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

Securities class action lawsuit filings in Canada hit record levels in 2011 according to a new report from NERA Economic Consulting. The January 31, 2012 report, entitled “Trends in Canadian Securities Class Actions: 2011 Update” (here) concludes that the persistent growth in Canadian securities class action lawsuit filings “is not a transient phenomenon.”

 

According to the report, in 2011, there were 15 new securities class action lawsuit filing in 2011, more than in any previous year. The 2011 filings bring the total number of pending and unresolved Canadian securities class action lawsuit filings to 45.

 

The growth in securities lawsuit filings in Canada is largely a result of the growth in new filings under Bill 198, the Ontario legislation that amended the Ontario securities laws with regard to issuer’s continuous disclosure obligations. The report notes that there have been a total 35 Bill 198 cases since the Act became effective at the end of 2005, including nine in 2011. The Bill 198 cases account for more than two-thirds of all of the suits filed between 2008 and 2011. The other claims filed in 2011 include, among other things, one prospectus claim; one related to a takeover bid; two related to investment fund management; and two related to Ponzi schemes.

 

Just as was the case with 2011 securities lawsuit filing in the U.S, a significant driver in the 2011 Canadian filings was the rise in filings against Chinese companies whose shares trade on North American exchanges. Among the highest profile case in Canada was the lawsuit involving Sino-Forest, whose shares trade on the Toronto stock exchange. (As noted here, U.S. investors recently have attempted to bring a class action in U.S. federal court against Sino Forest alleging violations of NY state law.) At least three of the other new 2011 filings involve Chinese companies.

 

Interestingly, the report notes that one Chinese company involved in a 2010 Canadian securities lawsuit filing did not have shares listed on a Canadian exchange, but did have shares listed on Nasdaq. So far, the case, involving Canadian Solar, has been permitted to proceed.

 

Canadian companies with listings on U.S. exchanges also face a securities class action litigation risk. The report notes that in 2011, five Canadian domiciled companies were named as defendants in six securities class action lawsuits in the U.S. At least one of these companies was also named in a securities class action lawsuit in Ontario. Since 1987, Canadian-domiciled companies have been named in 74 securities lawsuits in the U.S. Of these, 21 had parallel actions in the U.S., although most of these parallel actions were filed after the enactment of Bill 198.

 

Historically, class action lawsuit filings in Canada have been concentrated in the financial sector, as well as the energy and minerals sectors. In 2011, five of the Canadian filings involved companies in the minerals sector and four involved companies in the finance sector.

 

Only two cases settled in 2011, involving total payments of $58.6 million. Of the ten settlements so far of Bill 198 cases, the average settlement amount is $10 million and the median settlement is $6.2 million. The report notes that given the small number of settlements to date, “it is unclear whether these are indicative of the size of settlements that should be expected in the future.”

 

The report concludes that the upward filing trend is likely to continue in 2012 and beyond. The report’s authors cite a number of factors in support of their conclusion that “we are likely to continue to see an increasing number of new cases filed,” including the growth in the Canadian securities class action bar; the track record that has been established with the certification of global classes (in the IMAX and Arctic Glacier cases) and with plaintiffs being given leave to proceed in Bill 198 cases; the success of counsel in achieving large settlements (and obtaining large fees); and the barriers in the U.S. under the Morrison decision to investors who purchased shares outside the U.S. proceeding in U.S. courts.

 

Discussion

Although the number of securities class action lawsuit filings in Canadian courts remains well below the number of filings in the U.S., both the growth in the filings and the indicated trends suggest that Canadian securities class action litigation could be increasingly important.

 

The report’s comment about the growth in the size of the Canadian plaintiffs’ securities bar may be the most telling point. Clearly, the plaintiffs’ attorneys sense that there is an opportunity. As non-U.S. investors search for alternative ways to pursue claims in the wake of the U.S. Supreme Court’s decision in Morrison, Canada may be emerging as one of the most attractive alternatives. The Canadian courts’ willingness to certify global classes in the IMAX and Arctic Glacier cases suggests the opportunity for investors to pursue their claims in Canadian courts.

 

Among the many very interesting comments in the NERA study of Canadian securities litigation was the comment about the action that is pending in Canada against Canadian Solar, Inc. The case has been allowed to proceed so far, even though the company’s shares did not trade on a Canadian securities exchange but did trade on Nasdaq. Although there undoubtedly is more to the story, it is interesting to note that the investors chose to file their action in Canada. The company has also been sued in a separate action in the U.S. (refer here), but the circumstances do suggest the possibility of an emerging jurisdictional competition.

 

The sense of a jurisdictional competition is reinforced with the filing of the state law class action filed by Sino-Forest in the U.S. The same circumstances were also the subject of a separate action in Canadian court.

 

The emergence and growth of significant securities class action litigation outside the U.S. is one of the most interesting developments in recent years, and the U.S. Supreme Court’s holding in the Morrison case has added increased importance to the issue. It could be increasingly important to watch developments in Canada and elsewhere.

 

Special thanks to NERA for providing me with a copy of their report.

 

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The changing mix of corporate and securities litigation is a recent phenomenon on which I have frequently commented on this blog. While identifying the fact of the change is relatively straightforward, explaining it is more challenging. According to a January 11, 2012 article in The Review of Securities & Commodities Regulation entitled “Shareholder Litigation After the Fall of an Iron Curtain” (here), written by Boris Feldman of the Wilson Sonsini law firm, the changing pattern in corporate and securities litigation filings is a result of changes in the plaintiffs’ securities litigation bar – particularly, the elimination of a dominant plaintiffs’ firm. These changes, according to Feldman, have resulted in the five recent securities litigation trends he identifies in his article.

 

For many years, according to the article, the Milberg Weiss law firm was the “dominant securities plaintiffs’ law firm.” Even after it split into two separate law firms on the East and West Coasts, it was, according to Feldman, “the 800-pound gorilla of the shareholder litigation jungle.” In addition to dominating the litigation, the firm “exercised some discipline” on the rest of the plaintiffs’ securities bar, demonstrating “substantial influence over smaller firms and parvenus.”

 

Now, “for reasons of retirement and incarceration,” the familiar patterns of the past have been disrupted. Feldman analogizes this disruption in the standard order of the securities litigation world to the disruptions that followed in the political world in the wake of the fall of the Iron Curtain.

 

Without a dominant firm, smaller firms are now “free agents,” and new entrants have appeared. These smaller and newer players are “less predictable (and often less rational).” According to Feldman, these changes in the plaintiffs’ bar explain five trends in shareholder litigation he identifies in his article.

 

First, Feldman notes the recent rise in multi-jurisdiction litigation, where a single company can face multiple suits in different jurisdictions arising out of the identical factual circumstances. Feldman notes that although this might have happened from time to time in the past, when it did, the plaintiffs firms worked things out among themselves. But this is far less common now. Instead, firms that have “decided they have a better shot at participating in the litigation” have consciously chosen to file outside the company’s home jurisdiction, particularly in connection with shareholder derivative litigation. This multiplication of litigation has forced corporate defendants to have to defend themselves in multiple courts, resulting in added expense and uncertainty.

 

The second trend Feldman notes is the proliferation of demand letters. In the past, plaintiffs would bypass this statutory prerequisite to the filing of derivative litigation, out of a concern that the demand represented a concession that demand was not futile. More recently, however, demand letters have become “fashionable,” as secondary players, eager “to get in on the action,” will submit a demand even if derivative litigation has already been filed. Feldman notes that this may “actually be advantageous to defendants,” as courts will often stay derivative litigation while the defendant company considers the demand.

 

Third, Feldman notes the rise of derivative litigation paralleling shareholder class action lawsuits. In the past, the type of stock drop that would trigger a 10b-5 class action would not also spawn a derivative suit, at least in the absence of a major accounting problem and restatement. Now, parallel derivative suits are “de rigeuer.” The plaintiffs bar now “just cannot resist cribbing the class complaints,” even though the company’s setback does not suggest any breach by the company’s board. This change is attributable to a simple explanation: “different suits for different folks.”

 

The fourth trend Feldman notes is the automatic filing of litigation when a merger is announced. When “giants roamed the earth,” there was merger objection litigation, but not every single time a merger was announced. Now the litigation is pervasive and it follows a standard pattern of an initial suit alleging a breach of fiduciary duty after the deal is announced, followed by an amended complaint alleging disclosure violations after the proxy has been filed. The other change Feldman notes about this litigation is that in the past, the litigation went away once the deal closed, as the defendants defeated the preliminary injunction seeking to block the deal. Now the merger suits are increasingly surviving the closing, based on amended allegations that “range from weak to laughable.” Though few of these suits result in a payout, the plaintiffs’ lawyers “persist,” seeking “a place in the sun.’

 

Finally, Feldman notes the rise in actions under Section 220 of the Delaware Code seeking to inspect the corporate defendant’s books and records. Feldman says there has been more of this litigation in the past year than in all prior recorded history. In part this rise is due to encouragement from members of the Delaware judiciary. But this rise is also attributable to a cottage industry of plaintiffs’ firms eager to “get in on the action.” Defendant companies find these suits impossible to avoid; whatever they produce, the plaintiffs ask for more until they have “created an impasse and gotten a ticket to sue.” Feldman suggests that this “epidemic” of Section 220 litigation is “unlikely to be solved without intervention by the Delaware legislature.”

 

Feldman closes by suggesting that in the current, rapidly changing world, the “more fragmented world of plaintiffs’ securities lawyers will continue to amaze and surprise us with their innovation and resilience.”

 

Very special thanks to Boris Feldman for sending me a link to his article.

 

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Securities class action filings rise slightly in 2011 compared to the prior year but remained below historical averages according to the annual study of Cornerstone Research, prepared in conjunction with the Stanford Law School Securities Class Action Clearinghouse, which was released today. A copy of the report can be found here, and Cornerstone Research’s January 19, 2012 press release can be found here. My own analysis of the 2011 securities class action lawsuit filings can be found here.

 

According to the report, there were 188 securities class action lawsuit filings in 2011, compared to 176 in 2010, and compared to the 1997 to 2010 average annual average number of filings of 194. The two largest factors in the number of 2011 filings were the heightened number of M&A-related filings (43) and the elevated number of filings involving U.S.-listed Chinese companies. (33).

 

The Cornerstone Research report contains a number of insights about the 2011 filings beyond those that have appeared in previously published analysis of the filings. Among other things, the report notes that three percent of companies listed on the three major U.S. exchanges (NYSE, NASDAQ and Amex) were sued in securities suits in 2011. This represents the highest annual percentage since 2004 and is above the 1997 to 2010 annual average percentage of 2.4 percent.

 

On the other hand, in 2011 only 3.2 percent of S&P 500 companies were sued, “making it the least litigious year for S&P 500 companies since 2000.” Historically, larger companies have been more likely to be sued in a securities class action lawsuit, and that trend continued in 2001. Thus, while only 3.2 percent of the S&P 500 companies were sued in 2011, those companies represented 5.1% of the S&P 500 market capitalization.

 

This year’s Cornerstone Research report also contains a number of new analyses, including an analysis of the number of private securities class action lawsuits filed between 1996 and 2011 involving Foreign Corrupt Practices Act allegations. The report shows that there were four such filings in 2011, the highest annual number of filings since 2006 (when there were also four filings).

 

The report also contains a new analysis of the experience of the judges handling securities class action lawsuits during the period 1996 to 2011. The analysis shows that while there are a relatively small number of judges that handled more than ten cases during that period (65), a much larger number of judges (329) handled only one case, and the vast majority of judges (582) handled only three or fewer cases. The inference is that many securities cases are being handled by judges who are relatively inexperienced with securities cases – although there is also a smaller number of judges that are very experienced with these types of cases.

 

The report also reflects some interesting insight about the plaintiffs’ law firms’ involvement in these cases. The report sets out which law firms are selected most often as lead counsel in securities class action cases that do not involve M&A related allegations and then separately lists the firms most often selected as lead counsel in the M&A cases. The interesting thins is that the lineup of law firms leading the M&A cases looks very different than the lineup for the other cases. These differences shed some light on the changing mix of corporate and securities lawsuits and the growth in the number of M&A cases, suggesting that among other things the rising M&A related litigation activity may reflect dynamics within the securities’ plaintiffs’ bar.

 

Speaking of M&A related cases, Cornerstone Research has also recently released a separate companion report specifically focused on M&A related litigation, which can be found here.

 

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Investors have a number of rights under federal and state law which they can enforce through litigation, including for example the right to file individual or class actions for damages. But can investors be required to submit these kinds of claims to binding arbitration in lieu of litigation? That is the question posed by a two different initiatives corporate reformers are currently pursuing.

 

One of the basic features of our system of corporate laws is that aggrieved shareholder can enforce their rights or seek damages by filing a lawsuit. But at the same time, our litigation system is costly and court processes can be both time-consuming and burdensome. For that reason, there have been many proposals over the years to provide for the arbitration of shareholder disputes. For example, in its November 2006 report (here), the Committee on Capital Markets recommended that public companies be allowed to have shareholder votes on the use of arbitration to resolve shareholder claims.

 

A couple of different developments are bringing these issues to the forefront now. First, on January 10, 2012, the Carlyle Group, an investment partnership preparing to conduct a public offering, submitted to the SEC an amended filing on Form S-1 that, among other things, specifies that its partnership agreement will provide that all limited partners must submit any claims to binding arbitration.

 

 A January 18, 2012 Bloomberg article by Miles Weiss entitled “Carlyle Seeks to Ban Shareholder Lawsuits Before IPO” (here) discusses the mandatory arbitration provisions described in Carlyle’s filing. Susan Beck’s January 18, 2012 Am Law Litigation Daily article about the Carlyle filing can be found here.

 

The Carlyle offering is a little unusual, because the firm does business as a limited partnership and the securities in the planned offering will consist of limited partnership units. The rights acquired with the units are defined by a limited partnership agreement. According to the company’s filing, the partnership agreement will provide that every limited partner “irrevocably agrees” that “any claims, suits, actions or proceedings arising out of or relating in any way to the partnership agreement or any interest in the partnership…shall be finally settled arbitration.” The filings explain that the kinds of actions to which this dispute resolution provision apply include without limitation disputes under the Delaware Limited Partnership Act and the federal securities laws. The filing also explains that the dispute resolution provisions specify that the each limited partner “irrevocably waives” any objection he or she may have to arbitration. (The filing’s disclosures relating to the partnership agreement’s dispute resolution provisions can be found here.)

 

The arbitration requirements reported in the filing are quite detailed. The dispute resolution provisions specify that the arbitration must take place in Wilmington, Delaware. The arbitration proceedings must be confidential and the amount of any award will not be disclosed. The provisions further specify that the person bringing the claim may only pursue arbitration in an individual capacity “and not as a plaintiff, class representative or class member,” and the arbitrators may not consolidate more than one person’s claim.

 

UPDATE: As discussed in Victor Li's February 3, 2012 Am Law Litigation Daily article (here), Carlyle Group has announced that in response to pressure from the SEC and others, it as decided to withdraw its proposed provision requireing investors to arbitrate claims.

 

A separate unrelated development involves the efforts of certain investors to put a proposal on 2012 proxy ballots to require shareholder claims to be arbitrated. According to information provided to me by University of Michigan Law Professor Adam Pritchard, shareholders at Pfizer and Gannett are currently seeking to have proposals included on upcoming proxy ballots that would amend the companies' corporate charters to require the arbitration of shareholder disputes.

 

The companies are seeking SEC authorization to omit the shareholder arbitration proposals from their proxy ballots, arguing that the arbitration requirement would violate both state and federal law. The companies contend that the arbitration requirement would violate Delaware law, which they contend provides shareholders with the right to litigate claims in the Delaware Court of Chancery absent a clearly expressed intent to arbitrate. The companies also argue that the arbitration requirement would violate Section 29 of the ’34 Act, which voids any contractual provision that would seek to waive any right under the statute. Finally, the companies contend that the SEC itself historically has taken the position that a mandatory arbitration charter provision would be against public policy.

 

Advocates for the shareholders seeking to introduce the shareholder proposals argue that there is liberal federal policy favoring arbitration agreements and that there is no support for the argument that an arbitration requirement would violate state law. They contend that Delaware law allows the use of corporate charters to embody agreements between a corporation and its shareholders.

 

They also argue that the Supreme Court has dealt with anti-waiver clauses in federal statutes and has consistently supported arbitration. In its January 10, 2012 opinion in CompuCredit v. Greenwood, the Court held that a right to sue provision in the federal consumer credit statute does not prohibit the enforcement of an arbitration agreement. The advocates for the shareholders argue the antiwaiver clause in Section 29 prohibits the waiver only of substantive rights, not procedural rights and is not a barrier to the enforcement of an arbitration requirement. The advocates (who include Professor Pritchard) contend that arbitration would not undermine the remedial and deterrent purposes of the federal securities law, arguing in further reliance on the CompuCredit case that the Supreme Court has said that arbitration is the equivalent of litigation.

 

Each of these initiatives is poised to be addressed shortly. The SEC will be called upon to respond to the Carlyle Group’s offering document and decide whether the offering may go forward with the dispute resolution requirement unchanged. Among other things, the SEC will have to determine whether or not Carlyle’s partnership ownership structure is a differentiating consideration. According to the Bloomberg article linked above, in 1990 the SEC refused to allow the offering of a savings and loan to go forward until the firm removed the arbitration clause from its corporate charter.

 

The SEC will also have to determine whether or not Pfizer and Gannett can omit the shareholder proposals from their proxy ballots. With deadlines for proxy mailings approaching, the SEC will have to reach a decision in time to allow the companies to prepare their proxy ballots. Of course even if the shareholder initiatives are included on the proxy ballots, a majority of shareholders would have to vote in favor of the proposals in order for them arbitration requirements to come into force.

 

Discussion

The motivations behind these efforts to require shareholder disputes to be arbitrated rather than litigated are perfectly understandable. Anyone who has ever been involved in any way in a material shareholder lawsuit knows that they are terribly costly and that they impose enormous burdens on all of the litigants. Taken collectively, shareholder litigation imposes an enormous cost on corporations in our country.  Reducing these costs is a highly desirable objective.

 

On the other hand, requiring shareholders to arbitrate their corporate claims would represent a massive change in the way that investor rights are addressed. Even if the U.S. Supreme Court thinks arbitration is equivalent to litigation, the fact is that in arbitration certain procedures are unavailable – like, for example, the ability to appeal.  And there are features of the Carlyle requirements that are clearly designed to ensure that arbitration would not be equivalent to litigation (for example, the prohibition against claimants proceeding collectively).

 

A change of this magnitude that has at least been approved by a shareholder vote has more of a sympathetic appeal. But even if the Carlyle offering is allowed to go forward with its offering with the dispute resolution procedures in its partnership agreement, or if Pfizer or Gannett have a mandatory arbitration shareholder proposal on this year’s proxy ballot, it would remain to be seen what would happen and how the arbitration provisions would be enforced when claims arise later. Court would then have to determine whether or not the provisions were valid and enforceable.

 

If any of these initiatives are permitted to go forward, it will be interesting to see what happens next. If Carlyle were able to include the mandatory arbitration provision in its charter (and if the reason Carlyle is permitted to do so is not linked to the fact that it is a partnership), it would seem likely that other companies would seek to implement similar provisions in the charters prior to their initial public offerings. And if the activist shareholders are successful in getting the mandatory arbitration issue on the Pfizer or Gannett proxy ballots, it seems likely that shareholders at other companies would pursue these same initiatives.

 

Though I could see these kinds of initiatives quickly spreading to other companies, these initiatives may not be popular with all shareholders. Indeed, I could easily imagine many shareholders actively opposing these types of efforts, taking the view that the opportunity to resort to the courts to seek redress of grievances is a basic and important right and an important tool to ensure that corporate officials abide by their legal duties.  The plaintiffs’ securities bar undoubtedly would become actively involved in resisting efforts to introduce these kinds of changes elsewhere.

 

Thus even of these current initiatives succeed, we would still be a very long way from the elimination of our current system of shareholder litigation. Nevertheless, it will be very interested to see where these current initiatives lead. The possibility for the adoption of a requirement for the mandatory arbitration of shareholder claims presents at least the theoretical chance for a radial revision on our current system of shareholder litigation.

 

One final note. The arbitration provision in the Carlyle partnership provision is far from the only restrictive aspect of the Carlyle structure. As Ohio State Law Professor Steven Davidoff notes in a January 18, 2012 post on the Dealbook blog (here), Carlyle "is propsing the most shareholder-unfriendly corporate goverance structure in modern history."  He notes that under the Carlyle structure shareholders have no right to elect directors and the company will not hold annual meetings of shareholders. In light of thse constraints and the arbitration provision, "the real question is whether prospective shareholders protest and refuse to participate in Carlyle's IPO because of the governance issues."

 

Thanks to the several readers who sent me links to the Bloomberg article and very special thanks to Professor Pritchard for sending me the information about the Pfizer and Gannett shareholder proposals.

 

Jobs Link: One of the great blogs that I follow closely is The FCPA Professor blog, which is written by Butler University Law Professor Mike Koehler. Professor Koehler’s posts are always interesting and well written. Now there is another reason to visit the site. Professor Koehler has added a Jobs link to his site (here), in which he will post job openings in his field. Great to see a fellow blogger expanding the universe of blogging possibilities.

 

The M&A Litigation Problem: In the latest issue of InSights, entitled “Why Mergers and Acquisitions Related Litigation is Such a Serious Problem” (here), I take a look at the issues arising from the growing levels of litigation surrounding M&A transactions.  These kinds of cases are becoming increasingly common and increasingly costly, both of which pose significant problems for companies and for D&O insurers. 

 

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On January 17, 2012, in a development with important implications for the evolution of post-Morrison remedies for non-U.S. investors, a Dutch court has held for the first time that a collective securities settlement is legally binding. Of even greater significance, the decision arose in a circumstance where none of the liable parties and few of the claimants were domiciled in the Netherlands. The court’s action suggests the possibility of a potentially important mechanism for aggrieved investors who bought shares outside the U.S. to obtain compensation.

 

A January 18, 2012 memorandum from the De Brauw, Blackstone and Westbroek law firm describing the Dutch court’s ruling can be found here. A January 18, 2012 memo from the Deminor Group about the ruling can be found here.

 

Background

The Non-U.S. investor proceedings in the Netherlands follow the settlement of related proceedings the U.S. As discussed at length here, Converium investors first filed a securities class action in the Southern District of New York in October 2004. The plaintiffs alleged Converium and certain of its officers and directors, as well its corporate parent, Zurich Financial Services, had made misleading statements about Converium’s financial condition, including the adequacy of its loss reserves for its North American business during the class period. (Converium had spun out of Zurich in a 2001 IPO.)

 

In 2007, while the U.S. case was pending, SCOR Holding (Switzerland) acquired the voting rights of Converium pursuant to a tender offer.

 

In rulings dated March 6 and March 19, 2008 (refer here and here, respectively) Southern District of New York Judge Denise Cote, applying pre-Morrison standards for determining the reach of the U.S. Securities laws, certified a class consisting of all persons who purchased Converium American Depositary Shares on the NYSE, and all U.S residents who purchased their Converium Shares on a non-U.S. exchange. Excluded from the class were investors who had purchased their shares on any non-U.S. exchange who were not U.S. residents at the time of their purchased.

 

The U.S. action ultimately settled for a total of $84.6 million, consisting of $75 million from SCOR and $9.6 million from Zurich. The Southern District of New York approved this settlement and entered final judgment on December 22, 2008.

 

As detailed here, in July 2010, two groups acting on behalf of the non-U.S. Converium investors entered settlement agreements with Scor and Zurich. The total amount of the two settlements is $58.4 million, of which $40 million is to come from SCOR and $18.4 million is to come from Zurich. The SCOR settlement agreement can be found here and the Zurich settlement agreement can be found here. The two groups acting on the investors’ behalf were Stichting Converium Securities Compensation Foundation, Dutch foundation formed for the purpose of seeking recoveries on behalf of the Non-U.S. Converium investors. Dutch investors in particular were represented by Vereniging VEB NCVB.

 

Pursuant to the Dutch Collective Settlement of Mass Damages Claims Act (known as WCAM), enacted in 2005, the parties then petitioned the Amsterdam Court of Appeals for approval of the settlement. An English translation of the parties’ petition, as amended, can be found here. The Act basically allows parties to seek court approval for collective settlement of mass actions entered for the benefit of class members who do not opt out.

 

On November 12, 2010, the Amsterdam Court of Appeals entered a provisional judgment acknowledging its right to recognize the settlements and scheduling a hearing for interested parties to appear and present their arguments with respect to the petition. Interestingly, the November 12 order specifically references the U.S. Supreme Court’s Morrison decision and the impact the decision has on the ability of Non-U.S. investors to pursue securities claims in U.S. courts.  The hearing to determine whether the settlement agreements will be binding was held on October 3, 2011.

 

On January 17, 2012, the Amsterdam Court of Appeals issued its ruling holding the settlements to be binding. As discussed in the De Brauw law firm memo, there two principal objections to the non-U.S. settlements. First, the objectors contended that the amount of the settlement was unreasonable because the benefit amount under the U.S. settlement was relatively greater than was the case under the non-U.S. settlement. The objectors also took exception to the amount of fees awarded to U.S. counsel was unreasonable.

 

In its January 17 ruling the Amsterdam Court rejected these objections. The rejected the objection about the settlement amount because the legal position of the non-U.S. investors was weaker than that of U.S. investors because the non-U.S. investors had been rejected from the U.S. class action. In dismissing the objection about the U.S. lawyers’ plaintiffs’ fees, the Court noted that much of the work in support of the settlement had been carried out in the U.S. by U.S. law firms, and that what was considered customary in the U.S. could be taken into account by the Dutch court.

 

Discussion

The significance of the Amsterdam court’s decision to accept the settlements as binding is that it represents the first time that the Amsterdam Court has approved a settlement “regarding the securities of a company which is not based in the Netherlands and whose securities are not traded on an exchange in the Netherlands.” At least in principle all EU member states, as well as Switzerland, Iceland and Norway will have to recognize the Amsterdam court’s ruling as binding.

 

The Court’s acceptance of the settlement, particularly given the limited connection of the settlement to the Netherlands, is particularly significant in light of the fact that the Netherlands is “the only European country where a collective settlement can be declared binding on an entire class on an ‘opt out’ basis.” As the DeBrouw law firm’s memo states, the Dutch courts not only have the power to declare the settlement to be binding but “it has the appetite to facilitate such settlements even if the parties to the settlement and the class members only have a limited connection to the Netherlands.” The decision confirms that the Netherlands is “Europe’s most attractive venue for facilitating international settlements.”

 

As a more general level, as the Deminor memo notes, the settlement also shows that “there is a legally binding settlement mechanism available in Europe that can help to solve complex securities litigation in Europe in an orderly way.”

 

These settlements represent the latest occasion when the new Dutch procedures have been used to reach settlements on behalf of non-U.S. investors in connection with securities claims that were also the subject of U.S. securities class action lawsuit claims and settlements.

 

The first and highest profile of these prior settlements was the $381 million settlement on behalf of non-U.S. Royal Dutch Shell investors. As discussed here, in May 2009, the Amsterdam Court of Appeals approved the settlement and authorized payment to Non-U.S. investors. The Dutch settlement followed an earlier settlement of a parallel U.S. securities class action lawsuit settlement on behalf of U.S. investors and arising out of the same factual allegations.

 

The Royal Dutch and the Converium settlements illustrate possible means by which, even in the wake of Morrison, non-U.S. investors can obtain recoveries for their investment losses. As plaintiffs’ attorneys cast about for alternatives for non-U.S. investors to pursue in the wake of Morrison, the use of settlements under the Dutch procedures may provide a possible remedy.

 

On the other hand, there are limitations on the usefulness of the Dutch procedure for investors. Only court authorized representatives can pursue claims on behalf of investors, and representatives cannot seek damages. Instead, the Dutch courts can only certify the class and approve out of court settlements. In addition, while the judgment of the Dutch court is in principle enforceable in courts outside the Netherlands, it remains to be seen whether or not other courts will in fact recognize the judgment.

 

But those limitations notwithstanding, the decision of the Dutch court to recognize the settlements as binding represents a significant step in the evolution of remedies for non-U.S. investors in the wake of Morrison. There is some irony that one of Morrison’s consequences is that has spurred investors to seek remedies elsewhere and thereby advance the development of remedial mechanisms outside the U.S Indeed in its preliminary ruling in the case the Dutch court specifically cited the advent of the Morrison decision as one reason that it should provide relief. In the one of Morrison’s consequences may be the encouragement of the process for developing investor remedies outside the U.S.

 

Special thanks to the several good friends who alerted me to this development and who sent me links to the law firms’ memos.

 

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There seems to be a general consensus that the amount of M&A-related litigation is increasing. The question of how to quantify the increase has attracted quite a bit of attention lately. In a recent post, I previewed a forthcoming report from Cornerstone Research that will provide detailed statistic analysis of the M&A litigation phenomenon.

 

My post attracted considerable commentary, and also drew a communication from NERA Economic Consulting, which has released its own statistical analysis of M&A-related litigation, and which they shared with me.

 

In addition, this week I separately received from Ohio State University Law Professor Steven Davidoff a copy of the January 1, 2012 paper that he and Notre Dame Finance Professor Matthew Cain have written entitled “A Great Game: The Dynamics of State Competition and Litigation” (here), in which they analyze M&A related Litigation from 2005-2010., with particular attention to the question of whether or not there is now competition between the states for this type of corporate litigation. Davidoff should be familiar to many readers as The Deal Professor from the New York Times Dealbook blog.

 

These two reports add substantial additional quantitative and analytic support for the general observations surrounding the growth in M&A-related litigation. Both of these reports corroborate the explosive growth in M&A-related litigation in recent years. I examine both of these reports below, starting first with Professors Davidoff and Cain’s analysis.

 

Professors Davidoff and Cain’s Paper

The Professors’ primary interests relate to the question of whether or not the states are competing for corporate litigation. Their interest in this question is driven in part by recent analyses suggesting that Delaware may be losing “market share” for this type of litigation. In order to determine how “both attorneys and courts interact in this game,” the authors examine state court merger litigation. The authors analyzed 955 merger transactions that took place between 2005 and 2010 and having a transaction value great than $100 million.

 

The authors found that 49.7 percent of transactions during that period attracted at least one shareholder lawsuit, and that the litigation rate increased “sharply” during the period, with only 38.7 percent of the transactions incurring litigation in 2005, compared to 84.2 percent in 2010. In addition, merger transactions increasingly are attracting multiple lawsuits. In 2005, only 8.6 percent of the deals attracted litigation in more than one jurisdiction, compared to 46.5 percent in 2010.

 

The authors found that during the sample period, 69.8 percent of cases settled, while 30.2 percent were dismissed. Only 4.9 percent of the settlements involved in increased in the amount of the transaction consideration, while 52.1 percent of the settlements involved only the disclosure of additional information. The average plaintiffs’ attorneys’ fee for settled suits is $1.4 million. Cases that settled for additional disclosure only pay the lowest level of attorneys’ fees (average attorneys' fees of $793,000) while settlements involving an increase in the deal consideration  pay the most (average attorneys fees $8.5 million)

 

The authors used this information to calculate an expected dismissal and attorneys’ fee baseline, as a way to measure “unexplained” dismissal rates and attorneys fees. The authors used these unexplained amounts as an “indicator for state competition.” The authors found significant variation across states, with certain states awarding higher fees than others. Delaware awarded fees $400,000 to $500,000 higher while dismissing a greater portion of cases than other states.

 

The authors found some statistical support for the claims that Delaware is losing the state court litigation competition, but they also found that “the game” is complex and that the dynamic varies depending on which states are compared. The authors also found evidence that Delaware’s courts are responsive to this competition, concluding that Delaware’s courts award” higher attorneys’ fees to compensate for a higher dismissal rate,” and adjust “dismissal rates down when it loses prior cases to other jurisdictions.” The authors cite the recent $300 million award in the Southern Peru Copper case as an indication that Delaware is” competing more overtly in this game.”

 

The NERA Economic Consulting Presentation

In a December 6, 2011 presentation done in conjunction with the Wilson Sonsini law firm and entitled “Merger Objection Litigation” (here), NERA provided a detailed statistical review of M&A-related litigation. The NERA study is based on the firm’s examination of the 731 merger transactions it identified as having been announced between 2006 and 2010 and that were completed by February 28, 2011, and that had a value equal to or greater than $100 million. NERA found that 285 of those transactions were challenged in a state or federal lawsuit, through June 20, 2011. NERA also found that litigation settlements had been reached in connection with 162 of the deals.

 

The NERA study found that while there were fewer deals overall in the last three years of the 2006-2010 study period, the incidence of M&A related litigation escalated significantly in those three later years. Thus, while only 26.1% of the 2006 deals and only 21.9% of the 2007 deals attracted litigation, 45.4% of the 2008 deals, 78.6% of the 2009 deals, and 60.7% of the 2010 deals attracted litigation. Though the 2010 figure represent a slight decline from the prior year, the 2010 level of litigation still represents a significant increase compared to the earlier years in the study period.

 

The NERA study also found that throughout the 2006-2010 period, the litigation rate increased as the size of the deal increased. Thus, only about 25% of the deals under $500 million attracted litigation, but 38.7% of the deals between $500-$999 million, 40.8% of the deals between $1 billion and $1.9 billion, 53.0% of the deals between $2 billion and $4.9 billion and 70.1% of the deals equal to or greater than $5 billion attracted litigation.

 

Merger objection litigation can be expected to arise fairly quickly after the deal is announced. The NERA study shows that a third of the litigation arrives in the first two days after the deal is announced and about 60% arrived in the first week. 81% of the merger litigation arrives within the first thirty days after the deal is announced. Although the takeover target is consistently named as a defendant in this litigation, 70% of the time the named defendants also include the acquirer.

 

The vast majority of the litigation is filed in state court only. 83% of the deals that were litigated attracted only state court litigation. Another 14% attracted both state and federal litigation. Only three percent of the deals attracted only federal court litigation.

 

The NERA study suggests that many of the deals that attract litigation are attracting litigation outside Delaware. Of the deals that were litigated, 20% were litigated only in Delaware and another 13% were litigated in both Delaware and another state. So about one third of the deals that attracted litigation were litigated at least in part in Delaware. The remaining two thirds of the deals were litigated only outside Delaware. However, the presentation does not show how many of the deals that were litigated only outside Delaware involved target companies that were incorporated in Delaware. The presentation also does not show whether or not the prevalence of litigation outside Delaware changed during the 2006-2010 study period.

 

With respect to the M&A-related lawsuits in the study period that had settled, the NERA report found that the vast majority of the settlements involved cash payments of less than $1 million. 106 of the 154 settlements in the settlement analysis (nearly 69%) settled for less than $1 million. Another 33 out of the 154 in the settlement analysis settled for less than $10 million. Only 15 of the 154 settlements in the analysis settled for amounts of $10 million or greater, including only 4 with settlements between $100 million and only one with a settlement greater than $1 billion. (The NERA presentation includes a detailed list of the largest settlements at slide 19.)

 

Thus, while the settlement period included a few very large settlements, the vast majority of the settlements were for less than $10 million, and more than two-thirds were below $1 million.

 

In fully 87% of the litigated deals that had settled, the only beneficiary from the monetary settlement was the plaintiffs’ attorneys. In only 9% of the settlements did the beneficiaries include both the plaintiffs’ attorneys and class members. Thus the vast majority of monetary settlements pay only for the plaintiffs’ attorneys’ fees and expense, and the “benefits” to the class, although occasionally monetary, more often take another form, such as reduced target company termination fee; fuller disclosure; or improved corporate governance.

 

Discussion

The information in these two studies provides valuable additional perspective on the increasingly important M&A-related litigation phenomenon. The two studies corroborate that in creasing numbers of M&A transactions are attracting litigation. The NERA data also provides some interesting additional information that has not been a part of other statistical perspectives on this litigation phenomenon, including in particular the data showing how quickly the lawsuits arrive and the information showing the range of settlement outcomes.

 

The Professors’ report provides additional information about the increasing prevalence of multi-jurisdiction litigation, as well as average attorneys’ fees and dismissal rates. Perhaps most significantly, the Professors’ study provides important insight into the question of state competition for corporate litigation.

 

The data in these studies are directionally consistent with the previously released studies, including the information I previewed in a recent post about the forthcoming Cornerstone Research report. They are also directionally consistent with each other, while differing somewhat in their details. The two reports also differ somewhat from the Cornerstone Research data I previously reviewed.  (The Cornerstone Research analysis suggests a higher litigation rate both in 2007 and in 2010 than the analysis in either of the two studies discussed above, although all three of the analyses agree that that the litigation rate increased between 2007 and 2010.)

 

The difference between the analyses may be attributable to the differing data sources used in the studies. There may have been methodological differences as well. For those of use who are studying and trying to understand the growing M&A-related litigation phenomenon, it will be important to understand these differences. We can certainly hope as the various research sources release their analyses that they will help the rest of us understand not only where their data came from and how it was analyzed, but how the approach they used may differ from other analyses that have been published.

 

In any event, no matter how you slice it, the level of M&A related litigation is growing. The defense expenses and settlement amounts associated with this litigation represent a growing problem as well. All signs are that this phenomenon will remain a significant part of the corporate and securities litigation landscape for the foreseeable future. For that reason it will remain important to understand what this litigation means. The willingness of NERA and of the Professors to share their analysis is extraordinarily helpful in that regard. Along those lines, I would like to express my deep thanks here to NERA and to Professor Davidoff for their willingness to share their presentations with me.

 

Seven Nation Army: Even though I was not even really focusing on it, I had noticed recently that marching bands and sporting fans everywhere have picked up the same tune, as a rallying cry, as a communal chant, as basic crowd background noise. But if you had asked me to focus on it, I still might not have been able to name the tune. A January 13, 2011 article on Deadspin identified the tune, and also explained how it managed to take over the sportworld.

 

The song is “Seven Nation Army,” a 2003 tune from the alternative rock band, The White Stripes. Just in case you don’t think you know the tune, I have included a video below of the band performing the song. (I guarantee you if you listen to it, you will say – “Oh yeah, that song. I always wondered what that was.”) I was on the alert for it this past weekend, and I noticed that both the San Francisco crowd at the 49ers/Saints game and the west London crowd at the English Premier League game between Chelsea and Sunderland were chanting the tune during their respective games on Saturday. All very odd for an alternative rock song. But I guess it isn’t any weirder than that fact that a lot of marching banks have also picked up “Carmina Burana” from classical composer Carl Orff.

 

In any event, for today’s musical interlude, here’s The White Stripes performing “Seven Nation Army.” Now you will know what the heck all of those fans are trying to chant. (My apologies to all of those rock music aficionados – most half my age -- who think I am an idiot for not knowing the song before; please consider my age, location and occupation, and I think you will see how unlikely it is that I would be fully versed in the contemporary alternative rock scene.)

 

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The tone public companies use in their disclosure statements can affect the companies’ susceptibility to securities class action litigation, according to a recent academic study. The authors found that firms hit with securities litigation generally used more optimistic language in their disclosure statements than did firms that were not sued. Based on these findings, the authors conclude that managing “disclosure tone” could provide “a straightforward means of reducing litigation risk.”

 

In their November 2011 paper “Disclosure Tone and Shareholder Litigation” (here), University of Chicago Business School Professors Jonathan Rogers and Sarah L.C. Zechman and Ohio State Business School Professor Andrew Van Buskirk set out to determine whether or not corporate managers’ use of optimistic language increases litigation risk. Using statistical techniques, they examined the extent to which differences in qualitative language are systematically related to differences in litigation risk.

 

The authors began by examining a range of plaintiffs’ complaints, in order to determine which disclosure channels are likeliest to affect the probability of litigation. Based on their review, the authors determined that the earnings announcements are the most consistently cited type of communication referenced in plaintiffs’ complaints.

 

The authors then used dictionary-based measures of optimism to analyze the tone used in the portions of earnings announcement that plaintiffs chose to quote in their class action complaints. In order to determine whether or not the sued firm’s disclosures were “unusually optimistic” the authors compared the tone of the sued firms’ earnings announcements to the tone of disclosures made my non-sued firms at the same time, in the same industry and experiencing similar economic circumstances. The authors concluded that the firms that are hit with securities class action lawsuits use “substantially more optimistic language in their earnings announcements than do non-sued firms.”

 

The authors also took a look at the combined effect of optimistic language and insider trading. The evidence they reviewed “is consistent with optimism and insider selling jointly affecting litigation risk.” The interaction between optimism and “abnormal insider selling” is “associated with an increase probability of being sued.” The authors found no evidence that insider selling on its own exposes the company to increased litigation risk; insider selling is “only associated with litigation when firm disclosures are optimistic.”

 

The authors’ conclusions suggested to them some ways that companies can try to mitigate litigation risk. That is, though disclosure tone “is certainly not the sole determinant of litigation,” disclosure tone “is both associated with litigation risk and under the discretion of management.” All of which led the authors to conclude that “monitoring and adjusting disclosure tone could provide a straightforward means of reducing litigation risk” – that is, “managers can reduce litigation risk by dampening the tone of disclosure.” On the other hand, the authors also note that shareholder litigation can be “an effective ex post mechanism” to assure investors that managers “are not simply engaging in cheap talk when they use positive language.”

 

One final note about the authors’ methodology. In order to quantify the tone used in firms’ disclosures, the authors used a form content analysis that relies on a pre-specified word list. The analysis simply counts the occurrence of words characterized defined as optimistic or pessimistic based on prior research and linguistics theory. However, rather than relying on a single categorization, the authors used three different libraries of words, each of which was used to study firm disclosures. The word counts using the three measures were then compared against a benchmark standard that was based upon a control group of non-sued firms. The sued firms “optimism” was then compared against the benchmark standard. The authors also applied control variable to isolate the effect of a firm’s optimism that is driven by management discretion, rather than by the firm’s economic circumstances.

 

Discussion

On the one hand, the authors’ analysis might seem simply confirm a common sense proposition that companies that are hype-ish with their disclosures are likelier to get sued. But a closer reading of the authors’ analysis suggests that the authors have established a more specific and more important conclusion. That is, the authors’ analysis establishes that there is a direct statistical relationship between a firm’s use of unusually optimistic language and the likelihood of the firm being sued. This statistical relationship has two important implications.

 

First, the existence of this relationship could have important D&O insurance underwriting implications. D&O insurance underwriters interested in selecting away from companies that are likelier to be sued in securities class action lawsuits will want to develop tools to help them identify disclosure statements that are unusually optimist. The key here is that the predictive relationship is based on the use of unusually optimistic language. That is, in order for an underwriter to use the existence of the relationship as a risk selection tool, the author would have to have a developed ability to determine what constitutes unusual optimism.

 

In connection with the D&O underwriting implications of the authors’ analysis, it is also significant to note the added relationship the authors found about the interaction of optimistic disclosure and unusual insider trading. The two factors together had a combined predictive effect. In other words, the presence of insider selling in combination with overly optimistic disclosure is particularly predictive of securities litigation risk.

 

The other significant implication of the authors’ analysis has to do with their conclusions about how companies might mitigate their securities litigation risk. There is definitely some good news in the authors’ report. That is, companies that are interested in trying to control their securities litigation risk exposure can reduce their litigation risk by managing their disclosure language. The authors’ conclusion in this regard are consistent with larger messages that many of us who advocate securities litigation loss prevention have been preaching for year – that is, that companies can control their securities litigation exposure by managing the disclosure process, in order to avoid the kinds of statements that attract the unwanted attention of class action securities lawyers.

 

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The SEC has commenced an enforcement action against a private company and its former Chairman and CEO in connection with the company’s repurchase of company shares from company employees and others prior to the company’s acquisition.

 

The action involves Stiefel Laboratories, which prior to its April 2009 acquisition by GlaxoSmithKline for $68,000 a share, was, according to the SEC “the world’s largest private manufacturer of dermatology products.”  On December 12, 2011, the SEC filed a complaint (here) in the Southern District of Florida alleging that the company and Charles Stiefel, its former chairman and CEO, defrauded shareholders by buying back their stock at “severely undervalued prices” between November 2006 and April 2009. The SEC’s December 12, 2011 press release about the enforcement action can be found here.

 

The company had an Employee Stock Bonus Plan through  which employees gained ownership of company shares. The company also engaged in direct share transactions with other shareholders. Because the shares did not trade on public markets, company share purchases were essentially the only way for shareholders to liquidate their shares of company stock.

 

The price for company share purchases was set through an annual l third-party share valuation each March. The company relied on a third-party accountant to perform the valuation. However, the SEC alleges that the accountant “used a flawed methodology and was not qualified to perform the valuations.” In addition, the SEC alleges that that shareholders were not told that after the valuation process, the defendants “discounted the stock by an additional 35%.”

 

In addition, beginning in 2006, the company began a series of conversations that culminated in the April 2009 sale of the company to Glaxo Smith Klein. During the course of these various discussions, the defendants received a series of valuations that were significantly higher than the third party valuation used for share repurchase purposes. The company did not advise employees or the accountant who performed the annual share price valuation of these much higher valuations. In addition, the company not only did not inform the employees about the ongoing negotiations, but repeatedly indicated that the company would remain private.

 

While these discussions were going forward, the company continued to repurchase company shares at valuations that were significantly below both the valuations that the prospective company buyers were using and that were also well below the ultimate sale price of $68,000 per share. Thus between November 2006 and April 2007, the company purchases 750 company shares at $13,012 a share. Between June 2007 and June 2008, the company purchased more than 350 additional shares at $14,517 a share, and bought an additional 1,050 shares from shareholders outside the Plan at an even lower stock price. Between December 3, 2008 and April 1, 2009, the company purchased more than 800 shares of its stock from shareholders at $16,469 per share.

 

The SEC alleges that shareholders lost more than $110 million from selling their shares back to the company based on the misleading share valuations. The SEC alleges that the defendants violated Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder, by repurchasing the shares at undervalued prices and in reliance on undisclosed material information, including both the higher valuations and the possibility of the company’s sale. The SEC’s complaint seeks declaratory relief, permanent injunctive relief, an officer and director bar, disgorgement and civil penalties.

 

Discussion

The allegations against the company and its former Chairman involve alleged misconduct that took place when the company was still a private company. I suspect that many readers will be surprised to learn that an SEC enforcement action against or in connection with the actions of a private company.

 

As explained in a January 10, 2012 memorandum from the Stites & Harbison law firm (here), Rule 10b-5 “prohibits, in connection with the purchase or sale of any security (public or private) making any untrue statement or omitting to state a material fact necessary in order to make the statements not misleading.” The allegations against the defendants here present a “cautionary tale for any private company,” underscoring the fact that federal and state securities laws govern even private company securities transactions and “restrict small closely held firms no differently than they restrict large, publicly-held corporations.” 

 

The law firm memo emphasizes that a private company in possession of material nonpublic information that is under a contractual obligation to consummate a transaction involving its own securities could face a dilemma -- for example, a pending transaction may put the company in a position where it may neither disclose pending negotiation nor abstaining from repurchase obligations under stockholder or similar agreements. The memo’s authors observe that private companies should “thoughtfully scrutinize the structure of a transaction in its own securities and would be well served to tailor corporate policies to ensure compliance with securities law obligations.”

 

The SEC’s allegations here present a cautionary tale in another sense as well. Some private company D&O insurance policies may be procured or written based on the assumption that, because the company is privately held, the company and its directors and officers face no potential liability under the federal securities laws. Or at a minimum, D&O insurance policies may be structured with insufficient awareness about the possibility that even a private company potentially could fact liability under the federal securities laws. This case shows that a company and its officials can fact potential liability under the securities laws in connection with transactions involving the companies own securities, even if the company’s shares are not publicly traded.

 

Of particular concern here is the securities offering exclusion found in many private company D&O policies. The wordings of these exclusions vary widely. Depending on the wording used in any particular private company policy, the exclusion might potentially preclude coverage for the type of claim presented here. The best versions of these types of exclusions specify that they do not apply unless the company has conducted an initial public offering. But as this case highlights, a private company D&O policy could be called upon to respond to an action alleging a securities law violations; indeed, it could be called upon to respond to an SEC enforcement action even where, as here the company’s shares are not publicly traded and where there has been no IPO. There might ultimately be no coverage under the policy for amounts representing disgorgements or fines or penalties, but the question of whether or not there is coverage for defense expenses (which could be quite substantial) could well depend on the wording of the securities exclusion.

 

All of which means, at a minimum, that the wordings of the securities offering exclusion in private company D&O insurance policies need to be reviewed closely with an eye toward the possibility of claims of this type.

 

Don’t Be That Guy: According to a January 12, 2011 Wall Street Journal article (here), Alan Gilbert, the conductor of the New York Philharmonic, brought a performance of Mahler’s Ninth Symphony to a halt when the orchestra’s performance of the music piece’s final movement – a sonorous rumination on the meaning of mortality – was interrupted by a persistent cellphone ringtone the article described as having a xylophone sound with a marimba beat. The cellphone’s owner apparently was seated in the front row at the performance at Avery Fisher Hall. 

 

I suspect that the next time the cellphone owner is asked to turn off their cellphone, he or she will actually make sure the phone is powered down.

 

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In several recent posts (most recently here), I have written about the problems associated with the growing wave of M&A related litigation. In writing about this topic, I have tried to marshal the evidence supporting my position, but for many reasons my analysis has been more descriptive than statistical. However, I have been provided with advance access to some of the data from a forthcoming Cornerstone Research publication to be entitled “Recent Developments in Shareholder Litigation Involving Mergers and Acquisitions.” The data provide interesting additional statistical perspective on the recent M&A-related litigation trends.

 

UPDATE (as of Jan. 17, 2012): Cornerstone has now released its report, entitled "Recent Develpments in Shareholder Litigation Involving Merger and Acquisitions" (here) online. The full report iincludes additional information beyond what is discussed in this blog post.

 

In their preparation of the report, Cornerstone Research reviewed SEC filings related to acquisitions of U.S. public companies valued at $100 million or greater and announced during 2010 and 2011. For purposes of historical comparison, Cornerstone Research also collected information on litigation related to deals announced in 2007 valued at $500 million or greater.

 

Based on their review, Cornerstone Research identified 789 lawsuits filed in connection with U.S. public company acquisition transactions valued at $100 million or greater and announced in 2010 and 696 lawsuits for deals of that size announced in 2011.

