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

In what the plaintiffs’ lawyers claim to be the largest derivative lawsuit settlement ever, the parties to the News Corp. shareholder derivative litigation have agreed to settle the consolidated cases for $139 million. The company also agreed to tighten oversight of the company’s operations and to establish a whistleblower hotline, as well as other corporate therapeutics. The cash portion of the settlement is to be funded entirely by D&O insurance. The settlement is subject to court approval.

 

The parties’ April 17, 2013 memorandum of understanding regarding the settlement can be found here. The plaintiffs’ lawyers’ April 22, 2013 press release in which, among other things, the plaintiffs’ lawyers state that the settlement is “the largest cash derivative settlement on record” can be found here. The lead plaintiffs’ press release can be found here. As reflected in the press releases as well as is stated in the many media reports about the settlement (refer for example, here), the entire cash portion of the $139 million settlement is to be funded by D&O insurance.

 

The first of the lawsuits against the News Corp. board was filed in Delaware Chancery Court in March 2011, asserting claims in connection with the company’s $675 million acquisition of Shine Group, Ltd., a U.K.-based television production company owned by Elizabeth Murdoch, daughter of News Corp. Chairman Rupert Murdoch. Elizabeth Murdoch allegedly made $250 million in the acquisition.. Later complaints expanded on claims relating to the Shine Group acquisition and  added extensive additional claims seeking to hold the company’s directors accountable for the scandal surrounding the company’s use and attempted cover-up of illegal reporting tactics of some News Corp. journalists in the U.K. The various cases were later consolidated in the Delaware Chancery Court.

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In their Third Amended Consolidated Complaint (here), the plaintiffs alleged that the company’s board’s oversight of the company’s affairs represented a “textbook example of failed corporate governance and domination by a controlling shareholder.” The complaint alleges that for years “the Board has condoned Murdoch’s habitual use of News Corp. to pursue his quest for power, control and political gain and to enrich himself and his family members, at the Company’s and its public shareholders’ expense.” The complaint alleges that the ongoing scandals have not only harmed the company’s reputation and cost it millions of defense costs and other expenses, but also that the company’s share price is artificially depressed because of the negative association of the company with Murdoch.

 

The defendants filed a motion to dismiss the consolidated amended complaint. The parties argued the motion to dismiss on September 19, 2012 (refer here). While the dismissal motion was pending, the parties engaged in mediation that ultimately resulted in settlement.

 

The plaintiffs’ lawyers claim that this is the largest cash shareholders’ derivative settlement ever, and I am certainly in no position to dispute that. I have been tracking derivative suit settlements for years. There have been several shareholder derivative suit settlements that were nearly as large as the News Corp. settlement but as far as I can tell none that were quite as big:

 

• The El Paso/Kinder Morgan merger-related derivative suit settled in September 2012 for $110 million (refer here)

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• In 2005, the Oracle derivative suit settled based on the payment by Oracle CEO Larry Ellison of a total of $122 million (refer here and here).

 

• In September 2009, the parties to the Broadcom Corp. options backdating-related shareholders’ derivative suit agreed to settle the case, as to most but not all of the defendants, for the D&O insurers’ agreement to pay $118 million (as discussed here).

 

• In September 2008, the parties to the 2002 AIG shareholders’ derivative lawsuit agreed to settle the case for a payment of $115 million (of which $85.5 million was to paid by D&O insurance) in what was touted at the time as the largest Delaware Chancery Court derivative lawsuit settlement (about which refer here).

 

These settlements are all dwarfed by the  $2.876 billion judgment entered in June 2009 against Richard Scrushy in the HealthSouth shareholders' derivative lawsuit in Jefferson County (Alabama) Circuit Court, but that astronomical judgment represents its own peculiar point of reference, like some odd parallel universe. It also was of course a judgment following trial rather than a settlement.

 

Another peculiar point of reference is the $1.262 billion judgment that Chancellor Leo Strine entered in October 2011 the Southern Peru Copper Corporation Shareholder Derivative Litigation (about which refer here). That case also represents its own form of litigation reality, and it too represents a derivative suit judgment following trial, rather than a settlement.

 

Another derivative lawsuit resolution that is worth considering in the context of the “largest ever” question is the December 2007 settlement of the UnitedHealth Group options backdating-related derivative lawsuit. As discussed here, the lawsuit settled for a total nominal value of approximately $900 million. However, while the press reports at the time described the settlement as the largest derivative settlement ever, the value contributed to the settlement consisted of the surrender by the individual defendants of certain rights, interests and stock option awards, not cash value in that amount.

 

Aside from the question of the News Corp. derivative suit settlement’s sheer size, there is also the fact that the settlement was funded entirely by D&O insurance. Given the amount of the settlement, the settlement costs undoubtedly were distributed across the several carriers that participated in News Corp.’s D&O insurance program. This large settlement not only represents a serious and unwelcome development for the specific carriers involved but it also represents a potentially unwelcome event for the D&O insurance industry in general, for what it might represent as far as the severity potential of shareholders’ derivative litigation.

 

In the past, going back ten years or so, shareholders’ derivative suits typically did not present the possibility of significant cash payouts for D&O insurers, at least in terms of settlements or judgments. The cases did present the possibility of significant defense expense and also of the possibility of having to pay the plaintiffs’ attorneys’ fees, but by and large there was usually not a cash settlement component. As the significant examples above show, that has clearly changed in more recent years.

 

This trend gained particular momentum with the options backdating scandal. Many of the options backdating cases were filed as derivative suits rather than as securities class action lawsuits (largely because the options backdating disclosures did not always result in the kinds of significant share price declines required to support a securities class action lawsuit). Many of the options backdating cases settlements included a cash component, and as illustrated by the Broadcom case mentioned above, some of the options backdating derivative suit settlements included very substantial cash components

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The inclusion of a significant cash component has also been a feature of the settlements of some of the merger objection suits that have been filed as part of the current upsurge in M&A-related lawsuit that have been filed in recent years, as illustrated by the El Paso settlement mentioned above.

 

This upsurge in the number of derivative suit settlements that include a significant cash component can only be viewed with alarm by the D&O insurance industry. For many years, D&O insurers have considered that their significant severity exposure consisted of securities class action lawsuits. The undeniable reality is that in at least some circumstances, derivative suits increasingly represent a severity risk as well. And the settlement amounts themselves represent only part of the D&O insurers’ loss costs. The D&O insurers also incur millions and possibly tens of million of defense cost expense in these derivative suits. I can only imagine that in the News Corp. derivative suit, for example, that the cumulative defense expense was in the millions of dollars.

 

An even more concerning aspect of the rise of significant cash settlements in derivative cases for D&O insurers is that these settlement amounts represent so-called “A Side” losses. That is, the losses are paid out under the portion or the D&O insurance policy that provide insurance for nonindemnifiable loss. A derivative suit settlement obviously is not indemnifiable, because if it were to be indemnified, the company’s would make the indemnity payment to itself. For the “traditional” D&O insurance carriers, there is perhaps no particular pain associated with the fact that the loss is paid under the “Side A” portion of the policy, as opposed the other policy coverage (that is, the “Side B” or “Side C” coverage that are more typically called into play). But these days many companies carry --in addition to their traditional D&O insurance that includes all three coverages (that is, they include Sides A, B and C coverage) -- additional layers of excess Side A insurance.

 

This excess Side A insurance would not be available to provide funding for, say, a securities class action lawsuit, at least if the corporate defendant were solvent, because the settlement of a securities class action lawsuit is an indemnifiable loss to which coverages B and C might apply but to which coverage A does not apply. However, the Side A coverage does apply to a shareholders’ derivative lawsuit settlement because the settlement amount represents a nonindemnifiable loss. So while a jumbo securities class action settlement typically would not trigger coverage under an Excess Side A policy, a jumbo derivative settlement would trigger the Excess Side A policies.

 

The question for the carriers providing this type of excess Side A insurance is whether or not the premiums they are getting are adequate to compensate them for the risks of the kinds of losses associated with large cash shareholders derivative settlements. By and large, the carriers providing this insurance consider that their most significant exposure is related to claims in the insolvency context. But as this settlement and the Broadcom settlement mentioned above demonstrate, it is also possible that the Side A insurance can be implicated in a jumbo derivative settlement as well as in a settlement in the insolvency context.

 

The increasing risk of this type of settlement represents a significant challenge for all D&O insurers, but particularly for those D&O insurers concentrating on providing Excess Side A insurance. Those insurers will have to ask how they are to underwrite the risks associated with these kinds of exposures, and how they are to make certain that their premiums adequately compensate them for the risk.

 

Dan Fisher has an interesting April 22, 2012 article in Forbes (here) discussing the questions associated with the funding of this type of settlement exclusively through D&O insurance.

 

Finally, as Alison Frankel points out in an April 22, 2013 post on her On the Case blog (here), the News Corp. settlement includes what she describes as an “historic concession”: in the settlement, News Corp. agreed “to disclose its campaign and political action committee contributions to shareholders and its lobbying and Super PAC spending to the board.” Frankel quotes sources to the effect that the News Corp. case represents the first time that a derivative lawsuit has been used as a vehicle to obtain enhanced disclosure of corporate political spending.

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One of the more vexing litigation problems to emerge recently has been the proliferation of multi-jurisdiction litigation, where corporate defendants are forced to litigate essentially the same claim in multiple courts at the same time. This problem is a particular issue in the context of M&A litigation, although not contained to those kinds of lawsuits. In the midst of what has become essentially a jurisdictional competition, Delaware’s courts have tried to establish themselves as the preferred and presumptive court for corporate litigation.

 

As discussed here, in June 2012, in a high-profile and controversial example of the efforts of Delaware courts to control litigation involving Delaware corporations, Vice Chancellor Travis Laster refused to give effect to the judgment of a California federal court dismissing a derivative suit parallel to the case pending in Delaware.

 

However, in a harsh rebuke to Laster, on April 4, 2013, the Delaware Supreme Court entered an opinion reversing the Chancery Court ruling and recognizing the California federal court’s prior dismissal. The Supreme Court’s opinion represents a recognition that principles of federalism and comity require Delaware’s courts to respect the preclusive effects of the California court’s judgment.

 

Background

In September 2010, Allergan pled guilty to a criminal misdemeanor for misbranding its Botox product and paid a total of $600 million in civil and criminal fines. Various plaintiffs’ firms filed multiple derivative suits both in federal court in California and in Delaware Chancery Court. The California cases went forward more quickly, while in Delaware, at least one of the plaintiffs sought to pursue a books and records action against the company, in order to obtain further information pertinent to the company’s board’s actions. The Delaware plaintiff used the information and documentation to amend its complaint. The California plaintiffs ultimately also obtained the same information and documentation and supplemented their complaint as well.

 

The defendants moved to dismiss the California action on the ground that the plaintiffs had not made a demand on the Allergan board to pursue the claims, nor had they established demand futility. The California court granted the defendants’ motion to dismiss. The defendants then sought to have the Delaware action dismissed, arguing that the collateral estoppel effect of the California dismissal was preclusive of the demand futility issue.

 

In an extensive June 11, 2012 opinion (here), Vice Chancellor Laster firmly rejected the suggestion that the California court’s prior ruling compelled him to dismiss the Delaware action. He relied on two grounds in rejecting the argument that the California judgment is preclusive; first, he found that the California judgment was preclusive only as to the individual California shareholder plaintiffs, and second, he found that the California plaintiff did not adequately represent Allergan. The defendants pursued an interlocutory appeal to the Delaware Supreme Court.

 

The April 3, 2013 Opinion

In an April 4, 2013 opinion written by Justice Carolyn Berger for the full Court, the Delaware Supreme Court reversed the Chancery Court’s ruling, holding that the Vice Chancellor had erred with respect to both aspects of his ruling. The Supreme Court concluded that the California judgment was preclusive of the Delaware case and also rejected Vice Chancellor Laster’s conclusion that the California plaintiffs were inadequate representatives.

 

In rejecting the Chancery Court’s conclusion that the California judgment was not preclusive, the Supreme Court noted that the U.S. Constitution’s full faith and credit clause requires courts to give full force and effect to the judgments of other jurisdiction’s courts, including the judgments of federal courts. Vice Chancellor Laster’s refusal to give effect to the California judgment was based on a “mistaken premise” that the question of the effect of the California judgment was controlled by “demand futility” law controlled by Delaware legal principles.

 

The Supreme Court stated that “once a court of competent jurisdiction has issued a final judgment … a successive case is governed by principles of collateral estoppel, under the full faith and credit doctrine, and not by demand futility law,” adding that “in the Court of Chancery, the motion to dismiss based on collateral estoppel was about federalism, comity, and finality. It should have been addressed exclusively on that basis.’  Delaware’s “undisputed interest” in governing the internal affairs of its corporations “must yield to the stronger national interests that all state and federal courts have in respecting each other’s judgments.”

 

The Supreme Court also rejected the Chancery Court’s conclusion that the California plaintiffs were inadequate plaintiffs. The Supreme Court noted that Vice Chancellor Laster had “sua sponte announced and applied an irrebutable presumption that derivative plaintiffs who file their complaints without seeking books and records very shortly after the announcement of a ‘corporate trauma’ are inadequate representatives.” The Supreme Court said that “we reject the ‘fast filer’ irrebutable presumption of inadequacy.” The Court noted that “undoubtedly there will be cases where a fast filing stockholder also is an inadequate representative” but that “there is no record support for the trial court’s premise that stockholders who filed quickly, without bringing a Section 220 books and records action, are a priori acting on behalf of their law firms instead of the corporation.” The Court added that although it “understands the trial court’s concerns about fast filers,” the remedies “for the problems they create should be directed at the lawyers, not the stockholder plaintiffs or their complaints.”

 

Discussion

As I discussed at the time, Vice Chancellor Laster’s opinion in this case was a broadside against certain segments of the plaintiffs’ bar, who, in his view, rush to file actions in other jurisdictions’ courts, to the detriment of litigants that proceeded more deliberately by first pursuing a books and records action in Delaware court and then in due course filing an action in Delaware based on the results of the books and records search.

 

While Laster’s effort to create a Delaware-centric solution to the chaos of multi-jurisdiction litigation is understandable, it put the defendants in the unacceptable position not only have having to face a multi-front war,  but also having to fight the war in piecemeal fashion, rather than trying to move toward a single, comprehensive solution.

 

The Supreme Court’s opinion does not directly take on the problems arising from multi-jurisdiction litigation, but merely recognizes that basic principles of “federalism, comity and finality” required that the judgment of California court be given full force and effect. However, the Supreme Court did reject the Chancery Court’s suggestion that the plaintiffs in the California case were inadequate representatives simply because they failed to first pursue a books and records action before launching their suit. As Alison Frankel noted in an April 5, 2013 post on her On the Case blog (here), the Supreme Court Opinion “puts an end to Chancery’s recent insistence that shareholder lawyers seek corporate books and records before filing derivative complaints.”

 

In effect, Laster’s Chancery Court opinion seemingly embodied a belief that both that Delaware’s courts should be in charge, and that if the Delaware courts were in charge, an orderly process would replace the unseemly spectacle of multi-jurisdiction litigation. There is no doubt that the curse of multi-jurisdiction litigation imposes enormous, duplicative costs on the litigation targets. But Vice Chancellor’s Delaware-centric manifesto threatened to exacerbate the problem rather than solve it, presenting as it did the prospect for multiple conflicting rulings in different jurisdictions on identical issues.  The Supreme Court’s opinion suggests a recognition that the curse of multiple-jurisdiction litigation won’t be resolved by Delaware’s courts grabbing authority or disdaining other courts. 

 

In its April 4, 2013 client alert (here), the Wachtell Lipton law firm noted that the Delaware Supreme Court’s ruling “makes clear that Delaware is sensitive to the unfairness that multiple parallel lawsuits can work on corporations and their directors and is prepared to enforce scrupulously rules of interstate comity that limit this mischief.”

 

The Delaware Supreme Court's decision is a welcome outcome for corporate litigants. As the Wilson Sonsini law firm noted in its April 2013 client alert about the decision, the ruling "may calm the concerns of those facing multi-forum shareholder litigation that a resolution on the merits in one forum will be given preclusive effect in Delaware (and presumably other jurisdictions)."

 

Just the same, though defendants undoubtedly will welcome the Delaware Supreme Court’s ruling, it will not eliminate the problem of multiple-jurisdiction litigation. The unseemly scramble of competing claimants to pursue claims against companies experiencing adverse developments or involved in corporate transactions will continue. The solution to the problem of multi-jurisdiction litigation has been and remains particularly elusive.

 

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In the current global economy, many companies have operations and assets in far-flung corners of the world. These geographically dispersed arrangements have a number of implications for the concerned companies. According to a recent decision from the Delaware Court of Chancery, the arrangements may also have important implications of these companies’ outside directors, at least for those companies organized under Delaware law. These implications could include heightened responsibilities and even heightened liability exposures that may come as a surprise to some outside directors.

 

These issues arose at a February 6, 2013 Delaware Court of Chancery hearing before Chancellor Leo E. Strine, Jr. in a shareholders’ derivative lawsuit involving Puda Coal, a Delaware corporation with significant operations in China. As a clear from the hearing transcript (a copy of which can be found here, Hat Tip to the Delaware Corporate & Commercial Litigation Blog) the parties at the hearing conceded that one of the Chinese members of the board –and at the time of the hearing, the sole remaining board director – had, in the words of Chancellor Strine “stolen” significant assets from the company, and that the “theft” had gone undetected for an extended period of time. (Further background regarding these events can be found here.) After the misappropriation of corporate assets was discovered (apparently by an online analyst) and after the two outside company directors who were represented at the hearing were unable to get answers to their questions, the two individual directors had resigned.

 

The shareholders’ derivative suit had been filed before the two individuals had resigned. The two individuals moved to dismiss the suit, arguing that the plaintiffs had failed to make the requisite demand on the company’s board, and also arguing that the plaintiffs had failed to state a claim on which relief could be granted.

 

Chancellor Strine largely denied the defendants’ motions, granting the motion (with leave to amend) solely with respect to the plaintiffs’ unjust enrichment claims. Chancellor Strine was particularly contemptuous of the defendants’ demand failure arguments, given that upon uncovering the problems at the company, the individuals did not take up the suit against the wrongdoer, but rather quit, which had the effect of leaving the alleged wrongdoer as the sole remaining director.

 

In rejecting the defendants’ motion in this regard, Chancellor Strine called the defendants’ arguments “astonishing” particularly since the if the motion were to be granted “control of the entire lawsuit” belongs to the remaining director’s determination. Among other things, Chancellor Strine invoked Kafka to characterize the result that the individual defendants sought in their demand failure argument.

 

The far more significant portion of Chancellor Strine’s discussion of the defendants’ dismissal motion has to do with his rejection of the defendants’ arguments that the plaintiffs had failed to state a claim. In rejecting the defendants’ arguments, Chancellor Strine articulated a vision of responsibility for independent directors of companies with overseas operations or assets that I think might come as a shock to many outside directors; he said that

 

If you’re going to have a company domiciled for purposes of its relations with investors in Delaware and the assets and operations of the company are situated in China that, in order for you to meet your obligation of good faith, you better have your physical body in China an awful lot.  You better have in place a system of controls   to make sure that you know that you actually own the assets. You better have the language skills to navigate the environment in which the company is operating. You better have retained accountants and lawyers who are fit to the task of maintaining a system of controls over a public company

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This is a very troubling case in terms that, the use of a Delaware entity in something along these lines. Independent directors who step into these situations involving essentially the fiduciary oversight of assets in other parts of the world have a duty not to be dummy directors. I’m not mixing up care in the sense of negligence with loyalty here, in the sense of our duty of loyalty. I’m talking about the loyalty issue of understanding that if assets are in Russia, if they’re in Nigeria, if they’re in the Middle East, if they’re in China, that you’re not going to be able to sit in your home in the U.S. and do a conference call four times a year and discharge your duty of loyalty. That won’t cut it.

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If it’s a situation where, frankly, all the flow of information is in the language that I don’t understand, in a culture where there’s, frankly, not legal strictures or structures or ethical mores yet that may be advanced to the level where I’m comfortable? It would be very difficult if I didn’t know the language, the tools. You better be careful there. You have a duty to think.

 

Chancellor’s comments appear in a hearing transcript and not in written order, but as Francis Pileggi notes in a February 19, 2013 post on his Delaware Corporate and Commercial Litigation Blog about the ruling in the Puda Coal case (here), in Delaware courts, transcript rulings can be cited in the briefs.

 

As Tariq Mundiya of the Willkie Farr law firm noted in a February 23, 2013 post about the case on the Harvard Law School Forum on Corporate Governance and Financial Regulation (here), Chancellor Strine’s ruling “highlights the risks and challenges that may exist for directors of Delaware corporations with significant foreign assets or operations.”

 

Chancellor Strine articulates a very broad vision of independent directors’ oversight responsibilities for Delaware companies’ foreign operations or assets. The expectation that independent directors physically visit and inspect the foreign operations and also speak the local language in the foreign locations may come as something of a shock to many outside directors. These days many companies have operations in multiple companies; larger companies have operations around the world. Chancellor Strine’s expectation that outside directors must be both regularly physically present and culturally literate in the each of the locations of the company’s overseas operations may represent a vision of board responsibility that likely would exceed the expectations of many company directors.

 

As if that were not enough, Chancellor Strine also had words about the independent directors’ decisions to resign. As he said, “there are some circumstances in which running away does not immunize you. In fact it involves a breach of fiduciary duty.” He added that “if these directors are going to eventually testify that tat the time that they quit they believed that the chief executive officer of the company had stolen assets out from under the company, and they did not cause the company to sue or do anything, but they simply quit, I’m not sure that that’s a decision that itself is not a breach of fiduciary duty. And that’s another reason for sustaining the complaint.”

 

To be sure, this case involved admittedly extreme circumstances. And arguably Strine’s comments could be limited to cases in which a company’s assets or operations are exclusively concentrated in a single foreign country. But the sweeping vision of independent directors’ oversight responsibilities for their companies’ overseas operations -- premised as it is on the presumption that it is the job of the directors to try to prevent what happened here – arguably could require a complete overhaul of the way that the boards of global companies think about their directors’ responsibilities. At a minimum, the requirements for a regular physical presence and a cultural literacy in the locations where a Delaware company has operations or assets may far exceed the expectations of many independent board members. If Strine’s vision of board oversight responsibilities were to become established and come to represent the Delaware standard, it could require a substantial revision of the way that many Delaware boards and directors think about their board responsibilities.  

 

At a minium, I expect that Chancellor Strine's comments will launch a discussion on the question of directors' roles in overseeing a company's far-flung operations. The hot topic for directors used to be financial literacy. Perhaps the question will soon become language fluency and cultural literacy.

