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

The current securities litigation wave first arose out of the collapse of the residential real estate subprime mortgage market. As I have previously noted (here), the wave long ago ceased to be just about subprime mortgages, as the litigation as expanded to encompass the fallout from a more general credit crisis. As demonstrated in a recent lawsuit, the wave now includes litigation arising from disruptions in major development construction project financing.

 

According to their August 20, 2008 press release (here), plaintiffs’ counsel have initiated a purported securities class action in the United States District Court for the District of Massachusetts against Perini Corp. and certain of its directors and officers. A copy of the complaint can be found here.

 

According to the press release, the complaint alleges that Perini, a company that offers general contracting, construction management and design-build services to private clients and public agencies worldwide, failed to disclose:

(a) that the developer of Perini’s Las Vegas, Nevada projects, including the CityCenter Project, was experiencing financial problems because it failed to secure financing for the entire project and was dependent upon raising the remainder of the financing from the expected sale of residential units. However, the proceeds from the residential unit sales were based on unrealistic and aggressive prices at a time when the condo market in Las Vegas, Nevada was extremely weak; (b) that the Company’s Las Vegas projects were being delayed, and could possibly be halted; (c) that the developer was in risk of defaulting on its construction loan; (d) that the Company’s future revenue and profit was dependent upon the Las Vegas projects since the projects consisted of approximately 20% of its backlog; and (e) as a result of the foregoing, the Company’s ability to maintain its profit margins was in serious doubt.

Then, on January 17, 2008, the Company issued a press release announcing that Deutsche Bank "delivered a notice of loan default to the developer of the Cosmopolitan Resort and Casino project under construction in Las Vegas, Nevada." In response to this announcement, shares of the Company’s common stock fell $10.05 per share, or 27%, to close at $27.65 per share, on heavy trading volume.

The general economic downturn is now affecting a broad variety of companies in diverse industries. As I have previously noted (most recently here), in all likelihood, in the weeks and months ahead, other companies will be finding that transactions entered in more clement circumstances now appear troubled. As more companies stumble on these troubled transactions, further lawsuits undoubtedly will emerge. And as is the case with the Perini lawsuit, most of these lawsuits will have little to do with subprime mortgages directly.

 

In any event, I have added the Perini lawsuit to my list of subprime and credit crisis-related securities class action lawsuits, which can be accessed here. With the addition of the Perini lawsuit, the current tally of subprime and credit crisis-related securities lawsuits now stands at 108, of which 68 have been filed in 2008.

 

For those who are curious, information about the CityCenter Las Vegas project can be found here. Background about the Cosmopolitan Resort and Casino can be found here.

 

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Over the past two days, plaintiffs’ attorneys have launched a couple of new securities lawsuits. Nothing particularly noteworthy about that, in and of itself. But upon closer review, there are some rather interesting things about these new lawsuits. I note my observations below after briefly describing each of the two new lawsuits.

 

The first of these lawsuits was filed on August 5, 2008 in the Southern District of Indiana against medical device manufacturer Zimmer Holdings, its CEO, and its CFO. A copy of the plaintiffs’ August 5 press release can be found here, and the complaint can be found here.

 

According to the press release, the Zimmer complaint alleges that:

defendants failed to disclose material flaws in the quality systems at Zimmer’s Dover, Ohio facility, which manufactured Zimmer Orthopedic Surgical Products. In addition, defendants failed to disclose that patients receiving the Company’s Durom Acetabular Component, used in total hip replacement procedures, disproportionately experienced cup loosening requiring additional corrective surgery after implantation. As a result of defendants’ materially false and misleading statements, Zimmer’s common stock traded at artificially inflated prices during the Class Period. When the true condition of the Company, its facilities, and its products began to come to light, the price of Zimmer stock declined, falling from $70.88 to $66.01 per share in one day.

The second of the two lawsuits was filed on August 6, 2008 in the Eastern District of Virginia against automobile retailer CarMax and certain of its directors and officers. A copy of the plaintiffs’ August 6 press release can be found here and the complaint can be found here.

 

According to the press release, the CarMax complaint alleges that:

during the Class Period, CarMax was not meeting internal sales targets and was facing a 55% shortfall in its net income for first quarter of fiscal year 2009, later prompting the Company to suspend its financial guidance for the rest of fiscal 2009. According to the complaint, CarMax publicly issued materially false and misleading statements and failed to disclose: (i) that CarMax was not positioned to meet its sales targets or earnings objectives for fiscal 2009; (ii) that the Company had completed a refinancing of its warehouse facility which had materially increased the Company’s funding costs; and (iii) as a result of the foregoing, defendants had no reasonable basis for their revenues and earnings guidance for fiscal 2009.

On June 18, 2008, the Company issued a press release announcing its financial results for the first quarter of fiscal 2009, the period ended May 31, 2008. The Company also announced that it was suspending its financial guidance for the rest of fiscal 2009. Upon this news, shares of the Company’s stock fell $2 per share, or approximately 11%, to close at $16.34 per share, on heavy trading volume.

The first noteworthy thing about these two lawsuits is the relative modesty of the stock price drops they allege. In general, plaintiffs’ lawyers’ try to rely on allegations of dramatic stock price drops to try to show that the marketplace was shocked by the unexpected revelation of previously withheld information. Stock price drops of 11% in CarMax’s case, and less than 7% in the case of Zimmer, are not really the type of dramatic share price declines that you might expect to attract plaintiffs’ lawyers’ attention.

 

In CarMax’s case, it clearly was not just the stock price decline that caught the plaintiffs’ attorneys’ eyes. CarMax was also the subject of a June 25, 2008 Wall Street Journal article entitled “CarMax Executives Sold Before Shortfall” (here), noting that CarMax insiders had sold $4.3 million in company stock in April and May 2008, ahead of the company’s June announcement of disappointing revenue.

 

The Journal article stated that the “had the insiders waited and conducted their transactions after the earnings report, their proceeds would have been just $2.7 million, a drop of nearly 40%.” As might be expected, the CarMax complaint quotes the Journal article extensively.

 

The Zimmer lawsuit is little harder to fathom. Not only does the complaint allege only a 7% stock price drop, but unlike the CarMax complaint, it contains no insider trading allegations. Perhaps even more significantly, not only was Zimmer’s stock price drop modest, but it has been completely erased in the eleven trading days following the company’s July 22, 2008 second quarter earnings release. Indeed, Zimmer’s stock closed today at 70.89, which is basically unchanged from the company’s share price of 70.88 preceding the stock drop.

 

To be sure, these are both large companies and even modest share price declines represent significant amounts in dollar terms. The two dollar share price drop alleged in the CarMax complaint represents a market capitalization loss of roughly $440 million. The $4.87 share price drop alleged in the Zimmer complaint represents a slightly more than $1 billion drop in Zimmer’s market cap – although all of that has been recovered in the eleven trading days since the decline. While these dollar figures represent undeniably impressive sums, as a percentage matter they make less of an impression.

