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

One feature of the recent changing mix of corporate and securities litigation has been the rise in the filing of follow-on derivative lawsuits in the wake of securities class action lawsuit filings. As Wilson Sonsini partner Boris Feldman recently noted, “like a moth drawn to a candle,” the derivative bar watches class action filings and “just cannot resist cribbing the class action complaints, even though the company’s setback does not suggest any breach of fiduciary duty.”

The rise in the number of follow-on derivative lawsuits seems to be attributable to the efforts of smaller or newer plaintiffs’ firms to try to get a piece of the action. The problem with these kinds of cases is that they just compound the defendant company’s litigation expense and threaten distraction from or even prejudice to the company’s defense in the class action suit – all as a result of a derivative action supposedly brought on the company’s behalf.

One way to try to reduce at least some of the potential evils associate with these follow-on suits would seem to be to stay the derivative suit until the securities suit has concluded. In many cases, the derivative plaintiffs agree to a stay. The question whether the court itself should order a stay of one of these follow-on suits was addressed in a January 27, 2012 Delaware Chancery Court opinion (here) in a derivative action involving SunPower Corporation.

The litigation arose after SunPower announced that it would have to restate its prior financials due to the underreporting of expenses at its Philippine manufacturing operations. Following these announcements, the company and several of its directors and officers were named as defendants in securities class action lawsuits (later consolidated) in the Northern District of California. The consolidated class action case was initially dismissed without prejudice, but the class action plaintiffs’ amended pleading survived the defendants’ renewed motion to dismiss. The court’s December 19, 2011 denial of the defendants’ renewed motion to dismiss can be found here.

Following the filing of the securities class action lawsuits, additional plaintiffs filed five derivative lawsuits in California state court, seeking indemnification from the individual defendants for any expenses the company incurs in the class actions. Those five California derivative actions were stayed by agreement.

However, yet another plaintiff filed a separate derivative action in Delaware Chancery Court, after having first exercised his rights to inspect the company’s books and records. The Delaware plaintiff contended that his access to confidential company documents has shown that the company had incurred million of dollars of costs, even before the class action lawsuits were filed, due to the accounting issues with the company’s Philippine operations.

The defendants moved to stay the Delaware plaintiffs’ action, arguing that proceeding with the derivative suit would prejudice the company’s defense in the securities suit. The defendants also argued that because the relief the Delaware derivative plaintiff seeks is largely contingent on the outcome of the securities suit, it would be premature for the derivative suit to proceed. The derivative plaintiff argued that because his filings were under seal, the defendants overstated the prejudice, He also argued that the because of the $8 million in expenses the defendants had already incurred in connection with the restatement, there were noncontingent damages ripe for adjudication.

In granting the defendants’ motion for a stay, Vice Chancellor Donald F. Parsons, Jr. concentrated on the overlap between the factual allegations in the class action lawsuit and in the derivative lawsuit. Both actions accused the individual defendants of having knowledge of the alleged wrongdoing or having ignored red flags. But, Parsons noted, the derivative plaintiff “makes these arguments on behalf of the corporation while the Securities Class Action plaintiffs make them against SunPower.”

Parsons said that “it is not practical for two actors … to pursue divergent strategies in two simultaneous actions on behalf of the same entity.” As a result, “simultaneous prosecution of both actions” would be “unduly complicated, inefficient and unnecessary.” The prosecution of the derivative suit would involve “taking actions designed to refute the merits of the Company’s defense of the Securities Action and vice versa.” This creates a “significant risk that the prosecution of [the derivative suit] will prejudice SunPower.” Parsons notes there is also a significant risk of inconsistent rulings.

Parsons also rejected the plaintiffs’ argument that the derivative suit was ripe for adjudication because at least a portion of the claimed damages are not contingent. Because the fill extent of the alleged damages cannot be known until the class action is resolved, “the wisdom as a practical matter of treating the indemnification claims as unripe until the liability for which the indemnification is sought is determined is plain.” Because the derivative claims cannot be adjudicated in full, the sensible ordering of events is for the class action to go first.

Accordingly, Parsons ordered the derivative suit to be stayed indefinitely, allowing the plaintiff to seek to have the stay lifted upon the earlier of the final dismissal of the securities class action or December 31, 2012.

Discussion

As discussed in a January 27, 2012 memorandum from the Morrison Foerster law firm (here), Vice Chancellor Parsons ruling provides “the clearest articulation to date of the danger follow-on derivative actions poste to corporations on whose behalf they are supposedly brought.” The ruling, according to the memo, “should prove a valuable guide to courts” trying to manage simultaneous derivative and class action litigation in the future.