 

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The Deepwater Horizon platform explosion and oil spill took place in the Gulf of Mexico, about 250 miles southeast of Houston. The environmental damage took place in the Gulf and along the Gulf shore in the Southeastern United States. When BP’s shareholders tried to sue the board of directors of BP -- a corporation organized under the laws of England -- in a derivative suit filed in federal court in the U.S. alleging breaches of fiduciary duty, they clearly hoped their suit would do better in a court closer to the site of the disaster and ensuing spill. But the district court dismissed the suit on forum non conveniens grounds. In a January 16, 2013 opinion (here), a three-judge panel of the Fifth Circuit affirmed the dismissal.

 

As discussed here, plaintiffs filed the first of several derivative lawsuits in connection with the Deepwater Horizon oil spill in May 2010. Though many of the lawsuits were first filed in the Eastern District of Louisiana, the cases were ultimately consolidated through the multidistrict litigation process in the Southern District of Texas. However, while the lawsuits were filed in U.S. courts, they asserted claims under the U.K. Companies Act 2006 (about which refer here). The defendants moved to dismiss the consolidated derivative litigation in the grounds of forum non conveniens.

 

In a September 15, 2011 ruling, Judge Keith Ellison of the Southern District of Texas determined that, notwithstanding the fact that the Deepwater Horizon disaster took place in the U.S. and caused extensive environmental damage here, “the English High Court is a far more appropriate forum for this litigation,” and accordingly he granted the defendants’ motion to dismiss the cases.  Judge Ellison’s decision can be found here. My prior post discussing Judge Ellison’s opinion can be found here.

 

In its January 16 per curiam opinion, the Fifth Circuit panel affirmed the district court’s decision, concluding that the lower court had not abused its discretion in granting the dismissal on forum non conveniens grounds.

 

Among other things, the Fifth Circuit reviewed the multipart analysis a district court must use in order to determine whether or not to dismiss a case on forum non conveniens grounds. Among the most important of considerations is whether or not there is an alternative forum where the matter can be heard. In order to satisfy the availability requirement, the district court had conditioned its dismissal on the Defendants filing a stipulation that they would submit to the jurisdiction of the English courts, which the Defendants had done. The Fifth Circuit concluded that the stipulation satisfies the availability requirements.

 

Another important consideration a district court must consider in connection with a motion to dismiss on forum non conveniens grounds is the existence of a local interest in the dispute. The Fifth Circuit concluded that the district court had not abused its discretion in determining that, because this dispute was not intended to redress the impact of the Deepwater Horizon disaster in the United States but rather was intended to compensate the British company BP for its financial and reputational harm, England had the greater local interest in the matter.

 

The Fifth Circuit also concluded that the district court had “reasonably” determined that public interest factors weighed heavily in favor of England as a more convenient forum, given that the English statute on which the plaintiffs sought to rely had only recently been enacted leaving the U.S. courts with little jurisprudence to use to try to apply the statute properly.

 

The plaintiffs chose to file their suit in the U.S. rather than in the U.K. undoubtedly had something to do with a perception that a court in closer proximity to the damages caused by the spill might prove to be a more receptive forum. The selection of a U.S. court over an English one also reflects the more general advantages a plaintiff enjoys here by comparison to English courts – for example, the absence in the U.S. of a “loser pays” model, among other things.

 

These kinds of advantages often encourage plaintiffs with claims involving non-U.S. companies to try to pursue their claims in U.S. courts. But the outcome of the dismissal motion in the BP derivative suit represents just one more example of the many ways prospective litigants are finding it increasingly more difficult to pursue corporate and securities claims against non-U.S. companies in U.S. courts. Courts interpreting the U.S. Supreme Court’s Morrison decision have significantly narrowed the circumstances in which securities claims involving foreign companies can go forward in U.S. courts. The Fifth Circuit’s affirmance of the dismissal of the BP derivative suit underscores the difficulties prospective claimants may fact in pursuing derivative suits involving non-U.S. companies here as well.

 

Among the many other lawsuits filed in connection with the Deepwater Horizon disaster, there also was, in addition to this shareholders’ derivative suit, a securities class action lawsuit. Though the separate securities class action lawsuit will be going forward at least in part, the preliminary motions in the securities suit also demonstrate some of the challenges plaintiffs now face in trying to pursue claims in the U.S. against non-U.S. companies. As discussed here, in a February 2012 ruling, Judge Ellison denied in part the motions of defendants to dismiss the securities class action lawsuit that BP shareholders had filed in connection with the Deepwater Horizon disaster.

 

Though Judge Ellison denied the motions to dismiss with respect to the claims asserted by securities class action plaintiffs who had purchased BP ADRs on the U.S. securities exchanges, he granted the motion to dismiss all of the claims – including claims asserted under New York state law and English common law – of U.S.-domiciled investors who purchased their BP shares on the London Stock Exchange. Judge Ellison specifically concluded that because the federal securities laws do not apply to the securities transactions on LSE, he also lacked supplemental jurisdiction to consider the English common law claims. By shaving off the claims of the shareholders who purchased their shares, Judge Ellison dramatically narrowed the scope and range of potential damages in the securities class action lawsuit.

 

Jan Wolfe’s detailed January 18, 2013 Am Law Litigation Daily article about the Fifth Circuit’s ruling in the BP derivative suit can be found here.

 

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Our legal system is one of our society’s crowning achievements. But for all of its grandeur, our legal system is not without its flaws. Among other things, our system encourages litigiousness that all too often involves frivolous suits and lawyers’-fee driven litigation, including the recent phenomenon of multi-jurisdiction derivative litigation driven by plaintiffs’ lawyers competing to get control of the dispute in order to try to capture the fee.

 

Two separate opinions this past week – one out of the Seventh Circuit and one from the Delaware Court of Chancery – harshly criticized these kinds of practices. Both of the opinions were entered in shareholders’ derivative lawsuits, too. Though both of the cases are sharply critical of fee-driven plaintiffs’ lawyers’ practices, only one of the cases resulted in the dismissal of the suit. Interestingly, in the Delaware case, owing to the Court’s disdain for the practices of “fast-filing” plaintiffs’ firms in parallel California proceedings, the Delaware case will be going forward.

 

The Allergan Case in Delaware

In September 2010, Allergan pled guilty to a criminal misdemeanor for misbranding its Botox product and paid a total of $600 million in civil and criminal fines. Various plaintiffs’ firms filed multiple derivative suits both in federal court in California and in Delaware. The California cases went forward more quickly, while in Delaware, at least one of the plaintiffs sought to pursue a books and records action against the company, in order to obtain further information pertinent to the company’s board. The Delaware plaintiff used the information and documentation to amend its complaint. The California plaintiffs ultimately also obtained the same information and documentation and supplemented their complaint as well.

 

The defendants moved to dismiss the California action on the ground that the plaintiffs had not made a demand on the Allergan board to pursue the claims, nor had they established demand futility. The California court granted the defendants’ motion to dismiss. The defendants then sought to have the Delaware action dismissed, arguing that the collateral estoppel effect of the California dismissal was preclusive of the demand futility issue.

 

In a massive and muscular June 11, 2012 opinion (here), Delaware Chancery Court Vice Chancellor Travis Laster firmly rejected the suggestion that the California court’s prior ruling compelled him to dismiss the Delaware action. He relied on two grounds in rejecting the argument that the California judgment is preclusive; first, he found that the California judgment was preclusive only as to the individual California shareholder plaintiffs, and second, he found that the California plaintiff did not adequately represent Allergan.

 

Both of these lines of analysis are interesting and so I discuss both below, but it is the inadequate representation issue that is the main interest to this blog post.

 

Vice Chancellor Laster first held that question of whether or not pre-suit demand is futile is controlled by the internal affairs doctrine and therefore governed by the law of the state of incorporation – in this case, Delaware. It should not, he said, be governed by potentially different rules across “twelve different circuits, fifty states and the District of Columbia, Puerto Rico and the other territories.”

 

He held further that under Delaware law a shareholder seeking to pursue a derivative claim on behalf of a corporation represents only his own individual interest until it is established that he has the right to pursue the claim. Because the California plaintiff was found not to have the right to pursue the claim, the California court’s judgment is preclusive only the California plaintiff alone, not on all other shareholders or the corporation (that is, the California plaintiff is not in “privity” with the other shareholders).

 

As an independent basis for rejecting the preclusive effect of the California judgment, Laster held that the California plaintiffs did not adequately represent Allergan. In concluding that the California plaintiff had not provided adequate representation, Laster launched a lengthy disquisition of the motivations and actions of the specialized plaintiffs’ shareholder bar and the specific actions taken on this case.

 

These specialized firms face a competitive environment where they often can only control the case and capture the fee if they are the first-to-file. The first-filed rule “incentivizes the plaintiffs’ lawyers to file as fast as possible in an effort to gain control of the litigation.” These firms, facing first-to-file pressure “rationally eschew conducting investigations and making books and records demands, fearing that any delay would enable to gain control of the litigation.” As he put it, “No role, no result, no fee.”

 

For the “fast-filing lawyers” their lawsuit “has the dynamic of a lottery ticket,” since in most cases their hastily prepared complaint will risk dismissal. However “in the rare case, fate may bless the fast-filer with something implicating the board,” which will make the case likelier to survive the motion to dismiss and improve the settlement value of the case exponentially.

 

 “A fast-filer” can “readily build a portfolio of cases in the hope that one will hit.” Filing a derivative claim “is relatively cheap” and search costs are minimal. Indeed, derivative plaintiffs “often piggyback on the efforts of other specialized plaintiffs’ firms.” The lawyer’s “most difficult task will be finding a suitable plaintiff.’

 

The “first-to-file” regime “disserves stockholder interests across multiple dimensions.” It prevents plaintiffs’ lawyers from “acting optimally” and “forces defendants to respond to multiple complaints in multiple jurisdictions” but at the same time gives defendants litigation advantages, because the hastily filed complaints are more likely to be dismissed. Noting Delaware’s courts’ resistance to the first-to-file regime, Laster commented that “a state that ritualistically favored defendants might embrace such a regime, but Delaware has a long history of striving to balance the interests of stockholders and managers to craft an efficient corporation.”

 

Laster found that the California proceedings demonstrate all of the shortcomings with the race-to the courthouse phenomenon:

 

By leaping to litigate without first conducting a meaningful investigation, the California plaintiffs’ firms failed to fulfill the fiduciary duties they voluntarily assumed as derivative action plaintiffs. Rather than seeking to benefit Allergan, they sought to benefit themselves by rushing to gain control of a case that could be harvested for legal fees. In doing so, the fast-filing plaintiffs failed to provide adequate representation.

 

Moreover, the California plaintiff’s shortcomings were not later redeemed when the California plaintiff belatedly asked for and received the fruits of the Delaware plaintiff’s books and records action. Laster concluded that “rather than representing the best interests of the corporation, the California plaintiffs sought to maximize the potential returns of the specialized law firms who filed the suit on their behalf.”

 

Having rejected the defendants’ suggestion that the California court’s determination was preclusive on the issue of demand futility, Laster then went on and rejected the basis on which the California court had determined that demand was futile. He said that he found the California court’s analysis “unpersuasive.” He concluded that the Delaware plaintiffs, pleading with the benefit of the results of their books and records action, had established that demand was excused as futile. 

 

The Seventh Circuit’s Decision in the Sears Case

Following the 2005 merger of Kmart and Sears, the merged company board included two individual directors who also served on the boards of other companies that competed with Sears. Two Sears shareholders filed a derivative lawsuit alleging that the two directors’ interlocking directorships violated the Clayton Act. Sears moved to dismiss the suit on the grounds that the plaintiffs had not made a pre-suit litigation demand on the Sears board. Northern District of Illinois Judge Ronald Guzman denied the motion to dismiss. Faced with the prospect for further litigation, Sears agreed to a settlement of the case that consisted of agreements for one of the two directors to step down and for the defendants not to object to the plaintiffs’ attorneys’ fee request of $925,000.

 

Sears shareholder Theodore Frank moved to intervene in the case in order to object to the settlement. Judge Guzman denied Frank’s request to intervene. Frank appealed the denial of his request to intervene. In a June 13, 2012 opinion written by Chief Judge Frank Easterbrook for a three-judge panel of the Seventh Circuit (here), the appellate court ruled that Frank’s motion to intervene had been improperly denied. That determination would seem to represent all that the appellate court was called upon to do. But the Court did not stop there; it went on to add a few choice words about the case (and perhaps about the District Court as well).

 

The district court’s reason for denying Frank’s motion to intervene, the Seventh Circuit said, is “unsound.” The district court denied the motion because the existing plaintiffs adequately represented Frank’s interests. But as the Seventh Circuit said, “that the plaintiffs say they have the other investors’ interests at hear does not make it so.” The Seventh Circuit emphasized that its case decisions encourage liberal allowance of intervention.

 

“We could,” the Court said, “stop at this point and leave the parties to slug it out In the district court.” But, “this litigation is so feeble that it is best to end it immediately.” The only goal of this suit “appears to be fees for the plaintiffs’ lawyers.” It is “impossible to see how the investors could gain from it – and therefore impossible to see how Sears’ directors could be said to violate their fiduciary duty by declining to pursue it.” The court went on to note how unlikely it is that a consumer or regulator would pursue any claim based on the interlocking directorates.

 

It is “an abuse of the legal system to cram unnecessary litigation down the throats of firms whose directors serve on multiple boards, and then use the high costs of antitrust suits to extort settlements (including undeserved attorneys’ fees) from the targets.”

 

In short, the Court said, “the suit serves no goal other than to move money from the corporate treasury to the attorney’s coffers, while depriving Sears of directors whom its investors have freely elected.”

 

Discussion

In both of these two decisions, the courts criticized derivative actions motivated by plaintiffs’ attorneys’ desire to collect a legal fee but otherwise to the detriment of the company involved. To the extent the views expressed in these opinions represent an evolving judicial view of how some plaintiffs’ firms are conducting business, they could represent a troubling threat to the business model of at least certain parts of the plaintiffs’ bar

 

But though there are similarities of perception and expression between these two cases, there are some very important differences between the two cases as well.  For example, as a result of the Seventh Circuit’s opinion, the Sears case, which was to have continued to go forward in the district court (owing to the fact that the proposed settlement had for unrelated reasons come apart), will now not be going forward. By contrast, owing to Vice Chancellor Laster’s opinion, the Allergan case, which seemed like it was over as a result of the California court’s opinion, will now be going forward in Delaware.

 

The Seventh Circuit was concerned that the district court had allowed a fee-driven frivolous suit to go forward (and it certainly does seem as if its opinion in the Sears case is a very carefully aimed slap at the district court); Vice Chancellor Laster seems concerned that as a result of inadequate actions of fee-driven plaintiffs’ lawyers proceeding in another jurisdiction, a potentially meritorious case was being threatened with being shut down.

 

The key may be Laster’s insight that the hastily prepared “first to file” complaints actually benefit the defendants, as the cobbled together complaints are easier to get dismissed – which is what happened in California. Laster also seemed troubled that the Delaware plaintiffs, who were in his court and who had proceeded deliberately, could have deprived of the benefit of their labors owing to the hasty actions of the inadequately prepared California plaintiff.

 

An important context for Vice Chancellor Laster’s opinion is the ongoing problem of multi-jurisdiction litigation and the jurisdictional competition that has ensued. Laster seems to have just about had it with courts in other jurisdictions presuming to interpret and apply Delaware corporate law and making a mess of it. You can imaging him shaking his head in disgust as he notes, first, the plaintiffs’ lawyers rushing to file actions in other jurisdiction’s court and making a hash of it, and then the courts in those other jurisdictions making a further mess of the situation.

 

It will not be lost on any plaintiffs’ lawyers in the room that the outcome of Laster’s opinion is that a case that appeared dead will now be going forward. It is as if to say to the plaintiffs’ bar, go ahead, rush off to those other courts and file your actions if you want, maybe the lottery ticket will produce a winner. But take your time and prepare appropriately, and file your suit in Delaware, and you will receive a full and fair hearing. Laster expressly contrasts Delaware with a (supposedly hypothetical) state “that ritualistically favored defendants.” Delaware, he said, “has a long history of striving to balance the interests of stockholders and managers to craft an efficient corporation law.” The message to the plaintiffs ‘ bar seems to be that Delaware’s courts are open for business – and its courts are not going to be put off by competing litigants pushing ahead on other courts.

 

Maybe I am reading too much into Judge Laster’s opinion. But it sure seems like there are some things for defendants to worry about here. Not just the fact that the case is going forward after being dismissed in California. It is this case, taken in combination with other developments – such as the massive plaintiffs’ award in the Southern Peru case—that seemingly would give corporate defendants cause for concern. The question for defendants is what to make of these developments and what they might mean as Delaware tries to protect its turf in the jurisdictional competition.

 

There is still the problem of the lack of recognition given to the California court’s ruling on the demand futility issue. As Alison Frankel said in her June 12, 2002 article in her On The Case blog (here) discussing Laster’s ruling, Laster’s collateral estoppel analysis could prove to be “very controversial.” The principles of judicial efficiency militate very heavily in favor of a presumption that issues are decided only once. Anything that seemingly gives litigants a second bite at the apple flies in the face of these principles.

 

The prospects of multiple, competing demand futility determinations is potentially troubling. Multi-jurisdiction litigation may be the result of the actions of a competitive, fee driven plaintiffs’ bar, but it is not going to go away any time soon. It is already a serious problem. But if courts stop giving effect to determinations made in other courts, the problems of multi-jurisdiction litigation could get a whole lot worse.

 

All of that said, it is very encouraging to see courts actively worrying about problems caused by frivolous and fee-driven litigation. If these opinions do represent an evolving judicial perception about the motivations driving certain kinds and categories of litigation, the environment for that type of litigation has become decidedly more hostile. And as Justice Laster’s opinion shows, eliminating the abuses would be a good thing not just for defendants, but also for plaintiffs that proceed responsibly.

 

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On April 25, 2012, Cornerstone Research released a report written by Stanford Business School Professor Robert Daines and Cornerstone Research Principal Olga Koumrian entitled “Recent Developments in Shareholder Litigation Involving Mergers and Acquisitions – March 2012 Update” (here). This memorandum is the latest in a series of recent papers documenting the growth in merger related litigation in the United States. The research described in this paper is consistent with the prior reports but it also contains some new additional insights.

 

The report opens with a number of observations about the incidence of litigation in connection with mergers valued at $500 or greater during the period 2007 to 2001. The report shows that while in 2007 only about 53% of such deals attracted litigation, by 2011 almost all deals (96%) of those deals attracted litigation.

 

In addition, with respect to the deals of that size that attracted litigation during that period, the number of lawsuit per deal also increased between 2007 and 2011. Thus, while in 2007, the average number of lawsuits per litigated deal was 2.8, in 2011, the average number of lawsuits per litigated deal was 6.2 million. The report also shows that these trends were not limited just to the largest deals; during 2010 and 2011, for deals valued between $100 million and $500 million, 85% of the deals attracted litigation, and the average number of lawsuits per litigated deal was 4.1.

 

The absolute count of lawsuits involving deals with values of $500 million or greater also nearly doubled during that period, with 289 lawsuits filed in 2007 and 502 lawsuits filed in 2011.

 

The authors also note that as of March 2012, 67 lawsuits have already been reported for thirteen out of seventeen deals announced during January and February 2012. 

 

Certain deals attracted far more than the average number of lawsuits. A table in the report shows that fifteen deals with a valuation of $100 million or greater during the period 2007-2011 attracted fifteen or more lawsuits. Interestingly, of these fifteen, twelve of these deals were announced in 2010 or 2012. The report notes that size alone does not explain which deals attracted these large numbers of suits, and that in fact several relatively small acquisitions attracted fifteen or more lawsuits.

 

The report also shows that deals in certain industries seem to attract the most numbers of lawsuits. Thus, deals in the energy industry attracted an average of 8.6 lawsuits per deal, and deals in the consumer goods industries attracted an average of 6.0 lawsuits per deal.

 

There is a common perception that there is a “race to file” these lawsuits after deals are announced. However, the report shows that while filings arrive quickly after deal announcements, the time to filing has not accelerated in any material way since 2007. Indeed, the proportion of lawsuits filed in the first week after the deal announcement declined from 55 percent in 2007 to 39 percent in 2011. In all years studied, “a significant percentage of lawsuits were filed more than four weeks after a deal’s announcement.”

 

One phenomenon that has been the subject of discussion with respect to this type of litigation is whether or not there has been a “flight from Delaware” as claimants seek to pursue claims in the courts of other states. This study shows that with respect to merger litigation involving Delaware corporations, the share of M&A lawsuits filed in Delaware was higher in 2011 (45%) than in 2007 (34%) and that the percentage has increased steadily since 2008. However, according to the report, the “most striking trend in venue choice” is that challenges to the same deal in both Delaware and some other venue (as opposed to just Delaware alone or to some other venue alone) are now more common than in 2007. Most lawsuits brought in non-Delaware courts were filed in California, Texas and New York, “likely reflecting where many deal targets are headquartered.”

 

The report shows that M&A shareholder lawsuits “typically settle and often settle quickly.” Of the 2010 and 2011 lawsuits where the authors were able to track the resolution, 28 percent were voluntarily dismissed, four percent were dismissed by the court, and 67 percent settled. This represents a “significant change in outcomes observed a decade ago.” A prior study cited in the report shows that in 1999 and 200, 59 percent of cases were dismissed and only 28 percent settled. Of the 202 unique settlements involving 2010 and 2011 deals, 194 were reached before the merger closed. The median time between lawsuit filing and settlement was forty-four days.

 

Settlement terms have also changed over time. Whereas during 1999 and 2000, the majority of settlements (52%) involved cash awards and only 10% involved additional disclosures only, only 5% of 2010 and 2011 lawsuits related to M&A deals involved cash payments, and a large majority (83%) involved additional disclosure only settlements.

 

The average fee awards in connection with the M&A suits in 2010 and 2011 in connection with deals valued at $500 million or greater was $1.2 million. However, this average was pulled upward by some larger awards. Only 23% of plaintiff fee awards were $1 million or higher, while 44 percent were at or under $500,000 or under. Of the largest plaintiffs few awards, several were associated with settlements that did not involve any payment to shareholders. Average fees per deal fluctuated between 2007 and 2011, and while the average fees as a percentage of deal value in 2010 and 2011 remained higher that in 2007, the average fees as a percentage of deal value declined in 2010 and 2011 compared to 2009.

