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

Earlier this week when I posted my list of subprime lawsuits dismissal motion grants and denials (here), I was hoping the publication would encourage readers to let me know about case dispositions of which I was previously unaware. My strategy worked, because a loyal reader who prefers anonymity responded to my post by alerting me to the May 19, 2008 opinion (here) in the subprime-related securities class action lawsuit involving Standard Pacific. Because the court’s opinion is particularly thorough, it merits a detailed review.

 

Standard Pacific is a California-based residential construction company that concentrated in recent years on the formerly go-go growth areas of California, Florida, Texas and Nevada. As s result of the residential real estate slump, the company’s sales activity declined in 2006 and 2007. Plaintiff shareholders initiated a securities class action lawsuit against two Standard Pacific executives in August 2007.

 

The plaintiffs alleged that the defendants misrepresented Standard Pacific’s ability to open new, successful communities; misled the public about the demand for Standard Pacific homes; and lied about the company’s ability to continue its historically strong earning growth. Further background regarding the lawsuit can be found here.

 

In a May 19, 2008 opinion, Judge Margaret M. Morrow of the United States District Court for the Central District of California granted the defendants’ motion to dismiss, but allowed the plaintiffs’ 45 days’ leave to amend.

 

The defendants first argued that the plaintiffs’ complaint failed to satisfy the PSLRA’s pleading requirements because it is a “classic example of prohibited puzzle-pleading,” in that it contains extensive block quotations from the company’s class period statements “without specifying the particular statements that are false and misleading.”

 

The plaintiffs sought to address this issue in their reply papers, but the court found that “the organization the plaintiffs offer in their opposition brief does not cure the deficiencies in the complaint. To the contrary, it highlights plaintiffs’ failures to plead defendants’ purportedly false and misleading statements with specificity as required by the PSLRA,” and accordingly the court granted the motion to dismiss, with leave to amend.

 

The defendants also moved to dismiss on the grounds that the plaintiffs had not adequately pled scienter. The plaintiffs alleged, based on the confidential witness information, that defendants misled investors because they continued to cite sales information in reliance on internal reports they supposedly knew to be inaccurate. Defendants contended that, to the contrary, they informed investors that the company was experiencing sales declines, and that “the crux of plaintiffs’ fraud claim is not that the defendants flatly misrepresented the company’s performance but that they were deliberately reckless because the failed to lower their projections enough.”

 

The court found that

the fact that defendants reduced earnings and home delivery guidance cuts against plaintiffs’ claim that defendants acted with fraudulent intent. As no facts are pled supporting an inference that defendants selected the level of reductions they announced fraudulently or with deliberate recklessness, the complaint suggests a plausible nonculpable explanation for defendants’ conduct…. Taken as a whole…plaintiffs’ allegations do not give rise to a “strong inference” that at the time they made the statements, defendants knew or should have known that the state of affairs was much worse than they had acknowledged publicly….In effect, by arguing that defendants’ predictions and forecasts were not low enough, plaintiffs improperly attempt to allege “fraud by hindsight.”

The court similarly rejected the plaintiffs’ attempt to rely on the defendants’ certifications of the company’s SEC filings.

 

The dismissal, even though it is without prejudice, is still significant. First, the opinion is very detailed and thorough, which could carry some weight in other subprime securities cases, particularly the numerous other cases pending in the Central District of California.

 

Second, many of the other subprime complaints arguable share the “puzzle pleading” defect of the complaint in this case – all too often, the complaints in these subprime cases consist of block quotations from the defendants company’s disclosure documents, without direct connections specifying what about the disclosure the plaintiffs allege is false and misleading, and in what way the statements are false and misleading.

 

Third, many of the companies named in subprime securities lawsuits, like Standard Pacific, are accused not of failing to acknowledge problems but of failing to recognize the problems enough. To the extent other courts view these pleadings with the same level of skepticism as Judge Morrow, the complaints could face some formidable challenges at the motion to dismiss stage.

 

In any event, I have added the Standard Pacific opinion to the list of subprime lawsuit dismissal motion grants and denials. I hope other readers will let me know of any other subprime lawsuit dismissal motion rulings of which they are aware, so that the list can be as complete as possible.

 

Special thanks to the anonymous loyal reader for alerting me to the Standard Pacific opinion.

 

Another Option ARM Lawsuit: In a different post earlier this week (here), I noted the lawsuits that had been filed up to that point relating to Option ARM mortgages, and I suggested the likelihood that there would be further lawsuits relating to Option ARMs. In a quick confirmation of my prediction, on June 11, 2008, plaintiffs’ counsel initiated a securities class action lawsuit in the Central District of California against IndyMac Bancorp and certain of its directors and officers. A copy of the plaintiffs’ lawyers’ June 11 press release can be found here. A copy of the complaint can be found here.

 

According to the press release, the complaint alleges that

defendants issued materially false and misleading statements regarding the Company’s business and financial results. Specifically, defendants downplayed and concealed IndyMac’s growing exposure to non-performing assets, particularly loans in its pay-option adjustable-rate mortgage (“Option ARM”) and homebuilder construction portfolios, and made numerous positive representations regarding the Company’s capital position to alleviate investors’ fears concerning the Company’s capital erosion. As a result of defendants’ false statements, IndyMac stock traded at artificially inflated prices during the Class Period.

It is important to note that IndyMac had previously been sued in a subprime-related securities class action lawsuit, the background regarding which can be found here. In concluding that this latest lawsuit is sufficiently distinct from this prior lawsuit to represent a new lawsuit, I note the following: first, the class period of the prior lawsuit was May 4, 2006 to March 1, 2007, whereas the purported class period for the new lawsuit is from August 16, 2007 to May 12, 2008. In addition, the substantive allegations in the two lawsuits relate to different alleged misrepresentations. In particular, the prior lawsuit does not appear to relate to the companies representations regarding Options ARM mortgages or the company’s capital position.

 

Accordingly, I am recognizing this latest complaint as a new and separate filing. However, I encourage readers who may disagree to let me know of any circumstances that might militate in favor of a different conclusion.

 

I have added the new IndyMac lawsuit to my running tally of subprime and credit-crisis related securities lawsuits, which can be found here. With the addition of the new IndyMac lawsuit, the tally of subprime and credit crisis-related lawsuits now stands at 90, of which 50 have been filed in 2008.

 

Finally, it is worth noting that, as reflected in my list of subprime dismissal motions grants and denials referenced above that motion to dismiss have twice been granted with leave to amend in the prior IndyMac lawsuit.

 

More Subprime ERISA Lawsuits:  I have also added two subprime-related ERISA lawsuits to my running tally of subprime-related lawsuits.

 

First, in a June 11, 2008 press release (here), plaintiffs’ lawyers announced that they had initiated a lawsuit in the Southern District of New York under ERISA against Wachovia Corporation and various of its officers and administrators. According to the press release, the defendants allegedly violated their duties to participants in the Wachovia Savings Plan by “continuing to invest in and hold Wachovia stock despite the fact that they knew or should have known that Wachovia was not properly reporting its financial condition and was not disclosing significant problems which had the effect of inflating the value of Company stock.”

 

Second, on May 9. 2008, plaintiffs’’ counsel initiated a lawsuit in the Western District of Tennessee on behalf of past and present employees of First Horizon National Corporation who participated in the First Horizon Savings Plan. A copy of the complaint can be found here. The complaint alleges that the defendants breached their fiduciary duty by requiring plan participants to invest in First Horizon shares, which the plaintiffs contend was “imprudent… because First Horizon was not fairly and accurately disclosing the risks and likely consequences of a number of its banking practices such that the Plan was purchasing shares of First Horizon Stock at an inflated price.” Among the undisclosed risks alleged is the company’s exposure to subprime and Alt-A mortgages.

 

I have added the Wachovia and First Horizon ERISA lawsuits to my running tally of subprime-related ERISA lawsuits, which can be found here. With the addition of the new ERISA lawsuit, the tally of subprime-related ERISA lawsuits now stands at 17

 

Special thanks to a loyal reader for identifying the new ERISA lawsuits.

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The subprime and credit crisis-related litigation wave has come a long way since the first of the subprime lawsuits was filed in February 2007. Now that the litigation phenomenon is now nearly a year and a half old, the rulings on the motions to dismiss are finally starting to accumulate. It appears to be time for The D&O Diary to initiate the latest in its ongoing and ever-popular series of lists, this most recently created one to track the accumulated subprime and credit-crisis related lawsuit dismissals and dismissal motion denials.

