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

As discussed in a prior post (here), at an April 1, 2009 hearing, Southern District of New York Judge Jed Rakoff had raised concerns that a proposed lead plaintiff’s law firm may have a "blatant, shocking conflict of interest," as a result of free portfolio monitoring services the firm performed for its client, the Iron Workers Local No. 25 Pension Fund. On April 25, 2009, Judge Rakoff entered an order (here) naming the Public Employees’ Retirement System of Mississippi (MissPERS) as lead plaintiff, stating that he would explain his reasons in a forthcoming opinion.

On May 26, 2009, Judge Rakoff entered his opinion (here) explaining his lead plaintiff selection in the case, which involves consolidated lawsuits relating to Merrill Lynch mortgage pass-through certificates. The opinion contains some interesting comments and observations about the two competing plaintiffs and their relations to their counsel

In his opinion, Judge Rakoff explained that because of "problematic relationships" between plaintiffs and their counsel, he was faced with a choice between "two less-than-perfect plaintiffs." He was particularly concerned with the relationship between the Iron Workers Fund and its counsel, because of testimony at the April 1 hearing showing that the Fund had a contractual arrangement with counsel whereby the law firm provided "free monitoring" of the Fund’s portfolio, in exchange for which if the firm recommended that the Fund pursue securities litigation, the firm would be retained on a contingency fee basis.

Judge Rakoff said that this arrangement goes "far beyond any traditional contingency arrangement" and creates a "clear incentive" for the firm to "discover fraud" and to recommend litigation, a practice that "fosters the very tendencies toward lawyer-driven litigation that the PSLRA was designed to curtail."

As the April 1 hearing, Judge Rakoff had questioned whether this arrangement was ethical. Following the hearing, the concerned law firm filed an affidavit from distinguished scholar Geoffrey Hazard, who opined that the arrangement did not create an improper conflict of interest. Among other things, Professor Hazard based his opinion on the conviction (speaking with respect to securities litigation) that plaintiffs’ lawyers had every incentive to proceed only if the claim is reasonably viable. He also noted that in contemporary practice, most plaintiffs are sophisticated and have access to sophisticated advisors.

Judge Rakoff noted that while he has "the very greatest respect" for Professor Hazard, he was not persuaded. First, the Professor’s statements about plaintiffs’ counsel’s incentives to pursue only viable claims are contrary to the concerns of Congress in enacting the PSLRA "regarding abusive lawyer-driven litigation."

And with respect to the supposed sophistication of plaintiffs and their access to sophisticated advisors, Judge Rakoff noted that the Iron Worker’s Fund’s administrator "was not particularly sophisticated in evaluating securities actions" and "only had a rough idea what this lawsuit was all about," and the "sophisticated advisors" on whom the Fund was relying were "the very lawyers who would be bringing suit."

Judge Rakoff concluded that he "need not determine whether there here exists a conflict of interest that violates ethical rules," since it is clear that the Iron Workers Fund is "in no position to adequately monitor the conduct of this complex litigation."

Which is not to say that MissPERS, the lead plaintiff he selected, is "without blemish," since it too relies on portfolio monitors and has very regularly served as a lead plaintiff. However, Judge Rakoff found that MissPERS relies on twelve different monitors, rather than a single monitor, and it employs a group of lawyers to evaluate litigation recommendations and "plainly had a sophisticated knowledge of such matters."

As for the objection that MissPERS was a "professional plaintiff" of the kind the PSLRA disfavors, Judge Rakoff noted that when the alternative plaintiff had little expertise, "the accumulated experience of MissPERS in pursuing multiple securities fraud actions seems a benefit more than a detriment."

In a final footnote, Judge Rakoff raised, but did not address, concerns about Pay-to-Play arrangements that could affect relations between plaintiffs’ firms and elected officials, but he declined to address the issue, which he said was not "presently before the Court in this case."

