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

Though many include the rating agencies among the list of culprits that contributed to the global financial crisis, the rating agencies have up until now largely dodged attempts to hold them liable. While there have been a small number of cases (refer for example here) where courts have denied the motions of rating agencies to dismiss claims that had been filed against them, those few cases have not (or least not yet) resulted in the imposition of liability against the rating agencies.

However, in a gargantuan September 5, 2012 opinion that appears to represent the first imposition of liability on a rating agency in a case arising out of the financial crisis,, an Australian Judge that ruled that S&P’s AAA rating of a complex financial instruments was “misleading and deceptive” and “involved negligent misrepresentations” and therefore that S&P was liable to twelve local Australian governments that purchased the investments. The 1,459 page ruling by Federal Court Justice Jayne Jagot can be found here. A November 5, 2012 Bloomberg news article describing the ruling can be found here.

The financial instruments in question were structured financial product known as a constant proportion debt obligation (CPDO), which one witness in the case described as “grotesquely complicated” (a description that Judge Jagot affirmed to be  “accurate”). The CPDO structure involved a special purpose vehicle that issued notes allowing investors to invest in the CPDO’s performance. The CPDO was a complex and highly leveraged vehicle that would make or lose money through notional credit default swap (CDS) contracts referencing two CDS indices. (Got that? Good.)

The CPDO was created in April 2006 by ABN AMRO, which had determined that in order to obtain a AAA rating, the rating model needed to show a very low likelihood of default (less that 0.728%). ABN AMRO determined what model inputs were needed in order to produce a determination that the instrument’s likelihood of default was within the desired range. According to Judge Jagot’s opinion, ABM AMRO convinced S&P to use the these desired inputs, even though ABN AMRO had reason to know that at least some of the inputs did not correspond to known marketplace conditions. Judge Jagot found that S&P used these inputs even though it could have determined on its own that at least some of the inputs did not correspond to marketplace conditions.

Thereafter, ABN AMRO created and sold additional versions of the CDO, including the Rembrandt 2006-2 CPDO and Rembrandt 2006-3 CPDO. S&P gave these later financial instruments the same AAA rating using the same methodology. Judge Jagot found that S&P gave these later offerings the same AAA rating and using the same methodology even though during the period between these two subsequent offerings a number of questions had been asked internally within S&P about the methodology (Internal S&P emails from this time period and cited by Judge Jagot in her opinion contain statements asking whether there was “a crisis in CPDO land” and asking whether the rating agency had been “bulldozed” by ABN AMRO.)

In late 2006 and early 2007, the Local Government Financial Services Pty (PGFS), an authorized deposit-taking institution organized by and actin g on behalf of Australian local governments (“councils”), purchased a total of A$40 milli0on of Rembrandt 2006-3 CPDO. Between November 2006 and June 2007, a number of councils in New South Wales purchased a total of A$16 million of these CPDO notes from LGFS, which kept the remainder of notes it had purchased on its own balance sheet.

As 2007 progressed, the global financial crisis began to unfold, which, among many other things, caused spreads to widen between the instruments credit default swaps and the referenced CDS indices. As the spreads widened, S&P downgraded the notes and the value of the notes declined substantially. LGFS sold the notes it continued to hold for a principal loss of $16 million. The various local councils cashed out in October 2008, receiving back less than 10% of the capital they had invested.

Judge Jagot found that S&P’s AAA rating of the Rembrandt notes was “misleading and deceptive and involved the publication of information or statements false in material particulars and otherwise involved negligent misrepresentations to the class of potential investors in Australia, which included LGFS and the councils.” She also found that ABN AMRO “engaged in conduct that was misleading and deceptive and published information or statements false in material particulars and otherwise involved negligent misrepresentations to LGFS specifically and to the class of potential investors with which ABN AMRO knew LGFS intended to deal.” Judge Jagot also concluded that LGFS has also engaged in “misleading and deceptive conduct.”

Judge Jagot concluded that ABN AMRO and S&P were equally liable to LGFS for the entity’s losses, although a part of LGFS’s claimed losses were reduced by LGFS’s own conduct. She also concluded that S&P, ABN AMRO and LGFA were each proportionately liable for one third of the councils’ losses. S&P has said publicly that it intends to appeal the ruling.