The D&O Diary’s newly created list of subprime and credit crisis-related dismissals and motion denials can be found here.

As befits the relatively early stages of most of this litigation, the list of case dispositions is, as of the time of the list’s initial creation, pretty sparse. I will endeavor to update the list as new dismissal motion rulings emerge, and wherever possible I will provide a link to the actual ruling. As I update the list, I will indicate at the top of the list the date of the list’s most recent revision.

The more complete the list is, the more useful it will be for everyone, so all readers are strongly invited and encouraged to let me know about any subprime and credit crisis related lawsuit dismissal motion rulings that are not already on the list.

As of the date of the creation of this post, I am not aware of any subprime or credit-crisis related lawsuit settlements. The settlements will emerge sooner or later, and when the do, I will created a supplemental document tracking the settlements.

Readers who may be unaware of the other lists that I am maintaining may be interested to know about the following lists:

1. The List of Subprime and Credit Crisis-Related Securities Class Action Lawsuit Filings (which may be accessed here).
2. The List of Subprime and Credit Crisis-Related Derivative Lawsuits (here).
3. The List of Options Backdating-Related Lawsuit Filings (here)
4. The List of Options Backdating-Related Dismissals, Denials and Settlements (here).
5. The List of Securities Class Action Opt-Out Settlements (here).

I am always interested in any additional information or correcting information that is required to make these lists more accurate or complete. I am also always interested in readers’ thoughts and comments, about these lists or anything else.

Welcome Back: Serial blogger Bruce Carton is back at it again, with his new blog, Unusual Activity, which can be found here. The blog describes itself as "The Securities Litigation and Enforcement Reporter."  Many readers will recall that Bruce is the founder and long-time author of the Securities Litigation Watch blog. Bruce more recently wrote the Best in Class blog. Everyone here welcomes Bruce back to the blogging circuit, and we look forward to reading his new blog.

Speakers's Corner: On June 19 and 20, 2008, I will be co-Chairing the Mealey's Subprime Mortgage & Insurance Coverage Litigation Conference at the Ritz-Carlton in Pentagon CIty, Virginia, with my good friend, Matt Jacobs, of Jenner & Block.

The agenda (which can be found here), includes many distinguished speakers and panelists, such as Andrew Carron of NERA Economic Consulting, Adel Turki of Cornerstone Research, Robert Rothman of the Lerach Coughlin firm, Dan Bailey of Bailey & Cavalieri, John McCarrick of Edwards Angell Palmer & Dodge, David Hensler of Hogan & Hartson, and Mitchell Dolin of Covington & Burling.

Registration instructions and other intormation about the conference can be found here.

And Finally: If you have never heard of the Social Science Research Network (SSRN), then you will want to review the article yesterday's New York TImes (here) discussing the latest in academic anxieties. It used to be all publish or perish, but it is now all about the downloads and links. And you thought your job was competitive.

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 As I have previously observed, the current credit crisis is about more than subprime loans. Among the other kinds of credit are so-called Option ARMs, which frequently involve prime borrowers. These loans are adjustable rate mortgages where the borrower has the option of paying less than the full amount of interest due, with the unpaid balance added to the principle (that is, the loan can negatively amortize). My prior post describing and discussing the nature of Option ARM loans can be found here.

 

This negative amortization payment feature of Option ARMs only makes sense (if at all) at a time of rising home prices. At a time of declining home values, it can quickly put the borrower in a position where they owe more than the value of their home. As unattractive as this position is, it can get worse when the interest rate adjusts upwards, leaving the borrower in a position of paying even more to stay in a home that is worth less than the mortgage debt.

 

Unsurprisingly, borrowers are having difficulties with Option ARM loans, which in turn is leading to problems for lenders with Option ARM portfolios. These problems in turn are leading to litigation.

 

The latest company to be sued in a securities class action lawsuit arising out of problems with Option ARM loans is Wachovia Corporation, which was sued, together with certain of its directors and officers, on June 6, 2008 in the United States District Court for the Central District of California. The plaintiffs’ lawyers’ June 9, 2008 press release about the lawsuit can be found here. The complaint can be found here. UPDATE: As correctly noted in the reader comment, this case is actually pending in the Northern District of California, rather than the Central District as original text incorrectly stated.

 

According to the press release, the complaint alleges that:

Defendants misled investors by falsely representing that Wachovia had strict and selective underwriting and loan origination practices and a conservative lending approach that set it apart from other lenders. Such reassurances were repeated by defendants throughout the Class Period in order to artificially support Wachovia's stock price in the midst of a weakening mortgage market. In response to increased market concern with the mortgage lending industry, and Wachovia's option ARMs in particular, Wachovia falsely represented that its loan underwriting practices were much better than at other banks and that this would allow it to prosper while lenders with less exacting standards and procedures would fare much worse. In reality, Wachovia's actual lending practices differed materially from the description of those practices in statements made to investors. The Company's ability to weather the deterioration in the real estate and credit markets was grossly exaggerated by Defendants, at precisely the worst time, when analysts began to ask tough questions. The Company, moreover, had inadequate loan loss reserves and falsely represented that its capital position was sufficient to fund its dividend.

Shortly after last assuring the market of its liquidity, the strength of its underwriting practices, and the adequacy of its reserves, Wachovia reported a surprise quarterly loss, undertook emergency measures to increase capital, and cut its dividend. On April 14, 2008, before the open of ordinary trading, Wachovia reported a loss of $350 million, or $0.20 per share, for the first quarter of 2008. The Company attributed the results to: (1) a $2.8 billion increase credit loss reserves, including $1.1 billion specifically for ``Pick-A-Pay'' reserve build, the lending program highly touted by the Company during the Class Period. The need to increase Pick-A-Pay reserves was attributed to Wachovia's adoption of a ``refined reserve modeling'' that resulted in ``higher than expected loss factors on Pick-a-Pay''; and (2) $2 billion in mark-to-market losses for mortgage backed securities, including a ``$729 million loss on unfunded leveraged finance commitments.'' In order to shore-up its capital, Wachovia announced the following steps: (1) reduce the dividend 41% to $0.375; and (2) plan to raise capital by $7-8 billion through public offerings.

Wachovia is only the latest company to become embroiled in securities litigation arising out of Option ARM problems. Companies previously sued in securities lawsuits involving Option ARM allegations include Washington Mutual (about which refer here) and Downey Financial (refer here). It seems highly unlikely that these companies will be the only ones to become involved in lawsuits involving these concerns.

 

Indeed, as bad as the situation involving Options ARMs may now appear, circumstances are likely to deteriorate in the months ahead. As discussed in the June 5, 2008 Business Week article entitled “The Next Real Estate Crisis” (here), foreclosures on Options ARMs have already tripled in the last year, but could further hasten as “monthly options recasts are expected to accelerate starting in April 2009, from $5 billion to a peak of about $10 billion in January 2010.” The Option ARM loan defaults “could accelerate next year even if subprime defaults subside.”

 

The possibility of further Option ARM related securities litigation seems likely.

 

In any event, I have added the new Wachovia case to my running tally of subprime and credit-crisis related securities class action lawsuits, which can be accessed here. The current tally now stands at 89, of which 49 have been filed in 2008.

 

It is probably worth noting that this new case is the third in which Wachovia has become involved as part of the current credit-crisis related litigation wave. In addition to the new lawsuit, Wachovia was previously sued in an auction rate securities lawsuit (refer here), and in a Prospectus Liability case arising out of the company’s offering of certain Trust Preferred Securities (about which refer here).

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As the subprime crisis has unfolded, one of the recurring themes has been the conflicted role of the rating agencies. Last week’s announcement (here) of a negotiated resolution of the New York State regulatory investigation of the rating agencies reflects one aspect of the recurring questions surrounding the rating agencies’ role in the current crisis. These questions are likely to persist in light of the recent revelation (here) that Moody’s continued to assign mortgage-backed securities investment grade ratings despite a whistleblower’s alarm about potential problems with the ratings.

But while the questions about the rating agencies’ role have persisted, and while the agencies own shareholders have sued the rating agencies over the agencies’ own disclosures (about which refer here and here), to date subprime investors have not targeted the rating agencies for their rating activities, to the best of my knowledge.

