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

In the most in-depth review yet of a subprime-related lawsuit complaint, Judge Mariana Pfaelzer of the Federal District Court in Los Angeles, in an order dated May 14, 2008 (here), denied the defendants’ motions to dismiss the amended complaint in the consolidated derivative lawsuit filed against Countrywide Financial, as nominal defendant, and against eleven individual current and former officers and directors.

The derivative complaint (a copy of which can be found here) accuses the defendants of misconduct and of disregard of their fiduciary duties, and alleged lack of good faith and lack of oversight of Countrywide’s lending practices, financial reporting and internal controls. The amended complaint also contains insider trading allegations, based on the individual defendants’ sale of over $848 million of their holdings in Countrywide stock while in the possession of material inside information, between 2004 and 2008.

The defendants moved to dismiss the plaintiffs’ derivative claims on the ground that the plaintiffs had not make pre-suit demand or adequately pled that demand was excused.

Judge Pfaelzer began her analysis with some harsh words for the plaintiffs’ complaint, which she described as “prolix and sprawling.” Notwithstanding these concerns, she proceeded to the merits in a ruling that largely went the plaintiffs’ way.

She opened her analysis with the observation that standards to determine whether demand is excused “overlap considerably” with the standard for establishing a claim under Section 10(b) of the ’34 Act. She said that the two issues are “inextricably intertwined,” and proceed to determine that in several material respects the plaintiffs’ allegations satisfy the pleading requirements under the standards of the recent Tellabs case.

Judge Pfaelzer found that the plaintiffs’ allegations create a “cogent and compelling inference that the individual Defendants misled the public with regard to the rigor of Countrywide’s loan origination process, the quality of its loans, and the Company’s financial situation – even as they realized that Countrywide had virtually abandoned its own loan underwriting processes.”

In support of these allegations, the plaintiffs relied on confidential witnesses, whom the court said “paint a compelling picture of a dramatic loosening of underwriting standards in Countrywide branch offices across the United States.” The court said that “plaintiffs’ numerous confidential witnesses support a strong inference of a Company-wide culture that at every level emphasized increased loan origination volume in derogation of underwriting standards.”

The court found further that the plaintiffs' allegations support the contention that many of the individual defendants were aware of the deterioration of standards. After reviewing the “red flags” that should have alerted the individual members of various board committees, the court found that the plaintiffs’ allegations raise “a cogent and compelling inference that the Audit & Ethics committee members were aware of (or proceeded with deliberate recklessness with respect to) the significance of red flags related to increasing delinquencies, negative amortizations, and other signs of loan nonperformance.”

Similarly, the court also found that the allegations “give rise to a compelling inference” that Credit Committee members were made aware of signs of deterioration. The court also found that members of the Finance Committee “either knew or proceeded with deliberate recklessness with respect to, the fact that loans to borrowers who could not pay back their mortgages would ultimately be counterproductive, lucrative as it was in the short run.”

The court also found that plaintiffs had asserted facts to support a strong inference that members of the Operations & Public Policy Committee had acted with scienter. However the court found that “without more, the court does not fund membership on the Compensation Committee probative of scienter.”

In concluding that the allegations taken as a whole support an inference of scienter, the court stated that

independent of any turmoil in the capital markets, the widespread violations of underwriting standards would significantly raise risk of loan defaults. When combined with what the Plaintiffs allege are misrepresentations concerning the quality of Countrwide’s loans, the underwriting issues would ultimately undermine confidence in the secondary market for Countrywide products.

In further support of the scienter findings, the court referred to the company’s aggressive stock repurchase program, undertaken and continued at a time when the company’s share price escalated and while insiders were dumping their own shares. While the defendants offered competing innocent explanations for the insider sales, the court found that the plaintiffs’ “repurchase-related insider trading allegations … are at least consistent with their theory of fraud” and “provide some support” against the motion to dismiss. The repurchase program could be viewed as “an attempt to keep the ball rolling” by steadying the company’s share price “before the weight of the loan origination practices began taking their toll on the company’s operations and the value of its stock.”

