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

In a November 26, 2008 opinion (here), the Ninth Circuit affirmed the lower court’s dismissal of a lawsuit asserting securities law violations against InVision and certain of its directors and officers based on FCPA-related disclosures. The case is noteworthy not only for its involvement of FCPA-related allegations, but also for the appellate court’s consideration of "collective scienter" issues, as well as of the significance of Sarbanes-Oxley certification issues.

Background

On March 15, 2004, InVision announced it would be acquired by GE in a cash-for-stock transaction. That same day, the company filed its annual filing on Form 10-K to which the merger agreement was attached. On July 30, 2004, InVision announced that an internal investigation had revealed possible violations of the Foreign Corrupt Practices Act (FCPA). The company voluntarily reported the activities to the SEC and the DOJ. The company later entered negotiated arrangements with the DOJ and the SEC (refer here). GE later consummated the pending merger.

Shortly after InVision announced the FCPA concerns, shareholders initiated a securities class action lawsuit against the company and certain of its directors and officers. (Refer here for further background regarding the case). The plaintiffs based their claims on three alleged misstatements in the merger agreements, which InVision had attached to its 10-K.

The plaintiffs alleged that the merger agreement misleadingly stated that the company was "in compliance … with all applicable law"; in compliance with the "books and records" provision of the FCPA; and that that neither the company nor any of its officers, directors or employees had knowledge that the company had violated the FCPA’s antibribery provisions.

The district court dismissed the complaint and the plaintiffs appealed.

The Ninth Circuit’s Decision

The appellate court essentially assumed that the plaintiff had satisfied the requirement to plead falsity with respect to the three alleged misrepresentations stating that "even if [the plaintiff, Glazer] properly pled falsity, the district court’s dismissal would still be appropriate if Glazer failed to plead scienter adequately with respect to the three statements."

In order to satisfy the scienter requirement, the plaintiff urged the Ninth Circuit to adopt the "collective scienter" theory, following the Second Circuit’s recent decision in the Dynex Capital case (refer here) and the Seventh Circuit’s recent decision in the Tellabs case (refer here). Under this theory, as articulated by the Seventh Circuit, "it is possible to draw a strong inference of corporate scienter without being able to name the individuals who concocted and disseminated the fraud."

After reviewing the case law concerning corporate securities liability, including its own prior decision in the Nordstrom v. Chubb case (a decision that will be familiar to many of this blog’s readers), the Ninth Circuit ultimately concluded that this case did not require the court to decide whether or not to adopt the theory of collective scienter.

The court concluded that because of "the limited nature and unique context of the alleged misstatements" involved in the case, the "collective scienter" issue was not before the court. In reaching this conclusion, the court noted that

Glazer rests its securities fraud claim on three statements, all of which appear in a sixty-page legal document. If the doctrine of collective scienter excuses Glazer from pleading individual scienter with respect to these legal warranties, then it is difficult to imagine what statements would not qualify for an exception to individualized scienter pleadings. In fact, because the merger agreement warranted that the company was in compliance "with all laws," then under the collective scienter theory urged by Glazer, so long as any employee at InVision had knowledge of the violation of any law, scienter could be imputed to the company as a whole. This result would be plainly inconsistent with the pleading requirements of the PSLRA.

 

Accordingly, the Ninth Circuit held that in order to succeed on his claim, the plaintiff had to establish that individual defendants acted with scienter in making the statements in the merger agreement. The court said that "we see no way that [the defendant] could show that the corporation, but not any individual [director or officer] had the requisite intent to defraud." Only the company’s CEO and CFO had signed the merger agreement, and the plaintiff alleged scienter only with respect to the CEO, Magistri.

The court found with respect to Magistri, however, that Glazer had not pled any facts to demonstrate that "Magistri was personally aware of the illegal payments or that he was actively involved in the details of the details of InVision’s Asian sales."

The Ninth Circuit also refused to infer scienter from the CEO’s and the CFO’s signature of the Sarbanes-Oxley certifications, holding that the mere signature, without more, is insufficient to raise a strong inference of scienter.The Ninth Circuit followed prior decisions of the Eleventh and Fifth Circuits, concluding that there was no evidence that the SOX certification requirements were intended to alter the PSLRA’s pleading requirements. The Court said that "the Sarbanes-Oxley certification is only probative of scienter if the person signing the certification was severely reckless in certifying the accuracy of the financial statements.

Discussion

The Ninth Circuit’s decision is noteworthy for its discussion of the "collective scienter" issue, although in the end it is of limited significance on this point given the court’s conclusion that it did not need to reach that issue. The decision is also noteworthy for its discussion of the Sarbanes-Oxley certification issue, but in that respect it also merely followed existing precedent.

But perhaps the greatest significance about the Ninth Circuit’s opinion may be what it suggests about securities cases based on FCPA-related disclosures. The Ninth Circuit’s refusal to allow the claim to proceed in the absence of allegations that senior officials were aware of the improper conduct could present a significant hurdle for FCPA-related securities claims, at least in the circuits that have not adopted the "collective scienter" theory.

As the Ninth Circuit noted in the InVision case, "the surreptitious nature of the transactions creates an equally strong inference that the payments would have deliberately kept secret – even within the company." Obviously, payments of this kind invariably are of a surreptitious nature and of a kind that would be kept secret, even within the company. The implication is that in order for a securities claim alleging FCPA-related disclosures to survive the initial pleadings stage, the claimants may have to plead that the company officials who prepared the company’s public disclosures were aware of the improper activities.

In prior posts (most recently here), I have noted the increasing prevalence of follow-on civil litigation accompanying FCPA investigations, including the increasing frequency of follow-on securities litigation alleging misrepresentations in the FCPA-related disclosures. The Ninth Circuit’s decision in the InVision case suggests that, at least in jurisdictions that have not recognized the collective scienter theory, the ability of these follow-on securities lawsuits to get past the pleading stage may depend on the existence of allegations that senior company officials were aware of the improper payments. Given the invariably "surreptitious nature" of these payments, claimants may find this a challenging requirement to satisfy.

The SEC Actions blog has a thorough analysis of the Ninth Circuit’s discussion of the pleading issues in the InVision case, here. The FCPA Blog also has a good discussion of the case, here.

Special thanks to Neil McCarthy of Lawyerlinks.com for providing me with a copy of the Ninth Circuit’s opinion.

Another New Wave Securities Lawsuit: In a recent post (here), I noted that there have been several recent securities class action lawsuits in which the companies involved have been hit with significant losses due to wrong way bets on commodities or currencies.

The latest example of this type of securities litigation involves a case filed on November 26, 2008 in the Southern District of Florida against Brazilian forest products manufacturer Aracruz Cellulose S.A. and certain of its directors and officers on behalf of investors who purchased the company’s American Depositary Receipts on the NYSE., as well as purchasers of the company’s common stock, which trades on the Sao Paulo Bovespa.

According to the plaintiffs’ lawyer November 26 press release (here), the complaint alleges that

During the Class Period, Aracruz entered into undisclosed currency derivative contracts to purportedly hedge against the Company's U.S. dollar exposure. The Company characterized the use of these contracts as protection against foreign interest rate volatility and assured investors that this type of trading did not represent "a risk from an economic and financial standpoint." However, these contracts violated Company policy in that they were far larger than necessary to hedge normal business operations. As a result of Aracruz's clandestine and speculative currency wagers, credit rating agencies downgraded Aracruz, the Company's CFO resigned, and Aracruz's stock suffered a severe decline, plummeting to the lowest levels in 14 years.

As I noted in my prior post, many companies were also exposed to sudden and unexpected losses by dramatic changes in the commodities and currencies markets earlier this year. For example, the November 29, 2008 Wall Street Journal reported (here) on several airlines that have recently reported the negative impact from fuel cost hedges that generated huge losses. These kinds of developments and other unexpected fallout from the crisis roiling global financial markets are likely to affect a wide variety of companies, some of which may be subject to securities litigation.

It is interesting to note that the plaintiffs’ lawyers in the Aracruz case appear to have made a conscious decision to include within the class the Brazilian company’s common shareholders. Within this group are likely to be a number of shareholders domiciled outside the U.S. that bought their shares against the foreign company on a foreign exchange. The presence of these so-called "foreign-cubed" litigants could pose subject matter jurisdiction issues, at least as to those claimants.

My recent post discussing the Second Circuit’s recent "foreign-cubed" litigant ruling in the National Australia Bank case can be found here. The November 24, 2008 Southern District of New York decision granting the motion to dismiss the securities class action lawsuit that had been filed against Vodafone for lack of subject matter jurisdiction, in reliance upon the National Australia Bank decision, can be found here. (Note: Special thanks to the reader who pointed out that I had incorrectly referred to the Vodafone case as the Vivendi case. My apologies for any confusion.)

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There no longer seems to be a question whether European countries will adopt some form of collective action procedures. The questions now are what form the collective action mechanisms will take and to what extent will the processes will adapt or reject features of the U.S. class action model.

A November 6, 2008 article by NYU law professors Samuel Issacharoff and Geoffrey Miller entitled "Will Aggregate Litigation Come to Europe?" (here) takes a look at these questions and examines whether current European reforms are, in light of the extent of the aversion to the U.S. model, "likely to be effective in realizing their stated aims."

The authors begin their analysis by noting that while class actions were long "decried as the perversity of rapacious Americans," class actions are now "the focus of significant reforms in many European countries and even at the level of the European Union." Indeed, a "consensus" has emerged that "aggregate litigation will soon be the norm" in Europe. But by the same token, there is also a consensus that the European model of aggregate litigation "will not replicate American class action litigation with its domination of entrepreneurial plaintiffs’ attorneys."

The European movement toward aggregate litigation models has advanced because of the "need to create ex post accountability mechanisms" and the create mechanisms for the "efficient resolution of numerous intertwined claims." Aggregate litigation also mobilizes "efforts to foster prevention through the prospect of civil litigation."

The authors note that the criticisms of the U.S. model in many ways correspond with concerns raised inside the U.S. But the authors also ask whether or not the categorical aversion to the U.S. model may leave European reform efforts without the means to achieve desired results.

In order to assess whether the European rejection of the U.S. model sweeps too broadly, the authors examine the recurring criticisms of U.S. class action litigation. Among other things, the authors suggest that by framing the debate this way, the discussion will reflect both the weaknesses and the strengths of the U.S. approach and allow the reform process to benefit from the beneficial aspects of the U.S. approach.

The four criticisms of U.S. class action litigation on which the authors focus are:

(1) the danger that mass settlements may overgeneralize, by treating differently situated claimants as if they were similar, particularly where "an unsolicited and effectively unsupervised" agent resolves the case on behalf of absent class members;

(2) the most significant recovery is "often by successful class counsel, not by any class member;

(3) the uneasy relation between entrepreneurialism and avarice (as evidenced most recently by the criminal pleas of leading plaintiff securities attorneys); and

(4) the manipulation of the judicial forum for litigation gain (particularly through serial exploitation of "judicial hellholes").

The authors observe that what unifies these four controversies is "the role of private entrepreneurial lawyers" – which, the authors note, is "precisely what troubles Europeans about American class action practice." Nevertheless, motivated lawyer action is the "engine that fuels American aggregate practice." The authors ask whether the comprehensive rejection of the U.S. model "throws the baby out with the bath water" and whether "the controversies that arise in a system build on self-interest can be mitigated without disabling the entire undertaking."

In order to examine these questions, the authors look at the common features of European collective action reform efforts. While the legal reforms represent a broad spectrum of initiatives, there are three common features: (1) the tendency to allow only organizations to represent consumers in class actions; (2) the interaction between rules on litigation funding and class action procedures; and (3) the preference for "opt-in" rather than "opt-out" systems.

The authors find that there are potentially significant limitations to each of these unifying features. The authors also note that the evolving European efforts attempt to realize the benefits of collective action, but are "limited in their conception of how these processes will be realized."

The threshold issue that current European reform efforts must address is who will "organize, fund and lead the collective efforts." Both the strength and weakness of the American collective approach has been the "willingness to entrust a great deal of social regulation to private initiative and common law forms of adjudication." The authors express their concern that the European "cultural revulsion" to "accepting the reality of legal enforcement as entrepreneurial activity may leave the reforms without the necessary agents of implementation."

Discussion

The excesses of the U.S. class action system are a familiar hobby horse for social critics, both in the U.S. and abroad. Nevertheless aggrieved parties continue to pursue relief and redress through class litigation -- and not just consumers whose interests critics contend are hijacked by self-interested lawyers, but also well-financed institutional investors that are fully informed about their interests and fully able to act independently.

While Europeans disdain the excesses of the U.S. model, there have been periodic outbursts over the past several years where the need for collective action mechanisms has been so obvious that the local legal systems had to respond. Among the various corporate scandals that came to light earlier this decade were several instances where large group of aggrieved European investors were adversely affected and collectively sought redress. The current credit crisis underscores these issues. The further European development of collective action mechanisms does, as the authors note, seem to be inevitable.

On the other hand, the limitations of the U.S. model have been painfully apparent lately. The criminal sentencing of the leading plaintiff securities attorneys certainly highlights the corrupting potential of class litigation where the agent controls or even selects the principal.

There is also recent evidence that aggrieved parties involved in U.S-based litigation increasingly may perceive their interests to be best served outside of class litigation. Significant securities class action opt-out actions, in which would-be class members proceed independently to maximize their recovery and even to reduce counsel fees (about which refer here), suggest deep concerns about the utility of class litigation.

The authors may be correct that class litigation is most effective if it is driven by motivated entrepreneurs who can drive the process and maximize class results. Nevertheless, the lessons of the recent past in the U.S. highlight clearly how important it is for strict controls over class counsel.

The recent lessons also suggest the need for some modesty in advocating the U.S. class counsel model to Europeans. Indeed, rather than expecting the success of the European reforms to depend on European’s willingness to adopt aspects of the U.S model (such as the involvement of entrepreneurial counsel), perhaps it will be the case that the improvement of the current flawed U.S. model will depend on the adoption in the U.S. of existing or yet-to-emerge European innovations that develop as part of current European reform efforts.

Hat tip to the Point of Law blog (here) for the link to the article.

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In a recent post (here), I raised concerns about the possibility of U.S.-domiciled companies becoming subject to securities litigation under the Ontario Securities Act. Now, a recent decision by an Ontario Superior Court judge interpreting the Act’s provisions suggests the possibility of litigants using a parallel Ontario proceeding to circumvent the PSLRA’s discovery stay.

The decision arose in connection with the prospective securities action that claimants seek to pursue in Ontario court against IMAX and certain of its directors and officers. Under the provisions of Bill 198, enacted in 2005 and codified in Section XXIII.1 of the Ontario Securities Act (which can be found here), a preliminary procedure is required to determine whether a liability action under the Act can proceed.

Section 138.8 (1) of the statute, a liability action cannot be commenced "without leave of court granted upon motion with notice to each defendant." The court is to grant leave only "where it is satisfied" that the action "is being brought in good faith" and there is a "possibility" the plaintiff will prevail at trial.

The procedure specified for this determination is that the plaintiff and each defendant are to serve affidavits "setting forth the material facts upon which each intends to rely." The affiant may be "examined" on the affidavit "in accordance with the rules of the court."

The issue addressed in the recent decision in the IMAX case is the breadth of the examination that is to take place in connection with this authorization proceeding. In addressing this question, Madame Justice Katherine van Rensberg issued a ruling that potentially could compel defendants to answer questions under oath about a broad range of issues, even issues the claimants have not initially raised. A November 18, 2008 Globe and Mail article regarding the decision can be found here.

Justice van Rensberg wrote that the Act itself "provides no guidance as to the interpretation of the threshold test and what type, quality and quantity of evidence the court is to consider." IMAX had urged her to restrict examination to publicly available information. However, she found that shareholders seeking leave to proceed under the Act have "special powers" generally not available otherwise and she held that anyone being examined must answer questions that have a "semblance of relevance" even if it "might also reveal some other potential issues or wrongdoing not currently contemplated by the statutory claim."

