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

The September 2008 collapse of Lehman Brothers resulted in the largest bankruptcy filing in U.S. history, as well as an explosion of litigation and regulatory actions and investigations. In the pending bankruptcy proceedings a recent motion by the debtor’s counsel details the massive legal costs accumulating in the various legal proceedings and also raises some interesting D&O insurance implications.

Special thanks to Wayne State University Law Professor Peter Henning, who provided me with copies of the bankruptcy-related documents and who previously these issues on the Dealbook blog, here.

On July 27, 2010, counsel for the debtor filed a motion in the Lehman Brothers bankruptcy proceeding under Bankruptcy Code Section 362 for relief from the automatic stay in order to allow certain of Lehman’s excess D&O insurers to advance defense expenses.

According to the motion papers, for the policy period May 16, 2007 to May 16, 2008, Lehman carried an aggregate of $250 million in D&O insurance, consisting of a $20 million primary policy and sixteen layers of excess insurance. A copy of the Lehman primary policy, which is included in the bankruptcy pleadings, can be found here.

In March and November 2009, respectively, the bankruptcy court previously entered orders granting relief from the stay to allow defense fees to be paid first from the $20 million primary policy and then from the $15 million first excess policy.

However, the motion papers note, submitted defense fee statements already exceed the limits of liability of the first excess policy (i.e., the aggregate fees already exceed $35 million). The motion seeks relief from the stay to allow the second excess insurer, whose policy provides limits of $10 million in excess of $35 million, to advance defense expenses.

The motion goes on to state that the second excess policy’s $10 million excess of $35 million limits are likely to be exhausted "by August of this year." (That is, fees apparently already have or are about to top $45 million.) Accordingly the motion asks for relief from the stay for third excess policy, which provides limits of liability of $10 million excess of $45 million.

The third excess policy may also soon be exhausted. The motion suggests that the third excess policy may be exhausted by October. So the motion also asks for relief from the stay for the fourth excess policy, which provides limits of $15 million in excess of $55 million.

In answer to the obvious question of how so much defense expense could be accumulating so rapidly, the motion provides a brief recitation of the various proceedings in which the company’s former directors and officers are involved. First, there are the various securities class action lawsuit which have been brought by Lehman security holders. Then there are the various securities lawsuits which have been brought against former directors and officers in connection with the plaintiffs’ purchases of mortgage-backed securities. There are also additional actions or arbitrations which have been brought against certain individuals in connection with Lehman-issued securities, auction rate-securities and other alleged conduct.

In addition, the U.S. Department of Justice as well as the SEC and the New Jersey Bureau of Securities have "commenced formal grand jury and regulator investigations concerning the circumstances surrounding the collapse of the Lehman enterprise and have issued various requests and subpoenas," according to the motion papers.

All of these various proceedings undoubtedly took on a heightened sense of urgency after the March 11, 2010 release of the report of the bankruptcy examiner, Anthon Valukas, in which he referred, among many other things, to what he regarded as "actionable balance sheet manipulation."

In light of all of these various proceedings and given the fact that each of the individuals undoubtedly has their own counsel, it may be unsurprising that defense fees are accumulating so rapidly. Indeed, as Professor Henning notes in his Dealbook post, the fees seem to have been accumulating more rapidly in recent months, to the point that the fees now seem to be running at about $5 million a month. At that rate, even the fourth excess policy is likely to be exhausted before year’s end.

Given the size of Lehman’s insurance tower, there may be no immediate reason for the individual defendants to be alarmed. Even were the fourth excess policy to be soon exhausted, that would still leave $180 million in insurance available to cover the defense expenses.

But even if there may be no immediate cause for alarm for the individuals, the events so far and that likely lie ahead do present some noteworthy issues.

First, the sheer volume of defense expense so far dramatically underscores the enormous potential for a catastrophic claim to produce astonishing levels of defense expenses. To be sure, the Lehman collapse, as the largest bankruptcy in U.S. history, may represent an extreme case. But it is not as if the Lehman situation is the only case where enormous defense expenses have rapidly accumulated. To cite just two examples, in prior posts I have detailed the huge defense expenses that accumulated in the Broadcom options backdating lawsuit (refer here) and in connection with the Collins & Aikman bankruptcy (refer here).

