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

As reflected in their agreement filed on August 26, 2010, the parties to the New York and Delaware derivative actions involving former AIG CEO Maurice Greenberg, as well as certain other former AIG directors and officers, have agreed to settle the case for a payment to AIG by its D&O insurers of $90 million. The agreement also provides that the insurers will pay $60 million to Greenberg and Howard Smith, AIG’s former Chief Financial Officer, for their legal fees.

The settlement is subject to the approval of Delaware Chancery Court Vice Chancellor Leo Strine. Jef Feeley and Hugh Son’s August 27, 2010 Bloomberg article about the settlement can be found here.

This derivative lawsuit settlement follows AIG’s $725 settlement of a related securities class action lawsuit, and also follows the $115 million settlement in 2008 of a separate shareholders derivative lawsuit involving directors and officers of AIG.

Background

In 2004, the first of many separate shareholders derivative lawsuits (later consolidated) were filed in New York and in Delaware, against AIG as nominal defendant, and against numerous former AIG directors and officers, including Greenberg and Smith. The investors alleged that AIG insiders to misstated AIG’s financial performance in order to deceive investors about AIG’s financial condition.

The centerpiece of the lawsuit was an allegedly fraudulent $500 million reinsurance transaction in which various AIG insiders staged an elaborate artificial transaction with Gen Re Corporation. The complaint also alleged AIG insiders allegedly used secret offshore subsidiaries to mask AIG losses, misstated accounts with no basis for their adjustments, failed to correct well-documented accounting problems in an AIG subsidiary, and hid AIG’s involvement in controversial insurance policies that involved betting on when elderly people would die. The complaint also related to alleged bid-rigging allegations and alleged sale of illegal financial products.

In a lengthy February 2009 opinion, Delaware Vice Chancellor Leo Strine denied the motions to dismiss of Greenberg, Smith and certain other senior former AIG officials, although he granted the motion as to certain other individuals. Strine observed, among other things, "The Complaint fairly supports the assertion that AIG’s Inner Circle led a — and I use this term with knowledge of its strength — criminal organization. The diversity, pervasiveness, and materiality of the alleged financial wrongdoing at AIG is extraordinary."

Following further procedural wrangling and developments, the parties participated in a series of mediations involving retired Judge Layn Phillips, which resulted among other things in this settlement agreement.

The Settlement

The August 26 agreement seems to resolve all of the litigation involving all of the parties. However, the agreement is also not self-sufficient, as it is "conditioned upon execution of and compliance with a written settlement agreement under which the D&O carriers" pay the agreed upon amounts. I have not been able to obtain a copy of the separate insurance agreement and indeed the wording of the August 26 agreement suggests that at least at the time the August 26 agreement was drafted, the implied insurance agreement had not yet been drafted or fully executed.

The August 26 agreement does recite that the applicable insurance consists of AIG’s 2004-2005 D&O insurance tower, which has aggregate limits of liability of $200 million. The agreement does not identify the insurers in the tower or their respective limits of liability. The agreement also recites that the parties to the August 26 agreement have claims pending against the insurance tower in excess of its $200 million limit.

The agreement also states that the insurers "dispute that the D&O Insurance Tower is available to pay the claims made under the policies," but that the parties "desire to resolve their disputes regarding the appropriate allocation of their respective rights to the D&O Insurance Tower."

The agreement also incorporates certain understandings as the plaintiffs’ attorneys’ fees. Among other things, the agreement provides that the Delaware plaintiffs’ attorneys shall seek and the other parties shall not oppose attorneys’ fees of no more than 22.5% of the Settlement Amount (i.e. no more than $20.25 million) and no more than $1 million in expenses. The New York plaintiffs’ attorneys will seek a fee of no more than $2.5 million. If the two sets of attorneys were to realize the full amount of these fee awards and expenses, the net recovery to AIG from the settlement would be $66.25 million.

Discussion

There are a number of interesting things about this settlement. First, the cash payments specified in the agreement are to be funded exclusively with the proceeds of the D&O Insurance Tower.

Indeed, the Bloomberg article linked above quotes Greenberg’s attorney as saying that all of litigation by or on behalf of AIG again Greenberg "was settled with Mr. Greenberg paying nothing and other parties paying money to Mr. Greenberg." (This statement is probably worthy of an entire blog post some day all on its own.). Victor Li’s August 27, 2010 Am Law Litigation Daily article (here) about the settlement quotes the Delaware litigation lead plaintiffs’ attorney as saying that as a result of the settlement, $90 million is going to AIG that otherwise would have gone to Greenberg and other defendants based on a 2009 settlement between AIG, Greenberg and Smith, under which AIG agreed to reimburse up to $150 million of their legal fees.

While others can debate who gave or got what in this settlement, the bottom line is that the money for this settlement is coming entirely from insurance.

Without details about the separate insurance settlement referenced in the August 26 agreement, it is hard to know for sure, but it seems as if the $150 million of insurance funds exhausts the remaining funds under the D&O Insurance Tower, either by actual payment of loss or by compromise. (There obviously is some linkage between the $150 million total of payments in the August 26 agreement and the November 2009 agreement between AIG and Greenberg, but the precise connection isn’t apparent from the face of the documents I have seen so far.)

