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

In a January 18, 2013 order (here), the U.S. Supreme Court granted a writ of certiorari to hear the appeals of three separate petitioners in cases arising out of the Ponzi scheme of R. Allen Stanford. The petitioners are two former law firms for the Stanford International Bank and an insurance brokerage that allegedly was involved in the sale of certificates of deposits for the bank. The petitioners are asking the Supreme Court to decide whether or not the plaintiffs are precluded under the Securities Litigation Uniform Standards Act (“SLUSA”) from asserting state-law class action claims against the three firms. By taking up the case, the Supreme Court will decide important issues about SLUSA’s scope that have divided the lower courts.

Congress enacted SLUSA in 1998 in order to prevent erstwhile securities law claimants from circumventing the restrictions of the Private Securities Litigation Reform Act (PSLRA) by filing their claims in state court under state law. As the Supreme Court said in 2006 in the Dabit case, “To stem the shift from Federal to State courts and to prevent certain State private securities class action lawsuits alleging fraud from being used to frustrate the objectives of the [PSLRA], Congress enacted SLUSA.”

SLUSA precludes most state-law class actions involving a “misrepresentation” made “in connection with the purchase or sale of a covered security.” The lower courts have wrestled with the question of what it required in order to satisfy the “in connection with” requirement and trigger SLUSA preclusion.

In these cases, the investor plaintiffs contend they were misled to believe that the CDs in which they invested were backed by quality securities traded on major exchanges (though it later appeared that the CDs in fact had little or nothing behind them). The defendants moved to dismiss the state law class actions that had been filed against them, arguing that, though CDs themselves were not “covered securities” within the meaning of SLUSA, the state court class action claims were nevertheless precluded under SLUSA because the plaintiffs claimed they were induced to purchase the securities by misrepresentation that the CDs were backed by SLUSA-covered securities.

The district court before which the cases were consolidated granted the defendants’ motions to dismiss and the plaintiffs appealed. In a March 19, 2012 opinion (here), a three-judge panel of the Fifth Circuit reversed the district court, specifically holding that the alleged purchases of covered securities that back the CDs were “only tangentially related to the fraudulent scheme” and therefore that SLUSA does not preclude the plaintiffs from using state class actions to pursue their claims.

In reaching its decision, the Fifth Circuit panel exhaustively reviewed the prior case law in which other Circuit courts had considered the question of what connection between an alleged fraud involving uncovered and a downstream transaction in covered securities is required for SLUSA preclusion to apply. The Fifth Circuit’s review of the case law shows that there are divergent and potentially inconsistent views among the various Circuit courts on this question.

The two defendant law firms and the defendant insurance brokerage firm filed petitions for writ of certiorari to the U.S. Supreme Court. The cert petitions of the Proskauer Rose and Chadbourne & Parke law firms can be found here and here, respectively. The cert petition of the insurance brokerage, Willis of Colorado, Inc., and its related entities and firms, can be found here. (Hat tip to the SCOTUS Blog for the links to the cert petitions.)

In its petition, the Chadbourn & Parke law firm argued that split in authority among the various circuit courts has resulted in inconsistent interpretations and applications of SLUSA preclusion. The firm argued that the Fifth Circuit had adopted an interpretation of the “in connection with” standard that resulted in a determination that SLUSA preclusion did not apply, allowing the case against the firm to go forward, while at the same time rejected a conflicting standard prevailing in the Second, Sixth and Eleventh Circuits that would have resulted in the application of SLUSA preclusion here. The petitioners argued that the Circuit split not only threatened inconsistent outcomes among the Circuits, but it frustrated the very purposes for which Congress enacted SLUSA – that is to establish “national standards” for class actions “involving nationally traded securities.”

The Supreme Court’s consideration of these three consolidated cases promises to be interesting and potentially significant. If nothing else, the consolidated cases involve a high-stakes dispute relating to a high-profile fraud. This consideration alone ensures that the Supreme Court’s consideration of these three consolidated cases will receive significant attention.

On a more basic level, the Supreme Court’s consideration of these issues should resolve the split among the Circuits in their interpretation of the “in connection with” requirement in the SLUSA preclusion provision. Resolving this split should reduce the possibility of different outcomes in different cases based on nothing more than the judicial Circuit in which the different cases were filed.

More importantly, the Supreme Court’s consideration of these issues will help define the scope of SLUSA preclusion in more complex cases where the alleged fraudulent scheme involves a multi-layered transaction. These kinds of questions have been unfortunately common in recent times: for example, the same kinds of questions arose in connection with the Madoff feeder fund suits. (The Courts in the Madoff feeder fund cases concluded that SLUSA preclusion applied.)