The "semblance of relevance" test Judge Van Rensberg used is the threshold used in connection with discovery, the procedures with respect to which ordinarily apply once a case is underway. In effect, the Judge’s ruling permits discovery in the precertification stage, before the case has even been authorized to proceed. As comments quoted in the article note, defense advocates had militated in favor of inclusion of the precertification procedure in the Act as a way to bar frivolous claims, but now it appears that procedure can be used to compel defendants "to disclose evidence relevant to the merits."

This development, if it stands, not only seems to authorize plaintiffs to use the procedure to conduct a fishing expedition, it also could be used as a way to aid a parallel proceeding filed in U.S. courts, by allowing shareholders to examine company officials, even as to matters not raised either case.

As Adam Savett points out on his Securities Litigation Watch blog (here), this procedure, pursued in parallel with a U.S. filed lawsuit, could permit claimants to use the Ontario procedure to circumvent the PSLRA’s stay of discovery. Savett points out that IMAX itself is not only subject to the Ontario action but also to a separate action under the U.S. securities laws in the Southern District of New York, in which a motion to dismiss is pending. Savett observes that the Ontario court’s IMAX ruling "raises the specter of cases being filed cooperatively in Canadian and U.S. courts, with discovery in the Canadian action possibly being allowed to be used in the U.S. action."

This possible PSLRA discovery stay end-around takes on even greater potential significance in combination with the possibility of U.S.-domiciled companies and their directors and officers getting hauled into securities litigation in the Ontario courts. As I noted in my prior post (here), discussing the Ontario securities lawsuit recently filed against AIG, the prospect for U.S. companies of securities litigation outside the U.S. is unattractive. But perhaps even more unwelcome is the possibility of litigants using a parallel Ontario case against a U.S. company as a way to try to get material to be used to support a separate U.S. proceeding against the company.

If the recent IMAX ruling stands, U.S. securities litigators might have to become a great deal more familiar with Ontario’s securities laws and procedures.

Special thanks to Mark Renzel for providing me a link to the Globe and Mail article.

More about the AIG Lawsuit: A couple of interesting items about the AIG lawsuit appeared after I wrote my recent post about the case.

First, in a Guest Column on the Securities Docket (here), Dimitri Lascaris of the Siskinds law firm provides interesting additional detail about the "substantive and procedural advantages" offered to aggrieved claimants under the Ontario Act, as well as the potential damages available. The Siskinds firm is lead counsel in the Ontario proceedings filed against both AIG and against IMAX.

Lascaris also wrote in his column that "for a long time, America has largely dictated the standards by which issuers are obliged to conduct themselves in a globalized capital market. Like much else that is coming to an end in today’s capital markets, that era may be over. "

Second, Law.com has a November 19, 2008 article (here) about the case against AIG filed in Ontario. Among other things the article quotes Lascaris as saying that the AIG action is the first use of the use of the liability provisions of the Ontario Securities Act against a non-Canadian company.

And Finally: I would like to thank all of the many Canadian readers who commented to me about the AIG case. Numerous readers provided me with helpful additional information about the Ontario Act and about securities litigation in Canada. In that respect, several readers added helpful and interesting comments to the blog post about the AIG case, and I commend those comments to everyone's attention.

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Questions surrounding the susceptibility of foreign domiciled companies to U.S. securities laws and to the jurisdiction of U.S. court are frequently recurring issues, as I noted most recently here. However, a new case filed in Ontario under Ontario’s securities laws presents an interesting variation on these questions.

The Ontario Action Against AIG

According to its November 13, 2008 press release (here), the Siskinds law firm has filed a class action application and accompanying statement of claim in the Ontario Superior Court of Justice under the Ontario Securities Act against American International Group, American International Group Financial Products, and ten current or former AIG directors and officers. According to the press release, the claim is brought on behalf of Canadian investors who bought AIG securities between November 10, 2006 and September 16, 2008.

A copy of the application and statement of claim can be found here. According to the press release, the statement of claim alleges as follows:

The AIG class action arises out of AIGFP's credit default swaps and the crippling decline in AIG's stock price when the true effect of those credit default swaps became known to the investing public. The AIG disclosures out of which the class action arises are currently the subject of investigation by law enforcement authorities, and are alleged in the class action to have caused massive losses to Canadian investors.

The Ontario Securities Act

The action is brought under the investor protection provisions in Part XXIII.1 of the Ontario Securities Act. (Refer here for the provision of the Act.) The statutory provision specifies the liability standards in connection with "secondary market disclosure."

Section 138.3 of the statute provides a cause of action for damages on behalf of persons who trade in a company’s security -- "without regard to whether the person or company relied on the misrepresentation" -- where "a responsible issuer or a person or company with actual, implied or apparent authority to act on behalf of a responsible issuer releases a document that contains a misrepresentation."

The persons against whom the action may be brought are specified to include, among others, the issuer, "responsible" directors and officers, as well as persons who "knowingly influenced" the issuer or responsible persons.

Jurisdictional Issues

The plaintiff’s statement of claim takes great pains to emphasize that the action has "a real and substantial connection with Ontario." Indeed, in paragraph 155, the statement of claim alleges that the financial disclosures that are the basis of the action were "disseminated in Ontario"; that "a substantial proportion of the Class Members reside in Ontario"; that AIG "carries on business in Ontario"; that AIG considers its Canadian revenue as "domestic" for accounting purposes"; that "key AIG personnel charged with oversight of the above conduct were domiciled in Ontario and undertook part of that effort from Ontario."

The pains taken in the statement of claim to specify the claim’s connection to Ontario suggests an anticipation of a question whether the case properly belongs in Ontario courts. AIG is, after all, domiciled outside of Canada, and its shares do not trade on Canadian securities exchanges (or at least the plaintiff does not so allege). The alleged misstatements were prepared and issued outside of Canada.

On the other hand, the statement of claim does allege misconduct, harm and damages within Ontario. Without presuming the outcome, allegations of this type are of the kind that at least some U.S. courts have found a sufficient basis for the exercise of jurisdiction and the application of U.S. securities laws on companies domiciled outside the U.S.

Discussion

Setting aside these subject matter jurisdiction issues, and disregarding potential personal jurisdiction issues, there are some larger questions about this case. AIG faces extensive litigation in the U.S. on similar or related issues. Should any particular jurisdiction’s court have priority? Should courts defer to another jurisdiction’s courts?

These kinds of questions have come up before, for example, in connection with the Royal Dutch Shell cases, where there were also parallel proceedings in different countries (refer here). The way that these proceedings should coordinate is very much an evolving issue. But the noteworthy difference between that prior example and this instance is that here the target company is a U.S.-based company. It will be interesting to see whether that distinction makes a difference and how the respective cases unfold.

I also have these vague, unformed questions whether or not it makes a difference that AIG is now effectively owned by U.S. taxpayers. The taxpayers’ highest priority right now is getting repaid for the astonishing obligations to the U.S. treasury that AIG has recently undertaken. I haven’t worked it all out yet, but there does seem to be something inconsistent with the U.S. taxpayers’ interest in having the company’s limited resources siphoned off to defend and possibly to pay damages in a foreign jurisdiction. Canadian investors probably don’t care much about that, I suppose.

Of course, it might be argued that U.S. courts have been doing similar things to other countries’ companies (including Canadian companies) for some time now. Indeed, the plaintiff’s lawyers’ press release quotes one of the plaintiff’s attorneys as saying:

for many years, Canadian corporations have had to confront the long arm of America's justice system. But with the enactment of Part XXIII.1 of the Ontario Securities Act, Canadian investors can finally pursue remedies in our own Courts against American corporations that fail to respect Canada's securities laws. Canadian investors are entitled to have Canadian Courts hear their claims.

The one thing that is clear is that a class action under the Ontario securities laws is a serious matter. As I noted in a prior post (here), a prior class under the Ontario securities laws against FMF Capital recently settled for over CAN$28 million. This settlement apparently represents the largest securities class action settlement in Canada, and while the amount may seem small compared to some of the massive U.S. settlements, the amount did represent a very significant percentage of the investors’ claimed investment loss.

At a minimum, the FMF Capital settlement suggests that a claim under the Ontario securities laws represents a serious potential liability exposure. Along those lines, it should be noted that the press release states that the plaintiff class seeks damages of $550 million. (The press release does not state whether or not those are U.S. or Canadian dollars.)

UPDATE: Dimitri Lascaris of the Siskinds law firm has written a guest column on the Securities Docket blog (here), in which he explains the basis of jurisdiction in Ontario for the AIG lawsuit, as well as the operation and effects of the Ontario securities laws.

Two Final Observations

First, this new lawsuit represents yet another demonstration that the threat of securities litigation outside the United States continues to grow.

Second, this new lawsuit presents an interesting and potential dangerous expansion of this growing threat, which is the possibility that U.S. domiciled companies could find themselves the target of securities litigation in other jurisdiction’s courts under other jurisdiction’s laws.

To the extent it proves to be successful, the Ontario plaintiff’s new lawsuit against AIG could represent a very unwelcome and potentially complicated expansion of the liability exposures of U.S companies and their directors and officers.

Special thanks to Adam Savett of the Securities Litigation Watch blog (here) for providing a copy of the Ontario court application and statement of claim.

Now This: In this time of financial turmoil, it pays to be resourceful. And so, The D&O Diary is giving serious consideration to converting itself into a bank holding company, in order to be able to join other leading American business enterprises and participate in the bailout process.

While there might be those who would contend that we are not "too big to fail," we certainly are feeling the effects of the economic downturn, and recent 401(k) statements suggest that radical measures may be required. Capital infusions would be particularly welcome here.

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On November 10, 2008, NERA Economic Consulting released a report entitled "SEC Settlements: A New Era Post-Sox" (here) that details trends in the number of SEC settlements and of SEC settlement values in the six years since the enactment of the Sarbanes-Oxley Act.

The Report has a number of interesting findings, including the observation that prior to SOX’s enactment, the largest SEC enforcement action penalty was the April 2002 penalty of $10 million imposed against Xerox. However, the Report notes, after SOX, "the SEC has imposed penalties of $10 million against 115 parties, include 14 that were penalized at least $100 million." The Report includes a "top ten" settlements list, which is headed by AIG’s 2006 settlement of $800 million.

The Report also contains an analysis of the five most frequent allegations. Topping the list is microcap fraud (such as broker room operations or pump-and-dump schemes), followed by misstatement/omissions (including options backdating), and misappropriation of investor funds. The majority of cases against publicly traded companies involve allegations of misrepresentations or omissions.

The Report note that the SEC is on pace to reach 739 settlements in 2008, which would represent an increase in the number of settlements for the second straight year. The increase is driven largely by an increase in the number of individual settlements. The number of company settlements, by contrast, is declining. The number of company settlements is on pace to reach 171, which would represent the lowest number of company settlements since SOX was enacted.

The median 2008 company settlement through the end of the third quarter is $1.0 million, which is up from the 2007 median of $700,000, but well below the annual medians during the years 2004-2006, when the medians ranged from $1.1 to $1.5 million. The median individual settlement throughout the post-SOX era has been approximately $100,000.

Median settlements for public company misstatement cases have declined from a 2006 high of $50 million to a 2008 median (through the end of the third quarter) of $12.0 million. The report speculates that this decline may be due to the 2007 institution of a requirement for Commission approval prior to beginning negotiations in public company cases. (It is also probably worth noting that three of the top ten settlements took place in 2006, whereas none of the top ten has yet taken place in 2008.) The majority of public company misstatement cases settle for less than 1% of market capitalization.

The Report did note that of 197 companies the study identified as having settled SEC enforcement proceedings related to company misrepresentations or omissions, 181 had announced the existence of an investigation. The average time from the investigation announcement to the settlement for these 181 companies was 2.3 years.

The report also found that forty-three percent of company payments have been in the form of disgorgement, with 57% representing penalties. With respect to individual settlements, disgorgement represents 88% of payment amounts.

Relation Between SEC Settlements and Securities Class Action Lawsuits?:  The Report anticipated a question that formed in my mind as I read its analysis, which is the relation, if any, between SEC settlements and private securities class action litigation. The Report notes "it might be tempting to draw a comparison" between the number of class action filings, which increased in 2007, and the increase in the number of SEC settlements in 2007 compared to 2006. The Report notes that this comparison would be "misleading" in two respects:

First, the filing of a securities class action represents the first stage of class action legal proceedings, whereas SEC settlements are part of the last stage of the legal process. Because the SEC does not announce its investigations publicly, it is generally not possible to track the beginning of investigations. Instead this paper tracks settlements, which are often the first public information about an SEC matter. Second, most SEC settlements do not parallel shareholder class actions. In 2007, only 22% of SEC settlements were with public companies or their employees and related to misstatements, and were therefore closely comparable to shareholder class actions.

SEC Settlements and D&O Insurance, Briefly Noted: It is probably worth emphasizing that very little if any of the amounts involved in these settlements would have been insured under a typical D&O insurance policy. Most policies exclude from their definition of insured "Loss" such items as "fines and penalties" and disgorgements of amounts are typically excluded or do not otherwise represent insurable loss. However, in many instances, defense fees incurred in connection with the enforcement proceedings would be covered, depending on the applicable policy’s definition of the term "Claim."

New NERA Website: In addition to its Report, NERA also announced on November 10 the launch of its new website entitled "Securities Litigation Trends" (here) where NERA will be centralizing its own securities litigation analysis and also collecting other useful links (including related blogs).

Special thanks to Ben Seggerson at NERA for providing links to the NERA study and to the new web page.

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On October 23, 2008, in a much-anticipated decision addressing what it called "the vexing question of the extraterritorial application of the securities laws," the Second Circuit in the National Australia Bank (NAB) case ruled (here) that U.S. courts lack subject matter jurisdiction over the claims of foreign claimants in that case who bought their NAB shares on a foreign exchange. Although the Second Circuit did not, as friends-of-the-court had urged, pronounce a bright line rule against jurisdiction in such "f-cubed" claims, it nevertheless provided guidelines that will be relevant to similar cases going forward.

Background

NAB is Australia’s largest bank. Its shares trade on securities exchanges in Australia, London, Tokyo and New Zealand. Its American Depositary Receipts trade on the New York Stock Exchange. NAB has a mortgage servicing subsidiary, HomeSide, based in Florida. In 2001, NAB disclosed that it was taking a significant write-down due to a recalculation of the amortized valuating of HomeSide’s mortgage servicing rights. Following this announcement, the price of NAB’s shares and ADRs declined, and investors filed a securities class action lawsuit in the Southern District of New York.

The claim was initially brought by four plaintiffs. One of the four purported to represent domestic purchasers of NAB’s securities. The three other plaintiffs bought their shares abroad and sought to represent a class of non-U.S. purchasers. Background regarding the case can be found here.

On October 25, 2006, the District Court granted defendants’ motion to dismiss the complaint. The District Court held that it lacked subject matter jurisdiction over the foreign claimants claim. The court dismissed the domestic plaintiff’s action for failure to state a claim because the domestic plaintiff failed to allege that he suffered damages. The three foreign plaintiffs appealed. The domestic plaintiff’s claim was not before the Second Circuit, and so the appellate court was exclusively concerned with the jurisdictional issue.

The Second Circuit’s Opinion

In its October 23 opinion, written by Judge Barrington Parker, the Second Circuit noted that the "difficulty of the case was heightened by its novelty" – that is, the involvement of so-called "foreign-cubed" claimants. The appellees and several amici had urged the Second Circuit to adopt a "bright-line rule" by holding that in "foreign-cubed" securities litigation that mere domestic conduct should not be enough for a U.S. court to exercise subject matter jurisdiction where the conduct had no effect in the U.S. Links to the briefs for the parties and the amici can be found here. My prior post detailing the issues surrounding "f-cubed claims" generally can be found here.

The Second Circuit duly acknowledged what it characterized as the "parade of horribles" the friends-of-the-court invoked in favor of a bright line test, including the possibility that exercising jurisdiction in those cases could bring U.S. securities laws in conflict with those of other jurisdictions.

