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

Eastern cultures ascribe events to destiny, fate, or “karma.” But in our culture we demand to know who is to blame. The Zeitgeist of America’s blame culture apparently has decreed that Ralph Cioffi and Matthew Tannin, the former Bear Stearns fund managers, are to be the first level scapegoats for the subprime crisis. The “perp walk” to which they were subjected last week – why? Whatever happened to the presumption of innocence?—is now a standard component of the American blame ritual.

But a review of the charges against them does raise some concerns. Indeed, many observers have already questioned the proceedings.

A number of commentators have observed that Cioffi and Tannin’s alleged misrepresentations were no different than those of many others on Wall Street. Indeed, both Bloomberg’s Caroline Baum (here) and Professor Peter Henning of the White Collar Crime Prof blog (here) see little difference between Cioffi and Tannin’s statements about the Bear funds and the remarks of Bear Stearn’s CEO Alan Scwartz two days before the company’s collapse that “our liquidity position has not changed.” Professor Ribstein, on his Ideoblog (here), suggests that the difference between Cioffi and Tannin on the one hand, and Schwarz on the other, is that Cioffi and Tannin made the mistake of being hedge fund managers rather than corporate executives (“the bad luck of their chosen line of work”)

Some commentators even question the culpability of the two individuals’ alleged misrepresentations. As Professor Henning notes:

A false hope that the hedge funds would pull through, no matter how misguided, can be a defense to a fraud charge. Showing that Cioffi and Tannin were of two minds, or conflicted about where the market was headed, does not mean that the statements to investors were part of a fraudulent scheme.

Professor Henning goes on to observe:

As a Wall Street case, the charges seem a bit thin to me. Hedge fund managers are essentially salesmen, touting their wares in much the same way that the man in the used car lot has a great deal for you….The fact that Wall Street salesmen talked out of both sides of their mouths is nothing new.

Professor Henning also questions the significance of Cioffi’s withdrawl of $2 million from one of the funds, noting that “withdrawing your own money is not the type of theft one expects to see in a fraud case.”

In a Wall Street Journal op-ed piece today (here), former prosecutor Robert Mintz suggests that the duo’s biggest mistake was failing first – “these two were among the first to see their funds implode and that, perhaps more than any other reason, is why they now find themselves facing the prospect of significant jail time.”

These observations are all interesting and might (perhaps under different circumstances) suggest that the government could face an uphill battle. However, the circumstances demand a burnt offering and that is why Cioffi and Tannin were dragged into the public square. A burnt offering we shall have.

There is one additional element of the indictment that has not received as much attention that may be worth noting here. That is, as discussed in the U.S. Attorney’s June 19, 2008 press release (here), one element of the indictment relates to a possible cover up. The press release states that, after the SEC had requested the production of documents and materials in Summer 2007, Tannin’s “tablet computer” and Cioff’s “notebook” apparently “went missing."

One of the ineradicable lessons from the Watergate era is that the evasion will get you even if the underlying conduct does not. (Just ask Martha Stewart.) If the government can show that the defendants did inappropriately dispose of their technological devices as part of an evasion, the cover-up charges could loom a great deal larger.

And while the commentators may question the criminal indictment, they recognize that the alleged misconduct might support civil liability. Indeed, Professor Ribstein acknowledges that while “not a criminal case,” this “sort of case is suited for a civil fraud claim.” It has been somewhat overshadowed by the criminal indictment, but the SEC did in fact file a civil enforcement proceeding against Cioffi and Tannin at the same time as the indictment.

The SEC enforcement action (as described in the SEC’s June 19, 2008 Litigation Release, here), contains additional allegations against the two, including for example, that they “misrepresented the funds’ deteriorating condition and the level of investor redemption requests in order to bring in new money and keep existing investors and institutional counterparties from withdrawing money.” Among other things, the SEC alleges that Cioffi and Tannin “misrepresented their funds’ investment in subprime mortgage-backed securities.” It is alleged that the funds’ monthly performance summaries described the exposure as from 6 to 8 percent, when it supposedly later emerged that the “total subprime exposure – direct and indirect—was approximately 60 percent.”

