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 publish below a guest post from my good friend Kimberly M. Melvin and her colleague John E. Howell, both of the Wiley Rein LLP law firm. Kim and John’s article discusses a recent decision from New York’s high court and its implications for the scope of coverage under a fiduciary liability insurance policy. This article was first published by Advisen.

 

I would like to thank Kim and John for their willingness to publish their article on this site. I welcome guest posts from responsible commentators on topics of interest to readers of this blog. Any readers who are interested in publishing a guest post on this site are encourage to contact me directly. Here is Kim and John’s guest post:

 

The Employee Retirement Income Security Act (ERISA) virtually created the market for fiduciary liability insurance because it both expanded potential liabilities for fiduciaries of benefit plans and—crucially—extended liability to the personal assets of individual fiduciaries. The demand for fiduciary liability insurance largely grew out of a desire to protect fiduciaries from such personal liability. This insurance—focused on protecting individual fiduciaries—by design did not cover a plan sponsor’s non-fiduciary acts, such as making business decisions regarding its employee benefit plans. New York’s high court recently issued a decision that recognized and confirmed this basic limitation in Federal Insurance Co. v. International Business Machines Corp., 965 N.E.2d 934 (N.Y. 2012). 

 

Yet, commentators, carriers and insurance buyers alike continue to criticize the IBM decision as creating a new “gap” or marking a sea change in the scope of coverage. Such criticism does not hold up. The IBM decision is really nothing new. It reflects the traditional terms and function of fiduciary liability insurance—to protect fiduciaries. What’s more, the recent market trend toward expanding the scope of fiduciary liability coverage to plan sponsors may not ultimately serve the best interests of insurance buyers and the primary intended beneficiaries of the coverage—individual fiduciaries of employee benefit plans.

 

Settlor or Fiduciary: The Sponsor of an ERISA Plan May Wear Multiple Hats

A company that sponsors an employee benefits plan can “wear two hats: one as a fiduciary in administering or managing the plan for the benefit of participants and the other as employer in performing settlor functions such as establishing, funding, amending, and terminating the trust.”[1] A plan sponsor acts as a fiduciary when it exercises discretionary authority over the management of a plan or its assets or the administration of the plan. But when a plan sponsor makes business decisions regarding a plan, such as whether to create, fund or terminate a plan, it acts as a settlor, not a fiduciary. 

 

As a settlor, the plan sponsor may pursue the best interests of the company and its shareholders and is not subject to ERISA’s fiduciary duties. As a fiduciary, the sponsor’s overriding concern must be the best interests of the plan participants. Since ERISA does not impose breach of fiduciary duty liability on a plan sponsor acting as a settlor, it may be asked: why do these differing “hats” matter? Because a plan sponsor can—in rare cases—be liable under ERISA for non-fiduciary acts. For example, settlor acts like amending an ERISA plan may violate ERISA’s “anti-cutback” or anti-discrimination rules.

 

The IBM Decision: Fiduciary Liability Coverage for Liability as a Fiduciary

IBM was sued in a class action alleging age discrimination under ERISA in connection with amendments to IBM’s pension plan—a settlor function. IBM settled the litigation and then sought coverage from its fiduciary liability insurance carriers for the settlement. IBM’s first excess insurer, Federal Insurance Company, filed a lawsuit seeking a declaratory judgment that the settlement was not covered because the class action did not allege that IBM acted in a fiduciary capacity. The Federal policy afforded specified coverage in connection with a “Wrongful Act,” defined, in relevant part, as “any breach of the responsibilities, obligations or duties by an Insured which are imposed upon a fiduciary of a Benefit Program by [ERISA].” Because the class action undisputedly did not concern conduct by IBM in its fiduciary capacity under ERISA, Federal maintained that the class action did not involve a “Wrongful Act.” The Court of Appeals of New York agreed, finding that “[a] straightforward reading of . . . the ‘Wrongful Act‘ definition is that it covers violations of ERISA by an insured acting in its capacity as an ERISA fiduciary.”[2] Since “IBM was not acting as an ERISA fiduciary in taking the actions that gave rise to the allegations” in the class action, but instead was acting as a plan settlor, the New York high court held that there was no coverage for the settlement.[3]

 

Reactions to IBM: Separating Fact from Fiction

Despite its clear and straightforward holding, the IBM decision has generated unwarranted criticism from commentators, insurance carriers and insurance buyers:

 

The settlor capacity issue addressed by the IBM court is brand new, and now companies are suddenly left uninsured for something that always was covered.

 

The IBM decision does not create a so-called coverage gap. It recognizes the fundamental purpose of fiduciary liability insurance – to protect fiduciaries from liability for breaches of fiduciary duty under ERISA. Other courts uniformly have agreed that settlor liabilities are not covered by fiduciary liability insurance policies, and IBM cited no cases to the contrary. In fact, as the IBM court noted, IBM’s argument that the policy covered any violation of ERISA whether or not it implicated IBM’s fiduciary capacity, was “strained and implausible” and would expand fiduciary liability coverage to “almost every lawsuit imaginable” against a company that happened also to be an ERISA plan sponsor.[4] 

 

Claims often involve a settlor act where no breach of fiduciary duty is pled, and most fiduciary policies pick up such an exposure. 

 

ERISA plaintiffs can, in rare cases, sue a plan sponsor solely for acts in its settlor capacity. Typically, though, ERISA litigation concerns the plan sponsor’s acts as both a settlor and a fiduciary: for example, the sponsor’s amendment of a plan (a settlor function) and its disclosures about the amendment (a fiduciary function). Such a “mixed action” would trigger – at least – defense costs coverage. And under the policies at issue in IBM, such a mixed action likely would have been covered subject to other common coverage defenses. Virtually none of the fiduciary liability policies on the market would cover the rare case clearly involving only settlor allegations, because it would not allege a Wrongful Act necessary to trigger coverage. 

 

The primary carrier settled the claim with IBM and paid its entire policy limit toward defense costs and the settlement whereas the excess carrier took a different position and sued the insured.

 

In fact, the primary carrier did not acknowledge coverage for the underlying action or pay the full limits of the primary policy. Rather, the primary carrier advanced IBM’s defense costs subject to a reservation of rights and at all times disputed the availability of indemnity coverage. The primary carrier ultimately settled its coverage dispute with IBM in exchange for a payment that left over 30% of its policy limits untouched. 

 

The Landscape of Fiduciary Liability Insurance: Changing for the Better?

Even before the IBM decision, the fiduciary liability insurance marketplace has been moving toward providing limited coverage for settlor functions – limited to defense costs only or to particular types of settlor conduct. Whether such expansions of coverage will be beneficial for insurance buyers and viable in the long term for the carriers remains to be seen. It is not self-evident that such expansions will really benefit individual fiduciaries, whom the insurance was principally intended to protect. 

 

Costly investigations or litigation focused on settlor issues may drain or completely exhaust the insurance limits available to protect individual fiduciaries from personal liability. Limits adequacy therefore should be a paramount consideration for the insurance buyer in reviewing these newer policy forms. In addition, the settlor coverage afforded under these newer forms may frequently provide very little additional protection. First, claims involving purely settlor issues are rare and, as noted above, mixed cases likely would be covered already. Second, the additional coverage likely extends only to defense costs because the damages recoverable in pure settlor cases are likely to be benefits that would have been due but for the assertedly improper conduct. Such damages would be excluded from coverage by the policy’s “benefits due” exclusion or carved out from the definition of covered Loss. Thus, while insurance buyers often presume “the more coverage the better,” buyers should closely review these newer forms and consider the practical effects of the so-called extensions of coverage and the primary purpose of obtaining fiduciary liability insurance in the first place when selecting the appropriate coverage.

 

About the Authors

Kimberly M. Melvin is a partner in the Insurance Practice at Wiley Rein LLP in Washington, DC. She represents insurers in connection with coverage issues, including liability policies issued to directors and officers, financial institutions, mutual funds, investment advisors, Real Estate Investment Trusts (REITs), rating agencies, insurance companies, insurance brokers and lawyers. Ms. Melvin can be reached at 2.719.7403 or kmelvin@wileyrein.com.

 

John E. Howell is an associate in the Insurance Practice at Wiley Rein. He represents insurers in connection with coverage issues arising under directors and officers, financial institution, lawyers and other professional liability coverages. Mr. Howell can be reached at 202.719.7047 or jhowell@wileyrein.com.

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The conventional view is that plaintiffs may be faring poorly in many of the subprime-related cases. However, plaintiffs have in fact been doing relatively better in ’33 Act claims brought by purchasers of mortgage-backed securities. A recent ruling in the Wells Fargo Mortgage-Backed Certificates Litigation, in which a significant number of plaintiffs’ claims survived the defendants’ motions to dismiss, continues this trend of relatively favorable rulings in these cases. In addition, as also discussed below, the plaintiffs in the Lincoln National subprime related ERISA class action also recently survived dismissal motions.

 

Wells Fargo Mortage-Backed Certificates: In an April 22, 2010 order (here), Northern District of California Judge Susan Illston granted in part and denied in part the defendants motions to dismiss in the subprime-related Wells Fargo Mortgage-Backed Certificates securities class action lawsuit.

 

Purchasers of the mortgage pass-through certificates had filed their lawsuit in March 2009, alleging that the offering documents contained misrepresentations and omissions. The plaintiffs alleged that the documents misstated Wells Fargo’s underwriting processes and loan standards; falsely stated the appraisal value of the underlying mortgaged properties; and misstated the investment quality of the securities, which had been assigned the highest ratings regardless of the lower quality of the underlying mortgages.

 

In her April 22, 2010 order, Judge Illston granted the defendants motions to dismiss, for lack of standing, plaintiffs’ claims based relating to 37 out of the 54 referenced offerings in which the named plaintiffs had not purchased securities. She also granted the rating agency defendants’ motions to dismiss the plaintiffs’ claims against them, holding (in reliance on Judge Lewis Kaplan’s February 1, 2010 ruling in the Lehman Brothers case) that the rating agencies were not underwriters within the meaning of the ’33 Act.

 

As to the 17 offerings in which the plaintiffs had purchased securities, Judge Illston denied the remaining defendants’ motions to dismiss, holding that the plaintiffs, in reliance on confidential witness testimony, had adequately alleged misrepresentations in connection with the defendants’ underwriting practices, improper appraisal practices, and the process by which the securities obtained their investment ratings.

 

One particularly interesting part of Judge Illston’s opinion related to the defendants’ motions to dismiss the plaintiffs’ claims based on the statute of limitations. Plaintiffs first filed their complaint in March 2009. In order to avoid the statute, the plaintiff claims would "have to have accrued no earlier than March 27, 2008 to be timely." The defendants argued that due to widespread press coverage the plaintiffs were put on inquiry notice of problems involving mortgage-backed securities well before March 2008. Judge Illston found these arguments "unpersuasive" noting that the news articles on which the defendants relied "give rise to competing inferences."

