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

In an unpublished August 18, 2008 per curiam opinion (here), the United States Court of Appeals for the Eleventh Circuit has affirmed the district court’s summary judgment ruling in the CNL Resorts case that a Section 11 settlement is not covered "loss" under a D&O insurance policy. The appeals court reversed and remanded the case on other grounds, as discussed below.

This coverage action arose out of an underlying securities class action (about which refer here), in which the plaintiffs alleged violations of Section 11 of the Securities Act of 1933. The plaintiffs alleged that they had purchased their CNL shares at an inflated price of $20/share. The plaintiffs sought to recover the $8/share difference between what they had paid and the $12/share valuation that was later placed on the company. CNL settled this shareholder action for $35 million. Details regarding the settlement can be found here.

CNL had a $30 million D&O insurance program, arranged in three layers of $10 million each. CNL initiated a declaratory judgment action against the three insurers, seeking a determination of coverage for the settlement as well as related litigation costs and expenses and other amounts. CNL reached a settlement with the primary insurer, but the action proceeded as to CNL’s two excess insurers.

As I discussed in a prior post (here), on March 17, 2007, the district court granted partial summary judgment on behalf of the two excess insurers. The district court held that the $35 million settlement represented a disgorgement of CNL’s "ill-gotten gain," which did not constitute a "loss" under the relevant policy language and therefore is not insurable under applicable law.

In its August 18 opinion, the Eleventh Circuit affirmed this portion of the district court’s rulings. The Eleventh Circuit said that "because we conclude that the payment to the Purchaser Class was restitutionary in nature, the payment was not covered loss" and the excess carriers are "not liable for payment."

CNL had argued on appeal that the $35 million settlement did not represent the return of ill-gotten gains, contending that "without a finding of fraud, it is impossible to conclude that the money was wrongly acquired." The Eleventh Circuit said that "the return of money received through a violation of law, even if the actions of the recipient were innocent, constitutes a restitutionary payment, not a ‘loss’." The Eleventh Circuit also affirmatively held that Section 11 damages are restitutionary in nature.

The Eleventh Circuit also rejected CNL’s argument based on the statement in the settlement agreement that the $35 million was not "restitution or disgorgement." The Eleventh Circuit said that the settlement agreement "is not binding on any third party or this Court. The policy, not the settlement agreement, governs our resolution of this appeal."

The Eleventh Circuit did reverse a separate summary judgment ruling of the district court. The separate ruling related to the question of coverage for the settlement of the claims of a separate plaintiff class, the so-called Proxy Class, which had alleged misrepresentations in proxy materials. CNL had settled with this separate class in an agreement that, among other things, had resulted in its payment of the Proxy Class counsel’s fees of $5.5 million.

The primary insurer, in its separate settlement with CNL, had agreed to reimburse CNL for this $5.5 million settlement. The excess insurers argued, based on language in the primary policy, that the $5.5 million settlement did not represent covered "loss," and therefore the primary policy had not been depleted by payment of covered loss and the excess carriers’ payment obligation had not been triggered. The district court granted summary judgment on this issue for the excess insurers.

The Eleventh Circuit reversed this portion of the district court’s ruling. The Eleventh Circuit remanded the case to the district court for further factual proceedings on the question whether the language on which the excess carriers sought to rely properly is a part of the primary policy. The question to be determined is whether or not the relevant policy endorsement form had been filed with the Florida Office of Insurance Regulation, as the form would be void if not so filed.

At one level, the Eleventh Circuit’s affirmance of the district court’s ruling on the question of coverage for Section 11 settlements represents a significant development. A federal appellate court’s adoption of the position that a company’s Section 11 settlement is not covered loss under a D&O policy certainly reinforces the developing case authority on this point. The possibility that another court might reach a different conclusion seems increasingly remote.

