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

According to the March 11, 2010 bankruptcy examiner’s report, the collapse of Lehman Brothers was a result of the deteriorating economic climate, exacerbated by Lehman’s executives, whose conduct ranged from "serious but non-culpable errors of business judgment to actionable balance sheet manipulation."

 

The Report was prepared pursuant to a January 2009 bankruptcy court order directing the trustee to appoint an examiner to investigate the events leading up to Lehman’s collapse. The examiner appointed was Anton Valukas of the Jenner & Block law firm.

 

The full report is nine volumes long, consisting of 2,200 pages, and can be found here. The executive summary (which alone is 239 pages long) can be found here. According to news reports, Valukas spent $38 million conducting his examination. He and his team interviewed more than 100 people and scrutinized more than 10 million documents, plus 20 million pages of e-mails from Lehman.

 

The examiner’s report states that as conditions worsened during 2008 and in order to "buy itself time," Lehman "painted a misleading picture of its financial condition." For example, the report states, that while reporting a significant loss at the end of the second quarter 2008, Lehman "sought to cushion the bad news by trumpeting that it had significantly reduced its net leverage ratio," while failing to disclose that it had been using an "accounting device" – known as Repo 105 – that had "no substance" and whose sole purpose was to allow Lehman to "manage its balance sheet."

 

The report states that Lehman neither disclosed its use of nor "the significance of the use of the magnitude of its use of" Repo 105, to the Government, to rating agencies, to investors or even to its own Board. Its auditors were aware of but did not question the transaction. The Repo 105 balance sheet manipulation is summarized on the WSJ.com Deal Journal blog, here.

 

The examiner concluded that the business decisions that brought Lehman to a crisis "may have been in error but were largely within the business judgment rule." However, the "decision not to disclose the effects of these judgments does give rise to colorable claims against the senior officers who oversaw and certified misleading financial statements," including CEO Richard Fuld and the company’s CFOs, Christopher O’Meara, Erin Callan and Ian Lowitt.

 

The examiner also found that there is a "colorable claim that the "sole function" of the Repo 105 transactions was "balance sheet manipulation" that "created a misleading picture of Lehman’s true financial health."

 

The examiner also concluded that there are "colorable claims" against the company’s auditor, Ernst & Young, on the grounds that it "did not meet professional standards" for its "failure to question and challenge improper or inadequate as disclosures."

 

The examiner’s report explains that the report uses the phrase a "colorable claim" to mean one for which "there is sufficient credible evidence to support a finding by a trier of fact," without presuming the finder of fact’s ultimate conclusion.

 

The examiner also reviewed the actions of Lehman’s lenders, JP Morgan and Citigroup. The report concludes that "The demands for collateral by Lehman’s lenders had direct impact on Lehman’s liquidity pool," adding that "Lehman’s available liquidity is central to the question of why Lehman failed." Citigroup, which handled currency trades for Lehman, received a new guarantee from Lehman when Lehman was already insolvent and didn’t give enough value in return, the report said. The report concludes that "a colorable claim exists to avoid the Amended Guaranty as constructively fraudulent."

　

The examiner also reviewed the acquisition of Lehman’s North American brokerage, concluding that "a limited amount of assets" belonging to Lehman were "improperly transferred to Barclays."

 

The examiner recites at the outset of the report that under the relevant bankruptcy code provisions one purpose of a bankruptcy examination is to determine the existence of "a cause of action for the estate." Given the bankruptcy examiner’s conclusion that there are colorable claims against Fuld and the other former Lehman’s officials, as well as against its outside auditor, it seems reasonable to anticipate that the next step with be the bankruptcy trustee’s initiation of claims against these individuals and the auditor.

 

By way of comparison, after the New Century Financial bankruptcy examiner issued a report issued a report critical of company officials and the company’s auditor (about which refer here), the bankruptcy trustee filed a lawsuit (refer here) seeking to hold New Century’s auditors liable. In addition, the claimants in the New Century securities class action lawsuit relied heavily on the Examiner's findings in their amended complaint, which later suvived a motion to dismiss. I noted at the time of the dimissal that the bankruptcy examiner's findings may have strongly influenced the court in its dismissal motion ruling.

　

General Growth Properties Settles Credit Crisis-Related Securities Suit: According to a February 23, 2010 filing in the Northern District of Illinois, the parties to the credit crisis-related securities suit arising out of the collapse of General Growth Properties has been settled for $15.5 million, subject to court approval. The parties’ stipulation of settlement can be found here.

 

The General Growth Properties suit was one of the cases first filed in late 2008 as the subprime meltdown morphed into a full blown credit crisis, as I discussed in a post at the time, here.

 

The lead complaint, which can be found here, was filed in January 2009. The plaintiffs alleged that General Growth’s survival depended on its ability to refinance in November 2008 approximately $1.5 billion of its $27 billion of outstanding debt. Ultimately the company was unable to refinance its debt and it filed for bankruptcy in April 2009. The plaintiffs essentially alleged that the eleven individual defendants misrepresented the company’s ability to refinance its debt.

 

The complaint also alleged that the company’s senior executives had improperly loaned money to certain executives so that the executives did not have to sell their company shares in a margin call. The companies also allege that the company’s officials improperly sought to have the company’s shares included in the SEC’s short selling ban, so that the officials could sell their share at inflated prices.

 

In a September 29, 2009 opinion (here), Northern District of Illinois Milton Shadur granted in part and denied in part the defendants’ motion to dismiss. According to the settlement stipulation, in January 2010, the parties submitted the case to mediation, from which the settlement ultimately resulted.

 

The General Growth suit is one of only a handful of cases filed in the wake of the subprime meltdown and the ensuing credit crisis that has reached the settlement stage, and one of only a smaller handful of cases that have been settled following a dismissal motion ruling. We undoubtedly will see more settlements ahead as more cases work their way through the system.

 

I have in any event added the General Growth Properties settlement to my list of subprime and credit crisis-related case resolutions, which can be accessed here. My recent status update on the subprime and credit crisis related securities litigation can be found here.

 

Special thanks to Adam Savett of the Securities Litigation Watch blog for providing me with a copy of the stipulation of settlement.

 

Hello Polly: Many readers undoubtedly saw the article in yesterday’s Wall Street Journal (here) reporting that the Bank of America has apologized after its local contractor entered the home of a mortgage borrower, while she was away, and cutoff her utilities, padlocked the door and "confiscated her pet parrot, Luke." The homeowner, separated from her parrot for a week, filed a lawsuit against the bank for emotional distress.

 

This momentous story was deemed by the Journal’s editors to be worthy of a front page photograph of the homeowner, now fortunately reunited with her beloved parrot.

 

We mention this because, as was pointed out to us by a loyal reader, the Journal’s front page above- the- fold color photograph was headlined with the phrase "Hello, I Wish to Register a Complaint." We suspect that the Journal’s editors ran the picture on the front page for the sole reason that it gave them an excuse to use that headline.

 

If the topic is parrots, the only possible reference is to the immortal Monty Python dead parrot sketch, which believe it or not has its own Wikipedia page, here. The skit begins with John Cleese entering a pet shop and stating (as reflected in this script of the sketch) "Hello, I wish to register a complaint." Cleese’s problem in the sketch is not that his parrot has been confiscated; rather, his problem is that the parrot he had just purchased is dead. Deceased. It is no more. It has ceased to exist. It has joined the choir celestial. This is an ex-parrot

 

We are delighted to have this pretext to be able to embed a video of the sketch below. Because we think everyone should know a dead parrot when they see one.

 

 

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It has now been over three years since the first subprime-related securities class action lawsuit was filed in February 2007, yet many of the cases filed in the ensuing litigation wave are still only in their earliest stages. While the vast majority of these cases are still unfolding, there have been some important recent developments, suggesting that the evolving litigation wave has passed some significant milestones. With that possibility in mind, it seems appropriate to check in for a status report on the subprime and credit crisis-related litigation wave.

 

 

In the latest issue of InSights (here), I take a look at the developments to date as the subprime and credit crisis-related cases have worked their way through the system, including trends in motion to dismiss rulings and settlements, as well as with respect to issues such as gatekeeper liability and defense expense costs.

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In a ruling that may have potential significance for the many claims that have been filed against the rating agencies in the subprime litigation wave, on February 17, 2010, Southern District of New York Judge Lewis Kaplan dismissed all but one of the claims that had been filed against the individual defendants in the Lehman Brothers Mortgage-Backed Securities Litigation. A copy of Judge Kaplan’s February 17 order can be found here.

 

Background

Plaintiffs had purchased the mortgage back securities that Lehman Brothers issued in August 2005 and August 2006. The plaintiffs allege that the originators of the loans that backed the securities failed to comply with the general loan underwriting guidelines described in the offering documents. The plaintiffs allege that the offering documents had failed to disclose that the rating agencies, which were paid for providing their ratings, had conflicts of interest and had been involved in helping to structure the securities. The plaintiffs also allege that the offering documents failed to disclose that the credit enhancements supporting the loans were insufficient to support the investment ratings the rating agencies gave the securities.

 

The individual defendants in the case are the officers and directors of the Structured Asset Securities Corporation, which issued the registration statements and acted as depositor in the securitization process. The individual defendants moved to dismiss.

 

As noted in prior posts, Judge Kaplan has previously dismissed plaintiffs’ claims against the rating agencies themselves (refer here), rejecting plaintiffs’ arguments that the rating agencies were "underwriters" under the ’33 Act. Judge Kaplan also previously dismissed the separate ERISA class action claims (refer here, scroll down). In his February 17 decision, Judge Kaplan separately ruled on the individual defendants’ motion to dismiss.

 

The February 17 Decision

Judge Kaplan held that the plaintiffs’ allegations that the offering documents failed to disclose the rating agencies’ conflict of interest were insufficient to state a claim, for two reasons.

 

First, Judge Kaplan held that the Securities Act does not require disclosures of "that which is publicly known," and "the risk that the rating agencies operated under a conflict of interest because they were paid by the issuers had been known publicly for years."

 

Judge Kaplan then went on to hold that "the rating agencies’ role in structuring the certificates is not material as a matter of law." His conclusion is based on the following analysis:

 

If the fee arrangement undermined an investor’s confidence in the rating agencies’ independence, a disclosure that a rating agency was involved in structuring the Certificates prior to rating them would have added nothing important to the "total mix" of information. If, on the other hand, an investor trusted the ratings agencies to give an honest opinion notwithstanding the fact that they were paid by the issuer, the fact that they were involved in structuring the Certificates, assuming that they were, likewise would have been unimportant. In consequence, these claims are insufficient.

 

With respect to the plaintiffs’ allegations that the offering documents contained misrepresentations about the amount and form of credit enhancement, Judge Kaplan held that the statement about the credit enhancement was a "statement of opinion," which could be actionable only if the complaint alleged that the rating agencies did not actually hold that opinion.

 

Judge Kaplan found that "at best" the complaint’s allegations "support an inference that some employees believed the rating agencies could have used methods that better would have informed their opinions," which he held to be insufficient to state a claim.

 

But Judge Kaplan did hold that the complaint’s allegations that the loan originators "systematically failed to follow the underwriting guidelines" were "sufficient at this stage to support a reasonable inference that the offering documents’ description of the underwriting guidelines was materially misleading."

 

Accordingly, Judge Kaplan granted the individual defendants’ motion to dismiss all of the claims against them except plaintiffs’ Section 11 claims about the loan originators’ supposed departures from underwriting standards.

 

Discussion

Even though Judge Kaplan’s February 17 opinion was issued in connection with claims asserted against the individual defendants and not in connection with claims asserted against the rating agencies themselves, the opinion nevertheless potentially could be of great significance in other subprime mortgage-related cases in which claims have been raised against the rating agencies.

 

In particular, Judge Kaplan’s holding that the offering documents’ omissions about the rating agencies’ alleged conflicts of interest and role in structuring the securities were not legally actionable may be of particular significance.

 

In many of the other cases in which claims have been asserted against the rating agencies, the claimants have, like the plaintiffs in the Lehman case, alleged that the rating agencies had undisclosed conflicts of interest and were involved in structuring the investments at issue. The rating agencies will undoubtedly find Judge Kaplan’s holding that the alleged omission of this information is not legally actionable to be helpful.

 

Judge Kaplan did not reach the question whether or not the rating agencies’ ratings are protected by the First Amendment, which is another defense on which the rating agencies will attempt to rely. But if the alleged omissions about the rating agencies are not actionable in the first place, there may never be a need to reach the First Amendment issues.

 

Judge Kaplan conclusion that the disclosures concerning the securities’ credit enhancements represented opinion rather than statements of fact is also instructive, even without getting into the First Amendment issues. As his February 17 decision states, statements of opinion are actionable only if the allegations show that the opinions were not actually as disclosed. Again, Judge Kaplan’s rulings are instructive and potentially significant as they suggest ways in which the claims against the rating agencies may be considered without even getting into the First Amendment issues.

 

Finally, Judge Kaplan’s holding that the rating agencies’ alleged conflicts of interest and involvement in the securitization transaction are immaterial does raise interesting questions about claimants’ ability to overcome the rating agencies’ First Amendment defenses. The plaintiffs have argued that the rating agencies were not entitled to rely on the First Amendment defense in the context of these kinds of structured investments because of the conflicts of interest and involvement in the transaction. Perhaps Judge Kaplan’s rulings are unrelated to these issues, but it does seem incongruous that considerations that are immaterial would be sufficient to overcome a constitutional defense.

 

Of course, it is entirely possible that other courts may not be persuaded by Judge Kaplan’s analysis. It is not intuitively obvious that, because it was public knowledge that rating agencies had conflicts, the rating agencies’ involvement in the transactions is legally immaterial. Indeed, the jump between the public knowledge of the conflict of interest and the immateriality of the rating agencies’ involvement in the transactions is frankly unsatisfying. Other courts might well be unwilling to make that analytic jump.

 

I have in any event added Judge Kaplan’s February 17 opinion to my table of subprime-related lawsuit motion to dismiss rulings, which can be accessed here. Because a portion of the claims against the individual defendants survived the dismissal motion, I have listed the ruling in the table of dismissal motion denials.

 

Special thanks to a loyal reader for sending a copy of Judge Kaplan's February 17 opinion.

　　

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In one of the largest subprime-related securities lawsuit settlements so far, Moneygram Corporation has agreed to settle its subprime-related securities class action and accompanying derivative suit for $80 million, according to the company’s February 25, 2010 press release (here).

 

Background

As reported here, the MoneyGram case represented the distinct group of subprime-related cases in which the allegation was not that the company was involved in originating or pooling subprime mortgages, but rather that the company had purchased the mortgage-backed securities as investments and misrepresented the value of these assets on its balance sheet.

　

MoneyGram’s global payment and money transfer business requires the company to hold, transfer or to guarantee payments of large amounts of cash. To secure these payments and guarantees, MoneyGram maintains an investment portfolio. At the beginning of the class period in January 2007, the majority of MoneyGram’s $5.85 billion portfolio was held in asset-backed securities, mortgage-backed securities and collateralized debt obligations, backed in part by residential mortgages.

　

By the end of the class period in January 2008, the value of the portfolio had significantly deteriorated. In order to be able to maintain adequate capital, the company entered a substantial financing transaction that forced the company to recognize over $1 billion in losses in its investment portfolio. The company’s share price declined nearly 50%, and securities litigation ensued.

 

The consolidated complaint alleges that during the class period, the defendants made a series of misleading statements regarding the composition, valuation and quality of the company’s investment portfolio, and about its investment valuation processes, standards and controls.

 

As discussed here, on May 20, 2009, District of Minnesota Judge David Doty had denied the defendants’ motion to dismiss, holding that "a reasonable person could find lead plaintiff’s fraud narrative to be cogent and at least as plausible as defendants’ opposing fraud narrative."

 

According to the company’s February 25 press release, the plaintiffs have agreed in principle to settle the claims for an $80 million cash payment, all but $20 million of which will be paid by the Company's insurance coverage. The settlement of the derivative claims provides for changes to MoneyGram's business, corporate governance and internal controls. The agreement in principle is subject both to final documentation and court approval.

 

Discussion

The MoneyGram settlement is only one of a handful of subprime-related securities cases that have reached the settlement stage (and surprisingly, the first settlement of these kinds of cases announced since September 2009). As reflected in my running tally of subprime lawsuit settlements, which can be accessed here, there have only been ten settlements out of the over 200 subprime-related securities class action lawsuits that have been settled.

 

The short list of subprime-related lawsuit settlements is dominated by the massive Merrill Lynch related settlements, in which Merrill settled the subprime-related securities lawsuit for $475 million (refer here), its related bond action for $150 million (here), and the subprime-related ERISA class action for $75 million (here). These massive settlements were all reached shortly after the BofA acquisition closed and are perhaps best understood in that context.

 

Outside of the massive Merrill Lynch settlements, the $80 million MoneyGram settlement is the largest subprime-related securities class action settlement so far. The next largest is the $37.25 million American Home settlement, which included contributions of $8.5 million from seven offering underwriter defendants and $4.75 million from the company’s auditor.

 

There undoubtedly will be many more settlements to come, particularly among cases like MoneyGram where the plaintiffs have managed to survive a motion to dismiss. But in thinking about these likely future settlements, it is worth noting here that the $80 million MoneyGram settlement included a $60 million contribution from the company’s D&O insurers, which is a reminder of how massive a hit these subprime-related cases are likely to be in the aggregate to the D&O insurers – keeping in mind, too, that the $60 million settlement contribution is on top of the likely substantial defense expenses that the insurers undoubtedly incurred.

 

Before all is said and done, the mountain of subprime-related litigation is likely to impose an enormous amount of loss costs on the D&O insurers. I would hesitate to guess how big the aggregate total will be, but I know for sure it will be a very large number.

 

So How Do Public Pension Funds and Plaintiffs’ Firms Get Hooked Up?: Those who may wonder how pension funds and plaintiff’ firms get matched up will want to take a look at the article (oddly, dated March 15, 2010) by Peter Beller in Forbes entitled "Paying Public Pensions to Sue."

 

The article describes how plaintiffs’ firms have "created a multibillion-dollar business lining up public funds as plaintiffs to sue publicly traded corporations whose stocks don’t do well." The article focuses in particular on various conferences the law firms sponsor, in which pension fund representatives are invited to places such as New York or San Diego and feted with Broadway shows, dinners and other entertainments. The article describes the ways in which the firms are caught up in an "arms race to line up suit-happy state local and union pension funds," which has led to "all manner of wining, dining and dishing out of cash."

 

The article concludes by noting that "a curious irony of all this flattery of pension officials is that the ostensible purpose of securities litigation is to keep corporate managers honest."

 

And Speaking of Plaintiffs’ Lawyers: The February 25, 2010 Financial Times has a review (here) of a new book by Patrick Dillon and Carl Cannon about Bill Lerach, once one of the leading plaintiffs’ class action attorneys and now a convicted felon. The book, which is entitled "Circle of Greed: The Spectacular Rise and Fall of the Lawyer Who Brought Corporate America to its Knees," apparently was written with Lerach’s cooperation, and the FT review is quite favorable, noting the value of having a couple of Pulitzer-Prize winning journalists involved as authors.

 

Everyone here at The D&O Diary is hoping for an early opportunity to read this book, which according to the publisher’s website will be available on March 2, 2010. We hope to publish our own review of the book shortly.

 

And Finally: "Ten Wall Street Blogs You Need to Bookmark Now" (according to the Wall Street Journal) – find the list here.

　

　

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In an interesting and potentially significant February 22, 2010 opinion (here), Southern District of New York Judge Naomi Reice Buchwald denied defendants’ motions to dismiss the plaintiffs’ ’34 Act claims in the Ambac Financial subprime-related securities suit. Judge Buchwald also denied the motion to dismiss the plaintiffs’ ’33 Act claims relating to the company’s February 2007 securities offering, but granted the defendants’ motion to dismiss the plaintiffs’ ’33 Act claims relating to the company’s March 2008 securities offering.

 

Judge Buchwald’s decision is particularly noteworthy for her rejection of defendants’ attempts to argue that the company’s woes were not the result of fraud but rather were the result of the global financial meltdown; among other things, she stated that "the conduct that plaintiffs’ allege, if true, would make Ambac an active participant in the collapse of their own business, and of the financial markets in general, rather than merely a passive victim."

 

Background

Ambac Financial Group is a monoline insurer providing protection against credit risk. Traditionally the company insured municipal bonds, but in more recent years prior to the financial crisis, the company increasing provided default protection for structured financial products such as residential mortgage backed securities (RMBS) and collateralized debt obligations (CDO).

 

In early January 2008, Ambac announced that it was taking a $5.4 mark-to-market loss on its CDO portfolio, that it was taking a $1.1 credit impairment charge, and that it expected a net loss for the quarter. The company also announced the resignation of the company’s CEO. The company’s share price declined, and two days later the company received the first of several rating downgrades from the rating agencies.

 

As noted here, the plaintiffs first filed their complaint in January 2008. In their ’34 Act claims, in which the defendants named are the company and certain of its directors and officers, the plaintiffs allege that the defendants mislead investors by continuing to portray Ambac’s underwriting procedures as cautious and conservative, while failing to disclose that the company had lowered its underwriting standards; by stating that Ambac was actively monitoring its RMBS and CDO portfolios and that the portfolios continued to outperform; and by failing to disclose in a timely manner any material impairment to the RMBS-related instruments that Ambac insured.

 

In their ’33 Act claims, which the plaintiffs asserted against the company and certain of its directors and officers, as well as against the offering underwriters and the company’s outside auditor (KPMG), the plaintiffs allege that the defendants made misleading statements in the offering documents about the company’s underwriting standards as well as regarding the company’s RMBS and CDO-related exposures.

 

The defendants moved to dismiss.

 

The February 22 Ruling

In rejecting the defendants’ motions to dismiss the ’34 Act claims, Judge Buchwald found that "the plaintiffs allegations of recklessness support a strong inference of scienter" for each of the ’34 Act claim defendants.

 

Judge Buchwald cited numerous allegations which she found sufficient to show that Ambac’s officers were aware that "Ambac lowered its underwriting standards in several ways." Among other things, she cited an internal October 2006 email to one of the defendants asking "Why are we willing to insure stuff in the secondary market [i.e., the CDO market] that we would not touch with a ten foot pole in the primary market [i.e., the RMBS market]?"

 

Judge Buchwald also found that the officers’ own public statements "detail the regular reports by which they would have learned of the allegedly drastic deterioration of their CDO portfolio." She went on to note that in various public statements the officers "themselves described in the means by which the raw material was collated and analyzed, as part of the surveillance process, and how this formed the basis for defendants’ statements."

 

In concluding that the plaintiffs had adequately pleaded recklessness, she rejected the alternative inference that the defendants urged her to draw from the allegations, namely that the officers could not have predicted the economic collapse and therefore the company’s modeling tools failed to identify the risk of loss in the CDO portfolio. In reaching this conclusion she noted:

 

Viewing the allegations collectively, there is a vast gap between the picture that Ambac presented to investors – of an insurance company that maintained its conservative approach over the years – and the alleged practices within the company, namely the undisclosed lowering of underwriting standards to drive short-term profits. Additionally, defendants’ arguments on this issue are premised on a convenient confusion of cause and effect. The conduct that plaintiffs’ allege, if true, would make Ambac an active participant in the collapse of their own business, and of the financial markets in general, rather than merely a passive victim.

 

Judge Buchwald also found that the plaintiffs had adequately alleged misrepresentation and loss causation. Interestingly, in concluding that the plaintiffs had adequately alleged misrepresentation in connection with the CDO valuation issues, Judge Buchwald cited and apparently relied on the characterization of the company’s CDO portfolio in the plaintiff’s expert analysis, an interesting step at the motion to dismiss stage.

 

Finally Judge Buchwald held that the plaintiffs’ complaint adequately stated a ’33 Act claim with respect to the company’s February 2007 offering, but failed to state a claim with respect to the company’s March 2008 offering because the alleged misstatements in connection with that offering are not actionable under the "bespeaks caution" doctrine.

 

In allowing the claims relating to the February 2007 offering to go forward, she expressly rejected the defendants’ statute of limitations arguments, holding that the "storm warnings" on which the defendants sought to rely were not sufficient to put the plaintiffs on "inquiry notice," because Ambac’s officers had actively sought to reassure investors about those supposed storm warning.

 

Discussion

Judge Buchwald’s ruling in this case is interesting and perhaps significant in a number of respects.

 

First, reliable sources in the plaintiffs’ bar advise me that Judge Buchwald is viewed as a tough draw for plaintiffs. These same sources advise that the fact that she is the one that wrote the opinion makes it even more noteworthy.

 

Second, I think her language in rejecting the "hey, the whole economy tanked" argument is important. There are a number of companies about whom it might be alleged, as was alleged here of Ambac, that they were "an active participant in the collapse of their own business, and of the financial markets in general, rather than merely a passive victim." In other words, the general collapse of the financial markets alone might not be enough to refute the potential existence of fraud, if the plaintiffs sufficiently allege that the defendant companies nevertheless contributed to their own collapse.

 

This is significant because many companies that have been sued in the wake of the credit crisis have tried to refute the inference of fraud by arguing that that no one could have foreseen what subsequently happened. However, as Judge Buchwald noted, the collapse was not the result of the operation of some inevitable physical force. While there were many factors that contributed to the collapse, one of the causes may well have been various companies’ actions and statements prior to the collapse.

 

The fact that the subsequent collapse was generalized is not necessarily inconsistent with the possibility that prior to the collapse that fraudulent misconduct may have taken place at any one specific company – or, as Judge Buchwald noted, that the misconduct may have helped bring the collapse about.

 

I also think Judge Buchwald’s rulings are interesting because of her willingness to rely on plaintiffs’ expert’s analysis in finding misrepresentations on the CDO valuation issue and also because of her rejection of the statute of limitations argument based on the contention that "storm warnings" put the plaintiffs on "inquiry notice."

 

But the final reason that Judge Buchwald’s ruling may be significant is that it is a very strong opinion ruling in the plaintiffs’ favor in a high profile subprime-related case in the Southern District of New York. So many of the subprime related cases are pending in the Southern District, so the plaintiffs lawyer will of course seek to rely on Judge Buchwald’s holdings in other cases pending in that District.

 

It of course remains to be seen to what extent plaintiffs will be able to get mileage out of Judge Buchwald’s holdings in other cases. But it does in any event represent a significant victory for the plaintiffs.

 

I have added the Ambac decision to my table of subprime and credit crisis-related securities class action lawsuit dismissal motion rulings, which can be accessed here. It certainly does seem that recently the dismissal motion rulings have been coming down fast and furious.

 

Special thanks to a loyal reader for providing me with a copy of the Ambac decision.

 

Climate Change and D&O Coverage: In a recent post (here), I noted the possibility that the requirements of the SEC’s new interpretive guidance about climate change disclosure could create a context within which climate change disclosure claims might arise. If these kinds of claims do materialize, they potentially could create important coverage issues under applicable D&O insurance policies.

 

A February 19, 2010 memo by Collin Hite and Sung Yhim of the McGuire Woods law firm entitled "Global Warming Litigation and D&O Insurance Coverage Issues" takes a look at the kinds of coverage issues that might be involved if climate change-related disclosure cases do arise. The memo can be found here.

　

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Just when it seemed as if the dismissal motion rulings in the subprime-related securities suits might be breaking more favorably to the plaintiffs, two February 18, 2010 rulings granted the defendants’ motions to dismiss in two separate subprime cases. While only one of the two dismissals was with prejudice, both represent substantial defense victories. These latest rulings tend to support the view that, with some notable exceptions of course, the plaintiffs are as a general matter facing hurdles in many of the subprime cases.

 

Fortis: In a February 18, 2010 decision (here) that addressed recurring issues of the extraterritorial jurisdiction of U.S. courts under the U.S. securities laws, Southern District of New York Judge Denny Chin dismissed the subprime-related securities suit pending against Fortis and certain of its directors and officers, for lack of subject-matter jurisdiction.

 

As I detailed in a prior post about the Fortis lawsuit (here), Fortis is a Belgium-based financial company that in late 2008 received a massive bailout by the governments of Belgium, the Netherlands and Luxembourg. Fortis’ shares trade on several European exchanges and its ADRs trade over-the-counter in the U.S.

 

In their amended complaint, the plaintiffs allege that the defendants misrepresented the value of its collateralized debt obligations; the extent to which its assets were held as subprime-related mortgage backed securities; and the extent to which its ill-fated decision to acquire ABN-AMRO had compromised the company’s solvency.

 

In granting the motion to dismiss, Judge Chin found, applying the Second Circuit standard articulated in the National Australia Bank case, that the plaintiffs had not alleged either sufficient U.S.-based "conduct" or "effects" to support the court’s exercise of subject matter jurisdiction.

 

Specifically, the found that the company’s alleged New York-based data compilation was merely preparatory to the actual fraudulent misrepresentations, which were alleged to have been made by the company’s executives in Brussels. Judge Chin found that "the complaint describes the Brussels executives as the masterminds, and portrays the New York Office as uninvolved in decision-making regarding information to be communicated."

 

In finding that the complaint failed to satisfy the "effects" test, Judge Chin observed that the "lead plaintiffs do not explicitly allege what percentage of Fortis’s investors are U.S residents, nor the effect the fraud may have had in the United States."

 

Judge Chin noted that the complaint alleges that 17.2% of all institutional investors were located in North America, but "it does not break down what percentage of those were located in the U.S. – as opposed to Canada, Mexico or any of the approximately 38 countries on the continent."

 

In closing, Judge Chin denied plaintiffs leave to amend, noting that "plaintiffs have already had two bites of the apple, as they have already filed two complaints," adding that "it is difficult to imagine that plaintiffs did not allege all the facts they had a good faith basis for asserting," and a "third opportunity to plead would be futile."

 

Judge Chin’s refusal in the Fortis case to allow the plaintiffs’ to file an amended complaint stands in contrast to what happened in the Credit Suisse case, where, as I discussed here, Judge Victor Marrero at least allowed the plaintiffs to seek leave to file an amended complaint. Significantly, in the Credit Suisse case, the plaintiffs were able to present sufficient additional allegations to satisfy the "effects" test and to establish subject matter jurisdiction. Judge Chin’s refusal even to allow plaintiffs to seek leave to amend, and possibly to cure the pleading defect, stands in contrast to the Credit Suisse case.

 

MGIC: In a February 18, 2010 order (here), Eastern District of Washington Judge Lynn Adelman granted the defendants’ motion to dismiss in the subprime-related securities suit that had been filed against mortgage insurer MGIC Investment Corporation and certain of its directors and offices, as well as against certain officers of C-Bass, a subprime mortgage-securitizer in which MGIC was a joint venture partner with Radian Group.

 

In their complaint, the plaintiffs alleged that the MGIC defendants had misrepresented MGIC’s underwriting practices; that the MGIC defendants had misrepresented the performance of mortgages the company had insured in 2005 and 2006; and that the defendants had misled investors about the extent of C-Bass’s margin calls in July 2007.

 

Judge Adelman went through each of the allegedly misleading statements on which the plaintiffs sought to rely, and with respect to each, he found that the statements were either immaterial or not misleading, or even if misleading, that the plaintiffs had failed to establish that the statements had been made with scienter.

 

Judge Adelman granted the plaintiffs leave to amend, should they choose to do so. However, it will be very challenging for plaintiffs to overcome all of the concerns Judge Adelman noted. The very detailed, painstaking and comprehensive way that Judge Adelman considered each of the alleged misrepresentations may leave plaintiffs with very little room to try address his concerns.

 

In any event, the subprime-related securities suit filed against the other C-BASS joint venture partner, Radian Group, was previously dismissed, as discussed here.

 

Discussion

The plaintiffs’ difficulties trying to establish subject matter jurisdiction in the Fortis case are significant, because many of the other subprime-related cases also involve foreign-domiciled companies. Perhaps the pleading differences between the Credit Suisse case (where the plaintiffs had specifically identified the percentage of shares held by U.S. institutional investors) and the Fortis case provide plaintiffs in other cases enough of a road map, but the Fortis case still does suggest that plaintiffs may struggle to establish jurisdiction in many of these cases.

 

The difference in outcomes in the two cases may be a reflection of where each company’s ADRs traded. Credit Suisse’s ADRs traded on the NYSE, but Fortis’s ADRs traded only over the counter. As Ben Hallman noted in his February 19, 2010 Am Law Litigation Daily article (here) discussing the Fortis decision, over the counter purchases are "nearly impossible to track," and accordingly "the damage to U.S. investors impossible to quantify." The plaintiffs in subprime cases against other non-U.S. companies whose shares or ADRs do not trade on one of the formal U.S. exchanges may have similar difficulty quantifying the impact on U.S. investors.

 

One interesting related question is the extent to which the outcome of the National Australia Bank case, now pending before the U.S. Supreme Court, might affect these jurisdictional issues. Congress may also have its own say on these issues. The bottom line is that there are a lot of moving pieces that could affect consideration of these jurisdictional issues going forward.

 

In any event, these two dismissal motion rulings represent that much more evidence that overall plaintiffs do not seem to be faring particularly well in the subprime-related securities suits. As reflected on my running tally of the subprime and credit crisis-related dismissal motion ruling, which can be accessed here, the defendants have prevailed in far more motion rulings to date than have the plaintiffs.

 

Though plaintiffs have had some notable victories, and though plaintiffs have even managed to survive some renewed motions to dismiss after initial dismissal motions had been granted, in the majority of motion rulings, the defendants have prevailed. By contrast to historical patterns, where cases are dismissed somewhere between 33% and 40% of the time, in the subprime-related dismissal motion rulings, the defendants are prevailed about two-thirds of the time – at least so far. Many of the subprime and credit crisis cases have still not yet reached the dismissal motion stage.

 

So Many Updates, So Little Time: With all of the voices and sources, who is worth following? Bruce Carton, the author of the Securities Docket blog and a new media maven in the securities enforcement arena has put together an updated list of the 15 "must-follows" on Twitter. Special thanks to Bruce for including me on his list.

 

Some Winter Olympics Observations:

1. The key physical forces involved in the winter Olympics sports are the coefficients of friction and aerodynamic drag. (Contrary to what some might think, "aerodynamic drag" is not a description of Johnny Weir’s skating attire.)

2. Shaun White really did say, on camera, while describing his emotional state, "freaky deeky."

3. "Live curling." Discuss.

4. With reference to the commercial in which the female snowboarder leaves the earth’s atmosphere: (a) Does anybody have any idea what product or service is being advertised? (b) Where is she supposed to be snowboarding, the edge of some gigantic cosmic womb or something like that? (c) Am I the only one who is troubled that she never returns to earth, but instead drifts off further into the ether… it all seems so sad and weird.

5. In the summer Olympics, it was commercials with wind turbines. Now in the winter Olympics, it is commercials with girl ice hockey players.

6. Shen Xue and Zhao Hungbo not only came out of retirement to win gold in pairs figure skating, but they did something even more amazing – they managed to get us to root for a couple of Chinese athletes. (If you think that sounds xenophobic, just imagine how it is going to feel four years from now when Chinese snowboarders sweep the medals in the half pipe.)

7. In the entire history of the human race, from the dawn of man to the present moment, has there ever been anyone more unfortunately named than Dick Button?

 

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In an interesting February 11, 2010 decision (here), Southern District of New York Judge Victor Marrero allowed plaintiffs, whose subprime-related securities class action lawsuit Marrero had previously dismissed, leave to file a second amended complaint against Credit Suisse Global and certain of its directors and officers.

 

Judge Marrero also found the securities fraud allegations in the proposed amended complaint to be legally sufficient, meaning that the claims can now go forward, although he also ruled that the court lacked jurisdiction over the claims of plaintiffs that resided outside the U.S. and that had purchased their shares outside the U.S.

 

Background

Credit Suisse is domiciled in Switzerland. Its shares trade on several securities exchanges outside the U.S. and its ADRs trade on the NYSE. As reported in greater detail here, the plaintiffs filed their initial complaint in this action in April 2008. The plaintiffs alleged that the defendants had made material misrepresentations about the company’s asset valuation system, its internal controls (which allegedly allowed unauthorized placement of high risk mortgage-backed assets in client accounts), and its own exposure to losses related to subprime mortgages.

 

In an October 5, 2009 order (here), Judge Marrero had previously granted the defendants’ motion to dismiss, on the grounds that the court lacked subject matter jurisdiction over the claims of claimants who reside outside the U.S. and who had purchased their shares on foreign exchanges (so-called f-cubed claimants). The complaint had not identified the domicile of some other named plaintiffs, but Judge Marrero dismissed their claims as well.

 

In his prior ruling he required plaintiffs to seek leave to file an amended complaint, which the plaintiffs did. His February 11 opinion addressed the plaintiffs’ motion for leave to file an amended complaint.

 

The February 11 Opinion

In his February 11 decision, Judge Marrero granted the plaintiffs’ motion for leave to file their amended complaint, at least as to certain of the claimants.

 

Judge Marrero first found that the amended complaint failed to establish subject matter jurisdiction as to the foreign domiciled claimants that had purchased their shares on foreign exchanges. In reliance on the Second Circuit’s National Australia Bank standard (about which refer here), he found that because the alleged misrepresentations had originated in Switzerland, there was insufficient U.S.-based conduct to support the court’s exercise of subject matter jurisdiction over the claims of the non-U.S. claimants.

 

However, Judge Marrero found that the amended complaint contained sufficient allegations to permit the exercise of jurisdiction as to the claims of the U.S.-based claimants. The amended complaint alleged that more than 75 million Credit Suisse shares were held by institutional investors, representing over 11% of shares outstanding, and therefore there were sufficient "effect" alleged within the U.S. to support jurisdiction.

 

Judge Marrero then proceeded to determine that the plaintiffs’ securities fraud allegations were legally sufficient. Among other thing, he found that though the proposed amended complaint "contains much extraneous detail and irrelevant information," within the "remaining core of what is pertinent" the plaintiffs’ proposed complaint "sufficiently alleges scienter."

 

The proposed complaint relies heavily on confidential witness statements, from which Judge Marrero determined that the proposed complaint "alleges sufficient facts showing that the Defendants had direct knowledge of information contradicting their public statements or access to similar statements they should have monitored." Judge Marrero concluded that the proposed complaint properly pled scienter to support theories of fraud based on alleged schemes to "overvalue assets, underestimate risk, hide subprime exposure, ignored weaknesses of [the company’] risk management and internal controls, and violate GAAP."

 

Discussion

As a result of Judge Marrero’s February 11 ruling, the Credit Suisse Group subprime-related securities case, which had initially been dismissed, will now go forward. The Credit Suisse case is the latest in a series of subprime-related securities suits in which dismissal motions were initially granted, but in which the amended complaints later survived renewed dismissal motions. This list of cases in this series includes the PMI Group case (here), the Washington Mutual case (here), and the BankAtlantic Bancorp case (here).

 

The ability of the plaintiffs in these cases to cure initial pleading deficiencies and to overcome preliminary pleading hurdles is noteworthy. Among other things, it casts important light on the list of subprime-related securities cases in which motions to dismiss have been granted. Many of these dismissals are without prejudice, meaning that the plaintiffs in a number of these cases, like the plaintiffs in the Credit Suisse case, may yet find a way to survive renewed dismissal motions and live for another day.

 

The outcomes of many of the dismissal motion rulings (at least to this point) the subprime-related securities cases could possible be interpreted to suggest that the cases were not faring particularly well. As reflected in my table of subprime-related lawsuit dismissal motion rulings, which can be accessed here, of the 48 subprime-related securities lawsuits in which dismissal motion rulings had been entered, fully 31, or nearly 65%, had resulted in the dismissal motions being granted, a dismissal rate the far exceeds typical patterns.

 

However, in 16 of the 31 cases, the dismissals were without prejudice. Many of the cases in which dismissal motion motions have been granted may yet survive renewed dismissal motions.

 

In any event, there still have only been dismissal motion rulings in about 27% of the subprime and credit crisis-related securities suits. The dismissal motions have not yet heard in nearly three quarters of the subprime and credit crisis-related securities suits. Though the subprime litigation wave first started in February 2007 and is now entering its fourth year, it still has a very long way to run. And many cases yet to be heard and other cases surviving renewed motions to dismiss, it is far too early to try to say one way or the other that cases are or are not faring well.

 

The fact that the Credit Suisse claims involve a foreign-domiciled corporate defendant is also noteworthy. Many of the subprime-related securities cases involve non-U.S. companies. the Credit Suisse case show that in at least some of these cases against foreign companies, the plaintiffs will succeed in establishing jurisdiction, even if the allegedly misleading statements originated outside the U.S., although in those cases the claims of foreign domiciled investors who purchased their shares on foreign exchanges may or may be allowed to continue.

 

Many thanks to a loyal reader for sending me a copy of the Credit Suisse decision.

 

Speaking of Jurisdiction Over Foreign-Domiciled Companies: One of the ways in which companies domiciled outside the United States can, in at least some kinds of cases, seek to avoid the burden and risk of defending litigation in the United States is by asserting the principle of forum non conveniens. This judicial tenet allows a court to defer jurisdiction where principles of justice and convenience favor the action being brought in another forum.

 

A February 2010 memo by the Sherman & Sterling law firm (here) discusses this principle and analyzes its recent application in the Cadbury Shareholder Litigation, a purported derivative class action that had been filed in connection with Kraft Foods hostile takeover bid. The action was brought in New Jersey federal court though Cadbury is a U.K. company, U.K law governs the Board’s conduct, and none of the parties resided in New Jersey.

 

In the Cadbury case, the court granted the defendants’ motion to dismiss on forum non conveniens grounds, determining among other things that the U.K. was an adequate alternative forum and that the plaintiffs’ choice of forum was entitled to little deference. The court also found that the differences between U.K. and U.S. takeover law did not detract from the availability of an adequate alternative forum in the U.K.

 

The principles of forum non conveniens could provide a substantial defense in other derivative litigation involving foreign domiciled companies. It is less likely to be relevant in class action cases alleging violations of the U.S. securities laws, as the availability of an adequate alternative forum may be far less likely given the absence in many jurisdictions of adequate alternatives to the remedies available under the U.S. securities laws.

 

In any event, the recent decision in the Cadbury case represents yet another case in which U.S. courts have sought to determine the circumstances under which it is and is not appropriate for U.S. courts to exercise jurisdiction over foreign-domiciled companies.

 

Bankruptcy Court Did Not Abuse Discretion in Granted Relief From Automatic Stay Allowing D&O Insurer to Reimburse Individual’s Defense Expenses: In an opinion filed on January 29, 2010 (here), the Ninth Circuit Bankruptcy Appellate Panel held that the bankruptcy court did not abuse its discretion in granting relief from the automatic stay in bankruptcy to allow the company’s D&O insurer to advance an individual insured’s legal expenses.

 

Layne Sapp had been the sole director, chief executive officer and majority shareolder of MILA, Inc., a mortgage brokerage firm. The company had a $1 million D&O insurance policy. The company filed for bankruptcy and the trustee initiated an adversary proceeding against Sapp alleging a number of claims. Sapp incurred legal costs defending himself. The D&O carrier agreed to advance his defense expenses if Sapp obtained a comfort order stating that the Insurer was not violating the automatic stay by making the payments.

 

Sapp filed a request for relief from the automatic stay to allow the D&O insurer to pay his defense expense. The trustee opposed the motion on the ground arguing that the policy proceeds were estate property and that payment of Sapp’s defense expense would deplete the limits. (Oddly and unusually, MILA’s D&O policy did not have so-called entity coverage, so the Trustee’s assertions of the estate’s rights to the policy proceeds were limited to the company’s reimbursement coverage under Side B of the policy).

 

The bankruptcy court granted Sapp’s request and the Trustee appealed.

 

The appellate panel held that the bankruptcy court had not abused its discretion in granting relief from the stay. The appellate panel found that the bankruptcy court had appropriately weighed the parties’ respective harms and determined that Sapp had shown the requisite case for relief.

 

The debate about the right to D&O insurance policy proceeds in the bankruptcy context is a long-standing and sometimes vexatious issue. A good summary of the principles involved can be found in a 2006 memo by Wiley Rein’s Kim Melvin, here.

 

And Finally: A surprising number of people manage to figure this one out on their own without even requiring instruction -- "How to Suck at Facebook" (here).

　

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Rating agencies are not susceptible to ’33 Act liability as "underwriters," even if they helped structure the mortgage backed securities at issue, according to February 1, 2010 ruling (here) by Southern District of New York Judge Lewis Kaplan in which he dismissed Moody’s and McGraw-Hill (S&P’s parent) from the Lehman Brothers Mortgage-Backed Securities Litigation.

 

Plaintiffs had purchased the mortgage back securities that Lehman Brothers had issued in two offerings in August 2005 and August 2006. The plaintiffs allege that the originators of the loans that backed the securities failed to comply with the general loan underwriting guidelines described in the offering documents. The plaintiffs allege that the rating agencies determined the composition of the loans in the mortgage pool that the instruments securitized. The plaintiffs also allege that the credit enhancements supporting the loans were insufficient to support the investment ratings the rating agencies gave the securities.

 

The plaintiffs premised their securities liability claims against the rating agencies based on their argument that the rating agencies were "underwriters" within the meaning of Section 11 of the ’33 Act. The plaintiffs based their theory that the rating agencies were "underwriters" within the meaning of Section 11 on the argument that the "underwriter" liability extends to those "who engaged in steps necessary for the distribution."
 

 

Judge Kaplan found this argument "unpersuasive," noting that

 

The Rating Agencies’ alleged activities may well have had a good deal to do with the composition and characteristics of the pools of mortgage loans and the credit enhancements of the Certificates that ultimately were sold. But there is nothing in the complaint to suggest that they participated in the relevant "undertaking" – that of purchasing the securities here at issue, the Certificates – "from the issuer with a view to their resale." The Section 11 claim is insufficient in law.

 

Judge Kaplan also rejected plaintiffs’ arguments that the rating agencies had "seller" liability under Section 12(a)(2) or control person liability under Section 15.

 

The rating agencies dismissal from this subprime-related securities class action lawsuit is not as significant as it would have been if it had based on the rating agencies’ claims that their ratings opinions are proteced by the First Amendment. Though Judge Scheindlin rejected that argument on narrow grounds in the Cheyne Financial case (refer here), the First Amendment defense undoubtedly will play a crucial role in many of the subprime-related securities cases that have been filed against the rating agencies, and the litigants in the many cases that have been filed against the rating agencies will have to await a later date to get a clearer sense of how those arguments will fare in these cases.

 

But though Judge Kaplan did not reach the first amendment issue, his ruling nevertheless is significant. As the subprime litigation wave unfolded, there were a number of complaints filed against the rating agencies asserting ’33 Act claims against them in which the plaintiffs in those cases had argued that the rating agencies were susceptible to "underwriter" liability under Section 11. Judge Kaplan’s rejection of that theory undoubtedly will be influential in those other cases where the plaintiffs have attempted to assert Section 11 "underwriter" liability against the rating agencies.

 

I have in any event added Judge Kaplan’s ruling to my list of subprime and credit crisis-related lawsuit resolutions, which can be accessed here.

 

SEC Issues Climate Change Interpretive Guidance: The SEC decided recently to issue interpretive guidance on climate change disclosure. The SEC has now issued the interpretive guidance, which can be found here. I think this is a significant development, and not just because the SEC has now formally put climate change disclosure on the list of things to do for reporting companies.

 

It is clearly a topic worthy of much longer treatment than I am able to give it while I am in New York attending the PLUS D&O Symposium, but the danger is that the disclosure requirement establishes the predicate for a plaintiff to later claim that a public company failed to meet its climate change-related disclosure obligations. In my view, the SEC’s issuance of the interpretive guidance brings us that much closer to the day when we may start to see D&O claims arising out of misrepresentations or omissions concerning climate change related disclosures.

 

The End of the World: In response to my recent statement that I was tired and could use a nap, one of my much younger colleagues replied "O.K, first we take zee nap, ZEN WE DEESTROY ZEE WORLD!" She undoubtedly saw from the puzzled look on my face that I didn’t have a clue what she was talking about, so she immediately sat down and showed me this YouTube video, which she described as "the original viral Internet video." Readers should be forewarned that  the video uses vulgar language and contains humor that some may find crude or offensive. It is also seriously funny. Viewer discretion is, however, strongly advised.

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In a 90-page January 27, 2010 opinion (here) District of New Mexico Judge James Browning granted substantial parts of the defendants’ motions to dismiss in the Thornburgh Mortgage subprime securities suit, while also denying the motions to dismiss in connection with certain claims against Larry Goldstone, who served as the company’s President and COO, and after December 2007, as its CEO.

 

Judge Browning’s rulings dismiss all of the plaintiffs’ claims under the ’33 Act as well as many of the plaintiffs’ claims under the ’34 Act, except for the claims against Goldstone, which will go forward. Judge Browning reserved any ruling on the claims against the company itself, which is in bankruptcy, as well as to allegations of control person liability against three individual defendants, as those claims depend first upon the possibility of the company’s liability.

 

In a separate 38-page January 27, 2010 opinion (here), Judge Browning also granted the dismissal motions of the offering underwriter defendants, ruling that the plaintiffs’ consolidated complaint failed to allege sufficiently any material misrepresentations or omissions in the relevant offering documents.

 

Background

Thornburg was a publicly traded residential-mortgage lender focused on the market for "jumbo" and "super jumbo" adjustable rate mortgages. Beginning in 2006, real estate values around the country began to falter, but Thornburgh denied that it was affected, claiming its superior underwriting standards insulated the company from the deteriorating conditions. Thornburg’s executives also denied that it originated "subprime" or Alt-A mortgages.

 

Thornburg’s business model depended on a variety of borrowing and capital mechanisms to fund its lending activities. Thornburg maintained an investment portfolio as collateral for its borrowing. Plaintiffs allege that the portfolio consisted in part of securities backed by Alt-A mortgages, and that these securities were both illiquid and, in 2007, declining in value, which in turn triggered certain margin calls.

 

Specifically, in August 2007, Thornburg was forced to sell 35% of the highest-rated assets in its portfolio to meet margin calls, which in turn triggered both a stock price decline and the filing of the first of several securities class action suits against the company.

 

During 2007 and 2008, the company completed several securities offerings. However, Thornburgh also continued to face additional margin calls, and on February 28, 2008, J.P. Morgan notified the company of its failure to meet margin call requirements, triggering cross default provisions in other short term borrowing arrangements.

 

On March 4, 2008, the company’s auditor withdrew its unqualified audit opinion "due to conditions and events that were known or that should have been known to the company." On March 11, 2008, Thornburg filed a restatement of its prior financials. On March 19, 2008, Thornburg announced it had entered a "bailout" agreement with its remaining lenders that resulted in a substantial dilution of shareholders’ interests.

 

On May 1, 2009, Thornburg filed a petition for voluntary Chapter 11 bankruptcy.

 

The plaintiffs filed their consolidated amended class action complaint on May 27, 2008, on behalf of persons who purchased Thornburg shares between April 19, 2007 and March 19, 2008. The plaintiffs allege that the defendants had failed to disclose that the company was facing increasing margin calls and that its financial condition had deteriorated to the point where it was forced to sell assets. The plaintiffs further alleged that the company failed to disclose that it originated Alt-A mortgages and possessed a multi-million dollar portfolio backed by Alt-A loans.

 

The defendants moved to dismiss, arguing that Thornburg’s losses were the result of market forces beyond defendants’ control.

 

The January 27, 2010 Order

In his January 27 order, Judge Browning first focused on the plaintiffs allegations under Section 10(b). He found with respect to many of the statements or omissions that most of them were not false or misleading or related to matters that the company had no duty to disclose. He also found that the plaintiffs had not specifically attributed any wrongful conduct or statements to any of the individual defendants other than Goldstone, and therefore he granted the motion to dismiss the Section 10(b) claims as to all individual defendants other than Goldstone.

 

However, Judge Browning found that Goldstone had in several public statements sought to attribute the downturn to problems with Alt-A lenders, from which he sought to differentiate Thornburg. Judge Browning found that "on at least two occasions" in June and July 2007, Goldstone made statements that "could be construed and reasonably understood as asserting that [Thornburg} did not engage in Alt-A lending or purchase Alt-A assets," statements which Judge Browning found were false and misleading, taking the plaintiffs’ allegations to be true.

 

Judge Browning also found that statements in the company’s 2007 10-K (which Goldstone signed) about the presence of cross-default provisions in the company’s borrowing agreements also to be false and misleading.

 

On the issue of scienter, Judge Browning rejected the defendants’ suggestion that the absence of insider selling and the presence of insider buying negated the inference of scienter, finding rather that the financial crisis itself "provides another motive that adequately fills the gap left by the lack of suspicious insider-trading activity: survival." Judge Browning said that it was a plausible inference that the defendants were motivated by a desire to help the company survive the crisis, although this allegation alone is not sufficient to establish an inference of scienter.

 

Rather, Judge Browning held that Goldstone’s repeated efforts to distance the company from the mortgage crisis by differentiating the company from Alt-A mortgage originators, "gives rise to a strong inference that Goldstone was attempting to hide from the market that [Thornburg] engaged in Alt-A or subprime lending, and knew, or recklessly disregarded that withholding this information would mislead investors." Thornburg’s omission from its 2007 10-K of its failure to meet the J.P. Morgan margin call, and of the consequent triggering of cross-defaults in other agreements, suggests that Thornburg was "concealing information."

 

The most plausible inference, Judge Browning found, was that Thornburg was "a sinking ship," but that the defendants "tried to stay positive" and that Goldstone "made some statements that crossed the line between optimistic and false and/or misleading."

 

Judge Browning granted the motions to dismiss all of the plaintiffs’ claims based on Sections 11 and 12(a)(2) of the ’33 Act, finding that the plaintiffs had failed to allege any false or misleading statements in the relevant offering documents.

 

Due to its pending bankruptcy proceeding, Judge Browning reserved any ruling on the claims against Thornburg itself, as well as on the control person liability allegations under the ’34 Act that are predicated on the sufficiency of claims against the company.

 

Finally, as noted above, in a separate order, Judge Browning granted the dismissal motions of the offering underwriter defendants, based on his finding that the plaintiffs had failed to allege any false or misleading statements in the relevant offering documents.

 

Discussion

Judge Browning’s exhaustive analysis and his rulings are significant on several levels. First, his order present another example where a court has been willing to dismiss ’33 Act claims in a subprime-related securities class action lawsuit. As I noted in my recent post discussing the ACA Capital Holdings case, where ’33 Act claims were also dismissed, it previously had been the case that courts appeared reluctant to dismiss ’33 Act claims in subprime-related securities lawsuits. But with the ACA Capital Holdings rulings, and now with the rulings in the Thornburg case, the suggestion that Section 11 claims are likelier to survive dismissal motions seems to be less certain, if not entirely unsubstantiated.

 

Judge Browning’s analysis of the scienter issue is also significant. His willingness to overlook the defendants’ insider buying is interesting and noteworthy, particularly in light of his willingness to draw an inference that the defendants were motivated – and perhaps motivated enough to make misleading statements – by a desire to help the company survive the downturn.

 

Many defendants in many other subprime and credit crisis-related cases were similarly motivated to try to help their companies ride out the crisis. To be sure, not all companies or their officials made statements that plaintiffs in those cases will be able to allege diverged from actual circumstances at their companies. But the fact that the plaintiffs in the Thornburg Mortgage case were able to survive the dismissal motion, and to overcome the absence of any insider trading and the presence of insider buying, suggests one possible way that other plaintiffs may overcome initial pleading hurdles.

 

Judge Browning granted the dismissal motions in very substantial part, eliminating almost all of the defendants and many of the plaintiffs’ claims. But the plaintiffs were able to survive the dismissal motions at least as to certain substantial allegations against at least one defendant. Large swaths of their case were cut away, but enough made it through to give them a chance to live for another day and to try to salvage something from the case.

 

Because what remains is substantial, even if only a small part of what was initially alleged, I have placed these rulings on my list of dismissal motion denials, in my running tally of dismissal motion rulings in subprime and credit crisis-related securities suits. My table of dismissal motion rulings can be accessed here.

