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

The $277.5 million jury verdict in the Apollo Group securities lawsuit caused a great sensation at the time it was returned in January 2008 (as discussed here). The verdict heartened plaintiffs’ attorneys and it served as a counterweight to the defense verdict in the virtually contemporaneous JDSU Uniphase securities lawsuit trial (which is discussed here).

But on August 4, 2008, Judge James Teilborg of the United States District Court for the District of Arizona entered an order (here) granting the defendants’ motion for judgment as a matter of law, based on his finding that the trial testimony did not support the jury’s finding of loss causation. Judge Teilborg’s order vacated the judgment and entered judgment in defendants’ favor.

The Apollo Group securities lawsuit involved alleged misrepresentations and omissions relating to a February 6, 2004 “Program Review” in which a Department of Education representative discussed the company’ potential violation of DoE rules. News of the allegations in the Program Review first became public on September 14, 2004, but the company’s share price did not react. Apollo’s share price fell significantly on September 21, 2004, when a securities analyst issued a report (the “Flynn reports”) expressing concern about the company’s possible exposure to future regulatory issues.

Judge Teilborg had held in connection with the parties’ pre-trial cross-motions for summary judgment that the issue whether the Flynn reports constituted “corrective disclosure” sufficient to support a finding of loss causation was a question for the jury

In its post-trial motion, Apollo argued that the evidence at trial was insufficient to support a finding that the Flynn reports represented “corrective disclosure,” because they did not contain any new fraud-revealing information. Judge Teilborg found that “the evidence at trial undercut all bases on which [the plaintiff] claimed the Flynn reports were corrective.”

Accordingly, the court concluded that although the plaintiff “demonstrated that Apollo misled the markets in various ways concerning the DoE program review,” the plaintiff “failed to prove that Apollo’s actions caused investors to suffer harm.” The court therefore concluded that “Apollo is entitled to judgment as a matter of law.”

Judge Teilborg then went on to consider conditionally Apollo’s motion for a new trial, as a precaution against the possibility that the appellate court could reverse the grant of judgment as a matter of law. He found that “none of the reasons cited by Apollo warrant a new trial in the case” and so the court conditionally denied Apollo’s motion for a new trial.

The possibility of significant post-trial developments in the Apollo case is something I expressly suggested at the time of the jury verdict, and, indeed the case still has a great deal farther to run procedurally, with additional opportunities for even further developments in the case.

In the interim, the post-trial disposition in the Apollo Group case alters the mix of securities lawsuit trial outcomes. According to data from the Securities Litigation Watch (here), six post-PSLRA cases (including Apollo Group) have gone to verdict, with three of the verdicts in favor of the plaintiffs and three in favor of defendants, although on November 26, 2007, the Ninth Circuit reversed and remanded the defense verdicts in the Thane International case (about which refer here). With the vacatur of the plaintiff’s verdict in the Apollo Group case, the securities lawsuit jury verdict scoreboard now stands evenly distributed, three each for plaintiffs and defendants – subject to further procedural developments.

As for the significance of this development, it may be hard to say definitively until all proceedings are complete, but the verdict’s vacatur can’t be encouraging for plaintiffs’ lawyers. This development together with the defense verdict in the JDS Uniphase trial would seem to argue pretty compellingly in favor of avoiding jury trials and seeking pretrial resolution

One practical significance of the vacatur of the Apollo jury verdict is that it removes any suggestion that the jury’s verdict represents a finding of fraud sufficient to trigger the fraud exclusion in the company’s D&O insurance policy. This undoubtedly represents significant relief to the company and the other defendants, in addition to the sense of vindication the company likely feels following the court's ruling.

The company’s August 5, 2008 press release about the Judge Teilborg’s ruling can be found here. A detailed summary of the Apollo Group securities case, including links to pleadings, can be found here.

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I have previously noted (most recently here) the increasing significance of opt-out actions as a part of securities lawsuit resolution. Columbia Law School Professor John Coffee, in a March 27, 2008 paper entitled “Accountability and Competition in Securities Class Actions: Why ‘Exit’ Works Better Than ‘Voice’” (here) examines the opt-out phenomenon and concludes that while the increased recoveries in opt-out actions compared to class recoveries will encourage competition among plaintiffs’ counsel, shareholder litigation could become even costlier to resolve.