At the same time, there are limitations on the significant of the Eleventh Circuit opinion. The first is that the opinion itself carries the designation "Do Not Publish." This is less of a restriction in the Eleventh Circuit than it might be in other courts; some courts actually prohibit the citation of unpublished opinions. The Eleventh Circuit’s Rule 36-3 (refer here) specifies that "unpublished opinions are not binding precedent, but they may be cited as persuasive authority." Thus, the Eleventh Circuit’s opinion may at least be cited, but it still does not represent binding authority.

There is a practical development that also diminishes the significance of the Eleventh Circuit’s opinion. That is, since the time of the district court’s summary judgment ruling on the question of coverage for Section 11 settlements, most D&O carriers have introduced policy endorsements specifying that they will not take the position that there is no coverage under their policies for settlements under Sections 11 and 12 of the ’33 Act. Not all of these endorsements were created equal, and they are all as yet untested in court, but at a minimum they ought to restrain most carriers whose policies have this endorsement from taking the position that a Section 11 or Section 12 settlement does not represent a covered loss under the policy.

Of course, not all policies have yet been adapted to this new approach, and there are still many claims pending in which the relevant policy does not have this new language. In connection with these existing policies and claims, it is important to note a couple of things.

First of all, even if a company’s Section 11 settlement is not covered under a D&O policy, the company’s expense incurred in defending against the Section 11 claim still ought to be covered.

Second, because the settlement of Section 11 claims against individual defendants (as opposed to the company itself) typically would not represent the return of ill-gotten gains, (since typically they would not have received any of the offering proceeds), a D&O policy ought to provide coverage for the settlement of a Section 11 claims against them, as well as their costs of defense, all other things being equal.

Very special thanks to a loyal reader for providing me with a copy of the Eleventh Circuit opinion.

Auction Rate Settlements: Plaintiffs’ Bar Bummer?: As I noted in a recent post (here), one of the as yet unanswered questions surrounding the high-profile auction rate securities buybacks is what impact these settlements will have on the numerous auction rate securities class action lawsuits (about which generally, refer here).

In an August 18, 2008 Legal Week article entitled "Billions Not for the Plaintiffs Bar" (here), Michael Rivera and Erik Frias of the Fried, Frank, Harris, Shriver & Jacobson law firm suggest that these settlements could have a "debilitating impact on the numerous class actions and other private lawsuits filed since the market seized up." The basis on which the authors reach this conclusion is that as a result of the buybacks and other settlement elements, "the losses of individual investors who might be plaintiffs will now be fully compensated, leaving little to no damages to pursue in court."

The authors suggest that as a result of the buybacks and other reimbursements incorporated into the settlements, the "bottom line" is that the claimants "will be made whole without assistance from the courts." As they put it, "government and industry have worked cooperatively to craft a solution to the auction-rate securities problem in such a way that private litigation will be largely unnecessary and unavailable." As a result, the authors suggest, there may now be "little opportunity for the plaintiffs bar to profit."

The authors may have a point, but I haven’t yet seen the voluntary dismissal of any of the pending auction rate securities lawsuits. The plaintiffs’ lawyers may not go quietly, and one angle I can imagine them trying to work relates to institutional investors, benefits under the various settlements are less defined and less comprehensive.

In any event, there are still a host of auction rate securities lawsuits that have been filed against banks and other institutions that have not yet reached a regulatory settlement. To be sure, it may only be a matter of time before the regulators set their sights on these others. In the interim, the existence of the shareholder lawsuits may represent one additional factor pressuring them to reach a regulatory settlement.

Finally, as I recently noted (here and here), though the settlements have started to mount, auction rate securities lawsuits continue to accumulate. There apparently are some members of the plaintiffs bar who continue to perceive an opportunity to profit from the auction rate debacle. It will certainly be some time before it is all sorted out.

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In the past week, plaintiffs’ lawyers filed a raft of new subprime and credit crisis related securities lawsuits. The cases involve a wide variety of claimants and defendants, and a diverse array of legal theories. But while the lawsuits themselves are diverse, they do all evidence a common theme, which is that the subprime and credit-crisis related litigation wave continues to surge on.

