Mutual fund directors have been attacked before. For example, in his 2002 letter to shareholders of Berkshire Hathaway, Berkshire chairman Warren Buffett took a detour in an essay about corporate governance to express concerns about mutual fund directors. He noted that mutual fund directors effectively have only two “important duties”; to pick the fund manager and to negotiate the manager’s fee. The record of mutual fund managers pursuing either goal has been “absolutely pathetic.” The manager selection process for far too many funds has become a “zombie-like process that makes a mockery of stewardship.”


Within months of Buffett’s stinging criticisms, many participants in the mutual fund industry were ensnared in the so-called “market timing” scandal, in which it was alleged, among other things, that mutual funds were permitting trading in their fund shares after market close. In the wake of the market timing scandal, the mutual fund industry faced not only a great deal of scrutiny but also a wave of enforcement actions.


At least according to a March 25, 2013 Wall Street Journal article entitled “Fund Directors Are Feeling the Heat” (here), mutual fund directors are attracting attention once again. The Journal article was focused on the administrative proceedings that the SEC has filed against eight former members of the board of directors overseeing several Morgan Keegan mutual funds. The agency filed the administrative action, a copy of which can be found here, in December 2012. In its December 10, 2012 press release accompanying the filing, the agency said that the directors had “abdicated” their asset –pricing responsibilities.


The administrative proceeding relates to five Morgan Keegan mutual funds whose portfolios contained below-investment grade debt securities, some of which were backed with subprime mortgages. In its press release about the proceeding, the agency claims that the funds “fraudulently overstated the valuation of their securities as the housing market was on the brink of financial crisis in 2007.” The agency has previously charged the funds’ managers with fraud, and the Morgan Keegan itself agreed to pay $200 million to settle related charges.


The agency alleges that the directors delegated their fair valuation responsibility to a valuation committee without providing meaningful substantive guidance and made “no meaningful effort to learn how fair values were being determined.”


The Journal article reports that the parties to the administrative proceeding are in settlement negotiations, but in the meantime the proceeding is going forward. The Journal article notes that the directors met 30 times in 2007, including 14 times in three months, and received daily updates on the value of the five mutual funds they oversaw.


Regardless of how the administrative proceeding against the former Morgan Keegan mutual fund directors ultimately plays out, the proceeding is, according to the Journal article,  “making waves” across the mutual fund industry. According to a December 14, 2012 memorandum from the Debevoise & Plimpton law firm, the administrative proceeding against the Morgan Keegan directors represents “a stark warning to fund directors and all fund personnel charged with management or oversight duties that they need to take their responsibilities for overseeing fund management seriously, even with respect to the complex and technical area of asset valuation.” The action signals “the SEC’s willingness to charge senior officials for failing to ensure the fair valuation of hard-to-value securities.”


The SEC’s decision to pursue an administrative action against the fund directorsseems clearly calculated to send a message. The fact that the agency filed the administrative proceeding against the directors after it had concluded an enforcement action against the fund management company itself does seem, as the Debevoise law firm said in its memo, that the administrative proceeding was intended to serve as a “stark warning.”


The SEC’s action against the Morgan Keegan directors unquestionably is noteworthy, but it is far from the first instance where allegations have been raised against mutual fund directors in the wake of the financial crisis. There were in fact a number of private securities class action lawsuits filed against mutual funds after the subprime meltdown, and a number of these suits included the funds’ outside directors as named defendants.


For example, March 2008, investors in the Charles Schwab YieldPlus Funds initiated a securities suit alleging violations of the federal securities laws and seeking damages; the defendants in that action included the funds’ trustees. The federal litigation ultimately settled for $200 million (with an additional $35 million to settle separate but related state litigation). The consolidated subprime-related securities class action litigation involving several Oppenheimer mutual funds, and which also included the funds’ trustees as named defendants, ultimately settled for a total of $100 million, as discussed here.


Indeed, as discussed here, the Morgan Keegan funds themselves were also involved in separate securities class action litigation that included as named defendants the same individual outside directors as were named in the SEC administrative proceeding. The separate Morgan Keegan fund securities class action litigation ultimately was settled for $62 million (refer here). 


