found here. Further discussion of the details of the Lehman D&O insurance program can be found here.

Following Lehman’s bankruptcy filing, and  as the securities cases and other litigated matters went forward, from time to time the parties would appear in bankruptcy court to seek relief from the stay to allow the D&O insurers to fund ongoing defense expenses. As I noted in a prior post (here) anallyzing one of the prior requests from the relief from the stay, the defense costs have been accumulating extraordinarily rapidly.

The executives’ motions for relief from the bankruptcy stay for purposes of these settlements show just how rapidly the defense expenses and other items have been eroding the limits. In their motion with respect the $90 million securities class action settlement, the executives explain that they are seeking relief from the stay with respect to the sixth through twelfth level excess insurers in Lehman’s insurance program.

Footnote 4 of the motion identifies the excess insurers involved (their policies are also attached to the motion) and also explains that the sixth level excess insurer provide coverage of $25 million in excess of $85 million, and the twelfth level excess insurer provides coverage of $20 million in excess of $180 million. (The equivalent motion with respect to the New Jersey action seeks relief with respect to the sixth and if necessary the seventh level excess insurers, so the $8.25 million New Jersey settlement is assumed to have already eroded the limit for purposes of calculating the limits available for the consolidated securities lawsuit settlement).

Taking all of this information into account, and assuming the various stays and approvals are granted, the settlements, together with prior defense expenses and other payments, will erode up to $200 million of the $250 million tower. The two settlements together total $98.25 million.

There is nothing in any of the settlement papers to suggest that the individual defendants will contribute to either of these settlements out of their own assets. The settlements do not include the other defendants in the cases; in the securities class action lawsuit, the remaining defendants include Lehman’s offering underwriters, as well as its auditor, E&Y.

Discussion

Not only was the Lehman bankruptcy the largest in U.S. history, but the company’s collapse very nearly triggered a global economic catastrophe. The circumstances of its collapse have been the subject of extensive investigation and commentary. The company’s accounting prior to its collapse has also been the subject of intense scrutiny, most notably in the report of the bankruptcy examiner, who, among other things, he called the company’s quarter-end Repo 105 transactions “balance sheet manipulations,” about which refer here. Dick Fuld has become something of a poster child (or at least one of the poster children) for problems on Wall Street that contributed to the economic crisis.

Given that context, the fact that the individual defendants apparently are not going to contribute to this settlement is likely to be controversial. Many commentators have already bewailed the fact that cases of this type are settled exclusively with D&O insurance, and without any personal contribution by the alleged wrongdoers. These kinds of concerns will be even more exacerbated here, given the high profile nature of this case and the vilification that has heaped on Fuld and other Lehman executives. 

I have no insight into why the settlements were structured the way they were. But I can speculate at least that a major factor driving the timing, size and structure of these settlements was the alarming erosion of the policy limits as defense expense reduced the amount of insurance available with which to try to settle these cases.

The problem the plaintiffs’ lawyers faced, which is the one that claimants always face in the insolvency context, is that the plaintiffs can always hang tough and hold out for the optimal settlement, but in the meantime the policy proceeds out of which any settlement would have to be funded are rapidly disappearing. These concerns were particularly abrupt here because of the astonishing speed at which the policy limits were disappearing. An added concern for the plaintiffs here is that if they held out too long, they ran the risk that the SEC might suddenly file an enforcement complaint against one or more Lehman executive, or the DoJ might file a criminal action. If either of those things were to have happened, the rapid depletion of policy limits would have leapt into hyperspeed.

So to those who say that the plaintiffs’ lawyer here should have demanded a settlement in which the individuals contributed out of their own assets, I say that while that type of settlement might theoretically have been more satisfying at some level, it might not have produced a better result for the class members and other aggrieved parties. Indeed, if the settlement talks had dragged on too much longer, there might soon have been no insurance left at all out of which to settle the case.

I am realistic enough to know that not everyone will find this appeal to practicality to be satisfying. There is a lot of emotion associated with the Lehman collapse, and there undoubtedly will be those who will be outraged that Fuld and others are “getting off” here without having to contribute out of their own assets. This notion precedes from a basic sentiment that these executives should be punished. From my perspective, it is the job of the SEC and the DoJ to determine who needs to be punished. If the SEC and the DoJ believe these individuals should be punished in some way, they will pursue the appropriate sort of action. The types of private civil actions that are under discussion here are meant to provide a way to compensate aggrieved parties. That is the purpose of these settlements. Whether or not they are the optimal settlements, they may have been the most economically beneficial and viable settlements available given the rapid depletion of the policy limits.

I have in any event added these settlements to my running tally of credit crisis related case resolutions, which can be accessed here.

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On August 23, 2011, a three-judge panel of the Second Circuit in an opinion by Judge Barrington D. Parker affirmed the dismissal of the subprime-related securities lawsuit that had been brought against Regional Financial Corporation and certain of its directors and officers. A copy of the Second Circuit’s opinion can be found here.

Background

As reflected in greater detail here, the plaintiffs first filed a securities class action lawsuit in the Southern District of New York against Regions on April 1, 2009. The plaintiffs represented investors that had purchased securities in the company’s $345 million April 2008 trust preferred securities offering. The defendants included the company, certain of its directors and officers, its offering underwriters, and its auditor.

The plaintiffs alleged that the April 2008 offering documents were false and misleading because they incorporated by reference financial statements that overstated goodwill associated with Regions Financial’s 2006 acquisition of AmSouth and underestimated loan loss reserves associated with the AmSouth’s declining mortgage lending porfolio. Among the financial statements incorporated into the offering documents was the company’s 2007 Form 10-K.

The complaint alleged that the company "did not write down any of the massive goodwill" it recorded in its 2007 10-K "despite growing evidence indicating that serious problems existed at the time of the acquisition." The complaint also alleges that Regions "only marginally increased its loan loss reserves" despite "the high risk of loss inherent in its mortgage loan portfolio." The defendants moved to dismiss on the grounds that the plaintiffs had failed to allege any actionable misstatements or omissions.

As discussed here, in a May 10, 2010 opinion, Southern District of New York Judge Lewis Kaplan granted the defendants’ motions to dismiss, holding that the statement about goodwill and the loan loss reserves represented opinions that were not actionable because the complaint failed to allege that defendants did not honestly hold those opinions at the time they were expressed. The plaintiffs appealed.

The Second Circuit’s Opinion

The Second Circuit affirmed Judge Kaplan’s dismissal of the trust preferred securities investors’ securities lawsuit. With respect to the allegations regarding the statement concerning goodwill, the Second Circuit observed that “as Judge Kaplan correctly recognized, plaintiffs’ allegations regarding goodwill do not involve misstatements or omissions of material fact, but rather a misstatement regarding Regions’ opinions.”

In concluding that the plaintiffs had not adequately alleged actionable misstatements regarding misstatements or omissions regarding goodwill, the court said that

Plaintiff relies mainly on allegations about adverse market conditions to support the contention that defendants should have reached different conclusions about the amount of and the need to test for goodwill. The complaint does not, however, plausibly allege that defendants did not believe that statements regarding goodwill at the time they made them.

The Second Circuit went on to conclude that the plaintiffs’ allegations regarding loan loss reserves “suffer from the same deficiencies as those regarding goodwill.” The court approvingly cited Judge Kaplan’s statement that “determining the adequacy of loan loss reserves is not a matter of objective fact”; rather, loan loss reserves “reflect management’s opinion or judgment about what, if any, portion of amounts due on the loans ultimately might not be collectible.” Because the plaintiff failed to allege that the defendants’ opinions were “both false and not honestly believed when they were made,” the loan loss reserve allegations also fail to state a claim.

Discussion

The Second Circuit’s opinion in the Regions 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),  the Impac Mortgage Holdings case (refer here) and the HomeBanc 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.

What makes the Regions Financial trust preferred securities case noteworthy and even interesting is that the case was dismissed, and the dismissal was affirmed, while related complaints involving many of the same facts have actually survived dismissal motions. In particular and as noted here, in June 2011, Northern District of Alabama Judge Inge Prytz Johnson denied the motions to dismiss in the securities class action lawsuit filed on behalf of Regions Financial’s shareholders.

The Northern District of Alabama lawsuit also alleges that the company had failed to recognize the impairment of the goodwill associated with the AmSouth merger. As I discussed in my prior post about Judge Johnson’s ruling, she expressly recognized that Judge Kaplan had previously dismissed the Southern District of New York lawsuit filed on behalf of the trust preferred securities investors. However, she differentiated the allegations in the case in her court based on the plaintiffs’ allegations made based on the statements of confidential witnesses.

Judge Johnson concluded that the plaintiffs in the case before her 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 “overstated, false and misleading.”

On August 23, 2011, Judge Johnson denied the defendants' motion for reconsideration, rejecting the defendants' argument that the Supreme Court's recent decision in the Janus Capital case required a different result. Judge Johnson's August 23 order can be found here.

In addition, and as noted here, the plaintiffs in the separate shareholders’ derivative lawsuit filed in Alabama Circuit Court against Regions Financial, as nominal defendant, and certain of its directors and officers, also survived a motion to dismiss. However, it should be noted that the Alabama court was determining only whether or not the requirement for pre-suit demand was excused based on the circumstances alleged.

Finally, and just to complete the picture, in March 2010, the motions to dismiss was also denied in the Regions Financial ERISA action, about which refer here.

While the differences in the outcome between the New York lawsuit and the other lawsuits can be accounted for based on differences in the claims asserted and the specific matters alleged, there is also a sense in reading through all of these opinions that the outcomes may also be understood based on the respective court’s starting points. As I noted in my prior posts discussing the prior dismissal motions denials, for the other judges, the context matters, but for Judge Kaplan (and now for the Second Circuit) the context is irrelevant. There is also a sense that the more geographically proximate the decisions maker to the locus of the corporate defendant and its woes, the less sympathetic the courts are to the defendants’ position.

In any event, I have adjusted my tally of the dismissal motion rulings in subprime-related securities suits to reflect the Second Circuit’s opinion. The tally can be accessed here.

Special thanks to Douglas Henkin of the Milbank law firm for providing me with a copy of the Second Circuit’s opinion. Milbank represented the Underwriter defendants before the Second Circuit.

Deutsche Bank Subprime-Related Securities Suit Survives Dismissal Motion Ruling: In an August 19, 2011 opinion, here, Southern District of New York Judge Deborah Batts largely denied the motion to dismiss in the subprime-related securities suit filed against Deutsche Bank and certain of its directors and officers.

As discussed here, several groups of investors, who had purchased Deutsche shares in a series of offerings during the period 2005 to 2007, filed lawsuits asserting claims that the offering materials contained material misrepresentations and omissions in the associated offering documents. The plaintiffs basically alleged that the bank had misrepresented its exposure to residential mortgage backed securities and collateralized debt obligations. The various cases were later consolidated before Judge Batts and the defendants moved to dismiss.

In her August 19 order, Judge Batts granted the motion to dismiss as to stock offering from October 2006. However, Batts left intact claims relating to five other offerings, or gave the plaintiffs a chance to replead their allegations.

I have also added the Deutsche Bank decision to my tally of subprime related dismissal motion rulings.

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On August 22, 2011, when the FDIC filed a lawsuit related to the collapse of Silverton Bank, which is Georgia’s largest failed bank, the named defendants included not only bank officers that the regulators allege are responsible for the bank’s failure, but also the bank’s former outside directors and even the bank’s D&O insurers. A copy of the FDIC’s complaint, which was filed in the Northern District of Georgia, can be found here. Scott Trubey’s August 22, 2011 Atlanta Journal Constitution article about the lawsuit can be found here.

In addition, and as discussed further below, on August 23, 2011, the FDIC separate filed an action in the District of Arizona against certain directors and officers of the failed First National Bank of Nevada.

When Silverton failed on May 1, 2009, it had assets of over $4 billion. Prior to its collapse, Silverton had done business as a “banker’s bank” and had been chartered to do serve the needs of community financial institutions, by providing correspondent and clearinghouse services. The bank eventually expanded into residential and commercial real estate acquisition and development loans, which it accomplished through “participations” in which the Bank shared funding and risk with other banks.

The FDIC’s complaint alleged that its case represents “a text book example of officer and directors of a financial institution being asleep at the wheel and robotically voting for approval of transactions without exercising any business judgment in doing go.” The complaint, which seeks recovery of damages of $71 million, asserts claims against the individual defendants for negligence, gross negligence, breaches of fiduciary duty and waste.

The individual defendants named in the lawsuit include not only the bank’s former President and CEO and two other former bank officers, but also 14 additional former outside board members. In naming the outside directors, the FDIC stressed that what makes this case “so unique and troubling” is that the bank’s board was not composed of “ordinary businessmen” but, rather, in view of the bank’s business as a banker’s bank, of individuals who were all CEOs or presidents of other community banks. These outside board members “by virtue of their elevated positions within their own banks, were more skillful and possessed superior attributes in relation to fulfilling their duties” than “others who may serve in this capacity.

The complaint alleges that the individual defendants allowed the bank to pursue a strategy of rapid expansion, particularly with respect to commercial real estate lending, just as the economy started to head south, and allowed the bank to continue to pursue this strategy even after the signs of economic problems began to mount. The complaint alleges that the bank’s “aggressive banking plan” was accompanied by weaknesses in loan underwriting, credit administration and a complete disregard of a declining economy, which “led to the failure of the Bank.”

The complaint also alleged that the individual defendants “directed the Bank on a course of expansive and extravagant spending on unnecessary items for the Bank after the economy began to decline.” The individual defendants are alleged to have “authorized the purchase of two new aircrafts, a new airplane hanger to house three large and expensive airplanes, and a large and lavish new office building.”

