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

A couple of years ago, a "worrisome trend" developed in securities class action litigation, in which large institutional investors began routinely opting out of plaintiff class to separately pursue their own individual claims under the securities laws. The settlement of these individual opt out actions in many cases rivaled, in the aggregate, the amount of the class action settlement, and often exceeded the class settlement in terms of percentage of shareholder losses recovered.

These developments caused some observers to question whether we were headed toward a two-tiered system of securities litigation, where the large institutional investors separately pursued their own claims and the class action proceeded on behalf of other investors.

As it turned out, however, the phenomenon of the large individual opt out settlement separate from the class has ceased to be as prominent as it briefly was during the period 2006 to 2008. Since that time, there have been fewer high profile opt out settlements, and the predictions about fundamental alterations of securities class action litigation have died down.

However, in a development that seems to raise the possibility that the high profile opt-out action may be back, on July 22, 2010, New York Comptroller Thomas P. DiNapoli announced that he had filed two separate individual actions on behalf of New York state pension funds against Merrill Lynch and Bank of America and their respective individual directors and officers.

In the Merrill Lynch complaint (a copy of which can be found here), DiNapoli alleges that between October 17, 2006 and December 31, 2008, the defendants misrepresented the company’s "true exposures to poorly underwritten subprime mortgages, as well as the value of the Company’s subprime-exposed assets and liabilities and the effectiveness of Merrill’s risk management. The complaint alleges beginning in October 2007 the company began a series of stair step writedowns of the value of the company’s toxic assets, and that ultimately the company was forced to merge with Bank of America as a result of its exposure to subprime mortgages.

In the Bank of America Complaint (a copy of which can be found here), DiNapoli alleges in the documents for BoA’s merger with Merrill, the company and three of its senior executives failed to disclose Merrill’s massive fourth quarter 2008 losses and also failed to disclose BofA’s and Merrill’s agreement to permit Merrill to pay up to $5.8 billion in bonuses. The Complaint also alleges that the defendants violated the securities laws through a series of misleading statements and omissions during the period September 15, 2008 (when the merger was announced) and January 21, 2009 (when the information about the fourth quarter losses and the bonuses were made public).

The New York State Pension funds owned 17.7 million BofA shares at the time of the merger and acquired another 3 million between September 15, 2008 and January 21, 2009.

The circumstances described in DiNapoli’s complaints have previously been the subject of extensive litigation. Among other things, the allegations in DiNapoli’s complaint against the Bank of America defendants previously were the subjective of a high profile SEC enforcement action that ultimately resulted in a $150 million settlement. (For a discussion of the events surrounding this SEC settlement, refer here.)

In addition, there previously have been securities class action lawsuits filed against both the Merrill defendants and Bank of America defendants. The Bank of America class action lawsuit is in fact being driven by a group of public pension fund defendants, led by Ohio Attorney General Richard Cordray on behalf of Ohio public pension funds.

The circumstances referenced in DiNapoli’s Merrill Lynch complaint were also the subject of a separate securities class action lawsuit, about which refer here. Indeed, the parties to the Merrill Lynch lawsuit have already entered a $475 million settlement on behalf of the class, which the Southern District of New York Judge Jed Rakoff approved on August 4, 2009.

In bringing his separate lawsuits on behalf of the New York public pension funds, DiNapoli has made a conscious and deliberate decision to opt out of the preexisting class action litigation against the two sets of defendants. Public statements by representatives of DiNapoli’s office made it clear the reason he took the separate action on behalf of the public pension funds is because "our attorneys believe this gives us a chance to get a better recovery." The possible recovery on behalf of the funds could reach "tens of millions of dollars."

DiNapoli’s action to opt out of the class action on the theory that the funds’ recovery will be greater if they proceed individually rather than part of the class is exactly what commentators had been predicting a couple of years ago, before the opt-out phenomenon faded into the background. DiNapoli’s action is all the more noteworthy with respect to the Merrill Lynch suit is all the more noteworthy, given the fact that the class has already entered a massive $475 million settlement. DiNapoli’s action not only raises the question whether other institutional plaintiffs might opt out in these cases, but whether the plaintiffs will opt out in other cases as well.

