The D&O Diary

The D&O Diary


Court Rules No D&O Insurance Coverage for Civil Theft Jury Verdict

Posted in D & O Insurance

floridaIn a summary judgment ruling in a coverage lawsuit arising after a civil jury trial, a Southern District of Florida judge applying Florida law has ruled that there is no coverage under a D&O insurance policy for a jury verdict that included the award of treble damages based on the jury’s determination that the insured company had committed civil theft. The coverage opinion addresses a number of interesting issues but what makes the court’s analysis and rulings noteworthy is the fact that the coverage issues arose following a jury verdict, a relatively unusual circumstance, as discussed further below. Judge Robin L. Rosenberg’s March 11, 2015 opinion can be found here.



CR Technologies (CRT) provided Voice over Internet Protocol (VoIP) services to businesses. U.S. Datanet Corporation (Datanet) and its subsidiary USD CLEC (CLEC) provide both VoIP and traditional communications services to customers. In March 2004, CRT and Datanet entered a Rental Agreement pursuant to which Datanet rented CRT’s hardware and software. At the end of the parties’ 42-month agreement, Datanet informed CRT it would not renew the agreement. A dispute then arose over who was entitled to retain possession of the system components. Datanet refused to return the system components to CRT.


CRT initiated a Florida state court lawsuit against Datanet and CLEC alleging breach of contract, conversion, civil theft, tortious interference with an advantageous business relationship, violations of the Florida Deceptive and Unfair Trade Practices Act and negligent misrepresentation. The jury returned a verdict in favor of CRT on all counts except the tortious interference claim. The total amount of the judgment was $644,746, inclusive of treble damages awarded against the defendants and of contractual interest. The judgment explicitly noted that the verdict amount was trebled because the jury found that Datanet and CLEC had committed civil theft.


CRT then sought to enforce its judgment against Datanet’s D&O insurer. The insurer filed an action seeking a declaratory judgment that its policy did not cover the judgment, based as it was on a jury finding of civil theft. CRT filed a cross-claim and third party complaint against the insurer. The parties filed cross motions for summary judgment.


The policy’s definition of Loss provides, among other things, that “Loss” does not include “taxes, fines or penalties imposed by law, the multiple portion of any multiplied damage award, or matters that may be deemed uninsurable under the law pursuant to which this Policy shall be construed.”


The policy’s exclusions included a provision stating that the policy shall not pay any Loss for any Claim:


based upon, arising from, or in any way related to any deliberately fraudulent or criminal act or omission or any willful violation of any law by the Insureds if a judgment or other final adjudication establishes such an act, omission or violation.


The policy’s exclusions also include a separate provision stating that the insurer shall not pay any loss for any Claim:


based upon, arising from, or in any way related to the gaining, in fact, of an personal profit, remuneration, or advantage to which the Insureds are not legally entitled if a judgment or other final adjudication establishes that such a gain did occur.


Finally, the policy’s exclusions also contain yet another provision stating that the insurer shall not pay any loss for any claim:


based upon, arising from, or in any way relating to any liability under any contract or agreement, provided that this exclusion shall not apply to the extent that liability would have been incurred in the absence of such contract or agreement.


The March 11 Ruling

In her March 11 opinion, Judge Rosenberg granted the insurer’s motion for summary judgment and denied CRT’s motion for summary judgment.


In ruling as a matter of law that there is no coverage under the policy for CRT’s judgment against Datanet and CLEC, Judge Rosenberg concluded that the “a Final Judgment for Civil Theft is not a ‘Loss’ as that term is defined” in the insurer’s policy. Citing the CNL Resorts case (about which refer here) and the Seventh Circuit’s opinion in the Level 3 case (here), Judge Rosenberg said that “as a matter of law, ‘Loss’ does not include the ‘restoration of ill-gotten gains.’” She added that “the Final Judgment for civil theft is not insurable as a matter of public policy” under Florida law. Finally she said that the treble damages awarded for civil theft represent “the multiplied portion of a multiplied damage award” which is “expressly excluded from the definition of ‘Loss.’”


Judge Rosenberg then went on to hold that even if the judgment met the policy’s definition of Loss, each of the three exclusions on which the insurer relied nevertheless preclude coverage for the judgment.


First, Judge Rosenberg concluded that coverage for the judgment amount was precluded by the criminal act or willful violation of law exclusion.


The insurer had argued that the jury concluded that Datanet and CLEC had acted with felonious intent to steal CRT’s property and than in any event the jury finding of civil theft was clearly within the criminal act or willful violation exclusion. CRT, by contrast, had argued that the exclusion does not preclude coverage for the portions of the judgment attributable to the causes of action other than the civil theft claim and that the damages awarded in the case had nothing to do with the civil theft claim.


Judge Rosenberg concluded that because a final judgment for civil theft is based upon, arising from or related to a deliberately fraudulent or criminal act or omission or a willful violation of law it “falls squarely within the express language” of the exclusion.


Second, Judge Rosenberg also concluded that coverage for the judgment is precluded by the personal profit or advantage exclusion.


The carrier had argued that the jury’s verdict represented an adjudication that Datanet and CLEC had appropriated CRT’s property for its own use and that the judgment represented a requirement for the companies to pay restitution. CRT argued that the judgment did not establish that the defendant companies had gained a profit or advantage, but only that Datanet had caused CRT to suffer the loss of its property.


Judge Rosenberg found that a final judgment for civil theft is based upon, arising from or related to the gaining of a personal profit, remuneration or advantage to which Datanet and CLEC were not legally entitled. She said that the final judgment “falls squarely within the express language of this exclusion.”


Third, Judge Rosenberg concluded that coverage is barred by the breach of contract exclusion.


The insurer had argued that the underlying action incorporated allegations detailing the contractual relationship and that ultimately the jury found that there was a breach of contract. CRT argued that the exclusion preserves coverage so that the preclusive effect does not apply where liability would have been incurred in the absence of contract. CRT argued that the underlying claim included numerous causes of actin that would have resulted in liability in the absence of contract.


Judge Rosenberg ruled that final judgment for civil theft, which “occurred at the end of a contractual relationship” between Datanet and CRT “falls squarely within the express coverage language” of the contractual liability exclusion.


Finally, Judge Rosenberg concluded that coverage under the Crime Coverage part of the insurer’s policy was not triggered the crime coverage section only reimburses an employer when its employees steal from the employer, but does not indemnify an insured for stealing from others. Judge Rosenberg also concluded that there was no coverage for the judgment under the general liability policy the same insurer had issued to Datanet and CLEC.



There are a number of provisions typically found in management liability insurance policies that can only be triggered if the underlying claim goes all the way to verdict. Obviously, the conduct exclusions, which as worded these days typically contain an adjudication requirement, can only be triggered if there has been a trial or other adjudication. Even the treble damages provision typically found in the definition of Loss is going to be triggered only if a matter goes to trial and verdict. This coverage dispute presents the rare circumstances where these provisions were triggered because the coverage lawsuit arose after the jury had entered its verdict in the underlying claim.


(I should add parenthetically that the determination of coverage issues following a jury trial in the underlying claim may not be as rare as I previously might have assumed. This case is the second instance where I have had occasion recently to open the discussion of a coverage ruling by pointing out that the ruling arose in the relatively unusual context of a post-verdict set of circumstances. The recent prior occasion can be found here.)


It is worth pointing out that the potential post-verdict operation of the various relevant policy provisions is often one of the factors motivating parties to settle a claim before trial . That is, both the claimant in the underlying claim and the insured defendant have an incentive to avoid a trial determination that might trigger a coverage preclusive provision of the insurance policy. In this case, CRT found only after it tried to enforce the judgment against Datanet and CLEC’s insurer that it might have been a little too successful at the trial in the underlying claim. CRT might have had better luck obtaining insurance for the verdict amount (at least prior to trebling) if there had been no jury determination of civil theft – or better yet if it had managed to settle the case before it went to trial.


But given the fact that the jury did reach a verdict in CRT’s favor on the civil theft claim, it comes as little surprise that policy coverage was precluded. It could be anticipated that the carrier’s argument that providing insurance coverage for civil theft is against public policy would get a receptive hearing from the court. Given the jury’s determinations on the issue, it could also be expected that the insurer would seek to preclude coverage under the conduct exclusions, as well.


The one place where I have trouble with Judge Rosenberg’s rulings is with respect to her conclusions concerning the contractual liability exclusion. CRT asserted a number of claims against Datanet and CLEC some of which had nothing to do with the contract and several of which clearly could have resulted in liability in the absence of contract. As I have pointed out previously on this blog (most recently here), I think the way the contractual liability exclusion is worded and applied results in a unnecessarily overbroad and objectionable extension of the exclusion’s preclusive effect.


