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

Recent sharply-worded accusations that the FDIC had failed to preserve documents attracted quite a bit of media attention. For example, a January 27, 2012 Wall Street Journal article reported the charges of counsel for two former IndyMac bank executives, repeating counsel’s remarks accusing the agency of a “stunning display of incompetence” for failing to preserve documents. Counsel made these statements in a filing in an action the FDIC had filed against fhe individuals in its capacity as receiver for the failed bank.

The Journal article also quoted the individual defendants’ counsel’s statement that “the breadth and depth of the government’s document-retention failures are staggering, and violations of this magnitude rarely occur,” and that “it is a stunning display of incompetence from an agency that is supposed to be an expert at seizing and managing banks.”

Based on these accusations, two of the inidividual defendants  sought sanctions against the government for willful spoliation of evidence, dismissal of the relevant counts of the lawsuit and an adverse instruction to the jury based on the government’s failure to preserve evidence.

The defense counsel’s provocative language may have succeeded in getting his accusations published in the Wall Street Journal. However, the language proved less successful when the matter came before Central District of California Judge Dale Fischer in a hearing on January 30, 2012. As reflected in a transcript of the hearing, Judge Fischer had quite a lot to say about counsel’s approach, including in particular, counsel’s use of language.

Judge Fischer started her remarks with a comment about counsel’s pleading tactics and then went on from there:

THE COURT: Now, there were a number of declarations attached to the reply that apparently were not filed immediately after they were signed. Why was that?

DEFENSE COUNSEL: Your Honor, we waited to file them with our reply.

THE COURT: And you seriously thought that was the appropriate approach?

DEFENSE COUNSEL: Yes, I did, your honor.

THE COURT: Well, for future reference, it wasn’t. Don’t hold back evidence that relates to your motion until after the opposing party files its opposition and then just stick it to them at the end. So I’m not sure why you thought that was appropriate, but now you know.

Along those lines: I also want to tell you, I don’t know why lawyers do this, and there’s a lot of them in the room so take heed, all of you, language like failures are staggering, violations of this magnitude rarely occur, stunning display of incompetence, bitter irony, breathtaking dereliction of duty are not only unpersuasive, they’re somewhat annoying. I don’t have time for rhetoric. I’m really, really busy. Why anyone would want this job, I don’t know…

But in any event, it’s just – I don’t know whether you stay up nights trying to think of clever phrases, but trust me, no judge that I’ve ever spoken to has ever said, Boy, can that guy turn a phrase. They only say, Boy, why didn’t he get to the point. So, please, in future pleadings, remember that.

DEFENSE COUNSEL: Yes, your Honor.

THE COURT: In addition to that, I’ve been around awhile both in practice and on the bench, so I suspect I’ve seen a few more cases than you, and really, it’s not all that staggering and it’s not all that great a magnitude, so when your experience and mine differ, it just takes all of the punch out of those comments.

To make matters even worse, Counsel, your statement that the government failed to make any effort to preserve the documents is simply false. And your statements in your papers so often go beyond the bounds of zealous advocacy that I have to say your papers had very little persuasive value. In fact, as I was trying to check some of the references you made to deposition testimony, I looked at it three or four times because I thought I must be searching for the wrong page because the pages you were citing to had oftentimes no relationship to the proposition you were citing them for. You started off extremely poorly as I started reading the papers, and I had little confidence in anything you had to say as I went through them.

Judge Fischer denied the defendants’ motion.

Readers of this blog may also be interested to read the discussion in the hearing transcript, beginning at page 27, about the role that the D&O insurance program in the ongoing case. From reading the transcript, it appears that the individual defendants contend that there a second $80 million insurance tower is relevant to this claim, although defense costs are being funded out of a first $80 million tower. The lawyers present at the hearing disagreed about the exact amount, but it appears that defense expenses to date in all of the various IndyMac-related lawsuits have totaled $35 million or $45 million. There were various references in the transcript to the lack of responses from the carrier. (The make-up of the two insurance towers and a prior coverage dispute involving IndyMac’s D&O insurance are discussed here.)

Also, and though it is difficult to discern from the bare face of the transcript, it appears that the reason that the FDIC wants to take this case to trial is to substantiate damages in excess of the applicable policy limits, in an apparent attempt to impose a judgment in excess of the limits on the D&O insurer(s).

As Judge Fischer commented at the outset of the discussion about the D&O Insurance, the case “seems to be insurance-company driven.” Which corroborates a point I have made before on this blog, that the D&O insurance may be the real battleground in the FDIC’s failed bank litigation.