 

Cornerstone Research found that litigation arose in connection with 91% of all deals announced during the 2010-2011 period with values greater than $100 million. The average number of lawsuits per deal announced during that period was 5.1. Both of these figures grow relatively larger as the size of the deals grows larger. Thus for deals announced in 2010-2011 with valuations between $100 million to $500 million percentage of deals involving litigation is 85%, and the average number of lawsuits per deal is 4.1, while 96% of all deals valued over $1 billion during that period attracted litigation, and averaged 6.1 lawsuits per deal.

 

Certain deals announced during the 2010-2011 proved to be particularly litigation attractive. For example, Blackstone’s $600 million acquisition of Dynegy attracted 29 lawsuits. Express Scripts’ $29.3 billion acquisition of Medco Health Solutions attracted 22 lawsuits. Attachmate’s $2.2 billion acquisition of Novell attracted 19 lawsuits. Overall, there were nine deals during that period valued at $100 million or greater that attracted 15 or more lawsuits.

 

To provide historical perspective, Cornerstone Research compared M&A litigation in 2007 and in the 2010-2011 periods, by comparing deals valued greater than $500 million announced in each of those two periods. There were 289 lawsuits in connection involving deals of that size in 2007 and 557 involving deals of that size in 2010, representing a 92% growth in the absolute number of lawsuits between the two periods. There were 473 lawsuits involving deals of that size that were announced in 2011, which is 63% higher than in connection with deals of that size announced in 2007.

 

Obviously, this growth in the absolute number of lawsuits might be attributable to an increase in the level of M&A activity involving deals greater than $500 million. In fact, there were 195 deals valued over $500 million that were announced in 2007, but only 108 and 80 deals valued over $500 million that were announced in 2010 and 2011, respectively.

 

The Cornerstone Research analysis shows that only 50% of the deals valued at $500 million or greater announced in 2007 attracted litigation, whereas 95% of the comparably sized deals announced in 2010 attracted litigation, and 96% of such deals announced in 2011 attracted litigation. In other words, the litigation activity was both absolutely and relatively greater for deals valued at $500 million or greater in the 2010-2011 period compared with comparably sized deals announced in 2007.

 

In addition, the number of lawsuits filed per deal has also increased. Deals valued at greater than $500 million announced in 2007 attracted an average of 2.8 lawsuits, whereas deals of that size announced in 2010 attracted an average of 5.4 lawsuits, and deals of that size announced during 2011 attracted an average of 6.1 lawsuits.

 

One of the recurring questions associated with the increase in M&A-related litigation has been whether or not courts in Delaware, traditionally the forum of choice for this type of litigation, has been losing “market share” to other jurisdictions that may be perceived as more plaintiff-friendly. The Cornerstone Research analysis suggests that Delaware’s courts are not in fact losing market share, at least with respect to deals meeting Cornerstone’s criteria.

 

Cornerstone Research’s analysis of this issue compares deals involving Delaware incorporated companies that were valued at greater than $500 million announced in 2007, on the one hand,  to deals involving Delaware incorporated companies where the deal was valued at greater than $500 million and announced in 2010-2011, on the other hand.

 

The Cornerstone Research analysis shows that in terms of where the lawsuits were filed in the two respective periods, in 2007, 34% of the lawsuits were filed in Delaware, while in the 2010-2011 period, 41% of the lawsuits were filed in Delaware.

 

This analysis is reinforced when the lawsuits are looked at on a per deal basis. Looking at the venue of lawsuits in which acquisitions involving Delaware incorporated companies were being challenged, the Cornerstone data show that 29 of the 2007 deals involved at least one lawsuit filed in Delaware, and 32 of the deals involving only litigation outside Delaware. By comparison, in 2011, 41 of the deals had at least one lawsuit filed in Delaware, and just nine of the deals involved litigation only outside Delaware. In other words, in the later period, a much greater portion of the deals involved litigation in Delaware, either exclusively or in combination with litigation in other jurisdictions, and a much smaller proportion of the deals involved only litigation outside Delaware.

 

Discussion

The Cornerstone Research data tend to corroborate many of the points I have made in recent posts on this blog – that is, M&A litigation is increasing, on both an absolute and relative basis; that a much higher percentage of deals is attracting merger objection litigation; and the average number of lawsuits per deal is also increasing.  The Cornerstone Research analysis is particularly interesting with respect to the number of deals that are attracting unusually higher numbers of lawsuits.

 

The data in the Cornerstone Research report are directionally consistent with many other data sources I have cited in prior blog posts on this topic, but the Cornerstone figures appear to differ in certain specific details. For example, the Cornerstone Research analysis suggests that a much higher percentage of deals attract merger objection lawsuits than the figures in other reports have suggested (refer here, for example).

 

There likely are many explanations for the differences in the details between the Cornerstone Research data and other reports, but one particular aspect of the Cornerstone analysis should be kept in mind. That is, the Cornerstone Research analysis for the 2010 and 2011 period involves only M&A transactions with announced values greater than $100 million. Deals involving smaller valuations and the related litigation are not a part of the Cornerstone Research analysis. By the same token, Cornerstone Research’s historical analysis refers only to deals announced in the 2007 period with valuations greater than $500 million, which omits an even broader range of deals (and related litigation) based on the size of the deal valuations. These data set definitions could result, at a minimum, in differences between the Cornerstone Research data and other analyses of comparable time periods.

 

But in any event, the Cornerstone Research analysis makes a very important contribution to the consideration of these issues. The Cornerstone Research report clearly shows that M&A related litigation is becoming a more significant issue. With the increasing average numbers of lawsuits per deal, M&A-related litigation is becoming an increasingly more costly problem, as the increased numbers of lawsuits in multiple jurisdictions means both procedural complications and increased defense expense.

 

The Cornerstone Research analysis of the Delaware court “market share” issue could prove to be particularly interesting. The question whether or not litigants are self-selecting away from Delaware is and will be a very hot topic. The stakes are high, as the continued involvement of Delaware courts in corporate and securities litigation could determine whether or not Delaware’s courts continue to play a leading role on legal issues in these areas. And on a more practical level, if Delaware’s courts are not losing market share after all, there is no reason for its judges to be as concerned with attempting to curry favor with the plaintiffs’ bar in order to preserve market share.

 

The Cornerstone Research data certainly offers a variety of interesting statistical perspectives on the issues surrounding the growth of M&A litigation. We can all look forward to the forthcoming publication of Cornerstone Research’s complete report on these issues.

 

Very special thanks to Cornerstone Research for their willingness to share this data with me and with readers of this blog.

 

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Securities class action lawsuit filing activity seems to have picked right up in the New Year where last year’s filings left off, as what appears to be the first filed case of 2012 involves a U.S.-listed Chinese company. Camelot Information Systems, a Chinese-based company whose American Depositary Shares (ADS) trade on the NYSE, and certain of its directors and officers have been sued in a securities class action lawsuit dated January 5, 2012. A copy of the plaintiff’s complaint can be found here.

 

Camelot is a provider of IT business solutions. Unlike many of the other U.S.-listed Chinese companies that have been sued in securities suits involving Chinese companies, Camelot did not obtain its listing by way of a reverse merger; it actually conducted a full IPO, in July  2010. The company also conducted a secondary offering on December 9, 2010. 

 

The company was the subject of an August 15, 2011 article on Seeking Alpha entitled “Extremely Cautious on Camelot Information Systems” (here) that questioned the company’s statements regarding its employees, revenue and other key business components. The company’s ADS price declined. On August 19, 2011, the company released its fiscal second quarter results and also lowered its guidance for fiscal 2011. Its ADS price declined further.

 

According to the plaintiffs’ lawyers’ January 5, 2012 press release (here), the complaint alleges that the defendants concealed from investors that:

 

(a) the Company’s IT professionals were not a competitive advantage to the Company and many were dissatisfied with Camelot, which would adversely affect Camelot’s ability to retain its customers; (b) the Company was suffering from undisclosed attrition of employees, which was having a negative impact on the Company’s ability to attract new customers; (c) Camelot did not have the large numbers of highly trained professionals at its disposal that it had represented; and (d) Camelot’s contract with its most important customer, IBM, was not as solid as represented, and would not be renewed on the same terms.

 

The complaint also names as defendants the offering underwriters that conducted the companies ADS offerings.

 

As I recently noted (here), lawsuits against U.S.-listed Chinese companies were one of the most significant parties of 2011 securities suit filings. The 39 lawsuits filed against Chinese companies represented nearly one fifth of all 2011 securities class action lawsuit filings. Although these filings were weighted to the first half of the year, there were 13 in the year’s second half, including two in December.

 

Eventually this filing trend will go away, as the plaintiffs’ lawyers sooner or later run out of additional Chinese companies to sue. But for now the filing trend appears to have carried over into the New Year, with the filing of this new lawsuit involving Camelot Information Systems.

 

Deloitte Must Produce Longtop Financial Documents: In an interesting development in connection with the SEC's investigation of Longtop Financial Technology, a Chinese companies who had been delisted from a U.S. exchange, on January 4, 2012, a Magistrate Judge for the U.S. District Court for the District of Columbia ruled that Deloitte Touche Tohmatsu Ltd. must appear in court ad produce documents on work the firm did for Longtop. The Magistrate ruled that Deloitte could be compelled to appear even though it had not been served with a show-cause memorandum. A copy of the Maistrate's january 4, 2012 order can be found here. A January 4, 2012 Blog of the Legal Times article discussing the ruling can be found here.

 

 

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Surging levels of M&A-related litigation and a wave of lawsuits involving U.S.-listed Chinese companies drove federal securities class action lawsuit filings during 2011 to the highest levels since 2008. However, due to the growing wave of M&A-related litigation, much of which is filed in the state courts, the federal securities lawsuit filing statistics, while interesting, represent only a part of the overall corporate and securities litigation story. State court litigation, particularly state court M&A-related litigation, represents an increasingly important part of the picture.

 

According to my count (about which see more below), there were 218 securities class action lawsuit filings in 2011, well above the 176 filed in 2010, and also above the 1997-2009 average number of filings of 195, but below the 2008 credit crisis fueled total of 223. The 2011 filings were fairly evenly balanced throughout the year, with 113 in the year’s first half and 105 in the year’s second half.

 

The single largest factor driving the increase in 2011 filings were merger-related lawsuits. Sixty-one of the 218 filings during 2011 (or about 28%) were merger-related. By way of comparison, the M&A-related lawsuits represented slightly less than 20% of all 2010 filings, While these federal court filings represented an important part of the year’s overall federal securities class action lawsuit filings, these federal court filings represented only a fraction of all M&A-related litigation, most of which was filed in state court. Taking all of the cases, state and federal, into account, the number of M&A related lawsuits now greatly exceeds the number of federal securities class action lawsuits that are not merger-related. As discussed further below, the counts and relative comparisons can get tricky.

 

A second significant factor driving the 2011 securities class action lawsuit filings is the number of filings against non-U.S. companies, particularly U.S.-listed Chinese companies. 55 (or about 25%) of the 2011 federal securities filings involved non-U.S. companies.  The targeted non-U.S. companies are domiciled in 12 different countries. 39 of these 55 foreign companies are U.S.-listed Chinese companies (or U.S. listed companies that have their executive offices or principal places of operation in China). These 39 alone represent about 18% of all 2011 filings. Though the 39 lawsuit filings involving Chinese companies were heavily weighted to the first part of the year, there were still 13 in the year’s second half (which is more the 10 total filed against U.S.-listed Chinese companies during all of 2010) -- including two in December.

 

At one level, the fact that a quarter of all 2011 securities class action lawsuit filings involved non-U.S. companies is surprising, given that it seemed probable that the U.S. Supreme Court’s decision in the Morrison v. National Australia Bank case would result in a reduction in litigation involving non-U.S. But the 2011 actions involving non-U.S. companies either (like the cases involving the Chinese companies) involved firms with shares or ADRs listed on U.S. exchanges – and that therefore come within the requirements of Morrison – or were filed only on behalf of shareholders who purchased their shares in the U.S. The November 2011 action on behalf of the very few Olympus Corporation shareholders who purchased their Olympus ADRs over the counter in the U.S. is a good example of this latter kind of case. The Olympus case, which involves only a very small fraction of the company’s shareholders, show that Morrison is still having a very significant impact on filings, notwithstanding the number of filings involving non-U.S. companies.

 

The merger cases and the cases involving U.S.-listed Chinese companies together represented 100 of the 218 securities class action lawsuit filings during 2011, or nearly 46% of all filings. Clearly these two lawsuit phenomena were significant factors in driving 2011 filings, and more than account for all of the increase in 2011 filings compared to filing levels in 2010 and 2009.

 

The companies targeted in the 2011 securities class action lawsuit filings were very diverse, representing 114 Standard Industrial Classification (SIC) code categories. Unlike recent years in which filings against companies in the financial services industries predominated, filings against companies in the 6000 SIC code category (Finance, Insurance and Real Estate) represented only about 12% of all filings, compared to 2010, when filings against companies in that group represented about 20% of all filings, and 2009, when suits against financial companies accounted for over half of all filings.

 

This decline in the percentage of cases involving financial companies is largely due to the winding down of the subprime and credit crisis-related litigation wave. But while the wave is fading, it is not yet completely gone. There were still four new subprime relates securities class action lawsuit filings in 2011. However, none of these were filed during the year’s second half, which suggests that we could be very close to the end of the litigation wave, at least in terms of new filings.

 

There really was no SIC code classification that predominated in the 2011 filings. However, as always seems to be the case, there were a large number of cases involving companies in the life sciences sector. The SIC code classification with the single largest number of filings was SIC Code classification 2834 (Pharmaceutical Preparations), in which there were 11 lawsuits in 2011. Overall there were 13 lawsuits in SIC Code Group 283 (Drugs). There were another 5 companies sued in SIC Code classifications 3841 (Surgical and Medical Instruments) and 3845 (Electromedical and Electrotheropeutical Apparatus), meaning that overall there were 18 new lawsuits filed against life sciences companies, or about 8% of all 2011 filings. These 2011 figures were down from filings against companies in the SIC Code categories in 2010, when there were 27 lawsuits against companies in these sectors, representing about 15% of all filings.

 

Another sector that had a significant number of filings was SIC Code Group 737 (Computer Programming, Data Processing and Other Computer-Related Services). There were a total of 21 lawsuits involving companies in this group. There were also another 11 lawsuits filed against companies in SIC Code Group 367 (Electrical Components and Processors), including nine in SIC Code classification 3674 (Semiconductors) alone. Together, these various technology categories accounted for 32 of all 2011 filings, or about 15%. 

 

The 2011 securities class action lawsuits were filed in 47 different federal district courts, although a few courts accounted for most of the filings. 48 of the filings, or about 22%, were in the Southern District of New York (both the merger filings and the lawsuits against Chinese companies helped to swell the number of filings in this judicial district). The Central District of California accounted for 33 of the filings (again swollen by filings involving Chinese companies), and the Northern District of California accounted for 16, largely as a result of the number of lawsuits involving technology companies. These three districts together accounted for 97 of the 2011 filings, or nearly 45% of the total.

 

Discussion

My tally of the 2011 securities class action lawsuit filings will differ from other published counts of the 2011 lawsuits. My count is larger than the tally of the Stanford Law School Securities Class Action Lawsuit Clearinghouse, because I included all federal court merger objection lawsuits while the Stanford web site chose to omit some. My count is smaller than that of NERA Economic Consulting (about which refer here) for a number of reasons, primarily because I count multiple lawsuits involving a corporate defendant only once, whereas NERA will count multiple lawsuits in multiple jurisdictions involving the same company multiple times, unless the separate lawsuits are consolidated in a single case in a single jurisdiction.

 

The differences in counting the M&A lawsuits underscores a recurring general difficulty with trying to count federal securities class action lawsuits. There is an inevitable definitional issue, as deciding whether or not to “count” individual cases presents recurring questions abut exactly what it is that you are trying to count. The M&A related cases present a particularly challenging category of cases, because increasingly a single merger transaction will give rise to multiple lawsuits in multiple different jurisdictions, sometimes based on a differing legal theories. Because there cases are sometimes filed in different states’ courts, or in both federal and state courts, there are recurring and vexing issues involved with trying to count these cases, all of which is compounded by the fact that it can be very difficult to accurately track the state court filings.

 

Though I have elected to include all federal court M&A-related lawsuit filings in my tally, these filings represent only a fraction of all M&A-related lawsuit filings in 2011. The vast majority of 2011 corporate and securities lawsuits – particularly the merger objection cases – were filed in state court. The fact that my 2011 count, like most of the published securities class action lawsuit filing counts, is based on federal filings necessarily means that it omits numerical recognition and analysis of the state court filings. At least from a frequency standpoint, the exclusively federal court focus could lead to a distorted impression of corporate and securities litigation activity levels.

 

At the same time, my inclusion of the federal merger objection lawsuits could result in a distortion the other way as well. There is a very legitimate argument that these cases should not be included, or at least many of them should not be included, in a tally of federal securities class action lawsuit filings. Some of them may not allege a breach of the U.S. securities laws. For that reason, the Stanford website omits some of these cases. I decided to go ahead and include all of them and not just some of them, first, because it can become extraordinarily difficult to make selections at the individual case level. The categorical distinctions are not always apparent. But the larger reason I decided to include these is that I felt that without including these cases, the overall levels of federal court litigation might appear understated.

 

There is another significant way in which the federal court litigation may be understated, at least as a matter of analysis. That is, most analysis of federal securities lawsuit filings levels focus exclusively on the absolute numbers of filings. Though the absolute number of annual filings has fluctuated over the years, they have generally held pretty steady, even allowing for the occasional annual blip up or down. But a simple focus on the absolute numbers of filings levels does not consider the relative filing levels – that is, the number of filings relative to the number of public companies.

 

The fact is that there are significantly fewer public companies than there were only a few years ago, due to bankruptcies and mergers, along with declining numbers of IPOs. As I discussed here, by one estimate, there are 40% fewer public companies than there were in 1997, yet the annual number of new securities class action lawsuits is more or less consistent with that earlier time. All of which supports the argument that because absolute filing numbers have held steady while the number of publicly traded companies has declined, overall filing levels have actually increased over time. In any event, regardless of what you make of this argument, I think that consideration of relative filing levels is a part of the analysis that is routinely omitted from the consideration of the changes in annual litigation activity.

 

Looking ahead to 2012, it seems probable that the wave of new lawsuits involving Chinese companies will wind down, since sooner or later the plaintiffs’ lawyers will simply run out of companies to sue. However, there seems to be no reason to expect that the surge of M&A-related litigation will not continue to grow. The procedural and substantive barriers to traditional securities litigation and the prospects for quick settlements and attorneys’ fee recoveries in the M&A suits have encouraged many of the smaller plaintiffs’ securities firms to adapt M&A litigation as their new business approach. The vexing problems this type of litigation presents will increasingly challenging in the New Year. My own view is that the growth in M&A litigation represents a secular rather than a merely cyclical change.

 

The bottom line is that with growing levels of M&A-related litigation and relatively greater frequencies of federal securities class action lawsuit filings, the likelihood that any particular public company will get hit with a serious corporate or securities lawsuit has never been greater (as I analyze in greater detail here).

 

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In a prior post (here), I examined the mounting problems associated with the increasing levels of M&A-related litigation. A recent academic paper takes a closer look at these issues and concluded, among other things, that M&A-related lawsuit filings now outnumber federal securities class action lawsuit filings, and M&A-related litigation has “replaced traditional stock drop cases as the lawsuit of choice for plaintiffs’ securities lawyers.”

 

In her article entitled “Securities Class Action Lawsuits in State Court” (here), Lewis & Clark Law School Professor Jennifer Johnson examines a database of class actions filed in state court between 1996 and 2010. Her analysis shows that as a result of several Congressional enactments in recent years – particularly SLUSA and CAFA – the prevalence of many types of state court securities class action filings has declined. However, the number of state court class action lawsuit filings involving M&A transactions has been “skyrocketing” and now even outnumber federal securities class action lawsuit filings.

 

Indeed given that the database of state court filings on which Professor Johnson relied almost certainly understates the number of state court filings, it is probable that the number by which the state court M&A-filings exceeds the number of federal court filings is even greater than her analysis shows.

 

According to Professor Johnson, the growth of M&A-related litigation is a consequence of the various Congressional enactments intended to restrict traditional securities class action lawsuits to federal court. As legislative enactments like SLUSA and CAFA drove plaintiffs’ lawyers away from federal court, “dispossessed plaintiffs’ lawyers increasingly have turned to filing alternative class actions in state court” – particularly M&A-related class actions. As a result, M&A-related class action lawsuits “have replaced traditional stock drop cases as the lawsuit of choice for plaintiffs securities lawyers,” particularly because the cases are filed and resolved quickly, owing to the pressure on the defense attorneys’ to complete the underlying transaction.

 

While the increased numbers of M&A-related lawsuits has led to an increase in the numbers of filings in Delaware state court, “the relative percentage of Delaware cases compared to those in other jurisdictions has fallen.” Increasingly, plaintiffs’ lawyers are choosing to file cases outside the defendants’ state of incorporation. At the same time, while the growth in M&A-related litigation has primarily been a state-court phenomenon, there have also been growing numbers of federal court M&A related lawsuit filings as well.

 

The proliferation of M&A-related litigation outside of Delaware is in part due to the fact that increasingly any one M&A event is likely to “induce multiple filings.” During 2010, for example, each M&A event spurred an average of 1.8 filings, but this statistic is “slightly misleading” as larger entities often faced suits in 4 or 5 different jurisdictions.

 

The reasons for increase in M&A-related filings outside of Delaware may include concerns among plaintiffs’ attorneys that Delaware’s courts are “increasingly diligent in policing the conduct of lead counsel and the award of attorneys’ fees.” There may also be a perception that Delaware is a “manager-friendly state” and that “settlement values may be higher outside of Delaware state court.”

 

The growing levels of multi-jurisdiction litigation “makes it difficult for courts to manage cases, as there is no prescribed orderly procedure for consolidation as would exist in the federal courts.” There are also no mechanisms for coordination between states or between state and federal courts.  The phenomenon of multi-jurisdiction M&A litigation “wastes judicial resources,” leads to “obvious inefficiencies and increased costs” for defendants, and even leads to problems among plaintiffs’ counsel “as they jockey for position and ultimately for fees.”

 

Johnson observes that “effective coordination” between the courts could help ameliorate these difficulties. She also reviews various proposals that have been offered for corporations to amend their charters to include clauses specifying the forum for specifying intra-corporate disputes. But, she also speculates, “absent a major change,” the concerns associated with the proliferation of multi-jurisdiction M&A related litigation “is likely to come to the attention of Congress.”

 

Johnson suggests that Congress might attempt to address these concerns through an outright repeal of the so-called “Delaware Carve-Out” from SLUSA, which preserves state court jurisdiction for state law claims involving shareholder communications involving voting rights, such as in M&A transactions, forcing the class actions into federal court. Alternatively, Congress might revisit SLUSA and restrict the carve-out to preserve state court jurisdiction for the courts of an entity’s state of jurisdiction (which, Johnson speculates, would have the effect of making Delaware the sole forum for the majority of cases).

 

Discussion

Johnson’s article further substantiates the alarms being sounded in connection with the exploding levels of M&A-related litigation. The growth of M&A-related litigation is a vexing and costly problem, and her article helps to substantiate the growth and seriousness of the problem. However, her speculation about possible solutions may be optimistic. The inability of the current Congress to confront even matters of the greatest urgency is hardly reassuring about its ability to deal with issues of the type involved here.

 

But even Congress were to address these issues, I am skeptical that Congress would outright eliminate the Delaware Carve Out from SLUSA and make all corporate litigation into federal litigation. It is relatively likelier that Congress might be willing to revise the carve-out to restrict the preserved jurisdiction to the court of the state of an entity’s incorporation, but even there I have my doubts that Congress would be willing to act in a way that would so clearly favor the courts of a single jurisdiction.

 

Even if we assume for the sake of discussion that Congress will eventually be able to address these issues, that action could well be a long time coming. In the meantime, courts and litigants face a growing and costly problem. Courts and litigants alike will have to continue to grapple with these problems. Absent a congressional directive, informal cooperation between and among the courts and parties involved will be the only practicable solution available – a solution that admittedly could be frustrated in any specific case by a recalcitrant party or court.

 

Setting aside the questions of what to do about it, it is important simply to recognize that the problems associated with the growing levels of M&A-related litigation activity exist. As Johnson’s article documents, corporate and securities litigation overall is changing. It is no longer sufficient to focus just on federal securities class action litigation. M&A related litigation is an increasingly important part of the overall mix of corporate and securities litigation. For anyone whose tasks include understanding the risks and exposures associated with corporate and securities litigation, this is an important development with significant implications.  

 

Special thanks to a loyal reader for forwarding a copy of this article.

 

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E*Trade Financial Corporation has reached an agreement in principle to settle the subprime-related securities class action lawsuit pending against the company and certain of its directors and officers, the company reported in its December 21, 2011 filing on Form 8-K. The agreement calls for the company and its D&O insurance carriers to pay a total of $79 million, of which the company’s portion is approximately $10.75 million. The agreement is subject to court approval.

 

As reflected in greater detail here, the plaintiffs first filed their securities actions against E*Trade in October 2007, alleging that the company had failed to disclose deterioration in its mortgage and home equity loan portfolio. The defendants moved to dismiss, arguing among other things that the company's losses were the result of a "worldwide economic catastrophe" and the plaintiffs' claims were nothing more than "fraud by hindsight."

 

In a May 10, 2010 order (here), Southern District of New York Judge Robert Sweet denied the defendants' motion to dismiss. Judge Sweet rejected the "global meltdown" argument, saying that "because the issue in this action is what the Defendants knew and when they knew it, a securities violation has been adequately alleged." 

With the announcement of the settlement to which the D&O insurers will be contributing about $68.25 million, the E*Trade case becomes the late subrime-related securities class action lawsuit to be settled largely with D&O insurance proceeds. For example, the $90 million Lehman Brothers directors and officers settlement (about which refer here), the $10.5 million Colonial Bank settlement (refer here), and $105 million of the $208.5 million Washington Mutual securities class action lawsuit settlement (refer here).

 

These and many other examples suggest that the subprime and credit crisis-related litigation wave have produced very substantial aggregate losses for the D&O insurance industry, with many more cases yet to be resolved. Even though the litigation wave is about to enter its sixth year, the losses are still accumulating and will do so for some time to come.

 

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

 

‘Tis the Season: In light of the yuletide season that is now upon us, The D&O Diary will be taking a short holiday break for the next few days. The D&O Diary’s normal publication schedule will resume on January 3. To put everyone in the holiday spirit, here is a little Christmas cheer, flash mob style (watch for the dancing security guard). Best wishes for a happy and healthy holiday season to all.  

 

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A long-standing question under New York law is whether the state’s Martin Act preempts private claimants’ efforts to bring non-fraud common law claims in the securities context. A well-developed body of case law has generally held that it does, although recently some judges questioned this conclusion.

 

In a December 20, 2011 opinion (here), the New York’s highest court held that the Martin Act does not preclude private claimants from bringing common law causes of action. As discussed below, this ruling not only clarifies a long-standing question but also has important implications. It could represent a big win for securities plaintiffs.

 

Background: The Martin Act

The Martin Act has been a potent weapon in the New York Attorney General’s toolkit. The Act prohibits fraudulent securities practices, but it does not require the NYAG to plead or prove scienter. The Act does not, however, provide for a private right of action and New York’s courts have declined to imply one. Claimants unable to pursue private rights of action under the Martin Act have sought to plead alternative non-statutory liability theories. These efforts have run afoul of case law suggesting that the Martin Act preempts these alternative theories as well.

 

A 1987 New York Court of Appeals decision, CPC International, Inc. v. McKesson Corp., has been interpreted by most later courts as having held that the Martin Act precludes not only private actions brought under the Act itself but also alternative common law claims. This view of the McKesson opinion has been, until recently, the generally prevailing view in the Southern District of New York. As a result, investors asserting claims of common law negligence and breach of fiduciary duty have generally had their claims dismissed. However, more recently, some courts and commentators have questioned whether McKesson definitively answered the question, and more to the point, whether the Martin Act does preclude common law claims. A split in decisions has been emerging in the trial courts.

 

The Assured Guaranty Case

J.P. Morgan Investment Management managed the investment portfolio of Orkney Re II PLC, whose obligations Assured Guaranty guaranteed. In its complaint, Assured Guaranty, as an express third-party beneficiary of J.P. Morgan’s investment management agreement with Orkney, alleged that J.P. Morgan invested Orkney’s assets in risky subprime mortgage-backed securities, as a result of which Orkney suffered financial losses that triggered Assured Guaranty’s payment obligations.

 

J.P Morgan moved to dismiss Assured Guaranty’s complaint, arguing that the Martin Act precluded Assured Guaranty’s claims for breach of fiduciary duty and gross negligence. The trial court granted J.P. Morgan’s motion to dismiss, but the intermediate appellate court reinstated Assured Guaranty’s claims. The intermediate appellate court granted J.P. Morgan leave to appeal to the New York Court of Appeals on certified questions.

 

The December 20 Opinion

In a December 20, 2011 opinion written by Judge Victoria Graffeo, the New York Court of Appeals held that the Martin Act does not preempt Assured Guaranty’s common law causes of action for breach of fiduciary duty and gross negligence.

 

The court state that the “plain text” of the Martin Act “does not expressly mention or otherwise contemplate the elimination of common law claims,” adding that J.P. Morgan “cannot point to anything in the legislative history” demonstrating a legislative “mandate to abolish preexisting common-law claims that private parties would otherwise posses.” Accordingly, the court agreed with Assured Guaranty that “the Martin Act does not preclude a private litigant from brining a non-fraud common law cause of action.”

 

The court distinguished claims “premised on a violation of the Martin Act” that “would not have existed absent the statute.” By contrast, however, “an injured investor may bring a common-law claim (for fraud or otherwise) that is not entirely dependent on the Martin Act for its viability.”

 

Discussion

If for no other reason than the fact that the decision of the New York Court of Appeals sets aside a generally accepted, conventional  view of New York law, the decision will have a significant impact. It also clears up what was becoming a vexing situation, where some judges were holding that the common law claims were not preempted, while most others were holding that they were.

 

The decision would seem to be an enormous boost for claimants seeking recoveries for alleged wrongdoing involving securities. In his December 20, 2011 Am Law Litigation Daily article about the decision (here), Nate Raymond quotes a leading plaintiffs’ attorney  who had filed an amicus brief in the case on behalf of a group of unions as saying that “this decision will tremendously enhance plaintiffs’ ability to vindicate their rights under New York law.” The December 20, 2011 New York Law Journal article about the decision says that "the decision is likely to have a wide impact as it resolves an issue that arises with some frequency, and shatters the long-held assumptions of lower state and federal courts." 

 

Martin Act preemption and the heightened pleading standards under the PSLRA together represented significant barriers for investors seeking to recover their losses. The heightened pleading standards often knocked out the federal securities law claims and the Martin Act preemption generally  knocked out the common law claims – indeed, in many instances, claimants often  omitted the common law claims altogether, in recognition of the Martin Act preemption.

 

Now, in light of the Court of Appeals ruling, most claimants will now likely include common law claims along with their federal securities claims – or simply assert common law claims alone, as Assured Guaranty did. Without the preemption argument, defendants will find it more difficult to knock out the common law claims at the initial pleading stage, particularly given that many of common law claims do not require the claimant to plead fraud. Without having to satisfy the heightened pleading requirement under the federal securities laws, aggrieved investors may be able to overcome the initial pleading hurdles, at least with respect to their common law claims.

 

This development may be most useful for claimants proceeding individually. In light of SLUSA as well as constraints in pleading common law claims on behalf of a class of claimants, the decision of the Court of Appeals may have less impact in class actions. At a minimum, the Court of Appeals decision seems likely to have a significant impact in the way that aggrieved investors plead their claims, and it potentially could have a significant impact on the numbers of cases, like that of Assured Guaranty, surviving the preliminary motions stage.  The Court of Appeals decision in this case could potentially represent a significant development for securities claimants proceeding under New York law.

 

About That Big Fee Award in Delaware: Judging by the number of comments I received, Chancellor Leo Strine Jr.’s $285 million plaintiffs’ fee award in the Southern Peru case, has quite a few people really stirred up. (Actually, as Nate Raymond noted in his December 19, 2011 Am Law Litigation Daily article, here, due to an increase in the amount of the underlying judgment, the value of the fee award is actually closer to $300 million.)

 

One particularly provocative question about the award is whether or not it has anything to do with the concerns some have raised about whether Delaware is losing corporate litigation “market share,” as plaintiffs’ attorneys’ increasingly resort to the courts of other jurisdictions they regard as more plaintiff friendly. In her December 20, 2011 article on Thomson Reuters News & Insight, Alison Frankel suggests that the fee award in the Southern Peru case was a “message…to the entire securities class action plaintiffs bar.” Frankel reports that at the hearing on the fee award, Strine made it clear that he wants certain kinds of cases to remain in Delaware, and that plaintiffs resort to Delaware courts with the kinds of cases in which they are taking risks will be well compensated for their efforts.

 

As I have previously noted, it is a serious concern if Delaware’s judges feel obliged -- in order remain competitive in the jurisdictional competition and to try to preserve declining market share -- to prove that plaintiffs’ lawyers will be rewarded for resorting to the state’s courts.

 

A Negative Take on the SEC’s Lawsuit Against Fannie and Freddie: The SEC made quite a splash with the lawsuit it filed last week against several former officers of Fannie Mae and Freddie Mac. New York Times columnist Joe Nocera is unimpressed. In his December 19, 2011 column (here), Nocera describes the complaint as “extraordinarily weak.”

 

The complaint alleges that the organizations misled investors about their exposure to subprime mortgages. Nocera contends that in order to make its case, the SEC lumps together all kinds of mortgages as subprime. He also notes that there are no damning emails and no allegations of insider stock sales. In addition, he contends that in their regulatory filings the firms “clearly laid out the credit characteristics of their mortgage loan portfolios,” noting in that regard that the federal judge presiding over the Fannie Mae lawsuit threw out their complaint because the company’s disclosures were adequate. His final point is that Fannie and Freddie’s mortgage loan default rate is actually well below the national average. Fannie and Freddie, Nocera suggests, are not to blame for the entire crisis.

 

A December 20, 2011 column on the Bank Think blog (here), challenges Nocera’s conclusions, referencing earlier New York Times articles about the moral hazards of the policy Fannie and Freddie adopted in the 90s (as a result of political pressure) to ease mortgage lending standards. The earlier articles quoted commentators as saying that looser standards could lead to increased defaults and even bank failures that could in a time of crisis require a government bailout. The institutionalized imprudent lending caused the crisis, the author contends.

 

Whatever else might be said about the lending policies, it should be noted that the lawsuits are not about the policies, but about Fannie and Freddie’s disclosures. Nocera’s point is not that Fannie and Freddie are beyond reproach; to the contrary, his concern is that these organizations “real sins” are being “largely overlooked in favor of imagined ones.”

 

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With the implementation of potentially rich whistleblower bounties under the Dodd-Frank Act, there have been concerns that the incentives will  not only lead to increased numbers of reports and increased enforcement activity, but that the regulatory action will in turn generate follow-on civil litigation. A securities class action lawsuit filed this past week against Bank of New York Mellon give a glimpse of how heightened whistleblower activity could lead to increased follow- on civil litigation.

 

As reflected in their press release (here), on December 14, 2011, plaintiffs’ lawyers initiated a lawsuit in the Southern District of New York against the Bank of New York Mellon, twenty of its directors and officers, and its offering underwriters. According to the press release, the plaintiff’s complaint, which can be found here, alleges that the defendants “misled investors regarding the Company's financial condition by reporting inflated revenue and concealing risks attributable to BNY Mellon's participation in a scheme to fraudulently overcharge its custodial clients for foreign currency ("FX") trades.”

 

According to the complaint, the details about the bank’s alleged practices first surfaced in January 2011 when two whistleblower lawsuits (in the form of qui tam actions) against BNY Mellon in Virginia and Florida were unsealed. Among other things, the whistleblower suits alleged that BNY Mellon manipulated FX rates, which were selected to maximize the company’s fees. As a result of publicity surrounding these allegations, the Virginia attorney general filed a complaint in intervention relating to the company’s foreign currency. In October 2011, the New York Attorney General and the U.S Department of Justice each filed civil actions against BNY Mellon. The securities lawsuit complaint alleges that the company is also the subject of an SEC investigation.

 

The regulatory actions against BNY Mellon all followed in the wake of the initial whistleblower allegations, which in turn led to the various civil actions against the company, now including the securities class action lawsuit.

 

The qui tam actions that the initial whistleblower filed against the BNY Mellon are not directly related to the whistleblower provisions of the Dodd-Frank Act. (However, as noted in a November 16, 2011 Wall Street Journal article, here, BNY’s foreign currency practices are also the subject of whistleblower reports to the SEC.) The train of events that the BNY Mellon whistleblower allegations set in motion shows how the revelation of whistleblower allegations can lead not only to significant regulatory action but also to significant follow on civil litigation.

 

The whistleblower provisions of the Dodd-Frank Act have only recently been implemented and the SEC’s program is only in its earliest stages. It remains to be seen exactly where the program will lead. But given the substantial bounties provided for in the Act it seems likely there will be increased numbers of reports to the SEC, which in turn could mean increased levels of enforcement activity. Along with all other concerns these possibilities present, there is also the concern that the increased number of reports and increased enforcement activity could, following the same sequence illustrated in connection with the BNY Mellon, lead to a surge in follow-on civil litigation. As we head into 2012, we will have to watch whether increased whistleblowing lead to increased follow-on civil litigation, similar to the suit with which BNY Mellon was just hit.

 

A View from a Window: In those days, the car ferry traversed the Cook Strait twice daily, in the morning heading south from Wellington, on the Southern end of the North Island of New Zealand, and in the evening heading north from Picton, on the Northern end of the South Island. (There are more ferries now, and the crossings more frequent.)

 

After the ferry leaves Picton, the first hour of the northward journey runs through the Queen Charlotte Sound, winding through sea-drowned valleys and steeply sloped channels. Where the Sound finally opens up into the Strait, a single white house sits on a huge bluff, standing alone against a stark landscape.

 

Sometimes when I am having trouble falling asleep, I picture myself standing in the window of the house, in the evening, just as the ferry passes below. A few sounds from the ship drift up to house – a bit of conversation, the clink of a glass, a few notes of music. But the ship moves quickly and it soon disappears into the gathering night. The white foam from the ship’s wake quickly dissipates as well, and all is quiet, in a place remote from the troubles and worries of the world.

 

I watch for a time as the unfamiliar stars of the Southern sky emerge. I turn from the window and slide into bed. And then gentle Sleep envelops me in her warm, soothing embrace, and I drift away, dreaming dreams of serenity and contentment.  

 

The essay question on one of my son’s college applications supplied only the brief prompt: “You are looking out of a window.” For some reason, I felt compelled to respond to this odd prompt. Strangely, my son was uninterested in my brief essay, and uninterested in showing me what he came up with as his response, as well.

 

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As a result of legal changes taking place in many countries around the world, as well as U.S. Supreme Court case law developments, questions involving the possibility of securities litigation outside the U.S. has become an increasingly high profile issue. In a guest post, Robert F. Carangelo, Paul A. Ferrillo and Catherine Y. Nowak of Weil, Gotshal & Manges LLP take a detailed look at the issues surrounding the emergency of securities litigation activity and exposures out side the U.S.

 

Many thanks to Robert, Paul and Catherine for their willingness to publish their article here. I welcome guest posts from responsible commentators on topics relevant to this blog. Any readers who are interested in publishing a guest post on this site are encouraged to contact me directly. Robert, Paul and Catherine’s guest post follows:

 

 

 

Key developments in both the litigation and regulatory context are compelling multinational corporations to reassess their global securities litigation and regulatory compliance strategies. In the litigation context, recent U.S. Supreme Court activity has limited the ability of overseas plaintiffs to bring securities class action claims within the United States. As such, plaintiffs have shifted litigation to more flexible jurisdictions in Europe and overseas, thereby forcing global firms listed on multiple exchanges to increasingly defend against securities class action claims and regulatory investigations in numerous jurisdictions. At the same time, governments around the world have responded to the recent financial crisis by bolstering their regulatory capability. Governments have not only adopted more robust legislative regimes with respect to securities regulation, but they have also invested heavily in stronger enforcement protocols.

 

Clearly the rules of the game have changed within the global securities litigation landscape over the past few years. In turn, multinational companies are revaluating their response and responsibilities to adapt to these new challenges. For instance, how do these new realities affect litigation and settlement strategy for securities class actions? [1] What is the impact of a shareholder derivative action being commenced against a multinational firm simultaneously in the United States and abroad? How can global firms comply effectively with heightened U.S. and foreign regulatory investigations? Which of these trends could affect a company's compliance obligations in a post-Dodd-Frank world? Finally, how does all of this influence a company's purchase of directors and officers liability insurance? 

 

A new securities litigation strategy, or “Playbook”, is therefore key for global firms that must now compete under these new realities and regulations. Strategic suggestions are discussed below along with practical advice to help navigate global securities litigation and regulatory enforcement.

 

A.  Litigation Context: An Increase in Overseas Securities Litigation

Traditionally, the United States was deemed by overseas plaintiffs as the premier forum in which to mount a securities class action claim against a publicly-traded company. Federal courts were comfortable applying U.S. securities fraud laws to disputes arising outside of the United States and overseas plaintiffs enjoyed the efficiency and sophistication of the U.S. litigation system. However, last year, in an abrupt reversal, the United States Supreme Court dramatically limited the extraterritorial application of U.S. securities laws in Morrison v. National Australia Bank Ltd., 130 S. Ct. 2869 (2010). This reversal now not only bars plaintiffs from establishing jurisdiction in the United States over a multinational company traded on non-U.S. exchanges, it also limits U.S. jurisdiction in cases involving non-exchange-based securities transactions.

 

While Morrison will likely curb the filing of certain securities litigation actions in the U.S., the net effect of this case seems to be that such litigation will simply shift to other, more flexible, jurisdictions. For example, in 2010, the United States District Court for the Southern District of New York dismissed a securities fraud suit against Fortis, a Belgium-based financial services company.[2] Within one year of the SDNY decision, a Dutch law firm filed suit on behalf of foreign investors against Fortis in the Utrecht Civil Court. [3]  The Dutch Suit chch includes as plaintiffs some of the largest pension funds in Europe, mirrors the same allegations that were previously dismissed in the United States.[4]

 

Below is a list of likely jurisdictions where modified versions of U.S.-type securities litigation are likely to materialize. We also identify emerging jurisdictions that are expected to bolster their securities litigation and regulatory framework in the coming years.

 

Canada

Canadian securities class actions are sharply on the rise. Not only is there a record 28 active Canadian securities class actions currently being considered by Canadian courts, but these class actions are estimated to represent approximately $15.9 billion in claims.[5] This rise can be partly attributed to the perception that Canada has very similar securities class action legislation as the U.S. and therefore plaintiffs routinely launch parallel claims in Canadian jurisdictions. Some of these similarities include comparable certification requirements and the existence of both primary and secondary liability under the laws of most Canadian provinces. 

 

Two recent developments, however, stand out in their ability to increase significantly the number of securities suits brought forward in Canada. First, some Canadian jurisdictions have recently statutorily revoked the “reliance” element of a securities fraud cause of action.[6] By completely removing the reliance requirement in Ontario securities legislation, plaintiffs will no longer have to prove reliance at all, nor rely on a presumption, such as “fraud-on-the-market”, to properly mount a statutory-based claim. It seems likely then that plaintiffs may look to Ontario to advance claims that would otherwise be blocked in the United States due to deficiencies in proving reliance.The other major development is the endorsement of litigation funding in Ontario. In Dugal v. Manulife Financial Corporation, (2011 ONSC 1785, ¶ 3 (2011)),  the Ontario Superior Court approved a third party funding arrangement between the plaintiffs and Claims Funding International (“CFI”), an Irish corporation.[7] In arriving at his decision Justice Strathy commented on how the “loser pays” system, which is currently the typical method of assigning the costs of the litigation in Ontario, disincentivizes a class representative from coming forward: “the grim reality is that no person in their right mind would accept the role of representative plaintiff if he or she were at risk of losing everything they own ... no rational person would risk an adverse costs award of several million dollars to recover several thousand dollars or even several tens of thousand of dollars.”[8] It is therefore not surprising that analysts have observed that Justice Strathy’s comments “could prove persuasive to judges in other Canadian jurisdictions and could also encourage potential plaintiffs and litigation funders to enter into similar agreements”[9] throughout the country.

 

There are, however, some limitations on the breadth and scope of Canadian securities fraud claims. In Ontario, damages are limited to the greater of 5 percent of the market capitalization of the company, or $1 million.[10] Damages pertaining to directors and officers are also generally limited to the greater of 50 percent of compensation or $25,000.

 

United Kingdom

In the U.K., class actions have not reached the scale of the U.S., but are routinely applied under current legislation. Class actions, or “group actions,” may be brought under Part 19.11 of the English Civil Procedure Rules, which provides that a Group Litigation Order (“GLO”) can be made to provide for the management of cases alleging common issues of law and fact.[11] Securities fraud related claims, more specifically, can be made either under common law principles (e.g., fraud, deceit, or negligent misrepresentation), or under Section 90 of the Financial Services Markets Act of 2000 (for liability relating to statements made in a prospectus.)[12] Under these provisions, claims can be pursued in a representative action where one representative claimant or defendant acts on behalf of a class of individuals. Shareholders are also permitted to bring derivative suits for director negligence, breach of duty or breach of trust under the U.K. Companies Act 2006.[13] The increased use of litigation funding in the U.K. may also make securities class action claims more viable.[14]

 

 

Netherlands

The Netherlands is also no stranger to securities fraud claims.  In contrast to the U.S., the issue of jurisdiction has not been seriously challenged in Dutch courts. Therefore, courts in the Netherlands are much more flexible in asserting jurisdiction, such as Fortis, which we discuss above. Courts in the Netherlands have also adopted a class settlement procedure, known as WCAM, “to create legally binding multi-national settlements of class action suits alleging securities fraud.”[15] One such example is the landmark $352 million Royal Dutch Shell settlement, which arose from allegations by European investors that Shell overstated its oil and gas reserves.[16] As such, the Netherlands might be the new “place to be” for investors seeking large recoveries for their securities fraud claims.

 

Germany

Though not yet as class action friendly as other highly-industrialized countries, substantive securities fraud claims are filed in Germany. For instance, after a similarly-styled securities lawsuit was dismissed in the U.S. following Morrison, a Canadian bank brought suit in Stuttgart District Court alleging that Porsche manipulated the shares of Volkswagen common stock in 2008 when it was trying to take over Volkswagen.[17]

 

Important differences do, however, exist within the German approach to securities litigation. For instance, Germany passed the Capital Investors’ Model Proceeding Law in 2005. This legislation serves as the primary legal authority for securities fraud class actions.[18] Rather than providing a mechanism to certify a “class-type” claim, the German legislation instead provides for the designation or selection of a “model case.” This “model case,” allows common elements of claims to be litigated first, and its common rulings bind all petitioners.[19] Another difference is Germany’s use of an “opt-in” system. In contrast to the “opt-out” approach in U.S. securities cases, only those claimants who actively choose to opt into the model case before a final judgment or settlement are bound by the decision.

 

Other Emerging Jurisdictions

While some jurisdictions may not have as robust of a securities litigation framework as the countries mentioned above, recent developments across different regions reinforce the need for global firms to monitor potential litigation venues around the world. Australia, for instance, has a well-established history of litigation funding and has adopted legislation that is highly similar to U.S.-style securities laws. Mexico, also recently amended its laws to allow consumers and investors to bring class actions.[20] High-profile restructurings in the Middle East (e.g. Dubai) have spurred shareholders in that region to seek better legislative protections and possible compensation. Finally, securities experts have also speculated that China, in an effort to attract even more investment capital into the country, is likely to introduce more stringent corporate governance and securities standards in the near term.[21]

 

B.    Regulatory Context: Stronger Overseas Securities Regulatory Frameworks

Just as U.S. style securities fraud litigations are heating up in foreign jurisdictions, foreign governments are also enacting new laws and institutions designed to regulate securities and address corruption in the aftermath of Dodd-Frank.

 

Stronger Regulators in Canada and the United Kingdom

Canada and the United Kingdom are both undertaking substantial reform in order to implement stronger regulatory and enforcement agencies. One of the biggest adjustments in Canada is the recent initiative to consolidate the thirteen provincial securities commissions that currently exist into a single regulator at the federal level.[22] The proposed consolidation will bolster regulatory and criminal enforcement across the country and allow for a more consistent approach to securities regulation.[23] In February 2011, the U.K. HM Treasury published a consultation paper providing more detail regarding recent financial regulatory reforms in the U.K. These reforms would be overseen by three new regulatory authorities: the Financial Policy Committee (which would regulate the U.K. financial system as a whole); the Prudential Regulation Committee (which would regulate financial institutions that carried significant risks on their balance sheets); and the Financial Conduct Authority (which would be the successor to the U.K. Financial Services Authority (FSA), the U.K.’s equivalent of the U.S. Securities and Exchange Commission). Under this scheme, the Financial Conduct Authority will have “as it core purpose, protecting and enhancing the confidence of all consumers of financial services . . . .”[24] The introduction of these new institutions by 2012 highlights the commitment of each government to building a stronger enforcement regime for publicly-traded companies.

 

New Anti-Bribery Legislation in Europe

Many countries in Europe have also adopted new anti-bribery legislation that may affect international issuers. The U.K. Bribery Act, which went into effect earlier this year, creates new liabilities for companies that fail to prevent the use of bribery within their organizations.[25] Similarly over the past year, Russia and China both enacted anti-bribery legislation, and Spain updated its anti-bribery statutes thereby criminalizing corporate bribery in that country.[26]

 

An Additional Layer of Regulatory Oversight

Finally, public-traded companies listed on multiple exchanges will now have to navigate another layer of regulatory oversight in Europe, due to the recent introduction of a new European Union regulatory framework for securities and banking.[27] The new European Securities and Markets Authority will provide overall guidance to the European financial markets and will be responsible for ensuring that a single set of harmonized regulations are applied by national regulators.[28]

 

The result of this torrent of regulatory reforms is clear: global firms must be able to navigate not only multiple jurisdictions, but multilateral regulatory initiatives as well. This requires an intimate and thorough understanding of the new rules of the game to develop successful, sustainable securities strategies.