However, the Second Circuit observed that declining jurisdiction over all "foreign cubed" cases "would conflict with the goal of preventing the export of fraud from America." In particular, the Court was concerned that the U.S. should not be seen as a "safe haven for cheaters." The court said that "we are leery of a rigid bright line rule because we cannot anticipate all the circumstances in which the ingenuity of those inclined to violate the securities laws should result on their being subject to American jurisdiction."

Having rejected the bright line test, the Court went on to observe that "we are an American court, not the world’s court, and we cannot and should not expend our resources resolving cases that do not affect Americans or involve fraud emanating from America." The Second Circuit said that "in our view the ‘conduct text’ balances those competing concerns." Under the conduct test, subject matter jurisdiction exists "if activities in this country were more than merely preparatory to a fraud and culpable acts or omissions occurring here directly caused the losses abroad."

The Court then turned to applying the conduct test to the NAB case. The claimants urged that because miscalculation of HomeSide’s mortgage servicing rights had taken place in this country, U.S. courts could exercise jurisdiction. The Second Circuit nevertheless determined that U.S. courts lack jurisdiction, citing three factors: "the fraudulent statements at issue emanated from NAB’s headquarters in Australia; the complete lack of any effect on America or Americans; and the lengthy chain of causation between HomeSide’s actions and the statements that reached investors."

Discussion

Though the defendants in the NAB case prevailed, the case hardly means the end of f-cubed litigation. Arguably, in light of the Second Circuit’s refusal to adopt a bright line test, the jurisdictional standards remain largely unchanged, and litigants will continue to argue whether there is sufficient U.S. based conduct and U.S based effects to support the U.S. court’s exercise of jurisdiction.

Moreover, the Second Circuit made it clear that there will be circumstances in which it will be entirely appropriate for U.S. courts to exercise jurisdiction over the f-cubed claims. For that reason, and even though the Second Circuit held that the U.S. courts lacked jurisdiction of over the NAB case itself, foreign claimants likely will continue to try to assert claims against foreign-domiciled companies in U.S. courts.

That said, the claimants case against NAB did get tossed. The Second Circuit did caution against U.S. courts presuming to act as "the world’s court" and also cautioned against the exercise of jurisdiction over claims that do not affect Americans or involve fraud emanating from America. In other words, not all foreign claimants’ claims against foreign domiciled companies will go forward in U.S. courts.

Moreover, these issues are relevant not only at the motion to dismiss stage but also at the other procedural stages, including the lead plaintiff stage (refer here). As Adam Savett noted on the Securities Litigation Watch blog (here), courts have been increasingly willing to craft class certification to exclude foreign domiciled claimants at least in certain circumstances.

All of that said, the NAB decision will be grist for the mill in the onslaught of litigation involving foreign domiciled companies sued in connection with the current subprime and credit crisis litigation wave. The NAB decision necessarily implies a case-by-case determination and so litigants will continue to wrestle to determine whether these cases will go forward in U.S. courts. In the meantime, the cases will continue to be filed.

An October 23, 2008 Bloomberg article discussing the case can be found here.

Special thanks to George T. Conway, III of the Wachtell, Lipton law firm, who successfully represented NAB in the Second Circuit, for providing me with a copy of the opinion.

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In the latest of the decisions in which subprime and credit crisis-related securities lawsuits have failed to withstand preliminary judicial scrutiny, on October 6, 2008, Central District of California Judge Andrew Guilford granted (here) defendants’ motion to dismiss the plaintiffs’ second amended complaint in the IMPAC Mortgage Holdings case, with leave to amend.

As reflected here, the plaintiffs initially filed their purported class action complaint on August 17, 2007. The initial complaint was subsequently amended twice, and the October 6, 2008 ruling related to the plaintiffs’ second amended complaint. The second amended complaint essentially alleged that contrary to the company’s public statements, the company’s Alt-A loans were actually being sold to less creditworthy borrowers, so that the Alt-A loan portfolio was as risky as a portfolio of subprime mortgages. The plaintiffs further alleged that at the same time, the company misrepresented its true financial condition by its failure to write down the value of its loan portfolio.

In his October 6 opinion, Judge Guilford states that "plaintiff packs the Complaint with 30 pages of supposed misstatements or culpable acts, but none of them shows fraudulent intent or deliberate or conscious recklessness." The statements of the former employees on whom the plaintiffs sought to rely are, Judge Guilford found, "completely benign," or "so vague as to be meaningless."

Judge Guilford concluded that the plaintiffs’ allegations "do not provide any specifics, and they do not show fraudulent intent or conscious recklessness." The PLSRA, the court noted, "was intended to guard against exactly these sorts of vague, conclusory allegations." Judge Guilford therefore granted the defendants’ motion to dismiss, allowing the plaintiffs’ 21 days to file an amended complaint.

The plaintiffs in the IMPAC Mortgage case not only face a tight timeframe but also face an uphill battle to satisfy the shortcomings Judge Guilford identified. The complaint Judge Guilford rejected had already been amended twice, so it unlikely the plaintiffs held anything back or have a reservoir or additional powerful allegations to draw upon. The short work Judge Guildford made of their multifarious allegations could hardly be encouraging. In addition, Judge Guilford did not even reach the issues of whether the complaint adequately pled misrepresentation or appropriately relied on the group pleading doctrine, holding that his ruling on the scienter issue relieved him of the necessity to reach those other issues.

Judge Guilford’s approach in the IMPAC Mortgage case has appeared in a number of the preliminary rulings in the current wave of subprime and credit crisis-related cases. Even though we are still only in the very earliest stages of most of these cases, there have already been a number of cases where courts have been similarly skeptical of plaintiffs’ allegations. Some recent examples include the First Home Builders of Florida ruling (discussed here) or the NovaStar Financial ruling (here).

While there have of course been decisions going the other way, these skeptical courts have made it clear that they expect to see more than mere allegations that a mortgage loan portfolio underperformed prior expectations or that the lender’s financial condition has deteriorated. If the early returns are any indication, plaintiffs in many of the subprime and credit crisis-related cases may face similar skepticism in order on their preliminary motions.

In any event, I have added the IMPAC Mortgage decision to my table of subprime and credit crisis case dispositions, which can be accessed here.

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The economic crisis that began as the subprime meltdown has clearly entered a dark new phase. And just as the prior stages of the crisis generated waves of related litigation, this new phase already has produced its own distinctive round of lawsuits. Like the underlying economic circumstances, the new litigation phase also seems darker and more threatening.

As might have been predicted, shareholder lawsuits have already been filed against the directors and officers of some of the most prominent companies caught up in the recent events. For example, on September 15, 2008, Merrill Lynch shareholders filed a complaint (here) in New York state court against the company and certain of its directors and officers alleging that the company’s planned merger with Bank of America is the result of a "flawed process and unconscionable agreement" and that the defendants had breached their fiduciary duties.

Similarly, as reported on September 18, 2008 in CFO.com (here), shareholders have filed a Delaware Chancery Court lawsuit against certain current and former directors and officers of AIG. The lawsuit blames the defendants for the company’s "exposure to and grossly imprudent risk taking in the subprime lending market and derivative instruments." The lawsuit seeks the return to AIG of all compensation paid to AIG’s CEO and to its directors, among other things.

These lawsuits are perhaps the almost inevitable products of events reported in last week’s headlines. But along with these more predictable litigation consequences, there have also been additional developments and resulting litigation, and it is this further litigation that suggests that the credit crisis litigation wave my now have entered a new, more complex phase.

As widely reported last week, the Primary Fund money market fund of the Reserve Family of Funds "broke the buck" when its "net asset value" fell below one dollar a share. Reserve’s September 16, 2008 press release announcing that net asset value of the Primary Fund had fallen below one dollar can be found here. On September 18, 2008, plaintiffs’ counsel filed a securities class action lawsuit in the Southern District of New York (complaint here), on behalf of persons who purchased shares of the Primary Fund between September 28, 2007 and September 16, 2008, against the Fund’s underwriters, investment advisor, and officers and directors.

The complaint alleges that the Fund’s offering documents failed to disclose, among other things, "the lack of diversification of the Fund’s assets and exposure to, at a minimum, now largely worthless debt securities valued at $785 million of the now defunct Lehman Brothers Holdings, Inc."

The circumstances behind this lawsuit represent something of a second derivative of the subprime crisis. That is, the subprime meltdown led to problems with certain real estate assets and investments of Lehman Brothers, which ultimately led to Lehman’s collapse, which caused its debt securities to lose substantially all their value, which undermined the asset value of the Primary Fund and harmed its investors.

The reverberations of these second derivatives of the subprime meltdown are rippling through the economy, encompassing a broader array of participants, many of whom may have had little or no direct exposure to subprime-prime related investments per se. However, these companies had exposures to other companies that had exposures to mortgage backed assets.

The Primary Fund is far from the only market participant that has been harmed by its exposure to losses during this latest phase of the economic cycle. By way of illustration, on September 16, 2008, Conseco announced (here) that as of that date it held $108 million of securities of Lehman Brothers, AIG, and Washington Mutual, and that the company had during the third quarter realized losses of approximately $40 million on sales of securities of these issuers. Conseco’s shares fell over 40% the next trading day, although the share price has subsequently recovered somewhat.

Similarly, Japanese insurers have disclosed a combined $2.4 billion of potential losses from Lehman’s collapse (refer here).

On September 11, 2008, Progressive Corporation announced (here) August 2008 write-downs of $324 million (of which $278 million related to common and preferred stock investments in Fannie Mae and Freddie Mac), and also disclosed that the U.S. government’s take over of the companies produced an additional $171 million of September 2008 losses, bringing Progressive’s combined two month investment write-downs on its Fannie and Freddie holdings to nearly a half a billion dollars – a substantial amount even for a company with $20 billion in assets.

A multitude of other companies have announced or will be announced similar losses, and not just related to Lehman, but also in connection with Fannie Mae, Freddie Mac, AIG, and other companies whose securities have faced or that will face similar collapses. A September 18, 2008 CFO.com article entitled "Exposed and Disclosed: Filings Show Ties to Turmoil" (here) highlights recent filing in which companies have disclosed their exposure to investment declines as a result of adverse developments at these companies. A September 16, 2008 CFO.com article similarly identifying companies disclosing losses from the Lehman bankruptcy can be found here.

The losses on these investments are widespread and will affect a wide variety of market participants. The heroic (and astronomically expensive) bailout package that the Treasury department announced over the weekend (refer here) will not restore the value of these investments. In the weeks and months ahead, many other entities will be reporting losses or write-downs on these and other investments. In addition, in a completely different aspect of the current crisis, market participants who depended on Lehman for credit default protection will also be reporting the consequences of Lehman’s demise.

These announcements undoubtedly will trigger strong investor reactions for at least some of the disclosing companies, as was the case, for example, in connection with Conseco’s recent announcement. And in some instances, as was the case in connection with the Primary Fund, these announcements will also result in litigation.

Several months ago, I noted that the evolving litigation wave had long ago ceased to be just about the subprime meltdown. As lawsuits emerge from what I described above as the second derivative of the subprime meltdown, where companies lacking any direct exposure to subprime nevertheless experience losses because of exposure to other companies suffering credit crisis-related reversals, the ensuing litigation wave could threaten to become a generalized inundation deluging a substantial number of participants in the larger economy.

The ultimate wildcard is the impact that the current comprehesive Treasury bailout will have on litigation going forward. The analytic model for the current bailout plan is the formation of a government salvage operator along the lines of the Resolution Trust Corporation (RTC) during the Savings & Loan crisis. Those of us who were around then will recall that the RTC was an active litigant aggressively using litigation to try to recover taxpayer losses. Law.com has a September 22, 2008 article entitled "U.S. Could Emerge as Major Player in Suits Stemming From Financial Crisis" (here) that speculates on that the new government bailout agency could once again play an active litigation role.

How the current bailout package ultimately will shake out remains to be seen. But one of the important themes in the current dynamic is the urge to assign blame. Some congressional figures have already targeted executive compensation and compensation clawbacks as important considerations of the bailout effort. These kinds of considerations could well lead to an effort to target directors and officers as well as their professional advisors, as part of the overall bailout.

More Reserve Fund Litigation: Shareholders have raised an additional concern in connection with the recent events involving the Reserve Fund. In a separate September 19, 2008 lawsuit (complaint here), Fund investors have also alleged that the Fund tipped off "about a dozen institutional investors" to withdraw a total of $40 billion from the funds at one dollar a share immediately before the Fund’s announcement of the losses due to the Lehman investment’s drove the net asset value below one dollar.

In a September 19 order (here), Judge Paul Magnuson entered a temporary restraining order prohibiting the Fund from honoring withdraw requests of over $10,000, until an evidentiary hearing can be held. Among other things, Judge Magnuson’s order said that "plaintiffs would be irreparably harmed if Defendants were allowed to honor redemption requests of investors who were made privy to the bad news before the public was made aware." The court will hold further hearings on September 23, 2008.

Special thanks to a loyal reader for providing copies of the insider tipping complaint and the TRO.

Run the Numbers: I have added the AIG bailout lawsuit and the Merrill Lynch/BoA lawsuit to my list of subprime and credit crisis-related derivative lawsuits, which can be accessed here. With the addition of these two lawsuits, the current tally of subprime and credit-crisis related derivative lawsuits now stands at 23.

In addition, I have added the Reserve Fund lawsuit, together with a more conventional subprime-related lawsuit filed last week against the Canadian Imperial Bank of Commerce (about which refer here) to my list of subprime and credit crisis-related securities lawsuits, which can be accessed here. With the addition of these two new securities lawsuits, the current tally of subprime and credit crisis-related securities lawsuits now stands at 117, of which 77 have been filed in 2008.

Storm Surge: Plaintiffs’ securities attorneys were extraordinarily busy this past week. By my unofficial count, there were at least nine new securities class action lawsuits filed in the past week alone. And while some of this activity is directly attributable to the economic circumstances discussed above, a part of the activity is less directly connected.

Indeed the past week’s new lawsuits involve a broad variety of companies including clothing companies (refer here), wireless communications companies (refer here and here) and silicon wafer manufacturers (refer here).

We clearly are well past the securities lawsuit filing lull that prevailed from mid-2005 through mid-2007. The more troubling question now is whether we have entered a dangerous new phase of heightened litigation activity that includes but also extends well beyond lawsuits arising directly from financial difficulties attributable to turbulence in the credit markets.

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The heightened susceptibility of life sciences companies to securities class action lawsuits is a phenomenon that I and others have previously noted (refer here). But while life sciences companies may experience greater securities class action claim frequency, many of these lawsuits against life sciences companies are dismissed (as discussed here).

In a case the First Circuit itself called “paradigmatic” of securities cases involving life sciences companies, the appeals court recently affirmed the lower court’s dismissal of the securities lawsuit pending against Biogen Idec and certain of its directors and officers. The court’s analysis is noteworthy because of its emphasis of the issues that contribute to the vulnerability of these kinds of companies to securities lawsuits. But by way of contrast I also discuss below a recent Ninth Circuit opinion reversing the district court’s dismissal of a securities lawsuit involving Gilead Sciences.

The First Circuit’s Opinion in the Biogen Idec Case: On August 7, 2008, in an opinion written by Chief Judge Sandra L. Lynch, the First Circuit issued its opinion in New Jersey Carpenters Pension & Annuity Fund v. Biogen Idec (here). The case involves Biogen’s alleged misrepresentations and omissions pertaining to Tysabri, a new drug for multiple sclerosis and other autoimmune disorders.

In November 2004, the FDA granted accelerated approval of Tysabri. Less than three months later, on February 18, 2005, continuing clinical trials “revealed that two patients had contracted a type of infection perhaps associated with the drug.” One of the two patients died. On February 25, 2005, the company voluntarily withdrew the drug from the market. Its stock price dropped and several lawsuits were filed.