This case, which was filed in July 2010, was the first that the FDIC filed against former officers of a failed bank as part of the current bank failure wave, as discussed at greater length here. It is also one of two FDIC actions against former IndyMac officials. The agency separately filed an action against the failed bank’s former CEO, as discussed here.

Judge Fischer’s aside that she doesn’t know why anyone would want to be a federal judge, triggered as it was by her frustration with the  matter before her, was remarkably like my own reaction as I read through the transcript. As I read along, my own decision years ago to walk away from the active practice of law seemed more and more like a really smart move.

Reading about the tone and temper of the parties’ pleadings in this case reminded me of the lyrics from the Crosby, Stills & Nash song “You Don’t Have to Cry,” which I often sing to myself when I hear about litigators bashing each other: “You are living a reality I left years ago, it quite nearly killed me/In the long run, it will make you cry, make you crazy and old before your time.”

What Do You Make, He Asked?: If you have not seen this video about teachers, drop everything and watch it right now. Thank you.

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A federal court has denied the motion of former IndyMac CEO Matthew Perry to dismiss the action that the FDIC, as the failed bank’s receiver, had filed against him. In a December 13, 2011 order (here), Central District of California Judge Otis D. Wright II held that under California law the business judgment rule does not protect officers’ corporate decisions and accordingly he rejected Perry’s argument that the FDIC’s complaint must be dismissed for failure to plead around the business judgment rule.

As discussed here, in July 2011, the FDIC as receiver for the failed IndyMac bank sued Perry alleging that as the bank’s CEO he had breached his duties to IndyMac and acted negligently in allowing IndyMac to continue to generate and acquire more than $10 billion in risky residential loans for sale into the secondary market. As the secondary market became unstable, the bank was forced to take the loans into its own investment portfolio, where the generated substantial losses, allegedly in excess of $600 million. IndyMac failed on July 11, 2008 and the FDIC was appointed as the bank’s receiver.

Perry moved to dismiss the FDIC’s complaint, arguing that the FDIC failed to allege facts sufficient to overcome the business judgment rule. Perry argued that the business judgment rule applies and insulates him from personal liability for his actions prior to IndyMac’s demise.

In opposing Perry’s motion, the FDIC argued that under California law the business judgment rule does not apply to officers. Judge Wright agreed. He concluded that the relevant legal authority does not support a conclusion that common law business judgment rule encompassing the general judicial policy of deference to business decisions should apply to officers. He also found that California’s statutory business judgment rule does not extend its protection to corporate officers. After reviewing the statute, applicable legislative history and relevant case law, he concluded that when the California legislature codified the business judgment rule, “it purposely excluded its application to corporate officers.” Because the FDIC’s allegations against Perry in his capacity as an office, Judge Wright denied his motion to dismiss.

Discussion

Historically, courts in applying the business judgment rule have not always carefully examined whether or not the rule’s protection should apply to officers as well as to directors. Over time, some have argued rather vigorously that the rule should not apply to officers. Others have argued that officers should be entitled to rely on the business judgment rule. Certainly it would seem that in those jurisdictions where officers and directors are held to have the same duties then they should be entitled to the same protections.

In any event, the question of whether or not an officer is entitled to the same protection under the business judgment rule as a director is a question of state law on which state law will control. Judge Wright’s decision is clearly reflection of his analysis under California state law. But though it is limited on that basis, his conclusion nevertheless highlights the interesting question whether as a matter of public policy the decisions and actions of corporate officers should enjoy the same protection under the business judgment rule as directors.

Setting aside the question of whether or not officers are entitled to the protection of the business judgment rule is the question of whether or not questions involving the applicability of the protections should be addressed at the motion to dismiss stage. There is the further procedural question of whether the plaintiffs must be expected to plead around the defense in order for their case to go forward, or whether the protections are in their nature more in the form of an affirmative defense to be invoked and substantiated by the defendant as the case goes forward. Judge Wright’s analysis does not examine these issues in detail but they present and added level of inquiry beyond the issues Judge Wright does address.

In any event, special thanks to a loyal reader for providing me with a copy of Judge Wright’s decision.

More About the FDIC’s Settlement with WaMu Executives: As was widely reported yesterday, the FDIC has settled the action it brought as receiver for the failed Washington Mutual bank against three former WaMu executives and their wives.  The early reports did not specify the amount of the settlement, but a December 14, 2011 Wall Street Journal article (here) fills in some of the missing details.