 

More Failed Banks: On January 29, 2010, the FDIC took control of six more banks, bringing the year to date number of bank failures already this year to 15. By contrast, at this same point in 2009, there had only been a total of six bank failures. The bank failure closure rate is on pace for a total of 180 bank failures in 2010, compared to the 140 banks that failed in 2009.

 

The 15 bank failures so far this year have been spread across ten different states, with three bank failures already this year in the state of Washington, and two each in Georgia, Minnesota, and Florida.

 

This Week: I will be attending the PLUS D&O Symposium at the Marriott Marquis in New York this week. I know many readers will also be there. I hope that if you see me at the Symposium that you will say hello, particularly if we have not met before. While I am away for the Symposium, The D&O Diary may run a reduced publication schedule. "Normal" publication will resume next week. See you in New York.

 

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In a January 14, 2010 order (here), Southern District of New York Judge Robert W. Sweet granted the motion to dismiss in the ACA Capital Holdings subprime-related securities class action lawsuit. The decision is noteworthy in and of itself, but also because the plaintiffs’ securities claims were asserted under the ’33 Act. Subprime securities lawsuits asserting only ’33 Act claims have generally survived dismissal motions, but in the ACA Capital case the dismissal was granted -- with prejudice.

 

ACA Capital, which went public on November 10, 2006, was in the business of offering financial guaranty insurance products to participants in the global derivatives markets, and in its asset management business, it structured and managed collateralized debt obligation (CDO) transactions. During 2007, ACA began to experience deterioration in the credit obligations underlying the CDO transactions. ACA experienced losses in its portfolio, which caused its share price to decline. In November 2007, credit rating agencies downgraded ACA. In August 2008 ACA entered a global settlement with its structured credit counterparties, as a result of which the company effectively ceased operations.

 

Plaintiffs initially filed their securities class action lawsuit against ACA and its CEO in November 2007. Background regarding the lawsuit can be found here. In their consolidated amended complaint, Plaintiffs alleged that the defendants ACA’s prospectus had failed to disclose that "at the time of the IPO, the Company had materially increased its exposure to highly risky sub-prime CDOs and was planning to complete several more sub-prime CDO deals in early 2007 that would greatly increase the Company's exposure."

 

The plaintiffs further alleged that the Prospectus failed to disclose that due to "the rising default rates on sub-prime mortgages, it was highly likely that the Company would experience losses on the policies it had written to insure numerous CDOs and it would experience losses on its [collateralized debt securities] positions."

 

The defendants moved to dismiss, and in his January 14 order, Judge Sweet granted the defendants’ motion with prejudice.

 

Judge Sweet first held that, with respect to each of the sets of facts the plaintiffs alleged the defendants had failed to disclose that the allegedly omitted facts were disclosed in the Prospectus. He held that "the Prospectus’s disclosure of information alleged in the Complaint to have been withheld from prospective investors renders the Complaint insufficient as a matter of law."

 

The plaintiffs had also argued that the Prospectus had failed to comply with Item 303 of Regulation S-K by failing to describe "known trends and uncertainties" that the company faced. The plaintiffs argued that the Prospectus failed to disclose the existence of a "rising trend" of subprime foreclosures and delinquencies at the time of the IPO.

 

Judge Sweet held that the defendants could not be held liable for failing to disclose a trend of which they were unaware, and found that "the Complaint does not allege that the Defendants were actually aware of any purported ‘trend of delinquencies and foreclosures.’" Rather, many of the source on which the plaintiffs relied to try to establish the existence of a trend were not published until after the IPO. Only three of the sources on which plaintiffs relied were created prior to the IPO, one of which makes no references to delinquencies and foreclosures, another of which contains data reflecting less than a single calendar quarter (insufficient to show a "trend"), and material that was not publicly available at the time of the IPO.

 

Finally, Judge Sweet also granted the defendants’ motion to dismiss on the grounds of "negative causation" – that is, because, he found, that the complaint and the public filings on which the plaintiffs rely "establish that the decline in ACA’s stock was not caused by the allegedly false and misleading statements in the Prospectus." Instead, he found, "Plaintiffs cannot establish a causal relationship between Defendants’ alleged misrepresentations and subsequent declines in ACA’s stock price."

 

While there have been other dismissal motions granted with prejudice in subprime-related securities class actions, this dismissal stands out because the ACA plaintiffs’ claims were asserted under the ’33 Act. As I discussed in a recent post (here), research by Jon Eisenberg of the Skadden law firm regarding subprime dismissal motion rulings showed that all of the cases he studied that only asserted ’33 Act claims had survived motions to dismiss, in part, he speculated because of the absence of scienter pleading requirements for ’33 Act claims. Even claims that alleged ’33 Act claims in addition to claims under the ’34 Act tended to have a better survival rate than claims that asserting ’34 Act claims alone.

 

In light of the other dismissal motion rulings, Judge Sweet’s dismissal of the ACA Capital complaint with prejudice makes the case a noteworthy victory for the defendants. A significant number of the subprime and credit crisis-related cases asserted only ’33 Act claims, so the defendants in those other cases undoubtedly will be closely reviewing the ACA decision to see if they can use the decision in their cases.

 

I have in any event added the ACA Capital decision to my list of subprime and credit crisis-related securities class action lawsuit dismissal motion rulings, which can be accessed here.

 

Special thanks to the several readers who sent me a copy of the ACA Capital decision.

 

Small World: Wikipedia reports (here) that Eliot Spitzer served as one of Judge Sweet’s law clerks. And in light of my reference above to the research of Skadden attorney Jon Eisenberg, it seems relevant to note that prior to going onto the federal bench in 1978, Judge Sweet was in private practice at the Skadden law firm.

 

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Since the outset of the subprime securities class action litigation wave I have tried to keep track both of the lawsuits as they are filed (refer here) and on the outcome of the cases as they are resolved, including in particular the outcome of the defendants’ motions to dismiss (refer here). But these tabulations alone don’t tell you who is winning and who is losing, or why.

 

Those questions are the subject of a thorough and interesting December 30, 2009 Bloomberg.com article by Jon Eisenberg of the Skadden Arps law firm entitled "Subprime Securities Class Action Decisions: Who’s Winning, Who’s Losing and Why?" (here).

 

Eisenberg looks at dismissal motion rulings in 16 of the cases that have reached the dismissal motions stage. (Eisenberg explains that he narrowed the pool of decisions he reviewed from the universe of all subprime and credit crisis-related dismissal motion rulings in order "to focus exclusively on subprime cases…in which plaintiffs have alleged that defendants misrepresented or omitted material facts regarding the quality of subprime loans that the defendant company was making or financing or rating.")

 

He found that out of the 16 decisions, plaintiffs’ complaints survived motions to dismiss in ten cases and failed to survive in six cases.

 

Eisenberg has a number of observations about these dismissal motion rulings. First, he noted that all seven cases that asserted claims under Sections 11 and 12 (a)(2) of the Securities Act survived motions to dismiss. Indeed, even in cases in which ’33 Act claims were combined with claims under Section 10(b) of the ’34 Act, the Section 10(b) claims survived as well. By contrast, in the nine decisions involving standalone Section 10(b) claims, the dismissal motions were denied in only three cases.

 

Although the defendants asserted a number of defenses in their dismissal motions, scienter "turns out to be the perfect predictor of outcomes across all 16 cases." If plaintiffs were not relying on claims that required pleading scienter (i.e., the ’33 Act claims) or convinced the court that the scienter allegations were sufficient, they survived the motion to dismiss. And in the Section 10(b) cases in which the plaintiffs met the standard for pleading scienter, "they also convinced the court to reject the merits of the other defenses asserted in the motion to dismiss."

 

Plaintiffs were successful in pleading scienter when relying on statements by confidential witnesses that "allegedly detail executives’ knowledge of facts inconsistent with public statement" and when relying on "reliable external sources of information," such as bankruptcy examiner’s report, as well as when relying on "market events linked with questionable internal practices and representations fundamentally at odds with a company’s core business."

 

Plaintiffs were unsuccessful in pleading scienter when the factual allegations on which the plaintiffs are relying might "easily coincide with non-fraudulent misstatements or omissions." For example allegations such as senior level positions, certifications under Sarbanes-Oxley, resignations of senior executives, normal selling by insiders, GAAP violations, restatements and even decisions by auditors to not continue as auditors were found not to create a strong inference of scienter.

 

Eisenberg found further that massive complaints do not necessarily establish scienter and often backfire on plaintiffs. Similarly, though many complaints seek to rely on confidential witnesses, confidential witness statements "do not ensure that a complaint will survive." Courts have dismissed fraud claims where "the confidential witness statements failed to show what the executives knew or how the confidential witnesses knew what the executives knew."

 

Eisenberg concludes his article with an analysis of the problem of "hindsight bias" – the tendency for people with knowledge of an outcome to exaggerate the extent to which they believe the outcome should have been predicted. The risk of hindsight bias in the subprime cases exists because of the competing narratives; that is, the plaintiffs argue that defendants were reckless in not seeing what was coming and adjusting their business practices accordingly, and defendants argue that they, along with the entire rest of the global financial marketplace, were blindsided by events "so severe, unexpected and unprecedented" that no one saw them coming.

 

"The good news for defendants," Eisenberg concludes is that at least in cases involving standalone Section 10(b) cases, "defendants’ narrative is often persuasive and courts have granted motions to dismiss because they are not convinced that defendants knew, or were reckless in not knowing, of the calamity that lay ahead."

 

Very special thanks to Jon Eisenberg for providing me with a copy of his article.

 

My own status report, as of September 2009, on the subprime and credit crisis-related securities lawsuits can be found here.

 

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Beazer Homes has announced in its December 22, 2009 filing on Form 8-K (here) that it has settled the subprime-related shareholder’s derivative lawsuit that had been filed against the company, as nominal defendant, and certain of its directors and officers. According to the filing, the case has been settled in recognition of the corporate governance reforms the company has enacted and in exchange for the agreement to pay the plaintiff’s attorneys’ fees of $950,000. As reflected below, this appears to be the first settlement of a subprime-related derivative lawsuit.

 

The Derivative Lawsuit and Settlement

The plaintiff had filed a shareholders’ derivative complaint in Northern District of Georgia in April 2007. (A separate complaint filed in Delaware was later dismissed.). According to the plaintiff’s amended consolidated derivative complaint (here), the individual defendants breached their fiduciary duties and violated the federal securities laws by ignoring "numerous and obvious ‘red flags’ existing even prior to 2006 that alerted them or would have alerted them had they not consciously disregarded such red flags, to a plethora of improper loan practices at Beazer." The loan practices "eventually led to a vast amount of foreclosures and other problems, materially impacting the company’s stability."

 

The amended complaint also alleges that the defendants’ mismanagement has led to investigations of the company’s mortgage and accounting practices by the IRS, the Department of Justice, the FBI, HUD, and the SEC.

 

As part of the settlement and as reflected in the parties’ October 30, 2009 stipulation of settlement (here), Beazer acknowledged "that the commencement, prosecution and settlement of the Derivative Action were material contributing factors in causing the Company to agree to adopt and/or implement the corporate governance reforms and remedial measures" described in an attachment to the stipulation.

 

In addition, the stipulation provides that "Beazer and the individual defendants shall pay, or cause their insurers to pay, upon Court approval, an aggregate amount of $950,000 to Plaintiff’s Counsel for their attorneys’ fees and reimbursement of expenses."

 

There is nothing in the agreement to indicate that the company’s insurers have affirmatively agreed to pay these amounts.

 

Related Litigation

Beazer Homes and certain of its directors and officers had also been separately sued in a securities class action lawsuit, that later resulted in a $30.5 million settlement (here), that was, according to the company’s press release at the time, to be funded from insurance proceeds." Subsequent to the class action settlement, certain mutual fund investors in Beazer elected to opt out of the class action settlement and in September 2009 filed their own separate opt-out complaint in the Northern District of Georgia.

 

Beazer is now engaged in coverage litigation with its third level excess D&O insurer, as reflected in the declaratory judgment complaint that Beazer filed against the carrier on December 17, 2009, in the Northern District of Georgia. According to the coverage lawsuit, Beazer’s third level excess carrier "wrongfully denied coverage for Beazer Homes in connection with the Opt-Out Litigation." The complaint goes on to recite that the carrier’s "sole ground" for denying coverage "is the assertion that Beazer Homes purportedly breached a so-called ‘warranty letter.’" (My recent post discussing "warranty letters" can be found here.}

 

Discussion

With Beazer’s top level excess carrier denying coverage and engaged in coverage litigation with the company, it is unclear whether or to what extent insurance is presently available to fund the cash portion of the Beazer derivative settlement, even assuming insurance would otherwise apply to an agreement to pay the plaintiff’s attorneys’ fees.

 

But setting aside the issues surrounding the availability of insurance to fund the payment of the plaintiff’s attorneys’ fees, there is the overall question of the benefit of litigation that is settled in "recognition of" remedial actions that the company has already taken, undoubtedly due to the onslaught of regulatory and legal problems the company has encountered.

 

To be sure, the stipulation recites that the derivative litigation was a "material contributing factor" in causing the reforms to be initiated. Some observers may question whether the reforms would have been enacted in any event regardless of the derivative lawsuit, and might even question the social utility of a process the most tangible result of which is the transfer of monies to the plaintiffs’ lawyers who initiated the process. Those same observers would likely also note that the stipulation’s concession about the role of the derivative suit in the implementation of the governance reforms was simply a price the defendants had to pay to put an end the derivative suit, the same as the agreement to pay plaintiffs’ attorneys’ fees.

 

By my count, there were twenty seven subprime and credit crisis related derivative lawsuits filed, as reflected here. As far as I can determine, the Beazer Homes derivative settlement is the first of the subprime and credit crisis-related derivative suit to settle. There undoubtedly will be other settlements ahead.

 

Though Beazer Homes derivative suit is not options backdating related, it reflects the same settlement pattern as many of the options backdating derivative suits. As shown on my table of options backdating related derivative lawsuit case resolutions (which can be found here), many of the backdating derivative cases resulted in settlements comprised of an agreement to adopt corporate therapeutics and governance reforms, together with the payment of plaintiffs’ attorneys’ fees.

 

It remains to be seen whether others of the subprime and credit crisis related derivative suits will settle on the same or similar grounds. The plaintiffs’ lawyers that make their living off of these kinds of cases will have to accept that there will be questions about the value for shareholders and for society from this process, where the most visible thing that is accomplished is the plaintiffs’ lawyers collection of their fees. Of course, the plaintiffs’ lawyers themselves will cite the corporate reforms, a point which in the interest of balance, I acknowledge here.

 

I have in any event added the Beazer Homes derivative settlement to my tally of subprime and credit crisis related lawsuit resolutions, which can be accessed here.

 

Break in the Action: The D&O Diary will be on a short break over the next few days. We will resume the "normal" publication schedule after the holidays.

 

But before I go, I wanted to leave something to make you smile. Here, if you have not yet seen it, is Jill and Kevin’s Wedding Dance. Enjoy. (My oldest daughter says: "I like the bridesmaids’ dresses. They seem like people I would like, too --they dance the same way I do.")

 

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In a December 4, 2009 order (here), Southern District of Ohio Judge Michael H. Watson granted the defendants’ motion to dismiss the consolidated subprime-related securities class action lawsuit against Huntington Bancshares. Judge Watson granted the motion based on his findings that plaintiffs had failed to adequately allege both falsity and scienter. The dismissal is with prejudice.

 

Background

In December 2006, Huntington and Sky Financial announced their plans to merge. In July 2007, Huntington’s $3.3 billion acquisition of Sky closed. For many years, one of Sky’s clients had been Franklin Credit Mortgage Corporation. Franklin originated subprime mortgage loans, some of which it sold in the secondary mortgage market. For seventeen years, Sky made loans to Franklin that Franklin used to finance its mortgages. In July 2007, Sky had $1.5 billion exposure to Franklin.

 

On November 16, 2997, Huntington alerted its investors that Franklin recently announced the deterioration of its mortgage portfolio. Huntington announced that because of Franklin’s announcement, it (Huntington) would be taking a fourth quarter after-tax charge of $300 million to build up its allowance for loan losses. Huntington also stated that it expected to report a fourth quarter loss. On this news, Huntington’s share price declined from $16.08 to $14.75.

 

Plaintiffs filed a securities class action lawsuit on behalf of investors who purchased Huntington shares between the date of the merger and November 16, 2007. Plaintiffs allege that Huntington’s acquisition of Sky subjected Huntington to significant subprime exposure because of Sky’s relationship with Franklin. The plaintiffs allege that Huntington misled investors regarding its ability to weather the deteriorating real estate and subprime mortgage market. The defendants moved to dismiss.

 

The December 4 Order

In his December 4, Judge Watson granted the defendants motion to dismiss, on the grounds that the plaintiffs had failed to adequately allege falsity and scienter.

 

In reaching the conclusion that the defendant had not adequately alleged falsity, Judge Watson noted that:

 

The Complaint does not allege any specific facts that Huntington’s disclosures were incompatible with any reports, data, or signs that Franklin would be unable to pay its loans to Huntington, nor does the Complaint do anything more that allege Defendants should have known the continuing erosion of the real estate market would render the loan portfolio precarious. Significantly, Huntington’s public statements all address the faltering real estate market, … increases in delinquencies in the industry, and the prospect of increases of allowances for loan and lease losses. No information suggests Huntington knew of Franklin’s situation prior to Franklin’s own announcement that it was having problems.

 

Even though Judge Watson concluded that the plaintiffs’ failure to allege falsity was a sufficient basis on which to dismiss the complaint, he separate analyzed the scienter issue as "an alternative basis" for his ruling.

 

After reviewing the plaintiffs’ allegations, Judge Watson found that the Plaintiffs "fail to establish a strong inference of scienter." He noted that:

 

Viewed in their aggregate, Plaintiffs’ allegations do not give rise to a "cogent" inference that Defendants possessed the requisite knowing or reckless intent to manipulate, deceived or defraud. The allegations concerning Huntington’s alleged knowledge after the due diligence period during the acquisition, the self-interested motives of Defendants, and the closeness in time of the supposed fraudulent statements and later disclosures, all lack the factual particularity that would support an inference of fraudulent intent that is "at least as compelling as any opposing inference."

 

Judge Watson’s dismissal ruling was with prejudice.

 

I have added the Huntington Bancshares dismissal to my register of subprime and credit crisis-related lawsuit dismissal motion rulings, which can be accessed here.

 

Special thanks to Adam Savett of the Securities Litigation Watch blog for providing me with a copy of the Huntington Bancshares ruling.

 

Amended Complaint Survives Former IndyMac’s CEO’s Dismissal Motion: In a contrary development in a high profile west coast subprime-related lawsuit, on December 11, 2009, Central District of California Judge George Wu’s denied the motion of former IndyMac CEO Michael Perry to dismiss the plaintiffs’ Fifth Amended Complaint. Judge Wu’s minute order entry of his ruling can be found here.

 

The tortured procedural history of the IndyMac case, which among things led up to the filing of five amended complaints, can be found here. As a result of this twisted procedural path and Judge Wu’s December 11 ruling, this IndyMac suit will now go forward solely as to Perry.

 

Judge Wu’s December 11 ruling adds the IndyMac case to the now growing list of subprime lawsuits that were initially dismissed but that following amended pleading survived renewed motions to dismiss, including, for example, the WaMu case (here) and the PMI Group case (here).

 

I have in any event also added the December 11 ruling in the IndyMac case to my tally of dismissal motion rulings, linked above.

 

Apology: I sincerely apologize for the faulty link to the transcript of the hearing in the Broadcom case in yesterday’s blog post. Readers who were frustrated because they could not access the transcript can find a correct link to the transcript here. I have also corrected the link on the blog post.

 

Again, I apologize for the error, which is just one of those things that can happen with late-night blogging.

 

Sometimes I really wish I had a fact-checker or editor following along behind me to protect against blogging boo-boos like that.

　

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In a provocative statement suggesting the unlikelihood of "damage awards" against subprime lenders’ directors and officers, XL Capital Ltd. CEO Michael McGavick yesterday told a Goldman Sachs Group conference that "being collectively stupid is not a basis for a lawsuit," according to a December 9, 2009 Bloomberg article (here).

 

As reflected in the article, McGavick indicated that investors have little chance of extracting damages awards from executives and board members at firms that lost money, as the article put it, "betting on subprime mortgages." McGavick is quoted as saying that its "very hard to pick out the management team that did something wrong to the level that the law requires."

 

McGavick’s comments have already kicked up controversy, as reflected in Ross Todd’s December 9, 2009 article on Am Law Litigation Daily, entitled "Are Directors and Officers Safe from Securities Fraud Suits Because They Were ‘Collectively Stupid?’" (here).

 

However, it is difficult to tell from the Bloomberg article how comprehensive McGavick’s comments were intended to be. Was he talking only about companies that invested in subprime mortgages or was he talking about a larger group of companies, including subprime lenders and other companies that were brought down or seriously damaged by the subprime meltdown?

 

Subject to that uncertainty about the scope of McGavick’s comments, I have several thoughts and comments in reaction to his remarks.

 

As an initial matter I note that while it may be true that "collective stupidity" hardly represents a legal theory on which liability might be based, it also is not a very promising defense. Even setting aside the colorful use of the word "stupidity," it is not a great defense to argue that everybody managed to get it wrong, as proved to be the case in the connection with options backdating, for example.

 

And to the extent that McGavick’s statement was intended to be broadly based and was meant to suggest generally that plaintiffs are unlikely to even file lawsuits based on the subprime meltdown, the facts suggest otherwise. Plaintiffs have already filed over 200 subprime and credit crisis securities class action lawsuits (as reflected in the attachment to this prior blog post), as well as over 25 derivative lawsuits and over 15 ERISA class actions. Clearly, the plaintiffs’ lawyers perceive what McGavick characterized as "collective stupidity" to be a litigation opportunity.

 

If McGavick’s statement was intended to suggest that plaintiffs will not succeed in the cases arising out of the subprime meltdown, I have to say that from my perspective it is far too early to make any sweeping statements about who will come out ahead generally from the subprime and credit crisis lawsuits.

 

Specifically, even though there have been over 200 subprime and credit crisis related securities class action lawsuits, only a small portion of those cases have made it through the dismissal stage as reflected in my running tally of the rulings on subprime lawsuit dismissal motions, which can be accessed here.

 

Although the defendants have prevailed in many of the motions so far, there have also been a number of motions on which plaintiffs have prevailed – for example in the New Century and Countrywide cases (as reflected here and here, respectively). Indeed, there have been cases, like the Washington Mutual case (refer here), where the initial motion was granted, but the cases survived the renewed motion after the complaint was amended.

 

And even though there have only been a handful of settlements in the subprime and credit crisis cases so far, the settlements so far collectively represent nearly a billion dollars. Even if the out-sized Merrill Lynch settlements are disregarded, the other settlements still represent some very significant numbers. (The settlement data can be accessed here). Even modest extrapolation against the entire population of lawsuits suggests that even if plaintiffs don’t extract "damages awards," they are likely to notch some significant settlements before everything is said and done.

 

With so many of the subprime and credit crisis cases yet to be resolved, I think the most that can be said with respect to the D&O insurance industry’s likely aggregate exposure to the subprime and credit crisis lawsuits is that it is too early to tell. I will say that if you take into account the aggregate expenses that the D&O industry will sustain in defending insureds, it is clear that by any measure that the subprime and credit crisis litigation wave will in the final analysis represent a significant event for the D&O insurance industry, no matter what happens.

 

My prior interim update on the subprime and credit crisis-related litigation wave can be found here.

 

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In a series of recent rulings in coverage litigation arising out of the 2007 collapse of Brookstreet Securities Corporation, a California-based securities broker-dealer, Central District of California Judge Cormac Carney addressed the claims of several claimants to the proceeds of a professional liability insurance policy that had insured the defunct company. Though the rulings are narrow and tied to the specific facts presented, the issues in dispute are likely to recur in claims arising from the subprime meltdown and accordingly the rulings may be of more general interest on that basis.

 

Background

Brookstreet provided broker dealer services nationwide until mid-2008 when the company experienced a financial collapse. The company ceased operations in June 2007 and is now insolvent.

 

Brookstreet was insured under a Securities Broker Dealer Professional Liability Insurance Policy for the period November 8, 2006 to November 8, 2007. The policy provides coverage for claims made against Insured Persons for actual or alleged Wrongful Acts in the rendering of "Professional Services." The policy had limits of $3 million.

 

The policy is an express "claims made and reported" policy, requiring in order for coverage to apply both that the claim be made within the policy period and that notice of claim be given within thirty days and during the policy period.

 

The insurer brought an action for interpleader and posted a $3 million bond. The insurer then filed three separate motions for summary judgment as to certain separate groups of interpleader defendants, all of whom are in turn claimants against Brookstreet or certain of its former directors, officers or employees.

 

Judge Carney’s Rulings

In a three separate rulings, Judge Carney addressed each of the insurer’s summary judgment motions.

 

Claims Made/Late Notice Issues: First, in a November 20, 2009 opinion (here), Judge Carney addressed the insurer’s motion for summary judgment as to the defendant claimants who had not made their claim against Brookstreet prior to the policy’s expiration or with respect to whose claims Brookstreet had not provided notice of claim to the insurer prior to the policy’s expiration.

 

Judge Carney quickly granted the insurer’s motion as to the claimants whose claims were made after the policy’s expiration, or with respect to whose claims Brookstreet had not provided notice of claim to the insurer during the policy period.

 

The more interesting questions about notice sufficiency arose with respect to the claimants who had made their claims during the policy period and with respect to whose claims Brookstreet had provded notice of claim during the policy period, but with respect to whose claims Brookstreet had not provided notice within the 30-day period required under the policy.

 

Judge Carney, enforcing the policy’s notice requirements strictly, found that the insurer was entitled to summary judgment even as to this latter group of claimants. Judge Carney found that the 30-day notice requirement was a "condition precedent" to coverage and that "to force" the insurer to have to demonstrate prejudice in order for the notice provision to be enforced "would be to rewrite the insurance contract, and the Court is unwilling to take this step."

 

Derivative Claim Exclusion: The insurer had also moved for summary judgment as to those claimants whose claims arose out of or were based on transactions involving Collateralized Mortgage Obligations (CMO). The insurer relied upon a policy exclusion precluding coverage for claims "based upon, arising out of or attributable to the sale, attempted sale, or servicing of … any type of …derivative." Relying on this exclusion, the insurer argued that the CMOs are derivatives, and therefore the policy precluded coverage for claims relating to the CMOs.

 

In a November 20, 2009 ruling (here), Judge Carney concluded, based on extensive material provided by the insurer, that CMOs are "derivatives" within the meaning of the policy. Accordingly, he granted summary judgment as to those claimants whose claims were based on CMOs.

 

Interrelated Acts: The insurer had also moved for summary judgment as to a claimant who asserted that a Brookstreet employee had mismanaged her investments, through a pattern of "churning, making unauthorized trades, buying and selling high risk stocks, and failed to advise [her] of investment losses" during the period 1996 though June 2006.

 

The insurer argued that her claim arose out of an Interrelated Wrongful Act that first occurred prior to the policy’s September 10, 2002 retroactive date. The insurer further argued that the pre- and post-September 10, 2002 conduct constituted a single, non-covered Interrelated Wrongful Act. The claimant asserted that each of the improper acts was a separate Wrongful Act, and that each time Brookstreet failed to supervise its employee, it also committed a new and discrete Wrongful Act.

 

In a November 18, 2009 ruling (here), Judge Carney held that while he "does not discount the possibility that [the employee’s] actions may have constituted an Interrelated Wrongful Act …there are genuine issues of material fact as to whether the acts after September 10, 2002 were interrelated with those occurring before that date." Because a "reasonable jury could conclude" that each time the employee "made an unauthorized trade, churned [the claimant’s account] or bought and sold high risk stocks" each was a separate Wrongful Act.

 

Discussion

Judge Carney’s rulings are interesting in and of themselves, but they are also interesting for what they suggest more generally.

 

First, his holding that the claims based on CMOs were precluded from coverage under the Brookstreet policy’s exclusion for derivatives claims is a reminder that the way insurance policies respond to many of the current claims based on complex financial instruments could involve a host of complicated insurance issues.

 

Although the exclusion that the CMO claims triggered in the Brookstreet case is peculiar to the specific type of insurance policy involved in that case, similar questions could arise under other policies in connection with other claims relating to complex investment securities and other financial instruments.

 

Many of the types of recurring claims asserted in the current litigation wave (e.g., the auction rate securities suits and the Madoff feeder fund lawsuits) present allegations of the type for which professional liability policies like that involved in the Brookstreet case were designed to respond. However, as the Brookstreet case shows, there potentially could be a host of complex coverage issues associated with many of these claims, depending on the facts alleged and the specific policy language involved.

 

Second, Judge Carey’s ruling on the interrelatedness issue is a reminder of how difficult interrelatedness questions can be. The term "interrelated" is neither defined in the typical policy nor is it self-defining. At a certain level of generalization, everything in the universe is interrelated, and at the same time, at another level, nothing is interrelated. What makes something interrelated for insurance coverage purposes can become quite situational and subjective, which leads many judges, like Judge Carney here, to want to leave interrelatedness questions to the jury.

 

Many of the cases in the subprime and credit crisis litigation wave present interrelatedness questions. Different complaints against the same or similar defendants in different policy periods raise the question whether one or several policies have been triggered. Judge Carney’s ruling in this case shows how difficult it may be for carriers seeking to rely on interrelatedness arguments. My own experience, consistent with Judge Carney’s ruling, is that courts tend to resolve interrelatedness questions in a way that maximizes the amount of insurance available.

 

Finally, Judge Carney’s rulings on the claims made and late notice issues are largely unremarkable, except as pertains to the question of the timeliness of notice for notices provided within the policy period but beyond the 30-day notice period. Judge Carney strictly enforced the policy’s 30-day notice requirement, and declined to even consider arguments based on the absence of prejudice.

 

Judge Carney’s literal enforcement of the notice requirement is is particularly noteworthy in that his ruling operated to preclude coverage for the claims of claimants where were in no way themselves involved with or responsible for the late provision of notice. ‘

 

In any event, Judge Carney’s rulings present an interesting case study. Special thanks to a loyal reader for providing me with copies of Judge Carney’s rulings.

 

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Bankruptcy cases filed in the U.S. federal courts continued to surge in the twelve months ended September 30, 2009, according to statistics released on November 25, 2009 by the Administrative Office of the U.S. Courts. The statistical release, which can be found here, shows that for year ending on September 30, 2009, there were 58,771 business bankruptcy filings, up 52 percent from the 38,651 business filings in the 12-month period ending September 30, 2008.

 

Data accompanying the release show that the number of filings has increased in the 12-month periods preceding the quarter end for each quarter since the end of the third quarter of 2006.

 

Though the twelve-month data show a rising number of bankruptcy filings, the quarterly data for the most recent quarter show a slightly different picture, suggesting that the number of bankruptcy filings may have peaked earlier this year, and that during the most recent months the number of business-related bankruptcy filings may even have begun to decline slightly, at least from their 2009 year-to-date highs.

 

Thus, according to the Administrative Office’s monthly filing data (which can be found here), there were 15,177 business-related bankruptcies in the third quarter of 2009, compared to 16,098 during 2Q08, which represents a third quarter filing decline of about 5.7%. The highest monthly total during 2009 was in April 2009, when there were 5,621 business-related bankruptcy filings, compared to 4,853 in September 2009.

 

But while the 3Q09 business filings were down slightly from the preceding quarter, the third quarter filings nonetheless remained at very high levels. Thus, by way of comparison, the third quarter business bankruptcy filing total of 15,177 filings is considerably higher than the quarterly totals in 4Q08, when there were 13,021 filings, and in 1Q04, when there were 14,425 filings.

 

Whether or not bankruptcy filing peaked earlier this year, the number of bankruptcy filings remains significant. The possibility of bankruptcy remains a significant threat for financially troubled businesses. As I have previously noted (here), among the events that often follows after the filing of a bankruptcy petition is the arrival of claims against the bankrupt firm’s directors and officers.

 

Bankruptcy associated-claims present a host of complications, not least of which is the intricate way that D&O insurance policies respond in the bankruptcy context. One recent development illustrating the difficulties that can arise in the bankruptcy context was the July 2009 decision in the Visitalk case (about which refer here), in which the Ninth Circuit upheld the carriers’ denial of coverage for a lawsuit brought by a company as debtor in possession against former directors and officers of the company, as a result of the policies’ insured vs. insured exclusion.

 

These kinds of complications underscore the need for D&O insurance policies to be closely scrutinized for their ability both to withstand and to respond to claims arising in the context of bankruptcy.

 

Hat tip to the SOX First blog (here) for the link to the bankruptcy statistics.

 

More About FCPA Enforcement and Pharmaceutical Companies: As I recently noted (here, scroll down), both the DoJ and the SEC have indicated that Foreign Corrupt Practices Act enforcement has a high priority and that FCPA enforcement in the pharmaceutical industry is a particular focus.

 

A November 24, 2009 memo from the Latham & Watkins law firm entitled "U.S. Department of Justice Announces Stepped-Up Criminal Enforcement of Foreign Corrupt Practices Act Against Pharmaceutical Industry" (here) takes a closer look at these prosecutorial priorities.

 

The memorandum explains that among other reasons for the new focus on pharmaceutical companies is that "many foreign health systems, are regulated, operated and financed by government entities, and competition is intense, which creates more opportunities to ‘pay off foreign officials for the sake of profit.’" Of particular concern is the fact that it may not always be obvious which medical functionaries are "foreign officials" within the meaning of the FCPA.

 

The article includes a variety of suggested practical steps that pharmaceutical companies can take in light of these concerns.

 

Special thanks to Adam Savett of the Securities Litigation Watch for providing a copy of the law firm memo.

 

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As the dramatic events in the financial marketplace during fall 2008 recede further into the past, the wave of related litigation activity has also clearly started to slow. But a newly filed lawsuit arising directly from the financial crisis suggests that there may still be further credit crisis cases yet to come, particularly as plaintiffs’ lawyers continue to initiate class action litigation with proposed class period cut-off dates well in the past.

 

As reflected in their November 10, 2009 press release (here), plaintiffs’ lawyers have launched a securities class action lawsuit in the Southern District of New York against certain former officers VeraSun Energy Corp., a of South Dakota-based ethanol producer that filed for bankruptcy on October 31, 2008.

 

According to the press release, the complaint (a copy of which can be found here) alleges that the defendants failed to disclose that:

 

(i) VeraSun was, in part, a speculative commodities trader in addition to an ethanol producer; (ii) VeraSun engaged in speculative and risky derivate transactions that exposed the Company to substantial financial and liquidity risk; (iii) VeraSun experienced substantial loses on speculative derivative transactions causing margin pressures on the Company; (iv) as a result of margin pressures from bad speculative derivative transactions, the Company sold out of a large short position in corn and incurred substantial losses; (v) the Company entered into highly risky "accumulator" contracts that obligated VeraSun to purchase increasing amounts of corn after the price of corn fell in price per bushel; and (vi) VeraSun’s financial condition and especially its liquidity were negatively impacted as a result of speculative commodity transactions, ultimately causing the Company to file for bankruptcy.

 

The complaint further alleges  that:

 

On September 16, 2008, VeraSun announced that it commenced a public offering of 20 million shares of its common stock to raise money for "general corporate purposes." The true purpose of this public offering was to raise capital in an effort to prevent a disastrous impact from the huge losses experienced by the Company as a result of its speculative trading and risky bets on the price of corn.

 

Not only are these events all well over one year ago, but the proposed class period also covers a segment of time that is also well past -- the complaint purports to be filed on behalf of a class of persons who purchased VeraSun shares between March 12, 2008 and September 16, 2008.

 

The complaint’s allegations resemble the facts and circumstances alleged in a number of credit crisis-related cases that were filed last fall, where (as described here) the defendant companies were alleged to have suffered significant financial reverses due to wrong way bets on commodities or currencies, often (as was the case with VeraSun) in connection with hedging transactions. In each case, the sudden and dramatic events in the financial markets during September and October 2008 produced a magnified impact on financial condition of these companies.

 

The prior lawsuits generally were filed closer in time to the events involved, while the VeraSun case has only just been filed. The lapse in time between the events alleged and the VeraSun lawsuit filing is, however, consistent with the filing pattern that has emerged during 2009, where (as noted here) numerous newly filed complaints have proposed class period cutoff dates that fall well before the filing date.

 

I have previously speculated that these seemingly belated filings may perhaps reflect a filing backlog that developed as plaintiffs’ lawyers were caught up in the rush of credit crisis related lawsuits and Madoff related litigation. The VeraSun case filing suggests that this apparent backlog may even include yet to be filed credit crisis-related lawsuits, which in turn suggests that there there may be more credit crisis suits yet to come.

 

The VeraSun case is also the latest example of a securities class action lawsuit arising in the wake of a corporate bankruptcy. The surging numbers of business-related bankruptcies may further contribute to the further instigation of securities class action litigation. The possibility of these kinds of cases arising, like the VeraSun case, well after the bankruptcy date suggests these cases could continue to arrive for some time to come.

 

All of which suggests to me that, even of the pace of new credit crisis-related securities lawsuit filings have declined, the litigation fallout from the global financial crisis is likely to continue to accumulate in the months ahead.

 

I have in any event added the VeraSun case to my list of credit crisis related cases, which can be accessed here.

 

Another Options Backdating-Related Securities Suit Settlement: Another one of the remaining options backdating-related securities lawsuits has settled. As reflected in their October 15, 2009 stipulation of settlement (here), the parties to the Sonic Solutions options backdating-related securities suit have agreed to settle the case for $5 million.

 

A complete list of the options backdating-related lawsuit resolutions can be accessed here.

 

Adam Savett of the Securities Litigation Watch blog has been tracking (here) the options backdating related settlements.Adjusting his data to take account of the Sonic settlement would mean that 30 of the 39 options backdating-related securities class action lawsuits have now been resolved, with nine of these cases having been dismissed and twenty-one of them having been settled. Prior to the Sonic settlement, the average settlement amount was $77.8 million – or $33.23 million if the outsized UnitedHealth settlement is disregarded.

 

UPDATE: The Securities Litigation Watch has updated its options backdating settlement tally and analysis to reflect the Sonic settlement, here.

 

My Dinner with Bill: I am in Chicago this week at the PLUS International Conference, where the keynote speaker was none other than Bill Clinton. Let me just say that he though he is now "only" a former President, he retains all of his rhetorical powers. His speech was entertaining, thought-provoking, funny and serious, and impressive.

　

During the Q&A, one of the questions he was asked is a rather conventional parlor game question: if you could have dinner with any historical figure, who would you choose and why? Perhaps because it was a conventional question, he gave a rather conventional, almost undergraduate-approval-seeking type answer. And being a politician, he couldn’t name just one person – he named three: Socrates, Jesus, and Genghis Kahn. Clinton had his reason for each of the three.

 

I will grant you that Genghis Kahn is an interesting answer, but the other two are safe, predictable and, well, kind of boring. I will stipulate that everyone if they had a chance would want to meet Jesus. Socrates is pretty much in the same category. (Same with Gandhi and Winston Churchill) So if we all agree that Jesus and Socrates (and Gandhi and Churchill) are not available, which historical figure would you want to have dinner with?

 

Because Clinton gave himself three choices, I am going to give myself three as well.

 

First, I would choose Charles Maurice de Talleyrand-Perigord, also known as the Bishop of Autun. Talleyrand lived through some of the most interesting events in all of human history and somehow not only managed to be involved in them all, but what is perhaps a more impressive feat, to have survived them all. He was involved in the French revolution from the start and even acted as foreign minister to the revolutionary government. He later managed to become a key advisor to Napoleon, until they fell out over policy. Ultimately, he became one of the key players in the Bourbon restoration. Though often reviled as unprincipled and cynical, I believe he may have been one of the most interesting people in the grand march of history, and he certainly led one of the most interesting lives.

 

Second, I would choose Moshe ben Maimon, now known as Maimonides, the Jewish theologian, physician and philosopher. He also lived at an incredibly interesting time, having been born in Islamic Spain in the twelfth century and then fled persecution through Northern Africa. His wisdom, scholarship and knowledge of languages have shaped European thought up until this very day. He was among the first Europeans both to appreciate and advocate Aristotle. His rationalist philosophy would still appeal to most moderns, which to me is a reflection of what an original and powerful thinker he was.

 

Having chosen two historical figures, I feel I should be a little bolder and unconventional with my last choice. So my third selection is John Lennon. He was a radical advocate for peace whose art and originality touched the lives of millions.

 

A dinner with all three of these persons simultaneously would be chaos. But a dinner with any one of them (language and cultural issues aside) would be fascinating.

 

So, now you have Bill Clinton’s choices and my choices. Who would you choose? And why? If you are attending the conference and you have views on this question, I hope you will stop me and let me know your thoughts. And if you are not at the conference, I hope you will use the comment function on this blog to let me and other readers know what you think.

 

The one final thought I have to add is that , after having heard Bill Clinton speak today, honestly, I think a dinner with him would be pretty damn interesting, too.  I suspect we could talk about Talleyrand and Maimonides and even John Lennon or Genghis Kahn and it would be memorable and entertaining.

 

UPDATE: My friend and former colleague Marty Hacala provided the following e-mail answer to my dinner guest question: 

 

I agree that Clinton's answer was boring and conventional. We are after all talking about a dinner party and not a lecture. Who wants to listen to a failed carpenter and a suicidal Greek talk about the hereafter while picking at their food? Genghis Khan is an interesting choice if only because he might tire of the conversation and dispatch the first two before dinner has even begun.

 

My invitations would go to Oscar Wilde, Abraham Lincoln and Groucho Marx. (I could substitute Churchill for Lincoln, but I fear the alcohol wouldn't last and so the meal would end on an unhappy note.) Just imagine the stories they would tell? I see myself sitting there mesmerized listening to Wilde and Marx trade high and low-brow barbs, while Lincoln tells long stories of how they remind him of mostly made up characters from his youth. It would be an evening to remember. 　

 

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The onslaught of bank closures continues. The FDIC’s closure of five more banks this past Friday night brings the 2009 YTD total number of bank failures to 120 – including twenty-one in just the last three weeks alone. There are a variety of reasons for the growing number of bank failures, but clearly one important reason is the continuing deterioration of commercial real estate loans.

 

As I noted in a prior post (here), there may be further bank failures ahead as commercial real estate mortgages come due or default. A November 5, 2009 BusinessWeek article entitled "The Commercial Loan Nightmare Facing U.S. Banks" (here) suggests that banks’ commercial real estate loan problems may be worse even than may be currently apparent.

 

According to the article, "many banks have been forestalling the day of reckoning" by using an approach the article described as "extend and pretend," which consists of allowing "temporary extensions to trouble borrowers on maturing commercial loans to give them, and the bank, some breathing room."

 

The problem for the banks is that "surging delinquencies and defaults will eventually catch up with them." Many banks are currently showing no charge-offs, but as much as $500 billion in commercial real estate loans will mature within in coming months, while commercial real estate values have declined as much as 40 percent since the beginning of 2007. As these issues catch up with the banks, according to the article, more banks could fail.

 

The article includes a list of the 30 publicly traded banks that may have the most exposure to commercial real estate. The 30 banks have more than 50 percent of their loan portfolios in commercial real estate loans. To be sure, the banks’ heavy concentration in real estate loans is not the same as being burdened with bad loans, but it does mean that the listed banks "have more exposure to the commercial real estate sector."

 

Among the bank closed this past Friday night was the California-based United Commercial Bank, as reflected in this November 6, 2009 FDIC Press Release (here). The bank's parent holding company, UCBH, and certain of its directors and officers, were already the subject of a securities class action lawsuit, as I discussed in a prior post, here. The UCBH lawsuit and the failure of the bank operating company may represent examples of the ways in which the growing numbers of troubled banks could lead to an increased amount of litigation arising from the banks' woes.

 

Another Subprime Securities Suit Dismissal: In an October 6, 2009 order (here), District of Massachusetts Judge Nathaniel Gorton granted the defendants’ motion to dismiss the complaint that had been filed against the commercial construction firm, Perini Corporation and certain of its directors and officers. Judge Gorton’s dismissal ruling granted the plaintiffs leave to amend, but he warned that if the amended complaint is deficient, "dismissal will be with prejudice."

 

As reflected here, the plaintiffs had alleged that Perini had failed to disclose that the developer on a major Las Vegas construction project was experiencing financial difficulties, including difficulties in obtaining project financing for the Las Vegas project. The complaint further alleged that as a result of these difficulties the Las Vegas project faced possible delays and that the developer faced a risk of default. The complaint further alleged that the Las Vegas project represented as much as 20% of the Perini company’s construction backlog and that as a result of the difficulties the company’s ability to maintain its profit margins was in doubt.

 

As Judge Gorton later summarized, the "crux" of the plaintiffs’ complaint is that the company knew about the developer’s financial troubles, "which rendered statement that, in essence, all was well at Perini, false and misleading."

 

In his October 6 ruling, Judge Gorton found that the plaintiffs had failed to adequately allege scienter. He said that even assuming the defendants were aware of the developer’s financial difficulties "the complaint fails to attribute the requisite high level of culpability to them. To the contrary, the complaint sets forth facts showing that the defendants were actively and ultimately successfully, working to ensure that any difficulties of [the developer] did not impact Perini."

 

The court found that the non-fraudulent inferences from the defendants’ conduct and statements to be "more compelling that any inferences of culpable scienter." Moreover, Judge Gorton found further that the plaintiffs had failed to "plead adequately that the defendants were even ‘aware of’ [the developer’s] financing difficulties in the first instance."

 

Finally, Judge Gorton found that even if the plaintiffs had adequately alleged scienter, the allegedly fraudulent statements do not provide a basis of liability. He found that most of the statements came within the safe harbor for forward looking statements and that the few remaining statements that were not forward looking were not otherwise actionable

 

I have added the Perini decision to my running tally of subprime and credit crisis-related dismissal motion resolutions. The tally can be accessed here.

 

Special thanks to Adam Savett of the Securities Litigation Watch (here) for providing copies of the Perini ruling.

 

Another FCPA-Related Civil Lawsuit Settlement: Regular readers know I have written frequently about civil litigation that can follow in the wake of Foreign Corrupt Practices Act (FCPA) investigations and enforcement actions. (Refer for example here.) In the latest resolution of this kind of follow on civil action, on November 6, 2009, Nature’s Sunshine Products announced (here) that the court had preliminarily approved the settlement of the lawsuit in which the company had agreed to pay $6 million.

 

As reflected here, the plaintiffs in the securities lawsuit had alleged in connection with the improper payments that the company lacked appropriate internal controls and that the company’s books and records did not reflect the foreign transactions. As noted here, the court had denied the defendants’ motions to dismiss.

 

The company’s FCPA-related problems received additional attention earlier this year when (as noted here), the SEC brought control person liability charges against the company’s CEO and CFO, even though the individuals were not alleged to have had any involvement in or even awareness of the company’s allegedly improper payments.

 

The company’s $6 million securities class action settlement is just the latest in a line of settlements in securities cases following in the wake of FCPA-related investigations and enforcement actions. My prior overview of FCPA-related follow-on civil litigation can be found here.

 

The Financial Crisis and D&O Insurance: A wide variety of litigation has arisen out of the global financial crisis, much of which has implicated the D&O insurance of the defendant companies. The involvement of the companies’ D&O coverage in turn has underscored the importance of the applicable policies’ coverage and in particular the sufficiency of the policies’ terms and conditions.

 

A recent memo entitled "Directors’ and Officers’ Coverage Priorities in the Financial Crisis: A Seven-Point Inspection for Your D&O Policy" (here) by Ernest Martin Jr. and Micah Skidmore of the Haynes and Boone law firm presents a comprehensive overview of the critical D&O insurance issues arising from the current financial crisis. The article is thorough and timely.

 

Apologies: Due to a massive spambot attack directed at the "Comment" function of blog sites hosted by the LexBlog network (on which The D&O Diary is hosted), there have been a variety of service and performance disruptions on this site over the last several days. Among other things, the comment function has been disabled and the email notification system was interrupted. I have also had intermittent difficulties just adding new content.

 

I apologize to readers for any difficulties you may have had accessing this site, posting comments, or receiving email notifications. I am hopeful that the problems are now or will soon be completely resolved.

 

My special thanks to everyone at LexBlog for the courteous and attentive service while managing this crisis.

 

This Week: The D&O Diary’s publication schedule during the week of November 9 will be disrupted because I will be in Chicago for the annual PLUS International Conference. I know many readers will also be there and I hope readers who see me there will be sure to say hello and, if we have not met before, to introduce themselves. I look forward to seeing everyone in Chicago.

 

Upcoming Conference: On November 30-December 1, 2009, I will be co-Chairing the American Conference Institute’s Fifteenth Annual Advanced Forum on D&O Liability in New York. This event will include presentations from the leading figures in the D&O insurance field, and the program will address the most critical issues facing the D&O insurance industry today. The program agenda, including registration information, can be found here.

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As a result of a November 2, 2009 ruling (here) by Northern District of California Judge Susan Illston, the PMI Group securities class action lawsuit is the latest subprime-related securities suit to survive a renewed motion to dismiss following plaintiffs’ filing of an amended complaint after the motion to dismiss their initial complaint had been granted. As was the case with respect to the recent ruling in the Washington Mutual subprime-related securities class action lawsuit (about which refer here), the PMI Group lawsuit plaintiffs overcame the shortcomings of their initial pleading with an amended complaint reliant upon added confidential witness allegations.

 

Background

The PMI Group, a residential mortgage insurer that also owns a controlling interest in bond insurer Financial Guaranty Insurance Corporation, as well as certain of PMI’s directors and officers, were first sued in a securities class action lawsuit in March 2008 (about which refer here). As discussed here, on July 1, 2009, Judge Illston granted in part and denied in part the defendants’ motion to dismiss the plaintiffs’ consolidated complaint.

 

In her July 1 order, Judge Illston held that the plaintiffs had adequately alleged material misrepresentation and loss causation, but she granted the motion with leave to amend on the grounds that the consolidated complaint did not adequately allege scienter. Among other things, Judge Illston observed that the complaint "falls short of showing that the defendants were aware that the statements were false and misleading when made."

 

On July 24, 2009, the plaintiffs filed their first amended complaint and the defendants renewed their dismissal motions.

 

November 2 Ruling

In her November 2 decision, Judge Illston denied the renewed dismissal motion. She noted that the plaintiffs’ amended complaint "differs from the original complaint in a number of ways." Among other things, she noted that the plaintiffs had "supplemented their allegations regarding previous confidential witnesses and added three new confidential witnesses." The plaintiffs also added additional allegations regarding admissions the defendants had allegedly made, as well as allegations PMI itself had made in a lawsuit against a third party, among other things.

 

Based on these amended allegations, Judge Illston found that the plaintiffs had "cured the deficiencies" in the prior complaint and that the amended complaint "sufficiently alleges a strong inference of scienter." Among other things, Judge Illston referenced the amended complaints’ allegation, through the confidential witnesses, of the defendants’ awareness of the alleged problems in PMI’s credit risk assessments, as well as rising defaults.

 

Discussion

Judge Illston’s denial of the renewed motion to dismiss in the PMI Group case follows the October 27, 2009 ruling in the Washington Mutual subprime-related securities suit in which the renewed motion to dismiss following an initial dismissal similarly was granted. In both cases, the plaintiffs’ amended complaint overcame the pleading shortcoming found in their initial complaint.

 

If nothing else, these cases demonstrate that it is possible for plaintiffs to overcome an initial dismissal. Though not all plaintiffs will be able to muster sufficient confidential witness testimony and other allegations to cure the initial pleading shortcomings, these rulings at least show that plaintiffs who are able to muster enough can overcome the initial pleading hurdles and survive the motion to dismiss, even if the initial motions were granted.

 

And though two case decisions alone may represent far too little data from which to generalize, the success of these plaintiffs on renewed dismissal motions following pleading amendments does suggest that it might have been mature for some commentators (including me perhaps) to suggest that plaintiffs are not faring well in the subprime-related securities class action lawsuits.

 

Even though a number of dismissal motions have been granted in these cases, many of the motions were granted without prejudice. The recent rulings in the PMI Group and WaMu subprime-related securities suits suggest that a certain number of these initially dismissed cases may well survive renewed motions, and so the scoreboard could look different, perhaps quite a bit different, when all the initial pleading processes in these cases have fully played out.

 

I have in any event added the November 2 ruling to my register of dismissal motion rulings in the subprime-related lawsuits. The register can be accessed here.

 

It is probably worth noting that another significant corporate investor in the Financial Guaranty Insurance Corporation, The Blackstone Group, has also been sued in a subprime-related class action lawsuit in connection with the company’s write-down of its investment in bond insurer, about which refer here.

 

Another Subprime Lawsuit Settlement: It appears that I may have missed an earlier settlement of a subprime-related securities class action lawsuit. As reflected here, on September 2, 2009, the parties to the Hovnanian Enterprises subprime-related securities suit entered an agreement to settle the case for $4 million. I have added this settlement to my list of subprime-related lawsuit case resolutions, here.

 

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In a detailed October 27, 2009 opinion (here), Western District of Washington Judge Marsha J. Pechman substantially denied the defendants’ motions to dismiss the plaintiffs’ amended complaint in the Washington Mutual subprime securities class action lawsuit. Judge Pechman’s ruling is noteworthy in and of itself, but perhaps even more because Judge Pechman had previously granted the defendants motions’ to dismiss all of the plaintiffs’ ’34 Act claims and all but one of defendants’ ’33 Act claims.

 

As discussed here, in granting the prior motions to dismiss, Judge Pechman had been sharply critical of the clarity and organization of the plaintiffs’ initial consolidated amended complaint, which she characterized as "verbose and disorganized." and as embodying "puzzle pleading."

 

By contrast, in her October 27 ruling, Judge Pechman stated that the second amended complaint (hereafter, the "complaint") presents "cogent and concise allegations against Defendants." She also stated that the Plaintiffs have "largely succeeded in remedying the deficiencies of their initial complaint."

 

As described in the October 27 opinion, the complaint alleges that the defendants "(1) deliberately and secretly decreased the efficacy of WaMu’s risk management policies; (2) corrupted WaMu’s appraisal process; (3) abandoned appropriate underwriting standards; and (4) misrepresented both WaMus’ financial results and internal controls."

 

The complaint’s ’34 Act claims assert claims for securities fraud against the seven officer defendants, although the complaint also alleges Section 20 control person liability against the outside director defendants as well as the officer defendants.

 

With respect to the plaintiffs’ ’33 Act claims, the complaint alleges different specific allegedly misleading statement as to each of the individual officer defendants. The defendants moved to dismiss these allegations on the grounds that the complaint does not sufficiently allege that the statements are false and misleading and failed to allege "particularized facts giving rise to a strong inference of scienter."

 

In reviewing the adequacy of the plaintiffs’ allegations, Judge Pechman reviewed each of the alleged misstatements with respect to each of the individual officer defendants, grouping the allegedly false statements in four categories "(1) risk management; (2) appraisals; (3) underwriting; and (4) internal controls."

 

Other than with respect to two statement of WaMu’s former CEO, Kerry Killinger, which Judge Pechman found to "lack sufficient clarity to state a claim," Judge Pechman found that the plaintiffs’ ’34 Act claims were sufficiently pleaded, and therefore (other than with respect to two of the CEO’s statements), the motion to dismiss the ’34 Act claims was denied. Judge Pechman also denied the motion to dismiss the Section 20 control person liability claims against the individual officer defendants and the outside director defendants.

 

In denying the motion to dismiss, Judge Pechman referred repeatedly to the allegations drawn from internal memoranda and on testimony from confidential witnesses. With respect to the plaintiffs’ scienter allegations, Judge Pechman found with respect to each of the statements (other than the two statements of the CEO that were dismissed) that the "defendants have not raised a competing inference of innocence that outweighs the strong inference of scienter."