In their amended complaint, the plaintiffs alleged that, in order to facilitate their sale of shares of company stock at inflated prices, the defendants misrepresented the safety and efficacy of the drug. As the First Circuit summarized the case, the “key theme” of the lawsuit is that the defendants were “aware or at least recklessly unaware of greater safety risks with TYSABRI for opportunistic infections, particularly in combination with other MS therapies, than had been announced to the public,” and that defendants “intentionally failed to disclose this information in order to keep the share price high.”

The district court dismissed the complaint, finding that while the plaintiffs had alleged material misrepresentations and omissions with appropriate specificity, they had not alleged scienter with appropriate specificity. The plaintiffs appealed.

In evaluating the plaintiffs’ allegations, the allegations relating to the timing of defendants’ receipt of information were critical, because, as the First Circuit noted, “defendants cannot have committed fraud if they did not know at the time that the failure to provide additional information was misleading.” In that regard, the First Circuit found that “plaintiffs’ amended complaint fails to allege facts both (1) as to when defendant had information about non-PML opportunistic infection and (2) that the information available sufficiently suggested a causal connection between TYSABRI and non-PML opportunistic infections.”

The First Circuit expressed its willingness to consider factual allegations supported only by confidential sources, but the confidential sources’ allegations did not create a strong inference of scienter, because the allegations do not indicate when during the clinical trials information about infections became known.

The court also found plaintiffs’ allegations that defendants had fraudulently failed to disclose dangers of use of Tysabri in combination with other drug therapies were insufficient. Plaintiffs’ allegations that defendants had no reasonable basis to say that Tysabri was safe in combination with other drug therapies, the First Circuit found, were “not nearly so compelling as opposing inferences from the undisputed facts in the record.”

Because the First Circuit concluded that the plaintiffs had not “sufficiently alleged … that defendants had any reason to know their statements were misleading before February 18, 2005,” the Court disregarded all insider trading prior to that date. Only one insider sale was alleged on or after that date, a February 18 sale by the company’s General Counsel. But the General Counsel was not a defendant to the Section 10(b) claim, and the First Circuit held that based solely on the General Counsel’s trading “a strong inference of scienter on the part of Biogen and other individual defendants cannot be drawn.”

The First Circuit found that the plaintiffs’ allegations of scienter were not sufficient to support an alleged violation of Section 10(b), and affirmed the district court.

The court’s opinion was informed by its observations of the peculiar characteristics of securities lawsuits filed against companies involved in the drug and device development business:

The situation here is paradigmatic of securities fraud cases against drug companies where a promising drug or medical device is approved by the FDA and then later proves to have health risks which affect the market for the drug.

The court also noted that disclosures about regulatory developments provide an important context within which sudden stock price changes can occur:

The investing public is well aware drug trials are exactly that: trials to determine the safety and efficacy of experimental drugs. And so trading in the shares of companies whose financial fortunes may turn on the outcome of such experimental drug trials inherently carry more risk than some other investments.

With these comments, the First Circuit recognized the circumstances that make life sciences companies susceptible to securities lawsuits. These companies have volatile share prices that are vulnerable to sudden shocks due to the uncertainty of the regulatory process or to unexpected safety concerns. All too often these reverses result in securities lawsuits, supported only by allegations that the reverses occurred and therefore company management must have known about the problems from which the reverses arose.

The First Circuit’s opinion also evinced an appreciation of the fact that merely because a company has encountered these types of setbacks does not mean that the company has committed securities fraud. The First Circuit’s analysis helps explain why both life sciences may find themselves accused of securities fraud more frequently than other kinds of companies, and also why these cases are frequently dismissed.

Ninth Circuit Reverses Dismissal of Gilead Science Case: But while a number of the securities lawsuits filed against life sciences companies may be dismissed, that certainly does not mean that life sciences companies inevitably prevail. Indeed, there have been a number of significant settlements in securities cases involving life sciences companies (particularly large pharmaceutical companies).

Life sciences companies also face the same challenges involved in securities claims against any corporate defendant, including the possibility that a victory at the trial court level can be reversed at the appellate level. That is exactly what happened in the securities litigation involved Gilead Sciences. In an opinion dated August 11, 2008 (here), the Ninth Circuit reversed the lower court’s ruling dismissing the case for failure to adequately plead loss causation.

Gilead’s flagship produce, Viread, is an agent used with other drugs to treat HIV. The complaint alleges that the company actively marketed the drug for off-label uses, in violation of FDA rules. The company received a Warning Letter from the FDA on this topic, which the company disclosed on August 8, 2003. The company’s share price did not decline in response to this news; in fact, the share price was higher on the following trading days.

In order to address the absence of any share price decline, the plaintiffs alleged that it was not until October 28, 2003 that the public “finally realized the impact of the off-label marketing and the Warning Letter.” After market close that day, the company disclosed that Viread sales had fallen below expectations due to wholesaler overstocking during the quarter. Market analysts attributed the sales decline to “lower end-user demand.” The plaintiffs alleged that the reduced demand was “a direct result” of the Warning Letter, which exposed Gilead’s off-label marketing.

The district court found that the complaint failed to “connect the chain of events” between the failure to disclose the off-label marketing; that the decline in demand for Viread was due to the Warning Letter; and that the reduced sales caused a decrease in Gilead’s share price. The district court said there were “too many logical and factual gaps.” The district court said it could not make “the unreasonable inference that a public revelation caused a price drop three months later.” The district court dismissed the complaint for failure to adequately plead loss causation.

The Ninth Circuit, by contrast, found “the complaint sufficiently alleges a causal relationship between (1) the increase in sales resulting from the off-label marketing, (2) the Warning Letter’s effects on Viread orders, and (3) the Warning Letter’s effect on Gilead’s share price.”

The Ninth Circuit went on to observe that “perhaps what truly motivated the dismissal was the district court’s incredulity.” The Ninth Circuit said that a district court ruling on a motion to dismiss “is not sitting as a trier of fact,” and as long as plaintiffs allege a theory that “is not facially implausible, the court’s skepticism is best reserved for later stages … when the plaintiffs’ case can be rejected on evidentiary grounds.” The Ninth Circuit concluded that “a limited temporal gap between the time of the misrepresentation is publicly revealed and the subsequent decline…does not render a plaintiffs’ theory of loss causation per se implausible.”

The Ninth Circuit said the market “did react immediately to the corrective disclosure” which the plaintiffs claims to be the October 28 press release, the date on which it is alleged the market had complete information to process the revelations about off-label marketing.

It is hardly my place to comment on the merits of a judicial opinion. Suffice it to say that reasonable minds may differ whether the district court was guilty of “incredulity” or the Ninth Circuit of “credulity.” Reasonable minds may also differ whether the three months’ lapse between the disclosure of the Warning Letter and the stock price drop is a “limited temporal gap.” Reasonable minds may also differ whether plaintiffs’ Rube Goldberg explanation for the delayed market reaction “is not facially implausible.”

On the other hand, it seems apparent that the allegation of off-label marketing troubled the Ninth Circuit and it is certainly true that a company whose alleged reverses are not due to unexpected regulatory developments or unanticipated clinical outcomes but rather to marketing activities is in a less sympathetic postion. That is obviously why the plaintiffs strained so hard to try to make the stock price drop relate back to the off-label marketing Warning Letter, because that supposed connection put the defendants in a less favorable light. Regardless, I suppose, of whether or not the stock price drop was due to the wholesaler overstocking.

The one thing that is clear is that all litigants are susceptible to the vicissitudes of the litigation process, life sciences companies as well as any other kind of company. The plaintiffs in Gilead certainly established the value of continuing to fight, as you never know when an initially disfavored hand might still be just enough to take a trick. Of course, the plaintiffs must now go back to the district court and face a court whose skepticism even the Ninth Circuit acknowledged could justify rejecting plaintiffs’ case later.

The SEC Actions Blog has an excellent lawyerly analysis critical of the Ninth Circuit's opinion in Gilead, here.

More Drug News: Biogen Idec’s drug, Tysabri, which the FDA permitted the company to reintroduce to the market in July 2006, was back in the news recently. According to an August 1, 2008 Wall Street Journal article (here), two MS patients treated with the drug have recently contracted a potentially deadly brain infection. The article stated that the company “had no plans to recall the drug or restrict its use.”

The WSJ.com Health Blog also has a post (here) discussing this development. The comments following the post make for interesting reading. It is all too easy to consider these legal issues in a vacuum, but there are real patients whose only hope is the use of these kinds of drug therapies. The eloquent pleas of these patients for the drugs to remain available are moving and impressive.

But the adverse developments cannot be minimized, and in that regard it should also be noted that Biogen Idec also faces a lawsuit from the estate of one of the deceased patients. Recent procedural developments in the case were also discussed recently on the WSJ.com Health Blog (here).

All of that said,  this about business too, and it may come as no surprise that Carl Ichan viewed the stock price drop following Biogen’s recent advserse news as an opportunity to increase his holdings in the company’s shares, perhaps to advance his agenda of getting the company to sell itself, as discussed here.

There is a Balm in Gilead: Perhaps I am presuming too much, but for me the name Gilead Sciences evokes Jeremiah, Chapter 8, Verse 22: “Is there no balm in Gilead? Is there no physician there? Why then has the health of my poor people not been restored?” (New Revised Standard Version).

This line is memorably recalled in the African-American spiritual, There is a Balm in Gilead, whose refrain captures the soothing power of the song:

There is a balm in Gilead

To make the wounded whole;

There is a balm in Gilead

To heal the sin-sick soul.

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In recent days, settlements relating to two high-profile securities class action lawsuits were announced. Because there are some interest things about these two settlements, I take a closer look at each of them below.

Is the Qwest Securites Class Action Lawsuit Finally Settled?  In Qwest Communications  August 6, 2008 filing on Form 10-Q (here), the company announced that it would pay an additional $40 million, and that its former CEO, Joseph Nacchio, and its former CFO, Robert Woodruff, would “contribute a total of $5 million insurance proceeds,” to try to settle the long-standing consolidated Qwest securities litigation. These payments, together with amounts to which Qwest previously agreed, bring the total value of the class settlement to $445 million.

The court had previously approved the $400 million settlement, to which Nacchio and Woodruff were not parties, over Nacchio and Woodruff’s objections. Among other things, the two individuals contended that the prior settlement was structured to strip them of their indemnification rights. As I discussed here, on a January 16, 2008 opinion, the Tenth Circuit held that the two individuals had standing to challenge the settlement because provisions interfered with the two individuals’ potential rights and existing legal claims for indemnification. The Tenth Circuit remanded the case for the district court to provide further analysis of the individuals’ settlement objections.

According to the company’s 10-Q, the revised settlement resolves the class claims against the two individuals (in addition to all other defendants, the claims against who were resolved in the initial settlement), in exchange for which the two individuals withdrew their objections to the settlement and resolved their indemnification dispute with the company.

In a statement that is noteworthy in the larger context, the 10-Q reports that the company has “the right to terminate the settlement if class members representing more than a specified amount of alleged securities losses elect to opt-out.” The 10-Q provides no information as to what might constitute the “specified amount.”

This “blow up” provision, by which the deal is off if a specified percentage opts out, is not atypical, but it is interesting in the context of the Qwest settlement. As I noted in a prior post (here), the now superseded Qwest settlement had the distinction of being the first settlement (of which I am aware) in which the value of the individual opt-out settlements exceeded the value of the class settlement. (At that time, the aggregate value of the opt-out settlements totaled $411 million, compared to the $400 million class settlement).

The revised Qwest settlement value exceeds the aggregate value of the prior publicly disclosed value of the opt-out settlements. But given the magnitude of the prior opt-outs, there certainly is an interesting question of what greater quantity of opt-outs might be required to blow up the revised settlement? And are the prior opt-outs included in that equation? Along those lines, it should also be noted that in its October 30, 2007 filing on Form 10-Q (here), the company announced that the aggregate amount claimed by various persons then opting out from the class settlement is "in excess of $1.9 billion" (which presumably included the $411 million in opt out settlements entered to that point). And if that amount of opting out is not enough to blow up the settlement, then just how much is?

Whether or not this settlement finally resolves this class action, the entire sequence of events may be significant in another respect as well. The events have the potential at least to mark the end of an approach to securities class action case resolution that became fashionable during the era of corporate scandals – that is, to try to ensure that as part of the case settlement that the certain individual defendants were forced to pay out of their own assets to resolve claims asserted against them. The extreme cases reflecting this approach were Enron and WorldCom, where individuals were made to pay settlement amounts without recourse to insurance or indemnity.

The Qwest securities class action, and in particular the difficulties that the company encountered in trying to settle the case without resolving claims against Nacchio and Woodruff, could constrain future attempts to implement this approach. Of course, it may also be argued that the Tenth Circuit did not specifically disallow the prior settled that excluded the two individuals; it merely required the district court to provide further explanation of why it approved the settlement that arguably deprived the individuals of their indemnification rights.

One puzzling note about the amended settlement is the statement in the company's 10-Q’s that Nacchio and Woodruff were contributing $5 million “insurance proceeds.” The document does not specify the source of the insurance, nor how there could be further insurance available after prior settlements, defense expense and other litigation expense.

Another odd note about this insurance component of the settlement is the suggestion that the two individuals were "contributing" the insurance funds, as if the $5 million was drawn from funds that these two individuals alone controlled, or at least that they were in a position to direct. Given that this case first arose way back in 2001, it is relatively unlikely (albeit not impossible) that these individuals carried individual director liabiltiy (IDL) insurance or that the company carried separate Side A insurance (although if the company did carry separate Side A coverage, the company's refusal to indemnify would trigger the protection). The other possibiltiy is that earlier on the parties and the company's insurers reached some accomodation that dedicated certain insurance funds solely for these two individuals, an arrangement that would be unusual particulary in the context of a claim that would seem likely to exhaust all available insurance.

In any event, in the end, despite all the efforts to the contrary, the claims against Naccho and Woodruff were settled without these two individuals having to make a contribution out of their own assets. The Qwest securities class action, and in particular the difficulties that the company encountered in trying to settle the case without including the claims against Nacchio and Woodruff, could constrain future attempts to implement this approach. (Of course, it may also be argued that the Tenth Circuit did not specifically disallow the prior settled that excluded the two individuals; it merely required the district court to provide further explanation of why it approved the settlement that arguably deprived the individuals of their indemnification rights.)

An August 7, 2008 Rocky Mountain News article describing the revised settlement can be found here.

About the GM Securities Litigation Settlement: As noted on the 10b5-Daily blog (here), in the company’s August 7, 2008 filing on Form 10-Q (here), General Motors announced that on July 21, 2008, it had settled the securities class action lawsuit pending against the company and certain of its directors and officers. For background regarding the lawsuit, refer here. The company agreed to pay $277 million and its auditor, Deloitte & Touche, agreed to pay $26 million, bringing the total value of the settlement to $303 million.

The 10-Q also announced that on August 6, 2008, the parties had also reached an agreement to settle the related shareholders’ derivative lawsuit. The settlement agreement “requires our management to recommend to the Board of Directors and its committees that we implement and maintain certain corporate governance changes for four years.” The company also agreed not to oppose the derivative plaintiffs’ petition for attorneys’ fees and costs “not to exceed $7.465 million.”

The 10-Q states further that the company believes “that a portion of our settlement costs are covered by insurance.” The document states that the company anticipates “recording income of approximately $200 million in the third quarter with insurance-related indemnification proceeds for previously recorded indemnification costs” including “the cost incurred to settle the General Motors Securities Litigation suit.”

An August 8, 2008 Business Insurance article (here) reports that a GM spokeswoman clarified that only $100 million of the $200 million of insurance relates to the securities lawsuit settlement; “half” of the $200 million, the article reports that the spokeswoman said, “is for settlements of litigation the company is not disclosing.”

Notwithstanding the odd note about $100 million of insurance for the settlement of undisclosed litigation, the overall suggestion is that $177 million of GM’s contribution to the securities lawsuit settlement is uninsured – or perhaps $7.645 million more than that if the attorneys’ fees in the derivative lawsuit are to be paid by insurance.