 

The other interesting thing about these two lawsuits is what they do not involve. That is, they do not involve subprime or credit crisis-related allegations. As I discussed in recent posts (here and here), two recent studies confirmed that securities activity in the first half of 2008 was largely driven by subprime and credit crisis-related litigation. These two new lawsuits suggest that plaintiffs’ lawyers still have time to indulge in other pursuits.

 

But while these cases do not involve subprime or credit crisis-related allegations (at least not directly), the CarMax case does suggest that the more general economic decline is starting to burden companies and, in CarMax’s case at least, attract the unwanted attention of plaintiffs’ lawyers.

 

CarMax’s June 18, 2008 press release (here) that triggered its stock price drop quotes its CEO as saying that “the slowdown in the economy, the dramatic rise in gasoline and food costs and the related impact on consumer spending adversely affected our first quarter performance.” The release also states that “for the first time in more than two years, we experienced a modest decline in customer traffic in our stores. Additionally, credit availability from our third-party nonprime lenders declined slightly in the quarter.”

 

CarMax is far from the only company that in the weeks and months ahead will be reporting disappointing earnings as a result of the slowdown in the economy and declining consumer spending. Not all of the companies that report disappointing earnings will get sued. But if a stock price drop of 11%, or even just 7%, is enough to attract a lawsuit, there could be a period of heightened litigation activity ahead. Based on these two lawsuits, the plaintiffs’ securities bar seems primed for action – regardless of whether or not subprime or credit crisis-related issues are involved.

 

Politics on a New Plane?: A July 31, 2008 article in The Economist (here) reports the following about recent political events in India:

India’s coalition government went to outlandish lengths to win a vote of confidence in Parliament on July 22nd, a victory it hopes will prolong its life until early next year. To appease one politician, it even renamed the airport in Lucknow, a state capital, after his father. (The ingrate still voted the other way.) Asked to justify this ploy, India’s finance minister dryly remarked, “It will facilitate better take-offs and landings.”

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Following close on the heels of the Cornerstone mid-year report released earlier in the day, on July 29, 2008, NERA Economic Consulting also released its mid-year 2008 securities class action report entitled “2008 Trends: Subprime and Auction Rate Cases Continue to Drive Filings, and Large Settlements Keep Averages High” (here). A copy of the July 29 press release describing the NERA Report can be found here.

 

The NERA Report differs in its numerical particulars from the Cornerstone Report, but the two reports are at least directionally consistent. The NERA Report is also directionally consistent with my own mid-year securities litigation study, which can be found here.

 

According to the NERA Report, there were 139 securities lawsuits filed in the first half of 2008 (by way of comparison, Cornerstone has the number at 110). Based on NERA’s analysis, the 2008 filings are on pace to reach almost 280 (compared to Cornerstone’s estimate of 220). The NERA Report, like prior mid-year reports concludes that the increased pace of filing activity is largely driven by the current subprime and credit crisis-related litigation.

 

The NERA Report also concludes that market volatility is positively correlated with the number of securities class action filings, and the “if market volatility is higher during a quarter, controlling for market returns, filings are likely to be higher in the same quarter.”

 

The NERA Report also notes that “the probability of a suit rises with the size of the price decline: whereas only 9% of drops of 20-30% are followed by a shareholder class action within three months, almost 31% of drops of 40% or more are followed by a filing within that time frame.”

 

Taking into account the settlements over $1 billion, the average settlement in the first half of the year remained around $30 million, but excluding the $1 billion settlements reduces the average first half settlement to around $10 million. The median settlement in the first half of 2008 was $6.2 million. Both the average and median are below similar figures for recent years.

 

However, the Report also notes that the investor losses associated with the recently filed lawsuits were substantially higher than the median for cases settled in the 2005-2007 time frame, suggesting that the 2008 cases (largely driven by the subprime-related cases) potentially could result in much larger settlements.

 

The Report also contains interesting and detailed information regarding the 21 cases that have gone to trial since the enactment of the PSLRA.

 

The NERA Report is quite detailed and very interesting, and contains numerous other useful observations beyond those summarized here.

 

The material divergence in lawsuit count between the NERA Report and the Cornerstone Report (and for that matter between the NERA Report and my own mid-year analysis) is a cause of concern for anyone interested in a precise understanding of the current lawsuit trends. In my own mid-year analysis of the 2008 securities lawsuit filings, I noted some of the reasons why “counting” lawsuits is particularly difficult in the current environment, and some of those factors undoubtedly are at work here.

 

But these foreseeable difficulties notwithstanding, the divergence in the numbers is disconcerting. Because so many observers depend on these respectable sources to understand securities litigation developments, it is troublesome when the sources disagree so widely. If these industry sources are unwilling to make their lawsuit lists publicly available, it would be helpful if these sources would at least identify their sorting criteria. I know from my own experience that there are a lot of decisions that must be made about which lawsuits should be included and which should be kept out. At least with the benefit of these sorting criteria, we could try to understand the differences.

 

In the past, it has always been sufficient for me to recognize the numerical differences between different reports while noting their directional consistency. But the difference in count between the two leading reports of 29 lawsuits is a material difference. The differences in their respective year-end projections are even more dramatic. Differences of this degree not only cause problems for industry participants and observers. Without suggesting one way or another where the issues may be, at some level, questions regarding consistency and even reliability start coming into the picture.

 

I welcome comments from responsible sources on the issues surrounding the diverging lawsuit counts. There could be significant value in a public discussion of these issues and I would be particulary interested in adding comments to this post from the respective research groups that track this information.

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Over the last several years, Congress has made several different efforts to concentrate class action litigation in federal court.

 

For example, in the Securities Litigation Uniform Standards Act of 1998 (SLUSA), Congress amended portions of the Securities Act of 1933 and the Securities Exchange Act of 1934 to preempt class actions alleging fraud under state law in connection with the purchase or sale of securities. The Act specifically made state law securities class action lawsuits removable to federal court.

 

In addition, in the Class Action Fairness Act of 2005 (CAFA), Congress expanded federal court jurisdiction over class actions and mass actions. CAFA gives federal courts jurisdiction over certain class actions in which the amount in controversy exceeds $5 million and in which any of the class members is a citizen of a state different from any defendant.

 

But while Congress enacted these various legislative changes designed to concentrate class action litigation in federal court, Section 22(a) of the ’33 Act preserved state court jurisdiction by specifying that federal courts’ jurisdiction for ’33 Act lawsuits is “concurrent with State and Territorial courts.” Moreover, Section 22(a) specifically provides that no case “brought in any state court of competent jurisdiction shall be removed to any court of the United States.”

 

These jurisdictional provisions have been a part of the federal securities laws since the basic statutes’ enactment. But the legislative developments in the interim raise the question whether the subsequent enactments override the concurrent state court jurisdictional provisions in Section 22(a).

 

As I have previously noted (here), plaintiffs’ lawyers have chosen to file a number of subprime-related securities class action lawsuits alleging ’33 Act violations in state court. In particular, plaintiffs’ lawyers have elected to file in state court several class action lawsuits alleging misrepresentations in connection with the creation and issuance of subprime mortgage-backed securities. These lawsuits, of which by my count there have been at least four, exclusively allege violations of the ’33 Act.