In that regard, it should noted that not only has the pace of defense fee accumulation in the Lehman case accelerated in recent months, but the fees seem likely to accumulate even more quickly if the SEC were to file an enforcement action or the DoJ were to file criminal charges. As astonishing as are the fees that have accumulated already, it seems possible (arguably, probable) that even more astonishing fees could lie ahead. Professor Henning’s blog post, linked above, discusses these possibilities in greater detail.

While it is still only the catastrophic claims circumstances that produce these kinds of enormous fees, these cases do raise some very serious questions about traditional notions of limits adequacy. The fact is that the most important purpose of D&O insurance is to ensure that the individual directors and officers are protected in the event that the corporate entity is unable to indemnify them. These catastrophic claims scenarios demonstrate how challenging it may be to ensure that the D&O insurance can provide sufficient protection at the point where it is most needed.

One answer to this challenge may be the one that Lehman itself apparently followed, which is to buy very significant amounts of D&O insurance. Of course, not every company can afford to purchase anywhere near the amount of insurance that Lehman did. (To put the Lehman insurance program into perspective, the primary policy alone – which was written over a $10 million corporate reimbursement retention – cost Lehman more than $2 million. Clearly Lehman was willing to invest very substantial sums for its executives’ protection.)

For that matter, it remains to be seen if even the huge amount of insurance that Lehman put in place will be sufficient to protect the individuals from all of the defense expenses that may lie ahead. If the SEC were to file an enforcement action and the DoJ were to pursue criminal charges, it is not impossible that the accumulating defense expenses could test even the remaining limits

(And that is without even allowing for the possibility, raised by Professor Henning in his blog post, that one or more of the excess insurers might seek to disclaim coverage – "You know how insurance companies can be," he comments.)

There are no easy solutions to these kinds of concerns, although one consideration that should be taken into account is D&O insurance program structure. That is, in addition to considering the question of how much insurance is enough, the question of what structure of insurance should be put into place should also be considered. Among other things, one particular question is whether specific parts of the program should be designated solely for the protection of specific individuals (for example, outside directors) as one way to ensure that no matter what happens there is always a specific pot of money available for the protection of those individuals.

In any event, the consequences following the Lehman collapse are continuing to unfold and undoubtedly have much further to run. The astonishing accumulation of defense expense seems likely to continue if not accelerate. Whether or to what extent any of the D&O insurance might be available to pay settlements or judgments remains to be seen.

This last point, about possible funds for settlements or judgments, does underscore an issue that could well become critically important later on. That is, the D&O insurance tower that is responding to these various proceedings is the one that was in place for the period May 2007 to May 2008. However, Lehman filed for bankruptcy in September 2008. There is in fact, according to footnote 6 of the debtor’s memorandum in support of the motion for relief from the stay, a separate $250 million insurance tower that was in place for the period May 16, 2008 to May 16, 2009.

The 2007-2008 tower presumably is the one that is responding to these various proceedings because the first of the shareholder lawsuits apparently was filed in February 2008, during the policy period of the earlier tower, and later filed proceedings apparently have been treated as interrelated with the first filed claim, and therefore relate back to the date the first claim was made.

Given the huge amount of money at stake and in light of the fact that the 2007-2008 tower is being substantially eroded, it seems probable that someone will find it worthwhile to try to establish that one or more of the various claims triggered the 2008-2009 tower. (Indeed, it may well be that this type of effort is already well underway in one or more disputes or proceedings.) Before all is said and done in connection with the fallout from the Lehman collapse, there could be many twists and turns.

With as many as 17 different D&O insurers involved in this claim, there undoubtedly are quite a number of professionals in the D&O insurance industry involved in this matter. With a situation like this, there could be some pretty good scuttlebutt. I encourage anyone involved in this matter who is willing to share to post a comment using this blog’s comment function (anonymously if necessary). I am certain there is a lot more going on in this claim than can be discerned from the bare face of the pleadings.

Finally, for those practitioners who would appreciate insight into how the D&O insurance policy operates in the bankruptcy context, the debtor’s motion makes some pretty interesting reading. The motion not only shows how the the policy proceeds are administered and monitored in light of bankruptcy procedures, but it also illustrates how various key policy provisions (for example, the priority of payments clause) are intended to operate.