In addition to the fact that the August 26 agreement recites that the parties claims on the D&O Insurance Tower exceed the Tower’s $200 million aggregate limits of liability, another reason I assume that the Tower is actually or effectively exhausted is the interpleader action the primary insurer in this Tower filed against Greenberg and AIG, in order to avoid or resolve an arbitration dispute about priority rights to the proceeds of the $15 million primary policy. By interpleading the $15 million limits of liability, the primary insurer was effectively disclaiming any rights to those funds, indicating that those amounts at least consumed by claims costs. The next layers up above the primary insurance undoubtedly were also substantially eroded if not consumed by claims costs as well.

My final observation about the $90 settlement on behalf of Greenberg with AIG is that this represents yet another jumbo settlement of a shareholders’ derivative suit. There was a time when a derivative lawsuit settlement involving substantial cash payments was very unusual, but in recent years substantial payment of cash in connection with the settlement of derivative lawsuits has become increasingly common.

In addition to the $115 million settlement of the prior AIG derivative suit, other large recent derivative lawsuit settlements include the $118 million Broadcom options backdating related derivative settlement, the $122 million Oracle settlement and the $225 million Comverse Technology options backdating related derivative lawsuit settlement. It is particularly noteworthy that all of these payments are outside the insolvency context.

One consequence of this outbreak of jumbo settlements in derivative lawsuits is that the possibility that Excess Side A insurance might be called upon to pay loss – even outside of the insolvency context -- seems to be increasing. Certainly these massive settlements provide increasing evidence for the value to insureds of these kinds of insurance structures, whether or not the recent AIG settlement did or did not actually involve contributions from Excess Side A insurers. The increasing numbers of derivative settlements involving large cash payments certainly underscores that the Excess Side A insurers are exposed to potential losses -- even outside of the insolvency context -- an exposure that actually seems to be increasing over time.

Special thanks to Jef Feeley for providing a copy of the August 26 agreement.

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As the various subprime-related securities lawsuits have reached the motion to dismiss stage, some of the rulings have gone for the defendants and other have gone for plaintiff. Regions Financial Corporation experienced one of each kind of ruling in two separate cases involving allegations about the goodwill the company carried on its balance sheet as a result of its November 2006 acquisition of AmSouth.

As discussed below, the motion to dismiss was denied in the Alabama state court derivative suit, but the motion to dismiss was granted in the securities class action lawsuit pending in the Southern District of New York.

Regions Shareholders’ Derivative Lawsuit (Alabama)

Background

Plaintiffs filed their shareholders’ derivative complaint in May 2009 in Alabama (Jefferson County) Circuit Court against Regions, as nominal defendant, and certain current and former members of Regions’ board of directors. The complaint asserts claims against the company defendants for breach of fiduciary duty, corporate waste, and abuse of control. (The complaint asserts separate claims against the company’s offering underwriters and auditing firm for aiding and abetting and breach of professional duties).

The complaint’s allegations pertain to the company’s November 2006 $10 billion purchase of AmSouth and the alleged falsification of the company’s public statements and disclosure documents both during and following the transaction. The complaint principally focuses on the company’s disclosures between the time of the merger and the company’s January 2009 write down of over $6 billion of goodwill. Throughout that period, and despite the deteriorating real estate market, the merger allegedly was touted as a success, notwithstanding Regions’ acquisition of AmSouth’s exposure to the Florida real estate market.

According to the complaint in June 2008 the SEC questioned the company’s determination in its 2007 10-K that its goodwill balance was not impaired. Analysts also began to question this issue as well, but it was not until January 2009 that the company, as the Alabama court later put it "wrote down its goodwill and admitted that the value of its loan portfolio was billions less that [sic] what had been reported." The plaintiff alleges that the defendants knew of the true financial situation and misrepresented or concealed those facts.

The company defendants moved to dismiss on the grounds that the plaintiff had failed to make a pre-suit demand that the company itself bring the claims. The plaintiff countered that demand was excused.

The May 6 Ruling

In a May 6, 2010 order (here), Circuit Court Judge Robert S. Vance, Jr., applying Delaware substantive law and Alabama procedural requirements largely denied the defendants’ motions to dismiss, finding that the plaintiffs "have met their burden, at least at to the extent needed to establish demand futility at this point."

Judge Vance noted the widespread deterioration of the Florida real estate market, and also reviewed the duties of the board, particularly its audit committee, to consider critical financial issues such as goodwill impairment. Judge Vance noted that:

Given these duties along with the well-known and heavily publicized deterioration of the real estate market (especially in Florida) and the corresponding collapse in the credit market, and the letter received from the S.E.C. in June 2008, the members of the audit committee can fairly be said to confront a substantial likelihood of liability as a result of Regions’ failure to advise its shareholders prior to January 2009 that its financial situation was threatened.

Judge Vance also denied (in reliance on the Citigroup derivative lawsuit case) defendants’ motions to dismiss the plaintiffs claims for waste "to the extent that corporate waste allegations pertain to compensation issues specifically authorized by the directors."

However, Judge Vance found that the plaintiffs had failed to show enough to maintain claims based on an alleged failure to oversee Regions’ subsidiary, Morgan Keegan, holding that the plaintiffs "fail to show in what particular ways the Regions’ board has consciously failed to oversee the operations of its subsidiary."

Southern District of New York Securities Class Action Lawsuit

Background

As reflected in greater detail here, the plaintiffs first filed a securities class action lawsuit in the Southern District of New York against Regions on April 1, 2009. The plaintiffs represented investors that had purchased securities in the company’s $345 million April 2008 trust preferred securities offering. The defendants included the company, certain of its directors and officers, its offering underwriters, and its auditor.