　

Lincoln National ERISA Class Action: In an April 20, 2010 order (here), Eastern District of Pennsylvania Judge Anita Brody denied the defendants’ motions to dismiss the subprime related ERISA lawsuit that had been brought on behalf of two Lincoln National benefit plans.

 

During 2008 and 2009, Lincoln National had sustained heavy losses in its investment portfolio because of investments in mortgage-backed securities, structured investment products, and other derivative securities, including collateralized debt obligations. As the company sustained these investment losses, its share price declined substantially. The plaintiff alleged that because the defendants knew or should have known of the company’s exposure to investment losses, it was imprudent to continue to invest plan assets in the company’s stock. The plaintiff also alleged that the defendants’ failure to disclose the company’s exposure to investment losses prevented the plan participants from making informed investment decisions.

 

The defendants moved to dismiss, arguing first that because the plans were Employee Stock Ownership Plans, the plan fiduciaries are entitled to a presumption of prudence for the decision to invest in employer securities. The plaintiff argued that the presumption was inapplicable because the plan fiduciaries had discretion whether to offer the company stock as an investment options. The court found that the plaintiff had alleged sufficient facts to overcome the presumption, citing the alleged precipitous decline in the company’s stock, the defendants’ knowledge of the impending collapse and the defendants’ conflicted status.

 

In reaching this conclusion, Judge Brody noted that the complaint contains "specific allegations explaining why Defendants knew or should have known that the value of the LNC common stock would seriously deteriorate." She specifically referred to the complaint’s allegations that "Defendants knew or should have known of the Company’s exposure to losses in its investment portfolio due to declines in subprime and Alt-A residential mortgage-backed securities, the Company’s exposure to losses in its investment portfolio due to equity investments in troubled markets, and the Company’s exposure to decreasing capital levels."

 

In denying the motion to dismiss on this ground, Judge Brody commented that the plaintiff "faces a heavy burden going forward" as the "presumption of prudence is a difficult standard to overcome." She noted that the complaint "alleges sufficiently dire circumstances that might cause a prudent plan fiduciary to discontinue" the investment option in company stock.

 

Judge Brody also found that the plaintiff had adequately alleged claims that the documents distributed to plan participants contained materially misleading statements. However Judge Brody granted the defendants’ motion to dismiss on the plaintiff’s failure to disclose claim, holding that the plan documents "adequately informed plan participants about the risk inherent in investing solely in employer securities."

 

Discussion

The court’s holding in the Wells Fargo case is largely consistent with other recent dismissal motion rulings in ’33 Act claims involving mortgage-backed securities. It now seems to be fairly well established that plaintiffs are not going to be allowed to assert claims in connection with offerings in which they did not purchase securities. However, dismissal motions apparently will be denied where the plaintiffs have alleged that offering document statements about mortgage originating practices were misleading, at least when the plaintiffs allege in reliance on confidential witness testimony that the mortgage originator systematically disregarded its underwriting guidelines.

 

The statute of limitations issue in the Wells Fargo case is interesting. Judge Illston’s holding that the plaintiffs had not been put on inquiry notice in March 2008 raises the interesting question of when prospective plaintiffs were put on inquiry notice. At some point during 2008, as the financial markets deteriorated and then nearly collapsed, mortgage-backed securities investors clearly were on inquiry notice about possible problems in the mortgage securitization industry. Perhaps another case will narrow down that 2008 inquiry notice date. At a minimum by September 2008 when Lehman Brother collapsed and AIG had to be bailed out, the cat was clearly out of the bag.

 

The practical reality that there is some date during 2008 when the plaintiffs undeniably were on inquiry notice provides at least one explanation why the number of new subprime-related securities class action lawsuit filings began to decline. Clearly, the plaintiffs’ lawyers have no interest in brining claims that will likely be found to be time barred. Of course, as time goes on, the dates on which the toxic offerings took place recedes further and further into the past, and so that is one reason why, notwithstanding the dramatic recent allegations in the SEC’s enforcement action against Goldman Sachs may unlikely to generate a wave of new subprime related securities suits.

 

There is one interesting side note in the SEC’s complaint against Goldman Sachs that is tangentially related here. The SEC alleges that as Paulson company representative and ACA, the portfolio selection manager, worked out which securities would be included in the Abacus CDO, the Paulson representative deleted eight mortgage backed securities that had been issued by Wells Fargo. The SEC’s complaint alleges in paragraph 34 that "Wells Fargo was generally perceived as one of the higher-quality subprime loan originators."

 

It is probably cold consolation to the investors in the Wells Fargo securities that Wells Fargo’s mortgages were then perceived as sufficiently durable that Paulson didn’t want securities backed by those mortgages in his "built to fail" CDO. The money those investors lost on their investment hurt them every bit as badly as the money that investors in other securities lost hurt them. It is probably some measure of how widespread the subprime meltdown was that even securities perceived as stronger still produced significant losses for their investors.

 

As for the Lincoln National decision, this is the latest in a series of subprime-related ERISA class action lawsuit dismissal motion rulings suggesting that ERISA claims may be more likely to survive dismissal motion rulings. The most extreme example of this is in connection with NovaStar Financial, where the securities class action lawsuit was dismissed (and indeed the dismissal was affirmed by the Eighth Circuit), yet the NovaStar ERISA lawsuit survived the dismissal motion. At one level this is hardly surprising since ERISA plaintiffs, unlike securities plaintiffs, do not have to allege scienter, among other things.

 

The Lincoln National case does represent an interesting example of a lawsuit against a company not for its involvement as a mortgage industry participant or a mortgage securitization producer, but rather as a mortgage backed security investor. When losses are sufficiently widespread, the lawsuits go in every direction. Though Lincoln National is among the defendants in this ERISA case, it could well be a claimant in other mortgage-backed securities lawsuits, owing to the losses in its investment portfolio.

 

I have in any event added these two decisions to my running tally of subprime-related lawsuit dismissal motion rulings, which can be accessed here.　

 

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In several prior posts (most recently here), I have noted that defendants seem to be faring particularly well at the dismissal motion stage in the subprime and credit crisis-related lawsuits. However, in recent dismissal motion rulings in two subprime-related cases, one in a securities class action lawsuit and one in an ERISA class action lawsuit, the plaintiffs substantially prevailed, though in each cases portions of the plaintiffs’ complaint were also dismissed. If nothing else, these rulings demonstrate that in at least some of the cases, plaintiffs are to some extent managing to overcome the initial pleading hurdles.

 

General Growth Properties: In a September 17, 2009 order (here), Northern District of Illinois Judge Milton Shadur denied in part and granted in part the defendants’ motion to dismiss the complaint that General Growth Properties shareholders had filed against the company and eleven of its directors and officers. My prior post about the General Growth action can be found here and detailed background about the case can be found here.

 

The plaintiffs’ amended complaint contained three separate counts. The first count alleged that in a series of statements during 2008, the defendants misrepresented the company’s ability to refinance debt that was to mature in November 2008. The complaint’s first count further alleged that the company’s COO and CFO had received loans from the CEO’s family trust in violation of company’s ethics policies. Count II of the complaint alleged that the defendants allegedly "rigged the system" by obtaining a short-selling ban from the SEC prior to disposing of extensive share holdings. Count II alleged control person liability.

 

Judge Shadur granted the motions to dismiss Counts II and III, but denied in substantial part the dismissal motion with respect to Count I.

 

The defendants had moved to dismiss the allegations in Count I on the grounds that the allegedly misleading statements on which plaintiffs sought to rely all came with the "safe harbor" for forward-looking statements.

 

Judge Shadur agreed with the defendants that, except as to one of the alleged misrepresentations, all of the statements on which plaintiffs’’ sought to rely were accompanied by "meaningful cautionary language," as required to come within the safe harbor. As Judge Shadur noted, "General Growth’s cautionary statements were in fact entirely anticipatory of Plaintiffs’ claims."

 

However, even if they were accompanied by meaningful cautionary language, the statements only qualify for safe harbor protection if they were also "forward looking." In a very detailed and painstaking analysis, Judge Shadur went through each of the alleged misrepresentations on which plaintiffs sought to rely and found that while some of the statements were indeed forward-looking and therefore are within the safe harbor, many others were not forward looking and there for outside of the safe harbor.

 

Judge Shadur found further that the plaintiffs had adequately pled scienter. The defendants had argued that the plaintiffs impermissibly attempted to rely on "group pleading." Judge Shadur noted that, in general, it is insufficient to attempt to infer scienter from individual defendants’ corporate positions and generalized responsibility for corporate actions. However, he found further that the group pleading doctrine "does not render each individual defendant’s position within a company irrelevant."

 

In this case, Judge Shadur found that "the insider Defendants either had to know about General Growth’s ability or inability to refinance its looming debt, or if they did not, such lack of knowledge would amount to reckless disregard." As a result, Judge Shadur concluded that the defendants’ argument regarding group pleading "is without merit."

 

Judge Shadur also rejected defendants’ argument that their insider sales could not support scienter, because their sales were "the result of margin calls over which they had no control." However, he noted that the defendants’ arguments in that regard "fail to acknowledge" plaintiffs’ contentions that the defendants "attempted to inflate the stock price in an attempt to avoid margin calls."

 

Judge Shadur did dismiss Count II of the plaintiffs’ complaint relating to defendants’ alleged scheme to ban short selling of the company’s stock. He noted that "without an explanation as to who played what role in the alleged scheme," Count II fails to meet the pleading requirements. Judge Shadur also rejected the plaintiffs’ control person liability allegations, finding that "without alleging facts other than defendants’ status to support their conclusion, a count for control person liability is improperly pleaded and must be dismissed."

 

Thus, though Judge Shadur did dismiss significant parts of the plaintiffs’ complaint, a substantial portion of the plaintiffs’ claims remain and those allegations will go forward.

 

First Horizon: On September 30, 2009, Western District of Tennessee Judge S. Thomas Anderson denied in part and granted in part the defendants’ motion to dismiss the plaintiffs’ ERISA class action complaint that had been filed against First Horizon National Corporation (the holding company for First Tennessee Bank) and its plan fiduciaries.

 

As reflected in the plaintiffs’ complaint (here), the plaintiffs allege that the company required plan participants to invest in the company’s stock in order to received matching contributions. As of the end of 2005, more than half of the plan’s assets were invested in company stock.

 

The plaintiffs contend that after January 1, 2006, the investment in company stock was "imprudent" because the bank was lowering its underwriting standards, becoming more heavily involved with subprime and Alt-A loans, and increasing its use of off-balance sheet transactions. The plaintiffs contend that the company’s share price declined when the company announced on April 28, 2008 that it needed to raise $600 million of additional capital.

