Next Up: A Home Depot Data Breach-Related D&O Lawsuit?

By Kevin LaCroix on June 22, 2015

After claimants filed shareholders’ data breach-related derivative suits against the boards of Target (here) and Wyndham Worldwide (here), a number of commentators (including me) asked whether we could see a wave of cybersecurity related D&O lawsuits. Interestingly, since these two lawsuits were filed more than a year ago, there have been no further lawsuits of this type filed, even though there have been a number of very high profile data breaches since that time – including, for instance, those involving Home Depot, Sony Pictures Entertainment, Anthem (not to mention the massive breach last week involving U.S. government personnel records).

The absence of new data breach-related D&O lawsuit filings for over a year and the October 2014 dismissal of the Wyndham lawsuit (here) made a number of observers (including me) wonder whether the anticipated wave of D&O litigation might not materialize after all. (Although there are a number of commentators have continued to suggest that we should just be patient, the lawsuits will arrive sooner or later).

Though there have not been any further liability lawsuits filed, there have been developments that suggest we might soon see a lawsuit arising out of the Home Depot data breach. As discussed in a June 15, 2015 Law 360 article (here, subscription required), a plaintiff shareholder has filed an action in Delaware Chancery Court seeking to review Home Depot’s books and records related to the massive data breach the company sustained last year. (I do not have a copy of the plaintiff’s books and records complaint; if any reader can provide me with a copy, I will add a link to the complaint to this post. UPDATE: Thanks to the helpful response of a loyal reader, the complaint can be found here. )

The plaintiff reportedly seeks to inspect the records to determine whether the company’s directors and officers breached their fiduciary duties by failing to adequately protect customer credit card information on its data systems despite the many high profile cybersecurity problems that other retailers had previously experienced. The plaintiff apparently sent the company a request under Section 220 of the Delaware Corporations Code in September 2014. Two months later, in response to the request, the company produced over 500 pages of documents, but in her recent complaint, the plaintiff complained that this production was incomplete and that many of the documents were redacted. The company and the plaintiff’s attorney apparently had been in negotiations to arrange for the plaintiff’s counsel to review the redacted documents but apparently frustrated by the process the plaintiff filed the recent Delaware Chancery Court action to compel inspection.

The Law 360 article includes a statement from a Home Depot representative with respect to the books and records action that “we look forward to resolving the matter.”

The parties may (or may not) be able to work out the issues surrounding the books and records inspection, but it seems likely that in any event, the sequence of events eventually will lead to the filing of a liability lawsuit against Home Depot and its executives. Among other things, the plaintiff alleges in her books and records suit that “There is a credible basis to believe that officers and directors of Home Depot were aware of the risks that the company faced from a cyberattack but in breach of their fiduciary duties the board has failed in its responsibilities to implement systems and internal controls to properly protect the company from this threat,” and that “[T]he allegations of lax cybersecurity at the company, the pending government investigations, together with numerous lawsuits claiming misconduct at Home Depot, provide a credible basis from which mismanagement at the company can be inferred.”

It is clearly not too much of a stretch to suggest that the books and records action is merely prefatory to a later liability lawsuit that will be filed eventually. To be sure, there is always the chance that the lawsuit may not materialize, but just as the battle does not always go to the strong nor the race to the swift, that’s the way you bet. I am not a betting man, but if I were I would be that sooner or later we will see a D&O lawsuit related to the Home Depot data breach. Either way it will be interesting to watch and see what happens because it could tell us something about whether the much anticipated data breach-related D&O litigation will arise.

For an earlier post discussing the possible reasons why we have not seen data breach securities class action litigation so far and whether or not we may see these kinds of securities suits in the future, refer here.

São Paulo Scenes

By Kevin LaCroix on June 21, 2015

Posted in Travel Posts

The D&O Diary was on assignment in São Paulo last week, for meetings and for a little bit of a look around. I had never before been to Brazil, or for that matter, to South America. São Paulo turned out to be a bit of a revelation. For one thing, São Paulo, the financial capital of Brazil, is huge; with a population of about 21 million, São Paulo is the world’s 10^th largest city. For another thing, in the middle of June when I arrived, São Paulo was entering the Southern Hemisphere winter. My June visit to the city came just before the winter solstice. Many of the stores and shops were having festival de inverno sales while I was visiting.

Because the city is located at 23 degrees southern latitude — by way of comparison, Key West is at 24 degrees northern latitude — São Paulo winter does not involve frigid temperatures. In fact, on the day I arrived it was quite warm and sunny. Unfortunately for me, the sunshine did not last. Though I visited São Paulo during the dry season and in the midst of a record drought, it absolutely poured rain the first full day I was there, and much of the remainder of my visit was cooler and cloudy, as many of my pictures show.

Because São Paulo is so massive, it encompasses a multitude of different districts and neighborhoods. My hotel was located on a leafy, tree-lined street a block away from the Avienda Paulista (pictured right), a 1.7 mile thoroughfare lined with the headquarters of a large number of financial institutions, as well as an extensive shopping area and Latin America’s most comprehensive fine-art museum, Museu de Arte de Sao Paulo (MASP). The street also runs a strikingly philosophical course between two stations on Sao Paulo’s subway, the Metrô, from Paraíso (Paradise) to Consolação (Consolation).

The Metrô itself is quite impressive. It is clean, quiet, easy to use, and inexpensive (at current exchange rates, a single ride costs the equivalent of slightly more than one U.S. dollar). The Metrô can be quite busy at peak times (as shown in the first picture below) but it does make it possible to avoid the city’s congested roads (reflected in the second picture below). The Metrô also makes it possible to easily visit many of the city’s other districts and neighborhoods, including in particular Centro Histórico de São Paulo (or “Centro” for short), which, as the name implies, is the city’s historic center.

The city grew so quickly in the late 20^th century that few vestiges of the city’s earlier history remain, and almost all of the city’s most historical buildings are located in the Centro. The photo at the top of the post depicts the Cathedral da Sé, an early 20^th neo-Gothic revival structure that is in many ways the city’s heart. (However, given the general tenor of the crowd that inhabits the Praça de Sé in front of the Cathedral, I would suggest that most American tourists might want to allow pictures of the Cathedral to suffice). A warren of pedestrianized streets full of shops and cafes connects the Cathedral to the rest of the Centro.

The next pictures taken in the Centro, respectively, show the Teatro Municipal; the interior of the Mercado Municpal Paulistano; and the Estacão da Luz.

Though densely populated and urban, São Paulo has some magnificent parks. Right near my hotel was the Parque Tenente Siqueira Campos, universally referred to as the Parque Trianon, a little jewel of a park located directly across the street from the MASP. The Park, dense with native Brazilian plants and trees, some of which are said to be over 300 years old, is a reminder of the tropical rain forest that once covered much of the Brazilian coast.

To the south (from my hotel) was another beautiful park, the Parque Ibirapuera , which has the same urban oasis feel as Central Park. At 545 acres, Ibirapuera is one of the largest urban parks in South America, though it is smaller than New York’s 778 acre version. The view across one of the park’s large lakes is shown below. The park is laced with paths and trails.

In addition, there are several smaller (and a little bit more ragged) parks in the city center, including the Parque da Luz (which is pictured first below, and is just across from the Luz rail station pictured above), and the Parque da República, located adjacent to the Centro district.

There are many great reasons to visit Sao Paulo, but possibly the best is the food, which is absolutely phenomenal. I had several great meals while I was there, including in particular a memorable lunch on the day of my arrival, with my São Paulo hosts, Glaucia Smithson (of Zurich) and Marcus Smithson (of Generali), at the Jardineira Grill, a Brazilian barbeque in the Vila Olimpia neighborhood. The restaurant is a churrascaria; waiters move around the restaurant with skewers, slicing various types of grilled meat directly onto each customer’s plate. In the picture below, I am seated at the table and awaiting the first round of grilled meat, with Marcus on the left in the picture and Celso Soares (of Zurich) to my right. (Glaucia, who snapped this shot for us with my camera is, alas, not in this picture. Sorry Glaucia!)

I also had a great dinner with several industry colleagues at the Hotel Unique Skye Bar and Restaurant, the highlight of which was a wonderful dish of Filhote, an Amazon river fish. We toasted our gathering with a Caipirinha — the Brazilian drink made with cachaça (distilled spirits made from sugar cane juice), sugar, and lime — which has to be the best cocktail on the planet. But perhaps the most authentic and memorable meal I enjoyed in Sao Paulo was the bowl of feijoado, a traditional stew of black beans, beef and pork served with rice and cabbage, which I enjoyed for lunch Wednesday afternoon (the dish traditionally is served on Wednesdays and Saturdays for reasons no one could explain to me), as depicted in the picture below (the beans are in the bowl). When I tell you this meal stayed with me, you will I understand I mean that in more than one sense. I didn’t require any dinner that evening.

When I left Ohio to travel to São Paulo, the early summer sunset back home was well after 9 p.m. During my Sao Paulo visit, however, in the Southern Hemisphere early winter, the sun set was before 5:30 p.m. The abrupt shift in daylight hours was quite a shock to my system. My first evening in Sao Paulo, I found myself wandering in the unexpected early evening darkness in the streets near my hotel, feeling adrift and alone in the middle of a huge foreign (and now quite dark) city. Even though it was just after 6, I was about to call it quits and head back to my room when I came upon a street of lively cafes and bars, including one open air sports bar with outdoor seating and huge big screen TVs on the veranda. Purely coincidentally, as I walked up, the Copa America qualifying match between Brazil and Peru had just begun. I made my way into the crowded bar, ordered uma cerveja, and tried to blend into the crowd as they vocally registered every dribble, pass, shot, and goal in the game. (Only my closest family members would truly appreciate how, for me, stumbling upon the bar and the game was about as perfect of a development as could possibly have happened in the entire universe.)