As discussed in a prior post (here), case law suggests that the rating agencies enjoy First Amendment protection for their rating opinions and activities. And, as also discussed in my prior post, while thoughtful commentators have suggested bases on which these defenses might be overcome with respect to the rating agencies subprime-related investment rating activity, subprime investors have not targeted the rating agencies. Until now.

In a lawsuit filed on May 15, 2008 in New York Supreme Court (New York County), the New Jersey Carpenters’ Vacation Fund has filed a securities class action lawsuit under the ’33 Act on behalf of investors in the three HarborView Mortgage Loan Trusts. In a petition dated June 3, 2008, the defendants removed the case to the United States District Court for the Southern District of New York. A copy of the notice of removal, to which the original complaint is attached, can be found here.

The defendants in the lawsuit include the three HarborView mortgage pass-through certificate trusts; the Royal Bank of Scotland Group (“RBS Group”) and its subsidiary, Greenwich Capital Holdings and related entities, including Greenwich Capital Acceptance (“GCA”) and five individual directors of GCA; and the three rating agencies, Fitch’s Ratings, Moody’s Investor Services, and McGraw Hill, as corporate parent for Standard & Poor’s Rating Services.

The three trusts were issuers of bonds (the mortgage pass-through certificates) created by RBS Greenwich Capital. The offerings were collateralized with loans originated and underwritten by Countrywide Home Loans. The complain alleges that the Registration Statement issued in connection with the offerings failed to disclose “the true impaired and defective quality of the loans collateralizing the Bonds” and that the “loans were not originated pursuant to the underwriting guidelines stated in the Registration Statement.”

The complaint alleges that the rating agency defendants “failed to conduct due diligence and willingly assigned the highest ratings to such impaired instruments since they received substantial fees from the issuer.” The complaint alleges further that the rating agencies “issued the ratings based on an outdated methodology designed in about 2002.” The ratings were alleged to be misleading because the rating agencies “presumed that the loans were of high credit quality issues in compliance with the stated underwriting guidelines, when, in fact, Countrywide had systematically disregarded its stated Underwriting Guidelines.”

The rating agencies later downgraded the mortgage-backed securities. The complaint alleges that the rating agencies “admission that they had not used an appropriate rating methodology …resulted in a substantial decline in the value of the Bonds.” The plaintiff itself claims that its investment in the instruments has declined by 55 percent.

All of the claims asserted in the Complaint are based on the ’33 Act. In Count I of the Complaint, the plaintiff specifically alleges (in paragraph 98) that the rating agencies “served as appraisers” as defined in Section 11(a)(4) of the ’33 Act. The paragraph further alleges that the rating agencies “purportedly reviewed and analyzed each offering and provided the credit rating for each tranche of the HarborView Bonds.” The paragraph further alleges that the service of providing the ratings “was essential to pricing and marketing the Bonds,” and that the ratings were contained in the Prospectus.

As far as I am aware, the plaintiffs’ complaint in the HarborView Mortgage Loan Trust lawsuit represents the first occasion as part of the current subprime litigation wave where subprime investors have sought to hold the rating agencies liable for their ratings. The plaintiff’s allegations will face a number of hurdles, including the jurisdictional issue discussed below.

In addition, the rating agencies will undoubtedly assert a number of substantive defenses, including the First Amendment defense discussed in my prior blog post (here), as well as whether the rating agencies even owed the plaintiff any duties. The rating agencies will particularly dispute the plaintiffs’ attempt to rely on Section 11(a)(4) of the ’33 Act as a basis for the rating agencies’ liability.

The jurisdictional issue pertains to the plaintiff’s initiation of the lawsuit in state court pursuant to the concurrent state court jurisdiction in Section 22 of the ’33 Act. The HarborView case is just the latest of the state court ’33 Act lawsuits arising as part of the current subprime-related litigation wave, as discussed in my prior post (here). In each case, the defendants have sought to remove these cases to federal court, notwithstanding the express prohibition in Section 22 of removal of state court cases to federal court. In at least one of the prior cases, the federal court has remanded the case back to state court in reliance on Section 22’s express removal prohibition (refer here for a discussion of the prior remand case).

It remains to be seen whether or not these cases will go forward in state or federal court. Although it is not altogether clear why the plaintiffs have sought to pursue these cases in state court, the plaintiffs clearly perceive some advantage in doing so. In any event, the success of the plaintiffs’ attempts to hold the rating agencies liable for their investment in subprime-related securities will be interesting to watch. It will also be interesting to see if other investor plaintiffs similarly seek to hold the credit rating agencies liable.

Special thanks to Adam Savett of the Securities Litigation Watch blog (here) for providing a copy of the HarborView removal petition.

Run the Numbers: I have added the HarborView case to my running tally of subprime-related securities class action lawsuits. (My tally can be accessed here). According to my count, the addition of this case, as well as the case filed late last week against Franklin Bank Corp. (about which refer here), the current tally of subprime and credit crisis-related securities class action lawsuits now stands at 88, of which 48 have been filed in 2008.

Speakers’ Corner: On June 19 and 20, 2008, I will be co-Chairing the Mealey’s Subprime Mortgage & Insurance Coverage Litigation Conference at the Ritz-Carlton in Pentagon City, Virginia, with my good friend Matt Jacobs of the Jenner & Block law firm.

The agenda (which can be found here), includes many distinguished speakers and panelists, such as Andrew Carron of NERA Economic Consulting, Adel Turki of Cornerstone Research, Samuel Rudman of the Lerach Coughlin firm, Dan Bailey of Bailey & Cavalieri, John McCarrick of Edwards Angell Palmer & Dodge, David Hensler of Hogan & Hartson, and Mitchell Dolin of Covington & Burling.

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In arguably the most substantive ruling yet in a subprime-related securities class action lawsuit, Judge Ortrie Smith of the United States District Court for the Western District of Missouri, in a June 4 opinion (here) in the NovaStar Financial subprime-related securities class action lawsuit, granted the defendants’ motion to dismiss with prejudice.

The NovaStar lawsuit, which was first filed on February 23, 2007, was one of the first subprime-related securities class action lawsuits to be filed. Background regarding the lawsuit can be found here. The lawsuit alleges that NovaStar, a real estate investment trust, lacked adequate internal controls, as a result of which the company materially misstated its financial results and condition. The lawsuit followed the company’s February 20, 2007 announcement of disappointing results and deteriorating marketplace conditions.

Judge Smith granted the motion to dismiss on the grounds that the complaint does not adequately plead falsity and does not adequately plead scienter.

In addressing the falsity requirements, Judge Smith noted the PSLRA’s specificity requirements, and observed that the complaint, despite its over 100 pages and over 200 paragraphs “presents a very broad picture, and Plaintiff discusses his claims in generalities – precisely what the PSLRA counsels against.” This, Judge Smith said, allowed the Complaint to “create the illusion of detail and insinuate the existence of fraud, which in turn has made it exceedingly difficult for the Court to conduct the analysis required by law.”

After reviewing the complaint’s specific allegations of falsity and finding them each in turn to be inadequate, Judge Smith concluded that “ultimately, Plaintiff fails to identify a single false entry in the Company’s financial statements, nor does he identify the ‘truth’ that should have been disclosed.” Judge Smith goes on to add that the Complaint “reads more like a cautionary tale from a treatise on business management than a charge of knowing misstatements and concealments.” Companies, the court said, “are not expected to be clairvoyant and bad decisions do not constitute fraud.”

With respect to plaintiff’s scienter allegations, the court concludes that the plaintiff “had not presented facts creating an inference of scienter that is at least as strong as an inference that Defendants lacked fraudulent intent.” The court noted that the allegations are “more consistent with a company and executives confronting a deterioration in the business and finding itself unable to prevent it than they are with a company and executives recklessly deceiving the investing community.”

Judge Smith declined to allow the plaintiffs leave to replead, concluding it “would be futile,” since there is “no suggestion that any material was concealed or that any Defendant acted with fraudulent intent, and there is no reason to think further or different pleading will created the necessary inferences.”

The Court’s opinion is pretty much a clean sweep for the defendants, but it is hard to know what the larger significance of the opinion might be. There are few other subprime cases pending in the Western District of Missouri (for which the plaintiffs’ bar is undoubtedly grateful, given the outcome in the NovaStar case), and courts in other jurisdictions may or may attach weight to Judge Smith’s ruling.