I have long thought that the most appropriate wording for the exclusion would employ the narrower “for” wording rather than the broader “based upon, arising out of” wording, because the broader wording as interpreted and applied by the courts results in an application of the exclusion that inappropriately results in the swallowing up of the very coverage the policy was designed to provide.


I believe that even where the contractual liability exclusion has the broad preamble, courts should take care to differentiate between claims that relate directly to the contract and claims that relate to other conduct. (For an example of a case where a court took this approach in determining that the exclusion’s preclusive effect does not apply to an alleged intentional misrepresentations that preceded and allegedly induced a contract, refer here.) Or to put it another way, I do not believe it is an appropriate application of the contractual liability exclusion – even an exclusion with the broad preamble – to preclude coverage for all claims merely because there is a transaction involved in the underlying circumstances.


In the end, however, Judge Rosenberg’s ruling with respect to the contractual liability exclusion arguably is not outcome determinative because she found that coverage was independently precluded on a number of other grounds.


I have to say that this is the first time I have run across a case where there actually was an adjudication that civil theft has taken place. I am sure there have been other cases, but this is the first case of which I am aware in which a court considered the application of a D&O insurance policy’s conduct exclusions in the context of a judgment following trial for civil theft. In fact, it is the first case of which I am aware in which a court considered whether public policy precludes coverage for a judgment following a jury verdict for civil theft. Based on the outcome of this case, at least, I think we should all presume that your basic D&O insurance policy does not provide coverage when there has been a liability determination of civil theft.


Readers interested in thinking further about whether or not there should be coverage for the settlement of a claim for “ill-gotten gains” – as opposed to coverage for a judgment on a claim for recovery of ill-gotten gains – will want to review my prior post (here), in which the court determined that coverage was not precluded under a D&O insurance policy for a bank’s settlement of claims for repayment of allegedly excessive overdraft fees.


In Latest Jumbo Merger Suit Settlement, Duke Energy Agrees to Pay $146 Million to Settle Suit Over “Boardroom Coup” Following Progress Energy Merger

Posted in Securities Litigation

dukeenergyOne of the hot topics in the world of corporate and securities litigation in recent years has been the rise of M&A-related litigation. Among the many themes that are part of the discussion of this topic has been the fact that the M&A lawsuits often settle for the defendant company’s agreement to additional disclosures about the merger, with no cash payment to shareholders. The disclosure-only settlements continue to be a concern, but at the same time there recently have been a number of merger-related lawsuit settlements in which there has been very significant cash components.


On March 10, 2015, in the latest of these merger-related lawsuits with a significant cash component, Duke Energy announced that it had reached agreed to pay $146.25 million to settle the consolidated lawsuit filed in the wake of its $26 billion merger in 2012 with Progress Energy. Notably, the consolidated Duke Energy lawsuit was filed as a securities class action lawsuit, by contrast to many of the merger objection lawsuits that have been filed in recent years, which often are filed as shareholder derivative lawsuits. But while the consolidated Duke Energy lawsuit was a securities class action lawsuit rather than a shareholder derivative lawsuit, its settlement is noteworthy in a number of significant respects, as discussed below. The settlement is subject to Court approval.


Duke Energy’s March 10, 2015 press release about the settlement can be found here. The parties’ stipulation of settlement of the lawsuit can be found here. Liz Hoffman’s March 11, 2015 Wall Street Journal article about the settlement can be found here.



The dispute about Duke Energy’s merger with Progress Energy involved the change in management that occurred shortly after the merger closed. When the merger had been proposed to the companies’ shareholders, it had been stated that Bill Johnson, the head of Progress Energy, would be the CEO of the merged company. However, within hours of the merger closing, the board of the combined company voted to make Jim Rogers, the CEO of Duke Energy, the head of the combined company.


This development, which the Wall Street Journal called at the time a “boardroom coup,” proved to be highly controversial. The Journal quoted former Progress Energy directors as saying they would never have approved the deal if they had known what was going to happen with the CEO position. Progress Energy’s former lead director took the extraordinary step of writing a Letter to the Editor of the Wall Street Journal in which he described the post-merger vote to make Rogers the CEO of the combined company “an incredible act of bad faith” with regard to the undertakings in the Merger Agreement and “one of the greatest corporate hijackings in U.S. business history.” He also described it as “the most blatant example of corporate deceit I have witness during a long career on Wall Street and as a director of ten publicly traded companies.”


As detailed here, in July 2012, shareholders filed the first of several securities class action lawsuits against Duke Energy and certain of its directors and officers. Among other things, the plaintiffs’ consolidated complaint alleged that:


the representations made in the Merger Registration Statement and Prospectus Materials regarding Johnson’s role as CEO were materially untrue and misleading, and omitted material facts. Investors were never informed that for months prior to the filing of those materials – and even before the Merger Agreement was signed in January 2011 – Defendants were already discussing amongst themselves purportedly serious and irreconcilable concerns about Johnson and had adopted the view that Johnson’s appointment as CEO was merely a technical requirement of the Merger Agreement necessary to get the deal approved, and that the Duke board could simply get rid of Johnson once the Merger was complete.


The consolidated complaint was filed on behalf of shareholders who purchased or acquired shares of Duke common stock between July 11, 2012 and July 9, 2012, including former Progress Energy shareholders who acquired Duke shares directly in the merger of Duke and Progress.


In its March 10 press release about the settlement of the consolidated lawsuit, Duke Energy stated that it “maintains insurance coverage that would apply to most of the settlement amount.” The press release added that “company shareholders, not customers, would pay the remaining portion.” The press release also stated that the company previously recorded a $26 million reserve for the estimated portion not covered by insurance – which obviously suggests that the company expects insurance to cover around $120 million of the settlement amount.



According to Liz Hoffman’s Wall Street Journal article about the settlement to which I linked above, Rogers stepped down as Duke Energy’s CEO in 2013 as part of a settlement with North Carolina regulators about the “leadership shuffle.”


While the Duke Energy lawsuit was filed in the form of a securities class action, by contrast to many of the plethora of merger objection lawsuits which are filed as shareholders derivative lawsuit, its settlement is the latest in a series of recent very large cash settlements arising out of lawsuits filed by shareholders in the wake of corporate mergers.


The settlement follows just weeks after Leucadia National Corp. agreed in January 2015 to pay $70 million to former Jeffries Group to settle allegations that Leucadia underpaid when it bought the investment bank two years ago.


These settlements in turn follow the $137.5 million settlement in January 2015 over two by Freeport-McMoRan Inc., which I discussed in a prior post, here. These settlements in turn follow the November 2014 settlement of the lawsuit arising out of the acquisition of Activision Blizzard shares from Vivendi, which is discussed here.


The Duke Energy case obviously involved some highly unusual, case-specific facts. But like the other recent cases mentioned in the preceding paragraphs that resulted in significant cash settlements, the Duke Energy case arose out of a merger transaction. Even though the Duke Energy case was filed in the form of a securities class action lawsuit rather than a shareholders derivative lawsuit, the case’s settlement still underscores how merger and acquisition activity can give rise to serious shareholder litigation. All of these recent settlements highlight the fact that while many of the merger related lawsuits are resolved on the basis of a disclosure only settlement, there are certain merger related cases that result in very substantial cash settlements.


One final note about these settlements is that, as I have discussed elsewhere, the cash value of these settlements is being funded in whole or in substantial part by D&O insurance. With the upsurge in recent years of merger-related litigation, the D&O insurance industry has had to get used to the fact that merger-related litigation represents a significant D&O claims frequency risk. With the sudden upsurge in recent months of settlements of merger cases with very significant cash components, the D&O insurance industry is now having to adjust to the fact that these merger-related cases represent a significant severity risk as well.


Class Action Lawsuit with Three- Day Class Period Filed: I think for any of us that follow securities class action litigation ,we are very accustomed to the idea that the length of the class periods identified in the lawsuit complaints vary widely. However, a lawsuit filed earlier this week has a class period with an unusual length – three days.


As discussed in the March 10, 2015 press release (here), plaintiffs’ lawyers have filed a lawsuit in the Southern District of California against Orexigen Therapeutics, Inc. and certain of its directors and officers. The lawsuit purports to be filed on behalf of those who purchased the company’s stock between March 3, 2015 and March 5, 2015, inclusive. (If each trading day is counted and the period is inclusive, that makes a total of three days.)


According to the press release, on March 3, 2015, the company released details of an ongoing interim study, “despite, the complaint alleges, having been previously admonished by the FDA for inappropriately releasing interim study data in the past.” The press release says that the complaint alleges that the company’s share price rose “significantly” on the information in the March 3 press release. Then, the press release states, on March 5, 2015, after the close of business, Forbes Magazine published a report entitled “Top FDA Official Says Orexigen Study Result ‘Unreliable,’ ‘Misleading.” The press release states that the complaint alleges that the price of Orexigen stock “fell substantially” when trading resumed on March 6, 2015.