In addition to naming the former officials of the failed bank as defendants, the complaint somewhat unconventionally also names as defendants the bank’s two D&O insurers.

At the time the bank failed, it carried a total of $10 million of D&O insurance, arranged in two layers consisting of a primary layer of $5 million and an additional $5 million layer excess of the primary. The complaint relates that when the binder for the relevant primary policy was issued on March 3, 2009 (that is, less than two months before the bank failed), the binder listed ten endorsements, including an endorsement containing the so-called regulatory exclusion (for background about the regulatory exclusion, refer here). However, when the primary carrier issued the policy on April 1, 2009, only seven of the ten endorsements that had been listed on the binder were included on the D&O policy. Among the endorsements that were listed on the binder that were not included on the issued policy was the endorsement with the regulatory exclusion.

On the afternoon of May 1, 2009 (that is, the day Silverton was closed), a representative of the primary carrier sent an email message that he “had noticed that the Regulatory Endorsement was on the Binder but left off the policy in error,” and attached to the email an endorsement with the Regulatory Endorsement dated May 1, 2009 but with an effective date of March 9, 2009. The complaint characterizes this as a “last minute attempt to unilaterally change the terms of the Policy.” The complaint further alleges that policy issuance terminated the binder.

The FDIC’s complaint seeks a judicial declaration that the regulatory exclusion is not a part of the primary or excess policy, and that the Insured vs. Insured exclusion, on which the carriers also purport to rely to deny coverage, does not preclude coverage for the claim. (Refer here for a discussion of the issues surrounding the applicability of the Insured vs. Insured exclusion in connection with a claim involving the FDIC as receiver.)

Discussion

The FDIC’s lawsuit against the former Silverton directors and officers is not the first lawsuit filed as part of the current round of bank failures in which the FDIC has included outside directors as defendants. For example, the lawsuit the FDIC recently filed in connection with the collapse of Haven Trust included the failed bank’s former outside directors as defendants, as discussed here.  The FDIC seems to have particularly targeted the outside directors of this failed bank, owing to the unusual circumstance that former directors were all themselves also senior executives of other banking institutions. The FDIC clearly intends to try to bootstrap this fact in order to argue that these specific directors should be held to a higher standard of care. (My recent post on issues surrounding questions of bank director liability can be found here.)

Upon reflection of the unique circumstances by which these directors came to be on the Silverton board, it occurs to me that the FDIC may have certain additional motivations in pursuing claims against the former outside directors of the bank. The parrticular circumstance I have in mind is the fact that each of these outside directors of Silverton was also an officer of another banking institution. To the extent these individuals were serving on the Silverton board at the direction of the sponsoring institution, these individuals potentially could have coverge for claims in connection with their Silverton board service under the outside director liability provisions of their sponsoring bank's D&O insurance policies. I am expressing no views on whether or to what extent such coverage actually would be available, nor could I without further information about their sponsoring banks' D&O insurance policies and about the circustances by which they came to be on the Silverton board. My purpose in noting the observations here is simply to suggest this possible additional motivation that the FDIC might have in pursuing claims against these particular outside directors. In any event, the outside director liability coverage, if any, under the sponsoring company's D&O insurance may be limited to outside director service on nonprofit boards.

The FDIC’s inclusion of the D&O insurers as parties defendant in the liability lawsuit is unorthodox to say the least. One the one hand, as the complaint recites, the D&O insurers have denied liability for the FDIC’s claim, which might set the predicate for a more conventional (and separate) declaratory judgment action against the carrier. From reading the complaint, it seems that the primary carrier’s belated attempt to correct the omission of the regulatory exclusion from primary policy may explain the FDIC’s more aggressive approach here.

Whatever else may be said about the FDIC’s inclusion of the insurers as defendants in this lawsuit, the alleged facts provide a veritable parable about the importance of making sure that the issued policy matches the terms of the binder. It will be interested to see how the Court addresses what allegedly appears to be a policy issuance error, as the insurance arrangement to which the parties had agreed unquestionably was intended at the time of contract formation to include a regulatory exclusion.  For that matter, it will be interested to see whether the Court permits the coverage action to remain joined with the underlying liability action, and whether or not the Court will permit the two related actions to go forward at the same time.

FDIC Also Files Lawsuit Against Former Officials of First National Bank of Arizona: In addition to its new lawsuit against the Silverton officials, the FDIC also filed a separate lawsuit in August 23, 2011 in the District of Arizona  against two former directors and officers of First National Bank of Arizona,  which had been one of the sister banks of First National Bank of  Nevada until they merged shortly before FNB Nevada failed. FNB Nevada was among the first banks to fail as part of the current round of bank falures when it failed on July 25, 2008. A copy of the FDIC's complaint in the case can be found here.  

The complaint alleges breach of fiduciary duty, negligence and gross negligence against the former officers, asserting that they cause the bank to sustain "losses from the unsustainable business model they promoted for FNB Arizona's loan portfolio -- a model that depended on real estate values rising indefinitely and low defaule rate." The complaint alleges that "when the real estate market collapsed and default rates skyrocketed, FNB Arizona was left holding millions of dollars of bad loans it could not sell." The FDIC alleges that as a result of the defendants' conduct, the FDIC has sustained losses in excess of $193 million.

The Current FDIC Failed Bank Lawsuit Count: These complaints represent the tenth and eleventh that the FDIC has filed against former directors and officers of a failed bank as part of the current round of bank failures. The Silverton lawsuit represents the third so far in Georgia. There undoubtedly will be more lawsuits to come, as the FDIC has indicated on its website that as of August 4, 2011, it has authorized suits in connection with 30 failed institutions against 266 individuals for D&O liability with damage claims of at least $6.8 billion. With the Silverton Bank and FNB Nevada lawsuits, the FDIC has now filed suits in connection with eleven failed institutions against 77 individuals. Even just taking account of the lawsuits that have already been authorized, there are many more suits to come, and undoubtedly even more lawsuits will be authorized.

But with the back to back arrival of these two lawsuits in the space of two days, both involving banks the failed early on the the bank failure wave, there is a sense that the long lagtime associated with the FDIC's lawsuit filings may be over. For what it is worth, both of these new complaints both involve the same lawfirm on behalf of the FDIC, the Mullin Hoard & Brown law firm of Amarillo, Texas.

It is probably worth noting that the FDIC’s lawsuit is not the first to be filed against the former directors and officers of Silverton. As reflected here, the bank’s defunct parent company earlier this year filed suit against the bank’s former CEO and its former accountant and accounting firm, seeking about $65 million in damages.

Special thanks to the several readers who sent me copies of the Silverton complaint and related links. Special thanks also to the loyal reader who sent me a copy of the FNB Nevada lawsuit as well.

Number of Problem Banks Declines: According to the FDIC’s latest Quarterly Banking Profile, released on August 23, 2011 (refer here), the number of problem institutions during the second quarter of 2011 declined to 865, from 888 at the end of the first quarter of 2011. This reduction represents the first quarterly decline in the number of problem institutions in 19 quarters. (The FDIC identifies banks as problem institutions as those that are graded a 4 or a 5 on a 1-to-5 scale as a result of “financial, operational, or managerial weaknesses that threat their continued financial viability.” The FDIC does not release the names of the individual problem institutions.)

While the quarterly decline in the number of problem institutions is good news, the latest quarterly figure still represents a significant number and percentage of all banks. The 865 problem institutions represents about 11.5% of the 7513 of all reporting institutions. This is slightly lower than the 11.7% of all banks that were rated as problem institutions at the end of the first quarter.

With the continued weakness in the sector, the number of failed and troubled banks will continue to remain a concern for some time to come.

The FDIC’s August 23, 2011 press release regarding the latest Quarterly Banking Profile can be found here.

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One of the hottest current topics in the field of D&O insurance is the question of coverage for costs incurred in connection with regulatory investigations. As discussed in the following guest post from Paul Ferrillo, who is Of Counsel and a senior litigator in the Securities Litigation/Corporate Governance Group of Weil Gotshal & Manges, LLP, these issues are likelier to become even more important as the Dodd-Frank whistleblower rules go into effect.

I would like to thank Paul for his willingness to publish his article on this site. (Paul's article previsously appeared in Propery & Casualty 360.) I am interested in publishing guest posts from responsible commentators on topics of interest to readers of this blog. Please contact me directly if you are interested in submitting a guest post for consideration.

Here is Paul’s guest post:

            Though most in-house risk professionals and in –house corporate lawyers do not exactly relish the opportunity to review their company’s directors and officers (“D&O”) liability insurance policy, the passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”), coupled with an increasingly active regulatory environment, should cause all companies (especially smaller ones) to consider the scope and breath of their D&O policies. Particularly important under Dodd-Frank is whether and how their policies will cover internal corporate investigations caused by whistleblowers out to recover a bounty (10 to 30 percent) on potential penalties collected by the SEC in excess of $1 million. Should these sorts of complex internal investigations be covered under the Company’s pre-existing directors and officers liability insurance coverage? Here are the considerations, and here are some potential answers.

            Scope of D&O Coverage for Corporate Investigations – Then and Now

            Before we begin, its probably important to re-emphasize why this question is important. Simply put, corporate investigations set in motion by a whistleblower or regulatory authorities (SEC, DOJ, and/or the states attorney generals), can lead to a whole host of problems for a company and its directors and officers, including: (1) potential fines and penalties, (2) potential criminal repercussions for individuals who are accused of potential wrongdoing, and (3) follow-on civil litigation commenced by the plaintiff’s bar seeking to take advantage of potentially damaging facts that came to light as a result of the investigation.  It also goes without saying that internal corporate investigations are expensive to conduct, including not only the associated legal expenses, but also IT expenses as well, which are occasioned by the need to review email and other soft-copy documents that might be relevant to the investigation. A competently handled investigation where no wrongdoing is found may cause regulators to walk away satisfied that the company “did the right thing.” and will many times will add no fodder to the follow on civil litigation A poorly handled investigation can lead to disastrous consequences for all involved, especially the company who has to ultimately “foot the bill.”

            Prior to 2011, D&O coverage for certain categories of internal corporate investigations was relatively standard in most primary D&O policies. Individual directors and officers were generally covered (depending, of course, upon the primary carrier and policy form in question) for both informal inquiries and requests for information, and civil, criminal, administrative or regulatory investigations commenced by either the issuance of a Target Letter or Wells Notice, or after the service of a subpoena. The company was almost never covered, except when it was named (along with an individual directors and officer) in a “formal”[1] SEC investigation (and then only when the D&O policy at issue specifically allowed for such coverage). No coverage, at all, existed for the Company for responding to “informal” inquiries and requests for information from the SEC.

            The New Threat – More Investigations – More Risk – More Expense

            On May 25, 2011, the SEC adopted final rules implementing the whistleblower provisions of Dodd-Frank. Though these rules are somewhat complex, for the corporate risk professional they can be broken down as follows. Dodd-Frank provides that (1) an eligible individual (e.g. an employee of a company), (2) who “voluntarily” provides the SEC (3) with “original information” about a potential violation about a violation of the federal securities laws, (4) that ultimately leads to a “successful” enforcement action, (5) may be entitled to receive a cash award ranging from 10% to 30% of the total monetary sanctions, in excess of $1 million, recovered by the SEC in a civil or judicial action.[2]

            Importantly, despite the fact that the potential whistleblower might just have easily reported the potential wrongdoing through the company’s own internal reporting and compliance program, the whistleblower provisions of Dodd-Frank do not require him or her to first do so. Instead, the whistleblower may go directly to the SEC in order to be “first in line” to receive the potential bounty. The new rules enacted by the SEC do give the whistleblower an “incentive” to first report internally by (1) allowing him up to 120 days to report such information to the Commission after he or she first reports internally (and still retain her or her place in line to receive the bounty), and (2) allowing for the attribution to the whistleblower who first reports internally all subsequently reported information reported by the Company following its own internal investigation.

            These reporting provisions, along with the monetary incentives of Dodd-Frank present the company at issue with a number of potential challenges: (1) more internal investigations as a result of the clear financial incentives of employees and others to “blow the whistle” (in fact, there are reports already that the SEC has received an increased number of tips (often made with supporting documentation) since the passage of Dodd-Frank[3], (2) the potential need to quickly perform an internal investigation should the whistleblower report to the Company first (knowing that he or she has 120 days to report to the SEC). Indeed it may be in a company’s interest to self-report to the SEC before the SEC contacts it first, and/or (3) in any event, be ready to perform the investigation upon first contact with the SEC should the whistleblower choose to bypass internally reporting procedures.

            Corporate Investigations D&O Coverage Today

            Prior to 2011, companies generally had no insurance mechanism to cover a costly internal investigation triggered by a regulatory inquiry. Today that is not the case. One large insurer has created a stand-alone product that potentially covers a company for a wide variety of potential corporate investigations., whether triggered by internal reporting through a company’s internal compliance program (with subsequent self reporting of a potential securities law violation), or triggered by a direct formal or informal written or telephonic communication with the SEC requesting information, documents or interviews.[4] There are rumors that other companies will soon follow suit and provide similar, if not alternative products or solutions, to cover the costs of internal corporate investigations triggered by regulatory inquiries.

            A stand-alone corporate investigations D&O policy has a clear advantage for many companies seeking to insure for corporate investigations, and a compelling advantage from the stand-point of a director or officer of a public company. Since it is “stand-alone,” monies spent under an “investigations”  policy will not reduce the limits of the company’s pre-existing directors and officers insurance coverage. Simply put, separate dedicated limits for a corporate investigation is the best solution.