As a decision of an Australian court, the ruling will have no direct legal bearing on the outcome of any of the many cases pending against the rating agencies in the United States. Moreover, Judge Jagot’s ruling is very fact intensive and involves a host of specific factors that uniquely related to the circumstances at issue.

Nevertheless, the opinion (though dauntingly long and complicated) is very interesting and it offers a fascinating glimpse of the processes involved in rating at least one of the very complicated financial instruments that caused so many problems during the financial crisis. Judge Jagot’s opinion provides a look behind the scenes that can only be described as disturbing. Of course, S&P disputes her conclusions and intends to appeal her rulings. But Judge Jagot’s painstaking analysis suggests that, here at least, the rating agency was, as one email Judge Jagot  put it, “bulldozed” by the financial firm that created the instrument the rating agency was rating, and did not independently verify the validity of the inputs employed in the rating model it used.  

These conclusions are consistent with the allegations that have been raised in the many claims against the rating agencies here in the U.S.  -- that the rating agencies were insufficiently independent and used inadequate ratings methodologies in providing the highest investment rating to complex financial instruments in the run up to the financial crisis. The fact that a court expressly found that a rating agency misled investors as a result of which the rating agency must be held liable to the investors has no precedential effect in these other cases. But it could have an effect on the context within which these other courts consider the allegations against the rating agencies. At a minimum, Judge Jagot’s ruling could hearten the claimants in those other cases.

Without having read the entirety of Judge Jagot’s nearly 1,500 page opinion, I can’t say for sure whether or not she considered the issue that has proven so critical in so many of the cases here in the U.S. – that is, that the rating agency’s ratings are mere opinions for which the rating agency’s cannot be held liable unless the claimant can show that the rating agency did not in fact actually hold the stated opinions. The absence of this consideration could perhaps explain the difference in outcome between the Australian case and so man of the cases here in the U.S. Many of the cases in the U.S. have ben dismissed on this basis. The Australian case does show what kinds of things might come to light if the cases against the rating agencies are allowed to foreword.

ABN AMRO was of course acquired in October 2007 by a consortium of investors led by the Royal Bank of Scotland and that included Fortis, in a transaction that contributed substantially to the near collapse of both RBS and Fortis, both of which subsequently required massive government bailouts. There is a lot of competition among the deals completed in the run up to the financial crisis for the title of worst deal of all time (think, for example of BofA’s acquisition of Countrywide). But there is a good case to be made that the ABN AMRO deal takes the cake. Anybody trying to understand how it all went wrong might want to start by taking a look at the Judge Jagot’s opinion in this case. 

Felix Salmon has an absolutely terrific November 5, 2012 article on Reuters about Judge Jagot's opinion, here. Salmon is lavish in his praise for Jagot and her understanding of the complex financial instrument involved in the case.

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In this post, I review two recent law firm memos examining the state of class action litigation in Australia and Mexico, respectively. I first review class actions in Australia, and then examine class actions in Mexico below.

AUSTRALIA

Class actions, which have been available as a procedural alternative in Australia since 1992 are “now an established part of Australia’s litigation landscape, according to a March 2, 2012 memorandum from the King & Wood Mallesons law firm entitled “Class Actions in Australia: The Year in Review 2011” (here). Though the “introduction of class action regimes has not yet led to the flood of litigation that some commentators had prediction,” the memo notes, class actions “remain a significant concern for both directors and in-house counsel alike due to the scale of many of these claims.”

According to the memo, an average of only 14 class actions is filed every year in the Federal Court (including all types of cases, including consumer actions), representing less than 1% of all Federal Court proceedings. The authors note that during 2011, a number of significant new shareholder class actions were commenced, including cases involving Nufarm, Gunns, and ABC learning. Though there “was no single standout settlement” during the year,  the total value of 2011 shareholder class settlements was over $500 million.