The SEC seeks “permanent injunctive relief, disgorgement of all illegal profits plus prejudgment interest, and the imposition of civil monetary penalties.” But as serious as are these proposed sanctions, they still pale by comparison to the threat of incarceration the individuals face as a result of the criminal indictment.

As the U.S. Attorney’s press release states, “if convicted of securities fraud, Cioffi and Tannin face maximum sentences of 20 years imprisonment. If convicted of conspiracy, they each face a maximum sentence of five years.”

All of which leads to the final question. As Robert Mintz asked in his Journal op-ed piece today, “are we attempting to criminalize conduct primarily based upon the fact that we now know that the investing decisions led to a bad end?”

UPDATE: Professor Jay Brown has a paritcularly good post today on these same themes on his Race to the Bottom blog (here). Among other things, Professor Brown says that "this matter should be left to the Securities and Exchange Commission and the private investors...It should not be left to the criminal authorities."

Just the Thing: Even more American than the instinct to blame is the propensity for someone to try and profit off of another’s misfortune. And in that spirit, readers may be interested to know that a Ralph Cioffi signed Bear Stearns Hedge Fund Christmas Card is available (here) on eBay. As of the time of this blog post, the current bid was $81.

Sometimes I feel like the entire world is nothing more than abstraction of the old comic strip, The Strange World of Mr. Mum.

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In Bear Stearns’ March 16, 2008 announcement (here) of J.P. Morgan’s acquisition of the company, Alan Schwartz, Bear’s CEO, is quoted as saying that “this transaction represents the best outcome for all our constituencies based upon the current circumstances.” Apparently, a few of those constituencies take a different view.. In addition to the securities class action lawsuits and employees’ ERISA lawsuit noted in yesterday’s post, a Bear shareholder has also filed a New York state court lawsuit (complaint here) alleging that Bear and its senior officials breached their fiduciary duty to shareholders. (Hat tip to the Courthouse News Service for the complaint.)

The relatively short complaint, which bears certain indicia of having been prepared in haste, is not presented as a derivative lawsuit, but rather as a direct claim, and is filed as a class action on behalf of all Bear shareholders. Among other things, the complaint alleges that the company “allowed itself to be sold to the lowest bidder…at the lowest possible price,” which, the complaint alleges, “is far below Bear Stearns’ value.” The complaint quotes a statement from the Wall Street Journal that the deal constitutes a "fire sale."

Schwartz’s statement that the deal was the best for “all constituencies” is noteworthy for its seeming distinction from the usual formulation that it is the obligation of a corporation’s board to maximize the interests of the shareholders. In this context, the obligations to the shareholders are usually referenced as their Revlon duties, as noted on the Delaware Corporate and Commercial Litigation blog (here). One constituency that was particularly interested in outcome of this transaction is composed of the federal regulators. Another constituency consists of Bear’s creditors and counterparties, whose anxieties apparently triggered the crisis that led to the company’s sale. These constituencies are likelier to agree with Schwartz’s characterization of the transaction.  

The constituency that consists of Bear’s shareholders, or at least the ones who have retained plaintiffs’ attorneys, see things differently. Whether or not Bear’s shareholders have a legal basis on which to protest under Delaware law is the subject of an interesting post by BYU law professor Gordon Smith on the Conglomerate blog (here). In the post, Smith refers to a prior Delaware case in which minority shareholders complained that the majority shareholder should have pursued bankruptcy rather than foreclosure (effectively, sale, as here). Smith concludes that because “there is no hint of self-dealing” in this instance, the board’s actions will be evaluated under the business judgment rule. Smith states that stockholders may be upset, “but Delaware corporate law will not come to the rescue.”

A number of other legal scholars added comments to Smith’s original post, and I recommend reading all of the comments, which are particularly interesting and thoughtful.