During my visit to São Paulo, I was very self-conscious of my poor command of the Portuguese language. I know only a few phrases, so out of sheer self-defense, I kept my most useful Portuguese phrase at the ready – that is, não falo Português (I don’t speak Portuguese). As I was watching the Copa America game, a young man standing nearby started to speak to me, and more out of instinct than anything else, I quickly said to him, não falo Português. He looked at me sideways and said “Why in the world are you telling me you don’t speak Portuguese? Dude, I just spoke to you in English. I know you are American, you are the most American-looking person who has ever been in this place.” I recovered myself quickly, and introduced myself. It turns out that my new friend Luis had lived in Tampa for many years. He spoke perfect English. I bought him uma cerveja and we had a great conversation during the rest of the game.

As great as it was to become acquainted with São Paulo, the primary purpose of my visit was to attend and to participate as a speaker in the 3^rd Encontro Internacional de Linhas Financeiras (International Financial Lines Conference) of Federação Nacional de Seguros Gerais (FenSeg, the Brazilian national insurance association). It was my honor to participate in a panel with Marcus and Celso, to discuss the recent developments in the Brazilian D&O marketplace in the context of historical developments in the U.S. and U.K. D&O markets. It was a lively panel and a fascinating conference. The best part of all was to meet for the first time so many industry colleagues in Brazil and to find out how many of them read The D&O Diary. I have posted more pictures of the event below.

Here is a picture of Marcus, Celso, and me after our session.

Christopher Kramer (Zurich), me, and Victor Trapp (AON)

Christopher Kramer (Zurich), me, and Flavio Sá (AIG):

I wanted to be sure and include this picture (below) of Raquel Canossa da Silveira and Marco Antonio Mendes Miranda, both of AON in São Paulo. They had approached me during the lunch break to tell me how, as relatively new participants in the financial lines insurance market, they have found my blog to be an invaluable training source. Every now and then my energy for blogging starts to flag, but then when I meet some younger people in our industry like Raquel and Marco and they tell me how much they value the blog, I am completely rejuvenated. Isn’t it great that I sit in suburban Cleveland and write my little blog posts, put them out on the Internet, and then somehow my articles wind up getting read literally all over the world? It never ceases to amaze me.

I would like to thank Celso for inviting me to participate in the conference, for Glaucia for helping to make my participation happen in the first place, and to Glaucia and Marcus for being such good hosts during my visit to São Paulo.

More Pictures of São Paulo:

Here is the view looking south from my hotel room. This gives you a sense of how massive and sprawling São Paulo is. But do you see what is wrong with this picture, which was taken around Noon on the day of my departure? It is the sun – it isn’t in the picture. In the Southern Hemisphere, the afternoon sun is in the Northern sky, not (as is the case in the Northern Hemisphere) in the Southern sky. I suffered from massive solar disorientation throughout the visit, or at least I did when the sun was shining.

In a city as populous as São Paulo, even the pedestrianized streets are crowded.

A street fair on Avienda Paulista, near the Parque Trianon, the day I arrived.

Anhangabaú Square, in the Center City

As a final note, I feel I should acknowledge that while this most recent trip did take me below the equator during the Southern Hemisphere winter, I did have get the chance this past February to enjoy late summer in the Southern Hemisphere, in Australia (here) and New Zealand (here).

Guest Post: New York’s Highest Court Brings Finality to RMBS Repurchase Claims

By Kevin LaCroix on June 17, 2015

Posted in Securities Litigation

On June 11, 2015, in a closely watched case, the New York Court of Appeals, New York’s highest court, decided when the statute of limitations begins to run for claimants alleging breaches of the representations and warranties provisions in residential mortgage backed securities.

As Robert Fumerton and Alexander Drylewski of the Skadden, Arps, Slate Meagher & Flom law firm discussed in a prior guest post on this blog at the time of the oral argument in the case, the range of possible outcomes inthe case included an interpretation of the statute of limitations that could have led to a new wave of RMBS repurchase litigation that otherwise would be time-barred.

However, as discussed below, the Court rejected these more expansive possibilities. In the following guest post, the two Skadden attorneys discuss the June 11 decision of the New York Court of Appeals and examine the ruling’s implications. A version of this article previously appeared on Law 360 (here, subscription required).

A copy of the New York Court of Appeals June 11 decision can be found here.

I would like to thank Robert and Alexander for their willingness to publish their article as a guest post on this site. I welcome guest posts from responsible authors on topics of interest to readers of this blog. Please contact me directly if you would like to submit a guest post. Here is Robert and Alexander’s guest post.

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On June 11, 2015, New York’s Court of Appeals unanimously affirmed the Appellate Division, First Department’s decision in ACE Securities Corp. v. DB Structured Products, Inc. and held that New York’s six-year statute of limitations for breach of contract claims begins to run on the date that the RMBS defendant’s contractual representations and warranties were first made, not on the date of its refusal to comply with the parties’ agreed-upon remedy provision.

“Finality, Certainty and Predictability”

In a highly-anticipated opinion, the Court reaffirmed New York’s emphasis on the “objectives of finality, certainty and predictability that New York’s contract law endorses.” Among the key aspects of the decision was the Court’s conclusion that a defendant’s failure to comply with a contractual remedy provision is “not a separate and continuing promise of future performance” sufficient to defer accrual of the statute of limitations for breach of contract claims.

The Court stressed that “[a]lthough parties may contractually agree to undertake a separate obligation, the breach of which does not arise until some future date, the repurchase obligation undertaken by [defendant] does not fit this description.” The Court recognized that the representations at issue involved “certain facts about the loans’ characteristics as of” the date of the contract – “not a promise of the loans’ future performance” – and that “loans may default 10 or 20 years after they have been issued for reasons entirely unrelated to the sponsor’s representations and warranties.”

The Court also concluded that “[t]he Trust suffered a legal wrong at the moment [defendant] allegedly breached the representations and warranties.” Because the defendant’s obligation to repurchase was only a remedy for underlying breaches of representations, and not a substantive element of any breach claim, the Court reasoned that the remedial obligation was “a procedural prerequisite to suit” that did not delay accrual of the limitations period.

“Day 1 Breaches”

The Court’s decision was well reasoned. Indeed, the defendant’s representations and warranties were either true or false on the first day of the transaction – i.e., the date that they were made. As a result, any alleged breaches could only occur on Day 1 and the statute of limitations for breach of contract must expire six years from that date. RMBS representations and warranties typically relate to the characteristics of the mortgage loans, including the loan-to-value ratios and occupancy status of the underlying properties, as well as whether the loans complied with the applicable originator underwriting guidelines. These are static characteristics that cannot be altered or change in the future. Significantly, at oral argument, the trustee had no answer to the most critical question raised by the Court – namely, whether it could provide any example of a breach of representation or warranty that could occur after the transaction closed. The only specific example that the trustee offered was a situation where the borrower’s employment status was misstated on the loan application and later discovered to be false. But this is precisely the type of representation that is either true or false on Day 1 – a borrower’s employment status at the time of closing cannot later become false through subsequent events.

Rather than provide concrete examples of breaches that could occur after closing, the trustee emphasized that RMBS investors had no duty to conduct due diligence on the loans at issue and thus could not have discovered the breaches on Day 1. But this argument is, in essence, an attempt to import a “discovery rule” into New York’s statute of limitations. As the Court’s decision makes clear, New York case law is well-settled that the limitations period for breach of contract claims begins to run on the date of breach regardless of whether or when the plaintiff may have discovered the breach.

This principle is also reflected in N.Y. CPLR 206(a), which states that where a demand is necessary in order to institute a breach of contract suit, “the time within which the action must be commenced shall be computed from the time when the right to make the demand is complete” – not the time when demand is actually made. Indeed, in any breach of contract case, the parties understand that there is a risk that they will not discover any breach until more than six years after the date of contract. By focusing on the investors’ inability to discover potentially breaching loans, the trustee framed its position before the Court as contrary to long-standing New York law regarding statute of limitations accrual.

Preventing Open-Ended or Subjective Liability

The Court’s decision reinforces New York’s commitment to promoting certainty, predictability and finality in contractual matters by strictly applying the statute of limitations. Indeed, a contrary ruling would have twisted an agreed-upon remedy clause into a liability-enhancing provision, exposing RMBS defendants to nearly open-ended liability predicated on the plaintiff’s unilateral decision regarding when to make demand for repurchase. The Court’s application of a bright-line statute of limitations protects defendants’ reasonable expectations; at the same time, parties may bargain for additional contractual language giving rise to a separate and continuing obligation to repurchase. Such language – if sufficiently explicit – could protect investors for the life of the loans. As the Court recognized, “even though the result may at times be harsh and manifestly unfair, . . . a contrary rule would be entirely dependent on the subjective equitable variations of different Judges and courts instead of the objective, reliable, predictable and relatively definitive rules that have long governed this aspect of commercial repose.” Definitive rules like those endorsed by the Court can only help future commercial actors to reliably and efficiently structure their private affairs.