 

Discussion

The analysis in the Cornerstone Research report corroborates many of the observations noted in prior analyses of these same topics. That is, M&A related litigation is becoming increasingly more prevalent, and each deal is attracting an increasing number of lawsuits. At a minimum, the Cornerstone Report helps explain why M&A related litigation has become increasingly more expensive to defend. The impact of M&A litigation settlements and of plaintiffs’ fee awards on the cost of this litigation is less clear, but overall the implication is that the growing frequency of this type of litigation remains a very significant corporate and securities litigation trend, with important implications for D&O insurers.

 

One very important consideration to be kept in mind when comparing the various reports regarding M&A litigation is that each of the reports has used its own deal size definition to define the merger transactions that are the basis of each report’s analysis. The definitions used in the various reports are not necessarily consistent. At a minimum, the differences in the definitions used can make comparisons between the reports challenging. In any event, it is important in considering the analysis in any one of the reports to keep clearly in mind what definitions the report has used in determining what merger transactions to include the study.

 

The FDIC’s Latest Failed Bank Lawsuit: On April 20, 2012, the FDIC filed its latest failed bank lawsuits against ten former directors and officers of the failed First Bank of Beverly Hills. In its complaint (here), which the FDIC filed in its capacity as receiver for the failed bank, the FDIC seeks to recover losses of at least $100.6 million the bank allegedly suffered on nine poorly underwritten acquisition, development and construction loans and commercial real estate loans from March 2006 through July 2007.

 

The bank failed on April 24, 2009, or just short of three years prior to the date the FDIC filed its lawsuit. The complaint asserts claims against the ten defendants for negligence, gross negligence and breach of fiduciary duties. The complaint alleges that the defendants approved or allowed the loans in question in willful disregard of the bank’s own loan policies and with “willful blindness” to the risks and imprudence of the loan decisions. The complaint alleges that at the same time the defendants were approving these risky strategies, they were “weakening the Bank’s capital position by approving large quarterly dividend payments to the Bank’s parent company,” of which several defendants were shareholders. The complaint alleges that the individual defendants “lined their own pockets” with these dividends.

 

The FDIC’s lawsuit against the former directors and officers of the First Bank of Beverly Hills is the 29^th the FDIC has filed as part of the current wave of failed bank litigation, and the fifth so far involving a failed California bank. In its latest website update, the FDIC announced that as of April 25, 2012, the agency has authorized lawsuits in connection with 58 failed institutions against 493 individuals for D&O liability, inclusive of the 29 filed D&O lawsuits naming 239 former directors and officers. Given the large number of failed banks like the First Bank of Beverly Hills approaching the third anniversary of their closure, it seems likely that we will be seeing a flurry of new FDIC failed bank lawsuits in the months ahead.

 

In the meanwhile, the FDIC continues to take control of additional failed banks. This past Friday evening, the FDIC closed five additional banks, the most the FDIC has closed in a single day this year. These additional closures bring the 2012 year to date number of bank closures to 22. This flurry of bank closures is a little bit surprising as up to this point, the pace of closures had begun to suggest that the FDIC was winding down its new bank closures. The five closures on Friday night suggest that there may still be a number of bank failures yet to come.

 

For Almost As Long As Our Country Has Existed, Man Has Dreamed of Traveling to Cleveland: NASA announces its plan to put a man on a bus to Cleveland. Get the details here.

 

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Indemnification is the first and most important line of defense for the protection of directors and officers. But corporate officials are not always entitled to indemnification. For example, under Delaware law, they cannot claim mandatory indemnification if their defense is not successful. And they cannot seek permissive indemnification is they did not act in good faith.

 

A February 7, 2012 decision of the Delaware Court of Chancery takes a detailed look at the contours of these indemnification limitations, in the challenging context of a case involving a former CEO who was terminated for cause and who pled ultimately guilty to criminal charges. The court reviewed the indemnification questions in consideration both of statutory indemnification provisions as well as a separate indemnification agreement and concluded that further discovery was required in order to permit a determination whether or not the former CEO did or did not act in good faith in connection with at least some of the amounts for which he sought indemnification The decision, which can be found here, raises a number of interesting implications.

 

I should acknowledge at the outset Francis Pileggi’s February 19, 2012 post on his Delaware Corporate and Commerical Litigation blog (here), which first brought this decision to my attention.

 

Background

Mark Hermelin was the CEO of K-V Pharmaceutical Company from 1975 to 2008, as well as a member of the company’s board from 1975 to 2010. In 2008, the company became aware of concerns that it had manufactured oversized morphine. K-V launched an internal investigation into the cause of the manufacture and distribution of the oversized tablets. In the course of the investigation, K-V discovered it had manufactured additional oversized tablets of other pharmaceuticals. K-V notified the FDA of the oversized morphine tablets, but did not report its discovery of the other oversized tablets.

 

K-V’s audit committee subsequently conducted an internal investigation and ultimately terminated Hermelin as CEO for cause. K-V’s announcement of the termination in an 8-K triggered an investigation by the local U.S. attorney, and regulatory actions by the FDA and the Department of Health and Human Services. Hermelin sought advancement and indemnification for defense expenses he incurred in connection with these investigations and regulatory actions.

 

The outcome of Hermelin’s involvement in each of these proceedings is relevant to the consideration of his bid for indemnification. First, the audit committee investigation resulted in his termination. Second, the AUSA’s investigation ultimately resulted in Hermelin’s entry of a guilty plea to two counts of criminal misdemeanor strict liability based upon an application of the Responsible Corporate Officer doctrine. Third, in connection with the HHS investigation, the agency issued a formal determination to exclude Hermelin from all federal healthcare programs for twenty years (which given Hermelin’s age is tantamount to a lifetime ban); and finally, in the FDA matter, K-V and Hermelin among others entered a consent decree whereby the defendants agreed to destroy certain drugs and refrain from manufacturing or distributing any drugs until the company complied with certain quality control requirements.

 

In seeking indemnification, Hermelin relied not only on the statutory indemnification provisions, but he also sought to rely on a separate indemnification agreement he had entered with the company. As the Delaware court observed in the indemnification proceedings, the indemnification agreement generally make mandatory what are permissive provisions for indemnification under the relevant statutory provisions.

 

The February 7, 2012 Ruling

In a February 21, 2012 ruling, Vice Chancellor Sam Glasscock summarized his consideration of the indemnification issues as a determination whether Hermelin had succeeded on the merits in any of these proceedings, thus entitling him to indemnification as a matter of law, or whether additional discovery is required to determine whether Hermelin acted in good faith, in which case Hermelin would be entitled to indemnification under the indemnification agreement.

 

In seeking to establish that he had been successful in certain of these proceedings, Heremlin argued among other things that the outcomes had been successful in the sense that the avoided worse outcomes for himself and for the company, and in some respects that he had in effect “taking one for the team.”

 

Vice Chancellor Glasscock concluded that Hermelin had been successful in connection with the FDA matter, and therefore was entitled to mandatory indemnification for his fees in connection with that proceeding. He concluded further that Hermelin had not been successful in the criminal matter, the HHS investigation or the audit committee investigation, and was not therefore entitled to mandatory investigation in connection with those matters.

 

But as for whether Hermelin was entitled to permissive indemnification (made mandatory under the indemnification agreement) in connection with the criminal matter, the HHS investigation or the audit committee investigation, Vice Chancellor Glasscock determined that further discovery is required, as Hamelin will still be entitled to indemnification for these matters under the indemnification agreement unless KV can establish that Hermelin’s conduct underlying these matters for which he seeks indemnification does not meet the good faith standard required under the relevant Delaware statutes.

 

In reaching these conclusions, the Vice Chancellor referenced a number of the specific provisions of the indemnification agreement, including in particular the provisions specifying a presumption that Hamelin is entitled to indemnification and putting the burden of proof on the company to overcome the presumption. The Vice Chancellor also referenced the provisions of the agreement specifying that a specific outcome, order or plea will not by itself create a presumption that the indemnitee had a nonindemnifiable state of mind.

 

The Vice Chancellor did note the “dearth of case law addressing the scope of relevant evidence with respect to good faith” under the Delaware statutory provisions. The Vice Chancellor did note that none of the matters for which Hermelin seeks indemnification “contained a finding that Hermelin acted in bad faith or an admission of culpability by Hermelin.” The Vice Chancellor noted in particular with respect to Hermelin’s strict liability misdemeanor guilty pleas, that the “record is inadequate with respect to Hermelin’s conduct.” Similarly with respect to the HHS matter and the audit committee investigation that the record does not reflect findings that Hermelin acted in bad faith. The Vice Chancellor concluded that the parties must supplement the record before he can make the necessary determinations.

 

Vice Chancellor Glasscock concluded by noting that the probable explanation for the dearth of case law addressing the relevant scope of evidence with respect to good faith is that most disputes of this type likely often settle, particularly where as here the parties are subject to an indemnification agreement that at least as an initial matter compels the company to foot both parties’ costs to litigate the matter. He concluded by observing that “I leave it to the parties to determine whether the elusive joys and potential benefits of such litigation outweigh the substantial costs that will result.”

 

Discussion

This case provides a number of valuable insights. First, it provides a very useful perspective on the actual mechanics of the Delaware statutory indemnification provisions. Indeed, as Francis Pileggi points out on his blog post to which I linked above, the case presented a question of first impression under Delaware law as to the evidence relevant for the determination whether or not executive has acted in good faith for permissive indemnification purposes.

 

Second, and more to the point, it underscores the value to corporate executives of having a separate indemnification agreement. The Vice Chancellor’s consideration of Hermelin’s agreement’s provisions emphasize the importance of several aspects the agreement, including in particular the presumption of indemnification; the burden of proof on the company of overcoming the presumption; and the specification that the mere fact of the entry of an order or plea will not be determinative of the issue of whether or not the indemnitee acted in good faith.

 

This case does underscore the breadth of a corporate official’s indemnification rights under Delaware law in an expansively constructed indemnification agreement. Here, Hermelin may yet obtain indemnification for much of his attorney’s fees notwithstanding (1) his termination for cause from the company; (2) his entry of a criminal guilty plea (resulting in his incarceration and the imposition of a substantial fine); and (3) an agency’s entry of a lifetime exclusion order against him. Indeed, unless the company can bear its burden under the agreement of showing that Hermelin did not act in good faith, he will have a mandatory right under the agreement for the indemnification of his fees.

 

This outcome does underscore the fundamental tension that may underlie many indemnification provisions and agreements. That is, a corporate official seeking to negotiate an indemnification agreement will want to have the agreement drafted as broadly as possible. The company on the other hand may want the agreement constructed more narrowly. This tension highlights the fact that it is always critical in connection with the consideration of any draft indemnification to establish whose interests are being examined.

 

Vice Chancellor Glasscock’s consideration of Hermelin’s rights of indemnification for the fees he incurred in connection with the criminal proceedings is particularly interesting. It is important to note that the criminal charges against Hermelin were made pursuant to the responsible corporate officer doctrine. As I have discussed in prior posts (here and here), the word “responsible” in the doctrine’s title does not mean the officer is responsible for the alleged misconduct, but only that the officer is responsible for the company. A criminal charge under this doctrine is, as the Vice Chancellor noted, a strict liability offense. As such, these nothing specific about a guilty plea that establishes that the defendant officer acted with a culpable state of mind, much less that the official acted with bad faith. Accordingly, a corporate official convicted of a strict liability criminal defense may nevertheless be entitled to corporate indemnification, in the absence of any finding of bad faith.

 

Moreover, given the absence of any finding of willfulness or deliberate misconduct, the guilty plea may not (depending on the actual policy exclusion wording) trigger the conduct exclusion in a D&O insurance policy. In other words, the defense fees at least could be fully insurable under the corporate reimbursement provisions of the typical D&O insurance policy. The typical presumptive indemnification provision found in many D&O insurance policies (presuming indemnification to the maximum extent permitted by law) underscores the possibility of this outcome.

 

I anticipate that there will be some who question whether or not Hermelin ought to have any right to indemnification under these circumstances. At this point, he may or may not be, it has not yet been determined. If the remaining indemnification disputes do not settle and the company proves he acted in bad faith, he will not be indemnified. He only receives indemnification if the company cannot prove he acted in bad faith, in which case I would say, why shouldn’t he receive indemnification?

 

Vice Chancellor Glasscock put it this way: “Delaware law furthers important public policy goals of encouraging corporate officials to resist unmeritorious claims and allowing corporations to attract qualified officers and directors by agreeing to indemnify them against losses and expenses they incur personally as a result of their services.” He added, the complete the picture that “prohibiting unsuccessful ‘bad actors’ also relieves stockholders of the costs of faithless behavior and provides corporate officials with an appropriate incentive to avoid such acts to begin with.”

 

Accordingly, any argument that Hermelin should not be entitled to indemnification has to proceed on the theory that he is a “bad actor.” As Vice Chancellor Glasscock concluded, however, there is not a sufficient basis on the current record to conclude that Hermelin is a bad actor. I should add that the presence of the guilty plea to the strict liability criminal charge is an distracting and confusing irrelevancy. The criminal charge is basically a status offense; Hermelin was charged because of his title, not necessarily because of his actions – or even fault, as the charges were strict liability offenses.  

 

I have pointed out elsewhere the fundamental problems with the imposition of liability without culpability. As I have previously argued, this deeply troublesome trend is fundamentally inconsistent with traditional notions of justice and fair play. The problems associated with these types of prosecutions should not be compounded by efforts to try to use the prosecutions as a basis to try to strip corporate officials of their indemnification rights, at least in the absence of affirmative evidence of bad faith.

 

I suspect others may have strong views on this subject. I invite readers to add their views to the  dialog using this blog’s comment feature.

 

Readers with a penchant for historical references will definitely want to peruse Vice Chancellor’s musings on page 7 and page 13 about the proper historical allusion for Hermelin’s posture in the underlying actions, in light of his contention that his tactics of concession secured benefits and avoided worse detriments for himself and for the company. The possibilities include a Pyrrhic victory, a Hobson’s choice, a Morton’s Fork, or a Buridan’s Ass. Vice Chancellor Glasscock is of the view that the most appropriate historical reference for Hermelin’s defense is Lee’s surrender at Appomattox.

 

M&A Plaintiffs’ Attorneys as Toll Booth Operators: I have recently detailed on this blog the many problems associated with the upsurge in M&A related litigation, including among other things the problems associated with rising plaintiffs’ fee awards in these cases. I have also noted that the plaintiffs’ fee awards can be quite substantial even where there is no cash recovery for the benefit of the shareholders on whose behalf the plaintiffs’ lawyers supposedly brought the case.

 

A case in point is the recent $8.8 million plaintiffs’ fee award in the litigation related to the XTO Energy acquisition. As detailed in Nate Raymond’s February 14, 2012 article on Am Law Litigation Daily (here), a state appellate court has affirmed the award of these fees, notwithstanding the fact that plaintiffs’ attorneys recovered no cash for the plaintiff class. The appellate court’s ruling is the subject of Ronald Barusch’s scathing February 20, 2012 post on the Wall Street Journal’s Dealpolitik blog (here).

 

Among other things, Barusch contends that in the settlement, the shareholders received “nothing but words.” The author contends based on the appellate court’s decision that the fee award was calculated on “what appears to be a totally irrational basis” The author concludes that with “outrageous” outcomes like this, these kinds of cases these class actions “have become toll booths for just about every big merger.”

 

A Variation on the Chinese Company Litigation: As I and many others have noted, one of the most pronounced trends during 2011 was the wave of shareholder litigation involving Chinese companies. In an interesting variation on this litigation trend, a shareholder In one of the Chinese companies caught up in its own scandal has now been sued. According to a February 21, 2012 Wall Street Journal article (here), one of the investors in John Paulson’s hedge funds, which had invested in the scandal-ridden Sino-Forest Corp. (about which refer here and here), has filed a purported class action lawsuit in the Southern District of Florida against Paulson’s firm for failing to conduct sufficient due diligence in the firm.

 

According to the Journal article, Paulson’s fund lost about $500 million last year on its investment in Sino-Forest, although this figure includes the loss of the fund’s paper gains on the investment. The net total loss was $100 million. The lawsuit alleges gross negligence and a breach of the fund’s duties to investors for “failing to expend the resources to conduct the proper initial due diligence in Sino-Forest’s operations.”

 

Though the wave of litigation involving the Chinese companies seems to have peaked last year, litigation continues to arise. This latest suit presents the latest variation of efforts by U.S. investors to try to recoup losses based upon the companies involved in the accounting scandals. The interesting thing about this latest twist is that the litigation is extending not only to the Chinese companies and their directors and officers, as well as offering underwriters and auditors, but now it is even extending to shareholders.

 

Photography and the Physics of Canine Balance: All I can say is -- take a look at the oddly compelling photos in this collection captioned “Maddie the Coonhound Standing on Things” (here)

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In their paper “A Great Game: The Dynamics of State Competition and Litigation” (here), Ohio State Law Professor Steven Davidoff and Notre Dame Finance Professor Matthew Cain analyzed the M&A related litigation during the period 2005 to 2010. I discussed this article in a prior post, here. In a newly released February 2, 2012 paper entitled “Takeover Litigation in 2011” (here), Professors Davidoff and Cain supplement their prior research with the preliminary statistics for takeover litigation in 2011.

 

The authors review all 2011 transactions involving U.S. exchange traded companies with a deal size over $100 million, an offer price of at least $5 per share, with a publicly available merger agreement and a closing date by January 12, 2012. There were 103 transactions that met these criteria, which represents a slight decline from the 124 transactions in 2010. However, the 2011 figures do not include pending transactions from 2011, so these figures could change as more of the deals are completed.

 

But while the absolute number of transactions declined slightly in 2011, the number of transactions that attracted lawsuits increased, at least as a percentage matter. The authors found that while 84.6% of mergers attracted litigation in 2010, the percentage rose to 94.2% in 2011. The authors noted  in their original paper that in 2005 only 38.7% of deals attracted litigation, so the litigation is now brought “at a rate almost 2.5 times that of 2005. The authors expect that as the pending 2011 deals are completed “we expect that the ultimate 2011 litigation rate will match or exceed the 94.2% figure.”

 

In addition, the mean number of complaints per deal remained basically constant in 2011, to with a 2011 per deal mean of 4.8, from 4.7 in 2010. These mean figures represent a doubling of the 2005 mean number of lawsuits of 2.2. The percentage of deals that attracted multistate litigation declined slightly to 47.4% in 2011, from 47.6% in 2010.

 

Disclosure only settlements increase to 84% of all 2011 settlements, compared to approximately 80 percent in 2010.

 

The authors note that “so far for 2011 average attorneys’ fee awards are down substantially.” The mean plaintiffs’ attorneys fees awarded in all settlements declined in 2011 to $784,000, from $1.255 million in 2010. The mean attorneys’ fee award was smaller in disclosure only settlements, with the 2011 mean disclosure only attorneys fee award of $530,000, down from$710,000 in 2010. The mean fee award for settlements that involved other consideration declined to $1.952 million in 2011, down from $3.284. However the decline in median fee awards for both disclosure settlements and other settlements was much slighter than the decline in the mean. The median 2011 disclosure only settlement fee award was $450,000, compared to $546,000 in 2010, and the median fee award in 2011 for settlements involving other consideration was $1.1 million, compared to $1.25 million in 2010.

 

Delaware drew a much larger share of M&A-related litigation in 2011. The state attracted 64.3% of all lawsuits involving target companies incorporated in Delaware or with their headquarters in Delaware, compared to 44.1% in 2010. The 2011 rate was “the highest rate in the seven years we have tracked these figures.”

 

Delaware also seems to be dismissing fewer cases, “thus allowing more cases to be settled.” 85.7% of Delaware cases settled in 2011, compared to 79% of 2010 cases. The authors note that this finding is consistent with the analysis in their earlier paper, noting that “when Delaware loses cases to other jurisdictions it historically has dismissed fewer cases and allowed more to settle, consistent with conduct designed to reattract litigation.”

 

Consistent with the overall 2011 attorneys’ fee award trends, Delaware awarded lower average fee awards in 2011. The mean 2011 Delaware fee award was $1.051 million, compared to $2.052 in 2010. Delaware did continue to award higher attorneys’ fees than other jurisdictions, as Delaware’s 2011 average of $1.051 million was substantially above the overall 2011 average of $784,000.  

 

The authors emphasize however that all of the 2011 statistics are preliminary “should be read with caution” particularly given the delay in the availability of some information (particularly with respect to attorneys’ fees). The authors expect to update their information as the year progresses.

 

Special thanks to Professor Davidoff for providing me with a copy of his latest paper.

 

A D&O Primer: Readers interesting in a good, basic overview of the D&O insurance policy will want to take a look at the recently published paper “D&O Insurance: A Primer” by Lawrence Trautman and our good friend  Kara Altenbaumer-Price. Their paper can be found here

 

2011 Securities Litigation Overview: The Haynes & Boone law firm has a February 3, 2012 memo entitled “Securities Litigation Year in Review 2011” (here) which has a detailed overview of 2011 securities litigation developments. The memo has several very interesting sections including a section on extraterritorial litigation; a section on litigation involving auditors; and a section on litigation involving rating agencies.  

 

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During last week’s PLUS D&O Symposium, several of the panels discussed the problems surrounding the current onslaught of M&A-related litigation – and appropriately so, as the surging levels of M&A litigation is one of the most distinct and troubling current litigation trends. During the course of the discussion at the conference, several of the speakers referenced developments, materials and statistics. I thought it might be useful to assemble these various references in one site. (I have linked to some of these resources in prior posts on this site.)

 

First, though, by way of background about M&A-related litigation developments, I thought it might be useful to reference and to link to a recent paper that provides a good introductory explanation of what the M&A-related litigation is all about. In a February 6, 2012 paper entitled “Anatomy of a Merger Litigation” (here), Douglas Clark of the Wilson Sonsini law firm and Marcia Kramer Mayer of NERA Economic Consulting walk through the litigation developments surrounding a single merger transaction, by way of illustration and as a vehicle to discuss and consider a variety of aggregate statistics regarding merger litigation. The paper provides a useful starting point for understanding the current M&A-related litigation phenomenon. NERA's related statistical analysis of M&A litigation can be found here.

 

With respect to the conference panels, I am sure that many attendees were as struck as I was by the statement of Stanford Law School Professor Michael Klausner that if you take state court M&A-related litigation into account, then corporate and securities litigation filings are at “an all-time high.” I have in fact made the same point myself, but it just has so much more credibility coming from Professor Klausner. In making these statements, Professor Klausner was referring (with respect to the state court M&A litigation) to the recent Cornerstone Research paper entitled “Recent Developments in Shareholder Litigation Involving Mergers and Acquisitions” (here).

 

In connection with the initial panel discussion of these litigation statistics, John Spiegel of the Munger Tolles law firm referred to a recent paper by Ohio State University Professor Steven Davidoff and Notre Dame University Finance Professor Matthew Cain. The January 1, 2012 paper, entitled “A Great Game: The Dynamics of State Competition and Litigation” can be found here. (I discussed Professors Davidoff and Cain’s paper in a prior post, here.)