The Bear shareholders’ initiative to realize what they contend is (or was) Bear’s actual value may be frustrated by a quirk of Delaware law. As noted on the DealBook blog (here), because J.P. Morgan is offering stock, “there are no appraisal rights under Section 262 of the Delaware General Corporate Law Code.” If it had been a cash deal, shareholders could have gone to Delaware court for a determination of the fair value of their stock. It is in a way too bad that they cannot, because that would have made for an interesting leagl proceeding – arguably right up there with defining the value of a “burned and hairy hand.” (Readers who do not recognize this allusion should refer to the video clip below.)

As the DealBook blog details, the merger agreement (which can be found here) has a number of other interesting features, including the fact that the deal has no material adverse change clause, so J.P. Morgan has no “out.” On the other hand, Bear Stearns apparently retains what is in effect a “put,” providing Bear the right, even if Bear’s shareholder vote down the transaction, to require J.P. Morgan to reenter negotiations. (This provision may suggest one of the reasons why Bear’s shares are trading so far above the merger price – for further thoughts about which refer here..)

Readers of this blog will also be interested to note that in Section 6.6 of the merger agreement, Bear Stearns’ directors and officers are entitled to six years of tail D & O coverage. (All of those insurance markets clamoring to provide the tail coverage should form an orderly line, please.). In addition, Bear’s directors and officers are given full indemnification from J.P. Morgan. I suspect these provisions, and especially the J.P. Morgan indemnity, were particularly attractive to the Bear Stearns senior officials involved in the negotiations. While one might suppose that the very attractiveness of the indemnity put the Bear Stearns officials in a potentially conflicted position (as the terms represented a form of consideration valuable to the officials but not to Bear’s shareholders), in the end the J.P. Morgan indemnity might prove quite valuable to Bear’s shareholders in a roundabout sort of way, if you follow my drift….

In any event, it may come as little surprise that the SEC is reportedly investigating trading ahead of Bear’s collapse last Friday. According to a March 18, 2008 Bloomberg.com article (here), “U.S. regulators are investigating whether traders illegally sought to force Bear Stearns Cos. shares into a tailspin last week by spreading false information about the firm's finances.”

For its part, the SEC released today “Answers to Frequently Asked Questions Concerning The Bear Stearns Companies, Inc.” (here), which, among other things explains the role of the SEC staff in the Bear Stearns/J.P. Morgan transaction.

More About Credit Default Swaps: In an earlier post (here), I wrote about the rising litigation threat from credit default swap transactions, particularly due to the growing counterparty risk. A March 17, 2008 Time.com article entitled “Credit Default Swaps: The Next Crisis?” (here) takes a closer look at CDSs and concludes that the instruments “could soon become the eye of the credit hurricane.”

Among other things, the article notes that the market for these instruments exploded to $45 trillion in mid-2007 – by contrast to the mortgage market, which is “only” $7.1 trillion. The article details the conditions that have rattled the marketplace, and concludes that the “potential repercussions are far-reaching.”

Those prone to concerns that we could be facing a period of significant economic adversity may be reassured that we have many safeguards in place that did not exist, for example, in 1929 and 1930. But, as the article concludes, none of these safeguards “are directly targeted at CDS.”

More About Foreign Litigants: In earlier posts (refer here), I have discussed the problem of foreign litigations who purchased their shares in foreign companies on foreign exchanges (the so-called “f-cubed” litigants) who are suing the foreign companies in U.S court under U.S. securities laws. In a recent post on the Securities Litigation Watch blog (here), Adam Savett takes a look at the recent decision in the Converium case, in which the court denied class certification to all putative class members who were neither U.S. citizens nor purchased shares on U.S. exchanges. As I noted on post discussing the recent U.S lawsuits filed against SocGen, it appears that the plaintiffs’ counsel in that case conformed their putative class to conform to the limitations adopted by the Converium court.

Break in the Action: The D & O Diary will be on a reduced publication schedule for the next few days. We will resume our normal publication schedule some time after March 25.