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— By Robert Fumerton and Alexander Drylewski, Skadden, Arps, Slate, Meagher & Flom LLP

Robert Fumerton is a partner and Alexander Drylewski is an associate at Skadden, Arps, Slate Meagher & Flom’s New York office.

Criminal Proceedings, D&O Insurance and Corporate Indemnities

By Kevin LaCroix on June 16, 2015

Posted in Indemnification and Advancement

Here’s the scenario: A former company CEO faces criminal charges for alleged bribery in which he was involved while he was at the company. The company’s D&O insurance provides funding for his defense, but the amount of the insurance available proves to be insufficient to take him through trial. The officer then seeks to have his former company indemnify him for his continuing defense expenses. The company refuses, saying that applicable law prohibits the company from indemnifying him for criminal matters until it is known whether or not the criminal proceedings will result in a guilty verdict against him. The former officer files an action against the company seeking a judgment declaring that the company must advance his defense expenses while the criminal action is pending. The trial court rules in his favor and the company appeals.

In an appellate ruling that may not be all that surprising but that nevertheless has some noteworthy implications, on May 20, 2015, the Supreme Court of Victoria (Australia) Court of Appeal held in the case of Note Printing Australia, Ltd. v. John Leckenby (here) that Leckenby had a “present entitlement to be indemnified prior to verdict.”

The court’s ruling is discussed in an interesting June 8, 2015 post on The FCPA Blog (here), written by Alistair Craig, a London commercial barrister. Among other things, the case shows the importance of corporate indemnities and also demonstrates the problems that can arise when the applicable D&O limits are insufficient to needs when they arise, a consideration that has obvious limits selection implications.

Background

John Leckenby was CEO of Note Printing Australia, Ltd. (NPAL) from September 1998 to June 2004. Along with other NPAL officers and NPAL itself, Leckenby has been charged with conspiring to bribe foreign officials to secure bank note printing contracts for NPAL. The trial in the criminal matter is expected to take place in 2015.

Leckenby’s legal costs had been being paid by NPAL’s D&O insurer. However, the D&O insurance policy’s limits of liability will be insufficient to meet all of Leckenby’s legal costs in defending himself through trial. He sought to have NPAL pay his legal costs pursuant to a separate Deed of Indemnity into which Leckenby and NPAL entered in 2001. The company refused to indemnify him on the grounds that is not permitted under the Australian Corporations Act of 2001 to indemnify him until it has been determined whether or not he is found guilty in the criminal proceedings.

Leckenby filed an action in the Supreme Court of Victoria Trial Division seeking a judicial declaration that he is entitled to have NPAL indemnify his continuing legal costs, unless and until he is found guilty, under which circumstances he agreed he would have to refund the amounts that NPAL paid. The trial judge upheld his present entitlement to be indemnified for his ongoing legal costs, holding among other things that the statutory provision on which NPAL relied does not specifically or directly address the question of costs prior to verdict. NPAL appealed.

The appellate court, in an opinion by Judge Pamela Mary Tate, reviewed the provisions of the indemnity agreement as well as the statutory provisions on which NPAL relied. The appellate court found that the conclusion that Leckenby had a present entitlement to have his legal fees paid unless and until his is found guilty to be consistent with the statutory provisions on which NPAL relied. The court found that Leckenby was not required to provide security toward any repayment he might later be required to make.

Discussion

The issues in this case turned on the particulars of a contract between Leckenby and NPAL and an interpretation of Australian law. It nevertheless presents a set of circumstances that would be familiar to the judicial officers of the Delaware Chancery Court – indeed, perhaps all too familiar, if the comments of the Chancellor in a recent case in the Delaware Court are representative.

As I noted here in a recent blog post discussing the rights of former Massey Energy CEO Donald Blankenship for the advancement of his defense fees in connection with the criminal proceedings pending against him, Chancellor Andre Bouchard began his opinion in the case (in which Bouchard ruled that Blankenship was entitled to have his fees advanced), by saying that the case involves an “all too common scenario” – that is “the termination of mandatory advancement to a former director and officer when trial is approaching and it is needed the most.” In other words, though the setting was different and though the interpretation of a private contract and of Australian law were involved, the case nevertheless involved the all too familiar scenario of a company seeking to avoid or limit its obligations to provide a former officer’s defense expense, at the very moment when it is needed the most.

As Alistair Craig noted in his blog post about the Australian Court’s decision, the “result of the case may not be surprising.” But it nevertheless does underscore some important points.

The first is that the D&O insurance potentially can be critically important when a company’s directors or officers find themselves in legal difficulties. Here, Leckenby and other former officers of NPAL face criminal bribery charges. Even though the case involved criminal proceedings, the D&O insurance responded to the claim. Unfortunately for Leckenby – and presumably for the other officers facing the charges — the amount of D&O insurance will not be sufficient to pay for all of the costs to be incurred in the crisis. The problem of the insurance’s insufficiency may not have been a result of inadequate limits. I suspect that the limits proved insufficient because of the fact that it was a criminal proceeding, and therefore it is likely that each of the individual former officers involved in the case had their own counsel. With multiple counsel defending their clients in an unquestionably serious situation, the policy limits were quickly eroded and will soon be exhausted.

There is a lesson here for anyone considering or advising others with respect to the sufficiency of limits in a D&O insurance program. D&O insurance is what is referred to in the insurance industry as a low frequency, high severity line of business. That is, the claims are not common but when they arise they are serious. The insurance can, as this case arguably demonstrates, serve as a form of catastrophe protection. In assessing whether any given insurance buyer’s insurance program is sufficient to respond in a catastrophe, it is not enough to imagine that serious claims may arise. It must also be considered that when the claim arises, there could be multiple insureds seeking access to the limits of liability. Because the limits are shared, they can be eroded quickly, as this case also demonstrates. This potential for rapid erosion because the limits are shared is an obviously an important lesson to be considered in any limits selection analysis.

It is probably worth noting as well that though the D&O insurance policy here is responding to fund the defenses at least until the policy limits are entirely exhausted, if in the end the criminal proceedings result in guilty verdicts against Lackenby or any of the other criminal defendants, the insurer likely would have the right to seek recoupment of any fees or costs it paid on behalf of any individual against whom a guilty verdict is entered (assuming here that the applicable policy contains language giving the insurer the right to seek recoupment) – just as NPAL will have the right to seek recoupment of any amounts it has paid.

As Alistair Craig noted in his blog post, “While it may be tempting for exposed officers to retain expensive and high powered legal services on the back of such cover, there could be a nasty financial sting in the tail if guilt is eventually conceded or ultimately established.”

For a recent post in which I discussed the insurer’s rights to seek recoupment of amounts paid, please refer here.

Year-to-Date Securities Suit Filings Disproportionately Involve Non-U.S. Companies

By Kevin LaCroix on June 15, 2015

Posted in Securities Litigation

Historically, non-U.S. companies listed on U.S. exchanges were sued in securities class action lawsuits less frequently than were listed U.S. companies. For several years now, according to NERA, non-U.S. firms have represented about 16% of all companies listed on the U.S. exchanges, but according to Cornerstone, for the period 1997-2013, the average percentage of securities class action lawsuits involving foreign firms was only about 11%.

While the longer term average suggests that foreign firms have a lower likelihood of being involved in a securities suit than listed U.S. firms, in several recent years this relationship reversed, particularly in 2011. While the percentage of lawsuits involving non-U.S. companies was roughly proportionate to their percentage of U.S. listing in 2012 and 2013, in 2014 the percentage of foreign firms hit with securities suits again was above the percentage of foreign firms listed on U.S. exchanges. This disproportionate involvement of non-U.S. companies in U.S. securities class action litigation has continued in 2015.

The more recent trend involving more frequent suits against foreign firms gained significant momentum in 2011, driven by a wave of lawsuits against U.S.-listed Chinese companies. Many of these Chinese companies had gained their U.S.-listing by way of a reverse merger, in which the Chinese company merged with a U.S. domiciled shell company that had a U.S. listing. According to my analysis, there were 55 securities class action lawsuits filed against non-U.S. companies in 2011, representing about 25% of all securities suits filed that year. Of those 55 suits involving foreign firms, 39 were directed against Chinese-based or Chinese-domiciled firms. Those 39 suits involving Chinese firms by themselves represented about 18% of all securities class action lawsuit filed in 2011.

The percentage of annual lawsuit filings involving non-U.S. companies has declined since 2011. In 2012 and 2013, respectively, 16.6% and 16.3% of securities lawsuit filings involved non-U.S. companies, a figure much closer to even with the percentage of non-U.S. companies listed on U.S. exchanges but still above longer term annual average of the percentage of securities suits involving foreign firms. In 2014, the percentage increased to 20%. This trend toward a disproportionate securities litigation involvement of foreign firms has continued again in 2015, at least so far.

According to my unofficial running tally of year-to-date securities lawsuit filings, there have been 82 securities class action lawsuit filed so far in 2015. Of those 82 lawsuits, 18 involve companies based or organized outside of the U.S., representing about 22% of year-to-date securities suit filings. Of those 18, nine involve companies based or organized in China, and additional suit involved a Hong Kong company. In other words, 12.2% of 2015 year-to-date securities suit filings involve companies based or organized in China or Hong Kong.