 

In her prior ruling in the case, Judge Pechman had granted the defendants’ motions to dismiss the ’33 Act claims, finding that the plaintiffs at that time did not have standing to assert ’33 Act claims in connection with WaMu’s August 2006, September 2006 and December 2007 securities offerings. The most recent amended complaint purports to add several additional plaintiffs, in an effort to establish standing to assert ’33 Act claims as to the August 2006, September 2006 and December 2007 offerings.

 

Judge Pechman found none of the new plaintiffs had standing to assert claims as to the August 2006 offering of 5.50% Notes. Judge Pechman also found that the plaintiffs’ lacked standing to assert Section 12(a)(2) claims as to both 2006 offerings. She otherwise found that the plaintiffs had standing to assert ’33 Act claims as to the other offerings. She also found that the complaint’s allegations met the ’33 Act’s substantive pleading requirements.

 

In short, virtually all of the plaintiffs’ most recent amended complaint survived the renewed dismissal motions. This is a fairly dramatic turnaround from the outcome of the initial motions, in which the initial dismissal motions were substantially granted, other than with respect to the ’33 Act claims in connection with the August 2007 offering. The turnaround is all the more noteworthy given how critical Judge Pechman was of the plaintiffs’ initial complaint. It is a very long way from Judge Pechman’s assessment that the prior complaint was "verbose and disjointed" to her assessment that the most recent complaint is "cogent and concise."

 

But the difference in outcomes is not attributable solely to the improved organization of the amended complaint. It is also clear that the added allegations, particularly those drawing on confidential witness testimony, were instrumental in bringing about the different outcome.

 

This turn of events could be significant in connection with the many other pending subprime and credit crisis related securities class action lawsuits, particularly those in which initial motions to dismiss have been granted with leave to amend. If nothing else, Judge Pechman’s October 27 opinion shows that plaintiffs can successfully amend their complaints in order to remedy initial pleading deficiencies. This possibility underscores the fact that initial dismissals without prejudice are indeed provisional, and no one should assume that a case in which initial motions have been granted is done – the plaintiffs in those cases, like the plaintiffs in the WaMu case, may yet succeed in overcoming the initial pleading hurdles.

 

A couple of aspects of the way in which the WaMu plaintiffs overcame the initial pleading hurdles are instructive for other plaintiffs in subprime and credit crisis-related securities lawsuits. Clearly, Judge Pechman preferred the more organized presentation of the amended complaint to the "puzzle pleading" presented in the prior complaint. Clarity and brevity are indeed virtues, in pleading cases as in all other endeavors, which is a consideration other plaintiffs might well want to heed.

 

Another clear implication from Judge Pechman’s October 27 order is the value of allegations based on the testimony of well-placed confidential witnesses. This lesson was also apparent from the recent ruling on the renewed motion to dismiss in the Dynex Capital case (about which refer here). While not every plaintiff will be similarly able to present allegations based on the testimony of well-place confidential witnesses, that clearly is one way to overcome the steep pleading hurdles that plaintiffs face at the outset of these cases. And, as I noted in connection with the Dynex Capital ruling, even the rigorous requirements for pleading scienter under the Tellabs case can be overcome with the right kind and quantum of confidential witness testimony.

 

But perhaps the greatest significance of the ruling on the renewed motions to dismiss is that the motions were denied in a high profile case like the WaMu suit. As I have noted elsewhere on this blog, the defendants generally have seemed to be doing better on the motions to dismiss in the subprime and credit crisis cases. However, the WaMu ruling adds a significant counterweight to the plaintiffs’ side of the ledger, along with the dismissal denials in the Countrywide (refer here) and New Century Financial subprime suit (refer here). The WaMu ruling may be even more significant, given that the dismissal motion had previously been substantially granted.

 

One final note about the October 27 order in the WaMu case is that the motion was denied as to all defendants, including the offering underwriters and WaMu’s auditors, Deloitte. The fact that the gatekeepers have been kept in the case is significant if for no other reason that its suggestion that gatekeepers generally will continue to be a part of the subprime and credit crisis-related litigation, which could have important implications for how these cases are resolved, as well as what the aggregate costs of these cases might eventually be.

 

In any event, I have added the October 27 ruling in the WaMu case to my running tally of the dismissal motion rulings in the subprime cases, which can be accessed here.

 

Special thanks to a loyal reader for providing me with a copy of the October 27 opinion. I get my best material from readers and I am always grateful when readers take the time to send things along to me.

 

Andrew Longstreth’s October 28, 2009 article on AmLaw Daily about the WaMu decision can be found here.

 

Another Belated Securities Suit Filing: In several prior posts (most recently here), I have noted the recurring phenomenon during 2009 of new securities class action lawsuit filings in which the proposed class period cutoff is well in the past, in some cases nearly two years before the filing.

 

The securities class action lawsuit filed on October 28, 2009 against Pitney Bowes and certain of its offices pushes this belated filing phenomenon to its furthest edge of its theoretical possibilities. As reflected in the plaintiffs’ counsel’s October 28 press release (here) , the proposed class period in the case runs from July 30, 2007 to October 29, 2007. In other words, the plaintiffs filed their complaint on what appears to be the last day before the two-year statute of limitations would have expired. A copy of the complaint in the case can be found here.

 

The Pitney Bowes case is merely the latest (and arguably most extreme) example of this phenomenon. I have long speculated that this rash of seemingly belatedly filed lawsuits may be attributable to a backlog of case filings that built up over prior periods in which plaintiffs lawyers were concentrating on filing subprime and credit crisis related lawsuits as well as lawsuits related to the Madoff scandal. Now that the new filings in those other areas are dying down, the plaintiffs’ lawyers may be getting around to working off the backlog.

 

The Pitney Bowes case, as is the case with many of these other seemingly belated cases that have been filed during the latter half of 2009, was filed against a company outside the financial sector. This feature of the phenomenon seems to suggest that as the plaintiffs’ counsel work off what seems to be a backlog of cases, the mix of companies sued will shift back toward the more usual spread of kinds of companies, and away from the concentration in the financial sector that characterized filings during the period from mid-2007 through the first part of 2009.

 

The one thing about these belated filings is that it does create a challenge in trying to determine when a company is "out of the woods" with respect to any adverse developments the company might have had.

 

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On October 19, 2009, in a securities case from an earlier era involved allegedly misleading statements regarding asset-backed securities, Southern District of New York Judge Harold Baer substantially denied the defendants’ motions to dismiss the plaintiffs’ complaint as amended, following the long-running case’s trip through the Second Circuit on interlocutory appeal. A copy of the October 19 opinion can be found here.

 

Judge Baer’s decision in the Dynex Capital securities case is noteworthy not only because of the previous high profile appellate decision in the case, but also because Judge Baer found plaintiffs’ amended allegations sufficient to survive the renewed motion to dismiss, after prior pleadings had failed in whole or in part to withstand scrutiny.

 

Though the case is from a slightly earlier era (it was initially filed in 2005), it raises many allegations similar to those involved in the current round of subprime and credit crisis-related securities lawsuits, and therefore could be influential with respect to dismissal motions in the more recent cases.

 

Background

Dynex was in the business of packaging mortgage loans into securities. Between 1996 and 1999, Dynex originated or purchased 13,000 mobile home loans that served as collateral for bonds that a unit of the company issued. The underlying loans performed poorly and in 2003-04 the bonds were downgraded by the rating agencies. The bonds’ value dropped by as much as 85%.

 

The plaintiffs filed a securities class action lawsuit on behalf of investors who had purchased the bonds between February 7, 2000 and May 13, 2004. The plaintiffs allege that the defendants artificially inflated the bonds’ price by misrepresenting that the poor performance of the bond collateral was due to market conditions, concealing that the defendants’ "aggressive and reckless loan underwriting and origination practices generated a pool of collateral loans of poor credit quality and inherent defects."

 

In a February 2006 opinion (here), Judge Baer granted the defendants’ motion to dismiss the complaint as to the individual defendants for failure to adequately allege scienter, but he denied the motion as to the corporate defendants. In June 2006 he certified his opinion for interlocutory appeal on the question "whether scienter could be adequately alleged against a corporation without concomitant allegations that an employee or officer acted with the requisite scienter."

 

In 2008, the Second Circuit held (here) that corporate scienter may be sustained even "in the absence of successfully pleading scienter as to an expressly named officer." However, the Second Circuit held that the plaintiffs had not met the standard for corporate scienter, vacated Judge Baer’s prior ruling and remanded the case to allow the plaintiffs an opportunity to replead.

 

The plaintiff filed a second amended complaint (hereafter, the amended complaint) and the defendants’ renewed their motion to dismiss.

 

The October 19 Opinion

In their newly amended complaint, the plaintiffs added the statements of nine confidential witnesses and also identified and described for the first time four categories of reports that the plaintiffs alleged put the defendants on notice that their public statements were materially misleading.

 

Based on the confidential witnesses’ statements, which bolstered the plaintiffs’ allegations about how the defendants accessed and used the identified categories of reports, Judge Baer found that the plaintiffs had sufficiently alleged that several categories of the statements on which plaintiffs sought to rely were misleading and false. These categories included defendants’ statements regarding the adherence to underwriting standards; the defendants’ statements about the reasons for the deterioration in the collateral performance; and the defendants’ statements about the adequacy of the company’s loan loss reserves and internal controls.

 

More significantly in light of the case’s prior procedural history, Judge Baer found that the plaintiffs had adequately pled scienter. Judge Baer found that the plaintiffs’ allegations about the information available to defendants in the newly referenced documents represented strong circumstantial evidence of scienter. Judge Baer found that the amended complaint, by contrast to the plaintiffs’ prior complaint, "contains factual allegations about several forms of reports that collectively provided to Dynex’s senior management, including the Individual Defendants, information that contradicted their misleading statements."

 

The information in the documents was "available to and reviewed by the senior management responsible for the public statements at issue that either put them on notice of the falsity of these statements or clearly should have done so." Judge Baer found that the inference of scienter from these allegations was as least as compelling as the contrary inference that the defendants sought to draw.

 

Judge Baer found that when the amended complaint is viewed "holistically," a "cogent story of securities fraud is revealed":

 

The Defendants originated or purchased a large number of mobile home loans of generally low credit quality, a substantial number of which were "inherently defective," and packaged them into the Bonds failing to disclose that the stated underwriting guidelines were "systematically disregarded"; then, when adverse market conditions coincided with rising defaults and many loans were uncollectible as a consequence of inherent defects, Defendants publicly stated that market conditions were to blame in an attempt to forestall deeper drops in the value of the Bonds, many of which they held for their own account.

 

Accordingly, Judge Baer held that the amended complaint "alleges facts giving rise to a strong inference" that the statements he "found to be false and misleading were made with scienter."

 

Discussion

The Dynex Capital case arose in February 2005, two years before the current round of subprime and credit crisis litigation began, but the plaintiffs’ allegations are remarkably similar to many of the allegations raised in the more recent lawsuits. The fact that the amended complaint largely survived the most recent motions to dismiss is all the more significant given the plaintiffs’ early difficulties in the district and appellate courts in trying to get over the initial pleading hurdles.

 

The fact that the plaintiffs in the Dynex Capital case were ultimately able to overcome the initial pleading hurdles will obviously be of particular interest to the plaintiffs in the more recent cases. The plaintiffs were able to survive the renewed dismissal motion in this case because of the large number of well-placed confidential witnesses who were able to provide detailed descriptions of the company’s processes and of the key documents and their availability to senior management, as well as how the information in the documents allegedly contrasted with the defendants’ public statements.

 

Obviously not all plaintiffs in other cases will be able to muster the same number or caliber of confidential witnesses or success in being able to utilize confidential witnesses to show with such particularity what information was available to senior management and how the available information contrasted with public statements.

 

But the fact that the plaintiffs in this case were able to put those elements together, and were able to do so in a way sufficient to overcome the court’s original skepticism shows that plaintiffs in general can put together allegations to surmount even the heightened scienter pleading standards of the Tellabs case. The fact that these plaintiffs were able to do so after the initial pleading challenges also suggests that in other cases in which plaintiffs initial complaints failed to survive, the pleading defects still may be overcome with sufficiently particularized amended pleading, even on the critical issue of scienter.

 

In any event, because of the similarity of the allegations on this case to the allegations in many of the current cases, Judge Baer’s recent decision in the Dynex Capital case is likely to be important in the current cases similarly involving asset-backed securities allegedly misleading disclosures about underwriting standards, collateral quality, internal controls and adequacy of loan loss reserves.

 

Special thanks to Adam Savett of the Securities Litigation Watch blog for providing a copy of Judge Baer’s October 19 opinion.

 

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The worst of the global financial crisis may be past, and we may even be well on the road to economic recovery, but there still may be considerable pain yet to come, particularly in connection with commercial mortgages. Increased vacancies, declining property values and shortages of refinancing capital could mean increasing numbers of commercial mortgage defaults ahead.

 

These problems could spell trouble for banks holding commercial mortgage loans, as well as for those who invested in securities backed by commercial mortgages (CMBS). These problems likely will lead to commercial mortgage-related litigation, in what may be the final surge in the credit crisis-related litigation wave.

 

Background

The business pages recently have been full of tales of commercial mortgage defaults. For example, an October 6, 2009, Bloomberg article (here) reported that hotel foreclosures in California tripled in the first half of this year. An October 13, 2009 Wall Street Journal article (here) reports that declining hotel room demand in Hawaii "means a number of Hawaii’s resorts no longer generate enough revenue to pay the mortgage" and overall Hawaii’s distressed debt tied to hotels totals nearly $1.6 billion.

 

Similarly an October 15, 2009 Wall Street Journal article (here) detailed the danger of default on the massive mortgage debt of the Peter Cooper Village and Stuyvesant Town properties, which the article noted could "signal[] the beginning of what is expected to be a wave of commercial property failures." The lead article on the front page of the October 16, 2009 Cleveland Plain Dealer asks the question "Will Bad Commercial Loans Leave Cleveland Area Banks Targets" (here).

 

An August 31, 2009 Wall Street Journal article entitled "Commercial Real Estate Lurks as Next Potential Mortgage Crisis" (here) explores the sources of the problems in the commercial mortgage sector. Many of the mortgage-related problems "are simply the result of bad underwriting." The Wall Street "CMBS machine" lent owners money "on the assumption that occupancy and rents of their office buildings, hotels, stores or other commercial property would keep rising," but now "a growing number of properties aren’t generating enough cash to make principal and interest payments."

 

Another source of difficulty is that property owners are unable to refinance as mortgages come due. The August 31 Journal article reports that by the end of 2012, $153 billion in loans that make up CMBS are coming due, and as much as $100 billion will face difficulty in refinancing.

 

Declining property values are contributing to the problem. According to Bloomberg (here), commercial property prices have fallen 39 percent since their 2007 peak. As the Journal article notes, the property values have "fallen so far that borrowers won’t be able to extend existing mortgages or replace them with new debt."

 

All of this spells serious trouble for already struggling banks. Banks hold $1.8 trillion in commercial mortgages and construction loans, and as the Journal notes, "delinquencies on this debt already have played a role in the increase in bank failures this year."

 

Indeed, banks’ exposure to commercial mortgage losses is a serious concern for banking regulators, particularly since banks have been "slow to take losses on their commercial real estate loans," according to an October 7, 2009 Wall Street Journal article (here). According to one analysis quoted in the article, banks with heavy exposure to real estate loans have set aside just 38 cents in reserves during the second quarter for every $1 of bad loans. As the Journal article notes, "the recession combined with inadequate loan loss provisions when times were good have left banks dangerously vulnerable to the deteriorating commercial real estate market."

 

A significant amount of commercial mortgage debt is also held by the pools backing the CMBS. According to an October 2009 memorandum from the Robbins, Kaplan, Miller & Ciresi law firm entitled "Caught in the Credit Crunch: An Investigation into Commercial Mortgage Backed Securities" (here), there was nearly $650 billion in CMBS issuance during the period 2005 to 2007, at the same time as there was a "dramatic decrease in the underwriting standards for commercial mortgages." The recent problems in the commercial real estate sector have "resulted in more loan defaults and potentially significant losses for CMBS investors."

 

Potential Litigation

The commercial mortgage woes have already led to a certain amount of litigation. By far the most significant number of lawsuits growing out of commercial mortgage problems involves the handful of cases where companies and their directors and officers have been sued by the company’s own shareholders for alleged misrepresentations or omissions about the company’s ability to support its mortgage debt or commercial property acquisition debt obligations. Examples of the companies involved in these kinds of lawsuits include General Growth Properties (about which refer here); Station Casinos (refer here); Perini Corporation (refer here); and MGM Mirage (refer here).

 

There may well be more of this type of shareholder or investor driven "commercial mortgage disclosure" litigation ahead, as commercial mortgage defaults continue to emerge in the months ahead.

 

There also seems to be every prospect for litigation to emerge in the wake of bank failures caused by commercial mortgage defaults. There certainly has already been considerable litigation following in the wake of bank failures driven by residential mortgage losses. Example of this kind of residential mortgage-related failed bank litigation include the lawsuits filed by the shareholders of Corus Bank (refer here) and Pacific Capital Bancorp (refer here). At this point, it seems prudent to expect that as rising commercial mortgage defaults lead to further bank failures that there would be similar failed bank litigation pertaining to the banks’ commercial mortgage losses.

 

The more interesting question may be whether there will be investor litigation relating to the CMBS. The Robins Kaplan memo linked above notes that "while there hasn’t yet been much specific CMBS litigation yet," as the CMBS mature over the next few years, litigation could arise similar to the many lawsuits that have emerged involving residential mortgage backed securities (RMBS).

 

The law firm memo does go on to note that there could be some practical considerations that could forestall, or at least complicate, prospective CMBS-related litigation. For example, the memo notes, CMBS offering documents "generally have substantially more property specific information" than for example typically was found in RMBS offering documents, which "may eliminate" omission-based claims of the type that have been asserted in RMBS-related litigation.

 

In addition, as time passes, CMBS investors’ ability to bring ’33 Act claims based on alleged misrepresentations or omissions in the offering documents may face statute of limitations constraints. Indeed, given that the CMBS marketplace ground to a halt in after the financial crisis in September 2008, we may already be past the point where CMBS investors will even have the option to pursue ’33 Act claims alleging misrepresentations or omission in the offering documents, due to the operation of the applicable one-year statute of limitations.

 

Nevertheless, and despite these litigation impediments, as growing defaults mean mounting losses for CMBS investors, the aggrieved investors likely will seek alternative theories on which to pursue claims, including, for example, common law fraud or misrepresentation. A long-running CMBS lawsuit now being pursued against the Cadwalader law firm and related to a 1997 CMBS offering (about which refer here) dramatically underscores how far into the future the litigation threat may extend. Moreover, if the commercial mortgage-related losses prove to be anywhere near the current theoretical potential, investors will have substantial incentives to pursue claims, even if it means relying on a wider array of legal theories in order to assert their claims.

 

All of which suggests that there may yet be a further surge of credit crisis-related lawsuits before the credit crisis litigation wave has finally played itself out.

 

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In the latest of the subprime and credit crisis cases to be dismissed, on September 30, 2009, District of Massachusetts Judge Richard G. Stearns dismissed the securities class action lawsuit that had been filed by purchasers of mortgage pass-through certificates against Nomura Asset Acceptance Corporation, certain of its directors and officers, the eight mortgage trusts that had issued the certificates, and the offering underwriters who had supported the 2005 and 2006 public offerings of the certificates. A copy of Judge Stearns’s opinion can be found here.

 

As discussed in my prior post about this case (here), the plaintiffs initially filed their complaint against Nomura in Massachusetts state court, but the defendants removed the case to federal court. After plaintiffs had amended their complaint, the defendants moved to dismiss. More detailed background regarding the case can be found here.

 

In their amended complaint (here), the plaintiffs alleged that in connection with each of the eight separate certificate offerings, the defendants had misled investors with respect to the loan underwriting by the originators of the mortgages in the trusts; with respect to the originators’ appraisal practices; with respect to level of delinquencies for the mortgages in the trusts; and with respect to the certificates’ investment ratings.

 

The court first addressed the standing of the plaintiffs to assert claims against the eight trusts, which, Judge Stearns noted, "are separate legal entities" that "each issued its own securities backed by different pools of mortgages." Judge Stearns found that because the named plaintiffs had only bought certificates from three of the eight defendant trusts, "the named plaintiffs are incompetent to allege an injury caused by purchase of Certificates that they themselves never purchased."

 

Judge Stearns held, based on the "overwhelming weight of authority," that the named plaintiffs lacked constitutional standing to assert claims against the five trusts from which they had not purchased certificates. Judge Stearns also held that the named plaintiffs lacked standing to assert claims against the offering underwriter defendants that had supported offerings only with respect to the five trusts from which the plaintiffs had not purchased securities. Judge Stearns dismissed the claims against the five trusts and the associated offering underwriter defendants.

 

Judge Stearns also granted the remaining defendants motions to dismiss the plaintiffs Section 12(a)(2) claims. He held that in order to state a claim under Section 12(a)(2), the plaintiffs must allege that they purchased securities from the defendants. However, the plaintiffs alleged only that they "acquired" the securities "pursuant and/or traceable to" the offerings. In granting the motion to dismiss the Section 12(a)(2) claims, Judge Stearns noted that "if plaintiffs did in fact purchase the Certificates directly from the defendants, they should have said so. An evasive circumlocution does not suffice as a substitute."

 

Finally, Judge Stearns granted the motion of the remaining defendants to dismiss the remaining claims under Sections 11 and 15 of the ’33 Act. He found with respect to the plaintiffs’ allegations concerning the mortgage originators’ underwriting standards that the offering documents contain a "fusillade of cautionary statements" that "abound with warnings about the potential perils." Judge Stearns noted that plaintiffs’ contention that they were not "on notice" of those perils "begs credulity."

 

With respect to the alleged misrepresentations regarding loan delinquency, Judge Stearns, noting that the allegedly delinquent loans represent 0.1 percent of the mortgages in the pool, stated that "there is no plausible question regarding materiality."

 

Finally, with respect to the allegations concerning the certificates’ ratings, Judge Stearns noted that while questions regarding the process by which mortgage-backed securities received ratings have arisen in recent months, none of those questions pertain specifically to the ratings of these certificates. Moreover, none of the later developments "support the inference that the ratings were compromised as of the dates" on which the offering documents became effective.

 

Because Judge Stearns found that the plaintiffs "have failed to allege a sufficient factual basis to support their claims for Securities Act violations," he granted the defendants’ motions to dismiss with prejudice.

 

The Nomura action is only one of many securities lawsuits that investors have brought against the securitizers that aggregated mortgages into pools that issued mortgage-backed securities. In many of these cases, as in the Nomura case, the plaintiffs have lumped together many different issuing trusts and many different offerings. In some of these cases, the plaintiffs will face the same "standing" hurdles that confounded the plaintiffs in the Nomura case.

 

And more to the point, the offering documents provided in connection with many of these mortgage-backed securities offerings, like the documents relating to the offerings at issue in the Nomura case, also contained a "fusillade of cautionary statements" that abound with warnings" about the perils.

 

During most of 2008 and into early 2009, Plaintiffs aggressively filed these types of Securities Act cases against the securitizers, perhaps on the theory that a Securities Act case (for which there are no scienter pleading requirements) might more easily survive a dismissal motion. However, Judge Stearns opinion in the Nomura suit suggests that these cases could face rigorous scrutiny and may also face substantial difficulty getting over the initial pleading hurdles.

 

I have in any event added the opinion in the Nomura case to my register of subprime and credit crisis-related lawsuit dismissal motion rulings, which can be accessed here.

 

Special thanks to a loyal reader for providing a copy of Judge Stearns’s opinion.

 

Full Disclosure: On October 5, 2009, the Federal Trade Commission announced (here) that it had approved final revisions to the guidance it gives advertisers on how to keep their endorsements and testimonials in compliance with FTC requirements. The FTC’s formal Notice of Adoption of the guidelines can be found here.

 

These new guidelines have received a great deal of attention for the requirements they purport to impose on bloggers. For example, the Wall Street Journal seemed to think that the FTC’s requirements regarding bloggers is front page news (refer here). The guidelines do seek to impose certain requirements on bloggers. For example, in its press release, the FTC stated that "bloggers who made an endorsement must disclose material connections they share with the seller of a product or service."

 

Everyone here at The D&O Diary wants to reassure our readers that we have accepted no promotional considerations of any kind in connection with matters discussed on this blog. Of course, it is probably fair to note that no one has ever offered us any promotional considerations, darn it. But readers can be assured that if we ever did have the opportunity to accept any promotional consideration, we would fully disclose the consideration in compliance with FTC requirements.

 

Our "promotional consideration intake operators" are standing by …

 

Speakers’ Corner: On October 16, 2009, at 11 am EDT, I will be participating in a one hour webinar sponsored by Advisen, about securities litigation during the third quarter of 2009. Joining me on the panel will be Arthur J. Gallagher’s Phil Norton, Zurich’s Paul Schiavone, and Advisen’s David Bradford. The session will be moderated by Advisen’s Jim Blinn.

 

This webinar will review securities cases filed and settled during the third quarter, include shareholder derivative suits, securities fraud suits, and other categories of securities-related litigation. The registration materials for the webinar can be found here.

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

She concluded that

 

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

 

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

 

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

 

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

 

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

 

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

 

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In my recent subprime and credit crisis lawsuit status update (here), I commented that the defendants seemed to be getting the upper hand at the dismissal stage in many of these cases. Two recent dismissal motion rulings tend to corroborate this view. In addition, the defendants in the auction rate securities cases continue to have their dismissal motions granted.

 

SunTrust Bank: The first of these two recent dismissal motion rulings is the September 24, 2009 opinion (here) by Northern District of Georgia Judge Thomas Thrash, Jr. in the SunTrust Banks auction rate securities lawsuit. As reflected in greater detail here, the plaintiffs alleged that SunTrust Bank’s broker-dealer subsidiary sold them auction rate securities. The plaintiffs allege that the defendants failed to disclose certain features about the securities and about the auction rate securities marketplace. The plaintiffs also allege that the defendants engaged in manipulative auction practices.

 

Judge Thrash granted the defendants’ motion to dismiss the disclosure related allegations because the allegations "about the Defendants state of mind do not meet the heightened pleading requirements applicable to securities fraud cases."

 

As an initial matter, Judge Thrash found that the plaintiffs’ allegations were "not stated with particularity." Though the plaintiffs contend that "high level corporate officials" issued certain management directives, the plaintiffs "do not identify any of these officials, by name, by title, or even by job description." With respect to the supposed directives, the Plaintiffs "do not describe what these documents may have said, who issued them, or when they were distributed."

 

Judge Thrash further found that the plaintiffs’ allegations "do not give rise to a strong inference that the Defendants’ acted with an intent to defraud or with severe recklessness." Thus, while the complaint refers to supposed management directives and uniform sales materials, the allegations are "not strongly supported" in the complaint. The confidential witnesses on whom plaintiffs rely do not reference the supposed directives or sales materials, and "none of the Plaintiffs’ allegations mention a single communication from any high level corporate officials, let alone any management directives or uniform sales materials."

 

Judge Thrash found that "the more plausible theory is that high level corporate officials carelessly or negligently provided training on how to sell auction rate securities, and because of the improper training, many SunTrust brokers exaggerated the benefits," noting further that the allegations overall were "more consistent with a negligent state of mind than a fraudulent or reckless one."

 

The court did noted that "the only allegation that might suggest otherwise" is the contention that the defendant entities were among the companies the SEC investigated in 2006 for auction rate securities practices, and therefore the defendants’ senior executives "must have been aware of manipulative auction practices." But Judge Thrash found that the inference that the plaintiffs seek to draw from this allegation is "simply too weak and convoluted," because it required the court to assume that the executives continued the manipulative practices after the SEC investigation and willfully trained brokers to sell the securities without changing the practices or disclosing the practices to the brokers. The court said "Plaintiffs do not provide sufficient allegations to make anything more than a weak and convoluted inference" about this contention.

 

Finally, Judge Thrash found that the plaintiffs’ market manipulation allegations "do not meet the heightened pleading requirements applicable to securities fraud cases." Because plaintiffs had previously amended their complaint, he denied plaintiffs further leave to amend.

 

The SunTrust Banks auction rate securities lawsuit is the latest of the auction rate cases to be dismissed. (Refer to my recent post here for an overview of prior dismissals.) The SunTrust Bank case also follows the recent dismissal in the Raymond James auction rate securities case, where the case was dismissed not on the basis of a prior regulatory settlement, but rather because of pleading deficiencies, without regard to whether or not the defendant company had entered a regulatory settlement.

 

While there are a number of other auction rate securities cases in which the dismissal motions are yet to be heard, at this point, the plaintiffs have not yet survived a dismissal motion in any of the auction rate securities cases in which dismissal motions have been heard.

 

There were almost two dozen separate auction rate securities lawsuits filed (some with multiple complaints) after the auction rate securities market froze up in February 2008. But though the plaintiffs’ lawyers rushed to file these cases, so far the suits are not faring well at all for the plaintiffs.

 

Huntington Bancshares: The second of the two recent dismissal motion rulings involves the shareholders’ derivative suit filed in the Southern District of Ohio against Huntington Bancshares, as nominal defendant, and certain of its directors and officers. The complaint relates to Huntington’s July 2007 acquisition of Sky Financial. At the time the deal was announced, Huntington officials stated that the acquisition would be "accretive to Huntington’s earnings.

 

The complaint alleges that in acquiring Sky, Huntington also acquired Sky’s long-standing relationship with Franklin, which included $1.8 billion debt in the form of high-risk residential mortgages. Just five months after the acquisition, Huntington took charges of $300 million for loan loss allowances on the Franklin debt, which was followed by a "restructuring" of the relationship with Franklin. In the weeks following the restructuring, Huntington’s share price declined.

 

In their February 2008 complaint, the plaintiff alleged that the defendants knowingly concealed material adverse facts about mortgage-related losses resulting from the Sky acquisition and that Huntington knowingly acquired and continued to hold high-risk financial instruments that could not properly be valued. The defendants moved to dismiss the complaint on the grounds that the plaintiff had failed to make a presuit demand on Huntington’s board.

 

In a September 23, 2009 order (here), Judge George C. Smith granted the defendants’ motion to dismiss, holding under Maryland law that the plaintiff had failed to sufficiently allege demand futility.

 

Judge Smith first held under the first prong of the demand futility analysis under Maryland law that "Plaintiff has failed to plead with particularity that a demand would have caused irreparable harm to Huntington."

 

Judge Smith found further that "because Plaintiff fails to establish that a single member of the Board is conflicted or committed for purposes of establishing demand futility," the plaintiff had failed to satisfy the second prong of the demand futility analysis under Maryland law.

 

While at this point, it is difficult to generalize with respect to the subprime and credit crisis related derivative suits, as there have been relatively few dismissal motion rulings either way, the plaintiffs do not seem to be faring particularly well in dismissal motion ruling so far (see for example my recent discussion of the dismissal in the Citigroup derivative suit, here).

 

I have in any event added these two dismissals to my list of subprime and credit crisis-related lawsuit resolutions, which can be accessed here.

 

Many thanks to a loyal reader for providing a copy of the SunTrust Bank opinion.

 

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In a ruling with potential significance for the other remaining auction rate securities lawsuits, on September 17, 2009, Southern District of New York Judge Lewis A. Kaplan granted the defendants’ motion to dismiss, with leave to amend, in the auction rate securities lawsuit pending against Raymond James Financial and certain of its subsidiaries. A copy of Judge Kaplan’s opinion can be found here.

 

There have been prior dismissals granted in the many pending auction rate securities lawsuits. For example, dismissal motions have been granted in the auction rate securities lawsuits filed against UBS (refer here) and against Northern Trust (refer here), as well as in the auction rate securities lawsuit involving Citigroup (refer here, scroll down).

 

The Citigroup case had been based on a market manipulation theory rather than on a misrepresentation theory, and is noteworthy in that respect, but the dismissal of the Citigroup case based on the plaintiffs’ failure to adequately plead market manipulation is less relevant to the many other auction rate securities cases – including the one filed against Raymond James—that are based on misrepresentation theories.

 

Judge Kaplan’s September 17, 2009 dismissal in the Raymond James auction rate securities case is noteworthy in its own right and by contrast to the prior dismissals in the UBS and Northern Trust cases, because in the Raymond James, by contrast to UBS and Northern Trust, had not entered into regulatory settlements involving its investors. Indeed, Raymond James has been the target of certain high profile media criticism (refer here) as a "holdout" for its resistance to entry into a regulatory settlement.

 

Because Raymond James has not entered a regulatory settlement, the defendants in the Raymond James auction rate securities case were unable to seek dismissal on the same "absence of recoverable damages" theory as did the defendants in the Northern Trust and UBS cases. Thus, by contrast to the dismissals in those other two cases that turned on the existence of the regulatory settlements, the dismissal in the Raymond James case actually related to the sufficiency of plaintiffs’ allegations on the merits, and therefore may be of greater potential significance for other auction rate securities cases, particularly those relating to other defendant companies that have not entered regulatory settlements.

 

In granting the dismissal motions, Judge Kaplan very carefully distinguished the allegations that had been made against the various corporate defendants, and he carefully assessed the adequacy of the allegations as to each.

 

Judge Kaplan determined that many of the alleged misrepresentations were made by or on behalf of Raymond James Financial Services (RJFS), the parent company’s retail sales subsidiary that actually sold to investors the auction rate securities that other corporate subsidiaries had underwritten or managed the related auction processes. Judge Kaplan found that there were insufficient allegations concerning the alleged misrepresentations supposedly made to the plaintiff or as part of the overall scheme to be able to attribute misrepresentations as to defendants other than RJFS. He stated that the complaint "fails to allege how the remaining two defendant entities are responsible for the omissions."

 

Although this failure to attribute the alleged misrepresentations to the defendants other than RJFS alone would have been sufficient to dismiss the defendants other than RJFS, Judge Kaplan further considered the plaintiffs’ scienter allegations and concluded that the insufficiency of the scienter allegations provided an independent basis on which to dismiss the defendants other than RJFS, as well as for dismissing the complaint as a whole.

For reasons similar to those he expressed with respect to his ruling on the misrepresentation issue, Judge Kaplan concluded that the lack of particularized allegations of scienter were "fatal" to the claims against the defendants other than RJFS.

 

Judge Kaplan further found that plaintiffs’ scienter allegations in general were insufficient. First, he concluded that the plaintiff had not adequately pled "motive and opportunity." He first found that plaintiff’s allegations based on motivations to profit were insufficient. He allowed that plaintiff "comes closer" with her allegation that "defendants’ motive was to unload their excess and soon to be illiquid ARS inventory on unsuspecting customers."

 

Even these allegations, about the defendants’ supposed motive to unload excess inventory, were found to be insufficient because, Judge Kaplan held, they presumed that "there was a shared knowledge of the entire scheme" among all the defendants – yet the complaint failed, for example, to show that RJFS has knowledge of the issues surrounding the auctions or the securities inventory at the other subsidiaries.

 

Judge Kaplan noted that in effect the plaintiff sought to "aggregate the knowledge of two or more separate corporate entities on the basis that they share the same corporate parent and nothing more" – which Judge Kaplan found insufficient.

 

Finally, Judge Kaplan concluded that the plaintiff had not sufficiently alleged "conscious misbehavior or recklessness." Among other things, he found that:

 

The Court cannot infer that RJFS was aware it was marketing ARS to potential investors fraudulently because there is no showing that RJFS or insiders had access to the underwriters’ "unique" knowledge of the ARS market. Indeed, the complaint itself states that RJFS’s agents, the financial advisors who allegedly made the misrepresentations to investors, "lacked a rudimentary understanding about the auction rate securities and how the auction rate securities market functioned."

 

The September 17 dismissal is without prejudice. The plaintiff has until October 16, 2009, to submit an amended complaint. Whether or not the plaintiff in this case is successful in curing the pleading defects Judge Kaplan noted remains to be seen. But even if the plaintiff is able to overcome the pleading hurdle, Judge Kaplan’s analysis suggests that other auction rate securities plaintiffs may face significant challenges, even with respect to the defendant companies that have not entered regulatory settlements.

 

Many if not most of the auction rate securities lawsuits, like the one against Raymond James, involve multiple corporate subsidiaries as defendants, each of which touched a separate part of the auction rate securities process. Unless the plaintiffs in those cases are able to allege that the different subsidiaries had knowledge of the activities and operations of the other subsidiaries, the plaintiffs may, like the plaintiff in the Raymond James case, have difficulty establishing pleading sufficiency for their complaint’s allegations of misrepresentations and scienter against some or all corporate defendants.

 

To be sure, there may well be cases where plaintiffs can show – or at least allege—that, for example, the sales subsidiary was aware of the difficulties in the auction rate process or with excess inventory. But to the extent the plaintiffs failed to make or establish these connections in their complaint, their complaint may well be dismissed on the same grounds as in the Raymond James case.

 

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It is now over two and a half years since the first subprime-related securities class action lawsuit was filed in February 2007, yet many of the cases filed as part of the ensuing litigation wave are still only in their earliest stages. But there have been some important developments recently – for example, the Eighth Circuit’s recent decision affirming the dismissal of the NovaStar Financial subprime lawsuit – suggesting that the evolving litigation wave may have reached a passed a significant milestone. With that possibility in mind, it seems appropriate to check in for a status report on the subprime and credit crisis-related litigation wave.

 

Filing levels

There have now been a total of 199 subprime and credit crisis-related securities class action lawsuits, of which 57 have been filed so far in 2007. A compete list of the lawsuits can be accessed here. While the subprime and credit crisis securities suits continue to be filed, in recent months the pace has definitely slowed. Of the 2009 filings, the bulk of them were filed in the first quarter, and there have only been a handful since April. Of course, the pace of filling activity could return at any time, but at least at this point there seems to be some possibility that the subprime and credit crisis litigation wave may have already crested.

 

Another circumstance suggesting that the litigation wave may be ebbing is changing mix of companies that are the targets of the latest securities class action lawsuits. In the first half of the year, approximately two thirds of the new securities lawsuits involved companies in the financial sector. But of the 37 new securities lawsuits filed in July and August 2009, only 13, or slightly more than a third, involved companies in the financial sector. In other words, the proportion of lawsuits against financial companies versus nonfinancial companies seems to have completely reversed.

 

Of course, another possibility to explain the recent filing patterns is that the litigation has changed as the nature of the financial circumstances changed. What started several years ago with the subprime meltdown has evolved into a global financial crisis, affecting all companies across the entire economy. As a result of these developments, it has become increasingly difficult to define precisely what constitutes a subprime and credit crisis-related lawsuit.

 

A good illustration of this definitional challenge is the case recently filed against MGM Mirage as a result of construction delays and financing issues relating to the company’s CityCenter project in Las Vegas. Whether this case should be grouped with earlier subprime and credit crisis-related cases depends on whether or not the company’s difficulties relate to a categorically separate set of issues or are simply a reflection of the overall economic turndown. In other words, it may not be so much that the subprime and credit crisis litigation wave has crested as it is that the wave has merged into a larger tidal movement and is no longer its own separately identifiable phenomenon.

 

Dismissal Motion Rulings

Even after two and a half years, there have still only been a handful of dismissal motion rulings in the subprime and credit crisis related lawsuits. For that reason, and because among the few rulings so far there are some that have gone one way and some that have gone the other way, it is difficult to generalize. Just the same, there have been some recent rulings suggesting that, even though there are still dismissal motion rulings going in the plaintiffs’ favor, on balance the rulings seem to be favoring the defendants, and recent rulings could be particularly useful for defendants going forward. (A complete list of the subprime and credit crisis-related lawsuit dismissal motion rulings can be accessed here.)

 

The most prominent among these recent developments is the Eighth Circuit’s September 1, 2009 decision in the NovaStar Financial case affirming the district court’s dismissal of the plaintiffs’ complaint, about which refer here.

 

There have also been a series of recent rulings in which the courts have granted motions to dismiss in recognition that the defendant company’s difficulties were the result of economic downturn, not fraud. Thus for example, in both the lawsuit that Luminent Mortgage Corporation filed against Merrill Lynch (refer here) and in the First Marblehead subprime-related securities class action lawsuit (refer here), the courts quoted with approval language from a prior RICO case in which the Second Circuit said "when the plaintiff’s loss coincides with a marketwide phenomenon causing comparable losses to other investors, the prospect that plaintiffs’ loss was caused by fraud decreases."

 

This latter argument – that is, if the plaintiffs were harmed, it was due to the global financial downturn, not to defendants’ supposed misconduct – could prove useful to defendants in a wide variety of subprime related cases. Given the magnitude of the economic downturn, which was nearly universally unanticipated, this argument could well be extended to many if not most of the subprime and credit crisis-related lawsuits. The extent to which the defendants are able to exploit this argument in other cases remains to be seen, but for now defendants seem to have established a significant formula for dismissal motion success in these cases.

 

Another development that suggests the balance may be shifting in defendants’ favor is the number of recent cases were district courts granted renewed motions to dismiss after plaintiffs had filed amended complaints seeking to cure pleading defects noting in the initial dismissal rulings. Renewed dismissal motions were recently granted in both the Downey Financial and Centerline cases (about which dismissals refer here, scroll down)– although, to be sure, the renewed dismissal motion was denied in the BankAtlantic case, where the plaintiffs’ amended complaint survived the renewed motion to dismiss, as discussed here.

 

Another significant recent development suggesting that defendants may have developed an advantage at the dismissal stage is the dismissal granted in the CBRE Realty case. As discussed at greater length here, the district court granted the dismissal motion even though the plaintiff asserted only claims under the ’33 Act, and therefore did not have to satisfy the more rigorous initial pleading requirements that apply to ’34 Act claims (as for example the need to plead scienter). This development may be particularly significant because many of the subprime and credit crisis-related lawsuits, particularly many of those filed in 2009, assert only claims under the ’33 Act. Of course, it remains to be seen whether or not the complaints in these other cases will be found to be similarly deficient as the one in the CBRE Realty case, but for now (based on admittedly few data points) the balance seems to be in the defendants’ favor on these cases.

 

One final note is that the apparent pendulum swing in defendants’ favor at the motion to dismiss stage is that it is not limited just to the subprime and credit crisis-related securities cases. As shown by the recent dismissals in the Citigroup subprime related derivative lawsuit (refer here, scroll down) and in the Citigroup subprime related ERISA lawsuit (refer here, scroll down), the recent development suggest that defendants may be faring well at the dismissal motions stage in these other kinds of cases as well.

 

To be sure, there are also cases in which the motions to dismiss recently have been denied, as for example in the Levitt Corp. subprime related securities lawsuit (about which refer here, scroll down). The dismissal motion rulings are by no means all going in defendants’ favor and the outcome of the dismissal motions in any particular case is by no means predetermined. There are many more dismissal motions yet to be heard.

 

Settlements

If there are only a few dismissal motion rulings in these cases so far, there are even fewer settlements, and it is even more difficult to generalize.

 

By far the most attention-grabbing feature of the settlements so far is the series of eye-popping settlements in subprime lawsuits involving Merrill Lynch. The three Merrill Lynch settlements so far are the three largest subprime-related lawsuit settlements. The $475 million securities lawsuit settlement (refer here), the $150 million bond action settlement (refer here) and the $75 million ERISA action settlement (refer here) stand out among the few other, more modest settlements.

 

It is not just their size that may set these Merrill Lynch settlements apart. The fact that these enormous settlements were entered before the motions to dismiss were heard in each of these cases and also shortly after Bank of America acquired Merrill Lynch suggests that following its acquisition of Merrill, Bank of America moved quickly to clear the decks of Merrill litigation that predated the merger, even if substantial sums proved to be required to accomplish that goal. Because of the possibility that these settlements may represent the outcome of their own unique settlement dynamic, they may be of little guidance with regard to possible settlement ranges of other cases.

 

There have been other significant settlements in other cases, from which some generalizations may or not be able to be drawn. Thus, for example, the RAIT Financial subprime-relates securities lawsuit recently settled for $32 million (refer here) and the Accredited Home Lenders case recently settled for $22 million (refer here). Both of these cases had survived the defendants’ motions to dismiss, which suggests that while it may difficult for these cases to survive dismissal motions, when the cases do survive they can be quite costly to resolve.

 

Two other noteworthy recent settlements include the $37.25 million settlement in the American Home subprime-related lawsuit (refer here) and the $30.5 million settlement in the Beazer Homes subprime related lawsuit (refer here). These settlements are notable because in both instances the cases settled before the motions to dismiss had been ruled upon. While each of these cases had their own particular features and each was resolved for reasons particular to each case, they do suggest that resolving more serious cases can be prove costly to settle. These cases also suggest that when the claims are sufficiently serious the plaintiffs may be able to avoid the initial pleading hurdle altogether.

 

So while the defendants may have won some important recent victories in the courtroom at the motion to dismiss stage, the overall costs of defending and settling these cases taken in the aggregate nevertheless continues to look as if it will be enormous. By any measure, the subprime and credit crisis-related litigation wave continues to represent a tremendous loss exposure for D&O insurers.

 

In any event, a complete list of settlements in the subprime and credit crisis-related lawsuits can be accessed here.

 

Gatekeeper Liability

One of the characteristics of many of these subprime and credit crisis related lawsuits is the extent to which the plaintiffs are seeking to impose liability on the gatekeepers of the target companies. The gatekeepers named as defendants include not only the directors and officers of the target companies, but also the companies’ auditors and offering underwriters, as well as the rating agencies that provided rating on the companies’ securities offerings.

 

The plaintiffs have shown particular willingness to pursue claims against the auditors. Thus, for example, the trustee for New Century Financial Corp. has initiated a claim against KPMG, the company’s former auditor (refer here). KPMG is also named as a defendant in the New Century subprime securities lawsuit, and the district court in that case specifically denied KPMG’s motion to dismiss (refer here). In addition, in the Countrywide subprime-related securities lawsuit, the district court found denied KPMG’s renewed motion to dismiss the claims against KPMG in the plaintiffs’ amended complaint (refer here, scroll down).

 

The possibility that these gatekeeper claims could prove valuable for claimants was highlighted in the recent $37.25 million American Home settlement. As here, the total settlement fund included contributions of $8.5 million from the seven offering underwriter defendants and $4.75 million from the company’s auditor, Deloitte & Touche. While it is always dangerous to try to generalize from a single settlement, the American Home settlement does at least suggest the possibility that resolving gatekeeper liability could be an important and costly part of subprime and credit crisis litigation wave’s overall consequences.

 

Another significant development in terms of gatekeeper liability is Judge Schira Scheindlin’s September 2, 2009 ruling in the Cheyne Financial case denying the rating agency defendants’ motions to dismiss. Although, as discussed at length here, there could be limitations on the overall impact of Judge Scheindlin’s ruling, the ruling could influence the many other cases in which plaintiffs are seeking to impose gatekeeper liability on the rating agencies.

 

One final note about the gatekeeper liability developments is that at least so far the claimants seem to have shown little inclination to try to pursue claims against the attorneys that may have been involved in the underlying circumstances. There is precedent for plaintiffs to pursue these kinds of claims against the attorneys; in a case involving a commercial mortgage backed securities transaction that took place in the 90’s, certain claimants are now pursuing claims against the Cadwalader firm, which had been the law firm that created the transaction documents (refer here for more details about this case). Significantly, the claimants did not initiate that claim until many years after the fact and only after extensive litigation involving other parties. All of which suggests that the claims against the attorneys, even if not yet filed, could be yet to come.

 

Defense Expense

In addition to the potential costs of settlement, these cases are in most instances proving enormously expensive to defend. The most substantial illustration of this proposition is the State Street’s August 10, 2009 announcement (here) that the approximately $625 million subprime-related litigation expense reserve the company had established in January 2008 was as of June 30, 2009 already down to $193 million, and further that there could be no assurances that the remaining amount would be adequate for the company’s continuing litigation.

 

The potential cost of serious corporate litigation was also highlighted in the recent Broadcom options backdating derivative lawsuit settlement (about which refer here). Among other things, the settlement papers reflected recitals that the company’s litigation expense to date in connection with company’s various options backdating related legal proceedings was in excess of $130 million. Even though the Broadcom case related to options backdating and not to subprime litigation, the defense expenses accumulated in that case underscores how expensive serious corporate litigation can become.

 

Many of the subprime and credit crisis related cases are equally as complicated and equally serious. And while the $130 million in litigation expense in the Broadcom case may be an extreme case, it is not unusual any more for costs of litigation in complex corporate and securities cases to run into the tens of millions of dollars. The costs of litigation alone have become staggering.

 

All of which is a long way of saying that in addition to the costs associated with settling these cases, the overall cost of these lawsuit also will include massive amounts of defense expense. These enormous defense expenses will add to the overall aggregate burdens of this litigation for the D&O insurance industry, as well as for the company’s themselves. Though it has been a while since anyone has attempted to calculate the overall cost to the D&O insurance industry from the subprime and credit crisis litigation wave, by any measure the aggregate cost included defense and settlement amounts will be enormous.

 

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Among the causes many cite for the subprime meltdown is the willingness of the rating agencies to assign investment grade rating to securities backed by subprime mortgages. For that reason, in many of the lawsuits filed as part of the subprime litigation wave, plaintiffs have named rating agencies as defendants, seeking to hold them responsible for their investment losses. However, as discussed here, whether the rating agencies could actually be held liable is unclear, because in the past courts have found the rating agencies’ rating opinions to be protected by the First Amendment.

 

However, in a September 2, 2009 opinion (here) in a lawsuit relating to investment notes issued by Cheyne Financial, Southern District of New York Judge Shira Scheindlin denied the rating agencies’ motions to dismiss. Most significantly, Judge Scheindlin rejected the rating agencies’ argument that their rating opinions were entitled to immunity under the First Amendment, and she also rejected their argument that their rating represented non-actionable opinion.

 

Background

Plaintiffs claims in the lawsuit related to their investment in certain notes that had been issued by Cheyne Financial, a $5.86 billion structured investment vehicle. The notes were collateralized by certain assets, included residential mortgage backed securities (RMBS). Cheyne collapsed amid the subprime meltdown in 2007. Cheyne was unable to pay the senior debt as it became due and Cheyne is now in bankruptcy. The investors lost substantially all of their investment.

 

The notes Cheyne issued received the highest possible ratings from the rating agencies. However, according to Judge Scheindlin’s factual recitation in her September 2 opinion, that rating agencies played a "more integral role" than merely providing ratings. The rating agencies were involved in "structuring and issuing" the notes. For example, the rating agencies "helped to determine how much equity was required at each level of the SIV."

 

For their efforts, the rating agencies were paid approximately $6 million, an amount the court noted was "three times their normal fees." Moreover, the rating agencies fees increased "in tandem with the Cheyne SIV’s growth." As Judge Scheindlin put it, "unbeknownst to investors, the Rating Agencies’ compensation was contingent upon the receipt of the desired ratings for the Cheyne SIV’s Rated Notes."

 

After Cheyne collapsed, the investors filed suit against Morgan Stanley, which had promoted and distributed the notes; Bank of New York Mellon, which had provided certain custodial and administrative services for Cheyne; and the rating agencies (including Moody’s and S&P and their corporate parents). The plaintiffs asserted thirty-two claims under twelve different legal theories. Essentially, the plaintiffs alleged common law fraud under New York law; common law tort claims alleging misrepresentation; and assertions based on alleged breach of contract. The defendants moved to dismiss.

 

Judge Scheindlin’s Opinion

The rating agencies moved to dismiss the plaintiffs’ fraud allegations, arguing that their ratings were protected by the First Amendment and represented non-actionable opinion.

 

Judge Scheindlin rejected the rating agencies’ attempt to rely on the First Amendment, noting that "where a rating agency has disseminated their ratings to a select group of investors rather than to the public at large, the rating agency is note afforded the same protection." Judge Scheindlin held that here, because the Cheyne note ratings were provided only to "a select group of investors" as part of a private placement, the First Amendment defense is inapplicable.

 

Judge Scheindlin further rejected the rating agencies’ argument that their ratings were in any event non-actionable opinion, holding that the "plaintiffs have sufficiently pled that the Rating Agencies did not genuinely or reasonably believe that the ratings they assigned to the Rated Notes were accurate and had a basis in fact."

 

In finding that the plaintiffs had adequately alleged that the rating agencies did not reasonably believe the rating had a basis in fact, Judge Scheindlin among other things noted that the complaint alleged that the ratings "appeared to investors to equate the Rated Notes to other investments" such as investment grade bonds, though the notes "in reality and unbeknownst to investors, differed materially"; that, contrary to representations, the SIV’s portfolio consisted of more that 55% of RMBS, which "made the SIV a risky investment and certainly not deserving of high ratings."

 

The complaint further alleges that the rating agencies were subject to numerous conflicts of interest. Thus, even the rating agencies allegedly were aware that "the process used to derive ratings was deeply flawed and unreliable," but they nonetheless issued the ratings because they were compensated by a fee "substantially larger than normally received" and their fee was "directly connected to the success of the Cheyne SIV." These conflicts "compromised the objectivity of the ratings."

 

Judge Scheindlin further found that the plaintiffs had adequately pled scienter, based on the complaint’s allegations of motive and opportunity. She noted that the complaint alleged that the rating agencies knew Morgan Stanley would have "taken its business elsewhere" if the notes did not receive the desired rating, and in exchange for their "unreasonably high ratings" the rating agencies received "fees in excess of three times their normal fees."

 

With respect to motive and opportunity, the complaint further alleged that the rating agencies’ "remuneration was dependent on the successful sale of the Rated Notes," and that "they could sell successfully only if they were highly rated."

Judge Scheindlin also rejected the rating agencies’ argument that as sophisticated investors, the plaintiffs’ could not show actionable reliance on the ratings.

 

Finally, with respect to the plaintiffs’ other claims, Judge Scheindlin found that New York’s Martin Act precluded the plaintiffs’ common law tort claims, and that the plaintiffs’ had not alleged sufficient facts to support plaintiffs’ claims sounding in contract. She allowed the plaintiffs’ leave to amend their contract claims, but the dismissal with respect to the plaintiffs’ tort law claims was with prejudice.

 

Discussion

Judge Scheidlin’s rulings in the Cheyne Financial case are potentially of great significance in the many other lawsuits that have been filed against the rating agencies as part of the subprime litigation wave. In those many other cases, the rating agencies will also attempt to rely on the same threshold defenses on which they sought to rely in the Cheyne Financial case. The claimants in those other cases will cite Judge Scheindlin’s opinion in attempting to argue that the defenses should not be available to the rating agencies.

 

Several aspects of Judge Scheindlin’s opinion could be particularly helpful to other claimants. In particular, the significance she attached to the involved role of the rating agencies in structuring the investments they later rated could be particularly helpful, as claimants have asserted these same kinds of allegations in many of the other cases against the rating agencies. The same is also true with respect to her findings that the rating agencies’ compensation arrangement put them in a conflict of interest.

 

But while Judge Scheindlin’s opinion undoubtedly will be helpful to other claimants, the Cheyne Financial decision is far from conclusive of the issues surrounding the protections the rating agencies may be able to rely upon in connection with their ratings. Thus, even in the Southern District of New York, the opinion is at most of persuasive not precedential value. Though Judge Scheindlin is a highly respected Judge, other court nevertheless may decline to follow her analysis, particularly if the factual allegations are distinguishable.

 

A further way that Judge Scheindlin’s opinion could be of limited value is that her rulings were made under New York law with respect to allegations of common law fraud. Many of the other lawsuits that have been filed against the rating agencies allege violations of the federal securities laws, which other courts could view as being a critical distinction – although it does seem that shouldn’t make any particular difference with respect to the First Amendment issue.

 

Another consideration could further limit the impact of Judge Scheindlin’s rulings is that her analysis of the First Amendment issue may not persuade other courts. Indeed, a September 4, 2009 Wall Street Journal article (here) discussing the opinion quotes First Amendment scholar Martin Redish as saying that "the fact that [a rating] was just to a select audience should not disqualify it from First Amendment protection."