The SEC’s administrative action against the Morgan Keegan funds’ outside directors not only has important implications in general about mutual funds outside directors’ accountability. It also has important implications about the scope of their potential liability exposure. Together with the possibility of private securities litigation, the possibility of an aggressive SEC pursuing administrative actions or even enforcement proceedings against the outside directors of mutual funds underscores the fact that serving as a mutual fund director entails significant liability exposures.


The extent of the liability exposures in turn highlights the importance for the outside directors to confirm that the mutual funds maintain D&O liability insurance sufficient to ensure that the directors can defend themselves against all claims that might arise against them. As the circumstances surrounding the Morgan Keegan funds demonstrate, when adverse developments lead to claims, numerous claims involving numerous parties can be involved. This fact underscores the need to ensure that the mutual funds maintain insurance limits of liability that are sufficient to respond in the complex claims situations. Finally, the need to ensure that the sufficient funds remain to protect the outside directors when multiple claims arise underscores the need to makes sure that the insurance program is structured to provide that a portion of the D&O insurance is dedicated solely to the outside directors’ protection.


Securities Suit Against U.S.-Listed Chinese Company Settles: In 2010 and 2011, plaintiffs’ lawyers rushed to file securities suits in U.S. courts against Chinese companies with shares listed on the U.S. securities exchanges. However, the suits have not proven to be as remunerative as the plaintiffs’ lawyers might have hoped. As I noted in an earlier post, many of the cases that have settled have involved only very modest settlements.


A recent settlement in one of these suits might provide modest grounds for encouragement for the plaintiffs’ lawyers. On March 25, 2013, the parties to the securities class action lawsuit pending in the Southern District of New York against Sinotech Energy Limited filed a stipulation of settlement indicating that they had agreed to settle the case for a total of $20 million. (The settlement does not include the company’s auditor, Ernst & Young Hua Ming LLP). The settlement is subject to court approval. The parties’ settlement stipulation can be found here.


Though this settlement is more substantial than the prior settlements, it should be noted that Sinotech Energy’s contribution to the settlement is only $2 million. The remaining $18 million is coming from several offering underwriter defendants who were also named as defendants in the litigation. This outcome is in fact consistent with what many plaintiffs’ lawyers have told me about these cases, which is that while they hope to recover from the company defendants, their real hope for recovery is based on the attempt to try to recover from the outside professionals who helped the companies to go public. (I am guessing that the reason that Ernst & Young Hua Ming was not a party to this settlement may have something to do with the $117 million that Ernst & Young agreed to pay in the Ontario securities suit relating to Sino Forest; the plaintiffs may be hoping they can use that prior settlement as a “price of poker” indicator.)


Whether or not the plaintiffs can succeed in recovering from the outside advisors, they likely will have to set their expectations of recoveries from the Chinese companies themselves at modest levels. It isn’t just that the Chinese companies have not contributed significantly to the settlements so far; it is that apparently in many instances, the Chinese companies are not even paying their own defense lawyers. As reflected in a March 14, 2013 Reuters article entitled “Defense Attorneys in China Securities Cases Look for an Exit” (here), defense counsel in several of these cases involving U.S.-listed Chinese companies are seeking to withdraw from the cases because their Chinese clients are not paying them. It doesn’t bode well for any eventual recovery for the plaintiffs if the defendant company isn’t bothering to pay its own lawyers.


Special thanks to a loyal reader for sending me a copy of the Reuters article.


The M&A Litigation Problem: As anyone following recent litigation trends knows, litigation relating to M&A transaction has become a serious problem. If it is any consolation, the courts are working on it, at least in Delaware, according to Vice Chancellor Donald Parsons of the Delaware Chancery Court. In a forthcoming article entitled “Docket Dividends: Growth in Shareholder Litigation Leads to Refinements in Chancery Procedure” (here, Hat Tip to the Delaware Corporate and Commercial Litigation Blog), Parsons contends that the Delaware Chancery Court is developing tools to address the concerns associate with the M&A litigation.


According to Parsons, Delaware’s courts are best positioned to respond to this litigation, although, owing to the phenomenon of multi-jurisdictions litigation, it is can’t resolve all of the concerns. Those who are interested in Parsons’ views may want to review Alison Frankel’s tidy summary of the article in a March 26, 2013 post on her On the Case blog (here).


You Think Your Job is Tough?: Next time you are feeling that your job is too demanding or stressful, spend a little time considering this guy’s job.