            If for cost reasons, a stand-alone product is not affordable, but a carrier agrees to attach or “blend” corporate investigations coverage directly into the primary directors and officers policy, the directors and officers should insist either (1) that company only purchase such coverage with a significant “sublimit,” (meaning that only a portion of the primary policy can be used for a corporate investigation), or (2) purchase much higher D&O limits from a “tower of insurance” perspective, knowing that “on any given Sunday” a complex investigation could eat up millions of dollars of the tower. For many companies, it may be a good idea to consult with an insurance broker or advisor that has a high degree of experience in insuring public companies, as they can often help inform and effectuate some of the corporate investigations D&O insurance strategies laid out above.

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In its comments about the elevated level of filings against U.S.-listed Chinese companies during the first months of 2011 in its mid-year report on securities class action litigation (here), Cornerstone Research noted both that the total  number of such companies is relatively small and even made second-half projections based on the assumption that there would be no further litigation in the year’s final six months involving Chinese companies that had obtained their U.S. listings by way of a reverse merger. But as the year’s second half has progressed, lawsuits involving U.S.-listed Chinese companies have continued to be filed. Signs are that there will be even more filings ahead.

The latest U.S- listed Chinese company to be targeted is SinoTech Energy Ltd. According to news reports, on August 19, 2011, plaintiffs’ filed a securities class action lawsuit in the Southern District of New York against the company, its directors and officers, and its offering underwriters.  The company was the subject of an August 16, 2011 Internet post by the online research firm (and short seller) Alfred Little. Among other things, the report claimed that the company, its largest customers and suppliers “are likely nothing more than empty shells with little or no sales or income.”

In an August 17, 2011 response, the company said that its board of directors is “not aware of inaccuracy with respect to material facts or material omission contained in its previous public reports and filings with the United States Securities and Exchange Commission,” and called the Alfred Little report “inaccurate and defamatory.” The company also noted that as a short seller, Alfred Little stands to profit by driving down the company’s share price.

In its August 19, 2011 press release (here), the plaintiffs’ firm that filed the lawsuit said that the complaint references assertions in the Alfred Little report that:

(a) SinoTech Energy’s  five largest subcontracting customers appear to be shell companies with unverifiable operations and minimal revenues; (b) SinoTech Energy’s sole chemical supplier appears to be an empty shell, with little or no revenues, a deserted office and no signs of production activity; (c) SinoTech’s audited financial statements filed with Chinese authorities confirm the Company’s negligible business operations; and (d) other facts showing that Company’s business operations are smaller than it represents in SEC filings.

Many of the U.S.-listed Chinese companies have been hit with U.S. securities class action lawsuits obtained their U.S. listings through a reverse merger with a publicly traded shell company. Indeed, the Cornerstone Research mid-year litigation study reports that 24 of the 25 securities class actions filed during the first half of 2011 against U.S.-listed Chinese companies involved companies that obtained their listings through a reverse merger. However, as the Alfred Little report notes, SinoTech is not a reverse merger company. Rather, SinoTech (like Longtop Finanical, which is also caught up in allegations of financial misstatements and in securities litigation, as discussed here) obtained its U.S. listing through a standard IPO, underwritten by UBS and Lazard Capital Markets. SinoTech also has a big 4 auditor, E&Y. If nothing else, it is clear that the online analysts are not going to limit their Internet commentary about Chinese companies to reverse merger companies.

Moreover, it is clear that the various online commentators that are targeting U.S.-listed Chinese companies are going to be continuing to keep the plaintiffs’ law firms supplied with material for still more lawsuits. Indeed, press releases from the plaintiffs’ firm that filed the SinoTech lawsuit indicate that the firm is “investigating” other U.S.-listed Chinese companies, and in each case, the company involved has been the subject of a negative online report.

For example, in an August 4, 2011 press release, the law firm has said that it is investigating allegations that L & L Energy, a coal company with its principal operations in China, “may have issued materially inaccurate financial statements to the investing public.” The press release cites an August 2, 2011 online report about the company issued by Glaucus Research questioning whether the company actually owns some of its most important assets and claiming that corporate funds were used to procure assets on behalf of company principals. L & L apparently obtained its U.S. listing by way of a reverse merger.

In a separate August 4, 2011 press release the law firm has also said that it is investigating Lihua International. The press release cites an August 1, 2011 report by Absaroka Capital and an August 4, 2011 report from Karrisdale Capital to the effect that “had engaged in a series of undisclosed self-dealing and related party transactions that diminished the value of the Company.”

It should be noted that many of the companies targeted in the online reports contend, as SinoTech contends, that the reports are nothing more than financially motivated attacks lacking any basis, as I discussed in an earlier post, here.

With the arrival of the lawsuit against SinoTech Energy, there have now been five securities class action lawsuits filed against U.S. listed Chinese companies so far in the year’s second half,  bringing the year to date total to 29. The law firm’s “investigation” press releases suggest that there may well be more suits yet to come. It appears that as long as the online commentators continue their barrage of negative reports about the Chinese companies, the plaintiffs’ lawyers will have a steady supply of lawsuit fodder.  To be sure, eventually the wave of lawsuits against U.S.-listed Chinese companies will play itself out. It just seems that for now the lawsuit filing phenomenon still has further to run.

An August 21, 2011 Business Insurance article (here) discusses the current challenging D&O insurance market for Chinese reverse merger companies. A recent Client Advisory that I co-authored and that can be accessed here discusses the critical D&O insurance issues facing these U.S.-listed Chinese companies.

Who Would Talk to the Fisherman If He Could Talk to the Fish?: Because  the fish and the other animals have quite a bit to say, and it turns out they are pretty entertaining to listen to.

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When corporate officials face an SEC enforcement action, the testimony of non-party corporate employees is sometimes required. The insurance question that may arise when this happens is whether the attorneys’ fees incurred in connection with these witnesses’ testimony is covered under the company’s D&O policy. According to an interesting August 15, 2011 decision from the Southern District of California and applying California law (here), the employee witnesses’ attorneys’ fees are covered under the specific language of the D&O policies  involved.

Background

Three individual officers of Gateway, Inc. were the subject of an SEC enforcement action. During the course of the SEC action, certain of Gateway’s current and former employees who were not parties to the SEC lawsuit were compelled by subpoena to give deposition testimony in the SEC lawsuits as fact witnesses. Ultimately, the SEC lawsuit was resolved by way of a settlement.

At the time of the SEC action, Gateway carried a total of $35 million in D&O insurance, arranged in three layers: a primary layer of $10 million; an excess layer of $10 million; and a second excess layer of $15 million. The primary and first excess layers were exhausted through payment of loss. The second excess layer advanced a total of about $12.18 million in payment of defense expenses, leaving about $2.82 million.

In connection with the testimony of the witness employees, attorneys’ fees of about $553, 875 were incurred. The second excess carrier denied coverage for this amount (referred to as the amount in dispute). Gateway sued the second level excess carrier to recover the amount in dispute. The parties filed cross motions for summary judgment on a stipulated record.

Relevant Policy Language and the Parties’ Respective Positions

The second excess policy incorporated the terms of the primary policy. Insuring Clause B of the primary policy provided that the insures shall pay loss “which the Company is required or permitted to pay as indemnification to any of the Directors and Officers resulting from any Claim firm made against the Directors and Officers during the Policy Period.”

Policy Section II.H.2 defined the term “Directors and Officers” to mean “to the extent any Claim is for …a Securities Law Violation, all persons who were, now are, or shall be employees of the Company.” Policy Endorsement No. 7 amended the definition of “Directors and Officers,” inter alia, by adding Policy Section II.H.5, to include within the definition “employees of the Company. However coverage for employees who are not directors or officers shall only apply when an employee is named as a co-defendant with a director or officer of the Company.”

Gateway argued Policy Sections II.H.2 and II.H.5 were independent clauses and that the attorneys’ fees incurred in connection with the employee witnesses were covered under Section II.H.2, because the SEC lawsuit was a Claim for “Securities Law Violation” against” Directors and Officers” (the three officer defendants in the SEC action), and the company incurred loss in connection with indemnifying the employees, who are “Directors and Offices” within policy section II.H.2. 

The second excess carrier argued first that as mere witnesses, the testifying employees were not parties to the civil action, and therefore no claim had been made against them. The second level excess carrier argued further that Endorsement No. 7 had modified the policy language to provide that “However, coverage for employees who are not directors shall only apply when an employee is named as a co-defendant with a director or officer of the Company.” The second level excess carrier argued that because none of the employee witnesses had been named as co-defendants, they were not “Directors and Officers” for whom reimbursement coverage was available under the policy.

The Court’s Decision

The fundamental question for the Court to decide was whether or not the “However” clause in Policy Section II.H.5 applied only to the preceding sentence in Policy Section II.H.5 or also applied to Policy Section II.H.2. (“However coverage for employees who are not directors or officers shall only apply when an employee is named as a co-defendant with a director or officer of the Company.”)

In his August 15, 2011 opinion in the case ruling in favor of Gateway, Southern District of California Judge William Q. Hayes found that the “clear and explicit reading” of the policy showed that Policy Sections II.H.2 and II.H.5 “are independent provisions” and the Gateway employees on whose behalf the disputed fees were incurred “constitute ‘Directors and Officers’ pursuant to sub-paragraph II.H.2.” The court said that “alternatively” the two “competing interpretations” of the definitional sections “highlight an ambiguity” in the policy language, which the Court construes in favor of Gateway.

Judge Hayes also rejected the second level excess carrier’s position that the employee witnesses attorneys’ fees did not come within Insuring Clause B of the policy because as mere witnesses no claim had been made against them. Gateway argued that Insuring Clause B required only that a claim have been made against Directors and Officers, which was the case in connection with the SEC action against the three Gateway officers, and in any event, the subpoenas directed to the employee witnesses constituted a claim against them as well. Judge Hayes said that the two parties “have advanced a reasonable interpretation of the Insuring Clause,” and accordingly the policy is ambiguous on this issue, and therefore the policy is interpreted in Gateway’s favor.

Judge Hayes granted summary judgment in favor of Gateway and against the second level excess carrier.

Discussion

At one level, this decision is just a reflection of the interaction between the specific policy language and the circumstances presented. In the end, rather than choose between two alternative views, Judge Hayes found that the alternatives reflected an ambiguity and therefore ruled in favor of the insured on a more or less “tie goes to the runner” basis.

I am sure that at least some carrier-side observers may find it a surprising outcome that there was found to be coverage in connection with fees incurred for  non-party employee witnesses who were not defendants in the SEC action. In that regard, it is possible to look at the policy language as amended and to conclude that the Endorsement No7 had not been intended simply to add an alternative and independent provision bringing employees within the definition of covered “Directors and Officers,” but instead to fundamentally alter the policy’s coverage for employees.

Thus, in the base form, Policy Section II.H.2 afforded coverage for employees by bringing them within the definition of Directors and Officers, but only in connection with Claims for Securities Law Violations. The Endorsement amended the policy to remove the limitation restricting the coverage for employees only to Claims for Securities Law Violations, extending the policy’s coverage afforded to employees even for claims that did not involve Securities Law Violations, but specifying further that this broader employee coverage is only available when the employees are co-defendants with officers and directors of the company.

I think there is a good case to be made that that was what was intended at the time the changes were made. Unfortunately for the second level excess carrier, the amendments were accomplished through additional provisions rather than through delete and replace alterations. Because the Endorsement No. 7 amended by adding, the policy provisions necessarily had to be read together, thus creating the possibility that two different provisions could potentially apply to the same circumstance.

There is a practical lesson here for everyone who is involved in the process of modifying policy language through endorsement. That is, it is not enough that the language in the endorsement accomplishes what is intended to be accomplished. In addition, the endorsement language must also interact as intended with the language in the base policy form. Because I know how hard these issues are to manage, I am reluctant to postulate how these changes should have been done, as I may establish nothing but to show that in hindsight this language could have been structured differently. (My reluctance here is underscored by the fact that the second excess carrier that was forced to argue these issues here was forced to make these arguments based on language negotiated by the primary carrier, not by the excess carrier itself.) But all of that said, the disputes here could have been avoided if rather than simply adding an additional policy provision about coverage for employees, the endorsement had deleted and replaced the base form’s provision for employee coverage.

Because of his findings of ambiguity, Judge Hayes managed to sidestep a number of interesting issues, including, for example, whether or not the deposition subpoenas served on the employee witnesses constituted “Claims” within the meaning of the policy. As I have discussed in prior posts (most recently here), the question of whether or not a subpoena is a claim is one of the perennial D&O insurance coverage issues. It would have been particularly interesting for the Court to have explored in particular whether or not a deposition subpoena is or is not a claim under the applicable policy language. But Judge Hayes managed to make a decision without issuing rulings on many of the parties’ disputed issues, and so we will have to await another case and another day on many of these issues.

An Alternate List of Top Colleges: If for no other reason than its sheer perversity, the recently released Forbes Magazine list of theTop 100 U.S. colleges makes for some fascinating reading. What can you say about a list where West Point outranks Stanford, Harvard, MIT and Yale? (For that matter, Yale is not even in the top 10, coming in at number 14). Or where Haverford outranks Swarthmore, Claremont-McKenna outranks Pomona (that one was particularly unpopular in our house), Washington & Lee outranks Dartmouth, Colby and Bates are ranked ahead of Bowdoin, and Penn is ranked 52nd? And Michigan is ranked 93rd, just above Transyvania University? (The methodology used in compiling the Forbes list can be found here.)

One thing you can say is that the Forbes listmaker has a bias against public universities. The highest ranked public college on the list is UVa, coming in at 46th (another ranking particularly unpopular in our house).