 

Among the many issues discussed relating to the M&A-related litigation were the problems associated with multiple suits pending in separate jurisdictions relating to the same transaction. Among the suggestions that have been proposed as a way to avert the problems associated with multi-jurisdiction litigation and to discourage plaintiffs from forum shopping is the adoption by companies of a by-law amendment designating Delaware as the sole forum for all corporate and securities litigation. This suggestion has attracted a great deal of interest and a number of companies have adopted by-law amendments designating Delaware as the sole forum for corporate and securities litigation.

 

As several of the panelists mentioned during the conference, certain plaintiffs’ lawyers have now launched a litigation assault on these by-law amendments. On Monday and Tuesday this past week, the lawyers filed at least nine complaints against companies that had adopted these types of by-law amendments. Nate Raymond’s February 8, 2012 Am Law Litigation Daily article discussing the suits can be found here. Alison Frankel’s February 8, 2012 article on Thomson Reuters News & Insight about the cases can be found here. Francis Pileggi’s February 7, 2012 post about the cases on his Delaware Corporate and Commercial Litigation blog can be found here.

 

The nine companies targeted in the suits are: Chevron; Priceline.com; AutoNation; Curtiss-Wright; Danaher Corporation; Franklin Resources; Navistar International; SPX Corporation: and Superior Energy Services. An example of one of the complaints, which are substantially the same, can be found here.

 

The plaintiffs complain that the by-law applies to broad categories of kinds of litigation, is not limited just to derivative or class litigation, and applies to individual claims. But while the shareholders are required by the by-laws to bring their claims in Delaware, the bylaws provide no forum restrictions on the corporations themselves. The plaintiffs also complain that the bylaws seemingly require claim to be brought in Delaware even where there may not be personal jurisdiction over prospective defendants (for example, in connection with claims against individual directors and officers).

 

The plaintiffs in these suits seek a judicial declaration that the by-laws are invalid. The interesting attribute of the by-laws in dispute is that in each case, the by-laws were adopted by board action and not put to shareholder vote. So even if these particular board adopted by-laws are struck down, the cases may not address the question of whether a forum selection by-law that has been adopted by shareholder vote can be enforced (for example, on former shareholders, or even where there is no personal jurisdiction over prospective defendants).

 

It is worth noting that in the only judicial decision to date to consider a forum selection by-law, the by-law was found to be unenforceable. As discussed here (scroll down), in January 2011, Northern District of California Judge Richard Seeborg found Oracle’s forum selection by-law to be unenforceable, in part because it had not been put to shareholder vote. Because Seeborg was applying federal common law rather than Delaware law, his ruling may have only limited impact on the Delaware proceedings.

 

At least one member of the Delaware Chancery Court has voiced his approval at least of the concept of a forum selection by law; in the Revlon Shareholders’ Litigation, the Delaware Court of Chancery suggested that corporations organized under Delaware law are "free" to adopt "charter provisions selecting an exclusive forum or inter-entity disputes." In the wake of this suggestion, many lawyers began to recommend that their client companies adopt charter provisions designating the Delaware Court of Chancery as the preferred forum. The newly filed litigation may provide guidance on this important issue.

 

Finally, if you have not yet checked it out, the PLUS Blog has a number of video highlights from the PLUS D&O Symposium, including among other things an interview with yours truly.

 

Another FDIC Failed Bank Lawsuit: Another topic of discussion at the PLUS D&O Symposium was the growing wave of FDIC litigation against former directors and officers of failed banks. On Thursday, February 9, 2012, the FDIC filed its latest lawsuit in the District of Nevada, against four former officers of the failed Silver State Bank of Henderson, Nevada. The FDIC’s complaint can be found here.

 

The lawsuit is the 22^nd that the FDIC has brought as part of the current bank wave. Interestingly, this complaint was brought well over three years after the September 2008 failure of Silver State Bank. Informed sources advise that the parties had entered a tolling agreement. A February 10, 2012 Las Vegas Review-Journal article discussing the new suit can be found here.

 

A Preview of Warren Buffett’s Annual Letter to Shareholders: Berkshire Hathaway’s 2011 annual report will not be published for a few more weeks yet. But readers interested in a preview of Warren Buffet’s annual letter to Berkshire shareholders, which is the highlight of the company’s annual report, may want to take a few minutes to review an excerpt of the forthcoming letter that was published on February 9, 2012 in a blog on the CNN Money website (refer here). The basic thrust of the excerpt is that due to the impact of inflation and taxation, stocks outperform bonds and gold. The interesting excerpt is vintage Buffett.

 

“Investing,” Buffett writes, “is forgoing consumption now in order to have the ability to consume more at a later date.” Real risk then is not volatility, but the possibility that your investment will lose purchasing power -- that is, that you will actually only be able to consume less later. Investments denominated in currentcy, such as bonds or money market funds, though often charactized as "safe"  lose value due to the "inflation tax," not to mention actual taxes. Buffet says, "right now, bonds should come with a warning label." .

 

A Piano Duet: For today’s musical interlude, I feature a video of a 90-year old couple, playing an entertaining piano duet in the atrium of the Mayo Clinic. They have been married 62 years and they can still play a mean piano.

 

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One feature of the recent changing mix of corporate and securities litigation has been the rise in the filing of follow-on derivative lawsuits in the wake of securities class action lawsuit filings. As Wilson Sonsini partner Boris Feldman recently noted, “like a moth drawn to a candle,” the derivative bar watches class action filings and “just cannot resist cribbing the class action complaints, even though the company’s setback does not suggest any breach of fiduciary duty.”

 

The rise in the number of follow-on derivative lawsuits seems to be attributable to the efforts of smaller or newer plaintiffs’ firms to try to get a piece of the action. The problem with these kinds of cases is that they just compound the defendant company’s litigation expense and threaten distraction from or even prejudice to the company’s defense in the class action suit – all as a result of a derivative action supposedly brought on the company’s behalf.

 

One way to try to reduce at least some of the potential evils associate with these follow-on suits would seem to be to stay the derivative suit until the securities suit has concluded. In many cases, the derivative plaintiffs agree to a stay. The question whether the court itself should order a stay of one of these follow-on suits was addressed in a January 27, 2012 Delaware Chancery Court opinion (here) in a derivative action involving SunPower Corporation.

 

The litigation arose after SunPower announced that it would have to restate its prior financials due to the underreporting of expenses at its Philippine manufacturing operations. Following these announcements, the company and several of its directors and officers were named as defendants in securities class action lawsuits (later consolidated) in the Northern District of California. The consolidated class action case was initially dismissed without prejudice, but the class action plaintiffs’ amended pleading survived the defendants’ renewed motion to dismiss. The court’s December 19, 2011 denial of the defendants’ renewed motion to dismiss can be found here.

 

Following the filing of the securities class action lawsuits, additional plaintiffs filed five derivative lawsuits in California state court, seeking indemnification from the individual defendants for any expenses the company incurs in the class actions. Those five California derivative actions were stayed by agreement.

 

However, yet another plaintiff filed a separate derivative action in Delaware Chancery Court, after having first exercised his rights to inspect the company’s books and records. The Delaware plaintiff contended that his access to confidential company documents has shown that the company had incurred million of dollars of costs, even before the class action lawsuits were filed, due to the accounting issues with the company’s Philippine operations.

 

The defendants moved to stay the Delaware plaintiffs’ action, arguing that proceeding with the derivative suit would prejudice the company’s defense in the securities suit. The defendants also argued that because the relief the Delaware derivative plaintiff seeks is largely contingent on the outcome of the securities suit, it would be premature for the derivative suit to proceed. The derivative plaintiff argued that because his filings were under seal, the defendants overstated the prejudice, He also argued that the because of the $8 million in expenses the defendants had already incurred in connection with the restatement, there were noncontingent damages ripe for adjudication.

 

In granting the defendants’ motion for a stay, Vice Chancellor Donald F. Parsons, Jr. concentrated on the overlap between the factual allegations in the class action lawsuit and in the derivative lawsuit. Both actions accused the individual defendants of having knowledge of the alleged wrongdoing or having ignored red flags. But, Parsons noted, the derivative plaintiff “makes these arguments on behalf of the corporation while the Securities Class Action plaintiffs make them against SunPower.”

 

Parsons said that “it is not practical for two actors … to pursue divergent strategies in two simultaneous actions on behalf of the same entity.” As a result, “simultaneous prosecution of both actions” would be “unduly complicated, inefficient and unnecessary.” The prosecution of the derivative suit would involve “taking actions designed to refute the merits of the Company’s defense of the Securities Action and vice versa.” This creates a “significant risk that the prosecution of [the derivative suit] will prejudice SunPower.” Parsons notes there is also a significant risk of inconsistent rulings.

 

Parsons also rejected the plaintiffs’ argument that the derivative suit was ripe for adjudication because at least a portion of the claimed damages are not contingent. Because the fill extent of the alleged damages cannot be known until the class action is resolved, “the wisdom as a practical matter of treating the indemnification claims as unripe until the liability for which the indemnification is sought is determined is plain.” Because the derivative claims cannot be adjudicated in full, the sensible ordering of events is for the class action to go first.

 

Accordingly, Parsons ordered the derivative suit to be stayed indefinitely, allowing the plaintiff to seek to have the stay lifted upon the earlier of the final dismissal of the securities class action or December 31, 2012.

 

Discussion

As discussed in a January 27, 2012 memorandum from the Morrison Foerster law firm (here), Vice Chancellor Parsons ruling provides “the clearest articulation to date of the danger follow-on derivative actions poste to corporations on whose behalf they are supposedly brought.” The ruling, according to the memo, “should prove a valuable guide to courts” trying to manage simultaneous derivative and class action litigation in the future.

 

The larger context for the problems Vice Chancellor Parson addressed is the increasing proliferation of conflicting litigation surrounding any type of corporate event. The phenomenon of multiple class action lawsuit filings following a stock drop has long been part of the corporate and litigation scene. These kinds of cases are more easily consolidated and managed. What has changed is increasing numbers of follow on derivative lawsuits, often, as here, filed in multiple jurisdictions, and which are not so easily consolidated or coordinated.

 

Just to quantify this problem and to proviide a little bit of historical context, in its 2011 securities class action litigation report, NERA Economic Consulting reported that the number of settled securities class action cases that were accompanied by parallel derivataive lawsuits has grown dramatically in recent years. NERA reports that prior to 2002 (when the Sarbanes-Oxley Act was enacted) the number of settled cases that were accompanied by a parallel derivative action ranged between 11 and 22 percent a year. However, from 2007 through the first half of 2011, the range was from 56 to 65 percent.

 

The threat of prejudicing the defense of the securities class action lawsuit is only one of the problems associated with the increase in follow-on derivative litigation. The proliferation of multiple simultaneous suits in multiple jurisdictions imposes a costly and vexatious burden on the companies involved. The SunPower case provides a good illustration of these problems. The Delaware derivative plaintiffs alleges that the company “is largely self-insured so that expense, settlements or damages in excess of $5 million in these actions will not be recoverable” under insurance. The costs associated with the derivative plaintiffs’ action simply add to this burden. As NERA noted in its year-end securities litigation report, in commenting on the phenomenon of folllow-on derivative lawsuits, "to the extent [the individual defendants] have indemnification agreements or continue to hold board or management positions, derivative litigation may prove expensive for the issuer." 

 

Unfortunately for the company, the derivative action has merely been stayed, not dismissed, which raises the question of what will happen in the future. The likelihood is that the class action lawsuit will settle at some point. (Yes there is a chance that it will be resolved on summary judgment, and an even smaller chance that it will be resolved at trial, but the greatest likelihood is that it will be settled.) Given the apparent limited amount of insurance available, the class action settlement will likely be modest. And if the case settles, the stipulation undoubtedly will include the usual defense disclaimers of liability or wrongdoing.

 

At that point, the stayed derivative litigation will finally be ripe. But at that point, the remaining insurance will almost certainly be gone. The derivative plaintiffs, without the benefit of any factual findings in the class action suit, will have to try to establish liability, forcing the individual defendants to incur additional defense expenses (which almost certainly would be advanced to the defendants under the company’s indemnification provisions), all to try to extract some payment out of the personal assets of the individual defendants. Given these factors, it seems highly probable that any ultimate recovery in the derivative suit – and therefore any benefit to the company – would be slight. But in the meantime, the company and its senior management are forced to endure the burden and expense of continued, redundant litigation.

 

There may be (infrequent) occasions where this kind of liltigation-about-litigation is not burdensome, vexatious and wasteful. Nevertheless, it is very hard to observe the expansion of this kind of follow-on derivative litigation with anything but alarm. If, as seems likely at least for now, this kind of litigation is going to continue to increase, it is going to be increasingly important for courts to develop rules of the road, if for no other reason to make sure that these suits do not further harm the very companies on whose behalf they supposedly are brought. That is the reason I think Vice Chancellor Parsons ruling is important, because it represents a practical recognition that the courts are going to have to police things to prevent the whole process from getting out of control.

 

I know that the plaintiffs’ attorneys behind these cases will argue that the cases are necessary to protect companies from the expenses the corporate defendants are forced to incur when alleged management misconduct leads to shareholder litigation. Other observers might perhaps more accuratey characterize these cases as nothing more than a vehicle by which the plaintiffs' firm involved is seeking to extract a fee.  I would argue that a better way to address the cost of litigation problem is through a prudent risk management approach including a comprehensive program of D&O insurance. If the company has an appropriate D&O insurance program in place, the class action litigation costs would not fall on the company, and there would be no even theoretical need for (or indeed any justification for) these types of follow-on lawsuits in most circumstances.

 

At least from the allegations Vice Chancellor Parsons recites in his opinion, it appears that this company carried only nominal amounts of D&O insurance. The amount and extent of litigation in which this company has become involved underscores the fact that in this day and age, well-advised firms should carry more than minimal amounts of insurance. Indeed, this case shows that in a changing litigation environment, traditional notions of limits adequacy may no longer be sufficient. The possibility that companies may have to be prepared to fund a multi-front defense suggests that companies may need more insurance than in the past in order to be fully protected.

 

A Dated Debate: We generally refer to the year 1901 as “nineteen-oh-one.” Similarly, 1909 is “nineteen-oh-nine.” But we refer to 1910 as “nineteen-ten” not “nineteen-and-ten.” My point here is that conversational conventions eventually tend toward to simplest and most economical expression.

 

In our current century, 2001 is referred to as “two thousand and one.” 2009 is referred to as “two thousand nine.” I suspect the convention will shift as the century progresses. For example, when we finally reach 2020 (if we do in fact make it that far), I feel quite certain the year will be referred to as “twenty-twenty” and not as “two thousand twenty.” Similarly, 2021 will be “twenty-twenty-one,” not “two thousand twenty one.”

 

Which brings me to the current year, 2012. Why do we refer to it as “two thousand twelve” rather than “twenty twelve”? I am not sure why, but “twenty twelve” is not in widespead usage. I feel quite certain that eventually we will all shift to the “twenty – “ formulation, just as a century ago, usage shifted to the “nineteen –“ custom.

 

Maybe it won’t be until 2020, but the “twenty –“nomenclature will eventually be the conversational way to refer to years during the current century. It may be too late now to change the way we refer to the current year, but it still may be possible to make some progress on this now.

 

As part of our forward-looking mission here at The D&O Diary, we would like to propose that we all get an early start on the rest of the century. Specifically, and with next year still a good eleven months off, we would like to respectfully suggest that everyone make a mutual commitment to refer to next year as “twenty-thirteen” rather than as “two thousand thirteen.” Why wait until 2020 to get on with the future?

 

I am sure many of you are wondering why I am so concerned about this. Here at The D&O Diary, we consider it part of our job to worry about these things so you don’t have to. Now remember, its “twenty thirteen,” not “two thousand thirteen.” O.K., everybody back to work.

 

There’s Nothing Quite Like a Real Book: Ironically, I first saw this video on my iPad. Ironically, it is a video about the magic of books. Irony notwithstanding, it is still a pretty cool video.

 

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In an interesting October 14, 2011 post-trial opinion, Delaware Chancellor Leo Strine entered a $1.263 billion award in the Southern Peru Copper Corporation Shareholder Derivative Litigation. The lawsuit relates to Southern Peru’s April 2005 acquisition of Minerva México, a Mexican mining company, from Groupo México, Southern Peru’s controlling shareholder. Chancellor Strine concluded that as a result of a “manifestly unfair transaction,” Southern Peru overpaid for Minerva Mexico. A copy of Chancellor Strine’s 106-page opinion can be found here.

 

Background

Southern Peru is a NYSE company. (After the events involved in this lawsuit, Southern Peru changed its name to Southern Copper Corporation. Its shares trade on the NYSE under the symbol “SCCO.”) Groupo México is the controlling shareholder of Southern Peru. In 2004, Groupo México owned 54.17% of Southern Peru’s outstanding stock and 63% of the voting power. In February 2004, Groupo México proposed that Southern Peru buy its 99.15% share stake in Minerva in exchange for 72.3 shares of newly-issued Southern Peru stock. At market price of Southern Peru’s stock then, the proposed deal had an “indicative” value of $3.05 billion.

 

The Southern Peru board appointed a special committee to assess the proposed transaction. The special committee in turn hired numerous outside experts, including Goldman Sachs, to assist the committee in assessing the transaction. As Chancellor Strine later concluded, when it became clear that Minerva’s value was substantially less than the value of proposed amount of Southern Peru stock, “the special committee and its financial advisor instead took strenuous efforts to justify a transaction at the level originally demanded by the controller.”

 

As a result, “the controller got what it originally demanded: $3.1 billion in real value in exchange for something worth much, much less -- hundreds of millions of millions of dollars less.” Even worse, the special committee agreed to a fixed exchange ratio. Because Southern Peru’s stock price rose between the date the parties entered the deal and the date the deal closed, the actual value of the transaction was $3.75 billion. Even though the special committee had the ability to rescind the deal, the special committee did not seek to update the fairness opinion or otherwise alter the transaction. The upshot was that “a focused, aggressive controller extracted a deal that was far better than market, and got real, market-tested value of over $3 billion for something no member of the special committee, none of its advisors, and no trial expert was willing to say was worth that amount of actual cash.”

 

Shareholders then filed a derivative lawsuit alleging that the transaction was unfair to Southern Peru and its minority shareholders. By the time of trial, the defendants remaining in the case were Group México and its eight affiliate directors who were on the Southern Peru board at the time of the transaction. The plaintiffs argued that the 67.2 million shares of Southern Peru stock that Groupo México received in the transaction were worth substantially more that the 99.15% interest in Minerva that Southern Peru received. 

 

The October 14 Opinion

Following trial, Chancellor Strine concluded that “the process by which the Merger was negotiated and approved was not fair and did not result in the payment of a fair price.” He found that “from inception, the Special Committee fell victim to a controlled mindset and allowed Groupo México to dictate its terms and structure of the Merger.”

 

Strine also concluded that the committee was “not ideally served by its financial advisors,” Goldman Sachs, which having concluded that the value of what Southern Peru would receive in the transaction was substantially less than the value of stock Groupo México was to receive, “helped its client rationalize the one strategic option available within the controlled mindset that pervaded the Special Committee’s process.” But, as Strine found, “Goldman and the Special Committee could not generate any responsible estimate of the value of Minerva that approached the value of what Southern Peru was asked to hand over.”

 

Strine found that as a result, the transaction was “unfair” to Southern Peru, because the special committee’s “cramped perspective” resulted in a “strange deal dynamic,” in which “a majority shareholder kept its eye on the ball – actual value benchmarked to cash – and a Special Committee lost sight of market reality in an attempt to rationalize doing a deal of the kind the majority stockholder proposed.” As a result of this “game of controlled mindset twister,” the committee “agreed to give away over $3 billion worth of actual cash value in exchange for something worth demonstrably less, and to do so on terms that by consummation made the value gap even worse, without using any of its contractual leverage to stop the deal or renegotiate its terms.” Because the deal was “unfair,” Strine concluded that “the defendants breached their fiduciary duty of loyalty.”

 

Since the time of the merger, Southern Peru’s share price has continued to climb. For that reason, and because of “the plaintiff’s delay in litigating the case,” Strine concluded that a rescission-based approach would be “inequitable.” Instead, Strine, utilizing a “panoply of equitable remedies,” crafted “a damage award that approximates the differences between the price that the Special Committee would have approved had the Merger been entirely fair (i.e., absent a breach of fiduciary duties) and the price that the Special Committee actually agreed to pay.” Strine noted that given the differences in values involved, the record arguably could support a damages award of $2 billion or more.”

 

However, taking into account the “imponderables” involved in many of the valuations, Strine took an approach he characterized as “more conservative.” His approach basically consisted of coming up with a value for Minerva based on an average of three possible valuation methodologies. This method came up with a valuation for Minerva of $2.409 billion. The 67.2 million shares Groupo México received were worth $3.672 billion.

 

Based on the difference between these two figures, Strine entered an award of $1.263 billion. Strine also awarded interest, without compounding, at the statutory rate from the merger date, and also from the date of judgment until payment. He also awarded plaintiffs’ attorneys’ fees, to come out of the award, in an amount he directed the parties to agree upon. Strine added that Groupo México could satisfy the judgment by agreeing to return to Southern Peru the number of shares necessary to satisfy the award.

 

Discussion

The addition of pre- and post-judgment interest could as much as another $100 million to the value of this award, meaning that the total value of this award is arguably as much as $1.36 billion (and counting). But as massive as this amount is, it does not represent the largest amount awarded in a shareholder derivative suit. As far as I am aware, that distinction belongs to the $2.876 billion awarded in the shareholder derivative lawsuit filed against former HealthSouth CEO Richard Scrushy, about which refer here. (Actually, the total amount of the damages in Scrushy case was $3.115 billion. It was only the application of $239 million credit for judgments entered against other defendants that brought the number down to the $2.876 billion.) The Southern Peru award does likely represent the largest award in a derivative suit in Delaware Chancery Court.

 

In light of the dollars involved, Groupo México has a strong incentive to appeal, although the accumulation of post-judgment interest could provide a reason to carefully assess the likelihood of success on appeal.

 

If it comes down to payment of the award, it looks to me like Groupo México’s best option would be to return the number of Southern Peru shares required to satisfy the award. The shares have dramatically escalated since the transaction closed (at current market valuations, and allowing for stock splits, the shares appear to be worth more then ten times what they were in April 2005). Paying the award with an inflated currency would appear to allow Groupo México to retain substantial benefits of this transaction.