An Alarming Liability Award Against Not-for-Profit Organization’s Directors and Officers

Posted in Director and Officer Liability

paA question that frequently recurs when I am speaking to directors and officers of non-profit organizations is why – given that their firms have no shareholders – they need to bother with D&O insurance. The reality is that even though officials at non-profit firms don’t have to worry about the possibility of shareholder claims, non-profit officials still face other potential claims from other potential claimants.


These potential liability issues were underscored in a recent decision by the United States Circuit Court of Appeals for the Third Circuit. In a January 26, 2015 opinion in In re Lemington Home for the Aged (here), the appellate court, applying Pennsylvania law, affirmed the jury’s entry of a liability verdict for the benefit of a bankrupt non-profit nursing home’s creditors against the home’s directors and officers, including the entry of punitive damages against the officers. The appellate court reversed the award of punitive damages against the home’s directors.


As discussed in a March 3, 2015 memo from the Cadwalader law firm about the appellate court’s ruling (here), the court’s opinion “provides a cautionary tale for the corporate officers as well as board members of not-for-profit heath care organizations – for the most part, volunteers – that they may be held to the same standards of accountability as those of for-profit, public corporations.”



The Lemington Home had a long history operating a nursing home under a number of prior names going back to 1883. From September 1997 until the Home closed, Defendant Mel Lee Causey acted as the Home’s Administrator and Chief Executive Officers. From December 2002, Defendant James Shealey acted as the Home’s Chief Financial Officer.


Though the Home had a long history, its more recent history involved a significant number of deficiency citations from the Pennsylvania Department of Health. A number of outside consultants recommended that the Home hire qualified staff and outside specialists. A 2001 study funded by a community foundation recommended that that the Home’s board replace its existing administrator with a “qualified, seasoned nursing home administrator.” The community fund provided a grant of over $175,000 to hire a new administrator; however, the board did not act to replace its administrator, and the grant funds were used for other purposes.


In 2004, the Pennsylvania Department of Health, citing the Home’s failure to properly maintain resident’s clinical records as well as lapses of care (which included the Department’s investigations of two patient deaths that occurred in 2004), concluded that the Home’s administrator “lacks the qualifications, the knowledge of the regulations, and the ability to direct staff.” Even though the administrator had by that time transitioned to a part-time status – in violation of Pennsylvania law – the board still did not replace the administrator.


In addition, the Home’s financial administration lacked appropriate processes and controls. Among other things, beginning in November 2003, the Home’s CFO had ceased to maintain a general ledger of accounting records. In addition, by omitting to bill Medicare, the CFO failed to obtain up to $500,000 in payments that were due for patient services.


In January 2005, the Home’s board voted to close the Home. However, the Home’s Chapter 11 petition was not filed until April 13, 2005. During the interim the patient census dropped significantly. In June 2005, the bankruptcy court approved the Home’s closure. It was later revealed that because the Home delayed until September 2005 filing its Monthly Operating Reports for May and June 2005, the Home did not receive nearly $1.4 million in Nursing Home Tax Assessment Payments (an amount, which if it had been paid might have increased the Home’s chances of finding a buyer).


In November 2005, the bankruptcy court authorized the Committee of Unsecured Creditors to file an adversary proceeding against Causey, Shealey and the individual members of the Home’s board. The committee asserted claims for breach of fiduciary duty, breach of the duty of loyalty, and deepening insolvency. The adversary proceeding had a long procedural history that included two prior trips to the Third Circuit.


In February 2013, following a six-day trial, a jury returned a compensatory damages verdict against fifteen of the seventeen defendants, holding the defendants jointly and severally liable for $2.250 million. The jury awarded punitive damages of $1 million against Shealey and $750,000 against Causey, as well as punitive damages of $350,000 against five of the director defendants.


The January 26 Opinion

In a January 26, 2015 opinion written by Judge Thomas I. Vanaskie for a unanimous three-judge panel, the Third Circuit affirmed the jury’s compensatory damages verdict and the award of punitive damages against Shealey and Causey, but vacated the award of punitive damages against the five director defendants.


Pennsylvania statutory law provides that “An officer shall perform his duties as an officer in good faith, in a manner he reasonable believes to be in the best interests of the corporation and with such care, including reasonable inquiry, skill and diligence, as a person of ordinary prudence would use under similar circumstances.”


The appellate court found with respect to Causey that the evidence presented at trial demonstrated that Causey “fell far short of fulfilling these responsibilities.” Throughout her tenure, the Home was out of compliance with state and federal regulations. The Home was repeatedly cited for failing to keep proper documentation. It also appeared that at the time of a patient’s death at the Home, Causey was not working full-time, despite holding the title of Administrator and drawing a full-time salary, and even though Pennsylvania law required the Home to employ a full-time administrator. At trial Causey tried to claim she was in fact working full-time, but when confronted with long-term disability benefits application she had submitted, in which she said she was working only “20 to 24 hours a week” at the Home, she admitted that she was working part-time.


The court also concluded that the jury was presented with sufficient evidence that Shealey breached his duty of care. The jury heard evidence from a consultant that a creditor had hired that Shealey had tried to evade inspection of the Home’s financial records until finally being forced to admit that the records simply didn’t exist, and that the Home had operated without a general ledger since at least June 2004. The testimony also showed that Shealey failed to bill Medicare after August 2004, as a result of which the Home failed to collect at least $500,000.


The appellate court concluded that the evidence supports a finding that the director defendants breached their duty of care by failing to take action to remove Causey and Shealey once the results of their mismanagement became apparent.


The appellate court also found that the Creditors Committee had introduced sufficient evidence to support the jury’s finding that the defendants had “deepened the Home’s insolvency.” (The appellate court had previously predicted that Pennsylvania’s courts would recognize the tort of deepening insolvency.) The Court found, among other things, that the delay in filing the bankruptcy petition after the decision to close the facility resulted in a depletion of the patient census resulted in a “slow death” of the facility’s ability to generate revenue. The board contributed to the facility’s inability to find a buyer by failing to preserve and record the Home’s entitlement to a $1.4 million Nursing Home Assessment Payment. The appellate court also said there was sufficient evidence to support the deepening insolvency verdict against Causey and Shealey, due to the failure to maintain financial records and to recoup Medicare payments that were due.


Finally, while the appellate court concluded that there was insufficient evidence to support the award of punitive damages against the director defendants, “we have no such concerns about the punitive damages assessed against the Officer Defendants.”



It is very difficult to read the appellate court’s opinion without concluding that the Home was badly run for many years and that despite numerous concerns raised over the years, neither the officers nor board did anything to remedy the identified concerns – with tragic consequences for some of the Home’s residents. So to some extent the outcome of this case my simply be a reflection of the truly lamentable factual circumstances.


Just the same, there are a number of important lessons from this case. First and foremost, the case highlights the fact that even though non-profit organizations do not have shareholders, the organizations directors and officers can still face D&O claims – as illustrated here, where the claims against the Home’s former directors and officers were asserted by the Creditor’s Committee for the Home’s bankruptcy estate.


Second, even though an organization is a not-for-profit entity, its directors and officers are still expected to perform their duties in compliance with the applicable standard of care, and can be held accountable if their conduct falls below those standards. As the Cadwalader law firm put it in its memo about this decision, this case shows that “the risk that officers and directors of not-for-profit corporations may be personally liable for breach of fiduciary duty is real.” Moreover, the standard of care against which the non-for-profit entity’s directors and officers’ performance of their duty will be judged is the same standard as that applicable to the directors and officers of for-profit organizations.


Third, the most important job for the board of any organization is to make sure that the organization’s professional day-to-day management personnel are qualified to perform their duties and are indeed actually performing those duties. The board of this organization was informed repeatedly that the Home needed an Administrator that had the qualifications and experience required for the position, yet – even though the incumbent Administrator was working only part-time – the board did not replace the Administrator. Indeed, the organization even received a grant from a community foundation to replace the Administrator, yet the organization made no change and the funds from the grant were spent for other purposes.


Fourth, while many jurisdictions do not recognize or at least have not recognized the tort of deepening insolvency, the Third Circuit’s decision does highlight the fact that directors and officers of non-profit organizations may be held accountable for their actions after their organization has become insolvent. The board may owe duties to the organization’s creditors in addition to their fiduciary duties to the corporation. As the Cadwalader memo put it, “it is critical that entities facing financial challenges be mindful of the interests of all of their constituents in making decisions that impact creditor recoveries.”