The plaintiffs alleged that the April 2008 offering documents were false and misleading because they incorporated by reference financial statements that overstated goodwill and underestimated loan loss reserves. Among the financial statements incorporated into the offering documents was the company’s 2007 Form 10-K.

The complaint alleged that the company "did not write down any of the massive goodwill" it recorded in its 2007 10-K "despite growing evidence indicating that serious problems existed at the time of the acquisition." The complaint also alleges that Regions "only marginally increased its loan loss reserves" despite "the high risk of loss inherent in its mortgage loan portfolio."

The defendants moved to dismiss on the grounds that the plaintiffs had failed to allege any actionable misstatements or omissions.

The May 10 Ruling.

In his May 10, 2010 opinion (here), Southern District of New York Judge Lewis Kaplan granted the defendants’ motions to dismiss.

With respect to the plaintiff’s allegations regarding goodwill, Judge Kaplan concluded that "in the absence of particularized allegations that management believed that the goodwill figure was materially overstated, the amended complaint is insufficient as a matter of law."

In reaching this conclusion, Judge Kaplan noted that the goodwill was intended to reflect the excess of the acquisition price over the fair value of AmSouth’s assets at the time of the acquisition. He noted that the value of AmSouth’s loan portfolio "was not a matter of objective fact," as its loan assets were not traded on an efficient market, adding "nor has plaintiff pointed to any other objective standard of value." Given the lack of "any objective or readily determinable value," the question of the falsity of the goodwill presented in the offering documents is not a question of whether or not the value was wrong in some empirical sense, but whether or not the offering documents actually reflected management’s "honest opinion." Because the complaint did not allege that the goodwill did not reflect management’s opinion, the complaint’s allegations regarding goodwill were insufficient as a matter of law.

Even though the SEC’s June 2008 inquiry letter came two months after the April 2008 securities offering, Judge Kaplan expressly addressed the letter’ implications He noted that the SEC did not question the validity of Regions’ goodwill balance, but rather asked only for Regions to disclose how it determined that the goodwill balance was not impaired. Regions had responded that the goodwill reflected the fact that a potential buyer would offer a control premium for the business franchise. The SEC had replied that it had no further comments. Judge Kaplan concluded that the exchange with the SEC did not support an inference that Regions was aware that its goodwill was impaired at the time its alleged misstatements.

Judge Kaplan reached a similar conclusion with respect to the alleged insufficiency of Regions’ loan loss reserves, noting that the loan loss reserves are not a matter of objective fact, but rather were statements of opinion. He noted that the complaint is "devoid of any allegation that the defendants did not truly hold those opinions at the time they were made public."

Discussion

The difference in outcome of these two dismissal motion rulings is largely a reflection of the fact that the two courts were engaged in significantly different exercises. The Alabama court was determining only whether or not the requirement for pre-suit demand was excused based on the circumstances alleged.

Judge Kaplan was not only examining the legal sufficiency of the allegations, but he was also considering whether or not the complaint met the specific legal requirements for the specific claims alleged.

But the difference between these two opinions reflects more than the difference in the precise questions before the respective courts.

The two opinions also reflect strongly different starting points. Judge Vance in the Alabama case took it as a given that the residential real estate marketplace was rapidly deteriorating during the relevant time period, and that the deterioration was a relevant consideration. Judge Vance also considered the SEC’s letter relevant to whether or not the company’s financial statements were misleading due to the company’s delay in recognizing the impairment of the goodwill.

Judge Kaplan’s analysis seems to suggest that that these external considerations were irrelevant, and the only consideration was whether or not the offering documents accurately reflected management’s opinion about goodwill.

Judge Vance was, of course, concerned with a broader period of time and a broader range of communications than was Judge Kaplan. And unlike the plaintiffs in the securities fraud lawsuit before Judge Kaplan, the plaintiffs in the derivative lawsuit had expressly alleged knowing or reckless misrepresentation. Because the claims before Judge Kaplan were asserted under the ’33 Act, the plaintiffs in that case had not alleged knowing or reckless misrepresentation.

Accordingly, it might be asserted that the differences between the two opinions are simply a reflection of the differences in the facts alleged and the substantive difference in the claims asserted. That assertion might even be true. However, I find it very hard in reading these two opinions not to conclude that these opinions are best explained by the differences in the two Judge’s starting points. For Judge Vance, it was all about the external context. For Judge Kaplan, the context is irrelevant.

Just to round out the picture here, it is worth noting that in a March 9, 2010 order (here), Western District of Tennessee Judge Samuel H. Mays, Jr. denied the motion to dismiss in the Regions Financial subprime-related ERISA class action lawsuit. On the one hand you might say that this is yet another decision relating to the same set of circumstances, but it could also be argued that the ERISA plaintiffs have alleged a substantially broader array of misrepresentations. At a minimum, you can say that the dismissal motion rulings in the subprime-related cases involving Regions Financial Corp. are basically all over the map.

Once final note is that Judge Vance’s ruling may be significant due to the fact that it is a higher-profile subprime related derivative suit in which the complaint survived the initial motions to dismiss. This outcome stands in contrast to prior rulings in subprime-related derivative suits – for example, in the Citigroup derivative lawsuit (about which refer here) and AIG derivative lawsuit (refer here). Based on these rulings, a perception has been growing the plaintiffs are struggling in these cases.