One aspect of the opinion that could be significant if it represents the perspective with which other courts will view these cases, and that is the extent to which Judge Smith viewed this case through the screen of the generally deteriorating financial markets and business conditions. Other judges, like Judge Smith, may be similarly disinclined to find anything nefarious in a company’s failure to anticipate declining business conditions – at least in the absence of insider trading or other more compelling factors.

While there may be cases such as the Countrywide derivative lawsuit which courts may be predisposed to allow (about which refer here), there may be others, like the NovaStar case, where courts prove unwilling to infer wrongdoing from business reverses. At a minimum, the NovaStar opinion is a reminder that merely because a company’s fortunes have declined and the plaintiffs have filed a lawsuit does not necessarily mean that the plaintiffs will prevail or make any recovery. There may be more than a few of the cases filed as part of the subprime litigation wave that also fail to survive the initial pleading hurdles.

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In a prior post (here), I described the growing litigation risk arising out of credit default swap (CDS) transactions. In their recent overview of subprime-related litigation entitled “The Pebble and the Pool: The (Global) Expansion of Subprime Litigation” (here), John Doherty and Richard Hans of the Thacher Proffitt and Wood law firm note that “more lawsuits involving credit default swaps are likely to be initiated in the near future, as the current trend has the potential for huge losses resulting from the defaults on ‘high-yield’ or ‘junk” bonds in connection with the general market failure.”

In a June 1, 2008 article entitled “First Came the Swap. Then It’s the Knives” (here), New York Times columnist Gretchen Morgenson takes a close look at one failed CDS transaction and the litigation that has followed, about which she quotes “experts” as saying that the case is “the first of what will likely be a flood of disputes between big banks and hedge funds that typically strike swap deals.”

The swap involved was issued by a Paramax Capital hedge fund in early 2007 to insure $1.31 bilion of AAA-rated super senior notes that “reflected performance of subprime mortgages in a collateralized debt obligation underwritten by UBS.” The Paramax fund, which itself had just $200 million in capital, organized a special purpose entity capitalized with just $4.6 million, to conduct the swap. Paramax was to receive an annual fee of 0.155 percent of the notes’ $1.31 billion value (or slightly more than $2 million), and would be subject to additional collateral requirements if the notes’ value declined.

Over the course of 2007, UBS presented escalating requirements that Paramax post a total of $33 million in additional collateral. When Paramax refused, UBS sued. According to the Times article, Paramax now contends that a UBS managing director (no longer with the company) induced Paramax to enter the transaction, and to address Paramax’s concern that it might be called upon to post additional collateral, reassured Paramax that the mark-to-market risk on the underlying securities was low because UBS used “subjective valuations” designed to reduce the impact of market fluctuations.

As detailed further in the Times article, there are a number of interesting things about this transaction. From my perspective, the most noteworthy aspect is that UBS considered a special purpose entity with only $4.6 million in capital to be an appropriate source of default insurance for instruments with a face value of $1.31 billion. UBS’s contractual right to demand additional collateral from the hedge fund, which itself had capital of only $200 million (which presumably was deployed in other ways and accordingly unavailable in its entirety as additional collateral), seems a woefully inadequate explanation for this transaction.

The Naked Capitalism blog (here) notes that “UBS was clearly well aware of Paramax’s limits, so the next question is: was UBS solely responsible for pulling a fast one on the CDO buyers or is Paramax a co-conspirator?”

This litigation between UBS and Paramax resembles the CDO Plus litigation I discussed in my prior post (here) about swaps. In those cases as well, a thinly capitalized hedge fund was unable to meet demands for additional collateral and wound up in litigation with the large commercial banks that had purchased CDS protection from the fund. As consequences from the credit crisis continue to roll through the financial marketplace, CDS counterparties are likely to face further collateral demands, which can only fuel further litigation.

But the counterparties themselves are not the only potential litigants. Behind the CDS purchaser are the investors who made investments in the belief that the investment interests were “insured” against default. As it emerges that this insurance depended upon facially inadequate counterparties, investors may join the fray. As the Naked Capitalism blog post linked above notes, “since over 30% of the credit default swaps were written by hedge funds, many of whom were probably as incapable as Paramax of performing in the event of default, it’s not unreasonable to assume that some of these CDS lawsuits will lay the groundwork for investor litigation.”

Another aspect of the role of CDS in the financial marketplace is leading to yet another variety of CDS-related litigation. That is, because there is no requirement that a CDS buyer hold the underlying instruments, swaps are often used as a means to speculate on interest spreads. That means that these instruments can serve an investment purpose separate apart from their insurance purpose.

The problem for companies that have used swaps for investment purposes is that as a result of the credit turmoil, the market for these instruments in an uproar, and the instruments’ valuation has become uncertain. Indeed, as recent circumstances have shown, these valuation issues are present whether a company holds the swap as an investor or as an insurer. Several of the most significant recent financial institution asset write-downs have involved these CDS valuation uncertainties; for example, a substantial part of the recent write-downs of Swiss Re and of American International Group related to CDS valuation issues. Significantly, in both instances, shareholders litigation ensued following the write-downs. (Refer here regarding the Swiss Re litigation and refer here regarding the AIG litigation). It seems highly improbable that there will not be further shareholder litigation over these CDS valuation issues.

As reflected in the June 6, 2008 Wall Street Journal (here), the recent signs are that the turmoil in the financial marketplace is far from over , as a result of which the pressure on CDS will remain, and there likely will be further litigation. Even if only a tiny percentage of CDS transactions beget litigation, the problem could be huge. According to the International Swaps and Derivatives Association (here), the aggregate notional value of credit defaults swaps outstanding at the end of 2007 was $62 trillion, an amount which arguably exceeds the value of bank deposits worldwide. It is nearly three times the value of the U.S. stock markets.

With numbers that astronomical, even a small sliver represents a mammoth problem. With nominal values of $62 trillion, issues concerning valuation present a potentially frightening prospect for companies, their investors, and their insurers. As Time Magazine said in its recent article entitled “Credit Default Swaps: The Next Crisis?” (here), “a meltdown in the CDS market has potentially even wider ramifications nationwide than the subprime crisis.”

Susan Mangiero has an interesting post (here) on her Pension Risk Matters blog about these issues.

The “Pebble in the Pool” article I linked to above presents a very good overview of the subprime-related litigation generally and is worth reviewing on its own for those purposes.

Another Subprime-Related Lawsuit Against Mutual Fund: On June 5, 2008, plaintiffs’ attorneys initiated a securities class action lawsuit in the United States District Court for the District of Massachusetts under the Securities Act of 1933 on behalf of purchasers of the Fidelity Ultra-Short Bond Fund who purchased their fund shares within three years of the lawsuit’s filing.

According to the complaint (which can be found here), the defendants in the lawsuit include Fidelity Management & Research Company, which is the investment advisor to the Fidelity mutual funds, and related entities, and also include the 21 individual trustees of the Ultra-Short Bond Fund.

According to the plaintiffs’ lawyers’ June 5, 2008 press release describing the complaint (which can be found here), the plaintiffs allege that the defendants solicited investors to purchase fund shares by making statements that described the fund as a fund that “(i) “Seeks a high level of current income consistent with the preservation of capital”; (ii) “allocates its assets across different market sectors and maturities”; (iii) has a “similar overall interest rate risk to the Lehman Brothers® 6 Month Swap Index”; and (iv) is geared toward the “preservation of capital.”  

The complaint alleges that these statements were false because “defendants did not adequately disclose the risks associated with investing in the Fund, including, for example, that the Fund was: (i) failing to compete with the Lehman Brothers® 6 Month Swap Index; and (ii) so heavily invested in high-risk mortgage-backed securities.”

I have added this case to my running tally of subprime-related litigation, which can be found here. With the addition of this lawsuit, the tally now stands at 86 subprime-related securities class action lawsuits, of which 46 have been filed in 2008.

I note that by my count, this new lawsuit represents the fourth subprime-related lawsuit against a mutual fund or mutual fund family. The other include Calamos Global Dynamic Income Fund (about which refer here), Regions Morgan Keegan Funds (refer here), and the Schwab Yield Plus Fund (refer here).

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In the past week, plaintiffs’ lawyers filed a raft of new subprime and credit crisis related securities lawsuits. The cases involve a wide variety of claimants and defendants, and a diverse array of legal theories. But while the lawsuits themselves are diverse, they do all evidence a common theme, which is that the subprime and credit-crisis related litigation wave continues to surge on.