 

Even if other courts agree that the First Amendment protection does not apply to ratings that have only been disseminated to a small group, many of the claims that have asserted against the rating agencies in other cases do not involve the same kind of restricted offering involved in the Cheyne case. Many of the ratings that are now being challenged were issued in connection with public offerings, for securities that subsequently traded on the public securities exchanges. For ratings on those kinds of securities that were issued as part of those kinds of offerings, Judge Scheindlin’s analysis of the First Amendment issue, based on the fact that ratings of the Cheyne notes were not widely distributed, simply would not be applicable.

 

That does not necessarily mean that in those cases the rating agencies would be able to rely on the First Amendment defense, but it does mean that Judge Scheindlin’s First Amendment analysis would appear to be unavailing. Because so many of the cases in which the rating agencies have been named as defendants involve public securities offerings, Judge Scheindlin’s opinion could well have little impact at least on the First Amendment issue itself in many other cases against the rating agencies.

 

Nevertheless, as the Journal article puts it, Judge Scheindlin’s opinion is "one of the first to interpret the extent to which the [rating agencies] can expect First Amendment protection for their ratings of certain securities." The Journal quotes attorney David Grais as saying that Judge Scheindlin’s opinion "breaks new ground." Andrew Longstreath’s September 4, 2009 Law.com article about the opinion (here) quote Patrick Daniels of the Coughlin Stoia firm as saying "This is what we needed." Investors apparently believe that her ruling is a "landmark decision"

 

So, even though the Cheyne Financial decision is by no mean dispositive of the issue, it is nevertheless a highly significant development that could have a very significant impact in the many other subprime-related cases that have been filed against the rating agencies.

 

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In the first appellate court decision related to the subprime and credit crisis litigation wave, the United States Court of Appeals for the Eighth Circuit on September 1, 2009 affirmed the dismissal of the NovaStar Financial subprime related securities class action lawsuit. A copy of the Eighth Circuit’s opinion can be found here. The Eighth Circuit’s action represents a milestone in the evolving litigation wave, but because the decision is focused on pleading deficiencies in the plaintiff’s complaint, the decision’s impact may be somewhat limited.

 

Background

The NovaStar lawsuit (described in greater detail here), was one of the first subprime-related securities lawsuits to emerge, with the initial complaint filed in February 2007. The lawsuit essentially alleged 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.

 

As discussed in a prior post (here), on June 4, 2008, Western District of Missouri Judge Ortrie Smith granted the defendants’ motion to dismiss the complaint, with prejudice. A copy of the dismissal opinion can be found here.

 

Judge Smith Held that the complaint did not satisfy the PSLRA’s pleading requirements, because it did not specify the statements the plaintiff alleged to be misleading, nor did it specify why any such statements are misleading. In addition, Judge Smith held that the complaint did not adequately plead scienter. The plaintiff appealed.

 

The Eighth Circuit’s Opinion

The Eighth Circuit’s Opinion, written by Judge Raymond Gruender, affirmed the dismissal, but because the Court found that the complaint’s deficiencies alone were sufficient to affirm the district court, the Court did not reach the scienter issue.

 

The plaintiff had argued that the district court erred in concluding that the complaint failed to specify the allegedly misleading statements, citing a thirty-six page section of the complaint that reproduced numerous public statements, press releases and SEC filings during the class period. The Eighth Circuit noted that "absent from this section (and from any other section of the complaint) however, is any indication as to what specific statements within these communications are alleged to be false and misleading."

 

In his appellate brief, the plaintiff had attempted to identify specific statements that allegedly were misleading. But the Eighth Circuit said that "identifying specifically false and misleading statements for the first time on appeal, however, doe not excuse a litigant’s failure to comply with the pleading requirements," concluding that the district court did not err in dismissing the complaint for failure to identify which statements were misleading.

 

The plaintiff also argued that the district court erred in concluding that the complaint failed adequately to allege that the statements were misleading, with respect to which the Eighth Circuit noted "absent an indication of precisely what statements [the plaintiff] alleged to be misleading, it is difficult, if not impossible, to determine whether the complaint adequately specified why each statement was misleading."

 

The Eighth Circuit went on to note that "even if we were able to identify specific statements that were alleged to be misleading," the complaint "does not provide any link between an alleged misleading statement and specific factual allegations demonstrating the reasons why the statement was false and misleading."

 

In his appellate brief, the plaintiff reference an omnibus paragraph in the complaint, with respect to which the Eighth Circuit noted "arguably attempts to boil down the complaint’s thirty-four pages of background material … into a generalized one-paragraph summary." The Eighth Circuit found the "broad allegations" in this summary "do not necessarily show that the defendants’ statements were misleading" or "provide the level of particularity required by the PSLRA."

 

Finally, the Eighth Circuit concluded that the district court did not err in decline to allow plaintiff leave to amend, finding as a procedural matter that the plaintiff had not preserved the right to seek amendment.

 

Discussion

Because the Eighth Circuit’s decision in the NovaStar case is the first substantive action by an appellate court in connection with the subprime and credit crisis-related litigation wave, the decision represents a noteworthy development that could hearten defendants in other cases. However, because the decision focuses exclusively on the pleading deficiencies in the plaintiff’s complaint, the decision is likely to be of limited impact in other cases, arguably even in the Eighth Circuit.

 

Certainly, defendants in other cases will try to show that the complaint in their case is as deficient as the complaint in the NovaStar case. As the Orrick law firm put it in their September 2, 2009 memo about the decision (here), "the court announced stringent standards making clear that plaintiffs cannot rely on a kitchen sink approach to pleading securities fraud that leaves judges to identify what statements were allegedly false and why." But the decision would have been much more valuable to defendants had the Eighth Circuit affirmed on the critical battleground issues of scienter and loss causation.

 

Moreover, the Eighth Circuit said nothing that would aid other arguments that defendants typically try to make in these cases, such as for example that their companies’ misfortunes were simply the result of the global financial downturn. Indeed, the Eighth Circuit’s opinion seems peculiarly detached in its omission of any detailed discussion of the controversy presented or what it might signify.

 

Even though the Eighth Circuit’s decision may not represent a breakthrough, it nevertheless is a victory for the defendants and serves as a prominent example of the difficulty plaintiffs continue to face in many of these cases. Though plaintiffs have indeed survived motions to dismiss in a number of subprime and credit crisis-related lawsuits, there is a large and growing number of cases where plaintiffs have not managed to survive the initial pleading motions. The Eighth Circuit’s decision represents a higher profile example of the problems that plaintiffs face.

 

I have in an event updated my table of subprime and credit crisis-related lawsuit resolutions to reflect the Eighth Circuit’s affirmance in the NovaStar case. The tablecan be accessed here.

 

Interestingly enough, though Judge Smith granted the defendants’ motion to dismiss in the NovaStar subprime securities lawsuit, a different judge in the same district court denied the motion to dismiss in the companion NovaStar ERISA class action suit, as discussed at greater length here.

 

More About Outside Director Exposures and D&O Insurance: In a prior post (here), I discussed the massive $55.95 million settlement involving the outside directors of Peregrine Systems and the implications it may have for D&O insurance protection of outside directors. An August 27, 2009 memorandum from the King & Spaulding law firm (here) takes a closer look at the settlement and review the specific D&O insurance issues that should be considered in light of the settlement.

 

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Finacial Downturn, Not Fraud, Caused Plaintiffs’ Losses: In a ruling that is interesting for what it says about the relevance of the overall economic downturn to the wave of subprime lawsuits, on August 20, 2009, Eastern District of Pennsylvania Judge R. Barclay Surrick, Jr. granted the motion to dismiss the securities fraud lawsuit that Luminent Mortgage Corporate had filed against Merrill Lynch and related entities. A copy of the August 20 opinion in the case, which was filed solely on behalf of the named plaintiffs and not as a class action, can be found here.

 

In August 2005, Luminent had acquired $26 million worth of the most junior tiers of Mortgage Loan Asset-Backed Certificates that were backed by nearly $1 billion of underlying mortgage loans. Merrill and the related defendant entities underwrote, issued and sold the securities. Luminent acquired the securities as part of a complex transaction whereby Merrill had financed Luminent’s purchase and then held the securities as collateral, while Luminent retained the rights to the income stream from the certificates. As the court later noted, Luminent’ purchase of securities from the most junior layers represented a riskier investment, a consideration that clearly affected the court’s analysis.

 

In April 2007, Luminent reviewed a sampling of some of the underlying mortgages and found that several of the mortgages deviated from information about the mortgages Luminent had been given prior to the purchase transaction. Luminent contended that a result of these deviations, which allegedly showed the mortgages to be less secure than had been represented prior to the purchase transaction, the underlying mortgages were experiencing an unexpectedly harsh rate of default and delinquencies.

 

The investment performance on the certificates was so poor that in September 2007, Luminent demanded rescission of its purchase. After the defendants refused to rescind, Luminent filed suit under a variety of legal theories, among other things alleging that the defendants, in violation of the federal securities laws, had misrepresented the composition of the pool of mortgages and had misrepresented their due diligence in scrutinizing and selecting the mortgages. The defendants moved to dismiss.

 

Judge Surrick granted the defendants’ motion on several grounds. First, he held that the complaint did not adequately plead scienter, finding that the plaintiffs had not alleged facts sufficient to show that the discrepancies in the loan sample Luminent reviewed were the result of anything more than negligence. He also found that the plaintiffs’ theory of fraud was inconsistent with the fact that Merrill retained Luminent’s securities as collateral for the purchase loan, as a result of which any purported fraud would have harmed Merrill as well as Luminent.

 

Judge Surrick also granted the defendants’ motion to dismiss on the grounds that the plaintiffs had not adequately pled economic loss or loss causation. With respect to the economic loss issue, Judge Surrick found that Luminent did not hold the securities themselves and did not and could not have sold them at a loss, and he found further that the plaintiffs had failed to allege how their diminished income stream "can be distinguished from the market-wide losses in mortgage-backed securities generally."

 

This latter point, about the indistinguishability of the plaintiffs’ losses from market-wide losses is the most interesting aspect of Judge Surrick’s opinion. In similarly holding that the plaintiffs had not adequately alleged loss causation, Judge Surrick cited Second Circuit case law to the effect that "when the plaintiff’s loss coincides with a marketwide phenomenon causing comparable losses to other investors, the prospect that plaintiffs’ loss was caused by fraud decreases."

 

Though the Second Circuit case from this cited language is drawn is a RICO case, Judge Surrick’s opinion is the second recent decision in which a district court granted a motion to dismiss in a subprime-related securities class action lawsuit on loss causation ground in reliance on this language. As noted here, on August 5, 2009, District of Massachusetts Judge Joseph L. Tauro also granted a motion to dismiss in the subprime-related securities class action lawsuit pending against First Marblehead, citing the identical language from the Second Circuit.

 

In convincing courts to grant their securities lawsuit dismissal motions on loss causation ground in reliance on the language drawn from a RICO case, defendants seem to have hit on a formula that appears to be drawing a sympathetic judicial response – that is, the argument is that if the plaintiffs were harmed at all, it was due only to the global financial crisis, not to the defendants’ alleged misconduct. Given the magnitude of the economic downturn, which was nearly universally unanticipated, this argument could well be extended to many if not most of the subprime and credit crisis-related lawsuits. The extent to which the defendants are able to exploit this argument in other cases remains to be seen, but for now defendants seem to have established a significant formula for dismissal motion success in these cases.

 

Luminent’s directors and officers were themselves a target of a subprime-related securities class action lawsuit. (Luminent itself filed for bankruptcy in September 2008.) As noted in detail here, the Luminent securities lawsuit settled in December 2008 based on defendants’ agreement to pay $8 million.

 

An August 28, 2009 article in the Legal Intelligencer about Judge Surrick’s opinion can be found here.

 

Citigroup Shareholders’ Derivate Lawsuit Dismissed: In an August 25, 2009 order (here) that largely tracks the earlier dismissal of the related Citigroup derivate lawsuit that had been pending on Delaware, Southern District of New York Judge Sidney Stein, applying Delaware law, granted the defendants’ motion to dismiss the consolidated Citigroup derivative lawsuit, holding that "the complaint fails to allege with specificity facts showing that plaintiffs are excused from pre-suit demand."

 

The plaintiffs had filed their complaints, later consolidated, against certain directors and officers of Citigroup, in connection with the billions of dollars Citigroup had lost from its investments in mortgages and mortgage-related securities. The consolidated complaint alleged that the defendants should be liable for allowing Citigroup to invest in subprime mortgages; failing to disclose the extent of Citigroup’s exposure to subprime mortgages; approving a stock repurchase plan despite Citigroup’s subprime exposure; committing securities fraud for failed to adequately disclose the company’s subprime exposure; and engaging in or allowing others to engage in insider trading.

 

The allegations were similar to but not identical to the allegations in the separate Delaware derivate lawsuit. The Delaware action, for example and by contrast to the New York action, also contained a claim for waste based on the severance package awarded former CEO Charles Prince. The New York action, by contrast, contained claims not alleged in the Delaware suit based on securities fraud and insider trading allegations.

 

In concluding that the plaintiffs in the New York action had failed to establish that the pre-suit demand was excused, Judge Stein, applying Delaware law, largely followed (and expressly quoted from) Chancellor Chandler’s prior dismissal ruling in the Delaware case

 

The interesting part about Judge Stein’s opinion is with respect to the claims that were raised in the New York action but not in the Delaware lawsuit, and therefore with respect to which Chancellor Chandler did not rule in his earlier opinion.

 

Specifically, in concluding that the plaintiffs had failed to establish that demand was excused with respect to their derivative claim for securities fraud, among other things, Judge Stein concluded that the plaintiffs had not established that the defendants "face a substantial likelihood of liability of securities fraud." (If the faced such liability, then the plaintiffs’ pre-suit demand would be excused as futile.)

 

Judge Stein found that the plaintiffs’ complaint "fails to allege with specificity which statements plaintiffs contend are fraudulent," and that it does not "allege with specificity why any alleged misstatement is fraudulent." In addition, Judge Stein held, citing Tellabs, that the complaint "does not state with particularity facts giving rise to a strong inference that the defendants acted with the required state of mind."

 

While Judge Stein found that the plaintiffs had failed to show a substantial likelihood of liability for securities fraud, he was careful to note that his ruling related only to the allegations in the consolidated derivative complaint in this case, and not to the securities fraud allegations that may have been raised in other lawsuits involving Citigroup and the same or related circumstances.

 

Judge Stein expressed skepticism that the plaintiffs could cure their pleading defects, and therefore rather than simply allowing the plaintiffs leave to file an amended complaint, he required them to file a motion seeking leave. The plaintiffs’ motions are due September 14, 2009.

 

I have in any event added Judge Stein’s ruling to my register of subprime-related lawsuit dismissal motion grants and denials, which can be accessed here.

 

My prior post discussed the corporate waste allegations in connection with Charles Prince’s severance package in the Citigroup derivative lawsuit in Delaware, which allegations survived the initial motion to dismiss in that case, can be found here.

Plaintiffs Target Stanford Financial’s Outside Counsel: On August 27, 2008, former Stanford Financial investors claiming damages of over $7 billion filed a purported class action lawsuit in the Northern District of Texas against former Stanford Financial outside counsel Thomas Sjoblum and his law firm, Proskauer Rose. A copy of the plaintiffs’ complaint can be found here.

 

In an apparent attempt to circumvent the limitations of the Stoneridge case, the plaintiffs filed their aiding and abetting claims against Sjoblum and his firm under the Texas securities laws rather than under the federal securities laws. The plaintiffs also assert alternative legal theories under Texas law, including civil conspiracy, aiding and abetting civil conspiracy and respondeat superior.

 

Given the revelations of former Stanford CFO James Davis at his August 27, 2009 guilty plea, it may not be surprising that Sjoblum has now gotten drawn into the case. (In an August 27, 2009 post, here, the WSJ.com Law Blog details Davis’s revelations.) Among other things, Davis, in the factual recitations in his plea agreement, suggested that Sjoblum, in concert with Stanford officials, made representations to the SEC that were contrary to information he had been given about the company and its operations, including problematic characterizations of the company’s portfolio.

 

The extent to which the plaintiffs will succeed in imposing gatekeeper responsibility on Sjoblum remains to be seen. The interesting thing to me about the lawsuit is how unusual it is for the lawyers to have gotten dragged into the litigation. There have been very few instances (if any) where lawyers have become targets in the litigation arising out of the various other Ponzi scheme scandals or any of the collapses associated with the subprime meltdown and credit crisis. To my knowledge neither the Madoff scandal nor the subprime litigation wave drawn in gatekeeper claims against the lawyers involved in the underlying transactions, even though gatekeeper claims have been an important part of both related categories of litigation (primarily with respect to auditors, offering underwriters and rating agencies).

 

I have in any event added the lawsuit against Sjoblum to my running register of the Stanford-related lawsuits, which can be accessed here.

 

An August 31, 2009 National Law Journal article about the Sjoblum lawsuit can be found here.

 

Upcoming Directors and Officers Liability Conference: On November 30, 2009 and December 1, 2009, I will be co-Chairing the American Conference Institute’s Fifteenth Annual Advanced Forum on D&O Liability, in New York City. The program features an all-star cast of experts in the field on a wide variety of critical topics in the area. A copy of the agenda and registration information can be found here.

 

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It seems that Southern District of New York Judge Jed Rakoff has been busy lately reviewing proposed settlements related to Merrill Lynch. But unlike his recent well-publicized refusal to accept the SEC’s proposed settlement of its enforcement action regarding the Merrill Lynch bonus disclosures, he did agree on August 21, 2009 to preliminarily approve the proposed $150 million settlement in the securities class action lawsuit brought on behalf of purchasers of certain Merrill Lynch bonds and preferred securities. A copy of Judge Rakoff’s August 21 order can be found here.

 

This settlement relates to what has come to be known as the "Bond Action," to differentiate it from the "Securities Action." As reflected here, the parties to the securities action had previously agreed to a $475 million settlement in that case (as well as a $75 million settlement of a related class action under ERISA).

 

As reflected at greater length here, the Bond Action was brought on behalf of those who invested in the more than $24 billion in preferred and debt securities that Merrill had issued to the public between October 2006 and May 2008.

 

As reflected in the plaintiffs’ Corrected Amended Complaint (here), the lead plaintiffs asserted claims on behalf of the class under Sections 11, 12 and 15 of the Securities Act. The defendants included not only Merrill itself and certain of its directors and officers, but also the offering underwriters as well.

 

The complaint alleged that the offering documents issued in connection with the specified securities offerings failed to "accurately disclose the existence and the value of tens of billions of dollar of complex derivative securities linked to subprime mortgages" that Merrill was carrying on its balance sheet. The complaint further alleges that these exposures "nearly wiped Merrill out by September 2008" and also "nearly toppled Merrill’s white knight acquirer," the Bank of America, and only a massive federal bailout rescued the banks’ merger.

 

There are several interesting things about this settlement, beyond just its size alone. The first is that the defendants entered the settlement while the motions to dismiss the amended complaint were still pending. While there may be any number of reasons for the timing of this development, it does (together with the timing of the prior Securities Action settlement) suggest that following its acquisition of Merrill, Bank of America moved quickly to clear the decks of Merrill litigation that predated the merger, even if substantial sums proved to be required to accomplish that goal.

 

The substantial sums of cash raises another interesting question, which is the omnipresent question for all bailed out financial institutions – is this being financed with federal bailout money? Or, to put it another way, are taxpayer funds going to pay off the plaintiffs and their lawyers in this case? (For an earlier discussion of the question whether TARP money would go to settle securities lawsuits, refer here.)

 

The bare face of Judge Rakoff’s order preliminarily approving the settlement does not broach any of these subjects. However, he did take a parting shot at the end of the order, by adding a handwritten paragraph just above his signature, stating that "notwithstanding any provision anywhere in this case that could otherwise be interpreted, no attorneys’ fees shall be paid or otherwise distributed until after all other authorized distributions of funds have occurred."

 

I have in any event added the Merrill Lynch Bond Action settlement to my register of subprime and credit crisis case resolutions, which can be accessed here.

Andrew Longstreth's August 26, 2009 article in the American Lawyer about the settlement can be found here.

Special thanks to Adam Savett of the Securities Litigation Watch (here) for providing a copy of Judge Rakoff’s order.

 

And Speaking of Subprime-Related Securities Lawsuit Case Resolutions: In recent orders in separate subprime-related securities lawsuits, two separate courts granted renewed motions to dismiss after the plaintiffs had filed amended complaints seeking to address concerns noted in prior orders dismissing the plaintiffs’ initial complaints.

 

First, on August 4, 2009, in the Centerline Holding Company case (about which refer here), Judge Schira Scheindlin entered an order (here) granting defendants’ motion to dismiss the plaintiffs’ amended complaint. Judge Scheindlin had previously granted the defendants’ motion to dismiss plaintiffs’ initial complaint (as discussed here), but she had previously also allowed plaintiffs leave to amend. In her August 4 order, she denied plaintiffs leave to amend.

 

Second on August 21, 2009, Central District of California Judge John F. Walter granted the defendants’ motion to dismiss the plaintiffs’ second amended complaint in the Downey Financial case. A copy of Judge Walter’s opinion may be found here. As reflected here, Judge Walter had previously dismissed plaintiffs’ initial complaint with leave to amend. However, the dismissal entered on August 21 was with prejudice.

 

The Downey Financial case may be of particular interest, because Downey Financial represents one of the relatively few bank failures out of the recent wave of closures that has resulted in shareholder litigation. The plaintiffs’ lack of success in that case may suggest why plaintiffs’ lawyers’ have at least so far pursued relatively few lawsuits in connection with the bank failures. The dismissal could discourage others as well.

 

I have in any event added the two dismissals to my running tally of subprime and credit crisis-related securities lawsuits case dismissals and dismissal motion denials, which can be accessed here.

 

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Two recent dismissal motion rulings in cases arising out of the subprime and credit crisis litigation wave involve two companies from outside the original core of the subprime lending sector – student lender First Marblehead and residential home builder Levitt Corporation. When these cases were filed early in 2008, I cited each of them as examples of how the subprime litigation wave was expanding to encompass a broader range of companies.

 

Both of the recent opinions in these two cases are quite detailed and allegation-specific, but in many respects they point in divergent directions. The First Marblehead decision is a sweeping defense victory, but the Levitt Corp. opinion, while a split decision, is generally more favorable to the plaintiff in that case.

 

First Marblehead: In an August 5, 2009 opinion (here), District of Massachusetts Judge Joseph L. Tauro granted defendants’ motion to dismiss. Judge Tauro’s opinion essentially rejects all of plaintiffs’ allegations. (Background regarding the case can be found here; my prior post about the lawsuit’s filing can be found here).

 

Judge Tauro found that the plaintiffs had not sufficiently pled misrepresentation, because, he concluded, "First Marblehead disclosed what the Complaint alleges it concealed" with respect to the company’s supposedly changed lending criteria and loan standards; default rates; relationship with its insurer affiliate; and changes in the various factors that could undermine its financial projections.

 

Because he found that the company had disclosed what the plaintiffs alleged was withheld, Judge Tauro also found that the plaintiffs had failed to plead sufficient facts to give rise to a strong inference of scienter. He also found that the complaint’s insider trading allegations were not sufficient to establish a strong inference of scienter, because the individual defendants who traded were not alleged to have particularized knowledge of the alleged fraudulent scheme, and because one individual’s trades were distant in time from the alleged corrective disclosure while the other individual’s trades were pursuant to trading plans whose existence had been publicly disclosed.

 

Finally Judge Tauro rejected plaintiffs’ loss causation allegations, finding that the company’s "drop in share price coincided with a significant downturn in the credit markets and its own preexisting patter of stock declines." He also quoted with approval from a Second Circuit opinion in a RICO case, which stated that "when the plaintiff’s loss coincides with marketwide phenomena causing comparable losses to other investors, the prospect that the plaintiff’s loss was caused by fraud decreases."

 

Judge Tauro’s opinion does not state whether or not the dismissal is with prejudice, but the opinion does not offer the plaintiffs’ leave to amend.

 

Levitt Corp.: Southern District of Florida Judge Donald L. Graham’s August 10, 2009 opinion in the Levitt Corp case (here) grants in part and denies in part the defendants’ motions to dismiss. (Background regarding the case can be found here. My prior post about the lawsuit’s filing can be found here.)

 

With respect to many of the factual allegations in the plaintiffs’ complaint, Judge Graham found that the plaintiff had sufficiently alleged misrepresentation, except as to a few with respect to which he found the allegations were insufficient, and several others he found came within the safe harbor for forward looking statements. Other than with respect to the statements he found to be within the safe harbor, he allowed plaintiff leave to amend his allegations to attempt to correct the pleading deficiencies noted.

 

Judge Graham also found that the plaintiff had adequately alleged scienter as to the company’s CEO Alan Levan, based on the plaintiffs’ allegations that Levan had knowledge of the need for updated pro forma financial analyses of the company’s home building subsidiary and was aware of circumstances that necessitated an impairment analysis.

 

However, Judge Graham concluded the plaintiff’s scienter allegations were insufficient as to the company’s CFO George Scanlon, finding that the plaintiff had "insufficiently alleged his knowledge of the failure to update pro formas and, as a result, to conduct the impairment analysis." He did allow plaintiff leave to amend the scienter allegations as to Scanlon.

 

Finally Judge Graham found based on the complaint’s allegations of the company’s share price declines following the alleged disclosure revelations that the plaintiff had adequately pled scienter.

 

Judge Tauro’s opinion in the First Marblehead case appears tough and skeptical by comparison to Judge Graham’s, particularly with respect to loss causation issues. In those respects the two cases may well appear at odds, although the difference may largely be due to Judge Tauro’s initial conclusion that the defendants had disclosed what the plaintiffs alleged had been withheld. With that as a starting point, he seemed clearly inclined against the plaintiffs’ allegations.

 

Whatever else may be said about the opinions, the two decisions do illustrate how the outcome of the dismissal motions in these cases have shown a broad range of approaches and outcomes. While a fair number of these cases are being dismissed, a number are surviving as well, notwithstanding such considerations as the overall market decline in which so many of these companies participated.

 

In any event, I have added these cases to my register of subprime and credit crisis-related securities lawsuit dismissal motion resolutions, which can be accessed here.

 

Special thanks to Adam Savett of the Securities Litigation Watch blog (here) for providing me with copies of the opinions.

 

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On July 30, 2009, Eastern District of New York Judge Thomas C. Platt entered an order (here) preliminarily approving the settlement of the securities class action lawsuit that had been filed certain directors and officers of American Home Mortgage Investment Corporation. The total value of the settlement is $37.25 million, which alone makes the settlement significant. However, the settlement is also significant because it appears to be the first subprime-related securities lawsuit settlement to which the target company’s auditors and offering underwriters contributed toward settlement.

 

As reflected in greater detail here, plaintiffs first initiated the lawsuits in July 2007. Because American Home itself had filed a voluntary petition for bankruptcy under Chapter 11, the company itself was not named as a defendant. In addition to the individual directors and officers, the defendants named in the case included the company’s outside auditor, Deloitte & Touche LLP, as well the investment banks that had acted as offering underwriters in connection with the company’s August 9, 2005 and April 30, 2007 public offering of its securities. Deloitte issued reports as to the company’s financial statements that were incorporated into the offering documents.

 

American Home had been a real estate investment trust that engaged in the investment in and origination of residential mortgage loans. The complaint (which can be found here) essentially alleged that the company was experiencing an increasing level of loan delinquencies. The complaint alleged that this was due to the company’s shift from higher quality loans to higher risk subprime loans, though the company allegedly continued to represent that it was not a subprime lender. As a result of the decline in loan quality, the company allegedly was experiencing increasing difficulties selling its loans, which compelled the company to reduce prices, reducing profits and margins. The company allegedly was also failing to write-down the value of certain loans and mortgage-backed assets in its portfolio. As a result of these developments, the plaintiffs alleged, the company was overstating its financial results.

 

The plaintiff filed a motion for preliminary approval of the settlement (here) on July 7, 2009. According to the document, the settlement was reached while the motions to dismiss were still pending and as the result of formal mediation as well as settlement discussions. As reflected in the document and its attachments, the $37.25 settlement is actually a reflection of three separate settlement stipulations: a settlement of $24 million with ten individual defendants; a settlement of $4.75 million with Deloitte; and a settlement of $8.5 million with the seven underwriter defendants. (The details of the settlement are summarized here, see paragraph 8.)

 

According to the individual defendants’ stipulation of settlement, the company’s D&O insurers (who are named in the stipulation) "agreed to pay the Settlement Amount on behalf of the Settling Defendants."

 

While the settlement is noteworthy in and of itself, it is significant because the settlement includes significant monetary contributions from the offering underwriters and the company’s outside auditors. So far as I am aware, this is the first subprime-related securities class action lawsuit settlement in which either offering underwriter or audit firm defendants have made a monetary contribution toward settlement. These defendants’ settlement contributions are all the more noteworthy given that the motions to dismiss in the case had not even been heard in the case.

 

Many of the subprime and credit crisis related securities suits name offering underwriters or audit firms as defendants. Whether or to what extent these parties will find themselves contributing toward settlement in these other cases remains to be seen. But if they are required to participate in settlements in significant amounts as was the case in the American Home suit, the overall costs of litigation for these firms could quickly mount to some truly impressive aggregate figures.

 

The D&O insurers’ contribution toward the individuals’ settlement is also a reminder that these cases could wind up being collectively very expensive for the D&O insurance industry. There are still only a handful of settlements but the ones have been entered so far include some sizeable settlements, and if the settlements so far are representative, there could be some huge claims payments ahead.

 

Even the few settlements that have been entered so far would seem to be starting to have their impact on the insurers – for example, the recent $32 million settlement in the RAIT Financial subprime-related securities case (refer here) and the recent $22 million settlement in the American Home Lenders subprime-related securities case (here) were also entirely funded by the D&O insurers. If these settlements are any indication, the industry’s overall claim loss exposure from the subprime and credit crisis-related litigation wave could be enormous.

 

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

 

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Earlier this year, when the auction rate securities lawsuit against UBS was dismissed (refer here), the obvious question was whether the dismissal signaled the end of the auction rate securities litigation. Certainly, the growing number of companies that, like UBS, had entered regulatory settlements (the basis of the UBS dismissal) or otherwise agreed to redeem the ARS seemed to suggest that the auction rate securities lawsuits pending against other financial companies would suffer the same fate as the UBS suit.

 

But while this anticipated effect is now being realized in some cases, the end of at least a major chunk of the auction rate securities litigation may be nowhere near.

 

There are recent significant developments regarding the possibility that the ARS regulatory settlements and repurchase agreements may mean further auction rate securities lawsuits dismissals. Along those lines, on August 6, 2009, Southern District of New York Judge Victor Marrero granted the defendants’ motion to dismiss in the Northern Trust auction rate securities lawsuit. Judge Marrero’s opinion can be found here. Background regarding the case can be found here.

 

In granting the motions to dismiss, Judge Marrero ruled, citing the decision in the UBS auction rate securities lawsuit dismissal, that the plaintiff had "not alleged recoverable damages," owing to the fact that the plaintiff had "already received compensation for losses suffered as a result of the alleged misstatement or omissions." (In December 2008, the plaintiff had "received par value" for his ARS investments under Northern Trust’s ARS repurchase program.)

 

The UBS and Northern Trust dismissals do seem to suggest that the auction rate securities litigation could be coming to an end -- at least for companies that have entered regulatory settlements or repurchase agreements.

 

But not all of the targeted firms have agreed to repurchase the ARS.

 

For example, as reflected in an August 1, 2009 New York Times article (here), Raymond James Financial is "among the holdouts." According to the article, the firm’s clients currently hold approximately $800 million (presumably, par value) of illiquid securities that the first sold them. The firm is working to try to reduce these investor holdings, primarily through issuer redemptions. However, the article, reports that the firm has stated in its disclosure documents that it does not "at present" have the "capacity" to redeem all of the securities.

 

As reflected here, Raymond James is the subject of a pending auction rate securities lawsuit in the Southern District of New York. However, without having made a redemption offer, Raymond James will not be in a position to seek dismissal on the same basis as did UBS and Northern Trust.

 

In addition to the firms that have not redeemed securities, there are the investors whose securities have not yet been redeemed.

 

For example, many of the regulatory settlements either do not extend to institutional investors or only provide for the redemption of institutional investors securities at a later date (in some cases, a much later date.) As a result of the continuing illiquidity of these investors’ securities, many of these investors have filed and are continuing to file lawsuits against the firms that sold them the securities.

 

A very recent example of this type of suit is the lawsuit filed on August 5, 2009 – the day before the Northern Trust dismissal – in the Southern District of New York, by Teva Pharmaceutical Industries and affiliated companies against Merrill Lynch and related entities. The complaint, which can be found here, alleges that Teva purchased CDO action rate notes and other auction rate securities that Merrill Lynch structured and underwrote. The complaint alleges that as a result of the failure of the ARS market, the plaintiffs now holds ARS for which it paid $273 million that now have a market value of less than $10 milllion. (Among the CDO auction rate notes in which Teva invested is the infamous Mantoloking CDO, about which I wrote here.)

 

Nor is Teva alone in its predicament. Teva is just one of several public companies cited in a July 15, 2009 CFO Magazine article entitled "Buyer’s Remorse" (here), which describes the continuing woes of many companies that invested in auction rate securities. Among other things, the article cites a source as saying that nonfinancial public companies still have $24 billion (par value) of ARS on their books. Many of these companies, like Teva, have sued the firms that sold them the securities. A prior post in which I discuss other recent examples of institutional investor auction rate securities litigation can be found here.

 

But a lawsuit by the company against the firm that sold them the securities is not the only litigation possibility involved here. As I previously noted (here), some public companies have been hit with lawsuits by their own investors who claim they were misled about the companies’ exposure to auction rate securities in which the companies had invested.

 

If nothing else, the recently filed Teva lawsuit signals that we may be nowhere near the end of the auction rate securities litigation, even if some of the cases (like those against UBS and Northern Trust) are dismissed. The continuing illiquidity of the securities, the complexity of the transactions and the sheer quantity of dollars involved suggest that at least some of the auction rate securities litigation could and probably will go on for some time to come.

 

I have in any event added the Northern Trust dismissal to my running register of credit crisis-related lawsuit resolutions, which can be accessed here.

 

An Interesting Note: According to his official biography, Judge Marrero filed the seat on the Southern District of New York previously occupied by the newly confirmed Supreme Court Justice, Sonia Sotomayor, prior to her appointment to the Second Circuit.

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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Another Subprime-Related Securities Lawsuit Dismissal: In yet another subprime-related securities class action lawsuit decision in defendants’ favor, on July 29, 2009, District of Connecticut Judge Stefan Underhill granted the defendants’ motion to dismiss in the securities lawsuit pending against CBRE Realty Finance and certain of its directors and officers. A copy of the opinion can be found here. Background regarding the case can be found here.

 

As reflected in Alison Frankel’s July 30, 2009 article about the decision in The American Lawyer Daily (here), the court’s order in the CBRE Realty case may be particularly noteworthy because the plaintiffs’ complaint asserts claims under the ’33 Act, in connection with which the plaintiffs would not have to plead scienter or even loss causation in order to survive a motion to dismiss -- they only need to plead a material misrepresentation or omission.

 

In his July 29 order, Judge Underhill found that the plaintiffs had not adequately pled that the alleged misrepresentations or omissions were material. The plaintiffs had alleged that in connection with company’s IPO, the company’s offering documents had not adequately disclosed the risk of default in connection with two Maryland condominium conversion projects known as Triton. Judge Underhilll concluded that plaintiffs had failed to allege that there was not sufficient collateral to back the $51 million loan to Triton.

 

Judge Underhill’s ruling does not indicate whether or not it is with or without prejudice; however, he did order the court clerk to close the file.

 

I have added the CBRE decision to my register of subprime and credit crisis-related lawsuit dismissal motion outcomes, which can be accessed here.

 

Still More Bank Failures: In case you missed it, this past Friday night, the FDIC closed five more banks, bringing the year to date total number of bank failures to 69. The FDIC has taken control of 32 banks just since June 19, 2009. An August 1, 2009 Bloomberg article detailing the latest bank closures can be found here.

 

The most recent round of bank closures continues the trend concentration of recent bank closures within the community banks. Four of the five latest bank closures involved institutions that had assets of under $1 billion. Of the 69 banks that have closed this year, 59 have had assets under $1 billion.

 

The signs are that the bank closures will continue for some time to come. The July 31, 2009 Wall Street Journal reported (here) that banking regulators have already entered at least 285 memoranda of understanding with banking institutions this year, on pace for nearly 600 by year end, compared with 399 for the full year last year. While the MOUs are designed to try to direct the institutions away from closure, the sheer number of agreements is a reflection of the difficult circumstances that many banking institutions are facing.

 

The FDIC’s complete list of banking institutions that have failed since October 2000 can be found here.

 

Another Madoff-Related Insurance Coverage Action: In an earlier post (here), I noted the arrival of the Madoff-related insurance coverage litigation and suggested there would be much more similar coverage litigation ahead. Another Madoff-related coverage lawsuit has now arrived.

 

On July 20, 2009, Blezak Black filed an action (here) in New Jersey (Camden County) Superior Court against its crime insurers. The plaintiff alleges to have invested over $13 million with Madoff, which it lost. The plaintiffs’ crime insurers have denied coverage for the claim. The plaintiff’s complaint alleges breach of contract and seeks a judicial declaration of coverage.

 

I have added this lawsuit to my register of Madoff-related insurance coverage litigation, which can be found in Table V of my register of Madoff lawsuits. The register can be accessed here.

 

Special thanks to a loyal reader for providing a copy of the latest Madoff-related insurance coverage lawsuit complaint.

 

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In a July 15, 2009 motion (here), the plaintiff in the subprime-related securities class action lawsuit involving RAIT Financial Trust moved for preliminary approval of a proposed settlement of the case. According to the company’s May 27, 2009 filing on Form 8-K (here), the parties entered a preliminary agreement on May 26 2009 to settle the case for a cash payment of $32 million, to be funded entirely by the company’s D&O insurers.

As reflected in greater detail here, the company was first sued in August 2007 in a securities class action lawsuit alleging that in the offering materials accompanying the company’s January 2007 IPO as well as subsequent statements, the defendants made misrepresentations and omissions about the company’s credit underwriting, exposure to investments in debt securities, loan loss reserves and other financial items.

In a December 22, 2008 ruling, Eastern District of Pennsylvania Judge Legrome Davis substantially denied the defendants’ motions to dismiss. Among other things, Judge Davis’s ruling was noteworthy for its acceptance of the "core business operations" theory in concluding that the plaintiffs had adequately pled scienter, as discussed at greater length here.

The RAIT settlement joins the recent Accredited Home Lenders settlement (refer here) as subprime-related securities lawsuits in which the cases settled after the motions to dismiss were denied. The $22 million settlement in the Accredited case together with the $32 million settlement in this case suggest that companies (or at least their D&O insurers) may face significant financial consequences for losing the dismissal motion in these cases. These settlements and the recent $30.5 million settlement in the Beazer Homes case also start to create an impression that overall, the subprime and credit crisis cases might prove to be very expensive to resolve.

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

Very special thanks to a loyal reader for calling my attention to the RAIT settlement.

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In the latest subprime-related securities lawsuit to be settled, on July 15, 2009, the parties to the Accredited Home Lenders Holding Company securities fraud lawsuit filed a motion for preliminary approval of their proposed $22 million settlement of the case. A copy of the parties’ stipulation of settlement can be found here. Background regarding the case can be found here.

 

The Accredited Home Lenders case was one of the earliest subprime-related securities lawsuits to be filed – the first filed complaint in the case was filed in March 2007. And as reflected here, it was also one of the early subprime-related cases to survive a motion to dismiss.

 

In her January 4, 2008 order denying the motion to dismiss, Central District of California Judge Marilyn Huff found that the plaintiffs’ complaint adequately pled that the alleged misrepresentations were false and misleading. In making this finding Judge Huff relied on the "group pleading doctrine" which she found properly applied to the officer defendants because they had "direct involvement with the company’s day to day affairs and financial statements." She also found that the complaint adequately pled scienter, based on confidential witness information that the defendants directed "deviations" from company policy.

 

Accredited itself filed for bankruptcy protection in May 2009. According to the settlement stipulation, the settlement is conditioned upon receiving bankruptcy court approval for the company’s participation in the settlement.

 

According to the stipulation, the settlement was the result of "extensive settlement discussions" in April 2009, following mediation.

 

The $22 million settlement apparently is to be entirely funded by a transfer of funds from the company’s directors’ and officers’ liability insurers, who are identified in the definitions section of the stipulation. The stipulation recites that settlement is also conditional on bankruptcy court approval of the use of the insurance proceeds to fund the settlement.

 

The Accredited settlement joins the recent $30.5 million settlement announced in the subprime-related securities lawsuit involving Beazer Homes (about which refer here). Because the Accredited case was one of the first subprime lawsuits to be filed and because it had already progressed past the motion to dismiss, it may or may not immediately prefigure coming events in other subprime cases, as so many of the cases are still just in their earliest stages. Nevertheless, as settlements like those in the Beazer and Accredited cases accumulate, a better sense of the range of possible settlements may begin to emerge.

 

I have in any event added the Accredited settlement to my register of subprime and credit crisis-related lawsuits settlements and case resolutions, which can be accessed here.

 

ABA TIPS Panel: "The Financial Collapse -- What Caused It and How Will It Continue To Impact Corporations and Their Boards?": The American Bar Association Tort Trial & Insurance Practice Section (TIPS) Task Force on Corporate Governance will hold this meeting at the ABA Building in Chicago on July 30, 2009 as part of the ABA Annual Meeting, to discuss the 2008 financial collapse and how corporations can manage risk throughout the remainder of the ongoing crisis.

 

I will be participating in this free session, which will be chaired by my good friend Kim Hogrefe from Chubb. The panel will also include Fiona Phillip of Howrey LLP and Dr. Faten Sabry of NERA Economic Consulting. The event will be followed by a reception. More information about the event, including event registration can be found here.

 

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In a July 1, 2009 opinion (here), Northern District of California Judge Susan Illston denied in part and granted in part the defendants’ motion to dismiss the plaintiffs’ consolidated complaint in the subprime-related securities class action lawsuit pending against the The PMI Group and certain of its directors and officers. Among other things, Judge Illston specifically found that insider trades pursuant to a Rule 10b5-1 trading plan cannot serve as the basis of a finding of scienter. Background regarding the case can be found here.

 

Judge Illston denied the defendants’ motion in part, finding that the plaintiffs’ consolidated complaint had sufficiently alleged material misrepresentations with respect to the adequacy of PMI’s risk management practices and its reporting of its loss reserves. She also found that the complaint adequately alleged loss causation. However, she nevertheless granted the defendants’ motion to dismiss with leave to amend on the grounds that the consolidated complaint did not adequately allege scienter.

 

With respect to scienter, Judge Illston found that the complaint "falls short of showing that the defendants were aware that the statements were false or misleading when made."

 

Judge Illston specifically found that the confidential witness testimony on which the plaintiffs sought to rely was insufficient. Judge Illston noted with respect to the internal reports that one confidential witness referenced that "the complaint does not describe these reports in any detail, and thus there is no information in the complaint as to whether the reports should have alerted the defendants" as to the falsity of the disclosures.

 

With respect to the other confidential witnesses’ testimony, she said that the complaint does not disclose how the witnesses would have had "personal knowledge" of the items they reference or that that the individual defendants were aware of this information.

 

Judge Illston also rejected as insufficient the plaintiffs’ attempt to satisfy the scienter requirements by arguing that the individual defendants are company officers who may be presumed to have knowledge of the company’s "core operations." She found that the "plaintiffs have not shown that this case fits within the unusual circumstances" to which the "core operations" theory might apply, noting that in addition to alleging the defendants’ corporate positions, the complaint must detail the defendants’ actual exposure to information. She noted that the plaintiffs can attempt to amend their complaint if they can to show that the defendants "actually had information showing the problems."

 

In addition, Judge Illston rejected as insufficient the plaintiffs’ attempt to rely on the existence of a bonus plan and of insider trading to establish scienter. She noted that "the simple fact that PMI had a bonus compensation plan, without more does not support scienter."

 

She rejected the alleged insider trading allegations as insufficient both because the complaint does not contain any allegations regarding the defendants’ prior trading histories and because she found that three of the defendants had actually increased their holdings during the class period, "which is inconsistent with the intent to defraud."

 

Finally, Judge Illston noted on the issue of scienter that 98% of on individual defendant’s sales were pursuant to Rule 10b5-1 trading plans, with respect to which she further noted that "sales according to pre-determined plans may rebut an inference of scienter." (Refer here for discussion of another recent case where trades pursuant to a Rule 10b5-1 plan were also found sufficient to rebut the inference of scienter.)

 

Because she concluded that plaintiffs had not adequately alleged scienter she granted defendants’ motion to dismiss with leave to amend. The plaintiffs have until July 24, 2009 to file their amended complaint.

 

I have in any event added Judge Illston’s opinion to my running register of subprime and credit crisis-related securities lawsuit dismissal motion rulings, which can be accessed here.

 

Special thanks to Adam Savett of the Securities Litigation Watch for providing a copy of Judge Illston’s opinion.

 

Bloomberg Podcast on Directors’ Accountability Now Available: On June 24, 2009, I participated in a Bloomberg-sponsored roundtable discussion on the topic of "Corporate Directors’ Accountability During and After the Economic Crisis." Also participating on the panel were Professor Charles Elson, Director of the John L. Weinberg Center for Corporate Governance at the University of Delaware, Michael Barry of Grant & Eisenhofer, and Michael Forman of Dorsey & Whitney. The hour-long panel discussion can now be accessed or downloaded from Bloomberg’s website, here.

 

The Latest Stanford Financial Group Lawsuit: According to a July 13, 2009 Bloomberg article (here), Stanford Group investors have filed a class actoin lawsuit in the Southern District of Texas against The Commonwealth of Antigua and Barbuda, alleging that the Caribbean nation helped the financier engineer a massive fraud. The complaint (here) , purports to be filed on behalf of all individuals and investors who were customers of Stanford International Bank as of February 16, 2009, alleges violations of and seeks to recover damages under RICO.

 

I have added this latest lawsuit to my running register of all Stanford Group-related litigation, which can be accessed here.

 

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As the credit crisis litigation wave has evolved, an increasing number of related lawsuits have “targeted asset management firms and involved complex financial instruments,” according to a new study from NERA Economic Consulting. The June 15, 2009 study, written by Dr. Faten Sabry with her colleagues Anmol Sinha and Sungi Lee, is entitled “An Update on the Credit Crisis Litigation: A Turn Toward Structured Products and Asset Management Firms,” and can be found here.

 

The study provides an update of what the study describes as “credit crisis filings,” which category includes not only securities cases (i.e. those involving allegations pertaining to the purchase, ownership or sale of securities) but also includes ERISA claims, shareholder derivative actions, individual state and federal cases, and international cases. The category excludes predatory lending, mortgage loan repurchase disputes and actions involving consumer finance.

 

 

The study reports that this broad category of “credit crisis filings” increased by 172% in 2008 compared to 2007. The study, which reports data through March 17, 2009, notes that the filing activity shows no sign of slowing in 2009, with 46 “credit crisis filings” through March 17 of this year, compared with 188 in all of 2008 and 69 during 2007.

 

 

Though the study reports on a broad category of kinds of filings, even within this broad category, the study found that the percentage of filings that name individual directors and officers as defendants is high – 62% in 2008 and 72% in 2009.

 

 

The study found that within the broad category of “credit crisis filings” that while claims against shareholders involved 57% of filings in 2007, they represented only 37% in 2008 and 33% in 2009. The filings over time increasingly have involved other claimants, including auction rate securities investors, non-ARS investors, plan participants, and other plaintiffs. The non-ARS investors include those who invested in preferred securities, corporate bonds, mortgage-backed securities, mutual funds, and money-market funds.

 

 

Just as the type of claimants has shifted over time, so too has the type of claim target. The study reports that as the credit crisis has moved from the mortgage-related markets to the overall credit markets, “the focus of the related litigation has also shifted towards more complex financial instruments and different market participants.”

 

 

Among other things, the study reports that asset management firms and issuers/underwriters now represent the majority of the defendants named. The percentage of lawsuits involving asset managers more than doubled between 2007 and 2008.

 

 

The study includes a particular examination of lawsuits involving collateralized debt obligations (CDOs). As CDOs have experienced increasing numbers of “events of default,” the lawsuits have followed. The CDO-related lawsuits generally allege failures to disclose proper valuations and misrepresentations about the quality of the underlying collateral.

 

 

In addition, as the financial crisis has continued, the underlying debt and the indices that are used as reference entities for credit default swaps have declined in value and the providers of CDS protection have experienced significant losses, also resulting in litigation. A key allegation in the CDS lawsuits is the failure to pay the protection promised following the occurrence of certain credit events.

 

 

The study notes that though there have been some reported resolutions of the credit crisis cases, which the report describes generally, most cases remain in their earliest stages.

The report concludes by noting that “as the losses continue to mount, it is not clear that the litigation will slow down,” adding that the lawsuits remain in their early stages and the credit crisis story is far from over.”

 

 

The study’s update of the credit crisis litigation wave provides useful and interesting analysis of the evolving litigation. Indeed, perhaps as a result of the depth of interesting information and analysis in the study, a variety of additional interesting questions that the data might also answer follows from reading this study.

 

 

The study’s aggregation of a wide variety of kinds of claims into a larger category denominated “credit crisis filings” does raise the question of what portions within this larger category each of the included types of claims represents. It would be interesting to see a breakdown within the larger category of “credit crisis filings” how many and what percentage each of the constituent subcategories represents and how they have changed over time. By way of illustration, how many of the “international cases” have there been, and when were they filed?

 

 

Similarly, within the category of claims identified in the study as having been filed against directors and officers, it would be interesting to know how these claims break down by lawsuit type.

 

 

It would also be interesting if the study’s descriptive analysis of the claims involving CDOs and CDS, which included also descriptions of some representative cases, also included aggregate numerical analysis of claims involving these financial instruments – that is, over time, how many claims have there been involving these kinds of financial instruments, and how have the numbers changed?

 

 

The study also specifies that the authors identified a category of claims involving non-ARS investors. It would be interesting to know specifically how many of these claims by each of these kinds of investors have been filed over time. For example, with respect to claims involving investors in preferred or subordinated investors, which I have noted (here) is an increasingly important part of securities lawsuit filings, how many filings have there been? How have the filing numbers changed over time?

 

 

Finally, while the report intentionally and by its own terms intends to describe and analyze lawsuit filings trends broader than those just involving securities class action lawsuits, that filing subcategory is generally an area of widespread interest and it would be interesting to have the benefit of the authors’ analysis of this specific subcategory.

 

 

All of that said, the study provides an interesting and important overview of the way that the credit crisis litigation wave has evolved over time. We can all hope that the authors will continue to track the filings and to provide further updates as the credit crisis litigation wave continues to evolve.

 

 

A complete list of the credit crisis-related securities lawsuit filings is accessible here, and a table reflecting credit-crisis related securities lawsuit case resolutions is accessible here.

 

 

Speakers’ Corner: During the period June 21-23, 2009, I will be in Palo Alto, California, where I will be participating as a faculty member at the Stanford Law School Directors’ College. A summary agenda for the event can be found here.

 

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In its most significant enforcement action yet related to the subprime meltdown, on June 4, 2009, the SEC filed a civil securities fraud complaint (here) in the Central District of California against Angelo Mozilo, the former CEO of Countrywide Financial Corp., as well as the company’s former COO and CFO. The complaint alleges that the defendants mislead investors by misrepresenting the company’s loan origination standards and practices and by hiding the company’s deteriorating financial condition. The complaint also contains allegations of improper inside trading against Mozilo for initiating Rule 10b5-1 trading plans to sell shares while he was aware of material nonpublic information about the company’s deteriorating loan practices.

 

As discussed in its June 4, 2009 press release (here), the SEC’s complaint charges that from 2004 through 2007, Countrywide engaged in "an unprecedented expansion of its underwriting guidelines and was writing riskier and riskier loans, which these senior executives were warned might curtail the company’s ability to sell them" to investment bankers and other mortgage buyers.

 

The complaint alleges that while the company was issuing reassuring statements to investors, Mozilo "internally issued a series of increasingly dire assessments of the various Countrywide loan products and the risks to Countrywide in continuing to offer or hold these loans."

 

One of the more interesting aspects of the SEC’s press release about the suit is the accompanying document (here) in which the SEC summarizes email messages from Mozilo in which he delivered some of his "increasingly dire assessments." Among other things, an email attributed to Mozilo is quoted as saying that "we are flying blind on how these loans will perform in a stressed environment." Another email is also quoted as saying, with respect to the company’s subprime 80/20 loans, that "in all my years in the business I have never seen a more toxic prduct [sic]."

 

In other emails, Mozilo refers to the company’s 100% subprime second mortgages as "poison" and says that the 100% loan-to-value subprime mortgage is "the most dangerous product in existence and there can be nothing more toxic."

 

All of these statements attributed to Mozilo allegedly were made before Mozilo established several Rule 10b5-1 trading plans during the period October through December 2006. In December 2006 and February 2007, as the company’s share price was rising to record highs, he adjusted several previously established plans to allow him to sell even more shares. Pursuant to these plans and during the period November 2006 through August 2007, Mozilo exercised over 51 million stock options and sold the underlying shares for total proceeds of over $139 million.

 

Among other things, the complaint alleges that Mozilo approved his October 2006 trading plan one day after sending the email quoted above about "flying blind" on how the loans would perform. The complaint also alleges that five days before executing his December 2006 trading plan he circulated a memorandum to all managing directors and to the company’s board of directors noting a number of substantial concerns about the company’s subprime loan origination processes and noting that Countrywide expected its 2006 subprime loans to be the worst performing on record.

 

While many of these same kinds of allegations also appear in the pending Countrywide securities class action litigation (about which refer here), the SEC’s allegations nonetheless represent a significant development. SEC officials have been saying for over two years (as noted here, for example) that the agency would be cracking down on alleged Rule 10b5-1 trading plan abuses. Indeed, as discussed here, in an October 8, 2007 letter (here) to then-SEC Chairman Christopher Cox, North Carolina Treasurer Richard Moore had specifically asked the SEC to examine Mozilo’s stock trading pursuant to his Rule 10b5-1 plans.

 

With the SEC’s public commitment to cracking down on Rule 10b5-1 abuses and with the bull’s-eye drawn so specifically on Mozilo’s trading, it may have simply been a matter of time before some version of this complaint was filed. (Indeed, Alison Frankel’s June 4, 2009 American Lawyer article about the SEC’s complaint, which can be found here, is entitled "SEC (Finally) Charges Former Countrywide CEO Angelo Mozilo.") The SEC’s action nevertheless is a significant development, if for no other reason than the prominence of the company and of Angelo Mozilo and because of the nature and specifics of the allegations.

 

The more interesting question is the extent to which the SEC will be targeting other officials, whether for Rule 10b5-1 plan abuses or for disclosures relating to subprime loans and other lending practices. Given the continuing current public need to assign blame for the current crisis, the prospect for further enforcement activity in these areas seems likely.

 

Indeed, according to a June 4, 2009 Washington Post article (here), new SEC Chairman Mary Schapiro has specifically said that as part of her plan to try to rebuild the SEC’s tarnished reputation, she intends to step up enforcement efforts and to push cases related to the financial crisis. As a result, the Countrywide complaint may be only the first in a series of SEC enforcement actions designed to assign blame for the meltdown while also demonstrating that the SEC is "tough" again.

 

The World Was So Much Nicer Before Aggrieved Homeowners Had Access to Counseling Services:  Mozilo’s email practices got him in hot water even while he was still CEO of the company. In May 2008, Mozilo drew media attention (refer for example here) when he accidentally hit the "Reply" button rather than "Forward" after calling a homeowner’s plea for help "disgusting."