Judge Vance’s holding that demand in this case is excused is a potentially significant holding, although its impact is likely to be limited both due to the somewhat case specific facts (including in particular the SEC’s June 2008 letter inquiry), and due to the fact that the ruling is the product of an Alabama state court applying Delaware law. These factors may restrict the impact of the case.

Nevertheless the May 6 order does represent an example where plaintiffs were able to overcome the challenging initial hurdles involved in shareholders’ derivative litigation.

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

Special thanks to several loyal readers for providing me with copies of the various Regions Financial rulings. .

E*Trade Subprime Securities Suit Dismissal Motion Ruling Denied: And speaking of subprime-related securities lawsuits in which the dismissal motions were denied, in another order dated May 10, 2010 (here), Southern District of New York Judge Robert Sweet denied the defendants' motion to dismiss in the subprime related securities suit pending against E*Trade and certain of its directors and officers.

As reflected in greater detail here, the plaintiffs had first filed their securities actions against E*Trade in October 2007, alleging that the company had failed to disclose deterioration in its mortgage and home equity loan portfolio. The defendants moved to dismiss, arguing among other things that the company's losses were the result of a "worldwide economic catastrophe" and the plaintiffs' claims were nothing more than "fraud by hindsight."

In denying the defendants' arguments, Judge Sweet rejected this "global meltdown" arguments saying that "because the issue in this action is what the Defendants knew and when they knew it, a securities violation has been adequately alleged." 

Andrew Longstreth's May 12, 2010 Am Law Litigation Daily article about the dismisal motion ruling in the E*Trade case can be found here. I have also added the E*Trade ruling to my running tally of subprime lawsuit dismissal motion rulings.

Reflection: Judge Vance is the eldest son of Robert Smith Vance, who served as a United States District Circuit Judge, first in the Fifth Circuit and later in the Eleventh Circuit. The elder Judge Vance is one of the few federal judges to be assassinated as a result of his judicial service. Judge Vance was killed by a mail bomb in 1989. Prosecutors later concluded that the bomb had been sent by a convicted criminal upset because the Eleventh Circuit had refused to expunge the conviction.

In memory of Judge Vance, the name of federal building and courthouse in Birmingham, Alabama as been changed to the Robert S. Vance Federal Building and United States Courthouse.

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In what is one of the largest ever shareholders’ derivative lawsuit settlements, the parties to the consolidated federal options backdating related derivative lawsuit involving Broadcom Corp. have agreed to settle the case for $118 million, to be funded entirely by the company’s D&O insurance carriers. The settlement does not include the company’s co-founders, Henry Samuels and Henry T. Nichols, III, against whom the suit will continue. As discussed below, the settlement has a number of interesting features, including certain details surrounding the insurers' settlement participation, particularly the substantial participation in the settlement of Broadcom's Excess Side A insurance carriers.

As reflected in Broadcom’s August 28, 2009 filing on Form 8-K (here), and the accompanying stipulation of settlement (here), the $118 million settlement, which is subject to court approval, is to be funded by the company’s D&O insurers and includes $43.3 million that "Broadcom had already recovered in connection with prior reimbursements from its insurers (subject to a reservation of rights that will be released upon settlement approval."

The stipulation also provides that in connection with the settlement Broadcom will pay plaintiffs’ attorneys’ fees and costs of $11.5 million.

There are a number of interesting things about this settlement. The first is its size. The settlement’s total value of $118 million would make this the second largest options backdating related derivative lawsuit settlement, exceeded only by the $900 million UnitedHealth Group options backdating derivative settlement (about which refer here and here).

Indeed, the $118 million settlement may be among the largest shareholders’ derivative settlements of any kind, exceeded or equaled only by a small handful of prior derivative settlements (including, in addition to the UHG settlement noted above, the $115 million AIG derivative settlement and the $122 million Oracle derivative lawsuit settlement).

These settlements are of course all dwarfed by the  $2.876 billion judgment entered against Richard Scrushy in the HealthSouth shareholders' derivative lawsuit, but that astronomical judment represents its own peculiar point of reference, like some odd parallel universe. 

But notwithstanding the settlement’s size, the net overall benefit to the corporation on whose behalf the lawsuit nominally was filed is an interesting issue. Not only is $43.3 million of the total settlement amount in the form of previously reimbursed defense expense, and not only is the settlement amount further reduced by the plaintiffs’ attorneys’ fees of $11.5 million, but the roughly $63.2 million remainder from the $118 million total is more than offset by litigation expenses the company has incurred in connection with the options backdating scandal.

As stated in the recitals in the separate Insurance Agreement (here) filed as an exhibit to the settlement stipulation, Broadcom has "advised the Insurers that it has claims for reimbursement exceeding $130 million in respect of the Broadcom Stock Option Matters, of which approximately $85 million remains outstanding."

Broadcom and its directors and officers were and are involved in a diverse range of lawsuits and claims as a result of the options backdating scandal, not just the shareholders derivative lawsuit. But the fact is that the remainder of the forthcoming cash settlement payment (after payment of plaintiffs’ attorneys’ fees) effectively represents only a partial offset of the company’s enormous options backdating related litigation expenses.

The corporation’s recovery of disputed legal expenses is unquestionably a benefit to the corporation, but how much additional litigation expense was generated along the way? It does seem to raise certain questions about the efficiency of the process. Indeed, in an August 31, 2009 American Lawyer article about the settlement (here), Susan Beck commented that "we’re still scratching our heads over this one."