American International Group: The most prominent lawsuit filed in the past week is the securities class action lawsuit filed in the United States District Court for the Southern District of New York against American International Group, its CEO Martin Sullivan, its CFO Steven Bensinger, and two other officials. A press release describing the lawsuit, which was filed by the Bernstein Litowitz Berger & Grossmann firm on behalf of the Jacksonville Police and Fire Pension Fund, can be found here. A copy of the complaint can be found here.

According to the press release, “Defendants repeatedly reassured investors that AIG had successfully insulated itself from the recent turmoil in the housing and credit markets due to its superior risk management. In particular, defendants touted the security of [American International Group Financial Products] ‘super senior’ credit default swap portfolio, making numerous statements that this portfolio was secure and that AIG’s method for accounting for this portfolio accurately reflected its value.” The press release goes on to state that:

Investors began to learn the truth regarding AIG’s financial condition and the Company’s exposure to the mortgage market when, on February 11, 2008, the Company disclosed that its outside auditor had determined that there was “material weakness in its internal control” over the financial reporting and oversight relating specifically to its accounting for the CDS portfolio, and that the Company was revising the loss valuations it previously reported. Under the new valuations, losses on the CDS portfolio more than quadrupled – from the $1.4 billion reported on the CDS portfolio just weeks before to over $4.5 billion. Two weeks later, on February 28, 2008, AIG disclosed that the market valuations on the CDS portfolio would increase to $11.5 billion and revealed for the first time that the Company had notional exposure of $6.5 billion in liquidity puts written on collateralized debt obligations (“CDOs”) linked to the sub-prime mortgage market.

Finally, on May 8, 2008, the Company disclosed that market valuation losses on the CDS portfolio for the quarter climbed an additional $9.1 billion, for a cumulative loss of $20.6 billion, and that the Company was expecting actual losses on the portfolio to be about $2.4 billion. As a result of these disclosures, the price of AIG stock plunged from a Class Period high of $75.24 per share on June 5, 2008, to $38.37 per share on May 12, 2008, wiping out tens of billions of dollars in shareholder value and causing damage to the class.

A May 22, 2008 New York Times article describing the AIG lawsuit can be found here. A May 23, 2008 Law.com article about the suit can be found here.

Falcon Strategies/Citigroup: Another prominent lawsuit filed during the last week involved a hedge fund affiliated with Citigroup, which is also a defendant in the lawsuit. The lawsuit is filed on behalf of all persons “who have tendered or been asked to tender their shares” in Falcon Strategies Two LLC. According to the plaintiffs’ lawyers’ press release (here), Falcon was established as a “multi-strategy fixed income alternative seeking to provide investors with absolute returns, current income and portfolio diversification.” However, the complaint (which can be found here) alleges that Falcon was “not conservative” but “employed bond arbitrage, carried commercial debt obligations, and held asset-backed mortgage investments” that declined in value when the markets failed.

The complaint is somewhat unusual in that, which it alleges affirmative violations of the federal securities laws, it does not expressly seek damages, but rather seeks a preliminary injunction to enjoin the tender offer until the defendants correct the “allegedly false and misleading” tender memorandum.

A separate lawsuit against a Falcon Strategies fund seeking damages and filed on behalf of Fifth Third Bank is detailed in a May 20, 2008 Wall Street Journal article (here). The Falcon Strategies fund had previously been the target of a separate securities class action lawsuit, but that lawsuit was voluntarily dismissed (refer here concerning this prior dismissed lawsuit).

The Falcon Strategies lawsuit is the second subprime or credit crisis-related securities class action lawsuit brought against a Citigroup-affiliated hedge fund. In early May 2008, investors brought a securities lawsuit against MAT Five LLC, Citigroup and other defendants alleging misrepresentations in MAT Five’s placement memorandum (Refer here for further background regarding the MAT Five lawsuit.)

Bank of America: In addition to these two lawsuits, investors also brought a securities class action lawsuit against Bank of America and related entities on behalf of all persons who purchased auction rate securities from the defendants during the period May 22, 2003 and February 23, 2008. A copy of the plaintiffs’ lawyers’ press release can be found here and a copy of the complaint can be found here.

I have written extensively about the auction rate securities lawsuits in prior posts, most recently here.

National City/Harbor Bank: Finally, in the fourth of last week’s flotilla of new subprime lawsuits, on May 20, 2008, the defendants removed to the United States District Court for the Northern District of Ohio a lawsuit that had been filed in the Court of Common Pleas of Cuyahoga County Ohio on behalf of all persons who acquired shares of National City Corporation in connection with National City’s December 1, 2006 acquisition of Harbor Bank. A copy of the complaint and removal petition can be found here.

The plaintiffs allege that the Registration Statement issued in connection with the merger contained material misrepresentations and omissions concerning National City’s lending practices, financial results and liquidity. In particular, the complaint alleges among other things that the Registration Statement failed to disclose that National City was “dangerously overexposed” to “risky and impaired CDOs” and that the company had “failed to properly account for its highly leveraged loans and mortgage securities.”

National City previously has been sued in a securities class action lawsuit (as I discussed in a prior post, here) filed on behalf of its shareholders. But this new lawsuit is filed on behalf of a distinct set of claimants and is based on a different set of alleged misrepresentations, and therefore in my view it represents a separate new lawsuit. As discussed below, I have accounted for it separately in my running tally of subprime-related securities lawsuits.

The lawsuits against National City on behalf of the former Harbor Bank shareholders alleges violations of Section 11 of the ’33 Act, but was filed initially in state court under the ’33 Act’s concurrent jurisdiction provisions. I have previously noted (refer here) the plaintiffs’ lawyers’ recent interest in attempting to pursue ’33 Act claims in state court. While defendants routinely remove these cases to federal court, the plaintiffs’ lawyers’ have has some success in having the cases remanded to state court (refer here). While one can only speculate on the plaintiffs’ interest in pursuing these cases in state court, it is nonetheless a very interesting development that possible represents a new trend in securities litigation prosecution.

One other interesting thing about the National City/Harbor Bank lawsuit is that in addition to National City itself and its current and former directors and officers, the complaint names as a defendant, National City’s auditors, Ernst & Young. There have been some lawsuits where the target company’s outside auditors have been named as defendants (for example, refer here regarding the amended complaint in the Countrywide subprime litigation where the companies’ auditors have been named). The bankruptcy examiner in the New Century case also suggested that there may be claims against the company’s auditors (refer here for a discussion of this report). However, so far, the auditors have been an infrequent target, likely because of the Stoneridge decision. The cases involving outside auditors have tended to be bases where an offering of securities is involved, and the auditors potentially have their own primary liability in connection with the offering.

Special thanks to Adam Savett of the Securities Litigation Watch blog (here) for a copy of the National City/Harbor Bank complaint.

Run the Numbers: With the addition of last week’s four new subprime and credit-related securities lawsuits, the current tally (refer here) of the subprime related securities lawsuits now stands at 85, of which 45 have been filed in 2008. With the addition of the new Bank of America lawsuit, the total number of auction rate securities lawsuits now stands at 17.

While the numerical specifics are important, the more important point is that the subprime and credit crisis-related litigation wave continues to churn on, the passage of time apparently doing nothing to diminish its intensity.

Speakers’ Corner: On Thursday May 29, 2008, I will be in New York speaking on a panel at IQPC’s 4^th Securities Litigation Conference (brochure here). The panel on which I am participating is entitled “Discussing Recent Trends in Director & Officer Liability (D&O) Liability,” and includes as co-panelists Ray DeCarlo of AIG and Adam Savett of RiskMetrics.

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In my preceding post, I quoted recent reassuring words from Treasury Secretary Henry Paulson about the current credit crunch. Billionaires Warren Buffett and George Soros apparently have a less sanguine view, and there is in any event substantial recent evidence to support the view that, whether or not the worst is over, the effects will be felt for some time to come.

According to news reports (here), Warren Buffett told reporters in Europe yesterday that “I don’t necessarily think we’re halfway through or necessarily a quarter of the way through the effects throughout the general economy. The initial effects are felt by people who really did the silliest things, but you can have a whole bunch of domino-type effects that eventually can get to people who are doing fairly sound things.” Buffett added that “I think there will be rippling secondary, tertiary effects.”