The larger context for the problems Vice Chancellor Parson addressed is the increasing proliferation of conflicting litigation surrounding any type of corporate event. The phenomenon of multiple class action lawsuit filings following a stock drop has long been part of the corporate and litigation scene. These kinds of cases are more easily consolidated and managed. What has changed is increasing numbers of follow on derivative lawsuits, often, as here, filed in multiple jurisdictions, and which are not so easily consolidated or coordinated.

Just to quantify this problem and to proviide a little bit of historical context, in its 2011 securities class action litigation report, NERA Economic Consulting reported that the number of settled securities class action cases that were accompanied by parallel derivataive lawsuits has grown dramatically in recent years. NERA reports that prior to 2002 (when the Sarbanes-Oxley Act was enacted) the number of settled cases that were accompanied by a parallel derivative action ranged between 11 and 22 percent a year. However, from 2007 through the first half of 2011, the range was from 56 to 65 percent.

The threat of prejudicing the defense of the securities class action lawsuit is only one of the problems associated with the increase in follow-on derivative litigation. The proliferation of multiple simultaneous suits in multiple jurisdictions imposes a costly and vexatious burden on the companies involved. The SunPower case provides a good illustration of these problems. The Delaware derivative plaintiffs alleges that the company “is largely self-insured so that expense, settlements or damages in excess of $5 million in these actions will not be recoverable” under insurance. The costs associated with the derivative plaintiffs’ action simply add to this burden. As NERA noted in its year-end securities litigation report, in commenting on the phenomenon of folllow-on derivative lawsuits, "to the extent [the individual defendants] have indemnification agreements or continue to hold board or management positions, derivative litigation may prove expensive for the issuer." 

Unfortunately for the company, the derivative action has merely been stayed, not dismissed, which raises the question of what will happen in the future. The likelihood is that the class action lawsuit will settle at some point. (Yes there is a chance that it will be resolved on summary judgment, and an even smaller chance that it will be resolved at trial, but the greatest likelihood is that it will be settled.) Given the apparent limited amount of insurance available, the class action settlement will likely be modest. And if the case settles, the stipulation undoubtedly will include the usual defense disclaimers of liability or wrongdoing.

At that point, the stayed derivative litigation will finally be ripe. But at that point, the remaining insurance will almost certainly be gone. The derivative plaintiffs, without the benefit of any factual findings in the class action suit, will have to try to establish liability, forcing the individual defendants to incur additional defense expenses (which almost certainly would be advanced to the defendants under the company’s indemnification provisions), all to try to extract some payment out of the personal assets of the individual defendants. Given these factors, it seems highly probable that any ultimate recovery in the derivative suit – and therefore any benefit to the company – would be slight. But in the meantime, the company and its senior management are forced to endure the burden and expense of continued, redundant litigation.

There may be (infrequent) occasions where this kind of liltigation-about-litigation is not burdensome, vexatious and wasteful. Nevertheless, it is very hard to observe the expansion of this kind of follow-on derivative litigation with anything but alarm. If, as seems likely at least for now, this kind of litigation is going to continue to increase, it is going to be increasingly important for courts to develop rules of the road, if for no other reason to make sure that these suits do not further harm the very companies on whose behalf they supposedly are brought. That is the reason I think Vice Chancellor Parsons ruling is important, because it represents a practical recognition that the courts are going to have to police things to prevent the whole process from getting out of control.

I know that the plaintiffs’ attorneys behind these cases will argue that the cases are necessary to protect companies from the expenses the corporate defendants are forced to incur when alleged management misconduct leads to shareholder litigation. Other observers might perhaps more accuratey characterize these cases as nothing more than a vehicle by which the plaintiffs' firm involved is seeking to extract a fee.  I would argue that a better way to address the cost of litigation problem is through a prudent risk management approach including a comprehensive program of D&O insurance. If the company has an appropriate D&O insurance program in place, the class action litigation costs would not fall on the company, and there would be no even theoretical need for (or indeed any justification for) these types of follow-on lawsuits in most circumstances.

At least from the allegations Vice Chancellor Parsons recites in his opinion, it appears that this company carried only nominal amounts of D&O insurance. The amount and extent of litigation in which this company has become involved underscores the fact that in this day and age, well-advised firms should carry more than minimal amounts of insurance. Indeed, this case shows that in a changing litigation environment, traditional notions of limits adequacy may no longer be sufficient. The possibility that companies may have to be prepared to fund a multi-front defense suggests that companies may need more insurance than in the past in order to be fully protected.

A Dated Debate: We generally refer to the year 1901 as “nineteen-oh-one.” Similarly, 1909 is “nineteen-oh-nine.” But we refer to 1910 as “nineteen-ten” not “nineteen-and-ten.” My point here is that conversational conventions eventually tend toward to simplest and most economical expression.