 

There are at least a couple of important things to be drawn from the outcome of this case. First, this case represents a very substantial refutation to the many commentators who regularly complain that derivative litigation in Delaware courts provide shareholders’ with a toothless remedy. This case shows that the Delaware derivative litigation definitely can have bite.

 

Second, this case has some very important implications for board’s duties when considering a transaction proposed by a controlling shareholder. In particular, Chancellor Strine seemed particularly concerned that the special committee considered only the deal that the controlling shareholder proposed, suggesting that in these circumstances, boards and the committees must consider all alternatives and not just the one proposed by the controlling shareholder. More broadly, the board and its committee have a duty to consider more than just trying to figure out a way to complete the transaction that the controlling shareholder has proposed.

 

In view of the massive size of the award, the presence or absence of D&O insurance to pay part of the cost of this award is unlikely to be a material consideration. Were Groupo México to try to get its D&O insurer to pay a part of this award, it would face at lest a couple of likely objections from its carrier(s). First the carrier would contend that its policy provides coverage if at all for Groupo México itself only for “securities claims,” a term that is usually defined with reference to the insured company’s own securities. Since this transaction involved Southern Peru’s securities not Groupo México’s, the carrier would contend that there is no coverage for the award against Groupo México, because the award did not arise out a securities claim.

 

The carrier would likely also contend that in any event, because of the rescissionary nature of the award, there is no coverage under the policy, nor is there coverage under the policy for the return of amount for which the insured is not legally entitled.

 

This latter argument would likely also take care of any contentions by the individual defendants that they are entitled to coverage. An interesting issue though is the question of which company’s policy is the relevant policy. Though the individual defendants were affiliated with Groupo México, they were sued in their capacities as directors of Southern Peru. Accordingly, it would look as though the relevant policy for them to seek to access would be Southern Peru’s (although they might have also potentially have outside directorship liability coverage under Groupo México’s policy on an excess basis, a likelihood that is probably remote because that coverage is usually restricted to service on nonprofit boards).

 

The individuals’ prospects for obtaining coverage for the award under the Southern Peru policy would depend as an initial matter on their ability to overcome the carrier’s likely objections that there is no coverage under its policy for rescissionary damages. Those objections may well be insurmountable, but assuming for the sake of argument that that obstacle could be circumvented, the question would then be whether the policy’s Side A coverage would kick in, as providing coverage for nonindemifiable loss.

 

Given the size of the award and the hurdles the defendants would have to overcome in order to establish coverage, these insurance questions could all be more theoretical than real.

 

In any event, the eye-popping amount of the award here makes this case a noteworthy, and Chancellor Strine’s analysis makes these circumstances interesting. I suspect this decision will occasion a great deal of discussion, particularly around the duties boards’ face when forced to assess transactions that will benefit a controlling shareholder.

 

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

 

Alison Frankel has a very interesting October 17, 2011 commentary on this case on her blog on Thomson Reuters News & Insight (here). Professor Davidoff also has an interesting commentary about the case on the Dealbook blog (here).

 

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In a lawsuit suggesting a new area of potential liability for corporate directors and officers, a shareholder of J.P. Morgan Chase has filed a sderivative lawsuit against the company, as nominal defendant, and certain of its directors and officers alleging breaches of fiduciary duty in connection with the company’s recent $88.3 settlement with the U.S. Department of Treasury’s Office of Foreign Assets Control (OFAC). A copy of the derivative lawsuit complaint, filed September 6, 2011 in the Southern District of New York, can be found here.

 

OFAC is responsible for the administration of various trade sanctions regulations. In an August 25, 2011 press release, OFAC announced (here) that J.P. Morgan had agreed to pay $88.3 million to settle alleged violations of U.S. trade sanction regulations. Among other things, the OFAC press release described three alleged violations it characterized as “egregious.” Among the programs that OFAC alleged that the company had violated are those involving sanctions against Cuba, Iran and Sudan. The OFAC press release described the settlement as the largest settlement to date obtained by OFAC.  

 

On September 6, 2011, the Louisiana Municipal Police Employee Retirement System filed a derivative lawsuit in the Southern District of New York, naming eleven directors and officers of J.P. Morgan as defendants. The complaint alleges that the defendants “knowingly allowed and rewarded the Company’s violations of The U.S. Department of Treasury’s multiple sanctions programs.” The lawsuit alleges that “the misconduct occurred, unchecked, under the Defendants’ watch because of their complicity in the improprieties alleged herein.” The lawsuit seeks to “recover damages caused by the Individual Defendants’ unlawful course of conduct and breaches of fiduciary duty.” Among other damages alleged are “the costs to the Company associated with the settlement, remedial measures, damage to goodwill and increased regulatory scrutiny.”

 

As reflected in a September 23, 2011 memo from the Fried Frank law firm entitled “State Pension Plan Files Claim Seeking $88.3 Million OFAC Penalty” (here), among the implications of these developments is that “OFAC violations can have significant follow-on consequences for not only the company --- but officers and directors as well.” The payment of a settlement “sometimes is just the beginning,” as a settlement “can spark the attention of shareholders and result in the filing of a derivative lawsuit to hold officers and directors liable for repayment of any amounts paid in settlement.”

 

The prospect of a follow-on civil lawsuit following a civil settlement for OFAC violations raises a number of interesting challenges, particularly from an insurance standpoint. The settlement amount itself would not be covered under the typical D&O policy. The defense costs the defendants incur in a follow-on civil lawsuit would likely be covered. The interesting question comes in with respect to the damages alleged in the follow-on lawsuit. The question of the coverage for the alleged damages is analogous to the damages claimed in the follow-on civil actions filed following companies’ payment of Foreign Corrupt Practices settlements (about which refer here).

 

The complaint itself in this action actually has some things to say about D&O insurance. In arguing that its failure to make a pre-litigation demand on the J.P. Morgan board ought to be excused as futile, the plaintiff argues among other things that if the board were to sue themselves or other officers in connection with the OFAC violations, the claim would run afoul of the D&O policy’s Insured vs. Insured exclusion and therefore “there would be no directors’ and officers’ insurance protection” which is a “reason why they will not bring a suit.” The complaint notes that the Insured vs. Insured exclusion will not apply if the suit is brought derivatively.

 

Although the Insured vs. Insured exclusion would not apply to the plaintiff’s derivative suit, it remains an interesting question of what position the carrier would take with respect to the damages that the plaintiff seeks to recover. In any event, the lawsuit raises the possibility of a potentially significant new liability exposure for directors and officers of company’s engaging in transactions subject to OFAC’s oversight.

 

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Only small a small number of companies experienced a negative “say on pay” vote this past proxy season, but many of the companies that did found themselves hit with a shareholder lawsuit in the wake of the negative vote. Cincinnati Bell is one of the companies that with both a negative vote and subsequent shareholder lawsuit.  Now, in a September 20, 2011 opinion (here) that expressly references and even relies on the negative vote, Southern District of Ohio Judge Timothy S. Black denied the defendants’ ‘motion to dismiss the shareholder suit, finding that whether the defendants would be entitled to rely on the business judgment rule is a question for trial, and also finding hat the shareholders’ pre-lawsuit demand was excused.

 

Under Section 951 of the Dodd-Frank Act, reporting companies must seek a non-binding shareholder vote in the form of a resolution to approve the company’s executive compensation plan at least every three years. Cincinnati Bell’s 2011 proxy included a resolution seeking shareholder approval of its 2010 executive compensation plan. On May 3, 2011, 66% of the company’s voting shareholders voted against the resolution.

 

Thereafter, a shareholder plaintiff filed a derivative lawsuit alleging that the company’s board breached its fiduciary duty of loyalty when it approved large pay raises and bonuses to its top three executives in a year that, according to the plaintiff, the company performed poorly. The plaintiff’s complaint specifically referenced the negative say of pay vote.

 

The defendant board members moved to dismiss, arguing that their actions with respect to executive compensation were protected by the business judgment rule, and arguing further that the plaintiff had failed to make the requisite pre-lawsuit demand that the board consider the claims that he asserted in his lawsuit.

 

In his September 20 opinion, Judge Black found that that the plaintiff had adequately alleged that the Cincinnati Bell board was not entitled to rely on the business judgment rule, and that while the defendants may attempt to rely on the business judgment rule at trial, they were entitled to rely on the rule as a basis for dismissal.

 

In making this ruling, Judge Black noted that the plaintiff’s factual allegations “raise a plausible claim that the multi-million dollar bonuses approved by the directors at a time of the company’s declining financial performance violated Cincinnati Bell’s pay-for-performance compensation policy and were not in the best interests of Cincinnati Bell’s shareholders and therefore constituted an abuse of discretion and/or bad faith.”

 

Judge Black also rejected the defendants’ argument that the plaintiff’s lawsuit must be dismissed due to the plaintiff’s failure to make a pre-lawsuit demand on the company’s board. In reaching the conclusion that the demand was excused as futile, Judge Black said that:

 

Given that the director defendants devised the challenged compensation, and suffered a negative shareholder vote on the compensation, plaintiff has demonstrated sufficient fact to show that there is reason to doubt these same directors could exercise their independent judgment over whether to bring suit against themselves.

 

In reaching both of these conclusions, Judge Black specifically referenced and even relied on the fact of the negative say on pay vote. In reaching the conclusion that the defendants were not entitled to rely on the business judgment rule at the dismissal motion stage, and in concluding in particular that the plaintiff had adequately alleged that the board’s actions were “not in the best interests of Cincinnati Bell’s shareholders,” Judge Black specifically cited the plaintiff’s allegation that the negative say on pay vote “provides direct and probative evidence that the 2010 executive compensation was not in the best interests of the Cincinnati Bell shareholders.” As noted in the preceding paragraph, Judge Black also specifically referenced the negative say on pay vote in concluding that demand was excused as futile.

 

Discussion

As I have noted before, it is hardly surprising that there is shareholder litigation over executive compensation. Executive pay is a hot button issue that generates a great deal of interest and emotion. Indeed, in a footnote, Judge Black expressly cited a media commentary that “excessive executive compensation is the No. 1 problem in corporate governance.” This perspective clearly influenced Judge Black’s consideration of the dismissal motion.

 

But though the litigation itself may not be surprising, it is somewhat surprising that Judge Black in effect conceded the shareholder’s entitlement to rely on the negative say on pay vote. The Dodd-Frank Act is quite clear that the required vote is not binding on the company or its board. Moreover, Section 951(c) of the Act expressly states, among other things that the shareholder vote “may not be construed” to “create or imply any change to the fiduciary duties of such issuer or board of directors” or to “create or imply any additional fiduciary duties for such issuer or board of directors.”

 

Judge Black acknowledged these statutory limitations on the vote’s significance. He even acknowledged the concerns of Dodd-Frank critics that the say on pay requirement will lead to “extensive, frivolous litigation.” He nevertheless quoted with approval from other sources that “a negative say on pay vote give the court evidence that there’s been a breach of duty. It doesn’t mean there’s been a breach of duty, but it can support a finding of breach.”

 

On the one hand, all that has happened here is that the complaint has survived a dismissal motion. That is far from a finding that the defendants have actually violated any duties. On the other hand, it is highly unlikely that the defendants will context these claims all the way through trial. Most corporate and securities cases settle and their will be pressure on the defendants here to settle as well.

 

There is something very ironic about the fact that on the one hand the say on pay vote is nonbinding but was also expressly built to leave existing legal standard unchanged, and on the other hand the outcome of the say on pay vote can be used as a basis for denying a motion to dismiss an excessive compensation lawsuit – which in turn will create pressures for the corporate defendants to settle.

 

It is true that for companies whose executive compensation practices receive a positive shareholder vote, the say on pay requirement will not encourage litigation. But nevertheless, those who question whether the say on pay requirement will encourage litigation need to take a look at this case. The company’s negative say on pay vote was followed by litigation, and the outcome of the say on pay vote was used as a basis for denying the motion to dismiss. The vote created the context for the claim and also provided the plaintiffs a tool with which to maintain the claim.

 

As UCLA Law Professor Stephen Bainbridge said in an April 26, 2011 post on his blog (here), he knew these kinds of problems were coming when Congress incorporated the advisory say on pay provision in the Dodd-Frank legislation, having warned that the process “would be abused and turned from a supposed non-binding voting exercise into a club to beat directors with.”

 

The saving grace, perhaps, is that the vast majority of companies did not have a negative say on pay. However, for the companies that did, and who thereafter got caught up in shareholder litigation, these cases will be costly to defend and could be costly to resolve. These costs are a concern not only to the companies themselves but to their D&O insurers, who may wind up having to foot the bill at least for the defense expenses. All of this because of a non-binding vote that wasn’t supposed to change the legal standards in any way….

 

Alison Frankel notes in her post on Thomson Reuters News & Insight (here) that Judge Black’s ruling in the Cincinnati Bell case is contrary to the ruling of the Georgia state court in the Beazer Homes say on pay case.

 

Many thanks to Dan Gilman of SCN Strategies for providing me with a copy of Judge Black’s decision.

 

Ain’t Too Proud to Beg: The LexisNexis Insurance Law Community has now begun the process to select the Top 50 Insurance Law Blogs of 2011. I am pleased to note that The D&O Diary is among the blogs nominated for this list. The editors at LexisNexis are now soliciting comments from legal practitioners and others as part of the process to select the Top 50 blogs. The comments will serve as a part of the information the editors use to select the Top 50 blogs.

 

The initial list of nominees includes a number of fine blogs. I encourage readers to visit the site and post a comment about their favorite insurance law blog. I would be humbled if any reader would consider posting a comment about my site on the LexisNexis Insurance Law Community. To submit a comment, visitors need to log on to their free LexisNexis Communities account.  More detailed instructions about how to post a comment can be found here. If you haven’t previously registered, you can do so at the Insurance Law Community for free. The comment box is at the very bottom of the blog nomination page. The comment period for nominations ends on October 7, 2011. 

 

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A wave of litigation followed in the wake of the April 2010 Deepwater Horizon oil spill. Among this litigation were several shareholder derivative suits filed against certain directors and officers of BP and of its U.S. subsidiary. At the time these cases first arose, I asked whether or not these suits involving (and ultimately for the benefit of) an English corporation and even asserting claims under English law would be permitted to go forward in U.S. courts.  

 

A September 15, 2011 ruling from Judge Keith Ellison of the Southern District of Texas determined that, notwithstanding the fact that the Deepwater Horizon disaster took place in the U.S. and caused extensive environmental damage here, “the English High Court is a far more appropriate forum for this litigation,” and accordingly he granted the defendants’ motion to dismiss the cases.  Judge Ellison’s September 15 decision can be found here.

 

As discussed here, plaintiffs filed the first of several derivative lawsuits in connection with the Deepwater Horizon oil spill in May 2010. Though many of the lawsuits were first filed in the Eastern District of Louisiana, the cases were ultimately consolidated through the multidistrict litigation process in the Southern District of Texas. However, while the lawsuits were filed in U.S. courts, they asserted claims under the English Companies Act of 2006 (about which refer here). The defendants moved to dismiss the consolidated derivative litigation in the grounds of forum non conveniens.

 

In his September 15 ruling, Judge Ellison granted the defendants’ motion to dismiss. He summarized his ruling by saying that “this case is a shareholder derivative action brought under a recently enacted U.K. statute on behalf of an English Company against numerous English defendants and other foreign nationals.” The Court, he said, is “persuaded that the Complaint should be dismissed under the doctrine of foreign non conveniens, as the English High Court is the more appropriate forum for this case.”

 

Judge Ellison found that considerations of public interest “most strongly favor England as the appropriate forum in which to proceed with this case.” He noted that the focus would not be the events in the Gulf that led up to the oil spill, but rather the actions of the company’s board, which took place in England. He commented that “this lawsuit is not intended to redress the devastating impact of the Deepwater Horizon disaster in the Unites States. Instead the lawsuit is intended to compensate BP for the financial and reputational harm the company suffered as a result of its high level management’s alleged disregard for the safety of its operations.”

 

Judge Ellison noted that “the primary concern of this derivative litigation is the internal affairs of an English corporation, and the suit seeks to recover damages for the benefit of BP only.” He concluded that England “has a far greater interest in the resolution of this dispute.”

 

Judge Ellison was particularly concerned that were the case to remain in a U.S. court, the court would have to interpret and apply the recently enacted Companies Act. If the case were to go forward in a U.S. court, “the Court would be faced with the formidable exercise of interpreting and applying a still nascent and evolving body of law.”

 

Judge Ellison did condition his dismissal on the defendants proferring adequate proof that they are amenable to service of process in England or submitting a stipulation that the will submit to the jurisdiction of the appropriate English court.

 

Although the claimants clearly would have preferred to pursue their mismanagement claims against the BP officials in the U.S., where the disastrous oil spill occurred, Judge Ellison found that the allegations in this case involve alleged actions or inactions that took place in England. The fact is that though the shareholders chose to file their action here in preference to England, with full awareness that English courts presented an alternative forum. The decision to file here rather than there undoubtedly had something to with a perception that a court in closer proximity to the damages cause by the spill might prove to be a more receptive forum. The selection of a U.S. court over an English one also reflects the more general advantages a plaintiff enjoys here by comparison to English courts – for example, the absence in the U.S. of a “loser pays” model, among other things.

 

These kinds of advantages often encourage plaintiffs with claims involving non-U.S. companies to try to pursue their claims in U.S. courts. But the outcome of the dismissal motion in the BP derivative suit represents just one more example of the many ways prospective litigants are finding it increasingly more difficult to pursue corporate and securities claims against non-U.S. companies in U.S. courts. Courts interpreting the U.S. Supreme Court’s Morrison decision have significantly narrowed the circumstances in which securities claims involving foreign companies can go forward in U.S. courts. Judge Ellison’s decision in the BP case underscores the difficulties prospective claimants may fact in pursuing derivative suits involving non-U.S. companies here as well.

 

Alison Frankel’s September 16, 2011 Thomson Reuters News & Insight article about Judge Ellison’s decision can be found here. Victor Li’s September 16, 2011 Am Law Litigation Article about the decision can be found here.

 

For Whom the Statute Tolls: Under Section 13 of the ’33 Act, liability actions alleging a violation of the statue must be brought within one year of “discovery of the untrue statute or omission.” Section 13 provides further that in no event shall the action be brought more than three years after the security was first offered to the public. The one year provision represents a statute of limitation and the three year provision represents a so-called “statute of repose.”

 

Questions of statutes of limitation and repose might seem obscure, but they can often be critical in determining whether or not a case will go forward. A September 15, 2011 decision by Southern District of New York Judge Laura Taylor Swain in the Morgan Stanley Mortgage Pass-Through Certificates Litigation (here) presents interesting and potentially significant rulings on both the statute of limitations and statute of repose issues.

 

The case involves claims asserted by investors who purchased certain mortgage-backed securities issued by various Morgan Stanley related entities. The plaintiffs allege that the offering documents related to these securities misrepresented and omitted material facts regarding the underwriting standards applied by the loan originators. As detailed in Alison Frankel’s September 16, 2011 article in Thompson Reuters News & Insight (here), this lawsuit has a convoluted procedural history, in part due to the plaintiffs’ efforts to assemble a group of prospective class representatives whose claims were not time-barred. This latest dismissal motion round involved amended allegations and additional named plaintiffs. The defendants again moved to dismiss based on the statute of limitations and the statute of repose.

 

Judge Swain’s 40- page opinion reflects a number of interesting rulings, particularly with respect to the timeliness questions. First, she rejected the defendants’ arguments, based on information that was publicly available more than a year before the initial complaint was filed, that the claims of the Public Employees’ Retirement System of Mississippi (MissPERS) were untimely. Judge Swain said that though there was ample publicity on issues pertaining to circumstances relevant to the securities, none of the various items of publicity “addresses, even at a speculative level, the disregard of underwriting practices, neglect of appraisal standards, or consequent LTV ration misrepresentations alleged in the [amended complaint]”

 

Nevertheless, though she found that the early warnings were not sufficient to trigger inquiry notice, she also found that the plaintiffs had not alleged with sufficient specificity the time and circumstances of their discovery of the conduct alleged in their claims. Accordingly she allowed the plaintiffs leave to replead to establish the circumstances of their discovery in order to establish compliance with the one year statute of limitations.

 

Perhaps even more interesting is Judge Swain’s ruling on the question of the three-year statute of repose, and in particular her application of what is known as the American Pipe tolling doctrine. Under this doctrine, which derives from a 1974 U.S. Supreme Court opinion, the initiation of an earlier class action suit tolls the running of the statute of limitations for other purported class members who may later seek to intervene and represent the class. The application of the American Pipe tolling doctrine to the running of the statute of limitations is well established. A long standing question has been whether American Pipe tolling also applies to the statute of repose. Judge Swain held that American Pipe tolling does apply to the statue of repose, and denied defendants’ argument that the claims of certain new plaintiffs were barred by the statue of repose in the ’33 Act.

 

In holding that American Pipe tolling applies even to the three-year statute of repose, Judge Swain declined to follow two recent decisions by other Southern District of New York judges. She reasoned that the tolling doctrine is equitable in nature and “permits a court – after weighing the equities in the discrete case before it – to authorize plaintiffs to bring actions outside the limitations period.”

 

Judge Swain’s ruling about the statute of repose represents a potentially big deal. If followed by other courts, it could potentially be very significant in cases where an initial plaintiff’s purported class action is dismissed for the plaintiff’s lack of standing. Other prospective claimants who might want to come forward at that point might find their claims blocked by the statute of repose, if the initial filing did not toll the statute’s running.

 

This possibility is not merely theoretical, particularly with respect to the many mortgage-backed securities class action claims that have been asserted in the wake of the financial crisis. In many of these cases, the claimants have had some of their initial claims dismissed because the named plaintiff did not actually buy securities in all of the offerings in which the securities were sold. Judge Swain’s ruling, if followed, would remove one potentially significant impediment that might other wise exist for other prospective claimants who did buy securities in the other offerings and who might want to come forward and assert class claims on behalf of other investors who bought those securities.

 

The question is whether other courts will follow Judge Swain on these issues, or will follow the other two Southern District of New York decisions that recently went the other way and held that American Pipe tolling does not apply to the statute of repose.  In her September 16, 2011 Am Law Litigation Daily article about Judge Swain’s ruling in the Morgan Stanley case (here), Susan Beck identifies and links to the two other recent Southern District of New York rulings that Judge Swain declined to follow. She also speculates that the Second Circuit will likely weigh in on these issues, given that the two prior cases (which resulted in dismissals) are on appeal to the Second Circuit and have been consolidated for one hearing before that court.

 

Special thanks to a loyal reader for sending me a copy of Judge Swain’s decision in the Morgan Stanley case.