 

The borrower’s email had come from Daniel Bailey, a homeowner who was trying to stay in his home of 16 years. Bailey signed an adjustable rate mortgage and was told at the time that he could refinance after one year, before the payments became unaffordable. In drafting his note, Bailey had relied on suggested language from an Internet website that provided coaching services for troubled borrowers.

 

The email response Mozilo inadvertently sent Bailey said "Most of these letters now have the same wording. Obviously they are being counseled by some other person or by the Internet. Disgusting."

 

Mozilo seems to have had a deep commitment to ensuring that he would later look like a cartoon villain. I mean, here’s a guy who had just made a cool $140 million, yet when one of the suckers stuck with one of the loans that Mozilo himself described as "toxic" has the audacity to ask for relief, all Mozilo can think about is how "disgusting" it is that all of the losers stuck with these loans have the same grievances.

 

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Most of the cases filed in the subprime and credit crisis-related litigation wave are still in their earliest stages, but as the early returns have trickled in, one recurring question as been how the cases are faring. More than once (refer here for example) I have questioned whether the plaintiffs are doing poorly in dismissal motions in these cases, although more recently plaintiffs do seem to have been doing a little better (refer here and here).

 

My analysis of the plaintiffs’ success levels has been rather subjective and impressionistic. As an alternative to this unscientific approach, blogger Cliff Shnier on his eponymous blog (here) has applied more arithmetic rigor to the analysis and reached the conclusion that plaintiffs are in fact doing better on dismissal motions in recent months.

 

Using the data from The D&O Diary’s running tally of credit crisis securities lawsuit dismissal motion rulings, which can be accessed here, and applying the methodology similar to that used by blackjack players to count cards, Shnier has performed a quantitative analysis of the trend in credit crisis cases securities lawsuit dismissal motion rulings.

 

In order to perform the analysis, Shnier assigned a numeric value to each dismissal motion outcome, ranging from a score of minus one for a dismissal with prejudice to a score of plus one for a denial of a motion to dismiss, with intermediate values assigned for inconclusive outcomes such as dismissals without prejudice. Shnier then arrived at a running count by adding together all of the scores, and plotting the running count on a graph showing how the aggregate score has varied over time.

 

The resulting graph, shown on the left (a more legible image is linked on Shnier’s blog) shows that beginning in November 2007 and for the following twelve months “the running count started out in the negative numbers,” which is “favorable to defendants.” But the trendline crossed into positive numbers – more favorable to plaintiffs – and has stayed there ever since December 2008. Schnier’s conclusion? The “trendline is moving upward in favor of dismissals being denied.”

 

Shnier concedes that the outcome of this exercise may reflect the values he has assigned to various outcomes, particularly dismissals without prejudice. But even if more conservative values are assigned to these determinations, the trendline is still favorable to the plaintiffs.

 

There are of course many ways to analyze a range of case outcomes, and a numerical analysis is just one approach. And in any event, these cases are still mostly in their early stages, so any analysis at this point may be premature. Nevertheless, Schnier’s blackjack counting approach is interesting, and is certainly different, and it may have advantages over more subjective or impressionsitc approaches to the question. It will be interesting to continue to monitor Shnier’s analysis as the credit crisis-related securities cases continue to develop. 

 

The Infamous “Suzanne Researched This” Commercial (Circa 2006): How a lot of people wound up with more debt than they could afford and living in a house that is too big and beyond their means.

 

Clusterstock comments (here) that the “the commercial touts the fact that your Century 21 broker will team up with your browbeating wife and guilt you into buying the home you can't afford. It must be watched. We still think it kind of might be a parody.”

 

If it is a parody, it is a perverse kind of unconscious self-parody. All I know is that the words “You guys can do this” were used far too frequently in that era.

 

 

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Many of the subprime and credit crisis related securities lawsuits, particularly those filed in early in the subprime meltdown, involve subprime mortgage originators and financial institutions that pooled the mortgages into investment securities. A separate category of litigation distinct from that relating to originators and securitizers involves the companies that purchased the investment securities and that are alleged to have misrepresented the value of these assets on their balance sheet.

 

One company whose balance sheet exposure to toxic subprime mortgage backed assets resulting in securities litigation is the international money transfer and payment company MoneyGram International. Background regarding the MoneyGram securities lawsuit can be found here.

 

On May 20, 2009, District of Minnesota Judge David Doty issued a detailed opinion (here) substantially denying defendants’ motion to dismiss the plaintiff’s consolidated complaint in the MoneyGram case. Because many of the other credit crisis-related securities lawsuits contain allegations similar to the balance sheet toxic asset exposure allegations in the MoneyGram case, and because the parties’ arguments in the MoneyGram case reflect the battle lines that are likely to be drawn in many of these cases, Judge Doty’s opinion represents an interesting and potentially significant examination of the issues that may well recur in other cases.

 

Background

MoneyGram’s global payment and money transfer business requires the company to hold, transfer or to guarantee payments of large amounts of cash. To secure these payments and guarantees, MoneyGram maintains an investment portfolio. At the beginning of the class period in January 2007, the majority of MoneyGram’s $5.85 billion portfolio was held in asset-backed securities, mortgage-backed securities and collateralized debt obligations, backed in part by residential mortgages.

 

By the end of the class period in January 2008, the value of the portfolio had significantly deteriorated. In order to be able to maintain adequate capital, the company entered a substantial financing transaction that forced the company to recognize over $1 billion in losses in its investment portfolio. The company’s share price declined nearly 50%, and securities litigation ensued.

 

The consolidated complaint alleges that during the class period, the defendants made a series of misleading statements regarding the composition, valuation and quality of the company’s investment portfolio, and about its investment valuation processes, standards and controls.

 

The May 20 Opinion

Judge Doty’s May 20 opinion undertakes a detailed and painstaking review of all of the parties’ arguments. However, after having detailed the parties’ positions, he then in a few efficient paragraphs reduces the parties’ positions to two "competing narratives," as reflected on pages 67-68 of the opinion.

 

The "defendants’ narrative," Judge Doty writes, "maintains that at the beginning of the class period the eventual scope of the market failure was unforeseeable," but as 2007 progressed and the market decline became apparent, "defendants maintain that they proactively disclosed additional sufficient details" about the investment portfolio and its susceptibility to further declines.

 

The defendants further assert that their "increased recognition of unrealized losses and [other than temporarily impaired] securities accurately tracked the actual market decline." They also allege that they "made disclosures in good faith as reflected by the absence of insider trading allegations and financial restatements," and therefore they argue it is "improper to impose liability for failure to presage the nation’s worst economic meltdown in decades."

 

The "plaintiff’s narrative," on the other hand, argues that by the beginning of the class period "external ‘red flags’ reflecting the failure of the subprime and Alt-A markets were so apparent that defendants knew or should have know" that the investment assets were substantially impaired and could not be reliably priced. Moreover, the plaintiffs contend, the defendants "selectively and misleadingly released information about the investment portfolio," misleading investors into believing that the general market decline did not threaten MoneyGram.

 

In the meantime, the plaintiff alleges, the defendants were exploring bankruptcy and recapitalization options that were not revealed to the investing public, and rejected buyout overtures "to prevent revelation of [the company’s] financial problems." The plaintiffs allege that the defendants failed to disclose these problems "for fear of the market’s reaction."

 

Judge Doty found that "despite the shortcomings of some of lead plaintiff’s additional allegations of scienter," considering all of the circumstances "and with particular emphasis on the alleged misrepresentations and omissions, a reasonable person could find lead plaintiff’s fraud narrative to be cogent and at least as plausible as defendants’ opposing fraud narrative."

 

In finding that the plaintiff adequately alleged that the defendants had made material misrepresentations or omission, Judge Doty found that "the complaint connects the external ‘red flags’ with the defendants’ internal recognition of the effect of those flags," without which connection the allegations "would fail as prohibited hindsight claims." The complaint does not merely assert that "later disclosures should have been made earlier or that later-determined facts show that earlier statements were false," but rather allege why the statements may have been false when made or the omission should have been made earlier in light of the then-existing facts. Therefore, although "extensive, repetitive and occasionally abstruse," the complaint adequately alleges the existence of material misrepresentations.

 

Judge Doty concluded that the complaint’s allegations were sufficient to survive the motion to dismiss, except as to one individual defendant.

 

Analysis

In many ways, Judge Doty’s succinct presentation of the two competing narratives recapitulates the arguments that likely will be raised in many of the toxic asset balance sheet valuation securities cases that have been filed. The defendants will contend, as did the defendants in the MoneyGram case, that the plaintiffs’ allegations are simply fraud by hindsight, depending on later asset valuation declines or losses as supposed evidence of prior disclosure shortcomings.

 

Judge Doty’s opinion shows that in at least some instances plaintiffs will be able to overcome the fraud by hindsight "narrative." Significantly, Judge Doty found the plaintiffs’ narrative to be at least as compelling as the defendants, even in the absence of insider trading or a restatement.

 

To be sure, many aspects of Judge Doty’s ruling depend on specific allegations particular to this case. In particular, Judge Doty’s ruling on the scienter issue depended, for example, on allegations relative to a specific communication company officials had with an institutional investor in which defendants refused to disclose details of the company’s portfolio for fear the disclosures would be "disruptive," and on allegations that, contrary to the company’s public statements, the company’s securities were not of a higher quality and different vintage than those being downgraded by rating agencies.

 

Nevertheless, while Judge Doty’s ruling undeniably depended on factors specific to the case, the opinion does demonstrate that "fraud by hindsight" defenses may be overcome, a suggestion that is likely to hearten the plaintiffs in other cases. What seemed to matter, and what will likely matter in other cases involving toxic asset valuation disclosures, is not whether or not the company’s losses were greater than those of other companies, but rather what the company said or failed to say about its losses as they accumulated, as well as about the company’s exposure to losses before they occurred.

 

I have added the MoneyGram decision to my table of subprime and credit crisis settlements, dismissal and dismissal motion denials, which can be accessed here.

 

Securities Litigation and the Foreseeability of the Housing Decline: One of the critical issues imbedded in the MoneyGram case, and in many of the other cases in which plaintiffs seek to recover investment losses related to the subprime meltdown, is "the extent to which the downturn in the housing market and the resulting financial institutions’ writedowns and losses on securities with substantial real estate exposure was foreseeable earlier in time."

 

This question is examined in a May 6, 2009 paper entitled "Securities Litigation and the Housing Market Downturn" (here) written by Harvard Law Professor Allen Farrell and Atanu Saha of Compass Lexecon. The authors examined the question of foreseeability of the housing downturn (and related investment decline) beginning in 2006, as that is when the vast majority of class periods in the current wave of securities lawsuits begin, even though the bulk of the subprime investment writedowns took place in the fourth quarter of 2007 and the first quarter of 2008.

 

The authors posit that in order for disclosures prior to the massive writedowns to be actionable the possibility of these writedowns occurring had to be foreseeable. A company’s failure to disclose its exposure to certain asset valuation risks, or to create reserves for future losses on those assets, would be relevant only to extent it was foreseeable at the time of the disclosure that the valuation of the assets would decline. By the same token, the scienter element can only be established of senior managers’ actions were reckless in light of the foreseeable risks that the asset valuations would decline.

 

Based on their detailed review of housing price and interest rate data, the authors conclude that "there is little indication that the market was anticipating during the course of 2007 the serious market downturn that in fact occurred in the fourth quarter of that year." The authors conclude that "the evidence is consistent with the proposition that the serious housing market downturn was not generally foreseeable and was not foreseen by sophisticated market participants prior to the fourth quarter of 2007."

 

The authors’ paper provides substantial grist for the mill for litigants seeking to contend that class action plaintiffs’ securities lawsuit allegations constitute fraud by hindsight. Defendants can hardly be held liability for failing to anticipate or failing to disclose the risks of circumstances that not only were not foreseen but that were not foreseeable.

 

Unfortunately for defendants in these cases, these arguments may be unavailing. Very few of these cases ever go to trial; for most cases, the most critical stage is the determination of the dismissal motion. At the motion to dismiss stage, the plaintiffs’ allegations must be taken as true and the extensive factual data of the kind on which the authors rely is not considered or even relevant.

 

The presumption at the motion to dismiss stage that the plaintiffs’ allegations are true permits them to posit circumstances that might later prove to be demonstrably untrue. The authors’ paper may well establish that plaintiffs could struggle to prevail were they ever put to their proof. However, the name of the game for the plaintiffs is usually just to get past the dismissal motions, with the assumption that the case will settle long before the allegations are tested. It may not matter what the plaintiffs ultimately might be able to prove about forseeability; they are concerned rather only with what they can allege.

 

Special thanks to Kelly Rehyer for forwarding a link to the article.

 

A Reliable List of Tweeters: Within the world of Twitter are a few worthwhile notes dispersed in a deluge of noise. Filtering the notes from the noise requires identifying the tweeters worth following, a process that can be hit or miss. Fortunately, for those who want to identify reliable Twitter sources on securities litigation issues, Bruce Carton of the Securities Docket has developed a comprehensive list of the "15 People All Securities and Corporate Litigators Should Follow on Twitter" (here).

 

I commend Bruce’s list – I already follow everyone on Bruce’s list, and so I know it to be trustworthy and complete. Very special thanks to Bruce for including me in the company of illustrious tweeters.

 

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In an earlier post (here) in which I raised the question whether lawyers would find themselves the targets of gatekeeper blame from the subprime meltdown, I discussed a malpractice action that had been brought against the Cadwalader law firm by Nomura Securities, in connection with a commercial mortgage securitization transaction in which Cadwalader had acted as counsel.

 

According to Susan Beck’s May 21, 2009 Law.com article (here), Nomura’s lawsuit has survived Cadwalader’s motion to dismiss. As the article notes, the "backstory" on this case "is complicated." Cadwalader had been Nomura’s counsel in connection with the securitization. After one of the underlying commercial mortgages defaulted, LaSalle National Bank, the loan servicer, had sued Nomura. Nomura settled the LaSalle case for $67.5 million and then sued Cadwalader for malpractice in connection with the securitization documentation.

 

In his April 28, 2009 opinion (here) denying Cadwalader’s motion to dismiss, New York Superior Court Judge Melvin L. Schweitzer ruled that Nomura’s position in the LaSalle case that Cadwalader’s actions were proper did not preclude Nomura’s claims in the malpractice action, and that Cadwalader’s reliance on standard language from a Standard & Poor’s publication did not create a defense for a motion to dismiss.

 

Though the underlying securitization is from an era long ago (the transaction took place in 1997), the attempt to impose gatekeeper liability on the law firm raises the possibility that lawyers may find themselves among the targets in connection with more recent securitization transactions. The Nomura lawsuit’s survival of the initial motion to dismiss, though for reasons very specific to the particular case, may motivate other erstwhile plaintiffs to consider the possibility of targeting the transaction attorneys involved in the many securitizations now the subject of extensive litigation.

 

If the Nomura case is any indication, aggrieved parties may well attempt to seize on purported defects in the securitization documents to attempt to target the law firms that drafted the documents. To the extent law firms' clients and former clients are compelled to pay investor losses on securities they sold to investors, the clients and former clients may attempt to shift those losses to the lawyers that drafted the securitization documents.

 

Interestingly, according to the Law.com article, the attorney that initiated the Nomura lawsuit was none other than Marc Dreier, who recently pled guilty to a series of criminal actions that may be even harder to believe than they are to summarize. The Nomura case is being carried forward by two attorneys from Drier’s former law firm.

 

Florda Bank Becomes Larges Bank to Fail This Year:  In a rare Thurday night regulatory action, on May 21, 2009, BankUnited FSB became the thirty-fourth bank failure so far this year when regulators took control of the bank and sold its assets to a group of investors. According to news reports (here), the BankUnited closure is also the biggest bank failure so far this year. The failed bank had assets of $12.80 billion.

 

According to the Wall Street Journal (here), BankUnited's woes were due in part to its significant exposure to "nonresident alien" mortigage, which foreign domiciled individuals (primarily in Latin America) used the loans to acquire Flordia residential properties.

 

The DealBook blog has a lengthy description (here) of the private equity process that resulted in the transfer of BankUnited's assets.

 

In connection with prior bank closures this year, the FDIC had waited until after the close of business at the end of the week on Friday afternoon to announce its regulatory action. The FDIC’s Thursday afternoon action on BankUnited breaks this otherwise consistent pattern. Perhaps the banking regulators wanted to get ahead to allow them to get an early start on the upcoming holiday weekend.

 

The FDIC’s press release regarding the closure can be found here and additional background information from the FDIC can be found here. The FDIC’s complete list of failed banks can be found here. A helpful Wall Street Journal table regarding the recent bank closures can be found here.

 

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In prior posts (most recently here), I have noted the continuing litigation efforts of institutional investors excluded from the various auction rate securities regulatory settlements to try to compel their broker-dealers to buy back the investors’ ARS. In a complaint filed on May 13, 2009 in the Southern District of New York by Monster Worldwide against RBC Capital Markets (here), Monster raises the novel theory that RBC’s settlement-related offer to repurchase ARS from "eligible investors"is a "tender offer" that RBC must extend to all investors -- including institutional investors like Monster.

 

Between May 2007 and February 2008, Monster acquired $71.6 million of student loan backed ARS from RBC that Monster was left holding when the ARS market collapsed. In October 2008, RBC entered a regulatory settlement in which it agreed repurchase ARS from "its individual customers, charities, non-profits and government entities with less than $25 million on deposit." Pursuant to this arrangement, RBC will repurchase more than $850 million in ARS from "eligible investors." News reports regarding the regulatory settlement can be found here.

 

On December 1, 2008, RBC initiated an offer pursuant to the settlement to repurchase the ARS from eligible investors. Monster characterizes this repurchase offer in its complaint as a "tender offer," which offer was not extended to Monster and other institutional investors.

 

In its complaint, Monster describes its exclusion from RBC’s regulatory settlement as "arbitrary and unlawful," and alleges that RBC’s limitation of the "tender offer" only to "eligible investors" as a "clear violation" of Section 14(d) of the Exchange Act, giving rise to a claim for relief.

 

Monster also alleges that the repurchase offer violates SEC Rule 14d-10(a)1, the "All Holders" Rule, which provides that "No bidder shall make a tender offer unless … The tender offer is open to all security holders of the class of securities subject to the tender offer."

 

Finally, Monster alleges violations of the securities laws and common law in connection with RBC’s representations regarding the ARS.

 

Monster’s "tender offer" theory is unique and creative. By characterizing RBC’s repurchase offer, Monster seeks to secure for itself the benefit of a settlement from which it was excluded. The court will be challenged in addressing these allegations, because were the court to accept Monster’s theory, the floodgates could be opened for investors excluded from the other regulatory settlements to seek to bring themselves within the repurchase requirements. The critical question will be whether or note Monster is able to sustain its theory that RBC’s repurchase offer pursuant to the settlement is in fact a tender offer. This case will be very interesting to watch.

 

Special thanks to Thom Weidlich of Bloomberg for providing a copy of the Monster complaint.

 

Apologies: I would like to extend my deepest apologies to all readers who have experienced difficulties trying to access The D&O Diary over the last couple of days. A series of extended service outages at the blog’s hosting service has interrupted access to the site. I sincerely hope that these extremely annoying and frustrating service outages will not recur.

 

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In a pair of separate rulings late last week, district court judges took on the plaintiffs’ allegations in a couple of high profile lawsuits arising out of the subprime meltdown. The courts’ rulings make it clear that the plaintiffs’ allegations in these cases will be highly scrutinized, but that (in one of the two cases) the judicial hurdles are not entirely insurmountable.

 

First, in a May 15, 2009 ruling in the Washington Mutual Securities Class Action, Western District of Washington Judge Marsha Pechman granted the defendants’ motions to dismiss with respect to the plaintiffs’ ‘34 Act allegations, with leave to amend. She also granted the motion with respect to certain of the plaintiffs’ ’33 Act allegations, also with leave to amend, but she denied the motions to dismiss with respect to the plaintiffs’ ’33 Act allegations concerning the company’s October 2007 securities offering.

 

In granting the motions with respect to the ’34 claims, Judge Pechman was sharply critical of the clarity and organization of the plaintiffs’ consolidated class action complaint. She characterized the complaint as “verbose and disordered” and states that the plaintiffs’ allegations concerning the elements of the claim are “spread disjointedly” throughout the complaint, as a result of which the complaint “never offers a cohesive presentation of the required elements for securities fraud for each defendant.” Judge Pechman refers to the complaint as embodying “puzzle pleading.”

 

The opinion recounts that two days prior to oral argument on the dismissal motions, Judge Pechman had directed plaintiffs’ counsel to address the alleged misleading statements of each of the defendants and to connect the statement to the allegations allegedly showing that the defendant knew the statements were false. At the hearing, the opinion recounts, plaintiffs’ counsel “indicated that the relevant allegations were too numerous to identify even in three hours of argument.”

 

This response to her concerns clearly raised Judge Pechman’s ire; she said that she “remains mystified at counsel’s failure to allege cohesive claims, submit helpful briefing or prepare a response to the Court’s inquiry in advance of oral argument.” She added that counsel “cannot expect the Court to engage in the necessary analysis when counsel is not prepared to do so.” She added that if counsel is “unable to rectify the problems identified in this Order when they file the amended Complaint, the Court may be obligated to review whether counsel can adequately represent the proposed class.”

 

Given the attention-grabbing nature of Judge Pechman’s rebuke on the plaintiffs’ ’34 Act allegations, it might easily be overlooked that she denied the defendants’ motion to dismiss regarding plaintiffs’ ’33 Act claims relating to the company’s October 2007 securities offering. Judge Pechman specifically found that plaintiffs’ allegations with respect to the October 2007 offering were sufficient.

 

However, Judge Pechman granted the defendants’ motions to dismiss as to the company’s three offerings in August 2006, September 2006 and December 2007, because the plaintiff class lacked standing with respect to those offerings. The court allowed the plaintiffs’ leave to name additional plaintiffs to obtain standing as to the three other offerings. The court deferred consideration of the plaintiffs’ allegations with respect to these three offerings awaiting the plaintiffs’ efforts to establish standing. The court’s rulings with respect to the October 2007 offering raises the prospect that if the plaintiffs are able to establish standing, their ’33 Act allegations regarding these other offerings may also survive.

 

Though plaintiffs’ counsel cannot be happy with their rough treatment in Judge Pechman’s order, at least a portion of their complaint survive the motion to dismiss, and they now have the opportunity to try to amend the complaint to address the court’s concerns.

 

I have in any event added the May 15 ruling in the WaMu case to my table of subprime and credit crisis related dismissal motions grants and denials, which can be accessed here.

 

Andrew Longstreth’s May 18, 2009 Law.com article regaring the WaMu decision can be found here.

 

Cleveland Subprime Nuisance Case Dismissed: In a decision also dated May 15, 2009, Northern District of Ohio Judge Sara Lioi granted the defendants’ motion to dismiss in a case in which the City of Cleveland sought to hold 21 investment banks liable under Ohio nuisance law in connection with the banks’ securitization of subprime mortgages. The complaint alleged that the banks (which had not originated the mortgages) had facilitated the making of loans to subprime borrowers who could not afford the debt. After the borrowers defaulted, the lenders foreclosed. The city sought to hold the banks liable for its burdens and costs in maintaining the foreclosed properties.

 

My prior post criticizing the City of Cleveland for filing the lawsuit can be found here.

 

Judge Lioi granted the defendants motions to dismiss on four grounds: that the claims were preempted by Ohio law regulating mortgage lending; that the claim was barred by the “economic loss rule”; that the allegations failed to demonstrate that securitizing subprime loans constituted an “unreasonable interference with a public right”; and that the allegations were not sufficient to satisfy causation requirements – that is, the securitizers’ conduct had caused the City’s problems.

 

The opinion is interesting in a number of respect, perhaps first and foremost in connection with Judge Lioi’s holding that the securitizers’ conduct could not be deemed a public nuisance because the City had not alleged that the defendants had violated any laws. In reaching this conclusion, Judge Lioi extensively reviewed the panoply of governmental laws and regulations regarding mortgages, which she said were “specifically aimed at encouraging lending to traditionally underserved segments of the population.” From this Judge Lioi discerned a “picture” of “express governmental encouragement of the type of lending that forms the basis of the City’s claim.”

 

In holding that the banks can’t be liable for conduct that not only is not illegal but that the government expressly encouraged, Judge Lioi may implicitly be suggesting the true source of the City’s woes. It was, after all, governmental policy, for these kinds of loans to be made.

 

Judge Lioi’s extensive review (at pages 32 and 33 of the opinion) of the myriad of intervening causes that led to the City’s very real problems emphatically underscores the essentially foolishness of trying to hold the investment banks liable for the problems the City is facing because of its heavy load of foreclosed properties. As Judge Lioi observed, the “confluence of events certainly was no small problem given the large volume of foreclosures in Cleveland and the city’s budgetary constraints but under no circumstance can it be described as having been directly caused by Defendants’ conduct.”

 

A May 15, 2009 memorandum from the Skadden law firm analyzing Judge Lioi’s opinion can be found here. Plaintiffs’ counsel reportedly already has filed a notice of appeal.

 

Special thanks to Robert Rapp of the Calfee Halter law firm for providing a copy of Judge Lioi’s opinion.

 

Update: Readers may recall my recent post (here) about the questions surrounding the $9.3 million that was unaccounted for from the settlement of a settlement class action lawsuit. One of the plaintiffs’ lawyer, Gene Cauley, had asserted his rights under the Fifth Amendment at a April 20, 2009 hearing at which the court sought to establish the whereabouts of the money.

 

In a May 18, 2009 post (here), the WSJ.com blog reports that Cauley has now agreed to plead guilty to criminal charges and has also submitted a filing to the Arkansas Supreme Court in which he has agree to give up his law license. Unfortunately, the money itself is not yet accounted for, and according to statements of Cauley’s attorney cited in the blog post, may prove difficult to recover. 

 

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As the early returns have slowly accumulated for the subprime and credit crisis-related securities lawsuits, the question has arisen (refer here for example) whether or not these cases are faring poorly, in light of the numerous dismissal motions that have been granted thus far. Many of these dismissals have been granted, however, with leave to amend. And now at least one case in which a dismissal was granted with leave amend has survived a renewed motion to dismiss, suggesting that at least in the cases where dismissals were granted with leave to amend, it may be premature to write off the plaintiffs’ prospects.

 

As noted in a prior post (here), on December 11, 2008, Southern District of Florida Judge Ursula Ungaro granted defendants’ motion to dismiss, with leave to amend, in the BankAtlantic Bancorp subprime-related securities class action lawsuit. Judge Ungaro granted the motion on the ground that the plaintiff’s complaint failed to plead facts giving rise to a strong inference that the defendants acted with scienter in making the alleged misrepresentations and omissions.

 

On January 12, 2009, the plaintiff filed a first amended consolidated complaint (here), and the defendants’ renewed their motion to dismiss.

 

In a May 11, 2009 ruling (here), Judge Ungaro found that the amended complaint "cures the most pertinent deficiencies" that she had found in the earlier complaint. Thus, whereas the earlier complaint relied on confidential witnesses "about whom the Court knew nothing," and on allegations that were "vague and [that] failed to show what each of the individual defendants’ knew," Judge Ungaro found that the amended complaint "contains sufficient information regarding these confidential witnesses, including their employment duties, whether they were employed during the Class Period, and how they obtained direct knowledge of the facts they were reporting."

 

Judge Ungaro further found that the amended complaint "clearly states" how the individual defendants were reckless in not knowing the alleged misrepresentations regarding the bank’s lending practices.

 

Judge Ungar considered the defendants’ arguments for the court to consider competing inferences that might be drawn from the plaintiff’s allegations. Noting that the inferences of scienter "need not be irrefutable," she found that the facts alleged gave rise to a strong inference of scienter because the amended complaint "includes specific facts demonstrating that [the defendants] knew or were severely reckless in not knowing of the Company’s risk exposure, which was greater than they disclosed to investors."
 

 

With respect to defendants’ argument that the bank’s woes were due to the "deterioration in the real estate market," Judge Ungar said "whether or not Defendants’ alternative causation theory bars Plaintiff’s claim for damages is a question for another day."

 

Noting that the "pleading requirements under the PSLRA are stringent but are not insurmountable," Judge Ungaro concluded that plaintiffs had sufficiently alleged that the Defendants were "extremely reckless" in the company’s disclosure about the bank’s commercial loans, and so defendants’ renewed motion to dismiss was denied.

 

The amended complaint’s survival is most significant because it comes after the initial motion to dismiss had been granted, raising the possibility that even if the plaintiffs whose original complaints fails to survive dismissal motions may yet be able to file an amended complaint that can overcome the court’s concerns. It may be premature to count out the plaintiffs in the various other cases where initial motions to dismiss have been granted with leave to amend.

 

Judge Ungaro’s denial of the renewed motion to dismiss is also interesting because this case, perhaps by contrast to some other cases (such as the Countrywide and New Century cases) where dismissal motions have been denied, does not involve some of the more dramatic allegations involved in those other cases. For example, by contrast to the Countrywide case, allegations of insider trading were not a significant consideration in Judge Ungaro’s denial of the motion to dismiss in this case.

 

Plaintiffs’ lawyers may well find Judge Ungaro’s opinion as a positive development. Perhaps if the allegations in this case are sufficient, other cases may yet survive motions to dismiss as well. This impression is underscored by the fact that Judge Ungaro was not deterred by the general downturn in the real estate market or the economy.

 

In any event, I have added Judge Ungaro’s latest opinion to my running tally of settlements, dismissal and dismissal motion denials in the subprime and credit crisis-related lawsuits, which can be accessed here.

 

Special thanks to Chris Keller at the Labaton Sucharow law firm for providing me with a copy of Judge Ungaro’s latest opinion. The Labaton Sucharow represents the plaintiff in the BankAtlantic case.

 

Should He Stay or Should He Go?: In the recent Household Financial securities lawsuit jury trial (about which refer here), among the individual defendants who were found to have acted recklessly in making public disclosures was Household director William Aldinger. As a result, Aldinger not only faces the prospect of having to pay monetary damages; he also faces further questions about his continued service on other corporate boards.

 

As reflected in a May 12, 2009 Chicago Tribune article (here), Aldinger serves on the board of four other publicly traded companies: Illinois Tool Works; AT&T; Charles Schwab Corp.; and KKR Financial Holdings LLC. As the article notes, "the verdict raises the question of whether Aldinger should have to resign from the boards."

 

This is uncharted territory in many ways, because so few securities lawsuits actually go to trial. While the verdict does not "automatically disqualify" Aldinger from continued service on the other boards, according to one expert cited in the Tribune article, it certainly puts the boards of those other organizations in a difficult position. The article quotes governance commentator Nell Minow as suggesting that Aldinger should resign and save those other companies from embarrassment and shareholder scrutiny.

 

Aldinger had been CEO of Household prior to its 2003 acquisition by HSBC.

 

Special thanks to a loyal reader for the link to the Tribune article.

 

Speaker's Corner: On Thursday May 14, 2009, I will be in Los Angeles for the Professional Liabiltiy Underwriting Society Southern California Chapter eductional event. I will be participating as a panelist on a sesion discussion the State of the Insurance Market. Further information about the session can be found here. If you are attending the event, I hope you will make a point of greeting me and introducing yourself. 

 

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Though the subprime and credit crisis-related securities litigation wave is now well into its third year, relatively few of the cases have yet settled or otherwise finally been resolved. However, the parties to one of the securities lawsuits filed in the earliest stages of the litigation wave have announced that they have settled the case, in a development that potentially may have significance for the many other pending cases.

 

On May 5, 2009, Beazer Homes announced (here) the settlement of the securities lawsuit that had been filed in the Northern District of Georgia in March 2007 against the company and certain of its directors and officers. In the settlement, the plaintiffs agreed to dismiss the case with prejudice and release all claims against the defendants in exchange for the payment of $30.5 million. According to the press release, the settlement is to be “funded from insurance proceeds” on behalf of the Company and the individual defendants and “there will be no financial contribution by the Company.” The settlement agreement is subject to court approval.

 

 

As reflected in the May 5, 2009 memorandum the plaintiffs’ filed in support of their request for judicial approval of the settlement (here), the settlement apparently also applies to the company’s auditor, Deloitte and Touche, which had been named as a defendant in the case.

 

 

Beazer Homes is a residential home builder that also provided home loan and mortgage finance services to home buyers. As reflected at greater length here, in quick succession in March 2007, the company announced the resignation of its CFO and that the company had received inquiries regarding its mortgage lending practices. The company’s share price declined and plaintiffs filed several securities class action lawsuits. On May 12, 2008, Beazer restated its financial statements for the previous nine years.

 

 

As reflected in their amended complaint, the plaintiffs’ alleged that the audit committee of the company’s board concluded that the company’s mortgage practice violated certain federal and/or state origination requirements and also discovered accounting and financial reporting errors or irregularities that required restatement because of improper accumulation of reserves, improper revenue recognition and other accounting and financial misstatements. The plaintiffs allege that the company’s disclosures during the class period had misled investors about the company’s origination practices and financial condition.

 

 

Relatively few of the many subprime and credit crisis-related securities lawsuits filed to date have yet been settled or otherwise resolved to date. (A complete list of the subprime and credit crisis-related lawsuit settlements, dismissals, and dismissal motion denials can be accessed here.) The outsized Merrill Lynch settlement (about which refer here) is noteworthy for its sheer size, but otherwise may have relatively little to say about many of the other pending cases that involve relatively smaller companies, and relatively smaller investment losses. In this context then, the Beazer Homes settlement may be significant for a number of reasons.

 

 

First, the case appears to have been settled before the court had ruled on the plaintiffs’ motions to dismiss. Particular cases may settle for any number of reasons, so that fact that the Beazer Homes case settled prior to the dismissal motion ruling may or may not imply anything about other cases – but nevertheless, the settlement prior to dismissal motion ruling does at least raise the possibility for other cases. Along those lines it should be noted that the memorandum the plaintiffs filed in support of their request for settlement approval reports that the parties settled the case as a result of mediation in April 2009, while the dismissal motions were fully briefed by not yet argued.

 

 

The Beazer Homes case is also significant because it represents a substantial settlement funded entirely with proceeds of the company’s insurance. If the number of aggregate dollars required to resolve the many other pending subprime and credit cases is extrapolated out from the Beazer settlement, the implied resulting figure – even allowing for the likelihood that a substantial number of the cases will be dismissed – is potentially huge. There have in fact been some noteworthy estimates of the likely aggregate cost to the insurance industry required to resolve all of these cases; whether or not these estimates ultimately prove accurate, the Beazer settlement suggests at least for now that the final resolution of these cases could in the aggregate required some truly impressive sums from insurers.

 

 

All of that said, there are some material attributes of the Beazer case that might suggest that its settlement may not necessarily be representative of what to expect from other subprime and credit crisis cases. The first is that the company’s own audit committee concluded that it had violated certain applicable mortgage origination laws. The second is that (at least according to the amended complaint) the company remains under investigation from governmental and regulatory authorities, including the SEC. These circumstances may distinguish Beazer from many of the other cases that have been drawn into the subprime and credit crisis litigation wave, and to that extent at least the settlement may or may not provide a useful indication of likely future settlements in other cases.

 

 

I have in any event added the Beazer Homes settlement to my list of subprime and credit crisis-related lawsuit settlements and other case resolutions, which can be accessed here.

 

 

Delaware Amends Corporations Code to Address Indemnification and Advancement Concern: As I noted in an earlier post (here), in a March 2008 decision in the Schoon v. Troy case, the Delaware Chancery Court raised concerns when it held that a subsequent board may retroactively eliminate the advancement rights of a prior director.

 

 

As explained in the April 2009 issue of the Tressler, Soderstrom firm’s Special Lines Advisory (here, see page 3), the Delaware legislature has now amended Section 145 of the state’s General Corporation code to provide that “rights to indemnification may not be eliminated after the date an act giving rise to a claim takes place, unless a corporation’s indemnification provisions expressly preserve the right to retroactively eliminate the individual’s right to indemnification as permitted by the court in Schoon.“ The amendments are effective August 1, 2009.

 

 

Special thanks to my good friend Joe Monteleone for providing me with a copy of his firm’s memo.

 

 

Elliptically Speaking Awards (Euphemism Category): I might have considered this a bad parody if I had not seen for myself that this is an actual press release on the website of Nokia Siemens Networks. On November 11, 2008, the company announced (here) the following update on its “synergy-related headcount-adjustment goal.”

 

 

Nokia Siemens Networks has completed the preliminary planning process to identify the proposed remaining headcount reductions necessary to reach its previously announced synergy-related headcount adjustment goal. … To date, the company has achieved an adjustment of more than 6,000 employees and continues to expect a total synergy-related adjustment of approximately 9,000 employees. …Simon Beresford-Wylie, chief executive officer of Nokia Siemens Networks, [said] “With the successful completion of these plans, we will have the vast majority of the synergy-related headcount reductions completed and we can then start to put this chapter of our history behind us and focus on creating a world-class company.”

 

 

The proposed headcount adjustments are a result of merger-related synergies, including changes to the product portfolio; site optimization; streamlining of various functions; strategic, long-term R&D and workforce balancing; and other factors designed to build a competitive Nokia Siemens Networks. “We have now completed the preliminary planning necessary to identify the specific areas where we have additional synergy-related reduction needs,” said Bosco Novak, head of human resources at Nokia Siemens Networks. “It is our goal to engage constructively with employee representatives in Finland, Germany and other countries to quickly and fairly achieve these needed changes so we are able to remove the ongoing uncertainty that our employees have about synergy-related headcount reductions.”

 

 

Hat tip to Harper’s Magazine, which reproduced the press release in its May 2009 issue (here).

 

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Several of the recipients of TARP funding have also been the targets of securities class action lawsuits and other litigation. In an April 29, 2009 post on the DealBook blog (here), Dan Slater, formerly of the WSJ.com Law Blog, raises the concern that TARP money could be used “to line the pockets of allegedly aggrieved shareholders and the lawyers who, wrapped in the flags of corporate governance, are in the process of making a billion-dollar cottage industry out of filing strike suits.”

 

As an example, Slater cites the case of Merrill Lynch, which, on the same day as its new corporate parent Bank of America announced that it was receiving an additional $20 billion in TARP money, announced that it would pay $550 million to settle a securities class action lawsuit and an ERISA lawsuit. (For further detail regarding the Merrill settlement, refer here.) Slater contends that as a result of the settlement either BofA will be less able to repay its TARP obligation or must cut its TARP allotment to settle up

 

 

Slater also notes that 19 of the 32 recipients of $1 billion or more of TARP money have since January 2008 been sued in securities class action lawsuits. “Put another way,” Slater states, “of the more than $300 billion that’s been paid out in TARP money, nearly $240 billion of it, or 78 percent, is subject to shareholder suits.”

 

 

Slater argues that while there has always been a circularity involved in the funding of securities lawsuit settlements, now, “in the world according to TARP,” the securities settlement money could be coming from taxpayers.

 

 

Slater raises an interesting point, and the example of Merrill Lynch is particularly telling. I think his analysis is incomplete, however, to the extent that it disregards the existence of D&O insurance, E&O insurance, and fiduciary liability insurance, which will be funding a very substantial amount for the defense and settlement of these lawsuits.

 

 

However, the Merrill Lynch settlement unquestionably raises the concern, given its sheer size, that the resolution of these cases could require funding that far exceeds that amount of insurance available. To that extent, at least, there arguably is a concern that TARP money could fund, or at least offset the cost of, securities class action settlements.

 

 

Slater’s points are, to that extent at least, well taken. I think it should be noted that plaintiffs’ lawyers are well aware of these concerns – many of the lawsuits to which Slater refers were filed before TARP was instituted, and since the TARP payments were first made, plaintiffs’ attorneys have had to take these kinds of concerns into account on deciding whether or not to file new cases.

 

 

These kinds of issues may also be part of the constellation of considerations that has been affecting courts’ reactions to the early motions to dismiss. As I have previously noted (most recently here), while it is still early, many of the subprime and credit crisis-related cases have not been faring particularly well in the courts at the motions to dismiss stage, and concerns like those that Slater has raised may be part of the reason.

 

 

An April 29, 2009 Am Law Litigation Daily post discussing Slater’s article can be found here.

 

 

Madoff Redemption Clawbacks?: One of the more interesting and complicated questions that has arisen lately is the extent to which Irving Picard, the trustee for the Bernard Madoff Investment Securities liquidation, wil be able to "clawback" amounts from BMIS investors who redeemed their investors who redeemed their investments prior to the firm's collapse. An April 28, 2009 paper by NERA Economic Consulting entitled "Clawbacks from Madoff Investors: Questions of Economics, Equity and Law" (here) takes a detailed look at the issues surrounding the extent of the trustee's ability to recover the amounts previously redeemed. As the paper reviews at length, there are a variety of competing considerations that will have to be balanced in determing the extent to which the trustee appropirately may clawback these amounts.  

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The collapse of the market for auction rate securities (ARS)  has generated a flood of litigation, mostly brought by angry ARS investors against the broker dealers who sold them the securities or against the mutual funds that allegedly failed to disclose that their assets were invested in these kinds of securities. More recently (refer for example here), companies that invested in ARS and carried the securities on their balance sheet have been sued by their own shareholders in connection with the companies’ ARS disclosures.

 

A recently filed lawsuit presents yet another variant of ARS litigation – in this most recent case, the directors and officers of a student loan originator that issued ARS have been sued by the company’s own shareholders for failing to disclose the company’s dependence upon and susceptibility to the weaknesses of the ARS marketplace.

 

Until it filed for voluntary Chapter 7 bankruptcy on February 9, 2009, MRU Holdings was an originator and holder of federal and private student loans which it marketed through its consumer brand My Rich Uncle. MRU collected its loans into student loan pools that were packaged and sold by broker-dealers (including Merrill Lynch) to investors. The interests in the pool were issued as auction rate securities. This securitization process freed up capital to make new loans and also generated fee income and other revenues. During its fiscal year ended on June 30, 2007, 58% of the company’s income came from securitizations, more twice the income the Company earned on interest from student loans.

 

On April 15, 2009, plaintiffs’ counsel filed a complaint in the Southern District of New York against four of MRU’s former directors and officers on behalf of persons who purchased MRU’s shares between July 9, 2007 and September 19, 2008. A copy of the complaint can be found here. The company itself, which is in bankruptcy, was not named as a defendant.

 

The complaint alleges that the company failed to disclose that the ARS market was illiquid and depended on the illusion of liquidity created by the broker-dealers’ undisclosed interventions to prop up the marketplace and prevent failures of the auction process. The complaint alleges that this illusion "allowed the Company to pay a lower interest rate" in the notes issued in connection with the company’s 2007 securitization, and that the spread allowed the company to realize a $16.3 million gain.

 

The complaint also alleges that the Company failed to disclose that once the "true nature of the ARS market became known," the Company’s future securitizations would not be as favorable and that "without the favorable terms available in the ARS market as a result of the manipulation by broker-dealers, the Company would not have sufficient capital to originate loans, making the Company’s business model untenable."

 

The complaint alleges that the Company failed to disclose the impact that the February 2008 collapse of the market for ARS would have on its ability to depend on securitizations to sell loans and free up capital. The complaint further alleges that on July 3, 2008, the Company announced the pricing of a $140 million private student loan securitization; however, on July 7, 2008, the Company further announced that the bonds to be issued in the pending securitization would be sold at a discount, and that rather than generating income, "the securitization would result in a significant write-down of assets."

 

Thereafter, the company’s share price declined, and Moody’s subsequently downgraded the company’s ARSs. On September 5, 2008, the Company announced that it would "pause" its student loan program. On September 19, 2008, the Company announced that its September 15, 2008 audit report contained a going concern opinion. The company later filed for bankruptcy.

 

As noted above, this new complaint against the former MRU directors and offices differs from prior ARS lawsuits, both in terms of who the plaintiffs are and in terms of the allegations raised. In the vast bulk of the ARS lawsuits filed under the securities laws, the plaintiffs are ARS investors who are suing broker-dealers who sold them the securities and whom the investors allege made misrepresentation in connection with the ARS. Similarly, mutual fund investors have sued the funds for failing to disclosure the funds’ investments in ARS. More recently, shareholders of companies that were ARS investors and that suffered balance sheet write-downs (and ensuing share price declines) have sued the companies because of the companies’ investment in ARS.

 

By contrast to those other case, the plaintiffs are neither ARS investors nor shareholders of companies that invested in ARS instruments. Rather, the plaintiffs in the MRU case are shareholders of a company that put loans into pools out of which the securities were issued.

 

And again by contrast to the other cases, the misrepresentation alleged in the MRU case are not about the nature of the ARS investments (as in the broker dealer cases}, or even about a balance sheet exposure to ARS investments (as in the prior public company cases), but rather about the company’s alleged dependence on the availability of the artificially favorable ARS marketplace as a way to generate income and as a way to free up capital.

 

While the MRU case may represent a new variant on the ARS theme, more cases of the now familiar forms of ARS litigation have continued to accrue.

 

For example, on April 16, 2009, Ashland Inc. filed a lawsuit in the Eastern District of Kentucky against Oppenheimer & Co. (copy of complaint here), in which Ashland alleged that Oppenheimer convinced Ashland to hold and to continue to invest in ARS "at a time when Oppenheimer knew the market for those ARS was collapsing."

 

The Ashland complaint alleges that after August 2007 disturbances in the marketplace for ARS based on municipal government bonds, that Oppenheimer steered Ashland toward ARS based on student loan obligations ("SLARS"). The complaint alleges that after the market for SLARS collapsed in 2008, Ashland was left "with approximately $194 million of illiquid Oppenheimer-brokered SLARS."

 

In a separate complaint also filed on April 16, 2009, Braintree Laboratories and related entities sued Citigroup Global Markets in the District of Massachusetts (complaint here). Braintree alleges that between June 2008 and August 2008, Citigroup sold Braintree approximately $33.3 million of ARS, which Citigroup allegedly had referred to not as ARS but as "seven day rolls" and as "government backed ‘money market’ investments."

 

Braintree alleges that despite its admissions in its various regulatory settlements, Citigroup has refused Braintree’s demand for rescission of the transactions. Among other things, Braintree alleges that in connection with the sale of the ARS to Braintree, "Citigroup acted with criminal and flagrant indifference to the rights, interests and property of the Braintree Entities and the public" and that the sales "resulted from ongoing fraudulent practices."

 

The Braintree complaint also alleges that the ARS sales to Braintree "fell close in proximity to Citigroup erasing recordings of conversations involving employees at its auction rate desk." The complaint alleges that "when engaging in these acts of spoliation of evidence and obstruction of justice, Citigroup acted willfully and with scienter."

 

If nothing else, the one thing that is absolutely clear about the breakdown of the auction rate securities marketplace is that it has proven to be an absolute litigation generating machine.

 

The Ashland and Braintree cases also demonstrates, as I have argued elsewhere (refer here), that neither the dismissal of the UBS auction rate securities lawsuit nor the ARS regulatory settlements marked the end of ARS litigation. As I noted more recently (here), the ARS litigation has continued to come in – and as the Braintree lawsuit demonstrates, interesting new allegations (such as the spoliation charge) continue to emerge.

 

The MRU lawsuit also shows that the auction rate securities litigation wave has continued to evolve as it has continued to grow. Further lawsuit variants seem likely as the wave continues to progress.

 

I have in any event added the MRU lawsuit to my table of credit crisis related class action securities litigation, which can be accessed here.

 

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

 

A Tribute to Susan Boyle: If you have not yet seen the video of Susan Boyle, an unemployed 47 year-old, singing a song from Les Miserables on the April 11, 2009 episode of Britain’s Got Talent, then you must drop everything and watch the video right now. Due to YouTube restrictions, I can’t embed the actual video in this post, but the video can be seen here.Take the time to watch the entire video; it is worth the seven minutes it takes to watch it. (Hat tip to the Drug and Device Law Blog, here, for the link.)

 

The video is even more moving if you follow the lyrics of the song she is singing, which are as follows (thanks to the Conglomerate blog, here, for the lyrics):

 

I dreamed a dream in time gone by,
When hope was high and life, worth living.
I dreamed that love would never die,
I dreamed that God would be forgiving.

Then I was young and unafraid,
And dreams were made and used and wasted.
There was no ransom to be paid,
No song unsung, no wine, untasted.
 

But the tigers come at night,
With their voices soft as thunder,
As they tear your hope apart,
And they turn your dream to shame.
 

And still I dream he'll come to me,
That we will live [our lives] together,
But there are dreams that cannot be,
And there are storms we cannot weather!
 

I had a dream my life would be
So different from this hell I'm living,
So different now from what it seemed...
Now life has killed the dream I dreamed...
 

 

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On April 9, 2009, the subprime securities lawsuit pending against Radian Group joined the growing list of subprime-related cases in which the dismissal motions have been granted. Eastern District of Pennsylvania Judge Mary McLaughlin entered the order dismissing the case, without leave to amend. A copy of the opinion can be found here.

 

As reflected in an earlier post about the lawsuit (here), Radian provides credit protection products (such as mortgage guarantee insurance). The lawsuit related to an affiliate company in which Radian was a minority owner, Credit Based Servicing & Asset Securitization (C-Bass), an investor in the credit risk of subprime residential mortgages. Radian was a joint venturer in the affiliate with MGIC, with which Radian also had an agreement to merge.

 

The plaintiffs alleged that the defendants (the company and several of its directors and officers) made false and misleading statements about C-Bass’s profitability and liquidity position and thus, the value of Radian’s investment in C-Bass. The statements allegedly inflated Radian’s share price, which led to losses to shareholders when Radian announced an impairment of its investment on July 30, 2007. The turbulence surrounding the C-Bass affiliate may also have undermined the pending merger with MGIC. Further background about the case can be found here.

 

Judge McLaughlin granted the motion to dismiss based on the plaintiffs failure to adequately plead scienter. She found that the plaintiffs’ allegations "do not establish either motive and opportunity or conscious misbehavior or recklessness on the part of the defendants" and that the plaintiffs therefore have not "raised a strong inference of scienter." She also found that the inference of scienter the plaintiffs sought to draw "is neither cogent not at least as compelling as the plausible opposing inferences suggested by the defendants."

 

The plaintiffs had alleged that the defendants had delayed announcing the material impairment to the C-Bass investment in order to allow the completion of the MGIC merger, and also to allow the defendants to sell shares in their personal holdings of Radian.

 

Judge McLaughlin found the motivation to complete the merger is not "distinctively unique" as it is like "the motives that have been found to be generally possessed by most corporate directors." She also found that the plaintiffs failed to allege any concrete and personal benefit the completion of the merger might provide the individual defendants.

 

Judge McLaughlin found further that the allegations of insider trading inadequate to establish motive and opportunity. One of the three individual defendants more than tripled his investment during the class period, which a second sold only 2.7% of his holdings, and the related Form 4s showed they were sales of restricted stock, and in part motivated to pay taxes. The third individual defendant sold a much larger percentage of his holdings but the public record showed that he was not planned to be a part of the merged company and was divesting his ownership.

 

In support of their allegation that the defendants had been reckless, the plaintiffs had argued that as a result of their positions with Radian, the defendants were aware of the risky nature of C-Bass’s business and the deteriorating conditions of the subprime industry. Judge McLaughlin found first that the plaintiffs’ allegations did not establish that C-Bass was in fact impaired before the company took the impairment charge. Judge McLaughlin also found that the plaintiffs’ allegations "did not establish with sufficient particularity that the defendants knew or should have known that their statements presented an obvious danger of misleading the investing public."

 

The plaintiffs had also argued that the defendants had to be aware of the problems at C-Bass because of their positions of responsibility within the company and the relation of the C-Bass investment to the "core operations" of the company. Judge McLaughlin said that while some courts have found that knowledge of core activities can be imputed to company officials under some circumstances, they had done so only when there were particularized allegations showing that the defendants had ample reason to know of the falsity of the allegedly misleading statements.

 

Judge McLaughlin said that the plaintiffs had failed to explain why C-Bass’s activities were part of Radian’s core activities. She also found that the plaintiffs had failed to show why defendants must have known that their statements presented a danger of misleading investors. In this connection, Judge McLaughlin reviewed the plaintiffs’ extensive allegations about the deteriorating conditions in the subprime marketplace, which the plaintiffs alleged the defendants must have known.

 

With respect to these allegations, Judge McLaughlin observed that "these facts were known to the plaintiffs and by the market at large, and the [amended complaint] itself establishes that Radian publicly disclosed its knowledge of these facts and their potential to effect on Radian’s investment in C-Bass."

 

Judge McLaughlin also found that the plaintiffs’ attempt to establish scienter in reliance on confidential witnesses, the defendants’ sox certifications and the company’s alleged violation of GAAP were equally unavailing,

 

Judge McLaughlin’s opinion joins the growing list of subprime and credit crisis-related securities class action lawsuits in which courts have granted preliminary motions to dismiss. It is also is yet another case that seems to reflect a general judicial unwillingness to conclude that merely because companies were caught in the downdraft accompanying the subprime meltdown that the company had engaged in fraud. (Refer here for similar observation regarding the recent dismissal motion grant in the subprime case involving Downey Financial.)

 

I have in any event added the Radian opinion to the table in which I have been tallying the subprime case resolutions. The list can be accessed here.

 

Special thanks to a loyal reader for forwarding me a copy of the Radian decision.

 

Dismissal Denied Again in Countrywide Case: Perhaps by contrast, and in one of the prominent cases in which a dismissal motion has been denied, on April 6, 2009, Judge Mariana Pfaelzer largely denied the defendants’ renewed motions to dismiss. A copy of Judge Pfaelzer’s opinion can be found here.

 

In a prior opinion (available here), Judge Pfaelzer had substantially denied the defendants motions to dismiss, although she did granted the motion in certain respect with leave for the plaintiffs to amend. The plaintiffs filed an amended complaint and the defendants renewed their motions to dismiss.

 

In her April 6 opinion Judge Pfaelzer largely incorporated her reasoning from her prior opinion. However there were a couple of respects in which the April 6 ruling is noteworthy. First, she found that the plaintiffs’ revised allegations against defendant KPMG, whose dismissal motion previously had been granted, would now "suffice" and therefore KPMG’s renewed dismissal motion was denied.

 

However she also found that insider allegations as to certain insider defendants, whose sales were made pursuant to written Rule 10b5-1 trading plans, were insufficient and accordingly the insider trading were dismissed. However she refused to dismiss most of the insider trading allegations against former Countrywide CEO Angelo Mozillo, even though he too purported to have traded pursuant to a Rule 10b5-1 plan, because of "unusual" modifications he had made to his plan.

 

Allison Frankel’s April 8, 2009 American Lawyer article about Judge Pfaelzer’s latest opinion can be found here. I urge everyone to read it, if for no other reason that along the way Frankel refers to The D&O Diary’s author (that would be me) as "our favorite subprime litigation savant." I am humbled by the accolade.

 

Special thanks to several loyal readers who supplied me with a copy of the April 6 opinion.

 

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Earlier this week, I suggested (here) that the UBS auction rate securities lawsuit dismissal did not spell the end of the auction rate securities litigation. Two of the categories of likely future litigation involving auction rate securities I mentioned were lawsuits involving institutional investors (who are not covered, at least immediately, by many of the regulatory settlements) and lawsuits involving auction rate securities buyers that are targeted by their own investors.

 

As if to prove my point about the likelihood for continuing auction rate securities litigation, two significant auction rate securities lawsuits have arrived just since I added my post earlier this week.

 

First, in a lawsuit against an auction rate securities buyer, on March 31, 2009, PIMCO mutual fund investors filed a securities class action lawsuit in the Central District of New York against the funds’ investment manager and the funds’ sub-advisor, certain of the managers’ directors and officers (including bond investing guru Bill Gross). A copy of the complaint can be found here.

 

The complaint alleges that the funds concealed from the investors that

 

(a) The Funds lacked effective controls and hedges to minimize the risk of loss and risk of liquidity from auction rate securities ("ARS") which affected a large part of their portfolios; (b) The Funds lacked effective internal controls to ensure that the Funds would remain in compliance with restrictions and limitations related to their investment portfolios and strategies; (c) The extent of the Funds' liquidity risk due to the illiquid nature of a large portion of the Funds' portfolios, including ARS, was omitted; and (d) The extent of the Funds' risk exposure to ARS was misstated.