In our current century, 2001 is referred to as “two thousand and one.” 2009 is referred to as “two thousand nine.” I suspect the convention will shift as the century progresses. For example, when we finally reach 2020 (if we do in fact make it that far), I feel quite certain the year will be referred to as “twenty-twenty” and not as “two thousand twenty.” Similarly, 2021 will be “twenty-twenty-one,” not “two thousand twenty one.”

Which brings me to the current year, 2012. Why do we refer to it as “two thousand twelve” rather than “twenty twelve”? I am not sure why, but “twenty twelve” is not in widespead usage. I feel quite certain that eventually we will all shift to the “twenty – “ formulation, just as a century ago, usage shifted to the “nineteen –“ custom.

Maybe it won’t be until 2020, but the “twenty –“nomenclature will eventually be the conversational way to refer to years during the current century. It may be too late now to change the way we refer to the current year, but it still may be possible to make some progress on this now.

As part of our forward-looking mission here at The D&O Diary, we would like to propose that we all get an early start on the rest of the century. Specifically, and with next year still a good eleven months off, we would like to respectfully suggest that everyone make a mutual commitment to refer to next year as “twenty-thirteen” rather than as “two thousand thirteen.” Why wait until 2020 to get on with the future?

I am sure many of you are wondering why I am so concerned about this. Here at The D&O Diary, we consider it part of our job to worry about these things so you don’t have to. Now remember, its “twenty thirteen,” not “two thousand thirteen.” O.K., everybody back to work.

There’s Nothing Quite Like a Real Book: Ironically, I first saw this video on my iPad. Ironically, it is a video about the magic of books. Irony notwithstanding, it is still a pretty cool video.

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The changing mix of corporate and securities litigation is a recent phenomenon on which I have frequently commented on this blog. While identifying the fact of the change is relatively straightforward, explaining it is more challenging. According to a January 11, 2012 article in The Review of Securities & Commodities Regulation entitled “Shareholder Litigation After the Fall of an Iron Curtain” (here), written by Boris Feldman of the Wilson Sonsini law firm, the changing pattern in corporate and securities litigation filings is a result of changes in the plaintiffs’ securities litigation bar – particularly, the elimination of a dominant plaintiffs’ firm. These changes, according to Feldman, have resulted in the five recent securities litigation trends he identifies in his article.

For many years, according to the article, the Milberg Weiss law firm was the “dominant securities plaintiffs’ law firm.” Even after it split into two separate law firms on the East and West Coasts, it was, according to Feldman, “the 800-pound gorilla of the shareholder litigation jungle.” In addition to dominating the litigation, the firm “exercised some discipline” on the rest of the plaintiffs’ securities bar, demonstrating “substantial influence over smaller firms and parvenus.”

Now, “for reasons of retirement and incarceration,” the familiar patterns of the past have been disrupted. Feldman analogizes this disruption in the standard order of the securities litigation world to the disruptions that followed in the political world in the wake of the fall of the Iron Curtain.

Without a dominant firm, smaller firms are now “free agents,” and new entrants have appeared. These smaller and newer players are “less predictable (and often less rational).” According to Feldman, these changes in the plaintiffs’ bar explain five trends in shareholder litigation he identifies in his article.

First, Feldman notes the recent rise in multi-jurisdiction litigation, where a single company can face multiple suits in different jurisdictions arising out of the identical factual circumstances. Feldman notes that although this might have happened from time to time in the past, when it did, the plaintiffs firms worked things out among themselves. But this is far less common now. Instead, firms that have “decided they have a better shot at participating in the litigation” have consciously chosen to file outside the company’s home jurisdiction, particularly in connection with shareholder derivative litigation. This multiplication of litigation has forced corporate defendants to have to defend themselves in multiple courts, resulting in added expense and uncertainty.

The second trend Feldman notes is the proliferation of demand letters. In the past, plaintiffs would bypass this statutory prerequisite to the filing of derivative litigation, out of a concern that the demand represented a concession that demand was not futile. More recently, however, demand letters have become “fashionable,” as secondary players, eager “to get in on the action,” will submit a demand even if derivative litigation has already been filed. Feldman notes that this may “actually be advantageous to defendants,” as courts will often stay derivative litigation while the defendant company considers the demand.

Third, Feldman notes the rise of derivative litigation paralleling shareholder class action lawsuits. In the past, the type of stock drop that would trigger a 10b-5 class action would not also spawn a derivative suit, at least in the absence of a major accounting problem and restatement. Now, parallel derivative suits are “de rigeuer.” The plaintiffs bar now “just cannot resist cribbing the class complaints,” even though the company’s setback does not suggest any breach by the company’s board. This change is attributable to a simple explanation: “different suits for different folks.”