 

One of the first of these lawsuits to be filed is the case styled as Luther v. Countrywide, the background regarding which can be found here. The plaintiffs originally filed their complaint in California Superior Court for Los Angeles County. The Luther complaint names as defendants several Countrywide subsidiaries and affiliated individuals, multiple loan trusts, and Countrywide’s offering underwriters.

 

The claims in the Luther lawsuit are brought on behalf of purchasers of billions of dollars of mortgage pass-through certificates issued between June 2005 and June 2007. The complaint alleges that the defendants violated Sections 11, 12 and 15 of the ’33 Act, essentially on the grounds that the risk of investing in the mortgage pass-through certificates was much greater than represented by the registration and prospectus supplements, which allegedly omitted and misstated the creditworthiness of the underlying borrowers.

 

The defendants, in reliance on CAFA, removed the Luther case to federal court. The plaintiffs filed a motion to remand the case to state court.

 

As discussed here, on February 28, 2008, Judge Mariana R. Pfaelzer granted the plaintiffs’ motion to remand the case to state court, holding that Section 22(a)’s removal bar trumps CAFA’s general grant of diversity and removal jurisdiction. The defendants appealed.

 

In an opinion filed on July 16, 2008 (here), the Ninth Circuit affirmed the district court, specifically holding that CAFA, “which permits in general the removal to federal court of high-dollar class actions involving diverse parties, does not supersede Section 22(a)’s specific bar against removal of cases arising under the ’33 Act.”

 

The defendants had argued that CAFA superseded Section 22(a)’s removal bar. But the Ninth Circuit, applying principles of statutory construction, held that while CAFA applies to a “generalized spectrum” of class actions, the ’33 Act is “the more specific statute” and that the removal bar “more precisely applies only to claims” under the ’33 Act. The Ninth Circuit concluded that the plaintiff’s initial state court class action “was not removable” and that “the motion to remand was properly granted.”

 

In other words, the Luther lawsuit will now go forward in state court. In light of the Ninth Circuit’s opinion, it seems likely that the various other subprime-related class action lawsuits filed against the mortgage securitizers will also eventually proceed in state court as well.

 

The “where” question has been resolved, but the “why” question still remains – that is, why do plaintiffs’ counsel want to proceed in state court rather than federal court?

 

One possibility is that plaintiffs’ counsel believes that state courts will be more sympathetic to the interests of local claimants, especially in connection with their claims against out-of-state moneyed interests. The search for a more favorable court has always driven forum shopping, and there may be some of that here. But I do wonder why plaintiffs’ securities attorneys, whose practices historically (especially in recent years) have concentrated in federal court, want to litigate in a state court with which they may be less familiar, and that will be unfamiliar with federal securities laws and securities litigation generally.

 

Another possible reason plaintiffs lawyers want to proceed in state court is that they want to try to circumvent the procedural requirements of the PSLRA. I have speculated elsewhere (most recently here) that plaintiffs’ counsel may try to argue that the PSLRA’s procedural requirements do not apply to a ’33 Act case in state court. The plaintiffs’ argument would be that the PSLRA, codified in Section 27(a) of the ’33 Act, provides that the PSLRA applies only to private actions “brought as a plaintiff class action pursuant to the Federal Rules of Civil Procedure.” The plaintiffs’ counsel may argue that because their suit was not brought pursuant to the Federal Rules of Civil Procedure, the PSLRA’s procedural requirements (such as the notice provisions, the discovery stay, and the lead plaintiff provision) do not apply. There could be a great deal of litigation turbulence if plaintiffs’ lawyers pursue these arguments (which seems likely).

 

Plaintiffs’ counsel apparently have the right to pursue ’33 Act claims in state court, which for whatever reason they seem inclined to do. There were of course a few securities lawsuits filed in state court after the enactment of the PSLRA, but my recollection is that that experiment did not go particularly well. Due to the state courts’ crowded dockets and unfamiliarity with federal securities laws, the cases bogged down. The enactment of SLUSA seemingly ended this prior flawed experiment.

 

Nevertheless, plaintiffs’ securities attorneys, for reasons they deem good and sufficient, are back again in state court, a place where they now seem eager to be. Some recalibration may be required to accommodate the prospect of further state court securities litigation. The plaintiffs’ lawyers’ interest in pursuing state court ’33 Act class action litigation is an unexpected development with uncertain implications. The road could be rough for all concerned.

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Securities lawsuit filings remained elevated during the first half of 2008. The 105 new securities lawsuit filings during the first six months of 2008 were more than 50% higher than the number of new securities lawsuit filings (69) in the first six months of 2007. (Please refer to the note below regarding my lawsuit filing “count”, which may differ from some other published tallies).

 

The 204 new securities lawsuit filings during the 12-month period from July 1, 2007 to June 30, 2008 is 15% higher than the 176 filings for the full year 2007 and also represents a 65% increase compared to the 123 filings during the 12-month period from July 1, 2006 through June 30, 2007. The 204 new securities lawsuit filings during the 12-month period ending on June 30, 2008 is the highest 12-month total since the period July 2004 through June 2005, during which 228 lawsuits were filed.

 

The 105 lawsuits filed during the first half of 2008 projects to a year-end total of 210 securities lawsuit filings, meaning that the filing rate is above the post-PSLRA filing average. According to Cornerstone Research, here, the annual average number of securities class action lawsuits during the period from 1996 to 2006 was 194.

 

A year end total of 210 filings would also represent the highest annual total since 2004, when 237 securities lawsuits were filed. (Because my YTD lawsuit count omits a number of lawsuits, for reasons discussed below, my YTD tally and my year-end projection may be lower the numbers that may appear in other published sources.)

 

The most significant factor in the elevated securities filing activity is the number of new lawsuits associated with the subprime and credit crisis. 58 of the first half filings (about 55%) of the first half securities lawsuit filings are subprime or credit crisis related. As reflected on my running tally of the securities class action lawsuits, which may be accessed here, the total number of subprime and credit crisis related lawsuits, including those filed in 2007 as well as those filed in 2008, now stands at 98. (Please refer to the note below regarding the recent revisions to my subprime and credit crisis-related lawsuit tally.)

 

Only 46 of the 105 first-half securities lawsuit filings were not subprime or credit crisis-related, meaning that the subprime related litigation unquestionably was a driving factor in the elevated securities lawsuit filing levels (although one might also speculate that other filings are down because the plaintiffs’ securities’ bar is preoccupied with the still emerging subprime litigation).

 

The subprime and credit crisis filings show no sign of abating. Of the 58 subprime lawsuits filed in the first half of 2008, 29 – exactly half-- were filed in the second quarter, including eleven in June alone. This continued steady filing level suggests that the subprime and credit crisis-related litigation wave will continue during the second half of 2008.

 

An analysis of the first half filings by Standard Industrial Classification (SIC) code confirms the foregoing conclusions. Although the companies sued in the first half of 2008 represented 56 different SIC Code categories, fully 62 of the lawsuits (or about 59% of the first half filings) were filed against companies in the 6000 SIC Code series (Finance, Insurance and Real Estate). The two most prominent SIC Code categories were SIC Code 6021 (National Commercial Banks), which had 17 lawsuits, and SIC Code 6211 (Security Broker Dealers), which had 14 lawsuits. No other single SIC Code category outside the 6000 SIC Code series had more than three lawsuits. (Please refer to the note below regarding SIC Code categorization.)