An interesting aspect of this case is the identity of the lead plaintiffs. Despite the defendant company's iconic status as an American company, the lead plaintiffs were two overseas institutional investors, Deka Investment GmbH, an investment fund manager based in Germany, and Luxembourg-based fund manager Deka International S.A, both affiliates of DekaBank. The presence of foreign plaintiffs in U.S. class actions has become increasingly common, a trend that is likely to continue as U.S.-based plaintiffs firms expand their presence overseas. The Securities Litigation Watch has frequently discussed this trend, as noted here.

One additional interesting aspect of this settlement is that it the parties were able to resolve the case at such an early stage. According to an August 11, 2008 article on Law.com (here), the federal judge to whom the case was assigned sent the case to mediation while the defendants' motions to dismiss were still pending.

According to RiskMetrics data quoted in the Business Insurance article, the GM settlement ranks as the twenty-fifth largest securities fraud settlement ever. And again, citing RiskMetrics data, the August 9, 2008 Wall Street Journal reported (here) that the GM settlement is the third largest securities lawsuit settlement of 2008, after the $895 million UnitedHealth Group settlement and the $750 Xerox settlement.

Special thanks to a loyal reader for the link to the Business Insurance article.

D&O Funds Gone, Case Grinds On: In a prior post (here), I noted that in the criminal case arising out of the collapse of Collins & Aikman, one of the defendants had sought an early  trial date because of the approaching depletion of the D&O insurance policy limits, potentially leaving him without resources to fund his defense.

In an August 8, 2008 post on his Race to the Bottom blog (here), Professor Jay Brown reports that even though no date has yet been set for the criminal trial in the case, the D&O insurance policy limits are now entirely exhausted. Counsel for one of the defendants reportedly stated at a July 24, 2008 status conference in the case that “the fourth and final layer carrier has informed us that – basically not to assume that there’s going to be any money after invoices submitted on July 31^st.”

The possibility that $50 million in insurance limits might be exhausted before a trial date is even set is a nightmare scenario for any director or officer.

As I noted in my prior post, escalating defense expense is an increasingly important consideration in the D&O limits selection equation. The potential for defense expense alone to deplete all available insurance in a catastrophic claim like the one involving Collins & Aikman may seem like an extreme case, but D&O insurance ought to be able to respond and provide protection even in a catastrophic claim. However, increased limits along may not be the answer; rather, insurance structures, designed to ensure dedicated protection to specified individuals, may be the most important protection against the devastating potential of catastrophic D&O claims.

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Just when you thought it was safe to go outside again, the subprime litigation wave has struck once more. On August 7, 2008, plaintiffs’ lawyers filed a securities class action lawsuit in the Southern District of New York against KKR Financial Holdings LLC and certain of its directors and officers. A copy of the plaintiffs’ lawyers’ August 7 press release can be found here, and the complaint can be found here.

According to the complaint, KKR Financial Holdings LLC (KFN) is an affiliate of the private equity firm Kohlberg, Kravis, Roberts & Co. KFN is a specialty finance company that invests in multiple asset classes. The complaint relates to representations allegedly made in connection with May 4, 2007 merger and share issuance transaction associated with the affiliate’s conversion from a REIT to a limited liability company. In this transaction, investors holding shares in the predecessor company received an equal number of shares in the successor company.

The complaint asserts claims based on the Securities Act of 1933. According to the press release,

the Registration Statement was false and misleading in that it misrepresented and/or omitted material facts, including: (a) the problematic real-estate-related assets held by the Company were a much bigger risk to the Company than the Registration Statement had represented; (b) the Company’s capital would be insufficient given the deterioration in its portfolio which would necessitate capital preservation and the need to raise capital to the detriment of common stockholders; and (c) the Company was failing to adequately record loss reserves for its mortgage-related exposure, causing its balance sheet and financial results to be artificially inflated.

During May, June and most of July 2007, KFN’s stock traded above $25 per share. In late July, many mortgage-related companies’ stock prices declined, including KFN’s. Nevertheless, KFN’s stock closed at $18.02 per share on August 13, 2007. Then, on August 15, 2007, KFN issued a release which revealed that KFN would be selling $5.1 billion in mortgage backed securities at a loss. When this news was revealed, KFN’s stock price collapsed to as low as $9.39 per share, eventually closing at $10.52 per share, a decline from the prior day of 31%. KFN shares currently trade for approximately $10 per share, a 63% decline from the $26.90 per share at which they were sold to plaintiff and the Class.

After the last year and a half, when there has been a flood of new subprime-related lawsuits, there is perhaps nothing too surprising about the kinds of allegations in the KFN complaint. What may be a little bit surprising is that the disclosures on which the complaint is based, and the ensuing stock price drop, took place nearly a year ago.

While the subprime litigation wave has been unfolding, there have been occasional periods where it has seemed as if the plaintiffs’ lawyers are engaging in a little backing and filling, as if catching up with unfinished business that went unattended due to occasional logjams. Given the magnitude of the stock price drop associated with the disclosure (more than $1 billion), as well as the prominence of the company’s affiliated relations, this case seems like it might not have been overlooked.

But in any event, I have added this case to my running tally of subprime and credit crisis-related securities lawsuits, which can be accessed here. With the addition of the KFN lawsuit, the current tally of subprime and credit crisis-related securities lawsuits now stands as 103, of which 63 were filed in 2008.

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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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That sure didn’t take long.

GT Solar International completed its $500 million IPO on July 23, 2008. Then on August 1, 2008, a mere seven trading days later, the plaintiffs’ lawyers initiated a purported securities class action lawsuit in the United States District Court for the District of New Hampshire against the company and certain of its directors and officers, as well as the offering underwriters.

A copy of the plaintiffs’ lawyers August 1 press release can be found here. A copy of the complaint can be found here.

According to the press release, the proceeds of the IPO went to GT Solar Holdings, which in turn “intended to use the net proceeds … to make a distribution to its shareholders.” The press release also states that:

on July 25, 2008, before the market opened, LDK Solar Co., LTD (“LDK”), GT Solar’s largest customer, issued a press release announcing that it had signed a contract to purchase production equipment from one of GT Solar’s competitors. On this news, GT Solar’s stock price declined to as low as $9.30 per share before closing at $12.59 per share on July 25, 2008, losing 13% of its value in its second day of trading.

According to the complaint, the Registration Statement failed to disclose the true extent of the risks surrounding the Company’s relationship with LDK, including the fact that the Company was at imminent risk of losing out on a contract for future orders from LDK due to delays in shipping production equipment to LDK.

For whatever it may be worth, GT Solar’s amended filing on Form S-1 (here) did disclose the company’s dependence on a very few customers and consequent vulnerability (although there is no specific mention of any particular or imminent issues with LDK Solar); the risk factors in the company’s filing states:

We currently depend on a small number of customers in any given fiscal year for a substantial part of our sales and revenue.

In each fiscal year, we depend on a small number of customers for a substantial part of our sales and revenue. For example, in the fiscal year ended March 31, 2006 (on a combined basis), three customers accounted for 64% of our revenue; in the fiscal year ended March 31, 2007, three customers accounted for 70% of our revenue; and in the fiscal year ended March 31, 2008, one customer accounted for 62% of our revenue. In addition, as of March 31, 2008, we had a $1.3 billion order backlog, of which $769 million was attributable to three customers. As a result, the default in payment by any of our major customers, the loss of existing orders or lack of new orders in a specific financial period, or a change in the product acceptance schedule by such customers in a specific financial period, could significantly reduce our revenues and have a material adverse effect on our financial condition, results of operations, business and/or prospects. We anticipate that our dependence on a limited number of customers in any given fiscal year will continue for the foreseeable future. There is a risk that existing customers will elect not to do business with us in the future or will experience financial difficulties. Furthermore, many of our customers are at an early stage and many are dependent on the equity capital markets to finance their purchase of our products. As a result, these customers could experience financial difficulties and become unable to fulfill their contracts with us. There is also a risk that our customers will attempt to impose new or additional requirements on us that reduce the profitability of those customers for us. If we do not develop relationships with new customers, we may not be able to increase, or even maintain, our revenue, and our financial condition, results of operations, business and/or prospects may be materially adversely affected.

The lawsuit on the seventh trading day after GT Solar’s debut may represent some dubious kind of a record. Even Vonage Holding Company made it ten trading days before it was hit with a securities lawsuit (refer here for a more detailed discussion of the Vonage lawsuit). Indeed, Refco, which arguably represents the extreme example of an IPO flame out, was not hit with its first securities suit (about which refer here) until two full months after the company’s ill-fated IPO.

Historically, IPO companies have been more susceptible to securities lawsuits than the population of public companies as a whole. By my count, there have already been eleven securities lawsuits in 2008 alleging misrepresentations or omissions in connection with the defendant company’s IPO, even though 2008 has been an historically low year for IPO activity (although most of these eleven lawsuits relate to companies that completed their IPOs in 2007). Indeed, as I noted in my year-end analysis of the 2007 securities lawsuits (here), 29 of the 172 new securities lawsuits in 2007 were filed against IPO companies.

Because of IPO companies’ heightened susceptibility to securities lawsuits, a public company’s age (in terms of time since the company’s IPO) is one of the most important factors D&O underwriters consider in underwriting and pricing public company risks. The sudden turbulence GT Global has encountered certainly highlights the reason for that emphasis.

For a more detailed discussion of the considerations that D&O underwriters take into account in underwriting public company risk, refer here.

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On July 29, 2008, Cornerstone Research and the Stanford Law School Securities Class Action Clearinghouse released their mid-year 2008 report on securities litigation, entitled “Securities Class Action Filings: 2008 Mid-Year Assessment” (here). A July 29, 2008 press release describing the Report can be found here.

Although the Cornerstone Report differs in some details, it is otherwise entirely consistent with my own mid-year 2008 securities lawsuit filing report (which can be found here). Consistent with the observatoins in my prior report, the Cornerstone Report observes that securities filings in the first half of 2008 “continued the rebound that started in the second half of 2007.”

The Cornerstone Report states that there were 110 securities class action filings in the first half of 2008, which projects to an annualized total of 220. A year end total of 220 lawsuits would represent a 27.2 percent increase over 2007 and a 14.6 percent increase over the annual average for the 11 years ending in 2007.

The Report also notes that over half of the 2008 first-half filings (58) were driven by subprime and credit crisis-related allegations. Of these, 17 were related to auction rate securities.

The Report also notes that “market capitalization losses for defendant firms associated with filings in the first half of 2008 were higher than the average semiannual loss in the eleven preceding years,” and rival “the historical highs seen in 2000-02.” These market capitalization losses may well drive the value of future settlements in these recently filed securities lawsuits.

The Report also contains analysis suggesting that the so-called filing lull that prevailed from mid-2005 to mid-2007 “was partly due to a strong stock market with low volatility,” and that the more recently increased filing level was associated with increased volatility.

While the Cornerstone Report reflects analysis regarding the apparent connection between stock market volatility and securities lawsuit filings, the most recent Report omits analysis that appeared in Cornerstone’s mid-year 2007 report suggesting that the reduced filings during the period mid-2005 to mid-2007 was due to a “permanent shift” to a lower securities class action lawsuit filing level. As I noted at the time (refer here), I regarded the low stock market volatility as a much likelier explanation than any permanent behavioral shift as an explanation for the reduced filing levels.  

The Ultimate Solution to Stock Trader Misconduct: According to a July 27, 2008 Reuters report (here) , “A Chinese court upheld the death sentence of a former securities trader charged with embezzling 97.56 million yuan ($14.31 million).”

Hat tip to Kelly Rehyer for the link to the Reuters report.

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The intervening subprime meltdown makes it seem longer ago than it really was, but it was only a short time ago that regulatory reform was a very hot topic (as noted, for example, here). Dramatic intervening events have advanced other priorities. Indeed, efforts to increase rather than reduce financial markets regulation seem to be the current fashion.

Many of the same people whom only a short time ago were pleading that overregulation was harming U.S. financial markets’ global competitiveness are now clamoring for increased regulation. As former SEC Chairman Arthur Levitt noted in a March 21, 2008 Wall Street Journal op-ed piece entitled “Regulatory Underkill” (here), it is “ironic” now that the “most eminent voices in the business community” were “fixated on questionable measures of financial health” even while “the seeds of today’s market turmoil were being nourished not by regulatory excess, but by fundamental failures in oversight at almost every level.”

Even thought the climate unquestionably has changed, on July 24, 2008 the U.S. Chamber of Commerce’s Institute for Legal Reform released yet another call for reform, particularly with respect to securities class action litigation. The Institute’s Report, which is entitled “Securities Class Action Litigation: The Problems, its Impact and the Path to Reform,” can be found here. The Institute’s July 24 press release can be found here.

Among other things, the Report decries the “culture of abusive class actions” that is “eroding the competitiveness of U.S. capital markets at a time when the face perhaps their greatest threat from foreign competition.”

The Report is interesting and it is effective in summarizing the excesses and abuses of the current U.S. securities litigation system. The Report also contains some useful proposals. In particular, the Report focuses on the potential of abuses of a “pay to play” system where public officials responsible for public pension funds solicit campaign contributions from plaintiffs’ firms that are later selected to act as the pension funds’ litigation counsel. The Report advocates passage of the currently pending “Securities Litigation Attorney Accountability and Transparency Act” (H.R. 5463) to eliminate pay-to-play conflicts and other suspicious connections between attorneys and elected officials.

The Report also advocates a number of procedural reforms, including taking steps to ensure greater coordination between public and private enforcement, and enacting provisions to allow defendants whose motions to dismiss are denied to take immediate interlocutory appeals.

Overall, the Report’s recommendations are useful. There unquestionably is value in examining these issues, and the current litigation system unquestionably suffers from excesses and abuses. I question whether any of these kinds of reform proposals are likely to gain much traction in the current environment.

I also think that any reform initiative should also acknowledge several important additional considerations. The first is that our securities enforcement approach presumes active private litigation. As the Supreme Court noted in its 2007 Tellabs opinion, “meritorious private actions to enforce federal antifraud securities laws are an essential supplement to criminal prosecutions and civil enforcement actions.” While there unquestionably are excesses and abuses in the current system, any reform attempt should also acknowledge private securities litigation’s important role.

The other important consideration relates to the fundamental question of U.S. competitiveness in the global economy. Ultimately, the greatest advantage that the U.S. markets historically have enjoyed is their reputation for integrity. As Arthur Levitt wrote in the op-ed piece cited above,

Ultimately, those who were so concerned with Wall Street’s competitiveness need to realize that the true competitive advantage of America’s capital markets has long been their high quality. With that quality in doubt, leaders and policy makers need to put their ideological fixations aside and commit themselves to giving investors the levels of transparency and accountability they deserve and expect from the world’s strongest markets.

It may well be useful and even important to consider ways to improve our system of private securities litigation. But it is also critically important that any reform proposal appropriately take into account the very things that have historically given the U.S. markets their strength -- that is, their reputation for transparency and integrity, a reputation that U.S. financial markets already have much work to do to rehabilitate. Somehow, these rehabilitation efforts seem higher priority now than proposals for securities class action reform, no matter how meritorious.

Special thanks to several loyal readers for forwarding a link to the Institute’s Report.

More Credit Crisis Litigation: In prior posts (most recently here), I have detailed that the current litigation wave has spread far beyond the subprime lending arena where it first originated. A recently filed lawsuit underscores the extent of this spread.

As detailed in the plaintiffs’ counsel’s July 25, 2008 press release (here), plaintiff shareholders have filed a purported securities class action lawsuit in the United States District Court for the Southern District of New York against CIT Group and certain of its directors and officers. A copy of the complaint can be found here.

CIT is a commercial and consumer finance company whose share price fell in March 2008 after reports circulated about the possibility that the company would have to charge off loans made to students of Silver State Helicopter, which had filed for bankruptcy. The complaint alleges that the defendants made false statements about the company’s financial condition, and specifically that “CIT’s public financial statements failed to account for tens of millions of dollars in loans to [Silver State], which were highly unlikely to be repaid and should have been written off.”