One of the lessons of this case is that in general directors and officers of not-for-profit organizations will be held to the same standard of care as directors and officers of for-profit entities. However, at the same time, it is important to keep in mind that many states have adopted statutes providing individuals who serve as directors on nonprofit boards with limited immunity from liability, as discussed here. Whether or not this type of limited director immunity was available under Pennsylvania law for the Home’s directors was not discussed in the Third Circuit’s opinion. It is worth noting that the limited immunity available under these types of state statutes is typically limited to non-profit officials who are not compensated for their duties.

Guest Post: The Key Players in Cybersecurity Investigations

Posted in Cyber Liability

weilOne of the most immediate challenges when a company experiences a data breach is trying to figure out what has happened – how the breach occurred and how serious it is. Determining what has happened is also critical to re-establishing the company’s cybersecurity. In the following guest post Robert F. Carangelo and Paul A. Ferrillo discuss how important it is for a company to have developed a planned data breach response, well before any actual cyber-attack has occurred. They discuss how the involvement of certain key players will help to determine the effectiveness of the response. In particular, they discuss the critical importance of three key players: an experienced outside lawyer, a skilled cybersecurity forensic investigator, and the general counsel. A version of this article previously was published as a Weil client alert.


I would like to thank Robert and Paul for their willingness to publish their guest post on this site. I welcome guest post submissions from responsible authors on topics of interest to this blog’s readers. Please contact me directly if you are interested in submitting a guest post. Here is Robert and Paul’s guest post.



Following detection of a cybersecurity breach or discovery of potential indicators of one, a company will face numerous challenges that must be addressed quickly. The situation can rapidly deteriorate, particularly because at that point in time, it is likely that the hackers have had access to the company’s network for months, if not longer. Additional data exfiltration could occur, surfacing previously undisclosed thefts of customer information or key intellectual property. Depending upon the intrusion, malware or wiperware could further damage both the network and physical infrastructure of a company. These are but a few of the ways that a cyber-breach can evolve from the point of detection, but they highlight the importance of a rapid response and investigation.

Companies need to consider this potential scenario, and the planned response, well in advance of an actual cyber-attack. Key to an effective response are three important actors: an experienced outside lawyer, a skilled cybersecurity forensic investigator, and the general counsel.

In previous articles we have emphasized the need for an incident response plan (IRP) that can be implemented and executed on short notice.[i] Here, we explore the interplay between the roles and responsibilities of a cyber forensic investigator, outside counsel, and the general counsel of the company during the investigation portion of an IRP following a breach. It can be crucial for a company to execute such an investigation in a coordinated and efficient manner, as it and the information it generates will be important when responding to various inquiries, as well as to potential lawsuits.

Role of Outside Counsel

Large companies typically have capable in-house legal staffs that can handle many stages of the investigative process after a cyber-breach is confirmed by the IT department. However, one of the most important reasons why a company should work with an outside lawyer in the event of a cyber-breach is it needs to ensure that it maintains attorney-client privilege and attorney work product protections. Doing so will help minimize issues regarding the capacity in which the in-house lawyers are acting, and will offer the best argument for protecting communications about the results of the data breach investigation, and related communications between the forensic investigators and the company.

Though scenarios will vary based upon the severity of the breach, there are many communications, actions, and potential disclosures that should be considered and coordinated between the company, the forensic investigator, and third-parties.

  1. If criminal conduct is a possibility (especially if the cyber-attack is suspected to have been perpetrated by either a nation-state or cyber-terrorist organization), it may be necessary to quickly contact the FBI and/or the U.S. Secret Service to assist with the investigation. Each has different investigative tools at its disposal to pursue cybercriminals, and one or both may have had experience with the same actor with respect to different targets. The government may have useful information that can assist in not only identifying the full nature of the breach, but also potentially in remediation efforts.[ii]
  2. If insiders are suspected of the theft of important information or funds, it may be necessary for outside counsel to conduct an internal investigation so that the facts of the potential insider theft can be determined.
  3. As is critical in most investigations, the outside lawyer and the forensic investigators must work together to forensically copy network servers and hard drives, secure all evidence necessary to assist with containment and remediation, and help all involved constituencies (law enforcement, regulators, and the public) understand the full extent of the breach.
  4. If personally identifiable information (PII) was stolen, data breach notifications to customers or patients may be necessary under federal and state law. Depending upon the industry, communications may be necessary with one or more regulatory authorities. If confidential personal employee information was hacked, disclosure and communications between the company, its HR department, and its employees likely will be necessary, as well.
  5. Finally, if the breach is substantial enough as to be deemed material under federal securities laws, public disclosure to investors is likely necessary.[iii] Outside counsel may also be helpful in drafting the appropriate disclosures and in responding to inquiries from the SEC and other regulators.

The Role of the Cyber Forensic Investigator

There are scores of cyber forensic investigators in the marketplace for both large and small companies, and many companies have pre-existing relationships with cybersecurity vendors. There are also a number of ways that an investigation should be tailored based upon the initial indicators of compromise that are detected internally, and based upon the size of the company. Below are factors to consider when selecting a cyber forensic investigator:

  1. Experience: There is nothing more important than experience. Today’s major breaches are carried out by sophisticated cybercriminals focused on the wholesale destruction or theft of millions of pieces of customer or patient data. The malware tools used are complex and have likely been masked throughout the breach process. The time-lag before discovery on the network gives hackers a huge head start. The forensic investigator should have major breach experience and also be able to identify and understand the various threat vectors and signatures that could have been used based upon other attacks. While each incident is different, and the choice of a forensic investigator will often depend on the magnitude of the breach, a more expensive (but experienced) vendor may be able to shorten the investigation, remediation, and recovery time necessary to fix the breach.[iv] As noted by one IT commentator, being able to apply analytics sets good cyber forensic investigators apart:

Analytics is about the ability to extract meaning, sort through masses of data, and in patterns and unexpected correlations. It’s not about knowing everything − it’s about finding what is relevant and getting closer to the right elements with the right people. To do that, you need to maintain a level of objectivity; set aside your personal and professional influences and biases and focus on the data. Forensics professionals cannot solely rely on technology to solve problems − they must build analytical skills that are learned and refined by thinking through trial-and-error.[v]

  1. Responsiveness: Building relationships with forensic investigators before a cyber-attack occurs will help achieve two main goals. It will increase the chances that the vendor will be available when needed on short notice, and the chances that it will be able to act faster.
  2. Credibility: Given the technical nature of a cyber-attack, it is necessary to rely heavily on the forensic investigator. It follows, therefore, that vendors with experience and strong references are a safer choice. Additionally, the forensic investigator likely will need to interact with regulators and possibly courts, so finding one with stature is imperative.
  3. User Friendly: Similar to using experts in other complex areas, one of the most important attributes of a good forensic investigator is to be able to translate complicated technical topics into plain English. Often, people who lack technical expertise will be making decisions and taking actions based on information provided by the forensic investigator, so the easier it is to understand the expert, the more informed the decision-makers will be.
  4. Retain the Right Team: When a company is the target of a large-scale cyber-attack, it needs the best forensic investigator possible. However, there are different levels of expertise within a forensic investigation firm, so it is important to ensure that the team that attends the initial meeting with the board and/or general counsel is the same team that will run the investigation. Pay particular attention to the number two person on the team because she likely will be the one carrying the laboring oar.

The Role of the Company’s General Counsel

The company’s general counsel or designated in-house lawyer will manage communications and disclosures that likely will be necessary in the event of a material breach. It is critical that the general counsel is one of the first individuals contacted by IT after there is a confirmed cyber-breach. Working hand-in-hand with the outside counsel, the following responsibilities should be promptly considered by the general counsel:

  1. Managing board and/or audit committee involvement and expectations.
  2. Determining what information was stolen, and if it was customers’ PII, consider disclosure obligations to customers, federal and state regulators, and law enforcement. If employees’ PII was compromised, internal communications to employees and others may be necessary.[vi]
  3. Overseeing an internal fact investigation by outside counsel and forensic investigators, particularly if it is suspected that an employee or former employee may be involved in the alleged breach.
  4. Working with a crisis management/public relations firm to draft appropriate disclosures aimed at reassuring customers and investors that the company has a firm grip on the problem and is resolving it as quickly as possible – especially given the potential for a cyber-attack to damage the company’s reputation with consumers, investors, and other constituencies.
  5. Working with outside counsel on SEC disclosures in the event that the cyber-attack is considered material under the federal securities laws.

Prepare In Advance

Many of the tasks and goals described above should be part of a company’s cyber IRP. By practicing and testing the IRP with all parties involved, real-life execution will run much more smoothly. The better the preparation, the better the response will be.

[i] See “The Importance of a Battle-Tested Incident Response Plan,” available here.

[ii] See Mandia, et al., “Incident Response and Computer Forensics,” (McGraw Hill, 2014), at 115.