 

Judge Anderson granted the motion to dismiss with respect to plaintiffs’ allegations that defendants’ breached their fiduciary duty by requiring participants to invest in the company stock fund in order to receive matching contributions from the company in the form of company stock. Judge Anderson held that because these requirements are part of the Plan itself, the plaintiffs allegations failed to state a claim for breach of fiduciary duty.

 

However, Judge Anderson denied the defendants’ motion to dismiss plaintiffs’ claims that the defendants breached their duty by failing to take steps to remove the stock from the plan. Judge Anderson noted that the plan gave the defendants discretion to invest plan assets. Thought the plan required the fiduciaries to invest in company stock, " a plan does not impose on a fiduciary an unquestioning duty to follow the terms of the plan when doing so would be imprudent," holding further that under ERISA a plan fiduciary may only follow plan terms to the extent that those terms are consistent with ERISA.

 

Judge Anderson did dismiss plaintiffs’ claims that the defendants had breached ERISA by failing to provide employees with complete and accurate information about First Horizon’s financial condition, finding that the plaintiffs "have pointed to no provision in ERISA requiring a fiduciary to disclose the specific kinds of risks and factors" the plaintiffs claim the defendants omitted to disclose.

 

Similarly to the outcome in the General Growth Properties securities case, a material portion of the First Horizon ERISA complaint survived the motion dismiss, even though significant parts of the complaint were also dismissed. In both cases, the claims that survived the dismissal motion will go forward.

 

I have in any event added both decisions to my register of subprime-related dismissal motion rulings, which can be accessed here.

 

Court Grants Renewed Dismissal in Fremont General Case: While the plaintiffs in the above cases managed to overcome the initial pleading hurdles at least in part, the plaintiffs in the Fremont General securities lawsuit have now twice failed to survive a dismissal motion, although the court has given them yet another opportunity to amend their complaint to try to cure the pleading defects.

 

As noted here, Central District of California Judge Florence-Marie Cooper had previously granted the defendants’ initial motion to dismiss, with leave to amend. The plaintiffs subsequently amended their complaint, and the defendants renewed their dismissal motion.

 

In a September 25, 2009 order (here), Judge Cooper granted the defendants’ renewed motion to dismiss, but with further leave to amend.

 

As an initial matter, Judge Cooper found that "despite an effort to add allegations that would address the problems identified in the Court’s October 28, 2008 order, the [amended complaint] still suffers from inadequate organization and insufficient specificity to adequately plead falsity and the requisite level of scienter." She noted further that plaintiffs’ "puzzle pleading" makes it "extremely difficult to identify or follow Plaintiffs’ reasoning and to determine – with specificity — which allegations are intended to establish the falsity and scienter requirements."

 

She concluded that

 

Lead Plaintiff’s factual allegations are neither sufficient, nor sufficiently particularized, to satisfy the pleading standard for the falsity requirements, nor they [sic] do they articulate facts sufficient to give rise to the requisite strong inference that one or more of the Defendants made the challenged statements with the requisite level of scienter.

 

Finally, Judge Cooper commented that the plaintiff’s allegations that "Fremont’s underwriting was woefully inadequate and that some or all of Defendants utterly failed to implement policies and procedures sufficient to halt the company’s downward spiral," even if take as true, are "less likely to support an inference of fraud than they are to support an inference of profoundly misguided corporate mismanagement."

 

Judge Cooper gave the plaintiff thirty days to amend the complaint, but directed further that certain specific statements, which she said were "so broad or vague as to not be actionable" should be "omitted from the amended pleading."

 

I have also added Judge Cooper’s September 25 order to my register of dismissal motion rulings.

 

Special thanks to Adam Savett of the Securities Litigation Watch blog (here) for copies of the General Growth and Fremont General decisions.

 

Special thanks to Stephen Pincus of the Stember Feinstein Doyle & Payne law firm for providing a copy of the First Horizon decision. Pincus represents the plaintiffs in the First Horizon case.

 

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As D&O maven Dan Bailey noted in a recent memo (here), ERISA class action litigation represents a significant and growing liability exposure for benefit plan fiduciaries. With the recent addition of the $70.5 million settlement in the Tyco ERISA class action lawsuit (about which refer here) and the $55 million settlement in the Countrywide ERISA class action lawsuit (refer here) to the long and growing list of significant ERISA class action settlements, it is clear that the these ERISA class action lawsuit represent an increasingly important area of potential liability exposure.

 

In light of the increasing prevalence of these significant ERISA class action lawsuits, it seems to me that the time has arrived for a more systematic tracking of significant settlements.

 

Accordingly, I have prepared a list of the largest ERISA class action settlements of which I am aware. The list, in the form of a Word document, can be found here.

 

This list is comprehensive, but it likely is incomplete. I suspect strongly that there may be other similarly significant ERISA class action settlements of which I am unaware that should be included in order for the list to be complete. I would be very grateful if any readers who are aware of any specific settlements that I omitted from the list but that should have included would please let know so that I can incorporate them into the list and make the information available to all readers.

 

In any event, as new ERISA class action settlements arise in the future, I will add them to the list, and I will indicate on the top of the Word document the most recent date on which the list was updated. I encourage readers to let me know about any significant ERISA class action settlements of which they become aware.

 

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In a noteworthy subprime-related litigation development, on August 5, 2009, the parties to the Countrywide ERISA action filed a stipulation of settlement (here), together with a request for preliminary court approval. Under the stipulation, the case is to be settled by a payment of $55 million, to be funded entirely by Countrywide’s fiduciary liability insurers.

 

The plaintiffs first filed their complaint in September 2007. As reflected in the plaintiffs’ Corrected Second Amended Complaint (here), the case was brought on behalf of participants in the Countrywide benefits plan who made contributions to the plan between January 31, 2006 and July 1, 2008, and whose individual plan accounts were invested in Countrywide stock.

 

The plaintiffs’ complaint alleges that the plan fiduciaries "allowed the imprudent investment of the Plan’s assets in Countrywide’s equity," even though they knew or should have known that such investment was unduly risky," because of the company’s "serious mismanagement, highly improper and potentially unlawful business practices," particularly with respect to subprime loans. The plaintiffs alleged that the defendants breached their fiduciary duties to plan participants.

 

The Countrywide ERISA action joins the Merrill Lynch ERISA case as high profile subprime-related ERISA lawsuits that have resulted in significant settlements – as noted here, the Merrill Lynch ERISA action settled for $75 million. The Countrywide settlement may be particularly noteworthy given that the entire $55 million settlement amount is to be funded by the company’s fiduciary liability insurers. While the Countywide case may be particularly notorious, the ERISA action settlement size may represent an ominous sign for fiduciary liability insurers whose policyholders are involved in subprime-related ERISA litigation.

 

There have been a variety of estimates of the insurance industry’s overall prospective loss exposure due to the subprime meltdown and the credit crisis. Though the magnitude of many estimates is impressive, most of these estimates have largely been based on a series of conjectures about likely D&O and E&O losses. Potential fiduciary liability losses were not a prominent part of the calculation. But if the Countrywide ERISA action settlement is any indication, fiduciary liability insurance losses could prove to be a significant factor in the overall insurance industry exposure from the subprime and credit crisis events.

 

In any event, I have added the Countrywide ERISA action settlement to my roster of subprime and credit crisis-related lawsuit resolutions, which can be accessed here. The ERISA cases can be found in Section III of the roster.

 

State Street’s Subprime Litigation Contingency Reserve Too Small?: In a development that underscore both the massive scale of the subprime litigation exposure and the extent to which that exposure may largely be uninsured, on August 10, 2009 State Street Corporation filed its Form 10-Q (here), in which among other things the company reported that the approximately $625 million reserve it established in January 2008 (for the fourth quarter of 2007 reporting period) may not be sufficient in the event that regulators currently investigating the events were to bring an enforcement action. Details about the initial reserve can be found in a prior post, here.

 

State Street reports that as of June 30, 2009, $193 million of this initial reserve remains. But the filing goes on to note that on June 25, 2009, the SEC has served the company with a "Wells notice" and the SEC staff has recommended the initiation of enforcement proceedings. If the SEC or other regulators were to pursue enforcement actions, the report states, then, "depending upon the resolution of these governmental proceedings, the remainder of the reserve established in 2007 may not be sufficient to address ongoing litigation, as well as any such penalties or remedies."

 

The astonishing erosion of this massive reserve certainly highlights the expense involved in this type of litigation, and the company’s warning that the remaining reserve may not be sufficient, stresses the seeming boundlessness of the exposure. The fact that it is the company’s own reserve that is being eroded suggests that this exposure is largely or entirely uninsured, which shows that no matter how great the insurance industry’s exposure may be from the subprime and credit crisis-related litigation wave, the overall exposure, including uninsured liabilities and amounts, may be many multiples greater.

 

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A frequent securities class action lawsuit accompaniment is a companion ERISA stock drop lawsuit brought on behalf of employee participants in the defendant company’s benefit plan. These ERISA lawsuits have in recent years resulted in a string of impressive settlements, although the plaintiffs have not fared as well in the few cases that have actually gone to trial. In a ruling that could have significant implications for other cases, on June 1, 2009, the court in the latest of these cases to go to trial – the high-profile Tellabs ERISA case – entered a sweeping ruling (here) in defendants’ favor. 

 

Because the court in the Tellabs ERISA case ruled in defendants’ favor following trial both with respect to the “prudence” and the “disclosure” issues, and because the disclosures at issue involve many of the same alleged misrepresentation issues as are raised in the much-chronicled Tellabs securities class action (about which refer here and here), the defense ruling in the Tellabs ERISA case could proved to be particularly significant.

 

 

Background

 

The Tellabs ERISA case relates to issues raised by participants in Tellabs’ retirement and savings plan. During the class period of December 11, 2000 through July 1, 2003, the plan offered participants twelve different investment choices, including one fund that was invested exclusively in Tellabs stock. 

 

Tellabs itself had a record year in 2000, but beginning in the first quarter of 2001, Tellabs began to experience a downturn in product demand as well as increased costs. As the year progressed, senior company officials (many of whom were plan fiduciaries and who were subsequently defendants in both the securities lawsuit and the ERISA lawsuit) made a number of statements about the company’s business performance and business prospects. The company along with the rest of the telecommunications industry continued to face business challenges during 2002 and 2003. During the class period, Tellabs share price declined from $63.19 to $6.58 per share.

 

 

In their lawsuit, the plaintiffs contended that Tellabs and the individual plan fiduciaries breached their duties under ERISA. Among other things, the plaintiffs contended that the defendants breached their fiduciary duty of prudence by allowing and holding instruments in the Tellabs stock fund. The plaintiffs also alleged that the defendants breached their duty to honestly disclose material information.

 

 

The case was tried in an eight day bench trial in late April and early May 2009, and on June 1, 2009, Northern District of Illinois Judge Matthew Kennelly issued his findings of fact and conclusions of law, which can be found here.