It is probably worth noting that the strong language Judge Rakoff used at the April 1 hearing has drawn considerable attention in other forums. For example, in a May 5, 2009 hearing before Central District of California Judge Andrew Guilford to determine the lead plaintiff in a case pending there, Judge Guilford noted (here) that because the same law firm was involved in the case before him as in the case before Judge Rakoff, he was "concerned" by Judge Rakoff’s observations at the April 1 hearing, and he noted further that his lead plaintiff "determination will benefit" from the analysis Judge Rakoff was to provide in his then-forthcoming opinion. Clearly, Judge Rakoff’s various statements and rulings could have significance outside the confines of the specific case in which they were delivered. Special thanks to a loyal reader for a copy of the May 5 opinon

On the other hand, it is relevant to note that in another recent lead plaintiff decision by a judge in same courthouse as Judge Rakoff did not consider the monitoring services this particular law firm provided to the lead plaintiff to even be a relevant consideration. In a  May 22, 2009 opinion (here), Southern District of New York Judge Barbara S. Jones rejected arguments that the law firm had a conflict of interest due to the portfolio monitoring servicves it provided to the proposed lead plaintiff. Judge Jones said that "the Court has been shown no reason why this monitoring system causes any issues or impediments to teh firm's representation," noting that the firm "has substantial experience in representing shareholders in securiteis class actions" and that she "believes the firm will serve the class adequately." Special thanks to a loyal reader for a copy of the May 22 opinion.

Andrew Longstreath’s May 27, 2009 Law.com article about Judge Rakoff’s opinion can be found here.

More Problem Banks: In prior posts (most recently here), I noted concerns regarding the increasing number of failed banks, and conjectured that banking closures were likely to continue to accumulate for the foreseeable future, citing the FDIC’s estimates of the number of "problem banks."

In its latest Quarterly Banking Profile, released on May 26, 2009 for the first quarter of 2009 (here), the FDIC increased the number of banks on its "Problem List" from 252 at year end 2008 to 305 as of March 31, 2009, and increased the total assets at problem institutions from $159 billion to $220 billion. (The FDIC does not identify the banks it has designated as "problems" by name.)

To put this increase in context, the number of banks on the Problem List as of the end of the third quarter of 2008 was only 171, and at the end of the second quarter of 2008, the count was only 117. In other words, the number of banks on the Problem List not only increased 21% from year end 2008 to the end of the first quarter 2009, but it has increased 160% in just nine months between the middle of 2008 and the end of the first quarter.

As I have said before, all signs are that the current banking woes are likely to continue for the foreseeable future.

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One of the recurring issues in securities litigation is the way the erstwhile class counsel and their clients, the prospective class representatives, come together. In what one federal judge described as a "blatant, shocking conflict of interest," it appears, from testimony at a recent lead plaintiff selection hearing, that the leading plaintiffs’ firms are providing investment portfolio "monitoring services" for which the firms are paid only if their public pension fund clients pursue litigation recommended by the law firm. In a post-hearing brief in the case, the  firm involved defended its practices as appropriate.

These issues arose at an April 1, 2009 hearing before Southern District of New York Judge Jed Rakoff, involving two cases, the Credit Based Asset Servicing case (about which refer here) and the Merril Lynch Mortgage Pass Through Certificate case (refer here). Both cases involve alleged misrepresentations in connection with the initial public sale of certain mortgage-backed securities.

At the April 1 hearing, Judge Rakoff consolidated the two cases. The primary purpose of the April 1 hearing was to determine which of the two proposed plaintiffs was the "most adequate" to represent the class in the consolidated case.

As reflected in the hearing transcript (here), Judge Rakoff first heard testimony from an administrator for Iron Workers Local No. 25 Pension. In response to questions from the Judge, the administrator testified that they way he learned about the allegations in the case was that "they were brought to me by counsel."

The administrator explained that the lead plaintiffs’ firm representing the pension fund in the case has a long-standing investment portfolio monitoring contract with the fund. Under this contract, the law firm monitors the fund’s investments and advises the firm when circumstances arise that would warrant a lawsuit. The plaintiffs’ firm is only paid if they bring a lawsuit and recover.