American International Group: The most prominent lawsuit filed in the past week is the securities class action lawsuit filed in the United States District Court for the Southern District of New York against American International Group, its CEO Martin Sullivan, its CFO Steven Bensinger, and two other officials. A press release describing the lawsuit, which was filed by the Bernstein Litowitz Berger & Grossmann firm on behalf of the Jacksonville Police and Fire Pension Fund, can be found here. A copy of the complaint can be found here.

According to the press release, “Defendants repeatedly reassured investors that AIG had successfully insulated itself from the recent turmoil in the housing and credit markets due to its superior risk management. In particular, defendants touted the security of [American International Group Financial Products] ‘super senior’ credit default swap portfolio, making numerous statements that this portfolio was secure and that AIG’s method for accounting for this portfolio accurately reflected its value.” The press release goes on to state that:

Investors began to learn the truth regarding AIG’s financial condition and the Company’s exposure to the mortgage market when, on February 11, 2008, the Company disclosed that its outside auditor had determined that there was “material weakness in its internal control” over the financial reporting and oversight relating specifically to its accounting for the CDS portfolio, and that the Company was revising the loss valuations it previously reported. Under the new valuations, losses on the CDS portfolio more than quadrupled – from the $1.4 billion reported on the CDS portfolio just weeks before to over $4.5 billion. Two weeks later, on February 28, 2008, AIG disclosed that the market valuations on the CDS portfolio would increase to $11.5 billion and revealed for the first time that the Company had notional exposure of $6.5 billion in liquidity puts written on collateralized debt obligations (“CDOs”) linked to the sub-prime mortgage market.

Finally, on May 8, 2008, the Company disclosed that market valuation losses on the CDS portfolio for the quarter climbed an additional $9.1 billion, for a cumulative loss of $20.6 billion, and that the Company was expecting actual losses on the portfolio to be about $2.4 billion. As a result of these disclosures, the price of AIG stock plunged from a Class Period high of $75.24 per share on June 5, 2008, to $38.37 per share on May 12, 2008, wiping out tens of billions of dollars in shareholder value and causing damage to the class.

A May 22, 2008 New York Times article describing the AIG lawsuit can be found here. A May 23, 2008 Law.com article about the suit can be found here.

Falcon Strategies/Citigroup: Another prominent lawsuit filed during the last week involved a hedge fund affiliated with Citigroup, which is also a defendant in the lawsuit. The lawsuit is filed on behalf of all persons “who have tendered or been asked to tender their shares” in Falcon Strategies Two LLC. According to the plaintiffs’ lawyers’ press release (here), Falcon was established as a “multi-strategy fixed income alternative seeking to provide investors with absolute returns, current income and portfolio diversification.” However, the complaint (which can be found here) alleges that Falcon was “not conservative” but “employed bond arbitrage, carried commercial debt obligations, and held asset-backed mortgage investments” that declined in value when the markets failed.

The complaint is somewhat unusual in that, which it alleges affirmative violations of the federal securities laws, it does not expressly seek damages, but rather seeks a preliminary injunction to enjoin the tender offer until the defendants correct the “allegedly false and misleading” tender memorandum.

A separate lawsuit against a Falcon Strategies fund seeking damages and filed on behalf of Fifth Third Bank is detailed in a May 20, 2008 Wall Street Journal article (here). The Falcon Strategies fund had previously been the target of a separate securities class action lawsuit, but that lawsuit was voluntarily dismissed (refer here concerning this prior dismissed lawsuit).

The Falcon Strategies lawsuit is the second subprime or credit crisis-related securities class action lawsuit brought against a Citigroup-affiliated hedge fund. In early May 2008, investors brought a securities lawsuit against MAT Five LLC, Citigroup and other defendants alleging misrepresentations in MAT Five’s placement memorandum (Refer here for further background regarding the MAT Five lawsuit.)

Bank of America: In addition to these two lawsuits, investors also brought a securities class action lawsuit against Bank of America and related entities on behalf of all persons who purchased auction rate securities from the defendants during the period May 22, 2003 and February 23, 2008. A copy of the plaintiffs’ lawyers’ press release can be found here and a copy of the complaint can be found here.