 

 

The Court’s Rulings

 

Judge Kennelly found for the defendants on essentially all points. With respect to the issue whether the defendants violated the duty of prudence by allowing the plan to continue holding and investing in Tellabs stock, the court found that the defendants demonstrated “procedural prudence.” He found that “by virtue of their roles as high level executives,” they had extensive discussion of Tellabs’ business and future prospects “albeit outside the context of investment and administrative committee meetings.”

 

 

The court added that “though it would have been wise for defendants to conduct a more formal review of the Tellabs stock funds and to document that review, its absence does not mean they were imprudent in light of their intimate knowledge of Tellabs.”

 

 

Judge Kennelly further held, on the issue of so-called “substantive prudence,” that the “evidence shows that a reasonably prudent individual in similar circumstances who undertook such an examination would not have sold the Plan’s stock or removed it as an investment options,” notwithstanding the business challenges that the company was facing. Based on his review of how the business issues unfolded and how the defendants’ responded, Judge Kennelly concluded that “a reasonable fiduciary in similar circumstances would not have concluded that the Plan should have divested its Tellabs stock or ceased offering it to participants as an investment option.”

 

 

With respect to the plaintiffs’ allegations about the inadequacy of defendants’ disclosures about Tellabs and its financial results and prospects, the court concluded that the defendants did not make any material misrepresentations, adding that “Defendants certainly made a number of predictions about Tellabs and the communications industry that turned out to be wrong,” but the “evidence does not demonstrate that defendants misrepresented either the facts or their expectations when they made these statements.”

 

 

Finally, Judge Kennelly also ruled in the defendants’ favor on statute of limitations issues. The defendants had argued that the plaintiffs’ claims were barred by the three year statue of limitations. Plaintiffs had argued that due to defendants’ concealment of the fraud, a six-year statute of limitations should apply and therefore the claims were not time-barred. In a pretrial ruling, Judge Kennelly had found that there were disputed issues of fact on the question of concealment. But following trial, he concluded that there was no evidence of concealment and therefore that the three-year statute applied and accordingly the plaintiffs’ claims also failed because they are time-barred.

 

 

Discussion

 

It is not just that Judge Kennelly’s rulings represent a clean sweep for the defendants. It is that this is the latest of the high profile post-Enron ERISA stock drop cases in which the defendants have prevailed following trial. Other high profile examples include the DiFelice v. U.S. Airways case, in which the defendants’ trial court victory was affirmed in 2007 by the Fourth Circuit (refer here). In addition, in 2008, the Seventh Circuit affirmed (here) the defense verdict in the Nelson v. Hodowal ERISA stock drop case (albeit in a narrow ruling).  

 

 

Trials in these cases are rare, but the track record of defense verdicts at some point may begin to tell, both with respect to which cases get filed and with respect to how the cases settle. In particular with respect to settlement, a demonstrated defense willingness to take a case to trial could begin to have a downward effect on settlements.

 

Chuck Jackson of the Morgan Lewis firm, who successfully represented the defendants at trial in both the Tellabs ERISA case and in the earlier DiFelice case, wrote (here) with his colleague Christopher Wells following the DiFelice case that:

 

 

a plaintiff’s knowledge that an insured and insurer are willing to go through trial if necessary should have the effect of driving down settlements to more properly correspond to the merits of the particular claims, rather than simply fixing a price based on perceived trends, the limits of the insurance polices and a mushy ‘what if’ analysis based on Rule 12(b)(6) rules.

 

 

These points seem even more valid in light of the outcome of the Tellabs ERISA case.

 

 

The DiFelice case has rightly been viewed as significant because the court ruled in the defendants’ favor on the prudence issue, even thought the company wound up in bankruptcy. The Tellabs ERISA case may be even more significant because the court ruled in defendants’ favor on both the prudence issue and on the disclosure issue.

 

 

Plaintiffs are often attracted to ERISA stock drop cases because they can allege disclosure shortcomings without having to plead or prove scienter, as they would in trying to make a claim for securities fraud. Plaintiffs also try to insinuate in settlement negotiations that the court will be predisposed to favor their claims because the plan participants have seen their retirement funds substantially or entirely diminished.Judge Kennelly ruled in the defendants favor notwithstanding and seemingly without regard to these presumed plaintiffs’ advantages.

 

 

Judge Kennelly’s rulings on the disclosure issues may also be significant because of the prominence of the virtually identical disclosure allegations in the high profile Tellabs securities case. The Supreme Court opinion and the subsequent Seventh Circuit opinion in the Tellabs securities case were based solely on plaintiffs’ allegations, which were taken as true due to the procedural posture of the case.

 

 

However, Judge Kennelly made specific findings of fact based on an evidentiary record. . Judge Kennelly clearly credited he testimony of the Tellabs witnesses. His conclusion that the defendants did not make any material misrepresentations suggests that the securities plaintiffs’ allegations also ultimately may be unsustainable. Judge Kennelly’s conclusions that the defendants did not misrepresent either the facts or their assessments provide an important context for subsequent proceedings in the case.

 

 

Judge Kennelly’s final ruling on the statute of limitations issues may be significant in another way, as it seems to be one more basis on which the ruling could withstand appellate scrutiny. Adding the statute of limitations ruling at the end of his findings and conclusions seemingly another way for the appellate court to adopt the district court’s rulings.

 

 

Many of these ERISA stock drop cases contain very similar allegations to those in the Tellabs ERISA case. That is, as in the Tellabs case, the plaintiffs allege that the defendants were imprudent in allowing plan assets invested in company stock and that the defendants failed to disclose to plan participants what the defendants knew about the company’s business results and prospects. According to Jackson, Tellabs counsel in the ERISA trial, the detailed findings of fact and conclusions of law provide “a blueprint for how to try this kind of case.” The court’s findings and conclusions certainly show the challenges plaintiffs face in trying to substantiate these kinds of allegations and also show how defendants can go about refuting the allegations.

 

 

To be sure, there may not be a sudden rush of trials in these kinds of cases. These cases can be notoriously expensive to litigate, and costs and uncertainty of litigation will undoubtedly continue to motivate parties to these cases to seek settlement. But the outcome of the Tellabs ERISA case will hearten those who want to fight these kinds of allegations, and may increase the likelihood that the cases settle for reasons related to the merits.

 

 

Our congratulations to Tellabs’ trial counsel, Chuck Jackson of the Morgan Lewis firm, for his great victory in this case, as well as in the DiFelice case. Jackson has clearly staked out a very clear specialty in trying these kinds of cases. His track record certainly is solid. 

 

 

Special thanks to a loyal reader for providing a copy of the findings and conclusions.

 

 

Seinfeld on Risk Management: George Costanza has to read a risk management textbook, takes advice from a blind man, winds up lecturing (unintentionally) about Ovaltine. Hat tip to the Insurance Journal for the video link.

 

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Along with the flood of securities lawsuits, the current credit crisis has also generated a wave of litigation under ERISA, as I have detailed here. And just as many of the credit crisis-related securities cases have failed to survive preliminary judicial scrutiny (as noted recently here), at least some of the ERISA cases also may encounter judicial skepticism, if the recent decision in the Huntington Bancshares ERISA litigation is any indication.

 

On February 9, 2009, in an opinion that bespeaks a reluctance to sustain litigation based on the effects of the global financial crisis, Southern District of Ohio Judge Gregory Frost granted the defendants’ motion to dismiss in the Huntington ERISA case. A copy of the opinion can be found here.

 

Background

The lawsuit had been brought on behalf of participants in Huntington’s 401(k) plan. The plaintiffs alleged that the plan fiduciaries breached their fiduciary duties in connection with Huntington’s July 1, 2007 acquisition of Sky Financial. The plaintiffs alleged that Huntington’s risk of loss greatly increased by subjecting Huntington to $1.5 billion of subprime exposure through Sky’s relationship with Franklin Credit Management Corp.

 

The plaintiffs alleged that because of the merger with Sky Financial and its subprime exposure, Huntington stock became too risky to be considered a prudent plan investment. The plaintiffs alleged that the defendants failed to take any action to protect the plan assets from the "enormous and entirely foreseeable" risk that he increased subprime exposure would injure the plan and its participants’ retirement savings. The plaintiffs claim that defendants’ alleged breaches caused over $100 million in losses to the plan.

 

 

The February 9 Opinion

Judge Frost first agreed with the defendant’s contention that the plaintiffs’ allegation that Huntington violated ERISA when is acquired Sky "is simply an attempt to second guess Huntington’s business decisions and is not governed by ERISA."

 

Judge Frost also rejected plaintiffs’ claim that the defendants breached their fiduciary duty when they continued to invest in Huntington shares after the merger. Among other things, Judge Frost noted that large public pension funds had continued to invest in Huntington, and indeed had even increased their investment, after the merger.

 

He also noted that "although Huntington has experienced a significant drop in its stock price," its share price essentially "moved in tandem with the other regional banks in Huntington’s geographic footprint." Judge Frost also noted that the plaintiffs "do not point to any ‘red flags’ that should have placed Defendants on notice of a need to cease offering the Huntington stock."

 

Judge Frost also rejected plaintiffs’ allegation that defendants had failed to warn investors (including plan participants) of the risk, finding that in its SEC filings, Huntington "specifically disclosed its exposure to subprime, housing and construction markets and frequently disclosed the effect of increasing market turmoil."

 

Discussion

Judge Frost’s rejection of the plaintiffs’ ERISA claims was based on the specifics of plaintiffs’ allegations. However, his rejection was also clearly based in part on his perception of what the case represents. Among other things, he observed that:

 

it is clear that federal courts are currently experiencing a significant rise in "stock drop cases" due to the current status of the Stock Market and the economic climate in general, which of course includes the subprime lending crisis. However, ERISA was not intended to be a shield from the sometimes volatile stock market.

 

Judge Frost’s reference to "stock drop cases" shows not only how he perceived the Huntington case itself but also reflects a more general perception of the overall subprime litigation wave – that is, that the current influx of cases is the due to stock market volatility caused by the global economic downturn.

 

His general view the subprime cases represent an effort by investors to avoid the consequences of market volatility could, if widely shared, represent a substantial hurdle to the plaintiffs in many of these cases – both cases filed under ERISA as well as cases filed under the federal securities laws. Indeed, I have already noted (most recently here) numerous other credit crisis-related securities cases where courts clearly have shown skepticism that the plaintiffs’ losses were the result of anything other than the financial crisis itself.

 

To be sure, there have been subprime-related ERISA cases that have survived dismissal motions, just as there have also been subprime and credit crisis-related securities lawsuits that have survived motions to dismiss. For example, as I discussed here, the judge in the NovaStar ERISA case recently denied the defendants’ motion to dismiss, a decision that is particularly noteworthy because the motion to dismiss was granted in the NovaStar subprime-related securities lawsuit. (My discussion of the NovaStar securities lawsuit dismissal with prejudice can be found here.)