 

C.   Overseas Regulatory Enforcement Activity 

As international securities regulation increases, so does international regulatory enforcement activity. In the U.S., Dodd-Frank reforms allow the S.E.C. and U.S. Department of Justice to assert jurisdiction under the more lenient “cause” and/or “effect” tests, thereby significantly increasing the reach of these regulators. In July 2010, French regulators pursued a large French hedge fund for insider trading,[29] and in January 2011 filed insider trading charges against France’s largest publisher.[30] In 2010, regulators in Hong Kong prosecuted insider trading charges against a large hedge fund.[31] In 2011, the FSA levied a substantial fine against a large multinational company in the U.K. for failing to have proper anti-bribery controls in place.[32] Outside of the bribery context, the FSA also ordered another large fine against the former Chairman of a large U.K. supermarket chain for failing to properly disclose voting rights in such company.[33] In Canada, regulators have also been active. Most recently, the Ontario Securities Commission has been aggressively investigating allegations of securities fraud and insider trading against executives of Sino-Forest Corp.[34] 

 

Cooperation among international securities regulators has also become commonplace.[35] For instance, regulators in France, Costa Rica, and the United States recently collaborated, and later collected significant penalties from a global communications company relating to anti-bribery charges.[36] International issuers would be prudent to update their regulatory protocols with the understanding that future cooperation with multiple regulators may require a much more rigorous response.

 

D.   What Does All this Mean for the Multinational, Publicly Traded Company?

The possibility of trans-national securities litigation and enforcement activity is very real, especially as the plaintiffs bar adapts to the new landscape and foreign jurisdictions. Below are a few suggestions aimed at establishing the new “Playbook” regarding global securities litigation and regulation:

 

Designate a Global Quarterback -- Internally and Externally

The potential for U.S.-type securities litigation and enforcement activity abroad requires a reassessment of both internal and external resources. Internally, foreign companies trading on multiple foreign exchanges need to devote legal resources toward understanding the securities laws and regulations in potentially problematic jurisdictions, jurisdictions where new regulations have been implemented, or in jurisdictions where there is likely to be significant groups of potentially-affected shareholders. This type of understanding is crucial in instances where companies are contemplating or have already completed securities offerings on foreign exchanges.

 

For similar reasons, the company should also identify outside legal resources in these jurisdictions that have experience dealing with class actions, and are well-versed with cross-border issues relating to both litigation and regulatory investigations. It is also important to manage the expectations of the parties and regulators to ensure that one jurisdiction investigating alleged misconduct does not outpace the other regulators, thereby unfairly advantaging both existing and potential plaintiffs. For instance, there are currently two class actions proceeding simultaneously in New York and Ontario relating to securities fraud allegations pertaining to IMAX Corporation, the makers of a propriety motion picture film format. The Ontario Superior Court has endorsed plaintiffs’ ability to conduct some discovery, even though the litigation is still at an early stage.[37] Some commentators suggest that this discovery decision “may enable plaintiffs’ classes composed of both U.S. and Canadian investors to perform an end-run around the U.S. Private Securities Litigation Reform Act (“PSLRA”) by filing suit in Canada.”[38]

 

Counsel must also be acutely aware of complex data privacy laws in the European Union, which make electronic discovery considerably more difficult than in the U.S. Ideally, the best outside resource to coordinate all of these concerns is one international law firm that can efficiently plan and manage both litigations and investigations in multiple jurisdictions at the same time.

 

Review Compliance Activities

It has become especially apparent that Dodd-Frank did not just change the landscape of securities regulation and enforcement in the U.S. As noted above, the U.K. and the European Union are working mightily to coordinate regulatory measures already in place in the U.S. Similarly, many countries are either instituting for the first time, or revising already-established laws relating to insider trading and anti-bribery. As a result, it is important for companies to have the adequate internal compliance resources to monitor, train employees, and respond to a fast-changing international regulatory landscape.

 

Review D&O Insurance

Finally, with the increase in trans-national securities-related litigation and regulatory investigations, it is critically important to verify that the company’s directors and officers liability insurance policy (“D&O policy”) will adequately respond to these new challenges abroad. D&O policies are very tailored instruments and are often dependent on the specific jurisdiction where the litigation or investigation is commenced. Therefore a company must also investigate whether the current D&O policy in place will actually apply not only to potential litigation or investigation in a foreign jurisdiction, but also with regards to any settlement resulting therefrom.[39]  Also, it is important to confirm if the D&O policy in question for the particular claim provides coverage for investigations and shareholder derivative actions (as corporate indemnification obligations may vary from country to country). This is an important and complicated area; it is imperative that large companies carefully determine whether it is worth the expense to engage both experienced insurance counsel and a D&O broker experienced on the international playing field to review its D&O coverage from a trans-national claims and investigations perspective.  This is not an area to be penny wise and pound foolish, as the stakes have undoubtedly risen given the new paradigm of global securities litigation, regulation, and enforcement activity.

 

 

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During 2011, elevated levels of M&A related litigation and the surge of litigation involving U.S.-listed Chinese companies offset declining numbers of credit crisis-related lawsuits, leading to overall levels of securities class action lawsuit filings consistent with recent years, according to a annual securities litigation study of NERA Economic Consulting. NERA’s December 14, 2011 report, entitled “Recent Trends in Securities Class Action Litigation: 2011 Year-End Review,” can be found here.

 

Based on the 213 filings between January and November 2011, NERA projects 2011 year-end filings of 232, which would be slightly below the 241 securities class action lawsuits filed in 2010 but above the 218 filed in 2009, and consistent with the 1997-2004 average of annual filings of 231.

 

Though the 2011 filing levels are consistent with recent years, the mix of cases has “changed substantially.” Credit crisis-related case, which predominated among filings in recent years, declined, while at the same time, M&A-related cases accounted for nearly 29% of all filings and filings against U.S.-listed Chinese companies have accounted for 18%.

 

Filings in the Second and Ninth Circuits accounted for more than half of all 2011 filings. However, the M&A objection suits are much more evenly distributed, with eight to ten merger objection cases filed in each of the Third, Fourth, Fifth and Ninth Circuits.

 

By contrast to recent years in which filings against companies in the financial sector predominated, 2011 filings have not been concentrated against companies in any one sector. (Filings against companies in the financial sector accounted for about 16% of all filings, which is in line with pre-credit crisis averages). More filings were against companies in the electronic technology and technology services sector that any other sector, representing about 21% of filings. Health technology accounted for 15% of filings.

 

More than a third of 2001 filings were against foreign-domiciled companies, more than double the levels of such filings in recent years. This increase of filings against foreign-domiciled companies was largely driven by filings against companies either domiciled or having their principal executive offices in China, which accounted for 39 of the 2011 filings. The pace of filings against Chinese companies slowed as the year progressed, with 27 filings in the year’s first half and 12 during the period July through November. However, the 12 filings during the period July to November are still above the 2010 total of ten cases involving Chinese companies.

 

Securities class action lawsuit settlements during 2011 averaged $31 million, compared to $108 million in 2010. However, if settlements in excess of $1 billion and the IPO laddering settlements are excluded, the 2010 average falls to $40 million, while the 2011 average stays at $31 million.

 

The 2011 median settlement was $8.7 million compared to 2010’s all time-median settlement of $11 million. Though the median settlement fell in 2011 compared to 2010, the median still represents the third highest annual median.

 

The NERA study is quite detailed and contains a wealth of other information and it merits being read at length and in full.

 

Discussion

In “counting” securities class action lawsuit filings, NERA counts multiple lawsuits against the same defendant in the same circuit as a single filing. However, if there are filings against the same defendant in different circuits, NERA counts those filings in separate circuits as separate filings, which may result in NERA’s annual filing count being higher than filing accounts that are published elsewhere.

 

In addition, NERA’s 2011 filings count is the result of a year end-projection based on actual filings from January through November. The fact that NERA’s 2011 filing number is the result of a projection may also result in differences between NERA’s year end number and those shown in other year end reports.

 

NERA “counts” only securities class action lawsuits filed in federal court. That means it does not include securities class action lawsuits filed in state court (as is permitted under The Securities Act of 1933). Similarly, while the NERA report contains extensive analysis of M&A related lawsuit filings, that analysis is limited to M&A cases filed in federal court. Many M&A related cases are in fact filed in state court. NERA’s analysis of M&A related litigation does not relate to those state court lawsuits.

 

Finally, in reporting on annual filing levels, NERA’s analysis reflects a consideration only of absolute numbers of filings. NERA’s does not include an analysis of those filings compared to the total number of publicly traded companies. As I have commented elsewhere, the total number of companies whose shares are publicly traded in the U.S. has declines substantially in recent years. The fact that absolute numbers of filings have stayed more or les consistent while the numbers of public companies has declined could be argued to suggest that overall levels of securities class action lawsuit filing have been increasing.

 

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Despite marked alleged differences between revenues and profits reported in China Century Dragon Media’s U.S. IPO prospectus and the equivalent figures reported in its Chinese operations’ filings in China, a federal court has granted the dismissal motion in the securities class action lawsuit filed against the U.S.-listed Chinese company.

 

On November 30, 2011, Central District of California Judge John Kronstadt granted China Century Dragon Media’s motion to dismiss (without prejudice, it should be noted), finding that the plaintiffs had not sufficiently alleged that the figures the company reported in its offering documents were false. Although this is not the first time a dismissal motion has been granted in a securities suit involving a U.S.-listed Chinese company, Judge Kronstadt’s ruling may represent the first time a motion to dismiss was granted in a securities suit against one of the Chinese companies based on a assessment of the sufficiency of the factual allegations. A copy of Judge Kronstadt’s ruling can be found here.

  

Background

China Century Dragon Media sells advertising on Chinese television. Its Chinese operations are conducted through Beijing CD Media Advertising Co. China Century Dragon Media controls all of Beijing CD Media Advertising through contractual relationships between subsidiaries of China Century Dragon Media and Beijing CD Media Advertising.

 

China Century Dragon Media conducted an IPO in the NYSE Amex exchange on February 7, 2011. On March 28, 2011, the company announced that its auditor, MaloneBailey had submitted a resignation letter in which the auditor cited “discrepancies,” “irregularities” and the possibility that the company’s accounting records may have been “falsified.” Amex halted trading in the company’s shares. Shareholder litigation ensued. Separately, on June 21, 2011, the SEC initiated proceedings to dtetermine whether or not it should issue a stop order suspending the effectiveness of the company's registration statement (refer here).

 

In their amended complaint, the plaintiffs allege, among other things that the revenue and profit figures the company reported in its Prospectus differed substantially from figures that Beijing CD Media Advertising reported to the Chinese State Administration for Industry and Commerce (SAIC). The plaintiffs allege that the Prospectus reports, for fiscal year 2008, that the company had revenues $45 million and profits of more than $8 million, and for fiscal year 2009, the company had revenues of about $75 million and profits of nearly $15 million. By contrast, the plaintiffs allege, Beijing CD Media Advertising’s filings with the SAIC reported FY 2008 revenues of $15 million and profits of only about $360,000, and FY 2009 revenues of only $9.5 million and profits of only $260,000.

 

The plaintiffs allege that because all of China Century Media Dragon’s operations run though Beijing CD Media Advertising, the financial information reported to the SEC and to the SAIC should be substantially the same. The plaintiffs allege that the lesser figures reported to the SAIC are the true figures and that the figures reported in China Century Media Dragon’s prospectus were false and misleading. The defendants moved to dismiss.

 

The November 30 Order

In his November 30 order granting the defendants’ motion to dismiss, Judge Kronstadt first determined that though the plaintiffs asserted claims only under the ’33 Act, their claims “sound in fraud” and therefore must meet the heightened standards for pleading fraud under Fed.R.Civ.P 9(b).

 

Judge Kronstadt found that the plaintiffs’ allegations “fail to meet the heightened standard of pleading with respect to the claim that the profit and revenue reports in the SEC filings were false.” Though the CSAIC numbers and the SEC numbers were different, that is “merely consistent with” the possibility that the SEC figures were false, but “does not suffice to make that claim plausible.” In order to establish that the SEC figures and not the CSAIC figures are false, the plaintiffs must “plead with greater specificity.”

 

In order to establish the requisite specificity, the plaintiffs could, Judge Kronstadt suggested, allege that “Chinese and American accounting standards are sufficiently similar such that the SAIC and SEC numbers should be substantially the same,” or that “Defendants relied on the same underlying financial data in preparing the SEC and SAIC reports.”

 

Accordingly, Judge Kronstadt granted the defendants’ motion to dismiss, with leave to amend

.

Discussion

Judge Kronstadt’s ruling does not represent the first occasion on which the motion to dismiss has been granted in one of the many securities suits that have been filed against U.S.-listed Chinese companies since the beginning of 2010. For example, as noted here, in October 2011, the motion to dismiss was granted in the securities lawsuit involving China North East Petroleum. However the dismissal of that case, on loss causation grounds, was based on the fact that the plaintiffs had failed to sell their shares at a profit when the company’s share price spiked after its initial plunge on disappointing news. The dismissal in the China North East Petroleum case was due to the unusual circumstances surrounding the movement of the company’s share price. The ruling in the China North East Petroleum case did not address the sufficiency of the plaintiffs’ substantive allegations.

 

So Judge Kronstadt’s ruling apparently represents the first occasion as part of the current wave of securities suits against U.S.-listed Chinese companies when a dismissal motion was granted based on the insufficiency of the substantive factual allegations. This ruling is all the more striking given the circumstances surrounding the resignation of the company’s auditor, which came just weeks after the company’s U.S. IPO.

 

It should be emphasized, however, that the dismissal was without prejudice; the plaintiffs were given leave to replead their allegations. In preparing the amended pleadings, the plaintiffs will be aided by Judge Kronstadt’s observations about what kinds of factual allegations would be sufficient to establish that the financial figures reported in the company’s prospectus were false. Although it remains to be seen, the plaintiffs may well be able to overcome the initial pleading threshold after they amend their complaint.

 

And while the motions to dismiss were granted in this case and the China North East Petroleum cases, the dismissal motions have been denied in other securities suits involving U.S.-listed Chinese companies, including in the case involving Orient Paper (refer here); and in the case involving China Educational Alliance (refer here). To be sure, even in those cases in which the plaintiffs’ claims survive the initial pleading threshold, their claims stiff face substantial challenges, not the least of which are problems involved with effecting service of process and in conducting discovery in China, as well as deriving from the geographic distances and language issues involved. (Refer here)

 

Notwithstanding these challenges involved, plaintiffs’ lawyers continue to pursue claims involving U.S.-listed Chinese companies. For example, during November 2011, two more securities suits were filed involving Chinese companies: On November 16, 2011, a lawsuit was filed involving Keyuan Pharmaceuticals (about which refer here), and on November 29, 2011, an action was filed involving China Organic Agriculture (refer here).

 

With these latest lawsuits, there have now been a total of 37 cases filed so far this year against U.S.-listed Chinese companies, and since January 1, 2010, there have been a total of 48, representing a significant part of all class action securities lawsuit filings during that period.

 

 

What Better Place to Sink Your Money than a Publicly Traded Hole in the Ground?: There are many reasons why the various Chinese companies are running into difficulties in the U.S. Many of the companies may not have been prepared for the burdens and responsibilities involved with a U.S.-listing. For other companies, there may be a question whether or not the company should have been publicly listed in the first place.

 

Many of these questions may well be asked about the U.S.-listing of cave near the remote village of Yishui, in China. As discussed in a December 2, 2011 New Yorker online article entitled “China’s Cave, Inc.” (here), the cave bills itself as one of the “Top Ten Tourist Attractions in Shandong” and China’s “Underground Grand Canyon.” The cave company, BHTC XV, obtained a U.S.-listing through a reverse merger with a public traded shell; its shares trade over-the-counter.

 

There are no financial or accounting issues involving this company, and the cave may be a stellar tourist attraction. But one may well ask whether a U.S. listing really is a good idea for a company like this. The mere fact that a company like this went through the reverse merger whirlygig underscores how out of hand the whole process became. No wonder there were some problems when the music stopped. 

 

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Finally ending a case first filed back in October 2004 and that involved one of the few securities lawsuits to go to trial, the parties to the long-running Apollo Group securities suit have reached an agreement to settle the case for $145 million. This resolution is interesting not only because it concludes a long- running case with a complex procedural history, but also because the settlement amount appears to represent substantially less than the $277.5 million value that observers had placed on the plaintiffs’ January 2008 jury verdict.

 

District of Arizona Judge James A. Teilborg’s November 29, 2011 order preliminarily approving the $145 million settlement can be found here. The parties’ stipulation of settlement is attached to the November 29 order. David Bario’s December 2, 2011 Am Law Litigation Daily article, in which the settlement was first reported, can be found here.

 

It would be quite an understatement to say that this case has had a long and complex procedural history.

 

As detailed in greater length here, plaintiffs filed the suit after the company’s share price declined following the disclosure of a U.S. Department of Education report alleging that the company had violated DOE rules. On September 7, 2004, the company agreed to pay $9.8 million to settle the allegations. News of the settlement first became public on September 14, 2004, but the company’s share price did not actually decline until September 21, 2004, when a securities analyst issued a report expressing concern about the company's possible exposure to future regulatory issues.

　

On January 16, 2008, a civil jury entered a verdict in favor of the plaintiff class on all counts, awarding damages of $5.55 per share, estimated at the time to represent $277.5 million. Under the verdict, Apollo is responsible for 60 percent of the plaintiffs' losses, former Apollo CEO Tony Nelson is responsible for 30 percent, and former CFO Kenda Gonzales is responsible for 10 percent. The jury verdict is discussed at greater length here.

　

As discussed in greater length here, on August 4, 2008, Judge Teilborg entered an order (here) granting the defendants’ motion for judgment as a matter of law, based on his finding that the trial testimony did not support the jury’s finding of loss causation. Judge Teilborg’s order vacated the judgment and entered judgment in defendants’ favor.

 

In its post-trial motion, Apollo argued that the evidence at trial was insufficient to support a finding that the analyst reports represented "corrective disclosure," because they did not contain any new fraud-revealing information. Judge Teilborg found that "the evidence at trial undercut all bases on which [the plaintiff] claimed the (analyst) reports were corrective."　

 

Accordingly, Judge Teilborg concluded that although the plaintiff "demonstrated that Apollo misled the markets in various ways concerning the DoE program review," the plaintiff "failed to prove that Apollo’s actions caused investors to suffer harm." The court therefore concluded that "Apollo is entitled to judgment as a matter of law."

 

In a June 23, 2010 opinion (here), a three-judge panel of the Ninth Circuit held that the district court "erred in granting Apollo judgment as a matter of law." The opinion states that "the jury could have reasonably found that the (analyst) reports following various newspaper articles were ‘corrective disclosures’ providing additional or more authoritative fraud-related information that deflated the stock price."

　

The Ninth Circuit further held that Apollo is not entitled to a new trial and that there is no basis for remittitur (reduction of the verdict). The Ninth Circuit reversed and remanded the case with "instructions that the district court enter judgment in accordance with the jury’s verdict."

 

The company filed a petition for writ of certiorari to the U.S. Supreme Court. As discussed here, on March 7, 2011, the Supreme Court denied Apollo Group’s petition for writ of certiorari, leaving the Ninth Circuit’s decision standing. The case then returned to the district court for further proceedings.

 

Upon the case’s return to the District Court, the defendants’ raised a number of issues in connection with the entry of judgment in the case. For example the defendants raised issues with respect to the individual eligibility of class members to secure recovery, the calculation and assessment of damages per claimant and the procedures with respect to claims administration and processing for resolution by the District Court. The defendants also maintained that they are entitled to conduct individual discovery and, potentially, jury or bench trials, to rebut the presumption of reliance on the integrity of the market price with respect to individual class members, among other things.

 

In light of the potential for these disputes to prolong the case and postpone the ultimate payment of to the plaintiff class, the parties agreed to enter mediation proceedings that ultimately resulted in the settlement of the case.

 

According to the parties’ settlement stipulation, the settlement amount of $145 million is to be paid by Apollo Group. The settlement stipulation does not mention any payment into the settlement by the individual defendants. The settlement stipulation does not indicate whether any of the $145 million is to be paid or reimbursed by insurance. The stipulation of settlement states that the lead plaintiffs may seek an award from the fund of up to 33.33% of the amount of the fund, plus expenses of $1.875 million. (A one-third fee award would amount to about $48.33 million). Defendants agreed in the stipulation that they will take no position with respect to the fee request.

 

The apparent gap between the $145 million settlement and the reported $277.5 million value of the jury verdict is hard to figure, especially since both amounts purportedly represented a value of $5.55 per share. In the Am Law Litigation Daily article linked above, defense counsel is quoted as saying that he doesn’t know where the original estimate of the value of the jury verdict came from, particularly given that predicting the number of damaged shares that would actually be claimed would be unknown until the claims process had played out -- particularly given the defenses the defendants asserted to various of the potential individual claims. In other words, the jury verdict may never actually have been worth anything near the reported $277.5 million.

 

The significance of the settlement may be only that it finally brings an end to this long-running case. On the other hand, the amount and fact of the settlement may stand as a cautionary warning to any securities litigation defendants that are thinking about forcing their case to trial. To be sure, some of the post-PSLRA securities cases that have gone to trial have resulted in defense verdicts (most notably, the JDS Uniphase case, about which refer here). But as reflected in the securities case trial scoreboard maintained by Adam Savett, the current tally of post-PSLRA securities trials stands at 6 wins for plaintiffs, 5 for defendants (assuming that the Apollo Group case is still counted as a plaintiff win, even though it ultimately settled). With that tally, and in light of the magnitude of the Apollo Group post-appeals settlement, any defendant contemplating a trial would have to think hard about the downside of taking their case to the jury. 

 

Apollo Group has probably more than had its fill of securities class action litigation. The company not only had this case to contend with, but in November 2006, it got hit with an options backdating-related securities class action lawsuit. The options backdating securities case was ultimately dismissed, as reported here. Not only that, but in August 2010, Apollo Group was one of several for-profit education companies hit with shareholder suits in connection with an industry scandal involving student recruiting and student loans. That case remains pending in the District of Arizona, before Judge Teilborg. (The deadline for the plaintiffs to file their amended complaint is December 6, 2012.)

 

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In a strongly worded November 28, 2011 opinion (here), Southern District of New York Judge Jed Rakoff rejected the proposed $285 million settlement of the enforcement action that the SEC brought against Citigroup Capital Markets. But while he emphatically rejected the proposed settlement, his opinion may also suggest how the SEC might salvage this situation without a trial and even how it might structure settlements in the future in order to avoid the kind of blistering criticism that Rakoff administered in his November 28 opinion.

 

In October 2011, the SEC filed a civil enforcement action against Citigroup in the Southern District of New York and simultaneously filed a proposed Consent Judgment in which Citigroup offered to pay a total of $285 million (consisting of a disgorgement of profits of $160 million, plus $30 million in interest, and a civil penalty of $95 million). The complaint related to a billion-dollar fund that Citigroup created that allowed the company “to dump some dubious assets on misinformed investors.” The fund was marketed as consisting of attractive assets, whereas the fund was arranged to include a “substantial percentage of negatively projected assets.” Citigroup had then taken a substantial short position in the assets. Citigroup realized profits of $160 million, while investors lost more than $700 million.

 

Because Citigroup had agreed to the proposed settlement and Consent Judgment “without admitting or denying the allegations in the complaint,” Judge Rakoff had in an October 27, 2011 opinion raised a number of pointed questions about the proposed settlement (about which refer here).

 

In his November 28, 2011 opinion, Judge Rakoff stated that he was “forced to conclude that proposed Consent Judgment that asks the Court to impose substantial injunctive relief, enforced by the Court’s own contempt power, on the basis of allegations unsupported by and proven or acknowledged facts whatsoever, is neither reasonable, nor fair, nor adequate, nor in the public interest.” Judge Rakoff emphatically rejected the SEC’s argument that the public interest was not an appropriate consideration in his assessment of the proposed settlement.

 

He concluded that the settlement was not in the public interest because it “asks the Court to employ its power and assert its authority when it does not know the facts.” He added that “an application of judicial power that does not rest on the facts is worse than mindless, it is inherently dangerous.”

 

Judge Rakoff added that in a case like this that “touches on the transparency of financial markets have so depressed our economy and debilitated our lives,” there is “an overriding public interest in knowing the truth.” But instead of establishing what had gone wrong here, the SEC entered a settlement in which the defendant company neither admitted nor denied the allegations. He added that the SEC “of all agencies” has “a duty inherent in its statutory mission to see that truth prevails.” The Court, he said, “must not in the name of deference or convenience, grant judicial enforcement to the agency’s contrivances.”

 

Several different times, Judge Rakoff emphasized the paramount importance of judicial independence, particularly when it is called upon to exercise its injunctive power, which, he added, “is not a free-roaming remedy to be invoked at the whim of a regulatory agency, even with the consent of the regulated.” Without facts, established either by admission or denials, the use of the court’s injunctive powers “serves no lawful purpose and is simply an engine of oppression.”  

 

Judge Rakoff also noted that the proposed settlement left the defrauded investors “substantially short-changed” as it “deals a double blow to any assistance the defrauded investors might seek to derive from the SEC litigation in attempting to recoup their losses through private litigation” since they “cannot derive any collateral estoppel assistance from Citigroup’s non-admission/non-denial of the SEC’s allegations.”

 

Judge Rakoff concluded his opinion by consolidating the case with a parallel action against the Citigroup official responsible for the toxic fund and scheduling the case for trial on July 16, 2012.

 

At lease according to the November 28, 2011 statement of SEC Enforcement Division Director Robert Khuzami about the opinion, here, the SEC Enforcement Division is deeply aggrieved by Judge Rakoff’s rejection of the settlement. Judge Rakoff’s blistering opinion certainly leaves the parties with some unattractive choices.  It also raises a larger concern that the SEC might not only have to take this case to trial, but in general might have to be prepared to take more cases to trial. This could threaten to overwhelm the SEC’s resources and ultimately even lead to less vigorous enforcement as the increased trial load forces the SEC to conserve resources by bringing fewer cases.

 

But on further reflection and on closer review, Judge Rakoff’s opinion may offer a way out, both for these parties and for the SEC in general. In footnote 7 on page 13 of the opinion, Judge Rakoff draws a sharp contrast between this settlement involving Citigroup and the SEC’s earlier settlement with Goldman Sachs, which Judge Rakoff noted “involved a similar but arguably less egregious scenario.” (For a detailed background on Goldman’s settlement of the SEC action, refer here.)

 

The Goldman settlement, he noted, involved a substantially higher civil penalty (i.e., a $535 million penalty on only $15 million in profits, compared to the proposed Citigroup settlement in which the company agreed to pay a $90 million penalty on $160 million of profits). But even more importantly, as Judge Rakoff noted, the consent judgment in the Goldman case involved an “express admission” from Goldman that the marketing materials for its toxic securities “contained incomplete information.” Judge Rakoff also noted that the Goldman consent judgment involved remedial measures beyond those to which Citigroup agreed, and also involved Goldman’s undertaking to cooperate with the SEC in ways in which Citigroup had not.

 

The contrast that Judge Rakoff drew between the Goldman settlement and the Citigroup settlement may suggest a way that the SEC and Citigroup may yet be able to settle this case (and for that matter, for future parties to try to avoid the objections that Judge Rakoff raised in connection with this proposed settlement).  

 

First, just as when the SEC and the Bank of America previously faced Judge Rakoff’s rejection of the proposed settlement of the SEC’s action against BofA, it seems that Citigroup is going to have to make a greater monetary contribution for a proposed settlement to pass Judge Rakoff’s scrutiny. (Judge Rakoff’s summary of the sequence of events surrounding the SEC’s settlement with BofA is described here.)

 

But if the parties want to avoid the July 2012 trial date, they are also going to have to work out a deal that omits the “neither admits nor denies” formulation. Judge Rakoff disparaged the SEC’s long-standing practice of including formulations of this type in its enforcement action settlements as “hallowed by history but not by reason.” 

 

In order to reach a settlement that will pass muster with Judge Rakoff, Citigroup apparently also will have to agree to express admissions of the type included in the Goldman consent judgment. Citigroup has an obvious interest in avoiding any admissions, not the least because of the impact the admissions might have on pending investor litigation. But it is worth noting that Goldman’s admissions to which Judge Rakoff referred approvingly may not be prohibitive. Goldman admitted only that its marketing materials contained “incomplete information,” and that it was a “mistake” that the materials did not explain the role of Paulson & Co. in selecting the assets underlying the toxic securities. As distasteful as Citigroup might find it to make this type of admission, it would have to be far preferable to facing trial.

 

Whether or not the parties are able to work out a formulation that is mutually acceptable and that satisfies Judge Rakoff remains to be seen. The one thing that is for sure is that if the parties are not able to work out a revised deal that passes Judge Rakoff’s muster, there will be a very interesting trial in his courtroom next July.

 

One final thought. I found it particularly interesting that one of Judge Rakoff’s objections to the absence of any factual admission as part of the settlement was that this absence deprived the investor plaintiffs the benefit they might hope to derive from the SEC litigation. I am sure the private plaintiffs’ securities bar was heartened by this comment. No doubt the litigants in this case will be interested to see if there are any helpful admissions in any forthcoming settlement – as will private litigants with respect to SEC enforcement action settlements going forward.

 

Wayne State University Law Professor Peter Henning has an interesting November 28, 2011 post about Judge Rakoff’s opinion on the Dealbook blog (here). Among other things, Professor Henning questions whether admissions on the order of Goldman’s would be enough to satisfy Judge Rakoff. David Bario’s November 28, 2011 Am Law Litigation Daily article about Judge Rakoff’s opinion can be found here. Alison Frankel’s November 28, 2011 post about the opinion on Thomson Reuters News & Insight can be found here.

 

Special thanks to the several readers who sent me links to Judge Rakoff’s opinion.

 

Here’s One for My Friends at the SEC (Who Could Probably Use a Little Cheering Up): So, a lawyer dies and goes to heaven. (I know, I know, an implausible opening, but bear with me.) The lawyer has just walked through the pearly gates and she’s surveying the scene. She sees an old man walking down the street in judicial robes. So she says to St. Peter, “Who’s the old guy in the robes?” And St. Peter says, “Oh, that’s just God. He thinks he’s a federal judge.”

 

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One of the most noteworthy recent trends in corporate and securities litigation has been the dramatic growth in the frequency of lawsuits relating to mergers and acquisitions activity. These lawsuits are not only becoming increasingly more common, but also increasingly more costly. The growth in this litigation activity has been so rapid that the significance of these trends may remain underappreciated.

 

In this post, I first set the stage to examine these trends by reviewing the current landscape for traditional securities class action litigation, which differs in many ways from current conventional wisdom, and which provides a context for assessing the merger-related litigation trends. I then review important recent developments in M&A related litigation activity, both in terms of increasing frequency and escalating severity. I conclude with a review of the implications of these developments.

 

The Current Securities Class Action Litigation Environment

Traditionally, any discussion of corporate and securities litigation focused primarily (and sometimes exclusively) on securities class action litigation. In many ways, this makes perfect sense, as these kinds of lawsuits were for many years the most frequent and the most severe type of corporate and securities lawsuit.

 

More recently, the relative significance of securities class action litigation as a percentage of all corporate and securities litigation risks has shifted. As the insurance information firm Advisen has well-documented (refer here), securities class action litigation activity as a percentage of all corporate and securities litigation has declined dramatically over the past several years. Whereas securities class action lawsuits once represented among the most likely sources of litigation, in 2010 securities class action lawsuits represented less than 16% of all corporate and securities lawsuit filings.

 

As Advisen has also documented and as is discussed below, one reason for this relative decline is the growth in M&A-related litigation filings. Moreover, as is also discussed below, securities class action litigation is not the only source of corporate and securities litigation severity exposure; M&A-related lawsuits also represent a growing severity risk.

 

But, to set the stage for the discussion of M&A-related litigation trends and their significance, there are some important misperceptions about traditional securities class action litigation activity that I want to address.

 

A frequently recurring question is whether overall securities class action litigation filings are declining. Usually this discussion focuses exclusively on the absolute number of annual new securities class action lawsuit filings. In 2010, depending on the source to which you are referring, the absolute number of new lawsuit filings either declined compared to historical averages ( e.g., refer here regarding  the 2010 Cornerstone Research study) or held steady or perhaps grew (refer here regarding  the 2010 NERA Economic Consulting  study). The reasons these studies reach different conclusions are worthy topics for a separate blog post. But regardless of the conclusions about the absolute numbers of annual lawsuit filings, the key fact often  missing from the analysis is a consideration of how the absolute number of filings relates to the changing number of public companies.

 

The fact is, since, 1999, the number of companies listed on U.S. exchanges has declined every year. If you refer to the annual data from the World Federation of Exchanges (here), you will see that the number of companies listed on U.S. exchanges has declined from over 8,500 in 1999 to about 5,100 in 2010 – a decline of about 40%.

 

When the absolute number of annual lawsuits is compared to the declining number of companies trading on U.S. exchanges, it is clear that the frequency of securities class action lawsuit filings has not declined, but arguably is increasing, and at a minimum is at least holding steady.

 

But while frequency has not declined, median severity has increased. In 2010, the median securities class action settlement was $11.1 million, which is well over double the 1999 median settlement of $5.0 million and triple the 1996 median settlement of $3.7 million. These figures are not adjusted to account for the effect of economic inflation, but these figures nevertheless reflect a  substantial increase.

 

In short, even amidst the changing litigation landscape in which securities class action lawsuit filings have declined as a percentage of all corporate and securities litigation, the threat of securities class action litigation remains a very serious litigation exposure for publicly traded companies.

 

It is against this backdrop that the growth in M&A litigation must be considered.

 

The Exploding Growth in M&A-Related Litigation

Whatever else you want to say about M&A-related litigation, it is clear that there is a lot more of it now than there used to be, both in terms of absolute numbers of lawsuits filings and also relative to the number of merger transactions. Indeed, Advisen has commented that the number of M&A-related lawsuits has “skyrocketed “in recent years.

 

Reported data (refer for example here and here) show that as recently as ten years ago, there were only a handful of M&A related lawsuits filed each year. For example, in 2001, there were only four M&A related lawsuits filed, compared to the 341 filed in 2010 (up from “only” 191 the year prior). Just in the four- year period ending in 2010, the annual number of merger-related lawsuit filings has increased over 600%.

 

These numbers are even more startling when it is considered that these lawsuit filings are increasing even as the number of merger transactions is declining. The number of merger targeted companies declined in each of the three years from 2008 to 2010, yet the absolute number of merger-related lawsuits increased in each of those three years relative to the prior year. In 2010, there were 214 fewer companies targeted for mergers than there were in 2007, representing a decline of over 37%. Yet the number of merger-related lawsuits filed in 2010 was more than triple the number filed in 2007. Today, one out of every two companies announcing an acquisition is sued, and that is true whether or not the acquisition is friendly or hostile, and even whether or not the board of the target company has accepted or rejected the proposed acquisition.

 

There are a host of possible explanations for these filing trends. The first is that a changing case law environment has made securities class action litigation a more challenging game for plaintiffs (for example, as a result of the U.S. Supreme Court’s holdings in the Tellabs case and the Morrison case). In addition, the declining number of public companies over the past several years means that there are fewer prospective securities class action litigation targets. These developments may have encouraged plaintiffs’ lawyers to seek out an alternative business model.

 

And in the M&A related litigation, the plaintiffs’ attorneys seem to have found relatively easy money, as these cases often involve a quick resolution (due to the fact that the parties are often highly motivated to complete the underlying transaction) and the payment of plaintiffs’ attorneys’ fees, which average around $400,000 per case. These attributes of M&A related litigation were discussed in an August 27, 2011 Wall Street Journal article, written from the shareholders’ perspective, entitled “Why Merger Lawsuits Don’t Pay” (here) and in a July 12, 2011 Fox Business article entitled “M&A Lawsuits Skyrocket as Fee-Hungry Law Firms Smell Easy Money” (here).

 

The surest sign that M&A-related litigation represents an attractive proposition for the plaintiffs’ lawyers is the level of lawsuit competition that merger transactions increasingly are engendering. Increasingly, the announcement of a merger can trigger multiple separate lawsuits filed by separate plaintiffs’ firms in multiple separate jurisdictions, producing complicated procedural and jurisdictional issues (refer for example here and here) and also adding dramatically to the cost of litigation.

 

This latter point, about the costs involved, brings us to the heart of the matter. Not only are M&A cases increasingly more frequent, they are increasingly more costly, in a number of ways. I emphasize the costs involved because there is a perception in certain quarters that while M&A lawsuits may be numerous, they represent only a minor nuisance. To put this in insurance terms, M&A lawsuits are described as a high frequency, low severity risk. In fact, this is something I myself have said in the past. However, the truth now is, when all of the costs are considered on an all-in basis, that the cases actually are quite expensive, and increasingly are becoming more so.

 

Start with defense expenses. Because these cases often involve high stakes and short fuses, their defense often can trigger an explosion of legal fees. When you add in the additional expense involved when there are multiple cases in multiple jurisdictions, the expenses multiply. And when you add in the fact that these cases increasingly are continuing on even after the underlying merger transaction has closed, the defense costs can increase exponentially. Much of the time, these defense expenses are borne by the target company’s D&O insurer.

 

The D&O Insurers not only absorb the sometimes massive defense expenses, but they also often have to absorb the plaintiffs’ fees as well, as the payment of the plaintiffs’ attorneys’ fees often is a covered component of the case settlement. (Refer here for a recent discussion of the issues surrounding D&O coverage for a plaintiffs’ fee request in a derivative lawsuit settlement.)

 

The plaintiffs’ fees alone can sometimes be staggering. In the August 2010 Morgan Kinder lawsuit, the plaintiffs’ fee requests amounted to as much as $50 million (that is, 25% of the $200 million settlement, refer here). The plaintiffs’ fee request in the September 2011 Del Monte settlement was $22.3 million (refer here). And in the May 2010 settlement of the Atlas Energy case, the plaintiffs’ fee request was as much as $17.25 million ($25% of the $69 million settlement, refer here).

 

It should be emphasized that the plaintiffs’ fee request can be substantial even where there is otherwise no cash component to the settlement. For example, in the April 2010 XTO Energy settlement, in which there otherwise was no cash component, the plaintiffs’ fee request was $8.8 million (refer here) . In the September 2009 Pepsi Bottling settlement, which otherwise did not involve a cash payment the plaintiffs’ fee request was $7.7 million (refer here). Similarly in the February 2011 Atlas Energy case, the fee request was $4.0 million (refer here).

 

And beyond that – and the most important point here – it is increasingly common for the settlement of these cases to also involve significant cash payments. Indeed, the settlements in many of these cases suddenly are starting to resemble in order of magnitude the settlements of securities class action lawsuits. Thus, the Kinder Morgan case, as referenced above,  settled in August 2010 for $200 million (refer here); the Del Monte case, as noted above,  settled in September 2011 for $89 million (refer here); the May 2010 ACS settlement was $69 million (refer here); and the 2011 Intermix Media settlement was $45 million (refer here). In many instances, where these settlement amounts are not designated as an increase in the acquisition price, these settlement amounts may be insurable.

 

And not only have these cases become more expensive in every way, there are signs that the competition between jurisdictions could even further exacerbate this situation. At November 11, 2011 Columbia Law School conference about the Delaware Chancery Court, various observers commented on the question of whether the Delaware courts, the traditional forum for this type of litigation, were losing “market share” to other jurisdictions’ courts, possibly because plaintiffs’ lawyers believe they (and their clients too, don’t forget) think they can do better elsewhere.  Francis Pileggi has a good summary of the discussion at the conference in a November 11, 2011 post on his Delaware Corporate & Commercial Litigation blog (here).

 

As Alison Frankel discussed in a November 14, 2011 post on her Thomson Reuters News and Insight blog, here, this debate compelled one Delaware jurist to conduct a visual demonstration to try to prove that plaintiffs’ lawyers can expect to recover substantial fees in Delaware courts. It is an obvious concern if Delaware’s judges feel obliged -- in order remain competitive in the jurisdictional competition and to try to preserve declining market share -- to prove that plaintiffs’ lawyers will be rewarded for resorting to the state’s courts.

 

Discussion

Contrary to popular perception, the new M&A litigation model represents both a high frequency and a high severity risk. The severity risk is particularly acute given the exacerbating effects of escalating defense expenses and rising plaintiffs’ attorneys’ fees. Increasingly, M&A litigation is a recurring and very expensive feast for which D&O insurers are picking up increasingly larger tabs.

 

Another important point that should not be lost here is what the increasing risk of M&A related litigation means in combination with the ongoing risk of securities class action litigation. When all of the factors are considered – including the declining number of public companies and the increasing absolute number of lawsuits – it is apparent that publicly traded companies today  face a significantly increased risk of serious corporate and securities litigation than they did in the recent past.

 

Indeed, the probability of a U.S.-exchange listed company facing a merger lawsuit or a securities class action lawsuit in 2010 was more than double what the equivalent probability was as recently as 2006, as the number of public companies has declined and the number of lawsuits has increased. To be specific, the probability in 2006 that any given public company would get hit with a merger lawsuit or securities class action lawsuit was 2.8%; the equivalent probability in 2010 was 5.7%.  The probability of any given company being involved in serious corporate and securities litigation has never been greater.

 

All of these developments mean that publicly traded companies’ litigation risks represent an increasingly  serious and expensive problem, and that M&A-related litigation is increasingly a big part of that problem – in general, of course, but also for the companies’ D&O liability insurers as well.

 

Now, I am not the first to make some of these points about M&A-related litigation. But I think there still is a perception that if M&A-related litigation represents a problem for the D&O insurance industry, it is principally a problem for the insurers that are active in providing primary D&O insurance (refer for example here), and that this is not a problem for the carriers that confine their public company D&O exposures to the excess layers. The point I hope the above analysis gets across is that when you take into account the defense expenses, the plaintiffs’ fees and the M&A related indemnity exposure, the M&A-related litigation increasingly represents a risk for all of the carriers in companies’ D&O insurance programs. M&A litigation increasingly involves a threat of a flame-through loss, increasingly approaching the order of magnitude of securities class action litigation.

 

With both increasing frequency and severity, the casual observer might well assume that pricing for D&O insurance would also be increasing. The casual observer’s assumption would, however, fail to take into account the iron laws of supply and demand. There are more D&O insurers now than there were ten years ago, representing in the aggregate much greater levels of insurance capacity, while at the same time, there are many fewer public companies. What you have are increasing numbers of D&O insurers chasing decreasing numbers of public company D&O insurance buyers.  As a result, overall industry pricing has declined steadily since 2003.

 

It might well be asked how long this combination of circumstances in the D&O insurance marketplace can continue. Some commentators are already proclaiming that they thing they see a market turn on the horizon. I am making no predictions. I have been in this business one way or the other for nearly three decades and I think that every single day during that period someone has been predicting a hard market. We are still waiting. All I know is that if someone were looking around for reasons to explain increasing D&O insurance pricing (if it were in fact increasing), they wouldn’t have to struggle to find explanations. However, I also know that the insurance industry rarely changes as an act of will – it usually changes only as a matter of necessity. Until necessity requires, then, the D&O insurance industry likely will continue on in the same direction – even as the dashboard indicator lights flash caution.

 

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Companies that obtained their listings on U.S. exchanges by way of a reverse merger with a publicly traded shell have been the focus of a great deal of scrutiny and even litigation in recent months, particularly with regard to Chinese reverse merger companies, as discussed here.

 

Reverse merger companies are also now the focus of regulatory attention. The following guest post from Anjali C. Das (pictured to the left), a Partner in the Chicago office of Wilson Elser Moskowitz Edelman & Dicker, discusses recent regulatory actions from the SEC and the U.S. stock exchanges with respect to reverse mergers. Anjali’s practice focuses on professional liability insurance coverage. She represents the interests of domestic and foreign primary and excess insurers in connection with a variety of shareholder claims and class actions against directors and officers, financial institutions, investment banks, insurance companies, and ERISA plan fiduciarieues.

 

 

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

 

 

 

            For the past year, Chinese reverse merger companies have been the target of numerous shareholder suits, government investigations, and scathing analyst reports for alleged financial and accounting fraud. In some instances, the companies are purported to be a complete sham. In response to Congressional inquiries and public outcry by investors who claim they were duped, the United States Securities and Exchange Commission ("SEC") launched an investigation last year of foreign (non-U.S. based) reverse merger companies ("RMCs") and their auditors. The SEC has since suspended or halted trading of dozens of RMCs due to untimely, incomplete, or inaccurate financial information from these companies. This past summer, the SEC issued a bulletin (here) cautioning investors of the potential pitfalls of investing in RMCs, citing instances of fraud and inadequate audits. 

 

 

            Until now, it has been relatively easy for foreign private companies to access U.S. capital markets by merging with an existing public shell company through a so-called "reverse merger." For instance, a private company located overseas in China might merge into a public shell company listed on a U.S. exchange, whereby the bulk of the company's control and operating activities remain in China.  As some U.S. investors have discovered, this may pose logistical and other hurdles in terms of obtaining accurate information about the company's financial and business activities.

 

 

            On November 9, 2011, in an effort to stem the tide of fraud and investor abuse, the SEC unveiled new rules (here) approved and adopted by each of the three major U.S. stock exchanges which impose more stringent listing requirements for RMCs. 

 

 

            NASDAQ's new rules (here) prohibit an RMC from applying to list unless and until it meets each of the following requirements: (1) the company has previously traded in a U.S. over-the-counter market, on another national securities exchange, or on a foreign exchange for at least one year following the reverse merger (also known as the one-year "seasoning period"); (2) prior to listing, the company must timely file all required periodic financial reports for the prior year with the SEC, including an annual report which contains audited financial statements and information about the reverse merger transaction; and (3) the company must maintain a minimum closing share price of $4 for a "sustained period" -- at least 30 of the most recent 60 trading days as of the date of the listing application as well as the date of listing.

 

 

            NASDAQ's rules identify two exceptions from these new listing requirements for RMCs. First, an RMC that completes a firm commitment underwritten public offering at or around the time of listing with gross proceeds to the company of at least $40 million is not subject to the new listing requirements. The second exception applies to an RMC that has filed with the SEC at least four annual reports containing audited financial statements following the filing of all required information about the reverse merger transaction, in addition to fulfilling the one-year trading requirement.

 

 

            The SEC approved similar new listing requirements for the New York Stock Exchange and the NYSE Amex (here and here). In approving these new rules, the SEC expressed its belief that these enhanced listing requirements were specifically designed to curb the potential for accounting fraud and manipulation associated with RMCs by increasing the transparency of their trading history and financial statements. While it is too early to tell just how effective these new listing requirements will be in preventing future fraud on U.S. investors, the rules underscores regulators' commitment to fighting these abuses by RMCs. Meanwhile, the SEC's continues to maintain an aggressive stance against purported fraud by China-domiciled issuers and charged Longtop Financial Technologies on November 10 with failing to file timely and accurate financial statements (here).

 

 

Olympus Garners Securities Class Action Lawsuit After All: In a recent post, I speculated that the reason there had not yet been a securities class action lawsuit filed against Olympus Corp. in the wake of its high-profile accounting scandal is that most of its shareholders acquired their shares on the Tokyo stock exchange and therefore -- under the "transaction" standard enunciated by the U.S. Supreme Court in the Morrison case -- cannot assert a claim under the U.S. securities laws

 

 

I also noted that, according to news reports, about one percent of its public float trades in the U.S. on the pink sheets in the form of American Depositary Receipts. Well, either the ADRs represent greater value than i understood when I wrote my blog post or some plaintiffs lawyers are going after some fairly small potential recoveeries.

 

 

 

According to their November 14, 2011 press release (here), a plaintiffs' firm has filed a securities class action in the Eastern District of Pennsylvania against Olympus and certain of its directors and officers The complaint purports to be filed only on behalf of "purchasers of Olympus American Depository Receipts (pinksheets:OCPNY) (pinksheets:OCPNF) between November 7, 2006 and November 7, 2011, inclusive."

 

 

The plaintiffs did not include the Olympus shareholders that had purchased their shares on the Tokyo exchange, in an obvious effort to avoid Morrison problems. The Morrison effect on this case is that it is a much smaller scale case than would have been filed pre-Morrison.    

 

 

Meanwhile, a November 15, 2011 artice in The Asian Lawyer entited "What Will be the Legal Fallout for Olympus Corp." (here) discusses the various legal and cultural reasons why a significant litigation recovery or even regulatory fine involving Olympus Corp. is unlikely in Japan.         

 

 

LexisNexis Top Insurance Law Blogs of 2011: On November 11, 2011, the LexisNexis Insurance Law Community announced the top Insurance Law Blogs of 2011. The D&O Diary is honored to be listed among the 2011 designees.  The LexisNexis press release also lists all of the other designees, with links to their sites. Congradulations to all of the designees, and thanks to the LexisNexis Insurance Law Community for the selection. And thanks to all of the readers out there  who keep this blog alive.

 

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For those of you who like me have been watching in disbelief as the accounting scandal engulfing Olympus Corp. has slowly unfolded like a slow-motion train wreck, I am sure you have many questions, but one that occurs to me in particular to ask is – why haven’t there been any lawsuits yet? After all, the company has lost over 70% of its market capitalization value (representing more than $6.4 billion) since the scandal first came to light in mid-October.

 

Not only that, but after weeks of denial, on November 8, 2011, the company admitted in a press release (here) that “it has been discovered that the Company had been engaging in deferring the posting of losses on investment securities, etc. since around the 1990s,” and that the fees the company paid to advisors in connection with three business acquisitions “had been, by means such as going through multiple funds, used in part to resolve unresolved losses on investment securities, etc., by such deferral in the posting of these losses.” The company also separately announces on November 8, 2011 (here) that its board had voted to dismiss a company officer whom the company said in a press release “was found to be involved in such deferral in posting of the losses.” In addition, the company also announced that its Standing Corporate Auditor had resigned.

 

A few facts start to fill in the explanation of why there have been no lawsuits yet, despite all of these circumstances and revelations, and despite the magnitude of the drop in the company’s market capitalization.

 

First, the company’s shares trade on the Tokyo Stock Exchange. While American Depositary Receipts trade on the Pink Sheets in the U.S., those securities, according to Jonathan Stempel’s November 9, 2011 Reuters article entitled “Olympus Investors May Find Courthouse Door Closed” (here), represent only about one percent of the company’s float, and no single investor has as much as even $1 million of the ADRs.

 

With the vast preponderance of the company’s shares trading on the Tokyo exchange, only a very small number of Olympus investors, representing a very small share of the company’s pre-loss market capitalization, would be able to assert claims in U.S. court under U.S. law, in light of the “transaction” test first articulated by the U.S. Supreme Court in its June 2010 holding in the Morrison v. National Australia Bank case (about which refer here). Under the Morrison holding, the U.S. securities laws simply do not apply with respect to the transactions in which those investors who bought their Olympus shares on the Tokyo exchange.

