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

If the lawsuit filed on February 7, 2011 in the Northern District of Georgia is any indication, the FDIC’s efforts to pursue liability claims will not only include suits against the directors and officers of failed banks, but will also include in at least some instances the failed institutions’ outside law firms. The FDIC’s actions so far raise the question of how extensive the FDIC’s pursuit of these kinds of claims ultimately may prove to be.

As reflected in J. Scott Trubey’s February 8, 2010 Atlanta Journal Constitution article (here), the FDIC’s recent suit was filed against a Henry County, Georgia law firm, Smith Welch & Brittain, and J. Mark Brittain, in connection with the firm’s legal services on behalf of Neighborhood, Community Bank, a Newnan, Georgia bank that failed on June 26, 2009.

In its complaint, a copy of which can be found here, the FDIC as receiver for the failed bank seeks to recover damages "in excess of $6 million" plus legal fees, based on the defendants’ alleged legal malpractice in connection with the law firm’s handling of certain loans the bank made to a local real estate developer between 2005 and 2007. The complaint alleges that the bank hired the firm to process the documents for the bank’s loans to the developer, who allegedly was also a client of the law firm. The suit alleges the developer of obtaining loans based on inflated property values. The individual defendant allegedly facilitated this, among other things, by creating two sets of settlement statements.

The lawsuit filed Monday is the third liability suit filed in Georgia against a failed bank’s outside law firm. As reflected in press reports (here, scroll down), on October 19, 2010, the FDIC filed two separate lawsuits in the Northern District of Georgia against outside law firms for the failed Integrity Bank of Alpharetta, Georgia. (In January, the FDIC filed a separate suit against former directors and officers of Integrity Bank, as reflected here.) The defendants in one of these two lawsuits also include a title insurance company.

The FDIC has made no secret of the fact that it may pursue claims against the failed banks’ gatekeepers – not just banks’ former directors and officers, but also, according to the FDIC’s website, the banks’ "attorneys, accountants, appraisers, brokers, or others." The website also states that as of February 7, 2011, the FDIC has "authorized seven fidelity bond, attorney malpractice, and appraiser malpractice lawsuits." which presumably includes the suits described above. (As detailed here, the FDIC has to date filed four lawsuits against the directors and officers of failed banks as part of the current wave of bank failures.)

The FDIC’s pursuit of claims against lawyers and other outside professionals is entirely consistent with the actions the agency took during the FDIC crisis. According to NERA Economic Consulting’s August 2010 report about failed bank litigation, in connection with the 2,744 institutions that failed as part of the S&L crisis, the FDIC (or the Resolution Trust Corporation) filed a total of 205 legal malpractice claims and 139 accounting malpractice claims (about 7.5% and 5% of failed banks, respectively).

The outcome of the FDIC’s professional liability claims during the S&L crisis, more than anything else, explain the FDIC’s present actions to pursue these claims in connection with the current round of bank failures. According to the NERA report, as a result of the FDIC’s S&L crisis legal malpractice claims, the FDIC recovered $500 million, and as a result of its accounting malpractice claims, the FDIC recovered $1.1 billion. (By way of contrast, the FDIC’s S&L crisis related claims against the former directors and officers of failed banks resulted in recoveries of $1.3 billion). Given this track record, it is hardly surprising that the FDIC is pursing claims of the type described above now.

One question that all of this information raises is whether the FDIC will as part of the current round of bank failures pursue claims against the failed institutions’ accountants, as the FDIC did during the S&L crisis. The FDIC’s website does not specify whether or not the agency’s board has so far authorized any claims against accountants or accounting firms.

Thought the FDIC has not yet pursued (or indeed, apparently, authorized) claims against the accounting firms of failed banks, it may only be a matter of time until these claims emerge, at least according to a February 8, 2011 Legal Intelligencer article entitled "FDIC Professional Liability Group Set to Pursue Audit Firms" (here). The article lays out the legal theories on which the FDIC is likely to proceed in its claims against outside accounting firms, and also reviews the firms’ likely defenses.

Though there have only been a few legal malpractice claims to date and as yet no accounting malpractice claims, this process has really only just gotten started. The FDIC’s website describes an 18 month process that precedes the authorization for the filing of these types of claims. Indeed, the lawsuits discussed above were filed nearly two years after the failure of the related institution.. Given that the current bank failure wave really started to gain momentum in the second half of 2009, it seems likely that as this year progresses – and on into 2012 – we could be seeing a steadily growing number of these types of gatekeeper claims.