The plaintiffs also relied on Countrywide CEO Angelo Mozillo’s alleged manipulation of his Rule 10b5-1 trading plan, about which the court said that “Mozillo’s actions appear to defeat the very purpose of Rule 10b5-1 plans.” The court rejected the innocent explanations offered for the changes to Mozillo’s plan, saying that the factors “do not mitigate against the inference of scienter given the magnitude and timing of Mozillo’s trading,” which amounted to hundreds of millions of dollars in stock trading proceeds.

After this detailed review of the scienter requirements and allegations, the court quickly worked through the other pleading requirments and proceeded to the ultimate question whether the plaintiffs’ allegations satisfied the demand futility standards. In considering this issue, the court again reviewed the allegations that the various board committee members were aware of the deteriorating loan practices yet failed to take corrective actions.

Since the same individuals who would have had to have considered the litigation demand were involved in these alleged circumstances, the court found that “a majority of the directors are ‘interested’” and therefore demand is excused (except as pertains to a category of claims relating to Mozillo’s compensation). The court also dismissed out two individual defendants based on the specific allegations relating to their individual involvement. The court directed the plaintiffs to file an amended complaint consistent with the order within 20 days.

At one level, Judge Pfaelzer’s order is a reflection of the specific allegations in the Countrywide complaint, particularly as pertains to the allegations of deteriorating underwriting and loan origination practices, and as pertains to the Mozillo’s insider trading. The outcome was also influenced by the allegations based on the factual observations of numerous confidential witnesses. To that extent, Judge Pfaelzer’s order may simply be a reflection of the alleged circumstances of the specific case and have relatively little potential significance for other pending subprime-related cases.

However, there may yet be a sense in which this order is relevant for other cases, and that is the court’s clear discomfort for the allegedly deteriorating practices in contrast to the company’s statements and the insiders’ stock sales. Other pending cases contain allegations pertaining to the excesses of the subprime lending marketplace, and other cases also contain allegations of insiders profiting while underwriting and loan origination practices deteriorated.

While there is at least this potential relevance of the Countrywide case for other subprime-related litigation, the larger significance is simply its primacy. Because it is one of the first cases with a detailed review of the allegations, the courts’ apparent receptivity to the plaintiffs’ allegations may be significant. Other defendants in other cases may be able to establish the insufficiency of the plaintiffs’ allegations, but the Countrywide decision could be interpreted to suggest that the defendants will have to overcome courts’ receptivity to similar allegations.

Judge Pfaelzer’s analysis of the allegations concerning Mozillo’s Rule 10b5-1 plan are also interesting, because they underscore the extent to which courts will be wary of apparent attempts to use plans to shield improper trading. When the dust settles on this case, there likely will be a fruitful opportunity to consider the lessons from these circumstances for proper and improper uses and structures of Rule 10b5-1 plans.

The WSJ.com Law Blog has a interesting post here discussing the background and context of Judge Pfaelzer’s opinion.

Special thanks to a loyal reader who prefers anonymity for providing a copy of the order.

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As reflected in my running tally of options backdating lawsuit settlements (which can be accessed here), a number of the options backdating-related derivative lawsuits have settled for some combination of an agreement to pay the plaintiffs’ attorneys’ fees, some adjustment to the company officials’ options grants, and the company’s adoption of corporate governance reforms. But two April 7, 2008 opinions by Judge William Alsup of the United States District Court of the Northern District of California in separate options backdating derivative cases may raise potentially troublesome questions whether settlements in this form, without some cash payment directly to the corporation, are sufficient. As a minimum, the two opinions have important implications for the way settlements are presented to the court, and could also have important effects on the settlement dynamic in other cases going forward.