 

The investors might try to sue Olympus and its directors and officers in U.S. court under Japanese law, but that does not really seem like a realistic alternative. Toyota’s investors tried to assert  Japanese securities law claims in their securities class action lawsuit filed in the wake of that company’s sudden acceleration scandal. As discussed here, in July 2011, Central District of California Judge Dale Fischer rejected the argument that she had jurisdiction over the Toyota shareholders’ Japanese law securities claims. Among other things, she said that the requirements of comity strongly militated against her exercising jurisdiction over the Toyota shareholders’ Japanese law claims. 

 

While the Olympus shareholders might well consider the possibility of pursuing the claims under Japanese law in Japan, the problem they have is that Japan’s courts do not have a class action procedure like that in the U.S., and as the Reuters article linked above discusses, there may be questions about how damages would be calculated under Japanese law. (That said, prior corporate scandals in Japan have triggered securities litigation in that country, as discussed here.)

 

One alternative gambit the Olympus shareholder might try in order to be able to pursue claims in the U.S. is to try to assert claims under the law of one of the U.S. states. That is a maneuver the shareholder plaintiffs are trying to pull off in the BP shareholder litigation arising out of the Gulf oil spill, as discussed in Alison Frankel’s November 9, 2011 article on Thomson Reuters News and Insight about the BP case. But as Frankel discusses, this effort to try to assert class claims under state securities class is fraught with difficulties.

 

With all of these difficulties, we may not see any shareholder litigation arising out the Olympus scandal any time soon. In the meantime, though, there is a growing list of questions about this increasingly bizarre story, such as – what were the investment losses that the company was trying to mask, and how big were they? Exactly how were the merger transactions used to mask those losses? Are there other losses that have not been disclosed or were there other transactions used to mask those or other losses? Are there other inflated assets that have to be written off? Who among the company’s management were aware of these accounting maneuvers?

 

This is one of the more striking stories to come along in a long time, both in terms of the scale and the duration of the coverup, as well as the complexity of the means of the deception. It seems likely that whether or not there ultimately is any shareholder litigation, that there will (or should be) some type of regulatory action. (Refer here for the strory about the Tokyo Metropolitan Police investigation of the scandal.)

 

In any event, this case surely is another reminder of the impact of the Morrison decision. There is no doubt that if all of this had come up before Morrison, there would have been a raft of lawsuits in U.S court against Olympus and its directors and officers about all of this.

 

And speaking of the breadth of Morrison’s impact, Victor Li has a very interesting November 9, 2011 Am Law Litigation Daily article (here), describing how the lawyers for Aloca have successfully moved to reopen the bribery case brought against the company by Aluminum Bahrain, after the case had been administratively stayed to allow a criminal probe to go forward. The company recently sought to reopen the case in order to be able to move to dismiss it under Morrison. The company will now have a chance to try to have the claims, which are based on RICO, dismissed. (For more background about the Alcoa case, refer here.)

 

One final thought about the Olympus case. For those who have been trying to think about where the Dodd-Frank whistleblower provisions might lead, it is worth thinking about the fact that the scandal began with the company’s CEO confronting the board. It does not take too much imagination to picture someone like him or another officer of a company subject to the SEC’s jurisdiction running to the SEC with this story. The bounty provisions under the Dodd-Frank Act certainly would in these circumstances present a hefty incentive for the prospective whistleblowers.

 

When They Ask Later How Europe Went Bankrupt: There’s a scene in Ernest Hemingway’s novel, The Sun Also Rises, where Bill Gorton, the New York  friend of the book’s main character, Jake Barnes, asks Jake’s rival, Mike Campbell, “How did you go bankrupt?” Campbell responds, “Two ways. Gradually and then suddenly.”

 

I thought of this exchange as I was reading an article in the October 29, 2011 issue of The Economist about the euro crisis. I think the likely timing of the “suddenly” part of the euro crisis might be discerned in this sentence in the article: “[i]n the next three years Italy and Spain will have to refinance about €1 trillion-worth of bonds, not counting additional borrowing to finance their deficits.”  A three-year time frame may sound more like "gradually" -- that is, unless bond investors start assessing how likely likely ithe refinancing really is. .

 

 

And Finally: How about a map of every McDonald's in the United States?  (Did you know that the furthest you can get from a McDonald's Restaurant in the Continental U.S. is 110 miles?) 

 

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Overall levels of corporate and securities litigation declined during the third quarter of 2011 relative to recent quarters but 2011 annualized filings remain above historical levels, according to a recent report from the insurance information firm Advisen entitled “Securities Litigation Activity Dips, An Advisen Report: Q3 2011,” which can be found here. My own survey of the third quarter 2011 securities litigation filing activity can be found here.

 

Preliminary Notes

It is critically important to recognize that the Advisen report uses its own unique vocabulary to describe certain of the corporate and securities litigation categories.

 

The “securities litigation” and “securities suits” analyzed in the Advisen report include not only securities class action lawsuits, but a broad collection of other types of suits as well, including regulatory and enforcement actions, individual actions, derivative actions, collective actions filed outside the U.S. and allegations of breach of fiduciary duty. All of these various kinds of lawsuits -- whether or not involving alleged violations of the securities laws -- are referred to in the aggregate in the Advisen report as "securities suits."

 

One subset of the overall collection of "securities suits" is a category denominated as "securities fraud" lawsuits, which includes a combination of both regulatory and enforcement actions, on the one hand, and private securities lawsuits brought as individual actions, on the other hand. However, the category of "securities fraud" lawsuits does NOT include private securities class action lawsuits, which are in their own separate category ("SCAS").

 

Due to these unfamiliar usages and the confusing similarity of category names, considerable care is required in reading the Advisen report.

 

The Report’s Findings

There were 316 “securities suits” (as that phrase is used in the Advisen report) during the third quarter of 2011, which is down from the 367 “securities suits” filed in 2Q11 and 421 filed in 1Q11. This quarterly decline is attributable in part to the decline of breach of fiduciary duty suits (primarily merger objection suits) in 3Q11, when there were 76 breach of fiduciary duty suits filed, compared to 130 filed in the year’s second quarter.

 

In addition, the quarterly decline in overall corporate and securities lawsuit filing activity is also due in part to the decline in 3Q11 compared to 1Q11 in what the Advisen report calls “securities fraud suits” (which as noted above encompasses both regulatory actions as well as private securities lawsuits brought as individual rather than class actions). According to the study, the number of these so-called “securities fraud suits” declined to 109 in the third quarter, compared to 156 in the first quarter and 101 in the second quarter.

 

According to the Advisen study, the number of securities class action lawsuits filed during the third quarter was also down relative to the second quarter. The Advisen study reports that there were 56 securities class action lawsuits filed during 3Q11, compared to 61 during the second quarter. Though the third quarter filings were down relative to the prior quarter, the third quarter filing activity level was higher than the 2010 quarterly filing average of 47. Over 70 percent of Q311 class action lawsuit filings named companies in four sectors as defendants: information technology, healthcare, financial and industrial.

 

Litigation involving non-U.S. companies, filed both in the U.S. and elsewhere, was an important part of “securities suit” filings during the third quarter and overall during 2011. In the first three quarters of 2011, 16 percent of all “securities suits” were filed against non-U.S. companies, compared to 11 percent for both 2009 and 2010. During the third quarter, fifteen percent of all “securities suits” were filed against non-U.S. companies, down from 19 percent during the second quarter.

 

With respect to this activity involving non-U.S. companies, an increasing percentage of this “securities suit” activity is outside the U.S. The study reports that in the first three quarters of 2011, there were 55 “securities suits” filed in courts outside the U.S., 17 of which were filed during the third quarter. These 55 cases represent five percent of all YTD “securities suits,” which is “higher than the 3-percent level recorded in most recent years.”

 

Many of the cases involving non-U.S. companies in U.S. court involve Chinese companies. The number of “securities suits” filed in U.S. court involving Chinese companies has rise from five in 2009 to 24 in 2010, and up to 55 during the first three quarters of 2011.

 

Even though we are now well past the peak of the credit crisis (at least as a temporal matter if not as an economic matter), overall corporate and securities litigation activity remains highly concentrated in the financial sector. According to the Advisen report, 35 percent of all “securities suits” filed during the third quarter targeted companies in the financial sector. A large portion of the “securities suits” filed against financial companies in the third quarter involve regulatory actions, as 48 percent of all “securities suits” filed against financial companies involved regulatory actions.

 

But while the filing activity concentration in the financial sector remains elevated, the 3Q11 “securities suits” were “more broadly dispersed” during the quarter “than in previous years, especially compared to 2008 and 2009.” Suits against information technology firms and healthcare companies each represented 13 percent of all “securities suits,” while suits against industrials represented 11 percent of all such suits.

 

The average value of settlements of “securities suits” during the third quarter was $17.4 million, down from $22.8 million in the second quarter and from $18.2 million for all of 2010. The average securities class action lawsuit settlement during the quarter was $45.7 million.

 

Advisen 3Q11 Securities Litigation Webinar: On Thursday November 17, 2011 at 11:00 am EST, I will be participating in one-hour long Advisen webinar to discuss third quarter 2011 corporate and securities litigation filing activity. The panelists for this free webinar will also include Steve Gilford of the Proskauer law firm, Alliant Insurance’s Susanne Murray, and Advisen’s Dave Bradford. The panel will be moderated by Advisen's Jim Blinn. More information about this free webinar, including registration information, can be found here.

 

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After the October 19, 2011 news that Citigroup  had reached an agreement to pay $285 million settle SEC charges that it had misled investors in a $1 billion collateralized debt obligation linked to risky mortgages, a number of commentators raised questions about the settlement.

 

Among other concerns noted was that neither the SEC’s action nor settlement targeted or even identified the senior level executives who were responsible for the alleged misconduct. The proposed settlement was also compared unfavorably with the much larger settlement amount to which Goldman Sachs had agreed to pay to settle similar allegations. Commentators also noted that though upper level executives were not charged in the action, like the Goldman case a lower level operative was targeted, seemingly for having had the misfortune of having sent an indiscrete email. A particularly good critique of the settlement appears in Jesse Eisenger’s October 26, 2011 post on the New York Times Dealbook blog (here).

 

As luck would have it, the settlement (supposedly as a result of a random lottery) landed on the desk of Southern District of New York Judge Jed Rakoff, who famously refused to accept a prior settlement of the SEC”s action against BofA (about which refer here). In March 2011, Rakoff also challenged the SEC’s settlement with Vitesse Semiconductor (about which refer here).

 

As it turns out, Judge Rakoff has some questions about this settlement, too – nine of them, to be precise.

 

In a very pointed October 27, 2011 order (here), Judge Rakoff scheduled a November 9, 2011 hearing at which the parties were directed to be prepared to answer nine specific questions about the settlement. He also said that the parties were “permitted, but not required” to file written answers to his questions in advance of the hearing.

 

Among other things, Rakoff has asked why he should enter judgment in a case “In which the S.E.C. alleges a serious securities fraud but the defendant neither admits nor denies wrongdoing?” He also asked whether the SEC’s mandate to ensure transparency in the financial markets might provide “an overriding public interest in determining whether the S.E.C.’s charges are true,” particularly “when there is no parallel criminal case?”

 

Like many of the commentators, Judge Rakoff also viewed this proposed settlement in contrast to the $535 million Goldman Sachs settlement. He asked specifically how the $95 million penalty portion of the proposed $285 million settlement was calculated, given that it is “less than one-fifth” of the penalty assessed in the Goldman Sachs case.  

 

Judge Rakoff also questioned why the penalty is to be “paid in large part by Citgroup and its shareholders rather than by the ‘culpable individual offenders acting for the corporation.’”

 

The most challenging question Rakoff posed was his final query: “How can a securities fraud of this nature and magnitude be the result simply of negligence?”

 

Many of Judge Rakoff’s questions might well be asked in connection with many SEC enforcement action settlements, in which corporate parties routinely settle the action pay paying specified sums out of corporate resources without admitting or denying wrongdoing. However, the parties to these settlements are rarely challenged as Judge Rakoff has challenged the parties here to justify the settlement. However it is worth noting that Judge Rakoff asked several similarly challenging questions when he rejected the BofA settlement in 2009, but he ultimately (“reluctantly”) approved a revised settlement that arguably presented many of the same features of the original settlement. (Judge Rakoff discussed the BofA settlement in a speech at the Stanford Directors’ College in June 2010, as noted here.)

 

There will be those who believe that it is about time that somebody started asking these kinds of questions. But at the same time, it is worth noting that if companies must admit to wrongdoing in order to settle SEC enforcement actions, or if senior executives’ complicity must be alleged or even established in order for a settlement to be approved, it will be far more difficult for SEC enforcement actions to be resolved. Indeed, one clear implication if more courts start asking these kinds of questions about proposed SEC enforcement action settlements is that fewer cases will settle and more will have to go to trial. Even if more trials would advance the truth-telling function of SEC enforcement, it would also add enormous costs both for the SEC and for the corporate defendants. Whether the SEC could sustain the same level of enforcement activity if it had to absorb the added burdens and expense involved with more trials is one question. The added burden and expense for the corporate defendants presents other questions.

 

As noted in a guest post on this blog by Maurice Pesso of the White & Williams firm (here), the potential barriers to settlement posed by the kinds of questions Judge Rakoff has asked here may also present some significant challenges for D&O insurers, who often are paying the costs of defense associated with SEC enforcement actions.

 

An October 27, 2011 Bloomberg article discussing Judge Rakoff’s questions about the Citigroup settlement can be found here. Peter Lattman’s October 27, 2011 post on the New York Times Dealbook blog about Rakoff’s questions can be found here.

 

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Securities class action lawsuit filings continued to accumulate during the third quarter of 2011, and the filing levels remain on pace for an above average year of securities class action litigation. As was the case in earlier quarters this year, the third quarter filing level was significantly buoyed by merger-related litigation and by lawsuits involving U.S.-listed Chinese companies, although to a lesser extent than prior quarters. There are some other interesting trends emerging as well.

 

By my count, there were 49 new securities class action lawsuits filed in the third quarter of 2011, bringing the year to date total through September 30 to 154. (Please see below for some note about “counting “and the reasons my count may differ from other published tallies.) The third quarter filing levels held steady with the number in the second quarter of 2011, when 49 lawsuits were also filed. The 154 filings year to date implies an annual filing total of about 205, which would be above the 1997-2009 average of 195.

 

The two most significant factors in the securities lawsuit filings during the first nine months of the year are merger-related lawsuits and lawsuits involving U.S.-listed Chinese companies. Of the 154 federal securities lawsuits filed through September 30, 47 (30.51%) were merger-related. Non-U.S. companies were named as defendants in 43 of the securities lawsuits (27.9%) filed during the first three quarters, of which 32 involved U.S. listed Chinese companies (20.79%).

 

Though the merger-related filings and lawsuits against U.S.-listed Chinese companies both continued to accumulate in the third quarter, both trends were diminished in the third quarter compared to the year’s first half. During the third quarter, 11 of the 49 lawsuit filings (22.54%) were merger-related, and 6 of the 49 filings (12.24%) involved U.S.-listed Chinese companies, both figures down compared to the year to date as a whole.  

 

The 154 YTD lawsuit filings involve a surprising diversity of companies. The companies named as defendants in the securities lawsuit filings during the year’s first nine months represented 91 different Standard Industrial Classification codes (SIC). Unlike recent years, in which filings against financially-related companies predominated, the SIC code categories with the largest number of filings during the first three quarters of 2011 reflect industries that historically have been the focus of securities litigation.

 

Thus, the SIC code categories with the largest number of securities lawsuit filings so far this year are SIC code categoies 3674 (Semiconductor and Related Devices) and 7372 (Prepackaged Software). The next largest SIC code category includes one industrial group that has also been a frequent target in the past, SIC Code category 2834 (Pharmaceutical Preparations), in which six companies have been sued year to date. Another category that has also had six new filings so far this year is a group that in the past has not seen the same level of litigation activity, SIC Code category 1311 (Crude Petroleum and Natural Gas).

 

The federal securities class action lawsuits during 2011’s first nine months have been filed in 45 different federal district courts, but just two courts have accounted for more than half of the filings. During the first three quarters of the year, there were 33 new securities class action lawsuit filing in the Southern District of New York, and 29 in the Central District of California. Both of these figures were significantly increased by filings involving U.S.-listed Chinese companies. In the Southern District of New York, 21 of the 33 filings through September 30 involved non-U.S. companies, of which 13 were U.S.-listed Chinese companies. In the Central District of California, 13 of the 29 lawsuits filed during the first nine months of the year involved U.S.-listed Chinese companies.

 

In the overall category of corporate and securities litigation, including litigation filed in state courts, the merger-related litigation has been and remains the predominant story. By my count, during the first three quarters, there was merger objection litigation filed involving at least 129 transactions, and accounting for at least 185 different lawsuits (counting lawsuits filed in both federal and state court). These figures only take account of the lawsuits of which I am aware and are almost certainly understated. In other words, if you are attempting to track corporate and securities litigation and you are only monitoring federal securities class action litigation, you are missing a great deal of the action. In fact, you could be missing the majority of the action.

 

As I noted at the outset, my lawsuit count may differ from other published accounts for a number of reasons. First, I include in my count class action lawsuits asserting violation of the federal securities laws but that are filed in state court. There were at least two of these during the third quarter of 2011. In addition, I may not always decide to include the same merger-objection lawsuits in my tally as do other sources that track securities lawsuit filings. I include the merger-related lawsuit if it is in federal court and if it alleges a violation of the federal securities laws.

 

The decision to include the above described categories of cases and other factors will likely cause my count to be slightly higher than other published tallies. I think the tallies will remain directionally consistent but the differences might be enough to lead to differences of opinion about, for example, whether or not the number of annual filings is increasing or declining, or how the annual filing levels compare with annual averages.

 

The Towers Watson 2011 D&O Insurance Survey Form Released: Towers Watson has released the 2011 survey form for its annual survey of D&O insurance buying patterns. Everyone in the industry benefits from Towers Watson’s annual survey, the summary report for which Tower Watson makes freely available. Because everyone benefits from it, we all have a stake in making sure that there are sufficient responses to ensure that the survey results are meaningful. I hope everyone will take the time to ensure that as many D&O insurance buyers as possible will complete the survey. The survey can be found here.

 

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SciClone Settles FCPA Follow-on Derivative Suit : In a settlement that involves a company with significant Chinese operations -- and that also may represent something of a template for the settlement of FCPA enforcement follow-on civil lawsuits -- SciClone Pharmaceuticals and the individual defendant directors and officers have agreed to settle the consolidated derivative lawsuits that were filed following the company’s announcement that it was the target of SEC and DoJ investigations for possible FCPA violations.

 

According to the company’s October 12, 2011 press release (here), the parties have agreed, subject to court approval, to settle the consolidated cases based on the company’s agreement to adopt certain specified corporate governance reforms and the company’s agreement to pay $2.5 million in plaintiffs’ attorneys’ fees. The press release states that the payment of the plaintiffs’ attorneys’ fees is “to be paid by SciClone’s insurers under its director and officer insurance policy.” A copy of the parties’ stipulation of settlement can be found here.

 

The FCPA does not provide for a private right of action. However, as I have previously noted on this site, the advent of an FCPA investigation often triggers a follow-on civil lawsuit. In this case, multiple lawsuits were filed against the company, as nominal defendant, and certain of the company’s directors and officers, shortly after the company announced the existence of the investigation. The lawsuits, which were filed in San Mateo County (Calif.) Superior Court in September 2010, and which were later consolidated, alleged that “the Individual Defendants, by reason of their failure to implement and maintain internal controls and systems at the Company to assure compliance with the FCPA, breached their fiduciary duties and may be held liable for damages.”

 

As a result of mediation, the parties reached the settlement that the company announced in its press release. Among other thing, the settlement requires the company to adopt certain measures for three years, including the implementation of sanctions for employees violating the FCPA; the establishment of a compliance coordinator; the adoption of a compliance program and code; and the adoption of certain internal controls and compliance functions. The governance measures are described in detail in the parties’ settlement stipulation.

 

There are a number of interesting things to me about this settlement. The first is that it involves a company that, according to its own website, is a “China-centric” pharmaceutical company. Though the company has its headquarters in the U.S. its “strategy,” as described on the company’s website is to grow its sales in China.  The existence of the FCPA investigation underscores the challenges facing companies attempting to do business in China. Given the company’s business model, the compliance measures adopted in the settlement arguably are a good idea in any event, without regard to the fact that the company willingness to adopt the measures managed to resolve this consolidated litigation.

 

The D&O insurer’s payment of the plaintiffs’ attorneys’ fees shows how these kinds of lawsuits can contribute to insurers’ loss costs. Obviously, the D&O insurers also incurred the defense expenses as well, meaning that the total loss costs for this suit potentially represents a substantial figure. Moreover, depending on the nature and status of the government FCPA investigation, there could be additional covered loss costs as well. The company and certain of its directors and officers were also named as defendants in a related securities class action lawsuit (about which refer here), but that action was voluntarily dismissed without prejudice.

 

As antibribery enforcement activity is stepped up in this country and elsewhere, it seems likely that these types of lawsuits may become even more common. The likelihood is that this type of litigation could make a significant contribution toward insurers’ aggregate loss costs in the coming years. On the other hand, from an underwriting standpoint, it seems that companies that have already voluntarily adopted the kinds of compliance procedures that were the subject of this settlement should be view in a more favorable light, particularly with regard to those companies that might otherwise be viewed with caution owing to the countries in which they are doing business.

 

Dismissal Motion Denied in U.S.-Listed Chinese Company’s Securities Suit: In the second dismissal motion denial entered as part of the current wave of securities suits filed against U.S.-listed Chinese companies, on October 11, 2011, Central District of California Judge Christina Snyder denied the defendants’ motion to dismiss in the securities suit filed against China Education Alliance, Inc. (CEU) and  certain of its directors and officers. A copy of Judge Snyder’s opinion can be found here.

 

As discussed here, the plaintiffs first filed their action in December 2010. Among other things, the plaintiffs allege that the company overstated its revenue and profits by “exponential proportions.” The plaintiffs, in reliance on the report of an online securities analyst, alleged that the company maintained two sets of books, and that the revenue reported in the company’s Chinese regulatory filings was only a fraction of the revenue the company reported in its SEC filings. The complaint also alleges that the company’s educational website was not functional, and its education building allegedly is an empty building without classrooms.

 

The defendants moved to dismiss, arguing in part that the plaintiffs allegations, made in reliance on the online analyst report, merely repeated the unsubstantiated assertions of a professed short seller that was financially motivated to drive down the company’s share price. In rejecting the defendants’ argument in this regard, Judge Snyder relied on the earlier dismissal motion denial in the case involving another U.S.-listed Chinese company, Orient Paper (about which refer here). Judge Snyder found it was not appropriate to reject the allegations on that basis at this early stage.

 

Judge Snyder also found tat the plaintiffs had adequately alleged scienter, despite the absence of insider trading or other financially motivated conduct. Judge Snyder found that “additional facts” the plaintiff alleged “give rise to a strong inference of scienter.” Those alleged additional facts include the following:

 

That CEU has filed significantly disparate revenue figures in China and the United States: that plaintiffs’ own investigators toured CEU’s on-site “state of the art” facility in China only to find it an empty building; that witnesses told plaintiffs’ investigators that CEU was not the owner of the building; that CEU has had rapid turnover of its CFOs during the class period; and that many of the links on CEU’s website did not work properly despite its online segment purportedly deriving millions of dollars each year.

 

Judge Snyder said that “although each fact taken along might not give rise to an inference of fraudulent intent,” the allegations “taken together” establish that plaintiffs’ theory is at least as compelling as any opposing inference one could draw.

 

Judge Snyder’s dismissal motion denial suggests that in some cases at least the U.S.-listed Chinese companies draw into the wave of recent securities lawsuits may face difficulties evading these lawsuits, at least at the initial stages. Many of the cases, like this one, are based on the reports of financially motivated online analysts. Judge Snyder’s unwillingness to disregard the allegations based on the analyst’s report, notwithstanding the analysts admitted financial interest in driving down the value of the company’s stock, may represent a problem for the other companies tangled up in these cases as a result of negative reports by online analysts.

 

Moreover, Judge Snyder’s conclusion that the plaintiffs’ scienter allegations were sufficient, inter alia, on the discrepancies between the Chinese regulatory filings and SEC filings, may also suggest that a number of these cases could survive the initial pleading stages, as many of them are based on similar discrepancies between Chinese regulatory filings and SEC filings.

 

To be sure, some cases will nevertheless be dismissed, as was the case with the China North East Petroleum case, in which the dismissal motion was recently granted on loss causation grounds (about which refer here). But if Judge Snyder’s holding in the China Education Alliance case is any indication, other cases also will likely survive the initial dismissal motions.

 

Of course, it remains to be seen how valuable these cases ultimately prove to be for plaintiffs, even if they make it past the initial pleading hurdle. But the name of the game is making it past the dismissal motions, and at least in the China Education Alliance case, the plaintiffs have made it at least that far.

 

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

 

Fed Officials Pursue Actions Against Failed Bank Officials: In a significant development in the current wave of bank failures, that involves a failed bank that had significant ties to and operations in China, on October 11, 2011, federal officials concurrently filed a regulatory enforcement action and a criminal prosecution against certain former officers of the failed United Commercial Bank.

 

San Francisco based United Commercial Bank failed on November 9, 2009 (about which refer here). The bank had offices throughout the United States, as well as China and Taiwan. The bank grew rapidly. According to the SEC, it was the first U.S. bank to acquire a bank in the People’s Republic of China. However, during the economic crisis in late 2008 and early 2009, the bank experience significant difficulties in its loan portfolio, which regulators allege led to the bank’s failure, which in turn triggered the recently filed actions involving the bank’s former officers.

 

First, in an October 11, 2011 complaint (here), the SEC filed a civil enforcement action against four former officers of the bank. According to the SEC’s October 11, 2011 litigation release, the complaint alleges that the defendants “concealed losses on loans and other assets from the bank’s auditors, causing the bank’s holding company UCBH Holdings, Inc. (UCBH) to understate its 2008 operating losses by at least $65 million.” The complaint alleges that the further loan losses ultimately caused the bank to fail. The SEC action seeks permanent injunctive relief, an officer bar, and civil money penalties.

 

In addition, as reflected in the FBI’s October 11, 2011 press release (here), a grand jury has indicted two of these same former bank officials, for conspiracy to commit securities fraud, securities fraud, falsifying corporate books and records and lying to auditors.

 

Both the SEC’s litigation release and the FBI’s press release specifically reference the assistance they received in preparing their actions from the FDIC. The FDIC’s role in these actions is a reminder that as part of its failed bank post mortem, the FDIC is not only attempting to determine whether or not it has a valuable civil suit on its own as receiver, but is also looking to see whether or not wrongdoing has occurred that warrants referral to other authorities.

 

Both the SEC action and the indictment refer to securities fraud, which serves as a reminder that, by contrast to the institutions caught up in the S&L crisis a few years ago, many of these failed financial institutions in the current bank failure wave are publicly traded, a circumstance that has many ramifications.

 

It remains to be seen whether or not the FDIC will also file its own separate civil action against the former directors and officers of this bank. The bank’s former investors have in any event already filed their own class action lawsuit. As discussed here, the defendants’ initial motion to dismiss the class action lawsuit was granted, albeit with leave to amend.

 

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In what is as far as I know the first outright dismissal motion grant in the wave of cases filed against U.S.-Listed Chinese companies that began last year, on October 6, 2011, Southern District of New York Judge Miriam Goldman Cedarbaum granted the defendants’ motion to dismiss in the securities class action lawsuit filed against China North East Petroleum Holdings Ltd. and certain of its directors and officers. A copy of Judge Cedarbaum’s opinion can be found here.

 

As detailed here, the plaintiffs first filed their action in June 2010. According to their amended complaint, during the class period, the defendants inflated the amount of the company’s proven oil reserves, overstated reported earnings inflated profits and misrepresented the company’s internal controls. An allegedly “bizarre series of events” followed the company’s February 23, 2010 announcement that it would be restating prior financials, including “revelation of illicit bank transfers” made to company officials and “a dizzying number of resignations and replacements” of top executives. Over the next few months additional details were revealed regarding the transfers, ultimately resulting in the resignation of the CEO and several members of the board. The NYSE had halted trading on the company’s shares on May 25, 2010, but when trading resumed on September 9, 2010, the company’s share price “plunged.”

 

The defendants moved to dismiss the plaintiff’s complaint on loss causation grounds, arguing that the plaintiff had several opportunities to sell its shares at a profit following the allegedly corrective disclosure at the end of the class period, and contending that had the plaintiff “chosen to sell at those post-disclosure dates, it would have turned a profit.”

 

Judge Cedarbaum agreed. Even though the plaintiff ultimately sold its shares at a loss, she concluded that “that loss cannot be imputed to any of NEP’s alleged misrepresentations,” adding that “a plaintiff who forgoes a chance to sell at a profit following a corrective disclosure cannot logically ascribe a later loss to devaluation caused by the disclosure.” Because she found that the plaintiff “has not suffered any loss attributable to the misrepresentations alleged in the complaint,” she granted the defendants’ motion to dismiss.

 

The dismissal of the China North East Petroleum Holdings case may simply reflect the unusual movement of the company’s share price.. For whatever reason, the company’s share price quickly rebounded following the September 9, 2010 “plunge” – although the share price has steadily declined following that sharp, short rebound. The share prices of other U.S.-listed Chinese companies have not reflected this pattern. Particularly as the various accounting scandals have mounted, companies caught up in the scandals have seen their share prices drop down and stay down. (Indeed, the share prices of all U.S.-listed Chinese companies have been depressed as the scandals have spread.)

 

So the outcome of this particular lawsuit may be nothing more than a reflection of the rather atypical stock price movements that surrounded its various disclosures. Judge Cedarbaum’s ruling may have little bearing on other cases involving companies whose share price movements would not support the type of loss causation arguments that were successful in this case.

 

Nevertheless, Judge Cedarbaum’s ruling is a reminder that merely because a raft of lawsuits has been filed against U.S.-listed Chinese companies does not mean that the cases are meritorious or that the plaintiffs will be successful. The China North East Petroleum case was one of the first of these cases to be filed, as it was filed in June 2010, before the filings against U.S.-listed Chinese companies really began to pick up momentum in the second half of 2010. Because it was one of the first of these cases to be filed, it is among the first to reach the motion to dismiss stage. It remains to be seen how the other cases will fare .But the dismissal of this case shows that the plaintiffs in this cases face numerous obstacles in attempting to pursue these suits. (As I noted in an earlier post, here, there has also been at least one dismissal motion denial in a securities suit involving a U.S.-listed Chinese company.)

 

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

 

FDIC Files Suit Against Former Directors and Officers of Alpha Bank: On October 7, 2011, the FDIC filed a civil action in the Northern District of Georgia against 11 former directors and officers of the failed Alpha Bank & Trust of Alpharetta, Georgia. Scott Trubey’s October 7, 2011 Atlanta Journal Constitution article about the lawsuit can be found here. A copy of the FDIC’s complaint can be found here.

 

Alpha Bank failed on October 24, 2008, only about 30 months after it opened. The FDIC’s suit seeks damages of $23.9 million in connection with 13 specific loans that the suit contends were approved “despite plainly inadequate, incomplete, or outdated financials of the borrower and/or the guarantors” in the loans, resulting in loans to borrowers “with no apparent ability to repay or otherwise service the loans.”

 

The Alpha Bank lawsuit is the fifteenth lawsuit that the FDIC has filed as part of the current wave of bank failures, which began only shortly before the Alpha Bank failed. The Alpha Bank lawsuit is the fourth failed bank lawsuit that the FDIC has filed so far in Georgia, that state that has had more bank failures during the current bank failure wave than any other state. Many more lawsuits are likely to come, including many more lawsuits in Georgia.

 

This lawsuit is actually the first the FDIC has filed for several weeks. After the FDIC filed a total of five lawsuits in very quick succession in August, there was some speculation that the logjam in anticipated FDIC failed bank lawsuit filings had broken and that we were about to see a quick accumulation of additional suits. But after that flurry of August activity, new filing activity had dropped off until the filing of this Alpha Bank lawsuit on Friday. It will be interesting to see if the Alpha Bank filing is followed by another flurry of filing activity, as was the case in August.

 

It is worth noting that the FDIC has only now, nearly three years after Alpha Bank failed, gotten around to fling this lawsuit. This consistent in general with the lag time between the bank failure date and the initial lawsuit filing date that has characterized the lawsuits that the FDIC has filed so far. In view of this apparent timing pattern and the fact that the bank failure wave peaked during late 2009 and early 2010, the likelihood is that we may be in for increased numbers of new FDIC failed bank lawsuits in coming months and possibly for at least the next couple of years.

 

In addition to the FDIC lawsuit, the former directors and officers of Alpha Bank previously were the target of a lawsuit brought by shareholders of the bank, as I discussed in an earlier post, here.

 

Special thanks to a loyal reader for sending a copy of the FDIC's complaint.

 

Unauthorized Reincarnations Will Be Punished to the Maximum Extent of the Law: According to an October 6, 2011 New York Times article (here), the Dalai Lama’s recent announcement that his successor “may be an emanation and not a reincarnation” has upset the Chinese government, which apparently contends that its authority extends even to matters involving reincarnation.

 

The article quotes a statement about the affair from the People’s Daily, described as the Communist Party’s “mouthpiece,” as having warned that: 

 

All reincarnation applications must be submitted to the religious affairs department of the provincial-level government, the provincial-level government, the State Administration for Religious Affairs and the State Council, respectively, for approval.

 

Hannah Arendt had something like this in mind when she coined the expression “the banality of evil.”

 

Travel Journal: The Köln Concert: The D&O Diary’s European sojourn continued in Cologne this week, after a three-hour train ride from Amsterdam. Fortunately for me, the glorious weather I enjoyed in Amsterdam followed me to Cologne. After arrival at the Hauptbonhof (central train station) in Cologne and dropping my bags at the hotel, I emerged into a city swathed in October sunshine (quite a contrast to my prior visits to the city, which were uniformly water-logged).

 

For a visitor to the city, the three most distinctive things about Cologne are a river, a church and a beer. The river is the Rhine, which surges through the city on its way toward the North Sea. The church is the city’s great cathedral, or “Dom” as it is known locally, which looms large from its strategic perch along the river.  And the beer is kölsch, a light beer that according to convention and regulation can only be brewed in the Cologne region.

 

My visit to Cologne (or Köln as it is known in German) was quite a bit different than my trip to Amsterdam, owing to the fact that unlike my visit to Amsterdam, my trip to Cologne was business related. Due to meetings and other commitments, I had less opportunity for frolics and detours, alas..

 

Nevertheless, I did still manage to find ways  to enjoy some of Cologne’s distinctive features, including the city’s famous local brew, kölsch. It is a light and refreshing beer that is traditionally served in tall, thin cylindrical 0.2 liter glasses. The waiters in the brew pubs carry around trays full of the glasses, and in a smooth single motion they remove your empty glass at the same time as they provide a fresh one. They mark the number of glasses consumed with pencil marks on a coaster. First timers learn the hard way that the waiters will continue to bring fresh glasses unless you take your coaster and put it over top of your glass.

 

As special as the warm afternoon sunshine was on the day of my arrival in Cologne, my best opportunity to enjoy the city’s riverine location came later in the week, when I took a lunch break bike ride along the river. I pedaled my rental bike across the river to the east side and headed south along the paved bike path. (I was heading upstream, as the Rhine flows generally northward.)

 

Within minutes, I was away from the city center, and shortly thereafter, it was just me and the crickets and the birds. The riverside is flat and the bike path smooth, and the kilometers just rolled away. The serene countryside, softened in soothing autumnal tones of brown and gold, drew my on and on. I had intended to ride for only a short while,  but at each curve of the river, a church steeple ahead or a flock of birds in the river lured me to keep going. I am quite sure I traveled at least 30 miles roundtrip before I was done.

 

To be able to escape from a city into the countryside in less than 15 minutes on a bicycle is a very fine thing. It is a privilege we lack in most of the U.S., with our sprawling urban areas and our autocentric culture. In Europe, the urban density and the accessibility to the countryside are interrelated, and provide both a more vibrant city life and greater ease of access to rural areas. In the U.S., urban sprawl means many cities that are empty at night, and are surrounded by endless suburbs that blur into the countryside even far from city centers.

 

During my European trip, I had some very pleasant experiences, including my lunchtime bike ride on the Rhine. These kinds of experiences are available at home, too, but they occur less frequently. I think that when you are in a new place, you are more open to the possibilities, particularly in a foreign country. How frequently do any of us in our day to day lives at home drive further down the road just to see what is around the next bend? But in my all too brief European visit, every time I yielded to curiosity, I was rewarded with something novel, something interesting, something worth seeing.

 

If I bring anything home with me from my European visit, it is a renewed appreciation for the possibilities of the moment, where just ahead there are always new things to discover.

 

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Janus Distinguished: In an interesting opinion that distinguishes the U.S. Supreme Court’s decision in Janus, on September 30, 2011 Southern District of New York Judge John Koetl granted in part and denied in part the defendants’ motion to dismiss in the EnergySolutions securities class action lawsuit. Judge Koetl's opinion can be found here.

 

As discussed here, in October 2009, plaintiff shareholders filed a securities suit against the company, certain of its directors and officers, and its offering underwriters in connection with the company’s November 14, 2007 IPO and July 24, 2008 secondary offering. The plaintiffs also named as a defendant the parent company of Energysolutions (ES), ENV Holdings. The plaintiffs alleged that the company’s offering documents misrepresented the company’s financial opportunities in the nuclear energy decommissioning business, as well certain of its regulatory constraints.

 

ES had been formed by several sponsor institutional investors that had purchased several individual businesses through ENV Holdings. At the time of the IPO ENV owned 100% of the shares of ES. ENV was also a selling shareholder in the secondary offering.

 

The defendants moved to dismiss the plaintiffs’ complaint. Although the defendants’ motion was granted as to certain of the alleged misstatements, it was denied in other material respects.Among the more interesting aspects of Judge Koetl’s opinion is his analysis of the question whether the plaintiffs had stated a cognizable claim against ENV, which had been ES’s 100% owner prior to the IPO. ENV had moved to dismiss based on the U.S. Supreme Court’s holding in the Janus case, arguing that like the mutual fund management company in that case, it was a legally distinct entity lacking “ultimate authority” over the statement of its related entity, and therefore because it had not “made” the alleged misstatements, it could not be held liable under the securities laws.  

 

Despite the apparent parallels between the cases, Judge Koetl nevertheless held that the claim against ENV could go forward. Judge Koetl found that there are “significant differences” between EMV and the fund management company in the Janus case. Among the critical differences that Judge Koetl found were “ENV’s owndership of ES, its direct control over all corporate transactions, and its authority to determine when and whether to sell the shares beings sold.”

 

Judge Koetl went on to note that even though the individual directors and officers signed the registration statements in their capacities as directors and officers of ES, that did not “preclude attribution” to ENV as well. He added that Janus itself even said that attribution “could be implied from the surrounding circumstances.” A reasonable jury, Judge Koetl found, could conclude that ENV’s role went far beyond a “speechwriter drafting a speech,” because “ENV had control over the message, the underlying subject matter of the message, and the ultimate decision whether to communicate the message.”

 

Judge Koetl’s decision adds an interesting new layer to the evolving analysis of the question of when alleged misrepresentations made by one party can be attributed to another party. Under Judge Koetl’s analysis, there are times when the second party's alleged control is so complete that notwithstanding the legal separation between the two parties, the controlling party can be said to have “made” the misstatement delivered by the other party – almost as if the controlling party were using the other party as its mouthpiece. The critical element in Judge Koetl’s analysis seems to have been ENV’s complete ownership and consequent complete ability to dictate its actions. (I would certainly be interested in hearing a panel of informed securities law specialists discuss the question of whether or not the differences Judge Koetl cites are or are not distinctions without a difference between this case and Janus.)

 

It is worth noting that the EnegySolutions case is one of the so-called “backlog" cases that were filed in late 2009 and early 2010 (the name refers to the fact that the cases were filed more than a year after the proposed class period cutoff date). As the time, some commentators speculated that the plaintiffs were filing the belated cases because they were out of fresh ideas and they were scraping the bottom of the barrel. But as this case’s dismissal motion survival shows, merely because the cases were belated does not necessarily mean they are not meritorious. Indeed, a number of the so-called belated cases have survived their initial dismissal motions (refer for example here).

 

Special thanks to a loyal reader for sending me a copy of Judge Koetl’s opinion.

 

Eleventh Circuit on Loss Causation: On September 30, 2011, the Eleventh Circuit affirmed in part and reversed in part the district court’s partial dismissal and later entry of summary judgment on the defendants’ behalf in the FindWhat.com securities class action lawsuit.   The opinion, which can be found here, has a number of interesting features.

 

Among the more interesting aspects of the Eleventh Circuit’s opinion is its reversal of the district’s summary judgment grant on loss causation issues. The Eleventh Circuit observed that the district court’s reasoning “misapprehends” the relation of misstatements, the company’s share price, and the plaintiffs’ allegations.

 

The district court had rejected the plaintiffs’ loss causation arguments because the plaintiffs’ expert had found that the stock price inflation predated the alleged misstatements, and that the subsequent alleged misrepresentations had not increased the amount of price inflation.  The district concluded that the misstatements could not have caused the price inflation and therefore the misstatements could not have caused the alleged financial harm.

 

The Eleventh Circuit, declining to follow prior Fifth Circuit case law, and looking at the nature of the plaintiffs’ allegations, reversed the district court’s loss causation ruling, holding that “fraudulent statements that prevent a stock price from falling can cause harm by prolonging the period during which the stock price traded at inflated prices,” adding that “confirmatory information that wrongfully prolongs a period of inflation – even without increasing the level of inflation—may be actionable.”

 

In an interesting footnote (fn.32), the Eleventh Circuit also observed that the district court had also improperly conflated the “loss causation” and “reliance” issues. The Eleventh Circuit directed the parties on remand to clarify their reliance and loss causation arguments, particularly with respect to the defendants’ reliance-related arguments that the alleged misstatements had not caused the price inflation (as opposed to the defendants’ loss causation-related arguments that the alleged inflation had not caused the plaintiffs’ financial loss).

 

Special thanks to a loyal reader for sending me a copy of this opinion.

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I am pleased to present below a guest post by Kara Altenbaumer-Price, Esq., the Director of Complex Claims and Consulting for USI and part of its Management & Professional Services Group in Dallas. I would like to thank Kara for her willingness to publish her article on this site. I am interested in publishing guest posts from responsible commentators on topics of interest to readers of this blog. Please contact me directly if you are interested in submitting a guest post for consideration.

 

Here is Kara’s guest post:

 

 

As insureds try to navigate through the new language and products being offered by D&O carriers to address increasing costs and coverage issues associated with government investigations, insureds should consider recent remarks by the SEC’s Director of Enforcement pushing for separate counsel in SEC matters. The SEC’s initiative to encourage cooperation with the agency is likely force more corporate officials to seek separate representation, which in turn will only increase the extent of coverage sought under ever-broadening D&O insurance policies. 

 

 

In 2010, the SEC implemented a number of changes in its Enforcement Manual, a internal SEC document that guides the SEC’s enforcement staff in how—and in some cases whether—investigations proceed forward from informal inquiry to formal investigation to Wells Notice stage. Included in the 2010 revisions to the manual was a program called “Fostering Cooperation” designed to spur confessions by providing leniency—or in some cases, immunity—to individuals who provide valuable evidence to the SEC.

 

 

While voluntary cooperation with the SEC enforcement’s division has long yielded benefits for companies, individuals had not necessarily seen the same level of benefit because the SEC had never set out guidelines for granting so-called “cooperation credit” to individuals.  On the other hand, the “Fostering Cooperation” initiatives appear to also mean harsher outcomes for those who are offered a chance to cooperate but do not accept. The new enforcement policy, released in January 2010, also gives the SEC access to enforcement tools the DOJ has long used—Cooperation Agreements, Non-Prosecution Agreements, and Non-Prosecution Agreements.  Each of these gives incentives for individuals and companies to cooperate with the SEC to lessen their own punishment. 

 

 

        It is likely that more individuals will “confess” to the SEC in order to obtain the benefits of these initiatives.  The inevitable D&O insurance challenge is clear: more defense costs. Cooperation by one individual implies that other individuals will be negatively impacted by that individual’s testimony.  As more individuals cooperate and as others become the “target” of that cooperation, the need for separate counsel rises, causing a rise in defense costs.

 

 

      Although the Enforcement Manual is silent about whether the use of joint defense counsel will be considered in evaluating whether an individual has cooperated, the Manual itself acknowledges that multiple representations are common and that “representing more than one party … does not necessarily present a conflict of interest.” Yet, SEC Director of Enforcement Robert Khuzami recently warned against the common practice of defense counsel representing multiple defendants in one SEC matter. He said in a June speech, “We are taking a closer look at such multiple, seemingly adverse representations. You will likely see an increase in concerns expressed by SEC staff in those situations.”  While this common practice has always been a concern from a traditional conflicts perspective, Khuzami emphasized the cooperation initiatives only heighten the issue. As he warned in his speech, “this increases the likelihood that one counsel cannot serve the interests of multiple clients, given the real benefits that could result from cooperation, such as one client testifying against another client represented by the same counsel.” 

 

 

            There may be a number of scenarios in which multiple representations are not objectionable to the SEC or insureds, such as, in the SEC’s words, “when one lawyer or one firm represents employees who are purely witnesses with no conflicting interests or material risk or legal exposure.” However, there are many other scenarios in which defense counsel represent multiple clients whose interests may ultimately diverge. For example, Khuzami noted a scenario in which one lawyer represented both an employee and a supervisor in a failure to supervise case. 

 

 

            Indeed, not only is there the possibility that one individual may want to testify against another—or that the company may want to offer up an individual in order to gain cooperation credit for itself—there may be a conflict even between two individuals whose interests may otherwise be aligned because the cooperation incentives create a “race to the Commission.” The SEC has stated that the benefits of cooperation will be reserved for those whose assistance is timely. As Khuzami said in a speech when the initiatives were announced, “Latecomers rarely will qualify for cooperation credit, so there is every reason to step forward - before someone else does.” It is not hard to see the conflict created if a single lawyer or firm finds themselves in the position of choosing which client to help to the front of the cooperation line. This could be true even for insured executives whose culpability level may be low but who may want to avoid the dreaded career-ending director and officer bar.

 

 

            Interestingly, SEC staff have indicated that they will raise the conflict issue in scenarios in which they recognize that there are individuals who may benefit from a cooperation agreement. For example, the SEC raised just such an issue in an administrative proceeding against Morgan Keegan & Compay and Morgan Asset Management and two employees when it moved to disqualify counsel. The SEC had argued unsuccessfully that the defendants had “potential defendants involving the conflict of [each] other” but that their shared counsel prevented “any such blame-shifting.”

 

 

            The big insurance question is whether D&O carriers will agree to fund the additional counsel or whether insured companies will get caught in the middle of a push for separate counsel by the SEC (and executives) and the carriers’ push for shared counsel. In the securities context, insureds almost always choose white shoe law firms with corresponding top-of-the-market fees. Sharing defense counsel has long been a method of controlling litigation costs for both companies and carriers. Even with a push for some time by counsel for each executive potentially implicated in an investigation scenario to retain independent counsel, carriers often push back for as few counsel as possible, including offering the incentive of covering the insured entity if the entity shares counsel with individual defendants.

 

 

            In considering the likely increase in defense costs as separate representations becomes even more likely in SEC matters, insureds would be wise to consider the issue when examining the number of new D&O products on the market addressing insurance coverage for SEC investigations.  Companies may also want to consider increased limits as each separate counsel can significantly ratchet up the cost of defense, eating away at limits available for settlement of SEC matters or follow-on civil litigation.

. 

           

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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In the most recent of the securities litigation analyses, on July 26, 2011, NERA Economic Consulting issued its report on the securities class action lawsuit filing during the first six months of 2011. In a report entitled “Recent Trends in Securities Class Action Litigation: 2011 Mid-Review” (here), NERA  suggests, perhaps contrary to other recently published reports, that securities suit  filings during the first half of the year were  “on the rise” and “indeed unusually high.” As I discuss below, the seeming variance among the various published reports is a reflection of different counting methodology. I have comments about that below.

 

According to NERA (and by rather stark contrast to the conclusions of the analyses of the recently released Cornerstone Research report), during the first half of 2011 “securities class action lawsuits were filed at the second highest semi-annual rate in the last eight years.” According to NERA, there were 130 filings in the first half of the year. If the filing rate were to continue at the same pace for the rest of the year, “there would be 260 filings in 2011, the highest level since 2002, and the fourth highest in the 16 years since the passage of the Private Securities Litigation Reform Act.”

 

According to NERA, a decline in the year’s first six months was offset by a “surge in suits targeting Chinese companies.” Over a third of the lawsuits during 2011’s first half were filed against foreign domiciled issuers, a rate which is “extraordinary by historical standards,” and “more than double the prior peak of 2004.”

 

The filings themselves has “continued to migrate from the Second Circuit to the Ninth Circuit,” as the mix of companies targeted has shifted away from financial companies and toward technology companies. Filings against companies in the financial sector has declined from a 2008 peak of 49 percent to just under 20 percent in the first half of 2011. Filings in against companies in the electric technology and technology services sector represented 22 percent of filings in the year’s first six months.

 

The NERA report notes that filings activity continues to be positively correlated with market volatility. Controlling for market returns, volatility is positively and statistically significantly correlated with quarterly filings from the second quarter of 1996 through the second quarter of 2011. However, the correlation is “not one-for-one.” Indeed, market volatility and market returns together explain only about 20 percent of the variance in quarterly filings. In other words, volatility is important but it does not come close to telling you everything you need to know.

 

In looking at the status of cases from the 2000 filing year, the NERA report shows that about 63% of all cases from that year have settled and about 37% percent have settled.

 

With respect to the 245 credit crisis cases filed as of June 30, 2011, 79 have produced “current dismissals” and “only 23 settlements. “

 

With respect to first half 2011 settlements, the average settlement was $23 million, which is sharply down from the 2010 average settlement of $108 million. The median settlement during the year’s first six months was only $6.3 million, down sharply from the all time high median settlement of $11 million in 2011. The proportion of cases settling for less than $10 million reached a post-2006 high during the first half of 2011, when 58 percent of cases settled below $10 million , up from 41 percent in 2010.