The fourth trend Feldman notes is the automatic filing of litigation when a merger is announced. When “giants roamed the earth,” there was merger objection litigation, but not every single time a merger was announced. Now the litigation is pervasive and it follows a standard pattern of an initial suit alleging a breach of fiduciary duty after the deal is announced, followed by an amended complaint alleging disclosure violations after the proxy has been filed. The other change Feldman notes about this litigation is that in the past, the litigation went away once the deal closed, as the defendants defeated the preliminary injunction seeking to block the deal. Now the merger suits are increasingly surviving the closing, based on amended allegations that “range from weak to laughable.” Though few of these suits result in a payout, the plaintiffs’ lawyers “persist,” seeking “a place in the sun.’

Finally, Feldman notes the rise in actions under Section 220 of the Delaware Code seeking to inspect the corporate defendant’s books and records. Feldman says there has been more of this litigation in the past year than in all prior recorded history. In part this rise is due to encouragement from members of the Delaware judiciary. But this rise is also attributable to a cottage industry of plaintiffs’ firms eager to “get in on the action.” Defendant companies find these suits impossible to avoid; whatever they produce, the plaintiffs ask for more until they have “created an impasse and gotten a ticket to sue.” Feldman suggests that this “epidemic” of Section 220 litigation is “unlikely to be solved without intervention by the Delaware legislature.”

Feldman closes by suggesting that in the current, rapidly changing world, the “more fragmented world of plaintiffs’ securities lawyers will continue to amaze and surprise us with their innovation and resilience.”

Very special thanks to Boris Feldman for sending me a link to his article.

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A wave of litigation followed in the wake of the April 2010 Deepwater Horizon oil spill. Among this litigation were several shareholder derivative suits filed against certain directors and officers of BP and of its U.S. subsidiary. At the time these cases first arose, I asked whether or not these suits involving (and ultimately for the benefit of) an English corporation and even asserting claims under English law would be permitted to go forward in U.S. courts.  

A September 15, 2011 ruling from Judge Keith Ellison of the Southern District of Texas determined that, notwithstanding the fact that the Deepwater Horizon disaster took place in the U.S. and caused extensive environmental damage here, “the English High Court is a far more appropriate forum for this litigation,” and accordingly he granted the defendants’ motion to dismiss the cases.  Judge Ellison’s September 15 decision can be found here.

As discussed here, plaintiffs filed the first of several derivative lawsuits in connection with the Deepwater Horizon oil spill in May 2010. Though many of the lawsuits were first filed in the Eastern District of Louisiana, the cases were ultimately consolidated through the multidistrict litigation process in the Southern District of Texas. However, while the lawsuits were filed in U.S. courts, they asserted claims under the English Companies Act of 2006 (about which refer here). The defendants moved to dismiss the consolidated derivative litigation in the grounds of forum non conveniens.

In his September 15 ruling, Judge Ellison granted the defendants’ motion to dismiss. He summarized his ruling by saying that “this case is a shareholder derivative action brought under a recently enacted U.K. statute on behalf of an English Company against numerous English defendants and other foreign nationals.” The Court, he said, is “persuaded that the Complaint should be dismissed under the doctrine of foreign non conveniens, as the English High Court is the more appropriate forum for this case.”

Judge Ellison found that considerations of public interest “most strongly favor England as the appropriate forum in which to proceed with this case.” He noted that the focus would not be the events in the Gulf that led up to the oil spill, but rather the actions of the company’s board, which took place in England. He commented that “this lawsuit is not intended to redress the devastating impact of the Deepwater Horizon disaster in the Unites States. Instead the lawsuit is intended to compensate BP for the financial and reputational harm the company suffered as a result of its high level management’s alleged disregard for the safety of its operations.”

Judge Ellison noted that “the primary concern of this derivative litigation is the internal affairs of an English corporation, and the suit seeks to recover damages for the benefit of BP only.” He concluded that England “has a far greater interest in the resolution of this dispute.”

Judge Ellison was particularly concerned that were the case to remain in a U.S. court, the court would have to interpret and apply the recently enacted Companies Act. If the case were to go forward in a U.S. court, “the Court would be faced with the formidable exercise of interpreting and applying a still nascent and evolving body of law.”

Judge Ellison did condition his dismissal on the defendants proferring adequate proof that they are amenable to service of process in England or submitting a stipulation that the will submit to the jurisdiction of the appropriate English court.

Although the claimants clearly would have preferred to pursue their mismanagement claims against the BP officials in the U.S., where the disastrous oil spill occurred, Judge Ellison found that the allegations in this case involve alleged actions or inactions that took place in England. The fact is that though the shareholders chose to file their action here in preference to England, with full awareness that English courts presented an alternative forum. The decision to file here rather than there undoubtedly had something to with a perception that a court in closer proximity to the damages cause by the spill might prove to be a more receptive forum. The selection of a U.S. court over an English one also reflects the more general advantages a plaintiff enjoys here by comparison to English courts – for example, the absence in the U.S. of a “loser pays” model, among other things.