If nothing else, the Forbes list is reminder not to get too hung up on the U.S. News and World Reports college list -- it does not represent scripture, and there are many ways of looking at the many fine colleges in the U.S. As the excellent guidance counselor at my daughters' school says, "College admission is a match to be made, not a prize to be won." 

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In a settlement that apparently will be funded entirely by D&O insurance, the plaintiffs and 23 former executives of the failed Colonial Bank of Montgomery, Alabama have agreed to the settle the class action securities lawsuit that investors filed in connection with the bank’s 2009 collapse,  for $10.5 million. The settlement does not resolve the plaintiffs’ claims against the offering underwriter defendants nor does the settlement include the bank’s former auditor. The settlement is subject to court approval. A copy of the parties’ August 12, 2011 stipulation of settlement can be found here. The plaintiff’s August 12, 2011 motion for settlement approval can be found here.

When Colonial Bank failed in August 2009, it was the sixth largest U.S. bank failure of all time (as discussed here). The bank, which had assets of $26 billion, was brought down in part due to its involvement in the mortgage securities fraud scheme involving mortgage originator Taylor Bean, as discussed in a recent post. The bank’s holding company filed for bankruptcy shortly after the bank’s closure.

As discussed here, the plaintiffs had actually filed their securities lawsuit in February 2009, prior to the bank’s demise. The plaintiffs initially alleged that the defendants failed to disclose that "Colonial would be required to raise additional outside capital of $300 million before it could receive the $550 million in TARP funding." The complaint further alleges that Colonial "belatedly disclosed" this requirement, its share price plunged. The plaintiffs’ 334-page consolidated amended complaint (here) contains significantly broader allegations and contends that the defendants engaged in a broad, multipart fraudulent scheme that led to the bank’s collapse.

Given the bank’s size prior to its failure, and the high-profile nature of the allegations, including the bank’s association with the Taylor Bean fraud, the relatively modest $10.5 million settlement may seem low, especially by comparison to the string of nine-figure securities class action lawsuit settlements that recently have been announced (refer for example here). However, the dollar figure may also be reflective of the particularly challenging circumstances claimants may face when trying to pursue claims against the former officials of a defunct organization.

Without a solvent entity to fund claims settlements, the claimants may be left to try to salvage what they can from the remaining D&O insurance, which represents at best a declining fund that will only become smaller the longer the case continues and the more vigorously the parties contest the case, as defense expenses erode the limit of liability. The vulnerability of the insurance funds to claims cost erosion is a particular problem in a situation like this, where there are multiple proceedings and multiple parties.

Indeed, in their memorandum in support of their request for preliminary court approval of the settlement, the plaintiffs argue that the settlement represents n “outstanding result” given that they were facing a “significant risk of no or a much smaller recovery after protracted litigation.” The motion papers attribute this risk to the holding company’s bankruptcy and to “the limited resources of the primary Director and Officer defendants and the limited insurance policy proceed available.”

With respect to Colonial’s insurance, the plaintiff’s motion papers report that the bank had “a total of $35 million in liability insurance,” which were in the form of “wasting insurance policies.” At the time of the mediation “less that $32 million in funds remained available to satisfy all claims,” including not only the securities class action lawsuit but also a separate shareholder derivative suit filed on behalf of the company and the “claims of the FDIC-Receiver” as well as other matters.

In any event, this settlement is to be entirely funded by D&O insurance. Paragraph 6 of the settlement stipulation says that the Settling Defendants’ Insurance Carriers “shall pay the sum of $10,500,000 in cash into the Escrow Account.” (The carriers involved are identified in the definitions section, on page 13 of the stipulation.) The absence of any contribution to the settlement from the individual defendants is explained in the motion papers, which report that “during the mediation process, the plaintiffs acquired certain confidential financial information from certain selling Defendants that reflected an inability to contribute in any meaningful way to the settlement.”

Though this settlement may appear relatively modest, it may be worth noting that the settlement does not include the offering underwriter defendants or the bank’s former auditor, against whom the case will continue. Whether the plaintiffs ultimately will be able improve their overall recovery with settlements with these other defendants remains to be seen, but there is at least that possibility.

This settlement certainly reduces the insurance funds out of which the FDIC might have hoped to extract a recovery by pursuing claims against the bank’s former directors and officers. The reduction of the amount of insurance does underscore one problem the FDIC may face in pursuing claims against former directors and officers of some failed banks, which is that the FDIC may be a competition – or even in a race – with shareholder plaintiffs to try to capture remaining D&O insurance policy proceeds, before they are eroded by defense expense. That said, it does seem like an attempt was made as part of this settlement to preserve some remaining portions of the bank’s D&O insurance in order for them to defend or resolve the FDIC’s claims.

I have in any event added the Colonial Bank settlement to my running tally of subprime and credit crisis-related case resolutions, which can be accessed here.

Among the individual defendants party to this settlement is Colonial’s colorful and controversial former Chairman and CEO, Bobby Lowder. In addition to Colonial, Lowder has long been associated with Auburn University. I discussed Lowder’s Auburn connection in a prior post, which can be found here.

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In the wake of the current round of bank failures, the FDIC has filed a number of lawsuits against former directors and officers of failed banks, and has indicated that it intends to file more. Among the issues this litigation raises is the question of when the former directors of a failed bank can be held liable. As discussed in an August 10, 2011 memo from the Manatt, Phelps & Phillips law firm (here), a recent decision a case in the Central District of California involving a failed credit union may provide some insight into this question.

First, some background. Section 11(k) of the Federal Deposit Insurance Act provides that directors and officers of failed institutions can be held liable “for gross negligence.” in an action brought by the FDIC in its role as receiver.  As explained in the FDIC’s online materials about professional liability claims, case law interpreting this statute has established that “state law, not federal common law provides the liability standard for directors and officers, and that section 11(k) provided a gross negligence floor for the FDIC claims in states with insulating statutes.” (State insulating statutes allow corporations to amend their bylaws to limit the civil liability of the corporations’ directors.) As a result, even in states with insulating statutes, directors cannot protect themselves from FDIC claims based on gross negligence. 

The recent decision in the Central District of California involved a case brought by the National Credit Union Administration (NCUA) against 16 former directors and officers of Western Corporate Federal Credit Union (WesCorp). As discussed at greater length here, the NCUA alleged that the defendants had allowed WesCorp to purchase vast amounts of securities backed by Option ARM mortgages without appropriate analysis of the creditworthiness of the underlying securities or appropriate regard for the limits on concentrations in the company’ s portfolio.

In an August 1, 2011 order (here), Central District of California Judge George Wu granted the director defendants’ motion to dismiss the NCUA’s most recently amended complaint, for reasons discussed in the court’s July 7, 2011 minute order (here). In the July 7 minute order, Judge Wu noted that “the business judgment rule protects the director defendants,” adding that the director defendants “may have made choices—or not made choices – with which the NCUA disagrees, but that does not mean they failed in their responsibilities so severely that they lose the protection of the business judgment rule.”

Judge Wu drew a distinction between the officer defendants (whose dismissal motion he denied) and the director defendants, observing that “the question in assessing the director defendants’ liability vis a vis the Option ARMs and concentration levels is what the director defendants knew at the time that should have dictated to them that they do something more or different from all that they did do.” He concluded that the NCUA has “failed to present sufficient allegations in this regard, so as to fit within the exceptions to the business judgment rule.”

The law firm memo linked above observes that the holding in the WesCorp case is “equally applicable to actions brought by the FDIC against former directors of a failed bank.” In that regard, it is worth noting that the FDIC itself has said, in its online materials describing its approach to professional liability claims, that it is the FDIC’s “long-standing internal policy” of pursuing claims against outside directors only where “the facts show that the culpable conduct rises to the level of gross negligence or worse.” In other words, the FDIC itself has said that it is not its policy to pursue claims against directors based on mere negligence.  The law firm memo suggests, by reference to the WesCorp case, that conduct within the protection of the business judgment rule by definition is not grossly negligent, and therefore cannot serve as a basis for director liability.

In the law firm memo, the author notes that the misconduct that the FDIC has alleged in many of the cases it has filed as part of the current wave of bank failures arise in the context of the collapse of the residential real estate market and against the background of the global economic crisis. In light of those circumstances, the FDIC’s allegations may be susceptible to the argument that it is “attempting to substitute its after-the –fact judgment for that of the board made in real time.” The business judgment rule exists to “prevent a court from second guessing honest, if inept, business decisions.”

Directors’ protections under the business judgment rule may, however, be overcome where, for example, there is evidence that the directors’ “improper motives or undue influence, conflict of interest” or where the directors failed to be “fully informed before making decisions.”

The possibility of being drawn into an FDIC lawsuit is a recurring source of anxiety for outside directors of failed or troubled banks. Indeed, the FDIC has filed a number of these suits and clearly intends to file more. But directors concerned about the possibility of this type of litigation can be reassured, first, that it is the FDIC’s own policy only to pursue claims against outside directors where it believes there is evidence of gross negligence, and, second, that as a result of the protections of the business judgment rule, the directors cannot be held liable for actions that merely prove to have been mistaken or even inept. Judge Wu’s ruling in the Wescorp provides directors reassurance that defendant directors may even be able to get the claims against them dismissed -- even if claims against the officer defendants are not -- where the allegations presented are insufficient to meet these requirements.

The law firm memo concludes with a number of lessons for current bank directors from the current environment and from the FDIC’s allegations in the cases that it has filed so far. Among other things, the memo’s author notes the following: that board membership is a serious responsibility for which the individual directors must be willing to devote “substantial amounts of time” in order to perform their duties in accordance with the FDIC’s expectations;  that board members are “charged with holding management’s feet to the fire in addressing strategic challenges and operational problems”; that directors must act independently and must not “turn a blind eye to unsafe or unsound practices; and that directors “must be very sensitive to the appearance of a conflict of interest.”

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In the latest eye-popping subprime-related securities class action lawsuit settlement, the parties to the National City Corporation securities class action lawsuit have agreed to settle the case for $168 million. The proposed settlement is subject to court approval. The August 8, 2011 press release of the New York Comptroller, acting on behalf of the New York State pension funds as lead plaintiff, can be found here.

The settlement papers are not yet available on PACER (indeed, that is the reason I waited for a day to publish a post about this settlement, in the hope that I might be able to run down copies of the papers. No luck so far – should I get my hands on them, I will post them to this site.) Jan Wolfe’s August 9, 2011 Am Law Litigation Daily article describing the settlement can be found here.

As detailed here, this case arises out of the financial woes that beset Cleveland-based National City as its portfolio of subprime related mortgages nearly dragged the bank down. In their 249-page consolidated amended complaint (here), the plaintiffs alleged that as the residential real estate market began to collapse in 2007, the bank’s residential mortgage and construction loan portfolio – which allegedly was of much lower quality than the bank had disclosed -- began to deteriorate much more rapidly than the company acknowledged publicly. The plaintiffs alleged further that the bank’s failure to recognize this deterioration rendered the bank’s financial statements and other disclosures materially misleading.

National City’s financial difficulties proved so severe that in October 2008, it was acquired at fire sale prices by PNC. The transaction was highly controversial at the time, and not just because it involved a takeover of a landmark Cleveland institution by a bank based in Pittsburgh. As discussed at greater length here, because PNC moved to acquire National City using TARP funds that PNC had only just received and only after TARP funds were withhold from National City.  The PNC acquisition was itself the subject of separate litigation, which was later voluntarily dismissed. PNC’s acquisition of National City means that the likely source of funds for this settlement was PNC itself, to the extent not otherwise funded by D&O insurance – hence my interest in seeing the settlement papers.

The parties to the related-ERISA class action previously settled that action for $43 million, as discussed at greater length here.

The $168 million National City securities class action lawsuit settlement follows close on the heels of the announcement of the $627 million Wachovia bondholders’ settlement. I have long wondered when the overhang of subprime-related securities class action lawsuit would finally start to work itself off. With these settlements, it seems increasingly likely that the time may now be here.

There have been larger settlements announced in connection with the subprime-related securities class action litigation wave, but the National City settlement is still attention-grabbing. Among other things, the National City settlement, if approved, would be the 53rd largest all-time securities class action lawsuit settlement. As was the case with the Wachovia settlement, the National City settlement was not (prior to the settlement) one of the highest profile subprime-related cases. But while these two cases may not have been at the center of the radar screen, these two nine-figure settlements in quick succession undoubtedly have gotten everyone’s attention.

The problem for the parties in the remaining subprime cases is that these settlements -- and the recent $125 million settlement in the Wells Fargo mortgage-backed securities cases – create an even more challenging environment in which to try to work out a settlement. The plaintiffs in these other cases undoubtedly will by try to rely on these settlements as a way to try to argue that the price of poker is going up.

Here We Are Now, Entertain Us: It may not be quite the same thing without Kurt Cobain, but still this is pretty awesome.

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

In the latest of a growing list of recent cases examining these issues, on August 5, 2011, the Fifth Circuit, applying Texas law held, based on the language of the excess policies at issue, that where a policyholder has accepted a compromise payment from a primary carrier of less than the limit of liability of the primary policy, the excess carrier’s payment obligations were not triggered and they have no obligation to pay the policyholders ‘ loss. The Fifth Circuit’s August 5 opinion can be found here.

Background

In July 1999, Associates First Capital Corporation purchased $200 million of integrated risk insurance coverage, arranged in three layers. The primary $50 million was provided by Lloyd’s. In addition, there was a layer of $50 excess of the primary $50 million in the “Secondary Layer,” and a third layer, called the “Quota Share Layer,” provided $100 million excess of the primary and Secondary layers.

In November 2000, Citigroup purchased Associates and later sought insurance coverage from the insurers in connection with its settlement of two matters that had been pending against Associates. The settlement in the actions totaled $240 million plus $23 million in class counsels’ fees and costs. The Fifth Circuit opinion states that Citigroup entered the settlement “without the consent of the carriers.”