 

When Words Fail: Here in the blogosphere, the deadline is always right now. Because of the need for speed and the fact that I work alone (often late at night or very early in the morning), mistakes sometimes make their way into my blog posts. Because I don't the benefit of an editor's surveillance, I am always grateful when readers point out the errors to me, so that I at least have the opportunity to make a correction.

 

Massive media organizations publishing on a regular weekly basis with the benefit of a large editorial staff have fewer excuses for errors. For that reason, I am always appalled at the slips that make their way into print in some traditional print publications.

 

This week’s candidate for the boo-boo that someone really should have caught appears in the current issue of Time Magazine (cover date September 26, 2011). In an article entitled “After Three Years and Trillions of Dollars, Our Banks Still Don’t Work” (here, subscription required), Stephen Gandel writes, with reference to comments by analyst Meredith Whitney about the banking sector, “Eventually, Whitney says, growing litigation issues and a continued drop in housing market were bound to burst the levy.” I am pretty sure Whitney meant that eventually the “levee” was bound to burst, as a "levy" might be on a ballot or be imposed but I have never heard of one bursting. In addition, I feel pretty confident that if this were pointed out to Gandel, a “damn” would burst out as well.

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

Background

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

 

Umpqua’s “Say on Pay” Vote

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

 

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

 

The Lawsuit

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

 

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

 

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

 

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

 

Discussion

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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Berkshire Hathaway Chairman Warren Buffett was not exaggerating when he stated at the opening of the company’s March 30, 2011 press release (here) that the release “will be unusual.” Not only did Buffett disclose the resignation of David Sokol as Chairman and CEO of several subsidiaries, but the release also revealed that Sokol had acquired shares of Lubrizol before bringing the idea to Buffett that Berkshire should acquire Lubrizol. (Berkshire had announced its intention to acquire Lubrizol just days earlier.)

 

As odd and inexplicable as were the events described in the March 30 Berkshire press release, the story became even odder and more inexplicable as information came out that Sokol acquired Lubrizol shares after specifically discussing -- apparently as a representative for Berkshire -- with investment bankers that possibility that Lubrizol might be an appropriate acquisition target for Berkshire. Sokol also apparently acted as a representative for Berkshire in connection with negotiations with Lubrizol about a possible Berkshire acquisition.

 

Given the high-profile and sensational nature of these allegations, it was perhaps inevitable that litigation would follow. Indeed, a lawsuit was duly filed in Delaware Chancery Court on April 18, 2011. The complaint, which can be found here, presents a shareholders’ derivative claim against Berkshire, as nominal defendant, as well as against Sokol and against the twelve individual members of Berkshire’s board – including not only Buffett, but his chum Charlie Munger and his fellow billionaire Bill Gates. The complaint asserts two substantive claims, one against all of the individual defendants for breach of fiduciary duty and one against Sokol for disgorgement.

 

As a Berkshire shareholder myself as well as a long time Buffett devotee, I have to admit I winced – hard—when reading the March 30 press release. Just the same, the lawsuit makes me uneasy too. Perhaps my long devotion to Buffett biases my view. I confess that I have been unable to bring myself to write about the lawsuit until now because of my conflicted feelings. I do have to admit that the complaint does make for some interesting reading. The time line of events portrayed in the complaint does not reflect well on Sokol, to say the least.

 

The Complaint is less compelling when it tries to detail the specific harms these events have caused the Company. Among other things, the Complaint cites credit analysts to the effect that these events “could result in a negative credit rating for Berkshire” and that have “flagged concerns over the Company’s lack of traditional corporate infrastructure.” The Complaint also cites the decline in Berkshire’s share price that following the March 30 disclosure.

 

One threshold problem the claimant will face is showing that the requisite demand on Berkshire’s board would have been futile. In order to try to establish demand futility, the complaint alleges that the board could not be relied upon to “take proper action on behalf of the Company” due to their “inter-related business, professional and personal relationships” as well as “debilitating conflicts of interest” arising from “prejudicial entanglements and transactions which compromise their independence.” (Francine McKenna’s blog post about the demand futility issue on her Accounting Watchdog blog at Forbes.com can be found here. )

 

But assuming for the sake of argument that the plaintiff can overcome the demand futility hurdles there is the question of whether or not the plaintiff can hope to prevail on the merits.

 

Over at the Delaware Corporate and Commercial Litigation Blog (here), esteemed fellow blogger Francis Pileggi has assembled a host of helpful links and commentaries about the lawsuit. (I would be remiss if I did not also mention here my thanks to Francis for his blog’s provision of a link to the Complaint, as well.) Among the more interesting sources he cites is UCLA Law Professor Stephen Bainbridge’s thorough analysis of the possible merits of the claim, which can be found here and here.

 

Among other things, in the second of his two posts, Professor Bainbridge expressly raises the problems that the plaintiff will have meeting the demand futility test. More interestingly, in both posts, Bainbridge elaborates on the view that the disgorgement claim against Sokol seems to be supported under existing Delaware case law.

 

Professor Bainbridge’s analysis is interesting and persuasive. But it doesn’t answer what is for me the even more interesting question this lawsuit presents, which relates to the breach of fiduciary duty claim alleged against the Berkshire directors. Can the directors – or any one of them (say, for example, Buffett) -- possibly be held liable for failing to take actions that allegedly could have prevented supposed harm to the company?

 

UPDATE:In a subsequent post (here), Professor Baibridge has answered my question about the possibility that the Berkshire board could be liable for failing to supervise Sokol's trades. In Bainbridge's view, the answer to the question is "no," for reasons he explains in his post.

 

I guess I have too much of a practical habit of mind. Or perhaps it is just because I am a Berkshire shareholder. But I do have to wonder what this lawsuit ultimately is going to produce, other than the generation of massive amounts of legal fees (as if that were something that would be in any company’s interest). Sure, sure, if Professor Bainbridge is right, the disgorgement claim against Sokol might be meritorious, in which case Sokol would have to disgorge h is trading profits to Berkshire. Even so, the most that would garner for the company is about $3 million or so, as I understand it, at the cost of God know how much in legal fees (plus of course the payment of plaintiff’s  attorneys fees --  or at least so  the plaintiff’s  attorneys’ hope).

 

If all this case is about is the disgorgement claim, this sure seems like an enormous waste of everybody’s time. (Indeed, Sokol could save himself and everyone else a whole lot of aggravation if her were to just take out his checkbook and write Berkshire a check for his trading profits.)

 

Of course, there is always at least the theoretical possibility of damages for the breach of fiduciary duty claim against the other directors. It is only really conceivable to even think about this possibility by overlooking the highly speculative nature of the alleged harms the company sustained and the evanescence of the share price decline. And even then -- perhaps others can form a picture of say, Buffett, paying money to Berkshire, but it would take a lot more to persuade me that that could happen here and if it could that it would remotely make sense.

 

One other possibility that does come to mind is that, if the case gets that far, perhaps the resolution of this case, like the resolution of many shareholder derivative lawsuits, will include the company’s agreement to adopt certain corporate governance reforms. There would be something highly ironic about Berkshire, of all companies, taking on, say, board oversight obligations. However, the original source of the irony is in the events that led to all of this, which is that, at least as the plaintiff would have you believe, Buffett failed to follow the company’s own existing internal guidelines on these types of matters.  

 

There would be something ironic indeed if Berkshire were to have to implement more “traditional governance infrastructure.” I appreciate irony as much as anybody. But as a shareholder I do wonder whether that would actually be good for the company.

 

One final thought. To paraphrase a recent post on the Deal Journal blog (here) -- You don’t suppose there might be a question or two about all of this at next week’s meeting of Berkshire’s shareholder, do you?

 

Where are Today’s Tsunami Stones?: The April 21, 2011 New York Times has a fascinating article entitled “Tsunami Warning for the Ages, Carved in Stone” (here). The article is about the small village of Aneyoshi, Japan, where an aging stone marker set into the hills warns “Do not build your homes below this point!”  Village residents say this warning kept their homes safely out of reach of the deadly tsunami last month.

 

There apparently are hundreds of these stones scattered throughout Japan. Sadly, in modern times, residents came to put more faith in advanced technology and higher sea walls, and many of the warning were ignored.

 

The stones were meant to communicate a critically important message. But their very existence suggests something deeper. The people who put those stones up were capable of thinking very concretely about future generations. They were able to envision the people 80 or 100 years in the future who might need to know what they knew. The erection of the tsunami stones was an act of incredible foresight and incredible generosity.

 

Toward its end the article quotes a Japanese scientist as saying “We need a modern version of the tsunami stones.” The scientist was thinking specifically about potential harm from future tsunamis. But I think the need for warnings to future generations is not limited just to Japan and not just to tsunamis. There are so many things that future generations will need to know. I wonder whether we are able to look forward as those who built the original tsunami stones did. What are we willing to do to protect those unborn people who need to know what we have seen? I sometimes worry that we are incapable of thinking about the needs of those who will be living their lives 80 or 100 years from now.

 

And then finally, there is the lesson of the tsunami stones that were disregarded. As long as people insist on building in flood planes, for example, there will be people who suffer because they choose to disregard the evidence. And as someone who works in the insurance industry, I know all too well how significant economic activity can be carried out in complete obliviousness to the stark warnings of the past. . The landscape of the insurance industry is littered with its own version of tsunami stones yet the warnings of the past are so often disregarded.

 

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In the wake of Pfizer’s record-setting September 2009 $2.3 billion settlement of charges that it had engaged in off-label marketing of Bextra and other drugs, Pfizer investors filed shareholders derivative lawsuits against the company, as nominal defendant, and 19 of the company’s directors and officer, alleging that the defendants breached their fiduciary duties by failing to detect and prevent the illegal marketing.

 

The parties have now entered a $75 million settlement of the derivative lawuits. The settlement has several interesting features, particularly with respect to the insurance, which is funding the entire settlement amount. The settlement is subject to court approval.

 

Background

On September 2, 2009, the Department of Justice announced that Pfizer had agreed to pay a total $2.3 billion dollars in settlment of the off-label marketing allegations.. In its press release describing the settlement, the DoJ said that the settlement – which represented a criminal fine of $1.195 billion and a civil False Claims Act settlement of $1 billion, as well as certain additional civil forfeitures – represented the largest health care fraud settlement in the DoJ’s history.

 

Following the announcement of this settlement, investors filed a number of shareholder derivative lawsuits, which ultimately were consolidated in a single action in the Southern District of New York before Judge Jed Rakoff. Background regarding the derivative litigation can be found here. The plaintiffs’ consolidated amended complaint can be found here.

 

The Settlement

On December 2, 2010, the plaintiffs filed a motion for preliminary approval of the derivative litigation. The motion, to which the settlement stipulation is attached, can be found here (Hat tip to the Seeking Alpha blog for the settlement documents.).

 

In the settlement, Pfizer and the other defendants have agreed to set up a Regulatory and Compliance Committee to report to the company’s board and to take appropriate steps to prevent future drug marketing violations. Among other things the committee will review compensation policy and practices to ensure they are consistent with the compliance objectives.

 

One of the things that makes this settlement unusual is the way the committee’s activities are to be funded. As part of the settlement, a pool of funds – to be financed entirely by insurance – will be used to pay for the committee’s activities for five years.

 

Under the settlement stipulation, four of the company’s D&O insurers "shall pay a total of $75 million into an escrow account under the control of Pfizer." After payment of fees and expenses, the remaining escrow funds "shall be subject to the exclusive control of the Regulatory Committee for funding activities of the Regulatory Committee for its initial five years." If the committee spends more than the funds available, Pfizer will make up the difference. If the committee spends less that the remaining funds, unspent amounts are to be returned to the insurers. (The four insurers involved are listed on page 9 of the settlement stipulation.)

 

A further provision of the settlement stipulation specifies that settlement contribution by the fourth of the four insurers is subject to arbitration. Pfizer may have to pay the insurer up to $20 million depending on the outcome of the arbitration.

 

An exhibit to the settlement stipulation specifies that the plaintiffs' lawyers will seek attorneys' fees of $22 million plus costs of $1.9 million. The amount of the plaintiffs’ fees awarded is to come out of and thereby reduce the $75 million. If plaintiffs are awarded the full amount of fees and costs sought, the net funds remaining of the original $75 million would be $51.1 million.

 

At least one news report suggests that the company’s entry into this derivative settlement, together with the earlier DoJ settlement, may have hastened or even directly led to the abrupt departure of Pfizer CEO Jeff Kindler.

　

Discussion

A frequent component of derivative lawsuit settlements is the company’s agreement to adopt certain governance reforms or to implement certain corporate therapeutics. So from that perspective, Pfizer’s agreement as part of this settlement to set up a compliance committee to ensure good behavior is not unusual.

 

One of the things that is unusual about this arrangement is that, among other things, there is a specific pot of money that is to be set aside to fund the compliance reforms to which the company has agreed as part of a derivative settlement.

 

And what is even more unusual, and arguably unprecedented, is that the funds to be set aside for these activities are to be provided for exclusively by the company’s D&O insurers.

 

I am sure the D&O insurers’ contribution toward this settlement was the subject of extensive negotiation. I can certainly imagine the carriers taking the position that the cost of the company’s compliance or governance activities represents corporate overhead expenses and as such is not covered loss under the company's D&O liability insurance. I expect these kinds of questions had to be sorted out in the course of the negotiation of this settlement. (The fact that one of the four D&O insurer’s contribution toward the settlement is subject to arbitration suggests further that these questions were not fully sorted out as part of the settlement negotiations.)

 

On the other hand, the idea behind the settlement may be that the individual defendants nominally agreed to pay for the remedial measures, and the insurers are simply paying on the individuals’ behalf. From that perspective, the prospect of the D&O insurers undertaking to pay those amounts on the individuals’ behalf may make the arrangement more consistent with the D&O insurance policy’s basic proposition.

 

But while this latter analysis may make the insurers’ contribution explainable in insurance terms, the fact that the insurers are basically paying for corporate governance reforms arguably represents something of a novel development and may represent a noteworthy precedent going forward.

 

Another noteworthy aspect of this settlement of this settlement is its sheer size. The $75 million dollar value of the settlement makes it one of the largest shareholders derivative settlements of which I am aware, exceeded only by a very small handful of other derivative settlements, including the UnitedHealth Group settlement ($900 million, refer here ); Oracle ($122 million, refer here), Broadcom ($118 million, refer here), AIG ($115 million, refer here), and the AIG/Greenberg settlement ($90 million, refer here).

 

There was a time when a significant cash payment was not a part of shareholders’ derivative lawsuit settlements. However, as this growing list of jumbo settlements underscores, derivative suit settlements involving a large cash component are becoming increasingly common – which , among other things, has important implications for D&O insurers and their policyholders.

 

Along those lines, one thing the Pfizer settlement has in common with these other jumbo derivative settlements is that each of these settlements involves solvent entities. The relevance to me from the fact that Pfizer is solvent derives from the added fact that this settlement almost certainly represented a payment of the Side A of the company’s insurance program – indeed, the identity of the insurers involved strongly suggests that this settlement represents a Side A insurance loss.

 

If as I assume to be the case this settlement represents a Side A insurance loss, this settlement represents yet another case in which insurers have been called upon to fund a substantial Side A loss outside of the insolvency context. (Please see my discussion of the Broadcom settlement, here, for a more detailed review of the significant of the Side A loss payment outside of the insolvency context.)

 

These kinds of settlements provide concrete evidence of the value to policyholders of significant amounts of Side A insurance even outside of the insolvency context.

 

These settlements also underscore the fact that even Excess Side A insurers are exposed to potential losses – even outside of the insolvency context – and that this exposure seems to be increasing over time. Only the insurers themselves can answer the question of whether or not they are actually pricing their products for the risk of Side A losses outside the insolvency context.　

 

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As reflected in their agreement filed on August 26, 2010, the parties to the New York and Delaware derivative actions involving former AIG CEO Maurice Greenberg, as well as certain other former AIG directors and officers, have agreed to settle the case for a payment to AIG by its D&O insurers of $90 million. The agreement also provides that the insurers will pay $60 million to Greenberg and Howard Smith, AIG’s former Chief Financial Officer, for their legal fees.

 

The settlement is subject to the approval of Delaware Chancery Court Vice Chancellor Leo Strine. Jef Feeley and Hugh Son’s August 27, 2010 Bloomberg article about the settlement can be found here.

 

This derivative lawsuit settlement follows AIG’s $725 settlement of a related securities class action lawsuit, and also follows the $115 million settlement in 2008 of a separate shareholders derivative lawsuit involving directors and officers of AIG.

 

Background

In 2004, the first of many separate shareholders derivative lawsuits (later consolidated) were filed in New York and in Delaware, against AIG as nominal defendant, and against numerous former AIG directors and officers, including Greenberg and Smith. The investors alleged that AIG insiders to misstated AIG’s financial performance in order to deceive investors about AIG’s financial condition.

 

The centerpiece of the lawsuit was an allegedly fraudulent $500 million reinsurance transaction in which various AIG insiders staged an elaborate artificial transaction with Gen Re Corporation. The complaint also alleged AIG insiders allegedly used secret offshore subsidiaries to mask AIG losses, misstated accounts with no basis for their adjustments, failed to correct well-documented accounting problems in an AIG subsidiary, and hid AIG’s involvement in controversial insurance policies that involved betting on when elderly people would die. The complaint also related to alleged bid-rigging allegations and alleged sale of illegal financial products.

 

In a lengthy February 2009 opinion, Delaware Vice Chancellor Leo Strine denied the motions to dismiss of Greenberg, Smith and certain other senior former AIG officials, although he granted the motion as to certain other individuals. Strine observed, among other things, "The Complaint fairly supports the assertion that AIG’s Inner Circle led a — and I use this term with knowledge of its strength — criminal organization. The diversity, pervasiveness, and materiality of the alleged financial wrongdoing at AIG is extraordinary."

 

Following further procedural wrangling and developments, the parties participated in a series of mediations involving retired Judge Layn Phillips, which resulted among other things in this settlement agreement.

 

The Settlement

The August 26 agreement seems to resolve all of the litigation involving all of the parties. However, the agreement is also not self-sufficient, as it is "conditioned upon execution of and compliance with a written settlement agreement under which the D&O carriers" pay the agreed upon amounts. I have not been able to obtain a copy of the separate insurance agreement and indeed the wording of the August 26 agreement suggests that at least at the time the August 26 agreement was drafted, the implied insurance agreement had not yet been drafted or fully executed.

 

The August 26 agreement does recite that the applicable insurance consists of AIG’s 2004-2005 D&O insurance tower, which has aggregate limits of liability of $200 million. The agreement does not identify the insurers in the tower or their respective limits of liability. The agreement also recites that the parties to the August 26 agreement have claims pending against the insurance tower in excess of its $200 million limit.

 

The agreement also states that the insurers "dispute that the D&O Insurance Tower is available to pay the claims made under the policies," but that the parties "desire to resolve their disputes regarding the appropriate allocation of their respective rights to the D&O Insurance Tower."

 

The agreement also incorporates certain understandings as the plaintiffs’ attorneys’ fees. Among other things, the agreement provides that the Delaware plaintiffs’ attorneys shall seek and the other parties shall not oppose attorneys’ fees of no more than 22.5% of the Settlement Amount (i.e. no more than $20.25 million) and no more than $1 million in expenses. The New York plaintiffs’ attorneys will seek a fee of no more than $2.5 million. If the two sets of attorneys were to realize the full amount of these fee awards and expenses, the net recovery to AIG from the settlement would be $66.25 million.

 

Discussion

There are a number of interesting things about this settlement. First, the cash payments specified in the agreement are to be funded exclusively with the proceeds of the D&O Insurance Tower.

 

Indeed, the Bloomberg article linked above quotes Greenberg’s attorney as saying that all of litigation by or on behalf of AIG again Greenberg "was settled with Mr. Greenberg paying nothing and other parties paying money to Mr. Greenberg." (This statement is probably worthy of an entire blog post some day all on its own.). Victor Li’s August 27, 2010 Am Law Litigation Daily article (here) about the settlement quotes the Delaware litigation lead plaintiffs’ attorney as saying that as a result of the settlement, $90 million is going to AIG that otherwise would have gone to Greenberg and other defendants based on a 2009 settlement between AIG, Greenberg and Smith, under which AIG agreed to reimburse up to $150 million of their legal fees.

 

While others can debate who gave or got what in this settlement, the bottom line is that the money for this settlement is coming entirely from insurance.

 

Without details about the separate insurance settlement referenced in the August 26 agreement, it is hard to know for sure, but it seems as if the $150 million of insurance funds exhausts the remaining funds under the D&O Insurance Tower, either by actual payment of loss or by compromise. (There obviously is some linkage between the $150 million total of payments in the August 26 agreement and the November 2009 agreement between AIG and Greenberg, but the precise connection isn’t apparent from the face of the documents I have seen so far.)

 

In addition to the fact that the August 26 agreement recites that the parties claims on the D&O Insurance Tower exceed the Tower’s $200 million aggregate limits of liability, another reason I assume that the Tower is actually or effectively exhausted is the interpleader action the primary insurer in this Tower filed against Greenberg and AIG, in order to avoid or resolve an arbitration dispute about priority rights to the proceeds of the $15 million primary policy. By interpleading the $15 million limits of liability, the primary insurer was effectively disclaiming any rights to those funds, indicating that those amounts at least consumed by claims costs. The next layers up above the primary insurance undoubtedly were also substantially eroded if not consumed by claims costs as well.

 

My final observation about the $90 settlement on behalf of Greenberg with AIG is that this represents yet another jumbo settlement of a shareholders’ derivative suit. There was a time when a derivative lawsuit settlement involving substantial cash payments was very unusual, but in recent years substantial payment of cash in connection with the settlement of derivative lawsuits has become increasingly common.

 

In addition to the $115 million settlement of the prior AIG derivative suit, other large recent derivative lawsuit settlements include the $118 million Broadcom options backdating related derivative settlement, the $122 million Oracle settlement and the $225 million Comverse Technology options backdating related derivative lawsuit settlement. It is particularly noteworthy that all of these payments are outside the insolvency context.

 

One consequence of this outbreak of jumbo settlements in derivative lawsuits is that the possibility that Excess Side A insurance might be called upon to pay loss – even outside of the insolvency context -- seems to be increasing. Certainly these massive settlements provide increasing evidence for the value to insureds of these kinds of insurance structures, whether or not the recent AIG settlement did or did not actually involve contributions from Excess Side A insurers. The increasing numbers of derivative settlements involving large cash payments certainly underscores that the Excess Side A insurers are exposed to potential losses -- even outside of the insolvency context -- an exposure that actually seems to be increasing over time.

 

Special thanks to Jef Feeley for providing a copy of the August 26 agreement.