 

These statistics underscore an important point about the subprime and credit crisis related litigation. That is, with a couple of arguable exceptions, the subprime and credit crisis related litigation wave really has not spread beyond the financial sector. Although I have long speculated (most recently here) that the credit crisis litigation might hit nonfinancial companies, by and large that has not yet happened, at least not to any significant degree.

 

One consequence of the predominance of the subprime and credit crisis related litigation is that many of the first half lawsuits involved nontraditional plaintiffs and defendants. The traditional or conventional securities lawsuit to which I refer here involves a securities class action lawsuit brought by public company shareholders against the company and its directors and officers. This traditional type of securities lawsuit may sometimes include other third party defendants such as the company’s auditors or the company’s offering underwriters.

 

But many of the first half lawsuits involve plaintiffs other than public company shareholders. For example, among the first half filings were 17 auction rate securities lawsuits, in which the plaintiffs were not public company shareholders, but rather auction rate securities investors who were suing the broker dealers or financial institutions that sold them the instruments. (The securities issuers were not usually targeted in these lawsuits.) Refer here for my prior discussion of the auction rate securities lawsuits.

 

Similarly, the multiple securities lawsuits brought by mortgage-backed securities investors against the financial institutions that created the instruments also do not involve traditional shareholder plaintiffs. In addition, as I discussed here, the plaintiffs lawyers have chosen to bring many of these lawsuits against the securitizers in state court, to be be removed subsequently by the defendants to federal court. So the first half 2008 filing total is also noteworthy for its inclusion of a number of state-court initiated lawsuits.

 

The credit crisis litigation wave has also hit a number of nontraditional defendants. Rather than targeting just public company defendants, the plaintiffs in many of these lawsuits targeted, for example, hedge funds (refer here) and mutual funds (refer here). The presence of these nontraditional defendants sometimes pose some tough questions at the margins about whether or not a specific lawsuit should be included in the lawsuit count, as discussed further below.

 

It is probably worth noting that in addition to the lawsuits from the current credit crisis-related litigation wave, the first half filings also included two options backdating-related securities lawsuits filings.

 

Companies domiciled outside the United States were sued in 19 of the first half new securities lawsuit filings, representing 12 different countries, including four each from Canada and from Switzerland.

 

The lawsuits filed against domestic companies included corporate defendants from 27 different states, with the largest number from New York (22 lawsuits) and California (11 lawsuits).

 

The lawsuits were filed in 26 different U.S. district courts, but by far the largest number were filed in the Southern District of New York, where 43 (or about 41%) of the 105 lawsuits were filed. Other courts with a significant number of filings included the District of Massachusetts (11 lawsuits), the Northern District of Illinois (8 lawsuits), the Central District of California (5 lawsuits) and the Northern District of California (5 lawsuits).

 

A Note about “Counting” Lawsuits: As noted above, the presence of nontraditional plaintiffs and defendants, as well as the emergence of state court and other nontraditional filings, raises many hard questions about what to include in the lawsuit count. These factors by themselves create significant potential for different lawsuit counts.

 

In addition, the pattern of much of this litigation also poses some “counting” challenges. A couple of examples will illustrate the problem

 

Lehman Brothers (or at least one of its officers) was first sued in February 2008 in the Northern District of Illinois. That lawsuit was voluntarily dismissed. A second Northern District of Illinois lawsuit involving Lehman Brothers was filed in April 2008. Then a separate lawsuit was filed in the Southern District of New York in June 2008. I have only counted this litigation once, as has, for example, the Stanford Law School Securities Class Action Clearinghouse (as shown here).

 

By contrast, Falcon Strategies, a Citigroup-affiliated hedge fund, was sued in a securities lawsuit in April 2008, in federal court in Florida. That lawsuit was later voluntarily dismissed. (Refer here). Then the fund was sued in May 2008 in federal court in New York in a tender offer-related securities lawsuit (refer here) I could see counting this litigation once, but the Stanford website has counted each lawsuit separately and so have I.

 

But while I am in accord with the Stanford website to that extent, I could not agree with the Stanford site on some other specifics. For example, one of the lawsuits on their list is the Safeco litigation (refer here). The Safeco lawsuit is a merger objection suit. I have never counted these kinds of lawsuits in my tallies; were this lawsuit to be included, a whole raft of other merger objection litigation would also arguably have to be included. In my opinion, this lawsuit should not be counted in the securities lawsuit tally, but reasonable minds clearly could differ.

 

Similarly, the 2008 lawsuit involving Heartland Resources (about which refer here) contains allegations that the defendants improperly failed to register certain limited partnership interests. Alleged violations of the obligation to register securities seem to me to be fundamentally different than a lawsuit for securities law damages based on alleged misrepresentations or omissions relating to publicly traded securities. Reasonable minds could differ on this issue as well, but to my mind this kind of lawsuit should not “count.” This analysis applies not just to the Heartland Resources lawsuit, but also to the lawsuits involving Maximum Financial Group (refer here) and WCI Communities (refer here).

 

I have illustrated this analysis in detail here first to show how tricky this whole "counting" exercise is, and second to explain why there may be differences between my tallies and some others that may be published, including for example any lawsuit count based on the Stanford website. That does not mean that I think mine is right and the others are wrong – as I have stressed throughout, reasonable minds could differ on many of the specifics. The most important thing is that the various analyses are directionally consistent, which undoubtedly is and will be the case. The marginal differences are relatively unimportant.

 

A Note about SIC Code Categorization: As discussed above, the first half 2008 lawsuits include some filed against nonconventional defendants, including some, like hedge funds and mutual funds, that have not been assigned to an SIC Code category. In addition, many of the lawsuits included a host of related entity defendants.

 

Where the list of defendants includes a public company, I have used the public company’s SIC Code, even if it is not the primary defendant. Similarly, where a fund defendant is affiliated with a public company, I have used the public company’s SIC Code.

 

Nevertheless, there were a total of three of the lawsuits filed in the first half where I was unable to assign any SIC Code. These cases primarily involve mutual fund defendants.

 

A Note about the Subprime Lawsuit Tally: Regular readers know that I have been maintaining a running tally of the subprime and credit crisis-related securities lawsuits (which may accessed here). Readers that have been monitoring the list closely over time may have been somewhat surprised by the credit crisis lawsuit numbers I have used in this mid-year analysis. These numbers may appear suddenly larger than more recent tallies.

 

The reason for this adjustment is that as part of this mid-year review, I undertook a comprehensive audit of my lawsuit lists, and, in particular I conducted a cross-comparison with the Stanford website and a number of other sources.

 

As a result of this process, I added several items to my list of subprime securities lawsuits. Some of these additions were required because I had simply omitted certain items (where, for example, I was aware of the lawsuit but had simply neglected to add it to the list). Some of the additions were the result of recategorization, some simply new additions. All of these additions are highlighted in red in my updated list, which can be accessed here.