Each of the insurers initially denied coverage, but Citigroup ultimately entered a settlement with Lloyd’s by which Lloyd’s paid $15 million of its $50 million layer. The excess carriers continued to refuse coverage, and Citigroup filed suit. Citigroup later settled with the insurers in the Secondary layer, but the coverage litigation continued as to the insurers in the Quota Share Layer. The remaining parties moved for summary judgment.

The District Court granted summary judgment in favor of the excess insurers, holding that under each of the excess insurers’ respective policies, their liability did not attach until the primary insurer had paid its full $50 million limit of liability. Citigroup appealed.

The August 5 Opinion

On appeal, Citigroup attempted to rely on the holding of Zeig v. Massachusetts Bonding & Insurance Co., 23 F.2d 225 (2d Cir. 1928), arguing that where an excess insurance policy ambiguously defines “exhaustion,” settlement with an underlying insurer constitutes exhaustion of the underlying policy, for purposes of determining when the excess coverage attaches.

The Fifth Circuit, applying Texas law, declined to follow the “Zeig rule,” stating that “we conclude that the plain language of the policies dictate that primary insurer pays the full amount of its limits of liability before the excess coverage is triggered.”

The Fifth Circuit examined the exhaustion trigger language of each of the excess policies and concluded that the “plain language” of each of them “requires that Lloyd’s pay Citigroup the total limits of Lloyd’s liability before excess coverage attaches,” adding that “Citigroup’s settlement with Lloyd’s for $15 million of its $50 million limits of liability in exchange for a release from coverage for [the underlying claims], did not satisfy the requirements necessary to trigger the excess insurers’ coverage.” 

The Fifth Circuit affirmed the District Court’s entry of summary judgment in favor of the excess insurers.

Discussion

The Fifth Circuit’s decision in the Citigroup case joins a growing list of recent judicial decisions rejecting the Zeig rule and requiring as a trigger of coverage for excess insurance coverage that the limit of liability of the underlying insurance be exhausted by payment of loss. Indeed, the Fifth Circuit cited with approval the March 2008 California Intermediate appellate court opinion in the  Qualcomm case (about which refer here) and also cited the July 2007 Eastern District of Michigan opinion in the Comerica case (about which refer here), noting that “while not binding,” the Comerica case is “persuasive.” Another recent case reaching the same conclusion was the Bally case (about which refer here), although the Fifth Circuit did not refer to the Bally decision.  As first federal circuit court decision, the Citigroup case could prove to be the most significant in this line of cases.

While this list of case authority is growing longer, it is important to keep in mind that the outcome of each of these cases was a direct reflection of the specific language of the exhaustion trigger in the excess policies at issue. In each case, the courts concluded that the excess policies required complete exhaustion of the underlying limit of liability by payment of loss.

These cases underscore the critical importance of the language describing the payment trigger in the excess policy. In recent months, and in large part as a reaction to these cases, excess carriers increasingly have been willing to provide language that allows the excess carriers’ payment obligations to be triggered regardless whether the underlying amounts were paid by the underlying insurer or by the insured. This language was not generally available in 1999 when Associates First purchased its integrated risk insurance.

Increasingly larger settlement amounts and increasingly higher defense expenses are increasingly driving claims losses into the excess layers, and as a result these issues pertaining to the excess policies’ coverage triggers are also increasingly important. These cases underscore the critical importance of the specific wording used in the excess policies, which in turn highlights the need to have an experienced, knowledgeable insurance professional involved in the insurance placement process.

One interesting final note about the Fifth Circuit’s opinion is that it represents the unusual resolution of a case “by quorum.” Due to the July 14, 2011 death of Judge William Garwood, the opinion was issued by the remaining two judges of the three judge panel that heard the case.

What Makes a Marine Biologist Scream?: This is seriously cool. Warch very closely...

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According to Cornerstone Research’s recently released mid-year 2011 securities litigation report (here), during the 18 months ending on June 30, 2011, there were a total of 37 securities class action lawsuit filings involving U.S. listed Chinese companies, 33 of which obtained their U.S. listing by way of a “reverse merger” a publicly traded shell company. While some have questioned how these cases will fare, at least one of these cases recently survived a motion to dismiss, a development that an August 4, 2011 memo from the O’Melveny & Myers law firm (here) suggested “could signal the willingness of courts to her reverse merger securities fraud actions.”

As discussed here, plaintiffs first filed their complaint against Orient Paper, certain of its directors and officers, and its auditor in the Central District of California in August 2010. Orient Paper had obtained its U.S. listing by way of a reverse merger transaction. The plaintiffs allegations were largely based on an online report by Muddy Waters, a securities analysis firm and known short seller of shares of Chinese companies. The plaintiffs alleged that the company had failed to disclose related-party transactions with its main supplier, and that company misstated its financials in its annual reports in 2008 and 2009. The allegations financial statements were based on alleged differences between its SEC filings and its Chinese regulatory filings. The plaintiffs also alleged that the allegedly misleading financial statements had audited by a disbarred and unlicensed auditor.

The defendants moved to dismiss, contending that plaintiffs had not adequately alleged material misrepresentation, arguing that the company’s auditor had not been disbarred and that an internal company investigation conducted by the company’s audit committee determined that there was no evidentiary basis to substantiate the financial misrepresentation allegations. The defendants also alleged that the plaintiffs had not adequately pled scienter.

In a July 20, 2011 order (here), Central District of California Judge Valerie Baker Fairbanks denied the defendants’ motions to dismiss. The plaintiffs had provided PCAOB documentation substantiating that the company’s auditor had been disbarred. Judge Fairbanks also found with respect to the company’s internal investigation that it had been conducted by the company’s own audit committee “with no public or signed statements by any of the outside firms” the company had hired for the effort.” She added that “the truth of the Muddy Waters report and the audit committee’s conclusions is a factual dispute not appropriate for resolution at this stage.”

With respect to the issue of scienter, she found that “viewed holisitically … the inference of scienter advanced by the Plaintiffs is “at least as compelling as any opposing inference one could draw from the facts alleged.” Her find in this respect was based in part on the related-party transactions which indirectly benefited the company’s CEO. She also found the internal investigation on which defendants’ sought to rely in order to rebut the inference of scienter to be “questionable.”

According to the law firm memo, Judge Fairbanks’ ruling in the Orient Paper case is the first opinion involving a corporate defendant in a Chinese reverse merger company securities case. A prior ruling in the China Experts Technology case, discussed here, involved only the company’s auditors and also involved a case filed in 2007, prior to the current round of Chinese reverse merger litigation. The ruling in the China Expert Technology case did not relate to the company, which never responded to the complaint. The Orient Paper decision, by contrast, does not relate to the company’s auditor, who has not yet been served in the case.

With respect to Orient Paper decision, the law firm memo noted that Judge Fairbanks denied the motion to dismiss even though the plaintiffs had based “nearly all of their allegations on an Internet report authored by an admitted short seller.” The memo goes on to note that many of the cases filed against the Chinese reverse merger companies were, like that against Orient Paper, “preceded by disparaging reports from self-interested and often anonymous short sellers.”

In its assessment of the significance of the Orient Paper decision, the law firm memo says that “if this first motion to dismiss opinion is any view into the future, and defendants are unable to challenge the truth of the short seller reports at the pleading stage, most of these cases appear poised to proceed past the pleading stage, and instead, their issues will most likely be decided on motions for summary judgment.”

One obvious concern for these companies if they become involved in protracted U.S. securities litigation is the expense involved. This prospect may be particularly daunting for many of these companies because in many instances with which I am aware, the companies carry very low and in same cases minimal levels of directors and officers liability insurance. (My more detailed view of the D&O liability insurance issues involving the securities litigation exposures of U.S. listed Chinese companies can be found here.)

Alison Frankel’s June 21, 2011 report about the Orient Paper decision in Thomson Reuters News & Insight can be found here. My prior discussion about the role of the Muddy Waters firm in raising the allegations asserted in may of these Chinese reverse merger companies can be found here, in a post that also discusses the litigation hurdles that the plaintiffs in many of these cases will face.

Many thanks to the loyal reader who forwarded me a copy of Judge Fairbanks’ decision.

Securities Litigation in Japan: In a July 2011 publication entitled “Trends in Securities Litigation in Japan: 2010 Update” (here), NERA Economic Consulting provides a status report on the current state of securities litigation in Japan. Among other things the study reports that “the number of judgments related to damages litigation over misstatements has decreased substantially to seven in 2010 from 14 in 2009.”

The study also notes that the number of regulatory actions by the Japanese Securities and Exchange Surveillance Commission regarding monetary penalties for misstatement has “increased to a record high of 12 in 2010 from nine in 2009.” In light of the number of enforcement actions “the potential for future misstatement cases is expected to continue to rise.” The study also notes the increase in the number of shareholder petitions “for appraisal of stock purchase price in company reorganizations.”

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In what is the largest settlements so far to arise out of the subprime meltdown-related securities class action litigation wave, and apparently the largest settlement ever of a securities suit filed solely under the Securities Act of 1933, the parties to the consolidated Wachovia Preferred Securities and Bond/Note Litigation have collectively agreed to settle the suit for a total of $627 million. The settlement is subject to court approval. The lead plaintiffs’ August 5, 2011 memorandum in support of the motion to approve the settlement can be found here, and the parties’ settlement stipulation can be found here.

The settlement amount of $627 million represents two different settlement funds: $590 million on behalf of the Wachovia defendants, including 25 former directors and officers of Wachovia, as well as 72 different financial firms that underwrote bond offerings for Wachovia between 2006 and 2008; and $37 million on behalf of Wachovia’s auditor, KPMG. According to data from Institutional Investor Services, the collective $629 million settlement, if approved, would represent the fourteenth largest securities class action settlement of all times.

As impressive as these aggregate numbers are, one ratio may be the most impressive number of all. According to the plaintiffs’ motion for settlement approval, the settlement recoveries “collectively represent roughly 30% to 50% of the reasonably recoverable total damages that Lead Bond/Notes Counsel would have been able to credibly present to a jury.” This percentage recovery represents a far higher figure than is usually the case in securities class action lawsuit settlements. (According to NERA Economic Consulting’s Mid-Year 2011 Securities Litigation Report, the average percentage of investor losses recovered in 2010 securities class action settlements was 2.4%, and only 1% for 2011 settlements through June 30, 2011.)

The plaintiffs’ claims related to the financial disintegration that Wachovia experience between its 2006 purchase of Golden West Financial Corporation and Wells Fargo’s 2008 acquisition of Wachovia. Folloing Wachovia’s collapse, securities litigation ensured, filed, on the one hand on behalf of Wachovia’s shareholders (about which refer here) and on the other hand on  behalf of Wachovia’s bond and note holders (about which refer here).

In their May 2010 amended consolidated complaint, the lead bond/note plaintiffs alleged that in offering materials related to various Wachovia bond and note offerings, the defendants misrepresented the nature and quality of Wachovia’s mortgage loan portfolio and made  material misstatements regarding the risk profile and quality of the $120 billion pick-a-pay adjustable rate residential mortgage portfolio that Wachovia acquired in the Golden West acquisition.

In a lengthy and detailed March 31, 2011 order (about which refer here), Southern District  of New York Judge Richard Sullivan granted the defendants' motions to dismiss the equity securities actions, but he denied the motions to dismiss the bondholders' action, other than with respect to certain bond offerings in which the plaintiffs had not actually purchased any securities.

In granting the motions to dismiss the equity securities plaintiffs’ ’34 Act claims, Judge Sullivan held that the plaintiffs had not sufficiently alleged scienter. Judge Sullivan concluded that the “more compelling inference” is that “Defendants simply did not anticipate the full extent of the mortgage crisis and the resulting implications for the Pick-A-Pay loan portfolio. Although a colossal blunder with grave consequences for many, such a failure is simply not enough to support a claim for securities fraud.” He added that “bad judgment and poor management are not fraud, even when they lead to the demise of a once venerable financial institution.”

In concluding that the bondholders’ allegations were sufficient when the equity securities plaintiffs’ allegations were not, Judge Sullivan found that the bondholder plaintiffs had adequately alleged misrepresentation in the relevant offering documents with respect to loan to value ratios maintained in the mortgage portfolio and with respect to the alleged manipulation of the appraisal process to produce inflated appraisal values.

As I noted at the outset, the Wachovia bondholders’ settlement is the largest securities class action lawsuit settlement so far as part of the subprime and credit crisis-related litigation wave. The $627 collective million settlement amount is slightly larger than the $624 million settlement in the Countrywide case. Interestingly, both the Countrywide and Wachovia settlements included substantial settlement contributions from KPMG -- $37 million in the Wachovia case and $24 million in the Countrywide case. My running tally of the subprime and credit crisis-related settlements can be accessed here.

The settlement will now go before Judge Sullivan for approval. The settlement itself does not include any agreement or understanding with respect to the plaintiffs’ attorneys fees, but the settlement papers indicate that the lead plaintiffs’ counsel intends to seek court approval of a fee recovery representing 17.5% of the collective settlement amount – that is, roughly $110 million. (By way of comparison, the fee award approved for lead plaintiffs in the Countywide case was $46.4 million, although I am sure the Wachovia bondholders’ counsel could explain important differences that would make this comparison irrelevant).

The settlement papers do not reveal whether or not any portion of the Wachovia bondholders’ settlement is to be funded by insurance, although the released Wachovia parties and the released KPMG parties identified in the settlement stipulation in both cases include the respective entities’ “insurers.” In addition the settlement stipulation funding provisions specify that the Wachovia defendants and the KPMG defendants respectively are obliged to pay “or to cause to be paid” the specified amounts into the escrow account within the specified time.