The total amount of the settlement is $64 million, consisting of about $400,000 from the settling parties themselves, and the balance of the cash amount to be paid by insurance. The executives are also to forego a total of $24 million in retirement benefits and bonus claims.

The Journal article also makes a tantalizingly brief mention of a prior $125 million settlement that the FDIC previously reached “to release claims against other former outside directors and officers.” As I noted here, there had been some suggestion in the press when the FDIC first filed its action against the three executives that the agency had separately settled or reached an agreement with the failed bank’s outside directors, but the brief mention in the Journal article is the first affirmative substantiation I have seen since that time referencing this separate settlement. Any readers that can shed light on this separate settlement are encouraged to pass along whatever information they can.

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In the eighth lawsuit that the FDIC has filed so far as part of the current round of bank failures, on July 6, 2011, the FDIC filed suit in the Central District of California against former IndyMac CEO, Michael Perry. The FDIC’s complaint can be found here.  

IndyMac failed nearly three years ago, on July 11, 2008, as discussed here. The FDIC’s complaint against Perry alleges that he caused over $600 million in losses by causing the bank to purchase mortgage loans in 2007, just as the mortgage marketplace was destabilizing. The complaint alleges that Perry acted negligently when he allowed IndyMac to generate and purchase $10 billion in loans when the secondary mortgage market was becoming illiquid. When IndyMac was later unable to sell the loans, the bank transferred them to its own investment portfolio, which then caused over $600 million in losses.

The news articles report that the Complaint alleges the “instead of enforcing credit standards, Perry chose to roll the dice in an aggressive gamble to increase market share while sacrificing credit standards.”

Even though its complaint against Perry is only the eighth so far during the current banking crisis, the lawsuit is the second that the FDIC has filed against former IndyMac executives. As discussed at length here, the first lawsuit the FDIC filed during the current round was filed in July 2010 against four former officers of IndyMac’s Homebuilder Division.

The FDIC’s concentration on IndyMac likely has something to do with the fact that the bank’s closure represented the second largest bank failure as part of the current banking crisis, following only the massive WaMu failure. (IndyMac has assets of about $32 billion at the time of its closure). IndyMac was also one of the earliest banks to fail – it was just the fifth bank to fail during 2008, while there have been well over 300 bank failures since then. So the FDIC’s post-mortem processes may be further along on IndyMac than with respect to the many other bank failures that have followed.

The FDIC’s lawsuit is far from the first legal imbroglio in which Perry has become involved. As discussed here, on February 11, 2011, the SEC filed a lawsuit against Perry and two other former IndyMac officers, accusing them of “misleading investors about the mortgage lender’s deteriorating financial condition.”

Perry is also one of the defendants named in the consolidated securities class action lawsuit first brought in the Central District of California in 2007 by IndyMac shareholders. The shareholder suit has a long and involved history, as discussed here. On March 29, 2010, Central District of California Judge George Wu denied the defendants’ motion to dismiss the plaintiffs’ sixth amended complaint, while at the same time certifying the case for interlocutory appeal to the Ninth Circuit. Judge Wu’s order can be found here.

In any event, a list of the eight lawsuits that the FDIC has filed can be found on the FDIC’s website, here. As noted on the same page, as of July 7, 2011, the FDIC “has authorized suits in connection with 28 failed institutions against 248 individuals for D&O liability with damage claims of at least $6.8 billion.” Since the eight lawsuits filed so far involve only seven institutions and only 53 former directors and officers, there clearly are many more lawsuits (perhaps as many as 21 or more) the FDIC is preparing to file. In all likelihood, even further lawsuits will be approved in the future as well. All of which means that we could be heading into a period of very significant failed bank litigation.

Readers who scan the FDIC’s website closely will undoubtedly notice that one of the eight lawsuits has already settled. The settled case  is the lawsuit the agency filed in March 2011 in connection with Corn Belt Bank and Trust Company (about which here). As reflected in the FDIC’s May 10, 2011 motion (here), the parties settled the case. However, the court records do not reveal any of the details of the settlement.

The Name Game:  As far as I am aware, Michael Perry, the former Indy Mac CEO, is not related to Michael Dean Perry, who played football in the NFL, for the Cleveland Browns among others, during the 80s and 90s. According to Wikipedia (here), Michael Dean Perry had a McDonald’s hamburger sandwich named after him – the “MDP,” which was only served in Cleveland-area McDonald’s while Perry played for the Browns. As far as I am aware, the former IndyMac CEO did not have a sandwich named after him.