The fact that the first attorney malpractice claims were filed in Georgia may simply be a reflection of the fact that as part of the current found of bank failures, more banks have failed in Georgia than in any other state. Of the 336 banks that failed between January 1, 2008 and February 4, 2011, 51 have been located in Georgia (including four of the fourteen banks that have failed in 2011).

Special thanks to a loyal reader for providing a link to the Legal Intelligencer article.

Law Firm Memo Round Up: Among the long list of law firm memos that arrived in my inbox this past week were a number of noteworthy items. First, Jenner & Block attorney Lorelie Masters and her colleague Brian Scarbrough have a February 7, 2011 Law.com article entitled "5 Key Lessons from Stanford D&O Ruling" (here), which analyzes the implications of the Southern District of Texas’s October 13, 2010 ruling in the D&O insurance coverage case involving Allen Stanford. The article highlights the difficulties that that can arise from "in fact" wording in D&O insurance policy exclusions.

Second, the Lowenstein Sandler law firm has published a February 2011 memo entitled "Residential Mortgage-Backed Securities Litigation: 2010 Survey" (here), contains a helpful summary of the court rulings in securities lawsuits involving RMBS, and also includes a detailed description of a long list of significant cases.

Finally, the Simpson Thacher law firm’s January 2011 "Securities Law Alert" (here) contains a helpful review of recent significant securities law developments, including the district courts’ continuing application of the U.S. Supreme Court’s decision in Morrison v. National Australia Bank. The memo includes a detailed list of the cases to watch in 2011, including a description of the key cases currently before the U.S. Supreme Court.

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New York Attorney General Andrew Cuomo’s December 21, 2010 filing of a civil fraud lawsuit against Ernst & Young in connection with the audit firm’s services to Lehman Brothers has captured headlines in business pages around the world. The complaint itself, which can be found here, raises some serious allegations. But the complaint also raises a number of interesting questions, as discussed below. The NYAG’s December 21, 2010 press release about the lawsuit can be found here.

The Complaint

The 32-page complaint alleges that between 2001 and September 2008, E&Y "facilitated" Lehman Brothers’ "massive accounting fraud." The complaint alleges that during that period E&Y earned over $150 million in compensation from Lehman, which allegedly was one of E&Y’s largest clients.

The complaint alleges that Lehman manipulated its balance sheet through quarter-end sales of billions of dollars of fixed-income securities to European banks, with the express understanding that the Lehman would repurchase the securities days later. Lehman’s use of these transactions, know as Repo 105 transactions, allowed Lehman to mask its balance sheet leverage. The scale of these transactions grew as Lehman’s financial condition deteriorated in 2007 and 2008.

The complaint alleges that E&Y was aware of Lehman’s use of these transactions, yet approved Lehman’s use of financial statements that did not disclose the existence of the transactions or their effect on Lehman’s balance sheet. These actions, the complaint alleges, "directly facilitated a major accounting fraud, and helped mislead the public."

The complaint alleges that these actions by E&Y violated New York’s Martin Act. The complaint seeks to compel E&Y to repay the fees it earned from Lehman as well as investor damages.

Discussion

There are a number of very interesting things about the NYAG’s complaint against E&Y.

The first is that the only defendant in the lawsuit is E&Y itself. There are no other individuals or entities names as defendants.

On the one hand, it is hardly a surprise that a governmental authority has decided to pursue a regulatory claim against E&Y, in light of the March 2010 report by the Lehman Brothers bankruptcy examiner Anton Valukas (about which refer here). In his report, Valukas had concluded "there are colorable claims" against E&Y for its "failure to question and challenge improper or inadequate disclosures." Given the bankruptcy examiner’s conclusions it seemed probable that there might eventually be some kind of regulatory action taken against E&Y.

On the other hand, the bankruptcy examiner’s report not only concluded that there are "colorable claims" against E&Y, but also concluded that there are "colorable claims" against the senior Lehman officials who "oversaw and certified the misleading financial statements," including Lehman’s CEO Richard Fuld and its CFOs, Christopher O’Meara, Erin Callan and Ian Lowitt. Moreover, the NYAG’s complaint expressly refers to other financial executives at Lehman who were involved in the company’s use of the Repo 105 transactions.