Soros, while willing to concede (here) that the “acute phase” of the crisis may have passed, also said that “now we have to feel the effects,” which he said might “almost inevitably” include recessions in the U.S. and U.K.

An even more pessimistic voice is that of Meredith Whitney, the analyst for Oppenheimer who correctly predicted disaster for Citigroup and others last fall. She recently said (here) that "the credit crisis is far from over" and "what lies ahead will be worse that what is behind us." Dang.

There are already a wide variety of effects that are rippling through the economy and affecting a diverse array of companies, even outside the financial sector. For example, on May 19, 2008 Bloomberg reported (here) that “more than 300 companies are struggling to value auction rate bonds” that they are carrying on their balance sheets. These companies’ auction rate securities investments were valued at $98 billion as recently as January 1, 2008.

“About half” of these companies have “reported losses totaling $1.8 billion as the markets for securities, sold as higher-yielding alternatives to money markets, seized up.” Among the companies the Bloomberg article names as having taken auction-rate securities-related write-downs are UPS, Google, HCA and Teva Pharmaceuticals. But while half of the companies holding these assets may have recognized the valuations issues, the other half have not, and even the companies that have taken some recognition have the issue of whether or not they got it right.

The wide dispersion of these and other credit crunch-related exposures throughout the economy puts pressure on many companies to recognize the risk; companies that delay or avoid recognition may be laying in problems down the road. As one commentator said in another Bloomberg article (here), “the smart people are the ones who’ve identified the problems, put them out there in full transparency, and addressed them by raising more capital. There is still billions of dollars of crap out there that hasn’t worked its way through the system.”

The May 19, 2008 Bloomberg article in which this latter statement appeared is entitled “Banks Keep $35 billion Markdowns Off Income Statements” (here). The article describes multiple financial institutions that are “failing to acknowledge their in their income statements at least $35 billion of additional write-downs included in their balance sheets.” A commentator in the article notes that “keeping the markdowns off income statements just delays the realization of losses.” Indeed, the article suggests that ignored bad debt and postponing the inevitable losses is one of the reasons behind Japan’s decades long economic slump.

Behind every postponed day of reckoning is an optimistic hope that the reckoning might not just be delayed but perhaps avoided altogether. And perhaps things will come right. But the kinetic potential for the kinds of secondary and tertiary ripple effects Buffett projected inheres within every one of these postponements, laying the potential for further disruption when the day of reckoning arrives.

The consequences of these secondary and tertiary effects inevitably will include litigation, as is perhaps illustrated by the lawsuit, described in today’s Wall Street Journal (here), in which Fifth Third Bank has sued an insurer and a brokerage firm that arranged an investment for the bank in the Citigroup Falcon Strategies hedge fund. (A copy of the complaint can be found here.)

Fifth Third’s investment involved a complex life insurance investment, in which the aggregate premiums were invested in a diversity of assets. The complaint alleges that the defendants failed to monitor and manage Fifth Third’s $612 million investment, particularly when changing conditions (triggered by the credit crunch) should have triggered a reallocation of assets. This lawsuit demonstrates the range of potential litigation issues and the breadth of potential litigation targets that may become involved in future litigation. 

In a post on this blog last December (here), I discussed “the truth telling yet to come” in connection with the subprime meltdown. In many ways, the phrase is even more apt now. The dynamic possibilities of the truth telling yet to come include the litigation yet to come, as well. And as Buffett said, we are not necessarily even a quarter of the way through this yet.

A June 1, 2008 article in Corporate Counsel entitled “Wipeout!” (here) describes the credit crisis-related litigation to date and the litigation yet to come. Among other things, the article quotes one commentator as saying that “we haven’t seen most of the litigation yet.”

Top Ten Securities and Corporate Law Review Articles: The Securities Litigation Watch blog (here) has reproduced (with hyperlinks) the list of the Top Ten Corporate and Securities Law Review articles of the year. I was very pleased to see that my good friends Tom Baker and Sean Griffith's article "The Missing Monitor in Corporate Governance: The Directors' & Officers' Liabiltiy Insurer" (here) made the list. I discussed Professor Baker and Griffith's article at length in an earlier post, here.

A Big Fee Anwhere (But Especially in Tajikistan): A May 20, 2008 Financial Times article about lawyers’ fees entitled “Time to Stop the Lawyers’ Clock from Ticking” (here), noted that observers had

expressed concern about the £50m in fees that Herbert Smith, another top firm, expects to bill on behalf of Tajikistan in a dispute over alleged corruption at a state-owned aluminum smelter.

The projected costs, revealed at a High Court hearing in April, would represent 2.7 per cent of the central Asian nation’s gross domestic product, where the average monthly wage stands at a paltry $63.

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According to news reports (here), Treasury Secretary Henry Paulson has added his voice to the growing chorus declaring that the worst of the credit crisis may be past. Paulson reportedly said that “we are seeing signs of progress as capital and credit markets stabilize.” We can all hope for the sake of the financial markets, and indeed, the entire U.S. economy, that Paulson is correct.

But while the top level indications may be encouraging, it would be premature at this point to conclude that the subprime and credit crunch related litigation wave is spent. If the lawsuit filings just in the last week are any indication, the litigation wave will continue to roll on for the foreseeable future.

For example, on May 16, 2008, plaintiffs’ lawyers filed a securities class action lawsuit in the United States District Court for the Central District of California against Downey Financial Group and certain of its directors and officers. The plaintiffs’ counsel’s May 16 press release can be found here and a copy of the complaint can be found here.

According to the press release, on March 17, 2008, Downey (a savings and loan holding company) reported (here) an “increase in non-performing assets to almost 11% of total assets, up from 1.2% in May 2007.” According to the complaint, the “true facts, which were known to the defendants but concealed from the investing public” were that:

(a) defendants’ portfolio of Option ARMs contained millions of dollars worth of impaired and risky securities, many of which were backed by subprime mortgage loans; (b) prior to the Class Period, Downey had seen Countrywide’s growth and had started to get more aggressive in acquiring loans from brokers such that the loans were extremely risky; (c) defendants failed to properly account for highly leveraged loans such as mortgage securities; (d) Downey had very little real underwriting, which led to large numbers of bad loans that would cause huge numbers of defaults; and (e) Downey had not adequately reserved for Option ARM loans, the terms of which provided that during the initial term of the loan borrowers could pay only as much as they desired with any underpayment being added to the loan balance.

I have written previously (here) about the litigation threat that Option ARMs could present. Downey is far from the only financial institution that is vulnerable to defaults and delinquencies as Option ARMs readjust. Moreover, all lending institutions remain vulnerable to increasing defaults as rising unemployment, and rising energy and food costs (among other things), continue to undermine borrowers’ ability to remain current on their mortgages and other debt. Other lenders undoubtedly will be reporting increases in non-performing assets in the weeks and months ahead – which is one reason why the subprime and credit crisis litigation wave may have long way to go before it loses momentum.

In addition, on May 12, 2008, plaintiffs initiated a shareholder class action lawsuit in the United States District Court for the Eastern District of Michigan against private mortgage insurer MGIC Investment Corp. and its CEO and its CFO. Refer here for a copy of the complaint. MGIC’s woes relate back to its failed 2007 attempt to merger with Radian Group, as well as the deterioration of the joint venture, Credit Based Asset Servicing and Securitization LLC (“C-Bass”), in which MGIC had entered with Radian. The July 2007 collapse of the C-Bass venture and the August 2007 termination of the pending merger of the two companies previously led to the filing of a securities class action lawsuit against Radian Group (about which refer here).

The MGIC complaint alleges that even after the demise of the C-Bass venture and after the termination of the Radian merger, MGIC continued to struggle, and on February 13, 2008, the company announced (here) a loss for the fourth quarter of 2007 of $1.47 billion, part of a full year 2007 loss of $1.67 billion.

MGIC’s financial challenges, which continued well after the company’s mid-2007 crises, underscores that fact that many companies are continuing to grind through tough financial circumstances. MGIC’s continuing challenges suggest that even if, as Secretary Paulson observes, the worse of the credit crisis may have passed, the fallout will continue to filter through the system for many months to come. And as companies continue to wrestle with these circumstances, additional litigation, like that filed against MGIC, will continue to emerge.

Special thanks to Adam Savett of the Securities Litigation Watch blog (here) for a copy of the MGIC complaint.

Run the Numbers: With the addition of these two new lawsuits, my running tally (here) of subprime and credit crisis related securities class action lawsuits now stands at 81, of which 41 have been filed during 2008.