 

Break in the Action: The D&O Diary will slowing down in the next few days and will resume its normal publication schedule during the week of July 7.

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In prior posts (most recently here), I have discussed the fact that life sciences companies remain a favored target of the plaintiffs’ securities bar. A June 2008 memorandum by Michael Kichline and David Kotler of the Dechert law firm entitled “Dechert Survey of Securities Fraud Class Actions Brought Against Life Sciences Companies”  (here) takes a closer look at the 2007 life sciences securities lawsuits and concludes that “life sciences companies remain firmly in the crosshairs of the plaintiffs’ securities bar.”

 

The authors note that the 25 securities class action lawsuits filed in 2007 against life sciences companies represents a 64% increase over the 16 filed the preceding year, and also represents 14% of the 175 total securities lawsuits filed in 2007. (My own numerical analysis of the 2007 life sciences lawsuits, which can be found here, differs slightly, but only in the details, not the direction, and the difference undoubtedly is due to the narrow definition of “life sciences” I used in my analysis.)

 

The authors also have a number of interesting observations about the 2007 life sciences lawsuits, including the fact that “life sciences companies with the greatest market capital -- more than $10 billion – were sued at the same rate as companies with less than $250 million.”

 

The authors also note that the securities lawsuit allegations against life sciences companies “continue to span the product life cycle” and that many of the companies sued 2007 were sued “based on information they communicated, or failed to communicate, to the public about a drug’s efficacy, safety, and/or the results of the FDA approval process.”

 

One particularly interesting observation in the study is that “research personnel were frequently named as defendants,” and specifically that in five cases, the plaintiffs alleged that because “key research personnel had a high level position with the company and access to internal information, they both knew and failed to disclose the alleged adverse non-public information.”

 

The authors predict that life sciences companies will continue to be the targets of securities fraud lawsuits, noting that “the structural factors that lead plaintiffs’ lawyers to target life sciences companies – volatile stock prices and a drug or device product life cycle fraught with potential for adverse and unpredictable events, such as a negative clinical trial result of FDA decisions – remain challenging, especially in the current stock market and regulatory environment.” The authors predict that plaintiffs’ counsel will continue to strive to find new theories. The authors cite as an example the likelihood that “more securities lawsuits will be premised on off-label communication or sales.”

 

The survey, which concludes with practical risk minimization suggestions, is quite good and merits reading at length and in full.

 

While I concur in all of the authors’ views, I think that in order to fully appreciate life sciences companies’ securities litigation exposure, it is important to consider not only the lawsuit filings, but also the case dispositions. Life sciences companies may be frequent lawsuit targets, but that does not mean that all or even most of the lawsuits are meritorious.

 

As I have noted in prior posts (most recently here), many of the securities lawsuits filed against life sciences companies are dismissed. Indeed, many of the large life sciences companies that have been targeted in securities suits in recent months – including, for example, Guidant, Pfizer and Astra Zeneca – have successfully managed to get the cases dismissed. And it is not just the larger companies that have prevailed; smaller companies, such as, for example, Micrus Endovascular (which recently prevailed on its motion to dismiss, about which refer here), have also prevailed on their dismissal motions.

 

To be sure, there have also been many settlements of life sciences securities lawsuits, some of which have been quite significant. But overall life sciences securities lawsuits have not always been as productive for the plaintiffs’ lawyers as might be suggested by the sheer numbers of filings.

 

I do agree that the volatility of life sciences companies’ share price and the companies’ susceptibility to product-driven dislocations will continue to attract the unwanted attention of the plaintiffs’ lawyers. The good news for these companies is that they have potentially effective defenses available and they may be able to use these defenses to stave off the litigation assault. The risk protection steps suggested in the authors’ memorandum are particularly good starting points for preparing these defenses.

 

Special thanks to David Kotler of the Dechert firm for providing me with a copy of the life sciences securities litigation survey.

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In prior posts (refer here), I have discussed the increasing reluctance of U.S. courts to exercise subject matter jurisdiction over securities claims against foreign-domiciled companies brought by foreign claimants who bought their shares on foreign exchanges (so-called “f-cubed” claimants).

 

In the most recent example of this, Judge Thomas Griesa of the United States District Court for the Southern District of New York, in a June 3, 2008 opinion (here), granted the defendants’ motion to dismiss the claims of “f-cubed” claimants against AstraZeneca and certain of its directors and offices.

 

The complaint essentially alleges that Exanta, a pharmaceutical being develop by the AstraZeneca (a U.K.-based company) “was not as safe or effective as defendants’ public statements made it out to be.” The plaintiffs’ claimed that these statements inflated the company’s share price. Refer here for background regarding the lawsuit.

 

The outcome of the subject matter jurisdiction question was probably tipped in the court’s opening observation that “over 90% of the members of the putative class are foreigners who purchased their shares on foreign exchanges.”

 

The court reviewed the propriety of its exercise of jurisdiction over claims brought on behalf of these foreign shareholders, by considering whether or not there were sufficient allegations of U.S.-based conduct causing sufficient U.S.-based effects. The court found that while there were sufficient allegations of U.S.-based conduct, plaintiffs “do not allege facts in support of the second prong of the test – that the United States conduct ‘directly caused’ plaintiffs’ losses.”

 

The court said that in order to establish this requisite causal link, the plaintiffs must have “sufficiently alleged that the foreign purchasers relied on United States based conduct when deciding to acquire the stock”. In order to establish this kind of reliance, the plaintiffs urged the court in effect to adopt a global “fraud-on-the-market” theory, arguing that “it is illogical to suggest that the fraud-on-the-market theory applies within the United States but not outside of it.”

 

The court noted that other courts had rejected the global fraud-on-the-market theory, out of concerns that it would “extend the jurisdictional reach of the United States securities laws too far.” The court further noted that the Second Circuit had not yet provided guidance on whether the fraud-on-the-market theory should apply to foreign countries, and “in the absence of clear authority in favor of a global fraud-on-the-market theory, the court declines to adopt such a theory.” The court dismissed the claims of the foreign claimants based on lack of subject matter jurisdiction.

 

The court further concluded that the plaintiffs had not sufficiently alleged that two foreign-domiciled individual defendants had the requisite “minimum contacts” with the U.S. for the court to exercise personal jurisdiction over them.

 

Finally, the court concluded that the plaintiffs had not sufficiently pled scienter, and dismissed the remaining claims on that basis. The court held that neither the allegations of insider trading nor the allegations relating to a secondary offering were sufficient to establish scienter.

 

The court further rejected the plaintiffs allegations that the defendants had consciously disregarded the truth, based on the court’s own review of the various disclosure documents on which the plaintiffs sought to rely. The court concluded that the plaintiffs “have not alleged anything to negate the idea that that defendants were attempting to develop a drug they thought beneficial and were do describing it to the public.” The court found that the plaintiffs had “not alleged an inference of scienter as compelling as the opposing inference.”