The first and most detailed of the two opinions relates to the options backdating derivative suit filed on behalf of Zoran Corporation, about which lawsuit I first wrote here. In a June 5, 2007 opinion in the Zoran case (here), Judge Alsup had previously denied the defendants’ motion to dismiss, as I previously discussed here.

Following the dismissal denial, the parties to the Zoran case entered settlement negotiations, resulting in a February 26, 2008 stipulation of settlement, which the parties presented to the court on March 3, 2008. At the preliminary approval hearing, the plaintiffs’ damages expert, at the court’s request, presented a report calculating the plaintiffs’ maximum damages as $16 million (including prejudgment interest), which incorporated both the alleged damaged cause to company by the defendants’ option grants as well as by option grants to the rank-and-file employees.

The proposed Zoran settlement involved: the payment of up to $1.2 million of the plaintiffs’ attorneys’ fees and costs; the repricing or cancellation of certain of defendants’ options, which repricing or cancelation was represented to the court to have a value of $1.65 million; the company’s adoption of certain corporate governance reforms; and the grant of a broad claims release.

In an April 7, 2008 opinion (here) that contains some remarkably harsh language, Judge Alsup denied the parties’ request for preliminary approval of the settlement.

The parties undoubtedly knew the settlement was in trouble when Judge Alsup opened his analysis by stating that the class action procedure can “lend itself to abuse” and “one form of abuse is a collusive settlement.” Judge Alsup said that a collusive settlement “usually comes with a cash award to counsel, a broad release of claims, and a cosmetic non-cash recovery for the abused shareholders.” Courts, Judge Alsup notes, must take care that absent shareholders are treated fairly; here, he concludes, the settlement “falls short of deserving preliminary endorsement.”

In considering the settlement, Judge Alsup turned first to the substance of the plaintiffs’ claims (the implication being that the claims appeared to be meritorious), and to a declamation upon the plaintiffs’ expert’s $16 million damages estimate. Judge Alsup then addressed each of the settlement components, finding each component lacking.

First, Judge Alsup noted that the parties were not proposing to restore to the corporation the gains the defendants made from the sale of options, but rather that certain other options would be canceled or repriced. The option cancelation was represented to have very substantial value to the corporation, but the two sides’ experts had reached different conclusions about the value. Judge Alsup found that by using the most conservative valuation method and valuation date, the value of the cancellation was only $216,955, a small fraction of the value both sides had represented to the court.

The court next turned to the repriced options, with respect to which Judge Alsup noted, with incredulity, that the options had actually been repriced in December 2006, which was not only over a year before the settlement was presented to the court, but was even before the plaintiff filed the consolidated amended complaint. The court said that “it should have been plainly disclosed that the defendants were proposing to settle based on an old concession rather than a new consideration.” The court went on to note that “even if the flaw could somehow be ignored,” the value of the repriced options had been “exaggerated.” If a “meaningful” valuation date were used, the value of the repriced options is “zero.”

Judge Alsup had similar concerns with respect to the corporate governance reforms, in that several of the reforms “were already adopted by Zoran’s board well before the parties sat down to discuss settlement terms.” The reforms in any event “do not compensate the company for damages suffered by the company as a result of defendants’ backdating.” The reforms are “hard to accept in lieu of some substantial portion of the $16 million in damages asserted by the plaintiffs’ expert.” Judge Alsup also found that the claim release was overbroad, and swept in circumstances that were not asserted in the amended complaint.

In concluding that the settlement was inadequate, Judge Alsup stressed that “the corporation would recover no cash, all the cash is going to counsel,” and even the supposed value of the $16 million of the foregone benefits is “illusory” and he concluded that this “low end settlement” did not deserve approval.

Judge Alsup was clearly troubled that he had been obliged on his own to ferret out the settlement’s weaknesses, many of which were contrary to counsels’ representations.