Coffee also concludes, contrary to what others have “prematurely predicted,” that shareholder class action lawsuits “will not die or whither away, but that the current system of shareholder class action lawsuits may be abandoned in favor of a “two-tier system,” in which “the largest investors will opt-out and sue in state court individual actions, with the class action becoming the residual vehicle for smaller investors.” These possibilities have enormous implications for the future of securities litigation, which Coffee’s paper explores.

Coffee opens his paper comparing the changes wrought by the opt-out phenomenon with prior legislative efforts to reform class action litigation. Specifically, Coffee notes that unlike legislative efforts to give the class greater control, such as the lead plaintiff provision of the PSLRA, the increasingly utilized opt-out option may offer true oversight, actual competition, and even lead to better results for the plaintiff class.

In analyzing these developments, Coffee adopts terminology from the writings of economist Albert O. Hirschman. Hirschman describes two ways in which organizational behavior may be modified: (i) participants can be given greater “voice”; or (ii) participants can be given increased ability to “exit” the system. Coffee contrasts the legislative reforms, such as the lead plaintiff provision, designed to give class members greater “voice,” with the alternative of “exit” offered by the opt-out option. Coffee concludes that “ ‘exit’ works better than ‘voice,’” at least within realm of securities class actions.”

A critical component of Coffee’s analysis is that “when institutional investors exit the class and sue individually, they appear to do dramatically better – by an order of magnitude!” Coffee views this as an “optimistic development” because the opt-out outperformance can “kickstart active competition” among plaintiffs’ attorneys, by contrast to the PSLRA reforms which have had the perverse effect of reducing competition.

As Coffee notes, these developments have significant implications for the future of class litigation, as large institutional investors increasingly may conclude that their interests are better served by proceeding separately. Coffee specifically notes that the current wave of subprime-related cases are “particularly likely to produce a high rate of opt-outs,” because of the predominance of institutional investors among purchasers of the kinds of asset-backed securities that are at the heart of many of these lawsuits.

Coffee speculates that defendants (and indeed all class litigants) may seek to employ adaptive practices to offset these developments. Among other possibilities Coffee reviews are such practices as advancing the time of the opt-out decisions before the settlement is reached; structuring the settlement in a way to give class members “priority” over individual recoveries, such as given them a security interest in company assets to the extent of the settlement amount; including a “most favored nation” provision in class settlements so that class members are entitled to increase their recovery if opt-outs reach a higher settlement; or even reducing the settlement amount in respect of each opt-out.

In the final analysis, each of these potential adaptations has shortcomings. Over the long run, Coffee anticipates, “increased opting out will place class counsel under increased competitive pressure to improve the class settlement.” For that reason, Coffee concludes that “greater competition is coming.”

I very much agree with Professor Coffee that the emergence of significant opt-out settlements represents a watershed development in securities class action litigation, with the potential to have an enormous impact. However, I think it does still remain to be seen how widespread the opt-out phenomenon will prove to be.

The increased recovery percentages (so far) in the high profile opt out actions do provide obvious incentives for institutional investors to become more focused on their opt-out opportunities. But so far the significant opt-out activity has been limited to “mega” cases where the aggregate recoveries, for both the class and the opt-out litigants have run into the hundreds of millions and even the billions of dollars. It is entirely possible that rather than becoming a universal phenomenon affecting all, most, or even many securities class actions, significant opt-out activity will be limited only to a small handful of cases where the dollars involved reach this rarified range. Without more, it seems premature to project that shareholder litigation is about to enter a two-tier system where institutional litigants have abandoned class resolutions altogether.

That said, even if the phenomenon proves to be limited only to a small subset of securities cases, the opportunities and incentives involved could still affect the overall outcome of many securities cases. Just the threat of material opt-outs could affect the class action settlement dynamic. As Professor Coffee notes, some adaptive behavior is likely, as litigants seek to suppress or minimize the prospects for opt-outs. The likeliest adaptive behavior is that class settlements overall could be driven upward, as all class settlement participants seek to remove the incentive to opt out by improving the class settlement itself.

We are already in an era of increasing average claim severity. The emergence of the opt-out phenomenon can only amplify these trends. In any event, the developments related to opt-outs also present important implications for D&O insurers’ severity assumptions and for insurance purchasers’ assumptions about limits adequacy. The direct and indirect impacts from the emergence of significant opt out activity could make historical assumptions in this regard obsolete.

Very special thanks to Professor Coffee for his permission to cite and quote his paper, which, he emphasizes, is preliminary only.

Hat tip also to Werner Kranenburg of the With Vigour and Zeal blog (here) for the link to Professor Coffee’s paper.