 

The fact that the case will not be going forward even as to the domestic shareholders reduces the impact of the court’s ruling to exclude the f-cubed claimants from the class. The dispersion of the class, with such an overwhelming percentage of f-cubed claimants in the purported class members may well have inclined the outcome on the jurisdictional issue in any event.

 

Plaintiffs’ attorneys in the most recently filed cases seem to be anticipating that courts are inclined to exclude these claimants from the putative class and increasingly are taking that into account in their initial pleadings. For example, as discussed here, when plaintiffs’ lawyers recently launched a U.S. securities lawsuit against Société Générale, they included in the purported class only U.S residents and investors who bought ADRs on U.S. exchanges. Their purported class by its own construction excludes foreign residents who bought shares on foreign exchanges.

 

The increasing exclusion of f-cubed litigants from U.S. securities class actions (whether voluntary or as a result of court action) is one of the reasons that interest in U.S.-style securities relief is increasing in other countries, as I discussed in a recent post (here).

 

In any event, the court’s dismissal of the AstraZeneca case also continues another trend, which is that while life sciences companies are frequently sued (compared to companies in most other categories), the cases filed against them are often dismissed, as I also discussed in a prior post (here)

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As the subprime crisis has unfolded, one of the recurring themes has been the conflicted role of the rating agencies. Last week’s announcement (here) of a negotiated resolution of the New York State regulatory investigation of the rating agencies reflects one aspect of the recurring questions surrounding the rating agencies’ role in the current crisis. These questions are likely to persist in light of the recent revelation (here) that Moody’s continued to assign mortgage-backed securities investment grade ratings despite a whistleblower’s alarm about potential problems with the ratings.

But while the questions about the rating agencies’ role have persisted, and while the agencies own shareholders have sued the rating agencies over the agencies’ own disclosures (about which refer here and here), to date subprime investors have not targeted the rating agencies for their rating activities, to the best of my knowledge.

As discussed in a prior post (here), case law suggests that the rating agencies enjoy First Amendment protection for their rating opinions and activities. And, as also discussed in my prior post, while thoughtful commentators have suggested bases on which these defenses might be overcome with respect to the rating agencies subprime-related investment rating activity, subprime investors have not targeted the rating agencies. Until now.

In a lawsuit filed on May 15, 2008 in New York Supreme Court (New York County), the New Jersey Carpenters’ Vacation Fund has filed a securities class action lawsuit under the ’33 Act on behalf of investors in the three HarborView Mortgage Loan Trusts. In a petition dated June 3, 2008, the defendants removed the case to the United States District Court for the Southern District of New York. A copy of the notice of removal, to which the original complaint is attached, can be found here.

The defendants in the lawsuit include the three HarborView mortgage pass-through certificate trusts; the Royal Bank of Scotland Group (“RBS Group”) and its subsidiary, Greenwich Capital Holdings and related entities, including Greenwich Capital Acceptance (“GCA”) and five individual directors of GCA; and the three rating agencies, Fitch’s Ratings, Moody’s Investor Services, and McGraw Hill, as corporate parent for Standard & Poor’s Rating Services.

The three trusts were issuers of bonds (the mortgage pass-through certificates) created by RBS Greenwich Capital. The offerings were collateralized with loans originated and underwritten by Countrywide Home Loans. The complain alleges that the Registration Statement issued in connection with the offerings failed to disclose “the true impaired and defective quality of the loans collateralizing the Bonds” and that the “loans were not originated pursuant to the underwriting guidelines stated in the Registration Statement.”

The complaint alleges that the rating agency defendants “failed to conduct due diligence and willingly assigned the highest ratings to such impaired instruments since they received substantial fees from the issuer.” The complaint alleges further that the rating agencies “issued the ratings based on an outdated methodology designed in about 2002.” The ratings were alleged to be misleading because the rating agencies “presumed that the loans were of high credit quality issues in compliance with the stated underwriting guidelines, when, in fact, Countrywide had systematically disregarded its stated Underwriting Guidelines.”

The rating agencies later downgraded the mortgage-backed securities. The complaint alleges that the rating agencies “admission that they had not used an appropriate rating methodology …resulted in a substantial decline in the value of the Bonds.” The plaintiff itself claims that its investment in the instruments has declined by 55 percent.

All of the claims asserted in the Complaint are based on the ’33 Act. In Count I of the Complaint, the plaintiff specifically alleges (in paragraph 98) that the rating agencies “served as appraisers” as defined in Section 11(a)(4) of the ’33 Act. The paragraph further alleges that the rating agencies “purportedly reviewed and analyzed each offering and provided the credit rating for each tranche of the HarborView Bonds.” The paragraph further alleges that the service of providing the ratings “was essential to pricing and marketing the Bonds,” and that the ratings were contained in the Prospectus.

As far as I am aware, the plaintiffs’ complaint in the HarborView Mortgage Loan Trust lawsuit represents the first occasion as part of the current subprime litigation wave where subprime investors have sought to hold the rating agencies liable for their ratings. The plaintiff’s allegations will face a number of hurdles, including the jurisdictional issue discussed below.

In addition, the rating agencies will undoubtedly assert a number of substantive defenses, including the First Amendment defense discussed in my prior blog post (here), as well as whether the rating agencies even owed the plaintiff any duties. The rating agencies will particularly dispute the plaintiffs’ attempt to rely on Section 11(a)(4) of the ’33 Act as a basis for the rating agencies’ liability.

The jurisdictional issue pertains to the plaintiff’s initiation of the lawsuit in state court pursuant to the concurrent state court jurisdiction in Section 22 of the ’33 Act. The HarborView case is just the latest of the state court ’33 Act lawsuits arising as part of the current subprime-related litigation wave, as discussed in my prior post (here). In each case, the defendants have sought to remove these cases to federal court, notwithstanding the express prohibition in Section 22 of removal of state court cases to federal court. In at least one of the prior cases, the federal court has remanded the case back to state court in reliance on Section 22’s express removal prohibition (refer here for a discussion of the prior remand case).

It remains to be seen whether or not these cases will go forward in state or federal court. Although it is not altogether clear why the plaintiffs have sought to pursue these cases in state court, the plaintiffs clearly perceive some advantage in doing so. In any event, the success of the plaintiffs’ attempts to hold the rating agencies liable for their investment in subprime-related securities will be interesting to watch. It will also be interesting to see if other investor plaintiffs similarly seek to hold the credit rating agencies liable.

Special thanks to Adam Savett of the Securities Litigation Watch blog (here) for providing a copy of the HarborView removal petition.

Run the Numbers: I have added the HarborView case to my running tally of subprime-related securities class action lawsuits. (My tally can be accessed here). According to my count, the addition of this case, as well as the case filed late last week against Franklin Bank Corp. (about which refer here), the current tally of subprime and credit crisis-related securities class action lawsuits now stands at 88, of which 48 have been filed in 2008.

Speakers’ Corner: On June 19 and 20, 2008, I will be co-Chairing the Mealey’s Subprime Mortgage & Insurance Coverage Litigation Conference at the Ritz-Carlton in Pentagon City, Virginia, with my good friend Matt Jacobs of the Jenner & Block law firm.