The NYAG’s complaint does not name any of these individuals as defendants. Indeed, one of the very curious aspects about the NYAG’s complaint is that it is virtually silent about the role or involvement of the most senior Lehman officials in the Repo 105 transaction; the individuals referred to by name in the complaint are by and large not the most senior executives.

And just as the complaint names no Lehman executives as defendants, the complaint also names no E&Y-related individuals as defendants. The sole defendant is E&Y itself, even though the individual E&Y audit partners responsible for Lehman’s audit and financial reporting are identified by name in the NYAG complaint. Yet it is the audit firm itself that is named as defendant, not the individuals.

The complaint’s firm-level focus is all the more interesting as allegations in the complaint do not seem to suggest that the decision to allow Lehman the accounting treatment it received was made at a firm-wide level or that anyone at E&Y other than the specific individual audit partners were aware of Lehman’s use and reporting of the Repo 105 transactions.

Setting aside the question of who been sued, there is also the question of the timing of the filing of this complaint. The complaint was filed by New York’s departing AG, Andrew Cuomo, who is just days away from taking up his duties as New York’s incoming Governor. Of course, it was his deputies and assistants who prepared and filed the complaint, but the timing of their actions means that this case will shortly become the responsibility of the incoming NYAG Eric Schneiderman.

Given that the incoming AG will be responsible for the case, it seems odd that he was not allowed control over its filing. On the other hand, under the heading of media relations, it may not be surprising that the outgoing AG wanted to make sure that everybody knew this complaint was filed on his watch.

Another question that combines these questions of targets and timing is the question of sequencing. The sequencing issue has two aspects – the first is why the NYAG has proceeded first against E&Y without at the same time or first going against any company officials. The second issue is the question of why the NYAG’s office is proceeding forward in advance of any action by the federal regulators.

The NYAG may be proceeding first against E&Y for tactical reasons, as a way to secure a settlement and/or the firm’s cooperation in connection with a later action against the corporate officials. Peter Lattman reported on December 20, 2010 on the Dealbook blog (here) that E&Y and the NYAG’s office have been in settlement negotiations. The complaint may simply represent negotiations in another form.

As for the NYAG’s moves ahead of the federal regulators, Lattman speculates that the action may in fact spur the SEC or the DoJ to act – which may or may not have been an intended consequence of the move.

But the most interesting question of all is – what will happen next? Will E&Y reach a settlement with the incoming NYAG? Will the NYAG file a separate action against senior Lehman officials? Will the SEC or the DoJ now take action, either against E&Y or former Lehman officials?

Whatever else might be said about the NYAG’s complaint, its very presence begs the question why there has yet been no federal regulatory action related to Lehman, a question further highlighted by the bankruptcy examiner’s report. My own view of the reason the federal regulators have not yet acted is that they know all too well that the Lehman collapse is the highest profile event related to the credit crisis.

Given that high profile, they know they can’t take any chance that their Lehman-related enforcement actions might fail. The unacceptable consequences (to the federal regulators) of a failed regulatory action are compelling them to build the most durable case they think they can construct before proceeding. I still think it is a question of when, nor if, the federal regulators will initiate their own Lehman-related enforcement actions.

Assuming for the sake of argument that the federal regulators will eventually launch their own Lehman action, it will be interesting to see if the federal action will target E&Y. Francine McKenna suggests on her Accounting Watchdog blog on the Forbes website (here), that when it comes to pursuing the accountants, the feds are all too happy to have the NYAG do the "dirty work."

For the record, I disagree with the media voices trying to suggest this is the "beginning of the end" of E&Y. This is not a criminal case of the kind that killed Arthur Anderson. This is a civil action. E&Y has taken a massive reputational hit and it likely will  have to pay substantial amounts to extricate itself from this case. But the firm's continued existence is in no danger from this case.

Susan Beck has an interesting December 21, 2010 article on the Am Law Litigation Daily (here) about the defenses that E&Y has raised to similar allegations in investor litigation relating to the Lehman collapse.

"Year in Review" Webcast: On December 29, 2010 at 1 p.m. I will be participating in a free webcast sponsored by the Securities Docket, entitled "2010 Year in Review: Securities Enforcement, Litigation & Compliance."

