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

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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