The agenda (which can be found here), includes many distinguished speakers and panelists, such as Andrew Carron of NERA Economic Consulting, Adel Turki of Cornerstone Research, Samuel Rudman of the Lerach Coughlin firm, Dan Bailey of Bailey & Cavalieri, John McCarrick of Edwards Angell Palmer & Dodge, David Hensler of Hogan & Hartson, and Mitchell Dolin of Covington & Burling.

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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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According to news reports (here), Treasury Secretary Henry Paulson has added his voice to the growing chorus declaring that the worst of the credit crisis may be past. Paulson reportedly said that “we are seeing signs of progress as capital and credit markets stabilize.” We can all hope for the sake of the financial markets, and indeed, the entire U.S. economy, that Paulson is correct.

But while the top level indications may be encouraging, it would be premature at this point to conclude that the subprime and credit crunch related litigation wave is spent. If the lawsuit filings just in the last week are any indication, the litigation wave will continue to roll on for the foreseeable future.

For example, on May 16, 2008, plaintiffs’ lawyers filed a securities class action lawsuit in the United States District Court for the Central District of California against Downey Financial Group and certain of its directors and officers. The plaintiffs’ counsel’s May 16 press release can be found here and a copy of the complaint can be found here.

According to the press release, on March 17, 2008, Downey (a savings and loan holding company) reported (here) an “increase in non-performing assets to almost 11% of total assets, up from 1.2% in May 2007.” According to the complaint, the “true facts, which were known to the defendants but concealed from the investing public” were that:

(a) defendants’ portfolio of Option ARMs contained millions of dollars worth of impaired and risky securities, many of which were backed by subprime mortgage loans; (b) prior to the Class Period, Downey had seen Countrywide’s growth and had started to get more aggressive in acquiring loans from brokers such that the loans were extremely risky; (c) defendants failed to properly account for highly leveraged loans such as mortgage securities; (d) Downey had very little real underwriting, which led to large numbers of bad loans that would cause huge numbers of defaults; and (e) Downey had not adequately reserved for Option ARM loans, the terms of which provided that during the initial term of the loan borrowers could pay only as much as they desired with any underpayment being added to the loan balance.

I have written previously (here) about the litigation threat that Option ARMs could present. Downey is far from the only financial institution that is vulnerable to defaults and delinquencies as Option ARMs readjust. Moreover, all lending institutions remain vulnerable to increasing defaults as rising unemployment, and rising energy and food costs (among other things), continue to undermine borrowers’ ability to remain current on their mortgages and other debt. Other lenders undoubtedly will be reporting increases in non-performing assets in the weeks and months ahead – which is one reason why the subprime and credit crisis litigation wave may have long way to go before it loses momentum.

In addition, on May 12, 2008, plaintiffs initiated a shareholder class action lawsuit in the United States District Court for the Eastern District of Michigan against private mortgage insurer MGIC Investment Corp. and its CEO and its CFO. Refer here for a copy of the complaint. MGIC’s woes relate back to its failed 2007 attempt to merger with Radian Group, as well as the deterioration of the joint venture, Credit Based Asset Servicing and Securitization LLC (“C-Bass”), in which MGIC had entered with Radian. The July 2007 collapse of the C-Bass venture and the August 2007 termination of the pending merger of the two companies previously led to the filing of a securities class action lawsuit against Radian Group (about which refer here).

The MGIC complaint alleges that even after the demise of the C-Bass venture and after the termination of the Radian merger, MGIC continued to struggle, and on February 13, 2008, the company announced (here) a loss for the fourth quarter of 2007 of $1.47 billion, part of a full year 2007 loss of $1.67 billion.

MGIC’s financial challenges, which continued well after the company’s mid-2007 crises, underscores that fact that many companies are continuing to grind through tough financial circumstances. MGIC’s continuing challenges suggest that even if, as Secretary Paulson observes, the worse of the credit crisis may have passed, the fallout will continue to filter through the system for many months to come. And as companies continue to wrestle with these circumstances, additional litigation, like that filed against MGIC, will continue to emerge.

Special thanks to Adam Savett of the Securities Litigation Watch blog (here) for a copy of the MGIC complaint.

Run the Numbers: With the addition of these two new lawsuits, my running tally (here) of subprime and credit crisis related securities class action lawsuits now stands at 81, of which 41 have been filed during 2008.

An FCPA Follow-on Litigation Variant: In prior posts (most recently here), I have written about the growing liability threat arising from civil litigation following after Foreign Corrupt Practices Act enforcement activity. In a May 2008 article entitled “Suing Bribing Competitors: The Next Tool in the International Anti-Corruption Arsenal?” (here), James Maton and Joshua Gardner of the Edwards Angell Palmer & Dodge law firm describe yet another litigation threat arising out of corrupt practices enforcement proceedings.

The authors’ describe increasing litigation activity involving claims by companies that lose bids to bribing competitors. The disappointed bidders bring private lawsuits against the companies that are awarded the contracts. The losing bidders seek to recover lost profits, as well as costs wasted in bidding. Plaintiffs have asserted these kinds of claims under federal and state antitrust laws, RICO, and state common law theories such as intentional interference with contract and unjust enrichment.

The authors conclude that notwithstanding the litigation hurdles involved, “these types of private lawsuits are bound to increase in the United States, England and elsewhere.” All of which supports a view I have expressed numerous times on this blog – namely, the as anticorruption enforcement activity increases, the threat of related private civil litigation also increases, and that this litigation threat represents an important emerging liability risk for companies and their directors and officers.

Blog Bites Man: This past week, The D&O Diary passed its second anniversary, as two years have now passed since the blog’s May 10, 2006 launch. During its second year, the blog passed several important milestones, including most significantly its move from Blogger to LexBlog. And after almost 400 blog posts, The D&O Diary now has nearly 1,500 e-mail and RSS subscribers.

I would like to thank The D&O Diary’s readers for their continued support. I remain a highly motivated blogger because of the regular encouragement I receive from the blog’s readers.

I would also like to thank everyone who has sent me links, suggestions and comments over the last two years. I get most of my best material from readers’ suggestions, and I hope everyone out there will continue to send me the good stuff that I might not otherwise find. Please keep your suggestions coming. Thanks to all for their support for The D&O Diary.

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Next up as targets in the ever-growing wave of subprime-related class action lawsuits are closed-end funds that issued auction preferred securities. The auction marketplace for these securities, like the market for auction rate municipal bonds, has broken down, and investors who bought the securities are now suing the closed end funds that issued the instruments.

First, some background. According to the Investment Company Institute’s web page describing and explaining closed end funds (here), closed end funds are managed investment companies that issue a fixed number of shares. The shares trade on the open market. In addition to these common shares, many closed end funds also issue preferred shares. The owners of the preferred shares are paid dividends, but they do not participate in the fund’s gains and losses. The sale of preferred shares gives the fund leverage, by permitting the fund to make additional investments, hoping to improve the common shareholders’ returns. For auction rate preferreds, the dividend rate is set through periodic auctions, typically held every seven or 28 days.