Four lawsuits filed just since May 19, 2015 are representative of these 2015 lawsuits involving foreign companies and involving Chinese companies.

First, on May 19, 2015, a securities class action lawsuit was filed in the Southern District of New York against Vipshop Holdings Limited, a Chinese online retailer, and certain of its directors and officers. The complaint, a copy of which can be found here, alleges that the defendants “made allegedly false and/or misleading statements and/or allegedly failed to disclose that Vipshop Holdings Ltd manipulated and overstated sales, receivables, profit, cash flows, and asset accounts including inventory and investments, that Vipshop Holdings Ltd’s financial statements contain GAAP violations by reporting revenue on a ‘gross’ basis, despite the fact that the vast majority of the company’s sales are under a consignment arrangement, that Vipshop Holdings Ltd’s internal controls over financial reporting were ineffective, and that as a result of the foregoing, Vipshop Holdings Ltd’s public statements were materially false and misleading at all relevant times.” A copy of the plaintiffs’ lawyers’ May 19, 2015 press release about the lawsuit can be found here.

Second, on May 28, 2015, a securities class action lawsuit was filed in the Central District of California against Yingli Green Energy Hold. Co. Limited and certain of its directors and officers. The complaint, a copy of which can be found here, alleges that the defendants “made allegedly false and/or misleading statements and/or allegedly failed to disclose that the Company was inappropriately recognizing revenue, that Yingli Green Energy Hold. Co. Ltd.had no reasonable prospects to collect on certain accounts receivable based on historical customer conduct, that Yingli Green Energy Hold. Co. Ltd. was no longer able to borrow from commercial banks to fund its operations, that the Company’s inability to raise additional capital or borrow funds from commercial banks threatened the Company’s ability to continue as a going concern, and that, as a result of the foregoing, Defendants’ statements about Yingli Green Energy’s business, operations, and prospects were false and misleading and/or lacked a reasonable basis.” A copy of the plaintiffs’ lawyers’ May 29, 2015 press release about the lawsuit can be found here.

The third of the four lawsuits is a securities class action lawsuit that was filed in the Central District of California on June 5, 2015 against China Finance Online Co. Limited and certain of its directors and officers. The complaint, a copy of which can be found here, alleges that on June 3, 2015, a report was published asserted among other things, that the most current SAIC records in China show that Chairman and CEO Zhiwei Zhao suddenly resigned from his positions at three key Chinese subsidiaries of China Finance Online Co. over the past few months; that Chinese media reports exposing the detention of China Finance Online Co. independent director Rongquan Leng prompted China Finance Online Co. to announce his resignation, without addressing his alleged detention; and that Ling Wang, a former long-time China Finance Online Co. director and associate of Zhao, fled China in 2014, leaving his company indebted to China Finance Online Co. for $25 million. The plaintiffs allege that following these reports, the company’s share price declined. The plaintiffs’ lawyers June 5, 2015 press release about the lawsuit can be found here.

The fourth is a securities class action lawsuit that was filed on June 8, 2015 in the Central District of California against Xunlei Limited and certain of its directors and offices, as well as the underwriters who managed the company’s June 24, 2014 IPO. The complaint, a copy of which can be found here, alleges the defendants “made false and/or misleading statements and failed to disclose the material risk that Xunlei’s strategic focus on Project Crystal and its mobility initiative would have a detrimental impact on the Company’s financial condition.” The complaint alleges that “when the truth emerged,” the company’s share price declined. A copy of the plaintiffs’ lawyers’ June 8, 2015 press release about the lawsuit can be found here.

It is significant that these four lawsuits involving Chinese companies have been filed just in the last few weeks. These filings represent something of a surge of suits against U.S.-listed Chinese companies in a short space of time, although at least so far nothing on the scale of the wave of suits filed against Chinese companies in 2011.

I selected these four lawsuits representative in that they involve Chinese companies. Just the same, however, it is a little difficult to generalize about the non-U.S. companies that have been sued so far this year and the reasons why these companies have been sued. For example, two of the companies sued – Petrobras (Brazil) and Sociedad Quimica y Minera de Chile, S.A. (SQM, of Chile) – were hit with securities suits after bribery allegations involving the companies surfaced. Others, like the suits against Xunlei (mentioned above) and CHC Group Limited (Cayman Islands) involve IPO companies.

But while it may be difficult to generalize, the point is that at least so far the 2015 securities lawsuits disproportionately have involved non-U.S. companies. This obviously is an important consideration for foreign companies that have or are considering a U.S. listing. It is also an important consideration for D&O underwriters outside of the U.S. that are underwriting non-U.S. companies that have U.S. listings. These underwriters are well aware of the heightened risk that these companies have as a result of their U.S. listings. The fact is, however, that these U.S.-listed non-U.S. companies not only have a heightened risk, but their U.S. securities litigation exposure may be even greater than that of publicly traded U.S.-domiciled companies.

Delaware Legislature Passes Fee-Shifting Bylaw Prohibition — What Questions Remain?

By Kevin LaCroix on June 14, 2015

Posted in Shareholders Derivative Litigation

In a late night session on June 11, 2015, the Delaware House of Representatives overwhelmingly passed S.B. 75, which prohibits Delaware stock corporations from adopting “loser pays” fee-shifting bylaws and which confirms that Delaware corporations may adopt bylaws designating Delaware courts as the exclusive forum for shareholder litigation. The bill, which previously passed the state’s Senate, now goes to Delaware Governor Jack Markel for his signature. The bill provides that the changes will be effective August 1, 2015. A copy of the bill can be found here.

The dust-up in Delaware over fee-shifting bylaws got started in May 2014, when the Delaware Supreme Court in the ATP Tours, Inc. v. Deutscher Tennis Bund case upheld the facial validity of a bylaw provision shifting attorneys’ fees and costs to unsuccessful plaintiffs in intra-corporate litigation. This development quickly caught the eye of litigation reform advocates, as the adoption of fee-shifting bylaws seemed to offer a way for companies to reduce the costs of and possibly curb burdensome litigation. At the same time, however, shareholder advocates became concerned that these types of bylaws could deter even meritorious litigation.

The controversy that followed over fee-shifting bylaws seemed headed for a swift resolution when the Delaware General Assembly quickly moved to enact on a measure that would have limited the Supreme Court’s ruling to non-stock corporations (meaning that it wouldn’t apply to Delaware stock corporations). However, as discussed here, the legislature tabled the measure until the 2015 session.

While the proposed legislation was pending, institutional investors mounted a concerted effort in support of legislative action in Delaware “to curtail the spread of so-called ‘fee-shifting’ bylaws,” while business groups conducted a campaign opposing the legislation.

During the period while the legislation remained pending, a number of companies went ahead and adopted some version of a fee-shifting bylaw. Alibaba, one of 2014’s highest profile IPOs, was among several companies that completed offerings during the year and that adopted fee-shifting bylaws.

When the legislation recently was taken up again by the Delaware legislature, it quickly sailed through both houses – there was only one vote in opposition to the legislation when submitted to the Delaware House of Representatives.

The legislation itself does a number of things, but it does two basic things with respect to corporate bylaws.

First, the legislation invalidates a provision of either a certificate of incorporation or of a bylaw of a Delaware stock corporation that purports to impose liability upon a stockholder for the attorneys’ fees or expenses of the corporation or any other party for an “intracorporate claim” (These new restrictions do not apply to nonstock corporations.)

Second, the legislation confirms that the certificate of incorporation and bylaws of the corporation may specify that intracorporate claims must be brought only in the Delaware courts (including the federal court in Delaware). The provision also invalidates a provision that “may prohibit bringing such claims in the courts of this State”

For purposes of both of these provisions, the term “intracorporate claims” is defined to mean claims arising under Delaware’s statutory laws, including claims of breach of fiduciary duty by current or former directors or officers or controlling shareholders of the corporation, or persons who aid or abet such a breach.

While the legislation addresses the question of whether or not Delaware stock corporations validly may adopt fee shifting bylaws, other questions remain.

First, as detailed by Professor John C. Coffee, Jr. in a recent post on the CLS Blue Sky Blog, the Delaware legislation prohibits bylaws only to the extent they apply to “intracorporate disputes.” According to Coffee, as the term “intracorporate disputes” is defined in the legislation, it “does not clearly cover securities class actions (which need not and generally do not allege any fiduciary breach).” The result, according to Coffee, is “an unnecessary ambiguity and likely underinclusion, as federal antitrust, securities and related fraud actions (e.g., RICO) are not seemingly reached. Thus, fee-shifting bylaws could apply to these types of actions, unimpeded by the new statute.” So, at least according to Coffee, “this story has another chapter or two to go, and eventually the SEC will need to take a stand.”

Second, the legislation does not expressly address other types of litigation reform bylaws. For example, the legislation does not appear to address so-called minimum-stake-to-sue bylaws. As discussed here, these types of provisions require, for example, shareholders to deliver written consents representing at least three percent of the company’s outstanding shares in order to bring a class action or derivative suit. Others may also try to argue that the legislation does not address mandatory arbitration bylaws, requiring shareholders to arbitrate intracorporate disputes – however, those opposing the adoption or imposition of an arbitration bylaw may cite to the forum selection bylaw portions of the new statute, which invalidate bylaws that prohibit bringing intracorporate claims in Delaware’s courts. The argument would be that an arbitration bylaw runs afoul of this provision because it prohibits bringing claims in the Delaware courts.