[iii] See “CF Disclosure Guidance: Topic No. 2 (Cybersecurity),” Oct. 13, 2011, available here.

[iv] See “FireEye is ‘First in the Door’ on Big Cyberattacks,” available here.

[v] See “Tech Insight: What You Need To Know To Be A Cyber Forensics Pro,” available here.

[vi] See “M-Trends 2015: A View from the Front Lines,” at 5 (discussing rise in data breach disclosures), available here.

Whistleblowing: What Difference Does it Make?

Posted in Whistleblowers

whistlesecIn recent years, one of the favored responses of legislative reformers and regulatory enforcement authorities to financial fraud and other corporate misconduct has been the encouragement of whistleblowing activity. Both the Sarbanes-Oxley and the Dodd-Frank Act contained elaborate provisions designed to encourage and even to reward whistleblowers. There seems to be no question that the provisions have in fact encouraged whistleblowing. But does all of this whistleblowing activity actually produce any benefits? What difference does all of this whistleblowing activity make?


As discussed in a March 4, 2015 post on the Harvard Law School Forum on Corporate Governance and Financial Regulation entitled “The Impact of Whistleblowers on Financial Misrepresentation Enforcement Actions” (here), which in turn described their longer academic paper of the same title (here), four academics have examined the impact of whistleblowing activity on the outcome of regulatory enforcement actions for financial misrepresentation. The four authors are Andrew Call of the Arizona State University School of Accountancy, Gerald Martin of American University Business School, Nathan Sharp of Texas A&M University Accountancy Department, and Jaron Wilde of the University of Iowa Business School.


In order to examine these issues, the authors developed and analyzed a database of 1,133 enforcement actions by the SEC and DoJ from 1978 through 2012 involving allegations of financial misrepresentation. In order to identify whistleblowing activity, the authors obtained information from the Occupational Safety and Health Administration (OSHA), which agency the Sarbanes-Oxley Act tasked with fielding employee complaints of discrimination for blowing the whistle on alleged financial misconduct. The authors identified 934 allegations of financial misconduct in complaints filed with OSHA between 2002 and 2010. The authors also reviewed the enforcement complaints and other related documents to determine if any of the enforcement actions resulted from whistleblowing activity.


Through this process the authors determined that of the 1,133 financial misrepresentation enforcement actions between 1978 and 2012, 145 (or about 12.8%) were associated with at least one whistleblowing complaint.


The authors then developed a set of standards to identify the factors that determine the magnitude of the penalties and sanctions that were imposed in the cases in the database. For example, the factors included such items as the length of the period and magnitude of the financial misrepresentation. Based on this analysis, the authors developed a basis to predict the expected outcome of each case, and then compared this predicted outcome to the actual outcome of the cases in which whistleblowing activity was involved.


Using this approach, the authors identified “an association between whistleblowing involved and outcomes of enforcement actions,” which “suggests whistleblowers have an incremental impact on enforcement outcomes.”


First, the authors concluded that “whistleblowing involvement in an enforcement action is associated with a significant increase in penalties.” The authors concluded that whistleblower involvement increases penalties assessed against forms by an average of $76.96 million and that penalties assessed against employees average $39.29 million more when a whistleblower is involved.


The authors also concluded that in aggregate whistleblowers enabled regulators to obtain judgments (including penalties against both firms and their employees) of $16.86 billion beyond what they would have obtained without whistleblower involvement. The increase in monetary penalties attributable to whistleblower involvement accounts for approximately 56% of the $30.09 billion in penalties assessed against firms and employees with whistleblower involvement and 21% of the $79.46 billion in total penalties assessed in all enforcement actions from 1978 to 2012.


Second, the authors found that employees at targeted firms receive prison sentences that are on average 21.55 months longer than if no whistleblower had been involved.


Third, the authors concluded that these enforcement benefits come at a cost. The authors found that the total duration of an enforcement action increases approximately 10 months (or about 10.9%) with whistleblower involvement, as the involvement of whistleblowers has the effect of prolonging the enforcement process.


The authors also found that the existence of a whistleblower complaint significantly increases the likelihood that a firm will become involved in an enforcement action. Comparing the number of firms named in an enforcement action during the period covered by the enforcement action database to the number of companies listed during that period in the Compustat database, the authors found that the general risk of being involved in an enforcement action was 4.74%. However, when only the companies that were named in a whistleblower reports are considered, and taking into account how many of those companies were involved in an enforcement action, the authors found that the risk of an enforcement action increases to 20.49% — that is, the risk of an enforcement action is 4.78 times greater with a whistleblower complaint.


However, at the same time, the authors found that 520 out of the 654 (79.51%) firms named in at least one whistleblower complaint were not the subject of an enforcement action, “suggesting a large portion of whistleblower complaints either are frivolous, are not sufficiently informative to result in an enforcement action, or slip through the cracks. “ The authors note that the costs associated with these unproductive whistleblower reports likely offset some of the benefits gained through whistleblower involvement in enforcement actions.”


The authors’ extensive database of enforcement actions allowed them to make a number of observations about the enforcement activity during that period. Among other things, the authors concluded that a company executive was named as a respondent in the enforcement actions 84.1% of the time. The CEO is named as a respondent 60.8% of the time, other C-level executives 17.7% of the time, and a non-executive employee is named as a respondent 26.4% of the tie.


The authors also determined that the incidence of enforcement activity varied by industry. The most frequent industries with enforcement actions are Business Equipment (23.0%) of the time, Finance (14.0%), Wholesale, Retail and Services (12.4%), Manufacturing (9.0%) and Healthcare, Medical Equipment and Drugs (8.1%).


Given the disposition that legislators and regulators toward whistleblowing activity, it is reassuring to know that the track record so far seems to suggest that the involvement of a whistleblower seems to produce an improved enforcement outcome.


In addition, given the authors’ conclusion that the involvement of a whistleblower report seem to produce a much greater exposure for the companies named to become involved in an enforcement action, it appears to be the case that in at least some instances the occurrence of whistleblower activity results in the disclosure of at least some financial misconduct that might not otherwise come to light.


However, the authors’ analysis also suggests that the benefits associated with whistleblowing activity come at a cost. The added costs include not only lengthening of the enforcement process when whistleblowers are involved. The costs also include the burdens and expenses associated with the high number of whistleblower reports that do not result in enforcement activity. The authors concluded that fully four out of every five whistleblower reports were not associated with related enforcement activity. These unproductive reports impose costs on regulators and enforcement authorities. There may be no way to measure the aggregate burden associated with these unproductive reports. However, without taking the costs associated with these unproductive reports into account, it may be very hard to reach definitive conclusions whether the incremental benefits associated with the whistleblower activity outweigh the associated burdens. In that same regard, it should also be noted that the unproductive whistleblower reports not only involve burdens and expense for the regulators, they also mean distraction, burden and expense for the companies named in the whistleblower report.


A final question that needs to be asked given the high number of and the indeterminate magnitude of costs associated with unproductive whistleblower reports is whether in the end our social and political predisposition in favor of whistleblowing in fact means that there is less financial fraud. This seems like a question worth asking, because, even if we can’t determine with precision the extent of the burdens associated with the high number of unproductive whistleblower reports, it is clear that our social and political predisposition in favor of whistleblowing comes at a not insignificant cost.


Delaware Legislature Readies to Consider Litigation Reform Bylaw Legislation: As Francis Pileggi discusses in a March 6, 2015 post on his Delaware Corporate and Commercial Litigation Blog (here), the Corporation Law Section of the Delaware State Bar Association has submitted proposed legislation to the Delaware legislature that would limit the ability of corporations to adopt fee-shifting provisions in their charter and bylaws, but also provide additional support for adopting forum selection clauses in those same corporate documents. The proposed legislation can be found here, a memo describing the legislation can be found here, and a document addressing frequently asked questions can be found here.


Pileggi comments that this legislation will be the subject of enormous lobbying on both sides. He adds that “The only certainty about this proposed bill is that it will generate an enormous amount of commentary and discussion. I would not expect a final outcome until the last day of the session on June 30.” He concludes with the comment that “If some legislation is passed that ultimately limits the ability of a corporation to adopt fee-shifting bylaws, an interesting issue will be the impact, if any, that the legislation will have on those companies that already adopted fee-shifting provisions. Generally, there is a prohibition against ex post facto laws.”


Navigating Circuit Split, District Court Finds Omission of Item 303 Disclosure Actionable Under Section 10(b)

Posted in Securities Litigation

minnOne of the more interesting issues that has emerged recently in the securities litigation arena is the question of whether or not the alleged failure to make a disclosure required by Item 303 of Reg. S-K is an actionable omission under Section 10(b) and Rule 10b-5. The Ninth Circuit, in its October 2014 decision in the In re NVIDIA Corp. Securities Litigation (here), held that it is not, but in January 2015, the Second Circuit held in the Stratte-McClure v. Morgan Stanley (here), held that it is.