In a very important sense, the Supreme Court is just the latest battle in the continuing struggle that first emerged after the enactment of the PSLRA. The struggle involves the efforts of the plaintiffs’ securities bar to try to find ways to circumvent the strict standards that Congress imposed in the PSLRA. The plaintiffs’ lawyers first tried to avoid the PSLRA by pursuing their claims in state law suits to which the PSLRA. To avoid that, Congress enacted SLUSA. In these consolidated cases, the Supreme Court will determine the extent to which plaintiffs pursuing claims against remote actors are or are not subject to the constraints of the PSLRA as well as the subsequent Supreme Court case law interpreting the PSLRA

In their cert petition, Chadbourne Park argues that the plaintiffs’ filed their claims as state law class action precisely for the reason of circumventing Supreme Court case decisions that restricted federal securities law claims against third party advisors, which is precisely the outcome SLUSA was intended to prevent. In making these arguments, the law firm emphasizes that the aiding and abetting claims the plaintiffs are attempting to assert under state law are not allowed under federal law. The Supreme Court’s determination of these consolidated cases will significantly determine the extent to which plaintiffs can pursue state law securities-related claims against third party advisors. The determination matters because of the possibility it presents that the plaintiffs could pursue these state law claims in circumstances in which federal statutory and case law would not permit such claims.

The Supreme Court’s cert grant in these three consolidated cases is just the latest in a series of securities-related disputes that the Court has been willing to take up. The Court already has the Amgen case on its docket this term; the Amgen case has already been argued and the Court’s decision in expected before the end of the current term in June.

It used to be that years would pass between Supreme Court cases considering securities law issues. In the past five or six years, though, the Court has seemed to want to take up several securities cases each term. While the Court’s willingness to take up more securities cases certainly provides great blog fodder, it has made the securities litigation environment more volatile and it has occasionally introduced significant and unanticipated changes (as happened for example with the Supreme Court’s paradigm-shifting opinion in Morrison v. National Australia Bank). In final analysis, that is the real reason it is interesting when the Supreme Court agrees to take up a securities case – you never know for sure what might happen when the Supreme Court makes its determination.

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In the August 2012 issue of Business Law Today, the ABA Business Law Section published an article entitled “Training for Tomorrow: Corporate Counsel Checklist for Supervising Creation/Renewal of D&O Protection Program” (here). The article describes the critical components of a comprehensive executive protection program. A detailed description of the article and an explanation of the process by which the ABA Business Section created and published the checklist can be found in a September 11, 2012 post by Kevin Brady on the Delaware Corporate and Commercial Litigation Blog

The ABA checklist and accompanying commentary emphasizes that there are multiple components of a comprehensive program to protect corporate directors and officers from potential financial and criminal liability. The first element, statutory exculpation, should be incorporated into the company’s certificate or articles of incorporation.

Three additional elements of the program described in the ABA article are:  the right to advancement of defense costs; relief from the duty to repay advances; and indemnity against settlement and judgments. All three of these elements should be address in the company’s corporate by-laws. As the article notes, the changing legal environment poses “significant hurdles” to “making sure that the entity’s by-laws actually provide the maximum rights to advancement and indemnity that the law permits. The article provides a short, useful checklist to be used in reviewing corporate by-laws in order to ensure that the provisions provide the recommended components of executive protection program. Readers of this blog will find this portion of the ABA article particularly useful.

The article also notes that D&O insurance is a critical component of a comprehensive executive protection program. The article also contains a D&O insurance checklist. The list contains many useful items. D&Oinsurance professionals will want to be familiar with the list, as it is possible that their clients, armed with checklist, might expect the insurance professionals to respond to each of the checklist items.

One item that should be added to the list is the critical importance of associating in the D&O insurance placement process an experienced and knowledgeable insurance professional that is qualified to negotiate policy terms and conditions and that is able to make informed recommendations about policy limits and structure. Corporate counsel that want to ensure that their company’s D&O insurance program is state of the marketplace will want to enlist the assistance of a D&O insurance professional that is out in the marketplace every day and that is fully informed about what is available in general and from each of the carriers.

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One of the hottest current topics in the field of D&O insurance is the question of coverage for costs incurred in connection with regulatory investigations. As discussed in the following guest post from Paul Ferrillo, who is Of Counsel and a senior litigator in the Securities Litigation/Corporate Governance Group of Weil Gotshal & Manges, LLP, these issues are likelier to become even more important as the Dodd-Frank whistleblower rules go into effect.

I would like to thank Paul for his willingness to publish his article on this site. (Paul's article previsously appeared in Propery & Casualty 360.) I am interested in publishing guest posts from responsible commentators on topics of interest to readers of this blog. Please contact me directly if you are interested in submitting a guest post for consideration.

Here is Paul’s guest post:

            Though most in-house risk professionals and in –house corporate lawyers do not exactly relish the opportunity to review their company’s directors and officers (“D&O”) liability insurance policy, the passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”), coupled with an increasingly active regulatory environment, should cause all companies (especially smaller ones) to consider the scope and breath of their D&O policies. Particularly important under Dodd-Frank is whether and how their policies will cover internal corporate investigations caused by whistleblowers out to recover a bounty (10 to 30 percent) on potential penalties collected by the SEC in excess of $1 million. Should these sorts of complex internal investigations be covered under the Company’s pre-existing directors and officers liability insurance coverage? Here are the considerations, and here are some potential answers.