The panel, which will include Compliance Week editor Matt Kelly, Francine McKenna (re: The Auditors) , Mike Koehler (aka the "FCPA Professor"), Francis Pileggi (Delaware corporate law guru), Tracy Coenen (The Fraud Files), Lyle Roberts (The 10b-5 Daily) and Securities Docket’s Bruce Carton, will look back at 2010′s most significant events and trends in the areas of corporate compliance, auditor issues, the Foreign Corrupt Practices Act, Delaware corporate law, D&O insurance issues, white collar fraud issues, securities class actions and SEC enforcement.

For further information and to register, please visit the Securities Docket webinsar webpage, here.

Season’s Greetings: Over the next few days, The D&O Diary will be taking a short holiday break. We will resume our normal publication schedule after the New Year. In the meantime, we would like to thank everyone for their support this past year and wish everyone a healthy and happy holiday season.

As our final holiday gesture, we would like to share this video (which has quickly gone viral) of the flash-mob-in-the-mall performance of The Hallelujah Chorus from Handel’s Messiah. Apparently the flash mob performance of this work has become quite the phenomenon this holiday season, to the point that a Sacramento choir’s December 20, 2010 attempt to stage its own flash mob scene resulted in a mall’s closure, as reported here.

Fortunately, the performance in this video reflects a more peaceful scene. Happy Holidays.

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In the latest twist in the long-running options backdating saga, and in what appears to be a significant milestone in the options backdating-related gatekeeper claims, on June 15, 2009, Vitesse Semiconductor announced (here) that it had reached a settlement with its former auditor, KPMG LLP, in connection with the option backdating related allegations. In the settlement KPMG agreed to pay $22.5 million and to forgive past indebtedness.

As discussed at greater length here, in June 2007,Vitesse sued KPMG in Los Angeles County Superior Court alleging that KPMG had been negligent in auditing the company’s stock option grants and financial statements during the years 1994 to 2000. Vitesse later amended the complaint to include the years 2001 to 2004.

Vitesse itself had been the subject of an options backdating-related securities class action lawsuit in the Central District of California, as described here. Vitesse settled that lawsuit for a payment $10.2 million in cash, $8.75 million of which came from the company’s D&O insurance carrier, and the balance in payments from individual defendants. The settlement also included the transfer of shares of Vitesse stock from Vitesse and from the individual defendants.

The plaintiffs in the options backdating securities lawsuit had also sued KPMG and as reflected here, on June 16, 2008, the parties to the securities lawsuit filed a stipulation of settlement in which KPMG agreed to contribute $7.750 million toward the class settlement.

KPMG’s recent $22.5 million settlement of Vitesse’s own lawsuit is in addition to KPMG’s separate $7.750 million contribution to the settlement of the securities class action lawsuit.

As I recently noted (here), the options backdating securities class action lawsuits themselves appear to be winding down, but until word circulated of KPMG’s settlement with Vitesse, I had not heard of the resolution of any cases that companies themselves had filed against their outside professional advisors.

Even if there were prior outside gatekeeper settlements that I missed, the KPMG settlement with Vitesse has to be the most significant settlement between an outside gatekeeper and a company with respect to the options backdating scandal. It will be interesting to see whether the final stage of the options backdating saga includes further significant gatekeeper claim resolutions. Given the magnitude of the KPMG settlement, it would certainly seem that there could be other significant settlements and perhaps even the assertion of additional claims.

I would be very interested to know if readers are aware of the resolution of any other cases that companies have filed against their outside professionals in connection with the options backdating scandal.

As noted here, KPMG is also the subject of a trustee’s claim in connection with the New Century Financial Corp. bankruptcy proceeding. KPMG also remains a defendant in the New Century subprime-related securities class action lawsuit, after its motion to dismiss in that case was denied, as discussed here.

How Will GM Sell Cars Now?: General Motors certainly faces a daunting challenge trying to sell cars as a bankrupt company. I have posted a video link below of an irreverent but particularly funny take on what a bankrupt GM’s ads might look like. The spoof ad does a great job ripping conventional car ad clichés, which clearly won’t work now (if they ever did).

Hat tip to the Planet Money blog for the link to the video. Warning, the ad contains language some might consider offensive.

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