Third, the Delaware legislation obviously applies only to corporations organized under the laws of Delaware. It has no effect upon corporations domiciled elsewhere. Alibaba, mentioned above, is organized under the laws of the Cayman Islands, and so the new Delaware legislation has no effect on Alibaba’s fee-shifting bylaw. The laws of other jurisdictions may vary from those of Delaware. Indeed, the Oklahoma legislature has adopted a provision mandating the shifting of fees in derivative suits. The Oklahoma provision specifically applies to derivative suits “instituted by a shareholder” where there is a “final judgment.” In those circumstances, the court “shall require the non-prevailing party or parties to pay the prevailing party or parties the reasonable expenses, including attorney fees . . . incurred as a result of such action.”

Finally, at least one commentator has asked whether Delaware’s adoption of this legislation, which eliminates the availability of fee-shifting bylaws as a way for the state’s corporations to deter expensive intracorporate litigation, will cost Delaware in its competition with other states as the preferred location for company incorporation. In a June 11, 2015 post on the Real Clear Markets blog (here) former SEC Commissioner Paul Atkins suggests that Delaware’s adoption of the legislation, together with aggressive moves by other states to attract incorporations, “could be the straw that breaks Delaware’s position as the destination of choice.”

The Delaware legislation clearly takes much of the wind out of the sails for the effort in support of fee-shifting bylaws. But there still may be more of the story about litigation reform bylaws to be told. The question of whether or not fee-shifting bylaws can be applied to litigation other than Delaware “intracorporate litigation” will have to be sorted out, and there undoubtedly will be efforts to advance other types of litigation reform bylaws, such as the minimum-stake-to-sue bylaws. And there could be contrary development in other states. I strongly suspect we will all be hearing more about litigation reform bylaws, including perhaps even more about fee-shifting bylaws.

Break in the Action: Due to my travel schedule over the next several days, there will be interruptions in The D&O Diary’s publication schedule through next week. The D&O Diary’s regular publication schedule should resume by the end of next week.

Here’s Something Really Big: Insurance in China

By Kevin LaCroix on June 12, 2015

Posted in International D & O

As I learned during my recent visit to the country, just about everything about China is big. It is the world’s most populous country. China leads the world’s economic growth by size and speed. It is also one of the world’s largest and fastest-growing insurance markets. According to a June 10, 2015 Law 360 article entitled “A Primer on Insurance Underwriting in China” (here, subscription required) by Jiangxiao Hou, Qiamwei Fu and Jose Umbert of the Zelle Hoffman Voebel & Mason law firm, China not only has the world’s second largest economy by GDP, but it has the world’s fourth largest insurance market, and by 2020 it is expected to become the world’s third largest insurance market (following the U.S. and Japan).

In other words, China represents a tremendous opportunity to the global insurance industry. Those of us involve in working with policyholders on their insurance requirement find on almost a daily basis that increasing numbers of companies and firms located throughout the world operations or exposures in or related to China that require insurance solutions. For that reason, it is going to be increasingly imperative for just about everyone, regardless of geographic location, to develop some familiarity with the insurance environment in China. The insurance market in China has a number of important characteristics, with implications from a regulatory, underwriting and claims handling perspective. And as the memo’s authors note, “certain customary practices in Western countries to not necessarily have the same ramifications.”

First, the key characteristics of the Chinese market. The regulatory framework is, according to the memo’s authors, “constantly evolving.” The regulatory regime involves laws issues by the National People’s Congress, regulations issued by the State Counsel, and “a myriad of rules and guidelines issued by the Insurance Regulatory Commission [the CIRC].” The CIRC is the primary insurance regulator, and has issued voluminous insurance regulators.

A critical consideration for the global insurance industry, the Chinese insurance regulations provide a legal person or entity in China can only obtain domestic coverage from an insurer registered with the CIRC. In addition, insurance companies with a 25 percent or more of foreign shareholdings are deemed “foreign-invested” and are subject to more detailed regulations, particularly with respect to ownership, product offerings and product applications, branch approvals, reporting and disclosures.

From an underwriting perspective, the insurance regulations provide detailed requirements for the registration of insurers and for product and rate filings. Insurance forms, insurance clauses and premium rates for many insurance products must be approved by the CIRC before use. The insurance regulations also contain requirements analogous to the “plain English” requirements applicable in many states in the U.S., specifying that an insurer is required, for example, to “clearly explain” exclusion provision, with the proviso that an exclusion provision that is not properly explained will be voided.

A basic principle of Chinese Insurance law is the “good faith requirement.” This requirement applies to both insurers and policyholders. From an underwriting perspective, the good faith requirement applies to the application process and requires an applicant to “make an honest disclosure” in response to an insurers inquiry (although the principle is limited only to the specific matters about which the insurer inquires, and the burden is on the insurer to prove the scope of its inquiries). An insurer has a right to cancel a policy if an applicant intentionally or in gross negligence fails to make an honest disclosure. Where the nondisclosure is intentional, the insurer it not liable to pay indemnity; if the nondisclosure is grossly negligent and the matter not disclosed has an effect on the insured event, the insurer is not required to pay indemnity but must return the premium.

The good faith principle also applies to both the insurer and the insured in the claims handling process. The policyholder must provide claim information in a timely and truthful way, consistent with the requirements of the good faith principle. If a policyholder lodges a fraudulent claim, the insurer has the right to terminate the insurance contract. For the insurer, the insurance regulations specify a structured schedule for claims adjustment, which is also subject to the good faith principle.

The insurer must make a “timely” coverage determination, which in complex cases (and absent a provision in the policy to the contrary) is presumed to be within thirty days of completion of gathering all claims-related information. The determination of when information gathering is complete is subject to the good faith principle. The regulations also specify when payment must be made once the claims determination process is complete.

The authors note that “certain customary practices in Western countries do not necessarily have the same ramifications in China. For example, in many Western countries it is a standard practice at the outset of a claim for the insurer to issue a letter reserving its reserving its coverage defenses and in particular reserving its right to deny coverage for the claim should information uncovered in the course of claims handling reveal a basis for doing so. This practice is not a customary practice in China and “there are no legal ramifications to the issuance or nonissuance of a ROR.”

In short, China presents significant opportunities but it is critically important for those participating insurance transactions in China to understand both the requirements for disclosures in the underwriting process and the requirement for information and timeliness in the claims handling process.

D&O Liabilities in China: The potential liabilities of corporate directors and officers are of course dependent on the requirements of applicable law. That means that corporate officials’ liability exposures can vary from state to state. There are even greater variations from country to country. In a global economy, questions about the potential liability of directors and officers in non-U.S. countries arise with increasing frequency. Given China’s huge and growing role in the global economy, questions about the potential liability of directors and officers under Chinese law are increasingly frequent.

For that reason, readers may be interested in reviewing this May 8, 2015 article entitled “D&O Liability Insurance: Legal Issues under PRC Law” (here) by Jia Hui of the DeHeng Law Offices. The article provides a good overview of the basic legal duties and liability exposures of directors and officers under Chinese law. As the article points out, in light of the various accounting scandals involving Chinese companies that have arisen, these considerations are increasingly important.

EPL Risk and Applicant Background Checks: On an entirely different note, Inside Counsel has an interesting June 11, 2015 article about the rising numbers of EPL claims arising out of employer background checks (here). According to the article, “these lawsuits present an unanticipated and significant exposure for insurers.” The article, which is clearly written from the insurer perspective and has insurers in mind, says that insurers “protect themselves by including specifically targeted exclusions that should eliminate this exposure altogether.”

From my perspective, given the apparently rising importance of these types of claims, it will be very important for policyholders to ensure that the EPLI carriers do not include exclusions precluding coverage for these types of claims.

D&O Insurance: Debtor-in-Possession Claims and the Insured vs. Insured Exclusion

By Kevin LaCroix on June 9, 2015

Posted in D & O Insurance

The traditional Insured vs. Insured exclusion found in many D&O insurance policies is a frequent source of claims disputes, particularly in the bankruptcy context. As its name suggests, the Insured vs. Insured exclusion precludes coverage for claims brought by one Insured against another Insured. The typical Insured vs. Insured exclusion includes a provision (often referred to as a coverage carve-back) that preserves coverage for claims brought by a trustee in bankruptcy or by other representatives of the bankrupt estate.

While this carve-back provision broadly preserves coverage for many types of bankruptcy-related claims that might arise against the current or former directors or officers of a bankrupt company and that might otherwise be excluded by operation of the Insured vs. Insured exclusion, there is one type of claim that can arise for which the typical policy language does not preserve coverage – that is, a claim against the company’s former directors and officers brought by the bankrupt company as debtor- in- possession.

Along those lines, a June 5, 2015 decision by the Third Circuit, applying New York law, affirmed a district court ruling that a lawsuit initiated by a bankrupt company as debtor-in-possession against certain of its former directors and officers was precluded from coverage by the Insured vs. Insured exclusion in the company’s D&O insurance policy. A copy of the Third Circuit’s opinion can be found here.

Background

Robert Redmond was an officer of Industrial Enterprises of America, Inc. (“IEAM”). In 2009, IEAM filed for bankruptcy protection. In 2011, IEAM, acting as debtor-in-possession, brought an adversary proceeding against Redmond and certain other former IEAM executives and employees alleging that they had engaged in a fraudulent scheme to manipulate IEAM’s share price. In 2013, a Chapter 11 trustee was appointed to pursue IEAM’s claim.