These have been prior lawsuits as part of the current credit crisis litigation wave that have involved student loans. For example, both Sallie Mae (refer here) and The First Marblehead Corporation (refer here) previously have been sued in securities lawsuits arising from troubled student loans. Whether or not there will be further lawsuits relating to student loans, there undoubtedly will be further litigation involving other types of credit as the current economic turmoil unfolds.

In any event, I have added the CIT Group lawsuit to my running tally of subprime and credit crisis related litigation, which can be accessed here. With the addition of the CIT Group lawsuit, the current tally of subprime and credit-crisis related securities lawsuits now stands at 102, of which 62 have been filed in 2008.

Break in the Action: The D&O Diary will be on a reduced publication schedule for the next week. The D&O Diary will resume its normal schedule during the week of August 4^th.

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Lots has been written, even on The D&O Diary (most recently here), about the way the world is adjusting to investors’ growing desire to hold management accountable. At the same time, U.S. courts have proven increasingly reluctant to project the remedies available under its securities laws into situations where there is an insufficient connection to the U.S. (as discussed here).

But the lawsuit filed on June 12, 2008 against the European Aeronautic Defence & Space Co. (EADS) in the United States District Court for the Southern District of New York takes all of that and puts in into a truly interesting and potentially combustible mix   – the plaintiffs are U.S. citizens, but they exclusively bought their shares in this foreign-domiciled company outside the U.S. The company’s shares do not trade on any U.S. exchange.

The company and the individual defendants, all current and former directors and officers of EADS, are domiciled outside the U.S. EADS is a Netherlands company with its principle place of business in The Netherlands. This is a company that is foreign to the U.S. in every sense of the word and only the investor plaintiffs themselves have any connection to the U.S.

If there were ever a case to test the outer limits for the availability of U.S. courts for remedies under the U.S. securities laws, this case would appear to be the one.

The plaintiffs’ attorneys’ June 12, 2008 press release can be found here. A copy of the complaint can be found here.

As described in the press release, the complaint alleges that

EADS falsely assured the investing public that it would overcome the technical problems in the production of the Company’s Airbus A380 commercial jets (“A380”) and it would be able to meet its year-end delivery deadlines. Moreover, the Company issued numerous positive statements which described the Company’s increasing financial performance. According to the complaint, these statements were materially false and misleading because they failed to disclose and misrepresented the following adverse facts, among others: (i) that the Company was experiencing insurmountable delays in the manufacture of the A380 commercial jet; (ii) that the Company would be required to compensate its customers for these delays through discounts and certain customers would likely be canceling their entire orders; and (iii) that, as a result of the foregoing, the Company’s ability to receive new contract awards from commercial airliners and its ability to reap future revenues at the levels that it was projecting would be in serious doubt.

On June 13, 2006, the Company announced that its Airbus subsidiary was having production problems with the A380 commercial jet, which would cause a significant delay in delivery to its customers. The Company also issued a profit warning beyond 2006 which was attributable to these delays and announced that it anticipated annual shortfalls of €500 million, without taking into account possible contract terminations from existing customers.

What makes this case interesting is not the specific factual allegations, which, at least by U.S. standards, are not all that remarkable. What makes this case interesting is the putative class on whose behalf the claim is brought. According to the press release, the lawsuit is brought on behalf of “U.S. citizens who purchased the publicly traded stock of European Aeronautic Defence & Space Co. (“EADS” or the “Company”) on the Frankfurt (Frankfurt: EAD.F), Madrid (Mercado Continuo: EAD.MC) and/or Paris (Paris: EAD.PA) stock exchanges between January 17, 2005 and June 13, 2006, inclusive.”

There are several noteworthy points about this class description. First and foremost, the plaintiffs’ lawyers do not purport to represent foreign investors who brought their shares abroad, so they are consciously avoiding the so-called f-cubed litigant problem (foreign domiciled investors who bought their shares in a foreign domiciled company on a foreign exchange). But the class description underscores the fact that this company’s shares were not traded on a U.S. exchange. They were only traded on foreign exchanges.

This class description raises, in a fairly dramatic way, the ultimate question of how broadly the remedies available under the U.S. securities laws should reach. Do they reach even to a foreign company whose shares do not trade at all in the U.S?

The traditional standards, looking to whether there was (or were) fraudulent conduct or the effects of fraudulent conduct in the U.S., might post significant hurdles for the court to exercise jurisdiction in this case, except that those standards were developed to aid court to determine whether or not to exercise jurisdiction on behalf of investors domiciled outside the U.S. Courts have generally not hesitated to exercise jurisdiction, even against foreign domiciled companies, on behalf of U.S. citizens. But will the court be willing to exercise jurisdiction against a foreign-domiciled company whose shares do not trade in the U.S.?

There may well be prior cases that raise this particular set of issues, and if so I hope readers will let me know. To my knowledge this is a new angle on the perennial set of jurisdictional questions surrounding securities claims against foreign domiciled companies. If the U.S. court were to exercise subject matter jurisdiction here, it would in effect represent a projection of U.S court jurisdiction and U.S. style securities litigation to any company anywhere, as long as there is a U.S.-based investor. Maybe a court here will go for that, but it seems like a stretch to me.

Is there any company anywhere in the world that does not have U.S.-based investors? Should the mere presence of those investors in the U.S. courts allow U.S courts to exercise jurisdiction over all those companies, no matter where they are located and where their shares trade?

Finally, there is also the issue of personal jurisdiction over the individual defendants, and perhaps even over the corporate defendant. Have the defendants purposely availed themselves of the jurisdiction or otherwise established minimum contact with the forum such that the exercise of jurisdiction over them comports with traditional notions of substantial justice and due process?

There probably are also some very interesting questions here about the basic merits of the claim. But those questions may or may not ever matter. The first innings of this game are going to be the ones to watch. Make sure you have your beer and your hot dog and that you are in your seat for the national anthem, because this game is going to rock and roll from the very first pitch.

UPDATE: On June 13, 2008, a different plaintiffs' firm apparently initiated a separate lawsuit against EADS on behalf of a different plaintiffs' class. According to the firm's press release (refer here), this newest lawsuit "seeks to recover damages on behalf of all U.S. and non-U.S. purchasers of the publicly traded securities of EADS during the Class Period." The new lawsuit also names as defendants Lagardere and Daimler AG, EADS's largest shareholders. This second lawsuit presents faces even more significant jurisdictional barriers, since it purports to represent the so-called f-cubed claimants. Clearly these complaints are testing outer jurisdictional boundaries on the availability of remedies under the U.S. seecurities laws.

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 As I have previously observed, the current credit crisis is about more than subprime loans. Among the other kinds of credit are so-called Option ARMs, which frequently involve prime borrowers. These loans are adjustable rate mortgages where the borrower has the option of paying less than the full amount of interest due, with the unpaid balance added to the principle (that is, the loan can negatively amortize). My prior post describing and discussing the nature of Option ARM loans can be found here.

This negative amortization payment feature of Option ARMs only makes sense (if at all) at a time of rising home prices. At a time of declining home values, it can quickly put the borrower in a position where they owe more than the value of their home. As unattractive as this position is, it can get worse when the interest rate adjusts upwards, leaving the borrower in a position of paying even more to stay in a home that is worth less than the mortgage debt.

Unsurprisingly, borrowers are having difficulties with Option ARM loans, which in turn is leading to problems for lenders with Option ARM portfolios. These problems in turn are leading to litigation.

The latest company to be sued in a securities class action lawsuit arising out of problems with Option ARM loans is Wachovia Corporation, which was sued, together with certain of its directors and officers, on June 6, 2008 in the United States District Court for the Central District of California. The plaintiffs’ lawyers’ June 9, 2008 press release about the lawsuit can be found here. The complaint can be found here. UPDATE: As correctly noted in the reader comment, this case is actually pending in the Northern District of California, rather than the Central District as original text incorrectly stated.

According to the press release, the complaint alleges that:

Defendants misled investors by falsely representing that Wachovia had strict and selective underwriting and loan origination practices and a conservative lending approach that set it apart from other lenders. Such reassurances were repeated by defendants throughout the Class Period in order to artificially support Wachovia's stock price in the midst of a weakening mortgage market. In response to increased market concern with the mortgage lending industry, and Wachovia's option ARMs in particular, Wachovia falsely represented that its loan underwriting practices were much better than at other banks and that this would allow it to prosper while lenders with less exacting standards and procedures would fare much worse. In reality, Wachovia's actual lending practices differed materially from the description of those practices in statements made to investors. The Company's ability to weather the deterioration in the real estate and credit markets was grossly exaggerated by Defendants, at precisely the worst time, when analysts began to ask tough questions. The Company, moreover, had inadequate loan loss reserves and falsely represented that its capital position was sufficient to fund its dividend.

Shortly after last assuring the market of its liquidity, the strength of its underwriting practices, and the adequacy of its reserves, Wachovia reported a surprise quarterly loss, undertook emergency measures to increase capital, and cut its dividend. On April 14, 2008, before the open of ordinary trading, Wachovia reported a loss of $350 million, or $0.20 per share, for the first quarter of 2008. The Company attributed the results to: (1) a $2.8 billion increase credit loss reserves, including $1.1 billion specifically for ``Pick-A-Pay'' reserve build, the lending program highly touted by the Company during the Class Period. The need to increase Pick-A-Pay reserves was attributed to Wachovia's adoption of a ``refined reserve modeling'' that resulted in ``higher than expected loss factors on Pick-a-Pay''; and (2) $2 billion in mark-to-market losses for mortgage backed securities, including a ``$729 million loss on unfunded leveraged finance commitments.'' In order to shore-up its capital, Wachovia announced the following steps: (1) reduce the dividend 41% to $0.375; and (2) plan to raise capital by $7-8 billion through public offerings.

Wachovia is only the latest company to become embroiled in securities litigation arising out of Option ARM problems. Companies previously sued in securities lawsuits involving Option ARM allegations include Washington Mutual (about which refer here) and Downey Financial (refer here). It seems highly unlikely that these companies will be the only ones to become involved in lawsuits involving these concerns.

Indeed, as bad as the situation involving Options ARMs may now appear, circumstances are likely to deteriorate in the months ahead. As discussed in the June 5, 2008 Business Week article entitled “The Next Real Estate Crisis” (here), foreclosures on Options ARMs have already tripled in the last year, but could further hasten as “monthly options recasts are expected to accelerate starting in April 2009, from $5 billion to a peak of about $10 billion in January 2010.” The Option ARM loan defaults “could accelerate next year even if subprime defaults subside.”

The possibility of further Option ARM related securities litigation seems likely.

In any event, I have added the new Wachovia case to my running tally of subprime and credit-crisis related securities class action lawsuits, which can be accessed here. The current tally now stands at 89, of which 49 have been filed in 2008.

It is probably worth noting that this new case is the third in which Wachovia has become involved as part of the current credit-crisis related litigation wave. In addition to the new lawsuit, Wachovia was previously sued in an auction rate securities lawsuit (refer here), and in a Prospectus Liability case arising out of the company’s offering of certain Trust Preferred Securities (about which refer here).

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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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In October 2000, the SEC promulgated Rule 10b5-1 to provide company insiders with a way to trade their shares in company stock without incurring securities law liability, through the pre-trading adoption of a written trading plan. Despite the Rule’s protective purpose, concerns have arisen more recently about Rule 10b5-1 plan abuses, as I noted in prior posts (here and here).

Indeed, concerns about Angelo Mozilo’s possible Rule 10b5-1 plan misuse were an important part of the court’s recent refusal to dismiss the Countrywide subprime-related derivative lawsuit. (My prior post about the Countrywide dismissal denial can be found here. A more detailed analysis of the Countrywide court’s discussion of Rule 10b5-1 plan issues can be found on The Corporate Counsel.net blog, here.)

A May 27, 2008 paper by University of Chicago Law Professor Todd Henderson, Stanford Business School Professor Alan Jagolinzer, and Penn State Business Professor Karl Muller entitled “Scienter Disclosure” (here) looks at Rule 10b5-1 plans from a different perspective, asking what can be inferred from a company’s disclosure of its officials’ plans. The authors’ surprising conclusion is that the more detailed a company’s plan disclosure, the more likely are the subsequent trades to capture abnormal trading returns.

The starting point of the authors’ analysis is that, although Rule 10b5-1 itself does not require the plans to be disclosed, “disclosure can enhance the legal protection by increasing the likelihood of early dismissal of class action lawsuits.” This “litigation benefit” arises due to the fact a Rule 10b5-1 plan trading defense will only be available at to dismissal stage if the plan is identified and described in the company’s SEC filings (which a court may consider at the initial pleading stage). If the company fully discloses the plan details, “a court may better ascertain that the allegedly fraudulent trades fall within the Rule’s affirmative defense, thereby increasing the possibility of a low-cost dismissal.”

From this, the authors infer that companies perceiving a greater litigation risk are “more apt to disclose the existence and details of Rule 10b5-1 plans.” But there are costs associated with disclosing the plans, particularly “if investors infer a price relevant signal from disclosure or if disclosure enhances investors’ monitoring of insiders’ trade plan commitment.” The “signal” might encourage investor “front running” which could deprive the insider of anticipated trading profits. The monitoring “reduces the value of early termination options” the insider might have if a planned trade no longer appears desirable.

The authors hypothesized that insiders will nonetheless prefer Rule 10b5-1 plan disclosure if the “scienter disclosure” provides incremental litigation benefit – which is likely to be greatest precisely where the ability to trade provides the greatest opportunity to profit. That is, “pre-disclosure of trade may be strategic in the face of high legal risk if it mitigates legal risk and does not fully reveal privately held information.”

The authors examined company disclosures for hundreds of companies during the period between October 2000 and December 2006, and grouped the companies according to whether the companies had low, moderate or detailed Rule 10b5-1 plan disclosure. The authors then correlated the companies’ disclosure and “subsequent firm returns and earning performance.” The authors found that “more specific 10b5-1 plan disclosures are associated with more negative post-trade abnormal returns” and that “the association between sales transactions and subsequent negative performance is increasing in disclosure specificity, after controlling for other factors that are associated with firm returns.”

As a group, executives at those companies with the most detailed disclosure avoided an average of 12% loss in the companies’ trades relative to the broader market in the six months following their sales. The authors conclude that “voluntary Rule 10b5-1 plan disclosure is associated with the higher level firm legal risk and a proxy for insider’s potential strategic trade.”

In other words, the more detailed disclosure manifests insiders’ perception that subsequent trades are more likely to be advantageous – and therefore legal protection is more likely to be important, justifying the detailed disclosure.

These data suggest, and the authors hypothesize, that “investors should respond negatively to specific disclosures regarding 10b5-1 participation, if they infer that insiders have high strategic trade potential for which they seek high litigation protection.” However, the authors found that there is no observable negative investor response to Rule 10b5-1 disclosure.

The authors’ conclusions have a number of important implications. Obviously, investors may be missing an important signal related to 10b5-1 disclosure. Another important implication relates to the protection that the Rule affords; the authors’ conclusion that the companies with the most detailed disclosure are also the ones with the most fortunate timing suggests that, at least in some companies, transparency may be facilitating aggressive stock sales. The Rule was designed to provide company officials with a way to trade safely, but the authors’ study suggests that at least some company officials may be using the Rule as a shield to unload stock at an opportune time.

While I confess that initially I found the authors’ conclusions troubling, after further reflection I am less concerned. The problem here is not that insiders are using Rule 10b5-1 plans and plan disclosure strategically – after all, the whole idea of the Rule was to facilitate trading, and there is certainly no suggestion that trades made pursuant to the Rule cannot be advantageous. The problem is that at least so far, investors have missed the negative signal that Rule 10b5-1 plan disclosure implies.

The authors themselves speculate that the absence of negative investor reaction “may indicate that there are frictions to implementing strategies based on 10b5-1 disclosure signals or that investors do not understand 10b5-1 disclosure implications, which is possible if our same period reflects the transition period regarding 10b5-1 use.” To the extent, however, that the signal is better understood, the more the marketplace itself will discipline the process.