These kinds of advantages often encourage plaintiffs with claims involving non-U.S. companies to try to pursue their claims in U.S. courts. But the outcome of the dismissal motion in the BP derivative suit represents just one more example of the many ways prospective litigants are finding it increasingly more difficult to pursue corporate and securities claims against non-U.S. companies in U.S. courts. Courts interpreting the U.S. Supreme Court’s Morrison decision have significantly narrowed the circumstances in which securities claims involving foreign companies can go forward in U.S. courts. Judge Ellison’s decision in the BP case underscores the difficulties prospective claimants may fact in pursuing derivative suits involving non-U.S. companies here as well.

Alison Frankel’s September 16, 2011 Thomson Reuters News & Insight article about Judge Ellison’s decision can be found here. Victor Li’s September 16, 2011 Am Law Litigation Article about the decision can be found here.

For Whom the Statute Tolls: Under Section 13 of the ’33 Act, liability actions alleging a violation of the statue must be brought within one year of “discovery of the untrue statute or omission.” Section 13 provides further that in no event shall the action be brought more than three years after the security was first offered to the public. The one year provision represents a statute of limitation and the three year provision represents a so-called “statute of repose.”

Questions of statutes of limitation and repose might seem obscure, but they can often be critical in determining whether or not a case will go forward. A September 15, 2011 decision by Southern District of New York Judge Laura Taylor Swain in the Morgan Stanley Mortgage Pass-Through Certificates Litigation (here) presents interesting and potentially significant rulings on both the statute of limitations and statute of repose issues.

The case involves claims asserted by investors who purchased certain mortgage-backed securities issued by various Morgan Stanley related entities. The plaintiffs allege that the offering documents related to these securities misrepresented and omitted material facts regarding the underwriting standards applied by the loan originators. As detailed in Alison Frankel’s September 16, 2011 article in Thompson Reuters News & Insight (here), this lawsuit has a convoluted procedural history, in part due to the plaintiffs’ efforts to assemble a group of prospective class representatives whose claims were not time-barred. This latest dismissal motion round involved amended allegations and additional named plaintiffs. The defendants again moved to dismiss based on the statute of limitations and the statute of repose.

Judge Swain’s 40- page opinion reflects a number of interesting rulings, particularly with respect to the timeliness questions. First, she rejected the defendants’ arguments, based on information that was publicly available more than a year before the initial complaint was filed, that the claims of the Public Employees’ Retirement System of Mississippi (MissPERS) were untimely. Judge Swain said that though there was ample publicity on issues pertaining to circumstances relevant to the securities, none of the various items of publicity “addresses, even at a speculative level, the disregard of underwriting practices, neglect of appraisal standards, or consequent LTV ration misrepresentations alleged in the [amended complaint]”

Nevertheless, though she found that the early warnings were not sufficient to trigger inquiry notice, she also found that the plaintiffs had not alleged with sufficient specificity the time and circumstances of their discovery of the conduct alleged in their claims. Accordingly she allowed the plaintiffs leave to replead to establish the circumstances of their discovery in order to establish compliance with the one year statute of limitations.

Perhaps even more interesting is Judge Swain’s ruling on the question of the three-year statute of repose, and in particular her application of what is known as the American Pipe tolling doctrine. Under this doctrine, which derives from a 1974 U.S. Supreme Court opinion, the initiation of an earlier class action suit tolls the running of the statute of limitations for other purported class members who may later seek to intervene and represent the class. The application of the American Pipe tolling doctrine to the running of the statute of limitations is well established. A long standing question has been whether American Pipe tolling also applies to the statute of repose. Judge Swain held that American Pipe tolling does apply to the statue of repose, and denied defendants’ argument that the claims of certain new plaintiffs were barred by the statue of repose in the ’33 Act.

In holding that American Pipe tolling applies even to the three-year statute of repose, Judge Swain declined to follow two recent decisions by other Southern District of New York judges. She reasoned that the tolling doctrine is equitable in nature and “permits a court – after weighing the equities in the discrete case before it – to authorize plaintiffs to bring actions outside the limitations period.”

Judge Swain’s ruling about the statute of repose represents a potentially big deal. If followed by other courts, it could potentially be very significant in cases where an initial plaintiff’s purported class action is dismissed for the plaintiff’s lack of standing. Other prospective claimants who might want to come forward at that point might find their claims blocked by the statute of repose, if the initial filing did not toll the statute’s running.