The answer to the question of why the derivative lawsuit was a necessary vehicle to secure this extent of defense expense reimbursement from the carriers lies in the way Broadcom's D&O insurance was structured

The Insurance Agreement accompanying the settlement shows that Broadcom had a total of $200 million of D&O insurance, arranged in various layers, with $100 million of "traditional" D&O insurance, and an additional $100 million of Excess Side A insurance. Excess Side A insurance  only provides protection to individual directors and officers (and not to the company itself) and only against loss that is nonindemnifiable, whether due to insolvency or legal prohibition. This element of insurance for nonindemnifiable loss is critical to understanding this settlement.

The Insurance Agreement recites that the insurance carriers believed they had certain defenses to coverage, but that in connection with the settlement, these coverage issues were being compromised. In exchange for relinquishing these potential coverage defenses, the carriers each paid amounts less than their full policy limits, with each successive carrier contributing a correspondingly smaller amount.

The Insurance Agreement specifies the dollar amount each carrier is to contribute to the settlement. Among other things, the Insurance Agreement shows that the Excess Side A insurers will contribute a total of $40 million, with each of the successive Excess Side A carriers contributing a correspondingly smaller amount.

Given the number of carriers involved, the complexity of the coverage issues and the sheer quantity of dollars involved, the completion of this settlement is an extraordinary accomplishment. I tip my hat to all of the lawyers involved in putting this together.

The key to understanding the inner logic of this deal is to recognize that without the existence of a shareholders' derivative lawsuit against the individual directors and officers creating the type of nonindemnifiable loss that is the sole type of loss for which the Excess Side A policies provide coverage, the Excess Side A policies would not have been triggered.

The defense expenses incurred in connection with the other options backdating related litigation matters are presumptively indemnifiable. The company's payment of these indemnifiable amounts, in and of itself, would not have triggered the Excess Side A policies.

However, the derivative lawsuit's claim against the individual defendants for the harm to the corporation caused by the backdating includes claims on the corporation's behalf for the enormous litigation expense the company incurred due to the alleged misconduct. The settlement of the claims in the derivative lawsuit against the individual defendants to recoup the harm to the corporation was not indemnifiable, triggering a potential payment obligation for the Excess Side A carriers.

So if, for example, there had been no derivative lawsuit, and the company had, say, tried to recoup its defense expense from the carriers directly in a declaratory judgment action, the Excess Side A carriers would have taken the position that because there was no nonindemnifiable loss, their policies were not implicated. The derivative lawsuit, asserting nonindemnifiable claims against the individual defendants, triggered the Excess Side A policies, which ultimately contributed a total of $40 million toward the settlement.

The fact that the Excess Side A carriers are contributing so significantly to this settlement is particularly noteworthy. When the options backdating scandal first arose and the wave of derivative lawsuits began to flood in, it was a topic of discussion in the industry whether the options backdating scandal might be the event that would break through and produce significant aggregate losses for the Excess Side A insurers. Whether or not other options backdating claims have hit Excess Side A insurers, the Broadcom options backdating derivative lawsuit settlement certainly did, and the Excess Side A insurers’ $40 million contribution toward the settlement in and of itself makes this settlement a noteworthy event.

With jumbo derivative settlements now a more frequent occurence, Excess Side A insurers could begin to accumulate substantial claims losses. The rising tide of corporate bankruptcies as a result of the global financial meltdown could also produce significant Excess Side A claims losses ahead. Both developments underscore the value to policyholders of the inclusion of this kind of insurance within their D&O insurance program.

I have in any event added the Broadcom options backdating-related derivative settlement to my chart of options backdating related case resolutions, which can be accessed here.

Citigroup Subprime ERISA Class Action Dismissed: Following close on the heels of his dismissal of the Citigroup subprime-related derivative lawsuit (about which refer here), on August 31, 2009, Southern District of New York Judge Sidney Stein granted the defendants’ motion to dismiss the Citigroup subprime-related ERISA class action as well. A copy of Judge Stein’s August 31 opinion can be found here.

The plaintiffs had alleged that the defendants had breached their fiduciary duties under ERISA in a number of ways, most significantly by offering Citigroup stock as an investment option even though defendants knew or should have known that Citigroup was an imprudent investment. Among other things, Judge Stein held that the Plan itself required the Citigroup stock to be offered as an investment option and therefore the defendants had no discretion in that regard.

With respect to the plaintiffs’ allegations that the defendants had failed to give complete and accurate information, Judge Stein held that the defendants did not have an affirmative duty to disclose financial information about Citigroup because ERISA fiduciaries are not required to provide investment advice, and to the extent the defendants did provide information about Citigroup it was not in their capacities as ERISA fiduciaries, and, in any event, "plaintiffs have failed to allege facts showing that the defendants knew the statements were misleading."

I have in any event added the Citigroup ERISA class action dismissal to my register of subprime and credit crisis-related case resolutions, which can be accessed here.

Special thanks to Courtney Scott at the Tressler, Soderstrom law firm for providing me with a copy of Judge Stein’s opinion in the ERISA class action suit.

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Finacial Downturn, Not Fraud, Caused Plaintiffs’ Losses: In a ruling that is interesting for what it says about the relevance of the overall economic downturn to the wave of subprime lawsuits, on August 20, 2009, Eastern District of Pennsylvania Judge R. Barclay Surrick, Jr. granted the motion to dismiss the securities fraud lawsuit that Luminent Mortgage Corporate had filed against Merrill Lynch and related entities. A copy of the August 20 opinion in the case, which was filed solely on behalf of the named plaintiffs and not as a class action, can be found here.