The greater likelihood that the mere announcement of a 10b5-1 plan could undermine a company’s share price could provide a missing disciplinary constraint on strategic trading and reduce company officials’ ability to capture abnormal returns. In other words, the whole mechanism will function better if investors appreciate the significance of 10b5-1 disclosure – an appreciation that the authors’ research clearly should facilitate.

A May 27, 2008 USA Today article discussing the authors’ study can be found here. An entry on the University of Chicago Law School Faculty Blog discussing the article can be found here.

Very special thanks to Professor Henderson for alerting me to the article and for providing me with a link.

Another Options Backdating-Related Class Action Settlement: In its May 8, 2008 filing (here), Kratos Defense & Security Solutions (formerly known as Wireless Facilities) announced that in March 2008, it had reached a tentative agreement to settle the options backdating-related securities class action lawsuit pending against the company and certain of its directors and officers. The amount of the settlement is $4.5 million, of which $1.7 million will come from the company and the balance of which will come from the company’s D&O insurer.

I have added this settlement to my table of options backdating-related lawsuit settlements and dismissals, which can be accessed here.

Hat tip to Adam Savett of the Securities Litigation Watch blog (here) for providing the heads’ up about the Wireless Facilities settlement

Not Just Immune, But Infallible: If you were immensely rich and powerful, you too might well, as did the Sultan of Brunei in 2004, amend the constitution to “declare himself infallible and immune from any obligation to appear in court …and to subject anyone who criticizes him to criminal punishment.”

Those curious to know how a court might actually apply a provision like this and related legal issues will want to refer to Francis Pileggi’s Delaware Corporate and Commercial Litigation Blog (here), in which Pileggi reviews a May 23, 2008 Delaware Chancery Court decisions involving the Sultan and his brother. Among other things, Pileggi notes that in the course of reaching its decision, the Court “recites the background facts of royal family battles that could be part of a movie script.”

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The subprime litigation wave has been rolling along for well over a  year, so it might be expected that by now we have seen many of the likely litigation variations. I suspect there are hosts of new variations yet to come, but the most recent subprime-related lawsuits are substantially similar to prior lawsuits. Yet each one, briefly noted below, also involves some interesting additional variations on previously established subprime litigation themes.

Royal Bank of Canada Auction Rate Securities Lawsuit: On May 12, 2008, plaintiffs’ counsel announced (here) an auction rate securities-related class action lawsuit against Royal Bank of Canada and its subsidiaries, RBC Dain Rauscher and RBC Capital Markets Corporation. A copy of the complaint can be found here.

While there have been numerous prior auction rate securities lawsuits (about which refer here) and while the allegations in the RBC lawsuit appear substantially similar to the prior auction rate securities lawsuits, this lawsuit does present a couple of additional interesting elements.

The first is the lawsuit’s timing. The preceding auction rate securities lawsuits came in a rush between March 17, 2008 and April 21, 2008. There had been no new auction rate lawsuits since April 21, and the lengthening interval might have been interpreted to suggest that the filing onslaught had played itself out. The RBC lawsuit suggests that we may not yet have seen the last of the auction rate securities lawsuit filings.

The other interesting thing about the RBC lawsuit is that RBC itself is, obviously, a Canadian company. At a PLUS Chapter event in Montreal last week, there was a great deal of discussion about whether Canadian companies will feel the litigation effects of the subprime meltdown. The lawsuit against RBC suggests that at least Canadian companies with U.S. operating units exposed to subprime-related issues may find themselves swept up in the U.S.-based subprime litigation wave.

Indeed, RBC is not even the first Canadian company to be named in an auction rate securities lawsuit, as Oppenheimer, another Canadian company, was hit with an auction rate securities lawsuit in April 2008 (about which refer here). Even if Canadian companies are not being sued in Canadian courts on subprime-related issues, they are finding themselves involved in U.S.-based litigation.

Huntington Bancshares/Sky Financial/Waterfield Mortgage:  Huntington Bancshares, a Columbus, Ohio-based bank holding company, has previously been sued in a subprime-related securities class action lawsuit (about which refer here). The plaintiffs alleged in the prior lawsuit that, due to Huntington’s July 2007 acquisition of Sky Financial, Huntington had a much greater exposure to subprime mortgages than it had disclosed, allegedly harming a class of person who acquired Huntington shares between the time of the merger and the end of the class period in November 2007.

On May 7, 2008, Huntington was sued in a separate lawsuit in the United States District Court for the Southern District of Ohio (complaint here). In this most recent lawsuit, Huntington is sued as successor in interest to Sky Financial. The lawsuit is filed on behalf of the former shareholders of Waterfield Mortgage Company, whose shares Sky Financial had acquired in an October 2006 stock for stock-and-cash merger transaction.

The May 7 complaint, which also names as defendants Sky Financial’s former CEO and former CFO, alleges that the Sky Financial and the individual defendants violated Sections 11 and 12 of the ’33 Act through alleged false and misleading statements in the registration and proxy documents issued in connection with the Waterfield acquisition. The complaint alleges that Sky Financial had an undisclosed lending relationship that resulted in a significant residential mortgage exposure for Sky Financial.

This most recent Huntington lawsuit involves a different set of plaintiffs asserting claims based on a different set of representations yet involving a defendant bank that has already been drawn into the subprime litigation wave. There will likely be other lawsuits like this one ahead, as litigation emerges to fill in the interstices of the circumstances surrounding the subprime meltdown. So far, the most noteworthy attribute of the subprime litigation wave has been its breadth. Perhaps in the months ahead, as the wave spreads to fill in other gaps, the most pronounced aspect of the litigation wave will be its depth.  

Special thanks to Adam Savett of the Securities Litigation Watch blog (here) for a copy of the Huntington/Sky/Waterfield complaint.

Run the Numbers: With the addition of these two new subprime-related securities class action lawsuits, the current tally (refer here) of subprime and credit-related lawsuits stands at 79, of which 39 have been filed in 2008. With the addition of the RBC auction rate securities lawsuit, there have now been 16 auction rate securities lawsuits, all of which have been filed in 2008.

Subprime Litigation Down Under: According to a May 12, 2008 Wall Street Journal article (here), Centro Retail Ltd. and its management company, and Centro Properties Company Ltd. and its management company, collectively  an Australian shopping center group, have been named as defendants in two class action lawsuits filed in Australian federal court based on alleged misleading statements in Centro’s disclosure documents between August 9, 2007 and February 15, 2008.

As discussed in the May 13, 2008 issue of The Australian (here), the recently filed lawsuits, brought by the Maurice Blackburn firm, are actually the second set of lawsuits announced against Centro. As discussed here, lawsuits had previously been announced against Centro and its property trust by the Slater & Gordon law firm. Both sets of lawsuits relate to Centro’s alleged misrepresentations regarding its leverage and its vulnerability to adverse credit developments, as a result of which the company experienced a severe share price decline.

While the spread of subprime-related shareholder class action litigation to Australia is interesting in and of itself, one specific aspect of these two sets of lawsuits is particularly interesting to me. That is, both sets of lawsuits are proceeding in reliance on third-party litigation funding.

According to Slater & Gordon’s April 22, 2008 press release (here), its lawsuits are being funded by “U.S based litigation funder Commonwealth Legal Funding LLC.” According to the press release, litigation funders “take a percentage of the net amount recovered, after expenses and after legal fees, for advancing all expenses and accepting the risk of any adverse award.” (The law firm itself recovers a court-approved hourly rate.)

The Maurice Blackburn firm’s separate set of actions is being funded by Australian-based IMF (Australia) Ltd. IMF is actually a publicly traded company whose shares trade on the Australian stock exchange. IMF’s May 9, 2008 press releases announced the filing of the lawsuits against Centro can be found here and here.

It isn’t clear how the existence of these two competing ventures will be reconciled. One might argue that the free market should be allowed to decide; along those lines, the Slater & Gordon press release touts the “significant” advantage its funder affords, in that “it takes a lower amount of the net amount recovered, from 15 to 30 percent, compared to the top rate of 40 per cent for the other proposal.”

One of the time-honored traditions in international financial circles is to rail against the excesses of the U.S. litigation system. But for all of our litigation extremes, litigation funding is one innovation that has not caught on in this country. It obviously has, by contrast, caught fire in Australia, and according to a March 20, 2008 Legal Week article (here), it also apparently has spread to the U.K.

As to whether litigation funding might catch on in the U.S., the WSJ.com Law Blog has an interesting post discussing the issue here. The Re: The Auditors Blog also has an interesting post on the topic here.

Australia has been setting the pace on innovation lately, as, among other things, the Slater & Gordon firm itself recently became the world’s first publicly traded law firm (refer here).

Opt-Out Options for the Little Guy: In a recent post (here), I discussed Columbia Law School Professor John Coffee’s recent paper in which he speculated that that we might be moving to a two-tier securities litigation system in which institutional investors with large financial interests at stake might increasingly seek to opt out from class litigation. The class itself, Coffee speculated, might increasingly be populated only by smaller investors whose financial stakes were too slight to justify opting out or to attract the interest of plaintiffs’ attorneys.

But an aspiring plaintiffs’ attorney’s recent publicity bid suggests that there may be enthusiasm for encouraging the little guys to opt-out too. In a May 12, 2008 press release suggestively entitled “Study Finds Many Bear Stearns Employees Should Opt-Out of Class Actions” (here), Brett Sherman of the Sherman Law Firm seeks to point out to Bear Stearns employees that investors who opted out of prior cases have had a higher percentage recovery of their investment losses.

The press release cites a variety of sources regarding opt-out litigation (including, in a twist that feels odd to me, my own InSights article about opt outs). None of the studies specifically find, as the press release title suggests, that Bear Stearns employees should opt out. Rather, Sherman himself asserts that “the only reasonable conclusion is that Bear Stearns employees with substantial losses have a dramatically better chance to recover a higher percentage of losses in individual opt out cases rather than as participants in class actions.”

Perhaps if, as Coffee speculates, institutional investors will increasingly opt out of class actions, and if, as Sherman advocates, the little guys decide to opt out too, no one will be left in the class. The issue here is clearly potential class members’ perception that opt-outs recover a greater percentage of their investment loss. To the extent that perception is widely shared, class counsel may face significant pressure to show a greater percentage recover of investment loss. Otherwise, the class action itself could become an empty vessel.

Of course it remains to be seen whether either large or small potential class members actually do opt out in material numbers. But assume for the sake of argument that they do. All those who have reviled the class action litigation procedure for so many years might want to contemplate the procedural morass that would attend a multitude of individual opt-out actions. Class litigation does offer certain efficiencies whose loss we might one day mourn.

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Add corporate debt to the type of lending caught up in the current credit crisis, and add both commercial real estate financing companies and private equity firms (or at least one that recently completed a high profile public offering) to the kinds of companies now ensnared in the current wave of lawsuits. The latest round of lawsuits suggests just how far afield these cases may spread before all is said and done.  

The iStar Lawsuit: The lawsuit filed on April 14, 2008 in the United States District Court for the Southern District of New York against iStar Financial and certain of its directors and officers represents these latest variants in the evolving course credit crisis litigation wave. A copy of the plaintiffs’ lawyers’ press release about the iStar lawsuit can be found here, and the complaint can be found here.

The iStar lawsuit is brought on behalf of shareholders of the company who bought their shares in the company’s December 13, 2007 secondary offering, in which the company raised more that $227 million. According to the complaint, the offering documents failed to disclose that the company was at the time of the offering experiencing negative effects from the credit market turmoil and failed to recognize more that $200 million of losses on its “corporate loan and debt portfolio.”

On February 28, 2008, the company reported (here) a fourth quarter 2007 loss of 478.7 million, due in part to $134.9 million in charges associated with the “the impairment of two credits that are accounted for as held-to-maturity debt securities in its Corporate Loan and Debt portfolio.” and due to the fact that the company had increased its loan loss provisions by $113 million.

The Blackstone Lawsuit: In another example of the far flung effects from the current market turmoil, investors who bought shares of The Blackstone Group, L.P in the firm’s June 25, 2007 IPO have filed a lawsuit in the United States District Court for the Southern District of New York against the company and certain of its directors and officers.

According to the plaintiffs’ lawyers’ April 15, 2007 press release (here), the complaint alleges that the offering documents failed to disclose that Blackstone’s “portfolio companies were not performing well and were of declining value and, as a result, Blackstone’s equity investment was impaired and the Company would not generate anticipated performance fees on those investments or would have fees ‘clawed-back’ by limited partners in its funds.”

The complaint (which can be found here) alleges that in the company’s March 10, 2008 announcement (here)of fourth quarter and year end financial results, the company announced “announced that it was writing down its investment in Financial Guaranty Insurance Company by $122 million.”

Financial Guaranty Insurance Company is a bond insurer that has been struggling due to downgrades of its own credit rating. FGIC’s travails have already resulted in a prior securities class action lawsuit against the company’s other significant investor, The PMI Group. My prior discussion of The PMI Group securities litigation can be found here.

These events and ensuing lawsuits represent the latest extension of the circumstances that originated with the subprime lending meltdown but now are increasingly widespread. I recently highlighted (here) the turmoil (and ensuing litigation) that had affected the student lending sector. The extension of the effects and of the litigation, first to the commercial lending sector and to a commercial real estate financing company, and next to a private equity firm that went public only a short while ago amidst great hoopla and now has been sued for it, are merely the latest developments in what clearly promises to be an increasingly encompassing phenomenon.

As I have noted before, observers who persist in viewing the credit crisis and ensuing litigation as an exclusively “subprime”-related problem will not only fail to comprehend what has already occurred, but will likely underestimate what may lie ahead.

Another Auction Rate Securities Lawsuit: Another related recent development in this area is the lawsuit filed on April 14, 2008 on behalf of auction rate securities investors against Wells Fargo & Co. The plaintiffs’ attorneys’ press release can be found here and a copy of the complaint can be found here.

With the addition of the iStar, Blackstone and Wells Fargo lawsuits, my current tally of credit crisis-related securities lawsuits, which can be accessed here, now stands at 73, 33 of which have been filed in 2008. Thirteen of 73 lawsuits are brought on behalf of auction rate securities investors.

More Suits Against Securitzers: In earlier posts (here and here), I noted the emergence of securities class action lawsuits brought on behalf of investors against the investment banks and related entities that securitized mortgages and other types of debt into financial instruments in which the investors invested and in which they lost money.

The latest of these lawsuits was brought on March 19, 2008 in New York Supreme Court by the City of Ann Arbor Employees’ Retirement System on behalf of investors who purchased Mortgage Pass-Through Certificates as part of a December 12, 2006 offering of the instruments. Named as defendants are Citigroup Mortgage Loan Trust, which organized the offering of certificates backed by pools of mortgages, and 18 mortgage loan trusts, in which the mortgages were held. The defendants have removed the lawsuit to the United States District Court for the Eastern District of New York. Background regarding the lawsuit can be found here. A copy of the removal petition, to which the complaint is attached, can be found here.

The complaint alleges that the offering documents misrepresented the underwriting standards used in connection with the mortgage origination, and also misrepresented the various criteria used to qualify loans and properties. As a result, the complaint alleges, the offering documents misrepresented the risk profile of both the secured assets and the certificates.

The Citigroup lawsuit is substantially similar to the lawsuits previously brought against affiliates of Nomura (about which refer here), Countrywide (refer here) and Wachovia (refer here). This latest complaint is also similar to those prior complaints in that the plaintiffs (who in each case are represented by the Coughlin Stoia firm) sought to initiate each lawsuit in state court. My detailed analysis of the jurisdictional issues involved can be found in the post linked above regarding the Nomura lawsuit.  

Though the defendants have uniformly sought to remove these cases to federal court, in the Countrywide case, the earliest of these cases to be filed, the federal court granted the plaintiffs’ motion to remand the cases to state court. As noted in my discussion of the Countywide remand decision here, the federal court’s remand of the case to state court was based on the grant of concurrent jurisdiction to state courts for ’33 Act liability cases, a jurisdictional grant the federal court found has not been eliminated by subsequent legislation.

