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

Those eager to try to hold the credit rating agencies responsible for supposedly enabling the subprime mess will undoubtedly be encouraged by a July 8, 2008 SEC Report identifying rating agency “shortcomings.”

The Report, entitled “Summary Report of Issues Identifies in the Commission Staff’s Examinations of Selected Credit Rating Agencies” (here) reflects the SEC’s efforts to “evaluate whether the three leading rating agencies “adhered to their published methodologies for determining ratings and managing conflict of interest.” According to the Commission’s July 8 press release (here), the SEC was “particularly interested in the rating agencies’ policies and practices in rating mortgage-backed securities and the impartiality of their ratings.”

According to a July 8, 2008 CFO.com article about the Report (here), about 50 Commission staffers reviewed more than 100,000 pages of internal records and more than two million E-mail messages, mostly concerning rating activities related to Residential Mortgage Backed Securities (RMBS) and Collateralized Debt Obligations (CDOs) during the period 2002 through 2006. The SEC’s massive review of electronic communications unearthed exchanges that, while not necessarily incriminating, do not reflect well on the overall integrity of the rating process, to say the least.

The SEC’s Report, which does not cite any particular rating agency by name, concludes that the rating agencies “struggled significantly with the increase in the number and complexity of these securities.”

As evidence that the rating agencies struggled with the transaction volume, the Report cites a number of e-mail communications, including one stating that “our staffing issues, of course, make it difficult to justify our fees.”

As evidence that the rating agencies struggled to keep up with the deal complexity, the Report cites another e-mail communication in which an analyst expressed concern that her firm’s model did not capture “half” of the deal’s risk, but that “it could be structured by cows and we would rate it.”

The Report also examines the “issuer pays” conflicts at length. Under this payment approach, the entity that issues the security pays the rating agency for the rating. The Report found that while each of the rating agencies had policies that prohibited rating analysts from discussing fees with the issuers, “these procedures still allowed key participants in the rating process to participate in the fee discussion process.” The Report also found that the rating agencies “do not appear to have taken steps to prevent considerations of market share and other business interests” that “could influence ratings or ratings criteria.”

Along those lines, the SEC found evidence to suggest that analysts were concerned that specific rating actions might affect business or cost market share. The Report quotes one analyst’s email message as stating “I am trying to ascertain whether we can determine at this point if we will suffer any loss of business because of our decision and if so how much.”

The Report also found that there are particular aspects of the RMBS and CDO rating process that may exacerbate some of these “issuer pays” conflicts. For example, the Report noted that the deal “arranger” is “often the primary designer of the deal and as such has more flexibility to adjust the deal structure to obtain the desired credit rating as opposed to managers of non-structured asset classes.”

The high concentration of this business among a very small number of “arrangers,” together with the high profit margins associated with the business, potentially could allow or encourage influence on the use, application and revision of credit rating processes.

The SEC said that it found no evidence that these kinds of considerations affected “rating methodology or models.” However, the Report quoted emails inferentially suggesting that analysts at least turned a blind eye to concerns. One email referring to CDOs as a “monster” and went on to observes that “Let’s hope we are all wealthy and retired by the time this house of cards falters.”

The Report noted a number of other deficiencies, including the lack of disclosure about rating processes; insufficient documentation of process and of deviations from models to adjust ratings; and lagging surveillance in updating previously issued ratings.

As a result of September 2007 congressional action, the rating agencies must now register with the SEC as “nationally recognized statistical rating organizations” (NRSRO). In addition, in June 2008, the SEC issued a set of proposed rules that are designed to address many of the kinds of issues identified in the Report, particularly regarding conflicts of interest, documentation and report transparency. Because the SEC has only been regulating the rating agencies since 2007, it is unclear whether or not the SEC has the authority to file enforcement proceedings against the rating agencies in connection with the conduct described in the report, even if the SEC were otherwise so inclined.

Regulatory processes may well be underway to prevent the recurrence of the kinds of “shortcomings” identified in the Report. The Report also notes a variety of other remedial efforts already underway at the rating agencies themselves. But the Report also catalogs a litany of past practices that clearly may have played a role in the events that led up to the collapse of the subprime mortgage market. The ratings shortcomings apparently accompanied (and, it may be argued, enabled) the flood of mortgage securitizations that contributed to the subprime meltdown.