Among other things, Judge Rakoff called this arrangement "about as obvious an instance of conflict of interest as I’ve ever encountered in my life," noting that the plaintiffs’ counsel,

under the guise of monitoring the [pension fund’s] investment to determine whether or not there are any violations of the law …have made an arrangement whereby they will only get paid if there are lawsuits brought that they can recover on, and that they will be plaintiffs’ counsel in that lawsuit.

Judge Rakoff observed that "if that isn’t a gross conflict of interest in violation of the most elementary fiduciary duties, I don’t see what is." He added that the arrangement inherently compromises the objectivity of the monitoring they’ve been asked to undertake. Indeed, to be frank, I’m shocked that any law firm would enter into such an arrangement."

Counsel for the Iron Workers gamely defended the arrangement, among other things asserting that "this portfolio monitoring is not something unique to this firm," an argument that did not impress Judge Rakoff. In response to plaintiffs’ counsel’s suggestion that his law firm analyzes and evaluates the merits of the case before recommending that the fund become involved in litigation, Judge Rakoff said that arrangement "makes crystal clear that the Iron Workers are being led by counsel rather than the other way around," a circumstance the PSLRA had tried to eliminate.

Judge Rakoff then heard testimony from the Special Assistant to the Mississippi Attorney General, on behalf of the other proposed lead plaintiff, the Mississippi Public Employees Retirement System. The representative’s testimony established that Mississippi also had monitoring arrangements with plaintiffs’ law firms, but with twelve separate firms rather than just one. The representative also testified that the possibility of bringing this particular action had been brought to the state’s attention by a separate firm that performs bankruptcy related services for the state.

The representative explained by using plaintiffs’ firms for monitoring , rather that paying for independent monitoring services, the state was able to save costs. The state representative described the use of plaintiffs’ firms for monitoring services as a "commonplace practice," in response to which Judge Rakoff observed

Yes, well, I’m learning that, and to be frank, that doesn’t make me less shocked, that makes me more shocked, because what you’re telling me is that persons, entities with a fiduciary duty, which includes a fiduciary duty to monitor the investments they’re making with their members’ money, have concluded that to save a few bucks they will employ as monitoring entities firms that can only profit of their advice goes one way and not the other.

Judge Rakoff did find certain distinguishing characteristics in Mississippi’s case, in that one of its twelve monitoring firms had not brought the case to the state (although it turns out that the bankruptcy firm that did bring the case to the state does have a contingency fee interest in the case); and that even if one of the twelve firms were to bring a case forward, the case would be independently evaluated by other firms and the state’s own representatives. Finally, the state representative testified that in this case the state had reached out to the lead plaintiffs’ firm, rather than the other way around.

Ultimately Judge Rakoff did not rule at the April 1 hearing on the question of which of the two proposed plaintiffs would be the lead plaintiff in the case. Rather, he asked for further briefing, noting a concern that at the hearing he might have been "overreacting because of hearing about this arrangement for the first time."

Even though Judge Rakoff ultimately did not rule at the April 1 hearing, his shocked response to the practices that were described multiple times at the hearing as "commonplace" does seem to suggest that there may be concerns with the monitoring arrangements. Certainly, the language the Judge used to characterize the arrangements is impressive, to say the least.

Pursuant to Judge Rakoff’s briefing schedule, and in response to his comments, on April 8, 2009, the Iron Workers filed a legal brief (here), that among other things defends the monitoring arrangements on the grounds that the monitoring agreement does not itself authorize the firm to initiate litigation on the fund’s behalf without the fund’s authorization, and that the fund is under no obligation if it decides to pursue litigation to use that particular law firm.

In addition, the Iron Workers’ brief cites multiple cases in which various courts found that the existence of similar monitoring arrangements were not a barrier to the proposed plaintiffs’ service as a class representative.

Finally, the brief also includes an opinion from the distinguished legal scholar Geoffrey Hazard that the portfolio monitoring services were not "professionally improper" and that there is no conflict of interest in these circumstances because the pension fund is not obligated to bring suit even if the firm recommends it. Hazard also stated that the mere fact that the plaintiffs’ firm was "working for a contingent fee" does not present an "inappropriate bias."