The interesting thing about the public explanations for DiNapoli’s action is that the decision seems to be the result of persuasion from the attorneys who convinced DiNapoli’s office to opt out. The presence of an entrepreneurial group of plaintiffs’ lawyers motivated to try to obtain individual institutional investor representations by convincing the investors to opt out of the class suggests that, even if the prevalence of high profile opt out actions may have faded into the background, we are likely to continue more of these kinds of developments going forward. The political motivations of public pension fund representatives clearly support these developments.

Of course, it remains to be seen if the New York funds will actually fare better than the classes in these cases. As Adam Savett pointed out in an interesting January 22, 2010 post on the Securities Litigation Watch, even if some claimant fare better by opting out, there can also be a "downside." The post refers to the claimants that opted out of the Aspen Technology class action (which settled for $5.6 million) but ultimately had their claims dismissed based on lack of proof of fraud, and so received nothing.

Nevertheless, if other institutional investors are persuaded that they will do better by proceeding individually, securities class action litigation could become even more complicated than it already is. The existence of separate proceedings could both drive up total litigation costs and increase both the cost and complexity of case settlements. My prior discussion of the potential problems the opt-out phenomenon might represent can be found here.

DiNapoli’s decision to separate the New York funds from the Bank of America class action, in which the Ohio Attorney General is taking the lead, presents an interesting contrast to DiNapoli’s actions in connection with the securities litigation pending against BP, in which the Ohio AG and DiNapoli are collaboratively pursing the class action litigation on behalf of their respective states’ pension funds, and, as reflected here, are in fact together seeking lead plaintiff status in the litigation. Whatever else might be said, it seems that DiNapoli has not been persuaded that the New York funds will always do better outside of the class action process.

Understanding the Global Economy: If like me you find so much about the current circumstances of the global economy confusing, you will want to watch the following John Clark and Bryan Dawe video in which they summarize the basics in an admirable fashion, particularly the way the unbroken chain of governmental borrowing ultimately presents unanswerable questions. (Special thanks to the CorporateCounsel.net blog for the link to this entertaining video.)

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The 2008 securities lawsuit filings were dominated by new lawsuits filed against companies in the financial sector, as has been well-documented elsewhere (refer here). But while lawsuits against financial companies were the most prominent feature of the 2008 securities filings, there were also a significant number of lawsuits filed against companies outside the financial sector. In particular, life sciences companies, which historically have experienced a heightened level of securities litigation exposure, suffered a significant level of litigation activity once again in 2008.

For purposes of this post, I am including under the heading "life sciences" companies any company either in SIC Code series 283 (Drugs) or in SIC Code series 384 (Surgical, Medical and Dental Instruments and Supplies). Reasonable minds could differ about whether additional categories should also be included within life sciences companies, but the interests of simplicity and consistency with my own prior analyses support this categorical definition.

A review of the 2008 securities lawsuit filings shows that, notwithstanding the primacy of litigation involving financial companies during the year, heightened securities litigation activity involving life sciences companies continued in 2008.

According to my analyses, during 2008, there were 15 new securities lawsuits filed against companies in the 283 SIC Code series, including nine in the 2834 SIC Code category (Pharmaceutical Preparations). There were also eight securities lawsuits filed against companies in the 384 SIC Code category, including five in the 3845 SIC Code category (Electromedical Apparatus).

The fact that there were 23 new securities lawsuits filed against life sciences companies in 2008 is quite remarkable given the predominance of the credit crisis litigation wave.

The total number of life sciences lawsuits is significant in relative terms as well. By way of comparison to the 23 new securities lawsuits filed against life sciences companies in 2008, there were 21 securities lawsuits filed against life sciences companies in 2007. (My detailed analysis of the 2007 life sciences securities lawsuits can be found here.)

The fact that the number of lawsuits filed against life sciences companies actually increased in 2008 is extraordinary in light of the extent of the surging credit crisis litigation wave.

The 23 securities lawsuits filed against life sciences companies in 2008 represents approximately 10% of the total of 226 new securities lawsuits overall that were filed in 2008, which is comparable to the 12% that life sciences lawsuits represented of 2007 securities lawsuit filings.