I recently noted (here) that investors and their counsel are starting to try to hold the rating agencies responsible for their investment losses. These claims may well face formidable obstacles (refer here). But, even though the report does not attribute statements or actions to specific rating agencies or to particular transactions, the tenor and content of the SEC’s Report undoubtedly will encourage those who want to try to hold the rating agencies responsible.

Of course, the SEC was able to muster formidable resources and undertake a massive review of electronic communications while passing the cost along to U.S. taxpayers. Those eager to exploit the same communications in separate civil litigation against the rating agencies may be forced to undertake a massive expense just to try to establish whether or not these or similar communications related to the agency or transaction they have targeted.

A July 9, 2008 Wall Street Journal article discussing the Report can be found here. Bloomberg’s July 8, 2008 article about the Report can be found here.

Auditor Liability Cap Alternative: George Washington Law School Professor Larry Cunningham has an interesting post on the Concurring Opinions blog (here) in which he reiterates his proposal for a market-based solution to manage the potentially ruinous liability exposures of auditors. In the post, Professor Cunningham reviews his suggestion that the audit firms “issue bonds in debt markets to provide a backstop against the big judgment,” paying interest commensurate with the risk. I have previously commented on Professor Cunningham’s proposal here.

In his most recent blog post, Professor Cunningham argues persuasively that the auditor liability cat bonds are “a practical, cost-effective solution to the risk that another large auditing firm could disappear.” He also argues that making auditor liability cat bonds a serious point of public debate would reveal the “true stakes” involved in the auditor liability debate.

Special thanks to Professor Cunningham for the link to the blog post.

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One of the recurring suggestions in would-be reformers' standard litany of proposed changes for litigation relief is the introduction of auditor liability caps. For example, the Committee on Capital Markets Regulation interim report (about which refer here) proposed the “elimination or reduction of gatekeeper litigation, either through a cap on auditor liability or creation of a safe harbor for certain auditor practices.” Similarly, in early 2007, the European Commission launched a study (about which refer here) on “whether there is a need to reform the rules on auditor liability in the EU.”

But while these initiatives are only at the proposal or study phase, the U.K. has moved forward to permit “auditor liability limitation agreements,” under legal provisions that recently went into effect. The newly effective provisions are part of the Companies Act of 2006 (refer here for the Act’s text). The auditor liability limitation provisions are contained in Sections 532 to 538 of the Act, which took effect on April 6, 2008, according to the Act’s implementation timetable (here). For background regarding the Act, refer here.

The Act allows auditors to limit their liability by contract, provided that their client’s shareholders approve. Section 534(1) of the Act allows auditors to limit their liability “in respect of any negligence, default, breach of duty or breach of trust, occurring in the course of an audit of accounts.” The limitation cannot cover more than one financial year and it must be approved by a resolution of shareholders. Under Section 537, the liability limitations are not effective except to the extent they are “fair and reasonable” in the particular circumstances.

The Act itself does not specify the particular kinds of limitations that are allowable nor does it prescribe the form the limitation is to take. However, a working group of the Financial Reporting Council, the supervisory body for U.K. auditors, has proposed “draft guidance” (here) suggesting ways that the limitation agreement might be framed. The FRC guidance document even includes specimen language to be used as a reference in preparing limitation agreements.

The FRC guidance suggests three alternative ways the auditor’s liability might be limited: (a) proportionality, “where the auditor’s liability is limited to his share of the company’s loss, taking into account the liability of others”; (b) fair and reasonable, “where the auditor’s liability is limited to such amount as is fair and reasonable in accordance with Section 537 of the Act”; or (c) monetary cap, “where the auditor’s liability is limited to a particular amount, which is either stated or calculated in some way, e.g.. as a multiple of audit fees.”

The Act’s auditor liability limitation provisions represent an interesting experiment, but it will be even more interesting to see how widespread the acceptance of auditor liability limitations agreements becomes. The Act’s requirements themselves may deter widespread adoption, particularly the one-year time limitation and the requirement for shareholder approval. One might also conjecture that there might be some stigma associated with a company’s agreement to limit its auditor’s liability, to the extent the existence of an agreement is interpreted to suggest that the only way the company could procure an auditor’s services was by granting the auditor a liability limitation. There is also legal uncertainty surrounding such issues as the extraterritorial effect of any limitations, which may be of particular concern for auditors of companies that have shareholders, creditors or other business partners outside the U.K.

