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

The 2007 settlement of an Ontario securities class action may suggest the eventual direction of many of the lawsuits in the current subprime and credit crisis-related litigation wave. Even though the lawsuit was filed in a Canadian court and involved a company (FMF Capital Group Ltd.) whose shares traded only on a Canadian exchange, the lawsuit did arise from the early stages of the subprime mortgage meltdown in the U.S. And although the lawsuit preceded the current litigation wave, many of the allegations raised in the lawsuit have also arisen in the more recent U.S. subprime lawsuits.

 

Through an affiliate, FMF offered residential mortgages to subprime borrowers. According to the company (here), FMF originated mortgage loans throughout in 39 of the 50 United States and the District of Columbia. FMF resold packages of these mortgages to institutional buyers.

 

As summarized in a recent memorandum (here) written by NERA Economic Consulting, which served as the Ontario court’s damages expert and settlement consultant, in March 2005, FMF conducted a $197.5 million IPO. Following the offering, the securities issued in the IPO traded on the Toronto Stock Exchange. According to later news reports (here and here), the company apparently sought the Canadian listing as a way to obtain favorable treatment as a Canadian income trust.

 

In November 2005, just eight months after its IPO, FMF announced that it was suspending the monthly distributions due to investors in connection with its publicly traded securities. Within two trading days of the announcement, the company’s securities had declined 76.8% from their preannouncement price.

 

In January 2006, plaintiffs initiated a securities class action in the Ontario Superior Court of Justice against FMF and certain of its directors and officers, the offering underwriters, and FMF’s auditors. Background regarding the lawsuit can be found here.

 

As described in NERA’s memorandum, the plaintiffs alleged that the company "dismantled" its underwriting standards in order to maintain growth in its loan originations, and that the defendants concealed the company’s degraded underwriting standards and poor loan quality. FMF contended that its woes were due to industry-wide factors including interest rates and increased defaults, which undermined its ability to conduct securitizations and finance distributions.

 

According to co-counsel for the class (here), the class action ultimately was settled for over CAN$28 million. US$21 million of the settlement was funded by FMF’s insurers and by FMF’s privately-held affiliate. The remaining CAN$4.55 million of the settlement was to be paid by the IPO offering underwriters and FMF’s auditors.

 

According to NERA, the settlement, which the Court approved on April 11, 2007, is "the largest settlement in a class action securities case in Canadian history."

 

In addition to its status as the largest Canadian securities settlement ever, the settlement may be significant in a number of other respects as well, due to the circumstances surrounding the lawsuit.

 

That is, even though the lawsuit was filed in a Canadian court and involved a Canadian listed company, the lawsuit arose out of the meltdown in the U.S. subprime mortgage market. The claimants’ allegations about the lender’s deteriorating loan underwriting standards and poor loan quality, and the alleged failure to disclose these factors, are substantially similar to the allegations raised in class actions now pending in U.S courts against numerous other mortgage lenders. The company’s attempt to blame macroeconomic factors for its demise also mirrors the response of many defendants in the U.S subprime lawsuits.

 

Indeed, given these similarities, NERA described the FMF case as "the proverbial ‘canary in the coal mine’ for the current credit crisis." The similarities between the FMF case and many of the cases in the current subprime litigation wave suggest that the outcome of the FMF case could be a harbinger of things to come in the current subprime cases.

 

None of the securities lawsuits that have been filed in the current litigation wave have yet been settled, which makes the FMF lawsuit and its settlement at least potentially significant, for what it might indicate about the outcomes of the lawsuits in the current wave.

 

By my analysis at least, the FMF litigation settled for a fairly significant percentage of the company’s market capitalization loss. The company’s IPO raised $197.5 million at $10/share. The company’s share price declined by $5.21/share in the two days following the company’s announcement that it was terminating the income distributions. There undoubtedly are a number of ways the investors’ losses might be quantified, but by any measure, the eventual settlement of more than CAN$28 million appears to represent a significant percentage of alleged investor loss.

 

Because of the FMF lawsuit’s Canadian connection, litigants in the current U.S.-based subprime related litigation wave may or may not consider the case a relevant reference point. But to the extent it is relevant, the magnitude of the settlement as an apparent percentage of investor loss may point toward some very large settlements in the current U.S. subprime lawsuits, where the dollars involved are in many instances significantly greater than in the FMF case. Whether or not the FMF case does have significance for the eventual outcome of the current U.S cases, it is nonetheless interesting because the case has settled and been concluded while most of the recent U.S. cases are only in their earliest stages.

 

A prior post in which I discussed subprime related securities litigation in Canada, including a brief mention of the FMF lawsuit, can be found here.

 

More About Defense Expense and Limits Adequacy: In a prior post (here), I discussed the limits adequacy and program structure implications arising from the threatened depletion -- solely as a result of accumulating defense expense -- of the Collins & Aikman D&O Insurance program. As noted on the Race to the Bottom blog (here), counsel for one of the individual defendants has now advised the court that the remaining limits in the company’s $50 million D&O insurance program have been completely exhausted.

 

In his blog post, Professor Jay Brown of the University of Denver Law School, spells out what the depletion of the policy’s limits means for one of the minor defendants. The individual, Paul Barnaba, has now petitioned the court for the appointment of a legal aid attorney. Fortunately for Barnaba, it appears that his own counsel, whose fees previously had been paid by the now depleted insurance, is willing to accept the derisory legal aid fee rate. The other defendants may not be so fortunate.