 

But while some of the ERISA cases may yet survive preliminary motions, many of the cases could also face the same kind of judicial skepticism reflected in Judge Frost’s opinion in the Huntington case. If so, a substantial number of the lawsuits being filed in the current wave of subprime and credit crisis-related litigation could fail to make it past the preliminary stages.

 

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

 

Special thanks to a loyal reader for providing me with a copy of the Huntington opinion.

 

An Unusual Madoff Victim Has Unusual Problems: As reflected in my register of Madoff-related litigation (which can be accessed here), the Madoff scandal has resulted in a wide range of suits and other legal proceedings. But the most unusual of the Madoff-related proceedings may be the motion for temporary restraining order and preliminary injunction filed on March 11, 2009 against Bernard Madoff in the Middle District of Florida by Gino Romano.

 

In his hand-written motion (a copy of which can be found here), Romano, an inmate in the federal prison system, alleges that Madoff enlisted him to recruit other inmates to invest with Madoff, by guaranteeing Romano "an annual return of 18.5%." Romano alleges that Madoff initiated this contact with Romano by sending him an "investment package" in January 2005.

 

Romano alleges that he "collected $1 million dollars from gang leaders" including members of "the Mexican Mafia, Chicago’s Gangster Disciples, the Black Panthers, the Aryan Brotherhood, and D.C. Blacks." Romano asserts that "now I’m in danger from these gangs because Madoff Ponzi scammed us."

 

The dangers Romano claims he now faces include not only irate gang members, but Madoff himself, whom Romano asserts has sent Romano threatening letters. Among other things, Madoff allegedly has communicated to Romano that "he is going to kill me and he has stolen Ponzi money to hire the best hitman money can buy."

 

As readers might well imagine, Romano finds all of this very distressing. He alleges that because of Madoff’s threats he has "suffered a mental breakdown, bed wetting, [and] panic attacks."

 

Call my cynical, but I have my doubts about many of Romano’s allegations. However, I am willing to allow the possibility that the part about "bed wetting" might well be true – although it seems unlikely that Madoff is responsible for that.

 

Special thanks to loyal reader Jon Jacobson for providing me with copies of numerous new Madoff-related pleadings, including Romano’s. I have added all of these new pleadings to my register of Madoff-related suits (here).

 

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In a subprime-related lawsuit that highlights the advantages ERISA claimants may have over litigants seeking relief under the securities laws, a federal court has refused to dismiss the complaint filed under ERISA on behalf of benefits plan participants of NovaStar Financial.

 

In an opinion dated February 11, 2009 (here), Judge Nanette K. Laughrey of the Western District of Missouri denied the defendants’ motion to dismiss the action filed against the alleged fiduciaries of the NovaStar Financial 401(k) plan on behalf of plan participants. During the relevant time period, plan participants had the option to invest in a unitized stock fund that held NovaStar common stock.

 

The plaintiff’s complaint alleges that the defendants knew or should have known that investment in the company’s stock was imprudent, because of the company’s "serious mismanagement and improper business practices" The complaint alleges that the company was relying on subprime mortgage origination and servicing for revenue, while failing to maintain underwriting standards and appropriate risk management techniques. The complaint alleges that the company’s practices ultimately eliminated the company’s ability to elect to be taxed as a real estate investment trust, and that the company’s practices collectively caused the company’s financial statements to be misleading.

 

The plaintiff also alleges that the defendants knew about the company’s problems but did not disclose them to plan participants. The plaintiff also alleges that the defendants issued misleading statements to the plan participants, as a result of which the participants could not make informed decisions about their investments. Following revelations about NovaStar’s subprime-related difficulties, the company’s share price declined (approximately 99 percent from the beginning of the class period).

 

The complaint essentially alleges that the defendants breached their fiduciary duties in allowing plan participants to invest in company stock; by failing to monitor; and by issuing misleading communications.

 

The bulk of Judge Laughrey’s February 11 opinion relates to defendants’ arguments that the court should dismiss the complaint based on plaintiffs’ lack of standing. Suffice it to say here that the court concluded that the plaintiff alleged sufficient injury to support both statutory and constitutional standing, and the defendants’ motion to dismiss for lack of standing was denied.

 

Judge Laughrey also denied defendants’ motion to dismiss based on their argument that the defendants were not plan fiduciaries and in any event were entitled to a statutory presumption that they had acted with prudence. The court found plaintiffs’ allegations on which she contended that the defendants were fiduciaries to be sufficient. The court also found plaintiff’s allegation sufficient, at least at the pleading stage, to overcome the presumption of prudence, observing that the plaintiff has "pleaded facts indicating a precipitous decline in Novastar stock and that Defendants knew, or should have know, of NovaStar’s impending collapse."

 

Defendants further argued that the court should dismiss plaintiff’s allegations about the adequacy of communications to plan participants, contending that the allegations of insufficiency were inadequate and in any event that ERISA does not regulate the communications of which the plaintiff complaints. The defendants expressly cited the prior dismissal of the securities action concerning NovaStar stock (about which, more below).

 

In rejecting this argument, Judge Laughrey noted that the plaintiff had alleged "affirmative material misrepresentations to plan participants – as well as to the general public --- regarding the soundness of the NovaStar investment." The court specifically noted that "the heightened pleading requirements of securities laws do not apply to [the plaintiff’s] ERISA action," commenting further that the plaintiff "need not identify the author or specific content of each misrepresentation in order to survive a motion to dismiss."

 

Judge Laughrey’s recognition that ERISA class actions are not subject to the pleading requirements and other procedural hurdles to which class action securities claimants are subject highlights the advantages, at least in the initial stages, that an ERISA claimant may have over a securities plaintiff in seeking to recover alleged investment losses.

 

The advantages available even on more or less the same set of facts is underscored by the fact that the securities class action filed on behalf of NovaStar’s shareholders was, as Judge Laughrey noted, previously dismissed, with prejudice. (Refer here for a detailed discussion of the prior securities lawsuit dismissal.). The contrast in outcomes is even more noteworthy given how curt the prior court was in dismissing the securities action (among other things, in granting the dismissal motion in the securities case, the court noted that companies "are not expected to be clairvoyant" and that "bad decisions do not constitute fraud.")

 

By my count (refer here), there have been at least 22 ERISA class action lawsuits filed in connection with the current wave of subprime and credit-crisis related litigation. Whether or not these cases, or any one of them, ultimately will be successful remains to be seen. But if Judge Laughrey’s opinion is any indication, these cases may at least survive a motion to dismiss – or, rather, they may have a better chance of surviving the initial dismiss motion than their parallel securities lawsuit.

 

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In a case demonstrating the range of both the potential legal theories and the prospective litigants that could become involved in Madoff-related litigation, a pension fund has filed an ERISA class action against an investment advisory firm for the advisory firm’s investment of the pension fund’s assets in a Madoff "feeder fund."

 

On February 12, 2009, the Pension Fund for Hospital and Health Care Employees – Philadelphia and Vicinity filed an ERISA lawsuit against Austin Capital Management Ltd. in the Eastern District of Pennsylvania, on its own behalf as well as on behalf of all employee benefit funds for whom Austin acted as investment manager and whose assets were invested in whole or in part by Austin in any Madoff-related investment during the period February 12, 2005 to the present.

 

A copy of the complaint can be found here. A copy of the plaintiffs’ lawyers February 13, 2009 press release can be found here. A February 17, 2009 Law.com article describing the lawsuit can be found here.

 

The complaint alleges that in June 2008, the plaintiff’s investment consultant retained Austin "for the purpose of managing a portion of the [plaintiff’s] assets, to be invested in hedge funds." At the time, Austin, which is a wholly-owned subsidiary of Cleveland-based KeyCorp, had approximately $2.3 billion of assets under management.

 

In July 2008, the plaintiff’s investment consultant placed $10 million of the plaintiff’s assets with Austin for investment with the Austin Capital Safe Harbor Dedicated ERISA Fund, Ltd., an exempt corporation operating under the laws of the Cayman Islands. Austin is the investment manager for Austin Safe Harbor.

 

The complaint alleges that Austin invested a portion of Austin Safe Harbor assets in "Madoff-related investments, specifically funds managed by Tremont Holdings." According to a February 3, 2009 Bloomberg article (here), Tremont in turn "placed money through its Rye Select Broad Market Prime Fund, L.P.," which in turn invested with Madoff’s firm.

 

The complaint alleges that Austin was a fiduciary to the class of benefit funds, but that Austin failed to conduct adequate due diligence prior to recommending and investing monies in Madoff-related funds. The complaint also alleges that Austin ignored "red flags."

 

The complaint identifies several other public pension funds for which Austin acted as investment manager. The complaint states that Austin managed $170 million for the Massachusetts Pension Reserves Investment Management Board, of which $12 million was exposed to Madoff-related investment, and also managed $170 million for the New Mexico Education Retirement Board, of which $8-10 million was in Madoff-related investments. According to news reports (here), the Massachusetts pension fund recently voted to fire Austin due to the Madoff-related losses.

 

There are a number of interesting things about this lawsuit. The first is that it seeks relief under ERISA. So far as I am aware, this is the first Madoff-related lawsuit asserting claims under ERISA. The interesting thing about an ERISA class action, as opposed to a securities class action, is that the ERISA action is not subject to the PSLRA’s discovery stay and other procedural requirements. So the ERISA plaintiff is free to conduct discovery even while the dismissal motion is pending.

 

The opportunity under ERISA to avoid some of the challenges of litigating under the federal securities laws clearly was one of the plaintiffs’ attorney’s motivations in bringing the action. The Law.com article linked above quote the attorney as saying that ERISA provides "an easier and quicker route in repairing the damage."

 

By was of comparison, the attorney cites as the shortcomings (from his perspective) of seeking relief under the securities laws, the "high burden of proving fraud" and the "limitations on showing third parties were at fault." The attorney said that while Madoff may have been involved in fraud, "it would be much more difficult to prove that third-party investment funds that invested with Madoff were also defrauding clients."

 

The other interesting thing about the fact that this lawsuit was filed under ERISA is that it at least potentially draws into the mix yet another type of insurance. Up to this point, the likeliest source of insurance funds in connection with the prior Madoff-related lawsuits has been the target defendants’ D&O insurance or errors and omissions (E&O) insurance. A claim under ERISA at least potentially triggers coverage under applicable fiduciary liability policies (if any). The spread of Madoff-related insurance exposure to include fiduciary liability coverage may not have been among the factors considered in earlier estimates about aggregate Madoff-related insurance losses.