That this significant of a percentage of securities litigation activity is unrelated to the credit crisis litigation wave underscores a point I have previously emphasized (for example, here), that while the subprime and credit crisis-related litigation wave is a significant factor driving securities lawsuits filing activity, it is by no means the sole factor.

The lawsuits filed against life sciences companies in 2008 involved a wide variety of allegations. The most common allegation, asserted in five of the lawsuits, is that the defendant company misrepresented the results or progress of one or more of its clinical trials. Lawsuits filed against four companies alleged financial misstatements or improper revenue recognition.

Other lawsuits involved allegations relating to disclosures about product efficacy; manufacturing deficiencies or controls; merger integration issues; misrepresentations about an officer’s credentials; intellectual property concerns; and product commercial viability.

The attributes of these companies that most frequently attract litigation is the combination of their susceptibility to disruptive events and the vulnerability of their share prices. These kinds of setbacks are an almost inevitable attribute of the regulatory and scientific environment in which these companies operate. However, these kinds of risks are also often comprehensively disclosed.

As a result, though life sciences companies are frequently sued, they have not proven to be easy targets. As I noted here and here, lawsuits filed against life sciences companies are frequently dismissed. Nevertheless, life sciences companies continue to attract the unwanted attention of the plaintiffs’ lawyers.

Securities Litigation Survey: Readers interested in securities litigation topics under the year-in- review heading will want to take a look at  the January 2009 memorandum by the Skadden law firm entitled "Securities Litigation 2008 – Noteworthy Decisions" (here). The memorandum does a particularly good job briefly summarizing the eleven decisions discussed as well as identifying the significance of the decisions.

Early Registration Deadline Approaching: The early registration deadline for the C5 D&O Liability Insurance Conference is approaching. The Conference is scheduled to take place March 24 and 25, 2009 in London. As reflected in the program brochure, which can be accessed here, the program has a number of interesting speakers and will be addressing many of the current hot topics in D&O insurance. I will be participating in a panel entitled "Current Litigation Trends in Europe and the US: Are Class Actions on the Horizon?"

The early registration deadline for this conference is February 9, 2009, after which the registration fee becomes considerably more expense.

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Over the last several years, Congress has made several different efforts to concentrate class action litigation in federal court.

For example, in the Securities Litigation Uniform Standards Act of 1998 (SLUSA), Congress amended portions of the Securities Act of 1933 and the Securities Exchange Act of 1934 to preempt class actions alleging fraud under state law in connection with the purchase or sale of securities. The Act specifically made state law securities class action lawsuits removable to federal court.

In addition, in the Class Action Fairness Act of 2005 (CAFA), Congress expanded federal court jurisdiction over class actions and mass actions. CAFA gives federal courts jurisdiction over certain class actions in which the amount in controversy exceeds $5 million and in which any of the class members is a citizen of a state different from any defendant.

But while Congress enacted these various legislative changes designed to concentrate class action litigation in federal court, Section 22(a) of the ’33 Act preserved state court jurisdiction by specifying that federal courts’ jurisdiction for ’33 Act lawsuits is “concurrent with State and Territorial courts.” Moreover, Section 22(a) specifically provides that no case “brought in any state court of competent jurisdiction shall be removed to any court of the United States.”

These jurisdictional provisions have been a part of the federal securities laws since the basic statutes’ enactment. But the legislative developments in the interim raise the question whether the subsequent enactments override the concurrent state court jurisdictional provisions in Section 22(a).

As I have previously noted (here), plaintiffs’ lawyers have chosen to file a number of subprime-related securities class action lawsuits alleging ’33 Act violations in state court. In particular, plaintiffs’ lawyers have elected to file in state court several class action lawsuits alleging misrepresentations in connection with the creation and issuance of subprime mortgage-backed securities. These lawsuits, of which by my count there have been at least four, exclusively allege violations of the ’33 Act.

One of the first of these lawsuits to be filed is the case styled as Luther v. Countrywide, the background regarding which can be found here. The plaintiffs originally filed their complaint in California Superior Court for Los Angeles County. The Luther complaint names as defendants several Countrywide subsidiaries and affiliated individuals, multiple loan trusts, and Countrywide’s offering underwriters.