Redmond sought to have IEAM’s D&O insurer fund his defense in the adversary proceeding. The insurer took the position that coverage for the claim was precluded by the policy’s Insured vs. Insured exclusion [strictly speaking, for purposes relevant to this case, the exclusion was actually a Company vs. Insured exclusion], which provides that the insurer is not liable of losses arising from any “Claim brought or maintained by, on behalf of, or in the right of …the Company in any respect.” The term “Company” was defined as IEAM, its subsidiaries, and “any such organization as debtor-in-possession.”

Redmond filed a coverage lawsuit against the insurer. The insurer moved to dismiss Redmond’s complaint, arguing that coverage was precluded by the Insured vs. Insured exclusion. The district court granted the insurer’s motion to dismiss. Redmond appealed.

The June 5 Opinion

In a short June 5, 2015 opinion captioned as “Not Precedential” and written by Judge Patty Shwartz for a three judge panel, the Third Circuit affirmed the district court’s dismissal.

The appellate court said that the phrase “brought … by” as used in the Exclusion unambiguously means “commence” and that under the Exclusion the insurer is not liable for suits commenced or “brought” by the “Company.” The fact that the Chapter 11 trustee has been substituted as the plaintiff and is now pursuing the action on behalf of IEAM “does not mean the trustee initiated the suit or change the fact that IEAM commenced or ‘brought’ the action.” The “plain language of the Exclusion,” the Court said, allows the insurer to deny coverage for Redmond’s defense expenses. The appellate court concluded that the district court had not erred in dismissing Redmond’s complaint.

Discussion

The language of the Insured vs. Insured exclusion has changed over the years. In particular, the provision within the exclusion preserving coverage for claims brought against directors or officers by a bankruptcy trustee or other representative of the bankruptcy estate has evolved. For example, it is now fairly standard for the bankruptcy trustee carve-back provision in the Insured vs. Insured exclusion to preserve coverage for claims brought by a creditors’ committee.

While this bankruptcy trustee carve-back provision of the Insured vs. Insured exclusion has evolved, it is still rare for the carve-back provision to include language preserving coverage for claims brought by the bankrupt company as debtor-in-possession – even though it is now fairly standard, as was the case here, for the policy to include the company as debtor-in-possession within the meaning of Company. As a result, and as was the case here, the Insured vs. Insured exclusion operates to preclude coverage for claims brought against the former directors and officers of a bankrupt company by the company as debtor-in-possession.

This issue could be pretty easily cleaned up by including the company as debtor-in-possession in the list of bankruptcy-related claimants for whose claims coverage is carved back as an exception to the exclusion. The insurers’ concern with this relatively expedient solution is the possibility of collusive claims. As the Ninth Circuit noted in the Visitalk case (which I discussed here), if there were to be coverage for claims by the company as debtor-in-possession, the policy would

create a perverse incentive for the principals of a failing business to bet the dwindling treasury on a lawsuit against themselves and a coverage action against their insurers, bailing the company out with the money from the D & O policy if they win and giving themselves covenants not to execute if they lose. That is among the kinds of moral hazard that the insured versus insured exclusion is intended to avoid.

Not to minimize the collusive possibilities to which the Ninth Circuit referred, but there is a legitimate concern that without policy recognition in some way for debtor-in-possession claims, individuals could be left without insurance for claims of a kind for which D&O policies are intended to provide coverage.

There are, in fact, D&O insurance policies available in the current marketplace that attempt to address the problem of debtor-in-possession claims. For example, one policy’s list of the bankruptcy-related claimants for whose claims coverage is carved back include “a Claim by the Entity as Debtor-in-Possession after such Examiner, Trustee, Receiver has been appointed.” The prerequisite for the availability of coverage under this carve back for the appointment of an examiner or trustee does represent some check against the collusive possibilities about which the Ninth Circuit was concerned.

Whether or not this particular formulation is sufficient to preclude the possibility of collusive claims, it strikes me as a step in the right direction toward protecting against the possibility that individuals could otherwise be left without coverage for claims of a kind for which these policies were intended to provide protection.

One final observation about this particular coverage problem is that whether or not the primary D&O insurer will agree to provide a coverage carve back in the I v I exclusion for debtor in possession claims, an insured company may be able to purchase an excess Side A policy providing “difference in condition” protection and that either does not contain an I v. I exclusion or has one that is very narrowly circumscribed.

A Credit Crisis-Era Vestige: Fourth Circuit Affirms Bank Executives’ Criminal Conviction

By Kevin LaCroix on June 8, 2015

Posted in Failed Banks

Federal prosecutors have come in for considerable criticism over their failure to press criminal charges against executives of financial institutions whose stumbles led to the global financial crisis. As Southern District of New York Judge Jed Rakoff pointed out in his blistering January 9, 2014 opinion column in The New York Review of Books (here), “not a single high-level executive has been successfully prosecuted in connection with the recent financial crisis.”

Rakoff’s statement is not quite accurate, as there was at least one prosecution of a Wall Street banker. But while it may be true that few high-level Wall Street executives were prosecuted, it is not true that there were no criminal prosecutions. Prosecutors did file criminal actions against some financial executives, albeit largely against individuals associated with smaller institutions. In at least some cases, these prosecutions resulted in criminal convictions. On June 5, 2015, the Fourth Circuit Court of Appeals affirmed the convictions of three former officers of the failed Norfolk, Virginia-based Bank of the Commonwealth, in connection with the bank’s September 2011 failure. The Fourth Circuit’s opinion in the case can be found here.

Background

The Bank of the Commonwealth of Norfolk, Virginia failed on September 23, 2011. In connection with the bank’s failure, the FDIC sustained losses of approximately $333 million. As discussed in a prior post (here, second item), on July 11, 2012, a grand jury returned an indictment (here) against the bank’s former Chairman and CEO, Edward Woodard, Jr., for conspiracy to commit bank fraud, bank fraud, false entry in a bank record, multiple counts of unlawful participation in a loan, multiple counts of false statement to a financial institution, and multiple counts of misapplication of bank funds. Three other former officers of the bank and two of its customers are charged with a variety of related charges. The FBI’s July 12, 2012 press release regarding the indictment can be found here.

As described in its January 9, 2013 press release (here), the SEC separately filed a civil enforcement action against Woodard, Cynthia Sabol, the bank’s CFO, and Stephen Fields, the bank’s former executive vice president. The SEC’s complaint, which can be found here, asserts claims for securities fraud against the three defendants for alleged “misrepresentations to investors by the bank’s parent company.” The SEC charged the three “for understating millions of dollars of losses and masking the true health of the bank’s loan portfolio at the height of the financial crisis.” The SEC alleges that Woodard “knew the true state” of the bank’s “rapidly deteriorating loan portfolio,” yet he “worked to hide the problems and engineer the misleading public statements.” Sabol also allegedly knew of the efforts to mask the problems yet signed the disclosures and certified the bank’s financial statements. Fields allegedly oversaw the bank’s construction loans and helped mask the problems. As discussed here, the SEC ultimately reached settlements with each of the defendants, in which the individuals agreed to an officer bar and to pay fines.

Trial in the criminal case began on March 19, 2013, against Woodard; Fields; Troy Brandon Woodard, who is Woodard’s son and was the bank’s Executive Vice President and Commercial Loan Officer; and two other defendants. Trial in the case lasted ten weeks. The government called 48 witnesses and entered over 600 exhibits into evidence. The defendants called 44 witnesses and entered over 400 exhibits. All five defendants testified on their own behalf. On May 24, 2013, the jury returned guilty verdicts against both of the Woodards and Fields.

Woodard was convicted of conspiracy to convict bank fraud; making a false entry in a bank record; four counts of unlawful participation in a load; two counts of making a false statement to a financial institution; two counts of misapplication of bank funds; and bank fraud. Fields was convicted of conspiracy to commit bank fraud; two counts of making a false entry in a bank record; making a false statement to a financial institution; and two counts of misapplication of bank funds. Brandon Woodard was convicted of conspiracy to commit bank fraud; and three counts of unlawful participation in a loan. Woodard was sentenced to 23 years imprisonment. Fields was sentenced to a 17-year imprisonment term. Brandon Woodard was sentenced to eight years imprisonment.

All three appealed their convictions and Brandon Woodard appealed his sentence. On appeal, Fields challenged time limitations the district court placed on his direct testimony. Woodard challenged the sufficiency of evidence against him and the trial court’s exclusion of certain evidence. Brandon Woodard also challenged the sufficiency of the evidence and also challenged the trial court’s use of sentence enhancements in fixing the period of his imprisonment. All three defendants challenged various evidentiary rules the district court made during the trial.

The June 5 Opinion

In an unpublished June 5, 2015 opinion written by Judge Dennis Shedd for a unanimous three-judge panel, the Fourth Circuit affirmed the convictions and Brandon Woodard’s sentence.

With respect to Fields’s contention that his direct testimony was cut short, the appellate court noted that “throughout the examination, the court warned counsel repeatedly that he was straying into irrelevant or marginally relevant lines of questioning.” The appellate court also noted that Fields’s direct examination lasted over seven hours and was the longest direct examination of any witness in the case –longer than that of the other co-defendants who were charged with a larger number of substantive counts. Fields’s counsel also failed to avail himself of the opportunity for redirect examination. The appellate court concluded in light of these considerations, the district court did not abuse its discretion in limiting the duration of Fields’s testimony.