In August 2005, Luminent had acquired $26 million worth of the most junior tiers of Mortgage Loan Asset-Backed Certificates that were backed by nearly $1 billion of underlying mortgage loans. Merrill and the related defendant entities underwrote, issued and sold the securities. Luminent acquired the securities as part of a complex transaction whereby Merrill had financed Luminent’s purchase and then held the securities as collateral, while Luminent retained the rights to the income stream from the certificates. As the court later noted, Luminent’ purchase of securities from the most junior layers represented a riskier investment, a consideration that clearly affected the court’s analysis.

In April 2007, Luminent reviewed a sampling of some of the underlying mortgages and found that several of the mortgages deviated from information about the mortgages Luminent had been given prior to the purchase transaction. Luminent contended that a result of these deviations, which allegedly showed the mortgages to be less secure than had been represented prior to the purchase transaction, the underlying mortgages were experiencing an unexpectedly harsh rate of default and delinquencies.

The investment performance on the certificates was so poor that in September 2007, Luminent demanded rescission of its purchase. After the defendants refused to rescind, Luminent filed suit under a variety of legal theories, among other things alleging that the defendants, in violation of the federal securities laws, had misrepresented the composition of the pool of mortgages and had misrepresented their due diligence in scrutinizing and selecting the mortgages. The defendants moved to dismiss.

Judge Surrick granted the defendants’ motion on several grounds. First, he held that the complaint did not adequately plead scienter, finding that the plaintiffs had not alleged facts sufficient to show that the discrepancies in the loan sample Luminent reviewed were the result of anything more than negligence. He also found that the plaintiffs’ theory of fraud was inconsistent with the fact that Merrill retained Luminent’s securities as collateral for the purchase loan, as a result of which any purported fraud would have harmed Merrill as well as Luminent.

Judge Surrick also granted the defendants’ motion to dismiss on the grounds that the plaintiffs had not adequately pled economic loss or loss causation. With respect to the economic loss issue, Judge Surrick found that Luminent did not hold the securities themselves and did not and could not have sold them at a loss, and he found further that the plaintiffs had failed to allege how their diminished income stream "can be distinguished from the market-wide losses in mortgage-backed securities generally."

This latter point, about the indistinguishability of the plaintiffs’ losses from market-wide losses is the most interesting aspect of Judge Surrick’s opinion. In similarly holding that the plaintiffs had not adequately alleged loss causation, Judge Surrick cited Second Circuit case law to the effect that "when the plaintiff’s loss coincides with a marketwide phenomenon causing comparable losses to other investors, the prospect that plaintiffs’ loss was caused by fraud decreases."

Though the Second Circuit case from this cited language is drawn is a RICO case, Judge Surrick’s opinion is the second recent decision in which a district court granted a motion to dismiss in a subprime-related securities class action lawsuit on loss causation ground in reliance on this language. As noted here, on August 5, 2009, District of Massachusetts Judge Joseph L. Tauro also granted a motion to dismiss in the subprime-related securities class action lawsuit pending against First Marblehead, citing the identical language from the Second Circuit.

In convincing courts to grant their securities lawsuit dismissal motions on loss causation ground in reliance on the language drawn from a RICO case, defendants seem to have hit on a formula that appears to be drawing a sympathetic judicial response – that is, the argument is that if the plaintiffs were harmed at all, it was due only to the global financial crisis, not to the defendants’ alleged misconduct. Given the magnitude of the economic downturn, which was nearly universally unanticipated, this argument could well be extended to many if not most of the subprime and credit crisis-related lawsuits. The extent to which the defendants are able to exploit this argument in other cases remains to be seen, but for now defendants seem to have established a significant formula for dismissal motion success in these cases.

Luminent’s directors and officers were themselves a target of a subprime-related securities class action lawsuit. (Luminent itself filed for bankruptcy in September 2008.) As noted in detail here, the Luminent securities lawsuit settled in December 2008 based on defendants’ agreement to pay $8 million.

An August 28, 2009 article in the Legal Intelligencer about Judge Surrick’s opinion can be found here.

Citigroup Shareholders’ Derivate Lawsuit Dismissed: In an August 25, 2009 order (here) that largely tracks the earlier dismissal of the related Citigroup derivate lawsuit that had been pending on Delaware, Southern District of New York Judge Sidney Stein, applying Delaware law, granted the defendants’ motion to dismiss the consolidated Citigroup derivative lawsuit, holding that "the complaint fails to allege with specificity facts showing that plaintiffs are excused from pre-suit demand."

The plaintiffs had filed their complaints, later consolidated, against certain directors and officers of Citigroup, in connection with the billions of dollars Citigroup had lost from its investments in mortgages and mortgage-related securities. The consolidated complaint alleged that the defendants should be liable for allowing Citigroup to invest in subprime mortgages; failing to disclose the extent of Citigroup’s exposure to subprime mortgages; approving a stock repurchase plan despite Citigroup’s subprime exposure; committing securities fraud for failed to adequately disclose the company’s subprime exposure; and engaging in or allowing others to engage in insider trading.

The allegations were similar to but not identical to the allegations in the separate Delaware derivate lawsuit. The Delaware action, for example and by contrast to the New York action, also contained a claim for waste based on the severance package awarded former CEO Charles Prince. The New York action, by contrast, contained claims not alleged in the Delaware suit based on securities fraud and insider trading allegations.