During 2011, “significant pre-litigation requirements” were introduce in Federal Court, which requires parties to file statements setting out the “genuine steps” they have taken to try to resolve a dispute or to clarify the issues between them. The memo notes though is early yet to assess the impact of these requirements on class actions, “plaintiff representatives have stated that they consider the regime a powerful tool for obtaining information on liability from defendants sooner, thereby pushing class actions to early resolution.” With these rules in place, the authors expect that Federal Courts will “take a much more active approach to managing class actions in its jurisdiction.”

The Australian class action system has a number of distinctive features, including the use of an “opt out” class action system, whereby class members are included in the class unless they take positive steps to remove themselves from the class. The Australian approach to class actions is also characterized by the increasing presence of litigation funders that sponsor claims. These two characteristics have come together in the growth of “closed classes,” which limit the group members to persons who have retained the solicitors involved or have entered an agreement with the litigation funders.

Though this “closed class” approach has been criticized, they have also been approved by the courts, “even though the effect is to convert the statutory opt out regime into an opt in regime and so exclude potential claimants.” The memo notes that “the increased use of closed classes reflects a desire by funders and solicitors to have certainty of returns,” and may even be of benefit to defendants, “enabling them to better ascertain their potential liability and thereby promote settlement.”

Another recent development has been the rise in the involvement of law firms “not traditionally identified with class actions.” This has not only led to the rise of competing class action lawsuits, but it has also led to the procedural issues, due to the complexity of the litigation procedures involved. A series of decisions cited in the memo demonstrates that “class action practice remains technical” and any party involved in class litigation “must remain mindful of the additional requirements imposed concerning the conduct of such proceedings.”

On the other hand, “recent settlements also show that acting in class actions, either as the plaintiffs’ lawyers or the litigation funders, may be a good investment.” The authors cite one recent settlement in which the court approved plaintiffs’ attorneys’ fees of A$25 million. The authors also note that in the Oz Minerals shareholder class action, two plaintiffs’ firms were awarded just under A$5 million in legal fees, and the litigation funder reported a net gain of A$12.8 million.

During 2011, claimants showed an “increased willingness” to include advisors as class action defendants. The authors note that “in some cases, this is a pragmatic decision given the insolvency of the true target of the litigation” and reflects “a recognition by plaintiff lawyers that advisors, covered as they may be by professional indemnity insurance and with professional reputations to protect, could alter the settlement dynamic,” though the involvement of multiple defendants could result in greater costs, complexity and delay. The authors cite 2011 class actions in which the defendants include auditors, stock brokers and financial advisors.

In an observation that may be of particular interest to readers of this blog, the authors note that “one development that was predicted but has not been common” is “the inclusion of company directors as individual defendants to class actions.” The authors suggest that this “reflects the belief that it is the company that has the deeper pockets and reputation to protect, and it is generally the more lucrative target.” The authors do note at least a couple of exceptions, in which the target company was insolvent or in administration, where directors and advisors “remain attractive defendants.”

The involvement of litigation funding firms has been part of the scene for years but questions continue to arise, even through satellite litigation, including disputes over the funders’ funding arrangements. In addition, in 2011 draft regulations were introduced that would impose a requirement that all litigation funders have adequate policies and procedures in place to manage any conflicts of interest. Others have called for the funders to be licensed and registered. Despite this agitation, though, “litigation funding in Australia is an increasingly sophisticated business.” The authors also note that the funders’ “financial imperative,” which encourages selectivity to ensure returns, “will continue to impose some degree of discipline on the funding industry.”

The report notes that during 2011, courts considering proposed settlements took the involvement of litigation funders into account in assessing the settlements. The courts expressly took into account the amount to be paid to the funder.

The authors conclude their memo with the an expression of their expectation that during 2012, class action proponents will continue to push class action proceedings into nontraditional areas, and that many of the claims may be advanced by “new entrants” into the class action arena, including “overseas sources of funding.” The authors also expect that during 2012 there may be important rulings on critical issues such as causation and reliance, the potential liability of outside advisors (such as auditors and rating agencies). In addition, the question of increased governmental regulation of litigation funding is “expected to remain a live issue well into 2012.”