These two appellate decisions represent a clear split in the federal circuits on the question, leaving the federal district courts to try to sort their way through these issues. In a March 4, 2015 decision in the Tile Shop Holding securities litigation (here), District of Minnesota Judge Ann D. Montgomery followed the Second Circuit’s ruling on the question and held that an alleged failure to make a disclosure under Item 303 can serve as the basis of a Section 10(b) securities claim. The ruling is interesting in a number of other respects as well, as discussed below.



Item 303 of Reg. S-K states in pertinent part that in its periodic reports to the SEC, a company is to “[d]escribe any known trends or uncertainties that have had or that the registrant reasonably expects will have a materially favorable or unfavorable impact” on the company. Guidance provided by the SEC on Item 303 clarifies that disclosure is necessary where a “trend, demand commitment event or uncertainty is both presently known to management and reasonably likely to have material effects on the registrant’s financial conditions or results of operations.”


In its October 2014 decision in In re NVIDIA Corp. Securities Litigation, the Ninth Circuit held that Item 303 does not create a duty to disclose for purposes of Section 10(b). In reaching this decision, the Ninth Circuit relied on language in an earlier opinion written by then-Judge (and now U.S. Supreme Court Justice) Samuel Alito, when he was on the Third Circuit, stating that because the materiality standards for Rule 10b-5 and Item 303 differ significantly, a violation of Item 303 “does not automatically give rise to a material omission under Rule 10b-5.”


In its January 2015 decision in the Morgan Stanley case, the Second Circuit expressed its view that Judge Alito’s language merely suggested, without deciding, that in certain instances a violation of Item 303 could give rise to a material omission. The Second Circuit concluded that the language is consistent with its conclusion that an Item 303 omission can serve as the basis for a Section 10(b) securities fraud claim, but only if the other requirements to state a Section 10(b) claim – such as materiality and scienter – have been met. Ironically, though the Second Circuit held that an Item 303 omission can serve as the basis of a Section 10(b) claim, the appellate court nevertheless affirmed the dismissal of the plaintiff’s Section 10(b) claims, holding that the plaintiff had not adequately alleged scienter.


The Tile Shop Securities Suit 

Tile Shop is a specialty tile retailer. The company went public in August 2012, and conducted secondary offerings in December 2012 and June 2013, in which there were a number of selling shareholders including directors and officers of the company. The company sourced much of its tile product overseas, including from a company in China that the CEO’s brother in law had an ownership interest. The amount of tile product Tile Shop purchased from the Chinese company increased from 8.3 percent in 2011 to 32.2 percent in 2013. In addition to having the ownership in the Chinese tile manufacturer, the brother- in-law also worked for Tile Shop; beginning in 2011 and continuing until 2013, the brother in law was employed as Tile Shop’s purchasing supervisor.


In November 2013, a research analyst published a report identifying the connections between Tile Shop, its CEO and the brother in law and the Chinese supplier. The analyst report also stated that the company’s margins and profits were overstated due to favorable transactions between related parties. The company’s share price dropped 39% on the news. On November 15, 2013, plaintiff shareholders filed the first of several securities complaints filed against the company, certain of its directors and officers, and its offering underwriters. The defendants moved to dismiss.


The March 4, 2015 Order 

In a detailed, 36-page order dated March 4, 2015, Judge Ann D. Montgomery denied in part and granted in part the defendants’ motions to dismiss. Judge Montgomery’s order addresses a number of different substantive legal issues, two of which I touch on below.


First, Judge Montgomery denied in part and granted in part the plaintiffs’ claims under Section 10(b), in which the plaintiffs alleged that Tile Shop’s failure to disclose its dependence on companies controlled by the brother-in-law violated Item 303, by failing to disclose trends or uncertainties that would have a material impact on Tile Shop sales, revenues or income.


In denying the motion in part, Judge Montgomery considered the split between the Ninth and the Second Circuits on the question of whether a failure to make a required disclosure under Item 303 can serve as the basis of a claim under Section 10(b). Judge Montgomery reviewed both appellate courts’ reference to and analysis of Judge Alito’s Third Circuit opinion. She said that she found the Second Circuit’s reasoning “persuasive” and “consistent with” her own reading of the Third Circuit opinion.


However, the Second Circuit had gone on to state in the Morgan Stanley case that a violation of Item 303 can be actionable only if the other requirements to state a Section 10(b) claim – such as materiality and scienter – have been met. Indeed, in the Morgan Stanley case, the appellate court held that the plaintiffs had in fact not sufficiently pled scienter, and the court affirmed the district court’s dismissal of the case.


In the Tile Shop case, Judge Montgomery concluded that the plaintiffs had sufficiently pled materiality. In concluding that failure to disclose the trend of the company’s increasing reliance on the brother-in-law’s tile company was material, Judge Montgomery said that the “trend of consolidating the percentage of product sold to a single entity could have a material effect on Tile Shop’s financial condition if that relationship was somehow compromised.” She added that “given the significant reliance” of Tile Shop on the supplier “a disruption of this relationship would be reasonably likely to impact Tile Shop’s future performance.”


Judge Montgomery also concluded that the allegations of scienter were sufficient as to the CEO and as to the company itself, and accordingly she denied the motion to dismiss the Section 10(b) claims against the CEO and the company. However, she found that the scienter allegations were insufficient as to the other individual director and officer defendants, and she granted the motion to dismiss the plaintiffs’ Section 10(b) claims as to the other individual defendants.


Judge Montgomery also granted the motion to dismiss the plaintiffs’ Section 11 claims based on the June 2013 offering because none of the plaintiffs purchased securities in the June 2013 offering. The plaintiffs attempted to argue that they had standing to assert the claims related to the June 2013 offering, though they purchased no shares in that offering, asserting that because they had standing to assert Section 11 claims related to the December 2012 offering, they also had standing to represent the interests of those who purchase in the June 2013 offering because their claims implicated the same set of concerns. In making this argument, the plaintiffs relied on the Second Circuit’s 2012 decision in NECA-IBEW v. Goldman Sachs, in which the court held that a named plaintiff may have class standing to bring claims related to the residential mortgage-backed certificates that it had not purchased on behalf of absent class members who purchased them.


Judge Montgomery declined to follow what she called the Second Circuit’s “non-precedential position” on the matter, relying instead on a District Court opinion from the Central District of California in the Countrywide case, for the principle that a plaintiff must demonstrate standing for each claim he seeks to press.



When a circuit split exists, the district courts located outside of the circuits that have ruled on the issue have to decide which line of circuit authority to follow. The two issues from Judge Montgomery’s opinion that I discussed above show how district courts must struggle with these issues where there are competing lines of authority. Interestingly, on the Item 303 issue, Judge Montgomery followed the Second Circuit’s reasoning, but on the Section 11 standing issue, Judge Montgomery declined to follow the Second Circuit, preferring not the reasoning of a different circuit court, but rather the reasoning of a district court.


While the general topic of circuit splits is interesting, the split between the Second and Ninth Circuits on the Item 303 issue is particularly interesting. These issues are going to come up in other cases and other district courts outside of the Second and Ninth Circuits will have to wrestle with these issues. At a minimum, under the current state of play, there is the obvious risk of inconsistent outcomes on the issue between the courts in the Second Circuit and the Ninth Circuit. The existence of this type of circuit split is precisely the kind of thing that can, if teed up the right way in a particular case, attract the attention of the U.S. Supreme Court. Indeed, given the existence of the circuit split and the keen interest the Supreme Court has shown over the last eight years or so in taking up securities cases, the Item 303 issue could well wind up in the Supreme Court, perhaps sooner rather than later.


In any event, unless and until the Supreme Court has an opportunity to reconcile the holdings of the Second and Ninth Circuits on this issue, it is going to be increasingly important for companies to be particularly attentive in their periodic reporting documents to highlight company and industry trends and uncertainties, so as to ensure proper disclosure and to try to avoid attracting the unwanted attention of plaintiffs’ lawyers.


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



An Interesting Look at the Characteristics of Insider Traders

Posted in Insider Trading

insidertradingFor the past several years, insider trading has been one of the hottest topics in world of corporate and securities law. The controversy that has followed Second Circuit’s December 2014 dismissal of the insider trading convictions of Todd Newman and Anthony Chiasson ensures that insider trading will continue to be a hot topic for some time to come. But beyond the legal issues surrounding the question of what makes or should make trading on inside information illegal are the even more basic questions about insider trading itself, such as: who is sharing information, what type of information is shared, what is the source of the information and how are the people sharing information related to each other?