In concluding that the plaintiffs in the New York action had failed to establish that the pre-suit demand was excused, Judge Stein, applying Delaware law, largely followed (and expressly quoted from) Chancellor Chandler’s prior dismissal ruling in the Delaware case

The interesting part about Judge Stein’s opinion is with respect to the claims that were raised in the New York action but not in the Delaware lawsuit, and therefore with respect to which Chancellor Chandler did not rule in his earlier opinion.

Specifically, in concluding that the plaintiffs had failed to establish that demand was excused with respect to their derivative claim for securities fraud, among other things, Judge Stein concluded that the plaintiffs had not established that the defendants "face a substantial likelihood of liability of securities fraud." (If the faced such liability, then the plaintiffs’ pre-suit demand would be excused as futile.)

Judge Stein found that the plaintiffs’ complaint "fails to allege with specificity which statements plaintiffs contend are fraudulent," and that it does not "allege with specificity why any alleged misstatement is fraudulent." In addition, Judge Stein held, citing Tellabs, that the complaint "does not state with particularity facts giving rise to a strong inference that the defendants acted with the required state of mind."

While Judge Stein found that the plaintiffs had failed to show a substantial likelihood of liability for securities fraud, he was careful to note that his ruling related only to the allegations in the consolidated derivative complaint in this case, and not to the securities fraud allegations that may have been raised in other lawsuits involving Citigroup and the same or related circumstances.

Judge Stein expressed skepticism that the plaintiffs could cure their pleading defects, and therefore rather than simply allowing the plaintiffs leave to file an amended complaint, he required them to file a motion seeking leave. The plaintiffs’ motions are due September 14, 2009.

I have in any event added Judge Stein’s ruling to my register of subprime-related lawsuit dismissal motion grants and denials, which can be accessed here.

My prior post discussed the corporate waste allegations in connection with Charles Prince’s severance package in the Citigroup derivative lawsuit in Delaware, which allegations survived the initial motion to dismiss in that case, can be found here.

Plaintiffs Target Stanford Financial’s Outside Counsel: On August 27, 2008, former Stanford Financial investors claiming damages of over $7 billion filed a purported class action lawsuit in the Northern District of Texas against former Stanford Financial outside counsel Thomas Sjoblum and his law firm, Proskauer Rose. A copy of the plaintiffs’ complaint can be found here.

In an apparent attempt to circumvent the limitations of the Stoneridge case, the plaintiffs filed their aiding and abetting claims against Sjoblum and his firm under the Texas securities laws rather than under the federal securities laws. The plaintiffs also assert alternative legal theories under Texas law, including civil conspiracy, aiding and abetting civil conspiracy and respondeat superior.

Given the revelations of former Stanford CFO James Davis at his August 27, 2009 guilty plea, it may not be surprising that Sjoblum has now gotten drawn into the case. (In an August 27, 2009 post, here, the WSJ.com Law Blog details Davis’s revelations.) Among other things, Davis, in the factual recitations in his plea agreement, suggested that Sjoblum, in concert with Stanford officials, made representations to the SEC that were contrary to information he had been given about the company and its operations, including problematic characterizations of the company’s portfolio.

The extent to which the plaintiffs will succeed in imposing gatekeeper responsibility on Sjoblum remains to be seen. The interesting thing to me about the lawsuit is how unusual it is for the lawyers to have gotten dragged into the litigation. There have been very few instances (if any) where lawyers have become targets in the litigation arising out of the various other Ponzi scheme scandals or any of the collapses associated with the subprime meltdown and credit crisis. To my knowledge neither the Madoff scandal nor the subprime litigation wave drawn in gatekeeper claims against the lawyers involved in the underlying transactions, even though gatekeeper claims have been an important part of both related categories of litigation (primarily with respect to auditors, offering underwriters and rating agencies).

I have in any event added the lawsuit against Sjoblum to my running register of the Stanford-related lawsuits, which can be accessed here.

An August 31, 2009 National Law Journal article about the Sjoblum lawsuit can be found here.

Upcoming Directors and Officers Liability Conference: On November 30, 2009 and December 1, 2009, I will be co-Chairing the American Conference Institute’s Fifteenth Annual Advanced Forum on D&O Liability, in New York City. The program features an all-star cast of experts in the field on a wide variety of critical topics in the area. A copy of the agenda and registration information can be found here.

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Various blogs and news articles expressed surprise and astonishment at the $2.876 billion judgment entered against Richard Scrushy in the HealthSouth state court derivative lawsuit, but a review of the June 18, 2009 memorandum opinion (here) that accompanied the final judgment shows that Jefferson County (Alabama) Circuit Court Judge Alwin E. Horn III actually ruled that the total amount of the damages to be the even more eye-popping amount of $3.115 billion. It was only the application of $239 million credit for judgments entered against other defendants that brought the number down to the $2.876 billion figure ultimately entered against Scrushy and other individual defendants.

It may well be wondered how on earth the court could have come up with these astronomical figures, whether before or after the application of the judgment credit. Part of the answer is the fraud itself, with Judge Horn described as “remarkable and perhaps unique in its duration, size and scope.”

Judge Horn’s opinion details what he describes as HealthSouth’s fraudulently reported net income during the period 1996 through 2002. The annual figures stated in the opinion, when added up, suggest that HealthSouth’s fraudulently reported net income exceeded its actual net income by over $3.138 billion.