MEXICO

Beginning March 1, 2012, companies doing business in Mexico will face the risk of class action lawsuits in Mexican federal courts, according to a March 2012 memorandum from the Jones Day law firm entitled “New Class Action Rules in Mexico Create Significant Risks for Companies Doing Business in Mexico” (here).

Pursuant to a series of legislative enactments, private plaintiffs, government entities and certain nonprofits may bring consumer, financial, antitrust and environmental claims as “collective” lawsuits. The legislation authorizes the courts to award classwide-damages and injunctive relief. The provisions allow for a highly expedited class certification process, although the litigation regime is built on an “opt in” rather than an “opt out” scheme.

The memo’s authors note that among the many unknowns about this new Mexican class action regime is the res judicata effect of a judgment in a collective action. The memo notes that “it is not known whether an individual who fails to opt in to a collective action … will be precluded from bringing future lawsuits.”

The legislation’s features relating to fees may impose a certain limitation on the attractiveness of these kinds of actions. Thus, although an unsuccessful plaintiff will not be required to pay any portion of the defendant’s legal fees, the new laws cap plaintiffs’ fees based on a calculation linked to the minimum wages in Mexico City. The purpose of these provisions is to reduce the percentage of a judgment that goes to the plaintiffs’ attorneys. Obviously these provisions “reduce the incentive for plaintiffs’ attorneys to bring such lawsuits.

The memo, which also contains helpful comparisons between the new Mexican collective action scheme and collective actions under Brazilian law and class actions under U.S. law, concludes that “while there are a whole host of questions about the new laws that remain unanswered,” the new collective action procedure “presents significant new risks for businesses operating in Mexico.”

DISCUSSION

In the wake of the U.S. Supreme Court’s June 2010 decision in the Morrison case, non-U.S. investors have been forced to consider alternatives to securities claims in U.S. courts as a way to try to recoup losses based on alleged misrepresentations and omissions. Developments in Canada and Netherlands have raised the profile of procedures available in those countries as potential alternative means for shareholder recoveries.

Australia remains yet another alternative jurisdiction. With its opt out class action system and the availability of litigation funding to finance claims, the Australian class action scheme as certain attractive features. In addition, class action litigation is already a recognized part of the litigation landscape there. The Australian class action regime has previously been employed to facilitation shareholder class recoveries. Nevertheless, the Australian class action system is still evolving, with many critical legal issues yet to be addressed. As the authors of the legal memo note, “we have not yet seen a marked increase in the prevalence of Australian shareholder class actions.”

In the post-Morrison environment, class action litigation developments in any jurisdiction will be watched closely. The relative maturity of the Australian class action litigation scheme and the extent of activity already in that country will make Australia a country worth watching closely. The willingness of plaintiffs’ lawyers and litigation funders to take on these cases suggests that Australia may be a country in which shareholder class action litigation advances significantly in the years ahead.

As for Mexico, the new regime has only just become effective, and there are too many unanswered questions about the new provisions to make any sort of assessment. It is noteworthy that an increasing number of jurisdictions are adopting procedures that provide means for aggrieved persons to seek collective relief. As more countries adopt procedures of this type, aggrieved investors increasingly will seek to use these procedures. The U.S. Supreme Court’s Morrison decision may have had the unanticipated effect of accelerating this process.

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As a result of series of legal developments, securities class action lawsuits in Australia have become have become increasingly common in recent years, and signs are that these trends will continue, according to a comprehensive study of Australian securities class action litigation issued on May 7, 2010 by NERA Economic Consulting.

The report can be found here, and NERA’s May 7 press release can be found here. (Hat Tip to Adam Savett of the Securities Litigation Watch blog, who has a post about the NERA study here).

Although the Australian laws permitting securities class action litigation have been in place since 1992, there were only two cases filed prior to 2000. There were a total of five cases filed during the years 2000 to 2003, and the filings began to increase steadily during 2004 and thereafter. There were a record number of cases filed in 2009, when six securities class action lawsuits were filed. There were a total of 22 securities class action lawsuits filed during the period 2004 to 2009.