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While I have been keeping track of the subprime and credit crisis-related litigation as it has accumulated (refer here), it has been some time since I have undertaken a detailed litigation overview. Fortunately, NERA Economic Consulting, in a July 3, 2008 report entitled “Subprime Securities Litigation: Key Players, Rising Stakes and Emerging Trends” (here), has taken care of it, with an excellent analysis of the subprime litigation to date.

The NERA Report, written by my friend Dr. Faten Sabry and her colleagues Anmol Sinha and Sungi Lee, observes that the growing wave of subprime lawsuits has swept up an increasingly diverse array of plaintiffs and defendants. With respect the defendants, the Report notes that:

Almost every market participant in the securitization process—which transforms illiquid assets such as mortgages, auto loans, and student loans into tradable securities—has been named as a defendant. The list of defendants includes lenders, issuers, underwriters, rating agencies, accounting firms, bond insurers, hedge funds, CDOs, and many more.

The Report also describes the way that the litigation has evolved, noting that:

The majority of the early lawsuits have been against mortgage lenders. As various other market participants reveal the extent of their losses and exposure, they too are being dragged into litigation. The plaintiffs include shareholders, investors, issuers and underwriters of securities, plan participants, and others.

The NERA Report specifically discusses the subprime-related lawsuits that have been filed against lenders, issuers, rating agencies, bond insurers and asset management companies. The Report also observes (as has been noted on this blog, here) that as the litigation has accumulated, it has spread far beyond just subprime-related issues, and has encompassed parties and circumstances “in the context of the trouble in the broader markets.”

The Report notes that as the subprime litigation has evolved, the broader “credit crunch” litigation has encompassed a wider variety of lawsuits and litigants, including lawsuits involving asset-backed commercial paper, lawsuits related to failed deals, lawsuits related to corporate debt losses, and lawsuit related to asset-backed securities.

The NERA Report was clearly intended to be descriptive and not exhaustive, so it is no criticism of the report  for me to add some additional observations. There are, in fact, a few notes I would add to the report’s overview.

In addition to the categories of litigants the NERA Report discusses, there are some additional categories I think merit attention. The first relates to hedge funds. While the NERA Report does reference hedge funds, I think the involvement of hedge funds is worth of separate comment. Hedge funds have become involved both as plaintiffs (refer here) and as defendants (refer here and here). The likelihood of additional litigation involving hedge funds seems strong.

One group not specifically mentioned in the NERA report is the mutual fund industry. By my count, there have been at least five subprime securities lawsuits against mutual funds and mutual fund families. (Refer for example here and here.) These lawsuits are brought by investors claiming that the mutual funds misrepresented the relative stability of their investment strategy and assets.

The NERA report does specifically discuss the litigation against the credit rating agencies. The only thing I would add is that the credit rating agency litigation falls into two categories. The first involves lawsuits brought by the credit rating agencies’ own shareholders, for allegedly inadequate disclosures (refer, for example, here). The second involves investor lawsuits brought against the rating agencies for the rating company’s actual rating activities (about which refer here).

Yet another industry group that has been hit with subprime lawsuits is the mortgage insurance industry, in which all of the leading participants – including MGIC (refer here), The PMI Group (refer here), and Radian (refer here) – have all been hit with securities lawsuits. Indeed, the Blackstone Group was also hit with a securities lawsuit (refer here) for alleged disclosure issues relating to its investment in mortgage insurer FGIC. As discussed in a July 11, 2008 Wall Street Journal article (here), the mortgage insurers’ woes are one of the litany of problems besetting Fannie Mae and Freddie Mac. Freddie Mac has also itself been the target of a subprime-related securities class action, as noted here.

The NERA Report specifically acknowledges the fact that the litigation wave has long since moved past subprime lending alone. For example, the NERA report specifically mentions lawsuits involving corporate debt (as I also noted, here). An important corollary of this observation is that even with respect to residential real estate lending, the litigation wave has swept far beyond subprime lending alone; for example, it has also encompassed Option ARM loans, as I discussed here. IndyMac, the lending institution whose dramatic collapse over the weekend may potentially signal a dark new inflection point in the evolving credit crisis, was focused on so-called Alt-A loans.

In addition, other kinds of debt have also been the source of credit crunch litigation. For example, in addition to corporate debt, problems arising from student loans have also been the source of litigation, as discussed here and here.