I have written extensively about the auction rate securities lawsuits in prior posts, most recently here.

National City/Harbor Bank: Finally, in the fourth of last week’s flotilla of new subprime lawsuits, on May 20, 2008, the defendants removed to the United States District Court for the Northern District of Ohio a lawsuit that had been filed in the Court of Common Pleas of Cuyahoga County Ohio on behalf of all persons who acquired shares of National City Corporation in connection with National City’s December 1, 2006 acquisition of Harbor Bank. A copy of the complaint and removal petition can be found here.

The plaintiffs allege that the Registration Statement issued in connection with the merger contained material misrepresentations and omissions concerning National City’s lending practices, financial results and liquidity. In particular, the complaint alleges among other things that the Registration Statement failed to disclose that National City was “dangerously overexposed” to “risky and impaired CDOs” and that the company had “failed to properly account for its highly leveraged loans and mortgage securities.”

National City previously has been sued in a securities class action lawsuit (as I discussed in a prior post, here) filed on behalf of its shareholders. But this new lawsuit is filed on behalf of a distinct set of claimants and is based on a different set of alleged misrepresentations, and therefore in my view it represents a separate new lawsuit. As discussed below, I have accounted for it separately in my running tally of subprime-related securities lawsuits.

The lawsuits against National City on behalf of the former Harbor Bank shareholders alleges violations of Section 11 of the ’33 Act, but was filed initially in state court under the ’33 Act’s concurrent jurisdiction provisions. I have previously noted (refer here) the plaintiffs’ lawyers’ recent interest in attempting to pursue ’33 Act claims in state court. While defendants routinely remove these cases to federal court, the plaintiffs’ lawyers’ have has some success in having the cases remanded to state court (refer here). While one can only speculate on the plaintiffs’ interest in pursuing these cases in state court, it is nonetheless a very interesting development that possible represents a new trend in securities litigation prosecution.

One other interesting thing about the National City/Harbor Bank lawsuit is that in addition to National City itself and its current and former directors and officers, the complaint names as a defendant, National City’s auditors, Ernst & Young. There have been some lawsuits where the target company’s outside auditors have been named as defendants (for example, refer here regarding the amended complaint in the Countrywide subprime litigation where the companies’ auditors have been named). The bankruptcy examiner in the New Century case also suggested that there may be claims against the company’s auditors (refer here for a discussion of this report). However, so far, the auditors have been an infrequent target, likely because of the Stoneridge decision. The cases involving outside auditors have tended to be bases where an offering of securities is involved, and the auditors potentially have their own primary liability in connection with the offering.

Special thanks to Adam Savett of the Securities Litigation Watch blog (here) for a copy of the National City/Harbor Bank complaint.

Run the Numbers: With the addition of last week’s four new subprime and credit-related securities lawsuits, the current tally (refer here) of the subprime related securities lawsuits now stands at 85, of which 45 have been filed in 2008. With the addition of the new Bank of America lawsuit, the total number of auction rate securities lawsuits now stands at 17.

While the numerical specifics are important, the more important point is that the subprime and credit crisis-related litigation wave continues to churn on, the passage of time apparently doing nothing to diminish its intensity.

Speakers’ Corner: On Thursday May 29, 2008, I will be in New York speaking on a panel at IQPC’s 4^th Securities Litigation Conference (brochure here). The panel on which I am participating is entitled “Discussing Recent Trends in Director & Officer Liability (D&O) Liability,” and includes as co-panelists Ray DeCarlo of AIG and Adam Savett of RiskMetrics.

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A lawsuit filed late last week against First Marblehead Corporation underscores that the current lawsuit onslaught so often referred to as the “subprime” litigation wave is, and really has been for awhile, about so much more than just subprime. Although we are probably stuck with the “subprime” label as a shorthand way to describe these developments, the label encompasses a credit crisis that goes far beyond subprime lending.