With respect to Woodard’s and Brandon Woodard’s contention that the evidence against them was insufficient, the appellate court found that the government “presented ample evidence” in support of the conspiracy to commit bank fraud charge. In support of this conclusion, the court reviewed trial testimony showing how Woodard collaborated with various bank customers to try to help Brandon Woodard with various loan repayment difficulties he was having. The appellate court found that the testimony was sufficient to sustain the convictions.

Discussion

This case is not the only one in which former executives of a failed bank were criminally prosecuted. Other failed bank executives were also prosecuted (refer, for example, here and here). So as I said at the outset, it is not true that there were no criminal convictions in the wake of the financial crisis. However, when you look at the enormous resources the government deployed just to snag these relatively lower level individuals while no charges were brought against the Wall Street executives whose actions nearly brought down the entire global financial system, you do start to wonder what is going on.

On the other hand, when you look at the enormous effort that was required just to convict these smaller profile defendants, you can imagine what might have been required if the government had tried to go after some of the bigger fish. Former Attorney General Eric Holder may have had that kind of concern in mind when he said while testifying before Congress in 2013 that “I am concerned that the size of some of these institutions becomes so large that it does become difficult for us to prosecute them.”

In any event, this appellate court ruling does have a little bit of an end of an era feel about it. The final remnants from the financial crisis are slowly winding down. While the global financial system is still not yet fully recovered from the crisis, in many ways the world has moved on.

I did note while preparing this post that though the bank failure peak is now well in the past, banks are continuing to fail, albeit at a much reduced pace. The FDIC’s failed bank list shows that so far in 2015, five banks have failed (though only once since the end of February). There may yet be further bank failures. But by and large the bank failure wave seems to have just about played out. The time may soon come to close the book on the financial crisis.

Thinking About the FIFA Bribery Scandal

By Kevin LaCroix on June 7, 2015

Posted in Foreign Corrupt Practices Act

The U.S. Department of Justice’s blockbuster announcement in late May that U.S. prosecutors have indicted fourteen defendants on corruption charges involving activities of the International Federation of Football (FIFA) and related regional member organizations captured news headlines around the world. The story has continued to dominate the news, as new details about the scandal have continued to emerge. But while the press coverage has been comprehensive, it has not always been entirely precise. Among other things, contrary to the suggestion in many domestic U.S. press reports, the DoJ’s massive criminal indictment does not include any charges under the Foreign Corrupt Practices Act (FCPA). However, at least according to some commentators, based on the allegations made to date, certain companies could find themselves facing FCPA-related scrutiny.

The Department of Justice’s May 27, 2015 press release concerning the indictment can be found here. The government’s 161-page indictment itself can be found here. The Wall Street Journal’s May 28, 2015 front page article describing the allegations in the indictment and related government court filings can be found here.

Part of the confusion about the possible involvement of FCPA-related allegations has to do with the fact that the core misconduct alleged is the making of improper payments to FIFA officials by representatives of sports marketing companies. According to the DoJ’s press release, the criminal defendants are alleged to have “systematically paid and agreed to pay well over $150 million in bribes and kickbacks to obtain lucrative media and marketing rights to international soccer tournaments.”

But though the FIFA corruption-related indictment includes improper payment allegations, the criminal action is not a FCPA prosecution, as the Southern Illinois Law School Professor Mike Koehler points out in a June 1, 2015 post on his FCPA Professor blog (here). Rather, as the DoJ summarized in its press release about the indictment, the criminal action involves charges of racketeering, wire fraud and money laundering conspiracies. Some of the defendants were charged with obstruction of justice and tax evasion.

As Professor Koehler notes, the FCPA does not apply to every type of bribe. The FCPA’s anti-bribery provisions apply only to bribe payors and not bribe recipients. In addition, in order for there to be an offense within the ambit of the FCPA, the improper payment must have been made (or attempted to be made) to a “foreign official.” The FIFA officers involved do not, according to Koehler, appear to meet the statute’s definition of foreign official.

While the prosecutors are not relying on the FCPA, they relying a weapon that if they are able to use successfully here could broaden the U.S. authorities’ power to pursue corruption claims globally. As Wayne State Law Professor Peter Henning discusses in a June 1, 2015 post on his White Collar Watch blog on the New York Times website (here), the U.S. prosecutors’ indictment, made largely in reliance on the Racketeering Influenced and Corrupt Organizations (RICO) Act, will test the extent to which the U.S. law can be applied to conduct much of which took place outside of the U.S.

RICO, according to Professor Henning, gives the prosecutors “the firepower to bring all the defendants together in a single case by asserting that there was a pattern of rampant corruption tying the defendants together into a larger scheme.” The prosecutors are essentially alleging that the indicted individuals were using FIFA as a criminal enterprise.

As Professor Henning notes, the lower U.S. courts have struggled since the U.S. Supreme Court issued its 2010 decision in Morrison v. National Australia Bank to determine whether or not Congress intended RICO to apply extraterritorially. The criminal defendants will likely challenge the U.S. authorities’ ability to rely on RICO. As Henning notes, “If RICO can be added to a case involving multiple defendants to claim that they engaged in a pattern of misconduct, then the Justice Department will indeed have a very big stick to attack corruption almost anywhere.”

And even though the allegations thus far may not support FCPA-related allegations, the conduct alleged could, Professor Koehler notes, “result in FCPA scrutiny for certain companies.”

In particular, the government’s indictment includes allegations of bribery involving an unnamed U.S. sportswear company. According to the Wall Street Journal, the company referred to in these “barely veiled references” is Nike, Inc. Nike is not named in the indictment and neither it nor any of its executives have been charged with wrongdoing. However, as the Wall Street Journal detailed in a June 4, 2015 front page article (here), the indictment and related charging documents allege that up to $30 million from the sponsorship pact the clothing company signed in 1996 with the Brazilian soccer federation was paid through a side deal between the company and a middleman. The middleman used part of that money to pay bribes, according to the indictment. Jose Hawill, the owner of the middleman, Traffic Brazil, has admitted to crimes including money laundering, fraud and extortion.

These allegations relating to Nike, as more fully detailed in the FCPA Professor blog post linked above, could, according to Professor Koehler, “potentially implicate the FCPA’s books and records and internal controls provisions.”

These allegations not only, according to the Journal, “cast a long shadow” over Nike, but they also raise questions – rightly or wrongly — about other sponsorship companies. Let me emphasize here that insofar as I know, there has been no suggestion whatsoever that any other sponsorship companies have been involved in any misconduct. Nevertheless, as the Journal put it, the allegations in the FIFA scandal are “a big headache” for the several companies that have in recent years paid millions of dollars for marketing rights at the FIFA-sponsored soccer events. According to the Journal, six companies — Adidas, Coca-Cola, Emirates, Hyundai, Sony and Visa – paid nearly $190 million to FIFA to be official marketing sponsors for the 2014 World Cup. A second tier of sponsors paid an additional $171 million in connection with the World Cup. A May 28, 2015 Business Insider article detailed in the sponsors reactions to the news of the scandal can be found here.

There are yet other firms that have found themselves unfortunately associated with the unfolding FIFA scandal, including in particular the banks that are alleged to have funneled the cash associated with the improper payments. A detailed section of the indictment captioned “The Centrality of the U.S. Financial System” states that the “the defendants and their co-conspirators relied heavily on the United States financial system in connection with their activities,” adding that “this reliance was significant and sustained and was one of the central methods and means through which they promoted and concealed their schemes.”

According to the indictment, bribes ranging in the millions of dollars allegedly found their way between accounts at Citibank, JPMorgan, HSBC, Barclays and other banks. According statements of the U.S. Attorney for the Eastern District of New York, where the indictment was filed, as quoted in a May 28, 2015 International Business Times article (here), the banks are being probed as part of the continuing investigation, adding that “It’s too early to say whether there is any problematic behavior, but it will be part of our investigation.” According to a May 28, 2015 Daily Mail article about the allegations involving the banking institutions (here), Britain’s Serious Fraud Office is looking into whether any of the alleged corruption took place on British soil or involved any UK firms or individuals.

Another organization that has found itself associated with the unfolding FIFA scandal is KPMG, the global accounting and auditing firm. KPMG acted as FIFA’s auditor. FIFA also audits a number of the regional member organizations that operate under FIFA’s umbrella. According to an interesting June 5, 2015 Marketwatch article entitled “FIFA Auditor KPMG Totally Missed the Soccer Scandal” (here), by Francine McKenna, the author of the re: The Auditors blog (here), KPMG also prepares an audited summary at the end of each of the four-year World Cup cycles. In addition KPMG represented both the Russian and the Qatari organizing committees (although Qatar switched to E&Y in 2011). McKenna’s article quotes several commentators as stating, among other things, that KPMG should have caught and called out the illegal activities. A June 3, 2015 CFO.com article (here) raises many of the same questions concerning KPMG.

While many observers are shocked by the wrongdoing alleged in the FIFA scandal, others have been more outraged by the prosecution itself. For example, in a statement on the Kremlin website, Russian President Vladimir Putin charged that the criminal allegations are part of a U.S. conspiracy for world dominion; accused the U.S. of “persecution;” and asserted that criminal prosecution was “just one more brazen attempt [by the U.S.] to spread its jurisdiction to other states.” Putin also asserted with respect to the individual defendants named in the indictment that “aren’t U.S. citizens, and if anything happened, it didn’t happen on the territory of the U.S.”