 

The complete exhaustion of $50 million of D&O insurance solely through the accumulation of defense expense is a nightmare scenario for any director or officer. The individual defendants in the Collins & Aikman case, or at least those that are not independently wealthy, must now face serious criminal charges in a complex financial with only legal aid counsel to protect them. In addition, they continue to face significant civil litigation as well, again without any insurance remaining to fund a settlement.

 

As I noted in my prior post about the Collins & Aikman case, these developments may have important implications for traditional notions of limits adequacy. In addition, it is also clear that in order to make sure that individuals are not left to face serious litigation or even criminal charges without insurance, the consideration of alternative insurance structures should be an important part of every D&O insurance transaction.

 

They Stab it With Their Steely Knives, But They Just Can’t Kill the Beast:  The D.C. Circuit  rejected an attack on the constitutionality of SOX (here). OK, now everybody get back to work.

 

• Email This
• Print
• Comments
• Trackbacks
• Share Link

In arguably the most substantive ruling yet in a subprime-related securities class action lawsuit, Judge Ortrie Smith of the United States District Court for the Western District of Missouri, in a June 4 opinion (here) in the NovaStar Financial subprime-related securities class action lawsuit, granted the defendants’ motion to dismiss with prejudice.

The NovaStar lawsuit, which was first filed on February 23, 2007, was one of the first subprime-related securities class action lawsuits to be filed. Background regarding the lawsuit can be found here. The lawsuit alleges that NovaStar, a real estate investment trust, lacked adequate internal controls, as a result of which the company materially misstated its financial results and condition. The lawsuit followed the company’s February 20, 2007 announcement of disappointing results and deteriorating marketplace conditions.

Judge Smith granted the motion to dismiss on the grounds that the complaint does not adequately plead falsity and does not adequately plead scienter.

In addressing the falsity requirements, Judge Smith noted the PSLRA’s specificity requirements, and observed that the complaint, despite its over 100 pages and over 200 paragraphs “presents a very broad picture, and Plaintiff discusses his claims in generalities – precisely what the PSLRA counsels against.” This, Judge Smith said, allowed the Complaint to “create the illusion of detail and insinuate the existence of fraud, which in turn has made it exceedingly difficult for the Court to conduct the analysis required by law.”

After reviewing the complaint’s specific allegations of falsity and finding them each in turn to be inadequate, Judge Smith concluded that “ultimately, Plaintiff fails to identify a single false entry in the Company’s financial statements, nor does he identify the ‘truth’ that should have been disclosed.” Judge Smith goes on to add that the Complaint “reads more like a cautionary tale from a treatise on business management than a charge of knowing misstatements and concealments.” Companies, the court said, “are not expected to be clairvoyant and bad decisions do not constitute fraud.”

With respect to plaintiff’s scienter allegations, the court concludes that the plaintiff “had not presented facts creating an inference of scienter that is at least as strong as an inference that Defendants lacked fraudulent intent.” The court noted that the allegations are “more consistent with a company and executives confronting a deterioration in the business and finding itself unable to prevent it than they are with a company and executives recklessly deceiving the investing community.”

Judge Smith declined to allow the plaintiffs leave to replead, concluding it “would be futile,” since there is “no suggestion that any material was concealed or that any Defendant acted with fraudulent intent, and there is no reason to think further or different pleading will created the necessary inferences.”

The Court’s opinion is pretty much a clean sweep for the defendants, but it is hard to know what the larger significance of the opinion might be. There are few other subprime cases pending in the Western District of Missouri (for which the plaintiffs’ bar is undoubtedly grateful, given the outcome in the NovaStar case), and courts in other jurisdictions may or may attach weight to Judge Smith’s ruling.

One aspect of the opinion that could be significant if it represents the perspective with which other courts will view these cases, and that is the extent to which Judge Smith viewed this case through the screen of the generally deteriorating financial markets and business conditions. Other judges, like Judge Smith, may be similarly disinclined to find anything nefarious in a company’s failure to anticipate declining business conditions – at least in the absence of insider trading or other more compelling factors.

While there may be cases such as the Countrywide derivative lawsuit which courts may be predisposed to allow (about which refer here), there may be others, like the NovaStar case, where courts prove unwilling to infer wrongdoing from business reverses. At a minimum, the NovaStar opinion is a reminder that merely because a company’s fortunes have declined and the plaintiffs have filed a lawsuit does not necessarily mean that the plaintiffs will prevail or make any recovery. There may be more than a few of the cases filed as part of the subprime litigation wave that also fail to survive the initial pleading hurdles.

• Email This
• Print
• Comments
• Trackbacks
• Share Link

On January 22, 2008, National City Corporation, a Cleveland-based bank holding company, announced (here) a fourth quarter loss of $333 million, including a write-down of $181 million on its mortgage business and a $691 million provision for credit losses. On January 24, 2008, the company was hit with a securities class action lawsuit.

According to their January 24 press release (here), the plaintiffs' counsel filed a complaint (here) against the company and certain of its directors and officers in the United States District Court for the Northern District of Ohio.

According to the plaintiffs' counsel's press release, the complaint alleges that:

• Email This
• Print
• Comments
• Trackbacks
• Share Link