I have previously speculated that the plaintiffs’ strategy for pursuing these cases in state court is to avoid the requirements of the PSLRA, an impression that is reinforced by the fact that the plaintiffs’ lawyers did not issue a press release at the time they filed these state court complaints. Whether other defendants’ attempts to remove these lawsuits to federal court will ultimately prove to be successful remains to be seen, but the prospect of significant nationwide securities litigation going forward in state court seems fraught with the potential for uncertainty, opacity and complexity.

You’re Such a Lovely Audience, We’d Like to Take You Home With Us: As your reward for reading this far, I am going to share a wonderful little secret with you. Stanford Law School, which has long maintained its excellent Securities Class Action Clearinghouse (here) has now started the Stanford Global Class Action Clearinghouse (here). The new site is devoted to tracking the development of class action litigation throughout the world. While the site is new and is only just getting started, it already has very interesting materials and shows great promise. We can only hope its sponsors and guardians develop and maintain this new site as well as the predecessor.

Hat Tip to my good friends at the Drug and Device Law Blog (here) for the link to the new site.

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On April 8, 2008, PricewaterhouseCoopers released its 2007 Securities Litigation Study, which can be found here. The PwC study follows prior reports from NERA Economic Consulting (refer here) and Cornerstone Research (refer here and here). The PwC study differs from the other studies in certain details but the studies are all directionally consistent.

The PwC study observes that “after a two-year decline and a sluggish start to the year, total federal class actions filed in 2007 against foreign and domestic companies increased once more, reversing the previous downturn.” The PwC has some interesting thoughts about the prior downturn and the causes of the reversal; the study speculates that “much of the decrease in the 2006 numbers” was due to “the preoccupation of the plaintiffs’ bar with stock options matters filed primarily as derivative matters.” The study also observes that the upswing in 2007 “comes as no surprise” given that “the stock options matters appear mostly to have dissipated.”

The report also notes that the deterrent effect of Sarbanes Oxley “may have led to a lower number of overall cases” but adds that the economy may also have been a factor and “during hard times, the increased pressure to produce good financial results is more likely to lead to bad behavior which could result in higher levels of litigation” as a result of which “over the next few years” we could see “above the recent average number of filings.”

The study has a number of interesting observations about the role of accounting issues in securities lawsuits. Among other things, the study notes that while there have been a “burgeoning number of restatements in recent years,” the number of restatements associated with federal securities class actions is “relatively small” – the report notes that in 2007, the number of securities lawsuits associated with restatements fell to 29, from 47 in 2006. The report notes that this analysis supports the view that “market reaction to restatements is declining” and also supports the view that “the market does not react to all restatements.”

Somewhat differently than the recently released Cornerstone Research settlement analysis (here), the PwC study finds that the total value of settlements did not significantly change between 2006 and 2007. The PwC study also reports an average 2007 settlement of $56.3 million, compared to an average settlement of $57.5 million in 2006. Due to the few number of billon dollar settlements in 2007, if settlements greater than $2.5 billion are excluded, the average 2007 settlement was $28.3 million, compared to $57.5 million in 2006. 

The study includes commentary on a number of interesting topics, including the growth of subprime-related litigation and the growing importance of institutional investors in securities class action litigation. The study also includes interesting commentary on the increased prominence of hedge funds, about which the study notes:

As the subprime fallout continues into 2008, this will be one area to watch. Not only could litigation against hedge funds by investors increase, but large institutional investors such as pension funds – which have added hedge funds to their portfolios over recent years and which are increasingly active in shareholder lawsuits – may also begin to focus with similar activism on hedge funds in order to recover losses associated with the subprime crisis.

The PwC also has extended discussion of the issue of the growing importance of Foreign Corrupt Practices Act investigations and enforcement proceedings, a topic on which I have frequently commented on this blog (most recently here).

The study also has an interesting discussion of concerns facing foreign issuers. Among other things, the study notes that “the number of foreign IPOs climbed to 55 in 2007, surpassing the record of 34 IPOs set in 2006.” China “accounted for 55% of the foreign IPOs.” With these foreign listings has come litigation activity. According to the study, the number of 2007 securities lawsuits against foreign issuers increased by 93%, to 27 cases, in 2007, from 14 cases in 2006 (but short of the 30 cases filed in the record year of 2004). The report states that ten of these cases were against Chinese companies, of which five involved IPO-related allegations. My prior post discussing Chinese IPOs can be found here.

The report also has an interesting discussion of the growth of “global class actions,” involving both securities lawsuits in the US involving foreign domiciled companies, as well as the increasing number of lawsuits now being filed outside the U.S.

One concluding observation about the PwC’s settlement analysis. The study’s analysis of class action settlement data is interesting and useful, but I am concerned that as a result of trends in opt-out litigation and settlements, the study of class action settlements alone may no longer be sufficient to understand the full extent of companies’ potential loss severity exposure. To refer to but one example, in connection with the Qwest securities litigation, the aggregate value of the individual opt out settlements actually exceeded the amount of the class action settlement. (see my prior analysis of the Qwest opt out settlements here).

While the emergence of class action opt outs as a material issue is relatively reason, and for that reason still relatively uncertain, consideration of possible opt out litigation appears to be an increasingly indispensible part of the analysis of potential litigation exposure and of the total cost of securities litigation. My discussion of the emergence of opt out issues can be found here.

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Driven by the growing wave of subprime-related litigation (particularly a spate of auction rate securities lawsuits), the number of new securities class action lawsuit filings surged in March 2008. The total number of new securities class action lawsuit filings -- 25 – matches the number of new filings in November 2007, which in turn represented the highest monthly total of new filings since January 2005.

The 25 new securities lawsuits in March included 14 new subprime-related suits, taking account the new auction rate securities filed against J.P. Morgan Chase on March 31, 2008 (about which refer here). Of the 14 subprime-related suits, eight (including the new J.P. Morgan Chase lawsuit) were brought on behalf of auction rate securities investors against the companies that sold them the instruments. The remaining lawsuits (both those that are subprime-related and those that are not) were brought on behalf of public company shareholders against the companies and their directors and officers, other than one lawsuit brought on behalf of mutual fund investors.  

Largely because of the subprime-related litigation, many of the March lawsuits were filed in the United States District Court for the Southern District of New York – a total of 11 of March’s 25 new securities lawsuits were filed in the S.D.N.Y. Six of the new securities lawsuits filed in March involved companies domiciled overseas.

With the addition of the 25 new lawsuits in March, the total number of new securities lawsuits filed in the first quarter of 2008 totaled 52, of which 24 are subprime-related. All of the auction rate securities lawsuits were filed in March. (A complete list of the subprime-related lawsuits can be found on my running tally of subprime lawsuits, which may be accessed here.)

The 52 new securities class action filings in the first quarter of 2008, if extrapolated across four quarters, imply an annual filing rate of 208 new securities class action lawsuits, which is consistent with historical norms. (According to Cornerstone’s year-end 2007 securities analysis, here, the average number of securities class action filings during the period 1997 to 2006 is 1994). However, while this filing rate is consistent with historical levels, it is well above the annual levels seen in the most recent years, particularly 2006 (116) and 2007 (166).

Again, largely due to the number of subprime-related filings, the S.D.N.Y had the largest number of first quarter filings, with 21. The federal district with the next highest numbers of filings, D.Mass., had only five.

The companies sued in new securities lawsuits in the first quarter represented 31 different Standard Industrial Classification (SIC) Code categories, which might suggest that a broad diversity of companies were sued, but in most of those 31 categories only a single company was sued. The SIC Code categories with the largest numbers of companies sued were SIC Code category 6211 (Security Brokers and Dealers), with 7 companies sued, and 6021 (National Commercial Banks), with 6 companies sued. In all 29 companies in the 6000 SIC Code series (Finance, Insurance and Real Estate) were sued in the first quarter.

Nine of the companies sued for the first time in the first quarter of 2008 were domiciled overseas, representing eight different countries (including Switzerland, in which two of the companies are domiciled; the other seven countries had only one each.)

Six on the companies sued for the first time in the first quarter of 2008 had completed an initial public offering less than 12 months before the date of the first-filed lawsuit.

A final word about my lawsuit count: I am largely dependent on publicly available sources for my information about securities class action filings, although I have been able to supplement my information with data and links supplied by readers. (I am always grateful when readers bring information to my attention). I have compared my count to the information available on the Stanford Law School Securities Class Action Clearinghouse website (here) and have elected to omit certain cases that the Stanford site has included, largely because at least three of the cases listed on the Stanford site do not involved publicly traded companies. I will say that the diversity and variation of cases that have arisen in the last few months have created some very difficult categorization issues, and reasonable minds clearly could differ as to whether any particular case should or should not be “counted.”

While the securities class action lawsuit filing rate has fluctuated since mid-2007, the evidence remains consistent that the "lull" in filings that occured between mid-2005 and mid-2007 is over. It does remain to be seen if the filings will continue at their current rate, especially whethter factors such as the auction rate securities crisis will continue to drive litigation. On the other hand, the litigation activity is being driven by so many different aspects of the current crisis, it seems probable that subprime and other credit-related litigation will continue to accumulate. The more interesting question may be the extent to whcih the credit crisis litigation will spread beyond the financial sector.

A Further Thought about Securities Class Action Settlements: Earlier today I posted about the new Cornerstone report on 2007 class action settlements. The report is interesting and includes useful analysis and information. But upon reflection, it occurred to me that it is increasingly the case that class action settlement data alone may not provide all of the information necessary to understand the costs involved in resolving securities lawsuits. As I have noted in numerous prior posts (refer here), class opt outs are an increasingly important part of securities lawsuit resolution, a development that gained considerable momentum during 2007. Indeed, as I note here, the aggregate amount required to settle the Qwest opt-out actions actually exceeded the amount of the class settlement, and the amount paid in settlement of other opt actions is also very substantial.

For that reason, any assessment of the total costs involved in securities case resolution cannot be limited to class action settlements alone. The costs involved with separate opt-out actions must also be considered.

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On March 31, 2008, Cornerstone Research released its review and analysis of 2007 securities class action settlements. Cornerstone’s press release can be found here and the full report can be found here. The Cornerstone Report differs in certain particulars from the previously released NERA Economic Consulting report (about which refer here), but the two reports are directionally consistent.

Cornerstone’s press release emphasizes that the aggregate dollar value of all settlements was down 60% compared to 2006, but the full report emphasizes that, when the four largest settlements are removed from the analysis, the aggregate value of all settlements in 2007 exceeded all prior years except the unprecedented year of 2006.

The full report also highlights that the median securities class action settlement reached an all-time high of $9.0 million in 2007, compared to a median of $6.9 million for the years 1996 through 2006. The increase in the median settlement in 2007 is “partly due to the fact that the percentage of cases settling for $10-20 million increased substantially from prior years.” On the other hand, the number of settlements in excess of $100 million declined from 14 in 2006 to only nine in 2007.

According to the Cornerstone report, the average securities class action settlement fell from $105 million in 2006 (excluding the Enron settlement) to $62.7 million in 2007. But the 2007 average still exceeded the average of $54.7 million for the years 1996 through 2006.

The Cornerstone report examines the factors affecting settlement amounts and concludes that the presence of institutional investors lead plaintiffs and the existence of parallel shareholders’ derivative lawsuits both tend to have an upward effect on settlement values.

The press release quotes Stanford Law Professor Joseph Grundfest as saying that “it seems clear that the aggregate dollar value of settlements over the next two or three years is likely to decline significantly because the inventory of large cases in the pipeline just isn’t there. The interesting open question is whether the subprime crisis will cause an uptick in securities fraud settlement activity that might, given the settlement cycles in the litigation industry, only become apparent three to five years from now.”

The differences between the analysis in the Cornerstone and NERA Economic Consulting reports appears to be due at least in part to the different methods the two studies used to categorize settlements by settlement year, with one report categorizing the settlements by the year in which the settlement was announced and the other report categorizing the settlement by the year in which it was approved.

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As the markets for various types of subprime-related assets have seized up, many companies find themselves faced with complicated issues concerning asset valuation and disclosure. These issues have in turn both subjected companies to the possibility of litigation and encouraged investors to target the entities and institutions that sold them the assets in the first place. The extent of the asset valuation and disclosure issues suggests that the turmoil, and the ensuing litigation, will continue to spread.

One example where the valuation and disclosure issues have already led to litigation involves the securities class action lawsuit filed in the United States District Court for the District of Minnesota on March 28, 2008 against MoneyGram International and certain of its directors and officers. A copy of the plaintiffs’ attorneys’ press release can be found here and a copy of the complaint can be found here.

The complaint against Moneygram relates to the company’s January 14, 2008 press release (here) in which the company stated that it had completed its valuation of its investment portfolio as of November 30, 2007, as a result of which the company said that it had “experienced net unrealized losses of $571 million from September 30, 2007, bringing cumulative net unrealized losses to $860 million.” The company also announced that it has commenced a process to “realign is portfolio away from asset-backed securities,” as a result of which it had realized in January a loss of $200 million on asset sales of $1.3 billion.

According to the plaintiffs’ lawyers’ press release, the complaint alleges that the defendants “concealed from the investing public” that:

(a) the Company lacked requisite internal controls to ensure that the reserves for the Company’s investments in asset-backed securities were adequate, and, as a result, the Company’s projections and reported results issued during the Class Period were based upon defective assumptions and/or manipulated facts; and (b) the Company concealed the extent of its potential losses arising from its exposure to asset-backed securities containing uncollectible debt.

The prospect of securities litigation arising from asset valuation and disclosure issues is a potentially very substantial problem, because so many companies are facing these same kinds of issues due to asset-backed securities in their investment portfolio. Similarly, companies holding auction rate securities are facing particularly challenging valuation and disclosure issues, and as I have previously noted (most recently here), these challenges are not limited to companies in the financial sector, but indeed are widely dispersed throughout the economy. For example, a March 28, 2008 Wall Street Journal article entitled “’Auction Rates’ Clip Tech Firms’ Profits” (here) discusses the financial impacts that a variety of technology companies are facing because of the companies’ inability to convert their auction rate securities holdings into cash.

One measure of the depth of the problems arising from the failure of the auction rate securities market is that it is not just companies whose balance sheets are under pressure. Many households and individuals are also now about to recognize their own personal balance sheet hits due to the auction rate problem. According to a March 29, 2008 Wall Street Journal article entitled “UBS Plans Auction-Rate Price Cut” (here), UBS is going to lower the values of the auction rate securities held by its customers. The reduced values, which will be based on computer models and “will range from a few percentage points to more than 20%” will be reflected on their customers’ forthcoming statements.

As I have previously noted (most recently here), investors have already filed a number of class action lawsuits against the companies that sold them auction rate securities, and on March 27, 2007, Citibank became the latest to be sued in a securities class action on behalf of investors for its sale of auction rate securities (see press release here and complaint here). The reduction of the carrying values of auction rate securities on investors’ statements will likely further bestir investors and could lead to even more litigation. But making no adjustments could create a different set of issues and lead to greater problems later.

The question of how best to reflect the valuation of assets for which there is no current market is one that potentially affect participants at all levels of the economy. And while there undoubtedly will be more lawsuits on behalf of investors against the companies that sold them the auction rate securities, a potentially greater litigation threat may arise from shareholders who may contend they were misled about a company’s balance sheet exposure to these kinds of assets. There could well be a great deal of litigation in which it is alleged, as asserted in the complaint in the MoneyGram case, that a company failed to disclose the “extent of its potential losses arising from its exposure to asset-backed securities containing uncollectible debt.”

The extent of the problem shall be revealed in the fullness of time. But meanwhile the subprime-related securities class action litigation still continues to accumulate. With the addition of the MoneyGram and Citigroup lawsuits, my running tally of subprime-related securities lawsuits (which can be accessed here) now stands at 61, 23 of which have been filed in 2008, and seven of which are filed on behalf of auction rate investors against the companies who sold them the securities.

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