With the addition of the massive Wachovia bondholders’ settlement, the now 26 securities class action lawsuit settlements so far arising out of the subprime and credit crisis-related litigation wave total over $3.1 billion. With scores of cases still pending, the implications for aggregate amount for which all of these cases ultimately will be settled are truly staggering. The interesting thing is that the Wachovia bondholders’ case was not really on the radar screen as one of the big ones out there (compared, say, to the Citigroup,  Lehman Brothers or BofA/Merrill Lynch merger cases). The fact that a below the radar case can result in a settlement of this magnitude is an arresting development, particularly in view of the fact that many of the cases that remain pending are, like this one, filed under the Securities Act of 1933.

As impressive as the amount of the Wachovia bondholders’ settlement is, the most ominous aspects of the settlement for other defendants and their insurers is the percentage of investor loss that the settlement represents. If this settlement percentage winds up becoming a point of reference, it could have very serious consequences in connection with attempts to settle the remaining cases.

One thing about this settlement is that it does seem to suggest that Wachovia’s purchase of Golden West is a serious candidate for the title of worst deal leading into or as part of the credit crisis-related financial transactions. There is a lot of competition in the worst transaction category, including Bank of America’s purchase of Countrywide. But there is no doubt that the Golden West dealis one of the real stinkers.

Speaking of Wells Fargo, the litigation consequences for the bank of the mortgage meltdown are becoming rather breathtaking. The Wachovia defendants’ $590 contribution to this settlement, which presumably is being funded in substantial part if not in whole by Wells Fargo, comes closely on the heels of the recently announced $125 million Wells Fargo mortgage backed securities case (about which refer here)

There were a number of interesting items about this settlement out in the blogosphere. Alison Frankel has a nice August 5, 2011 piece on Thomson Reuters News & Insight (here) about the Bernstein LItowitz firm, which is one of the co-lead plaintiffs’ firms in the Wachovia bondholders’ case. Susan Beck’s August 5, 2011 write-up about settlement for the AmLaw Litigation Daily can be found here, and Luke Green’s August 5, 2011 post about the settlement on the ISS Securities Litigation Insight blog can be found here.

Special thanks to the Bernstein Litowitz firm for providing me with links to the settlement papers.

Dismissal Denied in State Street Subprime Securities Suit: In an August 3, 2011 order (here) in a securities suit against State Street Corporation and involving in part subprime mortgage-related allegations, District of Massachusetts Judge Nancy Gertner denied the defendants’ motion to dismiss.

The case, which involves consolidated securities and ERISA class actions, involves allegations that the investors deceived investors in two ways: first that State Street impermissibly charged its clients different exchange rates than the one the bank actually used to execute foreign exchange (“FX”) trades for clients; and that State Street misled investors in the fall of 2008 with statements that debt securities in its investment portfolio and in four specific off-balance sheet commercial paper conduits – collateralized in part by mortgage-backed securities – were of “high quality.”

In ruling that the plaintiffs’ allegations about the company’s statements regarding its debt securities were sufficient, Judge Gertner said "it is clear that some of the State Street disclosures simply failed to provide sufficient warning or detail, while others actually obscured as much as they revealed."

Nate Raymond’s August 4, 2011 article in the Am Law Litigation Daily about Judge Gertner’s ruling in the State Street case can be found here.

I have added the State Street ruling to my running tally of dismissal motion rulings in the subprime related securities cases, which can be accessed here.

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In an August 2, 2011 post on the New York Times  Dealbook blog entitled “Ex-Directors of Failed Firms Have Little to Fear”(here), Ohio State University Law Professor  Steven Davidoff voices his consternation that the former directors of Bear Stearns and Lehman Brothers seemingly will be able to “continue their prominent careers.” Davidoff seems miffed that the former board members of these failed firms have not only been able to get on with their lives but many of them have continued to serve as board directors. Others maintain roles of prominence in academia or business. (Bear Stearns of course did not actually fail but for simplicity of expression in this post I have referred to it using that term.)

Davidoff acknowledges that the financial crisis that accompanied these companies’ failures was an “enormously complex event” and that officials at these failed firms can argue that “it was the crisis itself – not poor management or inadequate board supervision – that caused their firm’s demise.” Given that, Davidoff is “not arguing that these directors be tarred and feathered or that they should not be able to earn a living.” He is just suggesting that “at a minimum…other public companies might be more hesitant to keep these failed directors on their boards.”

Davidoff’s column does strain to maintain a balanced point of view, but there is nevertheless an unmistakable underlying assumption that these former board members should be shunned or otherwise punished as a result of their former firms’ failures. Davidoff's apparent thesis is consistent with a prior post of his, in which  he argued that directors should be held liable more often, a point of view with which I disagreed here. I also have some concerns about Davidoff's latest post, which I have outline below. I acknowledge that I have certain biases, which I outlined in my response to Davidoff's prior post. My concerns with the latest post are as folllows.

First, the SEC has the authority to bring enforcement actions and, among other things, to impose lifetime bans on individuals from future service as board members of public companies. The SEC has not brought any such action against these individuals, presumably because it does not believe it could bring a meritorious claim against them. Indeed, these individuals have not been found blameworthy or culpable in any way by any legal authority in connection with the demise of these two firms

Second, there is a peculiarly American notion that is something has gone wrong, then somebody must be punished – even if the designated scapegoat is not directly to blame for what has gone wrong. But it seems to me that little purpose would be served by forcing these persons onto the shelf and out of productive contributions to corporate life. Stigmatizing them would accomplish nothing, except perhaps satisfaction of some tribal atavistic urge for retribution.

It bothers Davidoff that these individuals have been getting on with their lives and in particular that there these individuals apparently have not taken a permanent and disqualifying hit to their reputations. Davidoff ascribes this to the alleged “decline in importance of reputation on Wall Street.”

I suspect strongly that these individuals would have a far different view of whether or not their have been consequences for them as a result of the firms’ failures, and in particular I suspect they would have a lot to say on the specific topic of reputation.

Even though these individuals have not been found to have done anything wrong, I am quite certain that these individuals’ lives have been quite disrupted as a result of these firms’ collapses. Not only has there been the harsh scrutiny they have all had to face, but there has also been a seemingly endless procession of legal events and proceedings. These individuals are undoubtedly spending more time than is healthy in the company of lawyers.

I simply cannot agree that reputation has declined in importance, on Wall Street or anywhere else. For several years I have participated in the Stanford Law School Directors College, in connection with which an attendee survey is conducted in which, among other things, the attendees express their concerns about governance issues. An overwhelming majority of attendees indicate that their biggest concern with respect to problems at the companies with which they are associated is not the risk of liability as such, but the risk to their reputations.

Most corporate directors have spent their entire lives building their professional reputations and they take them very seriously. None of the former directors affiliated with Bear Stearns and Lehman Brothers can escape their association with those firms’ demises.

The fact that these individuals have been able to get on with their lives despite these failure of their former firms can be interpreted in a number of ways. One way is to conclude that in the “the old boy network of Wall Street,” as Davidoff calls it,  the corrupt fat cats complacently overlook each others’ peccadillos while lighting cigars with $100 bills. Another way to look at is that the kinds of individuals who serve on public company boards often are highly accomplished individuals whose talents and skills are sufficient that their services are still valued in other contexts despite the tarnish that comes even with association with an event like the collapses of Bear Stearns and Lehman Brothers.

It seems to me that Davidoff’s real gripe is not really with the individuals themselves but rather is with the rest of the corporate, academic and business world, which just doesn’t think, as he does, that these individuals really ought to be more seriously stigmatized for their association with the failed firms. Perhaps these other organizations can see that these individuals have not been found culpable in any way for what happened at Bear Stearns and at Lehman. Perhaps these other organizations, motivated to act in their own best interests, value the service of the individuals for all of their skill, knowledge and experience,  notwithstanding their association with Bear Stearns and Lehman.

The bottom line for me is that I see no value in demonizing individuals who have not been found to have done anything wrong. To me, allowing on the one hand that these individuals shouldn’t be tarred and feathered and should be able to earn a living, but on other hand suggesting that their should be some things they shouldn’t be allowed to do is like arguing that they should be allowed to continue their lives, but should just have to wear some type of scarlet letter for which they are universally shunned. I just can’t get on board with that.

There are plenty of legal mechanisms in our country for determining culpability and imposing penalties. I am very wary of any suggestion that there should be social penalties outside of those processes.

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One of the many distinctive traits of the litigation that surrounded the S&L crisis in the late 80s and early 90s was the plethora of lawsuits  between the FDIC (and other federal banking regulators), on the one hand,  and the failed banks’ insurers, on the other hand,  over the interpretation of the banks’ management liability insurance policies. Among the questions surrounding the current bank failure wave has been whether or not we will see a similar round of insurance coverage litigation. If a lawsuit filed last week in the Middle District of Alabama is any indication, the anticipated insurance coverage litigation may be on its way.

The coverage lawsuit arises out of the massive failure of Colonial Bancorp, which closed its doors on August 14, 2009. The bank’s holding company filed for bankruptcy on August 25, 2009. Among the factors contributing to Colonial’s failure was the criminal conspiracy relating to the failed mortgage lender, Taylor Bean & Whitaker. In April 2011, Lee Farkas, Taylor Bean’s ex-Chairman, was convicted of wire fraud and securities fraud.

Prior to Farkas’s conviction, two Colonial Bank employees pled guilty in connection with the Taylor Bean scheme. As reflected here, on March 2, 2011, Catherine Kissick, a former senior vice president of Colonial Bank and head of its Mortgage Warehouse Lending Division, pleaded guilty to conspiracy to commit bank, wire and securities fraud for participating in the Taylor Bean scheme. As reflected here, on March 16, 2011, Teresa Kelly, the bank’s Operations Supervisor and Collateral Analyst, pled guilty on similar charges.

The two bank employees allegedly caused the bank to purchase from Taylor Bean and hold $400 million in mortgage assets that had no value. The employees also allegedly engaged in fraudulent actions to cover up overdrafts of Taylor Bean at the bank. The employees are also alleged to have had the bank engage in the fictitious trades with Taylor Bean that had no value.

At the time of the bank’s failure, the bank carried three financial institution bonds. At or about the time that Colonial failed, the bank submitted notices of claim under the financial institutions bonds in connection with the activities and actions that ultimately were the topic of the criminal guilty pleas of the bank employees.

In a complaint filed on July 29 in the Southern District of Alabama (a copy of which can be found here), the FDIC as receiver for Colonial Bank, as well as the bankrupt bank holding company on its own behalf, filed an action against the bank’s bond insurer. Among other things, the complaint alleges that the losses caused by the misconduct “constitute recoverable losses under the Bonds up to the full aggregate limits of liability of the Bonds.” 

The complaint states that the bond insurer “has neither accepted nor denied the Plaintiffs’ claims under the Bonds.” The complaint alleges  that the insurer “has failed to investigate the claims and losses in a reasonable and appropriate manner.” After cataloging the back and forth between the FDIC and the insurer on their respective efforts to enter a confidentiality agreement, the complaint alleges that the insurer “has declined to enter into any of the proposed confidentiality agreements or offer appropriate confidentiality agreements of its own,” and “hence” the FDIC is unable to produce the confidential information that the insurer has requested. The complaint asserts a single claim for breach of contract.

Interestingly, the complaint does not specify whether or not the FDIC or the bankrupt holding company is entitled to recover under the bonds, but rather says that the amount of any recovery under the bonds is to be deposited in a bankruptcy court escrow account, where the issue of entitlement to the proceeds will be determined.

There are a number of arguably unusual features of this dispute. First, it is filed in connection with the failed bank’s financial institutions bonds, rather than in connection with the failed bank’s D&O insurance policy. To be sure, given the circumstances surrounding the bank employees’ guilty pleas, the implication of the bonds is hardly surprising. But the typical bank closure during the current round of bank failures will not implicate the failed bank’s financial institution bonds. The relevant insurance issues will more likely arise, if at all, under the failed bank’s D&O policy.

Another interesting thing about this dispute is that the parties are in coverage litigation even though the carrier has not even denied coverage. It looks as if the parties’ so-far unsuccessful attempts to hammer out a confidentiality agreement have gotten a little bit out of hand. It is mercifully uncommon for parties in similar circumstances to be unable to come up with a mutually acceptable confidentiality agreement. It may be that once the parties in this circumstance can finally manage to come up with a confidentiality agreement that this whole dispute will resolve itself without the need for further litigation (whether or not there was ever really any need for litigation in the first place.)

But the fact that the FDIC has not hesitated to file this suit in the first place certainly does evince a willingness to use the court to pursue its claims, as receiver, in connection with failed banks’ insurance policies. And while this case may not on its face present any significant coverage issues of more general significance, the likelihood is that as the FDIC presses claims for insurance recovery, that some of these claims will find their way into court with significant implications for questions of coverage under the applicable policies.

As I have said before, so many aspects of the current bank failure wave provide a feeling of déjà vu for those of us who lived through the S&L crisis. If the feeling is not necessarily one of nostalgia, it at least has a certain familiarity. Of course, it remains to be seen whether or not there will be any where near the amount of coverage litigation this time around. It just looks to me from this recent lawsuit that just like last time, the FDIC is not messing around, and it is not going to hesitate to use the courts to pursue claims against failed banks’ insurers.

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As numerous commentators have noted, one of the most distinctive litigation developments over the last twelve months has been the emergence of U.S. securities litigation against Chinese companies that obtained their listings on U.S. exchanges that a “reverse merger” with a publicly traded U.S. shell company.