A number of factors have contributed to the growing numbers of lawsuits. The first is that, according to the NERA study, "following the high-profile collapse of a number of companies in the early 2000s … shareholders have demonstrated that they are increasingly willing to use class actions as a tool to protect themselves from harmful conduct, and to punish offenders."

In addition, there have been several key case law developments that have removed some impediments, including decisions clarifying that shareholders can seek damages when their loss is distinct from any loss suffered by the company, and other decisions clarifying the rights of shareholders suing for damages against companies that are under administration.

However, perhaps the most significant development behind the increase in securities class action litigation in Australia is the "emergence of commercial litigation funding." Because of the prohibition against contingency fees, as well as the risks of costs awards against unsuccessful litigants, there were substantial financial barriers against pursuing this type of litigation.

Seventeen out of the 24 Australian securities class action lawsuits that have been filed since 2004 have been financed by a commercial litigation funder. The Australian commercial litigation funding business is dominated by IMF (Australia) Ltd., the first publicly listed litigation funder in Australia. IMF has financed 14 securities class action lawsuits and has proposed financing in an additional three suits that have not yet been filed. Though IMF dominates, according to the NERA study, a number of new firms have recently entered the market.

(Readers who, like me, are fascinated by this concept of litigation funding may want to have a look at IMF’s website, linked above.)

The two primary causes of action in Australian securities class action lawsuits are "contraventions of the continuous disclosure rules" and alleged violations of the laws prohibiting misleading and deceptive conduct. A number of suits also allege breaches of fiduciary trust. The two most common allegations, asserted in 52% of cases, are inaccurate earnings guidance and improper accounting.

Despite the dominance of the materials industry in the Australian economy, suits against mining or other companies represent only 14% of all cases filed. Actions brought against issuers in the diversified financial, insurance and real estate industries account for slightly more than half of all filings.

Because so many of the securities lawsuits have been filed in recent years, only a small number of all suits have been resolved. Of the 12 that were resolved as of December 2009, eight were settled, although all five of the resolved cases that were filed after 2003 were settled. The NERA report suggests that the litigation funding arrangements may have contributed to this trend toward negotiated resolutions, as the litigation funders are likely to "promote the selection and subsequent filing of actions that are stronger and for which a greater proportion of potential class members have signed a funding agreement."

Though Australian securities class action lawsuit filings have increased in recent years, they are many fewer securities lawsuit filed there than in the United States even allowing for the differences in size of the two countries’ economies. The NERA report comments that the class action filing levels in the Australia are "broadly similar to the level seen in Canada, once adjusted for the respective size of each economy."

The report concludes with the observation about Australian securities class action lawsuits that "with a number of recent common law developments having resolved many areas of uncertainty, it is likely that the rate of growth of filings evident since 2004 wil continue into the future."

NERA is of course well known for its periodic studies of U.S. securities class action lawsuits. Their new study of Australian class action lawsuits is the third in a series of studies concerning securities class action lawsuit litigation outside the U.S., following on its studies concerning securities litigation in Canada (refer here) and Japan (refer here).

More About the Schwab YieldPlus Securities Class Action Lawsuit Settlement: In an earlier post (here), I reviewed the $200 million settlement in the Schwab YieldPlus subprime related securities class action lawsuit. As noted at the time, the settlement did not resolved the related state law claims that the plaintiffs had filed.

On May 5, 2010, the Charles Schwab Company announced (here) that it had resolved the remaining state law claims as well, in exchange for an agreement to pay an additional $35 million, brining the total value of the Schwab YieldPlus settlement to $235 million. I have adjusted my table of subprime-related securities lawsuit case resolutions accordingly.

Farewell Ernie Harwell: Everyone here at The D&O Diary was saddened by the news earlier this week of the death of Hall of Fame baseball announcer for the Detroit Tigers, Ernie Harwell. One of my fondest memories from my three years at University of Michigan Law School is of listening to radio broadcasts of Tiger games, and of Harwell’s friendly, welcoming voice bringing the games alive. Harwell is perhaps better known for his signature home run calls ("That one is long gone!), but I will always remember the way he began games by saying "Its another great day for Tiger baseball." It was always a great day for Tiger baseball when Harwell was in the booth.

Ernie, we will miss you.

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