An FCPA Follow-on Litigation Variant: In prior posts (most recently here), I have written about the growing liability threat arising from civil litigation following after Foreign Corrupt Practices Act enforcement activity. In a May 2008 article entitled “Suing Bribing Competitors: The Next Tool in the International Anti-Corruption Arsenal?” (here), James Maton and Joshua Gardner of the Edwards Angell Palmer & Dodge law firm describe yet another litigation threat arising out of corrupt practices enforcement proceedings.

The authors’ describe increasing litigation activity involving claims by companies that lose bids to bribing competitors. The disappointed bidders bring private lawsuits against the companies that are awarded the contracts. The losing bidders seek to recover lost profits, as well as costs wasted in bidding. Plaintiffs have asserted these kinds of claims under federal and state antitrust laws, RICO, and state common law theories such as intentional interference with contract and unjust enrichment.

The authors conclude that notwithstanding the litigation hurdles involved, “these types of private lawsuits are bound to increase in the United States, England and elsewhere.” All of which supports a view I have expressed numerous times on this blog – namely, the as anticorruption enforcement activity increases, the threat of related private civil litigation also increases, and that this litigation threat represents an important emerging liability risk for companies and their directors and officers.

Blog Bites Man: This past week, The D&O Diary passed its second anniversary, as two years have now passed since the blog’s May 10, 2006 launch. During its second year, the blog passed several important milestones, including most significantly its move from Blogger to LexBlog. And after almost 400 blog posts, The D&O Diary now has nearly 1,500 e-mail and RSS subscribers.

I would like to thank The D&O Diary’s readers for their continued support. I remain a highly motivated blogger because of the regular encouragement I receive from the blog’s readers.

I would also like to thank everyone who has sent me links, suggestions and comments over the last two years. I get most of my best material from readers’ suggestions, and I hope everyone out there will continue to send me the good stuff that I might not otherwise find. Please keep your suggestions coming. Thanks to all for their support for The D&O Diary.

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In the most in-depth review yet of a subprime-related lawsuit complaint, Judge Mariana Pfaelzer of the Federal District Court in Los Angeles, in an order dated May 14, 2008 (here), denied the defendants’ motions to dismiss the amended complaint in the consolidated derivative lawsuit filed against Countrywide Financial, as nominal defendant, and against eleven individual current and former officers and directors.

The derivative complaint (a copy of which can be found here) accuses the defendants of misconduct and of disregard of their fiduciary duties, and alleged lack of good faith and lack of oversight of Countrywide’s lending practices, financial reporting and internal controls. The amended complaint also contains insider trading allegations, based on the individual defendants’ sale of over $848 million of their holdings in Countrywide stock while in the possession of material inside information, between 2004 and 2008.

The defendants moved to dismiss the plaintiffs’ derivative claims on the ground that the plaintiffs had not make pre-suit demand or adequately pled that demand was excused.

Judge Pfaelzer began her analysis with some harsh words for the plaintiffs’ complaint, which she described as “prolix and sprawling.” Notwithstanding these concerns, she proceeded to the merits in a ruling that largely went the plaintiffs’ way.

She opened her analysis with the observation that standards to determine whether demand is excused “overlap considerably” with the standard for establishing a claim under Section 10(b) of the ’34 Act. She said that the two issues are “inextricably intertwined,” and proceed to determine that in several material respects the plaintiffs’ allegations satisfy the pleading requirements under the standards of the recent Tellabs case.

Judge Pfaelzer found that the plaintiffs’ allegations create a “cogent and compelling inference that the individual Defendants misled the public with regard to the rigor of Countrywide’s loan origination process, the quality of its loans, and the Company’s financial situation – even as they realized that Countrywide had virtually abandoned its own loan underwriting processes.”

In support of these allegations, the plaintiffs relied on confidential witnesses, whom the court said “paint a compelling picture of a dramatic loosening of underwriting standards in Countrywide branch offices across the United States.” The court said that “plaintiffs’ numerous confidential witnesses support a strong inference of a Company-wide culture that at every level emphasized increased loan origination volume in derogation of underwriting standards.”

The court found further that the plaintiffs' allegations support the contention that many of the individual defendants were aware of the deterioration of standards. After reviewing the “red flags” that should have alerted the individual members of various board committees, the court found that the plaintiffs’ allegations raise “a cogent and compelling inference that the Audit & Ethics committee members were aware of (or proceeded with deliberate recklessness with respect to) the significance of red flags related to increasing delinquencies, negative amortizations, and other signs of loan nonperformance.”

Similarly, the court also found that the allegations “give rise to a compelling inference” that Credit Committee members were made aware of signs of deterioration. The court also found that members of the Finance Committee “either knew or proceeded with deliberate recklessness with respect to, the fact that loans to borrowers who could not pay back their mortgages would ultimately be counterproductive, lucrative as it was in the short run.”

The court also found that plaintiffs had asserted facts to support a strong inference that members of the Operations & Public Policy Committee had acted with scienter. However the court found that “without more, the court does not fund membership on the Compensation Committee probative of scienter.”

In concluding that the allegations taken as a whole support an inference of scienter, the court stated that

independent of any turmoil in the capital markets, the widespread violations of underwriting standards would significantly raise risk of loan defaults. When combined with what the Plaintiffs allege are misrepresentations concerning the quality of Countrwide’s loans, the underwriting issues would ultimately undermine confidence in the secondary market for Countrywide products.

In further support of the scienter findings, the court referred to the company’s aggressive stock repurchase program, undertaken and continued at a time when the company’s share price escalated and while insiders were dumping their own shares. While the defendants offered competing innocent explanations for the insider sales, the court found that the plaintiffs’ “repurchase-related insider trading allegations … are at least consistent with their theory of fraud” and “provide some support” against the motion to dismiss. The repurchase program could be viewed as “an attempt to keep the ball rolling” by steadying the company’s share price “before the weight of the loan origination practices began taking their toll on the company’s operations and the value of its stock.”

The plaintiffs also relied on Countrywide CEO Angelo Mozillo’s alleged manipulation of his Rule 10b5-1 trading plan, about which the court said that “Mozillo’s actions appear to defeat the very purpose of Rule 10b5-1 plans.” The court rejected the innocent explanations offered for the changes to Mozillo’s plan, saying that the factors “do not mitigate against the inference of scienter given the magnitude and timing of Mozillo’s trading,” which amounted to hundreds of millions of dollars in stock trading proceeds.

After this detailed review of the scienter requirements and allegations, the court quickly worked through the other pleading requirments and proceeded to the ultimate question whether the plaintiffs’ allegations satisfied the demand futility standards. In considering this issue, the court again reviewed the allegations that the various board committee members were aware of the deteriorating loan practices yet failed to take corrective actions.

Since the same individuals who would have had to have considered the litigation demand were involved in these alleged circumstances, the court found that “a majority of the directors are ‘interested’” and therefore demand is excused (except as pertains to a category of claims relating to Mozillo’s compensation). The court also dismissed out two individual defendants based on the specific allegations relating to their individual involvement. The court directed the plaintiffs to file an amended complaint consistent with the order within 20 days.

At one level, Judge Pfaelzer’s order is a reflection of the specific allegations in the Countrywide complaint, particularly as pertains to the allegations of deteriorating underwriting and loan origination practices, and as pertains to the Mozillo’s insider trading. The outcome was also influenced by the allegations based on the factual observations of numerous confidential witnesses. To that extent, Judge Pfaelzer’s order may simply be a reflection of the alleged circumstances of the specific case and have relatively little potential significance for other pending subprime-related cases.

However, there may yet be a sense in which this order is relevant for other cases, and that is the court’s clear discomfort for the allegedly deteriorating practices in contrast to the company’s statements and the insiders’ stock sales. Other pending cases contain allegations pertaining to the excesses of the subprime lending marketplace, and other cases also contain allegations of insiders profiting while underwriting and loan origination practices deteriorated.

While there is at least this potential relevance of the Countrywide case for other subprime-related litigation, the larger significance is simply its primacy. Because it is one of the first cases with a detailed review of the allegations, the courts’ apparent receptivity to the plaintiffs’ allegations may be significant. Other defendants in other cases may be able to establish the insufficiency of the plaintiffs’ allegations, but the Countrywide decision could be interpreted to suggest that the defendants will have to overcome courts’ receptivity to similar allegations.