 

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One side-effect from the oil slick spreading across the Gulf of Mexico following the blowout of the Deepwater Horizon oil rig, and a direct result of the massive economic and environmental damage it has caused, is the efflorescence of lawsuits from persons whose property or livelihood have been threatened or damaged by the spill. Given the magnitude of the damage and the extent of the ensuing litigation, it was perhaps only a matter of time before the expanding litigation wave came to include D&O claims too.

 

On May 7, 2010, a BP shareholder filed a shareholders’ derivative lawsuit (complaint here) against BP PLC, as nominal defendant, and 15 individual directors and officers, including Tony Hayward, BP’s CEO. The defendants also include Transocean Ltd. and related entities, the Deepwater Horizon’s rig owner; Cameron International Corp., which manufactured the blowout prevention devices that allegedly failed; and Halliburton Energy Services, which was installing cement casing on the well-head at the time of the explosion. The complaint also purports to name as defendants the third-party defendants’ insurers.

 

The complaint seeks recovery against the BP defendants for breach of fiduciary duty and corporate waste. The complaint alleges that despite numerous other prior safety and environmental concerns at BP the defendants "elected to cut costs, including safety and manufacturing expenditures in pursuit of profitable results, even lobbying regulatory authorities to "remove or decrease the extent of safety and maintenance regulation."

 

The complaint also asserts claims against the third-party defendants for contribution and constructive trust alleging that their misconduct was a "substantial factor in the disaster" and therefore they "should be held responsible for the effects of the disaster."

 

Among the damages to BP that the plaintiff alleges are the costs of $6 million per day that BP is spending to try to stop the leak and remediate its effects; BP’s required cleanup costs under federal and state statutory mandates; its exposure to lawsuits; as well as damage to BP’s reputation and good will, which as already resulted in a drop in BP’s share price.

 

There are a number of very interesting things about this lawsuit, particularly with respect to the claims against BP’s directors and officers.

 

The is that, in arguing that the BP board cannot objectively evaluate whether to bring the claims alleged in the complaint, the complaint explicitly references BP’s prior disasters, including the infamous 2005 Texas City, Texas refinery explosion and fire and the 2006 Prudhoe Bay oil spill. In particular this most recent complaint references the Prudhoe Bay shareholders’ derivative lawsuit filed against BP’s directors and officers, in which the defendants had (according to the latest complaint) agreed to "certain corporate governance changes at BP designed in part to prevent a recurrence of safety and maintenance problems at the company." (General background regarding the Prudhoe Bay lawsuit and its outcome can be found here.)

 

The Deepwater Horizon lawsuit complaint alleges that notwithstanding the commitment in the Prudhoe Bay litigation settlement agreement BP has "merely gone through the motions" to make the agreed upon changes, as a result of which the company has "not experienced one iota of improvement in its workplace and environmental safety." Elsewhere the complaint alleges that notwithstanding the severity of the safety concerns that led to this prior settlement that company has been "making purely cosmetic changes at the corporate level while ignoring the substance of the safety violations and the threat to" the environment as well as to "the Company’s own survival as a going concern."

 

Second, as another argument why demand on the current board should be excused, the complaint also cites the massive wave of litigation that has already been filed against BP in the wake of the Deepwater Horizon disaster. The complaint argues that the BP defendants "cannot reasonably be expected to defend BP itself against allegations of misconduct in [the other lawsuits] while simultaneously pursuing these claims" in the derivative suit "for the very same or very substantially related misconduct." Given the vast number of claims, the complaint contends, "it is not possible for the Director Defendants in this case…to impartially consider whether to bring these claims."

 

Third, the complaint, though filed in Louisiana, expressly references the standards identified in the British Companies Act of 2006, particularly the Act’s requirement in Section 172 that corporate boards ensure that their companies conduct operations with due regard for "the impact of the company’s operations on the community and the environment." This express reference to U.K. law is interesting given that the case is filed in Louisiana and highlights what may be one fundamental problem the plaintiff may face, as discussed further below.

 

Fourth the plaintiffs’ bid to join the third-party defendants’ insurers seemingly represents an attempt to take advantage of the fact that Louisiana is one of the few jurisdictions permitting tort claimants to bring so-called "direct actions" against their tortfeasor’s liability insurers.

 

Though the plaintiff’s complaint invokes the full-throated rhetoric of righteous outrage, it nevertheless faces certain hurdles that could shut the case down before it gets started.

 

The first of course is that the plaintiffs have not made the requisite demand on BP’s board to bring these claims directly on the company’s behalf. As noted above, the plaintiff has argued that due to prior litigation against BP and current Deepwater Horizon-related litigation now emerging, demand should be excused.

 

Setting aside the question whether or not demand is excused, there are other potential threshold hurdles. One that is amply illustrated in the complaint’s reference to the U.K. law noted above which is that BP is a U.K. corporation organized under the U.K.’s laws. BP will undoubtedly attempt to argue that the "internal affairs doctrine" dictates that the U.S. court should decline jurisdiction, so that these claims involving a U.K. corporation and U.K. law may be heard in U.K. courts.

 

The "internal affairs doctrine" was argued successfully by another U.K. corporation, BAE Systems, which successfully had derivative litigation in the U.S. arising from the company’s bribery scandal dismissed in reliance on the "internal affairs doctrine." Indeed, BP itself unsuccessfully raised similar arguments in the Prudhoe Bay derivative litigation.

 

The plaintiffs’ complaint attempts to anticipate these arguments. The complaint is full of explicit references to the myriad vital contacts between BP and the U.S. Among other things the complaint emphasizes that 39% of BP’s shareholders are located in the U.S. and that its energy production and capital expenditures are larger in the U.S. than in any other country. The plaintiff is clearly cueing up an argument that the circumstances uniquely affect the U.S. and its interests and therefore the case comes within an exception to the doctrine.

 

Where the BP derivative litigation may ultimately head remains to be seen. At a minimum, BPs directors and officers face the prospect of enormous expense defending against this litigation, and significant potential liability.

 

It should not be overlooked that this lawsuit represents yet another example of a company domiciled outside the United States facing a D&O claim in the U.S. courts. The susceptibility of non-U.S. companies to U.S.-based D&O litigation is a topic of recurring interest, among other reasons because of the securities law issues regarding the extraterritorial jurisdiction of the U.S. securities laws, of the kind raised in the National Australia Bank case now pending before the U.S. Supreme Court.

 

These questions of non-U.S. companies’ exposure to U.S. claims are also a topic of recurring interest to D&O insurers. The most obvious concern to insurers is the extent to which non-U.S. companies face threats of D&O litigation in the U.S. and therefore should be paying D&O premiums commensurate with the existence of the U.S.-based litigation exposure.

 

My final observation about the new BP lawsuit is that while I was reading the complaint I had the premonition that the BP derivative complaint may represent the precursor of the as-yet-unfiled but undoubtedly soon-to-arrive first D&O lawsuit based on global climate change related allegations.

 

The BP complaint’s allegations about the extent of the environmental and economic damage from the Deepwater Horizon oil spill, as well as the reputational harm to the company, and about management’s failure to anticipate and prevent the alleged harm, both to the spill victims and to the company, may prefigure the way the first global climate change lawsuit will be written (up to and including the tone of unrestrained moral outrage). The only thing missing is some event – or perhaps some alleged disclosure violation – and the existing environmental disaster derivative lawsuit template will be adapted for new global climate change derivative litigation.

 

Whether or not the litigation template is adapted to global climate change, the threat of environmentally-related D&O litigation undoubtedly will persist. Indeed, heightened concern and anxiety in the wake of the Deepwater Horizon disaster will only make this type of litigation more likely in the future.

 

A good overview of the litigation environment surrounding the oil spill and the general implications for the insurance industry can be found in a May 7, 2010 memo from Laura Foggen and Benjamin Theisman of the Wiley Rein law firm entitled "The Gulf Oil Spill: Considerations for Insurers" (here).

 

A May 10, 2010 Bloomberg article about the new BP derivative lawsuit can be found here.

 

Let Us Remember Justice Stevens – and The Bee, Don’t Forget the Bee: Everyone here at The D&O Diary is very interested in President Obama’s nomination of Solicitor General Elena Kagan to the U.S. Supreme Court. Press coverage in coming months undoubtedly will be filled with stories concerning her nomination and the confirmation process. Though attention is appropriately focused on the nominee, we think it is also appropriate to pause and consider the Justice she hopes to replace, John Paul Stevens.

We can think of no better place to being that in Ian Frazier’s piece, "Remember Justice Stevens" in this week’s issue of the New Yorker (here). Be forewarned, you may start to suspect that the article is going off the tracks right about the point where the author states: "A few minutes passed before Justice Stevens became aware of the bee under his shirt, just at the base of his neck."

 

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Various blogs and news articles expressed surprise and astonishment at the $2.876 billion judgment entered against Richard Scrushy in the HealthSouth state court derivative lawsuit, but a review of the June 18, 2009 memorandum opinion (here) that accompanied the final judgment shows that Jefferson County (Alabama) Circuit Court Judge Alwin E. Horn III actually ruled that the total amount of the damages to be the even more eye-popping amount of $3.115 billion. It was only the application of $239 million credit for judgments entered against other defendants that brought the number down to the $2.876 billion figure ultimately entered against Scrushy and other individual defendants.

 

It may well be wondered how on earth the court could have come up with these astronomical figures, whether before or after the application of the judgment credit. Part of the answer is the fraud itself, with Judge Horn described as “remarkable and perhaps unique in its duration, size and scope.”

 

 

Judge Horn’s opinion details what he describes as HealthSouth’s fraudulently reported net income during the period 1996 through 2002. The annual figures stated in the opinion, when added up, suggest that HealthSouth’s fraudulently reported net income exceeded its actual net income by over $3.138 billion.

 

 

However, Judge Horn’s damage calculation was not directly related to the massive scale of the fraud. Rather, it was calculated based on a variety of separate categories of damages including: excess bonuses paid to Scrushy ($10.4 million); amounts Scrushy gained on inside trades ($147.4 million); amounts the company spent on remediation, reconstruction and restatement of its financial records ($457.6 million); amounts the company spent during the period 2004 to 2006 on excess debt, consent fees, bond and credit payments as a result of the fraud ($1.147 billion);salaries and bonuses paid to fraud participants ($26.5 million); excess payments and loans to Scrushy-related enterprises ($260 million) and HealthSouth’s overpayment of taxes ($169.6 million).

 

 

These amounts, as staggering as they are, add up “only” to $2.2 billion. The total damages Judge Horn calculated reached $3.115 billion by the application of nearly one billion dollars in prejudgment interest. In determining the amount of interest, Judge Horn calculated the applicable interest rate in varying amounts over time, applying Delaware law and using the standard of five percentage points above the Federal Discount Rate, resulting in interest rates applied in some cases of as much as 10%.

 

 

Judge Horn’s opinion does not state whether post-judgment interest will also accrue, but presumably there are provisions for this interest under applicable law.

 

 

Whether or not further proceedings or appeals ultimately will substantiate all of these damage amounts and interest assessments, Judge Horn’s analysis represents a fascinating catalog of the harm caused to the company as a result of the fraud, as well as the ways that Scrushy himself profited. It should probably be noted that the possibility of an appeal may be complicated by the rather interesting question of how Scrushy could post an acceptable and adequate appeal bond.

 

 

Judge Horn’s opinion makes for interesting reading in other respects as well, particularly the ways that Judge Horn went about reaching factual conclusions despite having to deal with competing and conflicting testimony from witnesses he described as “six testifying felons.”

 

 

Among other things, Judge Horn relied on Scrushy’s own testimony in a prior case (the MedPartners case), in which Scrushy testified about what financial information a CEO must receive. Judge Horn described Scrushy’s testimony as an “unwitting confession,” because it showed that “for a fraud of even a billion dollars to occur over a period of years, the CEO had to know of the fraud.”

 

Assuming for the sake of argument that the massive judgment against Scrushy withstands further review, if any, the question will then become what if anything can be recovered on the company’s behalf. Though at one time he was a wealthy man, years of litigation and the panoply of claims against him undoubtedly have greatly reduced his former wealth. He may have a multibillion dollar judgment against him, but that does not make him a multibillion dollar man. Nor does it seem likely that the company’s recovery will ever remotely approach the amount of the judgment.

 

A June 19, 2009 Law.com article by Ben Hallman providing the backstory on the state court derivative lawsuit can be found here.

 

 

From Those Incredibly Large Amounts to Some Incredibly Small Numbers: After working with figures in the billions, it is hard focus on a dispute involving only very small fractions of a dollar, but that is what is involved in the securities class action lawsuit filed on June 18, 2009 in the Eastern District of Arkansas against Shearson Financial Network and certain of its directors and officers.

 

 

As reflected in the their June 19, 2009 press release (here), the plaintiff’s purported class action complaint (which can be found here) alleges that the defendants

 

caused a press release to be issued on May 7, 2009, that stated the Company had emerged from bankruptcy. In the press release, the Company used the ticker symbol, SHSNQ to identify itself, which was the ticker symbol belonging to the Company’s old stock which would ultimately be cancelled. However, at the time the Company issued the press release the stock listed under the ticker symbol SHSNQ was still trading and had not been cancelled. As a result of defendants’ false and misleading statements, Shearson’s securities traded at artificially inflated prices during the Class Period, reaching a high of $.039 on May 8, 2009.

On May 11, 2009, the Company issued a press release stating among other things that the stock trading under the ticker symbol SHSNQ would be cancelled and that Shearson’s new stock would trade under a different ticker symbol.

 

The complaint alleges that following the issuance of the May 11 press release the share price fell to $.0097 on trading volume of over 27.6 million shares. (That is, the share price decline three cents per share). Later, all shares traded under the symbol SHSNQ were canceled, meaning holders of those shares “were left with nothing but losses.”

 

The plaintiff, who bought his shares at $.039 per share on May 8, 2009, purports to represent a class of purchasers who bought the SHSNQ shares during the five-day period between May 7, 2009 and May 12, 2009.

 

I know that there have been class periods shorter than five days. But I suspect there have been very few classes brought on behalf of share price declines as small as three cents a share. I was unable to determine how many of the SHSNQ shares actually traded on the open market, but even assuming a three cent per share loss on all of the 27.6 million SHSNQ shares that traded on May 11, the market cap decline was $810,000. Obviously, not everyone selling bought their shares at the peak and some sold before the entire three cent share decline accumulated, so the actual losses on those trades is almost certainly quite a bit below that amount.

 

 

The relatively small amount in dispute is of course no reason to forebear from filing the lawsuit; however, the absence of any allegations of scienter of any kind, in combination with the small amount in dispute, would have been enough to discourage most self-interested plaintiffs’ attorneys from enlisting in this case.

 

More Bank Closures: After the close of business on June 19, 2009, the FDIC announced the closure of three more banks, bringing the year to date total number of bank closures to 40. The FDIC’s complete list of failed banks, including the latest three to be added, can be found here. The three banks all had assets under $1 billion dollars, continuing the trend of closures in the community banking sectors.

 

One of the three banks was located in Georgia, bringing the total number of Georgia banks to fail during 2009 to seven, and the total since January 1, 2008 to 12.

 

My recent overview of the growing number of bank closures and the implications for the D&O insurance marketplace can be accessed here.

 

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In what is, according to news reports (here), the largest settlement to date in a shareholders’ derivative lawsuit in Delaware Chancery Court, four former AIG executives and former AIG managing general agent C.V. Starr today reached a $115 million settlement in the 2002 AIG derivative lawsuit.

 

The lawsuit was filed by the Teachers’ Retirement System of Louisiana in 2002 against AIG, as nominal defendant; certain former AIG directors and officers (many of whom were later dropped from the case); and Starr.

 

According to news reports (here), the plaintiff alleged that half of the $2 billion AIG paid C.V. Starr between 2000 and 2005 "represented sham commissions for work that, in some cases, was done by AIG employees." The lawsuit also questioned "why some executives were allowed to serve simultaneously as officers of C.V. Starr, a closely held insurance agency, while profiting from business between the two companies." The complaint also alleged that Starr gave the individual defendants bonuses on fees from AIG. In effect the complaint alleged that the commissions were a mechanism for the defendants to "line their pockets."

 

The case was scheduled to go to trial on September 15, 2008. The four settling individual defendants include former AIG Chairman and CEO Maurice Greenberg; former AIG CFO Howard Smith; former Vice Chairman of Investments Edward Matthews; and former director and Vice Chairman of Insurance Thomas Tizzio.

 

The vast bulk of the settlement -- $85.5 million – is to be paid by AIG’s D&O insurance carriers. A list of the carriers on AIG’s D&O program can be found here.

 

The more interesting question is where the remaining $29.5 million will come from. Some of the news reports give the impression that the individuals are funding the settlement. However, it appears that the individuals themselves are funding only a small portion of the remaining $29.5 million.

 

Greenberg’s counsel’s statements to the press (for example, here) are quite emphatic that Greenberg himself will not be contributing anything the settlement. One news report (here) does suggest that Tizzio "is expected to pay between $1 million and $5 million," Smith and Matthews "would pay very small amounts, if anything."

 

It appears that the bulk of the $29.5 million will be paid by C.V. Starr. According to Greenberg’s counsel, Starr "expects to contribute between $20 million and $30 million."

 

The details about who will be paying what seem surprisingly imprecise. In particular, the wide potential variance in Tizzio’s contributions seem odd to me, as even a wealthy individual generally would require a more precise determination of how many millions of his dollars are going to be required. Which makes me wonder whether perhaps Tizzio has an individual source of insurance that may be contributing on his behalf.

 

There are a variety of other odd features to this settlement, at least as it is described in the news reports, the most striking of which is that Tizzio apparently will be making a material settlement contribution but apparently Greenberg will not. To be sure, C.V. Starr, of which Greenberg is still Chairman and CEO, will be making a more than $20 million contribution, raising the question whether the amount of Starr’s contribution and the fact that Greenberg himself is not contributing to the settlement are linked.

 

And even with respect to C.V. Starr’s contribution, certain questions arise. For example, given the fact that some or all of the individual defendants apparently were also officers of C.V. Starr, is Starr’s D&O carrier funding some or all of Starr’s contribution to the settlement?

 

It should also be noted with respect to Starr’s payment to AIG that Starr is in fact AIG’s largest shareholder. As of July 15, 2008, Starr owned 10.5% of AIG’s outstanding shares, which represents Starr’s largest asset. Maybe that is just context, but it is an interesting context nonetheless.

 

I also have questions concerning the $85.5 million contribution from AIG’s D&O carriers. Beyond sheer curiosity about how much of AIG’s D&O insurance tower was depleted by defense expense, I also wonder whether the insurer’s settlement contribution to this derivative settlement drew upon the insurance program’s Side A coverage, which provides protection for nonindemnifiable loss. You would not expect the $85.5 million payment to AIG to be indemnifiable in the absence of insurance, so all else equal the amount would seem to represent a Side A loss. The same would also seem to be true with respect to the individuals’ own separate contribution to the settlement.

 

My question about which D&O policy coverage funded the settlement may require some context. Given the size of this derivative settlement, as well as other recent large derivative settlements (including, for example, the $50 million Hollinger derivative settlement), there seems to be a growing threat of very large derivative settlements, which is a relatively new development.

 

Many companies, particularly large financial services companies, often have D&O insurance programs built exclusively or predominantly of Side A-only protection. These kinds of programs have become increasingly common in recent years, but in general losses have really not yet caught up to this coverage to a significant degree.

 

The options backdating derivative cases presented the possibility of significant potential losses for these types of coverages, but it is my understanding that the Side A-only losses from these cases really have not yet significantly materialized. There has been speculation that the subprime litigation wave might also produce significant Side A losses, but those cases are only in their earliest stages yet, so the losses have yet to fully develop.

 

The possibility of derivative settlements of the magnitude of the recent AIG settlement may represent the most significant threat to these Side A programs and coverages, at least outside of the bankruptcy context. Which is why I am curious to know which policy coverage funded the AIG D&O insurers’ portion of the AIG settlement.

 

Finally, I am curious about how likely coverage issues were dealt with in connection with this settlement. I expect that the insurers would have raised the personal profit exclusion typically found in most D&O policies as at least a potential defense to coverage. I am guessing that the existence of this issue complicated the settlement process (or at least the insurers’ contribution to the settlement). The absence of a judicial determination that the individuals had improperly profited undoubtedly ameliorated this potential impediment. The individuals' desire to avoid any determination that might preclude coverage may have helped precipitate settlement on the eve of trial.

 

As always, I am interested if any readers can shed any light on the details. I am particularly interested details involved with the individuals’ contributions; around the extent of insurance funding for C.V. Starr’s contribution; and concerning AIG’s insurers’ contributions. Anonymity will be scrupulously protected.

 

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Regular readers know that I have been tracking subprime-related class-action lawsuits (here). In a recent post, I noted my interest in trying to develop a similar list of subprime-related derivative lawsuits. In response to my request, a number of readers supplied helpful information, and as a result I have been able to develop a list of subprime-related derivative lawsuits, which can be accessed here.

The list is accurate but it may not be complete. Readers aware of any other subprime-related derivative lawsuits are encouraged to let me know, so that I can address any omissions. I will update the list as new lawsuits come in or as new information becomes available.

The table of cases I have compiled lists the companies that have been named as nominal defendants in shareholders’ derivative lawsuits. Some of the companies listed actually have been sued in multiple derivative suits, and some companies have been sued in multiple jurisdictions. However, where the allegations relate to substantially similar allegations, each company has only been listed once, regardless of the number of actual derivative lawsuits pending. Where I have been able to supply relevant links (in most cases to the actual complaint), the link pertains to the first filed suit.

As the list reflects, a total of 20 companies have been sued as nominal defendants in subprime-related derivative lawsuits. The derivative suits against seven of these companies were first filed in 2008, the rest in 2007. Most (but not all) of the companies named in the derivative suits have also been named in subprime-related securities class action lawsuits. Most of the companies sued in the derivative lawsuits are in the lending and banking industries, but the list also includes insurance companies, home builders, and REITs, among other.

Special thanks to Adam Savett of the Securities Litigation Watch (here) for providing information and links to several of the lawsuits, and thanks to all readers who provided information and suggestions in response to my inquiry.

Another Auction Rate Securities Lawsuit: On April 8. 2008, plaintiffs’ lawyers filed another purported securities class action lawsuit on behalf of auction rate securities investors against the companies that allegedly sold them the securities, in this case Raymond James Financial. A copy of the plaintiffs’ lawyers’ April 8 press release can be found here, and a copy of the complaint can be found here.

This brings the total number of auction rate securities lawsuits to eleven. My prior post discussing the auction rate securities lawsuits can be found here. I have been tracking the auction rate securities lawsuits as part of my running tally of subprime-related class action lawsuits, about which more below.