 

The final interesting thing about this lawsuit is what it says about just how broad the pool of Madoff-related defendants has become. The plaintiff pension fund in this lawsuit did not invest with Madoff. It did not even invest with a Madoff feeder fund. Instead, it invested with an investment advisor that invested with a feeder fund that in turn invested with Madoff. (Got that?) The sheer span of these increasingly remote connections required to establish the Madoff-related link underscores just how widespread the Madoff litigation may yet become.

 

I have in any event added the new lawsuit to my running tally of all Madoff-related litigation, which can be accessed here.

 

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On November 11, 2008, Citigroup (here) and Fannie Mae and Freddie Mac (here) announced plans to modify existing home loans in an attempt to help borrowers avoid further foreclosures.

 

These mortgage relief efforts unquestionably are constructive, even praiseworthy. But as noted on the Real Time Economics blog (here), these efforts represent only a “drop in the bucket.” Among other concerns is that these relief initiatives can only reach “whole loans,” those that have not been broken up and sold into complex debt instruments. Apparently only 20% of troubled loans are whole loans.

 

 

As a result, for example, the Citigroup program addresses only mortgages the company itself still holds. With respect to the mortgages that Citigroup services but does not own, Citigroup says that it “will work diligently with investors to secure their approval to expand the program.”

 

 

The complications that could arise from investors’ interests in the loans that have been sold is becoming apparent in the wake of  the Bank of America’s earlier relief efforts on the mortgage loans it acquired in the Countrywide acquisition. If the upshot from those efforts is any indication, changes to the underlying mortgages made without investors’ assent could well lead to controversy and even litigation.

 

 

Background

 

On October 6, 2008, Bank of America announced (here) a “proactive home retention program that will systematically modify troubled mortgages.” The program, which included up to $8.4 billion in interest rate and principal reductions for nearly 400,000 customers of Countrywide Financial Corporation, was hailed at the time as a “good framework” for similar arrangements with other mortgage companies.

 

 

The program was part of a deal Bank of America reached with the attorneys general of several states to settle claims brought regarding risky loans that Countrywide had originated. The press coverage at the time (refer here) noted that the deal would impact investors that own securities composed of mortgages originated by Countrywide, and that investors’ approval of the deal was required.

 

 

Investor’ Concerns

 

According to a November 10, 2008 Charlotte Observer article (here), it appears that investors may be balking at the Countrywide mortgage deal, and some may be considering suing.

The article cites a white paper (here) prepared by the New York law firm of Grais & Ellsworth, which paper asserts with respect to the deal that “even though Countrywide’s own conduct (or misconduct)” necessitated the deal,

 

 

Countrywide plans to pay not a cent of its own (or, rather, of its parent Bank of America) toward the $8.4 billion. Instead, it plans to impose the cost of its settlement on the trusts into which the to-be-modified loans were securitized, and thereby onto holders of certificates in those trusts. In our view, Countrywide’s plan will violate the agreements that govern those trusts.

 

 

The Charlotte Observer article quotes Bruce Boisture of Grais & Ellsworth as saying that as the deal reduces mortgage interest rates and principal balances, less cash will be paid into the mortgage trusts, as a result of which the trusts will note have enough cash to pay the trusts’ obligations. Boisture estimates that “385 trusts, representing hundreds of investors and outstanding debt originally worth $465 billion, could be eligible for a lawsuit.”

 

 

The white paper asserts that Countrywide had a “hopeless conflict of interest” between its obligations as the mortgage servicer under the securitization documents and as the originating lender that had allegedly engaged in predatory lending. Countrywide’s agreement as the mortgage servicer to modify the mortgages might extinguish the Countrywide’s liability as the loan originator, but, the white paper asserts, the agreements violate Countrywide’s obligations as the loan servicer under the securitization documents.

 

 

The white paper concludes by arguing that:

 

 

Countrywide and B of A must be assuming that the $8.4 billion will be spread over enough certificateholders that none will think it worth the trouble to protest. By working together for their mutual protection, certificateholders can disabuse Countrywide and B of A of this unfortunate assumption.

 

 

According to its website (here), the law firm is hosting a November 18, 2008 webcast “to brief investors” on Countrywide’s plan. The website states that the firm and several investors “are now organizing a coalition to contest Countrywide’s plan through demands on the trustees, and, if necessary, litigation.”

 

 

Discussion

The questions being raised on behalf of the investors in the securities backed by the Countrywide mortgages underscores how difficult it could be to try to provide relief to borrowers whose mortgages were broken up and sold. As the white paper contends, mortgage restructuring potentially could violate the rights of investors owning securities backed by the mortgages.

 

The dispersion of the Countrywide mortgages amongst as many as 385 trusts and many more investors demonstrates how daunting it could be to secure investors’ consent to the mortgage adjustments. While one might argue that investors would be better of if there are fewer foreclosures, obtaining the assent of investors, who may or may not agree, could prove challenging.

 

 

It may be worth noting that mortgage restructuring may not only arguably harm the interests of the investors directly involved, but it could also undermine the appetite of potential future investors for similar investments. If future investors cannot be confident that their interests will not be altered, efforts to reinvigorate the securitization process (and by extension, the home lending process) could be impeded.

 

 

The investors’ objections to the Bank of America mortgage workout deal and the prospect of litigation on the investors’ behalf highlights how challenging it may be to come up with solutions that address the predicament of all of the mortgage borrowers.

 

 

In each of bailouts and workouts that have flowed across the front pages of the nations’ newspapers in recent days, there have been constituencies that have been aided but there are also constituencies that have been harmed. Equity interests have been diluted or wiped out, debt interests have been subordinated or extinguished, and other interested parties have similarly been disadvantaged..

 

 

Some of these disadvantaged parties have sued. For example, AIG shareholders have initiated an action in the Delaware courts seeking to assert their rights to vote on the (original) AIG bailout. There undoubtedly will be others of these disadvantaged constituencies that will bring their grievances to the courts. Including, perhaps, the investors that purchased securities backed by the Countrywide mortgages.

 

 

More ERISA Lawsuits: It may be argued that the aggrieved constituencies include, at least in some instances, the employees of the bailed out companies. That appears to be the position of the plaintiffs’ attorneys who, according to their  November 10, 2008 press release (here), have filed a class action against Fannie Mae under ERISA on behalf of Fannie Mae employees who participated in the Fannie Mae ESOP between April 17, 2007 and the present and whose accounts included Fannie Mae common stock.

 

 

There may well be employees of other companies that have been affected by the recent financial market turmoil that similarly file actions under ERISA. For example, the Milberg firm issued a November 10, 2008 press release (here) that it is “investigating illegal conduct” by the Hartford Financial Group and certain fiduciaries of the Hartford Investment and Savings Plan. The purported investigation involves supposed violations of ERISA.

 

 

The new Fannie Mae ERISA action is merely the latest in a series of actions that have been filed under ERISA as part of the subprime meltdown and the current financial crisis. Since the beginning of the subprime meltdown I have been tallying these ERISA lawsuits here. With the addition of the Fannie Mae lawsuit, the current tally now stands at 19.

 

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About the UnitedHealth Group Class Action Settlement: UnitedHealth Group announced on July 2, 2008 (here) that it reached an agreement to settle its high profile options backdating-related securities class action lawsuit for $895 million. A July 3, 2008 Law.com article discussing the settlement can be found here.

 

Not only is this settlement the largest options backdating related securities lawsuit settlement to date, it is one of the largest securities settlements ever. The settlement does at least provide some counterweight to the view that some have expressed (refer here) that the options backdating related lawsuits may be settling low compared to historical standards.

 

This settlement, together with the $750 million Xerox settlement announced in March 2008 (including $80 million from the company’s auditor) and the flood of high profile, high stakes subprime-related litigation, may also undercut the view that has been expressed that overall settlements may begin to decline as the cases from the era of corporate scandals cycle out of the system.

 

It is probably worth noting that, as reported in the July 3, 2008 Wall Street Journal (here), the UnitedHealth settlement has not yet been completely resolved, as the settlement does not include United ealth’s former CEO William McGuire, nor does it include its former General Counsel, David Lubben.

 

Although it has not received nearly as much attention, it is also noteworthy that in its July 2 press release UnitedHealth also announced that it had also settled for $17 million the options backdating related ERISA lawsuit pending against the company and certain of its officials. As far as I am aware, this is the roughly half dozen options backdating related ERISA lawsuit to have settled. (To see a complete list of options backdating related ERISA lawsuits, refer here.)

 

Derivative litigation related to the options backdating woes at UnitedHealth previously resulted in the largest reported derivative settlement, as I discussed in a prior post, here.

 

I have added the UnitedHealth options backdating securities class action lawsuit settlement and ERISA lawsuit settlement to my table of the options backdating related settlements and dismissals, which can be accessed here.

 

Credit Rating Lawsuits: As I discussed in a recent post (here), even though the credit rating agencies’ conflicted role has been a central topic in the discussions surrounding the subprime meltdown, the plaintiffs’ lawyers have largely avoided drawing the credit rating agencies into the subprime litigation. However, lawsuits filed just in the past several days suggest that this may be changing, in addition to the lawsuit discussed in my prior post.

 

Though the plaintiffs’ lawyers had not generally been targeting the credit rating agencies for their rating activities, they have previously filed lawsuits on behalf of the shareholders of Moody’s (refer here) and  of The McGraw Hill Company, parent of Standard & Poor’s (refer here), alleging misrepresentation in their financial disclosures.

 

As described in a July 1, 2008 press release (here), plaintiffs’ lawyers have now initiated a shareholder securities class action lawsuit against Fimalac, S.A., the corporate parent of Fitch’s rating agency. According to the press release, the complaint (which can be found here) alleges that the defendants failed to disclose with respect to Fitch’s ratings of Residential Mortgage Backed Securities (RMBS) and Collateralized Debt Obligations (CDO) that:

(i) the information upon which Fitch based its ratings of RMBS and CDOs was misleading and in many cases fraudulent; (ii) to continue to collect fees for its ratings, Fitch was applying lax standards or no standards at all when issuing its RMBS and CDO ratings; and (iii) Fitch was failing to monitor the credit quality of RMBS and CDOs after issuing its initial ratings, as Fitch was obligated to do, and many of these securities had deteriorated badly after Fitch had issued its ratings. Fitch is now under investigation by the New York Attorney General, the Connecticut Attorney General, the Ohio Attorney General and the SEC as a result of its practices of rating billions of dollars of securities without a reasonable basis for doing so and Fimalac’s stock is trading at approximately 50% of its Class Period high.

But the new Fimilac shareholder lawsuit is directed against Fimilac as a reporting company, not directly against the company for Fitch’s rating agency activities. As I noted in my prior post, plaintiffs' lawyers have largely avoided allegations against rating agencies for their rating activities. However, in a lawsuit initiated in New York state court on June 3 , 2008 and removed to federal court on June 23, 2008, plaintiffs have alleged that entities affiliated with Credit Suisse, and the Moody’s, S&P  and the Dominion Bond Rating Service (DRBS) rating agencies misrepresented the values of Mortgage Pass-Through Certificates issued by the Home Equity Mortgage Trusts. (Refer here for background regarding the lawsuit.)