Judge Pfaelzer’s analysis of the allegations concerning Mozillo’s Rule 10b5-1 plan are also interesting, because they underscore the extent to which courts will be wary of apparent attempts to use plans to shield improper trading. When the dust settles on this case, there likely will be a fruitful opportunity to consider the lessons from these circumstances for proper and improper uses and structures of Rule 10b5-1 plans.

The WSJ.com Law Blog has a interesting post here discussing the background and context of Judge Pfaelzer’s opinion.

Special thanks to a loyal reader who prefers anonymity for providing a copy of the order.

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The subprime litigation wave has been rolling along for well over a  year, so it might be expected that by now we have seen many of the likely litigation variations. I suspect there are hosts of new variations yet to come, but the most recent subprime-related lawsuits are substantially similar to prior lawsuits. Yet each one, briefly noted below, also involves some interesting additional variations on previously established subprime litigation themes.

Royal Bank of Canada Auction Rate Securities Lawsuit: On May 12, 2008, plaintiffs’ counsel announced (here) an auction rate securities-related class action lawsuit against Royal Bank of Canada and its subsidiaries, RBC Dain Rauscher and RBC Capital Markets Corporation. A copy of the complaint can be found here.

While there have been numerous prior auction rate securities lawsuits (about which refer here) and while the allegations in the RBC lawsuit appear substantially similar to the prior auction rate securities lawsuits, this lawsuit does present a couple of additional interesting elements.

The first is the lawsuit’s timing. The preceding auction rate securities lawsuits came in a rush between March 17, 2008 and April 21, 2008. There had been no new auction rate lawsuits since April 21, and the lengthening interval might have been interpreted to suggest that the filing onslaught had played itself out. The RBC lawsuit suggests that we may not yet have seen the last of the auction rate securities lawsuit filings.

The other interesting thing about the RBC lawsuit is that RBC itself is, obviously, a Canadian company. At a PLUS Chapter event in Montreal last week, there was a great deal of discussion about whether Canadian companies will feel the litigation effects of the subprime meltdown. The lawsuit against RBC suggests that at least Canadian companies with U.S. operating units exposed to subprime-related issues may find themselves swept up in the U.S.-based subprime litigation wave.

Indeed, RBC is not even the first Canadian company to be named in an auction rate securities lawsuit, as Oppenheimer, another Canadian company, was hit with an auction rate securities lawsuit in April 2008 (about which refer here). Even if Canadian companies are not being sued in Canadian courts on subprime-related issues, they are finding themselves involved in U.S.-based litigation.

Huntington Bancshares/Sky Financial/Waterfield Mortgage:  Huntington Bancshares, a Columbus, Ohio-based bank holding company, has previously been sued in a subprime-related securities class action lawsuit (about which refer here). The plaintiffs alleged in the prior lawsuit that, due to Huntington’s July 2007 acquisition of Sky Financial, Huntington had a much greater exposure to subprime mortgages than it had disclosed, allegedly harming a class of person who acquired Huntington shares between the time of the merger and the end of the class period in November 2007.

On May 7, 2008, Huntington was sued in a separate lawsuit in the United States District Court for the Southern District of Ohio (complaint here). In this most recent lawsuit, Huntington is sued as successor in interest to Sky Financial. The lawsuit is filed on behalf of the former shareholders of Waterfield Mortgage Company, whose shares Sky Financial had acquired in an October 2006 stock for stock-and-cash merger transaction.

The May 7 complaint, which also names as defendants Sky Financial’s former CEO and former CFO, alleges that the Sky Financial and the individual defendants violated Sections 11 and 12 of the ’33 Act through alleged false and misleading statements in the registration and proxy documents issued in connection with the Waterfield acquisition. The complaint alleges that Sky Financial had an undisclosed lending relationship that resulted in a significant residential mortgage exposure for Sky Financial.

This most recent Huntington lawsuit involves a different set of plaintiffs asserting claims based on a different set of representations yet involving a defendant bank that has already been drawn into the subprime litigation wave. There will likely be other lawsuits like this one ahead, as litigation emerges to fill in the interstices of the circumstances surrounding the subprime meltdown. So far, the most noteworthy attribute of the subprime litigation wave has been its breadth. Perhaps in the months ahead, as the wave spreads to fill in other gaps, the most pronounced aspect of the litigation wave will be its depth.  

Special thanks to Adam Savett of the Securities Litigation Watch blog (here) for a copy of the Huntington/Sky/Waterfield complaint.

Run the Numbers: With the addition of these two new subprime-related securities class action lawsuits, the current tally (refer here) of subprime and credit-related lawsuits stands at 79, of which 39 have been filed in 2008. With the addition of the RBC auction rate securities lawsuit, there have now been 16 auction rate securities lawsuits, all of which have been filed in 2008.

Subprime Litigation Down Under: According to a May 12, 2008 Wall Street Journal article (here), Centro Retail Ltd. and its management company, and Centro Properties Company Ltd. and its management company, collectively  an Australian shopping center group, have been named as defendants in two class action lawsuits filed in Australian federal court based on alleged misleading statements in Centro’s disclosure documents between August 9, 2007 and February 15, 2008.

As discussed in the May 13, 2008 issue of The Australian (here), the recently filed lawsuits, brought by the Maurice Blackburn firm, are actually the second set of lawsuits announced against Centro. As discussed here, lawsuits had previously been announced against Centro and its property trust by the Slater & Gordon law firm. Both sets of lawsuits relate to Centro’s alleged misrepresentations regarding its leverage and its vulnerability to adverse credit developments, as a result of which the company experienced a severe share price decline.

While the spread of subprime-related shareholder class action litigation to Australia is interesting in and of itself, one specific aspect of these two sets of lawsuits is particularly interesting to me. That is, both sets of lawsuits are proceeding in reliance on third-party litigation funding.

According to Slater & Gordon’s April 22, 2008 press release (here), its lawsuits are being funded by “U.S based litigation funder Commonwealth Legal Funding LLC.” According to the press release, litigation funders “take a percentage of the net amount recovered, after expenses and after legal fees, for advancing all expenses and accepting the risk of any adverse award.” (The law firm itself recovers a court-approved hourly rate.)

The Maurice Blackburn firm’s separate set of actions is being funded by Australian-based IMF (Australia) Ltd. IMF is actually a publicly traded company whose shares trade on the Australian stock exchange. IMF’s May 9, 2008 press releases announced the filing of the lawsuits against Centro can be found here and here.

It isn’t clear how the existence of these two competing ventures will be reconciled. One might argue that the free market should be allowed to decide; along those lines, the Slater & Gordon press release touts the “significant” advantage its funder affords, in that “it takes a lower amount of the net amount recovered, from 15 to 30 percent, compared to the top rate of 40 per cent for the other proposal.”

One of the time-honored traditions in international financial circles is to rail against the excesses of the U.S. litigation system. But for all of our litigation extremes, litigation funding is one innovation that has not caught on in this country. It obviously has, by contrast, caught fire in Australia, and according to a March 20, 2008 Legal Week article (here), it also apparently has spread to the U.K.

As to whether litigation funding might catch on in the U.S., the WSJ.com Law Blog has an interesting post discussing the issue here. The Re: The Auditors Blog also has an interesting post on the topic here.

Australia has been setting the pace on innovation lately, as, among other things, the Slater & Gordon firm itself recently became the world’s first publicly traded law firm (refer here).

Opt-Out Options for the Little Guy: In a recent post (here), I discussed Columbia Law School Professor John Coffee’s recent paper in which he speculated that that we might be moving to a two-tier securities litigation system in which institutional investors with large financial interests at stake might increasingly seek to opt out from class litigation. The class itself, Coffee speculated, might increasingly be populated only by smaller investors whose financial stakes were too slight to justify opting out or to attract the interest of plaintiffs’ attorneys.

But an aspiring plaintiffs’ attorney’s recent publicity bid suggests that there may be enthusiasm for encouraging the little guys to opt-out too. In a May 12, 2008 press release suggestively entitled “Study Finds Many Bear Stearns Employees Should Opt-Out of Class Actions” (here), Brett Sherman of the Sherman Law Firm seeks to point out to Bear Stearns employees that investors who opted out of prior cases have had a higher percentage recovery of their investment losses.

The press release cites a variety of sources regarding opt-out litigation (including, in a twist that feels odd to me, my own