Judge Alsup concluded his opinion with a rather stern lecture on counsels’ “duty of candor,” which he said requires counsel to “lay out the weaknesses as well as the strengths” of the settlement. He also stressed that it is “unfair to try to slip a weak or collusive settlement past the judge, hoping he or she will sign off or will not stumble upon the right questions.” A $1.65 million settlement, while at the low end, might be adequate, but the “main vice is that the proposal does not come even close to the $1.65 million settlement it was advertised to be.”

Many of the problems the court identified clearly were the result of communications issues. The parties perhaps could have avoided some of the difficulties by making joint valuation presentations that were scrubbed and scrutinized ahead of time. The court was also clearly upset to discover upon inquiry (rather than being told) that some of the remedies proposed had been undertaken prior to the settlement agreement; better communication around these settlement components potentially could have averted some of the court’s concerns.

But there are other aspects of the court’s commentary that are not merely the consequence of poor communication. First and foremost, Judge Alsup appeared to be troubled by how little the corporation would be getting, and in particular that the corporation would be getting no cash. He was also troubled that the settlement’s putative $1.65 million value, even if valid, was at the “low end” of plaintiffs’ damages analysis. In a sign that may have important implications for other settlements, he was also clearly skeptical that the noncash portions of the settlement – including even the corporate governance reforms, to which he attached little value --had value commensurate with the claimed injuries to the corporation.

But while there clearly are important implications from Judge Alsup’s ruling in the Zoran case, before fully considering those implications, it is important also to review Judge’s Alsup’s opinion (here), also dated April 7, 2008, in the CNET Networks options backdating-related derivative lawsuit, which provides even further context.

In his CNET Networks opinion, Judge Alsup refused even to consider the parties’ proposed settlement. Judge Alsup had previously granted defendants’ motion to dismiss (refer here), on the grounds that demand was not excused, but stayed the case to allow the plaintiffs to seek discovery through the Delaware courts and to attempt to replead. In response to an inquiry from the court about status, the parties advised the court that settlement negotiations were underway, and the parties then presented a joint motion to lift the stay for the limited purpose of seeking a preliminary approval of a settlement. Judge Alsup said that it found these actions “disappointing” because the parties did not, as they had represented to the court they would, complete discovery, nor did plaintiff file an amended complaint. Instead the parties sought to settle the case, about which Judge Alsup said

any settlement, at this early stage, seems very premature, for the Court could not be in a position to evaluate a settlement until we know what claims are viable and what depositions, discovery, and damage assessments show about the strength and magnitude of those claims. At this stage, moreover, plaintiff has no standing at all to negotiate on behalf of the corporation and its shareholders. Plaintiff has never been excused from the demand requirement. Plaintiff is not in any way authorized to release claims on behalf of any shareholders or the corporation. It would be hard to see how plaintiff could do so intelligently without first framing the claims and then performing sufficient due diligence through formal discovery and investigation, including a full damage report. Now, any legitimate settlement reached later may be tainted by what could appear to have been collusion. To deal with this eventuality, all notes and materials generated by or during the recent settlement discussions should be preserved. For the Court’s views on collusive settlements see In Re Zoran Corporation Derivative Litigation.

Judge Alsup went on to note that “the best way to tee up this case for settlement is to find out first whether the plaintiff even has standing to sue (the demand issue) and thus to release claims on behalf of the corporation,” and then to evaluate which options were backdated and the dollar value to the corporation of these claims. “It would,” Judge Alsup said, “be very hard to evaluate a settlement without due diligence, including depositions and documents.”

Judge Alsup’s two opinions taken together represent a strong statement that, because of the court’s responsibilities to absent class members, the court must take its obligation to review proposed settlements very seriously. The court clearly should not be expected just to rubber stamp a settlement to which the parties’ representatives have agreed. In order to get settlement approval, and avoid the suggestion of collusion, the parties will have to show certain key considerations: first, and at a minimum, that the plaintiff even has standing to represent the class and enter the settlement; second, that the settlement is proportionate to the injury to the corporation that the plaintiff has claimed; third, that the claimed values to the corporation are supported; and fourth, that the corporation is fairly compensated for its damages and its release of claims.