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As the subprime litigation wave evolved in late 2008, among the many cases arising were cases I described at the time as "new wave" subprime-related cases, where the target company’s financial problems were due not to the company’s own exposure to subprime-related assets, but rather due to the company’s exposure to other companies that suffered reverses because of the subprime meltdown.

One particular type of these new wave cases involved companies that were sued because of the target companies’ exposure to Lehman Brothers. In a May 17, 2010 order (here), Southern District of New York Judge John G. Koeltl ruled on the motion to dismiss in a case pending against JA Solar Holdings and certain of its directors and offices, in which it was alleged that the company had misrepresented its exposure to Lehman Brothers. In what is as far as I know the first ruling in one of the Lehman exposure cases, Judge Koetltl denied the defendants’ motion to dismiss.

As discussed at greater length here, JA Solar was sued in December 2008, after the company announced on November 12, 2008 that it was recording an impairment for the entire principal value of a Note the company had purchased from Lehman Treasury, a Netherlands-based affiliate of Lehman Brothers.

In July 2008, JA Solar completed a $400 million financing, following which it purchased a $100 million note from Lehman Treasury with an October 9, 2008 maturity date. The note was supposed to have 100% principal protection and was guaranteed by Lehman Brothers.

The plaintiffs alleged that the company made two sets of misrepresentations or omissions about the Note. First, in an August 12, 2008 press release and subsequent conference call, the company and its CFO mentioned that Lehman brothers was managing its cash but did not mention the purchase of the Note, or the nature of the company’s relationship to Lehman as a result of the company’s investment in the Note.

Second in a September 16, 2008 press release and conference call, on the day following the Lehman bankruptcy, the company disclosed the $100 million Note for the first time, but stressed that the Lehman unit that had issued the Note had not filed for bankruptcy and emphasized that the note was "principal protected." In the subsequent conference call, the company’s CFO stated that the company expected that at the end of the Note’s term "there will be principal and interest returned to us."

In the same call, but only in response to analysts’ questioning, the CFO acknowledged that the only recourse if the Lehman affiliate company does not repay the Note was a guarantee by Lehman, which was in bankruptcy.

On November 12, 2008, the company recorded a $100 million impairment charge for the value of the Note.

The defendants moved to dismiss the complaint, arguing that the company had no duty to disclose the Note in the August communications and that the total information in the September call adequately disclosed the information about the Note and the Lehman guarantee.

Judge Koeltl found that the plaintiffs had adequately alleged that in the August conference call the company’s CEO had made a misleading statement about Lehman’s role with the company. He found that the statements misrepresented "how JA Solar’s cash was invested and the truthful nature of JA’s Solar’s relationship with Lehman Brothers."

Judge Koeltl also found that the plaintiff had adequately alleged misrepresentations in connection with the September statements. Among other things, the company’s CEO had stressed that the Note has "100% principal protection" without stating that "any possible protection was provided solely by the bankrupt Lehman Brothers." Judge Koeltl added that "it is difficult to understand how JA Solar could have assured investors that the Note was fully protected when the only protection was provided by a company in bankruptcy."

Judge Koeltl rejected the defendants’ arguments that, in response to the analysts’ questions, the CFO had clarified the full effect of the Lehman Brothers bankruptcy. Judge Koeltl said that whether the statements effectively counterbalanced the prior statements is a factual question "that cannot be resolved in a motion to dismiss," adding that the plaintiffs "have pleaded sufficient facts at this stage to call in to question whether Mr. Lui’s statements cleansed the allegedly misleading statements. "

Finally Judge Koeltl found that the plaintiffs had adequately alleged scienter, finding that the plaintiffs had adequately alleged that the defendants knew in August that "JA Solar had not simply engaged Lehman Brothers to manage its cash, but rather than JA Solar had purchased the $100 million Note" which was guaranteed by Lehman from a Lehman affiliate. He also found the defendants knew "in spite of their statements in September 2008 that the Note had 100% principal protection and that they expected the principal and interest to be returned, that Lehman Brothers was the only guarantor of the Note and that Lehman Brothers was, in fact, in bankruptcy."

Judge Koeltl found that the defendants’ knowledge of these facts, in contradiction of their public statements, "satisfies the scienter requirement."