 

The PIMCO mutual fund lawsuit joins recent lawsuits filed against Perrigo Company (about which refer here) and NextWave Wireless (refer here), as examples of cases in which auction rate securities buyers are targeted by their own investors for their exposure to the instruments. These lawsuits differ from the more standard auction rate securities lawsuits, in which the auction rate securities buyers were the plaintiffs and the defendants were the broker-dealers or others that had sold the instruments.

 

PIMCO’s woes with its funds’ investments in auction rate securities have been well-documented in the press in recent days, as the funds’ managers have struggled to manage problems stemming from the investments. A recent Wall Street Journal article discussing the funds’ woes can be found here.

 

The second of the two new auction rate securities lawsuits involves an institutional investor buyer, brining an action against the broker-dealers that sold the company the instruments. On April 1, 2009, Texas Instruments filed an Original Petition in Texas (Dallas County) District Court against Citigroup Capital Markets, BNY Capital Markets and Morgan Stanley, in connection with the company’s purchase of $524 million of auction rate securities backed by student loans. A copy of the Petition can be found here.

 

The Petition alleges that despite the defendants’ "assurances of liquidity and low risk," the company is now stuck with auction rate securities that it "cannot liquidate." The Petition alleges that the defendants "downplayed any risk of failed auctions" and "misrepresented the market demand" for the securities by omitting to disclose "the extent to which the entire ARS market depended on continued bidding and purchasing by the Defendants and other broker-dealers."

 

Beyond these more general allegations, the complaint contains some very case specific allegations relating to the defendants’ alleged failure to disclose that as 2007 progressed securities issuers (including issuers of securities that Texas Instruments held) were waiving the maximum interest rate limitations in connection with auctions of their securities. The company alleges that had it been advised of these waivers, it would have been alerted to the weakening demand for the instruments. The company alleges these omissions and affirmative reassurances induced it to continue to buy and hold the securities.

 

The Petition alleges violations of the Texas securities laws and seeks rescission of the securities purchase transactions as well as prejudgment interest.

 

Interestingly, the Petition does not mention the various regulatory settlements that Citigroup and others have reached with respect to the auction rate securities, presumably because the settlements do not provide relief (at least not immediately) to an institutional investor like Texas Instruments.

 

In any event, it is evident that the auction rate securities litigation is far from over.

 

Hat tip to the Courthouse News Service for the link to the Petition. Special thanks to Adam Savett of the Securities Litigation Watch for a link to the PIMCO lawsuit.

 

Dismissal Motion Ruling in Options Backdating-Related Securities Lawsuits: The options backdating cases continue to grind through the courts. On March 27, 2009, District of Arizona Judge Robert Broomfield issued a 138-page ruling (here) on the pending dismissal motion in the options backdating-related securities lawsuit against Apollo Group and several of its directors and officers. (Background regarding the case can be found here).

 

Judge Bloomfield’s ruling is very painstaking and detailed. He parsed the allegations against each of the defendants extremely finely. The outcome is rather complex, and it would require a spreadsheet to explain with respect to each of the plaintiffs' substantive claims which defendants have been dismissed with prejudice, which have been dismissed without prejudice, and which have had their dismissal motions denied. The most critical aspect of his ruling is that the Court denied the motion to dismiss the plaintiffs’ claims under Section 10(b) against the Company and its most senior officers.

 

Apollo Group was also involved in a separate, rather notorious securities class action lawsuit that resulted in a January 2008 plaintiffs’ jury verdict that was overturned by the trial judge in August 2008 on a post trial motion. Refer here for background on this separate case.

 

I have in any event added the Apollo Group decision to my table of settlements, dismissals, and dismissal motion denials, which can be accessed here.

 

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In a development that may foreshadow further "gatekeeper" claims as part of the current credit crisis litigation wave, on April 1, 2009, the trustee for the New Century Financial Corp. liquidation initiated lawsuits in California and New York against KPMG and its international parent, seeking to recover $1 billion in damages for negligence and for aiding and abetting breaches of fiduciary duty.

 

The California complaint, filed in the Los Angeles County Superior Court (copy here) against KPMG LLP, alleges that the firm "did not act like a watchdog" but rather "acted like a cheerleader for management."

 

The complaint alleges that KPMG "performed grossly negligent audits and reviews" and "failed to detect material errors" with respect to New Century’s residual interest on loans it securitized and on its loan repurchase liability. The complaint also faulted KPMG for its approval of faulty loan loss reserves, alleging that an audit partner silenced the concerns of a more junior audit team member who questioned the reserve calculation.

 

The complaint also alleges that KPMG "aided and abetted New Century’s directors’ and officers’ breaches of their fiduciary duties." The complaint alleges that KPMG knew that management was improperly reserving for risks the company faced and that management had failed to implement an effective system of internal controls.

 

The aiding and abetting allegations includes the charge that KPMG aided and abetted company officials "in maintaining material weaknesses and significant deficiencies in New Century’s system of internal controls over financial reporting." The complaint alleges that KPMG is "jointly responsible with the directors and officers for damages resulting from these breaches."

 

The complaint seeks compensatory damages of $1 billion, as well as punitive damages.

 

The complaint filed in the Southern District of New York (copy here) substantially repeats many of the same allegations as the California complaint, but addresses the alleged liability of KPMG’s international parent. The complaint alleges that the parent represented that it would "ensure that member firms’ work would meet professional standards and regulatory requirements."

 

The complaint alleges that KPMG International did not fulfill these responsibilities, and as a result New Century was harmed. The complaint seeks unspecified compensatory as well as punitive damages from KPMG International.

 

The trustee’s filings in these complaints certainly suggest the possibility that auditors and other "gatekeepers" could be targeted in the wake of the subprime meltdown. Leading accounting indusrty commentator Francine McKenna (also the author of the indispensible "re:The Auditors" blog) is quoted in the April 1, 2009 Wall Street Journal as saying that the case "may embolden others to look more closely at the possibiltiy of bringing [accounting] firms to some level of culpability for the things that happened" that led to the credit crisis.

 

But in assessing that possibility it may be important to note the particular key circumstances that preceded the trustee’s claims against KPMG.Specifically, the new lawsuits follow more than a year after the February 29, 2008 581-page report of Michael Missal, the KPMG bankruptcy examiner, in which the examiner concluded that KPMG had "contributed" to certain of New Century’s "accounting and reporting deficiencies by enabling them to persist in, and in some instances, precipitating the Company’s departure from, applicable accounting standards." A detailed review of the examiner’s report, including a link to the report itself, can be found here.

 

The examiner’s exhaustive review, which among other things specifically suggested the possibility of negligence claims against KPMG, was effectively a road map for the April 1 lawsuits. While the lawsuits might well have been filed even without the examiner’s report, few other prospective claimants considering "gatekeeper" litigation will have such a detailed script from which to compose their complaint.

 

On the other hand, many of the complaints already filed in numerous lawsuits as part of the current subprime and credit crisis-related litigation wave have already targeted a variety of gatekeepers, including offering underwriters, credit rating agencies, and, in some cases, even the outside auditors.

 

Indeed, the securities lawsuit filed against New Century’s former directors and officers also specifically named KPMG as a defendant. In his December 3, 2008 order denying the defendants’ motion to dismiss the securities lawsuit, Central District of California Judge Dean Pregerson specifically denied KPMG’s separate motion to dismiss, finding that the complaint in that case adequately alleged that KPMG was aware of accounting and internal control deficiencies but nevertheless issued its audit opinion in connection with the company’s 2005 financial statements. A detailed discussion of Judge Pregerson’s decision, including a link to the opinion, can be found here.

 

The outcome of KPMG’s dismissal motion in the New Century securities lawsuit, as well as the trustee’s filing of the April 1 lawsuit, among other things suggests that the U.S. Supreme Court’s decision in the Stoneridge case may not deter prospective litigants from pursuing claims against auditors and other gatekeepers.

 

One of the more interesting aspects of the trustee’s complaint against KPMG is his claim seeking to hold the accounting firm "jointly responsible" with New Century’s former directors and officers for the officials’ breaches of their fiduciary duties. While the trustee’s claims at this point represent nothing more than allegations and it remains to be seen whether his claims on this theory will result in any recovery, the possibility that auditors may be alleged to be "jointly liable" for directors’ and officers’ fiduciary breaches raises a host of concerns and questions, not the least of which relate to co-defendant (or third-party defendant) proceedings, such as cross-claims for contribution.

 

All of which leads to a point I have been asserting for some time, which is that we are still only in the earliest stages of the credit crisis related litigation wave. Not only are the cases against the defendant companies continuing to pour in, but the likelihood of further gatekeeper litigation like that filed against KPMG suggests that the litigation will continue for many, many years to come.

 

The "re: The Auditors" blog has an interesting and detailed analysis of the KPMG complaints, here.

 

Hat tip to the Wall Street Journal (here) for copies of the KPMG complaints.

 

Honoring Those Who Serve: A recent MSNBC segment reported on what my good friends, David Bell of AWAC and John McCarrick of the Edwards and Angell law firm, have been doing to honor those who have made the ultimate sacrifice in service to our country. As reflected in the video below, a group they helped to organize, Grateful Nation Montana, is taking steps to ensure that the children of U.S. soldiers killed in the battle will be able to pursue a college education.

 

Please watch this video. It is guaranteed to bring tears to your eyes, but it will also make you appreciate the efforts of a couple of industry leaders, who have done something substantial and worthy to help make a difference.

 

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A federal judge has ruled that securities class action plaintiffs who availed themselves of UBS’s auction rate securities regulatory settlement cannot separately maintain claims for damages against UBS. But while this ruling would seem to represent at least the beginning of the end for many similarly placed plaintiffs, we may still be a long way from the end of the auction rate securities litigation, despite the regulatory settlements.

 

Background

UBS was one of the 21 different companies named as defendants in the wave of auction rate securities lawsuits filed during 2008. The names of all of the auction rate securities lawsuit targets can be accessed here. Background regarding the case against UBS can be found here.

 

Essentially the plaintiffs alleged that UBS had failed to disclosure the liquidity risks associated with the auction rate securities, and also failed to disclose that UBS and other broker dealers regularly intervened in the market for the securities to maintain trading --and allegedly to manipulate the market as well. When the broker-dealers simultaneously stopped supporting the market on February 13, 2008, the market for the securities collapsed and investors were left with securities for which there was no active market.

 

On August 8, 2008, UBS announced a nearly $20 billion settlement with regulators regarding the auction rate securities (about which refer here). In the settlement, UBS agreed to buy the securities back from retail investors at par value, or to make up the difference to retail investors who had already sold for less than par.

 

The plaintiffs in the UBS auction rate securities settlement took advantage of the regulatory settlement and redeemed their securities as par. The defendants moved to dismiss the lawsuit on that basis.

 

Judge McKenna’s Ruling

In a March 30, 2009 opinion (here), Southern District of New York Judge Lawrence McKenna granted the defendants’ dismissal motion, with leave to amend. Judge McKenna found that

 

Given that Plaintiffs have availed themselves of the relief provided in the Regulatory Agreement, Plaintiffs cannot now allege out-of-pocket damages. When Plaintiffs elected to have UBS buyback their ARS at par value, they received a full refund of the purchase price. Therefore, Plaintiffs have already been returned to the position they were in before they purchased the ARS and before any fraud ensued….Plaintiffs’ out-of-pocket damages are necessarily zero because after choosing to rescind the ARS purchases, Plaintiffs have effectively paid nothing for their ARS.

 

Plaintiffs argued that they were entitled damages despite the regulatory settlement because "UBS’s fraudulent acts prevented Plaintiffs from receiving a sufficiently high rate of interest or dividends to compensate them for the risk of illiquidity associated with their ARS investments." Essentially, they were arguing that if they had been appropriately informed about the securities’ liquidity risk, they would demanded and would have been paid higher interest rates or otherwise have enjoyed a higher investment return.

 

Judge McKenna rejected this argument because plaintiffs in securities actions must choose among prospective remedies, between rescission and out-of-pocket damages. Having elected rescission, the plaintiffs "may not now seek additional interest or dividends as benefits of ARS purchases they have already elected to disavow."

 

Finally, Judge McKenna found that the class plaintiffs lack constitutional standing to asset claims on behalf of "class members who purchased UBS-underwritten ARS from brokerage firms other than UBS and investors who transferred to another brokerage firm ARS they purchased from UBS before October 2007."

 

Discussion

Judge McKenna’s ruling might seem to suggest that the regulatory settlements represent the end of the auction rate securities lawsuits. However, conclusions along those lines could well prove to be premature.

 

First, Judge McKenna granted the motion with leave to amend. Although there is ample reason to doubt that these plaintiffs can circumvent Judge McKenna’s concerns in an amended pleading, the case itself is not over yet.

 

Second, other courts may decline to follow Judge McKenna’s conclusions. Indeed, in a March 31, 2009 AmericanLawyer.com article (here) Alison Frankel quotes the plaintiffs’ attorney from the UBS case as saying "we’re not convinced other courts will rule the same way."

 

Third, there are still the claims of those erstwhile class members who were frozen out of the UBS regulatory settlement, such as those who bought the auction rate securities from a non-UBS broker or who transferred their account away from UBS. As the plaintiffs’ lawyer from the UBS case also is quoted as saying in the American Lawyer article, "the key to the auction rate securities litigation is plaintiffs whose securities were not bought back by the banks."

 

This category of investors who were shut out of the regulatory settlements also includes the investors who bought their securities from banks or broker dealers who have not yet entered regulatory settlements.

 

Fourth, in all the regulatory settlements, institutional investors’ interests were treated differently. For example, in the UBS settlement, institutional investors cannot hope to have their investment redeemed until at least 2010. These investors’ liquidity issues continue to give rise to new litigation; for example, I described in recent post (here) the lawsuit that KV Pharmaceuticals filed in late February against Citigroup, in which the company alleged that the illiquidity of its auction rate securities investments was, among other things, forcing the company to lay off workers.

 

And finally, there is the separate category of litigation that has arisen against auction rate securities investors, rather than against the auction rate securities sellers. These cases involved companies whose balance sheet exposure to auction rate securities has harmed their financial condition, and who face litigation from their own shareholders who claim the companies failed to disclose their exposure. The most recent of these cases, involving Perrigo Company, is discussed here.

 

In short, while Judge McKenna’s opinion unquestionably represents a significant milestone, it by no means represents the finish line for auction rate securities litigation. Unfortunately, these cases likely will be around for some time to come.

 

All of that said, Judge McKenna’s opinion does hold out the hope that a large portion of these cases can eventually be cleared out, and the problem at least reduced over time, perhaps to more manageable levels.

 

I have in any event added the UBS dismissal to my roster of settlements, dismissals and dismissal motion denials in connection with the subprime and credit crisis related lawsuits. The roster can be accessed here.

 

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

 

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

 

Background

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

 

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

 

 

The February 9 Opinion

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

 

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

 

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

 

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

 

Discussion

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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On March 18, 2009, Judge John F. Walter of the Southern District of California granted the defendants' motion to dismiss, with leave to amend, in the subprim-related securities lawsuit involving certain former directors and officers of Downey Financial Corp. A copy of the order can be found here.

Background

Securities class action lawsuits were first filed against Downey and certain of its directors and officers in May 2008, following the company's announcement before the market opened on March 17, 2008 that the company had experienced a significant increase in its nonperforming assets and that it found itself forced to restructure its loans with many borrowers. As reflected in its subsequently filed First Amended Consolidated Complaint , the plaintiff alleged 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.

In the amended complaint, the plaintiff alleged certain specific misrepresentations as to each of the three defendants, as well as other misrepresentation not attributed to any one defendant.

On November 21, 2008, the FDIC took control of Downey and sold its assets to another institution (about which refer here).

 The March 18 Order

The defendants moved to dismiss the plaintiffs complaint. Judge Walker summarized the plaintiff's amended complaint (and perhaps tipped his hand about how he felt about plaintiff's allegations) when he observed that "in short, Plaintiff alleges that the decline in Downey's shareholder value resulted from alleged misrepresentations made to the investing public by Downey's current and former officers and/or directors, and not from the current economic climate."

Judge Walker granted the motion on each of the grounds urged by the defendants: he found as follows: first, that the plaintiff failed to plead that the individual defendants made a material misrepresentation or omission; second, that the plaintiff failed to plead scienter adequately; and third, that plaintiff had failed to plead loss causation adequately.

With respect to the individual defendants' own alleged misrepresentations, Judge Walter found that "there is not a single actionable misrepresentation or omission in the 161 pages of the [amended complaint] attributed to the Individual Defendants."The specific statements on which plaintiffs sought to rely were "far too vague to be actionable."

He also found that "the general allegations against Downey cannot be attributed to the Individual Defendants under the group pleading doctrine, because as this Court previously held, the group pleading doctrine did not survive the PSLRA."

With respect to the issue of scienter, Judge Walter found that the plaintiff's allegations "when considered collectively, do not give rise to a strong inference of scienter." In reaching this conclusion, Judge Walter specifically observed that the defendants' corporate positions alone do not give rise to scienter.

He similarly found that the plaintiff had not adequately pled scienter in connection with Downey's public filings; the resignation and termination of Downey officials; the plaintiffs' allegations of GAAP violations; and allegations based on confidential witness statements. In each instance, Judge Walter said the allegation were too vague and general and lacked the requisite specificity.

Judge Walter also found the absence of insider stock sales also negated the inference of scienter. He observed that two of the individual defendants had not sold any of their massive holdings of Downey stock. He found that “their substantial losses suffered "¦due to the failure to sell any stock during the class period negates any inference of scienter that may have been raised by other allegations."

Finally, with respect to loss causation, Judge Walter found that "the public disclosures referred to in the [amended complaint] do not contain disclosure of wrongdoing, and, at best, demonstrate only that the market learned of and reacted to Downey's 'poor financial health' rather than any alleged fraud."

Judge Walter gave the plaintiff leave to file an amended complaint by April 1, 2009.

Discussion

Judge Walter's opinion has a number of interesting features. First, in rejecting plaintiff's contention that the defendants had misrepresented Downey's exposure to "subprime" loans, he rejected plaintiff's contention that a subprime loan is any loan made to a borrower with a FICO score below 660. He accepted defendantss argument that the company had fully disclosed that the company itself defined a subprime loan as one made to a borrower with a FICO score below 620. Because the company had fully disclosed its own definition of "subprime" loans (which definition Judge Walter also found had some support in financial literature), the defendants could rely on the company's own definition of "subprime" in arguing that there had been no misrepresentations about the company's exposure to subprime loans. 

Second, Judge Walter's blanket statement that the "group pleading doctrine" did not survive the PSLRA is interesting, but it is a view that is not necessarily universally shared. Indeed, as I have noted elsewhere, the group pleading doctrine has recently undergone something of a revival in recent months.

In any event, the Downey Financial case can now be added to the lengthening list of subprime-related securities lawsuits in which motions to dismiss have been granted. It is also yet another example of a case, along with NovaStar Financial

I have added the Downey Financial decision to my register of subprime-related securities lawsuit settlements, dismissals and dismissal motion denials, which can be accessed here.

Special thanks to a loyal reader for providing a copy of the Downey Order.

More Bank Failures: On March 20, 2009, the FDIC took control of three more banks: TeamBank N.A. of Paolo Kansas (refer here); Colorado National Bank, Colorado Springs, Colorado (refer here); and First City Bank, of Stockbridge, Georgia (refer here). The addition of these three banks brings the 2009 year to day bank failure tally to 20 (compared to 25 during the entire year of 2008). The FirstCity Bank closure is the eighth in Georgia since October 2007. The FDIC’s complete list of failed banks can be found here.

The possibility of additional claims growing out of these continuing banks failures undoubtedly remains as a significant factor, but prospective claimants might do well to review Judge Walter's opinion in the Downey Financial case before pulling the trigger on filing a new securities lawsuit against the failed bank's former directors and officers.

Apologies: I apologize for any typing, layout, font, or other errors that may appear in the published version of this post. I had more technical difficulties getting this one online than just about anything I have ever attempted with this blog. Gremlins, I suppose.

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The current global financial crisis may result in "unprecedented levels of litigation" that "will either serve to identify ‘weak links’ in the chain of participants who originate, appraise, and service collateral and underwrite, manage, insure, rate and sell securities," or it will serve to "highlight where the market may have underappreciated certain risks or failed to appreciate certain circumstances," according to a paper featured in a March 17, 2009 post (here) on the Harvard Law School blog.

 

The paper, entitled "Legal and Economic Issues in Litigation Arising From the 2007-2008 Credit Crisis," was written by Babson College Professor Jennifer Bethel, Harvard Law Professor Allen Ferrell, and Babson Professor Gang Hu, can be found here.

 

The paper explores the "economic and legal causes and consequences of the 2007-2008 credit crisis." In particular, the paper examines "the risks that can arise from financial and technology innovations and losses that are uniquely related to correlated events in the setting of loan markets." The paper sets for a detailed and interesting overview of the economic and financial causes that contributed to the current credit crisis.

 

The paper also notes that "the credit crisis is not solely an economic phenomenon, but a legal one as well." The paper discusses a number of different types of lawsuits that have arisen, but focuses in particular on securities class action lawsuits against public companies, which the paper describes as "by far the most important litigation likely to arise out of the credit crisis."

 

The paper asserts that "plaintiffs that bring Rule 10b-5 class action lawsuits will face substantial challenges," and notes in particular that the securities plaintiffs will have to navigate around three basic legal principles: "(i) there can be no ‘fraud by hindsight’; (ii) there can be no actionable disclosure deficiency with respect to information the market already knew (the ‘truth on the market’ defense); and (iii) plaintiffs must establish loss causation for their claims."

 

First with respect to the "fraud by hindsight" concern, the paper notes that it will not be enough for plaintiffs to show that there have been economic losses; they will also have to show that the adverse developments were reasonably foreseeable at the time the supposedly disclosures were made. The authors note that

 

Whether a failure of certain market participants to provide detailed disclosures regarding the implications of an event – the first full national fall in housing prices since World War II in conjunction with a dramatic and increasingly global crisis – from which the actors themselves suffered huge losses is actionable will likely prove an important stumbling block, in our judgment, for a number of actions being brought.

 

The authors add that "the presence of disclosure failures and materiality thereof must be assessed in light of what was known at the time of the disclosures without the benefit of 20/20 hindsight, even if losses occur."

 

Second, with respect to the "truth on the market" defense, the authors question whether the target companies in fact had "special knowledge that was not known by the market at large." The authors suggest that this may have been a situation where the market was at least as informed, or at least no less informed, than the defendants on relevant issues.

 

Third, the authors suggest that "loss causation is likely to be a challenging litigation issue for plaintiffs, because market prices, especially of financial-sector securities, declined overall."

 

The few dismissal rulings that have accumulated so far provide at least some support for the authors’ theories. In at least two cases where dismissal motions have been granted with prejudice – the NovaStar Financial case (about which refer here) and the Impac Mortgage case (refer here) – the courts seemed particularly concerned that the defendant companies had been caught in an industry-wide or even economy-wide downturn. Even if the courts did not use the price phrase "fraud by hindsight," the concept was seemingly implied in the rulings.

 

At the same time, however, there have also been significant cases where courts have had no difficulty denying dismissal motions – for example, New Century Financial (refer here) and Countrywide (here) – in which the courts have expressed open outrage regarding the alleged misrepresentations and omissions. The authors’ analysis seems deficient to me to the extent it fails to recognize the possibility that at least some courts’ judgments potentially may be affected by this sense of outrage, particularly over the extent of damage done, to investors and to the economy. (A list of all of the subprime dismissals and dismissal motion denials can be accessed here.)

 

In addition, given the authors overall hypothesis that plaintiffs will face substantial hurdles in pursuing these cases, it seems a noteworthy and even odd omission that the authors detailed and exhaustive paper neglects to even mention the possibility that the U.S. Supreme Court’s decision in the Tellabs case could also represent a significant hurdle for the plaintiffs. In that regard, the Tellabs decision has generally proven instrumental in those cases where dismissal motions have been granted thus far.

 

Finally, with respect to the authors’ suggestion that loss causation issues may prove critical, I note that in a prior post (here) I discussed the challenge that plaintiffs may face where they have sued for supposed economic losses on securities that continue to provide scheduled interest payments on time and in full. These arguments may be particularly relevant in claims brought by mortgage-backed securities investors who have sued the securities issuers and the securities offering underwriters.

 

Defenseless: Laura Pendergast-Holt, the erstwhile Chief Investment Officer of Stanford Financial Group, has a few legal problems to sort out. First, she is a defendant in an SEC enforcement proceeding involving the Stanford Group. Second, she was arrested on February 26, 2009 and charged with obstructing a proceeding before an agency of the United States. Third, she has been named as one of the defendants in numerous civil lawsuits brought by irate Stanford group investors. (A complete list of Stanford-related litigation can be accessed here.)

 

Ms. Pendergast-Holt clearly needs the services of an attorney. Unfortunately, she is also party to one more lawsuit, one in which she is the plaintiff, and which suggests the challenges she may have in providing for her legal representation in the above matters.

 

On March 17, 2009, she filed a lawsuit in Texas (Dallas County) District Court against Stanford Group’s directors and officers’ liability insurer, alleging that the insurer has "failed and refused to provide a defense so that she can defend herself in the SEC action, the civil class action, and in the criminal matter." A copy of her Original Petition can be found here.

 

Ms .Pendergast-Holt seeks a judicial declaration of coverage. Arguing that she has no way of satisfying any self-insured retention, she also seeks a "declaration that any self-insured retention or deductible be waived, held inapplicable or enjoined." She also alleges breach of contract and bad faith. She seeks damages estimated to exceed $5 million, as well as punitive damages estimated to exceed $40 million.

 

The bases on which the insurer has declined coverage for Ms. Pendergast-Holt’s defense are not specified in her Original Petition. While the scandal surrounding Stanford Group is notorious, as yet there have been no verdicts and no guilty pleas, nor to my knowledge have there even been any admissions. Whatever the facts ultimately prove to be, nothing has as yet been determined. These considerations may prove relevant to the coverage dispute, for example, with respect to the potential applicability of policy exclusions. On the other hand, representations made in connection with Stanford’s policy application (particularly with respect to Stanford’s finances) may also figure into the insurer’s coverage position.

 

A March 18, 2009 AmLaw Daily post regarding the coverage lawsuit can be found here. Hat tip to the Courthouse News Service (here) for a copy of the Original Petition.

 

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On March 9, 2009, in a short but strongly worded opinion, Judge Andrew Guilford of the Central District of California dismissed with prejudice the third amended complaint in the subprime-related securities class action lawsuit filed against Impac Mortgage Holdings. A copy of the opinion can be found here.

 

Background

As discussed here, on October 6, 2008, Judge Guilford had dismissed plaintiffs’ second amended complaint with leave to amend. Plaintiffs filed their third amended complaint on October 27, 2008, and the defendants renewed their motion to dismiss.

 

The third amended complaint essentially alleged that contrary to the company’s public statements and to the company’s own underwriting guidelines, the company’s Alt-A loans were being sold to less creditworthy borrowers, so that the Alt-A loan portfolio was as risky as a portfolio of subprime mortgages. The plaintiffs further alleged that at the same time, the company misrepresented its true financial condition by its failure to write down the value of its loan portfolio. Further background regarding the lawsuit can be found here.

 

The March 9 Opinion

In his March 9 opinion, Judge Guilford noted that the in opposing dismissal the plaintiffs had quoted from the court’s opinion in the New Century case denying the motion to dismiss (about which refer here), contending that this case, like the New Century case, is about a "staggering race-to-the-bottom of loan quality and underwriting standards as part of an effort to originate more loans for sale through secondary markets."

 

Judge Guildford said that he "disagrees" with this characterization, noting that in his view, "this case is about a company involved in a volatile industry at the onset of a long, destructive economic downturn."

 

The specific basis on which Judge Guilford granted the motion to dismiss is his finding that the third amended complaint "fails to plead a strong inference of scienter." He found that the former employees’ statements on which the plaintiffs relied were just "vague accusations and conjecture." The third amended complaint’s reference to follow due diligence or loan guidelines were just generalizations lacking connection to specific actions or events.

 

The plaintiff had also relied on the "core operations inference" to try to satisfy the scienter requirement. While noting that there may be rare instance in which an event is so prominent that it would be "absurd" to suggest that key officers lacked knowledge of it, this, Judge Guilford found, was "not one of those exceedingly rare cases."

 

Discussion

Judge Guilford’s opinion joins a growing list of subprime and credit crisis-related securities lawsuits in which dismissal motions have been granted. (To access my running scorecard of subprime and credit crisis-related securities lawsuit settlements, and dismissal motion denials, refer here.) To be sure, there have also been a number of cases, including some higher profile cases – particularly the Countrywide case (about which refer here) and the New Century case (refer here) – where dismissal motions have been denied.

 

However, Judge Guilford’s express rejection of the Impac plaintiffs’ attempt to compare their case to the New Century case, and to use that as a way to avert dismissal, may suggest the constraints that plaintiffs in other cases may face in trying to rely on the Countrywide and New Century dismissal motion denials.

 

It should be noted that relatively few of the dismissal motion denials thus far have been with prejudice. Indeed, of the dismissals granted, only the Impac dismissal and the dismissal in the NovaStar Financial case (about which refer here) have been with prejudice. However, in both of those cases, the courts seemed particularly concerned with the fact that defendant companies had been caught in an industry-wide or even economy wide downturn, and as a result were openly skeptical of plaintiffs’ claims of fraud.

 

It is still too early to generalize about how these cases are faring or will fare overall, as most of them are only in their earliest stages. But at a minimum it appears that some courts, fully aware of the global financial turmoil, are viewing at least certain of these cases with skepticism. By the same token, there have been courts that have found the plaintiffs’ initial pleadings to be sufficient to survive a motion to dismiss.

 

Judge Guilford’s refusal to consider the core business operations inference stands in contrast to the opinion denying the motion to dismiss in the RAIT Financial subprime-related securities case, where the court held that the allegations regarding the defendant company’s core business operations were adequate to satisfy the scienter requirement. As I noted in my discussion of that ruling (here), earlier courts had rejected this theory as inconsistent with the PSLRA’s pleading requirements, but more recently courts, for example, in the Ninth Circuit (refer here) and the Seventh Circuit (refer here), have taken it up. As noted in a recent commentary by the Katten Muchin law firm entitled "Reform Act Under Attack?" (here), the core operations theory "has made a comeback in 2008," which the authors contend is inconsistent with the PSLRA’s meaning and intent.

 

In any event, I have added the Impac dismissal to my list of subprime and credit crisis securities lawsuit resolutions, which can be accessed here.

 

The "Ultimate Solution" to Corporate Financial Misconduct?: In a March 10, 2009 press release (here), Fuwei Films, a China-based plastic films manufacturer whose shares trade on Nasdaq, reported that it had "become aware" of an "initial verdict" by the Jinan Intermediate People’s Court, in the city of Jinan, in the Shandong province. The verdict related to an action brought against three major shareholders of the company, for misappropriation of state-owned assets worth tens of millions of renminbi, during the reorganization of Shandong Neoluck Plastics. The three shareholders were identified as Mr. Jun Yin, Mr. Tongju Zhou, and Mr. Duo Wang.

 

According to the press release, the verdict found the three individuals guilty of the charges. The court "sentenced Mr. Yin to death, with a stay of execution of two years." The other two defendants received life imprisonment. The court will transfer to the Chinese government all of the personal property of the three defendants, including their holdings in two entities that owned approximately 65% of Fuwei’s common shares.

 

The press release stated that "none of these individuals is currently involved in Fuwei’s day-to-day operations."

 

Prospective investors will be happy to know that with this bit of unpleasantry put to rest, the company will now "be able to focus exclusively on executing Fuwei’s strategy to emerge from the current economic crisis." In light of the court-ordered ownership change, it is probably good that the company added that "we believe the Chinese government will support our long-term growth."

 

Special thanks to a loyal reader for the link to the Fuwei press release.

 

Options Backdating Update: The Securities Litigation Watch has updated (here) its helpful scorecard of the options backdating-related securities lawsuits. As reflected in the scorecard itself (here), of the 39 options backdating related securities lawsuits, 26 have now been resolved – nine have been dismissed and 17 have settled.

 

According to the Securities Litigation Watch, the average settlement for these cases is $83.1 million. However, if the largest settlement (United Health) is removed, the average is $32.37 million, which is roughly line with the overall average class action settlement level noted by Cornerstone in its recently released study of securities lawsuit settlements.

 

My own detailed running tally of the options backdating lawsuits settlements and dismissal motion grants and denials can be accessed here.

 

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Last year, investors filed numerous lawsuits against the investment banks and broker dealers who sold the investors auction rate securities. However, in a recent lawsuit, the targeted company was not an auction rate securities seller; rather, it was an auction rate securities buyer, which is alleged to have misrepresented to its own shareholders its exposure to auction rate securities in which it had invested.

 

According to their March 11, 2009 press release (here), the plaintiffs’ attorneys have initiated a securities class action lawsuit in the Southern District of New York against Perrigo Company, a Michigan-based pharmaceutical manufacturer and distributor, and certain of its directors and officers. The complaint (which can be found here) alleges that Perrigo had invested in $18 million in auction rate securities and that until September 15, 2008, the company had a reasonable expectation of redeeming its auction rate securities.

 

However, the complaint alleges that on September 15, Lehman Brothers, which had underwritten and sold Perrigo’s auction rate securities, went bankrupt. The complaint alleges that

 

On November 6, 2008, the beginning of the Class Period, defendants reported the "fair value" of Perrigo’s ARS as $14,500,000, but concealed the impact of Lehman’s bankruptcy on Perrigo’s ARS. Then just three months later, on February 3, 2009, defendants disclosed, for the first time, that Lehman had underwritten and sold the ARS to Perrigo. They also announced that the Company was writing off the entire value of its ARS, wiping out over a third of Perrigo’s earnings in the quarter. As a result of this disclosure, the stock price plunged 18% that day, causing massive losses to investors.

 

Although the allegations brought against Perrigo as an auction rate securities investor may seem unusual, the Perrigo complaint is actually not the first to assert securities fraud in connection with a company’s disclosures concerning its investment in auction rate securities. Indeed, as noted here, shareholders raised allegations against NextWave Wireless in connection with that company’s auction rate securities investment.

 

Nor is Perrigo the first company to be exposed to securities litigation as a consequence of Lehman’s bankruptcy. As I noted in prior posts, Constellation Energy (about which refer here), Reserve Fund (here), JA Solar (here), and Farmer Mac (here) have all found themselves hit with securities lawsuits in part due to the impact on them from the Lehman Brothers bankruptcy.

 

All of these cases represent what I previously called (here) the new wave of subprime and credit crisis-related securities litigation, in which the thrust of the allegations is not that the target companies themselves are exposed to subprime-related risks, but rather that the companies were exposed to other companies or assets that were themselves exposed to the subprime or credit risk.

 

The fact that this lawsuit is filed against Perrigo, a pharmaceutical company, underscores a point I have previously noted about the new wave of subprime and credit crisis related litigation, which is the potential for this new wave to bring the credit crisis litigation wave, which up until now has been largely restricted to the financial sector, to companies throughout the larger economy.

 

In any event, despite the much ballyhooed auction rate securities settlements, lawsuits related to the frozen auction rate investments continue to flow in. Indeed, on March 10, 2009 Careerbuilder LLC filed an action (here) in Illinois (Cook County) Circuit Court against Bank of America, alleging that even though BofA has reached at least two prior regulatory settlements regarding the auction rate securities, Careerbuilder remains stuck with the $32 million in auction rate securities that BofA sold them.

 

Yet Another Form of Credit Drawn in the Litigation Wave: As I have previously noted (most recently here), the current litigation wave long ago ceased to be just about subprime debt and has expanded to encompass a wide variety of different kinds of lending. The most recent example of this spread to other kinds of lending is the lawsuit filed on March 11, 2008 against Corus Bankshares.

 

According to their press release (here), plaintiffs’ counsel filed the suit against Corus and certain of its Chief Executive Officer in the Northern District of Illinois. The complaint (which can be found here) alleges that the company’s disclosures were misleading because they failed to disclose

 

(i) that Corus was failing to recognize losses on its condominium loans in accordance with generally accepted accounting principles ("GAAP"); (ii) that Corus and/or its affiliates was purchasing condominiums in developments Corus had financed in an attempt to: (a) inflate the appraised values of condominiums to delay having to recognize losses on financing for such condominiums; (b) inflate developers’ sales figures to increase the likelihood of successful future sales; and (c) create the illusion of successful sales histories in order to inflate appraisal values for the condominiums to ensure inflated future prices for the condominiums; and (iii) that Corus was involved in detailed and in-depth negotiations with the Federal Reserve Bank of Chicago and the Office of the Comptroller of Currency regarding its deteriorating pool of condominium loans.

 

The complaint alleges that when on the company released its financial results on January 29, 2009 and disclosed that "Corus is suffering from the extraordinary effects of what may ultimately be the worst economic downturn since the Great Depression," the company’s shares fell nearly 47% to close at $.59 per share on February 2, 2009.

 

So add condominium loans to the kinds of lending that has become involved in the subprime and credit crisis related litigation. I have added the Perrigo and Corus lawsuits to my running tally of the subprime and credit crisis related securities class action lawsuits, which can be accessed here. A spreadsheet with the 2009 subprime and credit crisis-related securities class action lawsuits can be found here.

 

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The current financial crisis involves a potent witches’ brew of bankruptcies, mortgage bailouts, failed banks, blame assignment, and liquidity issues. Because every one of these ingredients contributes in some important way to the total mix of current woe, this post briefly references each one of these issues and concludes with a video that manages to find humor despite the current dismal circumstances.

 

Bankruptcies Double: Though it is early yet, one of 2009’s stories of the year has to be the surge in corporate bankruptcies. According to recently published data (here), bankruptcies this year by publicly traded companies are running at more than twice their 2008 pace. Bankruptcies of companies with assets over $1 million are fueling the surge.

 

According to the data, there have been 46 bankruptcy filings (under Chapter 11 or Chapter 7) by public companies in 2009, with total combined assets of $74 million. As this point last year, there were only 21 bankruptcies totaling $11 billion.

 

Some context is required for these numbers, however. This year’s bankruptcy pace is still below that of 2002, a "record-breaking" year in which there were 60 bankruptcies by early March.

 

The financial market turmoil is producing numerous casualties. Indeed, Blackstone Chairman Stephen Schwarzman was quoted today (here) as saying that "between 40 and 45 percent of the world’s wealth has been destroyed in little less than a year and a half." Give the staggering scale of market losses, even optimists will recognize that further bankruptcies undoubtedly lie ahead.

 

My recent post discussing D&O insurance issues arising from bankruptcy can be found here.

 

A Successful Mortgage Bailout: As depressing as the current circumstances are, a sucessful bailout from an earlier era may provide reason to hope that it may be possible to manage our way out of the current mortgage crisis.

 

A March 6, 2009 post in the Harvard Business Review Editors’ Blog entitled "The Mortgage Bailout That Worked (here) describes a "remarkably similar catastrophe" that "happened during the real estate boom of the 1920s." In that earlier time, an investment frenzy developed over "guaranteed mortgage certificates" that were issues, in denominations as small as $100, for shares in residential mortgages and groups of mortgages. The certificates were issued by guaranty companies and backed by the state of New York.

 

Investor demand for the certificates soon outstripped the supply of mortgages, in turn fueling a demand for even more mortgages, whether or not the mortgages were compliant with regulatory requirements. The frenzy to supply investors with more certificates also encouraged the guaranty companies to assume borrowers’ loan fees and offer bonuses to brokers for mortgages. Ultimately, to protect their own investments, the guaranty companies swapped good mortgages out of customers’ certificates and transferred them to their own certificates. (Sound familiar?)

 

Eventually, the scheme collapsed and the state of New York stepped in and "amazingly, managed to clean up the bulk of the mess in just four years of hard, hard work." The state formed a Commission, which eventually had over 1,000 employees, to "take over the guaranty companies and sort out the certificates." What they did was to "preserve the value of the certificates by preserving the value of the underlying real-estate assets."

 

The process the Commission followed, which was designed to work out the mortgage or dispose of the property in some productive way, could be a useful model for today. The lesson for the current circumstances from the prior effort, according to the HBR post, seems to be to "hire a sufficiently large group of people to track down and preserve the value of the assets underlying all of our current toxic real-estate securities" in a similar manner. It certainly worked in the earlier era; the Commission "recouped 84% of the value of the certificates" and brought "order out of chaos."

 

Are Bank Failures a Necessary Recovery Prerequisite?: Some readers may have noted that this past Friday night, the FDIC took control of yet another bank, Freedom Bank of Georgia (as noted here). Prior to its closure, the bank, which was located in Commerce, Georgia, had assets of $173 million. This latest bank closure brings the year to date total of failed banks to 17, and the number of banks that have failed just since July 1, 2008 to 39. The FDIC’s complete list of banks that have failed since October 2000 can be found here.

 

While bank failures are one among the more disturbing parts of the current economic turmoil, they may also be a necessary part of the recovery as well. A March 7, 2009 Washington Post article entitled "Every Bank Failure is Also a Beginning" (here) states that the increase in bank closures is "a sign of the nation’s economic distress," but it is also a "first step toward revival." According to the article, "in wiping away problem loans and brining in new investors, the government is creating the necessary conditions for new lending."

 

The Post article explains the FDIC’s bank closure process, including its efforts to transfer the bank’s existing banking relationships to a healthier institution. The process is not without its pitfalls, but it is, according to the article, essential to ensuring that a community has banking resources available despite the closed bank’s failure.

 

The Post article focuses on the events surrounding the closure of the Community Bank of Loganville, Ga., which failed in November 2008 (refer here). Last Friday’s bank closure involved yet another bank from Georgia, the seventh bank in Georgia to fail since October 2007. Many of the failed banks were located in or around Alphretta, Georgia, which earlier this year the Wall Street Journal referred to (here) as "Bank-Failure Central."

 

Among other things, commentators cited in the Journal article ascribed the rash of bank failures in Georgia to "overabundant home building, years of risky lending and one of the most relaxed environments in the U.S. for starting new banks." The Journal article also states that the failures "reflect an unusually dense concentration of go-go optimism run amok."

 

Credit Agency Focus: When assigning blame for the current crisis, many commentators often cite the credit rating agencies. Indeed, Time Magazine’s list of the 25 people to blame for the current financial debacle included Kathleen Corbet, who ran S&P for most of the last decade. Whether or not the credit rating agencies are blameworthy is one question; whether they can be held liable for it is yet another, as this blog has previously noted (here).

 

A recent memorandum by the Jenner & Block firm entitled "Credit Rating Agencies in the Spotlight: A New Casualty of the Mortgage Meltdown" (here) admirably summarizes the legal issues that investor litigation against the credit rating agencies might present. One noteworthy observation in the memo is the possibility federal preemption of state regulatory action under the Credit Rating Agency Reform Act of 2006. In addition to discussing other defenses that may be available to the credit rating agencies, the article also helpfully cites a lists a number of cases currently pending against the firms.

 

A recent post in which I discussed the partial denial of the motion to dismiss in the securities lawsuit that Moody’s shareholders filed against the company, and the ruling’s possible implications for the rating agencies’ potential liability for their ratings activities, can be found here.

 

Liquidity Issues Affect Everything: A company’s inability to access cash when needed can raise a host of complications, including even with respect to pending securities class action lawsuit settlements. As reflected in its March 10, 2009 press release (here), due to liquidity constraints, Korean semiconductor company Pixelplus is unable to fund its agreed $1 million cash contribution to the settlement of the securities class action lawsuit that had been filed against the company.

 

According to the press release, the court has approved an addendum to the parties’ settlement stipulation with respect to the company’s agreed settlement contribution. The press release states that the company could not make its contribution "due to the economic turmoil in Asia arising from the global financial crisis and the world-wide recession, which continues to have a severe negative impact on the financial position and business operations of the company."

 

In lieu of the company’s contribution, its insurance carrier is paying about $331,000 (at current exchange rates). The company will make up the difference "if and when such funds become available."

 

There may be implications here for the growing wave of subprime and credit crisis-related litigation. A cause of action is not worth much if the target company can’t even fund an eventual settlement. There may be more than a few target companies that might eventually prove unable to fund their portion of any eventual settlements.

 

Citi of the Future: Citigroup’s shares were up today on relatively positive news. However, according to an article in today’s Wall Street Journal (here), "barely a week after the third rescue of Citigroup," U.S officials are weighing "what fresh steps they might need to take if its problems mount." The bank’s continuing problems have, among other things, fueled rampant speculation that the government eventually will be forced to nationalize Citigroup.

 

The prospect of a nationalized Citigroup might have been unimaginable even a short time ago, but now some at least some folks apparently have no trouble imaging what a government-owned Citibank might be like, as reflected in the following video. (Sensitive readers should be forewarned that this video makes rather promiscuous use of the F-bomb and may otherwise be offensive. On the other hand, it is also very funny.)

 

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General Motors’ March 4, 2009 filing on Form 10-K (here), among other things, reflected the doubts of the company’s auditor, Deloitte & Touche, of the company's ability to continue as a "going concern."

 

The auditors, quoted in the company’s filing, said that "the corporation’s recurring losses from operations, stockholders’ deficit, and inability to generate sufficient cash flow to meet its obligations and sustain its operations raise substantial doubt about its ability to continue as a going concern."

 

The company itself said in the filing that its future depends successfully executing its restructuring plan. The company said that "if we fail to do so, we will not be able to continue as a going concern and could potentially be forced to seek relief through a filing under the U.S. Bankruptcy Code."

 

General Motors may be the most prominent company to have been dealt a going concern opinion, but it is far from alone. Indiana-based insurer Conseco recently said (here) its auditors have doubts about its ability to continue as a going concern. Similarly, senior adult-residence developer Sunrise Senior Living also recently announced (here) that it has received a going concern opinion. Other companies that have recently announced that have received or anticipate receiving a going concern opinion include Allied Capital, Lear and UTStarcom.

 

The likelihood is that the number of going concern opinions will escalate in 2009. In a recent interview (here), the CEO of Grant Thornton predicted that the number of going concern opinions could hit an "all-time high" this year. Separately, he also said (here) that "we’ll see an unprecedented number of going concern footnote disclosures and clarifications from the auditors." Industries that are likely to be hard hit include automotive, residential construction, manufacturing, financial services and retail.

 

The problem with going concern opinions is that they can become self-fulfilling prophecies. A March 5, 2009 CFO.com article entitled "The Growing Concern over Going Concern" (here), stated that "the revised status can further hinder a company on the brink of filing for Chapter 11 from avoiding bankruptcy court," because the qualification spooks "investors, suppliers and lenders."

 

In other words, the increase in going concern opinions could amplify the already escalating number of bankruptcies. (According to one report, here, the number of bankruptcies in February 2009 was up 29% over a year ago.)

 

Among other things, this likelihood of increased bankruptcies also means the potential for an increase in claims against the directors and officers of the failing companies.

 

A bankruptcy filing is particularly likely to be followed by claims against the bankrupt company’s directors and officers. In its recent report analyzing the 2008 securities lawsuits (about which refer here), the information database firm Advisen noted that the rising number of bankruptcies "almost certainly will be accompanied by an increase in securities lawsuits."

 

The Advisen Report reports that since 1995, roughly 35 percent of large public companies (defined as having more than $250 million in assets, measured in 2008 dollars) that filed for bankruptcy were also named in securities class action lawsuits. During 2007 and 2008, that percentage increased to 77 percent.

 

Unfortunately, an increase in bankruptcy related claims could also mean an increase in D&O coverage disputes as well. As I noted in recent post (here), D&O claims in the context of bankruptcy raise a number of recurring and potentially significant coverage issues.

 

In addition, a significant increase in the number of corporate bankruptcies could have a magnified impact on the D&O insurers’ loss results. In recent years, many carriers substantially supplemented their revenue by writing extensive amounts of so-called "Side A" excess insurance, which effectively operates as catastrophe insurance to provide individuals with an added layer of protection in the event of insolvency (among other things).

 

Up until now, the carriers’ experience on the Side A product has been overwhelmingly positive. However, a dramatic surge in corporate bankruptcy filings and the associated litigation could quickly wipe out years of earnings on this product line.

 

In any event, among other critical issues the directors and officers of a company facing the facing bankruptcy is the amount, structure and coverage of the company’s D&O insurance. At perhaps no other time in a company’s life cycle is it more important to the company’s directors and officers for the company to have a D&O program designed to provide them the fullest extent of insurance protection.

 

Accordingly, it is particularly important for senior officials of financially troubled companies to ensure that the company’s D&O insurance has been reviewed by a knowledgeable insurance professional who understands the coverage challenges bankruptcy can present.

 

More About GM: One of The D&O Diary’s favorite blogs, Francine McKenna’s Re: The Auditors blog, recently underwent a radical facelift. The revised site, now in beta (here), has a visually attractive new face. But even more importantly, the new design makes it even easier to access McKenna’s trenchant observations about problems in the accounting industry, and the Big 4 accounting firms in particular.

 

Among other things, McKenna has an interesting and detailed explication (here) of her view that aGM bankrupcy may be the least bad alternative for all concerned.

 

A March 5, 2009 Business Week article (here) points out that GM’s plan to try to get back to annual sales of 16 million vehicles may represent nothing so much as a failure of the company’s management to accept the reality that those kinds of sales figures in prior years represented a bubble of the same kind that ultimately overwhelmed the residential real estate market. Both were fueled by cheap credit.

 

In Memoriam: The professional liability insurance community has lost a good friend. Last Friday, Michael J. Stringer, of the Duane Morris firm, passed away. He was only 42. Michael was a well known and respected member of the select group of attorneys who specialize in representing carrier interests in D&O coverage matters. He will be missed.

 

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Even though I was not even away a full week for the recent PLUS D&O Symposium, there was a flood of noteworthy developments while I was gone. Here is a roundup of last week’s news and notes.

 

Subprime-Related Derivative Lawsuit Largely Dismissed: In a detailed and painstaking February 24, 2009 opinion (here), Chancellor William Chandler dismissed the bulk of the consolidated subprime-related derivative suit pending against Citigroup, as nominal defendant, and certain of the company’s directors and officers, in Delaware Chancery Court. A very thorough review of the opinion can be found on the Delaware Corporate and Commercial Litigation Blog, here.

 

Chancellor Chandler dismissed all but one of plaintiffs’ claims for failure to adequately plead demand futility. He did, however, allow plaintiffs’ claims of waste concerning the compensation and benefits package for Citigroup’s CEO to continue.

 

The most interesting part of Chancellor Chandler’s opinion relates to the plaintiffs’ allegations that the defendants failed to monitor the company’s business risk with respect to Citigroup’s exposure to the subprime mortgage market. Chandler characterized this claim as an assertion that "the director defendants should be personally liable to the Company because they failed to fully recognize the risk posed by subprime securities."

 

Chandler noted that Delaware case and statutory law places "an extremely high burden on a plaintiff to state a claim for personal director liability for failure to see the extent of a company’s business risk." Chandler concluded that in light of this burden, plaintiffs’ conclusory allegations (and thus their failure to plead particularized facts) were insufficient to excuse demand.

 

Among other things, Chandler noted that the "oversight duties under Delaware law are not designed to subject directors, even expert directors, to personal liability for failure to predict the future and to properly evaluate business risk."

 

Chandler did take pains to distinguish the recent Chancery Court decision in which the "failure to monitor" claim against the directors and officers of AIG survived a motion to dismiss. (The February 10, 2009 opinion in the AIG case can be found here.) In that case, unlike the Citigroup action, the defendants "allegedly failed to exercise reasonable oversight over pervasive fraudulent and criminal conduct." The Citigroup case, by contrast, involved only alleged failure to recognize the extent of the company’s business risk.

 

Both because of the high-profile nature of the Citigroup case as well as Chancellor Chandler’s detailed review of the applicable provisions of Delaware law, his opinion could prove to be particularly influential in other pending subprime and credit crisis-related derivative suits. The basis on which he distinguished the AIG case could also prove to be an important distinguishing characteristic in the determination of which derivative suits will survive and which may be dismissed.

 

I have in any event added the Citigroup opinion to my table of subprime and credit crisis-related lawsuit settlements, dismissal and dismissal denials. The table can be accessed here. A list of the subprime and credit crisis-related derivative suits themselves can be found here.

 

One final observation about the Delaware Corporate and Commercial Litigation Blog, which I referenced above. If you have any inclination or desire to follow the important legal trends affecting the potential legal liabilities and responsibilities of corporate directors and officers, you will find the Delaware litigation blog absolutely indispensible. I would rank the blog among the few truly must-read resources in this area on the Internet. The blog’s post on the Citigroup case is just one example why.

 

More Stanford Financial Developments and Litigation: In addition to the initiation of criminal charges against former Stanford Financial Group investment officer Laura Pendergast-Holt for obstructing the SEC’s investigation (about which refer here), last week’s developments regarding the Stanford scandal included the SEC’s filing late Friday night of an amended enforcement complaint in the matter.

 

According to the SEC’s amended complaint (which can be found here), R. Allen Stanford and his firm’s CFO, James M. Davis, operated a massive Ponzi scheme and misappropriated at least $1.6 billion of investor money in bogus personal loans to Stanford. An unspecified additional amount was also put into speculative investments, which by the end of 2008 made up the bulk of the Stanford Financial Group’s investments, though the company marketed its portfolio as a "well-diversified portfolio of highly marketable securities."

 

The amended complaint also alleged that Stanford and Davis fabricated portfolio’s investment performance, deciding each month on the return to be reported and "reverse engineering" the financial statements to reflect investment income that was never earned.

 

A February 28, 2009 New York Times article describing the criminal charges and the amended SEC complaint can be found here.

 

In addition to these criminal and regulatory developments, the Stanford Group was also hit with an additional civil lawsuit, this time involving a case filed in a Canadian Court. According to a February 27, 2009 article in the Financial Post (here), on February 25, 2009, Calgary-based furniture manufacturer has initiated a class action lawsuit in the Alberta Court of Queen’s Bench against Allen Stanford, Stanford International Bank, Stanford Group Company, Stanford Capital Management LLC, James M. Davis and Laura Pendergast-Holt.

 

The company alleges that it invested $1 million in certificates of deposit issued by the bank. The complaint, which seeks class action status, seeks damages for misrepresentation, unjust enrichment, conversion, fraudulent conveyance and breach of trust. The complaint also asserts fraud in connection with other Stanford investments.

 

I have added the new Canadian lawsuit to my running tally of the Stanford related litigation, which can be accessed here.

 

More Madoff Litigation, Too: During the past week, additional litigation related to the Madoff scandal also continued to flow in. I have added multiple new cases to my running tally of the Madoff-related litigation, which can be accessed here. Special thanks to the several readers who have alerted me to new Madoff cases, particularly to loyal reader Jon Jacobson.

 

One of the more interesting new cases is the one filed on February 24, 2009 in the District of New Jersey. Though this case raises allegations similar to those asserted in prior cases, the complaint asserts claims neither against Madoff and firm nor against the Madoff feeder funds. Rather, the sole defendant in the case is Peter Madoff, Bernard Madoff’s brother.

 

According to the complaint in the case (which can be found here), Peter Madoff and his brother "have worked side by side" for "nearly 40 years," and their offices "were only a few feet from each other." The complaint alleges, among other things, that Peter Madoff was responsible for "regularly verifying and accurately reporting the financial condition" of the Madoff firm, as well as establishing and monitoring internal controls and detecting and reporting any legal violations. The complaint asserts claims under Sections 10(b) and 20 of the ’34 Act, for breach of fiduciary duty, aiding and abetting, negligence, and negligent misrepresentation.

 

Hat tip to the Courthouse News Service for the Peter Madoff complaint.