 

The basis of the claims of liability against the rating agencies in the Home Equity Mortgage Trust lawsuit, as alleged in paragraph 87 of the complaint (here), is that  the rating agencies  “prepared valuations, i.e., assigned ratings to the Certificates, in connection with the Offering, as defined in Section 11 (a)(4) of the Securities Act.” These allegations are similar to the allegations against the credit rating agencies in the HarborView case discussed in my prior post.

 

Whether or not these cases against the credit rating agencies for their rating activities ultimately go forward remains to be seen. As I have previously discussed (here), the credit rating agencies will contend that their rating activities are protected by the First Amendment.

 

In addition, it remains to be seen whether the Home Equity Mortgage Trust case will go forward in state or federal court. As discussed at length in my prior post (here), the ’33 Act expressly provides for concurrent state court jurisdiction and also expressly proscribes removal of state court ’33 Act actions to federal court. As discussed here, in at least one case, a federal court has concluded that a ’33 Act claim that has been initiated in state court and removed to federal court must be remanded back to state court.

 

One More Note About the Fimalac Lawsuit:  Fimilac is a foreign-domiciled company whose shares do not trade on U.S. exchanges. Many of its shareholders obviously are domiciled outside the United States. If these non-U.S. shareholders were to be included in the class, the new class action complaint against Fimilac might present the complicated f-cubed litigant problem (which I discussed most recently here). However, the plaintiffs’ counsel in the Fimilac case purport to represent a class composed solely of U.S. residents, apparently as a way of avoiding the f-cubed litigant problem.

 

As I discussed in my recent post relating to the new securities class action filed against EADS (refer here), these attempts to plead around the issues involving foreign-domiciled  plaintiffs still test the outer limits of the jurisdictional reach of U.S. securities laws against foreign-domiciled companies whose shares do not trade on U.S. exchanges. The case against Fimilac will be interesting to watch for reasons other than the involvement of a credit rating agency.

 

And Finally: The news about the dismissal of the lawsuit against Richard Grasso has gained a great deal of press attention. Indeed, the Wall Street Journal, in a July 3, 2008 editorial (here), congratulates Grasso and fellow defendant Kenneth Langone for their success in fighting the lawsuit, which the Journal viewed as an example of the overreaching of former New York AG Eliot Spitzer.  

 

The Journal’s editorial is perhaps closest to the mark in its observation that “Mr. Grasso is fortunate he had the resources to fight back.” Had Grasso not had the wherewithal to resist, he might never have tasted vindication. Readers of this blog will be particularly interested to know that it was insurance funds – a very large amount of insurance funds – that ultimately allowed Grasso to succeed.

 

According to Langone, and as reported on Bloomberg (here), in defending themselves against the lawsuit, Grasso, Langone and the NYSE directors “spent more than $70 million fighting the case, all covered by insurance.”

 

So Grasso is indeed fortunate that he had the resources to fight back, but perhaps contrary to the Journal’s suggestion, and even Grasso’s own prior comments (refer here) it was not his own treasure that financed the fight.

 

The expenditure of the mind-boggling sum of $70 million in litigating this case is yet another reminder of the extraordinary costs associated with the kind of high stakes litigation in which directors and officers can become involved. As I recently noted (here), the escalating expense associated with this kind of litigation has important implications for limits adequacy assumptions.

 

While it may be that only extraordinary cases consume these astonishing quantities of money, a company’s D&O program is expected to be able to respond even to catastrophic claims. As seems to be increasingly apparent, the costs associated with just defending a catastrophic claim could exhaust many insurance programs. All of this may suggest the need to reexamine conventional assumptions about limits adequacy.

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In an April 9, 2008 opinion (here) written by Chief Judge Frank Easterbrook, the Seventh Circuit held that there was no coverage under Arthur Anderson’s fiduciary liability policy for the firm’s settlement of a retiree pension benefits dispute.

The dispute arose after the firm’s Enron-related difficulties undercut the firm’s ability to honor retirees’ demands for lump-sum payment of retirement benefits. Litigation ensued. The retirees claimed, among other things, that the firm had breached its duties under ERISA. The firm retained defense counsel and also (through its broker) provided notice of claim to its fiduciary liability insurer. The plaintiffs then voluntarily dismissed the lawsuits and initiated arbitration proceedings instead. (The full details of the underlying retiree dispute and of the communications between the firm’s representatives and the insurer are set out at length in the district court’s summary judgment opinion, here.)

In November 2002, Arthur Anderson “proposed a compromise to all retirees and wrote to its insurers that it needed at least $75 million from them to fund a settlement.” The firm asked its primary fiduciary liability insurer to tender its full $25 million policy limit. The insurer responded that the arbitration claim did not allege negligence or breach of any fiduciary duty, but rather that it was a “pure contract action” for benefits due, for payment of which coverage is precluded under the terms of its policy. (The relevant policy provisions are set out in the district court opinion linked above.)

In January 2003, the firm settled with most of the retirees for $168 million, and it ultimately settled with the rest of the retirees in 2006 for a further $63 million. In February 2003, the fiduciary liability insurer initiated an action for a judicial declaration that it was not required to defend or indemnify Arthur Anderson.

The district court held (here) that the policy does not require the insurer to fund the settlement but that (as later summarized by the Seventh Circuit), the insurer’s “failure to provide a defense coupled with its delay in filing the declaratory judgment action might require it to pay anyway.” Following a jury trial, the district court entered judgment in the insurer’s favor except to hold that the insurer was liability for $5 million toward the arbitration settlement. Both sides appealed.

The Seventh Circuit affirmed the district court except to reverse as to the $5 million payment required toward the settlement. The Seventh Circuit found first that there was no coverage under the fiduciary liability policy for the retirees’ arbitration claim, because it did not allege negligence or breach of a fiduciary duty, but rather was limited exclusively to an alleged breach of contract. The Seventh Circuit also held that the policy’s “benefits due” exclusion also precluded coverage. Judge Easterbrook commented that “the settlement reflects the present value of the pension promise…rather than damages for anyone’s misconduct,” and he noted further that:

No insurer agrees to cover pension benefits; moral hazard would wipe out the market. As soon as it had purchased a policy, the employer would simply abandon its pension plan and shift the burden to the insurer. Knowing of this incentive, the insurer would set as a premium the policy’s highest indemnity, and no “insurance” would remain. Illinois would not read a policy in a way that made it impossible for people to buy the insurance product they want (here, coverage of negligence and disloyalty by pension fiduciaries).

The Seventh Circuit also found that the firm’s failure to obtain the insurer’s prior consent to the settlement provided another preclusion to coverage. Judge Easterbrook noted that “Arthur Anderson didn’t ask for the consent or even the comments of its insurer; it presented the deal to them as a fait accompli. By cutting [the insurer] out of the process, Arthur Anderson gave up any claim of indemnity.”

Having decided that there was no coverage under the policy, the Seventh Circuit then went on to consider whether Illinois principles of “equitable estoppel” nonetheless barred the insurer from asserting its defenses to coverage, as a result of the insurer’s delay in providing a defense and bringing its declaratory judgment action.

The Seventh Circuit first considered the question of what constitutes “delay,” noting that “treating eight months,” the period of the insurer’s putative delay, “as excessive is questionable.” Judge Easterbrook also noted that had the firm complied with the policy’s advance consent to settlement requirement, the insurer could have filed its declaratory judgment before the settlement.

In the end, the Seventh Circuit concluded that the question whether eight months constitutes delay is irrelevant, since at no point did the firm ever ask the insurer “to send a team of lawyers to represent it”; rather, the firm “made it clear that it would control both the defense and the law firm conducting the defense.” By “not tendering its defense," the firm “gave up and basis for demanding immediate action by the insurer.” Judge Easterbrook noted that:

An insured’s need to have legal assistance for its defense from the outset of a suit is the main justification for the rule that Illinois has adopted. When the insured does not want the insurer to supply a defense (lest the insurer also control the defense), it has no complaint if the insurer takes a while to contemplate the question of indemnity. The urgent need is for a defense to the pending suit; liability for indemnity (the coverage question) can safely be decided later.

Finally, Judge Easterbrook concluded that the insurer did not in the end have a duty to defend as the arbitration complaint was “based on contract and nothing but.”

There are several noteworthy things about Judge Easterbrook’s opinion. The first pertains to his commentary that adverse consequences might follow if the insurer were compelled to fund the settlement. It is the very rare court that is willing to consider not only that in some circumstances compelling the insurer to pay might not only undermine the existence of the market for that type of insurance, but could even constitute a “moral hazard.” Judge Easterbrook’s analysis evinces an unusually developed understanding of the insurance mechanism’s fundamental components.

The court’s analysis of the consent to settlement requirement is also noteworthy; indeed, the Seventh Circuit’s discussion of this issue in many ways mirrors the analysis of the recent New York Court of Appeals opinion (discussed here) in which the New York court also enforced the consent to settlement opinion strictly according to its terms. These two holdings underscore not only that the provision means what it says but also that it will be enforced according to its terms. These rulings unmistakably highlight that policyholders who fail to follow the policy’s requirement for advance consent to settlement do so at peril to their insurance coverage.

There is a further important lesson from this case, one that is similar to the lesson of the prior New York case, and that is that nothing good comes from a policyholder’s failure to keep the insurer in the loop. Indeed, if there is one common element in almost every litigated coverage dispute, it is that at some point preceding the litigation, there was some breakdown in communications between the policyholder and the insurer.

There are no guarantees that carriers will respond appropriately even when they are provided with full information. But the single most important way for policyholders to reduce the possibility of a litigated dispute with their insurer is to maintain full and professional communications with their insurer. Indeed, point number on in my list of “Seven Ways Counsel Can Help Clients with D&O Claims” (here) is to “Keep the Carrier Informed.”

Finally, I note that the Seventh Circuit’s discussion of the “benefits due” exclusion is an important accompaniment to my analysis (here) of the insurance implications of the U.S. Supreme Court’s opinion in the LaRue case. As Judge Easterbrook’s opinion makes clear, these policies are not intended to provide a substitute funding mechanism for companies’ benefit obligations to their employees. However, the policies are intended to provide companies with indemnity protection when an insured’s alleged or actual negligence or breach of a fiduciary duty harms a plan participant’s interests. For that reason, it is analytically consistent for insurers to offer, as some now do, an endorsement to their policies to carve out from the benefits due exclusion an agreement to cover a plan participant’s claim of harm to their individual plan investment interests, of the kind recognized in the LaRue decision.

Special thanks to a loyal reader for providing me with a copy of the Seventh Circuit’s opinion.