Given the prominence of these issues, I am very happy to publish the following guest post from Anjali C. Das, who is a partner in the Chicago office of the Wilson Elser law firm. Many thanks to Anjali for her willingness to publish her article 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.

Here is Anjali’s guest post:

D&O Spotlight on China: Claims Against China-Based Reverse Merger Companies: A Tempest in a Teapot of Gunpowder Green Tea?

Introduction

These days, nearly everything to do with China has grabbed the spotlight – not least of all the country’s extraordinary and seemingly unstoppable economic growth. Not surprisingly, many U.S. investors have been pouring millions of dollars into Chinese companies with the hopes of gaining super-sized returns. However, naysayers have long predicted a bursting of the China bubble. At least for investors in China-based issuers, perhaps that time is now. Not unlike the bursting of the internet bubble in the 1990s fueled by explosive growth and investment in “dot.com” companies, investors and regulators may now have reason to fear the rapid rise and fall of Chinese companies that have accessed U.S. capital markets through reverse mergers. While short-sellers are publicly denouncing the purported fraud at these companies (and making big bucks shorting the stock), U.S. regulators are investigating the rash of accounting scandals at these companies which have caused some auditors to abruptly resign. Meanwhile, D&O insurers have to contend with the collateral damage resulting from the multitude of claims against China-based issuers and their directors and officers. This article highlights the following topics involving Chinese reverse merger companies: 

PCAOB's Research Note on Chinese reverse mergers

SEC's investigation of China-based issuers and their auditors

NASDAQ's proposed new listing requirements for reverse merger companies

SEC's Investor Bulletin on reverse merger companies

Moody's "Red Flags" report on China-based companies

D&O insurance coverage issues for claims against China-based issuers

PCAOB Issues a Report on China Reverse Mergers

On March 14, 2011, the Public Company Accounting Oversight Board ("PCAOB") issued a report examining the audit implications for reverse mergers involving China-based companies. A copy of the report can be found here. As explained in the PCAOB report, a reverse merger is an acquisition of a private operating company by a public company shell company. While the public shell company is the surviving entity, the  private company's shareholders typically control the surviving company or hold publicly traded shares in the company.  A perceived benefit of a reverse merger is that it enables a company to become an SEC reporting company with registered securities without having to file a registration statement under U.S. federal securities laws.

The PCAOB report identified 159 companies from China that accessed the U.S. capital markets in a reverse merger transaction from 2007 through March 2010, representing 26% of all reverse mergers during the period. Reportedly, the market capitalization of these companies was $12.8 billion as compared to a $27.2 billion market cap of the 56 Chinese companies that completed initial public offerings in the U.S. during that same period. 

Reverse merger entities listed on U.S. exchanges are required to file audited financial statements with the SEC, and the auditors of the financial statements are required to be registered with the PCAOB. According to the PCAOB, U.S. firms audited 116 or 74% of the China-based reverse merger companies, while Chinese registered accounting firms audited 38 or 25 of companies. The PCAOB report raises concerns that some U.S. firms are not conducting proper audits of China-based companies, including handing off the audit work to a local Chinese accounting firm without verifying the accuracy of the results. The PCAOB has identified various "key considerations" to determine the appropriate level of oversight of firms that performs audits of foreign companies with the aid of assistants outside the firm, including:  the ability to supervise outside assistants; whether the outside assistants have appropriate language skills, and whether the auditor would have the ability to comply with the PCAOB's documentation requirements.

SEC Launches Investigation of China-Based Issuers and Auditors

In response to a congressional inquiry by House Representative Patrick T. McHenry, Chairman of the Committee on Oversight and Government Reform, SEC Chairman Mary L. Schapiro issued a letter on April 27, 2011 seeking to assure Congress and the public that the SEC "has moved aggressively to protect investors from the risks that may be posed by certain foreign-based companies listed on U.S. exchanges" -- particularly those companies based in China.  As SEC Chairman Schapiro noted in her letter, there has been a recent marked increase in China-based companies listed on U.S. exchanges through the process of a reverse merger.

Last summer, the SEC reportedly launched a "proactive risk-based inquiry into U.S. audit firms" which have a significant number of issuer clients based outside the U.S.  Among other things, the SEC has requested auditors to provide information concerning the firms' compliance with U.S. audit standards for foreign-based reverse merger companies based in China.  Since the SEC launched its investigation, dozens of China-based companies have disclosed auditor resignations and accounting problems.  Since February 2011, Big Four accounting firms have resigned or been dismissed from at least seven Chinese companies listed in the U.S., as reported here. These auditors have reportedly experienced difficulty obtaining independent bank confirmations of a company's bank accounts, balances, and transactions, as reported here.   In at least one case, the auditor purportedly received false information directly from the bank itself, prompting the auditor to resign. 

In an effort to protect U.S. investors, the SEC has reportedly suspended trading in several China-based reverse merger entities.  In addition, the SEC has revoked the securities registration of many other China-based reverse merger companies.  In some instances, the SEC is also pursuing these companies' auditors for improper audits.   As the SEC Chairman observed, the Dodd Frank Wall Street Reform and Consumer Protection Act ("Dodd Frank") has enhanced the SEC's ability to obtain audit documentation in connection with its investigations of issuers based in China and other countries. 

NASDAQ Proposes New Listing Requirements for Reverse Mergers

On June 8, 2011, the NASDAQ filed proposed rules with the SEC to adopt additional listing requirements for companies that become public through a reverse merger. Under the proposed rules, which can be found here, a company that is formed by a reverse merger shall only be eligible to submit an application for initial listing if the combined entity can satisfy the following conditions: 

traded for at least 6 months in the U.S. over-the-counter market, on another national securities exchange, or on a foreign exchange following the filing of all audited financial statements;

maintained a bid price of $4 or more per share for at least 30 of the most recent 60 trading days;

in the case of a U.S. domestic issuer, the company has timely filed its two most recent financial statements (i.e., Form 10-Q or 10-K);

in the case of a foreign based issuer, the company timely files comparable financial statements (i.e., Form 6-K, 20-F or 40-F) that includes an interim balance sheet and income statement presented "in English"

In support of its proposed enhanced listing requirements, the NASDAQ cited the "extraordinary level of public attention to listed companies that went public via a reverse merger," and "allegations of widespread fraudulent behavior by these companies, leading to concerns that their financial statements cannot be relied upon." The NASDAQ believes that these new listing requirements will protect investors and "discourage inappropriate behavior" by companies. 

SEC Issues an Investor Bulletin on Reverse Mergers

On June 9, 2011, the SEC issued a bulletin cautioning investors of the potential pitfalls of investing in reverse merger companies. The bulletin can be found here. Among other things, the SEC observed that many reverse merger companies ("RMCs") "either fail or struggle to remain viable following a reverse merger"; there have been instances of fraud and other abuses involving RMCs; and some RMCs have been using smaller U.S. auditing firms that may not have sufficient resources to conduct adequate overseas audits. The SEC bulletin also cited recent examples where it suspended trading of RMCs due to accounting irregularities and/or revoked the securities registrations of RMCs due to the companies' failure to timely file required periodic financial statements.

Moody's Issues its "Red Flags" Report on China-Based Companies

To address investors' increasing concerns with the quality of financial reporting from publicly listed Chinese companies, on July 11, 2011 Moody's credit rating agency issued a "Red Flags" report for China-based companies. The report examines 20 red flags grouped into five categories that identify possible governance or accounting risks for China-based companies, including:

            Weaknesses in corporate governance: short track record of operations and listing history,         murky shareholders' background, large and frequent related-party transactions;

            Riskier or more opaque business models: unusually high margins compared to peers,     concentration of customers, complicated business structures;

            Fast-growing-business strategies: very rapid expansion, big capital investments resulting         in large negative free cash flow and intangible assets;

            Poorer quality of earnings or cash flow: discrepancy between cash flows and accounting             profits, disjointed relationship between growth in assets and revenues, large swings in working capital, insufficient tax paid compared to reported profits;

            Concerns over auditors and quality of financial statements: a switch in auditing firm or    legal jurisdiction of auditor's office, delay in reporting, or adverse comments from      auditors.

Moody's applied its red flags analytical framework to 61 rated Chinese companies. According to Moody's report, due to the rapid growth of Chinese companies, nearly all Chinese high-yield issuers tripped red flags related to aggressive business and financial strategies and quality of earnings. Moody's observed that fast-growing companies put pressure on managerial and financial resources. Additionally, these companies may make large capital investments that could negatively impact cash flow for a prolonged period of time. Also, due to the prevalence of strong founding families, many Chinese companies tripped the red flag for concentration of family ownership which may reflect weaknesses in corporate governance.  Moody's also noted the so-called arms-length related-party transactions were not always transparent. Interestingly, according to Moody's report, concerns over auditors arose less frequently compared to other red flags. 

Shorts-Sellers Creating Havoc

Meanwhile, short-sellers are wreaking havoc on China-based issuers' stock and publicly accusing these companies of fraud. In several instances, detailed reports issued by short-sellers have triggered a wave of internal investigations, investigations by regulators, and shareholder litigation against companies. While some companies have gone to lengths to deny short seller's often unsubstantiated accusations, the damage is done when the investors get spooked and the company's stock price spirals downward. 

All of the negative publicity has impacted Chinese companies across the board, regardless of whether specific allegations of fraud have been asserted. Where investors were once rushing to dump huge sums of money into any business with ties to China, they are now rushing to liquidate their stock holdings at the slightest sign of any trouble. The fallout has had a devastating impact on the number of reverse merger transactions of Chinese companies. Not surprisingly, some Chinese companies have postponed plans to sell shares in the U.S., either through reverse mergers or initial public offerings ("IPOs"). As reported here, compared to 47 reverse merger transactions in the first half of 2010, there have been only 29 for the first half of 2011.  At least for now, Chinese companies are no longer the darling of Wall Street.

The Rise of Shareholder Litigation

Approximately 30 shareholder suits were filed in the first half of 2011 against China-based companies listed on U.S. exchanges and the companies' directors and officers. On the surface, many of these suits are classic securities class actions alleging securities fraud and violations of Section 10(b) of the Securities Exchange Act of 1934 ("1934 Act") for materially false and misleading financial statements and related derivative actions.  However, suits against China-based companies may pose unique hurdles and added expense to the defense of shareholder claims in the U.S. For one thing, many or most of the individual defendants, corporate documents, and key witnesses may reside in China. Moreover, testimony and documents may need to be translated from Chinese to English. As such, defense costs can escalate rapidly. Also, given the current regulatory climate and increased suspicion of China-based issuers, the company may also be the subject of parallel proceedings or investigations by the SEC and other regulators. In some situations, the company's Board may simultaneously launch an internal investigation – particularly if the company's outside auditor abruptly resigns without issuing a clean audit opinion. That could also trigger a wave of management departures, putting added strain on the company's already stretched resources. 

D&O Insurance Coverage Issues

Claims against China-based issuers and their directors and officers may raise a host of coverage issues under traditional Directors and Officers (“D&O”) liability insurance policies including, but not limited to: 

Reasonable and necessary defense costs

Coverage for parallel proceedings and investigations

Rescission

Known Claim exclusion

Fraud and personal profit exclusions

Severabiity of the policy exclusions and application

D&O policy limits for public companies are typically eroded by defense costs. This may occur more rapidly in suits against Chinese companies in light of the complexities of transnational discovery. As such, it is in the interests of D&O insurers and insureds alike to ensure that these claims are being defended with maximum efficiency to minimize the possibility that the D&O insurance is significantly impaired or even exhausted by defense costs alone. While many large defense firms now have outposts in China, it is still imperative to gain an understanding of the anticipated division of labor between the U.S. based lead defense attorneys and their colleagues in China with respect to discovery, document collection, witness interviews, and other matters. Additionally, there should be an objective assessment to determine whether it is cheaper and more efficient to outsource certain discovery-related tasks such as collection and translation of documents.

Shareholder litigation against Chinese companies may spawn multiple parallel proceedings and investigations by the government, regulators, the Board, a Special Litigation Committee, and others. A key issue is whether such investigations constitute covered Claims or Securities Claims under the D&O policy. Historically, many D&O policies narrowly limited the availability of coverage for investigations, such as formal investigations by the Securities and Exchange Commission (“SEC”) commenced by service of a subpoena on a director or officer. However, in the past few years, some D&O policies began to offer enhanced coverage, including coverage for both formal and informal investigations by regulators. Nowadays, the definition of a Securities Claim is less standard and may contain many subtle, yet critical nuances impacting coverage. Not surprisingly, there has been a significant amount of litigation and reported decisions with respect to coverage for investigations under D&O policies. However, many of these decisions are fact-specific and driven by now obsolete D&O policy language and definitions which continue to evolve. 

Recently, on July 1, 2011, the Second Circuit Court of Appeals issued an opinion in MBIA, Inc. v. Federal Ins. Co., 2011 U.S. App. LEXIS 13402 (2d Cir.), that sets forth a comprehensive analysis of coverage for various investigations under a D&O policy. In that case, the policy definition of a covered Securities Claim included “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.” First, the Second Circuit held that investigations commenced by the SEC and the New York Attorney General (“NYAG”) were covered under the policy definition of a Securities Claim. The court observed that the issuance of a subpoena by NYAG was, at a minimum, a “similar document” related to a “formal or informal investigative order”. The court also opined that requests for information by the SEC pursuant to oral requests and subpoenas were covered because they were connected to the SEC’s formal order of investigation. The court also concluded that fees incurred by an independent consultant retained by MBIA in the context of negotiating a settlement with the SEC and NYAG were also covered.