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Add E*Trade and SunTrust Bank to the growing list of companies that have been sued in purported class action lawsuits on behalf of auction rate securities investors against companies that sold them the instruments. The plaintiffs’ attorney’s April 2, 2008 press release regarding the E*Trade auction rate securities lawsuit can be found here, and the complaint can be found here. The plaintiffs’ attorneys’ April 2, 2008 press release regarding the SunTrust lawsuit can be found here and the SunTrust complaint can be found here. With the addition of these two new suits, there have now been a total of ten companies sued in these auction rate securities class action lawsuits.

The auction rate lawsuits are interesting. Clearly the plaintiffs’ lawyers think they are worth pursing. And if the intensity of the auction rate securities investors’ anger is an accurate gauge, then the plaintiffs’ lawyers filing of these lawsuits ultimately could be justified. As a result of prior posts on this blog (here and here) about auction rate securities, I have received numerous emails and inquiries from upset auction rate securities investors. Notwithstanding the investor anger, it is probably worth noting that so far as I can tell the leading plaintiffs’ securities firms are not (at least not yet) active in this space. Most of the auction rate securities class action lawsuits thus far have been filed by two plaintiffs’ firms (refer here and here).

The allegations in these auction rate securities class action lawsuits are largely identical. Essentially the plaintiffs contend that the defendants failed to disclose material facts about the instruments. In particular, the defendants are alleged to have failed to disclose that the auction rate securities were not cash alternatives, but rather that there were only liquid at the time of auction. More to the point, the complaints allege that the defendants failed to disclose that the auction rate securities would become illiquid as soon as the broker-dealers stopped maintaining the auction market.

In each of these class action lawsuits, the complaint names as defendants a specific financial institution and its broker-dealer affiliate. No individual defendants are named. While each complaint contains substantially identical generalized allegations of misrepresentations or omissions, the complaints contain virtually no allegations about specific statements the particular defendants companies are alleged to have made.

And even though the complaints purport to allege breaches of Section 10(b) of the ’34 Act, the complaints’ only basis for alleging scienter are generalized allegations of knowing falsity; there are no allegations of insider trading, and no particularized factual allegations supporting the general allegations of knowing falsity. The complaints similarly depend on the failure of the auction rate market itself as satisfying the loss causation requirement, rather than referring to any alleged curative disclosures or anything else in particular about the specific securities in which the class members invested.

The defendants undoubtedly will argue that these generalized allegations are insufficient to meet the threshold pleading requirements, in reliance in particular on Tellabs and Dura Pharmaceuticals. But while the defendants may seek to have the actions dismissed, the plaintiffs’ lawyers clearly intend to keep filing these actions.

The lawsuits potentially may also raise some interesting D & O liability insurance coverage issues. Because the complaints do not name any individuals as defendants, the sole potential coverage under the typical D & O policy that these claims might trigger is the so-called “entity coverage” found in most policies. In most public company D & O policies, the entity coverage is strictly limited to “securities claims.” While the auction rate securities lawsuits purport to raise claims under the securities laws, these allegations may or may not trigger the potentially applicable entity coverage, depending on how the term “securities claim” is defined in the applicable policy.

There are two general variants of the “securities claim” definition. One variant defines the term “securities claim” by reference to the securities laws themselves, including within the definition claims that assert breaches of federal or state securities laws or their equivalent. The other definitional variation defines “securities claim” by reference to the claimants and securities allegation with respect to which would be recognized as a securities claim. For example, this latter category might limit a “securities claim” to claims brought by holders of the company’s securities, or alternatively, might limit a securities claim to alleged breaches in connection with trading of the company’s own securities.

Clearly this definitional distinction could make a difference in connection with these recently filed auction rate securities lawsuits, as these claims might assert a “securities claim” and trigger the entity coverage in policies that use the former variants, but may or may not trigger the entity coverage in the policies that have the latter variant.

It is probably also worth noting that a number of the companies (for example, E*Trade) that have been sued in these auction rate securities class actions have also separately been sued in securities class action lawsuits by the companies’ own shareholders. These companies’ available insurance coverage may be under significant pressure already.

With the accumulation of these lawsuits, whose numbers are likely to continue to grow, it may well be time for these lawsuits to be broken out into their own separate statistical category, much as the IPO laddering cases were when the were filed in 2001. The auction rate securities lawsuits clearly represent a litigation category distinct from the more typical securities class action brought by public company shareholders.