However, Judge Horn’s damage calculation was not directly related to the massive scale of the fraud. Rather, it was calculated based on a variety of separate categories of damages including: excess bonuses paid to Scrushy ($10.4 million); amounts Scrushy gained on inside trades ($147.4 million); amounts the company spent on remediation, reconstruction and restatement of its financial records ($457.6 million); amounts the company spent during the period 2004 to 2006 on excess debt, consent fees, bond and credit payments as a result of the fraud ($1.147 billion);salaries and bonuses paid to fraud participants ($26.5 million); excess payments and loans to Scrushy-related enterprises ($260 million) and HealthSouth’s overpayment of taxes ($169.6 million).

These amounts, as staggering as they are, add up “only” to $2.2 billion. The total damages Judge Horn calculated reached $3.115 billion by the application of nearly one billion dollars in prejudgment interest. In determining the amount of interest, Judge Horn calculated the applicable interest rate in varying amounts over time, applying Delaware law and using the standard of five percentage points above the Federal Discount Rate, resulting in interest rates applied in some cases of as much as 10%.

Judge Horn’s opinion does not state whether post-judgment interest will also accrue, but presumably there are provisions for this interest under applicable law.

Whether or not further proceedings or appeals ultimately will substantiate all of these damage amounts and interest assessments, Judge Horn’s analysis represents a fascinating catalog of the harm caused to the company as a result of the fraud, as well as the ways that Scrushy himself profited. It should probably be noted that the possibility of an appeal may be complicated by the rather interesting question of how Scrushy could post an acceptable and adequate appeal bond.

Judge Horn’s opinion makes for interesting reading in other respects as well, particularly the ways that Judge Horn went about reaching factual conclusions despite having to deal with competing and conflicting testimony from witnesses he described as “six testifying felons.”

Among other things, Judge Horn relied on Scrushy’s own testimony in a prior case (the MedPartners case), in which Scrushy testified about what financial information a CEO must receive. Judge Horn described Scrushy’s testimony as an “unwitting confession,” because it showed that “for a fraud of even a billion dollars to occur over a period of years, the CEO had to know of the fraud.”

Assuming for the sake of argument that the massive judgment against Scrushy withstands further review, if any, the question will then become what if anything can be recovered on the company’s behalf. Though at one time he was a wealthy man, years of litigation and the panoply of claims against him undoubtedly have greatly reduced his former wealth. He may have a multibillion dollar judgment against him, but that does not make him a multibillion dollar man. Nor does it seem likely that the company’s recovery will ever remotely approach the amount of the judgment.

A June 19, 2009 Law.com article by Ben Hallman providing the backstory on the state court derivative lawsuit can be found here.

From Those Incredibly Large Amounts to Some Incredibly Small Numbers: After working with figures in the billions, it is hard focus on a dispute involving only very small fractions of a dollar, but that is what is involved in the securities class action lawsuit filed on June 18, 2009 in the Eastern District of Arkansas against Shearson Financial Network and certain of its directors and officers.

As reflected in the their June 19, 2009 press release (here), the plaintiff’s purported class action complaint (which can be found here) alleges that the defendants

caused a press release to be issued on May 7, 2009, that stated the Company had emerged from bankruptcy. In the press release, the Company used the ticker symbol, SHSNQ to identify itself, which was the ticker symbol belonging to the Company’s old stock which would ultimately be cancelled. However, at the time the Company issued the press release the stock listed under the ticker symbol SHSNQ was still trading and had not been cancelled. As a result of defendants’ false and misleading statements, Shearson’s securities traded at artificially inflated prices during the Class Period, reaching a high of $.039 on May 8, 2009.

On May 11, 2009, the Company issued a press release stating among other things that the stock trading under the ticker symbol SHSNQ would be cancelled and that Shearson’s new stock would trade under a different ticker symbol.

The complaint alleges that following the issuance of the May 11 press release the share price fell to $.0097 on trading volume of over 27.6 million shares. (That is, the share price decline three cents per share). Later, all shares traded under the symbol SHSNQ were canceled, meaning holders of those shares “were left with nothing but losses.”

The plaintiff, who bought his shares at $.039 per share on May 8, 2009, purports to represent a class of purchasers who bought the SHSNQ shares during the five-day period between May 7, 2009 and May 12, 2009.

I know that there have been class periods shorter than five days. But I suspect there have been very few classes brought on behalf of share price declines as small as three cents a share. I was unable to determine how many of the SHSNQ shares actually traded on the open market, but even assuming a three cent per share loss on all of the 27.6 million SHSNQ shares that traded on May 11, the market cap decline was $810,000. Obviously, not everyone selling bought their shares at the peak and some sold before the entire three cent share decline accumulated, so the actual losses on those trades is almost certainly quite a bit below that amount.

The relatively small amount in dispute is of course no reason to forebear from filing the lawsuit; however, the absence of any allegations of scienter of any kind, in combination with the small amount in dispute, would have been enough to discourage most self-interested plaintiffs’ attorneys from enlisting in this case.

More Bank Closures: After the close of business on June 19, 2009, the FDIC announced the closure of three more banks, bringing the year to date total number of bank closures to 40. The FDIC’s complete list of failed banks, including the latest three to be added, can be found here. The three banks all had assets under $1 billion dollars, continuing the trend of closures in the community banking sectors.

One of the three banks was located in Georgia, bringing the total number of Georgia banks to fail during 2009 to seven, and the total since January 1, 2008 to 12.

My recent overview of the growing number of bank closures and the implications for the D&O insurance marketplace can be accessed here.

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