According to a March 9, 2008 New York Times article entitled “As Good as Cash, Until It’s Not” (here), the marketplace for municipalities’ auction rate notes is $330 billion, and the market for closed end fund auction rate preferred securities is $65 billion. But more to the point, investors in auction rate preferred securities, like investors in municipalities’ auction rate notes, have discovered that due to the February 2008 breakdown of the auction rate marketplace, investors find they are “stuck” with their investments and unable to sell them through the auction market.

But auction rate preferred investors are, according to the Times article, faring “far worse than investors stuck with municipal issues,” because many municipal note investors are receiving a penalty rate of up to 12 percent or more, a rate that is “much higher than the caps on closed-end notes, which are currently around 3.25 percent.” The closed end issuers “have no incentive to redeem their notes since the interest rate resulting from the failed auction is so low.”

A March 30, 2008 New York Times article entitled “If You Can’t Sell, Good Luck” (here) explains that auction rate preferred investors’ difficulties put the closed-end fund issuers “in something of a conflicted position,” because the common shareholders’ returns are enhanced by the leverage from the preferred securities investment. While the preferred holders would like their shares to be redeemed, the “common shareholders would lose out on extra income generated by the preferred share structure.”

Under these circumstances, it is hardly surprising that the class action securities attorneys have now gotten involved. According to their press release (here), on April 21, 2008, the plaintiffs’ attorneys’ filed a purported securities class action lawsuits in the United States District Court for the Southern District of New York against the Calamos Global Dynamic Income Fund, on behalf of investors who acquired “Auction Rate Cumulative Preferred Shares” (ARPS) in the fund’s September 17, 2007 offering of $350 million of the securities. The complaint, which can be found here, also names as defendants the two investment banks that led the offering.

According to the press release, the complaint alleges that the offering documents omitted that:

(i) the purported “auctions” used by Calamos Fund to get the dividend rates were not bona fide auctions at all, but rather a mechanism to maintain the illusion of an efficient and liquid market for the ARPS so that the Calamos Fund could continue to earn fees from the so-called auctions and from the ongoing stabilizing of the market because of the lack of buyer demand; (ii) the default interest rate set as a consequence of a failed auction is less than the interest rate paid when auctions of certain competing municipal auction rate securities (“MARS”) offered directly by municipal issuers fail; (iii) the ARPS suffer from an additional disadvantage compared to MARS because the ARPS are securities which exist in perpetuity until such time as the Fund calls them due while MARS have a set due date; and (iv) the default interest rate as set would cause the ARPS to trade at a discount to their par value if, and when, the auctions began to fail.

The complaint further alleges that as a result of the auction rate marketplace failure “auction rate securities that were once offered as ‘cash equivalents’ are now illiquid, resulting in economic losses and severe hardships for investors.”

As I have previously noted (most recently here and here), there already is a growing wave of auction rate securities class action lawsuits. However, this most recent lawsuit differs from the prior actions, and not merely because it involves closed end fund auction rate preferred securities rather auction rate notes issued by municipalities. The new lawsuit is also different because it targets the issuer; in the prior auction rate lawsuits, the plaintiffs targeted the broker dealers that sold the securities, not the municipalities that issued the securities.

One thought I had while reviewing the Calamos complaint is that many of these auction rate lawsuits may present some interesting issues related to damages. In most instances, the instruments are continuing to pay interest according to their terms. With respect to the closed end fund notes, the securities are backed by real assets held in the funds, which would seem to suggest that the instruments retain substantial economic value. Even if the auction rate market itself proves to be permanently broken, it would seem that there should be strong economic incentives all the way around for a secondary market for these shares to develop. Of course, whether a fully functional secondary market emerges, and whether the marketplace requires a significant discount for these shares to trade, remains to be seen. But right now, calculating the alleged damages does seem to pose some challenging issues, particularly some mechanism to trade the shares develops while these cases are pending.  

Subprime Litigation Wave Hits Credit Suisse: On April 21, 2008, plaintiffs’ counsel also initiated a securities class action lawsuit in the United States District Court for the Southern District of New York against Credit Suisse Group and certain of its directors and officers. According to the plaintiffs’ attorneys’ press release (here), the complaint alleges that the “defendants failed to write down known impaired securities containing mortgage-related debt.” Specifically, the complaint alleges that

(a) that defendants failed to record losses on the deterioration in mortgage assets and collateralized debt obligations (“CDOs”) on Credit Suisse’s books caused by the high amount of non-collectible mortgages included in the portfolio; (b) that Credit Suisse’s internal controls were inadequate to ensure that losses on residential mortgage-related assets were accounted for properly; and (c) that Credit Suisse’s traders had put incorrect values on CDOs and other debt securities, concealing the exposure the Company had to losses.

The complaint (which can be found here), also alleges that on February 19, 2008, the company announced (here) fair value reductions of $2.25 billion following its repricing of its asset-backed positions, triggering a sharp decline in the company’s share price.

The plaintiffs’ lawyers have engineered the purported class on whose behalf the action is brought, in a clear attempt to avoid jurisdictional challenges and other concerns. The purported class includes all shareholders who purchased Credit Suisse ADRs on the NYSE, and all U.S. residents or citizens who purchased Credit Suisse stock elsewhere. This purported class excludes non-U.S. investors who purchased their securities outside of the United States.

This class composition seems tailored to match the composition of the class recently certified in the Converium securities lawsuit (as discussed in greater detail on the Securities Litigation Watch blog, here). This class composition also avoids many of the so-called “f-cubed” litigant problems (involving foreign domiciled shareholders who bought their shares in a foreign company on a foreign exchange). Avoiding this issue could eliminate friction at the lead plaintiff, motion to dismiss, and class certification stages. It does raise questions about the foreign litigants and their apparent inability to seek class remedies of the type that other securityholders in the same company are able to pursue in the U.S. Whether that triggers these securityholders to file a bunch of individual actions, as happened after the foreign litigants were excluded from the Vivendi lawsuit (as also discussed on the Securities Litigation Watch blog, here), remains to be seen.

For further background about the “f-cubed” issue, refer to my prior posts, here and here.

Run the Numbers: With the addition of these two new lawsuits, the current tally of subprime and other credit crisis related lawsuits, which can be accessed here, now stands at 76, 36 of which have been filed in 2008. Of the 38 so far in 2008, 15 (including the Calamos lawsuit described above) are auction rate securities lawsuits.

Excess D&O Insurance Coverage Issues: In several posts (most recently here), I have examined the increasingly important emergence of coverage disputes involving excess D&O insurance. In the latest issue of InSights, entitled “Excess Liability Insurance: Coverage Disputes and Possible Solutions” (here), I take a more comprehensive look at the coverage issues involving excess D&O insurance.

Speaker’s Corner: On April 22, 2008 at 1:00 P.M. EDT, I will be participating in a one-hour webinar sponsored by Merrill Corporation entitled “The Subprime Ripple Effect: Preparing for the Wave of Litigation.” The other participants include Thomas Reilly, the former Massachusetts Attorney General and a shareholder in the Greenburg Traurig law firm, and Mark Kindy, EVP of Strategy and Operations for Merrill Corp. Registration (which is free) can be accessed here.