But with the addition of the two latest lawsuits, the total number of subprime related lawsuits, as reflected on my running subprime lawsuit tally (which may be accessed here), now stands at 64, of which 26 have been filed in 2008. As noted above ten of these 64 lawsuits represent lawsuits brought by auction rate securities investors. Two of the 64 were brought by asset-backed securities investors against the investment banks who created the instruments. Two of the 64 were brought by mutual fund investors against the fund companies and fund managers. The remaining lawsuits were brought by public company shareholders.

Subprime Derivative Lawsuits: In addition to securities lawsuits, some shareholders have also filed subprime-related shareholders’ derivative lawsuits against company management alleging breach of fiduciary duty and other legal breaches. The latest of these subprime-related derivative lawsuits was filed on April 1, 2008 in the United States District Court for the District of Maryland against Municipal Mortgage & Equity (“Muni Mae”) , as nominal defendant, and certain of its directors and officers (complaint here). Muni Mae has previously been sued in a subprime-related securities lawsuit (refer here).

The derivative suit against Muni Mae joins other subprime-related derivative lawsuits that previously have been filed against, among others, Countrywide, American International Group, Regions Financial, and Bear Stearns. I have not been separately tracking the subprime-related derivative lawsuits, basically because I failed to anticipate that shareholders would file as many subprime-related derivative actions as they have. In response to readers’ inquiries, I will now endeavor to track the subprime-related derivative suits.

Unfortunately, because I am coming at this task belatedly, I may fail to account for derivative lawsuits that were filed previously and of which I am unaware. I would be grateful if readers would let me know of any pending subprime-related derivative lawsuits of which they are aware, so that I can add them to my tally and the list will be as complete as possible.

Subprime Litigation Overview: The field of subprime-related litigation has continued to grow and expand, to the point where it is difficult to get an organized sense of the range of issues and litigants involved. An April 1, 2008 memorandum from the Gibson Dunn law firm entitled “Subprime-Related Securities Litigation: Where Do We Go From Here?” (here) provides a top-level overview of current exposures facing companies involved in subprime-related businesses. The paper identifies early trends and key defenses, takes a brief look at likely D & O insurance issues, and describes the factors that are likely to affect the likely future direction of this litigation.

A Canadian Backdating Lawsuit: Though the backdating scandal now seems like ancient history, it seems that the lawsuits are still continuing to come in, although the most recent instance involves a Canadian company sued in a Canadian court.

According to news reports (here), a shareholder of Savanna Energy Services Corp. has filed an action in Alberta’s Court of Queen’s Bench against eleven current or former directors and officers of the company, alleging that the defendants manipulated the company’s stock options in order to profit personally. The lawsuit seeks damages equal to the defendants’ ill-gotten gains and a ban on issuing options to the company’s executives. The plaintiffs’ complaint relies on an affidavit from Eric Lie, the University of Iowa professor whose research initially triggered the options backdating scandal. Lie’s affidavit reports “a high statistical probability” that individuals at Savanna backdated options between 2004 and 2007.

Because Savanna is a Canadian company whose shares trade only on the Toronto Stock Exchange and because it has been sued in Canadian court under Canadian law, I have not tried to shoehorn the case into my running tally of options backdating lawsuits (which may be accessed here). The Savanna lawsuit may represent its own unique category of one.

Delaware Corporate Law Update: Francis Pileggi has posted on his Delaware Corporate and Commerical Litigation Blog (here) an interesting series of posts (here, here and here) reporting on the proceedings at Tulane University's Corporate Law Institute, which took place this past week. The posts include a number of interesting commentaries from members of the Delaware judiciary. Francis's post (here) about Delaware law regarding the sale of companies is particularly noteworthy and interesting, particularly Vice Chancellor Strine's remarks about the duties of boards of companies in the process of the sale of a company.

Death by Blogging?: Readers who may not appreciate how stressful it can be to maintain a blog may want to review the April 6, 2008 New York Times article entitled “In Web World of 24/7 Stress, Writers Blog Till They Drop” (here), which surveys the toll that blogging is taking on some authors.

While no one here at The D & O Diary seems to be in any immediate danger, maintaining the blog is unquestionably stressful. The authors described in the Times article are (or rather, were) at least getting paid for their troubles, whereas The D & O Diary lacks even that consolation. Our blogging efforts defy Samuel Johnson’s sage words that “No man but a blockhead ever wrote except for money” -- words that we frequently contemplate to our distress. Yet on we blog, as if by compulsion. A blog is indeed a harsh mistress.

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