These questions are examined in an interesting February 5, 2015 article entitled “Information Networks: Evidence from Illegal Insider Trading Tips” (here) by University of Southern California business school professor Kenneth Ahern. Using a compilation of all insider trading cases filed by the SEC and the DoJ between 2009 and 2013, Professor Ahern examined 183 insider trading networks. Because the case documents are highly detailed, Ahern was able to analyze biographical information and the relationships within the trading networks, as well as the information that was shared and the amount and timing of the trades. The information in the database covered 1,139 insider tips involving 465 events, shared among 622 insiders who made an aggregate of $928 million in illegal profits.


Based on his review of the data, Ahern was able to discern a number of characteristics about the information that was shared and how it was shared.


First, he observed that the insiders share information about certain types of corporate events that have a large effect on share prices. Merger-related events accounted for 51% of the insider tips, followed by earnings-related events (26%). Another major category of events involved clinical trial and regulatory announcements (8.0%) or operational news such as CEO turnover (2.8%)


Next, Ahern determined that trading in advance of these events yielded large returns. On average, trading on inside information earns returns of 34.9% over 21.3 trading days. Clinical trial and drug regulatory announcements generate the largest returns, on average, with gains of 101.2% for positive events and -38.6% for negative events, with an average holding period of just 9.2 days. M&A related tips generated average returns of 43.1% in 30.5 days.


The firms involved in the sample tend to be relatively large firms; the average firm involved had market equity of $10 billion and the median firm’s market equity was $1 billion. Ahern speculates that dollar trading volume of larger firms may be attractive for illegal traders because they are less likely to affect the stock price through the trades. The firms involved in the trades tend to be overweighted toward the high-tech industries.


The insider trading networks involve a wide variety of people. The average insider trader is 43 years old and about 10% of the insiders in the data set are women. In order to understand some of the characteristics of the insiders, Ahern looked that the value of the insiders’ homes as a proxy for wealth. He found that the average insider’s home was worth an estimated $1.1 million in September 2014, and the median value was $656,300, which by comparison to national average and median home values led Ahern to conclude that “the inside traders in the sample tend to be among the nation’s wealthiest people.”


Ahern found that the total amount invested per tippee ranges from a minimum of $4,400 up to a maximum of $375 million. The average total amount invested is $4.3 million and the median amount invested is $226,000. Many of the SEC complaints document how some insider traders sell all of the existing assets in their portfolio and borrow money to concentrate their holdings in the target firm. The median inside traders invests an amount worth 39% of his median home values. On the other hand, the trades tend to be highly profitable. The median investor realized gains of $133,000, and the average investor realizes gains of $2.3 million. Per tip, the median investor gains $72,000.


The most common occupation among inside traders is top executive, with 107 people identified in the database. Of these, 24 are board members and the rest are officers.


Ahern then compared the insiders in the dataset to their neighbors, using public databases to identify the insiders’ next door neighbors. Ahern determined that the insiders are different from their neighbors in many ways. Among other things, he determined that the insiders “have a higher likelihood of owning residential real estate, are more likely to be accountants and attorneys, and [are] significantly less likely to be registered as a Democrat, compared to their neighbors.” He also determined that the “insiders are considerably more likely to have a criminal record compared to their neighbors,” which he interpreted to mean that the insider trading activity was “consistent with other patterns of behavior,” adding that “it seems more likely that the insiders have less respect for the rule of law and are more brazen in their illegal activities than their neighbors.”


With respect to the relationships between the tippers and the tippees, Ahern examined the 461 pairs of tippers and tippees in the sample and determined that 22.6% of the relationships were familial, 34.7% are business-related, 35.1% are friendships, and 21.3% do not have any clear relationships. The pairs in this later category tended to be relationships formed through expert networking firms, where insiders are paid consultants to clients in the expert networking firm. Of business associates, about half of the relationships are between a boss and a subordinate or client. Across the whole sample, 74% of pairs of insiders met before college and 19% met during college. Excluding family members, about 43% met during college.


Insiders are connected in other ways as well. Insiders tend to live close to each other. The median distance between a tipper and tippee is 26 miles. Women are more likely to be tipped by other women. Insiders are more likely to share tips with people who share a common surname ancestry. Ahern also found that as information diffuses away from the original source, top executives and mid-level executives are less likely to send or receive tips, and after three degrees of separation, buy-side managers and analysts account for the majority of the information sharing. The first links in a tip chain are more likely to be friends and family, but as the information diffuses further from the source, business links become more prevalent. People further from the source invest larger amounts, make smaller percentage returns, and earn larger dollar gains.


Using information available from public databases, Ahern constructed a broader network of insiders’ family members and associates, in order to test what he called “counterfactual tippees” as a way of investigating why some people received tips and others do not. He found that insiders tend to share information with people that are closer in age and of the same gender, and are less likely to tip family members compared to non-family members. Using the counterfactual database, Ahern also examined the existence of selection bias in the database (which makes sense, since the database is by definition limited to insiders who were caught). Based on his analysis, Ahern concluded that the sample tends to omit infrequent, opportunistic traders who make smaller investments and share information with family or friends, while the sample comprises traders that are more likely to actually impact the share price: wealth CEOs and fund managers who are likely to be in larger networks and invest larger sums.


Ahern’s paper is interesting but it involves aggregate data and generalizations. Those who prefer more narrative flow and more specific detail will want to read the October 2014 New Yorker article entitled “The Empire of Edge” (here), which details the facts surrounding one of the S.A.C. Capital Advisors insider trading prosecutions.


A March 3, 2015 FT Alphaville blog post about Ahern’s paper can be found here.


Special thanks to a loyal reader for sending me a link to Professor Ahern’s paper.

The New Zealand Edition

Posted in Travel Posts

058aThe D&O Diary continued its South Pacific sojourn over the weekend with a short stop in Auckland, New Zealand’s largest city, for meetings and for a brief look around. Auckland is located on New Zealand’s North Island, about a three-hour plane flight from Sydney. Because Auckland is located just inside the International Date Line, every morning, the kiwis get first crack at the day.


I visited Auckland once before, 29 years ago. The transformation that has come over the city in the interim is remarkable. The city’s population, now over 1.3 million, has nearly doubled. And the city has gone upmarket. Queen Street, at the center of the city’s central business district, is now lined with new glass and steel office buildings. Viaduct Harbor (pictured below), the area where I stayed, is a new development of low rise office buildings and swish nightspots built on former docklands. Thanks to changes in the country’s immigration laws, the face (or perhaps the faces) of the city has changed as well – Auckland has to be one of the most diverse cities on the planet. It has the largest Polynesian population of any city in the world and a huge Asian and southeast Asian population as well.




On the evening of my arrival, I stepped right into an example of the city’s diverse ethnicity. A stroll through the city center took me to Albert Park, where, it turned out, the city’s annual Lantern Festival was taking place. The park was decorated with illuminated displays, and there were musical performances and food carts. The lanterns glowed as the evening gathered and crowds strolled through.








037aOn Friday morning, before my first meeting, I went out to One Tree Hill, a prominent, nearly 600-ft volcanic cone located about a 15-minute cab ride from the city center. The hill’s name in Maori is Maungakiekie. Before European settlement, the hill had served as the location of a Maori pa (or fortification), and the remnants of many of the entrenchments can still be seen on the hillside. Unfortunately, there no longer is a tree on One Tree Hill. The original tree was cut down by a European settler in 1852, and Maori protestors cut down the replacement tree in 2000. The hilltop does afford absolutely fabulous views of Auckland and its surroundings, including Auckland’s two harbors — Waitemata Harbour to the north, which opens east to the Hauraki Gulf (as depicted in the first picture below), and Manukau Harbour to the south, which opens west to the Tasman Sea (second picture below). The views are great, but I have to admit that my primary interest in visiting the hilltop was because of the song, “One Tree Hill,” on U2’s 1987 album, The Joshua Tree. (“A sun so bright it leaves no shadows/ Only scars carved into stone on the face of earth.”) It was cool.







On Friday afternoon, I took a ferry across Waitemata Harbor to Devonport, a pleasant seaside suburb with small shops, cafes and restaurants on the harbor’s north side, to meet some friends for drinks. I arrived early so I took advantage of the opportunity to hike to the top of Mt. Victoria, a nearly 300 ft. volcanic outcropping that affords great views back toward the city center (as reflected in the picture at the top of the post) as well as out beyond the harbor to Hauraki Gulf (see the picture below). At the crest of the hill, there is a retractable gun emplacement. A placard explains that the guns were installed in the 1890s out of concerns over Russian expansion into the South Pacific. Which just shows you how quickly things can change. A pedestrian walkway, the Prince Edward Parade, winds along the harborside back into the town, as shown in the second and third picture below.