 

Auction Rate Securities Litigation Continues to Amass: As I have previously noted (here), the various massive auction rate securities settlements do not seem to have stemmed the tide of auction rate securities litigation, and cases involving institutional and entity investors, who are not part of the regulatory settlements, continue to file new lawsuits.

 

The latest example of this phenomenon is the complaint filed on February 25, 2009 in the Eastern District of Missouri by KV Pharmaceutical Company against Citigroup Global Markets. A copy of the complaint can be found here.

 

The complaint alleges that between May 2005 and February 2008, Citigroup counseled KV into investing $72 million in auction rate securities that are now illiquid. Among other things, the complaint alleges that the securities can now be sold, if at all, at substantial discounts to par value. The complaint alleges that "holding $72 million of illiquid ARS exacerbates KV’s current cash crisis, which is requiring KV to seek borrowed capital and engage in overall cost-cutting by, among other things, eliminating approximately 700 jobs."

 

Clearly the auction rate securities market’s continued failure to function is causing enormous stress for the persons and entities unfortunate enough to have been stuck holding these instruments when the music stopped last February.

 

Hat tip to the Courthouse News Service for the KV Pharmaceutical complaint.

 

More Failed Banks: Add two more banks to the growing list of 2009 bank failures. On Friday, February 27, 2009, the FDIC took control of the Heritage Community, Glenwood, Illinois (about which refer here), and of the Security Savings Bank of Henderson, Nevada (refer here). Prior to its closure, the Heritage Community Bank had assets of $232.9 million, and Security Savings Bank had assets of $238.3 million.

 

The closure of these two banks brings the total number of  banks closed during February 2009 to ten, and the 2009 year to date total to 16 (compared to 25 during all of 2008). The FDIC's complete list of failed banks can be found here.

 

As I recently noted (here), a significant number of the 2009 bank failures, including the two most recent examples, involve smaller community banks. These troubling developments raise serious concerns both for the banking community and for the larger economy. The rash of bank closures also raises the likelihood that there will be increased litigation involving the failed banks and their former directors and officers.

 

Did the Milberg Kickback Scheme Hurt Class Members?: Those readers who were fortunate enough to have attended the PLUS D&O Symposium among other things heard interesting comments from St. John’s University law professor Michael Perino about the fascinating video, "The Rise and Fall of Bill Lerach" (to see the video trailer for which, refer here). Perino mentioned in his discussion the research he had completed about the impact on shareholder class members from the kickback payments the Milberg firm made to the paid plaintiffs.

 

In light of Professor Perino’s remarks, I thought readers might appreciate having a link to the Professor’s research paper, which can be found here. As reflected in the paper’s abstract, Perino concluded that not only were the firm’s fee requests and awards overall higher in the cases identified in the indictment, but that these findings are consistent with the hypothesis that class members were harmed.

 

An interesting commentary on the paper can be found on Professor Ribstein’s Ideoblog, here.

 

Insurance Persons of the Year: The LexisNexis Insurance Law Center is receiving nominations for the "Insurance Law Persons of the Year." The Center will be making four awards: the Policyholder Attorney of the Year; the Insurer Attorney of the Year; the Insurance Regulator of the Year; and the Insurance Jurist of the Year. In each case, the award will go to the person in each area that had the most impact in insurance law during 2008.

 

The deadline for nominations is March 6, 2009. Nominations can be sent to Karen Yotis the following address: karen.yotis@lexisnexis.com.

 

My New All-Time Favorite Headline: The table I have assembled regarding the Stanford Financial Group litigation, which I mentioned above, has proven to be a popular addition to this blog. I am grateful that a number of other blogs and sites have linked to the post in which the table can be accessed.

 

But as nice as it is for other blogs to recognize my post, nothing can top the article posted on February 24, 2009 on the American Lawyer website (here), entitled "D&O Diary Launches Stanford Financial Litigation Tally; Kevin LaCroix is Our Hero." That one even impressed my wife (I think), which is really saying something.

 

My thanks to AmLaw reporter Alison Frankel for this nice but undeserved accolade.

 

And Finally: Just a reminder to all my readers that I continue to report additional items between blog posts on Twitter. Among other things, I am increasingly active in retweeting interesting items from other Twitterers. Readers interested in monitoring my "tweets" are encouraged to click on the Twitter button in the right-hand column above to follow my Twitter posts.

 

In addition, I remain interested in connecting with readers on LinkedIn. I have recently become much more active in various LinkedIn groups and I would like to draw other readers into the dialog. I encourage readers interested in connecting with me on LinkedIn to click on the button in the right hand column above and join my network.

 

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In the lists of those supposedly responsible for the current financial mess, the rating agencies are among those usually featured prominently. Numerous investors have in fact sued the rating agencies claiming the ratings misled them into making their investment (about which refer, for example, here). Whether these investor actions will succeed remains to be seen, but in a recent ruling, at least one court has held that much of the subprime-related securities lawsuit brought against Moody’s by its own shareholders can go forward.

 

Background

In 2007, Moody’s shareholders sued the company and several of its directors and officers in a series of lawsuits that ultimately were consolidated in the Southern District of New York. (For the background of the case, refer here.)

 

The consolidated amended complaint alleged that the defendants had falsely claimed that the company was an independent and impartial body, while in fact the company’s arrangements for rating asset-backed securities and other structured investments put it in a conflict of interest and compromised its independence. The amended complaint also alleged that the company falsely claimed to have verified the quality of the underwriting practices at the loan originators whose mortgages were consolidated into the securities being rated.

 

The amended complaint further alleged that the company misrepresented that the rating scale used for the structured investments was equivalent, and reflected the same risk of default, as the company’s rating scale for traditional financial instruments. Finally, the amended complaint alleged that the defendants had falsely represented that the company derived its revenue from legitimate business practices.

 

The defendants moved to dismiss the amended complaint, arguing that the plaintiffs’ initial complaint had been filed after the statute of limitations had expired; that the amended complaint failed to adequately allege misrepresentations and materiality; and also that the amended complaint failed adequately to allege loss causation and scienter.

 

The Court’s February 18, 2009 Order

In a February 18, 2009 order (here), Judge Shirley Wohl Kram denied the motion in part and granted the motion in part, with leave to amend. The practical consequence of the court’s order is that a significant portion of the plaintiffs’ case will now be going forward.

 

The court first reached the defendants’ argument that the plaintiffs’ claims were barred by the statute of limitations. The defendants had argued that the plaintiffs were put on "inquiry notice" about the supposed fraud due to "storm warnings" as early as 2003. However, the court found that the statements on which the defendants sought to rely "refer to the credit rating industry in general terms and make no specific reference to Moody’s" and there is in any event "no mention of fraud." The court also found that Moody’s management’s "words of comfort preclude a finding of inquiry notice."

 

The court next determined that the amended complaint adequately alleged material misrepresentations in connection with Moody’s assertions of independence and also with respect to its statements about its assessment of the quality of loan originator underwriting as part of its ratings process.

 

However, the court found that the plaintiffs had not adequately alleged material misrepresentations in connection with the company’s statements about the equivalence of its structure finance rating system to its corporate finance rating system, and about the company’s statements concerning the sources of its revenue.

 

Even though the court found that the amended complaint’s "poor organization…dilutes Plaintiffs’ allegation of loss causation," the court found that the complaint alleges "sufficient corrective disclosure" to survive a motion to dismiss on the loss causation issue. The court also held that because the defendants failed to establish that Moody’s share price had declined as part of an industry-wide downturn, the defendants had failed to establish a "direct intervening cause" for the share price decline.

 

Finally, the court held that the amended complaint adequately pled scienter on the part of the company’s CEO as well as the company itself, finding that the CEO’s statements in a confidential slideshow were "revealing" of the CEO’s knowledge that the company "was not truly independent." With respect to the company itself, the court found that the plaintiffs had "alleged specific statements indicating that various top officials knew that Moody’s independence, ratings and methodology had been compromise," and that "consequently" the allegations of the amended complaint "sufficiently plead" the company’s scienter.

 

The court did however find that the amended complaint had not adequately pled scienter as to the other two individual defendants, the company’s COO and the Managing Director of the Asset Finance Group.

 

Regarding the claims and defendants with respect to which the motion to dismiss was granted, the court allowed plaintiffs leave to amend, directing them to file their amended complaint by March 18, 2009.

 

Discussion

The court’s opinion in the Moody’s case is significant in and of itself, as yet another subprime-related securities lawsuit that has survived the motion to dismiss, if only in part. Though the nature of the allegations against Moody’s may be somewhat distinct from those raised in many of the other subprime and credit crisis-related securities lawsuit, and though the dismissal motion was in fact granted in part, the outcome of the dismissal motion ruling nevertheless underscores that some of the many pending subprime and credit crisis-related securities lawsuits will be going forward.

 

The ruling, even if based on factual circumstances that arguably are specific to Moody’s, may be of particular significance to the separate securities lawsuits brought by the shareholders of McGraw-Hill (corporate parent of S&P) and by the shareholders of Fimalac (corporate parent of Fitch’s).

 

The more interesting question is what significance any of the court’s order in the Moody’s case may have for the many lawsuits brought against the rating agencies not by the agencies’ own shareholders but rather by investors who claim to have made their investments in reliance on the integrity and quality of the agencies’ ratings. These other investor lawsuits raise categorically different factual and legal issues that the suits brought by the agencies’ own shareholders.

 

Nevertheless, even given the differences between the two sets of claimants and the two categories of cases against the rating agencies, the ruling in the Moody’s case may at least provide some context for the investor lawsuits, particularly with respect to the court’s holdings that the shareholder plaintiffs adequately alleged that Moody’s had made material misrepresentations about its independence and processes, and had sufficiently alleged scienter as to the company’s CEO and the company itself. These particular holdings could be relevant in the separate investor lawsuits, at least on those issues.

 

I have in any event added the court’s February 18 ruling in the Moody’s case to my table of subprime and credit crisis-related securities lawsuit settlements, dismissals and dismissal motion denials, which can be accessed here.

 

A February 23, 2009 Reuters article regarding the court’s ruling in the Moody’s case can be found here.

 

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By now it is not news that the current credit crisis and related litigation wave have both spread far beyond the residential real estate sector in which they both first began. But the details surrounding the extension remain interesting and may even contain hints about what may lie ahead, as suggested by a recent lawsuit.

 

As reflected in their February 20, 2009 press release (here), plaintiffs’ attorneys have filed a securities class action lawsuit in the Southern District of New York against American Express and its CEO and CFO. The complaint (which can be found here) is filed on behalf of those persons who purchased the company’s securities between March 1, 2007 and November 12, 2008.

 

According to the complaint, American Express is the world’s largest issuer of charge cards. The complaint alleges that during the class period, the company "deviated from its historical strategy" of targeting the "premium market sector" and instead "engaged in riskier lending," while it "reassured investors and analysts that it did not engage in such riskier transactions."

 

The complaint alleges that the defendants "mislead investors by falsely representing American Express’s exposure to the riskiest credit card holders." The complaint alleges that the defendants repeated these reassurances to "artificially support" the company’s share price "as the building credit crisis in the market punished most companies that dealt with risky customers."

 

The complaint further alleges that as a result of the company’s "shift to risky card business," its brand has been "cheapened" and its stock has dropped over 65%. The complaint also alleges that the company won approval to convert to a bank holding company in order to qualify for TARP money – "a capital infusion required to save the Company from its risky endeavors."

 

On the one hand, it is hardly surprising in this environment that any credit lending facility should be experiencing difficulties or that those difficulties might result in litigation. But on the other hand, this new lawsuit does demonstrate both how far afield from the original subprime-related problems that triggered the current crisis, and how diverse the credit problems are that are now driving the related credit crisis litigation wave.

 

For some time now, the spreading subprime and credit crisis-related litigation wave has spread to encompass sectors of the credit marketplace beyond just subprime lending. Some time ago, for example, student lenders were drawn in (refer here), as were commercial construction companies (refer here). The involvement of a credit card company represents just another category of the credit marketplace to be drawn into the litigation wave.

 

But even though this new lawsuit may be just an extension of previously existing trends, it still has some ominous overtones. For one thing, American Express may be one of the largest providers of consumer credit, but it is far from the only one. Many businesses, other than just credit card companies, depend at some level upon the extension of consumer credit as part of their business model. The financial troubles these companies are now facing could also mean vulnerability to possible future litigation.

 

Another troubling note suggested by American Express’s woes is that a great deal of consumer debt, like the residential real estate debt, was packed into securities backed by the debt. The challenges facing the mortgage-backed securities market are at this point well known. Deteriorating conditions in the consumer credit arena could have significant implications for securities backed by the consumer debt.

 

In the meantime, American Express seems to be taking matters into its own hands to try to avoid further defaults as the recession deepens. According to February 23, 2008 news reports (here), American Express has offered to pay some cardholders $300 to pay off their outstanding balances and close their accounts by April 30, 2009. According to the news reports, analysts are concerned that credit card defaults could reach 11 percent by year end. One commentator is quoted as saying that what the company is trying to do is to "move to the front of the line in terms of getting paid back."

 

In any event, I have added the American Express complaint to my running tally of the subprime and credit crisis related securities litigation, which can be accessed here. With the addition of the American Express complaint, the current litigation tally now stands at 162, of which 19 have been filed so far in 2009. A spreadsheet reflecting the 2009 cases can be found here.

 

Special thanks to Adam Savett at the Securities Litigation Watch for the link to the American Express Complaint.

 

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As the difficulties and challenges from the global economic crisis continue to mount, one recurring question has been – how could things possibly have gone so wrong?

 

One way to try to answer this question is to look at the root causes – that is, the financial and economic conditions that produced the current circumstances. A February 19, 2009 memorandum by my friend Faten Sabry of NERA Economic Consulting and her colleague Chudozie Okongwu and entitled "How Did We Get Here?: The Story of the Credit Crisis" (here) does an excellent job explaining how "problems that first manifested in a relatively small part of the mortgage market" have "led to a contagion" that has "quickly spread to threaten the liquidity and possible solvency of may financial institutions around the world."

 

As alternative to looking for root economic causes is to try to determine who, rather than what, is responsible for the current mess. It is perhaps inevitable given the magnitude of the current crisis that attempts would arise to assign blame. Time Magazine’s recently published gallery (here) of the 25 persons most responsible for the financial crisis is just one manifestation of this inevitable fault finding process.

 

The supposed regulatory shortcomings of the SEC are among the contributing factors cited by some commentators.Indeed, former SEC Chairman Christopher Cox is among those whose names appeared on the Time Magazine list.

 

With the SEC under scrutiny and facing questions, the incoming agency leadership faces pressure to burnish the agencies’ supervisory credentials. It appears that this rehabilitative exercise may include in part the assignment of responsibility for the financial crisis, a process that apparently may target corporate boards.

 

According to a February 20, 2009 Washington Post article entitled "SEC to Examine Boards’ Role in Financial Crisis" (here), one of new SEC Chairman Mary Schapiro’s "first tasks" will be looking into "whether the boards of banks and other financial institutions conducted effective oversight leading up to the financial crisis," as part of an SEC effort to "intensify scrutiny at the top levels of management."

 

This process, described as an "inquiry into what went wrong at the board level," will examine boards that "signed off on the risks the companies took." The Post article quotes observers who note that "the boards of top financial firms had characteristics that promoted risky business practices and harmed shareholders." Among the characteristics the article cites are: board members overloaded with commitments to multiple boards; failure to separate the CEO and Chairman functions; and insufficient oversight of compensation issues.

 

To a certain extent, the Post article, and perhaps even the reported SEC initiative to scrutinize boards, reflects something of a faulty premise. The article states that "with few exceptions, boards have received little media attention as the country has sought explanations for financial firms’ taking on such perilous risks. Whether or not boards have received "media attention," they certainly have not escaped scrutiny, as the boards of numerous companies already have been subjected to extensive private securities class action litigation by shareholders. Were there to be an SEC initiative targeting boards, plaintiffs’ attorneys’ undoubtedly would be emboldened to bring even further litigation in the SEC’s wake.

 

To be sure, the Post article also cites comments by other observers who question whether boards should be "held culpable for a financial crisis that just about everyone missed." One commentator observes that the "universe of people who misread the risks…is very broad" and "could extend to rating agencies, managements and regulators." (The mention of regulators’ own potential culpability adds a certain ironic note here.) Regrettably, in the current environment, this observation about the broad dispersion of culpability may represent less of a statement of exculpation that a justification for enlarging the list of persons on whom blame might be cast for the present predicament.

 

The causes of the current situation may be myriad and the responsibilities widely dispersed. Nevertheless, for cultural reasons buried deep in the American psyche, particularized blame apparently must be assigned. The prospect of the SEC deliberately targeting financial institutions’ boards unquestionably elevates directors’ potential liability exposures. This heightened exposure extends not only to the boards of the high profile companies that have already failed, been bailed out or been merged out of existence. It also extends to the boards of the many other banks, insurance companies and other financial institutions, and even companies outside the financial sector, that are currently struggling.

 

The prospect of heightened board scrutiny inevitably leads to questions concerning the adequacy of the potentially targeted board members’ D&O insurance. Now more than ever, board members will want to ensure that they have appropriate insurance structures in place to protect themselves should they attract the unwanted attention either of regulators or plaintiffs’ attorneys.

 

Potential Liability of Other Professionals: Consistent with the suggestion cited above that a wide range of persons potentially culpable for misreading the risks, investors seeking to recover their massive losses are targeting numerous other "gatekeepers," in addition to the directors and offices of the troubled companies. These gatekeepers include companies’ outside professionals, many of whom have been named as defendants in the subprime and credit crisis-related securities lawsuits.

 

On February 24, 2009 at 2:00 p.m. EST, the Securities Docket will be hosting a webcast on the "Liability of Professionals in the Financial Crisis." In this free webcast, Stuart Grant of Grant & Eisenhofer and Michael Young of Wilkie Farr and Gallagher will be addressing questions surrounding the potential liability of professionals such as auditors, investment bankers, rating agencies, lawyers and others.

 

For further information about the webcast and to register, refer here.

 

Did the Media Fail Their Gatekeeper Function, Too?: Add the media to the list of gatekeepers that arguably failed in their gatekeeper responsibilities. In a February 21, 2009 interview in the Wall Street Journal (here), NYU Professor Nouriel Roubini observes that

 

in the bubble years, everyone becomes a cheerleader, including the media. This is the time when journalists should be asking tough questions, and I think there was a failure there. The Masters of the Universe were always on the cover, or the front page -- the hedge-fund guys, the imperial CEO, private equity. I wish there had been more financial and business journalists, in the good years, who'd said, 'Wait a moment, if this man, or this firm, is making a 100% return a year, how do they do it? Is it because they're smarter than everybody else . . . or because they're taking so much risk they'll be bankrupt two years down the line?"

And I think, in the bubble years, no one asked the hard questions. A good journalist has to be one who, in good times, challenges the conventional wisdom. If you don't do that, you fail in one of your duties.

 

There is, it seems, no shortage of blame to spread around. The question remains whether anyone in particular can or should be held directly responsible for failing to see what no one else saw – and if so, whom.

 

The Week Ahead: The PLUS D&O Symposium: This week, I will be in NYC to help co-Chair the annual Professional Liability Underwriting Society (PLUS) D&O Symposium, which will take place on Wednesday, February 25, 2009 and Thursday 26, 2009, at the Marriott Marquis hotel in Times Square. Details about the Symposium, including the agenda and registration information, can be found here.

 

I know that many readers will be attending the Symposium, and I hope readers at the conference will make a point of greeting me, particularly if we have not previously met. I look forward to seeing everyone in New York.

 

Because of the Symposium and related PLUS duties and functions, The D&O Diary will not be appearing according to its usual schedule. Regular publication activities will resume next week.

 

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Even after Merrill Lynch’s recent $550 million settlement of the subprime-related securities and ERISA lawsuits pending against the company (about which refer here), the consolidated subprime-related derivative lawsuit against the company’s directors and officers remained pending. By contrast to the massive settlements in those other lawsuits, the derivative litigation was recently dismissed, because of the company’s January 2009 acquisition by Bank of America.

 

In a February 17, 2009 opinion (here), Judge Jed Rakoff of the Southern District of New York granted the defendants’ motion to dismiss the derivative action. The defendants had argued that as a result of the Bank of America’s acquisition of Merrill in a stock-for-stock transaction, the plaintiffs are no longer Merrill shareholders and therefore lack standing to pursue the derivative actions as filed. Judge Rakoff granted the motion in light of the requirement under Delaware law for a derivative plaintiff to show "continuing ownership."

 

In his opinion, Judge Rakoff expressly noted that the dismissal "is without prejudice to plaintiffs’ filing with this Court, if and when they have standing, a renewed action, recast as a derivative action against Bank of America, or as a so-called ‘double derivative action, or otherwise, but based on the same underlying allegations as the actions here dismissed." (As reflected here, a "double derivative action" is a lawsuit in which a shareholder of a parent corporation brings an action on behalf of a wholly owned subsidiary for alleged wrongs to a subsidiary.)

 

The subprime-related derivative litigation involving Countrywide was also dismissed, following Bank of America’s acquisition of Countrywide, based on the requirement that derivative plaintiffs must demonstrated continuing ownership in order to have standing to assert the derivative claim, as reflected here and here.

 

Bank of America’s acquisition of Merrill is itself now the subject of extensive securities litigation, as discussed here.

 

A February 20, 2009 Law.com article discussing the dismissal in the Merrill subprime-related derivative litigation can be found here.

 

Second Stanford Financial Lawsuit Alleges Madoff Connection: As noted in a prior post (here), the same day as the SEC announced that it had launched a civil enforcement proceeding against R. Allen Stanford, the Stanford Financial Group and related entities and individuals, aggrieved investors also launched a securities lawsuit against many of the same entities and individuals in the Southern District of Texas.

 

A second lawsuit has now been commenced in the Southern District of Texas against the Stanford International Bank and related Stanford entities. Among other things, the second complaint expressly alleges a connection between the Madoff scandal and the new Stanford Financial scandal.

 

As reflected in the plaintiff’ lawyers February 19, 2009 press release (here), the action is brought "on behalf of purchasers of Stanford International Bank Ltd. ("SIB") certificates of deposit ("CDs") or shares in SIB’s Stanford Allocation Strategy proprietary mutual fund wrap program ("SAS") between February 19, 2004 and February 17, 2009."

 

According to the press release, the Complaint (which can be found here), alleges that the defendants

 

fraudulently peddled CDs that promised rates of return far above those available from other banks. Defendants claimed that these superior returns were possible because SIB invested its deposits rather than loaning them. To ensure that depositors could redeem their CDs, defendants assured them that SIB’s investments were liquid and diversified. In fact, nearly 80% of SIB’s investments were concentrated in just two high-risk, illiquid categories: private equity and real estate. Now that the real estate and private equity markets are in free fall, many of those who purchased SIB’s CDs have recently been informed that they cannot redeem them.

 

The complaint also alleges with respect to the defendants mislead investors about the SAS program. The complaint alleges that the defendants

 

picked a handful of mutual funds that had performed extremely well in 1999-2004 and claimed the returns of those high-performing funds as the historical returns of the SAS program. Defendants also inflated the claimed returns of the SAS program in 2006 and 2007. Investors, misled by defendants’ claims of historic returns, have fared very poorly in the SAS program.

 

The complaint also alleges that the defendants misled investors about SIB’s exposure to the Madoff scandal. The complaint alleges that the bank sent investors a letter

 

unequivocally stating that "Stanford International Bank did not have any exposure to the Madoff Fund." Just two days before this letter was sent, an SIB analyst informed all three of the individual defendants, including R. Allen Stanford ("Stanford"), that SIB had invested in Meridian, a New York-based hedge fund that used Tremont Partners as its asset manager. Tremont, in turn, had invested a portion of Meridian’s – and SIB’s – money with Madoff.

 

The two fraud schemes seem to have come together as if they were subatomic particles drawn by some unwritten law of physics.

 

The Sox First blog has an interesting post here on the parallels between the Madoff and Stanford scandal.

 

Yet Another Bank Closure: By contrast to the last several Friday nights in a row, the FDIC did not assume control of multiple banks following their closure by regulatory authorities. Rather than multiple banks, this Friday the FDIC announced that it had assumed control of just a single bank.

 

As reflected in its February 20, 2009 press release (here), the FDIC assumed control of Silver Falls Bank of Silverton, Oregon. Prior to its closure, the bank had assets of approximately $131.4 million.

 

The closure of the Oregon bank already brings the 2009 year to date total of bank failures to 14 (by contrast to the 25 banks that failed during all of 2008). As I have recently noted (here), the surging bank failure levels has some very troublesome implications, and the now standard Friday bank closure announcement is one more reflection of the current challenging financial circumstances.

 

Auction Rate Securities: Balance Sheet Valuation Concerns: With all the long-standing publicity surrounding the difficulties in the auction rate securities markets, and the extensive related litigation, you might expect that companies with balance sheet exposure to auction rate securities had long since adjusted the securities’ carrying values to reflect the current market conditions. But according to a recent study, many companies with auction rate securities exposure have yet to make any accounting adjustments.

 

As reported in a February 20, 2009 CFO.com article (here), a recent study of 625 corporate auction rate securities holders found that 186 of them, or nearly 30 percent, continue to report them at par value. The study’s author is quoted as saying that "there’s still an awful lot of companies out there that are not properly accounting for [the auction rate securities]."

 

These companies failure to recognize their balance sheet exposure to auction rate securities could represent a significant litigaton risk factor. There have already been at least one securities lawsuits against a nonfinancial company that included allegations based on the company’s alleged failure to disclose its exposure to auction rate securities (refer, for example here). Companies delaying their recognition of this exposure could be exacerbating an already serious concern. The delay potentially could represent a heightened litigation risk.

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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In a February 12, 2009 FINRA Dispute Resolution Award, a panel of three arbitrators ruled that Credit Suisse must pay ST Microelectronics more than $400 million based on the company’s claims that Credit Suisse misled the company into buying subprime-exposed auction rate securities. A copy of the award can be found here.

 

The FINRA Award

As I detailed in an earlier post (here), ST Microelectronics had filed the FINRA claim against Credit Suisse (USA) LLC, while also separately filing a civil lawsuit against Credit Suisse Group, the U.S. affiliate’s Switzerland-based parent. The separate lawsuit complaint can be found here.

 

According to the February 12 Award, the FINRA complaint against the U.S. affiliate asserted claims under Section 10 of the ’34 Act and Rule 10b-5, alleging that the claimant "requested investments in student loan securities backed by U.S. government guarantees" but that instead their funds were invested in what the civil lawsuit complaint described as "illiquid, risky and unsustainable auction rate securities consisting of collateralized debt obligations and credit linked notes, some of which were backed by subprime real estate loans." (The separate complaint alleged that Credit Suisse had an "intentional strategy" of "dumping into the accounts of unsuspecting clients some of the worst ARS on the market.")

 

The Award makes no specific findings of fact but instead simply species the amounts to be awarded to ST Microelectronics. Credit Suisse is ordered to pay the claimant "compensatory damages" of $400 million, which is to be "paid immediately in exchange for Claimant’s entire portfolio." The award also orders the payment of certain of fees and costs, interest, and $3 million attorney’s fees.

 

Discussion

The FINRA award has a number of significant implications, the most immediate of which may be those relating to Credit Suisse itself. The separate lawsuit complaint filed against the Credit Suisse parent company alleges that "at least a dozen other multinational corporations are victims of the same scheme," carried out by two Credit Suisse brokers who, in fact, are the subject of a current criminal prosecution (about which refer here). The complaint alleges that the supposed scheme involves "more than $2 billion of these clients’ money."

 

A July 31, 2009 Wall Street Journal article (here) listed ten overseas companies (including ST Microelectronics) that have initiated arbitration proceedings against Credit Suisse-affiliated companies based on auction rate securities. The February 12 FINRA Award may bode ill for Credit Suisse in these other proceedings.

 

In addition, the outcome, magnitude and prominence of the February 12 Award could also spur similar claims by other aggrieved parties against other broker-dealers, particularly other aggrieved institutional investors. By and large, institutional investors were excluded from the massive auction rate securities regulatory settlements that have been announced to great fanfare. These excluded investors may be encouraged by ST Microelectronics’ success, and seek to pursue their own claims. A February 13, 2009 Bloomberg article (here) discussing the Award quotes one observer as saying "this decision will likely lead to either more arbitrations or settlements between investors and broker-dealers."

 

To be sure, the circumstances relating to Credit Suisse’s involvement with auction rate securities may be distinct. As noted above, criminal proceedings have arisen from its brokers’ activities. Other prospective claimants’ claims may not be as sympathetic.

 

It is important to emphasize that while the Award itself describes the relief granted as "compensatory damages," what it actually accomplished is a rescission of the underlying securities transaction. Credit Suisse basically has to buy back the company’s securities at face value. (In that regard, the Award itself noted that what the claimant had requested was "relief equivalent to rescission" – which appears to what the claimant got.) Though the Award provides for the payment of other fees and costs, it does not award any other type of damages. The Award expressly denied the claimant’s request for punitive damages.

 

The absence of the award of other damages potentially could affect other prospective claimants. That is, while these cases may provide an avenue of relief, there is nothing about this Award to suggest that that a claim of this type is going to produce some kind of a bonanza. On the other hand, for many prospective institutional investor claimants, the opportunity to return their auction rate securities for face value at this point would be more than enough incentive for them to pursue a claim.

 

The Award does provide one very particular kind of encouragement for these kinds of claims. The panel’s award of $3 million in attorneys’ fees undoubtedly will capture the imagination of many would-be claimants’ attorneys. The prospect of this kind of fee recovery undoubtedly will encourage many attorneys to seek out and pursue these claims.

 

It is unclear from the Award what preclusive or superseding effect the Award might have on the separate federal court lawsuit ST Microelectronics filed against the Credit Suisse corporate parent. It seems that the company secured the relief it sought. What reason or even opportunity there might be to continue to prosecute the civil case is not immediately apparent.

 

Hat tip to the WSJ.com Law Blog (here) for the link to the FINRA Award.

 

Don’t Tell Me How to Fix It, Just Tell Me Who to Blame: If you missed it, you may want to take a look at the list of the "25 People to Blame" (here) in the February 23, 2009 issue of Time Magazine. The magazine’s attempt to identify the individuals responsible for the current financial mess is actually kind of interesting, even thought provoking.

 

The list includes the usual suspects: Dick Fuld, Jimmy Cayne Angelo Mozillo and Stan O’Neill.( I agree that Angelo Mozillo of Countrywide also belongs on the list, although I don’t think I would have put him first, as Time Magazine did.) Time also included, correctly in my view, Fred Goodwin of Royal Bank of Scotland, whose ill-fated and ill-time take over assault on ABN AMRO is record setting in a number of extremely negative ways.

 

The list also recognizes others who rightfully should shoulder some of the blame, but who sometimes elude the harsh spotlight. In this category I would put Marion and Herb Sandler, whose Golden West Savings bank initiated the Option ARM mortgage. Sandy Weill also (correctly, in my view) appears on the list for the mess he made of Citigroup.

 

A couple of U.S. Presidents make the list -- Bill Clinton and George W. Bush. Alan Greenspan, Hank Paulson and Chris Cox are also there. There is also one former Prime Minister, Davíð Oddsson of Iceland, and one Premier, Wen Jiabao of China.

 

There are a several interesting names on the list. For example, John Devaney appears as a sort of a stand in for the whole hedge fund industry, and Lew Ranieri gets belated recognition for having fathered mortgage securitization. Kathleen Corbett, the former head of rating agency Standard & Poor’s also gets a nod for the plethora of triple-A rating on mortgage backed securities that encouraged so much misdirected investment. Joe Casano gets due recognition for basically taking down AIG.

 

There are others whom I think are misplaced on this list. For one thing, what is Bernie Madoff doing there? He may have been a big crook, but in the end he is just a crook.

 

There are also at least two very significant omissions from the list.

 

First and foremost, the U.S. Congress deserves to be recognized for its encouragement of housing policy that was misguided and disproportionate to the requirements and limitations of sound principles. Congress is great at holding hearings and making speeches when things go wrong. Their own abysmal record of implementing policies that prevent problems warrants its own set of hearings. I’d like to put some of them in the dock and subject them to the same kind of sneering cross-examination that they have been imposing on others in recent days. (To be fair to the list-makers, they did slot former Texas congressman Phil Gramm at No.2 on the list, which arguably is a Congressional designation by proxy.)

 

And finally, why isn’t the American Homebuyer on the list? Yes, the American Consumer is recognized, but I think we need to be specific here. Within the larger group of well-intentioned home buyers are those who were driven by some weird form of housing lust to buy gigantic houses they couldn’t afford. There also appear to have been some who were all too willing to hide or even misrepresent their true financial condition to secure credit. Sure, the lenders were complicit, but as long as we are assigning blame, let’s put some everywhere that it belongs.Of course, many homeowners who are now struggling had nothing to do with any of this kind of conduct, but there are also those who were involved.

 

When you come right down to it, there is no shortage of culprits. Sadly, there are many, many victims. Some of them are even the same people.

 

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I have previously tried to anticipate the future direction of the credit crisis litigation wave (refer, for example, here), but what I failed to foresee is that as the credit crisis itself has entered the remedial phase – or what we all hope turns out to be the remedial phase – there also would be litigation arising from the administration of the remedies. A recent securities lawsuit demonstrates how circumstances surrounding the government’s bailout efforts can lead to litigation.

 

As reflected in their February 9, 2009 press release (here), plaintiffs’ lawyers have filed a securities class action lawsuit in the Middle District of Alabama against Colonial BancGroup and certain of its officers. Colonial is a bank holding company that operates Colonial Bank, N.A., which has 347 bank branches in Florida, Alabama, Georgia, Nevada and Texas, and over $26 billion in assets.

 

The lawsuit relates to Colonial’s efforts to obtain TARP money, and in particular to the company’s December 2, 2008 and January 27, 2009 press releases discussing the company’s TARP-related efforts. A copy of the complaint can be found here. Special thanks to Courthouse News Service for the complaint.

 

In its December 2, 2008 press release entitled "Colonial BancGroup Received Preliminary Approval from the U.S. Treasury for $550 Million in Capital" (here), Colonial announced that it had "received preliminary approval" to participate in the Treasury Department’s capital purchase program, pursuant to which Colonial "will receive $550 million from the Emergency Economic Stabilization Act of 2008."

 

In the December 2 press release, Colonial also stated that in exchange for its investment, the Treasury was to receive preferred shares paying a 5% dividend for the first five years. If the preferred shares are not redeemed within five years, the dividend rate increases to 9%. The press release also stated that the Treasury will also receive warrants to purchase shares of Colonial.

 

According to the plaintiffs’ lawyers’ February 9 press release, in response to Colonial’s December 2 announcement, Colonial’s share price "surged over 50 percent from its $2 per share close on December 1, 2008 to close at $3.08 per share on December 2, 2008."

 

However, the complaint alleges that the defendants failed to disclose that "Colonial would be required to raise additional outside capital of $300 million before it could receive the $550 million in TARP funding." The complaint further alleges that Colonial "belatedly disclosed" this requirement after the markets closed on January 27, 2009. The complaint alleges that in response to the company’s January 27 announcement, Colonial’s share price declined 45%, from $1.58 per share to $0.85 per share.

 

Colonial’s January 27, 2009 press release, which can be found here, stated that Colonial’s participation in TARP is "subject to Colonial’s increasing equity by $300 million." The January 27 press release also states that Colonial is "actively pursuing a variety of capital raising alternatives to increase equity by $300 million, which should satisfy this condition of the TARP preliminary approval."

 

As discussed in a February 6, 2009 Birmingham Business Journal article (here), Colonial’s announcement that it must raise $300 million of additional funds to qualify for TARP "is raising eyebrows among some banking analysts and banking experts." The article quotes one commentator as saying that this item represents "a pretty significant omission" on Colonial’s part in its announcement of the TARP funding. The article also quotes an analyst as saying she felt "deceived" by the bank because it "withheld important information."

 

The Colonial lawsuit is far from the first credit crisis-related securities lawsuit in which governmental intervention of one sort or another is involved. For example, the government’s role in brokering Bank of America’s acquisition of Merrill Lynch features prominently in the securities lawsuit recently filed against BofA (about which refer here). The need for governmental rescues has also featured in a number of other credit crisis-related securities lawsuits, including for example, the lawsuits filed against Fortis (refer here), ING (refer here), and the Royal Bank of Scotland (refer here). But so far as I know, the Colonial case is the first securities lawsuit where the allegations are tied directly to the TARP funding program.

 

I supposed that after more than two years of credit crisis litigation, as well as massive governmental involvement in the financial markets, it should come as little surprise that we have reached the point where lawsuits relating to the bailout efforts themselves are starting to arise. I suppose we should start getting ready now for the inevitable stimulus-related lawsuits which undoubtedly will follow not long after Congress finishes its current efforts.

 

The Colonial lawsuit does raise an interesting categorization issue, which is whether the case properly should be counted as credit crisis-related and grouped with the previously filed credit crisis-related securities lawsuits. After reviewing Colonial’s press releases and considering the reasons why the company needed TARP money in the first place, I have concluded that the lawsuit is related to the ongoing credit crisis and therefore it belongs in my running tally of credit crisis related securities lawsuits.

 

My running tally of the subprime and credit crisis-related securities lawsuits can be accessed here. With the addition of the Colonial lawsuit, the tally of subprime and credit crisis-related securities lawsuits that have been filed during the period 2007 through 2009 now stands at 156, of which 15 have been filed in 2009. A spreadsheet showing the 2009 credit crisis related securities lawsuits can be accessed here.

 

One final note about TARP -- the Bank Lawyer's Blog reports (here) that some banks in the Dallas area are advertising the fact that they haven't taken TARP money because they don't need to. That line of analysis could get awfully murky under the Treasury department's proposed updated bailout approach, under which banks will be "stress tested" and only the likeliest to survive will receive aid.

 

Madoff Update: Regular readers know that in addition to my running tally of the subprime and credit crisis-related securities lawsuits, I have also been maintaining a separate tally of Madoff-related litigation. The Madoff-related litigation register, which can be accessed here, is subdivided into multiple tables, reflecting the various types of litigation that has arisen out of the Madoff scandal.

 

I recently updated the Madoff lawsuit register by adding a number of new Madoff lawsuits, based on excellent information, materials and links provided by several readers, including in particular Jon Jacobson of the Greenberg Traurig law firm. My special thanks to all for the contributions.

 

And Finally: Describing it as "the beginning of a long process," the SEC Actions blog has a post (here) discussing the partial settlement that Bernard Madoff has reached with the SEC. The WSJ.com Law Blog also has a post here describing the partial settlement. A link to the SEC’s litigation release regarding the partial settlement can be found here.

 

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The credit-crisis securities litigation wave, which began with the filing of the first subprime mortgage-related lawsuits in early February 2007, is about to enter its third year. Though the wave has evolved during the intervening period, it shows no sign of slowing down. The more interesting question going forward will be whether the litigation, which up until now has largely been concentrated in the financial sector, will spread to encompass companies in the wider economy.

The Wave’s History – So Far

The current subprime and credit crisis-related securities litigation wave began on February 8, 2007, with the filing of a securities lawsuit against New Century Financial Corporation and certain of its directors and officers. (Refer here for my most recent post on the New Century case.) Two years later, there have been 152 separate subprime or credit crisis-related lawsuits filed against companies and other entities, as reflected in my running tally of the suit, which can be accessed here.

The initial cases during 2007 were largely filed against subprime loan originators, banks, mortgages companies, home builders and residential real estate investment trusts. However, by year end 2007, a number of lawsuits had also been filed against investment banks, investment advisors, and rating agencies.

During 2007, there were a total of 40 subprime-related securities lawsuits filed.

In 2008, the lawsuits against banks and other mortgage originators continued to mount, but the litigation activity spread beyond just residential mortgage and real estate issues. The litigation also involved student lenders, commercial construction companies, commercial real estate investment trusts, bond insurers, and mortgage guaranty insurers. As I noted at the time (refer here), by early 2008, the litigation activity was no longer just about the subprime meltdown but had by that time become a credit crisis litigation wave.

The litigation wave also picked up considerable momentum during 2008, driven in part by the onslaught of cases involving auction rate securities. A total of 21 separate auction rate securities lawsuits were filed in 2008, against broker dealers, security issuers and mutual funds, among others. There were also a significant number of separate securities lawsuits filed on behalf of preferred shareholders and subordinated debtholders, which represents a relatively unusual securities litigation development, as discussed here.

The crisis in the global financial markets during fall 2008 also significantly affected the litigation wave. As I noted here, as a result of the financial market turmoil, the litigation wave reached an "inflection point" during the third quarter of 2008, where companies began to find themselves exposed to litigation not because of their own direct vulnerability to the credit crisis, but because of the companies’ exposure to other companies that were experiencing credit crisis-related issues.

During 2008, a total of 101 subprime and credit crisis-related securities lawsuits were filed.

As 2009 has begun, the litigation wave has shown no sign of slowing down. Indeed, during January 2009 alone, there were eleven new credit crisis-related securities lawsuits. A spreadsheet of the 2009 cases can be found here.

One important consequence of the litigation wave’s evolution over time is that it has become increasingly difficult to maintain absolute definitional clarity about what should be included in the category. This challenge has become even more difficult now that the financial crisis basically encompasses the entire global economy. It has become progressively tricky to determine whether or not newly filed lawsuits logically ought to be group together with the earlier suits, or whether they represent something entirely different. This categorization challenge has made simply "counting" the subprime and credit crisis-related lawsuits increasingly more difficult over time.

Financial Sector Concentration

Though the litigation has evolved and become more diverse, the litigation activity has largely been concentrated in the financial sector. Of the 152 subprime and credit crisis-related securities lawsuits that have been filed as of February 4, 2009 and that involved companies or other entities that have assigned standard industrial classification codes (SIC Codes), fully 117 of them have involved companies or other entities with SIC Codes in the 6000 series (Finance, Insurance and Real Estate).

Moreover, the 18 entities that have been sued but that have no SIC Code designated are also almost exclusive concentrated in the financial sector. These entities include mutual funds, private equity firms, hedge funds, and foreign firms whose shares do not trade on U.S. exchanges (e.g., Fortis and Société Générale).

Of the financial companies, the SIC Code categories with the largest number of lawsuits were SIC Code 6021 (National Commercial Banks) and SIC Code 6798 (Real Estate Investment Trusts), both of which had 16 lawsuits. Other categories with a significant number of securities lawsuits include SIC Code 6211 (Security Broker Dealers), which had 13 lawsuits; SIC Code 6189 (Asset Backed Securities), which had 12 lawsuits; and SIC Code 6035 (Savings Institutions, Federally Chartered), which had 11 lawsuits.

Has the Wave Entered a New Phase?

But while the litigation activity has largely been concentrated in the financial sector, there has more recently been a "new wave" of credit crisis lawsuits, as discussed at greater length here. These new wave lawsuits involved companies exposed to some of the credit crisis casualties (Lehman Brothers, Fannie Mae, Freddie Mac, Washington Mutual, American International Group, etc); that made wrong-way bets on commodities or currencies; and companies outside the financial sector whose balance sheets are laden with auction rate securities or other troubled assets.

The interesting question these new wave cases present is how far outside the financial sector these kinds of cases will spread as we go forward.

How are the Cases Faring?

Even though the subprime and credit crisis-securities litigation wave is about to enter its third year, most of the cases are still only in their earliest stages. There has really been only one significant settlement, the recent massive $550 million settlement involving Merrill Lynch (about which refer here). The few other settlements have been considerably more modest (refer here).

Only a handful of these cases have even reached the motion to dismiss stage. Among the cases where dismissal motions actually have been addressed, there have been several notable cases in which the dismissal motions were denied – for example, the New Century case (refer here) and the Countrywide case (refer here).

On the other hand, there have also been a handful of cases in which the motions to dismiss have been granted, and at least some courts have seemed skeptical that the target companies financial woes were the result of fraud (about which refer here).

My complete list of subprime and credit crisis-related securities lawsuit settlements, dismissals and dismissal denials can be found here.

Looking Ahead

Even though the litigation wave is about to enter its third year, it is clear that we have still only just begun. With the cases already filed only in their earliest stages and with new lawsuits continuing to pour in, the subprime and credit crisis-related litigation wave is likely to continue to remain an important feature of the litigation landscape for years and years to come.

 

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The growing problems surrounding option adjustable-rate mortgages (Option ARMs) are a concern I have previously noted (here). But it now appears that the problems may be far worse even than previously feared. These problems not only represent a growing threat to borrowers and lenders alike, but the also present the increasing likelihood for further shareholder litigation.

According to a January 30, 2009 Wall Street Journal article entitled “Option ARMs See Rising Defaults” (here), nearly $750 billion in Option ARMs were issued from 2004 to 2007. Unfortunately, as of December 2008, 28% of Option ARMs were in default or foreclosure, and an additional 7% involved properties that have already been take back by lenders. A chart accompanying the Journal article shows that the Option ARM default rate is already far greater now than was the subprime default rate at the beginning of 2008.

Borrowers holding Option ARM mortgages now find themselves having to play a particularly unattractive hand. In particular, as a result of the way these loans are structured, borrowers that have been paying only the minimum have likely seen their principal amount due increase as a result of so-called “negative amortization.”

At the same time, housing values around the country have declined. The Journal article reports that more than 55% of borrowers with Option ARMs owe more than the current value of their homes.

Think that sounds bad? Things are about to get worse. A lot worse.

As detailed in a lengthy January 4, 2009 post on the Seeking Alpha blog (here), the interest rates on billions of dollars are due to reset in 2009 and 2010. The problems that likely will ensue “are expected to be more pronounced than the subprime crisis since the economy is already nearing its trough, the consumer confidence has slumped to an all time recent history low and financial markets are in a gridlock.”

In explaining why the problems associated with the Option ARM resets could be so bad, the Seeking Alpha blog post goes through a detailed analysis of the timing and likely magnitude of the resets. In explaining the problems that could follow, the author notes:

The potential average payment increase on the loans recast is 63%, representing an additional $1,053 due each month on top of the current average payment of $1,672. These large payment increases could cause delinquencies to increase, and increase dramatically, after the recast. The fact that only 65% of borrowers have elected (or are able) to make only minimum payments underscores the magnitude of the potential problem. The potential payment shock combined with the continuous deteriorating outlook for home prices and lack of refinancing opportunities could be a negative cause of concern for investors in Option ARM securities. Even more ominous, is pall cast upon the banks that hold these assets and are additionally exposed to other forms of consumer credit, ie. HELOCs, credit card debt and other unsecured loans.

As a result of these problems and possibilities, sources quoted in the Journal article estimate that more than half of all option ARMs outstanding will default, and that nearly 61% of options ARMs originated in 2007 will eventually default.

These looming problems not only represent a threat to borrowers, investors and lenders, but they also present the possibility for even further litigation.

Problems arising from Option ARM mortgages have already been the source of considerable securities litigation. The most recent lawsuit involves Triad Guaranty, which provides private mortgage insurance products to residential mortgage lenders and investors in the United States.

As reflected in their January 29, 2009 press release (here), plaintiffs’ attorneys have filed a securities class action lawsuit in the Middle District of North Carolina against Triad and certain of its directors and officers. According to the press release, the complaint (which can be found here), alleges that

beginning in late August 2007 and continuing throughout 2008, Triad began to acknowledge serious issues surrounding its exposure to anticipated losses and defaults related to its book of business for its Alt-A and pay-option adjustable rate mortgage (“ARM”) products written in 2006 and 2007 due to a failure to engage in proper underwriting practices, resulting in a decline in Triad’s stock price. Then, on November 10, 2008, Triad issued its financial results for the third quarter of 2008, reporting a net loss for the quarter ended September 30, 2008 of $160.1 million. On this news, Triad’s stock price dropped $0.11 per share to close at $0.70 per share on November 11, 2008.

The complaint further alleges that the defendants concealed from the investing public that:

(a) the Company was not adequately accounting for its loss reserves in violation of Generally Accepted Accounting Principles, causing its financial results to be materially misstated; (b) the Company failed to engage in proper underwriting practices for its book of business related to insurance written in 2006 and 2007, including the insurance related to its Alt-A and pay-option ARM products; (c) the Company had far greater exposure to anticipated losses and defaults related to its book of business related to insurance written in 2006 and 2007, including its Alt-A and pay-option ARM portfolios, than it had previously disclosed; (d) the Company lacked effective internal controls to detect fraud and misrepresentations in the underwriting process; and (e) the Company failed to disclose the true risks associated with its ability to continue to write new business and, given rating downgrades and capital limitations, the Company would be forced to liquidate its Canadian subsidiary and stop writing new insurance policies and transition the business to run-off.

Even before this recent lawsuit was filed against Triad, there had already been a number of securities lawsuits raising allegations concerning Option ARMs, including for example cases filed against Wachovia (refer here), Washington Mutual (refer here) and Downey Financial (refer here).

All of those prior lawsuits involved either companies that issued the Option ARMs or the issuers’ successors in interest. Triad, by contrast, is not an issuer but rather is a mortgage insurer. Triad’s involvement in a securities lawsuit raising Option ARM-related allegations highlights the potential for extensive further litigation, involving not just the issuers themselves but other types of companies as well.

I have in any event added Triad to my running tally of subprime and credit crisis-related securities litigation, which can be accessed here. With the addition of the Triad lawsuit, the current tally of subprime and credit crisis related securities litigation filed during the period 2007 through 2009 now stands at 150, of which eight have been filed in 2009. A spreadsheet reflecting the 2009 lawsuits can be found here.

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As detailed in a recent post (here), one of the more worrisome trends in an economic environment full of thing to worry about is the increasing number of bank failures involving community banks. This trend continued this past Friday night when the FDIC closed three more banks, brining the 2009 bank closure tally up to six.

 

The three banks closed on Friday were MagnetBank of Salt Lake City, Utah, which has assets of $292.9 million (and the details about which can be found here); the Suburban Federal Savings Bank of Crofton, Maryland, with assets of $360 million (refer here); and Ocala National Bank of Ocala, Florida, with assets of $223.5 million (refer here).

 

 

A particularly troublesome note regarding the Utah bank’s closure is that the FDIC was unable to find a buyer for the bank’s assets or deposits, which the Wall Street Journal described (here) as a “rare event and an ominous sign for regulators.” According to news reports (here), this is the first time in over five years that the FDIC has been unable to find a buyer for a failed bank’s assets. In the absence of a buyer, the FDIC will issue checks to the bank’s depositors, increasing the impact on the FDIC insurance fund.

 

 

The failure of the Suburban Federal Savings Bank was the first bank failure in Maryland since 1992. As detailed in the Washington Post (here), the bank’s failure was precipitated by mounting losses in the bank’s mortgage loan portfolio.

 

 

Perhaps even more noteworthy than the fact that the total number of bank failures in 2009 is already up to six banks is the fact that the total number of bank failures in the seven month period between July 1, 2008 and January 31, 2009 is 27. (The FDIC’s complete list of failed banks for the period October 2000 through the present can be found here.) That is a huge number and all signs are that these numbers will continue to grow as 2009 progresses. The Journal article specifically observed that regulators are “bracing for dozens of more lenders to collapse in the coming months.”

 

 

Along those lines, it is worth noting that in the FDIC’s Quarterly Banking Profile for the Third Quarter of 2008 (here), which is the FDIC’s most recent quarterly profile, the number of institutions on the FDIC’s problem list increased from 117 to 171, and the assets of the “problem institutions” rose from $78.3 billion to $115.6 billion. This is the first time since 1994 that assets from problem institutions have exceeded $100 billion.

 

 

The FDIC’s next quarterly banking profile, for the quarter ending December 31, 2008, will not be released until later in February (the reports are issued 55 days after each quarter end). It will be interesting to see how significant the deterioration was in the fourth quarter.

 

 

As I detailed in my prior post, both historically and more recently, an increase in the number of failed banks has meant an increase in failed bank litigation. As the bank failures continue to mount, the threat of increased bank related litigation will also continue to grow.

 

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Among the many lawsuits that have flooded in as part of the subprime and credit crisis litigation wave has been a profusion of lawsuits against the mortgage-backed securities issuers and their securities offering underwriters. These lawsuits, typically filed under the ’33 Act and alleging misrepresentations in the offering documents, claim that investors who purchased securities in the offering have been harmed due to the deterioration in the performance of the underlying mortgages.

 

As discussed below, questions about the damages claimed in these lawsuits could present serious hurdles as the cases go forward.

 

Background

A recent example of the class action securities litigation filed on behalf on investors in these mortgage-backed securities investments may be found in the January 26, 2009 press release (here) in which the plaintiffs’ lawyers described the lawsuit they filed in the Eastern District of New York against Deutsche Alt-A, Inc., and certain other defendants in connection with the offering of mortgage-backed pass-through securities by 32 mortgage loan trusts.

 

As described in the press release, the complaint (here) alleges that the offering documents failed to disclose that:

 

sellers of the underlying mortgages to Deutsche Alt-A were issuing many of the mortgage loans to borrowers who: (i) did not meet the prudent or maximum debt-to-income ratio purportedly required by the lender; (ii) did not provide adequate documentation to support the income and assets required to issue the loans pursuant to the lenders’ own guidelines; (iii) were steered to stated income/asset and low documentation mortgage loans by lenders, lenders’ correspondents or lenders’ agents, such as mortgage brokers, because the borrowers could not qualify for mortgage loans that required full documentation; and (iv) did not have the income or assets required by the lenders’ own guidelines necessary to afford the required mortgage loan payments, which resulted in loans that borrowers could not afford to pay.

 

The complaint alleges as the underlying mortgages have deteriorated, "the Certificates are no longer marketable at prices anywhere near the price paid by plaintiff and the Class and the holders of the Certificates are exposed to much more risk with respect to both the timing and absolute cash flow to be received than the Registration Statement/Prospectus Supplements represented."

 

 

This case is only one of several recent lawsuits in which the same or similar allegations have been raised. Plaintiffs’ lawyers have raised similar allegations against, for example, mortgage-backed pass through certificates sponsored by JP Morgan Acceptance Corporation (refer here); mortgage backed securities sponsored by GS Mortgage Securities Corp. (refer here); mortgage pass-through certificates sponsored by Washington Mutual (refer here); and mortgage-pass through certificates sponsored by Residential Asset Securitzation Trust (refer here). By my count, there have been more than a dozen of these types of lawsuits filed in connection with the current subprime and credit crisis-related litigation wave.

 

Like many of these cases, the Deutsche Alt-A case was originally filed in state court, and removed by defendants to federal court. (The removal petition, which accompanies the complaint, can be found here.) The federal court subsequently denied the plaintiffs' motion to have the case remanded to state court, in this case on the relatively narrow and specific ground that that one of the entities that originated the underlying mortgages, American Home Mortgage Corporation, is in bankruptcy in the federal court in Delaware, and the securities case is related to the bankruptcy proceeding. A copy of the January 8, 2009 opinion denying the remand motion can be found here.

 

Special thanks to Adam Savett of the Securities Litigation Watch blog (here) for providing a copy of the removal petition and complaint in the Deutsche Alt-A case.

 

Damages Analysis

In each of these cases, the harm claimed is similar to that alleged in the Deutsche Alt-A case; that is, that as a result of problems associated with the underlying mortgages, the securities are "no longer marketable at prices near the price paid" and the holders are exposed to much more risk with respect to the timing and absolute cash flow."

 

These allegations raise some interesting and perhaps novel questions, as discussed in a January 2009 article from the Milbank Tweed law firm entitled "Subprime Litigation Against Issuers and Underwriters of Mortgage-Backed Securities—Where are the Actual Losses?" (here).

 

As the memo notes, these lawsuits embody "the relatively untested assumption" that the current paper value of these securities is "the appropriate reference point" for determining whether the investors have "suffered a loss that is ripe for litigation (and the extent of any such loss)."