A Burned and Hairy Hand:: The reference above to “the value of a burned and hairy hand,” is an allusion to the standard Contracts law case of Hawkins v. McGee, a case made famous (or perhaps infamous) in the classic scene from the movie The Paper Chase. I suspect that few law students have actually endured anything like this famous scene (I actually enjoyed law school), but for some reason the scene has become an archetypical representation of the legal classroom. Here is Professor Kingsfield in all of his sadistic glory:

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We knew it was coming but it sure got here fast. On March 17, 2008, plaintiffs’ counsel initiated a securities class action lawsuit in the United States District Court for the Southern District of New York against Bear Stearns and certain of its directors and officers. A copy of the plaintiffs’ lawyers’ press release can be found here, and the complaint can be found here.

According to the press release, the complaint alleges that during the class period between December 14, 2006 and March 14, 2008, defendants issued false and misleading statements, as a result of which “Bear Stearns stock traded at artificially inflated prices … reaching a high of $159.36 per share in April 2007.” The press release further states that:

In late June 2007, news about Bear Stearns’ risky hedge funds began to enter the market and its stock price began to fall. On March 10, 2008, information leaked into the market about Bear Stearns’ liquidity problems, causing the stock to drop to as low as $60.26 per share before closing at $62.30 per share. On March 13, 2008, news that Bear Stearns was forced to seek emergency financing from the Federal Reserve and J.P. Morgan Chase hit the market and Bear Stearns stock fell to $30 per share. Then, on Sunday, March 16, 2008, it was announced that J.P. Morgan Chase was purchasing Bear Stearns for $2 per share. By midday on Monday, March 17, 2008, Bear Stearns stock had collapsed another 85% to $4.30 per share on volume of 75 million shares.

The press release states that the defendants’ statements during the class period “due to defendants’ failure to inform the market of the problems in the Company’s hedge funds due to the deteriorating subprime mortgage market, which would cause Bear Stearns to have to rescue the funds, cause the Company and its officers possible criminal liability and hurt the Company’s reputation.”

The principals at JP Morgan clearly anticipated this development. According to a March 17, 2008 Law.com article (here), JP Morgan is “setting aside $6 billion to cover potential litigation” as well as other transaction and severance costs arising out of JP Morgan’s acquisition of Bear Stearns JP Morgan’s own March 16 press release (here) announcing the transaction does not mention any reserve or set aside for transaction expenses, but the March 18, 2008 Wall Street Journal (here) also says that “J.P. Morgan plans to set aside about $6 billion in reserves to cover the potential exposure and other costs.”

(Perhaps it is an idle thought but one does wonder why the $6 billion was not applied directly to the acquisition price. …)

Yet another possibility that may yet arise is that individual Bear Stearns investors might choose to pursue their own litigation separately. According to the March 17, 2008 Wall Street Journal (here), there are individual investors whose losses from the Bear Stearns collapse approach $1 billion. According to the March 18, 2008 Wall Street Journal (here), “billionaire investor Joseph Lewis, one of Bear Stearns's biggest shareholders, with a 9.4% stake, rejected [J.P. Morgan’s] offer, saying it doesn't represent the true value of Bear Stearns. Mr. Lewis, though a spokesman, said the offer ‘is derisory, and I do not believe that shareholders will approve it.’” Certainly individual losses of that magnitude, if nothing else, raise the possibility of their proceeding on their own rather than as part of a larger shareholder class.

Update: According to news reports (here), an action has also been filed against Bear Stearns and its executives on behalf of Bear Stearns employees alleging that they "breached their fiduciary duties to plan participants by allowing their retirement savings to be invested in the company's stock despite knowing such an investment was imprudent."  The complaint alleges that the investment bank failed to disclose material adverse facts regarding its financial well-being, the potential consequences of its "substantial entrenchment in the subprime mortgage market," that the firm's stock price was artificially inflated and heavy investment of retirement savings in company stock would inevitably result in significant losses to the plan and its participants.

Securities Suit Against Deutsche Bank for Auction Rate Securities: On March 17, 2008, a different plaintiffs’ firm launched a securities lawsuit in the United States District Court for the Southern District of New York against Deutsche Bank and its wholly owned broker–dealer subsidiary, on behalf of a class of persons who purchased auction rate securities from Deutsche Bank and the broker dealer between March 17, 2003 and February 13, 2008, inclusive (the “Class Period”), and who continued to hold such securities as of February 13, 2008. A copy of the plaintiffs’ counsels’ press release can be found here and a copy of the complaint can be found here. 