This possibility is not merely theoretical, particularly with respect to the many mortgage-backed securities class action claims that have been asserted in the wake of the financial crisis. In many of these cases, the claimants have had some of their initial claims dismissed because the named plaintiff did not actually buy securities in all of the offerings in which the securities were sold. Judge Swain’s ruling, if followed, would remove one potentially significant impediment that might other wise exist for other prospective claimants who did buy securities in the other offerings and who might want to come forward and assert class claims on behalf of other investors who bought those securities.

The question is whether other courts will follow Judge Swain on these issues, or will follow the other two Southern District of New York decisions that recently went the other way and held that American Pipe tolling does not apply to the statute of repose.  In her September 16, 2011 Am Law Litigation Daily article about Judge Swain’s ruling in the Morgan Stanley case (here), Susan Beck identifies and links to the two other recent Southern District of New York rulings that Judge Swain declined to follow. She also speculates that the Second Circuit will likely weigh in on these issues, given that the two prior cases (which resulted in dismissals) are on appeal to the Second Circuit and have been consolidated for one hearing before that court.

Special thanks to a loyal reader for sending me a copy of Judge Swain’s decision in the Morgan Stanley case.

When Words Fail: Here in the blogosphere, the deadline is always right now. Because of the need for speed and the fact that I work alone (often late at night or very early in the morning), mistakes sometimes make their way into my blog posts. Because I don't the benefit of an editor's surveillance, I am always grateful when readers point out the errors to me, so that I at least have the opportunity to make a correction.

Massive media organizations publishing on a regular weekly basis with the benefit of a large editorial staff have fewer excuses for errors. For that reason, I am always appalled at the slips that make their way into print in some traditional print publications.

This week’s candidate for the boo-boo that someone really should have caught appears in the current issue of Time Magazine (cover date September 26, 2011). In an article entitled “After Three Years and Trillions of Dollars, Our Banks Still Don’t Work” (here, subscription required), Stephen Gandel writes, with reference to comments by analyst Meredith Whitney about the banking sector, “Eventually, Whitney says, growing litigation issues and a continued drop in housing market were bound to burst the levy.” I am pretty sure Whitney meant that eventually the “levee” was bound to burst, as a "levy" might be on a ballot or be imposed but I have never heard of one bursting. In addition, I feel pretty confident that if this were pointed out to Gandel, a “damn” would burst out as well.

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On May 25, 2011, In the latest example of shareholders suing a company’s board following a negative “say on pay” vote, two union pension funds filed a shareholders’ derivative action claiming that Umpqua Holdings Corporation’s board violated its duties to investor by approving the2010 compensation plan despite the negative shareholder vote.. The lawsuit follows the April 19 annual meeting of the bank holding company, in which about 62% of shareholders voted “no” in the advisory shareholder vote on the company’s 2010 executive compensation plan. The claims asserted in the lawsuit rely directly on the negative note.

Background

As I discussed in a recent post (here), Section 951 of the Dodd-Frank Act expressly requires all but the smallest publicly traded companies to hold an advisory shareholder vote on executive compensation. This requirement has already started to have an impact on executive compensation practices, as many companies are adjusting certain compensation practices to avoid a negative vote. However, while the vast majority of companies have received shareholder support for their compensation practices, there are still some companieswhose shareholders have voted “no” on the shareholder resolution regarding executive compensation. (At last count, according to The CorporateCounsel.net,  there were over thirty companies whose “say on pay” resolutions had received a negative vote from a majority of their shareholders).

Umpqua’s “Say on Pay” Vote

As reflected in the company’s April 22, 2011 filing on Form 8-K, Umpqua is among those companies receiving a negative say on pay vote. The 8-K reflects that about 62% of shareholders voted against the company’s executive compensation shareholder resolution.

The 8-K explains that the negative vote followed a recommendation from Institutional Shareholder Services (ISS) that Umpqua’s shareholders vote against the resolution. The 8-K states that ISS found a “disconnect” between the company’s 2010 executive compensation and the company’s pay-for-performance standards. The 8-K states that the company takes the vote “seriously” and that it is committed to pay-for-performance principles. Nevertheless, the company takes exception to the ISS’s “formulaic” approach which, the company contends, inappropriately viewed 2010 compensation only by comparison to 2009 compensation, when the company’s executive compensation declined 29%. The company contended that the 2010 compensation plan is reasonable in light of prior compensation and in light of the company’s overall performance, particularly relative to its peers.

The Lawsuit

On May 25, 2011, two union pension funds filed a shareholder derivative lawsuit in the District of Oregon against the company, as nominal defendant; against the company’s individual board members; against four company executives; and against the company’s compensation consultant, PricewaterhouseCoopers. The complaint alleges that the Board’s “decisions to increase CEO and top executive pay in 2010, despite the Company’s severely impaired financial results, were disloyal, irrational, and unreasonable, and not the product of a valid exercise of business judgment.”