Adjusting the Subprime-Related Class Action Litigation Tally: Also as a result of my efforts to build the list of subprime-related derivative lawsuits, I received additional information regarding three previously filed securities class action lawsuits. In the past, I had determined that these three lawsuits were not appropriately categorized as subprime-related. However, upon further inquiry and based on conversations with some readers, I have now added these three additional lawsuits to my running tally of subprime-related securities class action lawsuits. The three added lawsuits related to Municipal Mortgage & Equity (about which refer here), WSB Financial Corp. (refer here), and CBRE Realty Finance (refer here).

With the addition of these three lawsuits, and with the addition of the Raymond James auction rate securities lawsuit referenced above, my running tally of subprime-related lawsuits now stands at 68. One unfortunate consequence of my decision to add these three cases is that now my running tally may no longer agree with others’ tallies, such as the Stanford Law School Securities Class Action website (here). There is an inherent categorization problem in trying to track the subprime lawsuits. Reasonable minds will disagree about whether a case is or is not appropriately categorized as subprime related. There are almost always going to be some disagreements at the margins.

Many thanks to the readers who supplied the information and commentary about the three class action lawsuits.

Subprime ERISA Lawsuit Update: As most readers know, I have also been tracking subprime-related ERISA lawsuits (here). As a result of my research and inquiries regarding subprime derivative lawsuits, I identified three additional subprime-related ERISA lawsuits of which I previously had been unaware. These three additional ERISA lawsuits pertain to Huntington Bankshares (refer here), National City Corp. (refer here), and Impac Mortgage (refer here).

With the addition of these three suits to my list, the number of subprime-related ERISA lawsuits now stands at 14, five of which have been filed in 2008, and the remainder of which were filed in 2007.

Two Options Backdating Case Developments: Two courts recently issued rulings on motions to dismiss in options backdating-related lawsuits.

First, on March 31, 2008, in the Juniper Networks option backdating-related securities litigation (about which refer here), Judge James Ware of the United States District Court for the Northern District of California largely denied the defendants’ motion to dismiss, except that he granted the motion (with leave to amend) as to one individual defendants, and he granted the motion to dismiss all alleged misrepresentations that took place prior to July 14, 2001, as time barrred. A copy of the March 31 order in the Juniper Networks case can be found here.

Second, and also on March 31, 2008, in the Microtune options-backdating related derivative litigation, Judge Richard Schiff of the United States District Court for the Eastern District of Texas granted the defendants’ motion to dismiss, albeit with leave to amend as to certain individuals on certain claims. A copy of the Microtune opinion can be found here. Judge Schell first concluded the Congress had not created a private right of action under Section 304 of the Sarbanes-Oxley Act, and dismissed that claim. Judge Schell also granted the dismissal with prejudice of claims of allegedly misleading proxy statements as to the individual defendants who were not on the board at the time of the proxy. The proxy allegations were dismissed without prejudice as to the remaining individual defendants. Similarly, the plaintiffs’ claims based on Section 10(b) were also all dismissed, but with prejudice as to some defendants and without prejudice as to others. The court declined to exercise jurisdiction over the plaintiffs’ state law claims.

I have added these two decisions to my table of options backdating related case dispositions, which can be accessed here. Readers are encouraged to let me know about case dispositions of which they become aware so that I can add them to the list.

Special thanks to Nick Even of the Haynes and Boone firm for the link to the Microtune decision.

New Century Updated: In an earlier post (here), I noted that the court had granted (with leave to amend) the defendants’ motion to dismiss in the first-filed subprime related securities class action lawsuit, involving New Century Financial Corporation. On March 24, 2008, the plaintiffs filed their amended complaint (here), which names as defendants not only certain former directors and officers of the company, but also the company’s former auditor, KPMG, and the company’s offering underwriters.

Readers will recall that in connection with the New Century bankruptcy proceeding, the bankruptcy examiner recently released a detailed report (about which refer here) in which, among other things, the examiner reviewed the question of the auditors’ and the company's directors and officers' potential responsibility for certain accounting practices and statements at the company. In light of the bank examiner’s report, the plaintiffs sought (and the defendants’ agreed not to oppose) leave to file a second amended complaint, which the court granted. The plaintiffs’ must file their second amended complaint by April 30, 2008. The court also set a briefing schedule for the anticipated motion to dismiss, to be argued September 8, 2008. A copy of the court’s order granting leave and setting the scheduling can be found here.

A German Securities Trial?: The Securities Litigation Watch has an interesting post (here) about the apparent mass securities lawsuits trial that has commenced in Germany involving Deutsche Telecom. An April 7, 2008 Business Week article discussing the trial can be found here.

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In the world of directors' and officers' liability, securities class action lawsuits dominate the dialogue. Securities lawsuits generate headlines and produce eye-popping settlements. There are even websites (refer here and here) devoted exclusively to providing the latest information about securities lawsuits. The same cannot be said for derivative lawsuits, but it has not always been that way. At least until 30 years ago or so, shareholders derivative lawsuits were the main vehicle for defining the duties of corporate directors and officers and establishing the standards of corporate governance.

A November 2007 law review article by Wisconsin Law School Dean Kenneth B. Davis, Jr., entitled "The Forgotten Derivative Suit" (here), takes a detailed look at the diminished role of derivative lawsuits and examines the ways in which derivative lawsuits nevertheless still matter.

The author begins with the view that until the mid-70s, courts, acting through derivative lawsuits, provided the principal means of corporate oversight. Over the last three decades, this role has shifted, principally to independent Board directors but to others as well. In analyzing derivative litigation's changing role, the author refers to historical analysis and prior research as well as to his own survey of 294 opinions involving derivative suits brought in federal and Delaware courts and involving Delaware corporations and issued between 2000 and the first quarter of 2007.

In Dean Davis's view, the two most important causes for the declining significance of derivative lawsuits is the judicial development of the demand requirement (and corresponding deference to independent directors) and the development of exculpatory statutes relieving directors of financial responsibility for many actions. These factors, the author finds, "have combined to marginalize the derivative suit for cases not involving self-dealing or other palpable breaches of the duty of loyalty."

In addition, a number of developments "began to supplement and supplant the derivative suit with respect to both of its recognized roles - compensation and deterrence." As for compensation, "securities and other class actions now perform many of the functions previously associated with the derivative suit." In addition, regulatory mechanisms (especially the SEC's enforcement program) and the threat of criminal prosecution 'have evolved to challenge the derivative suit's reputation as the chief regulator of corporate management." Moreover, as a result of a more vigorous business press and the publicity surrounding recent corporate scandals, "the stigma of corporate misconduct" also provides significant deterrence even in the absence of formal action. All of these mechanisms fulfill functions the derivative lawsuit would have provided in the past.

The author takes a particular look at the recent wave of options backdating derivative lawsuits (about which refer here), which he notes are "consistent with the critique that derivative suits simply piggyback on what the government (or perhaps the media) has already uncovered and investigated." In this circumstance, the derivative lawsuit can contribute to deterrence only if the government lacks resources and if the plaintiff is willing to follow through. He notes that "too often, however, the economic pressures facing the plaintiffs' attorney, coupled with the defendants' access to indemnification and insurance, leads to a quick and non-pecuniary settlement that supports the award of attorneys' fees but imposes little if any monetary cost on the individual defendant." (The latter point was underscored in the Wall Street Journal's November 19, 2007 article, here, discussing the outcomes of many of the options backdating cases.)

Notwithstanding these limitations on the continued meaningfulness of derivative lawsuits, there are still circumstances, the author concludes, when derivative lawsuits are likeliest to be valuable. The first involves "misconduct at smaller companies, whose shares are less actively traded" or not publicly traded at all, and where the misconduct "will be more likely to escape the awareness and the interest of governmental agencies and the media." The second involves "cases seeking the return of a substantial benefit" which "pose a greater threat of personal loss to individual defendants." In cases "challenging transactions between the corporation and those who control it" (which would tend to involve both smaller companies and personal benefit, both of the previously identified factors), "the derivative suit continues to make its most important contributions, both as a source of compensation and deterrence for the corporation's minority shareholders and as a public good."

The author, who clearly has devoted much time to studying and thinking about derivative lawsuits, bemoans their diminished role. He notes that:

There is no field manual, code of conduct, formal training or licensing body to spell out what directors ought to do in a specific situation....[Courts'] opinions are ... the raw material for a dialogue across the business and legal professions as to what should be expected of directors....One effect of the stricter demand requirements has been to reduce the volume of case law available to perform this culture shaping role.

As someone who has spent most of my professional career involved with directors' and officers' liability issues, I have always felt that derivative lawsuits are underappreciated, understudied, and poorly understood. Part of the reason for this is that there is relatively little centralized information about derivative lawsuits, especially by comparison to securities class action lawsuits. Dean Davis's article goes a long way toward helping to explain the role and significance of derivative lawsuits, and provides useful supporting data. The article helps to fill a significant void in the world of directors' and officers' liability.

Special thanks to Dean Davis for providing me with a link to this excellent article.

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On November 8, 2006, a sweeping bill affecting U.K. companies went into affect when the Companies Bill, which at 696 pages is Britain's longest piece of legislation, received royal approval. (The House of Lords site reflecting all information pertaining to the Bill may be found here.) The Bill contains a statutory statement of directors' general duties and extended authority for shareholders to sue directors for negligence, default, breach of duty or breach of trust - a broader range of conduct than under prior law.

The Bill's statutory statement of directors' general duties sets out seven duties:

• The duty to act within the company's powers;
• The duty to promote the success of the company;
• The duty to exercise independent judgment;
• The duty to exercise reasonable care, skill and diligence;
• The duty to avoid conflicts of interest;
• The duty not to accept benefits from third parties; and
• The duty to declare any interest in any proposed transaction or arrangement with the company.

The new general statutory duty to "promote the success of the company" is the most controversial clause in the Bill, and includes many considerations of which directors must now take into account - not only the long term business consequences of any decision, but also "the impact of the company's operations on the community and the environment." This new statutory duty requires directors to consider wider social responsibility factors when making decisions. The various statutory requirements may create obligations that conflict. But the decision of what constitutes the company's best interests will not be set aside if made in good faith and the directors have exercised reasonable care, diligence and skill.

The Bill extends existing shareholder rights to bring derivative claims. The new statutory procedure enables a shareholder to bring a claim with respect to any actual or alleged negligence, default, breach of duty (including the new statutorily codified duties) or breach of trust. A shareholder seeking to bring a claim must petition the court for the right to proceed, based upon a showing of good faith and taking into account whether the company decided not to pursue the claim. If leave to continue is granted, the company must reimburse the shareholder for brining the action; if not, the shareholder bears his or her own costs.

According to a detailed review (here) of the Bill by the Norton Rose law firm, the absence of the risk of costs if leave to pursue the derivative claim is granted "may make shareholders more likely to bring an action under the new procedure." The new right to bring an action for breach of any duty, including the new statutory duties, "provides another tool for use by activist shareholders to push for change at underperforming companies." But how useful this tool will be depends on "the court's willingness to exercise its discretion to intervene in what, in many cases, will be simply commercial decision making by the company, its directors and majority shareholders." In light of these considerations, the Norton Rose firm's memo suggests that "boards should review the wording of their D & O policies to ensure that defending derivative claims is covered."

A summary of other aspects of the Bill may be found at the CorporateCounsel.net, here.

A Private Conspiracy?: According to a November 15, 2006 Bloomberg.com article entitled "KKR, Carlyle, 11 Other Accused of Rigging Buyouts" (here), the law of Wolf, Haldenstein, Adler, Freeman & Herz has brought a purported class action accusing 13 private equity firms of rigging the market to take companies private. The complaint purportedly alleges that investors did not receive full value for their shares because of a conspiracy that violated antitrust laws. The purported class potentially represents tens of thousands of shareholders in dozens of deals in which public companies were taken private. Among the specific transactions named are deals involving Univision, HCA and Harrah's Entertainment. The list of defendants reads like a who's who in the world of private equity, including KKR, Carlyle, Thomas H. Lee Partners, Blackstone Group, Bain Capital, Apollo Management, Texas Pacific Group, and others.

Prior press reports had disclosed that the antitrust division of the U.S. Deparment of Justice in Manhattan is examing potential antitrust violations by private equity firms engaged in "club deals" to acquire public companies. An October 11, 2006 Wall Street Journal article entitled "Probe Brings 'Club Deals' to the Fore" can be found here (subscription required.)

Best Commercial Ever?: You decide. Roll the tape, here.

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In recent days, there has been extensive media attention (here and here) focused on the fact that plaintiffs' lawyers seeking to exploit the options backdating scandal are filing shareholders' derivative suits in preference to securities fraud class action lawsuits. Indeed, The D & O Diary's running tally of options backdating lawsuits (here) shows that only 16 companies have been named in securities fraud lawsuits, but over 70 companies have been named as nominal defendants in shareholders' derivative lawsuits. But while the observation that plaintiffs' lawyers are preferring shareholders' derivative lawsuits appears to be valid, this observation does not explain why plaintiffs' lawyers are so eager to file derivative lawsuits. Traditionally, derivative lawsuits have not been nearly as lucrative for plaintiffs' lawyers as securities fraud suits. So why are plaintiffs' lawyers preferring derivative lawsuits in connection with the options backdating scandal?

It may be supposed that recent trends in other recent derivative lawsuits' recoveries makes these suits more attractive to plaintiffs' lawyers now than perhaps they were in the past. The derivative lawsuit filed against the Hollinger board resulted in a $50 million settlement (here) - funded entirely by D & O insurance - and the Oracle derivative settlement resulted in Larry Ellison's payment of $100 million to charity, as well as his payment of the company's $22 million attorneys' fees. In addition, the existence of a derivative lawsuit was a "substantial factor" in the payment of $200 million in settlement of various litigation against AOL Time Warner. But there need to be numerous caveats around the purported value of the AOL Time Warner derivative settlement (see the prior D & O Diary post concerning the AOL Time Warner settlement here) and the Oracle settlement with its payment to charity rather than to the company requires a very big asterisk (and is probably a worthy topic of a separate post). The Hollinger settlement may be more apposite, but it may also represent an extreme case.

Whether or not these other settlements represent a trend that might be increaing plaintiffs' lawyers interest in filing shareholder derivative suits, the derivative lawsuits brought in connection with options timing allegations appear subject to numerous defenses or other practical limitations. To name but a few of the defenses and limitations:

Standing: For many of the companies involved in the backdating scandal, the period during which the alleged misdating took place covers a large swath of time, in some cases going back to the early or mid 90's. In order to have sufficient standing to pursue the derivative suit, a shareholder plaintiff will have to show continuous share ownership, at the time of the alleged wrongdoing as well as the at the time of the lawsuit. Some putative plaintiffs may satisfy this requirement, but not many, and most of the plaintiffs in whose name the options lawsuits have been brought lack the requisite standing (and for an additional comment about standing, see the note below about the Mercury Interactive shareholders' derivative lawsuit);

Statute of Limitations: The statute of limitations under Delaware law for shareholder derivative suits is three years. Shareholders' claims for alleged options timing misconduct more than three years' prior to the spring or summer 2006 (when most of the lawsuits were filed) may well be time barred. Plaintiffs' lawyers undoubtedly will seek to circumvent this bar by alleging concealment or some other excuse to stay of the limitations bar, but the whole point of a limitations statute is to avoid trying events from the distant past. The limitations period may well prove a substantial bar to many of the plaintiffs' claims.

Demand Requirement: In the race to the courthouse that followed the media frenzy surrounding the options backdating scandal, many of the plaintiffs' lawyers disregarded the derivative lawsuit filing prerequisite that the plaintiffs first demand that the board pursue the lawsuit on the corporations' behalf or present allegations to show why demand would be futile. The demand requirement is substantial and cannot be circumvented by mere conclusory allegations of futility; the plaintiff must plead with particularity why a majority of the board lack sufficient disinterest to consider the demand. This should be a particular burden in the many cases where the directors did not themselves benefit from the options timing. Moreover, where (as in most cases) the plaintiffs filed their suits without first pursuing a books and records request to obtain requisite factual information as a basis for their claim, a
dismissal based a failure to meet the demand requirement will be with prejudice;

Exculpatory Clause: Most corporations have adopted an exculpatory clause in their corporate charter, as permitted under Delaware law, precluding liability against the directors for breach of fiduciary duty except upon a showing of bad faith or disloyalty. Liability for mere breaches of the duty of care is waived under these exculpatory provisions. In most cases, the boards of directors of companies caught up in the backdating scandal were simply unaware of the backdating, and therefore allegations of wrongdoing amount to no more than alleged breached of the duty of care, the liability for which is precluded under the exculpatory clause.

To be sure, there are some companies with respect to which more substantial or active wrongdoing is alleged, and with to respect to which the derivative claim may be more substantial and perhaps potentially more lucrative for the plaintiffs' lawyers. But these claims amount to no more than a very small handful; almost all of the derivative complaints that have been filed are subject to the above defenses and other substantial defenses and limitations. It remains to be seen whether the flood of derivative lawsuits raising options timing allegations produces substantial value for the corporations on whose behalf the lawsuits have been filed, or for the plaintiffs' lawyers who filed the lawsuits. But the number and strength of the potential defenses makes the D & O Diary wonder: why are the plaintiffs lawyers filing all these derivative suits?

The D & O Diary is interested in readers' comments about the potential merits of the shareholders' derivative options backdating lawsuits.

Unique Standing Defenses in the Mercury Interactive Derivative Lawsuit: Among the companies involved in the options backdating scandal is Mercury Interactive, which also was named as the nominal defendant in a shareholders' derivative lawsuit brought by the Lerach Couglin firm. On July 25, 2006, while the derivative lawsuit was pending, Mercury Interative announced its acquisition by Hewlett-Packard. According to a September 11, 2006 story on Law.com entitled "H-P Deal May Kill Mercury Suit" (here), one of the individual defendants (who is represented by the Wilson Sonsini firm) has filed a motion to dismiss based on the argument under Delaware law that as a result of the H-P acquisition, the plaintiffs lack standing to assert the claim against the individual defendants. The only way the case can continue is if H-P decides to take it up on its own. The story has a definite "clash of the titans" feel to it, because the Lerach firm's response to the motion to dismiss is to contend that because of the Wilson Sonsini's firm's alleged involvement in the H-P board's brouhaha about its own Board investigation, Wilson Sonsini is or ought to be precluded from being involved in the Mercury Interactive lawsuit. Lerach's arguments based on the Wilson Sonsini firm's role with H-P probably indicates nothing so much as that the motion to dismiss is almost certainly meritorious, as mergers of this type generally divest plaintiffs of standing under Delaware law.

Thanks to Adam Savett of the Lies, Damn Lies blog (here) for the link to the Law.com article. (The comments about the case are strictly my own.)

Options Backdating Litigation Tally Update: The D & O Diary has updated its options backdating litigation tally (here) to add the new securities fraud class action lawsuit that has been brought against Aspen Technology (here). The addition of the Aspen Technology lawsuit brings the number of securities fraud lawsuits based on options timing allegations to 16. In addition, the number of companies sued in shareholders' derivative lawsuits is now stands at 71, with the addition to the lawsuit against Home Depot (here), THQ (here), and Witness Systems (here).

Request for Information: As previously noted on The D & O Diary (here), Lynn Turner, the former Chief Accountant at the SEC and now a managing director at Glass Lewis, testified on Capitol Hill on September 6, 2006. As part of his written testimony (here), Turner attached an appendix that listed the companies involved in the options backdating investigations. A column on the appendix purported to identify the companies that have been named in options backdating shareholder suits (but not differentiating between securities fraud suits and shareholders' derivative suits). There were some companies that were not identified in Turner's exhibit as having shareholder suits that have in fact been sued (e.g., Mattel), and there were others identified as having been sued that The D & O Diary simply cannot independently corroborate as having been sued. The companies that Turner lists as having been sued for which The D & O Diary can find no corroboration are: Amkor, Blue Coat, Boston Communications, Dot Hill, Molex, and Newpark Resoureces. Most if not all of these six companies have shown up on various plaintiffs' law firms' press releases as being "under investigation" but as far as I have been able to determine they have not actually been sued. The D & O Diary would greatly appreciate it if its readers could provide any further corroboration about the existence of lawsuits against these companies -- or any others that do not appear on The D & O Diary's list of options backdating lawsuits.

Special thanks to Michael Miraglia for a link to the Turner testimonial exhibit and to Bill Ballowe for his help in locating options backdating lawsuits.

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On May 12, 2006, the United States District Court for the Southern District of New York preliminarily approved the settlement of the consolidated derivative litigation filed on behalf of AOL Time Warner against 25 of the company's present and former directors and officers as well as other third party defendants. The various derivative lawsuits alledged that the defendants had breached their fiduciary duties in connection with the AOL/Time Warner merger. The settlement requires the company to undertake a wide variety of corporate governance reforms. A cursory reading of the settlement documents might also lead one to conclude that the settlement also involved a payment of $200 mm by the company's directors and officers insurance carriers in settlement of the derivative litigation, which would make this settlement by far the largest derivative settlement of which The D & O Diary is aware. However, a closer reading of the settlement documents reveals a more nuanced picture about the monetary portion of the settlement.

The Stipulation of Settlement filed with the Court states that on September 5, 2005, the derivative litigation plaintiffs made a policy limits demand under the Company's D & O Policy, and on September 7, 2005, "the Company was able to reach a settlement with its directors and officers insurance carriers pursuant to which the carriers will pay approximately $200 million in addional fund in connection with the securities and derivative claims listed in Exhibit D." Although the propinquity of the plaintiffs' demand and the insurers' settlment could be interpreted to suggest that the former caused the latter, that interpretation may be an illustration of the logical fallacy post hoc ergo propter hoc ("after this, therefore because of this"). By its own terms, the Stipulation states that the $200 mm payment under the insurance company settlement was in connection with both the derivative and the securities cases, not the derivative cases alone. Moreover, the referenced Exhibit D identifies 38 separate items of litigation in connection with which the insurance settlement had been made, including the SEC investigation, the DOJ investigation, the consolidated securities litigation, the ERISA litigation, and a very long list of many other items, including but definitely not limited to the derivative litigation.

Accordingly, it does not appear accurate to conclude that the $200 mm was paid just to settle the derivative litigation, or at least to settle the derivative litigation alone. Indeed, the parties never make that statement in any of the supporting documents. The documents state only that the "Derivative Actions were a substantial factor in the Company's ability to obtain an approximately $200 million insurance recovery." The settlement documents apparently are quite careful not to say how substantial of a factor the derivative actions were, or how substantial other factors (such as the $2.65 billion consolidated class action settlement) might have been.

The final settlement hearing in the consolidated derivative litigation is scheduled for June 28, 2006.

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