According to the press release, the plaintiffs allege that the defendants violated the securities laws “by deceiving investors about the investment characteristics of auction rate securities and the auction market in which these securities traded.” The press release states that the defendants failed to disclose that:

(1) the auction rate securities were not cash alternatives, like money market funds, but were instead, complex, long-term financial instruments with 30 year maturity dates, or longer; (2) the auction rate securities were only liquid at the time of sale because Deutsche Bank and other broker-dealers were artificially supporting and manipulating the auction rate market to maintain the appearance of liquidity and stability; (3) Deutsche Bank and other broker-dealers routinely intervened in auctions for their own benefit, to set rates and prevent all-hold auctions and failed auctions; and (4) Deutsche Bank continued to market auction rate securities as liquid investments after it had determined that it and other broker dealers were likely to withdraw their support for the periodic auctions and that a “freeze” of the market for auction rate securities would result.

The auction rate securities purchasers’ lawsuit against Deutsche Bank is not the usual class action securities lawsuits brought against a publicly trade company by its own shareholders. The Deutsche Bank auction rate securities lawsuit is, however, subprime-related and it is a class action that alleges violations of the federal securities laws. For those reasons, I have added it to my running tally of subprime-related securities lawsuits, which can be found here. On a going forward basis, I will try to keep the parallel tallies too, taking into account the different kinds of litigation within the larger running tally.

With the addition of the Bear Stearns and Deutsche Bank securities lawsuits, the current tally of subprime-related securities lawsuits now stands at 51, twelve of which have been filed so far in 2008. Of these 51, two are securities lawsuits filed by mortgage–backed securities investors against the asset securitizers, and one (as noted above) was filed by purchasers of auction rate securities. The remaining 48 are more traditional securities class action lawsuits by public company shareholders.

Bear Ironies and Morgan Echoes: Bear Stearns shareholders can be forgiven if they fail to appreciate it, but there is a certain irony that Bear Stearns was the bailout recipient last Friday. This weekend’s whirlwind meetings involving the Fed and the lions of Wall Street present an uncanny echo of the closed door meetings at the New York Fed on September 23 1998, when government officials and Wall Street bankers were struggling to avert the collapse of Long Term Capital Management that all feared might trigger global financial panic. As colorfully told in the prologue of Roger Lowenstein’s excellent book about LTCM, When Genius Failed (here), the government’s rescue efforts nearly aborted because one Wall Street bank refused to cooperate in the government’s rescue plan - none other than Bear Stearns, whose then CEO and current Chairman James Cayne refused to play along.

This past weekend’s events also harken back to an even earlier episode, one in which JP Morgan Chase’s founder and primary namesake played the central role. As described in Robert Bruner and Sean Carr’s readable recent book, The Panic of 1907 (here), a capital crisis that originated from a liquidity drain following the 1906 San Francisco earthquake culminated in October 1907 in runs on a series of New York banks. J.P. Morgan himself, in effect functioning as the central banker in the absence of any more formal institution, caused his firm to intervene to provide liquidity to the Trust Company of America, declaring, to his colleagues “This is the place to stop the trouble, then.”

A century later, his firm is once again playing a central role in an effort to avert a financial crisis, and while some may argue that an important difference is that in 1907 Morgan didn’t acquire any of the rescued banks, it is a fact that one of the steps Morgan took in 1907 was a U. S. Steel-led buyout of Tennessee Coal, Iron & Railroad Company, a move claimed at the time was designed to avoid a collapse that could have undermined the stock market. The TCI & R rescue efforts, for which he and his firm were later criticized and subjected to a congressional investigation, ultimately proved to be good both for the Morgan firm as well as for the financial markets.

UPDATE: CFO.com has an excellent March 18, 2008 article entitled "J.P. Morgan Returns to Its Rescue Roots" (here) going into much greater detail about J.P. Morgan's storied past.

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