 

The report speculates that one reason for the lower settlement levels may be that during the first half of 2011 “cases may have been more apt to settle within insurance limits, possibly due to defendants’ reduced ability to pay.” Of the 15 out of the 48 first half settlements for which NERA was able to determine the insurance contribution, insurance paid all of the settlement in eight cases, between 71 and 81 percent in three and an unspecified rate in the remaining four.

 

The full report, which has a wide variety of other interesting and useful information, warrant reading at length and in full.

 

Discussion

It is  purely coincidental that the NERA report’s publication came in such close conjunction with the publication of the Cornerstone Research report. But because they appeared so close in time, it is impossible not to compare the two reports’ findings. The contrast between the reports’ conclusions is striking. The Cornerstone Report suggested that securities class action laws filings are in decline and trending toward historically lower levels. The NERA Report, by contrast, suggests that filings “are on the rise” and “unusually high.”

 

What in the world is going on? Aren’t these two reports supposed to be analyzing the same thing?

 

The casual reader will be forgiven for assuming that the two reports are analyzing the same thing. But careful reading of the small print and footnotes will disclose that the two reports are not analyzing the same thing. Or to put it more accurately, they are not counting the same things in the same ways. I suspect there are even more differences in what is counted and how it is counted than can be discerned from the reports themselves. But even just based on what can be gleaned from the reports,, the NERA Report (as described in its footnote 1), counts separate filings against a company in separate circuits as separate lawsuits, at least until they are consolidated. Cornerstone, by contrast, counts each target defendant company only once. Cornerstone also counts separate lawsuits brought by separate classes of securityholders separately, at least until consolidated.

 

I know from my own experience that another very difficult category has to do with the lawsuits arising from M&A-related transactions. Whether or not to include these cases can only be decided on a case by case basis, and reasonable people almost certainly might reach different conclusions , which could produce significantly different lawsuit counts.

 

My point here is that how you count affects what you count. And what you count affects the ultimate outcome of your count. The net effect is that we have two very reputable analytic firms reaching quite different conclusions about the level of securities class action lawsuit filing activity during the first six months of 2011. Truthfully, that is the reason I keep my own count, because I find it too confusing trying to make sense out of the conflicting conclusions of the reporting firms.

 

The problem for everyone is that these conflicting conclusions get picked up in the mass media and reported as if they representing absolute conclusions rather than alternative analyses based on mixed data. These conflicting reports create a great deal of confusion among the general public.

 

I think part of the problem here as the respective commentators act as if they are publishing their data in a vacuum. Nothing could be further from the truth. I suspect to a very high degree of moral certainty that every single reader that reads any one of these report reads them all. Not only that, but the authors of these reports read each others reports and they know that everyone that reads their reports reads all the reports.

 

 It would be extraordinarily helpful if the authors would acknowledge this reality up front (not in footnotes, not in reduced text, not in text buried deep within the document) in a simple cover page statement that declares the counting methodology used and that explains how that contrasts with counting methodologies used in other published reports. It would be even more helpful if this initial disclosure explained how the methodology selected affects the ultimate count.

 

By making these remarks here, I hope that no one concludes that I am being critical of anyone. To the contrary, I am one of many people who are very grateful that these high-powered analytic firms are willing to publish their reports and make their analyses available for free. These reports are extraordinarily valuable and helpful. My point is simply that these reports would be even more useful if the reports were to recognize the context within which they are read.

 

Finally, I want to be sure to acknowledge the incredibly fine work that the folks at these firms produce. On behalf of myself and everyone else that devours these reports as soon as they are published. I would like thank everyone associated with the production of these reports. And since this particular post is about the NERA report, I would like to salute all my friends at NERA and to thank them for another fine report. I hope no one interprets my curmudgeonly remarks as anything other than a friendly suggestion.

 

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Among other things, Cornerstone Research’s mid-year 2011 analysis of securities class action lawsuit filings reported that during the year’s first half lawsuits were filed more quickly. The report said that in the first six months of 2011 “the median lag between the end of the class periods and the filing dates dropped to the lowest recorded semiannual level since 1997.” But while securities suits in general may be being filed with alacrity, there are still suits that are being filed only after considerable delay. At least one recent suit filing qualifies as belated, while yet another recent filing looks positively ancient.

 

First, on July 20, 2011, plaintiffs’ counsel filed a securities class action lawsuit in the Southern District of New York against Lockheed Martin and certain of its directors and officers. According to the plaintiffs’ lawyers’ July 20, 2011 press release (here), the complaint (which can be found here) purports to represent a class of Lockheed shareholders who purchased their shares between April 21, 2009 and July 21, 2009. 

 

In other words, the plaintiffs appear to have filed their complaint in the Lockheed Martin action on the last day of the two year statute of limitations period applicable to most private securities lawsuits. Given the lag between the class period cutoff date and the date the complaint was filed, the Lockheed Martin lawsuit filing would seem to qualify at least as “belated.”

 

But the lag time in the Lockheed Martin case is nothing compared to the time gap in the case recently filed involving Fairfax Financial Holdings Limited.

 

As reflected in their press release (here), on July 25, 2011, plaintiffs’ counsel filed a securities class action lawsuit in the Southern District of New York against Fairfax Financial Holdings, its auditor, and certain of its affiliated entities and certain of its directors and officers. In their complaint, the plaintiffs purport to represent a class of Fairfax shareholders who purchased their shares between May 21, 2003 and March 22, 2006. In other words, the plaintiffs filed their complaint in this case more than five years after the end of the purported class period.

 

Doesn’t this apparently tardy filing violate the statute of limitation? The plaintiffs knew you were going to ask that question, and so in their complaint they expressly address the statute of limitations issue. As reflected in the complaint’s preamble, on page 2 of the complaint, it is going to be the plaintiffs’ position in the case that the statute of limitations was tolled on April 14, 2006, with the filing of a prior action – Parks v. Fairfax Financial Holdings, et al. (about which refer here) -- in the Southern District of New York, against many of the same defendants and involving many of the same allegations.

 

In other words, as you might expect with an ancient set of circumstances, history is important. In particular, the history of the Parks case could be determinative of the statute of limitations issues in the recently filed action.

 

The Parks case, it turns out, was dismissed on March 29, 2010 on the grounds of lack of subject matter jurisdiction. Fairfax Financial Holdings is a Canadian company. In his March 2010 opinion, Southern District of New York Judge George B. Daniels, citing the Second Circuit’s opinion in Morrison v. National Australia Bank, held that the plaintiffs in the Parks case had not alleged sufficient “conduct and effects” in the United States in order to establish subject matter jurisdiction. The plaintiffs’ subsequent appeal to the Second Circuit was dismissed.

 

However, after that, in June 2010, the U.S. Supreme Court entered its opinion in the Morrison case, rejecting the “conduct and effects” text and substituting the “transaction” test. Moreover, the Supreme Court said that the questions of U.S. courts’ authority to hear securities cases involving foreign companies was not jurisdictional, but rather was simply a question of whether or not a claim was within the ambit of the securities laws.

 

The plaintiffs in the recently filed action involving Fairfax Financial Holdings, cognizant of the U.S. Supreme Court’s “transaction” test in the Morrison case, purport to represent only shareholders who purchased their company shares on U.S. exchanges. As a matter of pleading, the presentation of their claims in U.S. court should satisfy the Morrison standard, now that the “conduct and effects” test has been discarded.

 

While the plaintiffs in the recently filed case may avoid the jurisdictional problems that waylaid the prior plaintiffs in the Parks case, there are still those pesky statute of limitations issues. The most recent filing is not only well beyond the two-year statute of limitations, but it is even beyond the five year statute of repose. The question the parties will have to hammer out (and I expect they will) is whether or not the 2006 filing the Parks case not only tolled the statute of limitations but also stays the running of the statute of repose. There is a point where a claim or claims are not just old, but stale. The question is whether or not these claims are past their sell-by date. It will be interesting to see how these issues are resolved in this case.

 

An unrelated issue that comes to mind is whether or not the dismissal in the Parks case is determinative of the claims. That is, as lawyers would say, is the prior dismissal res judiciata? The question there will be whether a dismissal for lack of subject matter jurisdiction has a res judiciata effect, since it does not represent a determination of the merits of any of the claims asserted. Attorneys who have access to associates to research interesting question like that will know the answer to this question (or they will when their associates have completed their legal research).

 

But in the end, what is clear is that while securities lawsuits generally may be being filed more quickly, there are some of these older cases still kicking around out there. And they raise some potentially very interesting issues.

 

Summary Judgment Denied: Securities class action litigation observers know that very few securities suits actually go to trial. Most cases are either dismissed or settled. From time to time, a securities suit will make it all the way to the summary judgment stage. The securities suit pending against Motorola and certain of its directors and officers in the Northern District of Illinois is one of those cases where the case reached the summary judgment stage. In a July 25, 2011 order (here), Northern District of Ilinois Judge Amy St. Eve denied the defendants’ motion for summary judgment, holding inter alia that there are genuine issues of material fact on the issues of falsity, materiality and scienter. As a procedural matter, the case is now headed toward trial, depending on whether or not a settlement intervenes.

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Decreased credit crisis-related filings partially offset by an influx of new filings related to M&A transactions or involving Chinese companies resulted in slightly decreased overall levels of securities class action litigation filings during the first half of 2011, according to a recent report entitled “Securities Class Action Filings: 2011 Mid-Year Assessment,” jointly published by Cornerstone Research and the Stanford Law School Securities Class Action Clearinghouse. The report can be foundhere and the accompanying July 26, 2011 press release can be found here. My own analysis of the first half filings can be found here.

 

According to the report, there were 94 securities class action lawsuit filings during the first half of 2011, compared to 104 in the second half of 2010. The 94 first half filings annualizes (using calendar days rather than months) to 190 filings, which is slightly below the 1997-2010 annual filing average of 194. (Cornerstone’s lawsuit count may differ slightly from other published tallies because, among other things, it counts multiple complaints against the same defendants only once and because it does not count state court filings.)

 

The report notes that the quarterly number of filings has generally declined during the past twelve months. Quarterly filings decreased from 56 in the third quarter of 2010 to 48 in the fourth quarter of 2011, 46 in the first quarter of 2010 and 48 in the second quarter of 2011.

 

One factor driving the first half 2011 filings was the upsurge in lawsuits against Chinese companies. There were 24 securities class action lawsuits against Chinese companies in the first half of 2011, with 23 of those actions involving reverse merger companies, up from 12 filings against Chinese companies, nine involving reverse merger companies, in all of 2010. By the same token there were 21 M&A-related filings in the first six months of 2011, “continuing a new pattern” that emerged in the second half of 2010, when there were 27 M&A-related lawsuits.

 

The lawsuits involving Chinese companies and M&A-related activity collectively represent a very substantial part of all securities class action lawsuit filings in the first six months of 2011. These two groups of lawsuits together represented 46.8 percent of all filings in 2011’s first half, up from 32.7 percent in the second half of 2010. Excluding these two categories, there were otherwise only 50 securities class action lawsuits in the first half of 2011, 70 in the second half of 2010 and 57 in the first half of 2010. These figures, the report notes, are “similar to the low number of filings seen in 2006 and 2007.”

 

The report notes that the its own annualized projection for the 2011 year-end number of securities class action lawsuit filings assumes that the pace of new filings against Chinese companies seen in the year’s first half will continue in the second half. However, the report notes, the number of U.S.-listed Chinese reverse merger companies is finite, and the current level of new filings involving Chinese companies is unlikely to continue indefinitely. The report reckons, “at one extreme,” that if there were no new lawsuits involving Chinese companies in 2011’s second half and other filings continue at the same pace as in the year’s first half, there would be only a total of 166 filings this year, “making 2011 the second lowest year in filings activity during 2006.”

 

The report contains some interesting analysis of the frequency of new lawsuit filings involving S&P 500 companies. The report notes that only 8.5 percent of the first half of 2011 filings named companies in the S&P 500 index, down from 15.4 percent in the second half of 2010. Overall, eight companies, or about one out of every 63 companies in the S&P 500 Index, were defendants in a class action filed in the first half of 2011, compared with about one out of every 19 S&P 500 companies during the full year of 2010. Only one out of 81 companies in the S&P 500 Financials sector was named as a defendant in the first half of 2011, compared to an average of 11.7 percent of Financials sector firms named in class actions between 2000 and 2010.

 

The losses in market capitalization associated with adverse disclosures at the end of the class periods remains low compared to historical levels. The total disclosure loss during the first half of 2011 of $48 billion is well below the historical average of $64 billion occurring between 1997 and 2010. The market cap declines during the class periods also remained low during 2011.

 

Discussion

The report clearly substantiates that the number of lawsuits against Chinese companies and involving M&A transactions were a significant factor driving securities class action litigation activity during the first half of 2011. The report’s exploration of the counterfactual question of what the litigation levels might have looked like without these two categories of litigation activity is interesting. But the report’s implicit suggestion that – but for the anomalous Chinese company and M&A transaction lawsuits –  securities litigation filings are actually trending toward the lower levels that prevailed during the “lull” years of 2006 and early 2007 warrants scrutiny.

 

The lawsuits involving Chinese companies and M&A-related transactions may reflect short term filing patterns. But it has long been the case with securities class action lawsuit filings that they are substantially driven by short term filing patterns. For years, class action lawsuit filings have been reflected sector slides, contagion patterns, or industry events. The Internet bubble was followed by the telecom industry crash and that was filed by the era of the corporate scandals, which was followed by the mutual fund industry market timing scandal, and then came options backdating scandal and after that the subprime meltdown and then the credit crisis. Each one of these events involved an associated influx of securities class action lawsuits.

 

So while it is true that the current litigation activity is largely being driven by short-term trends, there is nothing unusual about that. There always seems to be something driving securities class action litigation activity and it seems likely that even after the current round of securities lawsuits involving Chinese companies winds down, the plaintiffs lawyers will find something else to agitate about. (And as for whether the pattern of lawsuits against Chinese companies is going to wind down soon, I note that there have already been four new securities class action lawsuits filed against U.S.-listed Chinese companies already this month, so there is no current suggestion that the filing phenomenon has started to slow down.)

 

The other thing about the “lull” period, from about mid-2005 to mid-2007, is that while securities class action lawsuit filings may have declined compared to historical norms during that period, overall litigation levels did not decline. The options backdating scandal unfolded during that period, and many more of the options backdating lawsuits that were filed during that period were filed as shareholder derivative suits (over 160) than were filed as securities class action lawsuits (only about 40). So while there may have been a decline in new securities lawsuits during that period, overall litigation levels remained at or near historical norms. It is important to keep this fact in mind when attempting to discern filing patterns over time, especially when considering the possibility that filing levels are or are not actually trending toward a putative lower level.

 

My own view, which is substantially dependent upon the assumption that the plaintiffs’ lawyers will always find the next new category of lawsuits to pursue, is that securities class action lawsuit filings are not trending toward some lower level. More specifically, I do not think that the mid-2005 to mid-2007 filing levels represent some sort of “new normal” to which filings levels are generally trending but for short-term anomalies that obscure the overall pattern. To the contrary, I think the lower securities class action filing levels during the 2005 to 2007 period represent the anomaly, and it is an anomaly that is entirely explainable by the plaintiffs’ bar’s temporary diversion into shareholders derivative lawsuit filings during the options backdating scandal.

 

As I have said before, fish gotta swim, birds gotta fly, and plaintiffs’ lawyers have to file lawsuits. The fish and the birds can be counted upon to continue their traditional activities, and so can the plaintiffs’ lawyers.

 

An important consideration to keep in mind along those lines is that going forward the lawsuit filings driving corporate and securities litigation may or may not involve securities class action lawsuits. As the insurance advisory firm Advisen has well documented in its periodic reports on corporate and securities litigation (refer for example here), securities class action lawsuits increasingly represent a declining percentage of all corporate and securities litigation. So it may happen, as was the case during the so-called “lull” period, that securities class action lawsuit filings may decline while overall litigation levels remain unchanged or even continue to increase.

 

Responding to Negative Say on Pay Vote: Although only a very small companies experienced a negative say on pay vote during this past proxy season (as detailed here), a number of the companies that did sustain negative votes wound up in litigation. For companies that find themselves in this position, the question arises of how the company and its board should respond.

 

In an interesting July 24, 2011 post on the Harvard Law School Forum on Corporate Governance and Financial Regulation blog (here), Paul Rowe of the Wachtell Lipton law firm examines the question of the how companies that have experienced a negative say on pay vote should respond.

 

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With the temperatures reaching mind-bending levels, we considered it advisable to stay inside, drink plenty of fluids, and limit our exertions. So in lieu of a more elaborate post, we have simply noted some mid-summer quick hits below.

 

Action against U.S.-Listed Chinese Companies Auditors Allowed to Proceed: A recurring question during the current wave of lawsuit filings involving U.S.-listed Chinese companies has been how the plaintiffs will pursue their claims and enforce any judgments against the Chinese defendants. One likely counter to these problems has been for plaintiffs to pursue the claims against the Chinese defendant company’s more accessible outside professionals. A number of recent suits have named outside auditors and other professionals as defendants (refer for example here). Given recent U.S. Supreme Court case law, making these claims against the outside professionals stick could be tough.

 

But in a July 18, 2011 decision in a case filed prior to the current wave of lawsuit filings against Chinese companies, a judge had held that the plaintiffs’ allegations were sufficient for the claims against the auditor to proceed. As reflected here, the plaintiff first filed its lawsuit against China Expert Technology in 2007. The original complaint included among the defendants the company’s outside auditors including affiliates of BDO Seidman and affiliates of PKF.

 

The case had been through several rounds of pleading. The defendants’ motions to dismiss were initially granted, but the dismissal as to the PKF parties was without prejudice. The plaintiff twice attempted to amend his complaint in an attempt to overcome the pleading concerns, but each time the motion as to the PKF parties was granted, without prejudice.

 

In the July 18 order, which is handwritten, Southern District of New York Judge Alvin Hellerstein concluded with respect to the plaintiff’s fourth amended complaint that “enough has been alleged to make out a plausible claim for relief.” Unfortunately for other litigants who might want to try and rely on or cite Judge Hellerstein’s ruling, his brief order does not provide any elaboration.

 

But despite the brevity of the ruling and the fact that it took four amended complaints for the China Expert technology plaintiff to overcome the pleading hurdle, the fact is that the plaintiff was ultimately able to present allegations sufficient to meet the pleading hurdles. That fact alone may provide comfort for the plaintiffs in pursuing claims against the Chinese companies’ outside professionals in other cases.

 

Success in overcoming the hurdles in pleading claims against the auditor in this particular case is for this plaintiff critical. As Nate Raymond pointed out in his July 20, 2011 Am Law Litigation Daily article about the case (here), China Expert Technology has never appeared in the case and a default was previously entered against the company. Plaintiffs in other cases may face similar challenges, and so the ability to pursue claims against the outside professionals may prove to be critical in other cases as well. Whether or not those claimants will be able to make their claims stick remains to be seen. But in at least one case, the plaintiff’s claims against a Chinese firm’s outside auditor are going forward.

 

A July 21, 2011 Reuters article about the decision can be found here

 

Who’s Paying for News Corp.’s Legal Costs?: The media frenzy over News Corp.’s phone hacking scandal has led to a host of actual and potential legal proceedings involving News Corp. and its senior managers. The legal bills no doubt are starting to mount, which inevitable leads to the question of who will be paying the lawyers. A July 20, 2011 Reuters article (here) speculates that the company’s D&O insurance may be paying for the the legal expenses.

 

The article appropriately notes some of the questions surrounding the availability of D&O insurance coverage for the legal fees. Among other things, depending on its terms and conditions, the D&O policy may not cover substantial amounts of the expense, even if there is coverage under the policy for some of the company’s expense. The fees the company and its senior officials incur in defending the various civil suits are likely to be most likely to be covered. The various investigations and criminal proceedings may or may not be covered depending on the nature of the proceedings and the specific wordings of the company’s policy.

 

And Speaking of D&O Insurance: As suggested in the prior item, the specific wording in a D&O insurance policy is critically important. Subtle wording differences can make a significant difference in whether or to what extent insurance is available for claims related expenses, settlements and judgments. In a competitive insurance marketplace , the more advantageous wordings often are available and are often available at little or no additional cost.

 

A July 2011 memo from the Lowenstein Sandler law firm describes the availability of more favorable coverage terms as “D&O Coverage at Little or No Additional Cost.” The memo explores some of the policy alternations that can increase the scope of coverage available under the D&O insurance policy.

 

They’re Getting Litigation Weary North of the Border, Too: In changes that went into effect in 2005, Ontario modified its securities laws to provide a different liability regime for holding corporate officials accountable to shareholders for material misrepresentations and omissions. One of the new law’s features was the inclusion of a procedural requirement that prospective litigants obtain judicial leave to proceed. The leave requirement was introduced at companies’ insistence as a way to try to ensure that only meritorious cases proceed.

 

But as discussed in a July 20, 2011 Reuters article (here), the leave requirement itself is proving to be burdensome, as the process of determining whether or not the case should be allowed to go forward is proving to be protracted and expensive. The article also reports that there are concerns in some circles that the courts have set the bar for granting leave too low.

 

It was perhaps inevitable that there would be grumbling in the wake of claims under the new regime. From that perspective, the complaints are hardly surprising. But it does seem as if the actual process under the new rules is turning out differently than at least some had envisioned.

 

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Overall levels of corporate and securities litigation during the second quarter and first half of 2011 remained at elevated levels despite a decline in regulatory and enforcement activity during the quarter, according to the latest Advisen quarterly litigation report. A copy of the report can be found here. My own survey of the second quarter and first half securities class action litigation activity can be found here.

 

Preliminary Notes

It is critically important to recognize that the Advisen report uses its own unique vocabulary to describe certain of the corporate and securities litigation categories.

 

The “securities litigation” and “securities suits” analyzed in the Advisen report include not only securities class action lawsuits, but a broad collection of other types of suits as well, including regulatory and enforcement actions, individual actions, derivative actions, collective actions filed outside the U.S. and allegations of breach of fiduciary duty. All of these various kinds of lawsuits, whether or not involving alleged violations of the securities laws, are referred to in the aggregate in the Advisen report as "securities suits."

 

One subset of the overall collection of "securities suits" is a category denominated as "securities fraud" lawsuits, which includes a combination of both regulatory and enforcement actions, on the one hand, and private securities lawsuits brought as individual actions, on the other hand. However, the category of "securities fraud" lawsuits does NOT include private securities class action lawsuits, which are in their own separate category ("SCAS").

 

Due to these unfamiliar usages and the confusing similarity of category names, considerable care is required in reading the Advisen report.

 

The Report’s Findings

According to the report, the annualized level of all corporate and securities litigation activity during the first half of 2011 remained “on par with the record-setting year of 2010,” notwithstanding a decline in the number of new regulatory actions against financial services firms, as enforcement activity in the wake of the global financial crisis waned.

 

Advisen tracked a total of 332 new actions across all categories of corporate and securities lawsuits during the second quarter, compared to 398 during 1Q11. Despite the falloff, the second quarter activity remained as a “high level” and the first half activity annualizes to a record level of corporate and securities litigation activity.

 

One category of litigation activity driving these numbers is the group of lawsuits alleging breach of fiduciary duties. Many of these breach of fiduciary duty lawsuits are merger objection lawsuits, the filing of which has been “mushrooming” in recent years. The number of merger objection suits has grown from only 21 in 2001 to 353 in 2010, and with 176 merger objection suits in the first half of 2011, the pace of merger objection litigation remains in line with 2010 levels. The report includes a chart on page 6 illustrating the dramatic growth in merger objection litigation activity.

 

According to the Advisen report, there were 63 new securities class action lawsuit filings during the second quarter, which is flat with the previous quarter, but above the 2010 quarterly average of 48 per quarter and in line with the 60 suits per quarter during 2009. Securities class action lawsuit filings as a percentage of all corporate and securities lawsuit filings remains down from historical levels although up slightly from 2010 levels. Class action securities lawsuits represented as much as a third of all corporate and securities litigation activity as recently as 2006, but during the second quarter, securities class action lawsuits represented only 19 percent of all corporate and securities lawsuits, which while below historical levels is up slightly from the 14 percent such suits represented in 2010. Three industrial sectors accounted for over 60 percent of all securities class action lawsuit during the first half: information technology, consumer discretionary, and industrial.

 

Actions involving companies in the financial services industry accounted for a smaller percentage of all corporate and securities litigation activity during the second quarter compared to recent periods. Financial firms counted for 45 percent of all corporate and securities litigation in 2008 and 45 percent in 2009. The number fell to 34 percent in 2010 and during the second quarter of 2011, the number fell to 25 percent. Despite the decline, the financial services industry still remains the “leading sector” for attracting corporate and securities litigation activity.

 

One prominent trend has been the growth in corporate and securities litigation activity involving non-U.S. companies. A certain amount of this litigation involving non-U.S. companies involves proceedings outside the U.S. The Advisen study reports that during the first half of 2011, there were 38 corporate and securities lawsuits filed outside the U.S., 18 of which were filed during the second quarter. Corporate and securities lawsuits involving non-U.S. companies, whether filed in the U.S. or elsewhere, have accounted for about ten percent of all corporate and securities litigation activity since 2005. But in the first half of 2011, corporate and securities lawsuit activity against non-U.S. companies accounted for 17 percent of all corporate and securities litigation activity, and during the second quarter of 2011, the figure for non-U.S. companies was up to 20 percent.

 

A substantial part of this rise in activity involving non-U.S. companies has been the rise in the number of corporate and securities lawsuits involving Chinese companies, of which there were 44 during the first half of 2011.

 

Discussion

Advisen’s report takes a broader view of corporate and securities litigation, because its scope reaches beyond just securities class action lawsuits to include all corporate and securities litigation, and not just in the U.S, but outside the U.S. as well. But even with this broader scope, it is apparent that a couple of identifiable factors are currently driving corporate and securities litigation activity, as is also the case with securities class action litigation – that is, the high levels of litigation largely  is a factor of the suits connected to merger and acquisition activity  and by lawsuits involving Chinese companies.

 

The table in the report depicting merger objection litigation filings dramatically illustrates the growth in this type of litigation activity in recent years. This development has a number of implications, including for the D&O insurance carriers that often wind up picking a significant part of the defense expenses and settlement amounts associated with these kinds of lawsuits. Even though these cases taken individually do not present a significant severity risk, taken collectively that represent a significant claims loss burden for the carriers, particularly those that are the most active in the primary layers.

 

As the mix of litigation has shifted away from higher severity claims such as securities class action lawsuits and toward higher frequency claims such as merger objection suits, the D&O carriers’ claims experience has shifted as well. As I noted in my own report on second quarter litigation activity, this is an under-discussed issue.

 

The burden these costs represent may be all the more painful for the carriers because the exposures involved with these kinds of suits likely are not priced into the risk premium. In addition, it is tough to underwrite the likelihood that any one company will be acquired. But because the discussion of carriers’ loss exposures tends to focus on the higher severity risk of securities class action litigation, there is relatively little consideration given to the higher frequency exposure that these merger objection lawsuits represent. This is one of those issues that just doesn’t get the airtime it deserves – at least not so far.

 

One interesting development involving these kinds of merger objection lawsuits is that the judges in the Delaware Chancery Court have started to show some resistence to the fee awards to plantiffs' counsel in cases that do not produce a material benefit for shareholders. The Wall Street Journal has a July 19, 2011 article (here) discussing these developments. The flip side of this judicial resistence is that in some instances the Delaware courts have proven more willing to approve larger fee awards where the court concludes the plaintiffs have produced substantial benefit for shareholders.

 

The surge in litigation involving U.S.-listed Chinese companies also has important D&O insurance implications, as noted in a recent Client Advisory I co-authored with Pillsbury Winthrop’s Peter Gillon, about which refer here. Alison Frankel has a July 18, 2011 post on the same topic on her Thomson Reuters News & Insight blog, here.

 

Second Quarter Litigation Update Webinar: And speaking of first half 2011 litigation filing trends, on Tuesday July 19, 2011 at 11 a.m. EDT, I will be participating in the Advisen's "Q2 Securities Litigation Webinar."  My fellow panelists will include Anderson Kill's Bill Passanante, Navigators' Scott Misson, and Willis’ John Connolly. The panel will be moderated by Advisen's Jim Blinn. Information about this event, which is free, can be found here.

 

Outside Directors and SEC Enforcement Actions: A July 16, 2011 post on the Harvard Law School Forum on Corporate Governance and Financial Regulation entitled “SEC Enforcement Actions Against Outside Directors Offer Reminder for Boards” (here) takes a look at recent SEC Enforcement actions targeting outside directors. The article concludes with respect to the recent SEC enforcement actions that “when taken together, the cases signal the commission’s continued interest in bringing enforcement actions against directors of publicly traded companies who personally violate securities laws or egregiously disregard their duties.”

 

Among other implications, the article notes the importance for board members of considering the coverage available through their company’s D&O insurance program for regulatory investigations and enforcement actions.

 

Cordray for Consumers? : Many readers may have seen the news that President Obama has nominated former Ohio Attorney General Richard Cordray to head the new Consumer Financial Protection Bureau. Cordray will be a familiar figure to readers of this blog, as I have commented in the past on Corday’s actions while Ohio Attorney General in pursuing securities class action lawsuits on behalf of Ohio’s pension funds.

 

Reactions to Cordray’s nomination to head the new consumer agency include concerns regarding Cordray’s connections to the securities class action bar. In a July 18, 2011 post on his Full Disclosure blog on the Forbes website, Daniel Fisher takes a look at the campaign contributions Cordray received in the past from prominent members of the securities class action litigation bar and comments that Cordray’s “record of taking money from lawyers who profit from private litigation that often follows closely on the heels of government investigations could provide fodder for his enemies.”

 

Ross Todd has a July 18, 2011 post on the Am Law Litigation Daily on the same questions about Cordray.

 

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The U.S. Supreme Court’s June 2010 decision in Morrison v. National Australia Bank looked like the end of securities claims in U.S. courts on behalf so-called “f-cubed” claimants – that is, foreign shareholders of foreign-domiciled companies who bought their shares on foreign exchanges. In the aftermath of Morrison, these foreign claimants have pursued a number of avenues to pursue their claims, including, for example, initiating litigation in the defendant company’s home jurisdiction.

 

Among the more creative approaches was the attempt to pursue – in U.S. courts – claims on behalf of non-U.S. claimants under the laws of the claimants’ home country. The highest-profile attempt along these lines emerged in the Toyota shareholder litigation pending in the Central District of California, where the plaintiffs had amended their complaint in shareholder arising from the company’s sudden acceleration problems to assert claims under the Japanese Financial Instruments and Exchange Act.  The plaintiffs had substantial incentive to pursue this approach since only a small fraction of the company’s shares (less than 10 percent) trade in the U.S. as American Depositary Shares.

 

However, in a July 7, 2011 opinion (here), Central District of California Dale Fischer made short work of this attempt to circumvent the impact of the Morrison decision. In her July 7 ruling, Judge Fischer rejected the plaintiffs’ argument that the court had original jurisdiction over plaintiffs’ Japanese law claims under the Class Action Fairness Act (CAFA). She further declined to exercise the court’s supplemental jurisdiction over the claimants’ Japanese law claims. He dismissed the plaintiffs’ Japanese law claims with prejudice.

 

In seeking to argue that the court had original jurisdiction over their Japanese law claims, the plaintiffs’ had contended that because Toyota shares were listed but did not trade on the New York Stock Exchange, they were not a “covered” security to which CAFA applied, and, because CAFA did not apply, they could assert claims in U.S. court under Japanese law even though they could not otherwise assert claims under U.S. law. (I have attempted to summarize the plaintiffs’ CAFA arguments as best I could; Alison Frankel has a more thorough discussion of these issues in her July 11, 2011 Thomson Reuters News & Insight article entitled “Morrison End Run Hits Brick Wall in Toyota Case” (here)). Judge Fischer declined to read into CAFA the requirements that plaintiffs urged, as “to do so would ignore the plain language of the statute.”

 

Judge Fischer’s refusal to exercise supplemental jurisdiction over the Japanese law claims is even more interesting, and is likely to spell the end of most future attempts by f-cubed claimants to try to assert claims in U.S. under foreign law. Among other things, because of the vast predominance of Japanese holders, “the damages analysis would focus overwhelmingly on these claims” and the Japanese law claims “unquestionably would dominate the litigation.”

 

Judge Fischer also found that the requirement of comity to Japanese courts “strongly argues against the exercise of supplemental jurisdiction.” He added that the respect for the rights of other countries to regulate their own securities markets “would be subverted if foreign claims were allowed to be piggybacked into virtually every American securities fraud case,” which would result in “imposing American procedures, requirements and interpretations likely never contemplated by the drafters of the foreign law.”

 

Judge Fischer did not say that there would never be an occasion when a U.S. court could properly exercise supplemental jurisdiction over foreign securities fraud claims. However, he specifically noted that “any reasonable reading of Morrison suggests that those instances will be rare.”

 

Whether or not any readers consider this outcome unexpected, the one thing that is clear is that the U.S. District Courts continue to take an expansive reading of Morrison. As Frankel put it in her article to which I linked above, the Toyota plaintiffs “fared no better than everyone else who’s tried to find any vulnerability in the Supreme Court’s ruling.”

 

M&A Litigation Soaring, For Sure: In my first half 2011 securities litigation analysis (here) one of the most distinctive trends I noted was the rise of M&A related litigation. Fox Business News has a July 12, 2011 article entitled “M&A Lawsuit Skyrocket as Fee-Hungry Law Firms Smell Easy Money” (here) which takes a closer look at the subject.

 

The article sounds themes that will be familiar to readers of this blog. However, the article is accompanied by a startling graphic that dramatically illustrates how massively the M&A-related litigation has ramped up since 2008. The article graphics also show how the M&A-related litigation has grown relative to M&A-related activity. In addition, the article provides numerical substantiation for the generalizations about the rising levels of M&A litigation.

 

I continue to believe that in the aggregate, these cases represent a serious problem for the D&O insurance industry, or at least for the carriers that are most active as primary carriers. I expect the increasing frequency of M&A –related litigation will be of increasing focus in the months ahead.

 

Second Quarter Litigation Update Webinar: And speaking of first half 2011 litigation filing trends, on Tuesday July 19, 2011 at 11 a.m. EDT, I will be participating in the Advisen's "Q2 Securities Litigation Webinar."  My fellow panelists will include Anderson Kill's Bill Passanante, Navigators' Scott Misson, and  Willis' John Connolly. The panel will be moderted by Advisen's Jim Blinn. Information about registering for this event, which is free, can be found here.

 

Parting Thought: Am I the only one that finds the new nickels, with Thomas Jefferson’s oversized and distorted face looming off to one side, weird and creepy?

 

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I am pleased to present below a guest post from Angelo G. Savino of the Cozen O’Connor law firm discussing the Southern District of New York’s application of the Morrison decision in an SEC enforcement action pending against Goldman Sachs employee Fabrice Tourre. This guest post will also be published and distributed in the future as a Client Alert from the Cozen law firm.

 

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

 

 

Here is Angelo’s guest post::

 

 

On June 10, 2011, Judge Barbara Jones of the United States District Court for the Southern District of New York issued a decision in a case entitled SEC v. Goldman Sachs & Co., No. 10-3229 (“Goldman Sachs”), that applied the Supreme Court’s Morrison decision to claims by the SEC under both the Securities Exchange Act of 1934 and the Securities Act of 1933. Goldman had previously settled the claims against it for $550 million, but left Fabrice Tourre, a Goldman Vice President who had worked at its New York headquarters, to face the SEC’s claims. 

 

The decision is noteworthy because it is the first to apply Morrison, which held that section 10(b) of the Exchange Act does not apply extraterritorially, to claims by the SEC. It is also the first decision to provide a detailed analysis of the second prong of Morrison’s transactional test involving domestic transactions in securities that are not listed on an exchange. Lastly, the decision is the first to apply Morrison to section 17(a) of the Securities Act. 

 

The SEC alleged that in 2007, Goldman structured and marketed a synthetic collateralized debt obligation (“CDO”) called Abacus 2007-ACI (“Abacus”) that was based on the performance of subprime residential mortgage-backed securities (“RMBS”). CDOs are debt securities collateralized by other debt obligations such as, in this case, RMBSs. The complaint also alleged that Goldman was assisted by a hedge fund, Paulson & Co. Inc. (“Paulson”) in selecting the RMBSs that would collateralize the CDO. At the same time, Paulson allegedly entered into a credit default swap (“CDS”) that essentially bet that the RMBSs would perform poorly. According to the SEC, Goldman and Tourre marketed the CDOs without disclosing to investors that the underlying portfolio of mortgage-backed securities had been selected by Paulson while Paulson was betting against their performance. Tourre was allegedly the Goldman employee principally responsible for structuring and marketing the Abacus securities. 

 

The SEC also alleged that Goldman and Tourre marketed and sold $150 million worth of Abacus notes to IKB, a German commercial bank, and $42 million worth of notes to ACA Capital Holdings, Inc. (“ACA Capital”), a U.S.-based entity. ACA Capital also entered into a credit default swap involving a $909 million super senior tranche of Abacus. Essentially, ACA Capital assumed the credit risk associated with that portion of Abacus’s capital structure in exchange for premium payments. Thereafter, through a series of credit default swaps among ABN, Goldman, and ACA Capital, ABN assumed the credit risk regarding that $909 million tranche. ABN is a Dutch bank.

 

The closing for Abacus occurred in New York City and Goldman delivered the notes through the book entry facilities of Depository Trust Company in New York City. Tourre, however, provided the court with trade confirmation indicating that Goldman Sachs International, located in London, was listed as the seller of the notes to an IKB affiliate based on the Island of Jersey, a British dependency. Similarly, the CDS confirmations regarding the ABN transaction listed the seller as Goldman Sachs International and the purchaser as the London branch of ABN. 

 

The SEC claimed that Tourre had violated section 17(a) of the Securities Act and section 10(b) of the Exchange Act, Rule 10b-5 thereunder, and aided and abetted violations of section 10(b). Tourre moved to dismiss and for judgment on the pleadings based on Morrison on the ground that the complaint failed to state a claim because it did not allege securities transactions that took place in the United States. 

 

Judge Jones first analyzed the SEC’s Exchange Act claims against Tourre. She noted that the Supreme Court, in Morrison, had adopted a clear transactional test: “whether the purchase or sale is made in the United States, or involves a security listed on a domestic exchange.” Nevertheless, Judge Jones also noted that, because the securities at issue in Morrison were traded only on foreign exchanges, the Supreme Court was largely silent regarding how lower courts should determine whether a purchase or sale is made in the United States. That, however, was the issue she faced because the Abacus securities were not traded on an exchange. 

 

The court began its analysis of the issue by looking to the statutory definitions of “purchase” and “sale” in the Exchange Act, which were relatively “unhelpful.” The court then turned to case law and determined that the concept of “irrevocable liability” was at the core of both a “sale” and a “purchase.” The court noted that at some time a purchaser incurs irrevocable liability to take and pay for a security while a seller incurs irrevocable liability to deliver a security. 

 

In applying this concept to the IKB transaction, the court rejected the SEC’s arguments based on Tourre’s presence in New York while he engaged in structuring and marketing of Abacus on the grounds that it was merely conduct, which had been rejected as the determinative factor in Morrison. Judge Jones also rejected the SEC’s argument that courts must look to the “entire selling process” to determine whether a securities transaction is foreign or domestic. The court observed “in reality, the SEC’s ‘entire selling process’ argument is an invitation for this court to disregard Morrison and return to the ‘conduct’ and ‘effects’ tests.” 

 

The SEC had also conceded at oral argument that the closing in New York, by itself, was not sufficient to make IKB note purchases domestic transactions for purposes of Morrison. For good measure, however, the court noted Quail Cruises Ship Mgmt. v. Agencia De Viagens CVC Tur Limitada, which also rejected the place of closing as determinative under Morrison. Accordingly, the court concluded as follows: 

 

In view of the fact that none of the conduct or activities alleged by the SEC, including the closing, constitute facts that demonstrate where any party to the IKB note purchases incurred “‘irrevocable liability[,]’” . . . the SEC fails to provide sufficient facts that allow the court to draw the reasonable inference that the IKB note “purchase[s] or sale[s were] made in the United States.” 

 

Turning to the ABN transaction, the court stated that the SEC provided no facts from which the court could draw the reasonable inference that any party to the ABN CDS transaction incurred “irrevocable liability” in the United States. Thus, Judge Jones ruled that the SEC failed to allege that the ABN CDS transaction constituted a domestic transaction under Morrison for the same reasons as the IKB purchases. 

 

Because AKA Capital was based in the United States, there appears to have been no opportunity for the court to apply Morrison to those transactions. Instead, the court analyzed whether the SEC had sufficiently pled the elements of a violation of section 10(b), and found that it had. 

 

The court also analyzed the sufficiency of the SEC’s claim under section 17(a) of the Securities Act, and whether Morrison applied to that statutory section. The court observed that Morrison did not involve or consider section 17(a), none of the parties had cited any cases applying Morrison to section 17(a), and the court was not aware of any such case. Judge Jones observed that In re Royal Bank of Scotland Grp. PLC. Litig. applied Morrison to sections 11, 12 and 15 of the Securities Act, but did not address section 17(a). Nevertheless, the court agreed with Tourre that Morrison applies to section 17(a), stating that “Morrison itself expressly states that the Exchange Act and the Securities Act share ‘[t]he same focus on domestic transactions.’” Because Morrison focused on whether sales of securities were domestic or foreign, Judge Jones concluded that, to the extent section 17(a) applied to sales, it does not apply to sales that occur outside the United States. The court therefore dismissed the section 17(a) claim, but only to the extent that it was based on sales to IKB and ABN. 

 

The court continued its analysis, however, observing that section 17(a), unlike section 10(b), applies not only to sales of securities, but also to offers to sell securities. The court examined the definition of the term “offer” in the Securities Act, which states that an offer includes “every attempt to offer or dispose of, or solicitation of an offer to buy, a security or interest in a security, for value.” The court stated that this definition left no doubt that the focus of “offer,” under the Securities Act, was on the person or entity attempting, or offering, to dispose of, or soliciting an offer to buy, securities. Applying this definition to the allegations of the complaint, the court noted that the SEC alleged Tourre, acting from New York City, offered Abacus notes to IKB and solicited ABN’s participation in Abacus CDSs. The court observed that Tourre allegedly engaged in numerous communications from New York City that constituted domestic offers of securities or swaps. Thus, Judge Jones permitted the section 17(a) claim to survive to the extent that it was based on such “offers.” 

 

Conclusion

This case adds significantly to the jurisprudence applying the Supreme Court’s Morrison decision. As an initial matter, the case represents the first time that any court has applied Morrison to claims by the SEC. Because this action was brought prior to the enactment of Dodd-Frank, which purports to grant subject matter jurisdiction over extraterritorial claims by the SEC, it remains to be seen whether subsequent post-enactment SEC cases will follow this decision. It is arguable that Dodd-Frank should not change the Morrison analysis as applied to the SEC. Although Dodd-Frank purports to grant subject matter jurisdiction over extraterritorial securities claims by the SEC, the Supreme Court, in Morrison, held that district courts already had subject matter jurisdiction, but that section 10(b) itself had no extraterritorial reach. Nothing in Dodd-Frank modified section 10(b) in that regard. Thus, courts in post-enactment cases may conclude that they are able to follow Judge Jones’s decision in Goldman Sachs. 

 

In addition, the Goldman Sachs decision is significant for its analysis of how Morrison applies to transactions in securities that are not listed on an exchange. As Judge Jones noted, because Morrison involved securities traded on foreign exchanges, the decision is essentially silent on the second prong of its transactional test involving the purchase or sale of any other security in the United States. The Goldman Sachs decision furnishes a well reasoned analytical roadmap for other courts to follow in this respect. 

 

Lastly, the decision is noteworthy for its articulation of the applicability of Morrison to claims under section 17(a) of the Securities Act involving sales of securities, and to the Securities Act generally. 

 

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The parties to the consolidated class action litigation arising out of the collapse of Washington Mutual – the largest bank failure in U.S. history -- have agreed to settle the suit for a combined $208.5 million. The settlement, which has a number of interesting features, actually consists of three separate agreements: one agreement to pay $105 on behalf of the individual defendants; another to pay $85 million on behalf of the underwriter defendants; and a third to pay $18.5 million on behalf of the company’s auditor, Deloitte & Touche. The settlement is subject to court approvals.

 

As reflected here, the first of the consolidated lawsuits was first filed in November 2007. Additional suits followed as the subprime meltdown continued to unfold during 2007 and 2008. Further suits followed WaMu’s September 2008 collapse (about which refer here).

 

The cases were consolidated in the Western District of Washington before Judge Marsh Pechman. The plaintiffs’ sprawling complaint asserted numerous allegations, but the gist is that the defendants: "(1) deliberately and secretly decreased the efficacy of WaMu’s risk management policies; (2) corrupted WaMu’s appraisal process; (3) abandoned appropriate underwriting standards; and (4) misrepresented both WaMus’ financial results and internal controls." Judge Pechman initially granted the defendants’ motions to dismiss (refer here), but she denied the defendants’ renewed motion to dismiss the plaintiffs’ amended consolidated complaints (refer here).

 

Following class certification as well as additional procedural wrangling well-detailed in Alison Frankel’s July 1, 2011 Thompson Reuters News & Insight article about the settlement (here) , the parties entered mediation, which ultimately resulted in the settlement  

 

The settlement stipulation entered on behalf of the individual director and officer defendants (the “D&O settlement agreement”) can be found here; the underwriters’ settlement stipulation can be found here; and the Deloitte & Touche settlement stipulation can be found here.

 

The $105 million D&O settlement on behalf of seven officer defendants and 13 outside director defendants apparently will be funded entirely by D&O insurance. The bank’s D&O insurers for the May 1, 2007 to May 8, 2008 policy period are identified in the definition of the term “Directors’ and Officers’ Liability Insurance Policies” on pages 14-15 of the D&O settlement agreement. The bank’s 2007-2008 insurance program apparently consisted of $150 million of traditional D&O insurance (arranged in eleven layers), with an additional $100 million of Excess Side A DIC insurance (arranged in six layers). Given the bank’s holding company’s bankruptcy, presumably the full $250 was at least theoretically available for defense and settlement of claims against the insured persons.

 

The parties released in the D&O settlement agreement include the “Contributing Insurers” who are not themselves identified by name, but are described as those insurers that have exhausted their respective limits of liability in payment of defense expense, that were contributing their limits of liability in connection with this settlement; or that had exhausted their limit in settlement of other claims against the insured persons. The settlement agreement does not clarify whether the D&O settlement will exhaust the D&O limits that remain after payment of the individuals’ defense expenses.

 

The question whether or not the insurance is exhausted is a potentially important issue, as numerous other claims remain pending against various of the WaMu directors and officers, most notably the claim that the FDIC filed against three former WaMu offices and their spouses in March 2011 (refer here). As far as I could tell, the D&O settlement stipulation in the consolidate securities suit does not mention the pending FDIC action, which reportedly is moving toward settlement itself. According to news reports about the efforts to settle the FDIC action, the prospective settlement requires the approval of third parties, which could possibly refer to the D&O insurers.

 

There is no doubt that the FDIC and the shareholder plaintiffs are potentially in competition for scarce D&O insurance funds. It is probably not a coincidence that, at least according to news reports, the parties to the consolidated securities suit first reached their settlement in principle to resolve the securities suit within a week of the filing of the FDIC action.

 

If the March 2011 FDIC suit “relates back” to the policy period of the bank’s 2007-2008 program, the funds remaining for any FDIC settlement would appear to be substantially depleted by the consolidated securities suit settlement, as well as by defense expenses. On the other hand, if the FDIC suit triggered a later or a different insurance program, there may well be additional insurance funds available. Of course, the individual defendants to the FDIC action may also be compelled to contribute toward any FDIC settlement out of their own funds.

 

In any event, the aggregate WaMu settlement is the fourth largest securities lawsuit settlement so far as part of the wave of securities litigation that followed the subprime meltdown and the credit crisis. As reflected in my table of the credit crisis lawsuit resolutions, which can be accessed here, the only three larger settlements are the over $600 million Countrywide settlement (refer here), the $475 million Merrill Lynch settlement (refer here), and the Charles Schwab settlement, which as revised amounted to $235 million.The three larger settlements all involve either solvent companies or at least sovlent successors in interest. Due to WaMu's bankruptcy, its settlement was restricted by the amount of available insurance. 

 

According to Alison Frankel’s Thompson Reuters article linked above, the $85 million underwriters’ settlement is the largest offering underwriter settlement of Section 11 claims since the $6 billion WorldCom settlement. According to a July 1, 2011 Seattle Times article (here), the WaMu settlement is the largest securities class action settlement ever in the Western District of Washington – although, according to the article, the WaMu investors stand to realize no more than 5 cents on the dollar through the settlement. The Seattle Times article also reports that the under the settlement agreements, the plaintiffs’ lawyers are to receive fees of $46.9 million and expense reimbursement of $5.8 million.

 

Special thanks to the several readers who sent me links about the WaMu settlement.

 

Yet Another Failed Bank Securities Lawsuit Settlement: On June 27, 2011, lead plaintiffs in the securities class action lawsuit filed in the Southern District of Florida on behalf of shareholders of the BankUnited Financial Corporation, the bankrupt holding company for the failed BankUnited FSB, filed a notice that the parties had reached an agreement to settle the case for $3 million. There are a number of interesting things about this notice and about the case in general.

 

First, the notice states that “the settlement of this case is part of a larger settlement that includes the FDIC and others who are not parties to this case.” The reference to the FDIC is interesting because as far as I know, the FDIC has not yet filed a civil action against BankUnited’s former directors and officers. (The FDIC’s online list of failed bank lawsuits it has filed as part of the current wave of bank failures does not list a lawsuit involving BankUnited.).

 

However, readers may recall my prior post (here), in which I discussed the November 5, 2009 demand letter that the FDIC had sent to BankUnited’s former directors and officers. In the letter, the FDIC presented its "demand for civil damages arising out of losses suffered as a result of wrongful acts and omissions committed by the named Directors and Officers." The letter explains that the demand for civil damages is "based on the breach of duty, failure to supervise, negligence, and/or gross negligence of the named Directors and Officers." Though the letter was nominally sent to the individual directors and officers, the message in the letter was clearly intended for the bank’s D&O liability insurance carriers.