The Mississippi Public Empoyees' Retirement System's brief regarding the alleged conflict and the lead plaintiff issue can be found here. Merrill's brief can be found here.

UPDATE: In an  April 23, 2009 order (here), Judge Rakoff appointed the Mississippi Public Retirement System as the lead plaintiff in the cases. In the April 23 order, Judge Rakoff also stated that  the lead plaintiff determination "involved the Court's resolution of several difficult issues, which will be elaborated in a written opinion." Judge Rakoff said that he would issue the detailed opinion after he completed an ongoing criminal trial that he has been conducting.

Special thanks to a loyal reader for providing a copy of the hearing transcript.

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The possibility that a conflict of interest could arise when an attorney or law firm simultaneously representes a corporation and one or more of its officers or directors is a a frequently recurring issue. The issue  was raised recently, for example, in the civil complaint that former Stanford Financial Group CFO Laura Pendergest-Holt filed against the firm’s former outside counsel, in connection with his conduct of the defense in connection with the SEC’s investigation of the firm. (A copy of Pendergest-Holt’s complaint can be found here.)

An April 1, 2009 opinion (here) by Central District of California Judge Cormac Carney in the Broadcom Corporation options backdating criminal case presents a far more dramatic example of the pitfalls that can arise from dual representations.

The opinion involves the Irell & Manella law firm’s "separate, but inextricably interrelated representations" of Broadcom and its CFO, William Ruehle. The law firm represented the company in its internal investigation of the backdating allegations. It also represented the company and Ruehle in the defense of the backdating related civil litigation.

In June 2006, two lawyers from the firm interviewed Ruehle, without disclosing possible conflicts or disclosing they might later reveal his statements to third parties (such as the government). Subsequently, the law firm, at the company’s direction, disclosed Ruehle’s statements to the company’s auditors, the SEC and the DoJ.

Ruehle sought to suppress the government’s reliance on his statements in connection with the criminal prosecution, because the statements represented privileged communications. Judge Carney agreed, but his April 1 opinion went far beyond this conclusion.

Judge Carney found that Irell "committed at least three clear violations of its duty of loyalty" – it failed to advise Ruehle of and obtain his written consent to the conflict; it interrogated him for the benefit of another client (Broadcom); and it disclosed privileged communications to a third party without consent.

Judge Carney said that he found Irell’s "ethical breaches" to be "very troubling," not only because they resulted in the suppression of relevant evidence, but also because they "compromised the rights of Mr. Ruehle, the integrity of the legal profession, and the fair administration of justice." Because of these concerns, Judge Cormac concluded that he "must refer Irell to the State Bar for discipline."

Judge Carney’s blistering opinion is noteworthy in and of itself, both because of the prominence of the firm involved and because of the heat of the rhetoric he employed. His opinion is also a cautionary example both to lawyers involved in corporate representations and to corporate officers whose interests may be being represented by the company’s own counsel in connection with serious investigations that may potentially involve criminal implications.

The opinion may also be relevant for insurance professionals who often are called upon to address questions surrounding the possible need for separate counsel for individual defendants. Judge Carney’s opinion in the Broadcom case underscores how serious these issues may be, and the consequences that can sometimes arise if separate counsel issues are not appropriately addressed.

Insurance professionals of course cannot become involved in the kinds of ethical questions presented in Judge Carney’s opinion, but an awareness of the kinds of issues that can arise is an important perspective to bring to the table when questions involving separate representation do arise.

It is sometimes the case that it is the firm’s outside law firm that is resisting the suggestion that the firm may not be able to maintain the multiple representations it has purported to assume. These kinds of discussions can be particularly vexing, as law firm can often dominate the dialog and the insured company or insured individuals may not see where their interests may diverge from the position the law firm is advocating. While these conversations can sometimes be extremely delicate, they can involve critical issues. Insurance professionals aware of the kinds of issues involved in the Broadcom case can at least raise appropriate questions to try to ensure that issues are discussed.

Special thanks to a loyal reader for proving a copy of Judge Carney’s opinion.

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