 

The authors note that these securities are not listed on any public exchanges, but rather all trades are privately negotiated. The securities themselves are essentially contracts that entitle the owner to certain portions of principal and interest from the pools of mortgages that serve as collateral for the securities. The securities also have various forms of credit enhancement, such as overcollateralization, subordination and excess spreads, so that defaults on the underlying mortgages will not necessarily trigger a default on the payment obligations on the securities themselves.

 

As a result, an investor could continue to receive payments under the securities as scheduled, even if GAAP accounting might require the carrying value of the securities to be reduced.

 

These circumstances lead the authors to ask

 

Is the fear that certain tranches of the [mortgage backed securites] might not be paid in full a sufficient basis for brining a claim under the ’33 Act? Is such a claim a ripe case or controversy for the courts? And is the fact that some "paper measure of price" for the [mortgage backed securities] tranche has declined since the time of purchase enough to overcome these hurdles?

 

In considering these questions, the authors note that the typical offering documents for these kinds of securities expressly warn that a secondary market for the securities may not exist and that investors may not be able to sell the securities at the price they hope to obtain. For most investors in these types of securities, this consideration is generally of less concern, because the investors "expect to make money by holding the bond through maturity and receiving the income stream they bargained for, not by trading on a secondary market."

 

Nevertheless, the lawsuits relating to these securities claim damages based on the decline in their valuation and the fears that payments may be at "risk" in the future. The memo reviews the well-publicized difficulties associated with valuing these securities, and notes the probable lack of valuation uniformity among holders of these securities, given the flexibility of the relevant accounting standards. As a result, the securities holders may face challenges in establishing with sufficient certainty that they have suffered an "economic loss," as the securities laws arguably require. These difficulties are particularly where, as is the case with many of these securities, the investors continue to receive all payments due to them.

 

The authors suggest that generally there is no basis in law for seeking damages where the damages cannot be quantified and may never come to pass. They suggest that defendants in these cases will attempt to argue based on these principles that investors "who continue to be paid the full amount of any principal and interest payments due to them may have little choice but to ‘wait and see’ whether feared, modeled, or projected losses…come to fruition (i.e., become ‘clear and definite’) before being able to state claims under the securities laws."

 

The authors add that this argument may be particularly compelling where "intervening events such as legislative or executive action….could drastically alter the future payment outlook for many mortgage-backed securities."

 

These lawsuits against the issuers of mortgage-backed securities represent a significant number of the subprime securities lawsuits. Plaintiffs’ lawyers seem inclined to file these lawsuits, undoubtedly in part due to the degree of investor concern about their investments. Whether and to what extent these cases ultimately will succeed remains to be seen. As the law firm memo demonstrates there may be a host of questions surrounding these lawsuits. At a minimum it will be interesting to see what the courts make of these cases, and in particular the alleged damages, as the lawsuits proceed.

 

A more academic overview of many of these issues may be found in the paper Harvard Law School professor Allen Ferrell and Babson Business School Professors Jennifer Bethel and Gang Hu entitled "Legal and Economic Issues in Litigation Arising from the 2007-2008 Credit Crisis" (here).

 

Largest FCPA Penalty Ever Against U.S. Company: Fast on the heels of Siemens recent agreement to pay $800 million to settle bribery allegations (about which refer here), Halliburton has now agreed to pay $559 million to settle charges that one of its former units bribed Nigerian officials during the construction of a gas plant.

 

According to Halliburton’s January 26, 2009 press release (here), Halliburton has agreed to pay $382 million to the U.S. Department of Justice in eight installments over the next two years. In addition, Halliburton agreed to pay the SEC $177 million in disgorgement. Both settlements are subject to final approval by the relevant authorities.

 

As reported on the WSJ.com Law Blog (here), the Halliburton penalty is by far the largest ever for a U.S. company, far surpassing the prior record of $44 million by Baker Hughes in 2007. More detail about the Halliburton agreement can be found on The FCPA Blog (here).

 

The Halliburton settlement is further evidence of a point I have made numerous times on this blog, that FCPA enforcement activity represents a growing area of concern. As I discussed most recently here, an important part of this exposure is the threat of civil litigation that frequently follows on after the enforcement proceeding. The sheer magnitude of the Siemens and Halliburton settlements suggest that potential FCPA liability could represent a significant exposure for corporations and their directors and offices.

 

Blast from the Past: Another Options Backdating Settlement: The options backdating cases are a vestige from another time and place, yet they remain, like so much cosmic dust, reminders of a distant catastrophe. In a recent development in one prominent case, the Delaware Chancery Court has approved a settlement that is noteworthy in at least a couple of respects.

 

As reflected in a January 2, 2009 opinion by Chancellor William Chandler in the Ryan v. Gifford case (here), the court has approved the settlement of the options backdating case involving Maxim Integrated Products, over shareholder objections. Under the settlement, which is detailed in the opinion, the defendants agreed to pay a total of $28,505,473 in cash. In addition, the defendants agreed to cancel, reprice or surrender claims with respect to certain options they continued to hold. The company also agreed to certain corporate governance reforms.

 

The settlement is noteworthy in a couple of respects. The first is simply that it involves the Ryan v. Gifford case, in which Chandler had written an influential and important February 2007 opinion denying the defendants’ motion to dismiss (as discussed here). Because of this opinion, the case is among the more prominent of the options backdating cases.

 

The other noteworthy aspect of the settlement is the individual defendants’ significant contribution toward settlement. Of the $28.5 million settlement amount, $21 million was paid by insurance. The balance of the cash was paid by the individual defendants. John Gifford, the company’s former CEO, agreed to make his own cash payment of $6 million to Maxim, even though, as the Court noted, he was "covered by insurance." The court’s statement in this respect seems to suggest that there were additional insurance funds available to fund this amount, but that as part of the settlement Gifford nevertheless agreed to pay this amount out of his own assets. Other individuals agreed to pay lesser amounts.

 

It is not entirely clear whether the insurance would in fact have covered the amounts of these individual payments. For example, in connection with the payments by the individuals other than Gifford, the court noted that the amounts paid "represent the entire amount that they were alleged to have benefitted from the exercise of backdated stock options." To the extent these amounts represent disgorgement or return of ill-gotten gains, the policy’s coverage would not apply. The court’s opinion is not as specific with respect to Gifford’s payment, but to the extent his contribution also represents his return of benefits from the exercise of backdated options, the insurance coverage similarly would not likely apply.

 

In any event, the size of the settlement, the prominence of the case and the significance of the individuals’ contributions make this a noteworthy settlement. I have added the settlement to my list of options backdating lawsuit settlements, dismissals and dismissal motion denials, which can be accessed here.

 

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In recent days, all eyes have been on two of the world’s largest banks. Commentators have questioned, for example, whether Citigroup should be nationalized (refer here) or if the Merrill Lynch-related losses might cost Bank of America CEO Kenneth Lewis his job (refer here). These institutions’ enormous size makes their problems predominant.

 

But while the woes of the financial titans are undeniably deeply troublesome, I have found myself increasingly concerned about the problems involving three much smaller banks: First Centennial Bank of Redlands, California; Bank of Clark County of Vancouver, Washington; and National Bank of Commerce of Berkley, Illinois.

 

My concerns about these banks are not about their business prospects – it is too late for that, as these three banks have already failed. Regulators closed First Centennial after the close of business this past Friday, January 23, 2009 (about which refer here), and Bank of Clark County and the National Bank of Commerce were closed the preceding Friday, on January 16, 2009 (refer here and here).

 

My concerns relating to these banks have to do with the facts and circumstances surrounding their closures, as well what the closures may portend.

 

1. The Number and Pace of Bank Failures: The closure of three banks on two successive Fridays in just the first few weeks of the New Year shows that the pace of bank failures, which accelerated as 2008 progressed, has continued unabated as we have headed into 2009. In 2008, there were a total of 25 bank closures (complete list here), of which 21 were in the second half of the year. With three closures already this year, signs suggest the heightened level of bank closures at year’s end has carried forward into 2009.

 

2. Community Banks are Not Immune After All: All three of these banks fall within a standard definition of "community banks" – that is, they had assets below $1 billion. National Bank of Commerce had assets of $430.9 million; Bank of Clark County had assets of $446.5 million; and First Centennial Bank had assets of $803.3 million. The community bank sector has largely been viewed as less affected by the worst of the current credit crisis. However, these three banks’ failures, and their geographic dispersion, suggest that the problems in the community bank sector could be more widespread than previously perceived.

 

3. Is the Worst Yet to Come?: These three bank failures are likely only the first of many yet to come in 2009. A January 23, 2009 Wall Street Journal article entitled "Banks Die Too Fast for Regulators" (here) reports that "federal regulators are bracing for more than 20 bank failures in the first quarter of this year," which were it to happen would mean nearly as many bank failures in the first quarter as during all of 2008 (which in turn was the most active year for bank failures since 1994).

 

Moreover, the Journal article specifically noted that the banks "are failing with accelerating speed, exposing holes in the regulatory infrastructure designed to catch collapsing institutions."

 

A vexing related issue is the apparent intervention of politicians on behalf of troubled banks. A January 24, 2009 Wall Street Journal article entitled "Politicians Asked Feds to Prop Up Failing Banks" (here) describes the efforts of two Illinois politicians on behalf of the National Bank of Commerce prior to its failure. As the article notes, politicians’ efforts "recall the savings and loan turmoil of the late 1980s, when members of Congress pressured the government to go easy on struggling thrift institutions." As one commentator cited in the article stated, these kinds of things "made the saving-and-loan debacle into a political scandal as well as a financial scandal."

 

4. Dead Banks Mean More Dead Bank Litigation: Both historically and more recently, failing banks have meant failed bank litigation. The Cornerstone Research Report on the 2008 securities litigation activity specifically observed that "five of the 25 banks that failed in 2008 were named in federal securities class actions filed in 2008," even though "only 11 of the 25 banks that failed were publicly traded."

 

Indeed, already in 2009, another one of the 25 banks that failed in 2008 has been sued in a securities class action lawsuit. As noted here, on January 5, 2009, plaintiffs initiated a securities lawsuit against PFF Bancorp and certain of its directors and officers, whose banking subsidiary was closed on November 21, 2008 (about which refer here). This 2009 lawsuit suggests the likelihood of even further "dead bank" litigation ahead, especially of the heightened level of bank closures persists.

 

5. Will Asset Woes Afflict More Banks – And Other Kinds of Companies?: There is a specific aspect of the National Bank of Commerce failure that I find particularly troublesome. As noted in much greater detail in a January 23, 2009 American Banker article entitled "Failure Over Securities Losses Sets Off Alarm" (here, registration required), the National Bank of Commerce failed not because of liquidity issues (the usual reason for bank failures) but "because it suffered such massive losses on its investments in Fannie Mae and Freddie Mac stock that it had negative capital levels." As the article notes, the bank’s failure "heightens concern about the fate of some other banking companies that had heavy securities losses."

 

The American Banker article also specifically notes that similar problems indirectly led to the failure of PFF Bancorp, the banking company noted above as having been sued in 2009. PFF apparently had agreed in June 2008 to sell itself to FBOP Corp. of Oak Park, Illinois, but after FBOP wrote down at the end of the third quarter $936 million of investment securities, the $17-billion asset bank found itself undercapitalized and regulators refused to approve the pending deal. Undoubtedly other banks face similar challenges in their investment portfolios.

 

Concerns about banks’ troubled asset portfolios were the original basis for TARP, but the American Banker article noted that TARP money wouldn’t have been sufficient to save the National Bank of Commerce, as "the bank would have been eligible for a maximum of $12 million but needed at least $26 million to become well-capitalized again."

 

Financial institutions’ exposures to troubled assets could be widespread and could become significantly worse as the credit crisis continues to spread. In particular, the number of assets that are troubled continues to grow. They included not only all of the toxic mortgage-backed assets, but also securities and other assets related to Fannie Mae and Freddie Mac, and also assets related to a growing list of other institutions, including Lehman Brothers, Washington Mutual, American International Group, and the Icelandic banks.

 

More recent financial turmoil has made this list even longer. For example, just in the past few days, Aflac’s share price fluctuated sharply and the company’s financial strength rating was downgraded because to the company’s exposure to debt securities issued by the Royal Bank of Scotland, Barclays and other troubled European banks.

 

The Aflac example shows that the asset issues that capsized the National Bank of Commerce stretch far beyond the banking sector. Indeed, a January 24, 2009 Washington Post article entitled "Life Insurers Take a Hit" (here) cites Aflac and states, among other things, that "financial markets downward spiral has drawn the nation’s life insurers into its vortex, reducing the already depressed value of its stock by a third since early this month." The article specifically notes concerns that life insurance companies’ balance sheets and financial statements might not "fully reflect the reduced value of the investments they hold."

 

Nor are these concerns limited just to the banking and life insurance sectors. The Wall Street Journal’s January 24, 2009 Heard on the Street column (here) notes balance sheet concerns involving reinsurer Swiss Re.

 

The various companies’ balance sheet vulnerabilities arising from their exposure to the securities of other failed or failing financial institutions is precisely the circumstance to which I was referring when I asserted (here) that the credit crisis and its related litigation wave had reached an "inflection point" – that is, companies are getting punished in the financial marketplace (and also getting sued) not necessarily because of their own direct credit crisis-related problems but rather because of their exposure through their investment portfolios to other companies’ credit crisis woes.

 

Whether or not a revitalized TARP program would be sufficient to remediate these problems for troubled banks is a question our political leaders must decide. But in the interim, the widespread balance sheet exposure to trouble assets will continue to burden a wide variety of companies, including but not limited to banks.

 

Moreover as the list of companies whose related assets are toxic continues to grow (now including Royal Bank of Scotland with others yet to come), the number of companies struggling with toxic balance sheet assets will also grow. One inevitable consequence undoubtedly will be further litigation, both in the banking sector and elsewhere as well.

 

A Case of Earlier Indigestion: Concerns surround the most recent financial institution mergers, such as the Bank of America’s acquisitions of Merrill Lynch and Countrywide; Wells Fargo’s acquisition of Wachovia; and PNC Banking Corporation’s merger with National City Corporation.

 

But a recently filed lawsuit is concerned not with these recent deals, but rather a transaction froman earlier era – Wachovia’s ill-fated $25 billion acquisition of Golden West, which at the time was the nation’s second largest savings and loan.

 

The new lawsuit was filed in California (Alameda County) Superior Court on January 21, 2009. The complaint, which can be found here, alleges that as a result of the Golden West acquisition, Wachovia acquired a $120 billion portfolio of Option ARM (or "Pick-A-Pay" loans as they were called) which the complaint alleges were not properly underwritten, inadequately capitalized, and became delinquent at very high rates. Within two years of the Golden West transaction, the complaint alleges, Wachovia "ultimately collapsed under the delinquencies and defaults on the Pick-A-Pay loans."

 

The complaint alleges that Wachovia, certain of its directors and officers, and its offering underwriters failed to disclose these risks to investors who purchased Wachovia’s shares in various securities offerings between 2006 and 2008. The compliant alleges that when the concerns were "ultimately revealed" the company was "forced into a fire sale by the FDIC that finally revealed to investors what had been misrepresented for months, if not years, as a result of its toxic subprime assets, Wachovia was a shell of a corporation that could not exist independently."

 

The plaintiffs’ lawyers have chosen to file their lawsuit in state court in express reliance on the concurrent jurisdiction provisions of Section 22 of the ’33 Act. I have previously discussed the plaintiffs’ lawyers’ possible forum selection (shopping?) motivations for filing federal securities lawsuits in federal court, here. As I also discussed in a recent post (here), the federal courts are split on whether SLUSA or CAFA preempted the concurrent jurisdiction provisions in the ’33 Act, although the law is most favorable to a finding of state court jurisdiction in the Ninth Circuit.

 

In any event, I have added the new securities suit to my list of subprime and credit crisis-related cases, which can be accessed here. With the addition of this case, there have now been a total of 147 subprime and credit crisis-related securities cases filed during the period 2007 through 2009, of which seven have been filed already in 2009. A spreadsheet of the 2009 cases can be accessed here.

 

A Word to the Wise: Those of you who may be planning on attending the 2009 PLUS D&O Symposium, to be held February 25 and 26 at the Marriott Marquis in New York, will want to know that the early registration discount is about to expire. The registration fee for those registering prior to January 30, 2009 is $845 for PLUS members and $1,045 for nonmembers. For after January 30, the fee will rise to $975 for members, and $1,175 for nonmembers. Registration and agenda information can be found here.

 

This year’s conference promises to be particularly interesting and informative. I am co-Chairing this year’s Symposium with my good friends, Chris Duca of Navigators Pro and Tony Galban of Chubb. The key note speakers include former Secretary of States Madeline Albright and New York Insurance Superintendent Eric Dinallo. Other panelists and speakers include a number of noteworthy individuals, including Stanford Law Professor Joseph Grundfest, Wilson Sonsini partner Boris Feldman and many others.

 

The Symposium will also feature a reprise of the excellent video, first shown at the PLUS International Conference in November, of "The Life and Times of Bill Lerach." The Securities Docket recently featured a trailer of the video, here.

 

And Finally: On January 28, 2009, the Securities Docket will be sponsoring the latest in its series of free webinars on securities related topics. The upcoming webinar is entitled "FCPA Enforcement: The Paradigm Shift" and will feature F. Joseph Warin of the Gibson Dunn law firm. Further information can be found here.

 

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As has been well-publicized, within a matter of weeks of closing its acquisition of Merrill Lynch, Bank of America announced previously undisclosed 4Q08 operating losses at Merrill of $21.5 billion that required BofA to obtain an emergency $20 billion cash injection from the U.S. Treasury, as well as an additional $118 billion asset backstop. BofA’s stock market valuation has dropped more $100 billion since the day before the merger was announced through the company’s January 16 earnings release.

 

As the Wall Street Journal reported (here), questions immediately arose following BofA’s announcement of the Merrill losses, such as why BofA’s CEO Kenneth Lewis "didn’t discover the problems prior to the Sept. 15 deal announcement" and "why he didn’t disclose the losses prior to the vote on the Merrill deal on Dec. 5 or before closing the deal on Jan. 1."

 

With these kinds of questions circulating, it comes as no surprise that plaintiffs’ attorneys have initiated litigation. There were actually two different lawsuits announced on January 21, 2009 relating to these circumstances. Both of the lawsuits purport to be filed on behalf of persons who held BofA securities on October 10, 2008, the record date for the December 5, 2008 special meeting of shareholders to approve the merger.

 

The first of these two lawsuits was filed in the Southern District of New York, as described in the plaintiffs’ lawyers’ January 21 press release (here). The second was filed in the Northern District of Georgia, as described a separate January 21 press release (here). The complaint in the N.D.Ga. action can be found here.

 

Both complaints name as defendants Bank of America and certain of its directors and officers. The S.D.N.Y. action also names Merrill’s CEO John Thain as a defendant as well. Both lawsuits allege that the defendants made materially false and misleading statements in the proxy materials in order to secure sufficient proxies to approve the merger. The defendants are alleged to have known that excessive losses at Merrill should have been disclosed to allow shareholders a well-informed vote on the merger.

 

Of all the interesting issues surrounding these circumstances, the most significant is the question of when BofA became aware of the magnitude of Merrill’s losses. (A related question is when Merrill became aware of the losses, but don’t expect any Merrill shareholders to raise the concern, as the completion of the merger was clearly in their best interest.)

 

The Journal article linked above reports that BofA now asserts that it learned of the magnitude of Merrill’s losses after the Dec. 5 shareholder vote, and that by Dec. 17, Lewis was so alarmed by the losses, which he reportedly characterized as "monstrous," that he traveled to Washington for an emergency meeting with Fed Chairman Ben Bernanke and Treasury Secretary Henry Paulson.

 

What happened at this Dec. 17 meeting presents its own interesting set of issues. Paulson and Bernanke apparently told Lewis that, according to the Journal, "failing to complete the Merrill acquisition would be disastrous" and would "further destabilize markets" and "hurt the bank" and potentially set off a "ripple effect that would exacerbate a fragile situation." The government officials also promised Lewis the backstop protection if the losses proved to be as significant as Lewis feared.

 

The meeting raises a host of questions, as discussed in the January 20, 2009 Wall Street Journal article entitled "BofA’s Merrill Deal Exposes Myth of Transparency" (here). The article suggests that "by most any reasonable measure, if the Merrill losses were concrete enough to seek a government lifeline, they were concrete enough to report to the company’s shareholders." The question is whether Lewis kept mum about the losses and the promised lifeline at Bernanke and Paulson’s request; the article asks whether perhaps the government was "complicit in nondisclosure."

 

While there may have been a marketplace interest in keeping the deal on track, there is no existing law that would relieve the company of its disclosure duties for the benefit of larger marketplace interests. The January 20 Journal article raises the question whether "a new legal standard could eventually emerge, sort of a ‘national interest’ doctrine absolving companies of governance actions that may be potentially harmful, but are important to an economic or defense emergency."

 

These are interesting questions. However, it should be noted that they arguably are irrelevant to the recently filed lawsuits, as the December 17 meeting took place well after the December 5 shareholder vote. There is of course always the possibility of a separate lawsuit on behalf of persons who acquired BofA shares, for example, between the December 17 meeting and before the company’s recent announcement of the Merrill-related losses. UPDATE: In the day immediately after I added this post, additional lawsuits came flooding in, including at least one (here) that is filed against, among others, a subclass of claimants who purchased Bank of America securities between January 2, 2009 and January 16, 2009.

 

Regardless whether or not other lawsuits in fact emerge, two questions will be paramount: when did the magnitude of the Merrill losses become apparent, and when did BofA have a duty to disclose this information to its shareholders?

 

Whatever else might be said about these circumstances, the certainly do underscore the magnitude of the problems confronting the economic and banking systems, as well as the challenges facing the incoming administration as it struggles to address these problems while taking up the reins of government.

 

These circumstances also raise serious questions about whether or not there are or should be exceptions to the transparency principles on which our entire system of securities and market regulation is based. It doesn’t require much imagination to picture the bedlam that could have ensued if the Merrill deal had fallen apart just before Christmas. The system can ill afford any more of the kind of chaos that enveloped the markets in September and October last year.

 

On the other hand, BofA’s shareholders might well feel that any analysis concluding that information was properly withheld from them for the sake of the overall market improperly negates their rights and expectations as shareholders.

 

It may or may not get addressed in a court in connection with the litigation involving the Merrill deal, but the question whether or not there is "national interest" exception to the standard disclosure principles is surely a very interesting question.

 

Professor Larry Ribstein discusses the question whether there is a national interest exception to the securities laws in his Ideoblog, here.

 

I have in any event added the Bank of America/Merrill Lynch litigation to my running tally of the subprime and credit crisis-related securities lawsuits, which can be accessed here. With the addition of this new litigation, the current tally of these cases now stands at 146, of which five have been filed in 2009.

 

More Madoff Litigation: The Madoff-related litigation wave has also continued to roll on. For example, on January 21, 2009, plaintiffs’ lawyers announced (here) that they had initiated a class action lawsuit in the Southern District of New York on behalf of persons who purchased between 2003 and the present variable universal life insurance issued by Tremont International Insurance Limited or Argus International Bermuda Limited.

 

The complaint (which can be found here) alleges that the insurer, an entity owned by Tremont Capital Management had breached its duties by offering Tremont-related funds as investment options for the variable investment account component of the policies. The complaint further alleges that the Tremont-related funds were heavily invested in Madoff funds.

 

The complaint alleges that the defendants violated a number of legal duties. The complaint does not, however, assert a violation of the federal securities laws. As a result I have included in the list of "other" litigation in my table of the Madoff-related litigation, which can be accessed here.

 

This latest lawsuit not only demonstrates that the Madoff litigation continues to roll in. It also shows what an incredible diversity of individuals and investors were harmed by losses from Madoff’s fraudulent scheme. It also shows how incredibly complicated it all is going to be to unwind this whole mess.

 

And Finally: Readers who registered the question posed on my preceding blog post whether President Obama had completed the oath of office as required by the Constitution will be relieved to know that the issue has been resolved.

 

On the apparent theory that there is nothing in the Constitution against do overs, Obama and Chief Justice reprised their roles in another rendition of the oath of office in a considerably less formal ceremony at the White House on the evening of January 21, 2009, as reported here.

 

That certainly is a load off my mind.

 

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They aren’t the first subprime lawsuit settlements, but the two massive settlements Merrill Lynch announced this past Friday are unquestionably the largest subprime subprime securities lawsuit settlements so far, and they certainly suggest the enormous stakes that may be involved in the mass of subprime and credit crisis-related litigation cases that remain pending.

 

In a January 16, 2009 filing on form 8-K (here), Merrill Lynch announced that the Lead Plaintiff, the Ohio State Teachers’ Retirement System, had accepted Merrill Lynch agreement to pay $475 million cash in settlement of the consolidated securities class action settlement pending against the company and certain of its directors and officers. As reflected more fully here, the consolidated case involved the claims of a variety of claimants, the basic allegations in the litigation were that the defendants

 

knew or recklessly disregarded that (i) the Company was more exposed to CDOs containing subprime debt than it disclosed; and (ii) the Company’s Class Period statements were materially false due to their failure to inform the market of the ticking time bomb in the Company’s CDO portfolio due to the deteriorating subprime mortgage market, which caused Merrill’s portfolio to be impaired.

 

My initial post about the filing of the Merrill Lynch subprime-related securities class action lawsuit can be found here.

 

In addition to the consolidated securities settlement, Merrill Lynch also announced on January 16 that it had entered into a proposed settlement of the class action brought on behalf of Merrill Lynch employees who invested in or held Merrill Lynch stock in their retirement plans. Merrill Lynch will pay $75 million in cash under the terms of this settlement.

 

Both consolidated cases focused primarily on Merrill Lynch’s subprime-related losses and related disclosures during the class period, and both settlements are subject to court approval.

 

The $475 million securities class action settlement ranks among the largest ever; according to a review of RiskMetrics data, it appears to be in the top 20 securities class action settlements of all time. The $75 milion settlement of the employees' claims is also one of the largest ERISA class action settlements ever; based on my informal survey, it may be among the top five largest of all time.

 

But the significance of the Merrill Lynch settlements may not be what they represent in and of themselves, but rather what their size may suggest for the remaining mass of subprime and credit crisis-related litigation.

 

To be sure, many of these cases may not be anywhere near the magnitude of the Merrill Lynch case, and many of the cases will be winnowed out through motions to dismiss. Yet among the over 140 subprime and credit crisis related securities lawsuits are many others that also involve huge shareholder losses, and many cases will survive the winnowing process of the motions to dismiss. If it is any indication of what may be yet to come, the Merrill Lynch settlements suggest the aggregate settlements of these cases could represent a staggering sum.

 

There are a couple of interesting things about the Merrill Lynch settlements. The first is that they came before any ruling on the many pending motions to dismiss in the consolidated cases. While the timing of the settlements, prior even to a ruling on the motions to dismiss, might be due to any number of factors, one likely possibility is that Merrill’s new owner, Bank of America, moved quickly to put the litigation in the past.

 

The other interesting thing about these settlements is that the 8-K does not mention the involvement of insurance money. That of course does not mean for sure that there will be no insurance contribution toward the settlements, but it does seem at least to make that suggestion. As I have noted elsewhere (here, for example), due to the insurance structures that many large banks have employed in recent years (some of which include only Side A insurance, which would not be triggered in many of these cases), insurance may not be a factor in many of the subprime and credit crisis-related cases involving the larger banks, which is a consideration that may mitigate the overall losses to the insurance industry from these lawsuits.

 

A January 16, 2008 Bloomberg article describing the Merrill Lynch settlement can be found here. Hat tip to the Securities Docket (here) for first highlighting the settlements.

 

In any event, I have added the Merrill Lynch settlement to my table of subprime and credit crisis related securities lawsuit settlements, dismissals, and dismissal denials, which can be found here.

 

And Finally: The January 18, 2009 Washington Post has an article entitled "Livid Investors Launch a Volley of Lawsuits" (here) that describes how investors angered by their investment losses are turning to the courts to seek recompense. (Full disclosure: I was interviewed in connection with the article.)

 

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On January 12, 2009, in the first dismissal motion ruling among the many subprime and credit crisis-related securities lawsuits pending in the Southern District of New York, Judge Shira Scheindlin granted the defendants’ motion to dismiss in the Centerline Holding Company securities case, with leave to amend. A copy of the opinion can be found here.

 

Background

As detailed more fully here, the plaintiff’s complaint basically alleges that the company and four individual defendants concealed from the investing public that they were structuring a sale of the company’s $2.8 billion portfolio of tax-exempt mortgage revenue bonds to a third party. When the company announced the sale, it also announced that it would be cutting its dividend from $1.68 per share to only 60 cents a share.

 

The company also disclosed at the same time that it had entered into a related party transaction with a company controlled by its Chairman, Stephen Ross, and its Managing Trustee, Jeff Blau, whereby this separate company agreed to provide Centerline with $131 million in financing in exchange for 12.2 million shares of newly-issued convertible stock that will pay an 11% dividend.

 

Upon the announcement of this news, the company’s share price declined 25% and the lawsuits followed.

 

The Motion to Dismiss Ruling

The defendants moved to dismiss the complaint on the ground that the plaintiff had not adequately pled scienter. Judge Scheindlin agreed. Specifically, she concluded that the plaintiff had neither alleged sufficient facts showing that defendants had the motive and opportunity to commit fraud nor adequately pled that defendants acted with recklessness.

 

The plaintiff had alleged that defendants Ross and Blau were motivated to "engineer" the related party transaction to increase their voting control of the company from 17% to almost 30%; to be paid an 11% coupon rate, "thereby diverting a material portion of the Company’s income to insiders…to the great detriment of shareholders"; and to have the opportunity to nominate an individual trustee.

 

Judge Scheindlin said that these allegations "do not explain why Ross and Blau would have wanted to fraudulently conceal the news" of their investment or of the bond portfolio sale. She also said that "if they had any motive, it would have been to disclose information about the bond sale and dividend cut sooner," since their preferred shares are only convertible at $10.75 a share, yet after the announcement of the bond sale, the company’s share price declined to $7.70 a share.

 

The court noted that if Ross and Blau had wanted a "sweetheart" deal, "the would have been motivated to cause information related to the sale of the bond portfolio and dividend cut to be disclosed sooner so that they could have negotiated a lower conversion price."

 

Judge Scheindlin also found insufficient the allegations that the other two individual defendants were motivated by reason of their high salaries, bonus compensation, equity awards or continued employment.

 

Judge Scheindlin also held that the plaintiff had not alleged facts sufficient to establish conscious misbehavior or recklessness. Specifically, she noted that "the Complaint does not allege any facts to show that defendants knew they should have disclosed information of the transactions prior to the date of the announcement, but recklessly failed to do so."

 

The defendants cited an SEC rule (promulgated in implement Section 409 of the Sarbanes Oxley Act) specifying that companies are required to disclose material definitive agreements within four business days of entry into the agreement, and argued that the plaintiff had not alleged that the company had failed to comply with the rule. The plaintiff argued that whether the defendants complied with the SEC’s rule, the company had failed to disclose information about the pending sale information about the pending sale and dividend cut while the company was making other disclosures on those topics, which made those other disclosures "false, inaccurate, incomplete or misleading."

 

Judge Scheindlin said that even if it were assumed that the statements were misleading, the defendants’ compliance with the SEC’s rule "suggests that Lead Plaintiff has failed to show defendants acted recklessly in omitting such information." She added that defendants conduct cannot be described as "highly unreasonable" when "it is arguable that they did not have a duty to disclose such information before they actually did."

 

Because she found that the plaintiff had not presented facts to make the Section 10 claims "plausible," Judge Scheindlin dismissed the claims, but she allowed plaintiff 30 days in which to file an Amended Complaint.

 

Discussion

The significance of Judge Scheindlin’s opinion is that it is the first dismissal motion ruling in a subprime and credit crisis-related case in the Southern District of New York. A very large number of the subprime and credit crisis-related securities lawsuits overall have been filed in the S.D.N.Y because the financial services industry is concentrated there. By my count, as many as 54 of the 101 subprime and credit crisis-related securities lawsuits that were filed in 2008 were filed in the Southern District of New York.

 

However, any inferences about the other cases that might be drawn from Judge Scheindlin’s grant of the dismissal motion in the Centerline case probably need to be heavily discounted because the opinion depends so heavily on case-specific allegations and the specifics of the transaction involved. For that reason the case may offer relatively little insight into the prospects for other cases pending in the S.D.N.Y., except to the extent that it illumines the legal standards that will be applied to scienter issues in other cases.

 

In any event, the ruling was without prejudice, and it remains to be seen whether or not the plaintiffs will be able to amend their pleadings sufficiently to survive a renewed motion to dismiss.

 

Those readers who may have had the thought, as I did, while reading about this case that the allegations really lend themselves more to a derivative lawsuit alleging breaches of the duty of loyalty and care will want to know that there was a separate derivative lawsuit filed in the S.D.N.Y. against Centerline, as nominal defendants, as well as certain of its directors and officers. A copy of the derivative complaint can be found here.

 

I have added the recent Centerline opinion to my table of subprime and credit crisis-related securities lawsuit dismissals, dismissal motion denials and settlements, which can be accessed here.

 

Another 2009 Credit Crisis Lawsuit: In their January 14, 2009 press release (here), plaintiffs’ lawyers announced their initiation of a securities class action lawsuit in the Western District of Washington on behalf of investors who purchased certain WaMu Mortgage Pass-Through Certificates. The Complaint (which can be found here) was filed against the various series of certificates, as well as Washington Mutual bank, WaMu Acceptance Corporation, and certain individuals.

 

According to the press release, the complaint alleges that the "defendants made material misstatements and omissions in connection with the offerings regarding the collateral underlying the certificates."

 

The new WaMu case is already the third subprime and credit crisis-related lawsuit filed so far in 2009. Because I thought that some readers might like to separately track the 2009 credit crisis securities lawsuits, I have created a separate spreadsheet (that can be accessed here) on which I will separately track the 2009 credit crisis cases. I will update the spreadsheet as new credit crisis cases are filed.

 

The addition of the WaMu case brings the total number of subprime and credit-crisis related securities lawsuits that have been filed since 2007 to 144. My list of all of the subprime and credit crisis securities cases can be accessed here.

 

Special thanks to Adam Savett of the Securities Litigation Watch for providing a copy of the WaMu complaint.

 

More about Social Networking: In a recent post, I revealed my New Year’s resolution to become more familiar with and involved in the various professional social networking sites, including LinkedIn and Twitter. The prior post elicited a promising initial response, but because I suspect that many readers may not have seen my prior note, I am reprising the message here.

 

Many readers may be interested to know that between the times when I enter new blog posts, I often add quick notes and links on Twitter. My Twitter site can be accessed here. It is relatively simple to register.

 

I also remain interested in trying to better develop my LinkedIn network. The LinkedIn button in the right hand margin above will take you to my LinkedIn profile. I am interested in trying to bring readers of this blog into my LinkedIn network, so please let me know if you would like to "connect." I am still learning what I might be able to accomplish with the network, but I proceeding on the theory that the only way to figure it out is to plunge in and try to make it work.

 

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We are barely into the New Year, but all signs are that two of the critical securities litigation trends of 2008 – the subprime/credit crisis related litigation wave and the Madoff-related litigation wave – remain significant factors and apparently will continue to drive new lawsuit filings as we head into 2009, as the recent lawsuit filings discussed below suggest.

 

The New RBS Lawsuit

First, with respect to the credit crisis litigation, on January 12, 2009, plaintiffs’ lawyers issued a press release (here) stating that they had initiated a securities class action lawsuit in the Southern District of New York on behalf of purchasers of Series S American Depositary Shares (ADSs) of the Royal Bank of Scotland Group and related entities and certain directors and officers. The complaint also names as defendants the offering underwriters that conducted the June 2007 offering of the shares.

 

The Complaint (which can be found here) alleges misrepresentations and omissions in the offering documents, which incorporated the Company’s 2004, 2005 and 2006 financial statements. The Complaint alleges that the company "ultimately announced huge multi-billion pound impairment charges associated with its exposure to debt securities, including mortgage-related securities tied to the U.S. real estate markets, causing the price of RBS’s Series S ADSs issued in the Offering to decline." The ADSs, which were originally offered at $25/share, now trade around $10/share.

 

According to the Complaint, the offering documents omitted that:

 

(a) defendants’ portfolio of debt securities was impaired to a much larger extent than the Company had disclosed; (b) defendants failed to properly record losses for impaired assets; (c) the Company’s internal controls were inadequate to prevent the Company from improperly reporting its debt securities; (d) the Company’s participation in the consortium which acquired ABN AMRO would have disastrous results on the Company’s capital position and overall operations; and (e) the Company’s capital base was not adequate enough to withstand the significant deterioration in the subprime market and, as a result, RBS would be forced to raise significant amounts of additional capital.

 

RBS is actually the second company from the ill-fated consortium that was the "successful" bidder in the ABN AMRO buyout to get dragged into U.S. securities litigation.

 

As I noted here, another consortium member, Fortis, was also hit with a securities class action lawsuit in October 2008. As I noted in that prior post, "it is one more of those amazing things about the current circumstances that, despite the size of the ABN AMRO calamity, it is effectively just background noise in the larger cataclysm." (An abridge version of the ABN AMRO debacle can be found here.) Both RBS and Fortis have also been the recipients of massive bailout efforts from their respective governments.

 

The ABN AMRO losses to RBS continue to amount. For example, on January 12, 2009, Bloomberg reported (here) that, as a result of loans RBS acquired as part of the ABN AMRO deal, RBS is the biggest lender to bankrupt U.S. chemical maker Lyondell Chemical Co., and may face losses on its $3.47 billion of loans. The loans were part of the $20.5 billion raised to finance Bassell AF’s 2007 leveraged buyout of Lyondell.

 

More Madoff Litigation

According to their release (here), on January 12, 2009, plaintiff’s counsel initiated another Madoff-related securities class action lawsuit in the Southern District of New York on behalf of investors in the Herald USA Fund, Herald Luxemburg Fund, Primeo Select Funds, and Thema International Funds, against the Funds, Medici Bank, Bank Austria Creditianstait, Unicredit S.A., Pioneer Alternative Investments, HSBC Holdings plc and Ernst & Young LLP, as well as Medici Bank’s founder Sonja Kohn and its former CEO Peter Scheithauer. A copy of the complaint in the case can be found here.

 

Austrian regulators took control of Bank Medici after the bank revealed that it had invested as much as $3.2 billion in funds managed by Bernard Madoff and his firm. Bank of Medici is 25% owned by Unicredit. As reported here, one of the Bank’s largest customers was Unicredit’s Pioneer Investments, which invested as much as €805 with the Funds. Further background can be found here.

 

According to the press release, the Complaint alleges defendants caused the Funds "to concentrate almost 100% of their investment capital with entities that participated in the massive, fraudulent scheme perpetrated" by Madoff and his firm.

 

Run the Numbers: With the addition of the RBS case, the total number of subprime and credit crisis-related securities lawsuits going back to 2007 now stands at 143, of which two have been filed already in 2009. My updated tally of the subprime and credit crisis-related cases can be accessed here.

 

The new lawsuit on behalf of the Bank Medici Funds investors brings the total of Madoff-related securities class action lawsuits to eight, as reflected on my running tally of the cases, which can be accessed here.

 

Keeping Count: In my analysis (here) of the recently released Cornerstone/Stanford Clearinghouse report regarding the 2008 securities litigation, I noted that the report’s count of new 210 securities lawsuit filings through December 15, 2008 contrasted with my own count of 224 securities lawsuits through December 31, 2008. As I noted in my analysis, the additional lawsuits filed between December 15 and December 31 were critically important in understanding fully 2008 filing trends, as they significantly affect relative and absolute filing numbers during the year.

 

The Stanford Law School Securities Class Action Clearinghouse website has now updated its count through year’s end, bringing their 2008 tally to 226. The Stanford website can be accessed here.

 

On further review of their figures, my account appropriately should be adjusted from 224 to 226.

 

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In recent posts discussing year-end trends, my observations included predictions that credit crisis related lawsuits would continue in 2009 and that increased levels of bank failures could lead to further "dead bank" litigation. As it turns out, 2009’s first-filed securities class action lawsuit appears to reflect both of these projected trends.

 

According to the plaintiffs’ attorneys’ January 6, 2009 press release (here), they have filed a securities class action lawsuit in the Central District of California alleging that PFF Bancorp and certain of its directors and officers issued false and misleading statements about the company’s financial condition and business practices in violation of the federal securities laws. Until the bank’s closure, PFF operated a community bank located in Pomona, California.

 

As the FDIC reported (here), on November 21, 2008, banking regulators closed PFF and its assets were transferred to U.S. Bankcorp. PFF is one of the twenty-five U.S. banks that failed during 2008. (The FDIC’s complete list of the failed banks can be found here.)

 

The only defendants named in the complaint (which can be found here) are the company’s former CEO and former CFO. According to the press release, the Complaint alleges that the defendants "concealed" the bank’s "improper lending to borrowers with little ability to repay the amount loaned and failed to inform investors of the impact of changes in the real estate market in San Bernardino and Riverside Counties."

 

Specifically, and according to the press release, the Complaint alleges that the defendants concealed that:

 

(a) PFF's assets contained hundreds of millions of dollars worth of impaired and risky securities, many of which were backed by real estate that was rapidly dropping in value; (b) prior to and during the Class Period, PFF had been extremely aggressive in generating loans, including being heavily involved in offering Home Equity Lines of Credit ("HELOCs"), which would be enormously problematic if the value of residential real estate did not continue to increase; (c) defendants failed to properly account for PFF's real estate loans, failing to reflect impairment in the loans; (d) PFF's business prospects were much worse than represented due to problems in the Inland Empire market, which was a key focus of PFF's business; and (e) PFF had not adequately reserved for loan losses on HELOCs and on other real estate-related assets.

 

In prior posts, I have speculated (most recently here) that the growing number of failed banks could lead to a wave of failed bank litigation. I also recently projected (here) the likelihood that credit crisis related litigation wave will continue in 2009. One case is obviously no basis from which to generalize, but it does at least indicate that the forces on which I based my speculations are at least at work.

 

The likely operation of these factors, as well as the Madoff litigation and the general turbulent conditions in the financial marketplace, are among the reasons that that 2009 could be a very active year for securities litigation.

 

The year has barely begun and the horizon is still wide open, but from my perspective we seemed to have picked up right where we left off.

 

In any event, I have added the PFF Bancorp case to my running tally of the subprime and credit crisis-related lawsuits, which can be accessed here. With the addition of the first-filed case of 2009 to the list, the number of subprime and credit crisis-related lawsuit filed during the period 2007 through 2009 now stands at 142.

 

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2008 was a remarkably eventful year, from the dramatic events that rocked the financial markets to the Presidential election that resulted in a change in national leadership. Virtually all of the significant events during 2008 also had an impact on the world of D&O insurance, one way or another. In all likelihood, significant developments will continue to emerge during 2009, with further implications for the D&O marketplace.

 

In a year as eventful as 2008, selecting as the most significant events is a challenging task. But with an eye toward the developments of greatest significance for the D&O industry, I have prepared the following list of the top ten stories of 2008.

 

1. Credit Crisis Becomes Global Financial Calamity: What began in 2007 as a subprime meltdown had by early 2008 become a credit crisis, which in turn evolved during Fall 2008 into a full blown global financial disaster.

 

Within the space of just a few short weeks, the government took control of Fannie Mae and Freddie Mac; the FDIC took over Washington Mutual, in the largest U.S. bank failure ever; Lehman Brothers collapsed, in the largest U.S. bankruptcy ever; Bank of America agreed to acquire Merrill Lynch in a government brokered deal; the government undertook a massive bailout of AIG; Congress enacted a colossal $700 billion bailout package; and Wells Fargo agreed to acquire Wachovia. And those events came after a raft of prior financial shocks, including the collapse of Bear Stearns, the seizure of the auction rate securities market, and the disintegration of U.S. residential real estate market.

 

Any one of these events on its own would be significant. Taken collectively these events represent an enormous upheaval, the full ramifications and consequences of which will only emerge over the months and years to come.

 

And those are just the headlines. In other developments reported "below the fold," companies around the world have grappled with a general business downturn, wrestled with the threat of their own insolvency or that of their customers or suppliers, and basically tried to maintain their ground in an increasingly hostile financial environment.

 

All of these developments have enormous potential significance, much of it yet to unfold. These events have not only fueled litigation, but they have also presented D&O underwriters with a dramatically altered underwriting environment. The perils involve not only the challenge of underwriting financially troubled companies, but also the trial of underwriting in the context of rapidly changing (and deteriorating) conditions in the financial and credit markets.

 

During 2008, the world became significantly more dangerous for D&O underwriters. All signs suggest the current perilous conditions will continue into 2009, and perhaps beyond.

 

2. Financial Market Disruptions Hit Major Insurers: The turmoil in the financial markets also battered three insurers that are major players in the D&O marketplace. AIG’s woes required an enormous government bailout. XL and Hartford both faced differing degrees of turbulence due to write-downs in their respective investment portfolios.

 

Each of one of these insurers is dealing with their own unique set of circumstances. Rating agencies have noted and responded to these developments. Insurance buyers remain anxious and wary. The implications of these developments, both for each of these insurers and for the marketplace as a whole, remain to be seen. At a minimum, these events have disrupted the D&O insurance marketplace and introduced a significant element of uncertainty. The disruptive impact from these developments is likely to continue to affect the D&O industry throughout 2009.

 

3. Subprime and Credit Crisis Litigation Wave Rolls On: The subprime litigation wave that began in 2007 continued to surge in 2008, as there were 101 new subprime and credit-crisis related securities lawsuits filed during 2008, bringing the two-year total to 141. My running tally of the subprime and credit crisis-related securities lawsuits can be accessed here.

 

As time has passed, the litigation wave has continued to evolve; for example, the 2008 subprime and credit crisis-related litigation included as many as 21 auction rate securities lawsuits all of which were filed in the earlier part of 2008. Later in the year, a string of lawsuits initiated by holders of preferred or subordinated securities emerged (as discussed here).

 

In February 2009, the subprime and credit crisis-related litigation wave will enter its third year, but the phenomenon shows no signs of abating. The credit crisis-related securities lawsuits continued to accumulate throughout 2008. Of the 101 subprime and credit crisis-related lawsuits filed in 2008, 45 were filed in the second half of the year, including ten in December alone.

 

The credit crisis lawsuit filings remained high as the year ended, suggesting that significant credit crisis litigation activity will continue well into 2009 and perhaps beyond.

 

4. Credit Crisis Litigation Spreads Beyond the Financial Sector: As massive as the subprime and credit crisis-related litigation wave has been, it had until recently been concentrated in the financial sector. But as 2008 wore on, and largely as a result of the dramatic events in the global financial markets during September and October 2008, the litigation wave spread beyond the financial sector.

 

The companies that have become involved in this extended litigation wave include, for example, those that had significant exposure to Lehman Brothers or other companies that collapsed this fall. (Refer here and here for discussion of these "new wave" credit crisis lawsuits). In addition, companies that have been drawn in include companies that made wrong way bets on commodities or currencies (about which refer here).

 

These developments suggest that the credit crisis-related litigation wave may have entered a dangerous new phase, as I discuss at greater length here. These developments also underscore the challenges for D&O underwriters in the current environment.

 

My complete rundown of all 2008 securities litigation can be found here.

 

5. Bank Failures Surge: Led by the FDIC’s assumption of control of Washington Mutual in the largest bank failure in U.S. history, bank failures surged in 2008. According to the FDIC’s website (here), there were 25 bank failures in 2008, the highest annual total since 1994, at the end of the last era of failed banks. Perhaps even more significantly, the pace of bank closures increased as the year progressed; 21 of the 2008 bank closures took place in the second half of 2008, 12 of them in the fourth quarter.

 

In many ways, other financial events have overshadowed this sudden surge in bank failures. Indeed, as I noted here, the WaMu failure, the largest in U.S. history, has largely been relegated to yesterday’s news pile. But the timing and pace of the bank closures during 2008 suggests that there are likely to be further bank failures ahead, carrying with it the threat of associated "dead bank" litigation, a possibility I previously discussed here.

 

6. Madoff Scandal Triggers Litigation Torrent: The revelation of the massive Ponzi scheme involving Bernard Madoff and his firm has triggered a wave of litigation as aggrieved investors scrambled to try to recoup their losses. The first Madoff-related lawsuits targeted Madoff and his firm. But given the unlikelihood of a significant recovery there, investors have quickly moved on to other targets. A running tally of the Madoff investor litigation can be accessed here.

 

The primary Madoff-related litigation targets are the so-called "feeder funds" that invested with Madoff on their clients behalf. Recent blog posts discussing these "feeder funds" lawsuits can be found here and here. Given the magnitude of the investor losses and the depth of investor outrage, these lawsuits are likely to continue to accrue for some time to come. Press reports (for example, here) suggest that lawyers are gearing up for a litigation onslaught.

 

7. Presidential Election Signals Changes: I don’t know whether you heard, but there was an election in November. The coming changes in the White House as well as the increased Democratic majority in Congress could signal significant future legislative and other developments.

 

The arrival of the new administration will likely mean a change in direction for judicial appointments. A more interesting question is whether the Democratic control of Congress and the White House could lead to legislative changes in the securities laws. As discussed at the PLUS International Conference in November (about which refer here), the current financial turmoil could be used as a justification for legislative reform efforts – for example, an attempt to overturn Central Bank and Stoneridge.

 

At a minimum, the coming changes in the leadership at the SEC, together with a different leadership interpretation of the meaning and value of regulation, could lead to a changed environment for the enforcement of the securities laws.

 

8. Largest-Ever Fine Underscores the Growing Significance of the FCPA: For some time now (most recently here), I have been writing about the growing importance of Foreign Corrupt Practices Act (FCPA) enforcement activity and associated civil litigation. The FCPA mounting significance was dramatically underscored recently when Siemens agreed to pay an $800 million fine.

 

The Siemens fine is the largest ever, dwarfing the previous record fine, paid by Baker Hughes, of $44 million (about which refer here). The outcome of the Siemens investigation is merely the latest development in a long chain of events highlighting the growing importance of the FCPA.

 

As I have previously noted (refer here), one of the usual accompaniments of an FCPA investigation is follow-on civil litigation. As the threat of FCPA-related exposure continues to grow, the threat of follow-on civil litigation will also increase.

 

The FCPA Blog has a detailed overview of 2008 FCPA enforcement activity here.

 

9. Defense Expense Tests Limits Adequacy: Companies ensnared in high stakes litigation may find themselves confronting an unexpected new challenge – the increasing likelihood that defense costs alone could exhaust the entire amount of available D&O insurance coverage. This threat was unfortuntately realized in connection with the Collins & Aikman bankruptcy and related criminal proceeding (about which refer here), where accumulated defense expense exhausted the company’s entire $50 million D&O insurance, before the criminal case even went to trial.

 

The possibility that escalating defense expense could entirely deplete available insurance presents a frightening prospect for individuals involved in a serious D&O claim, and also raises troubling questions about traditional notions of limits adequacy. In addition, the possibility of total limits exhaustion as the result of the requirements of multiple claims and multiple insureds underscores the need for insurance buyers to consider alternative insurance structures (such as, for example, separate insurance for an individual or a group of individuals) to ensure that segregated funds remain available in the event of a catastrophic claim.

 

10. Indemnity Developments Trigger Additional Insurance Structure Concerns: In the Schoon v. Troy case (about which refer here), the Delaware Chancery Court held that a board of directors properly could eliminate former directors' advancement rights retroactively. The possibility that former directors could lose their rights to advancement or indemnification comes as unwelcome news to many directors.

 

This case development, like the development about limits adequacy noted above, highlights the need to address program structure as part of the insurance acquisition process. In general, directors and officers have become more concerned about the availability of insurance protection when they need it most. As a result, interest in a wider variety of auxiliary insurance structures has increased. These structures can include new insurance solutions designed for the needs of retiring directors.

 

In a year as eventful as 2008, reasonable minds could differ about what events deserve to be included in any Top Ten list. I am very interested in readers’ views about the top stories, particularly those who feel that other events deserved to be included on the list.

 

More "Top" Lists: Making year-end lists seems to be a nearly universal phenomenon, and Top Ten lists abound. Time Magazine simplified things by creating "The Top Ten of Everything of 2008," which can be found here.

 

Then  there are always the lists of the "Bottom Ten," like Business Week’s list of the Ten Worst Predictions About 2008 (here). Fortune has a list (here) of the "dumbest" business decisions of 2008, but given the kind of year 2008 was, a list of just ten was not enough – the magazine’s targets 21 business decisions as "dumbest."

 

Perhaps the most entertaining "Top" list is VideoGum’s list of the Top Viral Videos of 2008, which can be viewed below. (Viewer discretion is advised as some persons may find some of the content offensive.)

 

PLUS D&O Symposium: Readers will also want to be sure to register for the annual PLUS D&O Symposium, which will be held on February 25 and 26, 2009, at the Marriott Marquis Hotel in New York. Information about the Symposium, including registration instructions, can be found here.

 

The Symposium will feature an all-star cast, including keynote speakers Madeline Albright and NY Insurance Department Superintendant Eric Dinallo. Wilson Sonsini partner Boris Feldman will once again be moderating the annual panel on securities litigation developments. The schedule also includes a panel on Bankruptcies and Bailouts, with panelists including VJ Dowling of Dowling & Partners Securities and David Bradford of Advisen.

 

The conference will also include a replay of the excellent video, "The Rise and Fall of Bill Lerach" (a movie trailer for which can be found here). Stanford Law Professor Joseph Grundfest will lead a panel discussion of the video. The video was shown at the PLUS International Conference in November 2008 and received rave reviews.

 

Readers with any questions about the Symposium should feel free to drop me a note or give me a call.

 

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In a development that attracted little notice at the time, on December 10, 2008, the parties to the subprime-related securities lawsuit pending in the Northern District of California against Luminent Mortgage Capital and certain of its directors and officers filed a Stipulation of Settlement (here), in which the defendants agreed to pay $8 million to settle the case.

 

As far as I am aware, the Luminent settlement is only the second of the subprime-related securities lawsuits in which the parties have reached a settlement.

 

As discussed at greater length here, the plaintiffs had alleged that in certain public statements in July 2007, the defendants has misrepresented Luminent’s liquidity, the quality of its mortgage backed securities (MBS) portfolio, and the safety of its dividend for the second quarter of 2007, payable August 8, 2007.

 

 

The plaintiffs’ Amended Complaint (here) alleged that the defendants failed to disclose margin calls on the company’s MBS portfolio, a write-down on its portfolio and significant exposure to subprime debt that negatively impacted the company’s liquidity. The company’s share price dropped over 75% after the company announced on August 6, 2007 that it was cancelling payment of the second quarter dividend.

 

 

As reflected in the Stipulation of Settlement, the parties reached an agreement to settle the case while the defendants’ motion to dismiss was pending. The settlement followed the parties’ agreement to attempt to resolve the case through court-appointed mediation. The settlement is subject to court approval. The settlement also includes defendants’ agreement to pay $100,000 administrative costs. The parties agree that plaintiffs’ counsel may apply for and receive a fee award of up to 25% of the settlement amount.

 

 

Though the Stipulation of Settlement was not filed with the court until December 10, it is dated September 10, 2008. On September 5, 2008, Luminent and its subsidiaries had filed for bankruptcy protection in the District of Maryland Bankruptcy Court. On October 3, 2008, Luminent filed a motion in the bankruptcy court to lift the automatic stay to permit the securities lawsuits settlement to be consummated and to approve the settlement as in the best interests of the debtor. On December 2, 2008, the bankruptcy court approved Luminent’s application and authorized the parties to proceed with the settlement.

 

 

The Luminent settlement follows the only other subprime-related securities lawsuit settlement of which I am aware, the $4.85 million WSB Financial Group settlement (about which refer here). I have added the Luminent settlement to my running table of subprime and credit crisis-related securities lawsuit settlements, dismissals and dismissal denials, which can be accessed here.

 

 

Special thanks to Adam Savett of the Securities Litigation Watch blog (here) for providing a copy of the Stipulation of Settlement. 

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