While a lot might be said about this decision, the overall impression is that Judge Koeltl was persuaded that the company had simply not been candid about its exposure to Lehman Brothers. Of course, it is hard now to recall how tumultuous and uncertain things were in the days in early fall 2008, but alleged facts create the impression that the company was straining to avoid disclosing how exposed it was to Lehman Brothers. Whether the defendants actually believed they would be able to redeem the Note at maturity, notwithstanding Lehman’s bankruptcy, is one issue that will have to be sorted out in this case as it goes forward.

I have in any event added the ruling in the JA Solar case to my running tally of subprime-related dismissal motions rulings, which can be accessed here.

Special thanks to a loyal reader for providing a copy of the JA Solar opinion.

Apologies: My apologies that this blog site was unavailable almost the entire day on May 17, 2010. Once again my hosting service, LexBlog, experienced server problems that managed to take the entire site offline for an extended period of time. I apologize to anyone inconvenienced by this hosting service failure.

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According to the March 11, 2010 bankruptcy examiner’s report, the collapse of Lehman Brothers was a result of the deteriorating economic climate, exacerbated by Lehman’s executives, whose conduct ranged from "serious but non-culpable errors of business judgment to actionable balance sheet manipulation."

The Report was prepared pursuant to a January 2009 bankruptcy court order directing the trustee to appoint an examiner to investigate the events leading up to Lehman’s collapse. The examiner appointed was Anton Valukas of the Jenner & Block law firm.

The full report is nine volumes long, consisting of 2,200 pages, and can be found here. The executive summary (which alone is 239 pages long) can be found here. According to news reports, Valukas spent $38 million conducting his examination. He and his team interviewed more than 100 people and scrutinized more than 10 million documents, plus 20 million pages of e-mails from Lehman.

The examiner’s report states that as conditions worsened during 2008 and in order to "buy itself time," Lehman "painted a misleading picture of its financial condition." For example, the report states, that while reporting a significant loss at the end of the second quarter 2008, Lehman "sought to cushion the bad news by trumpeting that it had significantly reduced its net leverage ratio," while failing to disclose that it had been using an "accounting device" – known as Repo 105 – that had "no substance" and whose sole purpose was to allow Lehman to "manage its balance sheet."

The report states that Lehman neither disclosed its use of nor "the significance of the use of the magnitude of its use of" Repo 105, to the Government, to rating agencies, to investors or even to its own Board. Its auditors were aware of but did not question the transaction. The Repo 105 balance sheet manipulation is summarized on the WSJ.com Deal Journal blog, here.

The examiner concluded that the business decisions that brought Lehman to a crisis "may have been in error but were largely within the business judgment rule." However, the "decision not to disclose the effects of these judgments does give rise to colorable claims against the senior officers who oversaw and certified misleading financial statements," including CEO Richard Fuld and the company’s CFOs, Christopher O’Meara, Erin Callan and Ian Lowitt.

The examiner also found that there is a "colorable claim that the "sole function" of the Repo 105 transactions was "balance sheet manipulation" that "created a misleading picture of Lehman’s true financial health."

The examiner also concluded that there are "colorable claims" against the company’s auditor, Ernst & Young, on the grounds that it "did not meet professional standards" for its "failure to question and challenge improper or inadequate as disclosures."

The examiner’s report explains that the report uses the phrase a "colorable claim" to mean one for which "there is sufficient credible evidence to support a finding by a trier of fact," without presuming the finder of fact’s ultimate conclusion.

The examiner also reviewed the actions of Lehman’s lenders, JP Morgan and Citigroup. The report concludes that "The demands for collateral by Lehman’s lenders had direct impact on Lehman’s liquidity pool," adding that "Lehman’s available liquidity is central to the question of why Lehman failed." Citigroup, which handled currency trades for Lehman, received a new guarantee from Lehman when Lehman was already insolvent and didn’t give enough value in return, the report said. The report concludes that "a colorable claim exists to avoid the Amended Guaranty as constructively fraudulent."

The examiner also reviewed the acquisition of Lehman’s North American brokerage, concluding that "a limited amount of assets" belonging to Lehman were "improperly transferred to Barclays."