However, as Professor Koehler notes, that while the indictment does refer to conduct outside the U.S., much of the conduct is also alleged to have taken place inside the U.S. or to involve U.S.-affiliated individuals and entities:

As to the core alleged bribery scheme, three of the defendants are U.S. citizens; various of the regional soccer associations implicated have offices in the U.S.; several of the intermediate sports marketing companies have headquarters, offices or affiliates in the U.S.; and the indictment contains several allegations concerning use of U.S.-based bank accounts, phone calls from the U.S.; and in-person meetings in the U.S. in furtherance of the alleged bribery scheme.

One might argue not only that Putin has challenged the criminal prosecution out of concern for where it might lead with respect to the 2018 World Cup, now scheduled to take place in Russia, but also that he clearly prefers a world in which bribes can be paid and received with impunity and without scrutiny.

One question I have received over the past few days has to do with what the potential D&O insurance implications might be from these events. The short answer, without further information about what D&O insurance protection the various organizations might carry (if any), is that it is just hard to tell. A typical domestic U.S. D&O insurance policy will include within the definition of a covered “Claim” the initiation of a criminal action following indictment. However, the 14 individuals who were named in the recent indictment represented a variety of different organizations and institutions, only some of which are domiciled in the U.S.

Nine of the indicted individuals are current or former officers or directors of FIFA or CONCACAF, the regional confederation for North America, South America, and the Caribbean. Several of the individuals were officers or directors of both FIFA and CONCACAF. FIFA is an international body and entity registered under Swiss law and headquartered in Zurich. CONCACAF is incorporated in Nassau, Bahamas, with its current headquarters location in Miami, Florida. (Before 2012, it was headquartered in New York). Because any D&O insurance policy FIFA might carry likely was issued in Switzerland, it is a little more difficult for me to assess what its terms might provide. Any separate coverage CONCACAF might carry likely would have been issued in the U.S. In any event, a challenging issue that will face those who were officers or directors of both FIFA and CONCACAF, is which policy (if any) should respond to the allegations that have been made against them.

In addition to the nine current or former FIFA or CONCACAF officials, the indictment also named five other individuals, four who were employed by sports marketing firms located in Argentina, Brazil and the U.S., while a fifth individual was employed by broadcasting-related firms. These individuals will have to look to their respective corporate employer’s D&O insurance policies (if any). The extent of protection available to these individuals may well depend on where the policies were issued, as terms and conditions often vary by country. Typically, however, private company D&O insurance policies include the initiation of a criminal action by an indictment within the definition of a covered Claim.

All of the individual defendants are alleged to have engaged in intentional criminal misconduct. The typical D&O policy will contain an exclusion precluding coverage for criminal or fraudulent misconduct. However, most modern D&O policies will provide that the precluded conduct must be established by an “adjudication” in order for the exclusion to be triggered. As long as the allegations are merely alleged but unproven, the exclusion will not be triggered. However, a conviction or even a guilty plea would likely trigger the exclusion.

As a result, all of these individuals will face the potential problem that if they are convicted (or even if they plead guilty), their respective D&O insurers would, depending on the nature of the charge for which they were convicted, likely have the right to seek recoupment from them of any amounts the insurers have paid in their defense (as I discussed in a recent post, here). In that regard, it is worth noting that in addition to the fourteen individuals who were named as defendants in the recent indictment, the DoJ’s press release also refers to four individuals and two entities that between 2013 and 2015 each pled guilty charges presented against them in a criminal information. There is no way to tell whether these individuals, affiliated with FIFA, CONCACAF and sports marketing firms, sought to have their respective organizations’ carriers pay for their criminal defenses. To the extent the carriers did pay any amount, and to the extent the criminal pleas triggered any potentially applicable policy exclusions, the carriers may have the right to seek to recoup those amounts.

A more interesting question from a D&O insurance standpoint will be whether or not there will be any follow on civil litigation. Because FIFA and CONCACAF are themselves membership organizations rather than commercial stock corporations, it is not immediately apparent who the potential claimants might be (except perhaps their respective affiliated membership organizations). The possibility of either criminal proceedings or civil litigation involving the various sponsors, banks and accounting firms who have been drawn into this scandal presents a different set of issues. While the possibility of these firms getting drawn into the legal proceedings at this point seems unlikely, the possibility at least raises a D&O insurance underwriting issue for the firms in question.

I will say this, that while the allegations in the U.S. indictment do not relate directly to the selection of World Cup sites for 2018 and 2022, and while much of the investigation has yet to play out (including in particular the ongoing investigation in Switzerland of the site selections for the 2018 and 2022 World Cups), if you wanted an example of how a corrupt process can produce distorted results, you wouldn’t need to look much further than the selection of Qatar as the site for the 2022 cup. Almost from the moment it happened, the Qatar site selection has been mired in controversy owing (among many other things) to questions about the suitability of the site for the event. In particular, the sheer impossibility of holding the event in Qatar during the summer months has caused innumerable problems, as a result of which the event has now been shifted from its traditional June and July time frame to a mid-November to mid-December time frame – which will of course wreak havoc with the schedule of most of the domestic soccer leagues.

This is all too bad, because as the 2014 event in Brazil showed, the World Cup is one of the world’s great spectacles. As a soccer fan, I find all of this news and controversy truly dismaying.

More About the 2008 Beijing Olympics: As long as I am passing along interesting links to the FCPA Professor blog, I though I should add one more link pertinent to an item I posted last week about the allegedly corrupt sponsorship activities in which BHP Billiton was implicated in connection with the 2008 Beijing Olympics. While in my blog post I suggested – and quoted others as saying — that the SEC’s enforcement action against BHP Billiton represented an aggressive use of the agency’s enforcement authority under the FCPA, Professor Koehler takes a different view. In a June 4, 2015 blog post (here), he writes that “while the BHP Billiton action is problematic on a number of levels… the enforcement approach in BHP Billiton was hardly unique. The SEC often charges or finds books and records and internal controls violations in the absence of anti-bribery charges or findings.” Koehler promises to provide a future post in which he will further detail his reasoning.

More About SEC Chair Mary Jo White: In my blog post last week in which I detailed Senator Elizabeth Warren’s scathing letter criticizing SEC Chair Mary Jo White, I noted that many of the charges Warren raised failed to take into account the fact that several of the specific items for which Warren criticized White are only within the purview of the Commission as a whole, and not within authority of the SEC Chair acting alone.

A front-page June 4, 2015 article in the Wall Street Journal article entitled “SEC Bickering Stalls Mary Jo White’s Agenda” (here) highlights how sharp political divisions among the various individual SEC Commissioners has not only poisoned the atmosphere at the agency but undermined White’s agenda and produced gridlock – the very gridlock for which Senator Warren lambasted White. A June 5, 2015 New York Times article (here) details how political divisions at the Commission nearly capsized the agency’s enforcement action against Computer Sciences Corporation. In a very interesting June 4, 2015 post on his TheCorporateCounsel.net blog (here), Broc Romanek asks, in a question that was not meant to be rhetorical, “Is Partisan Politics Destroying the SEC?”

Whether or not criticisms of White are warranted, I think it is patently unfair to question her leadership without acknowledging the contentious dynamic that has undermined her efforts. Senator Warren’s failure to acknowledge the problems arising from the agency’s sharp partisan divides is all the more surprising given that the Democratic Senator from Massachusetts in in the same political party as the President who appointed White.

More About Proxy Put Litigation: In an earlier post (here), I wrote about how the presence of provisions in corporate loan agreements requiring the acceleration of the debt maturity in the event of a management change has been producing D&O litigation. A June 5, 2015 memo from the Fried Frank law firm (here) takes at looks at these kinds of provisions – often called “proxy puts” – as well as the recent litigation that has surrounded the provisions.

According to the memo, all too often insufficient care is taken to distinguish between two kinds of corporate loan provisions, a simple “proxy put” and what the memo calls a “dead hand proxy put.” Both kinds require the acceleration of the debt maturity in the event of a change in control of the borrower’s board. A “dead hand” provision adds the additional requirement that any director elected as a result of an actual or threatened proxy contest will be considered a non-continuing director for purposes of the proxy put. The memo states proxy put provisions have frequently been used without controversy. Dead hand proxy puts, however, are now being challenged. While the memo contends that both proxy puts and dead hand proxy puts can be appropriate, the memo suggests that companies consult with their counsel, and identifies the factors that company’s should take into account, including in particular the motivations and interests of the lending bank involved.

Warren Buffett’s Management Model: Warren Buffett’s investment style and philosophy have been admired and emulated for many years. But as my good friend and George Washington University Law Professor Larry Cunningham contends, Buffett’s management style is also worthy of study and emulation. In an interesting recent Wake Forest University Law Review article entitled “Berkshire’s Disintermediation: Buffett’s New Managerial Model” (here), Cunningham argues that “While Buffett’s legacy to date has been to lead two generations of value investors, Berkshire’s radically ingenious disintermediation has the potential to shape the next two generations of value managers.”

Cunningham is the author of the recent book “Berkshire Beyond Buffett: The Enduring Value of Values,” which I reviewed here.

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