 007aWhen I had mentioned to folks back in Sydney that I was going to be stopping in Auckland before heading home, the uniform response was that I had to be sure to visit Waiheke Island. So Saturday morning, I took a 45-minute ferry ride to the island, located out in the Hauraki Gulf. In the ferry dock’s parking lot, I rented a bike. I thought I would be able to cover most of the nearly 12-mile long island. I soon realized that this was a hopeless plan. The island’s rugged terrain quickly wore me out. I also quickly figured out that just about every turning and side road led down to beautiful, shell-covered beaches. The beaches further away from the ferry landing were generally deserted, and each one seemingly more attractive than the one before. In this way, I was drawn further and further along the island’s coastline, only realizing as the afternoon progressed and as the fatigue from pumping up and down the island’s hilly roadways began to accumulate that I was going to have to beat it back to the ferry landing if I wanted to get back to the city before dark. I will say this, the people who told me that I had to visit Waiheke were right.













As it turns out, my visit to Australia and New Zealand this past week coincided with the early part of the World Cricket Cup, which is being played in locations around the two countries through March. On Saturday evening, after I had returned to Auckland from Waiheke Island, I wandered into a bar near my hotel and found that the New Zealand-Australia group stage qualifying match, which had begun earlier in the afternoon at the Eden Park pitch in Auckland, was still underway. Australia had scored only 151 runs, and so New Zealand needed just 152 runs to win, a target that seemed easily within reach, particularly at the point in the proceedings at which I arrived. New Zealand’s run total was quickly mounting and the Black Caps seemed to have the match well in hand. And then the wheels came off. Australian Mitchell Starc, who bowled superbly, claimed a number of quick wickets, and suddenly, with only one wicket remaining but with the Kiwis still six runs short, the contest seemed poised for a dramatic showdown. But New Zealand’s Kane Williamson hit a six to seal victory for New Zealand in a wonderfully tense climax – to put it in terms that Americans would understand, Williamson hit a walk-off home run. I was surrounded by excited, shouting fans, and I participated in the celebration as if I had as much of a right to the celebration as everyone else. The celebratory mood carried out into the warm summer evening, and the crowds strolling along the city’s busy streets as night time gathered had something of a festive air. 


On Sunday, it was time to return to the States, back to home and to work. However, while I was in the South Pacific, I spent a considerable amount of time contemplating the concept of summer in February. I have decided that the idea has merit and warrants further study. 







Cornerstone Research Releases 2014 M&A Litigation Report

Posted in Shareholders Derivative Litigation

cornerstone reserach pdfAccording to the latest report from Cornerstone Research, during 2014, over 90 percent of M&A transactions resulting in at least one lawsuit, but each deal attracted a smaller average number of lawsuits and in fewer jurisdictions than in past years. The report, entitled “Shareholder Litigation Involving Acquisitions of Public Companies: Review of 2014 M&A Litigation” can be found here. Cornerstone Research’s February 25, 2015 press release about the report can be found here.


The research reported in the Cornerstone Research study is generally consistent with the updated research that Professors Cain and Davidoff released earlier this week, as discussed here.


According to the Cornerstone Research report, 93 percent of M&A transactions during 2014 valued at over $100 million were litigated. The report does note that plaintiffs challenged fewer deals valued below $1 billion. 96 percent of deals valued at $1 billion drew at least one lawsuit, but for deals valued under $1 billion, the percentage of deals attracting a lawsuit declined slightly to 89 percent in 2014 from 94 percent in 2013.


By contrast to recent years, the majority of deals (60%) attracted litigation in just one jurisdiction (perhaps, the report speculates, because of the adoption of forum selection bylaws). Just four percent of deals were challenged in more than two courts, the lowest level since 2007. The average number of lawsuits per deal declined from 5.2 in 2013 to 4.5 in 2014. Interestingly, there were still a number of transactions that attracted quite a number of lawsuits; the Fusion-io/San Disk deal attracted 22 lawsuits, and the International Game Technology/GTECH deal attracted 21.


Fewer suits were resolved prior to the deal closing in 2014. Only 59% of lawsuits were resolved before deal close, compared to 74 percent in 2013.


Of the 78 settlements reached in 2014, only six percent provided monetary consideration to shareholders. 80 percent of settlements involved only the provision of additional disclosure.


The D&O Diary Goes Down Under

Posted in Travel Posts

067aThe D&O Diary is on assignment in Australia this week. Here’s what you need to know about Sydney in late February – if you traverse the vast expanse of the Pacific Ocean, fly across the Equator and the International Date Line, and then finally arrive Down Under, when you get there, it is summer. Warm, sunny, beautiful summer. Given that the day before I left home the thermometer on the dashboard of my car read minus 17 degrees Fahrenheit (or minus 27 Celsius as they would say in Australia, as if it would ever get that cold there), the trip to Australia came at a particularly welcome time.


Sydney, Australia’s largest city and financial center, is a modern, busy metropolis. It is also massive. Its population of 4.7 million is larger than that of either Los Angeles of Chicago. At the city’s center is its vast harbor, which Captain Arthur Phillip, who led the famous First Fleet to Australia in 1788, described as “without exception the finest harbor in the world.”




The city’s central business district sits along the harbor’s south shore, as shown above. The beautiful, lush Royal Botanical Gardens sit adjacent to the central business district and lead down to the water’s edge and the famous, iconic Sydney Opera House, which is one of the world’s most distinctive, beautiful and photogenic buildings.






Just west of the Opera House, beyond the Circle Quay, now in the place where the First Fleet landed back in 1788, is the Sydney Harbor Bridge, which crosses the harbor to northern shore. It is possible to cross the bridge on foot. The bridge’s pedestrian footpath affords fabulous views of the city and of the harbor.






This was actually my second trip to Australia, after my first trip there nearly thirty years ago. Just as happened on my prior visit, I found this time that I kept getting lost. Because I have a fair amount of pride in my sense of direction, I found this quite vexing. On my prior visit, I finally figured out the source of my disorientation. It was the sun. It was all wrong. It turns out that in the Southern Hemisphere, the sun passes from east to west through the northern sky (rather than through the southern sky, as happens in the Northern Hemisphere). When facing west, the sun has a right-left trajectory (unlike the left-right trajectory in the Northern Hemisphere). The sun’s position kept steering me in the exact opposite of my intended direction. Despite my prior acquaintance with this phenomenon, I still struggled to avoid getting lost. There is, however, no truth to the rumor that the water in Southern Hemisphere toilets circulate counter-clockwise because of the Coriolis effect.


056aOn the plane on the way over, I read The Fatal Shore, Robert Hughes’s excellent book about the European settlement of Australia. Among other things, Hughes describes how Francis Greenway, the so-called convict architect, working under the direction of the then-governor Laclan Macquarie, designed and directed the construction of the first durable civic architecture in Sydney. Several of the buildings he designed still stand along Macquarie Street, near Hyde Park. One of these buildings, the Hyde Park Barracks, pictured above, is noteworthy not merely because it is an important landmark from the city’s early days, but also because it has a simple, symmetric and utilitarian order that even today seems appropriate for the place.


Thanks to United Airlines, which if it is incompetent it is also at least consistent, I once again had an overseas trip cut short by a day because of mechanically-related flight delays. I also had the pleasure of spending the night last Saturday night sleeping on a bench in a concourse at LAX. So much for the “friendly skies.” As a result of the lost day, I didn’t have nearly as much time to visit Sydney as I would have liked, and as I had intended. (Basically, all of the pictures in this post were taken in the course of one very busy afternoon.)  I had just enough time to be reminded that Sydney is a great place full of friendly people. And best of all, in late February, it is full of warm, summer sunshine.


I would like to thank John Goulios and his colleagues at the DLA Piper law firm for inviting me to participate in their firm’s client event in Sydney. I was delighted to be introduced to so many industry colleagues at the event. (Please see my pictures of the event, below.) I was also delighted to learn how many of them — not just from Sydney, but also from Perth, Brisbane, Melbourne and Auckland – follow The D&O Diary.


More pictures of Sydney:


The lush Botanical Gardens are full of a fascinating array of flora and fauna. The trees and grounds are alive with bird life, including brightly colored lorikeets, white Cockatoos, and the Australian white ibis.










I love maps and signs, because they convey so much about places you might visit. Even a simple road sign suggests so many possibilities. What are the places referred to like? The sign not only points the way, it suggests that you might easily travel there. The world is full of such a vast array of places and possibilities.




In this picture, I demonstrate how to prevent half of a room full of Australians from seeing a powerpoint slide.




Here, I am joined by two of my new friends from Australia, Kathleen Warden of Berkley Insurance Australia in Sydney, and Andrew Quartermaine, of Arthur J. Gallagher in Sydney.




In this picture, I am joined Sophie Devitt of DLA Piper’s Brisbane office.




Here is a picture taken with John Goulios of DLA Piper’s Singapore Office.