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On February 20, 2008, the United States Supreme Court issued a unanimous holding (here) in LaRue v. DeWolff, Boberg & Associates that ERISA authorizes individual defined contribution plan participants to sue for fiduciary breaches that impair the value of plan assets in the individual’s plan account. This holding could have important implications for future ERISA litigation activity, and the individuals’ claims potentially could present significant insurance coverage issues.

James LaRue is a former employee of DeWolff, Boberg & Associates. He participated in DeWolff’s 401(k) plan. He claims that in 2001 and 2002 he directed DeWolff to “make certain changes to the investments in his individual account” but that DeWolff never made the changes and that this omission “depleted” his interest in the plan by $150,000.

LaRue sued the DeWolff firm and the DeWolff 401(k) plan seeking “make whole” or other equitable relief under Section 502(a)(3) of ERISA, codified as 29 U.S.C. Section 1132(a)(3). (Section 502, which is referred to throughout this post, can be accessed here.)

The district court dismissed LaRue’s complaint on the grounds that LaRue sought money damages, which are not permitted under Section 502(a)(3).

LaRue appealed to the Fourth Circuit, in reliance on both Section 502(a)(2) and 502(a)(3). The Fourth Circuit affirmed the Section 502(a)(3) dismissal on the same grounds as the district court. The Fourth Circuit rejected LaRue’s Section 502(a)(2) claim on the ground that the Supreme Court’s 1985 opinion in Massachusetts Life Ins.Co. v. Russell permitted Section 502(a)(2) claims only on behalf of the entire plan rather than on behalf of any one participant’s individual interest. LaRue sought and obtained a writ of certiorari to the United States Supreme Court.

Associate Justice John Paul Stevens wrote the majority opinion for the court. (There were two concurring opinions, one by Chief Justice Roberts, in which Justice Kennedy joined, and one by Justice Thomas, in which Justice Scalia joined). The majority opinion held that an individual plan participant does have the right to pursue an individual action, notwithstanding the court’s prior holding the Russell case (the majority opinion for which Justice Stevens also wrote). The majority opinion’s analysis turns on the view that, by contrast to the era when ERISA was first enacted and defined benefit plans predominated, “defined contribution plans dominate the retirement scene today.”

The circumstances for an individual participant in a defined benefit plan, Justice Stevens wrote, are quite different than under a defined contribution plan because misconduct relating to a defined benefit plan would not affect any one individual’s plan interest unless the misconduct caused a default of the defined benefit plan itself. Justice Stevens wrote that:

For defined contribution plans, however, fiduciary misconduct need not threaten the solvency of the entire plan to reduce benefits below the amount that participants would otherwise receive. Whether a fiduciary breach diminishes plan assets payable to all participants and beneficiaries, or only to persons tied to particular individual accounts, it creates the kind of harms that concerned the draftsmen of [ERISA’s liability provisions]. Consequently, our references to the “entire plan” in Russell…are beside the point in the defined contribution context.

Accordingly, the court held that Section 502(a)(2) “does authorize recovery for fiduciary breaches that impair the value of plan assets in a participant’s individual account.” The court vacated the Fourth Circuit’s judgment and remanded the case for further proceedings.

Press coverage of the LaRue case has suggested ( for example, here) that the decision may trigger “a raft of lawsuits by employees, particularly as stock market volatility once again is causing havoc with investment accounts.” It may well be that the LaRue decision will lead to a wave of new employee driven litigation. However, employees considering a lawsuit like LaRue’s should consider several things about the Supreme Court’s opinion.

The first is that the only thing LaRue has won is the right to continue his fight. He must now go back to the trial court to substantiate his claim. Justice Stevens specifically noted that “we do not decide whether petitioner made the alleged declarations in accordance with the requirements specified in the plan.”

An additional consideration is that LaRue will still have to overcome potentially significant defenses. For example, Justice Stevens also noted that the court did not decide whether LaRue is “required to exhaust remedies set forth in the Plan before seeking relief in federal court pursuant to Section 502(a)(2).” (Justice Roberts’ concurring opinion has extensive, technical discussion of the “exhaustion of administrative remedies” issue; suffice it to say here that the applicability of the exhaustion requirement is at best unresolved.)

Justice Stevens also said that the court did not resolve the question whether LaRue “asserted his rights in a timely fashion.”

In other words, even though LaRue’s has survived to fight another day, on remand he will face both potentially formidable defenses and daunting evidentiary challenges. Just because an individual may now have the right to pursue an individual claim for 401(k) losses does not mean that the individual has a great claim. Portfolio.com has a more detailed discussion of these issues here, stating among other things that “a ruling that should have been a comfort for the workingman is now a cause of concern.”

But assuming for the sake of argument that the LaRue decision will indeed result in a flood of litigation, these potential claims present a daunting prospect for company 401(k) plan sponsors. The possibility of many small, potentially vexatious individual claims arising out of the company’s defined contribution plan is an unwelcome development.

The prospect of a flood of claims also immediately presents questions about the availability of insurance protection for the claims. I have already had discussions with persons in the insurance industry about how the typical fiduciary liability policy might respond to this type of claim. These discussions have been preliminary only, but one question that has arisen is whether these individual 401(k) claims would trigger the “benefits due” exclusion found in the typical fiduciary liability policy.

While the various carriers’ policies vary, a fairly typical “benefits due” exclusion provides that the carrier “shall not be liable for that part of Loss, other than Defense Costs” that

constitutes benefits due or to become due under the terms of a Benefit Program unless, and to the extent that, (i) the Insured is a natural person and the benefits are payable by such Insured  as a personal obligation, and (ii) recovery of the benefits is based on a covered Wrongful Act.

There are several important considerations presented in this language, but a preliminary (and perhaps preclusive) consideration is whether the “benefits due” exclusion would even apply to the kind of claim LaRue asserted. This preliminary consideration turns on a critical distinction about LaRue’s claim. That is, his claims for breach of fiduciary duty were based on Section 502(a)(2), and he did not assert claims for “benefits due” under Section 502(a)(1)(B). Indeed, in his concurring opinion, Chief Justice Roberts made much of this distinction, and in fact argues that LaRue should have filed his claim as a benefits due claim under 502(a)(1)(B) – which would more clearly have required exhaustion of administrative remedies – rather than as a claim for breach of fiduciary duty under 502(a)(2). A subtle statutory distinction perhaps, but it strongly suggests that the “benefits due” exclusion is irrelevant to an individual’s breach of fiduciary duty claim under Section 502(a)(2).

(For regular practitioners in this area, the foregoing distinction may be obvious, but as I am only an occasional  visitor to this area of the law, the establishment of these critical distinctions requires conscious effort on my part)

Even assuming that the exclusion would be triggered, there are also several additional considerations that would determine how the exclusion would be applied. The first is that the exclusion does not in any event apply to defense expenses. This defense cost carve out from the exclusion could be very significant for companies confronted with a wave of individual employee 401(k) lawsuits. A host of small cases could become very expensive to defend.

The second point about the exclusion is that the exclusion’s coverage carve back at least preserves coverage for natural person insureds with a “personal obligation” to pay benefits due. (ERISA Section 409(a), the statute’s liability provision, specifies that plan fiduciaries are “personally liable”). Natural person fiduciaries are sometimes named as defendants in ERISA lawsuits, but it is noteworthy that LaRue at least named no natural person defendants in his lawsuit. If there were both natural person and entity defendants, and if this exclusion is otherwise triggered, there could potentially be difficult allocation issues for indemnity amounts.

One final note about the insurance issues is that most 401(k) plans are administered by third-party service providers. Plan fiduciaries of course retain their fiduciary responsibilities even if the plan retains a third party administrator, but to the extent insurers foot a loss, they might well seek to subrogate against the third party administrators.

The LaRue decision is still very fresh and reactions are still emerging. One issue that will be particularly interesting to watch, if the predicted flood of individual claims does indeed arise, is whether insurers will respond either through altered terms and conditions (such as requiring increased per claim self-insured retentions as a barrier to low level defense expense) or through changed pricing structures. Dramatic changes seem unlikely in the current environment, but if there really is a flood of claim, insurers may well react.

A particularly good, albeit technical, analysis of the LaRue decision can be found on the Workplace Prof Blog (here). An interesting analysis of the differences between and among the majority and the two concurring opinions can be found on the Boston ERISA & Insurance Litigation Blog (here).

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Earlier in the summer, it was a seemingly daily occurrence for one or more public companies to announce that they were launching internal probes of their options practices. (These announcements were accompanied, and no doubt encouraged, by numerous simultaneous announcements of SEC probes, U.S. Attorney's subpoenas, and the like.) Now as the summer has, alas, started to wane, the wave of new investigation announcements seems to have been replaced by a growing number of companies' announcements that they have completed their internal investigations and found no evidence of options fraud or timing manipulations.

Just in the last week, Intuit, Xilink, Equinix and Redback have each announced that they have completed internal investigations without finding intentional or fraudulent misconduct. The companies also announced that they have so advised governmental authorities. Several of these companies did announce that they were taking accounting charges, without restating, because their probes had found that some options were dated earlier than the actual grant date, due to administrative or processing delays.

In addition, on August 21, 2006, the Corporate Library announced (here) the results of a study of the stock options granted over the past decade by a dozen financial institutions. The study looked at stock option awards to executives at the nation's five largest banks, and at several other financial companies that made use of options. The study found no evidence of backdating of options issued to the executives at the institutions whose options were analyzed.

The AAO Weblog has an interesting August 21, 2006 post about Intuit's announcement, including a discussion of the factors that will affect how long these kinds of internal investigations are likely to take to complete.

Milberg Weiss Indictment Fall Out Continues: The WSJ Law Blog has an August 21, 2006 post reporting that four more partners have left the Milberg Weiss firm. At this rate, it may wind to be a moot point whether or not the prosecutors actually prove their allegations against the firm. In the meantime, Saxena and White, formed of attorneys from Milberg's Boca Raton office (including Chris Jones, the author of the PSLRA Nugget blog), has surfaced with an announcement of the filing of a securities class action complaint, as discussed here in the Lies, Damned Lies blog.

As The D & O Diary has previously noted (here and here), it is hard to say what the final consequential effect of the Milberg Weiss indictment will be, but the firm's slow dissolution and the setting up of competitor (successor) firms will each have their own impact, as will the perhaps opportunistic attraction to the securities litigation arena of plaintiffs' firms best known for their prominence in asbestos and tobacco litigation.

Freddie Mac Settles ERISA Lawsuit: Freddie Mac announced (here) on August 21, 2006 that it had agreed to pay $4.65 million to settle a class-action lawsuit that had been brought under ERISA following the company's restatement of financial results for the years 2000 through 2002. The company had been accused of overstating its earnings, inflating the value of its shares. Some of the allegely inflated stock was held in employee retirement plans. The company announced that the settlement was fully covered by insurance.

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