Finally, I do think it is noteworthy that at least one credit crisis lawsuit, involving MoneyGram International (refer here), relates to the company’s disclosures about its investments in subprime-related assets. Many companies, including many companies outside the financial sector, have balance sheet exposure to subprime assets, and therefore there is the potential at least for this kind of litigation to spread far beyond the financial sector. I have discussed this issue at length in prior posts (most recently here), but I recognize at this point that it remains to be seen whether or not there will be substantial credit crisis-related litigation outside the financial sector. As I recently noted in my mid-year review of securities litigation (refer here), the vast bulk of credit crisis-related litigation has been in the financial sector.

The NERA report concludes with the observation that “most of the lawsuits are still in their initial stages and it is too early to predict the outcomes,” but that “given the continuing turmoil in the financial markets, the mounting losses, and the growing list of lawsuits, this story is far from over.” I couldn’t agree more, and as the story continues to evolve, I will continue to track the lawsuits – the securities and ERISA lawsuits here, and the derivative lawsuits here. I will also continue to track subprime and credit crisis-related lawsuit case dispositions, here.

Rubble Without a "Cause"?: I was struck by the reports in the press coverage surrounding the regulatory seizure of IndyMac Bank, for example in the July 12, 2008 Wall Street Journal (here), that Office of Thrift Supervision director John Reich blamed the bank’s failure on “comments made in late June by Senator Charles Schumer, who sent a letter to the regulator raising concerns about the bank’s solvency.” Spooked depositors reportedly withdrew $1.3 billion in 11 days. The Journal reports that “Mr. Reich said Sen. Schumer gave the bank a ‘heart attack.’”  A July 14, 2008 Wall Street Journal article (here) also quotes Reich as saying that "Schumer sparked a deposit run that 'pushed IndyMac over the edge.' "

Schumer is reported to have responded that if the regulator had done its job and prevented the bank’s “poor and loose lending practices,” we “wouldn’t be where we are today.”  (This is of course the same Senator Schumer who barely a year ago urged that regulatory standards should be loosened in order for America’s financial markets to be more competitive globally.)

The sharp exchange between Reich and Schumer dramatically highlights the fundamental question of causation that surrounds so many problems arising from the entire subprime meltdown. While Senator Schumer’s letter may well have undermined IndyMac depositor confidence, it was also merely one link in a chain of events leading up to the bank’s failure. The bank’s very business model, built around so-called Alt-A loans, in which borrowers are not required to fully document income or assets, arguably could be a more fundamental cause. Or if plaintiffs’ allegations are to be believed, the bank’s failure to follow its own underwriting standards also could have led to the bank’s failure.

Indeed, it is arguably possible to take the causal chain even further back. Here, I have in mind several driving trips I made during 2005 and 2006 on the I-10 corridor between LA and Palm Springs. It seemed as if on each trip, yet another roadside hilltop even further east than the last had been scraped bare and festooned with hundreds of cookie-cutter monstrosities “attractively priced in the low 500,000s."

The continuing emergence of these self-described “lifestyle” communities depended in the end on ever-rising house prices, record low interest rates, and two dollar a gallon gas. When all of these circumstances changed, the construct collapsed. (A more technical summary of this analysis can be found in a July 14, 2008 Wall Street Journal article, here, entitled "Continuing Vicious Cycle of Pain in Housing and Finance Ensnares Market.")

The ensuing defaults may or may not have been inevitable but they surely were a latent possibility built into lending arrangements borrowers had to stretch to afford. Every participant in the process contributed and accepted some part of this risk. In other words. it could plausibly be argued that the ultimate cause of the subprime meltdown (even if not the collapse of IndyMac) was cultural, or perhaps social. Call it cultural complicity.

Theorists would contend that the cultural context was merely a causally relevant condition but not the proximate cause either of the subprime meltdown or of IndyMac’s collapse, and perhaps they would be correct. Indeed, in a society that insists on assigning legal blame, proximate causation may be the only relevant inquiry.

But on that score, it may be worth noting that Reich, the OTS official, is reported to have asked rhetorically, “Would the institution have failed without the deposit run? We’ll never know the answer to that question”

Reich’s rhetorical inquiry, technically a “counterfactual,” poses a causal inquiry based on possible consequences from alternative facts. An interesting recent discussion of counterfactuals in the securities litigation context appears in yet another recent NERA Economic Consulting paper, entitled “Shareholder Class Actions and the Counterfactual” (here). This interesting June 24. 2008 paper poses questions that may prove particularly provocative in the context of the subprime meltdown.

The courts will eventually assign blame for IndyMac’s collapse. (Somehow, I doubt the blame will ultimately be placed on Senator Schumer.) But, the legal inquiry aside, it is possible that the final answer to the question of ultimate causation may be found only at the bottom of a bottomless well.

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