            Scope of D&O Coverage for Corporate Investigations – Then and Now

            Before we begin, its probably important to re-emphasize why this question is important. Simply put, corporate investigations set in motion by a whistleblower or regulatory authorities (SEC, DOJ, and/or the states attorney generals), can lead to a whole host of problems for a company and its directors and officers, including: (1) potential fines and penalties, (2) potential criminal repercussions for individuals who are accused of potential wrongdoing, and (3) follow-on civil litigation commenced by the plaintiff’s bar seeking to take advantage of potentially damaging facts that came to light as a result of the investigation.  It also goes without saying that internal corporate investigations are expensive to conduct, including not only the associated legal expenses, but also IT expenses as well, which are occasioned by the need to review email and other soft-copy documents that might be relevant to the investigation. A competently handled investigation where no wrongdoing is found may cause regulators to walk away satisfied that the company “did the right thing.” and will many times will add no fodder to the follow on civil litigation A poorly handled investigation can lead to disastrous consequences for all involved, especially the company who has to ultimately “foot the bill.”

            Prior to 2011, D&O coverage for certain categories of internal corporate investigations was relatively standard in most primary D&O policies. Individual directors and officers were generally covered (depending, of course, upon the primary carrier and policy form in question) for both informal inquiries and requests for information, and civil, criminal, administrative or regulatory investigations commenced by either the issuance of a Target Letter or Wells Notice, or after the service of a subpoena. The company was almost never covered, except when it was named (along with an individual directors and officer) in a “formal”[1] SEC investigation (and then only when the D&O policy at issue specifically allowed for such coverage). No coverage, at all, existed for the Company for responding to “informal” inquiries and requests for information from the SEC.

            The New Threat – More Investigations – More Risk – More Expense

            On May 25, 2011, the SEC adopted final rules implementing the whistleblower provisions of Dodd-Frank. Though these rules are somewhat complex, for the corporate risk professional they can be broken down as follows. Dodd-Frank provides that (1) an eligible individual (e.g. an employee of a company), (2) who “voluntarily” provides the SEC (3) with “original information” about a potential violation about a violation of the federal securities laws, (4) that ultimately leads to a “successful” enforcement action, (5) may be entitled to receive a cash award ranging from 10% to 30% of the total monetary sanctions, in excess of $1 million, recovered by the SEC in a civil or judicial action.[2]

            Importantly, despite the fact that the potential whistleblower might just have easily reported the potential wrongdoing through the company’s own internal reporting and compliance program, the whistleblower provisions of Dodd-Frank do not require him or her to first do so. Instead, the whistleblower may go directly to the SEC in order to be “first in line” to receive the potential bounty. The new rules enacted by the SEC do give the whistleblower an “incentive” to first report internally by (1) allowing him up to 120 days to report such information to the Commission after he or she first reports internally (and still retain her or her place in line to receive the bounty), and (2) allowing for the attribution to the whistleblower who first reports internally all subsequently reported information reported by the Company following its own internal investigation.

            These reporting provisions, along with the monetary incentives of Dodd-Frank present the company at issue with a number of potential challenges: (1) more internal investigations as a result of the clear financial incentives of employees and others to “blow the whistle” (in fact, there are reports already that the SEC has received an increased number of tips (often made with supporting documentation) since the passage of Dodd-Frank[3], (2) the potential need to quickly perform an internal investigation should the whistleblower report to the Company first (knowing that he or she has 120 days to report to the SEC). Indeed it may be in a company’s interest to self-report to the SEC before the SEC contacts it first, and/or (3) in any event, be ready to perform the investigation upon first contact with the SEC should the whistleblower choose to bypass internally reporting procedures.

            Corporate Investigations D&O Coverage Today

            Prior to 2011, companies generally had no insurance mechanism to cover a costly internal investigation triggered by a regulatory inquiry. Today that is not the case. One large insurer has created a stand-alone product that potentially covers a company for a wide variety of potential corporate investigations., whether triggered by internal reporting through a company’s internal compliance program (with subsequent self reporting of a potential securities law violation), or triggered by a direct formal or informal written or telephonic communication with the SEC requesting information, documents or interviews.[4] There are rumors that other companies will soon follow suit and provide similar, if not alternative products or solutions, to cover the costs of internal corporate investigations triggered by regulatory inquiries.

            A stand-alone corporate investigations D&O policy has a clear advantage for many companies seeking to insure for corporate investigations, and a compelling advantage from the stand-point of a director or officer of a public company. Since it is “stand-alone,” monies spent under an “investigations”  policy will not reduce the limits of the company’s pre-existing directors and officers insurance coverage. Simply put, separate dedicated limits for a corporate investigation is the best solution.

            If for cost reasons, a stand-alone product is not affordable, but a carrier agrees to attach or “blend” corporate investigations coverage directly into the primary directors and officers policy, the directors and officers should insist either (1) that company only purchase such coverage with a significant “sublimit,” (meaning that only a portion of the primary policy can be used for a corporate investigation), or (2) purchase much higher D&O limits from a “tower of insurance” perspective, knowing that “on any given Sunday” a complex investigation could eat up millions of dollars of the tower. For many companies, it may be a good idea to consult with an insurance broker or advisor that has a high degree of experience in insuring public companies, as they can often help inform and effectuate some of the corporate investigations D&O insurance strategies laid out above.

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