 

Which brings us to the second interesting thing about the lead plaintiffs’ June 27 notice in the shareholder lawsuit. The notice specifically says that the parties’ settlement in principle is “subject to the approval of the Travelers Insurance Company, as primary directors and officers liability insurance carrier.” What makes the reference to the bank’s primary D&O insurer interesting is the combination of this reference to the insurer together with the reference to the fact that there is a larger settlement involving the FDIC.

 

As appears to be the case in connection with WaMu, the FDIC and the BankUnited shareholders were essentially competing with each other for the same pool of insurance dollars. In addition, defense expenses incurred were reducing the pool, and the longer the various proceedings dragged on the smaller would be the pool of available proceeds.

 

As discussed in my prior post about the FDIC’s demand letter, according to court filings in the bankruptcy proceedings, BankUnited carried $50 million in directors’ and officers’ liability insurance, arranged in four layers. The FDIC’s motion papers in the bankruptcy proceeding explain that the FDIC sent the demand  letter to the bank’s primary and first level excess D&O insurers, but not to the second and third level excess D&O insurers, because the second and third level excess insurer’s policies "contain a regulatory exclusion." In other words, the FDIC’s prospective recovery (if any) in these circumstances was even further constrained by possible constraints on the availability of the insurance to provide coverage for any claims it might bring.

 

These circumstance illustrate the kinds of challenges the FDIC will face as it tries to salvage losses the bank failures have caused the FDIC  insurance fund. In the S&L crisis, the FDIC faced some of these same challenges – for example, there were coverage issues then, too. But during the S&L crisis, the FDIC was rarely competing with shareholder claimants for scarce D&O insurance proceeds.

 

Most of the financial institutions that failed during the S&L crisis were small and very few were publicly traded. By contrast, many of the failed institutions involved in the current round of bank failures are larger, quite a few are publicly traded, and the ownership of many of the privately held institutions is widely distributed. The greater spread of ownership (particularly where the shares are publicly traded) increases the likelihood that following a bank failure, shareholders might pursue their own claims, putting them – as was the case with BankUnited – in competition for scarce and dwindling D&O insurance proceeds. These circumstances clearly represent a complicating factor for the FDIC as it seeks to try to recover the losses associated with the current wave of bank failures.

 

I have in any event added the BankUnited settlement to my list of credit crisis-related lawsuit resolutions, which can be accessed here.

 

And Speaking of Failed Bank Shareholder Lawsuits: According to the June 29, 2011 Santa Rosa Press Democrat (here), shareholders of the failed Sonoma Valley Bank have filed a class action shareholder lawsuit in Sonoma County (Calif.) Superior Court against eight former director s and officers of the bank. The lawsuit accuses the defendants of mismanaging over $40 million in loans. An earlier article about the shareholders claim (here) makes it clear that the purpose of the shareholder suit is to try to recover from the bank’s $20 million D&O insurance policy.

 

As I said, shareholder suits against the former directors and officers of failed financial institutions are a feature of the current wave of bank failures. The news coverage about the Sonoma Valley Bank lawsuit underscores that the litigation is all about trying to snag a recovery from the insurance proceeds. And as the BankUnited example above underscores, the shareholders’ efforts in that regard put them in competition with the FDIC for scarce and dwindling D&O insurance proceeds.

 

There are in any event many more FDIC lawsuits yet to be filed. The FDIC’s online page describing the agency’s efforts to pursue professional liability states that as of June 14, 2011, the FDIC has authorized lawsuits against 238 directors and officers of failed banks. However, as of that date the FDIC had only actually filed a total of seven lawsuits involving only 52 directors and officers. The difference of 186 directors and officers suggests that there are many more lawsuits yet to come.

 

While You Were Out: In case you missed it, on Friday July 1, 2011, I published my analysis of  securities class action lawsuit filing trends for the second quarter and for the first half of the year. Refer here.

 

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Largely driven by M&A-related litigation and securities suits against U.S.-listed Chinese companies, federal securities class action lawsuit filings continued to mount during the second quarter of 2011. With 48 new securities suits during the second quarter, the year-to-date total mid-way through the year stands at 105. The 2011 filings are on pace to finish the year with about 210 new lawsuits, which is well above the 1997-2009 average of 195.

 

The M&A lawsuits included in my tally are those that were filed in federal court and that allege a violation of federal securities laws. There were ten M&A-related federal securities lawsuits during the second quarter, or about 20% of all second quarter filings.  

 

Many of the M&A-related lawsuits are being filed in state court and so don’t enter into the count of federal securities suits. In addition, there are a number of federal court M&A-related lawsuits that don’t allege violations of the federal securities laws; these suits typically allege breaches of fiduciary duties.

 

M&A-related litigation overall, including all state and federal court suits, continues to surge. Because many of these suits are filed in state court, it is difficult to get complete information. But based on the filings I have been able to track, and counting all state and federal suits of which I am aware, there have been a total of at least 125 merger-related lawsuits YTD involving as many as 90 transactions (some transactions have drawn multiple lawsuits). While this information may be incomplete, it is clear that there are many more merger-related lawsuits now being filed than traditional securities class action lawsuits. This mix of litigation has some important implications, discussed below.

 

But the most interesting story line relating to 2011 securities class action lawsuit filings is the number of new filings involving U.S.-listed Chinese companies. As I have previously noted (most recently here), lawsuits filings against these Chinese companies have been surging, particularly during the second quarter. There have been a total of 26 securities suits against Chinese companies so far in 2011, 19 of them filed during the second quarter. The 26 lawsuits represent almost one-quarter of all 2011 securities class action lawsuit filings. The 19 securities suits filed against Chinese companies during the second quarter represent almost 40% of all new securities lawsuit filings during that period.

 

Signs are that the lawsuit filings against U.S.-listed companies will continue as we head into the year’s second half. Plaintiffs’ lawyers have published news releases that they are “investigating” additional U.S.-listed Chinese companies (refer for example, here). These types of releases usually precede lawsuit filings.

 

Lawsuit filings against foreign companies in general have been a significant part of the 2011 securities lawsuit filings. Although the vast majority of the suits against foreign companies have involved Chinese companies, lawsuits have been filed against a number of companies from other non-U.S. jurisdictions. There have been a total of 34 lawsuits against foreign companies so far this year (about 32% of all YTD 2011 filings), involving companies from eight different countries.

 

These filings against non-U.S. companies are all the more notable given the U.S. Supreme Court’s June 2010 decision in the Morrison v. National Australia Bank case, which seemingly would have produced a decline in the number of new securities suits involving non-U.S. companies. But because the shares of most of these foreign company defendants trade on U.S. securities exchanges, the Morrison decision poses no barrier to the shareholder plaintiffs suing these foreign companies in U.S. courts.

 

Although the year-to-date filings are largely characterized by the features noted above, the suits are in other ways remarkably diverse. For example, the 105 companies named as defendants represent 70 different Standard Industrial Classification (SIC) Code categories. The SIC Codes with the highest number of filings are SIC Code Category 7372 (prepackaged software), and SIC Code Category 6022 (state commercial banks), each of which has had six securities suits during the first six months of 2011.

 

Though there were a number of filings in the year’s first half against banking institutions, overall far fewer of the first half filings involved financial institutions than was the case in recent years in the wake of the credit crisis. However, as I noted in a recent post, there are still lawsuits coming in that are based on credit crisis-related events. By my count, there were at least four credit crisis-related lawsuits in the year’s first half.

 

The first half lawsuit filings were also quite dispersed geographically. The securities suits in the year’s first six months were filed in 32 different U.S. districts. The districts with the highest number of filings in the first half were the Central District of California, with 24 filings, and the Southern District of New York, which had 19.

 

Discussion

As is always the case and as I have frequently noted, definitional issues significantly affect the lawsuit count. For example, if I were to include the federal court M&A lawsuits that do not involve securities law allegations, I would be reporting 113 first half lawsuits, rather than 105. On the other hand, by including the federal court merger objection suits that have securities allegations, the count arguably is inflated in the other direction. (I have struggled for some time to decide whether or not the merger objection suits properly belong in this tally.) In other words, my count may vary from other published figures, largely due to these kinds of definitional issues.

 

The growing wave of M&A litigation is an under-discussed issue. Even though the M&A cases cases tend to be resolved quickly and usually don’t involve significant financial settlements, taken collectively they still impose an enormous cost on the system. Even if the settlement in any one case is modest (usually just the payment of the plaintiffs’ attorneys fees), there are still the defense expenses to consider. In the aggregate this litigation imposes a huge expense on the financial system. In the aggregate they are also imposing significant costs on D&O insurers, or at least those that are most active as primary insurers. Sooner or later these kinds of costs have to start taking a toll on the carriers.

 

The burden these costs represent may be all the more painful for the carriers because the exposures involved with these kinds of suits likely are not priced into the risk premium. In addition, it is tough to underwrite the likelihood that any one company will be acquired. But because the discussion of carriers’ loss exposures tends to focus on the higher severity risk of securities class action litigation, there is relatively little consideration given to the higher frequency exposure that these merger objection lawsuit represent. This is one of those issues that just doesn’t get the airtime it deserves – at least not so far.

 

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

 

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

 

 

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

 

 

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

 

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

 

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

 

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

 

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

 

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

 

Discussion

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

Pentwater, Michigan  June 26, 2011

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

Background

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

 

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

 

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

 

The June 13 Opinion

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

 

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

 

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

 

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

 

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

 

Discussion

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

 

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

 

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

 

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

 

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

 

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

 

 

Here is Brian’s guest post:

 

 

 

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

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

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

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

 

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

Background

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

 

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

 

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

 

The June 7 Opinion

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

Discussion

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

Background

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

 

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

 

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

 

The June 6 Opinion

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

 

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

 

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

 

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

 

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

 

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

 

Discussion

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

  

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

  

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I am pleased to reprint below as a guest post a detailed article about the oral argument this past week before the United States Supreme Court in the case of Erica P. John Fund v. Halliburton Co., No. 09-1403. This guest post was submitted by my friend Kimberly M. Melvin. Kim is a partner in the Wiley Rein law firm in Washington D.C. Background regarding the Halliburton case can be found here. The parties’ briefs in the case, including briefs from amici curiae, can be found here.

 

I would like to thank Kim for her willingness to publish her article on this site. I welcome guest post from responsible commentators on topics relevant to this blog. Any readers who are interested in publishing a guest post on this site are encouraged to contact me directly.

 

Here is Kim’s guest post: 

 

This week, the United States Supreme Court heard oral argument in Erica P. John Fund v. Halliburton Co., No. 09-1403 (U.S.). The case involves the denial of a motion for class certification in a securities fraud suit that was affirmed by the United States Court of Appeals for the Fifth Circuit. The argument signals that the Justices are virtually certain to reverse the Fifth Circuit’s decision. Even Halliburton’s attorney, David Sterling of Baker Botts LLP, distanced himself from the Fifth Circuit’s holding that loss causation must be proven at the class certification stage to invoke the fraud-on-the-market presumption of reliance. Yet the Justices’ questions reveal the challenges of determining the specific contours of plaintiffs’ burden of proof at the class certification stage under Basic, Inc. v. Levinson, 485 U.S. 224 (1988), given the scope of inquiry under Federal Rule of Civil Procedure 23. The Supreme Court’s ruling in this case therefore should provide greater guidance to lower courts regarding: (1) what elements plaintiffs must prove to trigger the presumption of reliance at the class certification stage, including whether plaintiffs must prove stock price impact tied to the operative misleading statements; and (2) the contours of plaintiffs’ initial burden of production and ultimate burden of persuasion when defendants present rebuttal evidence.

 

Factual Background

In Halliburton, the shareholder plaintiffs maintain that from 1999 to 2001, Halliburton made false and misleading statements that understated its asbestos liability and overstated its revenues. At the class certification stage, plaintiffs argued that that a class-wide presumption of reliance applied based on the fraud-on-the-market theory. Defendants countered that plaintiffs could not show any statistically significant price movements in response to either the allegedly false statements or the so-called “corrective disclosures” that assertedly revealed the truth about the prior misstatements. As such, they argued that plaintiffs had not satisfied their burden of proving the operative facts necessary to establish the applicability of the fraud-on-the-market presumption of reliance. Without the presumption, plaintiffs would need to show individual reliance by each class member on the alleged misrepresentation to proceed, and therefore common issues would not predominate over individual issues as required to certify a class under Rule 23. 

 

The district court agreed, denying plaintiffs’ motion for class certification based on the Fifth Circuit’s holding in Oscar Private Equity Investments v. Allegiance Telecom, Inc., 487 F. 3d 261 (5th Cir. 2007). According to the district court, plaintiffs were unable to employ the fraud-on-the-market presumption of reliance because they failed to show any price distortion as a result of defendants’ alleged misrepresentations. The district court reasoned that plaintiffs presented no evidence that “‘false, non-confirmatory positive statements caused a positive effect on the stock price.’” Archdiocese of Milwaukee Supporting Fund, et al. v. Halliburton Co., et al., No. 3:02-CV-1152-M, 2008 WL 4791492, at *3 (N.D. Tex. Nov. 4, 2008) (quoting Ryan v. Flowserve Corp., 245 F.R.D. 560, 569 (N.D. Tex. 2007)). They also did not show: “‘(1) that an alleged corrective disclosure causing the decrease in price is related to the false, non-confirmatory positive statement made earlier, and (2) that it is more probable than not that it was this related corrective disclosure, and not any other unrelated negative statement, that caused the stock price decline.’”  Id. 

 

The Fifth Circuit affirmed, reasoning that plaintiffs could not invoke the fraud-on-the-market presumption of reliance because they had not proven loss causation. According to the Fifth Circuit, “because loss causation speaks to the semi-strong efficient market hypothesis upon which class wide reliance depends,” loss causation must be proven to determine whether class wide reliance may be presumed so that common issues predominate over individual issues under Rule 23. Oscar, 487 F.3d at 269. The Fifth Circuit requires “this showing ‘at the class certification stage by a preponderance of all admissible evidence.’” Archdiocese of Milwaukee Supporting Fund, et al. v. Halliburton Co., et al., 597 F.3d 330, 335 (5th Cir. 2010) (citation omitted).

 

On appeal to the Supreme Court, plaintiffs maintain that the Fifth Circuit imposed an improper burden on them because loss causation is a merits issue that is not relevant to the class certification inquiry under Rule 23. Halliburton and its CEO contend that under Basic, defendants are entitled to rebut the presumption of reliance based on lack of market impact, and that the outcome of the Fifth Circuit’s decision is consistent with that theory.

 

Summary of the Oral Argument

            Plaintiff’s Opening Argument

Counsel for the shareholder plaintiffs, David Boies of Boise Schiller & Flexner, led off the argument by focusing on the limited nature of the inquiry to certify a class under Rule 23. Nearly immediately, however, Mr. Boies was stopped by Chief Justice Roberts, who asked whether the existence of an efficient market could be disputed at the class certification stage.  While noting that the issue had been conceded by defendants below, Mr. Boies responded affirmatively that the efficient market issue is properly addressed at the class certification stage because “the issue of [an] efficient market goes to the presumption of reliance,” and if the court holds that the presumption is not available, “you can have a situation in which the common issues do not predominate over the individualized issues.” Transcript of April 25, 2011 Oral Argument in Erica P. John Fund v. Halliburton Co., No. 09-1403 (U.S. Apr. 25, 2011) (“Tr.”) at 4. 

 

This concession shaped the remainder of Mr. Boies’s argument. Thereafter Justices Alito, Kagan, Scalia and Sotomayor posed questions largely focused on why a court could address the efficient market issue at the class certification stage but not the issue of price impact. Mr. Boies repeatedly responded that loss causation was a merits issue only because it is a class-wide common issue whereas market efficiency addresses the reliance issue, which could raise individualized issues if plaintiffs could not invoke the fraud-on-the-market presumption. As such, Mr. Boies maintained that Basic provides that defendants can only rebut the reliance presumption at the class certification stage with “proof generally disproving the efficiency of the market” and other proof (such as a lack of market impact) must be “reserved for trial,” relying on footnote 29 in Basic. Tr. at 6. 

 

During Mr. Boies’s argument, Justice Scalia honed in on defendants’ position that although the Fifth Circuit used the term loss causation, the court was focused on market impact as a means of rebutting the fraud-on-the-market presumption of reliance. In this regard, Justice Scalia inquired: “Would you be satisfied if we just said we agree with you that the requirement to prove loss causation is -- no good, and sent it back to the Fifth Circuit and then let the Fifth Circuit adopt the theory that Respondents assert they have already adopted?  I mean, it’s sort of a Pyrrhic victory, it seems to me, if you haven’t just disapproved loss causation.” Tr. at 9. Mr. Boies acknowledged in responding that “if [the Fifth Circuit] simply changed the wording and called loss causation reliance, obviously it wouldn’t make any difference.” Id. However, Mr. Boies did reply that loss causation and reliance are distinct elements, and that loss causation could only be a class-wide common issue. Tr. at 9-10. 

 

            Argument on Behalf of the United States as Amicus Curiae

Nicole A. Saharsky for the government was up next. She focused on three asserted deficiencies in the Fifth Circuit’s decision: “First, the Fifth Circuit [is] conducting a merits inquiry that’s not tethered to the Rule 23 requirements; second, it’s taking a presumption and requiring plaintiffs to prove it; and third, it’s confusing the distinct elements of reliance and loss causation.” Tr. at 15. In addressing the questions posed to Mr. Boies, she affirmed that “[t]he Fifth Circuit could not be more clear” that it “is not talking about rebutting the presumption of reliance . . . [i]t is putting an affirmative burden on plaintiffs [of proving loss causation] that they have to meet in every single case, even if the defendants do not come to court with any evidence.” Tr. at 15. 

 

Justice Scalia quickly focused Ms. Saharsky on price impact and secured the concession that defendants can rebut the efficient market issue. Ms. Saharsky, however, reiterated Mr. Boies’s view that the rebuttal evidence could not include loss causation-related proof because loss causation raises merits issues that “stand or fall on a class-wide basis.” The response prompted Justice Kennedy to posit, “[t]he rule isn’t . . . that simply because the issue is on a class-wide basis, it can’t be challenged at the certification stage. We don’t have a rule that’s that broad, do we?” Tr. at 17. He, together with the Chief Justice, went on to suggest through further questioning that if a class-wide, merits-based issue must be proven to show that common issues predominate (i.e., to invoke the fraud-on-the-market presumption of reliance), like an efficient market, then inquiry as to that issue is appropriate under Rule 23. Tr. at 17-18. 

 

Attempting to address this suggestion, Ms. Saharsky replied that the inquiry is more limited: “when the plaintiffs invoke fraud on the market and they show that there is an efficient market, this Court said in Basic, they can all proceed together because they are showing that . . . the material misstatement was reflected in the stock price. This is an impersonal market in which you rely on the stock price. They all rely on it the same way.” Tr. at 19. Justice Alito seized on this response raising the critical issue to be addressed in the Court’s decision: “And if they show that the statement was not incorporated in the price . . . , then why doesn’t reliance cease to be a common issue and become a question of an individual issue that would have to be proved by each . . . member of the class?” Tr. at 19-20. Ignoring that in such a circumstance individual plaintiffs may still be able to prove direct reliance, Ms. Saharsky responded “[w]ell, in that circumstance reliance ceases to be and the case cannot be established on the merits. They stand or fall together on the merits.” Tr. at 20. Justice Alito followed up, questioning: “[B]ut the fact that they would lose on the merits doesn’t necessarily mean that they are entitled to class certification.” Tr. at 20. Ms. Saharsky rejoined, “They’re entitled to class certification if they have a common issue.” Tr. at 20. 

 

At the end of Ms. Saharsky’s argument, Justice Scalia asked a series of question trying to show that reserving price movement for consideration later because it is a “class-wide common issue” makes little sense when the efficient market issue itself is a common issue: “Instead of proving the efficient market,” what if plaintiff “can prove that there was a statement correcting the alleged misrepresentation, the price of stock went down . . . and they can certify the class.” Tr. at 22.  Ms. Saharsky responded that such an approach does not square with Basic, which provided that “in order to establish the presumption that you need to show the efficiency of the market.” Tr. at 22. Scalia pressed further, “They’re not relying on that assumption. . . . [T]hey come in and show that there was a correction of what we alleged was a misstatement and the market went down. . . . And of course, that proves anything only if there’s an efficient market. But that will be a common question to the whole class, so we’ll . . . save that for later.” Tr. at 22. Ms. Saharsky simply responded “Certainly in the courts of appeals now, that’s not the way the plaintiffs proceed. The way they proceed is on the Basic theory.” Tr. at 23. Justice Scalia rejoined, “I understand that. I’m just saying that seems to me it’s a crazy way to run a railroad.” Tr. at 23. Ms. Saharsky concluded by indicating that the courts have applied Basic for 20 years, Congress “has not seen fit to change it,” and respondents have never suggested that it should be revisited. Tr. at 24. The “problem in this case,” according to Ms. Saharsky, is that the Fifth Circuit “was not satisfied with the rules as they exist, and it took the class certification stage and turned it into a merits inquiry stage.” Tr. at 24. 

 

            Defendants’ Argument

Mr. Sterling then faced the Court. Almost immediately, he conceded that defendants “are not defending all of the language in Oscar, clearly, but the basic test in the Fifth Circuit . . . is not loss causation; it’s price impact, because Basic says . . . any showing that severs the link between the misrepresentation and the stock price defeats the presumption.” Tr. at 26 (citing Basic, 485 U.S. at 248). According to Mr. Sterling, “Basic makes clear . . . that a showing that the stock price was not distorted by the misrepresentation defeats the presumption.” Tr. at 26. He also acknowledged that “the Fifth Circuit put the initial burden on plaintiff and that’s contrary to Basic.” Tr. at 29. 

 

In response to Justice Kagan’s questions, Mr. Sterling described the Fifth Circuit’s essential test espoused by defendants: The test is “not loss causation as this Court knows it in Dura; the test is simply price impact,” meaning plaintiffs had to show price impact to invoke the presumption of reliance. Tr. at 27. This showing can be made one of two ways. First, “[t]hey can show price inflation upon a misrepresentation, which, as this Court made clear in Dura, is not synonymous with loss causation.” Second, they can “show a price decline following a corrective disclosure.” Drawing the distinction between this showing and loss causation, Mr. Sterling posited “while [the price impact] showing is similar to loss causation, it’s an easier, less rigorous showing of loss causation, because under the price impact test at the Fifth Circuit, all the plaintiff needs show is that it’s reasonable to infer that some portion of the decline was attributable to the revelation of the truth.” 

 

In an interesting exchange, Justice Breyer interposed a hypothetical in which a Company issues a false statement saying it found oil in a well, numerous people buy the company’s stock and when it turns out there is no oil, those people lose their money. Tr. at 30. Under his hypothetical, Breyer explains that the presumption of reliance says to a typical plaintiff, “[w]e’re going to say what happened to the typical person on the stock market during that period happened to you, and there are a lot of people who bought and sold on the stock market. And that’s why efficient markets is needed to show at the certification stage.” Tr. at 30. Turning to defendants’ position, Justice Breyer opined, “[b]ut what you’re just saying in terms of whether the revelation lowered the price has nothing to do with the question of what happened to the typical person. . . . It has to do with whether anybody was hurt” and “that has nothing to do with the certification stage.” Tr. at 20. 

 

Mr. Sterling replied that Basic created “an exception to the long understood rule that fraud cases were not appropriate vehicles for class actions because each individual would have to say . . . I read Halliburton’s statement and I relied upon it.” Because such proof would be impractical in most cases, the presumption assumes the entire stock market is like the typical plaintiff and relies on the integrity of the stock price when the stock price is distorted by the misrepresentation.  But if the stock price was not in fact distorted by the misrepresentation, it makes no sense to say everybody relied on the misrepresentation through its effect on the stock price.” Tr. at 31. Mr. Sterling further stressed, “it’s not just enough to allege the operative facts” to invoke the presumption, Basic says plaintiffs “have to plead and prove them” subject to rebuttal proof. Tr. at 32. Ultimately, he explained these operative facts are “just surrogates of whether it is reasonable to believe or to infer that the stock price was in fact distorted by the misrepresentation.”  Tr. at 33. In contrast to “circumstantial proof” of general market efficiency or the other operative facts, proof of no market impact is “direct proof” undermining “the whole premise of the Basic class-wide presumption of reliance.” According to Mr. Sterling, the lack of price movement “is the DNA proof” and “it makes no sense for district courts to be certifying class actions based upon this indirect or circumstantial proof while ignoring the direct proof of the absence of price impact.” Tr. at 35. Appealing to the Court’s conservative Justices, Mr. Sterling opined that “it would do violence to [the Court’s] admonition [in Stoneridge Investment Partners v. Scientific-Atlanta, 552 U.S. 148 (2008),] that the 10b cause of action ought not be further expanded to make [the] rebuttable presumption of reliance irrebuttable at the class certification stage.” Tr. at 35. 

 

In response to Justices Ginsburg’s and Kagan’s questions regarding what would be left to decide on the merits after the class certification inquiry, Mr. Sterling argues that “falsity, scienter, actual proof of loss causation and damages” would all be undetermined at class certification. Tr. at 37. Along the same lines, Justice Kagan expressed concern about permitting defendants to rebut the presumption by putting an expert on the stand, and then the “Basic presumption falls away, and the plaintiffs have to actually prove their case at the very early stage.” Tr. at 40. Mr. Sterling explained, however, that showing price impact is “not a hard burden to show”: plaintiffs needed only to show a statistically significant price movement in response to any one of the 22 alleged misstatements or one of the alleged corrective disclosures. Tr. at 40. 

 

Mr. Sterling also attempted to address the concern regarding an early hearing on merits issues by indicating that Rule 23 provides district courts with discretion to permit discovery into the merits to the extent such discovery is relevant to the class certification issue, noting that plaintiffs asked for no such discovery in the instant case. Tr. at 41-42. This response drew sharp questioning from the Chief Justice and Justice Scalia, who asked why defendants would want to move up discovery if the class certification stage is so significant because of its in terrorem effect. Mr. Sterling responded that the grant of class certification is indeed a “seminal event” with “huge repercussions for the defendant.” Tr. at 43. The Chief Justice further posited that if one of Halliburton’s objections to plaintiffs’ view is that “it would just postpone the defendant’s ability to rebut the presumption” and “result in countless classes being certified with the certain knowledge that they would have to be decertified later,” if it is so certain, why is there an in terrorem effect? Tr. at 43. Mr. Sterling aptly replied that the Chief Justice’s question assumed “that the defendant has the wherewithal to stick it out through it all, but the sheer grant of class certification which aggregates hundreds . . . tens of thousands of these claims together in one big case makes every one of these cases, in effect, a company case, and it puts huge settlement pressure on the defendant.” Tr. at 43. 

 

            Plaintiffs’ Rebuttal Argument

Mr. Boies’ rebuttal attacked Mr. Sterling’s recitation of plaintiffs’ burden of proof under the price movement test as overly simplistic. In this regard, he pointed to the fact that plaintiffs showed a 42% stock price drop in response to a Halliburton asbestos-related statement that plaintiffs’ alleged was a corrective disclosure, which, as defendants’ expert conceded, did not disclose any other unrelated information. Tr. at 46. Nevertheless, the Fifth Circuit held such a showing was not sufficient because the statement did not specifically reference the prior announcement it was alleged to have corrected and therefore that statement was not a corrective disclosure. Tr. at 47. According to Mr. Boies, the Fifth Circuit therefore looked at more than just price movement in rejecting class certification; it looked at merits issues. 

 

Key Takeaways

Predicting how the Supreme Court will rule in a case by reading the tea leaves from oral argument is no easy feat. Yet, a few observations can be gleaned from the argument:

 

1. The Supreme Court appears likely to overturn the aspects of Oscar that require plaintiffs to prove loss causation (as opposed to price impact) at the class certification stage. 

 

2. The fundamental issue to be decided by the court is whether defendants are permitted to rebut plaintiffs’ evidence of an efficient market solely with proof that generally disproves the efficiency of the market. Mr. Boies conceded that the sole basis for plaintiffs’ position that defendants’ proof is limited to such evidence is footnote 29 of Basic, which Justice Alito described as “thin” support since the footnote was dictum and Basic was “issued at a time when conditional class certification was permitted.” Tr. at 6. A number of other Justices also seemed to struggle with why the inquiry should be so limited when the lack of price movement itself may at least be an indicator of an inefficient market and, even more, may in fact be direct evidence that the fraud-on-the-market presumption does not apply. Yet the challenge for the Court, if it does not stand on Basic’s footnote 29, will be in drawing the line between what proof should and should not be considered at class certification. For example, as raised in Mr. Boies’s rebuttal, will plaintiffs have to prove that certain statements were in fact corrective disclosures or will it suffice to allege that a statement was a corrective disclosure?  

 

3. Finally, the Justices will have to determine whether on the record before it, they can apply their ruling to the instant case or whether they will remand it. If the court adopts plaintiffs’ more limited class certification inquiry, it appears the Court could reverse the Fifth Circuit and grant class certification given Halliburton’s concession that the market for its stock was efficient. If the Court, however, adopts a middle ground approach, it is likely to remand the case to the Fifth Circuit even if such a result may only be a “Pyrrhic victory,” as Justice Scalia suggests.  

 

No matter how the Court rules, the decision should have a significant impact on the large number securities class actions working their way through the courts. By determining whether class certification will give defendants a real opportunity to test plaintiffs’ claims that the class wide presumption of reliance should apply, the Court’s decision will determine whether class certification can be an important event for settlement and will provide defendants with an opportunity to bring an early appeal. The threat of a negative ruling on the merits at the class certification stage or of an early appeal provides companies, their directors and officers and their insurers with additional leverage and an incentive to “stick it out,” as Mr. Sterling suggested, if a motion to dismiss is denied. 

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The jury verdict entered in favor of the plaintiffs in the BankAtlantic subprime-related securities suit has been set aside by the court in a post-trial ruling. On April 25, 2011, Southern District of Florida Judge Ursula Ungaro, in a 112-page opinion (here), granted the defendants’ motion for judgment as a matter of law and indicated that she will enter judgment in defendants’ favor following remaining procedural issues.

 

BankAtlantic’s shareholders had first sued the company and five of its directors and officers in October 2007. The plaintiffs essentially alleged that the defendants had violated the securities laws through misrepresentations and omissions about the poor or deteriorating credit-quality of BankAtlantic’s land loan portfolio; misrepresentations or omissions of its poor underwriting practices; and misrepresentations and omissions about the adequacy of its loan loss reserves and the accuracy of its financial statements. The claims were divided into two separate alleged damages periods corresponding with declines in the company’s share price on April 26, 2007 and October 26, 2007.

 

Judge Ungaro had initially granted the defendants’ motion to dismiss  but she denied their renewed dismissal motion after the plaintiffs amended their pleadings (refer here), and the case went to trial. On November 18, 2010, the jury returned its verdict, as discussed here.

 

As Judge Ungaro summarized the verdict in her April 25 opinion, “the Jury returned a verdict mainly in Defendants’ favor.” The jury found no liability as to any defendant with respect to the first alleged damages period. However, with respect to five alleged misstatements in the second period, the Jury concluded with respect to four alleged misstatements that the company it s former Chairman and CEO had violated the securities laws. The jury also concluded that the company, the Chairman and the company’s CFO violated the securities laws with respect to a fifth alleged misrepresentation.

 

The jury made a specific finding that one the alleged misrepresentations had caused damages of $2.41. At the time of the verdict there were statements in the press suggesting that this damages measure implied total damages of as much as $42 million.

 

The defendants moved to have the verdict set aside on a number of grounds. However, in granting the defendants’ motion, Judge Ungaro focused on one specific issue, whether the plaintiffs had presented sufficient evidence of loss causation and damages. Specifically, she addressed the question whether or not the plaintiffs had presented sufficient evidence that the plaintiffs alleged damages were caused by the concealment of risks about the bank’s real estate loan portfolio.

 

Judge Ungaro granted the defendants’ motion because she found that the plaintiffs’ damages expert had failed to “disaggregate” the effect on the company’s share price decline of the other negative information that was revealed at the same time the supposedly fraudulent information was revealed.

 

Judge Ungaro found that the Bank announced a “bundle” of negative information including negative information regarding the bank’s “builder land bank” (BLB) loan portfolio and non-BLB loan portfolio. Because the plaintiffs’ damages expert did not provide testimony providing this disaggregation, Judge Ungaro concluded that the plaintiffs’ had failed to produce sufficient evidence at trial of the loss caused by the disclosure of defendants’ misrepresentations and of the damages attributable to the misrepresentations.

 

Although Judge Ungaro’s conclusion may be stated simply, her April 25 opinion is complex and multilayered, largely as a result of problems arising out of the jury verdict form. The jury verdict from was, according to Judge Ungaro, “lengthy and complex – it was 75 pages long and contained over 150 questions.” As Judge Ungaro noted in her April 25 opinion, the form’s complexity was a result of “the intricate demands of the Reform Act as they applied to this case --- a numerous statement, varying-defendant, Rule 10b-5 class action involving two separate damages periods atop which was layered a varying-defendant Section 20(a) class action.”

 

It appears that, perhaps as a result of the form’s length and complexity, the jury had problems with the form. As discussed at length in Judge Ungaro’s April 25 opinion, the jury’s specific findings with respect to one of the alleged misstatements on which liability was based were inconsistent. And with respect to other misstatements on which liability had been based, there were no specific damages findings. As a result, the jury’s verdict makes for somewhat messy post-verdict analysis – hence the length and sprawling scope of Judge Ungaro’s opinion ruling on the post trial motions.

 

I suspect strongly that there will be further proceedings in this case, at a minimum including an appeal to the Eleventh Circuit. The plaintiffs undoubtedly will recall that in the Apollo Group securities lawsuit , in which the court had granted the defendants’ post-trial motion and set aside the jury verdict, the plaintiffs succeeded on appeal in having the post-trial ruling overturned and having the plaintiffs’ verdict reinstated. (The U.S. Supreme Court recently turned down the defendants’ petition for writ of certiorari in the Apollo Group case.)

 

But in any event, as a result of Judge Ungaro’s ruling, the post-Reform Act securities lawsuit trial scoreboard needs to be revised. Based on information compiled by Adam Savett of the Claims Compensation Bureau, there have been a total of only eleven  securities post-Reform Act lawsuits involving post-Reform Act conduct that have gone to trial. With the adjustments to reflect Judge Ungaro’s April 25 ruling, the scoreboard now stands at Plaintiffs 6, Defendants 5. (A tip of the hat to Savett for having already updated his scoreboard when I went and looked at it this morning.)

 

Special thanks to the loyal readers who alerted me to Judge Ungaro’s ruling.

 

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Among the reasons frequently cited for the higher incidence of litigation in the United States compared to the rest of the world is the acceptability of contingent fees for plaintiffs’ counsel and general rules that each party to a lawsuit in the U.S. bears its own costs. Many other countries have a “loser pays” model and also have restrictions or prohibitions on contingency fees, both of which may have the effect of discouraging  the filing of claims.

 

One development that has been emerging in some jurisdictions recently and that may overcome these claims obstacles is the rise of litigation funding arrangements. A March 21, 2011 opinion (here) by Ontario Superior Court Justice George R. Strathy examined the litigation funding agreement that the plaintiffs had entered in connection with their putative securities class action claims against Manulife Financial Corporation.  Justice Strathy’s tentative approval of the arrangement, subject to two specific concerns, may provide encouragement for other prospective plaintiffs and litigation funders, which in turn potentially could lead to increased litigation in Ontario and perhaps elsewhere in Canada.

 

Plaintiffs had filed a putative class action in Ontario Superior Court against Manulife and certain of its directors and officers seeking damages under the Ontario securities laws for alleged misrepresentations in the company’s public disclosures. The plaintiffs claim that Manulife represented that it “had in place enterprise-wide risk management systems, policies and practices that were effective, rigorous, disciplined, and prudent”. They claim that, contrary to these representations, Manulife failed to have appropriate risk-management systems for its segregated funds and variable annuities. When the equities markets collapsed in the fourth quarter of 2008, Manulife increased its reserves by almost $5 billion to cover its contingent liabilities under these financial products, triggering a sharp decline in the price of its securities.

 

Justice Strathy’s March 21 ruling relates to the plaintiffs’ motion for court approval of a litigation funding agreement the plaintiffs had entered with Claims Funding International, an Irish Corporation, pursuant to which CFI will pay any adverse costs award made against the plaintiffs in return for a commission of 7% on any settlement or judgment. The arrangement also provides for a cap on the commission of $5 million if the case if resolved at pre-trial stage and $10 million if resolved thereafter. The agreement specifies that counsel’s duties are to the plaintiffs not to CFI. The agreement is subject to court approval, but if approved it is binding on the parties and the class.

 

Justice Strathy first considered whether or not had jurisdiction to consider the agreement event though no class had yet been certified in the case. In considering this question, Justice Strathy noted that the plaintiffs had notified 25 institutional investors of the arrangement as well as 68 other potential class members of the arrangement, and that none of these prospective class members were opposed to the funding agreement. Justice Strathy concluded that “a part of the court’s responsibility in class actions is to protect the rights of prospective class members” and “to postpone the decision to post-certification, when the views of class members can be sought, could very well spell the end of this proceeding, because the plaintiffs cannot withstand an adverse costs award on certification.” Justice Strathy determined that he was entitled to “ask whether the agreement is fair and reasonable.”

 

The defendants opposed the plaintiffs’ motion for approval on the ground that it violated the Ontario statute barring “champertous” agreements. (The Ontario statute is a model of brevity, specifying that “All champertous agreements are forbidden and invalid.”) The prohibitions on Champerty are “designed to protect the administration of justice from abuse by the exploitation of vulnerable litigants.” Justice Strathy cited authority that a funding agreement will be champertous “if it is spurred by some improper motive,” such as “exacting an unfair price” which would result in “unfairness to the litigant.”

 

Justice Strathy then surveyed the case authority on litigation funding agreements. He found that courts in Alberta and Nova Scotia had approved litigation funding agreements, albeit without explanation. He also cited cases from England and Australia where agreements had also been approved.

 

Justice Strathy then considered some “practical concerns” with the “loser pays” model in the class action context, as a result of which the costs of losing could be “astronomical” and “well beyond the reach of all but the powerful and very wealthy” who are “not exactly the group the legislature had in mind” when the relevant statutes were enacted. He noted that: 

 

The grim reality is that no person in their right mind would accept the role of representative plaintiff if he or she were at risk of losing everything they own. No one, no matter how altruistic, would risk such a loss over a modest claim. Indeed, no rational person would risk an adverse costs award of several million dollars to recover several thousand dollars or even several tens of thousands of dollars.

 

Justice Strathy noted that while counsel may provide certain indemnities, those types of agreements “impose onerous financial burdens on counsel and risk compromising the independence of counsel.” He also noted that disbursements available from the Class Proceedings Fund established under statute by the Law Foundation of Ontario may or may not be available and may or may not be adequate.

 

In light of these considerations, Justice Strathy approved the agreement, ruling that it promotes the statutory goals by “providing access to justice.” This goal would be “illusory” if “access to justice were deterred by the prospect of a crushing costs award.” The presence of these kinds of agreements may actually be “beneficial to the proper administration of justice” because they “can avoid the unfortunate result that individuals with potentially meritorious claims cannot bring them because they are unable to withstand the risk of loss.”

 

Justice Strathy found that this specific agreement was appropriate because it left control of litigation in the hands of the representative plaintiff and because the commissions and caps are “reasonable” and “represent a fair reflection of the potential downside risk.”

 

He did note that he would not finally approve the agreement unless and until the defendants are “provided adequate security” that any costs award can and will be funded, and unless and until appropriate arrangements are made for “reasonable controls on the provision of information to the funder. “ Justice Strathy’s said that his approval of the finding agreement is subject to “satisfactory amendments to address” these concerns.

 

Discussion

As reflected in Justice Strathy’s opinion, there have been prior occasions on which Canadian courts have approved litigation funding agreements. However, his opinion may represent the most detailed explanation of the basis on which such agreements may be approved. His reference to the advantages these types of arrangements may have in the class action context could prove persuasive to other judges, and his analysis could encourage other prospective plaintiffs and litigation funders to enter similar agreements.

 

To be sure, any parties contemplating entering into litigation funding arrangements will have to heed the concerns noted in Justice Strathy’s opinion. He was clear that he was approving this agreement only because the commissions were reasonable and because the controls were appropriately kept with the named plaintiffs and are not with the litigation funder. Moreover, his final approval ultimately will depend on the plaintiffs adopting appropriate amendments to address the court’s security and information concerns.

 

But while any future litigation funding agreements will undoubtedly be subject to similar scrutiny, the fact is that the door seems to be opened to the use of this type of litigation funding mechanism in Ontario at least if not elsewhere in Canada, at least when appropriately structured. The ability to address the impediments of the “loser pays” model could encourage other litigants to come forward, or at least remove disincentives that might otherwise discourage prospective future litigants from coming forward.

 

The prospect that the availability of litigation funding might lead to increased litigation is not just conjecture. As NERA Economic Consulting noted in its 2010 study of Australian securities class action litigation (about which refer here) , among the most significant explanations for the reported increase in the number of securities class action lawsuits in Australia is the “emergence of commercial litigation funding” which removed financial barriers to pursuing litigation.

 

Of course, it remains to be seen whether or not other Canadian courts will follow Justice Strathy and approve similar litigation funding arrangements, and whether the availability of this type of arrangements leads to increased litigation levels. There are of course many possibilities, including the possibility that litigation funding does not catch on or become an important factor. On the other hand, it is possible that Canada might see the emergence a litigation funding industry that has developed in Australia, where there are even publicly traded litigation financing companies.

 

The development of these types of arrangements to overcome the limitations of the “loser pays” model is particularly interesting now, when as a result of the U.S. Supreme Court’s ruling in the Morrison v. National Australia Bank case, investors in non-U.S. companies may find themselves unable to resort to U.S. court to pursue damages claims. These investors may increasingly be turning to their home courts for relief. In the past, limitations such as the “loser pays” model have served as a litigation deterrent in many countries. But if these limitations can be overcome, for example through the use of a litigation funding mechanism, investors may be increasingly motivated to pursue claims in their own home jurisdictions. Just as in Australia, the availability of litigation funding could lead to increased securities litigation activity.

 

It probably should be noted in closing that litigation is not only catching on outside the U.S, but it also gaining traction in side the U.S. as well, at least according to June 4, 2010 New York Law Journal article (here). An October 2009 U.S. Chamber Institute of Legal Reform publication entitled “Selling Lawsuits, Buying Trouble” (here) proposes that third-party litigation finding in the United States be prohibited. The Institute for Legal Reform publication provides a comprehensive overview of recent developments in litigation funding.

 

Special thanks to loyal reader Greg Shields, who is a contributor at the Mitchell Sandham blog (here), for sending me a link to Justice Strathy’s ruling.

 

A Story You Might Have Missed: According to sources (here), The Economist magazine is temporarily suspending publication to allow its readers a chance to catch up. (They must have seen my coffee table.) The same source reports that ESPN The Magazine is suspending publication indefinitely to allow its readers a chance to learn how to read.

 

Apologies: My apologies to readers who may have tried to access this blog between 3:30 6:00 pm EDT yesterday. My hosting service was having server issues that interrupted accessibility. I am assured the problems will not recur. Technology is great when it works. But otherwise, not so much.

 

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Corporate and securities litigation filing activity reached a “crescendo” in the first quarter of 2011, according to the most recent quarterly report from Advisen, the insurance information firm. The filing rate in the year’s first three months if annualized would represent a record –settling annual level of corporate and securities litigation activity. A copy of the Advisen report can be found here. My own survey of the first quarter 2011 securities class action lawsuits filings can be found here.

 

Preliminary Notes

In considering the Advisen report, it is critically important to recognize that the report uses its own unique vocabulary to describe certain of the litigation categories.

 

The “securities” litigation analyzed in the Advisen report includes not only securities class action litigation, but a broad collection of other types of suits as well, including regulatory and enforcement actions, individual actions, derivative actions, collective actions filed outside the U.S. and allegations of breach of fiduciary duty. All of these various kinds of lawsuits, whether or not involving alleged violations of the securities laws, are referred to in the aggregate in the Advisen report as "securities suits."

 

One subset of the overall collection of "securities suits" is a category denominated as "securities fraud" lawsuits, which includes a combination of both regulatory and enforcement actions, on the one hand, and private securities lawsuits brought as individual actions, on the other hand. However, the category of "securities fraud" lawsuits does NOT include private securities class action lawsuits, which are in their own separate category ("SCAS").

 

Due to these unfamiliar usages and the confusing similarity of category names, considerable care is required in reading the report.

 

The Report’s Findings

According to the report there were a total of 363 corporate and securities lawsuits filed in the first quarter of 2011, which is up from the 342 filed in the fourth quarter of 2010 but below the quarterly record level of 386 set in the third quarter 2010. If the first quarter filing levels were to continue for the rest of the year, that would imply a 2011 year-end total of 1,448 corporate and securities lawsuits, which, according to Advisen would represent a “record-setting year.” Just to put this level of filing activity into perspective, prior to the credit crisis “new filings averaged less than two-thirds of this annualized level.”

 

According to Advisen’s tally, there were 61 securities class action lawsuits in the first quarter of 2011. However, securities class action lawsuits as a percentage of all corporate and securities lawsuit filings continue to decline. As recently as 2006, corporate and securities lawsuits represented as much as one third of all corporate and securities litigation, but in the first quarter of 2011, the securities class action suits represented only 17 percent of all corporate and securities lawsuit filings.

 

With respect to the securities class action lawsuit filings, 85 percent of the suits were filed against companies in just five sectors: financial, information technology, consumer discretionary, energy and industrial. With respect to all corporate and securities litigation generally, financial firms continue to be the most frequently sued albeit at a lower level in recent years. Financial firms were named as defendant in 34 percent of all corporate and securities lawsuits in the first quarter, compared to 45 percent in 2008 and 40 percent in 2009.

 

Breach of fiduciary duty suits, many of which are filed in state court and many of which are filed shortly after the announcement of a proposed merger or acquisition, represent a growing area of corporate and securities litigation. These breach of fiduciary duty suits represent about a third of all corporate and securities lawsuit filings in the first quarter of 2011, up from only eight percent of all corporate and securities filings as recently as 2004. Over 60 percent of the first quarter breach of fiduciary duty suits were filed in the state court.

 

Corporate and securities litigation activity outside the U.S. has also been on the increase. During the first quarter of 2011, Advisen recorded 17 of the corporate and securities lawsuits filed outside of the United States.

 

By the same token, 16 percent of all corporate and securities lawsuits filed during the first quarter involved non-US companies, compared to only 11 percent in 2009 and 2010. These figures were largely driven by cases involving Chinese companies whose shares trade on the U.S. exchanges. Cases against Chinese companies in U.S. courts “mushroomed” in 2010, and continued in the first quarter, when there were 11 new securities lawsuits in the U.S. against Chinese companies. (This trend of filings against Chinese companies has continued into the second quarter as well, as I noted in my recent posts, here and here.)

 

Finally, with respect to settlements, the Advisen report notes that the average securities class action lawsuit settlement announced during the first quarter of 2011 was $54.6.

 

Quarterly Advisen Conference Call: On Thursday, April 21, 2011, I will be participating in an Advisen conference call to discuss the first quarter 2011 filing statistics and trends. The free one-hour conference call will take place at 11 am EDT. The conference call panel will include a number of distinguished speakers, including Dan Bailey from the Bailey Cavalieri law firm, Carol Zacharias from ACE, Carolyn Polikoff from the Woodruff Sawyer firm and David Bradford from Advisen. Information about the session including registration information can be found here.

 

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For several years, Friday has been the day when the latest bank closures are announced (about which see further below). More recently, Friday also seems to be the day when the latest securities class actions involving Chinese companies are announced. This past Friday alone, three more securities suits involving Chinese companies were announced. Signs are that there are more to come. A brief description of the three latest cases follows.

 

Puda Coal: The first of the three latest Chinese suits involves Puda Coal, Inc., an NYSE company that is a Delaware corporation but which has its headquarters in Shanxi Province in China. There have actually been two separate lawsuits filed against Puda, one in the Southern District of New York (refer to the complaint here), and one in the Central District of California (here).

 

As reflected in plaintiffs’ counsel’s press release (here), the allegation is that Puda’s assets were transferred to a subsidiary of which Puda’s Chairman of the Board obtained control through a series of transactions, enabling the Chairman to profit personally from the sale of a minority interest in the subsidiary to a private equity firm. Following an internet website’s disclosures of the transactions, the company’s share price declined. In an April 11, 2011 press release (here), the company announced that its board had adopted the recommendation of the company’s audit committee to investigate the Chairman’s “unauthorized” transactions involving the subsidiary.

 

Subaye, Inc.: According to their April 15, 2011 press release (here), plaintiffs’ lawyers have initiated a securities class action lawsuit in the Southern District of New York against Subaye, Inc. and certain of its directors and officers. Subaye is a Delaware Corporation with its headquarters in Guangdong, China.

 

According to the press release, the complaint (which can be found here) was filed in the wake of the company’s April 7, 2011 announcement that its auditor PricewaterhouseCoopers Hong Kong had withdrawn and that prior to its resignation the audit firm had identified matters that might affect the fairness of the company’s previously issued financial statements. The press release states that

 

PwC’s was unable to obtain information and supporting documentation to verify: (a) cash settlements from sales agents to Subaye, (b) the end customer subscriptions for the Company’s services and the services rendered to the end customers, (c) marketing and promotion activities performed by sales agents in return for fees paid to such agents and recorded as expenses of the Company. PwC also stated that Subaye provided insufficient explanations regarding commonalities between certain customers and vendors. Lastly, PwC could find no evidence of any business tax payments by the Company for services rendered in China.

 

Universal Travel Group: According to their April 15, 2011 press release (here), plaintiffs’ lawyers have filed a securities class action lawsuit in the District of New Jersey against Universal Travel Group and certain of its directors and officers. Universal Travel is a Nevada corporation based in Shenzen, China.

 

The Universal Travel group lawsuit follows a March 2011 securities analyst’s report raising questions about the company’s business, its reported cash balances and revenues, and its relationship with an online travel service. The report stated that there were large differences between the revenues that a newly acquired subsidiary had reported to Chinese authorities and the revenues that Universal Travel reported.

 

 In an April 14, 2011 press release (here), the Company announced that it had hired a new auditor after its prior auditor resigned because “it was no longer able to complete the audit process” due to “the Company’s management and/or the Audit Committee being non-responsive, unwilling or reluctant to proceed in good faith and imposing scope limitations on [the auditor’s] audit procedures.”