It is probably also relevant that the auditor liability provisions were adopted as part of the Companies Act, which also contains provisions defining directors’ duties and incorporating new statutory procedures for bringing claims against directors. One wonders whether a company’s directors, newly sensitized to their duties and potential litigation risks, will be comfortable relieving their auditors of liability to the company for negligence or other misconduct. Even though the liability limitation has to be approved by shareholders, you can imagine the second-guessing and accusations that might surface if problems do arise later.

Within its draft guidance document, the FRC anticipates that companies may well wrestle with the question whether (or even why) they should agree to limit their auditor’s liability, and expressly observes that directors “will wish to establish that it is in the company’s interest to enter into a liability limitation agreement.” The guidance document does not attempt to suggest what interest a company would have in limiting its auditor’s liability.

Along with the question of what the take-up of the limitation agreement will be for U.K. companies is the question whether other jurisdictions will adopt the U.K. approach or similar auditor liability limitation provisions. A March 2006 report by Michael Gass and Ashwani Kochlar of Edwards Angell Palmer & Dodge entitled “U.K. Gives Auditor Liability Agreements a Greenlight, But U.S. is Unlikely to Do the Same” (same) takes a look at the new U.K. provisions and considers the possibilities for reform efforts in the U.S. The report concludes that current U.S. reform efforts are “ill-timed” and that given the turmoil in the financial markets, “garnering attention and support to adopt proposals … will be challenging” – unless one of the Big Four accounting firms implodes, in which case “all bets are off.”

The CorporateCounsel.net Blog also has an interesting post here discussing the newly effective U.K. provisions and expressing skepticism for the likelihood of auditor liability reform in the U.S. anytime soon.

Readers interested in the topic of auditor liability caps may want to refer back to my earlier post, here, in which I discuss the very interesting alternative proposal of George Washington University law professor Lawrence Cunningham. Professor Cunningham suggests having the audit firms issue bonds to the capital markets as a way to provide financial protection for their liability risks. 

U.K. Government to Appeal BAE Systems Ruling: In a recent post (here), I reviewed the April 10, 2008 decision by the U.K.’s High Court of Justice against the British government’s decision to terminate the investigation of alleged bribery involving BAE Systems in connection with a Saudi arms deal.

On April 22, 2008, Transparency International, on its own behalf as well as on behalf of several other organizations, wrote (here) to the U.K. Attorney General “urging the government not to appeal the judgment.” The letter stated that “halting the investigation has caused untold damage, both to the reputation of the U.K. and to global efforts to improve governance and combat corruption.” The letter also urged that the action to drop the investigation has “reduced [the U.K.’s] standing among its peers” in the OECD, and any move by the government to appeal “would compound the reputational damage to the U.K.” and would undermine the implementation of the United Nations Convention Against Corruption.

Nevertheless, on April 22, 2008, the Serious Fraud Office announced (here) that it will “seek permission to appeal to the House of Lords” against the lower court’s April 10 judgment. The SFO’s announcement quoted the current SFO director as saying that the April 10 judgment “raises principles of general public importance affecting, among other things, the independence of prosecutors and the role of the court in reviewing a prosecutor’s evaluation of the public interest in a case like this.”

It is very hard to argue that the U.K.’s efforts to suppress the BAE Systems investigation will not undermine its efforts elsewhere to fight corrupt practices. The unmistakable message is that the U.K. only cares about small scale corruption involving the less powerful, those whom the U.K. feels it can safely push around; but that these impediments can be overcome if the bribe is large enough and the corrupt official powerful enough. Nothing could do more to breed cynicism over anticorruption efforts that for the U.K. government to successfully suppress this investigation.

Hat tip to the Sox First blog (here) for the links to the Transparency International and Serious Fraud Office announcements.

Time Out for an Idol Thought: I was delighted to learn that my former partner from the Ross, Dixon & Bell law firm, Bill Hopkins, now apparently known by his nom de plume Will Hopkins, is a finalist in the American Idol songwriting competition. The WSJ.com Law Blog has an excellent interview of Bill, er, Will, here.

Hopkins, we shall call him, left active law practice to try to write music about the same time I left the law firm to become involved on the business side of insurance. Everyone must follow their own muse, I suppose.

Speakers' Corner: On Monday April 28, 2008, I will be speaking as a panelist at the C5 Conference on Securities Litigation in London, on a panel entitled "Liability Never Goes Away:Managing Risk and Tackling D&O Liability" The conference features a number of very distinguished speakers. A copy of the seminar materials, including conference agenda, can be found here. If you are attending the conference, I hope you will make it a point to greet me.

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