Even though Judge Alsup’s opinions technically have no precedential effect beyond the immediate cases themselves, the strength of the language he used, the seriousness of the concerns he noted, and the possibility of similar questions undermining other settlements could well have an in terrorem effect on other litigants in other cases. Certainly no litigant would want to take a chance that a court might suggest that their proposed settlement could be “collusive.” Even though many of the aspects of these opinions are a reflection of the particular circumstance involved, the opinions also bespeak more general principles that could have broad influence. In particular, Judge Alsup’s statement in the CNET Networks case that he could not even consider a proposed settlement until the plaintiff first establishes its right to enter a settlement and presents an adequate factual record and damages analysis suggests that cases must have progressed past a certain stage before the parties can even proffer a proposed settlement to the court.

There are several interrelated issues arising from Judge Alsup’s requirement for a damages analysis, his requirement that the settlement be proportionate to the alleged harm, and his obvious concern in the Zoran case that no cash was going to the corporation. The overall suggestion is that a few gestures and payment of some legal fees may not be enough. There may actually need to be some cash going to the corporation, proportionate to the alleged harm. Judge Alsup’s unwillingness to recognize significant value to the corporation for the corporate governance reforms may be particularly troublesome.

As I noted at the outset, many of the options backdating derivative cases that have been settled so far have been resolved on terms similar in many respects to the components of the Zoran settlement. The likely reason why there is no cash payment to the corporation in many of these cases is that D&O insurers balk at funding amounts they contend represent a disgorgement or a return of an ill-gotten gain. The individual defendants, for their part, resist making out of pocket payments for which insurance is unavailable. The parties thus perforce attempt to cobble together an agreement that resolves the case without any cash transfer other than the payment of plaintiffs’ counsel’s fees.

Judge Alsup’s opinion, particularly his repeated use of the word “collusive” and statement that the value to the corporation from the Zoran settlement was “illusory” could introduce a great deal of tension into this negotiation dynamic. Both insurance carriers and individuals could face heightened pressure to make cash contributions to the corporation to resolve these cases. Insurers will likely continue to resist any payment on their part, owing to policy exclusions for disgorgement and the return of ill-gotten gains.

Another important implication is that the parties must be prepared to substantiate their settlement, and that discovery, depositions, damages assessments and other procedures may be required to satisfy these requirements. These procedures could prove costly for all concerned – particularly for the D&O insurers, who not only will foot the bill for increased defense expense, but also ultimately could be called upon to pay the plaintiffs’ fees as well, as part of any eventual settlement.

Notwithstanding the foregoing, of the parties involved, the participants that may face the biggest problems if these cases become more difficult to resolve are the plaintiffs’ lawyers. There is a suggestion in both of these cases that the plaintiffs’ lawyers are starting to find the cases tiresome and just want them to go away. Indeed, one of the things that clearly seemed to be bothering Judge Alsup in these cases is that the plaintiffs’ lawyers were settling (too) cheap or walking away without even doing what the Judge at least believes to be minimally required. The plaintiffs’ lawyers piled into these kinds of cases with enthusiasm but they may now be repenting their involvement. The implication of Judge Alsup’s opinion may be that the plaintiffs’ lawyers may be challenged to extricate themselves.

According to my tally (which can be found here), there have been a total of 166 options backdating lawsuits filed. To date, only a small portion of these cases (less than a third) have been settled or otherwise resolved. The vast majority, well over one hundred, of these cases remain pending. Of course it remains to be seen, but I suspect that Judge Alsup’s opinions in these two cases will prove to have introduced significant challenges for parties trying to move these pending cases toward resolution.

Very special thanks to Zusha Elinson of The Recorder for providing me with copies of these opinions. Elinson’s April 24, 2008 article in The Recorder about the opinions entitled “Alsup Rejects Easy Options Deals” can be found here (Full disclosure: I was interviewed in connection with the article).

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