First Marblehead is a Massachusetts-based company in the business of underwriting, packaging and securitizing student loans. Operating out of First Marblehead’s offices is a nonprofit organization called The Education Resources Institute (“TERI”) that provides guarantees of student loans that First Marblehead originates. On April 10, 2008, plaintiffs’ lawyers filed a securities class action lawsuit in the United States District Court for the District of Massachusetts against First Marblehead and certain of its directors and officers. A copy of the plaintiffs’ counsel’s April 10 press release can be found here. A copy of the complaint can be found here.

The complaint alleges that during the class period of August 10, 2006 to April 7, 2008, the defendants made material misrepresentations “concerning the performance and quality of First Marblehead’s securitizations, its ability to perform additional securitizations, TERI’s ability to adequately guarantee [First Marblehead’s] student loans, and the Company’s financial results and its ongoing operations.” The complaint alleges that the company “misrepresented the level of default rates in its portfolio,” and “disregarded that TERI was underreserved and unable to adequately insure” the company’s loans. According to the complaint, TERI filed for bankruptcy protection on April 7, 2008, and the company’s stock plunged.

The First Marblehead lawsuit has nothing directly to do with subprime lending itself. Indeed, the occurrence of credit-related litigation essentially unrelated to subprime lending is really nothing new – First Marblehead is not even the student loan company to be sued in a securities class action lawsuit as part of the current litigation wave, given the lawsuit filed in January 2008 against SLM Corporation (“Sallie Mae”), about which refer here.

The student lending cases, like the auction rate securities litigation, are about the secondary and tertiary consequences in the credit marketplace following on the consequences first triggered by the subprime lending meltdown. But the spread of litigation to other types of credit and other kinds of companies underscores the dark possibilities for a crisis that began in the residential real estate lending sector to spread across the entire economy and activate a much broader array of litigation.

It is probably worth noting that the turmoil that has hit the student lending sector is not limited just to the student loan organizations themselves; companies that invested in student loan-backed securities are also experiencing financial and accounting difficulties as a result of their investment in these securities. For example, in a situation that encompasses both the student loan problems and the breakdown of the auction rate securities marketplace, Winnebago, in its March 20, 2008 fiscal second quarter earnings release (here), disclosed that it owned $54.2 million of auction rate securities collateralized by student loans. As a result of the auction rate securities market failure, the company deemed these securities as not currently liquid, and reclassified them on the company’s balance sheet as long-term investments. In its April 9, 2008 10-Q (here), the company recorded a temporary impairment charge to these securities of $3.4 million.

The fact that the student loan turmoil would affect a company as unrelated to the sector as Winnebago demonstrates how far afield the effects of the current crisis have and may yet spread. The essential point here is that as long as observers continue to describe and think about the current developments as merely subprime-related, they will not only fail to appreciate the extent of what has already happened, but also likely underestimate the possibilities of what may lie ahead.

Another Auction Rate Securities Lawsuit: And speaking of auction rate securities, on April 11, 2008, plaintiffs’ lawyers filed yet another lawsuit on behalf of auction rate securities investors against the companies that sold them the investments. As reflected in the plaintiffs’ lawyers’ press release (here), the latest lawsuit involves Oppenheimer Holdings. The Oppenheimer lawsuit is the twelfth of these auction rate securities lawsuits to be filed.

Run the Numbers: Like everyone else, I too am trapped by the now-established convention of referring to the current credit-related lawsuit onslaught as the “subprime” litigation wave, and as a reflection of that convention, I have added the First Marblehead and Oppenheimer lawsuits to my running tally of the “subprime”-related litigation, which can be accessed here. With the addition of these two new lawsuits, the current tally now stands at 70, of which 30 have been filed in 2008. As noted, 12 of these lawsuits involve class action auction rate securities litigation.

Subprime Litigation: The Grandaddy of Them All?: Although the crisis commonly referred to as the “subprime” meltdown is relatively recent, subprime loans have been around for a while. Indeed, problems with subprime loans are also nothing new. Even though the current wave of subprime-related litigation did not get started until February 2007, there were subprime-related lawsuits before that. These earlier lawsuits may provide some interesting perspective on the current round of litigation.