The examiner recites at the outset of the report that under the relevant bankruptcy code provisions one purpose of a bankruptcy examination is to determine the existence of "a cause of action for the estate." Given the bankruptcy examiner’s conclusion that there are colorable claims against Fuld and the other former Lehman’s officials, as well as against its outside auditor, it seems reasonable to anticipate that the next step with be the bankruptcy trustee’s initiation of claims against these individuals and the auditor.

By way of comparison, after the New Century Financial bankruptcy examiner issued a report issued a report critical of company officials and the company’s auditor (about which refer here), the bankruptcy trustee filed a lawsuit (refer here) seeking to hold New Century’s auditors liable. In addition, the claimants in the New Century securities class action lawsuit relied heavily on the Examiner's findings in their amended complaint, which later suvived a motion to dismiss. I noted at the time of the dimissal that the bankruptcy examiner's findings may have strongly influenced the court in its dismissal motion ruling.

General Growth Properties Settles Credit Crisis-Related Securities Suit: According to a February 23, 2010 filing in the Northern District of Illinois, the parties to the credit crisis-related securities suit arising out of the collapse of General Growth Properties has been settled for $15.5 million, subject to court approval. The parties’ stipulation of settlement can be found here.

The General Growth Properties suit was one of the cases first filed in late 2008 as the subprime meltdown morphed into a full blown credit crisis, as I discussed in a post at the time, here.

The lead complaint, which can be found here, was filed in January 2009. The plaintiffs alleged that General Growth’s survival depended on its ability to refinance in November 2008 approximately $1.5 billion of its $27 billion of outstanding debt. Ultimately the company was unable to refinance its debt and it filed for bankruptcy in April 2009. The plaintiffs essentially alleged that the eleven individual defendants misrepresented the company’s ability to refinance its debt.

The complaint also alleged that the company’s senior executives had improperly loaned money to certain executives so that the executives did not have to sell their company shares in a margin call. The companies also allege that the company’s officials improperly sought to have the company’s shares included in the SEC’s short selling ban, so that the officials could sell their share at inflated prices.

In a September 29, 2009 opinion (here), Northern District of Illinois Milton Shadur granted in part and denied in part the defendants’ motion to dismiss. According to the settlement stipulation, in January 2010, the parties submitted the case to mediation, from which the settlement ultimately resulted.

The General Growth suit is one of only a handful of cases filed in the wake of the subprime meltdown and the ensuing credit crisis that has reached the settlement stage, and one of only a smaller handful of cases that have been settled following a dismissal motion ruling. We undoubtedly will see more settlements ahead as more cases work their way through the system.

I have in any event added the General Growth Properties settlement to my list of subprime and credit crisis-related case resolutions, which can be accessed here. My recent status update on the subprime and credit crisis related securities litigation can be found here.

Special thanks to Adam Savett of the Securities Litigation Watch blog for providing me with a copy of the stipulation of settlement.

Hello Polly: Many readers undoubtedly saw the article in yesterday’s Wall Street Journal (here) reporting that the Bank of America has apologized after its local contractor entered the home of a mortgage borrower, while she was away, and cutoff her utilities, padlocked the door and "confiscated her pet parrot, Luke." The homeowner, separated from her parrot for a week, filed a lawsuit against the bank for emotional distress.

This momentous story was deemed by the Journal’s editors to be worthy of a front page photograph of the homeowner, now fortunately reunited with her beloved parrot.

We mention this because, as was pointed out to us by a loyal reader, the Journal’s front page above- the- fold color photograph was headlined with the phrase "Hello, I Wish to Register a Complaint." We suspect that the Journal’s editors ran the picture on the front page for the sole reason that it gave them an excuse to use that headline.

If the topic is parrots, the only possible reference is to the immortal Monty Python dead parrot sketch, which believe it or not has its own Wikipedia page, here. The skit begins with John Cleese entering a pet shop and stating (as reflected in this script of the sketch) "Hello, I wish to register a complaint." Cleese’s problem in the sketch is not that his parrot has been confiscated; rather, his problem is that the parrot he had just purchased is dead. Deceased. It is no more. It has ceased to exist. It has joined the choir celestial. This is an ex-parrot

We are delighted to have this pretext to be able to embed a video of the sketch below. Because we think everyone should know a dead parrot when they see one.

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