The complaint further asserts that the board’s approval of the 2010 pay hikes “violated its own pay-for-performance policy and, as intended, favored the interests of Umpqua’s CEO and top executives at the expense of the corporation and its shareholders.”

The complaint attempts to use the negative say on pay vote to try  to avert  the defendants’ reliance on the business judgment rule. The complaint states that the “adverse shareholder vote on the 2010 executive compensation is evidence which rebutted” the usual business judgment presumption. The complaint further states with reference to the negative shareholder vote that the company’s shareholders “concluded, in their independent business judgment, that the Umpqua Boar’s 2010 CEO and top executive pay hikes were not in the best interest of Umpqua and its shareholders.”

The complaint asserts a claim against the directors for breach of the duty of loyalty; against the compensation consultant for aiding and abetting breach of fiduciary duties and breach of contract; and against the four executive officers for unjust enrichment. The complaint seeks an award to Umpqua for damages; a declaration that the shareholder vote “rebutted the presumption of business judgment”; disgorgement of the allegedly excess compensation and implementation and administration of internal controls and systems to prevent excess executive compensation.

Discussion

At this point, it seems clear that plaintiffs’ bar intends to try to utilize a negative “say on pay” vote, in at least some instances, to try to bootstrap claims for allegedly excess executive compensation. At one level, this is hardly surprising, because the negative vote does create the possibility of the board appearing to be acting contrary to shareholders’ views. And executive pay unquestionably is a hot button issue right now.

But on the other hand, the vote required under the Dodd Frank is expressly and explicitly an “advisory” vote. Congress could have made the say on pay vote binding. The fact that Congress did not make it controlling but rather left the vote as advisory clearly allows for the possibility that the company and its board retained discretion and might elect to act contrary to the shareholder vote without acting improperly. Indeed, Section 951 (c) of the Dodd Frank Act expressly states that the say on pay requirement should not be interpreted to alter any existing fiduciary duties or to create any new fiduciary duties. Congress seemed to be going out of its way to try to avoid having the say on pay process to add compulsion or  to the legal exposures of directors and officers.

Indeed, given the express statutory provisions to make the vote advisory and to try to prevent against having the vote add to directors’ legal exposures, it seems clear that Congress was hoping that the vote, and the threat of the vote, would cause companies voluntarily to adjust their compensation practices, -- not out of fear of liability but out of a desire to maintain the affirmative support of shareholders. Indeed, that in fact seems to be happening, as many companies have adjusted their practices in order to try to avoid a negative shareholder vote.

Despite Dodd-Frank’s express provisions designed to eliminate the possibility that the say on pay vote should alter the legal responsibilities of directors and officers, the plaintiffs in this case are seeking to rely on the negative say on pay vote to argue that the defendants are not entitled to the usual protections of the business judgment rule. The plaintiffs do not explain why a purely advisory vote, which by its own enacting provisions is not intended to alter or create additional legal duties, should nevertheless deprive the board of the usual protections to which they are entitled.

The lawsuit has only just been filed and it remains to be seen how it will progress. But it will be interesting to see if the plaintiffs are successful in having the defendants’ rights to rely on the business judgment rule suppressed.  

The company itself seems to think that the best defense is a good offense, as the company’s spokesperson is quoted in a May 27, 2011 Portland Business Journal article as saying with respect to the plaintiffs’ firm that brought the suit, “our understanding of this firm is they create fees by dragging the names of reputable companies through the mud.”

Our Solar System’s Family Album: A wide variety of probes and vessels have been cruising the planets, taking some amazing pictures in the process. The truly stunning highlights are compiled in a May 27, 2011 post (here), on the InFocus blog on the Atlantic Monthly’s website.

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In what is, according to news reports (here), the largest settlement to date in a shareholders’ derivative lawsuit in Delaware Chancery Court, four former AIG executives and former AIG managing general agent C.V. Starr today reached a $115 million settlement in the 2002 AIG derivative lawsuit.

The lawsuit was filed by the Teachers’ Retirement System of Louisiana in 2002 against AIG, as nominal defendant; certain former AIG directors and officers (many of whom were later dropped from the case); and Starr.

According to news reports (here), the plaintiff alleged that half of the $2 billion AIG paid C.V. Starr between 2000 and 2005 "represented sham commissions for work that, in some cases, was done by AIG employees." The lawsuit also questioned "why some executives were allowed to serve simultaneously as officers of C.V. Starr, a closely held insurance agency, while profiting from business between the two companies." The complaint also alleged that Starr gave the individual defendants bonuses on fees from AIG. In effect the complaint alleged that the commissions were a mechanism for the defendants to "line their pockets."