As described in an April 9, 2008 Wall Street Journal article entitled “Subprime Lender’s Failure Sparks Lawsuit against Wall Street Banks” (here), American Business Financial Services was in the subprime loan origination business. It funded its operations through the securitization of loans, but, in addition, it also raised operating cash by selling notes through direct sales to individual investors.

According to the allegations in subsequent litigation, ABFS underestimated the number of its loans that would be paid off early as a result of refinancing, reducing the company’s cash flow, and ultimately leading to the company’s bankruptcy. The noteholders, of which there may have been as many as 22,000, lost millions.

The Journal article describes the Pennsylvania state court lawsuit that the bankruptcy trustee has filed against the Wall Street banks that sponsored ABFS’s securitizations, as well as against the company’s former directors and officers. But this trustee lawsuit follows two earlier lawsuits, one brought by the company’s shareholders and one brought on behalf of the company’s noteholders.

The ABFS shareholder securities litigation, background about which can be found here, was initiated in January 2004, following the company’s disclosure that the Department of Justice was investigating the company’s loan transactions and securitization agreements. The plaintiff shareholders alleged that the company and certain of its directors and officers misrepresented the company’s financial condition by artificially altering the company’s loan default ratio, to understate the level of the company’s troubled loans. In a June 2, 2005 memorandum opinion and order (here), the court granted the defendants’ motion to dismiss, on the ground that the plaintiffs did not adequately allege that the statements at issue materially misleading, nor did the plaintiffs’ allegations create a “strong inference” that the defendants acted with scienter.

The noteholder litigation, by contrast is going forward, albeit in a narrowed state. The background regarding the ABFS noteholder litigation can be found here. The noteholders also claimed that the defendants misrepresented the company’s financial condition. In two orders (here and here), the court dismissed the plaintiffs’ allegations concerning the company’s loan delinquency rates, as well as the plaintiffs’ solicitation claims under Section 12. A much-narrowed case is going forward.

The course of these earlier lawsuits casts an interesting light on the current wave of lawsuits. The ABFS shareholder lawsuit dismissal is a reminder that even a lawsuit involving a bankrupt company that is the subject of a DoJ investigation, and in connection with which shareholders lost substantially all their investment, still has to survive the formidable pleading requirements to which securities lawsuits are subject. Even the noteholders, whose plight may be particularly sympathetic, have seen their petition for redress of grievances substantially narrowed.

The fate of these earlier lawsuits is a reminder that merely because lawsuits are filed, even lawsuits filed in the context of significant financial losses and regulatory investigations, does not mean that the lawsuits will succeed. It may be important to keep in mind as the current wave of lawsuits continues to accumulate that these lawsuits will face the same formidable pleading barriers as did the ABFS lawsuits, and some of these lawsuits, like the ABFS lawsuits, will not survive or will only survive on a greatly narrowed basis.

Tellabs in the Ninth Circuit: Readers interested in following the implementation of the Supreme Court’s Tellabs decision in the lower courts will want to review the April 10, 2008 decision (here) in the Skechers USA securities litigation, in which the Ninth Circuit affirmed the district court’s dismissal of the lawsuit, in reliance on Tellabs.

However, the complications that may yet attend the implementation of the Tellabs decision in the lower courts is also suggested by the dissenting opinion in the Skechers appeal (here), in which the dissenting judge, applying the same Tellabs standard to the same facts, reached the opposite conclusion, finding that the district court’s dismissal ought to be reversed.

In the end however, while the Ninth Circuit’s majority and dissenting opinions in the Skechers case are interesting, they ultimately are of little value to the larger question of how Tellabs may be implemented in the lower courts, because the majority opinion is designated as “Not for Publication,” as a result of which it may not be cited. I have previously (here) decried the truly regrettable practice of courts designating opinions as not for publication or citation. Our entire system of jurisprudence relies on the usefulness of prior decisions to help resolve future cases, and it is fundamentally inconsistent with this arrangement for courts to try to remove decisions from this time-honored tradition and process.

Special thanks to a special friend of The D&O Diary for copies of the Ninth Circuit opinions.

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