 

These three new securities class action lawsuits follow closely on the heels of the four accounting-related  lawsuits involving Chinese companies filed earlier this month, as I noted in a prior blog post (here). With these three  latest lawsuits, there have now been a total of 14 securities class action lawsuits filed against Chinese and China-liked companies in 2011, out of a total of about 61 securities lawsuits that have filed so far this year, meaning that the suits against Chinese companies represent about 23% of all securities lawsuits filed so far this year. Ten of these have been filed just in the last 30 days.

 

The signs are that this recent outburst  of new lawsuit filings involving Chinese companies will likely continue. Plaintiffs’ law firms continue to publish press releases that they are “investigating” still other Chinese companies (refer for example, here and here) For that matter, the cascade of news raising questions about accounting practices involving some Chinese companies shows no signs of abating.

 

As Walter Pavlo notes on his White-Collar Crime blog on Forbes.com (here), many of the Chinese  companies involved in this rash of lawsuits obtained their U.S. listings through reverse mergers with a publicly traded U.S. shell company. In a later post (here), he also noted that many of these firms have the same auditors and used the same investment bank in their reverse merger transaction.

 

In an April 4, 2011 speech (here), SEC Commissioner Luis Aguilar noted that the problems arising involving Chinese companies that have obtained U.S. listing are a serious concern and that the SEC in cooperation with other organizations including the PCAOB is investigating the concerns that have arisen. Among other things, he noted that “a growing number” of these companies “are proving to have significant accounting deficiencies or being vessels of outright fraud.”

 

According to Commission Aguilar, since January 2007 over 150 Chinese companies have obtained U.S. listings using what he characterized as “backdoor registrations.” While not all of these companies are engaged in the kinds of activities described in the case summaries above, there definitely seems to be a pattern of involvement in conflicts of interest or accounting issues. The rash of recent resignations of the outside auditors from these companies suggests that the audit firms have had their consciences   raised about the dangers of becoming associated with these kinds of firms and accounting issues they may be having.

 

In any event, it seems likely that there will be further lawsuits involving these Chinese companies. David Bario’s April 4, 2011 Am Law Litigation Daily article profiling the plaintiffs’ lawyer behind many of these lawsuits can be found here.

 

Bank Failures Not Over Yet: Speaking of bank failures (as I was at the outset of this post), it now appears that my recent prediction that the bank failure wave may finally be over might have been premature. This past Friday night, the FDIC closed six more banks, bringing the year to date total number of bank closures to 34. While that is fewer than the 49 banks that had been closed at this point last year, the closure of six banks at one time does cut against the suggestion that the FDIC is winding down its bank closure activities.

 

With the addition of the latest six bank closures, the total number of banks that have failed since January 1, 2008 stands at 356. Of this total, 51 involve banks located in Georgia (including two of the six banks closed this past Friday night). After a while you do start to wonder if there how there could be any banks left in Georgia.

 

As I have noted elsewhere, the FDIC has still only brought a total of six lawsuits involving former directors and officers of the bank. However, on April 13, 2011, the FDIC did update the Professional Liability Lawsuits page on its website, to indicate the number of persons against who lawsuits have been authorized has been increased by 187 (up from the prior month’s total of 158). However, the six lawsuits filed to date involved only 42 individual defendants, which suggests that there are quite a number of lawsuit in the pipeline and yet to be filed. The updated page also notes that the FDIC has also authorized “11 fidelity bond, attorney malpractice, and appraiser malpractice lawsuits.”

 

Special thanks to the loyal readers who alerted me to the most recent bank closures and to the recent update to the FDIC website.

 

105 Years Ago Today: A rare 35 mm film of San Francisco just four days before the April 18, 1906 earthquake has been “found.” The person that send me a YouTube link to the file reports that “This film was originally thought to be from 1905 until David Kiehn with the Niles Essanay Silent Film Museum figured out exactly when it was shot --from New York trade papers announcing the film showing, to the wet streets from recent heavy rainfall & shadows indicating time of year & actual weather and conditions on historical record, even when the cars were registered (he even knows who owned them and when the plates were issued!).”

 

The film, which was shot by mounting a camera on the front end of a cable car, is simply amazing. The clock tower at the end of Market Street at the Embarcadero wharf is still there. The number of automobiles on the road in 1906 is staggering. The absolute chaotic traffic suggests that rules of the road were a later invention.

 

There is an element of sadness too in the film, as so much of the city was destroyed days later and as many as 3000 people died in the quake and in the fire that followed. The film is a remarkable piece of history. Special thanks to the loyal reader who sent me the link.

 

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A number of trends that had predominated in recent years diminished during 2010 while new trends emerged, according to PwC’s 2010 Securities Litigation Study, which can be found here. 2010 may also mark “the start of a new era” as a consequences of a new regulatory and enforcement environment take effect, which “could lead to a reinvigorated volume of reported securities violations and associated class actions.” PwC’s April 7, 2011 press release about its report can be found here.

 

In many ways the 2010 securities litigation filing activity was characterized by the  reversal of a number of trends. Thus, for example, the declining numbers of credit crisis related cases meant that fewer cases were filed against financially related companies than in the immediately preceding three years (although financial companies remained the most frequent litigation target in 2010). In addition, accounting-related cases continued to decline in 2010, as did the number of new cases against Fortune 500 companies.

 

On the other hand, the reversal of these trends was “offset” by other trends that emerged during the year, leading to an overall jump in the number of cases. The focus of activity shifted from an “overwhelming focus on the financial services industry” to a “medley of issues across a variety of industries.”  Increasing numbers of cases against companies in the health industry, a surge in M&A related cases, a jump in cases against Chinese companies and a rash of cases against for-profit education companies all contributed to the increased litigation activity.

 

Overall, the total number of federal securities class action filings rose 12 percent during 2010 compared to 2009, from 155 to 174. (PwC’s count may vary from other published reports as a result of its counting methodology, pursuant to which “multiple filings against the same defendant with similar allegations are counted as one case.”). There were more filings in the third and fourth quarters of 2010 than in either of the first two quarters. Among other things, the increase in filings in the year’s second half reflected the “increasing domination o f non-financial crisis-related cases and the decline in financial-crisis related cases.”

 

Among the principle drivers of the increased number of filing in the second half of 2010 was the increase in the number of M&A related cases. Overall, M&A cases represented 24 percent of all securities filings in 2010, compared to only 4 percent in 2009.

 

Health industry cases increased from 17 percent in 2009 to 21 percent in 2010, representing the second highest percentage of for any industry in 2010. The filings included cases against pharmaceutical, medical device and health services companies. (My recent post discussing 2010 securities filings against life sciences companies can be found here.)

 

The percentage of cases raising accounting-related allegations (including overstatement of revenues, understatement of expenses and liabilities and overstatement of assets) fell from 37 percent in 2009 to 35 percent in 2010, which represents the lowest level of accounting-related cases in 15 years. The report speculates that one possible reason for this decline in accounting-related cases could be “the effectiveness of SOX in combating accounting fraud.” On the other hand, the decline in the number of cases involving accounting allegations could also just be a reflection of the changing mix of cases; the options backdating cases that predominated a few years ago were replete with accounting-related issues, but the increasing numbers of M&A cases in 2010 rarely involved accounting allegations.

 

Surprisingly, in light of the U.S. Supreme Court’s June 2010 decision in Morrison v. National Australia Bank, the number of filings involving foreign issuers increased during 2010 by 35 percent, and of the 27 cases filed in 2010 involving foreign issuers, 16 (or 59 percent) were filed after the Morrison decision was announced. The percentage of cases involving foreign issuers as a percentage of all filings increased during 2010 from 13 percent in 2009 to 16 percent in 2010.

 

Of these 27 cases involving foreign issuers, 12 cases (44 percent) involved Chinese companies. Eleven of the 12 cases against Chinese companies involved accounting allegations.

 

The average settlement of securities related cases during 2010 decreased by 11 percent compared to 2009, from $34 million to $30.1 million.(PwC ‘s figures may differ from other published reports as PwC assigns the settlement to the year of the “primary settlement announcement,” and any subsequent announcements are attributed to the primary announcement year.” PwC also excludes zero dollar settlements.)

 

 However, the average settlement value of cases settled for more than $1 million and less than $50 million increased by 21 percent, from $10.7 million in 2009 to $12.9 million. In addition, median settlements increased by nearly 35 percent, from $7.5 million to $10.1 million.

 

The PwC report concludes with a survey of the changing liability  environment arising from  the new regulatory mandates introduced by the Dodd-Frank Act. Because enforcement activities “are likely to increase” and the new Dodd-Frank whistleblower provisions “could produce a surge in allegations of securities violations,” the financial regulatory environment is “vastly different in 2011 from what it was just one year ago, and companies will have to devote significant resources to understanding and adapting to its new topography.”  The decade ahead has “the potential to yield yet more transformations.”

 

My analysis of the 2010 securities class action litigation filing can be found here. My more recent study of first quarter 2011 filings (here) shows that many of the trends that emerged in 2010 continued in the first quarter, including in particular the heightened level of M&A related litigation. In addition, as I recently noted (here), the wave of accounting-related litigation involving Chinese and China-linked companies has also continued in 2011.

 

WaMu Subprime-Related Securities Lawsuit Settlement in the Works: In case you missed the news last week, the WaMu subprime-related securities lawsuit apparently has settled. According to the Court’s  April 6, 2011 minute order (here), the parties have advised the court that the lead case has settled, and the Court has suspended all of the schedules dates and motions. The settlement papers have not yet been filed so the details of the settlement are not yet known, but an April 6, 2011 Seattle Times article by Sanjay Bhatt (here) reports that the amount of the settlement “is in excess of $200 million.”

 

The WaMu case, of course, relates to the facts and circumstances surrounding the largest bank failure in U.S. history. The case itself did not necessarily unfold smoothly from the plaintiffs’ perspective. In a May 2009 opinion that was sharply critical of the plaintiffs’ pleadings (about which refer here) , Western District of Washington Judge Marsha Pechman has initially granted the defendants’ motion to dismiss. However, the plaintiffs’ amended pleadings survived the renewed motion, and now the parties apparently have settled the case.

 

The details of the settlement, once they are finally released, will be interesting in and of themselves, but they may be even more interesting in light of the recent action that the FDIC filed against three former WaMu executives and the wives of two of the officials (about which refer here). The possibility that the WaMu securities suit settlement could involve the payment of  hundreds of millions of dollars raises the possibility that the settlement would consume the remaining limits of WaMu’s D&O insurance policy, possibly leaving the defendants in the FDIC without insurance remaining for them to defend themselves against and to try and settle the FDIC claims.

 

So The D&O Diary is interested in a number of details about the settlement, beyond just the settlement’s dollar value. We are interested to see how much of the settlement will be funded by D&O insurance, and whether any of the settlement is to be funded out of the individual defendants’ assets. We are also interested to see if the settlement documents show whether the settlement exhausts the remaining D&O insurance limits. Along the same lines, it will be interesting to see (if possible) what kind of a release the insurers are getting in exchange for the insurance payment, if any, and whether it is a policy release or just a claim release.

 

In any event, the WaMu settlement is just the first of what I think will be a wave of subprime-related securities lawsuit settlements during the course of 2011. The WaMu settlement also vividly illustrates the competition for insurance policy proceeds that the FDIC will face as it seeks to pursue lawsuits against directors and officers of failed banks, particularly as in many cases the shareholders have been actively pursuing their claims while the FDIC has proceeded much more deliberately.

 

Speakers’ Corner: On Thursday April 14, 2011, I will be a panelist at the Professional Liability Underwriting Society Southwest Chapter’s Educational Event in Englewood, Colorado. The title of the even t is “Winds of Change in Executive and Professional Liability,” and I will be speaking on panels on the topics of Governmental Investigations and D&O Liability Developments. Information about the event can be found here.

 

If you are a part of the Southwest Chapter, I hope you are planning on attending. And if you are attending I hope you will take a moment to say hello, particularly if we have never met before.

 

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In my year-end securities litigation survey, I noted that while a number of new trends emerged during 2010, one securities lawsuit filing trend had remained constant during the year – that is, life sciences companies remained a favored securities class action lawsuit target. The heightened exposure that life sciences companies face is fully detailed in a March 2011 memo from David Kotler and Kathleen O”Connor  of the Dechert law firm entitled “Survey of Securities Fraud Class Actions Brought Against Life Sciences Companies.” A copy of the memo can be found here.

 

According to the memo, 29 different life sciences companies and their directors and officers were the subject of class action securities lawsuit filings in 2010, representing about 16.5% of all2010 securities lawsuit filings. Both the absolute filing numbers and the relative percentages of all filings are up from recent years. The 29 life sciences securities suits were up substantially from the 19 filed in 2009 (representing 10% of all securities suits that year) and from the 23% filed in 2008 (representing 10% of all securities suits).

 

It is worth noting that the count of 29 suits involving life sciences companies  does not include lawsuits involving allegations relating to mergers and acquisitions. If the merger objections suits were included, at least seven more suits would be added to the count.

 

The 2010 life sciences securities suits as a group do reflect certain distinctive characteristics. First, the 2010 lawsuits were more heavily weighted towards life sciences companies with larger market capitalizations. 28% of the 2010 lawsuits were brought against life sciences companies with market capitalizations over $10 billion, by contrast to only 5% in 2009.

 

The 2010 life sciences securities suits  also involved a significant number of lawsuits based not on such industry specific issues as FDA approvals or safety recalls. Consistent with the patterns of securities suit filings against life sciences companies in recent years, more than half of the filings involved allegations of financial improprieties, such as misstated or misleading financial reports or accounting mistakes or mismanagement.

 

To be sure, many of the 2010 did involve more industry specific allegations such as prospects or timing of FDA approval (9 of the 29 2010 lawsuits); allegations involving product efficacy (8); product safety (7); marketing practices (4); and manufacturing processes (2). Another five involved insider trading allegations.

 

The memo’s authors have been tracking the life sciences cases since 2007, and while the filings from those earlier years have not yet fully developed, there is some growing evidence to suggest that though life sciences companies may be sued more frequently than other cases, the cases may be dismissed more frequently than are cases in the larger universe of securities class action lawsuits.

 

The authors note that the SEC and the DoJ have made a priority of Foreign Corrupt Practices Act (FCPA) enforcement regarding life sciences companies and in at least one case (involving SciClone Pharmaceuticals), the FCPA enforcement has resulted in a follow-on securities class action lawsuit.

 

The authors also include a discussion of the U.S. Supreme Court’s recent decision in the Matrixx Initiatives case (about which refer here). They note that “by rejecting statistical significance as setting a minimal threshold for disclosure, Matrixx will require life sciences companies to assess … disclosures and investor impact more holistically, and on a case by case basis.” The authors also note that “life sciences companies are now faced with heavily fact-specific questions of where to draw the disclosure line in the absence of a bright-line standard.”

 

The authors conclude with a number of practical suggestions for life sciences companies to take to minimize the risk of, and impact from, securities fraud class actions.

 

Share the Road: The April 2, 2011 Wall Street Journal carried a rant entitled “Dear Urban Cyclists: Go Play in the Traffic” (here), written by alleged humorist P.J. O’Rourke. O’Rourke apparently is incensed by what he perceives as the increasing preference of traffic planners for urban bicycle lanes. His essay contains a lot of statements like “ bike lanes violate fundamental principles of democracy.” Some might say that Mr. O’Rourke’s comments want proportionality.

 

My own perspective on urban cycling took a completely unexpected turn during a recent visit to London. Owing to historically unprecedented weather conditions – it was sunny and pleasant six straight days in a row while I was there – I had occasion to try out the new Barclays Bicycle Hire arrangement. The way this arrangement works is that you pay a fee for bicycle access (one pound for a single day, five pounds for a week), and then you pay a one pound an hour usage fee. (There are other arrangements for longer term users.) The best part of the arrangement is that once you have paid the access fee, you can pick up or drop off a bike at any of the numerous bike racks around the city.

 

What this means is that you can rent a bike and tool around the city without having to cycle all the way back to the place where you first rented it. You can also drop the bike off at a rack if you just want to stop and get a snack or go in a store. The first day I tried the system, I picked up a bike in Green Park and cycled all the way around Hyde Park; dropped the bike off and took the tube to Trafalgar Square  and then biked down Whitehall, past Parliament, across Lambeth Bridge to Lambeth Park; then I dropped the bike off in Vauxhall and took the tube to Regent’s Park, picked up another bike at the tennis courts there and cycled around the Park.

 

The second time I tried it, I ran a relay of bicycles all across the west end into Kensington, Notting Hill and Bayswater, stopping and starting for meals and shopping, all the while traveling through and exploring parts of the city I have never seen before.

 

According to Wikipedia (here) , there are over 5,000 bicycles and 317 docking stations available in central London. The docking stations were first installed in London in July 2010, but the heavy, three-speed bicycles themselves are already ubiquitous (particularly on kind of bright, sunshiny days I enjoyed there last week).

 

There are downsides. Among other things, the rental does not include a helmet. In addition, the left hand lane rule of the road that prevails in London led to intermittent tense moments for me, particularly with respect to other cyclists whose behavior was not always predictable. Also, it takes a certain kind of courage to try to ride a bike through, say, Piccadilly Circus.

 

All of those concerns notwithstanding, I have to say that I found this bicycle hire scheme absolutely marvelous. One of the docking stations is located just outside the hotel I favor when I visit London, and now that I am comfortable with the scheme, I intend to take advantage of the arrangement on future visits. It is a convenient and enjoyable way to get around the city.

 

As for Mr. O’Rourke and his dyspeptic vision of urban bicycling, I can only surmise that he had not given the new London bicycle hire arrangement a chance. I think a cruise around Hyde Park on a sunny afternoon would do him a world of good, and might entirely alter his views about urban bicycling and democracy.

 

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With four more securities suits involving Chinese or China-linked companies this past Friday, the phenomenon of securities class action lawsuits against these firms has emerged as one of the most distinct securities litigation trends so far this year. The filing trend actually first emerged in the second half of 2010, but it has continued into 2011 and appears to have gained significant momentum in recent weeks following recent revelations of accounting irregularities involving Chinese companies.

 

The four latest suits involving Chinese-linked companies are as follows:

 

1. China Electric Motor, Inc.: According to their April 1, 2011 press release (here), plaintiffs’ lawyers have initiated a securities class action lawsuit in the Central District of California against China Electric Motor, a Delaware corporation with its principle place of business in China, as well as the certain of its directors and officers and the underwriters who underwrote the company’s January 29, 2010 IPO.

 

According to the Complaint (here), the lawsuit follows the company’s March 31, 2011 announcement that it is forming a special committee to investigate accounting discrepancies “concerning the Company’s banking statements” identified by the company’s auditors. The company has delayed release of its fourth quarter and year end financial statements and trading in the company’s securities has been halted.

 

2. Advanced Battery Technologies, Inc.: In their April 1, 2011 press release (here), the plaintiffs’ lawyers state that they have filed a securities class action lawsuit in the Southern District of New York against Advanced Battery and certain of its directors and officers. According to the complaint (here), the company is a Delaware corporation with offices in New York that, through subsidiaries, owns two Chinese operating companies.

 

The complaint alleges that the company made misleading statements about its ownership interests in certain Chinese operating companies and that it failed to disclose or fully disclose certain related party transactions involving the company’s CEO. The complaint also alleges, relying heavily on a securities analyst’s report , that the company made false statements about its supposed investment in a company that may not even exist.

 

3. China Intelligent Lighting and Electronics, Inc.: According to the their April 1, 2011 press release (here), plaintiffs’ attorneys have filed a complaint in the Central District of California against the company, certain of its directors and officer and the investment banks that underwrote the company’s June 18, 2010. (One of the investment banks, Westpark Capital, was also involved in the China Electric IPO described above.) The company is a Delaware Corporation with its principle place of business in China. A copy of the complaint can be found here.

 

The lawsuit follows the company’s March 29, 2011 press release in which it announced the termination of its auditor, MaloneBailey LLP; its auditor’s resignation and withdrawal of the audit opinion it issued in connection with the prior year end financial statement; and the formation of a special investigation committee. The press release also discloses that the SEC has launched a formal investigation of t he company.

 

In the press release, the company also discloses that MaloneBailey resigned “due to accounting fraud involving forging of the Company’s accounting records and forging bank records.” The auditors also allegedly stated that the “accounting records at the company have been falsified.” 

 

4. China Century Dragon Media: According to their April 1, 2011 press release (here), plaintiffs lawyers have filed a securities class action lawsuit against the company, certain of its directors and officers and against its offering underwriters. Among the offering underwriters named as defendant in the case is the Wespark Capital firm, which was involved in the China Electric Motor and China Advanced Lighting offerings described above. A copy of the complaint, which was filed in the Central District of California, can be found here.

 

The China Century Dragon Media lawsuit follows the company’s March 28, 2011 announcement of the resignation of its auditor, MaloneBailey LLP (the same firm as withdrew from auditing China Intelligent Lighting, as noted above), and the firm’s withdrawal of its prior audit opinions. The press release discloses that the auditor has resigned as a result of “irregularities” that may indicate that the company’s “accounting records have been falsified.” The discrepancies could also indicate material errors in the company’s prior financial statements. The company also disclosed that its shares have been delisted and the SEC has commenced a formal investigation.

 

These four new lawsuits join the seven suits that had previously been filed so far in 2011 against Chinese and China-linked companies. Of these eleven total lawsuits, six have been filed just since March 18, 2011. The eleven suits against Chinese-related firms already exceed the ten lawsuits that were filed against Chinese companies in 2010. Signs are that there may be further suits to follow shortly, as the law firm that filed all four of the above described lawsuits issued an April 1, 2011 press release (here) that it is investigating possible securities law violations involving Keyuan Petrochemicals (a Nevada corporation with its principal place of business in China), following the company’s April 1, 2011 announcement that it was delaying filing its year end financial statements and initiating an audit committee investigation of certain “concerns.” 

 

The rash of lawsuits has arisen at the same time that the Public Company Accounting Oversight Board raised concerns in a March 14, 2011 report (here) about accounting and auditing standards at Chinese companies that have conducted IPOs in the U.S. or that have become U.S. publicly traded companies through reverse mergers. The report identifies a number of factors that may undermine the ability of audit firms to complete their audit functions completely or effectively. In light of the concerns in the PCAOB report, it hardly comes as a surprise that accounting concerns are coming to light in connection with some of these Chinese firms.

 

The allegations raised in these cases, like the allegations in the four cases described in detail above, fall into two basic categories: Inadequate disclosures involved related-party transactions (see especially Tongxin [here], China Valves Technology [here], and China Integrated Energy [here]), and accounting irregularities or accounting improprieties (see especially China Media Express [here], China AgriTech [here], ShegndaTech [here] and NIVS Intellimedia Technology Group [here].

 

Another familiar theme running through at least a few of these cases is that the lawsuits followed the resignation of the MaloneBailey firm as the defendant company’s auditors. The audit firm’s resignation preceded the lawsuits filed against NVIS Intellimedia Technology Group, China Intelligent Lighting and Electronics, and China Century Dragon Media.  MaloneBailey is identified in Table 8 of the PCAOB report as the U.S.-based firm with the most Chinese reverse merger company clients. In addition, a number of the companies named as defendants in these suits conducted offerings with the investment bank Westpark Capital, Inc as one of their offering underwriters.

 

These firms’ involvement may well be purely coincidental. The larger pattern is that there seems to be a growing number of Chinese and China-linked companies that are announcing concerns related to the accounting and reported financial statements. Whether these issues will continue to emerge will remain to be seen. But for now, a securities litigation filing trend that first developed in the second half of 2008 seems to be going strong as we head into the second quarter of 2011. 

 

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Largely as a result of a flood of M&A related lawsuits, there were a significant number of new securities class action lawsuits filed in the first quarter of 2011, and even factoring out the M&A lawsuits, the first three months of the year still represented an active period for securities lawsuit filings.

 

Taking the merger objection suits into account, there were a total of 55 new securities class action lawsuits filed in the first quarter. That would imply an annualized rate of 220 securities suits for the year, which would be well above both the 176 filed in 2010 and the 1996-2009 annual average of 195 filings. However, the rash of merger suits filed during the first quarter does complicate the numeric analysis, as the changing mix of cases may make the year to year measures somewhat of an apples- to-oranges comparison.

 

There were 20 federal court merger objection lawsuits in the first quarter. (There were even more state court merger objection lawsuits, as discussed further below.)  Subtracting the federal court merger objection lawsuits from the first quarter securities class action lawsuit filing tally would reduce the number of first quarter filings from 55 to 35, which would be idenitcal to the 35 new securities suits filed in the first quarter of 2010. Obviously, the process of determining what to include in the lawsuit count has a huge impact on the ultimate tally.  I have further observations about “counting” the securities suit filings below.

 

The 55 securities suits in the first quarter represent a surprisingly diverse range of kinds of companies. The companies targeted in the 55 suits represent 42 different Standard Industrial Classification (SIC  Code categories. Only two SIC Code categories had as many as three companies sued – SIC Code Category 2834 (Pharmaceutical Preparations) and SIC Code Category 3674 (Semiconductors and Related Devices.).

 

By interesting contrast to recent years' filing patterns, the first quarter filings included relatively few companies in the 6000 SIC Code group (Finance, Insurance and Real Estate). While the credit crisis litigation wave was unfolding and lawsuits against financial companies flooded in, suits against companies in the 6000 SIC Code group predominated. The relative decline of litigation activity in this category provides even further proof that the credit crisis related litigation wave has largely played out. I count a total of only three cases in the first quarter that might even arguably be categorized as credit crisis related. Among these three were  two new securities suits in the first quarter involving failed or troubled banks, which is a filing phenomenon that seems likely to continue in the weeks and months ahead.

 

Among the 55 first quarter cases were nine suits filed against companies domiciled outside the United States. In addition to these nine, there were two additional companies sued that were incorporated in the United States but that have their principle place of business outside the U.S. These eleven total cases represent about 16.3% of all first quarter filings, a percentage that is above the approximately 12% of 2010 filings that involved non-U.S. companies. This relative increase in the incidence of filings against non-U.S. companies is frankly unexpected in light of the U.S. Supreme Court’s June 2010 decision in Morrison v. National Australia Bank (about which refer here).

 

The persistent elevated level of filings against non-U.S. companies is largely attributable to the surge in lawsuits involving Chinese companies. Four of the nine lawsuits filed in the first quarter against non-U.S. companies were filed against Chinese companies. Three additional lawsuits involved companies incorporated elsewhere but with their principle places of business in China. These seven suits together represent about 12.7% of all first quarter filings. Indications are that this phenomenon of suits involving Chinese companies is likely to continue, as in recent days, plaintiffs’ lawyers have issued numerous press releases (for example, here and here)  indicating that they  are “investigating” certain other Chinese companies (a development that usually presages a subsequent lawsuit filing.)

 

As the new filings have shifted away from financially related companies, the jurisdictions in which lawsuit filings have been concentrated have also shifted. During the credit crisis litigation wave, lawsuit filings were concentrated in the Southern District of New York. Indeed, there were nine new securities suit filings in the Southern District of New York during the first quarter 2011, but for the first time since 2007 there were more quarterly filings in a federal district other than the Southern District of New York. Specifically, there were ten new securities lawsuit filings in the Central District of California, and another five in the Northern District of California, a changing jurisdictional mix that reflects the shifting mix of companies that are getting sued.

 

More About the Merger Objection Lawsuits: As I noted above, there were twenty new federal court merger objection lawsuits filed during the first quarter of 2011. A total of at least 63 different M&A transactions produced merger objection litigation in the first quarter, but many of the lawsuits relating to these transactions were filed in state court rather than in federal court. In addition, some of the transactions provoked lawsuits in both state and federal court, and some provoked multiple different lawsuits in different states.

 

Breaking all of this M&A related litigation down, and counting both the state and federal merger objection lawsuits,  there were a total of at least 81 different lawsuits relating to at least 63 different transactions. OF these 81 lawsuits, 20 were filed in federal court and 61 were filed in state court. As indicated above, some transactions produced multiple lawsuits in different jurisdictions.

 

A Note About Counting: Some readers may note that my count of 55 first quarter securities lawsuits differs substantially that the 39 lawsuits reported as of today on the Stanford Law School Securities Class Action Clearinghouse website. There are two reasons for this difference. One is timing, as I have counted suits that have not yet made it onto the Stanford site’s list. The other is counting protocol, as I have included 11 federal merger objection suits on my list that are not included on the Stanford website list.

 

As I have noted numerous times in the past on this site, one of the most challenging parts about keeping a running tally of securities class action lawsuit filings is deciding what you are going to count. As part of my counting protocol used during the first quarter, I have chosen to “count” all federal court securities suits, including all merger objection suits. This has produced a count that differs in certain particulars from the Stanford website count. However, I should hasten to add that my count includes all of the cases noted on the Stanford site. It just includes a few more.

 

These differences underscored the importance of definitional consistency when making comparisons across time. The comparisons are only meaningful if the counting protocols are consistent over time.

 

Finally, and whatever else might be said about the increasing numbers of merger related lawsuits, it seems apparent that the mix of cases is decidedly shifting. While there may be fewer traditional securities class action lawsuits being filed than in some prior years, the amount of total litigation activity is at or above historical averages when the merger objection litigation is taken in to account. And it also seems to be the case that at least as a matter of percentages of all filings, the merger objection lawsuits now outweigh the tradtional securities class action lawsuits.

 

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I am pleased to reproduce below a guest post from my friend Maurice Pesso, who is a parner in the White & Williams law firm, and his colleagues Sarah Katz Downey. I welcome guest contributions from responsible commentators. This article first appeared as a White & Williams law firm memo. Please note that in an earlier post (here), I summarized a speech Judge Jed Rakoff gave last summer about the Bank of America case (mentioned below). Here is the guest post:

 

 

In a March 21, 2011 opinion by U.S. District Court Judge Jed Rakoff  in Securities and Exchange Commission v. Vitesse Semiconductor Corp., et al., Case No. 10cv9239 (S.D.N.Y. March 21, 2011) (the "Opinion"), Judge Rakoff, in approving the proposed consent judgments against Vitesse and two of its officers, questioned whether the SEC’s practice of allowing defendants to neither admit nor deny liability might render a proposed consent judgment “so unreasonable or contrary to the public interest as to warrant its disapproval.” Here are Judge Rakoff’s own words: “[h]ere an agency of the United States is saying, in effect, ‘although we claim that these defendants have done terrible things, they refuse to admit it and we do not propose to prove it, but will simply resort to gagging their right to deny it.’”

 

 

This is at least the second time that Judge Rakoff has publicly called into question the SEC’s settlement practices. In September 2009, Judge Rakoff initially refused to approve a $33 million settlement between the SEC and Bank of America relating to shareholder communications by Bank of America prior to its takeover of Merrill Lynch. Although Judge Rakoff subsequently approved the settlement on revised terms, he chastised the SEC for the initial settlement terms, stating that the settlement "does not comport with the most elementary notions of justice and morality, in that it proposes that the shareholders who were the victims of the Bank's alleged misconduct now pay the penalty for that misconduct."

 

 

If Judge Rakoff’s reasoning gains traction in judicial or political quarters, the SEC may be placed in a position where it must refuse to enter into settlements with defendants unless the defendants admit liability. This would create a strong disincentive for defendants, and especially individual defendants, to settle with the SEC for at least two reasons: (1) if they admit liability, they will have limited future prospects as directors or officers of any registered company; and (2) the admission of liability will significantly raise the cost of resolving any related civil litigation, such as a securities class action.

 

In the wake of the Vitesse decision, D&O underwriters should be thinking about how the inability to settle SEC enforcement proceedings will affect the costs of defense for SEC enforcement proceedings and impact defense and settlement costs for related shareholder class actions and derivative litigation. On the one hand, if defendants cannot settle with the SEC without admitting liability, there likely will be fewer settlements and some defendants may decide to litigate until a final judgment — all resulting in increased costs of defense. On the otherhand, if a defendant chooses to litigate until a final judgment and a verdict is rendered against the defendant, the D&O insurer may be able to deny coverage in its entirety based on conduct exclusions in the D&O policy.

 

SEC v. Vitesse, et al.

 

On December 10, 2010, the SEC filed an enforcement proceeding against Vitesse Semiconductor Corporation and four Vitesse officers and directors. In its complaint, the SEC generally alleged that the defendants made numerous material misrepresentations in Vitesse’s SEC filings in an effort to conceal their fraudulent revenue recognition practices and stock options backdatings. Simultaneously with the filing of the complaint, the SEC filed proposed consent judgments against Vitesse and two of its officers, apparently anticipating that the court would simply approve the settlement as negotiated.

 

The consent judgments were presented to Judge Rakoff for court approval. According to the Opinion, the consent judgments lacked information explaining why they should be approved and how they met the requisite legal standards for court approval. In response to Judge Rakoff’s request for additional information, the SEC provided a December 21, 2010 letter brief. In addition, on December 22, 2010, a hearing was held before Judge Rakoff at which time the parties provided further information.

 

In the Opinion, Judge Rakoff acknowledged that, at first glance, the terms of the proposed consent judgments appeared inadequate based on the allegations of material misconduct by the defendants. However, despite the fact that the three defendants neither admitted nor denied liability, Judge Rakoff concluded that the terms of the settlement were “fair, reasonable, adequate, and in the public interest.” In finding that the terms of the proposed settlement were adequate, Judge Rakoff considered factors outside the terms of the settlement with the SEC, such as the fact that the two officers pled guilty to parallel criminal charges and that Vitesse had little money to pay based on its current troubled financial condition.

 

Despite having approved the settlement, Judge Rakoff raised concerns with the SEC’s longstanding practice of seeking court approval for settlements in which serious allegations of fraud are asserted against the defendants without requiring the defendants to expressly admit or deny the allegations.

 

As a practical matter, the SEC’s practice of settling with defendants who neither admit nor deny liability benefits both the SEC and the defendants. By entering into the consent judgments without admitting liability, the defendants are not collaterally estopped from asserting their innocence in parallel civil actions. Because the defendants do not have to admit liability, the SEC benefits because the defendants are more likely to enter into SEC settlements at an earlier time, and without requiring the SEC to devote substantial resources to taking enforcement actions to trial.

 

According to the Opinion, the SEC’s practice of entering into settlements where the defendants neither admit nor deny liability began decades ago and has developed through the years. Prior to 1972, after a court approved a settlement, the defendant would publicly deny his or her liability in connection with the SEC’s allegations. In response, in 1972, the SEC began to require all defendants who settled with the SEC without an admission of liability to refrain from publicly proclaiming their innocence. Nevertheless, SEC defendants still found ways in which to make it known that they never admitted liability — while being careful to refrain from denying liability at the same time.

 

In the Opinion, Judge Rakoff questioned whether the SEC’s practice of allowing defendants to neither admit nor deny liability might render a proposed consent judgment “so unreasonable or contrary to the public interest as to warrant its disapproval.” According to Judge Rakoff, the public suffers from the SEC’s practice of allowing the defendants to settle serious allegations without admitting liability, leaving the public with no way of knowing whether there was any truth behind the allegations.

 

D&O Coverage Implications

SEC settlements themselves are generally uninsurable under D&O policies because they are composed of either: (1) fines/penalties; (2) disgorgement; and/or (3) equitable relief. However, the costs associated with defending against SEC enforcement proceedings are generally covered under D&O policies.

 

As discussed, if Judge Rakoff’s reasoning is followed, the SEC may find itself pressured — or obligated — to enter into settlements only with defendants who will admit liability. If defendants cannot settle with SEC without admitting liability, there will be fewer settlements, and some defendants may decide to litigate until a final judgment — all resulting in increased costs of defense. In recent years, defense costs for even a single SEC defendant have run into the millions of dollars, and sometimes even more than $10 million. Because defense fees associated with SEC enforcement proceedings are generally covered under D&O policies, D&O insurers would feel the impact of increased defense costs in SEC actions.

 

At the same time, if a defendant chooses to litigate until a final judgment and a verdict is rendered against the defendant, the D&O insurer may be able to deny coverage for the defendant based on the conduct exclusions. In addition, the D&O insurer may be able to rely on the judgment to deny coverage for one or more D&O defendants in any related civil litigations. Depending upon the policy terms at issue, the D&O insurer may also be able to seek reimbursement of all of the defense costs that it previously advanced following an adverse verdict in an SEC trial.

 

The SEC’s reaction to Judge Rakoff’s criticism remains to be seen. Although intended to be an independent regulator, the SEC can be subjected to political pressure — especially from the U.S. Congress, which sets the SEC’s annual funding budget. It will be interesting to see if there is a slowdown in SEC settlements over the next few months and if other judges refuse to “rubber stamp” SEC settlements where the defendants neither admit nor deny liability. We will follow this issue and report any findings.

 

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In a unanimous March 22, 2011 opinion by Justice Sonia Sotomayor, the U.S. Supreme Court rejected the argument of Matrixx Initiatives that adverse product reports must be "statistically significant" in order for a manufacturer to have an obligation to disclose the reports to investors. As a result of the Court’s decision, shareholders claims against the company for its alleged failure to disclose reports that its Zicam cold remedy caused loss of smell for some users will now be going forward. The Court’s opinion can be found here.

 

Background

Matrixx Initiatives manufactured an internasal cold remedy called Zicam. In April 2004, plaintiff shareholders filed a securities class action lawsuit against Matrixx and three of its directors and officers, alleging that the defendants were aware that numerous Zicam users experienced loss of the sense of smell. The complaint alleges that the defendants were aware of these problems because of calls to the company’s customer service line; because of academic research, which was communicated to the company; and because of product liability lawsuits that had been filed against the company.

　

The district court granted the defendants’ motion to dismiss, finding that the complaint failed to adequately allege that the alleged omissions were material, because the complaint did not allege that the number of customer complaints was "statistically significant."

　

As discussed at greater length here, on October 28, 2009, the Ninth Circuit reversed the district court, holding that the district court "erred in relying on the statistical significance standard" in concluding that the complaint did not meet the materiality requirement. The Ninth Circuit said that a court "cannot determine as a matter of law whether such links [between Zicam and loss of smell] was statistically significant, because statistical significance is a matter of fact." The defendants filed a petition for a writ of certiorari to the U.S. Supreme Court, and as discussed here, the Supreme Court granted the petition.

　

The Opinion

　

In their briefs before the U.S. Supreme Court, Matrixx urged the Court to adopt a "bright line" test that reports of adverse events with a pharmaceutical company’s produce cannot be material absent a sufficient number of reports to establish statistical significance. Matrixx argued that statistical significance is the only reasonable indicator of causation.

　

The Court declined to adopt the bright line test urged by Matrixx, reasoning that such a categorical rule would "artificially exclude evidence that would otherwise be considered significant to the trading decision of a reasonable investor."

　

The Court also rejected the notion that only statistical significance in the only reasonable indicator of causation, noting that medical professionals and the FDA regularly infer a causal event between a drug and adverse event. Justice Sotomayor wrote that "Given that medical professionals and regulators regularly act on the basis of evidence of causation that is not statistically significant, it stands to reason that in certain cases reasonable investors would as well."

　

This conclusion does not however mean that pharmaceutical companies have to disclose every adverse event. Rather, an adverse event is material and must be disclosed, the Court said citing its standing test for materiality, if it would "significantly alter the total mix of information." The "mere existence" of adverse reports "will not satisfy this standard." Rather, "something more is needed -- but "something more" is "not limited to statistical significance." and "can from the source, context and context of the reports."

　

Justice Sotomayor reiterated, however, that absent a duty to speak, silence cannot be the basis of securities liability. Disclosure is only required when necessary to make previous statements not misleading; "Even with respect to information that a reasonable investor might consider material, companies can control what they have to disclose under these provisions by controlling what they say to the market."

　

Applying this total mix standard to this case, the Court concluded that the loss of smell reports of which the plaintiffs allege the defendants were aware, "the complaint alleges facts suggesting a significant risk to the commercial viability of Matrixx’s leading product." "This is not a case about a handful of anecdotal reports, as Matrixx suggests," Sotomayor wrote. She added the investors intend to prove that "Matrixx received information that plausibly indicated a reliable causal link between Zicam and anosmia," the medical term for a loss of smell.  At its most basic level, the Supreme Court’s decision in the Matrixx Initiatives case is essentially just a reaffirmation of its prior case authority dealing with the question of materiality. In particular the Court reiterated its prior statement of the standard for materiality in the   Basic, Inc. v. Levinson case and  TSC Industries v. Northway.  "companies can control what they have to disclose under these provisions by controlling what they say to the market "

　

The Court also found the plaintiffs’ allegations were sufficient to satisfy the requirements for pleading scienter. The Court noted that it has not yet determined whether recklessness along is sufficient to satisfy the scienter requirements, saving that question for another day.

　

Discussion 　  　

Viewed in that light, the decision may not be all that surprising. Just the same, there is something a little bit unexpected about this decision. The unanimous opinion represents a clean sweep for the plaintiffs, which given this Court’s track record arguably is an unexpected outcome. The Supreme Court has produced a number of decisions highly favorable to defendants in recent years, and while that has not been entirely uniform (there was the Merck decision last term for example), the Court has seemed to have a predisposition for the defense perspective.

　

By rejected the proposed "bright line" test , the Court has relieved plaintiffs of the burden of having to come up with sufficient facts to prove statistical significance. The lack of a bright line test may, however, represent something of a challenge for reporting companies going forward. Manufacturers receive "adverse event reports" in the form of customer complaints all the time. A bright line test would have clarified when the number of reports has reached a sufficient level that they must be disclosed. In the absence of such a clear standard, companies will face quite a struggle in trying to figure out what must be disclosed.

　

Once place companies may want to turn for guidance is the statement in Justice Sotomayor’s opinion that "companies can control what they disclosre under these provisions by controlling what they say tot he market."This statement suggests to me that the judicious use of precautionary disclosure may go a long way toward alleviating disclosure challenges.

　

Special thanks to my friends in the Securities Litigation group at Skadden Arps for alerting me to the Matrixx Initiative decision and for sending me a copy of their analysis of the decision (hewww.skadden.com/newsletters/Supreme_Court_Rejects_Bright_Line_Test_for_Materiality.htmlre)

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I am pleased to reproduce below a guest post from my friend and colleague, David S. De Berry. Dave is an attorney and CEO of Concord Specialty Risk, a series of a Delaware limited liability companies owned by RSG Specialty Group, LLC. I want to emphasize that while Dave and I are now colleagues as a result of the common ownership of our two firms, I welcome guest post submissions from any responsible contributor. Dave’s topic is in an area not typically covered on this blog, but I still thought readers would find it of interest. Here is Dave’s post.

　

Companies could be facing a significant new exposure as a result of a new reporting requirement that goes into effect for tax returns that must be filed this year. The new reporting requirement expands beyond existing accounting requirements for tax uncertainty. The result is that tax liabilities not requiring a reserve for financial statement purposes may be directly disclosed to the IRS. This article discusses the new reporting requirements, the potential impact on securities litigation and the variety of insurance solutions available to address these issues.

 

The Requirement to "Confess & Rank"

The IRS now requires "large" corporations to "confess and rank" their uncertain tax positions when filing tax returns. Specifically, the IRS is now requiring corporations with (worldwide, gross) assets that exceed $100 million to provide the IRS with a "concise description" of all of their uncertain tax positions and to rank those positions by size of tax reserve, or by amount at issue (if not reserved), and to denote whether the position relates to transfer pricing. The information must be included in their 2010 U.S. income tax returns (generally filed on or before September 15, 2011 for calendar year taxpayers) under a new IRS form, Schedule UTP, which stands for "uncertain tax positions." The Schedule UTP form can be found here.

 

And the requirement to "confess and rank" to the IRS is slated to extend to all corporations as Schedule UTP phases in over the next five years. Corporations with total assets of $100 million or more must file Schedule UTP starting with 2010 tax years. Starting with 2012 tax years, the total asset threshold will be reduced to $50 million. Starting with 2014 tax years, it will be reduced to $10 million.　 The IRS stated that it will consider whether to extend the Schedule UTP reporting requirement to other taxpayers—such as pass-through entities or tax-exempt organizations—for 2011 or later tax years. The instructions for Schedule UTP can be found here.

 

The Dramatic Extension Beyond Current U.S. - GAAP

Companies reporting their financial statements in accordance with US-GAAP have recently had to follow a set of rules known as "FIN 48" when accounting for tax uncertainty. Essentially, FIN 48 requires that all tax positions be identified and evaluated in a two-step process: (1) the recognition step, which asks whether each tax position would more likely than not prevail under existing law - if not, then none of the tax benefits associated with the position are "recognized" (i.e., the entire amount at risk is charged or reserved and provisions for accruing interest and perhaps penalties must also be set forth in the financial statements); if the position is likely to prevail under existing precedent or authority, then the second (measurement) step is taken to determine how much of the tax benefits may be recognized for financial statement purposes and (2) the measurement step, which asks, as to each recognized position, how much of the position is more likely than not going to be allowed in a final resolution (via settlement or adjudication) with the taxing authority assuming the position were challenged and it would be settled on its own merits (no trading of positions for settlement purposes). The official publication of FIN 48 can be found here.

　

Schedule UTP is a dramatic divergence from the measurement step used in FIN 48 for accounting purposes. Under FIN 48, if a company believes (i.e., convinces its financial statement auditors) that it would never settle a tax position with the IRS and would more likely than not prevail in the adjudication of that position, no FIN 48 reserve is required. Under Schedule UTP, however, each such position must be disclosed and given a priority ranking as part of the corporate tax return filed with the IRS.

　

The Impact on Companies

The impact that Schedule UTP will have on securities class actions and derivative actions remains to be seen. The impact on corporate cash, balance sheets and income, however, is expected to be significant.For example, in a report by Credit Suisse dated May 18, 2007, entitled "Peeking Behind the Tax Curtain", Credit Suisse analyzed just 361 companies in the S&P 500 and found a total of $141 billion in unrecognized tax benefits for uncertain tax positions identified pursuant to FIN 48. A copy of an abstract of that repot can be found here.

 

To the extent that FIN 48 reserves relate to tax liabilities owed the IRS, Schedule UTP will almost certainly make the FIN 48 reserves a self-fulfilling prophecy. As discussed further below, however, there may be some relief for companies that posted large FIN 48 tax reserves of U.S. income tax liabilities. In cases where the tax position was not recognized, in part or in whole, because the company could not persuade its financial statement auditors with a tax opinion prior to the initial setting of FIN 48 reserves for the position, tax insurance may be available.

 

But regardless of the amount reserved for FIN 48 purposes, the amount not reserved but yet exposed by Schedule UTP will present a significant challenge to many companies. In certain instances, the discrepancy between tax liabilities reserved for FIN 48 purposes and tax liabilities disclosed to the IRS in Schedule UTP can be very significant. Many companies obtained tax opinions for certain tax positions and argued that they would never settle with (and would prevail over) the IRS to avoid FIN 48 reserves for those tax positions. As noted above, all such positions must now be disclosed in a concise narrative description and given a priority ranking as part of the corporate tax return.

 

When the discrepancy is material to the company’s financial condition and significant tax liabilities (and/or penalties) that were not reserved arise as a result of Schedule UTP, there may well be grounds for shareholder actions.

 

The Specter of Securities Class Actions & Derivative Suits

Absent rather extreme circumstances (e.g., Enron), it still seems fairly remote that an adverse, material, final determination of an uncertain tax position(s) not fully reserved in a company’s financial statements but reported on Schedule UTP could expose the company, its directors and officers and/or auditors to liability under securities laws or corporate law.

 

However, in instances in which the discrepancy between FIN 48 reserves and Schedule UTP exposure is both large (relative to liquidity) and protracted (not remedied over time by either increasing reserves or mitigating the tax risk, as discussed below), and/or if penalties are assessed, the plaintiff’s case becomes easier.

 

In Overton v. Todman & Co, 478 F.3d 479 (2d Cir. 2008), the Court vacated and remanded the trial court’s dismissal of a securities fraud claim against an accounting firm that purportedly failed to correct its certified opinion after learning that the company’s tax liability had not been correctly stated. (The appeal did not address the more difficult issue of loss causation because the trial judge had dismissed on the basis that the accounting firm had no "duty to speak.") The Court ruled:

 

Specifically, we hold that an accountant violates the "duty to correct" and becomes primarily liable under  Section  10(b) and Rule 10b-5 when it (1) makes a statement in its certified opinion that is false or misleading when made; (2) subsequently learns or was reckless in not learning that the earlier statement was false or misleading; (3) knows or should know that　potential investors are relying on the opinion and financial statements; yet (4) fails to take reasonable steps to correct or withdraw its opinion and/or the financial statements; and (5) all the other requirements for liability are satisfied [i.e., materiality, transaction causation, loss causation and damages]. { Id at pages 486-487.} 

 

A copy of the decision can be found here.

 

It would seem that the reasoning in Overton as to an auditor’s duty to correct and speak about an inaccurately disclosed tax liability should extend to corporate "speakers" when any corporate tax directors, CFO’s and the members of an Audit Committee discover a material discrepancy between FIN 48 reserves for U.S. income tax liabilities and Schedule UTP. For purposes of establishing liability under Section 10(b) of the Securities Exchange Act of 1934, a significant discrepancy followed by silence (and no action to mitigate loss or increase reserves) may well be viewed as the basis for establishing corporate scienter (particularly in jurisdictions that follow either a weak or semi-strong theory of corporate scienter) and/or scienter on the part of the CFO and members of the Audit Committee. And the "failure to take reasonable steps" language of Overton could well be applied to a derivative action taken against the Audit Committee that fails to correct or mitigate these discrepancies and subsequently incurs large legal and expert fees and/or penalties.

 

In fact, transparency regarding tax liabilities has taken center stage in recent corporate governance gatherings. On October 19, 2009, IRS Commissioner Doug Shulman addressed the 2009 National Association of Corporate Directors Governance Conference and urged that companies establish an open dialogue and regular meetings between their Audit Committees and Tax Directors and that directors are legally charged with oversight of their company’s compliance with tax laws. Commissioner Shulman made a number of detailed inquiries that should be undertaken by Audit Committees. The IRS’s suggested inquiries could one day serve as the checklist for proper corporate tax governance by many corporations and/or plaintiff’s counsel prosecuting a derivative action (particularly where penalties have been assessed). A copy of the Commissioner’s remarks can be found here.

　

Loss Mitigation Techniques

So how does a company protect itself from the risk that it failed to adequately reserve for tax liabilities? As noted above, the traditional approach of obtaining a tax opinion may no longer suffice. There are two major concerns: (1) the opinion will not prevent disclosure under Schedule UTP and (2) the opinion may not, in practice, protect the company against penalties, much less un-accrued taxes and interest.