Second, the Second Circuit concluded that legal fees incurred by MBIA’s Special Litigation Committee (“SLC”) to determine whether to pursue or terminate pending shareholder derivative actions were covered and did not clearly fall within the policy’s sub-limit of liability for shareholder derivative demands. Prior to the filing of the derivative actions, a shareholder demand on MBIA’s Board had been made and ultimately rejected. After the shareholder derivative suits were filed, the SLC sought and obtained dismissal of the lawsuits. The Second Circuit determined that the legal fees incurred by the SLC arguably fell within the policy’s coverage for “costs ‘incurred in . . . investigating’ ‘Claims’ or ‘Securities Claims,’ respectively, each of which is defined to expressly include lawsuits.” The Second Circuit also determined that that the insurer had failed to carry its burden of proving that the SLC’s legal fees were not covered under the policy definition of Loss which excluded “any amount incurred by [MBIA] (including its board of directors or any committee of the board of directors) in connection with the investigation or evaluation of any Claim or potential Claim by or on behalf of [MBIA]”. 

To the extent claims against China-based issuers and their directors and officers allege accounting improprieties and false and misleading financial statements, D&O insurers might have a potential rescission argument if the policy was issued in reliance on these false financials. In some instances, D&O policies and/or applications contain a Known Claim Exclusion which might serve as a basis for denying coverage if an insured knew and/or failed to disclose a fact, circumstance, act, error, or omission that might give rise to a Claim under the policy. Also, standard D&O policies contain fraud and personal profit exclusions that might apply; however, these exclusions are usually restricted to a finding “in fact” or “final adjudication” that the insured committed fraud or unlawfully profited. In addition, both the application and the exclusions might be “severable,” such that the knowledge or wrongful acts of one insured cannot be automatically imputed to other insureds except in limited situations.

Conclusion

Some might conclude that the spotlight on China-based reverse merger companies is merely a tempest in a teapot, as compared to the global financial crisis precipitated by the subprime market meltdown and collapse of numerous financial institutions at home and abroad. Nonetheless, the reality is that many China-based issuers have been targeted by regulators and investors alike for purported securities and accounting fraud that could ultimately cost D&O insurers millions in losses. At least for now, this trend seems to be gaining traction. Until the pot is done brewing and the tea leaves are read, D&O insurers should tread carefully in handling claims against their China-based issuers.

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Settlement opt-outs have been always been a feature of securities class action litigation. However, as part of the settlements of the huge cases filed during the era of corporate scandals at the beginning of the last decade, opt outs became more prevalent and they represented an increasingly significant part of the case resolution. Many of the opt out recoveries during that period were substantial, both in absolute dollars and in terms of recovery percentages, a phenomenon that occasioned much commentary and even some discussion about whether the rise in class action opt outs represented a fundamental change in the securities class action lawsuit paradigm.

But after a seeming cascade of opt out settlements as the securities cases associated with the corporate scandals were resolved, the phenomenon seemed to die down, or at least fade into the background. However, it seems that in connection with the larger cases associated with the credit crisis, the phenomenon of significant opt out cases may be back, at least if recent developments in one case are representative.

The securities lawsuit in question is the case filed by shareholders of Countrywide, which previously settled for $624 million. One of the questions I asked at the time was whether or not the class settlement, as large as it was, would be “enough” to keep the class intact. As it turned out, a number of large institutional investors opted out of that settlement and on July 28, 2011, they filed their own collective action against Countrywide and certain of its directors and officers in the Central District of California. (A copy of their massive 425-page complaint can be found here.)

The lengthy list of plaintiffs is interesting. The list includes the California Public Employees Retirement System (CalPERS). There are pension funds from Guam and Montana; Dutch pension funds; and investment funds from the Nuveen, American Century, T.Rowe Price, BlackRock and TIAA-CREF fund families; and many others. The list of plaintiffs alone is seven pages long. So if this isn’t a class action, then it is a group action of sorts, for sure.

In earlier interview (summarized here), counsel for the opt out plaintiffs was quoted as saying that the opt out litigants losses were “far greater than what they would have received in the proposed settlement” and that they were unwilling to settle for just "pennies on the dollar. " The attorney said that his clients, "are fully committed to recovering the substantial damages caused by the fraudulent conduct at Countrywide,” adding that "the conduct by the former officers of Countrywide was particularly egregious. And prominent institutional investors were completely blind-sided by [its] pervasiveness."

It certainly was the case with respect to many of the opt out cases filed in the wake of the class settlements associated the corporate scandals that many of the opt out litigants claimed to have recovered substantially more than they would have if they had remained in the class. It remains to be seen whether the Countrywide opt outs will fare as well.

But while the value of opting out of the Countrywide settlement for these institutional claimants remains to be seen, the spectacle of all of these institutional investors leaving the class and heading out on their own has to be truly daunting for both plaintiff and defense counsel in the other large unresolved credit crisis cases. At least in the large credit crisis cases where there is either a solvent or successor entity, the challenge that counsel on both sides will face is trying to come up with a settlement that is practically feasible yet  also “large enough” to keep the institutional investors in. And meanwhile, while the counsel struggle to complete a settlement, legal costs mount on both sides.

 If large institutional investors conclude that their interests are served by proceeding outside the class, the class action could quickly become a sideshow. Indeed opt outs get to a critical level, it could trigger the “blow up” provision that is a part of many settlement agreements. Even if the class action litigants can pull a class settlement together, the defendants may not achieve the finality and repose that are among the usual reasons for settling cases in the first place. Instead, the defendants may face the possibility of continuing litigation with a well-financed subset of the original class.

To be sure, the actions of the Countrywide opt outs may or may not be representative of the actions that institutional investors in the other large credit crisis cases will take. Nevertheless, with the apparent reemergence of the institutional investor class lawsuit opt out action, it seems  hard to disagree with the words of Columbia Law Professor John Coffee who called the emergence of the large class action opt-outs “probably the most significant new trend in class action litigation.”

Victor Li’s July 29, 2011 Am Law Litigation Daily article discussing the institutional investors Countrywide action can be found here.

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The facts and circumstances surrounding Bank of America’s credit crisis-induced acquisition of Merrill Lynch remain among the highest profile and most controversial events during the global financial crisis. In a July 29, 2011 opinion (here), Southern District of New York Judge Kevin Castel granted in part and denied in part the defendants’ renewed motions to dismiss in the consolidated Bank of America securities litigation arising out of BofA’s acquisition of Merrill.

Judge Castel’s opinion deals with two of the most controversial aspects of the events surrounding the deal – BofA’s alleged failure during the fourth quarter of 2008 to disclose Merrill’s deteriorating financial condition after the deal was announced but prior to the shareholder vote; and BofA’s alleged  failure to disclose the commitments of key government officials of financial inducements offered to BofA to complete the deal.

Background

In mid-September 2008, at the height of the global financial crisis, BofA agreed to acquire Merrill Lynch. In October and November 2008, while shareholder approval of the transaction was pending, Merrill suffered losses of over $15 billion and also took a $2 billion goodwill impairment charge. The Complaint alleges that BofA’s senior officials were aware of these losses as they occurred. The Complaint alleges that the losses were so significant that BofA management discussed terminating the transaction, prior to the December 5, 2008 shareholder vote on the merger, in which BofA shareholders approved the merger.

On December 17, 2008, BofA Chariman and CEO Kenneth Lewis called Treasury Secretary Henry Paulson to advise him that BofA was "strongly considering" invoking the “material adverse change” clause in the merger agreement, in order to terminate the deal prior to its scheduled January 1, 2009 close date.  At Paulson’s invitation, Lewis flew to Washington for a face-to-face meeting, at which Paulson and Federal Reserve Board Chair Ben Bernanke urged Lewis not to invoke the MAC clause.

In subsequent conversations, Lewis again advised the government officials that BofA intended to invoke the MAC clause. According to the plaintiffs’ allegations, BofA’s board voted on December 21, 2008 to invoke the MAC clause, but on the following day, the Board voted to approve the merger, apparently in part based on Lewis’s statement that he had received verbal assurances from Paulson that BofA would received a capital infusion and a guarantee against losses from risky assets if the merger concluded.

On January 16, 2010, BofA disclosed the fourth quarter losses of both BofA and Merrill and also revealed the federal funding package, which included $20 billion in capital and protection against further losses on $118 billion in assets. In following days, news reports revealed that in the days prior to the deal’s close, Merrill employees had been paid massive bonuses. 

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

In a lengthy August 27, 2010 opinion (about which refer here), Judge Castel denied in part and granted in part the defendants’ motions to dismiss. First, he denied the defendants’ dismissal motions with regard to the plaintiffs’ allegations concerning the disclosures of the Merrill bonuses. Next, he concluded that while the plaintiffs had also alleged that there were materially misleading misrepresentations or omissions about Merrill Lynch’s deteriorating 4Q08 financial condition and about the promised government financial inducements, the plaintiffs had not adequately alleged scienter as to these topics, and so he denied the defendants’ motion to dismiss as to these allegations.

Thereafter, the plaintiffs filed a Consolidated Second Amended Class Action Complaint (hereafter, the “complaint”). The amendments in the complaint were primarily intended to address the court’s concerns regarding the scienter allegations. The defendants renewed their motions to dismiss.

The July 29 Opinion

In his July 29 ruling, Judge Castel denied the defendant’s dismissal motion as to the allegations surrounding Merrill’s declining 4Q08 financial condition, but granted the dismissal motion as to the allegations about the government bailout. He held that the plaintiffs’ amended complaint adequately alleged scienter as to the Merrill’s financial condition in the fourth quarter of 2008, but did not adequately allege a duty to update prior disclosures  as to the financial support the government officials offered in order to facilitate the deal.

In considering the plaintiffs’ amended allegations concerning Merrill’s 4Q08 losses, Judge Castel first found that the plaintiffs’ had not adequately alleged   that the defendants had a “motive” to mislead. The plaintiffs had alleged that BofA CEO Kenneth Lewis wanted to complete the deal to realize a “long-time business goal.” Lewis, the plaintiffs had alleged, was also motivated to complete the deal to keep his position, after Paulson had “bluntly told Lewis that the Federal Reserve would remove BofA’s senior management if it tried to terminate the transaction.” Judge Castel said neither of these “raised a strong inference of scienter” as there is no allegation that Lewis or BofA’s CFO Joe Price “could personally have profited from either the delay or the closure of the Merrill transaction.”

However, Judge Castel concluded that, with respect to the BofA’s alleged omissions regarding Merrill’s deteriorating 4Q08 financial condition, that the plaintiffs had adequately alleged “recklessness” as to both Lewis and Price.

With respect to Price, Castel concluded based on the plaintiffs’ allegations that the CFO, upon receiving the initial recommendation of the company’s General Counsel that Merrill’s deteriorating results should be disclosed, kept the GC “out of the loop” which “impeded counsel from making a fully informed analysis.’ These allegations are sufficient to infer that upon receiving the GC’s initial discourse recommendation, Price “engaged in ‘conscious recklessness’ amounting to ‘an extreme departure from the standards of ordinary care.’”

Castel concluded, based on the plaintiff allegations that Lewis had full information regarding Merrill’s declining results and that, in light of the transaction’s importance and the magnitude of Merrill’s losses, and that Lewis was reckless in failing to seek guidance of BofA’s disclosure obligations, that  the complaint adequately alleges that “Lewis’s inaction on the disclosure issue raises a strong inference of recklessness.”

In granting the defendants’ motion to dismiss with plaintiffs’ allegations concerning the financial benefits the government officials had offered, Judge Castel said that the plaintiffs had to show that the defendants had a duty to update prior disclosures when subsequent events rendered prior statements misleading. Judge Castel said that the plaintiffs’ complaint “does not, however, allege which statements were rendered misleading by the non-disclosure of federal financial assistance.” Because the complaint “does not allege which statements were allegedly rendered fraudulent by the defendants’ omissions,” the plaintiffs failed to satisfy the PSLRA’s pleading requirements.

Discussion

One of the reasons the BofA/Merrill merger remains so controversial is that, only after the deal closed, the information came out about Merrill’s losses, the governmental financial inducements, and the payment of the Merrill bonuses. The shocked reaction of the financial marketplace reflected in part an expectation that this information should have been disclosed previously to BofA’s shareholders and to the investing public. While the actual facts and circumstances remain a matter of proof, the plaintiffs portray a set of circumstances in which BofA officials were straining to avoid disclosing potentially disruptive information in order to try to preserve the deal – in part because of threats and inducements from senior government officials.

But no matter how compelling this version of the events may be, they still have to fit within the analytic framework required in order to state a claim under the federal securities laws. Judge Castel’s careful consideration tests the allegations against this analytic framework. Nevertheless, plaintiffs’ suggestion that it was misleading not to tell BofA shareholders that the deal was competed only because of massive government financial inducements, as well as threats to senior BofA officials, does present its own kind of narrative plausibility.

It is probable worth noting that by concluding that the defendants’ had no duty to update prior statements in order to disclose the government financial inducements, Judge Castel avoided the need to get into the questions, which he had addressed in his prior opinion, whether or not the defendants acted with scienter in withholding this information. Indeed, one of the more controversial aspects of Judge Castel’s prior opinion was his conclusion that, in part because the BofA officials had been ordered by the government officials not to disclose the government bailout, they had not acted with scienter in withholding the information. 

In any event, plaintiffs have now succeeded in at least two respects in fitting their plausible narrative into the analytic framework required in order to pursue a securities class action lawsuit. The case will now go forward with respect to the claims relating to the alleged failure to disclose the Merrill bonuses and the alleged failure to disclose Merrill’s massive 4Q08 losses. Even without the provocative allegations regarding the actions of the government officials, this will remain an interesting and high-profile case.

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