The case was scheduled to go to trial on September 15, 2008. The four settling individual defendants include former AIG Chairman and CEO Maurice Greenberg; former AIG CFO Howard Smith; former Vice Chairman of Investments Edward Matthews; and former director and Vice Chairman of Insurance Thomas Tizzio.

The vast bulk of the settlement -- $85.5 million – is to be paid by AIG’s D&O insurance carriers. A list of the carriers on AIG’s D&O program can be found here.

The more interesting question is where the remaining $29.5 million will come from. Some of the news reports give the impression that the individuals are funding the settlement. However, it appears that the individuals themselves are funding only a small portion of the remaining $29.5 million.

Greenberg’s counsel’s statements to the press (for example, here) are quite emphatic that Greenberg himself will not be contributing anything the settlement. One news report (here) does suggest that Tizzio "is expected to pay between $1 million and $5 million," Smith and Matthews "would pay very small amounts, if anything."

It appears that the bulk of the $29.5 million will be paid by C.V. Starr. According to Greenberg’s counsel, Starr "expects to contribute between $20 million and $30 million."

The details about who will be paying what seem surprisingly imprecise. In particular, the wide potential variance in Tizzio’s contributions seem odd to me, as even a wealthy individual generally would require a more precise determination of how many millions of his dollars are going to be required. Which makes me wonder whether perhaps Tizzio has an individual source of insurance that may be contributing on his behalf.

There are a variety of other odd features to this settlement, at least as it is described in the news reports, the most striking of which is that Tizzio apparently will be making a material settlement contribution but apparently Greenberg will not. To be sure, C.V. Starr, of which Greenberg is still Chairman and CEO, will be making a more than $20 million contribution, raising the question whether the amount of Starr’s contribution and the fact that Greenberg himself is not contributing to the settlement are linked.

And even with respect to C.V. Starr’s contribution, certain questions arise. For example, given the fact that some or all of the individual defendants apparently were also officers of C.V. Starr, is Starr’s D&O carrier funding some or all of Starr’s contribution to the settlement?

It should also be noted with respect to Starr’s payment to AIG that Starr is in fact AIG’s largest shareholder. As of July 15, 2008, Starr owned 10.5% of AIG’s outstanding shares, which represents Starr’s largest asset. Maybe that is just context, but it is an interesting context nonetheless.

I also have questions concerning the $85.5 million contribution from AIG’s D&O carriers. Beyond sheer curiosity about how much of AIG’s D&O insurance tower was depleted by defense expense, I also wonder whether the insurer’s settlement contribution to this derivative settlement drew upon the insurance program’s Side A coverage, which provides protection for nonindemnifiable loss. You would not expect the $85.5 million payment to AIG to be indemnifiable in the absence of insurance, so all else equal the amount would seem to represent a Side A loss. The same would also seem to be true with respect to the individuals’ own separate contribution to the settlement.

My question about which D&O policy coverage funded the settlement may require some context. Given the size of this derivative settlement, as well as other recent large derivative settlements (including, for example, the $50 million Hollinger derivative settlement), there seems to be a growing threat of very large derivative settlements, which is a relatively new development.

Many companies, particularly large financial services companies, often have D&O insurance programs built exclusively or predominantly of Side A-only protection. These kinds of programs have become increasingly common in recent years, but in general losses have really not yet caught up to this coverage to a significant degree.

The options backdating derivative cases presented the possibility of significant potential losses for these types of coverages, but it is my understanding that the Side A-only losses from these cases really have not yet significantly materialized. There has been speculation that the subprime litigation wave might also produce significant Side A losses, but those cases are only in their earliest stages yet, so the losses have yet to fully develop.

The possibility of derivative settlements of the magnitude of the recent AIG settlement may represent the most significant threat to these Side A programs and coverages, at least outside of the bankruptcy context. Which is why I am curious to know which policy coverage funded the AIG D&O insurers’ portion of the AIG settlement.

Finally, I am curious about how likely coverage issues were dealt with in connection with this settlement. I expect that the insurers would have raised the personal profit exclusion typically found in most D&O policies as at least a potential defense to coverage. I am guessing that the existence of this issue complicated the settlement process (or at least the insurers’ contribution to the settlement). The absence of a judicial determination that the individuals had improperly profited undoubtedly ameliorated this potential impediment. The individuals' desire to avoid any determination that might preclude coverage may have helped precipitate settlement on the eve of trial.

As always, I am interested if any readers can shed any light on the details. I am particularly interested details involved with the individuals’ contributions; around the extent of insurance funding for C.V. Starr’s contribution; and concerning AIG’s insurers’ contributions. Anonymity will be scrupulously protected.

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