 

A "covered" tax opinion that satisfies the standards of Treasury Circular 230 (31 CFR 10.35) is often touted as the company’s defense against penalties. In practice, however, not many corporate taxpayers want to waive their attorney-client privilege and provide the IRS with a tax opinion that (in order to be a covered opinion) develops all relevant legal theories and considers all relevant authorities, support and arguments, both favorable and not favorable for the taxpayer.

 

Accordingly, tax practitioners may wish to consider advising their clients to consider tax insurance for their material uncertain tax positions. In fact, some tax practitioners already include such advice as a standard provision in any tax opinion. (E.g., "Of course, our opinion is not binding on the IRS and there is a reasonable basis by which the IRS could successfully challenge the tax position. If greater economic certainty around the tax position is desired, tax insurance may be available.")

　

Moreover, tax return preparers may wish to consider comparing the FIN 48 reserves (and work papers) with the Schedule UTP before filing the tax return and would be well advised to inform their clients that tax insurance may be available for discrepancies, if any, and/or for tax positions that have not been fully recognized.

 

Tax Insurance Protection: In fact, tax insurance may be available via several alternative (but not mutually exclusive) approaches:

 

1. Transactional Tax Insurance covering a particular uncertain tax positions (or set of related tax positions) taken in particular tax year(s) against claims made during the policy period (often co-extensive with the statutory period in which assessments can be made).

 

2. Schedule UTP/FIN 48 Tax Insurance covering the shortfall in FIN 48 reserves for those selected uncertain tax positions set forth on Schedule UTP. The policy period will often be co-extensive with the statutory period in which assessments can be made with respect to the U.S. (federal) corporate income tax return. The difference between Schedule UTP/FIN 48 Tax Insurance and Transactional Tax Insurance is that the scope of uncertain tax positions is expected to be far broader in Schedule UTP/FIN 48 Tax Insurance, with higher limits. Subsequently policies would cover subsequent returns on a non-cumulative basis with respect to tax positions covered under multiple policies (i.e., the full amount of tax exposure may be insured but not more than the full amount will be insured).

　

3. FIN 48 Tax Insurance – An annual claims-made policy with a one-year policy period covering the adequacy of the FIN 48 reserves with respect to the tax positions covered under the policy. A claim is made when an audit makes inquiry about a covered tax position. Each year, a new set of covered tax positions are covered (subject to underwriting approval) as new tax positions are reported and/or as former tax positions are no longer subject to challenge.

 

Variations of the above prototypes may also be available. Tax insurance almost always allows the insured to select its tax counsel (subject to consent) and typically contains no more than a few exclusions. It is not, however, available for "reportable transactions."

 

Because tax insurance provides cash when needed to pay a tax bill, and because its purchase reflects a prudent risk management approach to the inherent complexities of tax planning, reporting and reserving, as Schedule UTP becomes a corporate requirement, so too may tax insurance. The alternative may well be a new wave of shareholder suits.　

　

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Any list of the most important and influential Americans of the 20^th century would have to include William Brennan, whose 34-year tenure as an associate justice of the U.S. Supreme Court coincided with –and in many ways both reflected and influenced – a period of extraordinary change both in American society and in its jurisprudence. Liberal icon and lightening rod for conservative rancor, Brennan was at the center of many of the Court’s highest profile decisions.

 

In an authorized biography entitled "Justice Brennan: Liberal Champion," journalist Stephen Wermeil and attorney Seth Stern provide a balanced and thorough overview of Brennan’s long and extraordinary life. Because Wemiel had the opportunity to interview Brennan before his death in 1997 and because the authors had access to Brennan’s personal notes and files, the book provides significant insight into the Supreme Court’s inner workings.

 

The book explores Brennan’s early life, including his childhood and his years at Harvard Law School, where he took classes with Felix Frankfurter (with whom Brennan would later serve on the U.S. Supreme Court – Frankfurter did not remember Brennan, who had not been a particularly brilliant law student). The book also examines Brennan’s early career as a labor lawyer in Newark and then as a state court judge in New Jersey.

 

But the bulk of the book is devoted to Brennan’s years on the Supreme Court. Brennan was nominated for the Court by Republican President Dwight Eisenhower, though Brennan was a lifelong Democrat. With an eye on the 1956 presidential election, Eisenhower wanted to nominate a youthful Catholic, preferably one with state judicial experience. Few candidates met all of these criteria, so Brennan found himself on the Supreme Court at age 50, with only seven years of state trial and appellate court judicial experience. (Eisenhower is reported to have later regretted the nomination.)

 

Brennan would quickly become a key ally and working partner of Chief Justice Earl Warren, together exercising an expansive vision of judicial authority. The authors refer to Brennan’s collaborative relationship with Warren as "one of the most enduring friendships important alliances in the history of the Supreme Court," resulting, among other things in an historic and surprisingly enduring expansion of civil rights.

 

Brennan arrived after the Court’s landmark Brown v. Board of Education decision declaring "separate but equal" to be "inherently unequal." However, he soon became an indispensible part of the working majority on the court that operated with the view that for too long the Court had, in the name of judicial restraint, abdicated its responsibility to protect civil liberties.

 

Brennan himself developed an activist, results-oriented approach, first manifest in cases dealing with segregation and racial inequality, but soon extended to a host of other areas, including criminal procedure, privacy, voting rights and obscenity. Brennan would be in the majority in a wide range of controversial opinions, including those involving abortion, school prayer, busing and affirmative action.

 

As a result of these decisions, the Court attracted fierce criticisms that it was acting in the role of Platonic Guardian and operating as a "roving commission" to do justice as they conceived it, in the process trammeling majoritarian institutions.

 

The activist judicial approach of Brennan and his liberal colleagues on the Court triggered a strong political backlash. Barry Goldwater’s 1964 presidential campaign, as well as Richard Nixon’s campaign in 1968, was in many ways built around criticisms of the Court and its liberal agenda. As the Court’s membership changed in the 70’s and 80’s due to the conservatives political successes, Brennan found himself dissenting more frequently and sometimes isolated – but still able to influence colleagues and, to a certain extent, to protect decisions of the Warren Court era.

 

Though the biography is generally favorable, the portrait that emerges is relatively balanced. Brennan appears as a conscientious and effective jurist who, as a result of the strength of his personal charm, principles and intellect became, as the authors claim "one of the most influential justices of the 20^th century."

 

Brennan’s life story is well told in this detailed account, which not only examines his judicial career, but also his life off the court, including his marriage, his friendships, his religious life and even his finances. The book is filled with interesting insights and anecdotes, such as Brennan’s passionate opposition to the death penalty, and, on a more personal note, his marriage to his long-time secretary, Mary Fowler, just three months after the death of his first wife, Marjorie, to whom had had been married for nearly all of his adult life.

 

Along the way, the authors provide deep insight into how the Court works and how it has had such an extraordinary influence on so many aspects of American life and society.

 

Despite the many years of conservative majorities that followed Brennan’s tenure on the Court, a surprisingly large part of Brennan’s legacy remains intact. In areas such as civil rights, privacy, voting rights and criminal procedure, decisions that when first made were highly controversial remain the law of the land. It is perhaps fitting that in his confirmation hearing, David Souter, Brennan’s replacement on the Court, referred to Brennan as "one of the most fearlessly principled guardians the Constitution ever had."

 

I enjoyed reading this book and I have no hesitation recommending it. I will say that reading the book occasioned much thought and even concern as I reflected on Brennan’s brand of judicial activism. Though the Warren Court’s civil rights decisions were essential to removing deep racial injustices, the activist approach the Court employed led to other decisions about which it is difficult for me to feel quite as comfortable, even if just from an analytical point of view.

 

Moreover, an activist approach that finds rights and legal requirements without an explicit textual basis in the Constitution can be used for conservative as well as liberal purposes, as it might be argues subsequent courts have proven.

 

Reflecting on this afforded me a new appreciation for the merits of judicial restraint. In reading this book, I found it striking that after the first few years of the civil rights cases, Justices Hugo Black and John Marshal Harlan II, who had been important participants in many of the Warren Court’s early civil rights decisions, began pulling back and increasingly began refusing to follow the liberal majority. The book suggests the two justices (particularly Black) may have just been getting old. Perhaps I am getting old too, because I found myself appreciating their perspective.

　

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It has been a long road -- one that included among other things, an amicus brief filed at the U.S. Supreme Court in connection with Morrison v. National Australia Bank – but the defendants in the Infineon Technologies securities suit have managed to have the court dismiss the claims of company shareholders who purchased their securities outside the U.S. Northern District of California Judge James Ware’s March 17, 2011 order granting the defendants’ motion can be found here.

 

The plaintiffs first initiated their suit in September 2004, as detailed here. The plaintiffs allege that the company had participated in an illegal conspiracy to fix the prices of Dynamic Random Access Memory (DRAM) and then misrepresented the company’s financial condition as a result of the artificially inflated DRAM prices. Infineon’s American Depositary Shares and ordinary shares are listed on the NYSE, but during the class period 92% of its securities were traded on the Frankfort Stock Exchange.

 

Following the U.S. Supreme Court’s June 2010 decision in the Morrison case, the defendants moved to dismiss from the case the shareholders who purchased their Infineon shares outside of the U.S. In opposing the motion, the plaintiffs – citing Morrison’s holding that Section 10(b) of the ’34 Act applies only to "transactions in securities listed on domestic exchanges" and "domestic transactions in other securities" – argued that because Infineon’s ordinary shares are "listed on" the NYSE, Section 10(b) applies to all ordinary shares, even those purchased on the Frankfurt Stock Exchange.

 

Consistent with Southern District of New York Judge Deborah Batts’ January 2011 opinion in the RBS securities suit (about which refer here), Judge Ware had little trouble rejecting the plaintiffs’ "listed on" argument. Judge Ware stated that under Morrison "a securities transaction must occur on a domestic exchange to trigger application of Section 10(b) of the Exchange Act."

 

Judge Ware said that the plaintiffs’ "listed on" argument was "misplaced," noting that in the Morrison case itself, National Australia Bank had ADRs listed on the NYSE, but the plaintiffs in Morrison were unable to state a Section 10(b) claim because "that Section of the Exchange Act focuses only on securities transactions that take place in the United States."

 

Accordingly, Judge Ware granted the motion to dismiss with respect to "all claims asserted on behalf of individuals who purchased Infineon ordinary shares on the Frankfurt Stock Exchange."

 

Judge Ware’s opinion in the Infineon case joins a growing list of decisions in which federal district courts have dismissed from securities suits the shareholder claimants who purchased their shares of the defendant company’s stock outside of the U.S. What makes Judge Ware’s opinion noteworthy is that it is one of the first such opinions outside of the Southern District of New York. As far as I know, it is the first in the Northern District of California.

 

(Central District of California Judge Dale Fischer interpreted and applied Morrison for purposes of a July 2010 lead plaintiff ruling in the Toyota securities suit, but did not reach the question whether Morrison precluded the claims of shareholders who purchased their shares outside the U.S.)

 

It is increasingly clear that the district courts are applying Morrison broadly and are refusing to be persuaded to trim the decision’s effect or to reduce its impact on the claims of securityholders who purchased shares on foreign exchanges.

 

Plaintiffs seeking to circumvent Morrison may be forced to proceed by other means – as for example, are claimants whose federal securities suit against Porsche was dismissed based on Morrison. As reflected in their March 15, 2011 complaint (here), these plaintiffs are now attempting to assert state law claims of common law fraud and unjust enrichment against Porsche. The plaintiffs will face numerous obstacles as they attempt to chart an alternative course. But claimants barred by Morrison from asserting securities claims under the federal securities laws will continue to search for ways to try to assert their claims, both inside and outside the U.S.

 

Susan Beck’ March 19, 2011 Am Law Litigation Daily article about Judge Ware’s decision in the Infineon case can be found here.

 

Transatlantic Cable: Writing about the Infineon decision seems fitting as I am now in London for this week’s C5’s 20^th Forum on D&O Liability Insurance. I will be speaking on Thursday March 24, 2011 on a panel with my friend Rick Bortnick of the Cozen O’Connor firm on the topic "The Latest U.S. Judicial Decisions." If you are attending the conference, I hope you will take the time to say hello, particularly if we have not previously met.

 

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On March 7, 2011, in the latest development in a long-running securities suit that is among the few securities class action lawsuits to go to trial and that had previously resulted in a $277.5 verdict in plaintiffs’ favor, the U.S. Supreme Court denied Apollo Group’s petition for writ of certiorari. As a result, the ruling of the Ninth Circuit reinstating the jury’s verdict will now stand. In addition, as a result of the decision to decline taking up the case, the interesting and arguably important issues the cert petition raised will now not be reviewed by the Supreme Court.

 

As detailed in greater length here, plaintiffs filed the suit after the company’s share price declined following the disclosure of a U.S. Department of Education report alleging that the company had violated DOE rules. On September 7, 2004, the company agreed to pay $9.8 million to settle the allegations. News of the settlement first became public on September 14, 2004, but the company’s share price did not actually decline until September 21, 2004, when a securities analyst issued a report expressing concern about the company's possible exposure to future regulatory issues.

　

On January 16, 2008, a civil jury entered a verdict in favor of the plaintiff class on all counts, awarding damages of $277.5 million. Under the verdict, Apollo is responsible for 60 percent of the plaintiffs' losses, former Apollo CEO Tony Nelson is responsible for 30 percent, and former CFO Kenda Gonzales is responsible for 10 percent. The jury verdict is discussed at greater length here.

　

As discussed in greater length here, on August 4, 2008, Judge James Teilborg of the United States District Court for the District of Arizona entered an order (here) granting the defendants’ motion for judgment as a matter of law, based on his finding that the trial testimony did not support the jury’s finding of loss causation. Judge Teilborg’s order vacated the judgment and entered judgment in defendants’ favor.

 

In its post-trial motion, Apollo argued that the evidence at trial was insufficient to support a finding that the analyst reports represented "corrective disclosure," because they did not contain any new fraud-revealing information. Judge Teilborg found that "the evidence at trial undercut all bases on which [the plaintiff] claimed the (analyst) reports were corrective."　

 

Accordingly, the court concluded that although the plaintiff "demonstrated that Apollo misled the markets in various ways concerning the DoE program review," the plaintiff "failed to prove that Apollo’s actions caused investors to suffer harm." The court therefore concluded that "Apollo is entitled to judgment as a matter of law."

 

In a June 23, 2010 opinion (here), a three-judge panel of the Ninth Circuit held that the district court "erred in granting Apollo judgment as a matter of law." The opinion states that "the jury could have reasonably found that the (analyst) reports following various newspaper articles were ‘corrective disclosures’ providing additional or more authoritative fraud-related information that deflated the stock price."

　

The Ninth Circuit further held that Apollo is not entitled to a new trial and that there is no basis for remittitur (reduction of the verdict). The Ninth Circuit reversed and remanded the case with "instructions that the district court enter judgment in accordance with the jury’s verdict." The company filed a petition for writ of certiorari to the U.S. Supreme Court.

　

The basis for the company’s cert petition was basically that if the efficient market hypothesis means anything, then the information about the DoE investigation was fully incorporated into the company’s share price when the news first hit the market on September 14. Either the market did not efficiently incorporate this information, in which case the market for the company’s stock is not efficient and the plaintiffs ought not to be able to rely on the fraud on the market theory to establish reliance, or the market is efficient and the company’s share price simply did not decline at the time of the corrective disclosure.

　

In a June 28, 2010 guest post on this blog (here), noted securities litigation defense attorney Tower Snow of the Howard Rice law firm articulated the inherent tension between these two positions as follows:

　

The courts can't rely on the efficient market theory for purposes of creating a rebuttable presumption of reliance for purposes of class certification and then ignore its underpinnings for purposes of evaluating loss causation. Either one embraces the theory or one does not. If one embraces it, then once it is established that the prior disclosures revealed the truth about the allegedly misstated or omitted information, there is nothing left for the jury to decide. The later disclosure, by definition, cannot be corrective, as the market already had absorbed the information. Here, the "corrective" disclosure came out seven days after the information had been previously released. Seven days is an eternity in the financial markets.

　

As discussed in March 2011 memo from the Jones Day law firm discussing the U.S. Supreme Court’s cert denial in the Apollo Group case (here), the Circuits are split on the question of how soon after a corrective disclosure a stock price decline must occur in order for the loss causation requirement to be satisfied. At least two Circuits – the Second and the Third – have held that the claimant must show that the market immediately reacted. At least three Circuits – the Fifth, Sixth and Ninth – have head that the price decline may occur weeks or even months after the initial corrective disclosure.

　

In light of the Supreme Court’s refusal to take up the Apollo Group case, this split in the Circuits will remain unresolved. Moreover, the relatively plaintiff friendly standard articulated by the Ninth Circuit remains standing in that Circuit, where so many securities class action lawsuits are filed.

 

Finally, the Supreme Court’s cert denial means that the Ninth Circuit’s ruling in the Apollo Group case stands. The Ninth Circuit had remanded the case for "entry of judgment in accordance with the jury’s verdict." In other words, the Supreme Court’s cert denial means that the plaintiffs’ verdict in one of the very rare securities cases to go to trial will stand.

 

The Supreme Court’s cert denial was disclosed with little fanfare, as part of a long list of other rulings at the same time. Looking at the Apollo Group cert denial among the list of rulings might convey the impression that this is no big deal. But actually it is a little surprising. The U.S. Supreme Court has shown an active willingness to take up securities cases, having taken numerous cases up in each of the last few terms. And part of the willingness to take up these cases seemed to involve persistent hostility against securities suits in general. The opportunity to trim a plaintiffs’ victory and to resolve a circuit split certainly seemed to suggest the possibility that the Supreme Court might well grant the cert petition.

 

In any event, with the cert petition denial, the plaintiffs’ trial victory in this case appears as if it will stand. Even with the recent dramatic narrowing of the plaintiffs’ class in the Vivendi case, the plaintiffs overall are on a bit of a roll when it comes to securities lawsuit trials. The last three securities cases to go to trial (the Homestore case, refer here; the BankAtlantic case, refer here; and the Vivendi case, refer here) have all resulted in plaintiffs’ verdicts.

　

Trials in these cases are extremely rare, and these recent developments involve a very small percentage of all securities cases. Nevertheless, the plaintiffs’ bar undoubtedly will find this sequence of events, including the cert petition denial in the Apollo Group, to represent heartening developments.  Even with the cert denial in the Apollo Group case, however, there are still a couple of securities cases still pending before the court this term -- the Matrixx Initiative case (refer here) and the Janus Capital Group case (refer here) -- and it remains to be seen how plaintiffs will fare in those cases.　

　

　

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Though the average dollar value of securities class action settlements approved in 2010 declined slightly compared to 2009, the median settlement amount reached record levels, according to Cornerstone Research’s annual 2010 Securities Class Action Settlement Study. Cornerstone’s March 10, 2010 press release about the study can be found here, and the study itself can be found here.

 

Largely as a result of the decline in the number of mega-settlements, the average securities class action lawsuit settlement approved in 2010 declined to $36.3 million, compared to S37.2 million in 2009. Both of these figures are well the 1996-2009 average settlement of $54.8 million. Even if the post-Reform Act settlement average is "normalized" by excluding the top-three settlements during that era, the 2010 average is still below the adjusted 1996-2009 average of $38.8. (All historical averages are adjusted for inflation.)

 

The median average class action lawsuit settlement approved in 2010 increased to $11.3 million from a 2009 median of $8.0 million. This 40% increase represents the largest single year increase in the median settlement in the last ten years.

 

The sizeable gap between the averages and medians is a reflection of the presence of a few significant larger settlements During the post-Reform Act era, more than half of the securities class actions have settled for less than $10 million, about 80% have settled for under $25 million.. Only 7 percent of cases have settled for more than $100 million. Thus, "while large settlements tend to receive substantial attention, they tend to occur infrequently."

 

The Cornerstone study reports the number of securities class action lawsuit settlements approved during 2010 is the lowest in ten years. The "more likely cause" for this decline is combination of the substantial drop in the number of new securities class action lawsuit settlements and the fact that the credit-crisis suits have taken longer to settle. The average time to settlement for cases settled in 2010 was 4.1 years, compared to 3.9 years for the cases settled in 2009.

 

Obviously, the most significant factor with respect to the overall size of securities suit settlements is the overall amount of investor losses (although the proportionate relationship between the size of the settlement and the size of investor losses decreases as the size of "plaintiff-style" damages increases.)

 

There are a number of other lawsuit features that present statistically significant differences in the size of the settlements. First, cases involving accounting allegations are resolved with larger settlements than cases without accounting allegations. For example, cases involving a restatement settled during the 1996-2010 period settled for 3.9% of "plaintiff-style" damages, but cases without a restatement settled for 3.1% of those amounts. In addition, filings that do not involve accounting allegations are more likely to be dismissed than filings with accounting allegations.

 

The report goes on to observe that the increased complexity of cases involving accounting allegations means these cases may take longer to resolve, which may be a factor contributing to the increased interval between the filing date and the settlement date observed over time.

 

Second, the presence of public pension plans as lead plaintiffs is associated with higher settlements as well. Though this observation could be explained by these investors choosing to participate in stronger cases, the study reports that even controlling for observable factors that affect settlement amounts, "the presence of a public pension plan as a lead plaintiff is still associated with a statistically significant increase in settlement size."

 

Other lawsuit features that are associated with statistically significant settlement amounts are the presence of Section 11 and/or Section 12(a)(2) claims; the presence of a remedy of a corresponding SEC action; and the presence of companion derivative claims. On the latter point, the report notes that class actions accompanied by derivative actions tend to be associated with other factors important to settlement amounts, such as accounting allegations, the presence of related SEC action and the involvement of public pension fund plaintiffs.

 

The credit crisis cases have settled more slowly than "traditional cases." There have also been relatively few settlements of these cases to date, as well. Of the credit crisis cases that have settled so far, they have tended to settle for larger amounts (median settlements of $31.3 million and average settlements of $103.1 million) but for lower percentage of estimated "plaintiff-style" damages (3.2% on average compared to 4.9% for all cases). My compilation of all credit-crisis settlements can be accessed here.

 

Some readers may note slight variations between the averages and median settlement figures reported in the Cornerstone report compared to those reported elsewhere. Thought there are differences, the figures are directionally consistent. The differences may be due to a combination of timing and methodology. The Cornerstone report designates the settlement year as the year in which the hearing to approve the settlement was held. Cases involving multiple settlements are reflected in the year of the most recent partial settlement (subject to certain additional considerations).

 

Though all of the report’s findings are interesting and important and the report is well worth reading at length and in full, for me the most significant finding is the report’s conclusion about the dramatic increase in the size of the median settlement. Averages can be driven by outliers, but medians are more reflective of the overall direction of settlements in general.

 

The rapid increase in the median settlement amount has important implications for corporate insurance buyers as well as for their insurers, particularly at a time when costs of defense are also escalating rapidly. For buyers, the rising median settlement amount clearly has important implications for purposes of limits selection and limits adequacy. I think the unmistakable conclusion is that the questions of limits adequacy may now involve larger levels of insurance than may have been the case in the past.

 

For insurers, and particularly those insurers who more typically are involved in the excess layers, the rising median may have important implications for likely loss experiences. The clear implication is that higher attaching excess layers are increasingly likely to be called upon to participate in case resolution, particularly in light of rising costs of defense. Losses are likelier to push up into higher layers.

 

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Securities lawsuits rarely go to trial, but on February 24, 2011, just three months after the last securities suit trial concluded, a Central District of California rendered a verdict on behalf of plaintiffs against the sole trial defendant, the former CEO of the defunct Homestore company. The jury found that the defendant, Stuart H. Wolff, had violated the federal securities laws in connection with a series of statements the company made in 2001.

 

A copy of the jury verdict form can be found here. The court’s trial minutes for jury verdict can be found here. The February 25, 2011 press release about the verdict from the lead plaintiff, the California State Teachers’ Retirement System (CalSTRS), can be found here.

 

As detailed further here, investors first filed a securities class action lawsuit against the company and certain of its directors and officers in December 2001. CalSTRS was named as lead plaintiff in March 2002. Subsequent amended complaints named additional defendants, including the company’s auditor and certain other outside companies and entities.

 

Essentially, the plaintiffs alleged that the company had engaged in a scheme to create a circular flow of money through a series of roundtrip financial transactions whereby money flowed from Homestore to outside firms and then back to Homestore. Through these transactions, the company allegedly was able to represent itself as a successful and growing company. The company was later forced to restate more than $120 million in revenue.

 

During the course of the long and complicated procedural history of this case, a number of the defendants were dismissed out of the case, while other defendants, including the company itself, certain individual defendants, and the company’s outside auditor, entered into a series of settlements with the plaintiffs. On January 25, 2011, a civil jury trial commenced against the sole remaining defendant in the case – Stuart H. Wolff, the company’s former Chairman and CEO.

 

The jury returned its verdict on February 24, 2011. The Special Jury Verdict Form is very detailed and somewhat challenging to interpret. Basically, it appears that of the 22 allegedly misleading company statements on which the plaintiffs relied, the jury concluded ten were materially misleading. Of these, the jury found that Wolff was involved in the preparation of five of the statements, and that his involvement in those statements was knowing or reckless.

 

The jury also found with respect to four additional knowing or reckless misrepresentations that Wolff was responsible for the person making the statement, and therefore with respect to those four statements Wolff was subject to control person liability.

 

With respect to the question of damages, the jury found that a number of other company officials as well as Wolff were responsible, but in each case Wolff’s responsibility was 50% or greater. The jury also calculated the per share price inflation that resulted from each misrepresentation for which Wolff was responsible, in several cases calculating the inflation four places to the right of the decimal.

 

In its press release, CalSTRS said only that "the exact amount of damages is being calculated."

 

In some respects, the outcome of this jury trial may come as no surprise. In April 2010, Wolff was sentenced to four and a half years in prison after pleading guilty to conspiracy to commit securities fraud in connection with the company’s allegedly deceptive financial reporting. Wolff is incarcerated in the federal penitentiary in Lompoc, California, although he was transferred to facilities in Los Angles for the recent civil trial.

 

In addition, in December 2010, Wolff reached an $11.9 million agreement with the SEC, settling allegations that he had inflated the company’s reported revenues. As part of that settlement, Wolff did not admit to the SEC’s securities fraud allegations.

 

In light of these prior developments, the recent jury verdict may not be that surprising. But what is surprising is that the case went all the way to a jury trial at all. Trials in securities class action lawsuits are exceedingly rare, although there have been a rash of jury verdicts in recent months.

 

According to data compiled by Adam Savett, the Director of Securities Class Actions at the Claims Compensation Bureau, prior to the recent verdict against Wolff in the Homestore case, there had been a total of ten securities class action lawsuits filed after the 1996 enactment of the Private Securities Litigation Reform Act and involving post-PSLRA conduct that have gone to all the way through to jury verdict. In other words, the verdict against Wolff is just the eleventh verdict in a post-PSLRA securities class action lawsuit.

　

With the plaintiffs’ verdict against Wolff in the Homestore case, the securities class action jury verdict scoreboard (taking into account post-verdict proceedings and reflecting only the current status of post-verdict proceedings) is as follows: Plaintiffs 7, Defendants 4. (The scoreboard is subject to revision pending the outcome of additional proceedings in several of the cases.)

 

These numbers convey how rare securities lawsuit trials are. It is worth noting that the verdict in the Homestore case is the third in just thirteen months, coming as it does just three months after the verdict in the BankAtlantic case (about which refer here) and thirteen months after the verdict in the Vivendi case (refer here). My friends in the plaintiffs’ bar will undoubtedly be quick to point out that all three of these cases resulted in verdicts for the plaintiffs as well.

　

The histories of prior securities cases that have gone to trial show that verdicts in these cases are subject to extensive post-trial procedures. Indeed, just last week the Court in the Vivendi case entered an order substantially narrowing the scope (and value) of the plaintiffs’ verdict in that case. In all likelihood, there will be further developments in the Homestore case, particularly given the case’s long procedural history.

 

In addition to the prospect for post-trial procedural developments, the parties to the Homestore case also face a rather daunting challenge of trying to interpret and calculate the effect of the jury’s findings on damages. The combination the jury’s findings about Wolff’s proportionate level of responsibility and of its findings about the respective levels of per-share price inflation will require, in order to arrive at a precise dollar figure for damages, mathematical calculations approaching in terms of complexity the formulae used for calculating planetary motions.

 

Best Corporate Law Blogs: I am happy to report that Bschool.com included The D&O Diary in the site’s February 23, 2011 list of the 40 Best Corporate Law Blogs, which can be found here. The selection is all the more rewarding because the list includes so many other blogs that I respect and admire. My thanks to Bschool.com for the selection.　

 

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In the long-awaited rulings on the post-trial motions in the Vivendi securities case, Judge Richard Holwell has entered a February 22, 2011 order materially narrowing the plaintiff class based on the U.S. Supreme Court’s holding in Morrison v. National Australia Bank. A copy of Judge Holwell’s opinion, in which he eliminated ordinary shareholders from the class and further narrowed the class to only certain investors who purchased the company’s ADRs, can be found here.

　

The bulk of Judge Holwell’s 124-page opinion is taken up with the parties’ other post-trial motions, particularly Vivendi’s motion to set aside the verdict in whole or in part. Judge Holwell largely denied the motions. However, he declined to enter judgment for the plaintiffs, holding that Vivendi had the right to attempt to attempt to refute the presumption of reliance on an individual basis.

　

Background

Vivendi is one of the very rare securities class action cases to have gone to trial, and (as far as I know) the only case to have gone to trial involving so-called "f-cubed" claimants – that is, foreign domiciled shareholders of foreign companies who bought their shares on a foreign exchange. As discussed here, on January 29, 2010, following a four-month trial, a federal jury found that with respect to the 57 allegedly misleading statements at issue, Vivendi had violated Section 10(b). However the jury concluded that Vivendi CEO Jean-Marie Messier and CFO Guillame Hannezo had not violated Section 10(b).

　

The parties filed post-trial motions, and after the U.S. Supreme Court entered its opinion in Morrison v National Australia Bank, the parties submitted supplemental briefs.

　

With respect to the Morrison-related issues, it is important to note that during the relevant time period, Vivendi’s ordinary shares had traded only on the Paris Bourse. The company’s American Depositary Receipts (ADRs) were listed and traded on the NYSE. In its revised May 2007 order (here), the district court had certified a class in the Vivendi case consisting of Vivendi shareholders located in the U.S., France, England and the Netherlands.

　

The February 22, 2011 Opinion

In his February 22 opinion, Judge Holwell rejected the plaintiffs’ argument that because Vivendi ADRs were "listed" on the NYSE, the entire class of underlying shares (and not just the specific shares backing the ADRs) were "registered" with the SEC and therefore within the ambit of Section 10(b) (an argument on which the plaintiffs had elaborated in an earlier post on this blog, here).

　

Judge Holwell worked through the plaintiffs’ "listing" argument, an analysis that because somewhat abstruse as he labored with the complex factual questions whether or not the ordinary shares underlying the ADRs had somehow become "untethered" from the ADRs (perhaps through share redemptions or otherwise). Judge Holwell conceded that plaintiffs’ arguments did give him "pause," but ultimately he concluded that the argument "cannot carry the freight that plaintiffs ask it to bear."

　

Ultimately, Judge Holwell pushed past the complexity, and even stepped over the question whether Justice Scalia made a mistake in the way he used the word "listing" in the Morrison opinion. Judge Holwell finally dismissed the "listing" argument as "contrary to the spirit" of Morrison’s holding, citing with approval earlier district court opinions in the RBS case (refer here) and in the Alstom case (refer here), among others.

　

Judge Holwell also rejected the plaintiffs’ argument that Section 10(b)’s ambit extended to U.S. domiciled investors who purchased ordinary Vivendi shares outside the U.S (so-called "f-squared" claimants). In doing so, Judge Holwell, by his own account, joined other courts in "rejecting the argument that a domestic transaction occurs whenever the purchaser or seller resides in the United States." He observed that "there can be little doubt" that the phrase "domestic transaction" was "intended to be with relevance to the location of the transaction, not to the location of the purchaser."

　

On the basis of these Morrison-related rulings, Judge Holwell amended the class certification to exclude all purchasers of ordinary shares. As amended, the class certification includes persons in the U.S, France, England and the Netherlands who purchased or otherwise acquired Vivendi ADRs during the class period.

　

The (lengthy) balance of the opinion addresses the parties’ other post-trial motions, which Judge Holwell largely denied, except as to one of the 57 statements at issue, on which he granted Vivendi’s motion to set aside. Of particular interest, among Judge Holwell’s post trial motions is his conclusion that there want nothing fundamentally inconsistent about the jury’s finding of liability against Vivendi while at the same time finding no liability against the two individual defendants.

　

Finally, Judge Holwell denied plaintiffs’ motion for entry of judgment, holding that Vivendi was entitled to try to rebut the presumption of reliance as to individual investors.

　

Discussion

Given the prior district court rulings entered in the wake of Morrison, there is arguably nothing all that surprising about Judge Holwell’s Morrison-related rulings. To be sure, our friends in the plaintiffs’ bar had strong feelings about the "listed" argument, but at least one other judge had already rejected the argument, making Judge Holwell’s ruling that much less novel or noteworthy.

　

One issue that Judge Holwell did not address, because the parties apparently jointly conceded it, was the question whether or not the ADR transactions themselves did not did not come within the ambit of Section 10(b). At least one court has held, in light of Morrison, that ADR transactions are not "domestic transactions" within the meaning of Morrison. The Vivendi plaintiffs can at least be glad that they did not have the ADR transactions taken out of the class as well – there wouldn’t have been anything left.

　

But even with the ADR transactions (or at least some of them – see the discussion below) kept in the class, the class damages look materially smaller than they did when the verdict was first entered. At the time, the plaintiffs’ lawyers were quoted as saying that the aggregate class damages might be as much as $9.3 billion. In David Bario’s February 22, 2011 Am Law Litigation Daily article about Judge Holwell’s rulings (here), he quoted Vivendi’s counsel as saying that the effect of Judge Holwell’s rulings is to reduce the plaintiffs damages by 90%. (Of course, the 10% remaining still arguably represents a pretty big number – just not $9.3 billion.)

　

Though Judge Holwell substantially trimmed the class definition, the remaining class still has some rough edges as a result of the court’s prior class certification rulings. The complex process by which the court defined the class based on its determination that investors in certain countries might or might not enforce a securities law related judgment of a U.S. court is still a part of the revised class definition. Thus ADR investors in the U.S., France, England and the Netherlands are in the class, but not ADR investors in other countries (for example, Germany or Austria) are not . Though this particular issue does look different post Morrison, it is still a fundamental problem in the case left over from an earlier stage that is still out there as a potential source of further challenges, perhaps on appeal.

　

Judge Holwell’s final note about Vivendi’s right to rebut the presumption of reliance as to individual investors certainly poses some interesting procedural issues. It is not entirely clear how these issues are to be sorted out, although the possibility of individual trials certainly seems to be implied in Judge Holwell’s February 22 order. The possibility for further procedural wrangling seems high.

　

Special thanks to a loyal reader for sending along a copy of Judge Holwell’s ruling.

　

　

　

　

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In a settlement that has a number of interesting features, Satyam Computer Services, an Indian technology outsourcing company, has agreed to pay $125 million to settle the consolidated securities class action litigation pending against the company in Southern District of New York.

 

The only settling defendant is the company itself, which is now known as Mahindra Satyam. The settlement does not resolve claims against the individual defendants, including certain of the company’s former directors and officers, or against PricewaterhouseCoopers-related entities.

 

The settlement is subject to court approval, as well as other regulatory and governmental approval. A copy of February 16, 2011 settlement stipulation can be found here.

 

Background

Satyam was quickly dubbed the "Indian Enron" when it was revealed in January 2009 – in a stunning letter of confession from the company’s founder and Chairman -- that more than $1 billion of revenue that the company had reported over several years was fictitious. Investors immediately filed multiple securities class action lawsuits in the Southern District of New York.

 

The plaintiffs’ consolidated amended complaint alleges that in addition to fabricating revenues senior company officials siphoned off vast sums from the company to entities owned or controlled by the Chairman and members of his family. The defendants include ten former directors and officers of the company; certain entities affiliated with the company’s chairman and individuals associated with those companies; and certain PwC-related entities.The defendants filed motions to dismiss.

 

The Satyam Settlement

In the settlement stipulation, Satyam has agreed to pay $125 million into a settlement fund. The company, which is apparently funding the settlement entirely out of its own resources, is the only settling defendant. The claims against all of the other defendants remain pending.

 

In addition to the $125 million, Satyam also agreed to pay the settlement class 25% of any recovery the company may obtain against the PwC entities, in the event the company in its sole discretion decides to pursue a claim against the PwC entities.

 

There amount of plaintiffs’ attorneys’ fees specified or agreed to in the stipulation, however the settlement papers reflect that plaintiffs’ counsel intends to seek a fee award of 17% of the settlement fund, as well as out of pocket expenses not to exceed $2.5 million.

 

Lead counsel also intends to seek court approval to establish out of the settlement fund a $1 million litigation fund "to help pay for future litigation costs incurred during the continued litigation of the Action against the Non-Settling Defendants."

 

Discussion

There are a number of interesting things about this settlement, the first being its size. Even though it is only a partial settlement, the $125 million settlement amount would be tied for 69^th on the list of the all-time largest securities class action settlements.

 

Another very interesting feature of the settlement is that it resolves only the claims against the company – leaving all of the company’s former directors and offices in the lawsuit. These individuals include not only the company’s former Chairman and founder and his family members who were at the center of the scandal, but also the various outside individuals who were serving on the company’s board while the alleged fraud was going on. The suggestion seems to be that the current company management is prepared to leave all of the former board members hanging out there on their own.

 

The fact that the company apparently is also funding this settlement out of its own resources is also interesting. Shortly after the scandal broke, there were press reports that the company carried $75 million of D&O insurance. Of course, these press reports may have been mistaken. Or perhaps the insurance was unavailable to the company, either because the insurance did not include entity coverage or because the carriers are asserting coverage defenses. The possible availability of insurance raises the question whether the coverage is available for the individuals’ defense or any future settlements (assuming it has not already been depleted or exhausted by prior defense fees).

 

Another interesting component of the settlement is the composition of the settlement class to which the parties stipulated as part of the settlement. The class includes not only investors who bought the company’s American Depositary Shares on the NYSE, but also U.S. residents who bought ordinary company shares on Indian stock exchanges.

 

The interesting question is whether, in light of the U.S. Supreme Court’s holding in Morrison v. National Australia Bank, the U.S.-based investors who purchased their shares on the Indian exchange actually have claims they can assert under U.S. securities laws. (Indeed, the settlement stipulation expressly notes that the defendants had supplemented their pending motions to dismiss, seeking in reliance on Morrison to dismiss the claim of the U.S. residents who purchased their shares on the Indian exchanges.)

 

Several U.S. district courts (refer for example here and here) have already ruled that Morrison precludes Section 10(b) claims of so-called "f-squared claimants" – that is, U.S. residents who bought share of non-U.S. companies outside of the U.S. Nevertheless, the proposed settlement class includes these f-squared claimants. In other words, the proposed settlement class includes claimants who may or may not have the ability to assert claims under Section 10(b) in light of Morrison. Indeed, as the remaining defendants might even succeed in having those claimants’ claims dismissed as the case goes forward.

 

However, in recognition of the hurdles that these investors face, the settlement agreement provides that the U.S. investors who bought their shares on the Indian exchange will not receive the same proportion of compensation as the ADS investors.

 

As Alison Frankel notes in her February 17, 2011 Am Law Litigation Daily article about the settlement (here), common share holders will take a 90 percent discount on their potential recovery, by comparison to the ADS investors. The agreement states that this discount is "in recognition of additional legal hurdles facing U.S. residents who purchased Satyam ordinary shares on markets outside the United States in seeking to recover under federal securities laws." The estimated average recovery would be $1.36 per ADS and 6 cents per ordinary share.

 

But though the proposed class definition arguably includes a class of claimants broader than Morrison might prescribe, the proposed class does not include non-U.S. residents who purchased their Satyam shares on the Indian exchanges. These investors’ claims apparently are not resolved or even addressed by this settlement.

 

Another interesting feature of this settlement is the extent to which it seemingly encourages further litigation against the Non-Settling parties. The settlement not only includes the company’s agreement to pay the settlement class 25% of any recovery the company may obtain from the PwC entities, but it also includes a $1 million war chest for the claimants to use in order to continue their claims against the other defendants. This settlement might be good news for Satyam and for the settlement class, but it seems like bad news for the remaining defendants and for the PwC entities.

 

In other words, the company may be settling, but this case is far from over.

 

Bankruptcy and D&O Insurance: On March 2, 2011 at from 1:00 pm EST to 2:30 EST, the Torts and Insurance Practice Section of the American Bar Association will be sponsoring a teleconference on the topic of "D&O Insurance in the Context of Bankruptcy." The teleconference will feature a number of distinguished speakers, including my good friend Perry Granof. Information about the teleconference can be found here.

 

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In a February 10, 2010 opinion (here), the Second Circuit reversed the lower court’s dismissal of the securities class action lawsuit relating to The Blackstone Group’s June 2007 IPO. The decision, which represents a noteworthy victory for plaintiffs, contains an extensive analysis of "materiality" requirements and could prove significant in the many other pending cases alleging misrepresentations or omissions regarding the subprime meltdown and the ensuing deterioration of the financial marketplace.

 

Background

Blackstone, a leading asset manager and financial advisory firm, conducted an IPO in June 2007. As reflected here, in April 2008, investors who had purchased securities in the offering filed the first of several securities class action lawsuits against Blackstone and certain of its directors and officers, alleging that the company had made material misrepresentations and omissions in its IPO offering documents.

 

The investors alleged that at the time of the offering, Blackstone knew that two of its portfolio companies (FGIC Corporation, a monoline financial guarantor, and Freescale Semiconductor), as well as its real estate fund investments, were experiencing problems. The investors allege that the defendants knew that these problems could subject the company to a claw-back of performance fees or result in reduced performance fees. The defendants moved to dismiss.

 

In a September 22, 2009 order (here), Southern District of New York Judge Harold Baer, Jr. granted the defendants’ motions to dismiss, holding that the alleged misrepresentations or omissions regarding FGIC and Freescale were neither quantitatively nor qualitatively material, and further holding that the alleged misrepresentations regarding Blackstone’s real estate investments were insufficient because the plaintiffs’ allegations failed to specify how the residential mortgage woes would have a foreseeable material effect on Blackstone’s real estate investments. The plaintiffs appealed.

 

The February 10 Order

In an opinion written by Judge Chester J. Straub for a three judge panel, the Second Circuit reversed the district court, holding that the lower court had erred in dismissing the plaintiffs’ complaint.

 

The Second Circuit’s analysis focused on Blackstone’s obligation under Item 303 of Reg. S-K to disclose material risks, trends and uncertainties that could affect the firm’s financial results.

 

In holding that the complaint’s allegations regarding the offering documents’ omission in connection with Blackstone’s investments in FGIC and Freescale met both the quantitative and qualitative materiality requirements, the Court rejected Blackstone’s argument that a loss in one of its portfolio companies might be offers by a gain in another. "Blackstone," the Court said, "is not permitted, in assessing materiality, to aggregate the negative and positive effects on its performance fees in order to avoid disclosure of a particular negative event."

 

The Court added that "were we to hold otherwise, we would effectively sanction misstatements in a registration statement or prospectus related to particular portfolio companies so long as the net effect on revenues of a public private equity firm like Blackstone was immaterial." The question is not whether an investment’s loss in value will affect revenues but the firm "expects the impact to be material."

 

In concluding that the district court had erred in holding that the plaintiffs’ allegations did not satisfy the qualitative materiality requirements, the Court noted that the firm’s Corporate Private Equity division was the firm’s "flagship segment," adding that because the segment "plays such an important role in Blackstone’s business and provides value to all of its other asset management and financial advisory services," a reasonable investor "would almost certainly want to know information related to that segment that Blackstone reasonable expects will have a material adverse effect on its future revenues."

 

The Court added that it could not conclude that Freescale’s loss of an exclusive contract with it larges customer was immaterial in connection with one of the firm’s Corporate Private Equity firm’s largest investments. The Court noted that the failure to disclose the negative developments at FGIC and Freeescale "masked a reasonably likely change in earnings, as well as a trend, event or uncertainly that was likely to cause such a change."

 

With respect to Blackstone’s real estate investments, the Court held that the district court erred in concluding that the plaintiffs’ allegations were deficient because they failed to identify specific real estate investments that might have been at risk. The Court said:

 

This expectation …misses the very core of plaintiffs’ allegations, namely that Blackstone omitted material information it had a duty to report. In other words, plaintiffs’ precise, actionable allegation is that Blackstone failed to disclose material details of its real estate investments, and specifically that it failed to disclose the manner in which those unidentified, particular investments might be materially affected by the then-existing downward trend in housing prices, the increasing default rates for sub-prime mortgage loans, and the pending problems for complex mortgage securities.

 

The Second Circuit concluded that "plaintiffs provide significant factual detail about the general deterioration of the real estate market and specific facts , that drawing all reasonable inference in plaintiffs’ favor, directly contradict statements made by Blackstone in the Registration Statement."

 

Finally, the Court rejected the suggestion that the plaintiffs’ view of materiality would require investment firms like Blackstone to issue compilations of prospectuses of every portfolio company or real estate asset in with the firm has any interest. In order for omitted information to give rise to a claim under the ’33 Act, the reporting company would have to have an obligation (for example under Item 303 of Reg. S-K) to disclose the information and the omitted information would have to be "deemed material."

 

Discussion

The Second Circuit’s opinion in this case represents both a noteworthy victory for the plaintiffs and a development with potential significance for the many other subprime meltdown and credit crisis-related securities pending in Second Circuit.

 

It is not just that the district court’s dismissal was overturned, although that obviously is of most immediate significance for the parties involved. Rather, it is that the reversal was an act of the Second Circuit, to which all of the District Courts in the Southern District of New York – where so many cases are filed -- are answerable.

 

So many of the cases growing out of the subprime meltdown and the credit crisis were, like this case, filed in the Southern District of New York. As these cases have proceeded to the motion to dismiss stage, the courts have struggled with what is required to be alleged in order to survive the motion to dismiss. And although not all of the cases turn on questions of materiality, when materiality questions arise, the Second Circuit’s opinion in the Blackstone case could be important, particularly for plaintiffs in ’33 Act cases.

 

The Second Circuit emphasized that, in its view, materiality requirements may be satisfied relatively easily. The Court emphasized at the outset that a ’33 Act complaint "need only satisfy the basic notice pleading requirements" adding that "where the principal issue is materiality, an inherent fact-specific finding, the burden on plaintiffs to state a claim is even lower." With the Second Circuit specifying only minimal pleading requirements, the threshold standard, at least as far as materiality, should become less onerous for plaintiffs – at least in ’33 Act claims.

 

The significance of this is perhaps best seen with respect to the plaintiffs’ allegations concerning Blackstone’s real estate asset investments. Although the district court found that the allegations failed to link the general real estate downturn to Blackstone’s specific real estate investments, in essence the Second Circuit found the plaintiffs’ allegations about the general real estate downturn to be sufficient and required a relatively slight connection between these generalized allegations and Blackstone’s own circumstances.

 

Given that, at least in this case and under the circumstance alleged, allegations about the generalized real estate downturn were found to be sufficient could give heart to other plaintiffs in other subprime meltdown and credit crisis-related securities suits. The complaints in many of these other cases often contain extensive accounts of the generalized real estate downturn. These other plaintiffs will undoubtedly seek to rely on the Second Circuit’s opinion in the Blackstone case, at least in order to show that their allegations satisfy the materiality requirements.

 

All of that said, it should also be noted that a critical feature of this case is Blackstone's status as a publicly traded private equity firm. Both the district court and the Second Circuit were trying to deal with the threshold issues of what a firm like Blackstone has to disclose about its private equity portfolio investments. This aspect of the case arguably could limit the applicability of the Second Circuit's opinion. (I will say as an aside that the Second Circuit's supposedly reassuring words at the end of the Opinion that a firm like Blackstone would not have compile prospectuses of all of its portfolio companies are both unconvincing and unhelpful. The problem is that if materiality is as broad as the Second Circuit suggests, it is very difficult to find the outer edge of what a firm like Blackstone might have to disclose about its portfolio companies.)

　

The fact that the plaintiffs prevailed in their appeal in the Blackstone case may be noteworthy in and of itself. Up to this point, the plaintiffs’ appellate track record in securities suits related to the credit crisis was, well, not particularly encouraging for them. As reflected here, the plaintiffs had failed to overturn dismissals in the first three credit crisis securities appellate decisions, although just last month the plaintiffs in the Nomura Securities subprime-related securities suit did succeed in overturning one part of the dismissal of that case. Plaintiffs generally will take heart from the success in overturning the Blackstone lawsuit dismissal on appeal.

　

The Second Circuit’s reversal serves as a reminder that it may be dangerous to jump to too many conclusions about how plaintiffs are faring in the subprime and credit crisis related cases. There are still many more cases to be heard, and, as this case shows, there is always the possibility that further proceedings may alter or even undo prior results.

 

David Bario’s February 10, 2011 Am Law Litigation Daily article about the Blackstone decision can be found here. Peter Lattman's post on the Dealbook blog about the decision can be found here.

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The storm has passed and the sun is shining down on chilly Times Square for the second day of the PLUS D&O Symposium. For those at the conference and for those stranded at home by the weather, I wanted to pass along a couple of links as an accompaniment for today’s conference panels.

 

First, I wanted to pass along a link to a podcast posted yesterday on the webpage for the LexisNexis Corporate and Securities Law Community. The podcast, in which I discuss trends in corporate and securities litigation during 2010, can be found here. The podcast content provides a complement to the discussion during yesterday’s first panel at the conference.

 

Second, for those of you who have not seen it already, I wanted to make sure to pass along a link to the February 2011 Advisen report entitled "Merger Objection Lawsuits: A Threat to Primary D&O Insurers?" The report, which can be found here, provides useful statistical detail and additional commentary regarding the growing levels of M&A related litigation. Full disclosure: I provided commentary for the Advisen report.

 

To those at the conference, enjoy the rest of the day. Please say hello if we have not yet had a chance to meet yet.

 

By the way, I took the picture of Times Square accompanying this post this morniing using my camera phone. "I want to wake up/ in a city/ that doesn't sleep..."

 

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