The claims in the Luther lawsuit are brought on behalf of purchasers of billions of dollars of mortgage pass-through certificates issued between June 2005 and June 2007. The complaint alleges that the defendants violated Sections 11, 12 and 15 of the ’33 Act, essentially on the grounds that the risk of investing in the mortgage pass-through certificates was much greater than represented by the registration and prospectus supplements, which allegedly omitted and misstated the creditworthiness of the underlying borrowers.

The defendants, in reliance on CAFA, removed the Luther case to federal court. The plaintiffs filed a motion to remand the case to state court.

As discussed here, on February 28, 2008, Judge Mariana R. Pfaelzer granted the plaintiffs’ motion to remand the case to state court, holding that Section 22(a)’s removal bar trumps CAFA’s general grant of diversity and removal jurisdiction. The defendants appealed.

In an opinion filed on July 16, 2008 (here), the Ninth Circuit affirmed the district court, specifically holding that CAFA, “which permits in general the removal to federal court of high-dollar class actions involving diverse parties, does not supersede Section 22(a)’s specific bar against removal of cases arising under the ’33 Act.”

The defendants had argued that CAFA superseded Section 22(a)’s removal bar. But the Ninth Circuit, applying principles of statutory construction, held that while CAFA applies to a “generalized spectrum” of class actions, the ’33 Act is “the more specific statute” and that the removal bar “more precisely applies only to claims” under the ’33 Act. The Ninth Circuit concluded that the plaintiff’s initial state court class action “was not removable” and that “the motion to remand was properly granted.”

In other words, the Luther lawsuit will now go forward in state court. In light of the Ninth Circuit’s opinion, it seems likely that the various other subprime-related class action lawsuits filed against the mortgage securitizers will also eventually proceed in state court as well.

The “where” question has been resolved, but the “why” question still remains – that is, why do plaintiffs’ counsel want to proceed in state court rather than federal court?

One possibility is that plaintiffs’ counsel believes that state courts will be more sympathetic to the interests of local claimants, especially in connection with their claims against out-of-state moneyed interests. The search for a more favorable court has always driven forum shopping, and there may be some of that here. But I do wonder why plaintiffs’ securities attorneys, whose practices historically (especially in recent years) have concentrated in federal court, want to litigate in a state court with which they may be less familiar, and that will be unfamiliar with federal securities laws and securities litigation generally.

Another possible reason plaintiffs lawyers want to proceed in state court is that they want to try to circumvent the procedural requirements of the PSLRA. I have speculated elsewhere (most recently here) that plaintiffs’ counsel may try to argue that the PSLRA’s procedural requirements do not apply to a ’33 Act case in state court. The plaintiffs’ argument would be that the PSLRA, codified in Section 27(a) of the ’33 Act, provides that the PSLRA applies only to private actions “brought as a plaintiff class action pursuant to the Federal Rules of Civil Procedure.” The plaintiffs’ counsel may argue that because their suit was not brought pursuant to the Federal Rules of Civil Procedure, the PSLRA’s procedural requirements (such as the notice provisions, the discovery stay, and the lead plaintiff provision) do not apply. There could be a great deal of litigation turbulence if plaintiffs’ lawyers pursue these arguments (which seems likely).

Plaintiffs’ counsel apparently have the right to pursue ’33 Act claims in state court, which for whatever reason they seem inclined to do. There were of course a few securities lawsuits filed in state court after the enactment of the PSLRA, but my recollection is that that experiment did not go particularly well. Due to the state courts’ crowded dockets and unfamiliarity with federal securities laws, the cases bogged down. The enactment of SLUSA seemingly ended this prior flawed experiment.

Nevertheless, plaintiffs’ securities attorneys, for reasons they deem good and sufficient, are back again in state court, a place where they now seem eager to be. Some recalibration may be required to accommodate the prospect of further state court securities litigation. The plaintiffs’ lawyers’ interest in pursuing state court ’33 Act class action litigation is an unexpected development with uncertain implications. The road could be rough for all concerned.

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